Axos Financial, Inc. Q4 FY2020 Earnings Call

Greetings, and welcome to the Axos Financial Fourth Quarter 2020 Financial Results. At this time, all participants are in listen-only mode. A question-and-answer session will follow the formal presentation. Please note that this conference is being recorded. I will now turn the conference over to our host, Johnny Lai, Vice President of Corporate Development and Investor Relations. Thank you, you may begin.

Great, thank you, good afternoon everyone. Thanks for your interest in Axos. Joining us today for Axos' Financial Inc’s fourth quarter 2020 financial results conference call are the company's President and Chief Executive Officer, Greg Garrabrants; and Executive Vice President and Chief Financial Officer, Andy Micheletti. Greg and Andy will review and comment on our financial and operational results for the three and 12 months ended June 30, 2020, and they will be available to answer questions after the prepared remarks. Before I begin, I would like to remind listeners that prepared remarks made on this call may contain forward-looking statements that are subject to risks and uncertainties and that management may make additional forward-looking statements in response to your questions. These forward-looking statements are made on the basis of current views and assumptions of management regarding future events and performance. Actual results could differ materially from those expressed or implied in such forward-looking statements as a result of risks and uncertainties. Therefore, the company claims safe harbor protection pertaining to the forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. This call is being webcast and there'll be an audio replay available in the Investor Relations section of the company's website located at axosfinancial.com for 30 days. Details for this call were provided on the conference call announcement and in today's earnings press release. At this time, I would like to turn the call over to Greg for his opening remarks.

