Banc Of California, Inc. Q2 FY2020 Earnings Call

Hello and welcome to Banc of California Second Quarter Earnings Conference Call. All participants will be in listen-only mode. Operator instructions were provided to participants. Today's call is being recorded and a copy of the recording will be available later today on the company's Investor Relations website. Today's presentation will also include non-GAAP measures. The reconciliation for these and additional required information is available in the earnings press release. The referenced presentation is available on the company's Investor Relations website. Before we begin, we would like to direct everyone to the company's Safe Harbor statement on forward-looking statements included in both the earnings release and the earnings presentation. I would like to now turn the conference call over to Mr. Jared Wolff, Banc of California's President and Chief Executive Officer.

Good morning and welcome to Banc of California's second quarter earnings call. Joining me on today's call are Lynn Hopkins, Chief Financial Officer, who will talk in more detail about our quarterly results, as well as Mike Smith, our Chief Accounting Officer, and Bob Dyck, our Chief Credit Officer, who will all be available during Q&A. Our second quarter performance reflects both the conservative, well-capitalized bank we have built that is well positioned to manage through the impact of the COVID-19 pandemic, as well as a bank that has reached an inflection point in its transformation from restructuring to growth. We continue to benefit from the inherent advantages we had entering the crisis, most notably, high levels of capital and a well underwritten credit portfolio, predominantly secured by Southern California real estate with relatively low loan-to-values. Approximately 66% of our loan portfolio is secured by properties that serve primary residences, including the SFR, multifamily and warehouse portfolios, and we have very limited exposure to stressed industries such as hotels, restaurants, energy, airlines and other hospitality. Through our hard work over the past year, we have substantially enhanced the long-term earnings power of the Bank by improving our deposit base, lowering our cost of funds, increasing our net interest margin, and reducing operating expenses. These efforts have enhanced our operating leverage and brought us to an inflection point where we believe we are positioned to deliver profitable growth and generate higher levels of returns, subject to, of course, economic recovery from the effects of the pandemic. Despite the challenges created by the coronavirus, we continue to execute on our strategic initiatives and the transformation of our balance sheet. The run-off in our SFR portfolio continues with the low interest rate environment, while the Paycheck Protection Program enabled us to fund the type of relationship-based commercial loans that we are targeting. As a result, at June 30, loans to commercial customers increased to 75% of our total loans, up from 73% at the end of the prior quarter and 70% at this time a year ago. In other key areas, we made substantial progress in the second quarter. Our non-interest bearing deposits increased by $135 million or 11% from the end of the prior quarter, with a portion of this growth attributable to PPP loan proceeds received by our commercial customers. Over the past year, our non-interest bearing deposits have increased to 40%; this has resulted in significant improvement in our mix of deposits. Non-interest bearing deposits comprise 23% of our total deposits at June 30, up from 16% at this time a year ago. The improvement in our deposit mix, along with the lower interest rate environment contributed to a further decline in our average cost of deposits this quarter, which dropped to 71 basis points from 111 basis points in the prior quarter and reached the spot rate of 59 basis points at the end of the second quarter. And, largely as a result of the substantial reduction in our cost of deposits, our net interest margin expanded by 12 basis points compared to the prior quarter, reaching 3.09%. We believe the progress we are making reflects the clarity of our vision and the consistency of our execution. Our organization devotes considerable resources to providing high quality deposit products and high-touch services that enable us to gather low-cost deposits and to deploy them profitably into relationship-based loans to small and mid-sized businesses. While the value of these deposits may not be as obvious in times like this, over the long term, this focus and execution will provide a stable funding base that will protect both margin and earnings, and translate into true franchise value. The investments we have made in personnel and technology reflect our commitment to developing multiple channels for bringing in low-cost deposits. We are seeing strong deposit gathering contributions from all areas of the company; from our specialty deposits and private banking team to our relationship managers in both community and business banking, as well as the commercial real estate banking teams who are successfully increasing our deposit share of existing clients and adding the operating accounts of new clients each quarter. On top of our core business strategies, we have some additional opportunities to accelerate our progress as market conditions and timing permit. One of these opportunities was terminating our naming-rights agreement with LAFC, which we were able to complete in the second quarter. Under the terms of our new agreement, we have been released from over $89 million in future expense. While still retaining our position as LAFC's primary banking partner and remaining as a partner in a number of other collaborations, our restructured relationship will save the company approximately $7 million per year for the next 12.5 years. While the one-time charge associated with terminating our naming rights agreements impacted our second quarter results, this is a significant step forward in our continued efforts to reduce expenses and improve our future operating leverage. Let me address our near-term focus of managing the impact of COVID-19. We accommodated a significant number of deferral and forbearance requests for our clients early in the quarter and the pace of our loan deferral activity declined dramatically as we moved through the quarter. After approving a total of 205 loan deferrals in March and April, we approved 87 deferrals in May and just six deferrals in June. We ended the quarter with 298 active deferments on $604 million of loans or approximately 11% of the loan portfolio, and this includes both SFR where deferments are actually forbearances and non-SFR loans. A chart in our presentation lays out deferrals by asset class. Many of our borrowers with deferred loans are now coming up on the expiration of their 90-day deferral periods, and we are reviewing their current financials as we evaluate extensions of the deferral periods. For those commercial borrowers that demonstrate a continuing need for a deferral, we generally expect to obtain some additional credit enhancements, such as additional collateral, personal guarantees or putting in a reserve in order for an additional deferral period to be granted. We expect the legacy SFR loans to run with a higher percentage of deferrals or forbearances due to the consumer rules, but that portfolio is well underwritten with an average loan-to-value below 60%. As the Paycheck Protection Program has been extended, we continue to offer these loans as a means for helping clients manage through the crisis. We ended the second quarter with $262 million in PPP loan approvals for businesses that represent an aggregate workforce of more than 25,000 jobs. We viewed PPP loans as an opportunity to reinforce the high-touch client experience that we offer at the bank. So rather than opening up an online portal to take applications, we had our Relationship Managers guide our clients through the entire process to ensure a successful application and timely funding. Additionally, we believe this approach will provide administrative efficiencies to facilitate the loan forgiveness process with our clients. While we focused on serving existing clients with our high-touch model, we also used our framework to attract new clients and use the PPP to differentiate ourselves showing how true service can make a difference. As a result, we were able to add many new clients who are consistent with the type of commercial customers that we are targeting in our traditional business development efforts, substantially all of whom brought over their primary deposit relationship. New clients accounted for approximately 25% of our total PPP originations. We saw an increase in delinquencies and non-performing assets due mostly to one $11.5 million relationship that is well secured by both commercial and single-family properties. Additionally, we took a specific reserve of $5 million related to the legacy shared national credit that has been on non-accrual for several quarters. Lynn will address the components of the provision build under CECL for the quarter. Before I turn the call over to her, I want to briefly address our CLO portfolio as we received a number of questions about it following a piece on the CLO market that appeared in The Atlantic last month. While it isn't our place to be defenders of the overall CLO market, many investment banking analysts and firms did an excellent job of rebutting some of the assertions made in the Atlantic piece, and I would highlight Wells Fargo's analysis in particular. We do want to provide as much information about our particular CLO holdings as possible so that our shareholders are comfortable that we have minimal loss exposure in our portfolio. As with last quarter, in our slide deck, we have included some detailed information that should be helpful in understanding the level of risk in the portfolio. Without getting too much into the weeds on this, the key takeaways from our CLO portfolio are as follows: one, it consists entirely of AA and AAA rated securities; two, our portfolio is broadly diversified with minimal exposure to severely stressed industry; three, our analysis indicates that the underlying securities would need to experience approximately 25% in losses before we would take our first dollar of loss, and our analysis was also supported by the conclusions reached by two other brokerage firms; and lastly, perhaps most importantly, Moody's data shows that no U.S. AA or AAA rated CLO has ever had a principal impairment. All that being said, we still consider the CLO portfolio to be non-core legacy assets that we want to diversify away from as market conditions permit. Following the dislocation that occurred in the CLO pricing at the end of the first quarter, we saw tighter spreads at the end of the second quarter that reduced our unrealized loss in the portfolio by $44.8 million or approximately $0.63 per share on an after-tax basis. Given the level of credit enhancement we have in the portfolio, we continue to believe that at this point in time, we are best served by holding the securities until there is a more attractive opportunity to trade out of them. When the timing is appropriate, we would view this as another one of our larger opportunities to accelerate the progress of our franchise by removing the volatility that this portfolio experiences in diversifying and amplifying our investment returns. Now, I'll hand the call over to Lynn, who will provide more color on our operational performance. Then I'll have some closing remarks before opening up the line for questions.

