Earnings Call Transcript - BKU Q2 2020

Susan Greenfield, Corporate Secretary

Thank you, Josh. Good morning and thank you for joining us today on our second quarter results conference call. On the call this morning are Raj Singh, our Chairman, President and CEO; Leslie Lunak, our Chief Financial Officer; and Tom Cornish, our Chief Operating Officer. Before we start, I'd like to remind everyone that this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that reflects the company's current views with respect to, among other things, future events and financial performance. Any forward-looking statements made during this call are based on the historical performance of the company and its subsidiaries around the company's current plans, estimates and expectations. The inclusion of this forward-looking information should not be regarded as a representation by the company that the future plans, estimates or expectations contemplated by the company will be achieved. Such forward-looking statements are subject to various risks and uncertainties and assumptions, including, without limitation, those relating to the company's operations, financial results, financial condition, business prospects, growth strategy and liquidity, including as impacted by the COVID-19 pandemic. The company does not undertake any obligation to publicly update or review any forward-looking statement whether as a result of new information, future developments or otherwise. A number of important factors could cause actual results to differ materially from those indicated by the forward-looking statements. Information on these factors can be found in the company's annual report on Form 10-K for the year ended December 31, 2019, and any subsequent quarterly report on Form 10-Q or current report on Form 8-K, which are available at the SEC's website, www.sec.gov. With that, I'd like to turn the call over to Raj.