Thank you, Johnny. Good afternoon everyone and thank you for joining us. I'd like to welcome everyone to Axos’ Financial conference call for the fourth quarter of fiscal year 2020 ended June 30, 2020. I thank you for your interest in Axos’ Financial and Axos’ Bank. Axos announced record net income of $183.4 million for the fiscal year ended June 30, 2020, an increase of 18.2% over the $155.1 million earned in the fiscal year ended June 30, 2019. Axos' return on average equity for fiscal 2020 was 15.65%, and the bank's efficiency ratio was 39.81%. Fiscal year 2020 earnings per share increased 20.2% to $2.98 per diluted share compared to $2.48 per diluted share in fiscal year 2019. Excluding acquisition-related expenses, non-GAAP earnings per share increased 20.59% to $3.13 per share in fiscal year 2020, leading to a non-GAAP return on equity of 16.49%. Our book value per share was 20.56% at June 30, 2020, up 17.7% from the prior year. We had an excellent quarter with higher net interest margins, double-digit growth in net interest income and non-interest income, strong deposit growth, positive operating leverage, and stable credit performance. The highlights of this quarter include the following: Ending loans and leases increased by approximately $258.4 million, up 10% annualized from the first quarter of 2020 and up 13.3% year-over-year. Strong originations in jumbo single-family, commercial specialty real estate, and mortgage warehouse were offset by lower production in non-real estate, lender finance, and higher payoffs in multifamily in certain C&I loan portfolios. Excluding PPP loans, ending loans and leases increased by 11.6% year-over-year. Net interest margin was 3.89% for the quarter ended June 30, 2020, up 8 basis points from 3.81% in the fourth quarter of fiscal 2020 and up 10 basis points from March 31, 2020, excluding H&R Block-related loans. Our efficiency ratio for the three months ended June 30, 2020 was 49% compared to 51.1% in the comparable period ended June 30, 2019. Earnings per share was $0.75, up 13.6% compared to $0.66 in the fourth quarter of 2019 despite a 132% year-over-year increase in our loan loss provision, and a 33.3% tax rate this quarter compared to 26.6% in the corresponding quarter a year ago. Capital levels remain strong with Tier 1 leverage up 9.25% at the bank and 8.97% at the holding company, both well above our regulatory requirements. Our credit quality remains strong, with a small percentage of our loans in forbearance at delinquent on principal and interest payments. Our conservative underwriting with an emphasis on keeping asset-based loans with low loan-to-values on our balance sheet continues to serve us well. Total loan originations for the fourth quarter ended June 30, 2020 were $1.63 billion compared to $1.78 billion in the year-ago period. Originations for investment were down 12.2% year-over-year while originations for sale were up 16.4% year-over-year due to strong gain on sale mortgage banking production in Q4 of 2020. Our gain on sale mortgage banking group had a strong quarter with originations increasing 111% linked quarter to approximately $291 million. Record low interest rates drove strong demand for refinance and purchase transactions, and capacity constraints within the single-family mortgage lending industry resulted in a gain on sale margin of 321 basis points compared to 222 basis points in the quarter ended March 31, 2020. The outlook for mortgage banking remains strong. Our pipeline of single-family agency mortgages was $309 million at the end of the June quarter. We participated in the SBA's paycheck protection program, originating approximately $167 million of loans for 848 existing and new clients through June 30, 2020. We built our own PPP loan portal and deployed resources to quickly open deposit accounts and underwrite fund PPP loans. In addition to providing much-needed capital to our borrowers, participation in the PPP also helped generate incremental relationships in deposits for our small business and commercial banking groups. We have transitioned to helping clients get their PPP loans forgiven instead of making additional loans. Since we do not expect to recognize the majority of our processing fees associated with PPP loans until we submit our borrowers' loan forgiveness applications to the SBA. PPP loans had an immaterial impact on our fourth quarter net interest margin, loan yield, and non-interest income. Our net interest margin for the banking business unit was 3.95% in the fourth quarter compared to 3.85% excluding H&R Block in the prior quarter and 3.87% in the fourth quarter of 2019. On the asset side, the vast majority of our asset-based loans are variable rate, with 95% of all variable-rate loans being at their floor as of June 30, 2020. Excluding PPP loans, the average rate on our loan book was 5.21% in the 6/30/2020 quarter compared to 5.56% in the quarter ended June 30, 2019. Yields on loans originated in the quarter ended 6/30/2020 were 5.31% for jumbo single-family mortgages, 4.77% for multifamily, and 5.26% for C&I loans. Approximately 58% of our loans are 5/1 ARMs with single-family and multifamily mortgages as the underlying collateral. With the slowdown in prepayment activity and stability in new jumbo mortgage and multifamily loan yields, we expect to maintain overall yields in our residential real estate, mortgage loan book. The majority of our small balance commercial real estate portfolio, which represents another 3% of our loan balances at 6/30/2020, consists of fixed interest rates with staggered prepayment penalties through the first five years of the loan. In our C&I loan book, our asset-based lender finance and commercial specialty real estate loan portfolios have rates that adjust to an index. Of the $3 billion of lender finance and commercial specialty real estate loans outstanding at 6/30/2020, approximately 92% are at their floor rate. Our equipment leasing portfolio, which accounts for the remaining $156 million of C&I loans outstanding, consists of fixed rate loans and leases. We are making steady progress diversifying our consumer and commercial deposits and reducing our weighted average cost of funds through cross-marketing initiatives and software-enabled platforms. Consumer deposits represent approximately 52% of our total deposits at 6/30/2020 and are comprised of consumer direct checking, saving, money market, and non-interest-bearing prepaid accounts. Our consumer checking, savings, and money market deposit balances increased by $354 million from 3/31/2020, with strong growth in small business deposit accounts and balances. We reduced our high-yield savings and money market deposit rates in March following the Fed's rate action and reduced them further in the June quarter and again in early July, resulting in a 57 basis points sequential decline in our average interest-bearing demand and saving deposit cost. Average non-interest-bearing demand deposits were $2.1 billion in the quarter ended June 30, 2020, essentially flat linked quarter despite the seasonal decline in our prepaid deposit balances. We are making good progress in our specialty commercial and treasury management businesses, and our involvement with the SBA, PPP program provided incremental small business and commercial deposits. Our credit quality remains strong. Our annualized net charge-offs to average loans and leases was 67 basis points this quarter compared to 65 basis points in the corresponding period last year, excluding charge-offs related to Emerald Advance and refund advance loans. Our net charge-offs to average loans and leases were 5 basis points for the fourth quarter and 8 basis points for the full year 2020. Non-performing assets to total asset ratio was 82 basis points for the quarter ended June 30, 2020, compared to 55 basis points in our third quarter ended March 31, 2020. The majority of our non-performing assets are comprised of single-family and multifamily loans with low loan to values. Of the $82.1 million of non-performing single-family mortgage loans, approximately 71% had a loan to value at or below 60%. The vast majority of our single-family non-performing loans are for properties located in prime markets where housing supply is low and demand is high. We remain well reserved with our allowance for loan loss representing 86.2% coverage of our non-performing loans and leases as of June 30, 2020. We have taken proactive measures to manage loans that became delinquent, whether they are COVID-related or not. As of June 30, 2020, we have provided no deferrals of payment obligations on commercial loans of any kind, including all commercial real estate, multifamily small balance commercial, CRESL, lender finance, and leasing, except for one $5.6 million loan in our equipment finance business unit that was provided three months of interest-only payments. At June 30, 2020, Axos had 58 basis points of its multifamily and small balance commercial loans that were greater than 30 days delinquent. Of those 11 loans, 7 loans with a combined balance of $7.3 million have either been sold at par plus accrued or become current since June 30, 2020. We have two hotel loans held for sale for a balance of $24.5 million with a 56.4% LTV at origination. Of the portfolio of single-family loans, the banker has forbearance on approximately 5% of its portfolio until June 30, 2020. Of that 5% that were granted forbearance, 3% brought their loan