Thank you, Jared. First, as mentioned, please refer to our investor deck which can be found on our Investor Relations website as I review our second quarter performance. The net loss available to common stockholders for the second quarter was $21.9 million or negative $0.44 per share. Our net loss and net loss per share were impacted by our decision to exit the long-term naming-rights agreement with LAFC, which resulted in a one-time pre-tax charge of $26.8 million and a provision for credit losses of $11.8 million. In addition, during the quarter, we recognized the $2.5 million debt extinguishment fee for the early termination of $100 million in FHLB term advances and a $2 million gain on the sale of $21 million in corporate securities. The core operating performance of the company is more accurately reflected in our adjusted pre-tax pre-provision income of $16 million for the quarter which compares to $12.2 million in adjusted pre-tax pre-provision income for the prior quarter. We continue to build momentum in our core underlying earnings power and we think we can continue that progress in the second half of the year and into the future. I will start by reviewing some of the highlights of our income statement before moving on to our balance sheet trends. We saw strong growth in our total revenues compared to the prior quarter driven primarily by a 6.7% increase in net interest income. The increase in net interest income resulted from a combination of higher average rate assets of $165 million and an increase in our net interest margin. Our net interest margin was 3.09%, an increase of 12 basis points from the prior quarter as our cost of funds fell by more than the yield on our average earning assets. As Jared highlighted earlier, our average cost of deposits fell 40 basis points to 71 basis points during the second quarter, and illustrates the progress we have made in improving our deposit franchise. Also, as mentioned, the spot rate for our cost of deposits at the end of the quarter was 59 basis points. This is 12 basis points below the second quarter average, and it will provide us additional opportunities for NIM expansion in the third quarter. In addition, we have $497 million of CDs maturing over the next six months with a weighted average rate of about 1.7%, which will further reduce our cost of deposits. In late June, we restructured $111 million of FHLB term advances, lowering the rate of such advances by 79 basis points while extending their duration above 2.5 years, and we prepaid $100 million of FHLB term advances, which had a November 2021 maturity date and a 2.07% interest rate. As a result, the aggregate cost of our FHLB advances is expected to further reduce our overall cost of funds going forward. Turning to our earning assets, our average loan yield declined 8 basis points from the prior quarter, reflecting both the challenging interest rate backdrop and the relatively limited exposure to re-pricing within our existing portfolio given that a large portion of our fixed rate and hybrid loans are not scheduled to mature or re-price for at least three years. During the quarter, we collected $7.5 million or approximately 3% in fees on PPP loans which we recognized through interest income over an estimated life of nine months. Funded PPP loans added 3 basis points to our second quarter NIM. While our loan yield only decreased 8 basis points, our earning asset yield decreased 21 basis points, due primarily to our CLO portfolio repricing down into the current market, as well as temporary excess liquidity being held in lower yielding assets. Briefly, non-interest income increased $3.5 million to $5.5 million. The second quarter included a gain on sale of securities of $2 million and the prior quarter included an unrealized loss of $1.6 million to record loans held for sale at their fair value; these accounted for the majority of the linked quarter increase. I would also like to mention the three-year earnout from the sale of the Bank's mortgage banking division which contributed average quarterly fee income of approximately $800,000 concluded in the second quarter. Moving on to non-interest expense; while there has been a fair amount of volatility in non-core expenses which I'm happy to address in Q&A, core expenses declined 13% from last year's second quarter to $42.8 million and decreased by $558,000 from the first quarter. We received some benefit from reduced regulatory assessment costs for being below $10 billion in assets for four consecutive quarters. The second quarter regulatory assessment costs are reflective of our current run rate and higher than first quarter which benefited from an FDIC assessment credit. While the core expense to average assets ratio increased 16 basis points year-over-year to 2.22%, it's important to keep in mind that our total assets declined by 17% year-over-year as we work to reduce non-core assets and transform into a relationship-focused business bank. Turning to our balance sheet; our total assets increased by $108 million in the second quarter to $7.77 billion as we continued our repositioning efforts. We remain focused on increasing relationship-based lending. As of the end of the second quarter, we had $262 million in PPP loan approvals, of which $250 million had been funded. The PPP production offset the expected run-off of our legacy single-family residential portfolio, which declined by $97 million and declined in most other loan portfolio segments. We continue to expect a relatively flat balance sheet for the year, but also expect our operating leverage to continue to expand. The investor presentation includes updated details on the disclosures we provided last quarter around our loan portfolio, in addition to