Earnings Call Transcript - FBK Q2 2022

Operator, Operator

Good morning everyone and welcome to FB Financial Corporation’s second quarter 2022 earnings conference call. Hosting the call today from FB Financial is Chris Holmes, President and Chief Executive Officer. He is joined by Michael Mettee, Chief Financial Officer. Please note FB Financial’s earnings release, supplemental financial information, and this morning’s presentation are available on the Investor Relations page of the company’s website at www.firstbankonline.com and on the Securities and Exchange Commission’s website at www.sec.gov. Today’s call is being recorded and will be available for replay on FB Financial’s website approximately an hour after the conclusion of the call. At this time, all participants are in a listen-only mode. The call will open for questions after the presentation. With that, I would like to turn the call over to Robert Hoehn, Director of Corporate Finance.

Robert Hoehn, Director of Corporate Finance

Thanks Jamie. During this presentation, FB Financial may make comments which constitute forward-looking statements under the federal securities laws. All forward-looking statements are subject to risks and uncertainties and other factors that may cause actual results and performance or achievements of FB Financial to differ materially from any results expressed or implied by such forward-looking statements. Many of such factors are beyond FB Financial’s ability to control or predict and listeners are cautioned not to put undue reliance on such forward-looking statements. A more detailed description of these and other risks is contained in FB Financial’s periodic and current reports filed with the SEC, including FB Financial’s most recent Form 10-K. Except as required by law, FB Financial disclaims any obligation to update or revise any forward-looking statements contained in this presentation whether as a result of new information, future events or otherwise. In addition, these remarks may include certain non-GAAP financial measures as defined by SEC Regulation G. A presentation of the most directly comparable GAAP financial measures and a reconciliation of the non-GAAP measures to comparable GAAP measures is available in FB Financial’s earnings release, supplemental financial information, and this morning’s presentation, which are available on the Investor Relations page of the company’s website at www.firstbankonline.com and on the SEC’s website at www.sec.gov. I would say we have heard that the presentation up the Chorus Call app is the prior quarter’s presentation. The current presentation is available on EDGAR as well as our Investor Relations website. At this point, I’d now like to turn the presentation over to Chris Holmes, FB Financial’s President and CEO.