Raj Singh, Chairman, President and CEO

Thank you, Susan. Welcome, everyone, to our earnings call. Thanks for giving us your time. Let me make a few comments about the environment before we get into the quarter. Three months make a big difference. This is not a traditional economic downturn. It's not caused by anything other than the virus. It is still a very serious situation, but we feel a lot better today than we did 90 days ago. There have been some encouraging signs in the economy over the last 3 months, whether it's employment data from May and June, or retail sales, or home sales or capital markets generally, but there is still a lot of uncertainty. Unemployment is still very high. There are mixed signals about certain sectors in commercial real estate. The virus, obviously, is still not tamed, and there are a number of states that are reporting high levels, including Florida. The impact of all of this gets further compounded by the fact that we are 100 days away from the election. The political scenario in the country will make it even harder to read where the economy is headed in the next 100 days and beyond. But overall, we are much more optimistic today, but I would still say we are cautiously optimistic compared to where we were 3 months ago. When all this started, we began having Board meetings. Early on, it was actually on a weekly basis to inform our Board, but then eventually moved to every 2 weeks. In one of the early Board meetings, a question was brought up, which I want to share with the shareholders, which was about how we are going to deal with this crisis and, over the course of the next year or so? And what are the principles around which we will react to all this? Three principles were laid on the table, which we have used in making all our decisions at the bank. First is intellectual honesty with yourself, which is to say, don't try and be overly optimistic and say, oh, this is okay, it will all be fine. So be intellectually honest with yourself. Second, be transparent with all stakeholders. This includes shareholders, regulators, rating agencies, and even customers and employees. Be transparent, provide more information than usual and don't try and hide anything. Third, be proactive. In other words, don't try to kick the can down the road because eventually you're going to have to deal with the issues. So be proactive and deal with them early, getting in front of the issues rather than behind them. We've used these 3 principles in all the decisions that we've made over the course of the last 3, I guess, 4 months now. With that, let me quickly turn to the earnings for the quarter. We reported $76.5 million of earnings this quarter, $0.80 per share. This compares to $0.81 per share last year at this time. The annualized return on equity and return on assets were 11.6% and 90 basis points for ROA. We informed you during the last call that the pre-provision net revenue would trend favorably. We said that the net interest margin would increase. The cost of funds would decline, representing probably the biggest decline in the history of the company. We stated that operating expenses would trend downwards, and all of those predictions have come true. Pre-provision net revenue is up $37 million or 44% quarter-over-quarter. $10 million of that $37 million came from net interest income, $15 million from noninterest income, and $12 million from expenses. Overall, across the board, all items went in the right direction. Unlike peers, most of whom have reported declines in net interest margin, our margin actually improved from 2.35% to 2.39% as we had indicated 3 months ago, driven primarily by the cost of deposits. Our total cost of deposits declined 56 basis points from last quarter. We went from 136 down to 80. And on a spot basis, at the end of the quarter on June 30, our average pricing of interest and our deposits had already decreased to 65 basis points. In July, it continues to drop. So next quarter, you can expect another drop in the cost of deposits. Maybe not 56 basis points, but it will be a nice drop again. We expect that trend to continue throughout this year and into early next year. Provision also declined to $25.4 million from $125.4 million last quarter. Leslie will get into all the details around provision and reserve later, but at a high level, I would say that our reserve build from the end of December, so for the full year, we have more than doubled our reserves, and they've increased by 130%. We quickly looked yesterday at our peers and banks between $10 and $110 billion to see how much reserve build they have actually accomplished, and the average or median was around 60%. This is what I'm referring to in terms of getting in front of issues and taking the necessary measures early, which we did in the first quarter, resulting in the loss we posted last quarter. Quickly switching to some balance sheet items. Noninterest demand deposits grew by $1.3 billion, which is 28% quarter-over-quarter. Now demand deposit accounts stand at 23% of total deposits. Last quarter, we were at 18%, so a very healthy trend. Average noninterest-bearing demand deposits also increased by $944 million compared to last quarter. Interest-earning assets were also up for the quarter. Loans and leases grew by $656 million, and the securities portfolio grew by $819 million. Leslie will provide you with a little more detail on that. We also observed substantial recovery in the unrealized loss on securities in the second quarter. If you remember, in the first quarter, we had a $250 million negative mark on the securities portfolio. We had talked about how that was recovering and that over the course of months, we expected to claw all of that back. We're happy to report that we clawed most of it back. We're down to only $2.6 million. So from negative $250 million to negative $2.6 million, that's almost a 99% comeback in a 3-month period. There are still some unrealized losses in the commercial mortgage-backed securities and collateralized loan obligations asset class, but those are continuing to improve. We've always been very comfortable with the portfolio. Book value increased by $2.59 this quarter. Overall, I couldn't be happier with the performance. Our capital position remains robust. Our common equity tier 1 ratio is 12.2% at the holding company and 13.4% at the bank. Oh yes, we issued $300 million in holding company subordinated debt this quarter at 5%. That helps our total capital ratio, which now stands at 14.3%. Regarding the dividend, we evaluate our dividend based on two factors: our capital adequacy and our medium-term or near-term earnings. We feel good about both of those factors, so we paid out a $0.23 dividend in the second quarter, and management at this time expects to recommend the same going forward. A few remarks about credit, and Tom and Leslie will get into it more deeply. We have been very proactive in identifying certain subsegments and borrowers that we believe will be impacted by COVID-19 more than others. This strategy has not changed. Our ratios of non-performing assets and non-performing loans are basically flat compared to the prior quarter and down marginally compared to December 31. As of June 30, the NPA ratio was 60 basis points, but it was 47 basis points if you exclude the guaranteed portion of SBA loans. NPLs stood at 86 basis points, but again, if you exclude the guaranteed portion of SBA loans, then it's 67 basis points. Our efforts to assist borrowers with PPP loans and the various deferrals are likely helping to mitigate and keep these numbers down. The annualized charge-off rate for the quarter was 20 basis points. The majority of this was linked to one loan in the franchise portfolio. This loan had shown weaknesses prior to COVID but was resolved during the pandemic, leading to its bankruptcy filing right before it commenced. As you know, we’ve been very accommodating in granting 90-day deferrals. We started doing this in the last week of March. Most of our deferrals came in over a 3-week period from the last week of March and the first 2 weeks of April, after which the requests tapered off. We initially granted deferrals on $3.6 billion in loans, about 50% of our portfolio. However, far fewer people are asking for a re-deferral now. The requests we've received so far for re-deferrals are only $748 million. So think of it this way, earlier 50% of our portfolio or $3.6 billion requested deferral. Now as the 90-day deferrals are expiring or have expired, the requests are coming in much lower, only $748 million or 3%. This is a significant drop and indicative of customer behavior. This is not an estimate or model telling us anything; this is what customers are doing, and I see this as a very positive sign. Of course, this can change, but where we end up at the end of July is a positive place regarding the re-deferral rate. We did see an increase in special mention and substandard accruing loans. We performed a deep dive in the commercial portfolio this quarter and reached out to individual borrowers, especially those we thought were impacted. We've increased monitoring of the portfolio to levels we wouldn't have previously considered. We have been monitoring this on a weekly basis, and we're using this information to re-risk the portfolio. This increase should be considered a lagging indicator in relation to the CECL numbers because while CECL is primarily a modeling exercise we did at the end of March, this is a manual exercise where we literally analyze a loan file to assess risk and re-rate them. So this adjustment happened over the course of the quarter and is partially catching up to the reserves we established at the end of the last quarter. Our going-forward strategy this quarter is to prioritize the safety and wellness of our employees, and I am pleased to report that everyone is fine. There have been some COVID-19 cases, but none of them are serious. The bank is operationally sound. There are no liquidity issues. There was a significant focus on the entire system last year and last quarter, but I believe the Fed and others have done well. Liquidity is not an issue at this time. We directed much of our efforts this quarter towards PPP, and it's an understatement to say that it was a herculean task in April. We processed 3,600 loans in a month, which is truly surprising even to me now. The BU 2.0 initiative has been ongoing for the past 1.5 years, continues to progress. We expect to overshoot our expense targets, and while we anticipate some delays on the revenue side, launching some of these new efforts does become challenging when clients are locked down and it's hard to engage them. Regarding expenses, we initially targeted $40 million but are already at $47 million, with potentially more to come. Our revenue outlook remains positive; we're aiming for $20 million, but the timing is delayed. Some of the high-level initiatives include launching the commercial credit card this quarter, continuing with small business initiatives, and launching an automated underwriting platform later this year, which was a bit delayed. Additionally, we signed a fee-generating agreement with Goldman Sachs recently, shifted strategically towards enhancing treasury management products, and launched a new customer derivative program that will generate revenue on the commercial side. Overall, I'm very pleased with our progress. Let's turn it over to Tom, who can provide more detail on loans, deposits, credit, and more. Thank you.