details on deferments by loan segment. The portfolio continues to be largely weighted towards real estate loans which are supported by high quality collateral and underwritten by low loan-to-values. We also continue to have limited exposure to sectors that are most at risk from the pandemic: energy, hotels, restaurants, airlines and other hospitality. Deposits increased $475 million to $6.04 billion at the end of the quarter, with non-interest bearing deposits reaching $1.39 billion and representing 23% of total deposits. Demand deposits, non-interest bearing plus interest checking, increased from 41% to 54% of total deposits from the end of the second quarter of 2019 to the second quarter of 2020. This increase combined with the rate environment and our proactive efforts to reduce deposit costs and bring in new relationships drove our all-in average cost of deposits down from 162 basis points to 71 basis points over the same time period. As previously mentioned, we believe building a strong, truly low cost deposit base was one of the most valuable things we can do to create franchise value. While we recognize a portion of our non-interest bearing deposit growth relates to the PPP loan program, overall, our progress is generally ahead of plan due to our investment in products and systems and the tremendous dedication of our team. We have posted six consecutive quarters of growth in average non-interest bearing deposits, and our mix of non-interest bearing deposits and interest-bearing checking to total deposits continues to grow even on a growing deposit base. With deposit growth exceeding loan growth, our loan to deposit ratio declined from 102% at the end of the prior quarter to 94%. Our securities portfolio increased $207 million to $1.18 billion, driven mostly by net additions of $94 million of corporate securities and $61 million of agency CMOs and the $54.7 million reduction in the net unrealized loss of our portfolio. We ended the quarter with 88% of the portfolio in AAA or AA rated securities and the remaining 12% in BBB corporate securities. The majority of the BBB rated securities are subordinated bank debt investments. As Jared discussed, tighter spreads reduced the unrealized loss in our $668 million CLO portfolio. However, the CLO portfolio continues to weigh on our tangible book value with an unrealized pre-tax loss of $35.3 million at the end of the quarter. Turning to asset quality. Credit quality overall is showing resiliency given the challenges created by the pandemic. Nonetheless, delinquent loans increased to $95.2 million or 169 basis points of total loans, and non-performing loans increased to $72.7 million or 129 basis points of total loans. The increases in delinquent loans and NPLs of $10.2 million and $16.2 million are due mostly to one $11.5 million lending relationship that is well secured by both commercial and single-family residential properties. At quarter-end, non-performing loans included three relationships totaling $37 million or 51% of total non-performing loans. These are the $11.5 million relationship out of this quarter and the legacy $16.4 million shared national credit and $9.1 million SFR with a 58% loan-to-value, which had both been discussed in prior quarters. We believe the risk of loss on the single-family portfolio is low, given the weighted average loan-to-value is below 60%. However, due to consumer lending regulation, single-family loans tend to take longer to work through and can temporarily elevate our total delinquent and non-performing loans. As a result, we show our asset quality metrics for both the entire portfolio and for the portfolio excluding SFR in our investor deck. Let me turn to CECL and our provision for the quarter. As we've discussed in the past, our ACL methodology uses a nationally recognized third-party model that includes many assumptions based on our historical and peer loss data, our current loan portfolio and economic forecasts. Economic forecasts published by our model provider have deteriorated since the first quarter with June baseline unemployment rate forecasts for 2020 and 2021 increasing and the real GDP growth rates declining. Using current economic forecasts and the estimated impact of the pandemic on our portfolio's lifetime credit losses, we recognized a second quarter provision for credit losses of $11.8 million. The provision included $5 million in general reserves reflecting a deterioration in the macroeconomic variables in the updated forecast and other qualitative factors, offset by a decrease in total loans, and $6.8 million in specific reserves, including the $5 million related to the previously disclosed legacy non-accrual shared national credit. We also had a nominal amount of net recoveries with no charge-offs in the quarter. As a result, our total allowance for credit losses increased to $94.6 million, which is an allowance coverage ratio to total loans of 1.68%. Excluding the PPP loans, which have a 100% government guarantee, the ACL coverage ratio totaled 1.76%. Our capital position remained strong, with a common equity Tier-1 ratio of 11.7% and has benefited from the strategic actions completed over the past several quarters. We will continue to be prudent and strategic with the use of our capital to maximize benefits to shareholders and to build franchise value, while protecting our very well-capitalized position at a time when the outlook remains uncertain. While we are currently operating in a capital preservation environment, we plan to deploy our excess capital over time through organic growth, preferred stock redemption, resumption of share repurchase activity and other opportunities in the market. At this time, I will turn the presentation back over to Jared.