Chris Holmes, President and CEO

All right, thank you Robert. Good morning everybody. Thank you for joining us this morning. As always, we do appreciate your interest in FB Financial. For the quarter, we reported EPS of $0.41, an ROAA of 0.62%, and return on average tangible common equity of 7.1%. Adjusted for $12.5 million of mortgage restructuring charges and $2 million of negative mark-to-market adjustment on our commercial loan portfolio, we delivered adjusted EPS of $0.64 a share, adjusted ROAA of 0.975, and adjusted return on average tangible common equity of 11.0%. Those returns are a little below our standard, but with some good reason, and the quarter signaled some momentum that has us cautiously optimistic. We’ve grown our tangible book value per share, an important measure for us, excluding the impact of AOCI at a compound annual growth rate of 15.2% since our IPO in 2016. The bank had a very strong quarter of balance sheet and core profitability growth while mortgage had a challenging quarter as they continue to adjust for expected future market conditions. A few items that I want to highlight for the quarter: at $619 million or 31% annualized, loan growth was historically strong. With our markets and relationship managers, asset generation is not a problem. In the last 12 months, we’ve grown loans by $1.4 billion or 20% while not loosening our underwriting standards or expanding our credit box. In fact, in the second quarter, we became more selective in our credit process. In the second quarter alone, we estimate that we passed on well over $400 million in construction loan opportunities, and those were projects that we viewed as responsible credit opportunities that generally met our underwriting standards, but we passed as we managed our construction concentration down in the current economic environment. We also continued to see good activity in our non-interest bearing deposits. Excluding our mortgage escrow-related deposits, we grew 16% linked quarter annualized. Year-over-year excluding mortgage escrow deposits, we’ve grown our non-interest bearing deposits by 19%. Growing non-interest bearing operating account relationships is a strong focus for us, and our relationship managers continue to execute well on that goal. While we saw another good quarter of non-interest bearing growth, we saw pressure on our interest-bearing deposits, which declined by $565 million in the quarter. Of that $565 million, we estimate that just over $200 million of that was in seasonal public funds declines that should come back into the bank as part of the annual business cycle. We had an additional $325 million in larger balances move for higher rates that we chose not to match, and $120 million of that was also public funds relationships. We have another $400 million in higher rate public funds that we expect to exit during the second half of the year since we don’t intend to renew at the current terms. We went into 2022 with a goal of growing non-interest bearing deposits and holding our cost of deposits down, understanding this would cause our total deposit balances to move lower. We’ve executed on those goals with 82% of loans held for investment to deposits at the end of the second quarter, and we’ve right-sized the balance sheet while improving the composition of our deposit portfolio. As deposit balances have moved lower and assets, particularly loans, have grown faster than we expected, we will need to raise deposits in order to fund loan growth; but as we’ve historically done, we’ll increase our customer relationship deposit balances and have little reliance on wholesale funding and select use of public funds relationships. Our asset quality remains strong as our NPAs to assets and NPLs to loans HFI remained effectively flat at 46 basis points and 51 basis points respectively. Despite the lack of issues that we see in our portfolio, we do remain cautious in our outlook of future economic conditions. As a result, we maintained our 1.46% allowance for credit losses to loans held for investment. Paired with our loan growth, this resulted in a provision expense of $12.3 million for the quarter, which compares with a release of $4.2 million in the prior quarter. That difference of $16.5 million between the two quarters accounted for a delta of $0.26 in earnings per share this quarter. We also further reduced our commercial loans held for sale portfolio this quarter. Our exposure is down to four relationships and $37.8 million. Each of the remaining relationships are sponsor-backed healthcare companies. Three of those four relationships are performing well while one has been written down to 10% of par and has only $1.3 million of credit exposure remaining. We had a negative mark-to-market of $2 million in the quarter with that one non-performer I just mentioned accounting for a $3.6 million loss and the remainder of the portfolio delivering a $1.6 million gain, for the net of $2 million for the quarter. As we’re close to being completely out of this portfolio and we’ve provided updates on it each quarter, it’s important to note that since the close of the Franklin merger, we’ve realized gains of $12.2 million above our initial mark-to-market. Outside of the large provision expense and the mark-to-market on the commercial loans held for sale portfolio, profitability for the banking segment this quarter was exceptional. We saw our year-over-year growth in adjusted banking segment PTPP of 36.1%. That growth has been driven by strong loan growth and our margin benefiting from our asset sensitivity. We see those underlying trends largely continuing over the coming quarters, which should deliver continued strong loan growth and core profitability for our banking segment. Mortgage continues to face a difficult environment and delivered an adjusted operating loss of $2.7 million during the second quarter. We’ve materially completed the wind-down of our direct-to-consumer channel and made initial structure changes to our retail channel; however, with the market conditions that we anticipate over the foreseeable future, our remaining retail channel will need to continue to make adjustments over the coming months. Lastly, we were more active in our share repurchase this quarter than we have been historically. With our stock trading at what we believe were attractive valuations, we repurchased $26 million during the quarter. We were glad to retire those shares when we did, but with loan growth that we are experiencing and the economic uncertainty of the coming quarters, we’re not likely to be active in our repurchase program in the near term. As we look to the second half of the year, we anticipate loan growth slowing from the extreme levels that we’ve seen in the first half of the year to a more reasonable high single-digit, low double-digit range over the last two quarters of the year. Our local economies continue to be very strong and we see continued demand from our customers, but we intend to be disciplined on pricing given inflation and the general economic headwinds anticipated in the near term. We expect mortgage originations to decline from the already low current levels and we’re further reducing the size of our mortgage division to reflect the new market realities. We don’t expect a positive net income contribution from mortgage in the second half of the year. Strategically, we continue to focus on bringing in talent that’s been disrupted by the recent consolidation across our footprint. We’ve been able to upgrade our risk and compliance and finance and accounting teams with numerous associates that have held leadership positions at larger public banks across the southeast that have been recently acquired or are going through the process of being acquired. Michael and I continue to be impressed with the quality of resumes coming across our desks and we continue to put people in place that will allow us to double or even triple the size of the company. We also continue to have positive conversations with relationship managers across our footprint that are evaluating new homes. We’ve hired 32 revenue producers through the first two quarters of the year and those have been in every region across our footprint. With our younger executive team, our $12 billion asset balance sheet and strong organic growth prospects, we provide exceptional runway for relationship managers to come and spend the rest of their careers at First Bank. As an update on M&A, right now we have too many impactful internal initiatives to distract the team with broad option processes at this point, and with the pullback in the market and bank valuations, that activity has slowed anyway. We do continue to have dialogue with high-quality banks across our geography and contiguous geographies that have indicated they may be seeking a partner over the coming months or years. We don’t control that timing but we do have active conversations, and anything we’re considering at this point would be with banks we know well in geographies that we know well. Finally, our innovations group continues to have discussions with fintech and other technology companies. As customers, we look for vendors that can provide standard technology benefits of improved back-office efficiencies while making sure we’re up to date with technology for our customer experience. As investors, we focus on areas where we have deep niche knowledge and can provide value in a partnership above and beyond what other investors would be able to provide, such as mortgage and manufactured housing. We’re also interested in deposit gathering strategies that can supplement our traditional local community bank customer base. With that, I’ll now turn it over to Michael to discuss our financial results in some more detail.