Tom Cornish, Chief Operating Officer

Great, Raj, thank you. To amplify some of the comments Raj made earlier, it was an excellent quarter overall for deposit growth. Total deposits were up $1.1 billion for the quarter. As Raj mentioned, noninterest demand deposits actually grew by $1.3 billion. Diving a bit deeper into those numbers, while it's challenging to provide exact figures, as we finished the quarter, we estimated that we had between $400 million to $600 million of noninterest demand deposits related to the PPP loan proceeds still residing in the operating accounts of our clients. Remember, we funded over $800 million. While that contributed to our growth, we also witnessed strong growth in noninterest demand deposits across all geographies and business lines, with a significant portion coming from new client relationships. We generated over 700 new business relationships during the quarter, which is impressive given the challenges posed by generating business in a remote environment. Each line of business significantly contributed to this growth, representing close to $500 million in deposit growth from those new relationships. With this growth and solid liquidity position, we were able to allow some higher-cost deposits to roll off during the quarter. Total time deposits actually decreased by $811 million as we reduced our certificate of deposit rates. We believe some of that money likely moved into money market products. As Raj mentioned, we continue to systematically reduce our deposit costs. The spot rate on total deposits declined by 47 basis points for the quarter and 77 basis points year-to-date. We still have $2.3 billion in CDs that haven't yet repriced since the last Fed rate cut, with an average rate of 1.91. So we still see significant opportunities as we renew CDs at much lower rates. Regarding loan growth, it was primarily concentrated in PPP loans. We noted $827 million of growth in PPP and $308 million in mortgage warehouse. Our commercial and industrial (C&I) business saw a reduction of $317 million in the quarter, mainly due to lower production levels. We've observed substantial reductions in line utilization as we entered the second quarter, which is well below pre-COVID utilization numbers. Most other categories saw either marginal increases or declines for the quarter. The three key changes for the quarter are primarily related to these. From a PPP perspective, we facilitated over 3,500 loans totaling $876 million. We accommodated nearly all existing clients who sought a PPP loan, which is a significant achievement for us this quarter. The average loan size was about $245,000. Currently, we have not initiated the process for loan forgiveness applications yet, but we expect to do so shortly. In terms of growth and short-term opportunities from a strategic perspective, the first half of Q2 was primarily focused on PPP loans as Raj noted, but we did experience notable growth in the mortgage warehouse and identified opportunities exist in the residential lending sector. Generally, we are exercising caution and taking a selective approach, focusing on our existing client base at this time. We have numerous clients where we see potential to increase credit facilities, as they maintain resilient business models and exhibit revenue growth. We are also beginning to see M&A opportunities within our client basis present attractive valuations compared to historical norms. We're looking for new client businesses from those with strong financial conditions and performance within sectors that align with our long-term growth strategies. Despite this, we remain cautious until we see greater stability in the economy and the trends in the healthcare crisis within the markets we operate in. Overall, excluding any forgiveness activity from PPP, we anticipate a slight decrease in the loan portfolio for Q3. We continue to identify opportunities for onboarding new deposit relationships across all business lines, and our pipelines remain healthy. Our treasury management business continues to perform exceptionally well, with significant numbers of relationships moving to our bank. We expect deposit growth in Q3 again, though probably not at the same level as the current quarter. Our emphasis remains on establishing comprehensive banking relationships, including noninterest demand deposits. Shifting focus to loans on a deferral basis, Slide 21 in the supplemental deck provides more detail on this as well. Again, as Raj highlighted, our deferral rate has dropped considerably from the initial deferral rate we experienced. We approved initial 90-day deferrals on loans totaling $3 billion, accounting for about 17% of the total commercial book. Currently, we've received requests for second deferral on loans totaling only $696 million, or 4% of the commercial book as of July 17. This represents a very strong and encouraging reduction in the level of second deferrals we've received. Initially, our deferral requests were concentrated primarily in the commercial real estate segment, with an initial deferral rate of 29%, and in franchise finance with an initial 74% deferral rate. As of the 17th, the re-deferral rates in those segments are now down to 6% for the commercial real estate portfolio, and 25% for franchises. Most initial deferrals in the commercial real estate segment were largely concentrated in the hotel and retail property types. We also observed that the re-deferral rate on the C&I portfolio is only 1%, which indicates minimal requests. Most of the first-time deferrals were processed in late March and April, and as these are now approaching the 90-day period, while there may still be additional requests for re-deferrals, we believe the majority have already been submitted. New first-time deferral requests for loans significantly diminished after April, with only minor activity occurring since June 1. Switching to the residential portfolio, we granted approximately $594 million in initial 90-day deferrals, including the Ginnie Mae early buyout portfolio, representing about 13% of the overall portfolio. Of these, 42% or $252 million continued making payments during the deferral period. About $52 million or 1% of the portfolio has been deferred for an additional 90 days, either by request or through automatic extensions due to regulatory changes. I want to provide some data on rent collections, particularly within the commercial real estate portfolio regarding what we're seeing up to June. While it's not 100% of the portfolio, it's representative of a large percentage of our outreach efforts. For the office segment, Florida's collection rates were in the 80% range, while New York was in the 70s. Multifamily properties in Florida reported collection rates in the 90s, while those in New York were in the 80s. Retail collection rates overall averaged 62%, seeing greater dispersion depending on the specific property and location, but overall collection rates were higher in Florida. The warehouse and industrial segment maintained minimal collection issues with rates around 90%. As for hotel occupancy, nearly all hotel properties in both Florida and New York are open, though a couple remain closed. Currently, expected occupancy rates for July in Florida are in the 30% to near 60% range, trending upward since April, when occupancy was about 20%. We saw increased occupancy rates around holidays and weekends, though it's important to note that summer tends to be a slower season in Florida. We'll track how occupancy improves as fall and winter approach. While this environment presents challenges, we foresee some restructuring that could extend beyond the typical 90-day deferral period. We don't have occupancy data for New York yet, as hotels have only started to open up recently. Our largest one is scheduled to open tomorrow. Let’s examine the franchise operations. It's worth noting that performance varies considerably based on operating models. Locations offering drive-thru and delivery tend to perform well, with many franchises even reporting year-over-year increases in same-store sales during the April-May period. Conversely, full dine-in models, a smaller portion of our portfolio, have struggled. However, our May results indicate improvement over April's figures. Despite encouraging signs, we should remain cautious as the re-deferral rate in the franchise segment is still 25%, down from the initial 74%. I think we should turn it over to Leslie for more detail on loan performance and credit.