current prior to the expiration of the June 30, 2020 forbearance period. Of those loans that were granted forbearance, the LTV breakdown is as follows: 19% had a loan to value below 50%, 39% had a loan to value between 51% and 60%, 40% had a loan to value between 61% and 70%, and 2% of the loans granted forbearance had a loan to value greater than 70%, with only one loan greater than 75% LTV at origination, which was at an 80% LTV purchase, but is a current loan to value of approximately 65%. The 2% of the loans that were granted forbearance and had not become current by 6/30/2020, the LTV breakdown is as follows: 20% had a loan to value below 50%, 38% had a loan to value between 51% and 60%, 39% had a loan to value between 61% and 70%, and 3% of the loans granted forbearance that were not current by 6/30 had a loan to value greater than 70%, with no loan greater than 75% LTV. Auto loan deferrals were 9.7%, representing balances of $28 million, and 5% for consumer unsecured loans representing balances of $2.7 million of deferrals. We have a consistent track record of maintaining low credit losses through multiple economic cycles, given our conservative underwriting guidelines, senior structures in our commercial lines and loans, and the collateralized nature of our loan book. During the great financial crisis, our peak annual net charge-offs for loans we originated was less than 1 basis point for single-family mortgages and for multifamily loans. While the depth and duration of this economic downturn is uncertain, we believe our disciplined underwriting and proactive risk management will help us manage through this cycle. Approximately 94% of our loans outstanding at June 30, 2020 were collateralized by hard assets, with an average LTV in the 50s, including $9.5 billion of real estate assets and $550 million of loans secured primarily by consumer receivables. Single-family mortgages, representing 40% of our total loan portfolio, had a weighted average loan to value of 60%. At the end of the June 30, 2020 quarter, 62% of our single-family mortgages have loan-to-value ratios at or below 60%, 32% have loan-to-value ratios between 61% and 70%, 5% have loan-to-value ratios between 71% and 80%, and approximately 3 basis points or 1.3 million of combined balances have a loan-to-value ratio greater than 80%. We have a well-established track record of strong credit performance in jumbo single-family lending, with lifetime credit losses in our originated single-family loan portfolio of less than 3 basis points of loans originated. Our mortgage warehouse loan book with June 30, 2020 balances of $474 million is secured by single-family mortgages that can be sold if the borrower is unable to turn the book. Our initial advance rate on single-family mortgage warehouse loans varies between 90% and 100% of the note amount, and we typically curtail an additional 15% on day 45 and day 60. Our weighted average exposure to our loan to value on the $31 million in non-agency loan balances outstanding, distributed among four warehouse clients, was approximately 51%. We took advantage of competitors scaling back or exiting the mortgage warehouse business and grew balances by approximately $94 million or 25% compared to March 31, 2020. Our warehouse clients are benefiting from the elevated level of refinancing activity and higher margins across the industry due to capacity constraints. We believe that any potential losses in our real estate secured loan book will be manageable even in the case of a sharp economic and housing downturn. Multifamily loans, representing 18% of our total loan portfolio at 6/30/2020, had a weighted average loan to value of 56%. The lifetime credit losses in our originated multifamily portfolio are less than 1 basis point of loans originated over the 18 years we have originated multifamily loans. At the end of the June 30, 2020 quarter, 44% of our multifamily mortgages have loan-to-value ratios at or below 55%, 33% have loan-to-value ratios between 56% and 65%, 20% have loan-to-value ratios between 66% and 75%, and less than 3% have a loan-to-value greater than 75% loan to value. The average debt service coverage of our multifamily loans was 1.79% at 6/30/2020. As stated, we granted no deferrals in the multifamily loan book. Our small balance commercial real estate portfolio of $371 million, representing 3% of our total loans at 6/30/2020, had a weighted average loan to value of 52%. At the end of the June 30, 2020 quarter, 51% of our small balance commercial real estate loans have loan-to-value ratios at or below 50%. 18% have loan-to-value ratios between 51% and 60%, 24% have loan-to-value ratios between 61% and 70%, 4% are between 71% and 75%, and 3% are between 76% and 80%. In our small balance commercial real estate portfolio, we had approximately $66 million of loans to hotels and resorts, representing less than 1% of our total loans outstanding. The weighted average loan to value of this book is approximately 52%, including 51% for the hotel and resort deals. The average debt service coverage of our small balance commercial real estate loan portfolio was 1.71% at 6/30/2020. We granted no deferrals in the small balance commercial loan book. Our commercial loan book, including lender finance and commercial specialty real estate, is comprised of loans and lines of credit secured by single-family, multifamily, commercial real estate, land, and consumer receivables. The lender finance book consists of real estate and non-real estate transactions. The weighted average advance rate on the real estate lender finance book is 28.1% with no transaction having an advance rate greater than 50%. The non-real estate lender finance book, backed primarily by consumer loans, is approximately $546 million with an average advance rate of 49.6% of the receivables balance. These structures generally require rapid pay downs in the event of any significant collateral deterioration in the receivables and are also paid down rapidly if origination declines. We have granted no deferrals in our lender finance loan book. The weighted average loan to cost of our commercial specialty real estate loan portfolio is 43% with strong junior partner support backing the capital structure. We hold senior positions in all our lender finance and commercial specialty real estate loans, and every deal has significant capital support from borrowers and sponsors. We monitor the performance of the underlying collateral, housing and bankruptcy remote special purpose vehicle, allowing us to identify credit deterioration and take swift action to protect our principal and interest. In our commercial bridge and construction portfolios, we work with experienced developers and well-capitalized sponsors such as the Related Group and Blackstone. The projects are located in gateway cities such as Los Angeles, New York, San Diego, and Denver. The average CRESL loan size is approximately $18 million. The average remaining term is 15.6 months, and the average loan to cost is 43%. We have granted no deferrals in the CRESL loan book. We have no direct exposure to airlines, casinos, theme parks, oil and gas exploration companies, retailers, and movie theaters. Our equipment leasing portfolio represents our entire exposure to the oil and gas sector, aircraft, and restaurants. The average debt service coverage ratio for the five equipment leases in these higher-risk industries was 2.4% at the end of the fourth quarter. All the above-mentioned credits were current as of June 30, 2020. Although some of our leases are to companies that have cash flow-based leverage on their balance sheet, we have no cash flow-based leveraged loans. We have sole and absolute discretion to approve or deny draws on all of our real estate, lender finance, and mortgage warehouse lines. We had approximately $270 million of hotel and $150 million of retail mixed-use exposure in our commercial specialty real estate portfolio, representing 2.5% and approximately 1.4% of our total loans outstanding at June 30, 2020, respectively. The majority of our hotel loans are AB notes where we hold a senior position. Only one of our hotel borrowers is not current on their loan payments. The average LTV at the hotel and retail commercial specialty real estate loans was 56%, and no deferrals were granted for hotel loans. Our non-real estate consumer lending is comprised of approximately $291 million of auto loans, $50 million of personal unsecured loans, and $27.5 million of H&R Block refund advance loans. We source our auto loans primarily from dealers located in 10 states and lend to prime borrowers with an average FICO of 769. We fully underwrite and service every auto loan we hold on our balance sheet, and the portfolio continues to perform in line with expectations. We have managed the credit risk of our personal unsecured loan book by focusing on prime borrowers with an average FICO score of 751 and an average loan size of $14,000. Given the rapid deterioration in the economy and high unemployment originations nationwide, we temporarily suspended originations of new personal unsecured loans and recently reopened a very small origination bucket with even more conservative underwriting standards. We charged off 1% of the total refund advance loans in the fourth quarter and had an outstanding balance of approximately $27.5 million as of June 30, 2020. Given the processing delays at the IRS related to the 90-day extension