Michael Mettee, Chief Financial Officer

Thank you Chris and good morning everyone. I’ll speak first to this quarter’s results in our banking segment. Our baseline run rate pre-tax pre-provision income for the banking segment was $53.9 million in the second quarter. Pointing to the segment core efficiency ratio reconciliations, which are on Page 19 of the slide deck and Page 19 of the financial supplement, we had $102.9 million in segment tax-equivalent net interest income this quarter. Along with that $102.9 million in net interest income, we had $12.8 million in core banking segment non-interest income. Finally, we had $59.3 million in banking segment non-interest expense. This quarter, due to our lower level of taxable income, we had a geography shift of $1.4 million as tax credits were moved from a reduction in our tax expense to instead be a reduction in non-interest expense. We also had a true-up that resulted in a $1.1 million reduction in reported non-interest expense this quarter. Adjusting for those shifts, core banking segment non-interest expense would have been $61.8 million. Together, that comes to our $53.9 million in run rate segment PTPP, which has grown 30.5% over the comparable $41.3 million that we delivered in the second quarter of 2021. Moving onto our net interest margin with summary detail on Page 5 of the slide deck, our net interest margin of 3.52% showed significant improvement from the 3.04% that we reported in the first quarter. Part of that improvement was due to our accretion in non-accrual collection interest returning to a de minimis impact of positive 2 basis points in the quarter compared to negative 7 basis points in the first quarter. Another driver was our balance sheet mix as declining deposit balances and strong loan volume led interest-bearing cash to be a smaller percentage of our balance sheet. We estimate that excess liquidity had only a 14 basis point negative impact on our margin in the second quarter compared to 29 basis points in the first quarter. The remaining 20 or so basis points of expansion was due to assets re-pricing faster than our liabilities as our cost of total deposits increased by only 5 basis points while our yield on loans, excluding non-accrual and purchase accounting, increased by 25 basis points. Our securities portfolio increased by 12 basis points and our interest-bearing cash increased by 42 basis points. Looking forward for our margin, we had a run rate margin excluding the impact of liquidity for the month of June in the 3.7% range. We have only $239 million of our approximately $4 billion in variable rate loans above their floors as of June 30, and that $239 million should be roughly cut in half after the next rate hike later this month. We get a pretty sizeable bump in the yield on our variable rate loans on the day of a rate hike and then get a lingering benefit as loans hit their various contractual re-pricing dates. As an example, for the last 75 basis point increase, we saw roughly a 30 basis point increase immediately, and from June 16 to July 7, we saw another roughly 20 basis point increase in yields on our variable rate loans. We’ve also intentionally kept our securities portfolio smaller as a percentage of our overall balance sheet and have kept our duration fairly short. We have around $200 million of cash flows coming off the portfolio and available for reinvestment annually. Offsetting some of that sensitivity going forward will be higher deposit costs. In the month of June, we had a cost of interest-bearing deposits of 41 basis points compared to 33 basis points for the quarter, and we’ve done a good job so far of keeping our beta low; however, we expect costs to accelerate over the second half of the year as competition for deposits increases. For banking segment non-interest income, with the Durbin cap on interchange beginning to impact us as of July 1, we expect our banking non-interest income to be in the $10 million to $11 million range from quarter to quarter over the foreseeable future. As I mentioned earlier, we view our run rate core banking segment non-interest expenses being $61.8 million versus a reported $59.3 million due to the $1.1 million of true-up and $1.4 million of state tax credits that were shifted above the line and reduced non-interest expense this quarter. We expect continued growth in our banking segment non-interest expenses. As Chris mentioned, we have tremendous opportunity to add talent in both customer-facing and back-office roles, and we are continuing to build the infrastructure that will allow us to capitalize on these opportunities in front of us and achieve strong organic growth. Those opportunities that have us planning to add approximately $2 million to $2.5 million in expense in each of the next two quarters. In addition to expected growth from the $61.8 million over the remainder of the year, we also expect our segment non-interest expense to be elevated in either the third or fourth quarter as we create enough taxable income to move the state tax credit back to the tax line. Once we hit that threshold, we would reverse the $1.4 million benefit we saw in non-interest expense this quarter. As you would expect, that $1.4 million in movement of the tax credit was also the culprit for our higher tax rate this quarter. For the year, we expect our effective tax rate to be in the 22% to 23% area. When the tax credit reverses out of non-interest expense and makes that line item higher, it will reduce our tax rate below normalized levels in the same quarter. Moving to mortgage, the environment continues to be exceptionally difficult as retail channel lock volumes were down 18% in the second quarter compared to the first quarter and are expected to be down an additional 20% to 25% in the third quarter compared to the second quarter. We have made structural changes to our remaining mortgage operations to account for lower volumes, but with the continued declines, we will need to make further changes to reposition ourselves. We do not expect a positive pre-tax contribution from mortgage in the second half of the year. Moving to our allowance for credit losses, we saw our ACL to loans decline by 14 basis points this quarter after sizeable releases previously. Economic forecasts for the second quarter did not move materially from those that we utilized in the first quarter; however, they did get more negative in the July release and our optimism about our local economies is being tempered by uncertainty due to the inflation that we are experiencing and the general national narrative that we will soon enter into a recession, if we’re not already in one. If conditions do not change, we would anticipate maintaining a similar level of ACL to loans held for investment over the near term. I’ll close my section by speaking about our manufactured housing portfolio. For those that are unfamiliar with our manufactured housing portfolio, we acquired that business line with our Clayton Banks merger in 2017. If you recall, Clayton Bank & Trust, which was named for its owner, Jim Clayton, was considered by many to be the father of manufactured housing and the founder of Clayton Homes, which was acquired by Berkshire Hathaway for $1.7 billion in 2003. That background to say our manufacturing housing team has a long history in the industry and learned the business from the best. Today, our MH business has three revenue streams and at quarter end, it had roughly $520 million in total loans or 6% of the overall portfolio. The first line is our communities portfolio, which has $265 million of the $520 million in loans. The communities business is a strong portfolio of sophisticated operators who sometimes we refer to as multi-family investors, but with a horizontal apartment design. These are loans with significant cash equity positions, long-term seasoned operators who have been and continue to be the beneficiaries of an upward trend in affordable housing across the country. The second piece of our MH business is our portfolio of loans to the owners of the manufactured homes themselves, which we call our MH retail portfolio. We have approximately $245 million in MH retail, or just less than 3% of our total loans. Typically these are classified as chattel loans, and the majority of those balances sit in our consumer and other category. The average FICO for these portfolios is 663 and the average note size is about $50,000, but the size of new originations has been increasing as manufactured homes assume the same material cost increases as site-built homes. As you might expect, past dues and charge-offs are higher in this segment than the rest of our portfolio with delinquencies ranging anywhere from 4% to 8% in a given month. In a normal credit environment, we’re accustomed to seeing annual charge-offs in the 50 basis point area. In bad markets, that can move to around 1%; however, during the pandemic we put a qualitative reserve of 5% on this portfolio, so we feel well protected, and with yields in excess of 8%, this is a very profitable portfolio for us and we are excited for it to grow. Our third revenue stream for MH is our servicing book, where we service the retail loan portfolios of some of our MH community customers. This is strictly a fee-based business - no balance sheet risk, no credit risk, just servicing portfolios. With that, I will turn the call back over to Chris.