Leslie Lunak, Chief Financial Officer

Morning, everybody. Before I dive in, I want to remind you that we aren't conducting a walk-through of our deck today, but we've provided a supplemental deck for your reference that updates much of the information we shared at the end of the first quarter. Now, regarding CECL and the allowance for credit losses, there are several moving parts to the reserve estimate for the quarter, and I'll try to walk you through the most significant ones. For your future reference, Slide 15 in our supplemental deck details the reserve changes by major portfolio segment. So you can look through that as I discuss it. Let me begin with the economic forecast assumptions. The loss estimate is impacted by economic conditions at the balance sheet date, which were significantly worse as of June 30 compared to the previous quarter's model inputs. Additionally, the forward path of the economic forecast was mixed, being somewhat worse in certain areas and better in others when compared to the forecast from March 31. One distinct difference is at June 30, the worst point of the forecasted economic trajectory was behind us, whereas at March 31, it was yet to come. To provide you with a few high-level data points, the forecast for this quarter included unemployment starting at 13.4%, declining to 9% by the end of 2020, and further decreasing to 7% by the end of 2021. The annualized GDP growth forecast began at a negative 27%, but shows substantial recovery in Q3, ultimately returning to pre-recession levels by 2023. The mix trailing average started this quarter at 32. It remains elevated through 2020 but moderates thereafter, although it stays relatively volatile throughout the forecast horizon. The S&P 500 started at approximately 2,900 and is projected to decline to around 2,700 by the end of 2020, before rising above 3,000 by the end of 2021. The reserve experience this quarter, commonly described as a tale of three cities, is attributed to various economic conditions. We utilize three distinct models to estimate expected losses, and we apply them at the loan level—one for residential loans, one for commercial real estate, and another for commercial and industrial loans, each having different sensitivities to various economic variables. Beginning with residential, there was no significant change in the level of residential reserves this quarter, as the model is most sensitive to home price index, which saw improvements in the June forecast compared to March. However, it is also sensitive to unemployment, which worsened in the June forecast. These factors acted in opposite directions, resulting in a marginal reserve reduction this quarter as a result of an update to expected prepayment speeds. For the CRE portfolio, the reserve rose from 57 basis points on March 31 to 1.54% by June 30. The CRE model is highly sensitive to unemployment and commercial real estate forecasts by property type and geography, and both of these factors worsened from the prior quarter's forecast, leading to an increase of $48 million in the CRE reserve. Furthermore, we applied a qualitative factor of $24 million based on data gathered from individual borrowers reflecting a decline in current revenues and financial condition compared to the latest financial statements available. We collected this information from a representative sample of borrowers and extrapolated the results across the relevant population to derive the qualitative factor for reserves. In contrast, the reserve for the C&I portfolio decreased from 2% to 1.38% this quarter. The C&I model is sensitive to changes in the volatility index and S&P 500. Although all the initial data for these variables was worse as of June 30 than March 31, the forward path for the VIX and the S&P 500 improved in the June forecast compared to March, as did expectations for credit spreads, which largely offset the adverse effects of deteriorating unemployment. Similar to the CRE portfolio, we made qualitative adjustments for C&I reserves based on a representative sample of borrowers. One important factor affecting the C&I reserves this quarter was our assumption regarding loan prepayments on March 31, which we set at zero for a period of time, as we believed it was unlikely for anyone to prepay loans during a pandemic. However, we have since observed that actual prepayments increased beyond historical averages, leading us to eliminate the zero prepayment notion moving forward. This adjustment positively affected the reserves across all segments, particularly C&I. Presently, the franchise portfolio carries the highest reserve level at 3.12%, followed by CRE and then C&I. Although the franchise reserve percentage decreased this quarter primarily due to the significant charge-offs Raj mentioned, our reserve levels reflect the relative levels of stress exhibited across the different portfolio segments. It's worth noting that as of June 30, our reserve was at 60% of 2020 DFAST severely adverse losses. Under stress, our capital ratios remain comfortably above well-capitalized levels. Regarding expectations for the provision and reserve moving forward, various factors could lead to additional reserve builds aside from new production, including a material deterioration in the overall economic outlook. The primary catalyst for this would be a widespread return to shutdowns or a loss of confidence from rising virus cases. Our current reserve levels don't account for expectations of a widespread return to shutdowns. Furthermore, granular borrower-specific variations may lead to individual builds if borrowers’ responses diverge from our expectations or model projections. However, absent a significant economic downturn, I wouldn't foresee a material reserve build. Of course, circumstances can evolve in the other direction as well. Next, I want to touch briefly on risk rating migration. There are slides in the deck detailing this. Our guiding principle, as Raj noted, is to call it as we see it, striving for both proactive and objective assessments. We began the downgrade process early, addressing any observed weaknesses we encountered, which we believe is an essential approach. Comparing risk ratings bank to bank can be challenging, particularly in this period, as each institution may take a different approach. Some may decide to wait until all deferral periods are completed before making adjustments, but that’s not the approach we've chosen. It's also important to highlight that our portfolio’s risk rating distribution reflects the state of our reserves as of March 31; effectively, our risk rating process is catching up with our reserves this quarter. In terms of specifics, total special mention loans rose from $288 million to $1.3 billion during the quarter, with segments experiencing notable increases where we expected to see them: CRE, retail, and hotel. Within C&I, we noted significant increases in cruise line credits, retail trade, and food services, also integrating into franchise finance, which also rose by $147 million, consistent with expectations. We view special mention ratings as transitional for loans exhibiting potential weaknesses that could lead to repayment difficulties if not addressed. Substandard accruing loans rose from $239 million to $561 million this quarter, indicating significant increases concentrated in CRE, primarily hotel and retail sectors. Within C&I, notable increases are linked to borrowers associated with airport shops and concessions, which, six months ago, appeared robust businesses. Moving on to net interest margin, it improved by 4 basis points this quarter, from 2.35% to 2.39%. The yield on interest-earning assets declined by 44 basis points due to a 47 basis point decrease in loan yields and a 33 basis point decline in yields on investment securities. Resetting the coupon and floating securities significantly contributed to these declines. Overall, the decrease in asset yields stemmed from declines in benchmark rates, including turnover occurring at lower prevailing rates. Currently, we expect the NIM to remain stable during Q3. We anticipate further declines in both deposit costs and the yields on interest-earning assets, but overall, we expect the NIM to stabilize. We do not foresee much recognition of fees from PPP forgiveness in Q3, as we expect that to begin in Q4. In terms of specific impacts on noninterest income and expenses, securities gains totaled $6.8 million this quarter, in contrast to a loss of $3.5 million in the prior quarter. During that quarter, we had an unrealized loss of $5 million on marketable equity securities impacting our profit and loss. This quarter, that segment generated a gain of $1.1 million. Other securities gains emerged from our strategy in managing and positioning the portfolio effectively. Deposit service charges saw a decline compared to the previous quarter and the same quarter last year. There was some forgiveness of charges this quarter related to COVID, as well as a decreased volume of activity in certain fee areas which we attribute to the pandemic. Employee compensation and benefits dropped by $10 million compared to the preceding quarter, influenced by seasonal payroll taxes, 401(k) contributions, and health savings account setups, both historically elevated in the first quarter. Additionally, variable compensation costs fell this quarter, reflecting lower levels of production and earnings from the pandemic. A more valid comparison is to consider the 6 months ending June 30, 2020, against the prior year, which revealed a decrease in compensation and benefits by $14.7 million, highlighting our BankUnited 2.0 expense initiatives. Noninterest expense for the quarter includes $1.5 million of costs directly linked to the pandemic. This encompasses expenditures on equipment for remote work, expenses incurred standing up our PPP program, supplies, and equipping branches. We expect to see some additional recovery forthcoming. Operating expenses should maintain relative stability during Q3 compared to Q2. With that, I’ll turn it back over to Raj for closing remarks.