Thank you, Lynn. Since implementing our strategic plan to enhance the value of our franchise, our goal has been to show progress each quarter. Some quarters we will have more progress than others, but every quarter, we want to keep moving the ball down the field, improving franchise value and profitability. We think about our strategic plan in three phases. The first phase consisted of reorganizing the bank, realigning our personnel and business lines appropriately for the type of relationship-oriented bank that we want to be and building the foundation of a deposit-focused institution. Second phase builds on that foundation, enters the period of generating profitable growth and operating leverage. And the third phase is when the profitable growth and improved operating leverage have fully stabilized as a mature organization with the opportunity to be consistently a high performing financial institution. While we didn't put a timeline around these phases, given that market conditions put some of the timing outside of our control, we feel comfortable in saying that we are now entering Phase 2 of our strategic plan. We will continue to focus and execute on all of the initiatives that help build the foundation of Phase 1, improving our deposit mix, managing expenses, etc., but now we feel optimistic about our ability to generate greater operating leverage and better profitability. While we see loan demand, we are being selective in the credits that we pursue. There are attractive opportunities, particularly as stronger borrowers look to capitalize on current conditions in the marketplace. There is still a lot of uncertainty about the pace and the strength of the reopening in the economies in our markets, however. We serve clients from Santa Barbara to San Diego, and there are a lot of differences in how each market in Southern California is opening back up. But we are seeing enough activity and loan demand for us to continue to believe that in the back half of the year, loan production should outpace run-off and our balance sheet should remain relatively flat for the year as we continue to remix our loan portfolio as planned. And with the heavy lifting of cleaning up some of the legacy issues largely completed, we believe there will be less noise in our quarterly results going forward. We also continue to have a lot of additional levers that we can pull at some point in the future to further accelerate our performance, one of which is around our expense levels, as we make decisions about how we operate in the future based on what we have learned during this crisis. We have been very successful in delivering our services digitally to clients and the commercial customers that we have added are now accustomed to conducting business digitally. All of our experience will inform how we think about our real estate and what's appropriate for the type of commercial bank we are building. It's certainly a potential opportunity that will further enhance efficiencies without impacting our business development capabilities. As we look ahead to the end of 2020, we're very excited about what our bank will look like after two years of transformation: a bank that was well positioned defensively for the pandemic while having the foundation in place to substantially improve its earnings power in the years ahead. I think it is important to highlight the fact that from an operating standpoint, in just a year and a quarter, we have a vastly improved deposit base, an expanding net interest margin and improving operating leverage in core earnings, with significant excess capital and a healthy reserve. Our loan portfolio is 66% residential related, as mentioned, with very limited exposure to stressed industries. We have radically transformed our franchise, particularly on the deposit side and we are well-positioned to drive a higher level of earnings and returns. We have a strong credit culture that has made it a priority to exit and move beyond the few remaining legacy loans that represent the past. And most importantly, we have a truly incredible team, talented, experienced and dedicated colleagues that make a difference every day on behalf of our clients and in our communities. We have created a unique and powerful culture at Banc of California, and as a result, we are achieving our goals, continuing to attract high quality talent and supporting existing and new clients with our special brand of relationship banking. As a nearly $8 billion franchise in one of the top markets in the country, our continued execution should ensure significant value for shareholders going forward. Thank you for listening today. I hope that you and your families are safe and healthy, and I look forward to sharing more about Banc of California's progress in the coming quarters. With that, operator, let's go ahead now and open up the line for questions.