Chris Holmes, President and CEO

All right, thanks Michael for that color. We’re pleased with our results for the quarter and particularly proud of the team for the loan growth, and that will conclude our prepared remarks. Operator, at this point we’d like to take questions.

Operator, Operator

Our first question today comes from Matt Olney from Stephens. Please go ahead with your question.

Matt Olney, Analyst

Hey, good morning guys.

Chris Holmes, President and CEO

Good morning Matt.

Michael Mettee, Chief Financial Officer

Hey Matt.

Matt Olney, Analyst

I want to ask more about the construction portfolio - I think it’s now around 18% of the loan mix, which would put the bank at the higher end of the range in terms of just the mix. I think you also said you passed on quite a few construction loans this quarter, so just trying to appreciate if you’re trying to manage this down from the 18% or trying to prevent this from moving higher, and then I guess within that segment, would love to hear any commentary you have about which construction segment you’re keeping an eye on in this environment. Thanks.

Chris Holmes, President and CEO

Yes Matt, good morning. It’s Chris, I’ll start. Regarding the overall concentration, we are attentive to the guideline of 100% risk-based capital, and currently, we exceed that. We anticipated this, as many construction loans are made without immediate draws, leading us to project future balances. Completion timelines can be uncertain until we receive a certificate of occupancy, which signifies the end of construction, necessitating constant monitoring. We've been examining this for several quarters, and our available undrawn commitments have decreased over the last few quarters. We're closely tracking what contributes to this situation. Managing concentration is challenging; despite recognizing good projects in our geography, we have to limit concentration due to growth and migration trends. Regarding what we are particularly monitoring, the office sector is my primary focus. The impact of COVID on office spaces remains uncertain. Recently, there was a national announcement where Amazon paused construction on six office buildings while reevaluating their designs for the new work-from-home environment. This is something we are observing closely. Overall, the other segments have been performing well for us, with promising projects across various areas. Do you have any additional questions? Does this provide clarity?

Matt Olney, Analyst

Yes, that’s great, Chris. I appreciate that. Good color. Then I guess switching gears, I also want to ask more about deposit balances. I think you mentioned part of that deposit balance contraction in 2Q, there were some seasonal pressures there; but I guess beyond seasonal pressures, would love to hear more about what you’re seeing with deposit balances. It sounds like we should anticipate additional public funds coming down again in the third quarter - I think you mentioned that. Would love to get your take on expectations for total deposit balances in the back half of the year, if those should contract incrementally or do you expect those to turn positive.

Chris Holmes, President and CEO

Yes, certainly. There have been numerous public funds available recently, and they have been quite inexpensive for the last couple of years as various government entities, including municipalities and states, have received substantial funding from the federal government. This influx has led to these deposits appearing on bank balance sheets at a lower cost, so they have remained there. At times, banks faced losses after collateralizing these deposits. We chose to keep them on our balance sheet. You may have noticed the difference in our margin from last quarter to this quarter, and we anticipated that when interest rates increased, we wouldn't be retaining many of these deposits as we were not particularly interested in doing so. Additionally, we acquired several larger public fund relationships that turned out to be unprofitable, which we planned to let go of when the right opportunity arose, so we have been in the process of refining that. I also mentioned during my remarks that our deposit composition has improved, which contributes to this situation. We still have some funds on our balance sheet, approximately $300 million to $400 million, which we expect will likely leave, again due to interest rates. However, historically, we have relied very little on wholesale funds and when we have public funds, they are generally part of operational relationships at reasonable pricing, so there’s some restructuring happening in that regard. As I pointed out, this is also a favorable time regarding our loan to deposit ratio, but I also noted that slower loan growth is anticipated. Fortunately for us, even a slower growth rate means around 10% to 12%, which will enable us to continue to adjust and re-evaluate our deposit pricing.