Raj Singh, Chairman, President and CEO

Thank you, Leslie. The challenge with providing transparency and detailed information is that our calls tend to run long, and I apologize for that. I look forward to the day we can revert to normal, concise calls. Thank you for your attention today, and we’ll open the floor for Q&A.

Operator, Operator

Our first question comes from Stephen Scouten with Piper Sandler.

Stephen Scouten, Analyst

I'm curious, maybe first, on the expense run rate. I mean, a really impressive quarter-over-quarter change there. I know your guidance kind of previously, which, obviously, no one could be too specific, but it was just for expenses to be down year-over-year. So wondering if you could dig deeper into the salaries, migrations and what really caused that, if it was FTE reductions or more just the things you noted in the release? And then just lastly, if there was a FAS 91 impact within salaries as well.

Leslie Lunak, Chief Financial Officer

Yes. So I think the salary reduction, the most significant component of that, Stephen, is, in fact, FTE reductions year-over-year. There's also a minor element of reduced variable compensation. Regarding FAS 91, if you look at Q2 compared to Q1, yes, there were a few more FAS 91 costs deferred in Q2 due to PPP. However, year-over-year, that actually went the other way. There was significantly more FAS 91 deferrals in 2019 than in 2020 because loan growth was higher in 2019, and I apologize for not having those exact numbers readily available.

Stephen Scouten, Analyst

No, that's okay. That's really helpful. Okay. And maybe just one other question. You provided a lot of details on the migrations and the movements in the loan loss reserve, which are extremely helpful. However, generically, how would you respond to concerns that if someone looked at your reserve on a stand-alone basis—the 1.27 without the PPP and the mortgage warehouse debt on an absolute basis—may seem below peers? How can you frame that for us?

Raj Singh, Chairman, President and CEO

I think you have to consider the portfolio mix. When you compare bank A to bank B, there's often a significant difference in portfolio composition. We maintain a substantial residential portfolio along with other sizable portfolios that are not heavily impacted by this. For instance, our municipal portfolio carries very little reserve against it—around $1.5 billion. If you normalize for these elements, they explain the differences more than anything else. We've always stated our portfolio was designed with quality in mind rather than high yields. In other words, it lacks the high-risk components, which accounts for that discrepancy. Had we held a couple of billion dollars in construction loans or leveraged loans, our reserves would appear much higher.