in the federal tax filing deadline, we are experiencing more extended repayment timeframes for refund advance loans this year in comparison with prior years. In our securities business, we ended the quarter with approximately $207 million of margin loans, up $48 million from March 31, 2020, as some introducing broker dealers clients became more bullish in the June quarter. Despite elevated price volatility in the stock market since March, we've successfully managed our margin business with no incurred losses. Provisions for loan losses was $6.5 million in the quarter ended June 30, 2020, up $3.7 million compared to the same period a year ago. Approximately $3.4 million of the $6.5 million loan loss provision in the fourth quarter was attributable to loan growth and $3.1 million was attributable to deterioration in the economy. For the 12 months ended June 30, 2020, we increased our allowance for loan losses by $18.7 million. The $75.8 million of loan loss reserves at June 30, 2020 represents approximately 71 basis points of total loans and leases and 13.6 times our annualized net charge-offs, excluding block-related Emerald Advance and refund loans in the quarter ended June 30, 2020. Because our fiscal year ends on June 30, we adopted the current expected credit loss methodology or CECL on July 1, 2020. The original required date for our year-end. The immediate impact of adopting CECL, otherwise known as the day one adjustment, is estimated to be an increase in the bank's allowance for current loan losses of between $35 million to $55 million. The adoption of CECL means that we are now considering loan losses over only an approximate one-year timeframe, as generally used under the incurred loss method. While we currently see an improving economy and a modest impact due to COVID-19, the additional CECL reserves reflect long-term uncertainty of a variety of events, including a possible resurgence of COVID-19 cases, further severe governmental shutdowns, additional extensive government moratoriums, including real estate foreclosure moratoriums and tenant evictions, uncertainty of policy changes resulting from an election year, and potential long-term changes in certain business models that may impact the valuation of commercial and residential real estate values. The after-tax impact of the day one adjustment is expected to be between $24.5 million and $38.5 million and is recorded directly against stockholders' equity in accordance with GAAP. For regulatory purposes, we elected to defer and phase in the impact to our capital ratios over five years. Under this phase-in, the day one adjustment will not reduce Tier 1 capital for the first two years and will phase in one-third of the impact over the last three years of this five-year election. We continue to generate strong returns with return on average common shareholder equity of 14.71% and 15.65% in the three months and 12 months ended June 30, 2020, respectively. Our efficiency ratio for the banking business segment was 41% for the quarter ended June 30, 2020, an improvement of more than 200 basis points compared to 43% in the year-ago period. We continue to maintain strong operating efficiencies while investing in a prudent manner for future growth. Our capital ratios remained strong at 9.25% at the bank and 8.97% at the holding company. Despite a higher provision for loan loss reserves, our Tier 1 and CET1 capital ratios remained healthy at 9.25% and 11.89%, respectively, for the bank at June 30, 2020. Even though the expedient and broad-based monetary and fiscal support provided by U.S. government agencies have resulted in a rapid snapback in credit spreads and market liquidity, we believe there will be further rationalization in the competitive landscape among banks and non-bank lenders. Our top priority for capital is funding growth of our existing businesses while selectively evaluating businesses that could enhance our asset and deposit capabilities, increase our fee income in returns, or reduce our funding costs. Our loan pipeline remains solid with approximately $1.2 billion of consolidated loans in our pipeline at June 30, 2020. We have a healthy liquidity position on a diverse set of funding sources. Our on-balance sheet deposits increased by 26.2% year-over-year with checking and saving deposits increasing by 37.4%. Our consumer commercial cash and treasury management, small business banking, and specialty deposits continue to show strong growth. Concurrently, we reduced our average interest-bearing funding cost by 52 basis points linked quarter and 73 basis points year-over-year to 1.25%. Our weighted average interest-bearing funding cost at June 30, 2020 was 90 basis points, reflecting actions we took towards the end of last quarter. Client cash deposits from AFS and Axos Securities currently held at other banks was approximately $487 million at 6/30/2020. We have the ability to bring back a good portion of our off-balance sheet deposits if it's economically advantageous to do so. We also have access to approximately $3.8 billion of FHLB borrowing, $3.6 billion in excess of the $243 million we had outstanding at the end of the fourth quarter. Furthermore, we had $1.8 billion of liquidity available at the Fed discount window as of June 30, 2020. With many banks, brokers and FinTechs reducing rates on all deposit products, including consumer online, savings and money market deposits and commercial deposits, we have more flexibility than ever to fund our balance sheet growth at attractive rates. We have a relatively stable outlook with respect to loan growth and net interest margins. In jumbo single-family mortgages, many banks and non-banks have pulled back on the aggressive lending terms and conditions they offered in the prior 12 to 18 months. Pricing on new jumbo mortgages remains attractive despite some activity in the secondary market for non-agency mortgages and the re-emergence of a few non-bank lenders. The purchase market for single-family mortgages has rebounded strongly since most states relaxed their health-related restrictions through the pent-up demand and mortgage rates near record lows. The multifamily and small balance CRE dynamics vary by geographic market and property type. Rent payments in our primary markets where we lend are holding up relatively well. The stimulus checks, forbearance programs, federal subsidies on unemployment insurance, and the SBA's paycheck protection program have provided short-term cash flows for renters and borrowers. The diverse nature of our local economy on the West Coast and our limited exposure to urban markets have resulted in relatively stable values in our multifamily and commercial real estate markets. We continue to see opportunities to grow our multifamily and small balance CRE portfolios on a selective basis for high-quality borrowers at low leverage points. In our two largest C&I lending categories, lender finance and commercial specialty real estate, we continue to evaluate new opportunities, but are pivoting to leveraging real estate assets and adopting even more conservative advance rates. We have tightened our credit underwriting standards with respect to all our lending products. We continue to see demand for our lending products at these higher credit standards. Axos’ clearing continues to benefit from a flight to safety, with ending deposits increasing by approximately 9% linked quarter to $450 million. These client deposits held in approximately 90,000 individual brokerage accounts provide a stable, low-cost source of funding. We have chosen to keep the majority of that $450 million in other banks earning interest income for the securities business. We have the ability to bring these deposits back to our bank on relatively short notice to fund our loan growth. Like other broker-dealers, such as Schwab and E-Trade, Axos’ clearing rates earned from cash deposits have significantly compressed due to the Fed's zero interest-rate policy. With impending consolidation in this industry and the ability for the clearing and custody business to generate incremental fee income from sticky low-cost deposits and new retail relationships for the bank, we continue to be bullish on Axos Securities' long-term strategic value to our organization. Given the bank's long-term loan growth prospects that can be funded by these low-cost deposits generated from the securities business, overall, we feel good about our ability to maintain an annual net interest margin within a range of 3.8%. We anticipate being more opportunistic with respect to loan growth until we get more clarity on the sustainability of economic and housing recovery. We see stability in our new loan rates across most of our largest lending categories. In C&I, we may have some degradation in new loan yields as we enter new institutional lending relationships that provide high-quality loans with strong risk protection and marginally lower rates compared to our lender finance and commercial specialty real estate loans. The excess liquidity from PPP loans will have a short-term drag on our NIM until they are no longer on the balance sheet. With excess deposits and some longer-term CDs that can be called prior to maturity, we see additional downward pricing flexibility in some of our deposit categories, which should help us keep our net interest margin stable. Now I'll turn the call over to Andy who will provide additional details on our financial results.