Matt Olney, Analyst

Chris, that’s helpful, and I guess another part of that would be just the overnight or liquidity position has come down a little bit over the last few quarters. Would love to hear more commentary about how you expect to fund loan growth the back half of the year, whether it’s deposit growth or just liquidity, and then longer term, where do you see that overnight liquidity position going? Thanks.

Michael Mettee, Chief Financial Officer

Good morning, Matt. This is Michael. Yes, we observed a significant decrease in excess liquidity due to the funding of loan growth, amounting to $619 million, along with the deposit runoff that Chris mentioned. We anticipate further pressure on liquidity, and while Chris pointed out some public funds will be leaving, we expect a normalization in relation to the past few years. We’ve been maintaining excess liquidity for about two to three years, and we are returning to levels we would have anticipated around 2019. We will be focusing on deposit generation, targeting a growth rate of 10% to 12%. We plan to fund loan growth primarily through relationship deposits. Our deposit costs have been relatively low, but I expect them to rise somewhat to align with funding needs. We've strategically allowed some of these deposits to decrease in order to keep our costs down and utilize excess liquidity effectively. In the latter half of the year, we aim to align more closely with interest rate increases, not only to maintain our current interest-bearing deposits but also to grow them.

Chris Holmes, President and CEO

I’ll add one thing to that, Matt. Our traditional public funds that have been on the balance sheet for a long time typically reach their lowest point in the second quarter and then start to recover in the third and fourth quarters. Therefore, we anticipate that these funds will see some growth in the third quarter as well. We believe that when we introduce a premium deposit offering, our customers and relationship managers respond positively.

Matt Olney, Analyst

Okay guys, thanks for the commentary. Appreciate it.

Chris Holmes, President and CEO

Thanks Matt.

Operator, Operator

Our next question comes from Brett Rabatin from Hovde Group. Please go ahead with your question.

Brett Rabatin, Analyst

Hey guys, good morning.

Chris Holmes, President and CEO

Good morning Brett.

Brett Rabatin, Analyst

Wanted to first just talk about the loan growth, the $620 million - obviously extremely impressive. Wanted to hear any color you could give on how much of that was new versus existing clients, and then how much of that would have been fixed versus floating production?

Chris Holmes, President and CEO

Yes, those are good questions. A significant majority of that would come from existing clients, so I’m not certain of the exact percentage of existing versus new, but a large portion is from relationships with existing clients. The breakdown between fixed and variable is nearly equal, right at 50/50. Our loan portfolio is at 50/50, and what was added this quarter was also approximately 50/50.

Brett Rabatin, Analyst

Okay, and just given, Chris, that a lot of that production was existing customers, I’m curious to hear your thoughts on the perception or ability to possibly grow through a recession. There’s been some talk with that on larger banks about using a recession as an opportunity to move market share, and continue to grow through a recession. I think Michael mentioned are we in a recession or not. Assuming we are in a recession next year, what happens to that high single digit, low double digit number? How would you change, if anything, how you’re doing loan underwriting?

Chris Holmes, President and CEO

If anything, our loan underwriting has already become a bit more stringent. I want to clarify that we're not retreating; we're still open for business and actively engaging with customers. However, we are paying attention to the economic climate. It's important to take care of our customers and support their growth opportunities, which is a priority for us. This focus on customer care also makes us more attentive to this aspect of our business. We believe we can continue to grow, but simultaneously, we need to ensure that we are growing deposits alongside loans. We want to avoid becoming over-leveraged, especially when our local economies are performing well. We need to remain aware of the broader national and international economic picture. From a business perspective, we're not feeling any pressure; our customers are optimistic, and our credit quality, especially in our commercial sector, remains strong. Therefore, we are aiming for balanced growth, maintaining healthy capital levels, and ensuring we support our customers' growth in this environment. These are our current priorities.

Michael Mettee, Chief Financial Officer

Yes, Brett. Loan growth can occur even during a recession or throughout the economic cycle. It's important to note that Chris mentioned we’ve added 32 revenue producers and expanded into central Alabama last year, which has been successful. Our team in north Alabama is performing well, and our Memphis team, which joined us in the last one and a half to two years, has significant market share opportunities. Additionally, the disruptions we discussed regarding bank acquisitions and mergers in our area present us with further chances to grow, even if a recession occurs.

Brett Rabatin, Analyst

Okay, that’s helpful. One last question, if I could. The only information I've managed to gather geographically is that in the Carolinas, there are some lower-end manufacturing customers, like those in furniture manufacturing, whose orders have recently dropped significantly. Have you noticed any signs of a slowdown in any of your markets at this point?