Leslie Lunak, Chief Financial Officer

Yes, I would echo Raj’s sentiments. The reserve levels largely reflect our belief in the quality of the portfolio. I think the risk rating migration is a lagging indicator, and I believe that the risk rating distribution as of June 30 is much more reflective of the reserve level at March 31. The reserves are catching up with the current risk rating distribution.

Operator, Operator

Our next question comes from Brady Gailey with KBW.

Brady Gailey, Analyst

If you look at the BankUnited 2.0 plan, you’re clearly performing better than your expectations on the expense side. You've mentioned being at $47 million versus the initial estimate being around $40 million. How much further do you believe you can optimize expenses? It seems that the world has changed, and there may be opportunities to reduce branches or other items not anticipated when BKU first focused on 2.0.

Raj Singh, Chairman, President and CEO

Yes, Brady, we have not re-evaluated the initiatives in a major way to consider a reset or overhaul, so to speak. The last two to three months have been largely focused on reacting tactically to the challenges of the pandemic, especially surrounding everything PPP-related. However, we'll revisit our plans as customer behavior evolves and if there are opportunities to optimize our approach, whether that includes evaluating branch needs. But any significant decisions like that won't be made in the next quarter or two as they require extensive analysis and time to operationalize.

Brady Gailey, Analyst

Looking at the cost of funds and deposits, you've made great progress in reducing costs, though the cost of deposits still remains at 80 basis points which could go lower. How low do you think you can bring this down in this zero interest rate environment?

Raj Singh, Chairman, President and CEO

We’ve already shown some of that decline, as we communicated that by June 30, it was down to 65. It was 80 for the quarter, but as of a specific date, it dropped further. I believe we might bottom out in the high 50 basis points range. Last time when the Fed was at 0, we were able to exceed that comfortably. It’s difficult to predict whether we can reach the 40s or the 30s. What we’re primarily focused on is bringing in operating accounts, which will genuinely drive long-term value. We're having considerable success in this area. While PPP posed many challenges, looking back, it offered significant opportunities. That’s evident as many larger banks struggled to effectively manage that, leading to openings for us with customers who sought better experiences. Even though we were not the banks providing their PPP loans, many previous clients experienced poor treatment, giving us a chance to showcase our abilities. Our robust growth figures reflect those efforts, and we believe there’s substantial room for further growth in the pipeline.

Operator, Operator

Our next question comes from Jared Shaw with Wells Fargo.

Jared Shaw, Analyst

I just wanted to circle back on the allowance and credit. First, what percentage of the portfolio has already gone through that first 90 days? I see we were down to 4%, but is that indicative of the whole portfolio or just what we have at this moment?

Raj Singh, Chairman, President and CEO

Yes, most of the deferrals occurred within a 3-week period from late March to the first two weeks of April. As we now reach the end of July, I would estimate that a considerable majority have completed their 90-day window. Remember, discussions about re-deferrals generally begin about 2 months into the deferral period. We feel that we have addressed most of the requests for re-deferrals. What we shared with you reflects not approved deferrals. The figures indicate the requests made, and while most of them are likely to be granted, not every request will be approved. This demonstrates a much higher number than what we expect to process.

Jared Shaw, Analyst

Got it. And regarding the allowance and the provision level, looking at Slide 14, you have mentioned an 8.4% reduction in allowance relative to the economic forecast. That's distinct from what we've observed with other banks. I haven't heard others mention the VIX and S&P correlation. Regarding the baseline you used for GDP projections for 2021 from March to June, despite getting worse, was there a change in methodology from Q1 to Q2 regarding CECL?

Leslie Lunak, Chief Financial Officer

No, there was no change in methodology. I would direct you to Slide 15, which may address your question better than Slide 14, as it breaks down the details. In my previous remarks, I mentioned it is indeed a tale of three cities. The economic impacts were quite varied in the CRE portfolio compared to the C&I segment, where the forecast was particularly punitive. I can't speak to the models of other banks or their approach, but I can assure you that the model we use for our C&I portfolio, derived from Moody's, is very responsive to both the VIX and S&P 500. While other banks may not be discussing those factors, perhaps they don’t have substantial exposure in those areas. Our approach remains sound and unchanged in methodology.

Operator, Operator

Our next question comes from Steven Alexopoulos with JPMorgan.

Steven Alexopoulos, Analyst

I have to commend you on the quality of your credit-related disclosures, both in the slide deck and during the call. It's the most comprehensive I've seen in the industry, and I appreciate it. To follow up on Jared's inquiry, we're all observing Slide 15, and I'm perplexed regarding the impact of market volatility and the S&P 500 on BankUnited's credit quality in C&I. It seems to lack coherence.

Leslie Lunak, Chief Financial Officer

The correlation is based on robust analysis conducted by Moody's, connecting market performance variables such as the VIX and S&P 500 to credit performance, particularly for middle-market C&I loans. I can't fully elaborate on their extensive research, but according to their database analysis comprising millions of observations, these factors have shown a high correlation with loan performance. With our in-depth understanding of our borrowers and their conditions from the pandemic, we believe our reserves for the C&I portfolio are right where they need to be. The mathematical relationship is important, but the assessment of our portfolio quality is paramount.

Tom Cornish, Chief Operating Officer

The 1% deferral rate certainly supports that there are some pockets of resilience, and we have seen very minimal churn within that segment.