Thank you. Ladies and gentlemen, we will now begin our question-and-answer session. Operator instructions were provided to participants. Our first question comes from Matthew Clark from Piper Sandler. Please, go ahead.

Hi, good morning.

Good morning, Matthew.

Maybe just first on deferrals, as you speak with all your customers during the quarter, I guess, what percent of that deferral amount do you think might resume normal payments in the third quarter?

That's a good question. I don't have an exact number for you. A lot of it is going to be wait and see and it's pretty fluid. I think we're obviously very encouraged by the trend, and we're not seeing an uptick in requests. We're on top of it, but I'm nervous that at the last minute, people could just say, 'Look, we're not ready yet, we need another deferral.' And, of course, if they did that, we'd want to see the financials that support that. And as we mentioned, we would ask for some sort of credit enhancement to support that. Overall, our portfolio is performing very strongly. I went through our top retail credits. And as you know, we have limited exposure to retail. It's a small percentage; it's 5% of our total loan portfolio. But I went through our top retail credits and I was encouraged to see really high debt service coverage ratios, very low loan-to-values and a lot of rent collection. It didn't raise any flags for me. So as of right now, I think we're optimistic that we're not going to see an uptick, but there will be some, for sure, and we just don't know. The SFR portfolio is being serviced by a third party. They're doing okay. They're not doing great, which is why there's so much noise in the portfolio. It would be a terrible time to change servicers and we've been very vocal with them about the changes that we want to see. For example, at the end of the quarter, delinquencies went down by $28 million and a huge percentage of that was SFR. We keep mentioning it's running with a lot of noise, but we don't think there is loss exposure in the portfolio because of the loan-to-values and just knowing what we have; it's fundamentally a white-collar portfolio. So we think we're going to be good there.

Okay, great. And then on the $11 million new problem relationship, is there a resolution process there?

Yes. I'll let Bob Dyck, our Chief Credit Officer, address it, but it's basically a business divorce, it's two families that are split on two sides that disagree on the portfolio. It's tons of SFRs with some commercial property as well. Bob, do you want to talk about what our process is right now?

Yes. We're going to continue to monitor and work closely with the borrower. The relationship, as Jared said, is split about 50-50, just over $11 million between the commercial CRE piece and the SFR piece. Both of those pieces have very low loan-to-values. The commercial real estate piece has a family-related business in it as the primary anchor. So there is lots of motivation there; we'll just continue to monitor for payments. And the SFR piece, as Jared had mentioned, there are consumer protection issues that relate to that piece. So we will just have to move very slowly there.

And, Matthew, I believe, and Bob correct me if I'm wrong, but I believe they brought it current after the end of the quarter, but we have to leave it on non-accrual for quite a long time, because that doesn't show that it's going to come off non-accrual; but they actually brought it current. It's a family business divorce basically, and so we're monitoring it very closely. We're getting more aggressive. They went quiet on us and now they're starting to talk to us. So we're well secured, but we'll get out of it.

Okay, great. And then just shifting gears to the margin, maybe for Lynn, do you happen to have the spot rate on your borrowing costs at the end of June, just to give some visibility into the third quarter?

Sure. Actually, I did pull that. Matt, let me pull my support for you and I'll share it with the group. Apologize, I don't have it right here at my fingertips.

That's okay. And then, maybe lastly on the pipeline of new loan and deposit business, your deposit growth this quarter exceeded your PPP loans that were funded. I guess, can you just speak to the pipelines and how much of that deposit growth might have been there for taxes on July 15th and how much of that might stick?