Thanks, Greg. First, I wanted to note that in addition to our press release, an 8-K was filed with the SEC today and is available online through EDGAR or through our website at axosfinancial. Second, I will provide brief comments on two topics. Please refer to our press release or the 8-K for any additional details. First, as Greg mentioned, Axos Financial has adopted CECL effective July 1, 2020, and expects its day one entry to increase the allowance for current loan losses by between $35 million and $55 million. We do not expect a significant impact from CECL on any other balance sheet category other than our loan portfolio. Like many banks, we elected to provide a range for our day one entry since that entry is pending review and testing in the normal course of our quarter ended September 30, 2020. To implement CECL, we developed six portfolio models, which use Moody's forecasts of key macroeconomic variables to predict the probability of default and the loss given default or the severity of loss throughout the life of our loans. The formulas for probability of default were developed from 15 years of historic loss data and more than 1,800 Moody's macroeconomic variables measured historically each quarter. Moody's historical variables were systematically tested and eliminated using our square regression with back testing, leaving those Moody's variables most predictive of historical default results. The severity of loss in our CECL model is primarily based upon loan-level collateral values adjusted for liquidation costs and estimated changes in value over future periods of the loan life. Current liquidation collateral values are adjusted for value decreases or increases by using price indices, for example, Case-Shiller’s monthly home price index and Moody's RCA Commercial Property Price Index. When the adjusted value of the loan collateral falls below the loan balance at any month end in the future, a loss severity percentage is generated in our CECL model. So for each future monthly period in which a default rate is forecast, a loss is estimated by multiplying the default rate, the severity rate, and the loan balance at the time. All monthly estimated losses are discounted back to the reporting period using the effective interest rate of the loan. Macroeconomic models are designed to accommodate historical averages across Moody's variable parameters. They work well for your historical depressions and recoveries, but the macroeconomic models do not predict W-shaped recoveries, meaning economic improvement which has been dramatically reversed. Axos believes, as Greg mentioned earlier, that while we see forecasts and an improving economy with a modest impact due to COVID-19 over the next 15 months, there are long-term credit impacts associated with a variety of events, including the resurgence of COVID-19, a return to more severe governmental shutdowns, additional extensions of government moratoriums, including real estate foreclosure moratoriums and tenant evictions, uncertainty of policy changes resulting from an election year, and changes in certain business models that will adversely impact the U.S. workforce, all leading to another significant downturn. Thus, we added to our CECL models residential and commercial real estate value downward adjustments averaging 30% to 40% starting in October of 2021, about 15 months from now. This level of real estate price decline is based on the actual housing industry average price index declines between 2006 and 2011 in the last great recession, a period with high unemployment and a large volume of real estate borrower defaults. For all the reasons highlighted, our estimated current loss during the life of our loan portfolio includes collateral value price declines between 2006 and 2011 starting 15 months from now. The collateral value decline is the primary driver for our day one adjustment between $35 million to $55 million. The day one adjustment will not impact our regulatory capital ratios in the short-term since we have elected to phase it in over five years. This means that the full reduction to stockholders' equity from the day one adjustment will be added back to stockholders' equity, eliminating the negative impact to regulatory Tier 1 capital and Tier 2 capital each quarter for the next two years. After two years, the add-back to capital will be reduced by one-third for each of the next three years, fully phasing out the add-back benefit by the end of year five. The second topic is our income tax rate. For the quarter ended June 30, 2020, our effective income tax rate was 33%, up from 29.8% for the quarter ended March 31, 2020. This increase is associated with deferred tax RSU GAAP accounting, which requires us to expense an estimate of the RSU cost before the actual income tax compensation deduction is measured. The actual compensation tax deduction depends upon the final number of shares granted and our stock price at vesting. If the number of shares and/or the value of the shares is lower than estimated, generally an income tax rate increase adjustment is required. Due to our lower stock prices and fewer grants, we made a one-time adjustment. Going forward, we generally expect our tax rate to be between 29% to 30%. With those two quick items, I turn the call back over to Johnny Lai.