Raj Singh, Chairman, President and CEO

There’s another mechanical factor at play as well—our earlier assumptions regarding prepayments were overly conservative. Previously assuming no prepayments throughout the pandemic, we’ve adjusted based on updated data that shows actual prepayment rates have increased significantly, bringing about more realism to our reserve levels.

Leslie Lunak, Chief Financial Officer

We spent substantial time during June reaching out to individual borrowers to gauge current performance, rather than basing it solely on older data. All these observations contributed significantly to our reserve estimates for the C&I portfolio.

Steven Alexopoulos, Analyst

If I may follow up on the BankUnited 2.0 and your progress achieving $47 million in cost reductions instead of the targeted $40 million; can you specify where you are seeing the biggest improvements? And, have you realized all potential cost savings or could there be more in future due to the 2.0 initiative?

Leslie Lunak, Chief Financial Officer

Most of the cost savings stem from compensation reductions since that represents our largest expense line. That's where we've achieved most of our savings. Real estate-related expenditures have decreased, and some technology-related investments have begun yielding operational cost reductions. There are ongoing opportunities for savings, but they will come from decisions regarding our real estate footprint, continued enhancements in technology, and vendor-related expenses. However, it will take time to see that impact on the bottom line as you can imagine.

Raj Singh, Chairman, President and CEO

I want to clarify that these adjustments are in addition to investments we’re making as part of our 2.0 strategy. The $40 million target represents a net figure; the ongoing investments in our franchise are vital for long-term viability. While we aim to combat immediate challenges, we can't neglect future growth. Our pivotal investments will pay off long-term, which is vital for sustaining our franchise. For instance, the automated underwriting system for small businesses is a prime investment. We invested significant resources to establish that platform, and, although it has faced delays, we are committed to moving ahead. The USD initiative was valuable, providing insights as we engaged in high-pressure lending, which we'll apply to our future efforts.

Tom Cornish, Chief Operating Officer

To summarize, we had a great blend of automation combined with high-touch personal outreach. Raj mentioned, the PPP process showcased both aspects very well; we effectively engaged clients and kept them informed through direct communications, leading to solid results.

Operator, Operator

Our next question comes from Ebrahim Poonawala with Bank of America.

Ebrahim Poonawala, Analyst

A follow-up, I guess. Most of my questions have been addressed. Looking into the margin outlook, Leslie, you mentioned expecting stable NIM moving into the third quarter. Listening to Tom regarding net deposit growth, seems like that will be retained allowing for some future growth. Where do you anticipate the margin to head? Can it actually expand in this environment if the yield curve stays flat, or is it best to expect margins to hold?

Leslie Lunak, Chief Financial Officer

Looking beyond Q3, there are numerous variables at play, so I’m hesitant to provide guidance. PPP forgiveness will be a key factor, along with our success in continuing to drive down deposit costs—both are crucial. Additionally, how effectively we can augment interest-earning assets will also influence margins. Given the current landscape, making projections remains highly complex, so I'm cautious in offering insights beyond the immediate quarter.

Ebrahim Poonawala, Analyst

Now if you could remind us of the remaining PPP fees you expect to accrete?

Leslie Lunak, Chief Financial Officer

Our outstanding balance of PPP-related fees awaiting recognition totals approximately $21 million as of June 30. We anticipate that activity will remain subdued in Q3, with meaningful recognition occurring in Q4 to Q1. Regarding the funding for PPP loans, yes, most of it is federally funded. As of now, we hold $651 million in PPPL borrowings on the balance sheet and plan to position these by September 30, ensuring they are fully matched funded.

Operator, Operator

Our next question comes from Brock Vandervliet with UBS.

Brock Vandervliet, Analyst

To follow up on Ebrahim’s comments, it seems you have three catalysts on the funding side: a strong deposit mix, ongoing CD repricing, and a focus on growing operating accounts. Conversely, when can we expect runoff on asset yields? It feels like that’s the important question—targeting potential asset yield pressure.

Leslie Lunak, Chief Financial Officer

Assuming everything holds steady, this will likely be the final quarter for significant repricing to occur. However, the wildcard is prepayments. If they persist, the higher-yielding assets on the balance sheet may experience pressure as well, complicating predictions on yields.

Brock Vandervliet, Analyst

Regarding expenses, you’ve seen positive results from your BKU 2.0 efforts against potential normalization of activity levels along with upward pressure on expenses. Can you provide perspective on core expenses relative to recovery activity?

Leslie Lunak, Chief Financial Officer

We haven't provided guidance beyond 2020 yet, and I'm not prepared to do so just yet. The current situation is still in flux. For Q3 and Q4, I expect the expense run rate to hold relatively steady. As we proceed further into the year, I'll be in a better position to provide more detailed insights.

Brock Vandervliet, Analyst

So just to clarify, the outlook is flat for the next couple of quarters, and thereafter, you’ll have a clearer path forward?

Leslie Lunak, Chief Financial Officer

Yes, that's correct. Once we're a bit further in, I'll be able to provide more informative guidance.

Operator, Operator

Our next question comes from Dave Bishop with D.A. Davidson.

Dave Bishop, Analyst

I have a question about the recent partnership you announced with Goldman Sachs regarding fee income. How should we interpret that? Can you provide guidance on the potential revenue opportunity?

Tom Cornish, Chief Operating Officer

It's a bit early for us to quantify that accurately. However, there are clear opportunities we see with this partnership, particularly as we previously lacked a product offering in the 401(k), 403(b), and retirement services areas. Given our large client base in corporate and non-profit sectors, this alliance can help us unlock substantial potential. But as I mentioned, we are just starting to work through the training process and determining specifics; it may be premature to put a precise target on it.