We were talking about this. We think that about 50% of the deposit growth was non-PPP, and so we still have an engine that's working and we see a really good deposit pipeline right now and we're going to keep doing what we're doing. We have the right incentives in place, the right technology, the right tools, everybody is really aligned around this, which is why we're showing five consecutive quarters of very strong DDA growth. We want non-interest bearing, but we also are getting low-cost checking, which is just as valuable because it's true low-cost relationship deposits. I feel very good about that. We had said that we thought that run-off would outpace production in the first half of the year and production would outpace run-off in the second half of the year. I think that's still the case, whether we put on production in terms of earning assets, either through the investment portfolio or loans. We think the balance sheet will be relatively flat at the end of the year but it will be a better mix of assets and we're going to continue to expand our margin.

Okay, thank you.

The next question comes from David Feaster from Raymond James. Please, go ahead.

Hey, good morning everybody.

Good morning, David.

I just wanted to follow-up on Matt's question on deferrals and maybe the thoughts on reserve builds going forward. I mean, you had a larger than expected build this quarter, only some modest credit migration. I guess I would estimate the heavy lifting seems like it's probably been done, but as we start getting some more re-deferrals and maybe some risk rating downgrades, would you expect some modest builds in the second half of the year or just how you think about the reserve here?

I'll let Lynn address that. Go ahead, Lynn.

Sure. So as of the end of June, I think we are appropriately reserved. I think it's important to note that the second quarter provision had $5 million of general reserves. We did have some nominal recoveries. The majority was related to some specific credits that we called out: $5 million related to the shared national credit that's been on non-accrual. So looking forward, in the absence of significant loan growth, we'd expect the provision to stay relatively the same. We do have to look at updated economic factors and how that impacts it, but we think we've considered the risk in our portfolio appropriately now and I don't see significant reserve builds.

I think your note this morning got it right. We have our top three NPLs that are over 50% of our non-performers. We've got that shared national credit that we now have specific reserves against and I think we're well reserved against it. We've got a $9 million SFR, and this is all legacy stuff. We got a $9 million SFR that's being sold; that's like at a $16 million value, and we have this new $11.5 million relationship that's on non-accrual, that's well secured. So those three loans alone—if I expect some migration out of those credits as well—that's going to offset any sort of loan growth in terms of reserve build. And we also have, we're 66% residential. Look at our peers who have that concentration. They are nowhere near reserved the way that we are, and so I think that we are very healthily reserved right now, maybe in some ways conservative. In addition, as Lynn points out frequently, we've got a huge amount of capital too. So whether it's in the reserve or whether it's just sitting in capital, all those are buffers. I feel good about where we are and it would take a lot, I think, for us to reserve more.

Okay, that's terrific color. I appreciate that. And then just on the PPP program, got a couple minor ones. Do you have an estimate for the overall level of forgiveness, the timing of fees, I guess that nine month expected life, is that the rate that you're going to amortize those fees versus what we're seeing for most, it's like 24 months? And then how many of those loans were under $150,000? Just curious there.

So we did take a view that the estimated life is nine months. That is the period of time that we'd be amortizing our deferred fees related to it. So we've collected about $7.5 million by the end of the second quarter. The second quarter included about $1.7 million. Given how we approach the PPP program; we have about $250 million of PPP loans at the end of the second quarter, and the clients are known to us. For the most part, we do expect to move through the process, obviously subject to government timing. So we think we'd have a high level of success in helping our clients through the process and see that the majority of it is concluded by the end of the first quarter in 2021. As far as the percent of the portfolio that's below $150,000, from a dollar perspective there is a large percentage under $150,000. From a number-of-loans perspective, I can get those ratios for you; I have them on another piece of paper.

We have about that $260 million is about 1,100 loans. So you can do the average there.

Right. And then, that $7.5 million fee estimate; is that net of expenses or is that gross?

That's gross, and we do not have a material level of costs being deferred. We use our standard SBA deferral amount. But yes, that's the gross fee.

I saw that a lot of banks are using two years. I'm not sure I get why that is, because these funds are almost expired in August for the most part, and then they'll be applying for forgiveness. So I didn't understand why people were doing two years, but we just took the approach of nine months.

Yes. I hear you. That makes sense. And then just maybe more of a strategic question. You talked a bit about seeing good customer acquisition. I guess, thoughts on hiring or growth trajectory going forward and maybe just being a bit more aggressive when some others are fearful?