Thank you, Andy. Operator, we're ready to take questions.

Our first question comes from Andrew Liesch with Piper Sandler. Please state your question.

So just a quick question on the margin here. So cost of interest-bearing liabilities at 1.25 and it sounds like there's more room for us to go down on further here this quarter, given some of the movements you made even this month. And recognizing that the 3% to 4% margin has been a good guide now for the last several years. Do you think we can get to the point where now it's near the higher end of that on a core basis, just given the room on the funding side and fixed rate nature of the loan book?

I think there's potential for it, but I'd give it at least another quarter to see how that plays out. I think we are very focused on credit quality. And so when we look at some of the institutional relationships that we're interested in developing, we think they're very high quality. Sometimes, we're making some rate concessions with respect to certain loan products just given the nature of the index rate. So I do believe that there is an opportunity to lower our funding cost. But I also think we tend to have reasonable levels of prepayments and reasonable levels of originations. So depending upon the nature of those and the fact that we've tightened credit criteria across the board, we have to be thoughtful about where loan rates go. That being said, we don't have, obviously, the issues that other banks do concerning margin compression. And also, given where we are with respect to our fixed rate and floating rate loans, the vast majority of those adjustments are behind us.

And then on the nonperforming loans, correct me if I'm wrong, like 82 million of them are single-family mortgages. The total NPA of up to $94 million from $65 million a quarter ago. Was the bulk of the increase related to single-family mortgages?