Michael Mettee, Chief Financial Officer

Brett, I think our focus has been on the consumer, as we haven't observed significant issues in commercial or small business sectors. Our consumers remain healthy, with checking account balances still strong compared to pre-pandemic levels. However, we are monitoring mortgage delinquencies that are rising as forbearance periods end and with the conclusion of stimulus checks. It's important for us to keep an eye on consumer spending patterns and their loan payments. This area is where we have some concerns, but we have not detected a widespread economic slowdown, and as Chris mentioned, feedback from most of our commercial and small business clients has been quite positive.

Chris Holmes, President and CEO

Yes, I agree with all of that regarding our portfolio. In discussions with customers, we have observed that in some of our markets, there are now actual for sale signs in the residential market, which is noteworthy because properties were selling so quickly before that the signs didn't even make it to the yard. The increase in for sale signs shouldn't be interpreted as a sign of distress but rather as a return to normalcy. Some high-end builders have indicated that while the market has slowed, it is returning to a more typical state, and we've heard similar sentiments from others in the high-end segment.

Brett Rabatin, Analyst

Okay, great. Appreciate all the color.

Chris Holmes, President and CEO

Sure.

Operator, Operator

Our next question comes from Jennifer Demba from Truist Securities. Please go ahead with your question.

Jennifer Demba, Analyst

Thank you, good morning. Just curious about provision and what your outlook is over the next couple of quarters. I know credit quality has stayed really, really healthy, but do you have any thoughts about reserve build going forward?

Michael Mettee, Chief Financial Officer

Sure. Hi Jennifer, good morning, it’s Michael. For the allowance for credit losses this quarter and looking ahead, I mentioned that we expect the allowance to hold steady as loan growth continues. I don’t anticipate any releases. The economy and outlook have changed rapidly, particularly comparing the second quarter to the first quarter. On the quantitative side, there wasn’t a significant change in our Moody’s scenarios. We did observe a slowing GDP growth, so we maintained the same scenario in our model. However, due to loan growth, we saw an increase, and on the qualitative side, we made some adjustments by removing our troubled industries from COVID, which lowered that number. We also incorporated a stagflation outlook into the quantitative portion. As you can see in the presentation, slower GDP growth is expected to recover in the later years, specifically ’23 and ’24, along with some elevated unemployment in ’23. Nevertheless, commercial real estate remains stable, and I expect this consistency to continue over the next few quarters.

Chris Holmes, President and CEO

I don’t believe we expect our ACL percentage to change significantly, and we have seen provisioning in line with loan growth. Michael and the team have a better understanding of the CECL inputs than I do, but it seems we will follow the model. However, I am cautious about releasing any provisions right now, especially until we can assess the situation described as a hurricane that might be approaching. This could be a dated perspective, but until we gain more clarity, we will proceed cautiously, particularly regarding qualitative measures.

Jennifer Demba, Analyst

With less loan growth in the second half than you experienced in the second quarter, it follows that you’d probably see a lesser amount of provisioning than you did in the second quarter in the third and fourth quarters, assuming the outlook on the economic side doesn’t change materially?

Chris Holmes, President and CEO

Yes, I think that’s fair, Jennifer. I think you’re right on.

Jennifer Demba, Analyst

Okay. Second question is regarding the mortgage operation. You said you’re not expecting profitability in the second half of the year. Can you just talk about the overall strategy? I know you guys are still making changes on the retail side, but can you just talk about the strategy with mortgage over the long term and when you think it could return to profitability?

Michael Mettee, Chief Financial Officer

Yes, so mortgage, retail mortgage in particular, we feel is very important to the core strength of the community bank being well-rounded, so we’re interested in continuing to grow the business; but then within our branch footprint, maybe right around the outsides of that as we’ve traditionally done, we’ve had a little bit broader mortgage footprint than the bank footprint, and so very likely that there are a lot of revenue producers that are available coming through the next six to 12 months as we see some consolidation or wind-down of some other mortgage companies, so we’ll be very opportunistic in picking up loan officers that can generate revenue. At the same time, we realize that we need to create scale and we’ve been working through that, either via technology, Chris mentioned innovations, but just overall process overhaul. There are a lot of headwinds in the mortgage industry right now - we’re not immune to those higher rates. Chris mentioned home prices broadly normalizing is a good thing, but affordability is still significantly higher than where it was, or significantly more challenging than where it was this time last year, so. We don’t have a direct return to profitability number, but we do see further declines the rest of this year. We’d expect first quarter next year to be challenging as well from a seasonality perspective and have the ship righted and back on our feet.

Chris Holmes, President and CEO

Yes, and I think it’s important - when you have revenues that fall as rapidly as they have in mortgage, and if you look at the projections on mortgage originations expected to be less next year than they were this year, that requires some re-evaluation, I think Mike used the word structurally. We’ve already obviously done that with the wind-down of our direct-to-consumer where we got out of the business, and same we’ve got to really make sure that on the retail side structurally that it is where it returns to contribution in any market environment, so a little bit more adjustment to go there in the third and fourth.

Jennifer Demba, Analyst

Thanks so much.

Chris Holmes, President and CEO

All right.

Operator, Operator

Our next question comes from Kevin Fitzsimmons from DA Davidson. Please go ahead with your question.