Two different questions. On hiring, we're hiring production people. We've got a good formula, but folks have to pay for themselves and you want to see a quick return, otherwise expenses grow and there's a delay before production starts. So we've got to be thoughtful about bringing on people and make sure that production can support it. You want to hire ahead of the curve but not too far, so we're balancing that and want to continue to capitalize on the positive operating leverage we're getting right now. We did the core earnings $16 million versus $12 million prior quarter; we want to keep building on that. In terms of where we're being aggressive, we don't want to make credit missteps here as much as we want to grow. We're trying to be the bank for real estate entrepreneurs in our markets. People who are going to take advantage of dislocation—institutional real estate borrowers who will buy under-performing properties, turn them around, and we can bridge them and be there for takeout if needed. That's where we can really play. We're also grabbing relationships by providing high-touch service. We recently brought over a new $9 million relationship on the deposit side; they'd been working it for a while. They were concerned they wouldn't be treated as well at a new bank, and the bank they left didn't even counter. We focus on being a high-touch relationship bank. The way we did the PPP program, you picked up the phone and got somebody on the phone. We walked clients through. That experience will translate to high-quality client base. We're hiring people who understand this approach. It's not about throwing a rate up on the wall; it's about bringing real relationships. We're being as aggressive as we can, but we don't want credit errors because those are headlines we don't need.

That's extremely helpful. I appreciate it. Thanks, guys.

The next question comes from Timur Braziler from Wells Fargo. Please go ahead.

Hi, good morning.

Good morning. How are you, Timur?

I appreciate the Wells Fargo shout out, and I guess it'd only be fitting to start with a CLO question. We saw another bank exit their CLO portfolio earlier in the quarter. How close are we getting on price to seeing additional divestitures out of that portfolio, and how do you weigh the pace of that with the expectation for a flat balance sheet?

As far as progress on it, we still have a $35 million unrealized loss in the CLO portfolio. Given our stress testing, our analysis says that we believe the CLOs are still money good. None of them were downgraded during the quarter. They're still AA and AAA rated. For now, we are still looking to hold onto them and not divest at a loss. They are in the earning asset mix for the remainder of 2020 in the absence of significantly better opportunities. But we are evaluating and looking at it, and if opportunities arise, we will strategically exit them into alternative earning assets.

Given how low yields are now, it used to be that there was a yield benefit even with volatility. Now they have a poor yield. So how quickly can we get out of them? But we don't want to do it at a loss and we also don't want to taint the rest of the portfolio by selling one piece and realizing a loss that makes the picture worse. We have to be careful. I don't think it'll be much of a problem to replace them in terms of earning assets because yields are low across the board; we'll be able to find something. So that's less of an issue than avoiding taking a loss just to take a loss.

Okay, that's good color. On that topic, other investments increased during the quarter. What's the plan to put incremental liquidity into the securities portfolio at this point? And how much of PPP deposit stickiness will play into how fast or aggressive you are investing further liquidity?

On the PPP question, our deposit engine is continuing to perform. Just a portion of the deposits were PPP, and I don't think that's going to influence us much as long as we see general deposit flows continue the way they are.

We did take the opportunity during the quarter to put some of the additional liquidity into the securities portfolio. Our investments were in corporate securities and some agency CMOs, so the securities portfolio grew during the quarter. As we look forward, I'd expect a portion of additional liquidity will be deployed to the securities portfolio. But we would be looking for the net loan growth that we've talked about to achieve the flattish balance sheet goal for the year.

Do you have the investment yield for the quarter on new purchases?

Investment yields on new purchases during the quarter were in two buckets: about $100 million at roughly 5%, and the other portion around 2%. So about $60 million at about 2% and $100 million at about 5%, broadly speaking.

That's great color. Lastly from me, there was a statement in the release that part of the decline in C&I was in response to strategically reducing certain facilities due to the change in economic conditions. Could you provide more color on that?

In our warehouse group, the market backed up and we lend to non-bank lenders who originate mortgages on a short duration basis, 30 to 45 days. They lend, securitize and clean up the line. We saw the market seize up on the securitization side for non-QM mortgages, and we wanted to make sure we weren't left holding long duration. So we cut back our lines. Some borrowers also chose to slow down to ensure takeout. We have a very experienced warehouse lending team; it's an important but not outsized business for us and they did a great job looking out for the bank.

Have those trends reversed post quarter end or is it still jammed up on the securitization side?

After quarter end, it went down, but we see it building back up toward more historical levels.

Got it. Thank you very much.

The next question comes from Steve Moss from B. Riley FBR. Please go ahead.

Good morning.

Good morning, Steve.

On expenses, curious what your expectations are for the third quarter. Jared, you hinted about rationalizing expenses a bit further. How should we think about timing — initiatives this year or more of a 2021 event?

Our expenses have continued to come down over the last several quarters, due in part to the decrease in the overall balance sheet size, but also through creating operating efficiencies via technology and reduced consultant spend. Based on second quarter levels, I think there's continued opportunity, though at a lower degree moving forward. Large initiatives like real estate and remote-work lessons will continue into 2021. So there are opportunities, but they will be modest.