Yes.

And was there anything unique or common between all of them? Just curious what drove the increase.

No. I think that it's related to the economy. There is nothing particular with respect to it or a particular geography. It's not a particularly high number. When we go through and look at our collateral valuations, we think we're very well secured. With respect to folks coming current, they're adjusting their business models. Some of them got confused and thought that everything was free and they didn't have to pay. We're helping them with that confusion. I think it will be okay. But obviously, the longer the economy grinds on, the more folks are going to have to adjust. Not everybody will be able to, but we tend to lend to folks who have fairly nice homes and significant assets. Yes, there will be a few of those folks who will probably have to adjust how they live and their lifestyle. But I think they have equity, and they can do that, and the market's pretty good. If they have issues, we're encouraging them to list their home and access the equity from it.

Next question comes from Michael Perito with KBW. Please state your question.

I had a few things I wanted to touch on. I guess, one on helpful color kind of on the jumbo mortgage side. But I think I was curious, have you started to see, as we look out here, though, I mean, I know, for example, in the New York area by me, and I imagine in some other areas too, there's been big moves out of the city and the suburban real estate markets have picked up tremendously in some of these kind of wealthy, more densely populated areas. Are you starting to see an increase in accelerated demand? I know California and New York are some of your bigger markets in that product. Just curious what you guys are seeing as you look forward today?

Yes. I think that's right. We have exposure in the urban core in New York, and we have exposure in the Hamptons. If you had asked me what I was more worried about six months ago, I would have told you the Hamptons, and now it's reversed. We don't try to be perfect with respect to these trends; we try to build in enough cushion to deal with them. I think we are in reasonably good shape with respect to that. But I definitely think you are seeing a movement towards a little bit more space, and certain markets that were less attractive have become quite attractive, including certain areas, for example, in Florida, which we were always cautious about, and we're now seeing things appreciate well.

So I guess the next piece of that is, over the last few years now, I think kind of the seasoning of that portfolio and the size of it has put a limit a little bit on net growth on an annual basis. Has do you think those dynamics still hold as we think about the next fiscal year and kind of net growth opportunities on the mortgage side? Or do some of these forces have enough power to kind of pull the tide up, so to speak, a little bit in that portfolio?

I certainly think we're expecting growth in our single-family jumbo business, which would be the first growth in a while. That being said, we've also tightened LTVs, credit standards, and reserve requirements. So we do think there's a demand benefit, a secular demand benefit. There's reduced competition, and then we've tightened credit standards. That combination, we hope, will turn up some growth. I don't think it will be absolutely what it was in our heyday, but it will still be growth. I think it will be decent, and that will be an improvement from the last, let's say, prior six quarters, which experienced competitors getting way ahead of themselves with people offering 90% LTV jumbo mortgages, for example, which is always an error in any market.

And on the expense side, I think you were starting to see a lot of things in the industry announced, branch closures and things of that nature. Obviously, you guys are years ahead of that trend. As I think about kind of your acquisitive nature over the last few years, I do think you guys picked up some office space. If I recall, I think nationwide, there were some office spaces you occupied. With the pandemic and stay-at-home orders, I think a lot of workforces have moved remotely. Are you guys seeing any opportunities in this more challenging revenue environment on the cost side that you think you might be able to take advantage of over the near term here?

Not really. I think that our big focus over the next 18 months is going to be really on continuing to take advantage of the accelerant that this pandemic and the change in consumer behavior has brought to banking. For example, we have not fully incorporated all our small business clients into our universal digital banking architecture. We only have the best and newest account opening system available for small businesses for sole proprietors. That product has been extremely successful, and we can't keep up with the demand. We have a lot of opportunity there. So the short answer is we're going to invest in technology and leverage the dislocations in the industry. We believe that to be competitive over the long term, banking and securities products need to be seamlessly integrated and delivered. There may be a small drag from the security side of the business, but that may actually increase a little bit as we hire some folks for that business. However, we are implementing management frameworks and operational effectiveness programs that have resulted in very strong cost reductions and an improved operational outlook. In short, we are making targeted investments to establish ourselves as a digital leader, and we believe those investments will pay off significantly.

From a compensation and people growth perspective, we do continue to look at mortgage banking as additional possible growth, which does require additional bodies. So these are all good things that we would scale with the revenue and the business. The big picture is, we're not looking for operating expenses to come down in the next quarter.

Yes. We have a lot of really great operating efficiencies that are coming into play through RPAs and other straight-through processing activities. We're doing the interactions and pushing those into better-controlled environments for the customer and us, because we have the UDB platform. We can add every interaction that customers require through that. But then within it, we're also looking to dramatically improve the service and personalization to make ourselves a better place for consumers and small businesses than a branch-based bank. Given our anticipations of customers' needs and personalizing the experience, we have significant technology investments underway, which will positively position us in the next decade. However, we are not focusing on one quarter of expense reductions; that's not how we see things. Unfortunately, we are not getting quite the valuation we deserve for our investments, but that clarity will emerge as we respond effectively to the current credit concerns and as we emerge stronger on the other side with robust consumer, small business, and commercial products.