Dave Bishop, Analyst

I recall you provided granular insights about the uptick in special mention loans earlier. Could you revisit that?

Leslie Lunak, Chief Financial Officer

Absolutely. The total special mention loans aggregated increased from $288 million to $1.3 billion, up $527 million overall. Specifically, $168 million of that was in retail, and $270 million arose from the hotel sector, while around $50 million came from multifamily and the remaining came from other segments. In the C&I book, we recorded a $329 million increase, with $60 million from the cruise lines, $54 million within retail trade, food services drew $53 million, and the balance was minor exposures. The franchise portfolio increased by $147 million. So these numbers align with what we anticipated, reflecting increases concentrated among sectors with known pressures.

Dave Bishop, Analyst

Regarding cruise lines, I understand they haven't sought deferrals yet, correct?

Leslie Lunak, Chief Financial Officer

Correct. Our perspective is that cruise lines are relatively well-positioned as they have been effective in raising capital in the markets. However, we believe it's critical to acknowledge the elevated risk profile of that industry. Hence, we felt it necessary to move those credits into special mention, even when we believe they can continue servicing their debts.

Dave Bishop, Analyst

Lastly, can you share insights on the current outlook concerning your energy exposure via operating leases?

Leslie Lunak, Chief Financial Officer

As we've noted previously, oil prices have shown some recovery since last quarter, but remain volatile. Regarding railcar loads, we are observing a decline. Moving forward, we believe that as these assets are re-leased, they'll be subject to lower rates. Thus, expect lease rental income to trend downward for the foreseeable future. It remains challenging to predict the long-term trajectory considering the long-lived nature of these assets, which have historically been resilient to cycles.

Operator, Operator

Our next question comes from Steven Duong with RBC Capital Markets.

Steven Duong, Analyst

I apologize if this has already been covered. I joined late. Could you summarize what you are seeing regarding overall business activity in both Florida and New York, specifically from reopening through mid-June versus the spike of cases seen in Florida?

Raj Singh, Chairman, President and CEO

Sure, Tom, you can take this.

Tom Cornish, Chief Operating Officer

In Florida, while case counts are high, there’s been no significant halt to commercial activity. Essential businesses are operating and fulfilling supply chains. Overall, the commercial market is strong, businesses are open, and sectors such as manufacturing and food supply are actively shipping goods. Franchise restaurants with drive-thru capabilities and delivery models are thriving. In the CRE market, occupancy remains robust, particularly across industrial sectors, with high demand for warehouse space driven by e-commerce. We’ve seen positive business activity across various segments.

Raj Singh, Chairman, President and CEO

As for New York, the opening has been more cautious due to the initial impact of the virus. However, construction firms, classified as essential, are progressing with projects. The food distribution sector remains active as well, allowing us to observe a trend where businesses are adapting and operating competently within their markets. CRE and multifamily rental activity indicate acceptable collections. While businesses respond individually, overall trends tend to signal resilience.

Steven Duong, Analyst

If the recent spike in cases had not occurred, would you expect business activity to be significantly stronger?

Tom Cornish, Chief Operating Officer

It's hard to quantify the exact impact of that spike on consumer confidence; things are complex. People may be more hesitant to travel if public health metrics weren't an issue, influencing hospitality and related sectors.

Leslie Lunak, Chief Financial Officer

What I can share is anecdotal. We’re in constant communication with clients. Among CFOs in Florida I've interacted with, there's a positive sentiment. They're operating without the overwhelming fear of failure; rather, they focus on how to navigate these challenges. In summary, there is no talk of impending failures or closures, reinforcing the notion of steady operational feedback.

Raj Singh, Chairman, President and CEO

Tracking healthcare data closely shows a leveling off recently, which indicates potential stability. While we cannot overlook the increasing case counts, the perceived business sentiment persists without individuals expecting drastic revert to pre-lockdown patterns.

Steven Duong, Analyst

To clarify, if the economic recovery were to stall through next year, would that prompt a reevaluation of your reserves?

Leslie Lunak, Chief Financial Officer

Certainly. If the economic outlook showed no signs of recovery and continued economic strain, this would lead to reevaluation—this applies to all banks. Current reserves are predicated on a recovery path. Should conditions diverge from this forecast, we would need to reassess reserves across the board.

Operator, Operator

Our next question comes from Chris Marinac with Janney Montgomery.

Chris Marinac, Analyst

To be brief, while there’s been emphasis on Slide 15, should we not also consider Slide 10, particularly given your robust capital position, which serves as a cushion? As it relates, how do you evaluate your capital strength?

Leslie Lunak, Chief Financial Officer

Absolutely, Slide 10 indeed illustrates that our reserves are sitting at 60% relative to the 2020 DFAST severely adverse losses. Comparing this to several regional banks indicates that we are well-positioned even under stress scenarios. Our capital ratios remain comfortably above the well-capitalized minimums, highlighting the significant cushion available to handle potential challenges moving forward.

Operator, Operator

I'm not showing any further questions at this time. I would now like to turn the call back over to Raj Singh for any further remarks.

Raj Singh, Chairman, President and CEO

Thank you all for your time. I apologize for the lengthy call, but I appreciate your engagement. We look forward to returning to normal shorter formats in the future. Thank you, and we'll see you in three months.

Operator, Operator

Thank you. Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.