Kevin Fitzsimmons, Analyst

Hey, good morning everyone.

Chris Holmes, President and CEO

Morning Kevin.

Kevin Fitzsimmons, Analyst

Just a few remaining questions, most have been asked and answered already. The very strong loan growth this quarter, was one of the sources for that the relative absence of payoffs? We heard from another bank that there were virtually zero payoffs this quarter but they expected those to resume in the second half, and that was part of the reason for their strong loan growth moderating likely in the back half. Just wondering if that applies to you as well.

Chris Holmes, President and CEO

Yes, that's a good observation. We should have mentioned that we expected a few payoffs to come in right at the end of the quarter, but they didn't, so they carried over into the next quarter, which likely impacted the numbers a bit. Overall, it has still been an exceptional quarter, regardless of how you look at it. We anticipated those payoffs, and we'll see them in the second quarter. There was notably less payoff activity this quarter compared to the first quarter, where we experienced 21% loan growth along with normal payoff activity. We just didn't see that in the second quarter. I can't really explain why that happened, but it’s an interesting point. I wasn't aware another bank mentioned the same thing, but we did observe that.

Kevin Fitzsimmons, Analyst

Okay, that’s great. That’s good to know. I just wanted to clarify that when you were discussing the margin and where that stands, I want to make sure I heard it right, that you mentioned about 3.70 for the month of June, and is that a good starting point? If we have another Fed rate hike, I definitely understood that the ability to lag on deposit pricing has probably happened much quicker than we might have thought, and that ability is likely to be less, given what we’ve seen on deposit levels.

Michael Mettee, Chief Financial Officer

That’s right, Kevin. Yes - 3.70 is kind of where we were in June, and so definitely a good starting point. That excludes that excess liquidity number I spoke to, that’s on Slide 5. Certainly expect margin to continue to expand, just not at the velocity that it has because of deposit pricing pressure, so I think you said that well.

Kevin Fitzsimmons, Analyst

Okay, great. One last question from me. I understand that we’re at an interesting point where you aren’t seeing any significant credit problems or warning signs, but you are aware of the national trends and expectations. Have there been any changes from bank examiners or regulators regarding what they are focusing on more closely, such as specific capital levels, liquidity levels, types of lending, or concentrations that are different from a few quarters ago?

Chris Holmes, President and CEO

From a regulatory standpoint, I haven't noticed anything particularly different. Being over the $10 billion threshold has led to some changes with regulators, but I can't specifically attribute those to the current environment. Liquidity hasn't been an issue, and aside from the usual regulatory rigors associated with the loan portfolio, there haven't been any significant changes. We conduct thorough assessments of our portfolio to identify potential issues early, and it has been holding up well. We've been monitoring both our regular mortgage portfolio, especially the higher LTV products, and our manufactured housing units, which total around $245 million. Over the past two years, due to the significant financial support provided to consumers, defaults have been rare, resulting in unusually low past dues and non-accruals. This trend is particularly noticeable since we lack a large consumer segment. However, as these figures are likely to rise, which we anticipate, we will compare them to our 14-year history with the MH consumer portfolio. We noticed some past dues increased in June, but they remain within our historical limits. These are the key areas we are monitoring as we assess the economic landscape in the coming months and quarters.

Kevin Fitzsimmons, Analyst

Okay, thanks Chris.

Chris Holmes, President and CEO

All right, thanks Kevin.

Operator, Operator

Our next question comes from Catherine Mealor from KBW. Please go ahead with your question.

Catherine Mealor, Analyst

Thanks, good morning. I just want to dig into the 3.70 June margin that you talked about, and if you look at it on two components, one on loan yield, maybe where you’ve seen loan yields move through the quarter, and then also on the deposit side, where you maybe saw those for the month of June. As we think about you increasing your deposit growth in the back half of the year, what categories do you think are going to be growing the most - interest-bearing demand or CDs? Where do you think we’ll see most of that deposit growth come from balances? Thanks.

Michael Mettee, Chief Financial Officer

Hey Catherine, it’s Michael, good morning.

Catherine Mealor, Analyst

Good morning.

Michael Mettee, Chief Financial Officer

Contractual yields, if I think about kind of April to June, we saw about a 27, 28 basis point increase from around the 4.12 to 4.39 number where we ended June, so saw some pretty decent growth there versus deposits, total deposits. Our total cost of interest-bearing liabilities went from 19 to 30 on total deposits, so about an 11 basis point increase, and if you look at interest-bearing, it moved up 15 to 41 from 26, partially offset by that NIB growth, brought down the total cost of deposits, kind of helped balance that out. Does that make sense?

Catherine Mealor, Analyst

Yes.

Michael Mettee, Chief Financial Officer

And then if I think about where we would likely see growth, I would say it’s going to be in the money market side of the house.

Chris Holmes, President and CEO

It will be in money market and also in time. So far, we have observed a slight increase in time compared to money market. I anticipate that money market will rise over the next two quarters, with the next significant growth occurring in time. Our interest-bearing demand typically does not see much movement, so we expect it to develop in those two areas.

Catherine Mealor, Analyst

Great, the money market appears to be unchanged at 20 basis points. Where do you think it will go from here?