Just lastly for me and I'll step back. Just on capital. Following up on your last point, I mean, it seems like your deferral numbers are very low, and you feel good about the portfolio. I know the answer is probably not today, just because you have the CECL adjustment coming, and you probably want to work through that. But at some point, does it make sense to potentially get a little bit more aggressive with capital deployment, whether it's later this calendar year or early next calendar year? Just any updated thoughts on how you guys are thinking about that?

You mean with respect to share buybacks or dividends or something? Yes, even in a more aggressive scenario, possibly an acquisition opportunity or something like that?

Yes. No, I don't think it's hard to fathom them. We tend to try to buy capabilities. We like to build our businesses because then they fit culturally into our framework and systems. However, we are always looking around for the right opportunities. I don't think we are out of the acquisition game. There's nothing currently significant out there, but we are motivated and focused on our ambitious strategic plans and will execute on them. Nothing in this environment is impacting those plans. We are being conservative with the CECL adjustment, and if we took Moody's worst-case model, it resulted in a reduction of our loan loss reserves. So we are planning for severe housing downturns. If they happen, we’ll be well reserved; if not, then we will be over reserved, but that’s not a horrible problem either.

Next question comes from Steve Moss with B. Riley FBR. Please state your question.

Just wanted to start with you, Greg. You mentioned the new institutional loan products here. Just kind of wondering how large you envision that getting over the next 12 months? And kind of what's the clientele you're targeting? Can you give a little more color?

When you talk about institutional loan products, are you referring to CRESL Institutional loan products? Which ones are you kind of referring to specifically?

Yes, that exact type of products. It's just that as you work with more institutional sponsors that have enhanced financial wherewithal, you're lowering advance rates and ensuring sequences of funding are different—essentially, tightening credit characteristics and loan rates can go down. My main point is that, since you're seeing deposit costs come down, while loan rates are relatively fixed, your net interest margin should be trending upward.

That's correct. I think the broader point is that, while I'm indicating there may be more demand, our credit standards are also tight. This may lessen the net interest margin incrementally, despite declining deposit costs. That's the broader point here, to be very direct.

And then just in terms of loan growth, I want to clarify. I think you mentioned stability in loan demand. Are you still thinking low double digits, high single digits in terms of loan growth? How do you quantify that?

Yes.

And then third question, just on the equipment finance fees. I know it's small. You had one $5.6 million more challenging fees than we've seen with a few other banks with challenges there. Just wondering how you're thinking about that portfolio? Any thoughts about exiting it or anything along those lines?

No. The biggest industry there is the insurance industry, actually. Our exposure to industries are sensitive, and we have a small lease on equipment in our restaurant business, for example, which we've highlighted. We probably won't be doing many of those moving forward, but those leases are typically backed by senior loans that go on for an extended period of time. Our leases are short-term, highly amortizing, and often essential-use-related. The structure, in many cases, protects us, as the senior lenders often prefer not to take back equipment because that could harm their own cash flow. So we have indeed scaled back originations for now while we wait to see impacts from what lies ahead. This is a viable business, and we will focus on industries that do well and shift away from those under stress in the new market conditions.

Next question comes from Gary Tenner with D.A. Davidson. Please state your question.

I was curious about terms of commercial real estate lender finance business. I know one of the features there is that the underlying assets are held in a bankruptcy-remote SPE. Over the course of the last quarter, have you seen a lot of movement of the underlying assets securing those loans? In other words, have customers had to replace any of those assets?

Yes. There has definitely been some of that. There have been instances where the junior participants have taken us out or paid us down. So you definitely see that some of those assets are under stress. However, the structures are holding up, and we don't see anything particularly concerning given the loan-to-value ratios and those structures. Our partners and borrowers are cooperating well, ensuring that they are making the necessary payments, which is working out for us.

Our next question comes from Edward Hemmelgarn with Shaker Investments. Please state your question.

I just have one question, Greg. You've left your bank deposit balances grow rather significantly along with your customer deposits. Can you talk a little bit about what your plans are for that over the next year?

Yes, we probably overshot a little with respect to that. It's always a bit tricky to know because each stress we've seen in an economic downturn is a little different. This one appears to lack history around banking failures and stress, which is interesting. While having a little extra liquidity is not bad, we could have been a bit more aggressive about reducing our cost of funds. We definitely don’t need to run at this level; it was an overshoot, not particularly intentional. However, it does not represent a new norm with respect to our loan-to-deposit ratio. Historically, we like to maintain a better mix of FHLB borrowings, as their rates are very good. We don’t have a lot of that now, but there are significant opportunities to borrow long term at attractive rates, which we must consider.

While growth is uncertain, we have some view toward growth. So we would be poised for that as well.

That concludes the question-and-answer session. I'll turn it back over to management for closing remarks.

Thank you, everyone, for joining us this afternoon, and that concludes this session. Thank you.

Thank you. All parties may disconnect. Have a great evening.