We will look at branches as leases come up for renewal: right location, right size, do we need as many branches. We're likely to have less office space overall or rotate people, not increase it. We also think about lending to office and tenant mix and how comfortable we are with lease renewals. LAFC was a big one; we restructured that in a way more appropriate for our bank. Other accelerators include CLOs, FHLB restructuring — Lynn and her team did a great job — and we still have many maturing CDs close to 200 basis points that will reduce deposit costs. So there are multiple levers we can pull.

All right, thank you very much. I appreciate that.

The next question comes from Gary Tenner from D.A. Davidson. Please go ahead.

Good morning, everybody.

Good morning, Gary.

On PPP, what was the average PPP balance for the quarter?

Average outstanding for the quarter is about $153 million.

Perfect. And based on your comments about pickup in outlook for originations back half of the year, should we think about originations offsetting run-off of the portfolio in the back half of the year or run-off excluding PPP?

We've got to make up PPP as well. If we funded roughly $250 million of PPP, and our single-family is running off, plus other runoffs, we have $300 million to $400 million to make up. We expect originations in the back half of the year to help make that up.

Okay. That's all I had. Thank you.

The next question comes from Luke Wooten from KBW. Please go ahead.

Hey, guys. I wanted to ask about the CDs rolling off. Can you give a little more clarity on the timing and the amount of the CDs that will roll off? Is it concentrated or spread over the next 12 months?

The CDs we referenced, about $490 million, are pretty evenly spread over the next six months. There's about $170 million in December, but the rest is fairly evenly spread over the third quarter. A portion is retail, and we flagged some brokered CDs that were added as liquidity; those are running their course. Depending on liquidity in the marketplace, we'll look to let those go or roll them over. About $150 million of the brokered portion matures this year.

Okay. On loan yields, the CRE categories held up. Should we model roughly flat yields for CRE going forward?

On CRE, yields may come down a bit. We're trying to be a bridge lender, and bridge lending has been helping hold yields higher. We'll probably trade a little bit to put on more volume and to add earning assets, so yields might moderate slightly on the commercial and multifamily side, but we'll try to preserve pricing where we can.

And can you talk a bit more about the products that differentiate your deposit gathering? You've had tremendous DDA growth; what's driving that?

What distinguishes us are a few things: everyone at the company is focused on deposits and we bring deposit relationships with lending relationships. We have excellent deposit services and good technology, which lets us compete. We have a strong treasury management team to support the front lines and help structure deposit solutions, and a specialty deposits team that hunts larger institutional deposits. Company-wide, we're aligned, incentivized to reward deposit growth, and we deliver high-touch service. That combination is driving strong DDA growth.

Great. I'll follow up separately. Thank you.

The next question comes from Tim Coffey from Janney. Please go ahead.

Hey, morning. Thanks for taking my questions.

Good morning, Tim.

Looking at the FHLB borrowings, specifically the $566 million that have an average life of four years, what's your willingness to move out of those before trading out of the CLOs?

The $566 million are longer-term FHLB advances, with maturities between five and seven years on a portion of them. It's pretty expensive to break those given the rate and maturity, so carrying them is likely the better option. We did refinance and restructure some this quarter — we refinanced $111 million lowering cost by about 80 basis points and prepaid $100 million that matured in November 2021. The spot rate for our FHLB advances in particular has come down to 2.47% and our overall borrowing spot rates are at 3.12%. We do have a note payable at 5.46% for the longer term.

That's helpful. And on expenses as a percent of assets, you're around 240 basis points. Could you get closer to 2% or lower? What are your near-term and longer-term targets?

We were looking at peers yesterday. Getting to 2% is a great long-term goal though not many banks are below 2%. Getting close to 2% would be great but may require balance sheet growth. We plan to achieve that by growing the denominator and continuing to reduce the numerator where reasonable.

We believe we have the right expense base to create operating leverage. There's opportunity to leverage technology, rationalize expenses, and sharpen our pencil on a few line items. But given our growth objectives, expanding earning assets with the current expense base is our focus. The 2% target is a great long-term goal that would require balance sheet growth; in the nearer term we think we can continue to move the ratio down toward around 2.10% or so.

That all makes sense. Thanks very much.

A follow-up question comes from Gary Tenner from D.A. Davidson. Please go ahead.

I think you used to provide this information, but in terms of new loan origination yields in the quarter, now that the Fed rate cuts and LIBOR moved lower over the second quarter, what type of new business yields are you seeing?

In terms of production in the second quarter: C&I was in the low to mid-4% range, CRE in the upper-4% range, and multifamily in the mid-to-upper-3% range. We get the best pricing on loans where execution and structure matter — bridge loans and transactions that require close knowledge of the asset — and I expect pricing for those products to remain relatively stable.

Thank you.

There are no further questions in the queue. This concludes our question-and-answer session. I would like to turn the conference back over to Jared Wolff for any closing remarks.

Thank you very much. Just want to thank everybody for participating on our call today. As always, if investors have any questions, they can feel free to reach out to me or Lynn, and we look forward to hearing from you and reporting quality results for the next several quarters. Thank you all.

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time, and thank you for your participation.