KBRA Affirms Ratings for MidWestOne Financial Group, Inc.

22 Jun 2023   |   New York


KBRA affirms the senior unsecured debt rating of BBB, the subordinated debt rating of BBB-, and the short-term debt rating of K3 for Iowa City, Iowa-based MidWestOne Financial Group, Inc. (NASDAQ: MOFG) ("MidWestOne" or "the company"). In addition, KBRA affirms the deposit and senior unsecured debt ratings of BBB+, the subordinated debt rating of BBB, and the short-term deposit and debt ratings of K2 for its main subsidiary, MidWestOne Bank. The Outlook for all long-term ratings has been revised to Negative from Stable.

Key Credit Considerations

The Negative Outlook for MOFG’s long-term ratings is primarily due to its decreasing level of profitability and below peer capital levels. In common with most of the industry, MidWestOne has experienced meaningful deterioration in its earnings power in recent quarters from considerable NIM headwinds stemming from the Fed’s rate hikes. MOFG maintained a liability sensitive balance sheet entering this period of rising rates, which, combined with the substantial acceleration in deposit costs in recent quarters, has caused NIM to fall to 2.66% for 1Q23, or a 41 bp decrease from peak levels in 3Q22. Moreover, prior to the recent NIM pressure, the company’s margin and earnings capacity were both already below average given the excess liquidity on-balance sheet that lingered following the pandemic, most of which was invested into lower-yielding securities, with loans to earning assets averaging 60% since YE21 compared to 75% for similarly rated peers. Additionally, NIM compression is expected to continue moving forward, and while KBRA recognizes management’s efforts to improve operating efficiency, notably by reducing noninterest expenses, this will likely not be enough to offset the lower NII. As such, earnings capacity is anticipated to remain challenged and could potentially remain below peer levels (core ROA of 0.82% of 1Q23; excluding balance sheet repositioning). With regard to capital management, MOFG has typically reflected below average capital ratios, though following the all-cash acquisition of Iowa First Bancshares Corp. in 2Q22, the company’s capital levels are tracking even lower than prior year averages. Given the aforementioned lower earnings power, as well as ambitious loan growth targets for 2023, the ability to generate internal capital at a quick pace is expected to be difficult. KBRA also acknowledges that MOFG has experienced a gradual outflow in core deposit levels, which have fallen $532 million (10%) from peak levels at 2Q22, though the company observed manageable outflows during the volatility created in 1Q23 following the bank failures, with just $172 million exiting during the quarter, most of which was due to normal business decisions and seasonal factors. Moreover, deposit balances actually grew following the mid-March events. With that said, core deposits relative to total funding remains solid at 82%, albeit down from prior year averages of 87% between 2018-2022, though with a majority of excess liquidity tied up in the securities portfolio, a higher level of noncore funding utilization is expected to supplement potential loan growth prospectively. Despite some utilization of brokered deposits, as well as the continued shift in the deposit mix from NIB to higher yielding accounts, MOFG continues to reflect a reasonably priced deposit base, with average costs of 1.12% for 1Q23, which is slightly below average to the median in the KBRA rated universe among publicly traded banks. Moreover, while a near-term uptick in noncore funding is possible, the company has flexibility with its larger sized securities portfolio that represents 32% of total assets, which in the event of falling interest rates provides the ability to sell securities to de-leverage the balance sheet and reduce noncore funding. KBRA also recognizes MidWestOne’s diverse loan portfolio and revenue mix. The company reflects below average exposures to both investor CRE and C&D lending, and the loan book is more spread out from a geographic standpoint compared to similarly rated peers. Moreover, noninterest income has averaged 21% of total revenues the past five years (20% for 1Q23) and consists of more stable/recurring revenue sources, including a growing wealth management division. We also positively view the considerable reduction in NPA levels over the years, which was achieved without meaningful charge-off activity. With that said, the NCO ratio has tracked modestly above average in recent years. However, KBRA believes that the company reflects manageable risks in the loan portfolio as of 1Q23, with minimal problem assets. Additionally, as noted, the investor CRE concentration is below average (25% of loans; 201% of total risk-based capital as of 1Q23) , and includes a moderate level of investor office exposure at just below 5% of loans, with a nominal amount in central business districts.

Rating Sensitivities

Given the Negative Outlook, positive rating momentum is not expected at this time, though a reversion to a Stable Outlook could occur from continued growth in capital ratios and profitability metrics that both track closer to peer levels, as well as sound credit performance through a potential downturn. A downgrade in the ratings could occur over the medium term given the revised Outlook, which would transpire from continued core deposit outflows that exceed peers, weaker credit quality through challenging economic conditions, or capital rebuild targets not being realized.

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