Chris Holmes, President and CEO

I’m not sure, Catherine. I was hoping you could provide some insight. We've noticed some competitive pressure, particularly with large balance customers. Some of our key competitors are offering rates around 1% on money markets to attract and maintain those balances. If we look back to last quarter, nearly all the banks, especially those based in middle Tennessee, reported over 20% loan growth. We're among the first to share results from banks in this region, and I believe that we're not going to be the only ones demonstrating strong loan growth. The competition in the money market segment is likely to intensify. I can’t predict exact movements for the quarter, but we're already observing offers around 75 to 80 basis points from various competitors, indicating that rates will likely rise from that point.

Michael Mettee, Chief Financial Officer

Yes, Catherine, in June the money market was at 27 basis points, and I've noticed it starting to increase. However, as Chris mentioned, we expect it to rise significantly more in the second half.

Catherine Mealor, Analyst

Great, thank you so much.

Chris Holmes, President and CEO

Sure.

Operator, Operator

Once again, if you would like to ask a question, please press star and then one. To withdraw your question, you may press star and two. Our next question comes from Stephen Scouten from Piper Sandler. Please go ahead with your question.

Stephen Scouten, Analyst

Hey, good morning everyone.

Michael Mettee, Chief Financial Officer

Hey Stephen.

Stephen Scouten, Analyst

I guess my first question, I just wanted to clarify a couple of things. One, the 5% qualitative reserve on the manufactured housing you mentioned at the start of COVID, that’s still in place, still in existence?

Chris Holmes, President and CEO

Yes, it is.

Stephen Scouten, Analyst

Looking at some of the expense line items, there seems to be an increase in professional fees, while advertising expenses have decreased significantly. I'm curious about what factors contributed to these changes, particularly if some of the advertising expenses were related to mortgage lead generation or if there were impacts from the shutdown on consumer direct.

Chris Holmes, President and CEO

Yes, there are a few points to clarify. First, regarding the 5% reserve on manufactured housing, Michael mentioned that this portfolio consists of two main revenue streams on the balance sheet and a third related to servicing. The balance sheet includes the manufactured home community portfolio, which is approximately $265 million to $270 million, and the manufactured home retail portfolio. The community part involves commercial loans for manufactured home communities, while the retail aspect consists of loans for manufactured home units, which total around $240 million. The 5% reserve applies to this retail segment and is factored into our provisions for credit losses calculations. On the expense front, Michael has more insight, but I can share a couple of details. Part of the increase in professional fees is due to our ongoing initiatives, which have led us to outsource some functions to partners, particularly EY, who has assisted us with accounting, auditing, and internal audit tasks. They have been a valuable partner, which has contributed to additional expenses. Additionally, you are correct that advertising expenses significantly decreased because, in our direct-to-consumer efforts, we incurred substantial costs for lead generation. Since we have exited that business, we no longer face those expenses, resulting in a notable reduction in advertising costs. Michael, do you have any further comments on this?

Michael Mettee, Chief Financial Officer

I would say that part of the advertising and marketing line item is expected to increase in the second half of the year as well. Obviously, it won’t cover the $2 million difference from quarter to quarter, but that’s part of the $2 million to $2.5 million a quarter that I mentioned regarding expense growth.

Stephen Scouten, Analyst

Got it, got it. Then maybe drilling back into loan growth a little bit more, I know your answer to Kevin’s question about slower pay downs, but I’m wondering if you could kind of frame that up in terms of what you’ve seen production-wise, like maybe first quarter to second quarter, if that what relatively flat or if that was also a big increase, and then kind of note some of the movements in the unfunded loan book, how much of the growth may have been from the unfunded book funding and where that is as a total balance today.

Chris Holmes, President and CEO

We did notice an increase in some of our funding, particularly in construction. There was a notable rise in that area. Additionally, our production remains well distributed geographically. Our central Alabama team showed impressive growth this quarter and made significant contributions. Memphis also played a key role for us. The team there is expanding in size and production, as is our northern Alabama team in Florence and Huntsville, which has been performing well. Together, these regions were among our strongest growth areas, accounting for about a third of our overall growth, despite being smaller in terms of balances and branch presence. Their impact has been substantial.

Stephen Scouten, Analyst

Got it, and how big is that total unfunded book today? I would kind of imagine a lot of that growth may have been from the legacy Franklin resi construction home builder type construction, but I’m just kind of curious what’s the breakdown there, resi versus more CRE commercial.

Chris Holmes, President and CEO

Yes, so the total unfunded for us is about $1.5 billion in terms of totals, and let’s see - about 50% of that, it’s really close, about half of that is residential and about half of that is commercial. You are correct that, particularly on the residential side, a significant portion is coming from Nashville and suburban Nashville, especially in Williamson County and Rutherford County, which gives us considerable confidence. These are the two fastest growing counties in our entire area.

Stephen Scouten, Analyst

Yes, without a doubt. Okay, that’s great. Then maybe just last thing from me, I appreciate all the color on deposits and where we could see increases there. The deposit beta this quarter looks like it was maybe only about 10% on the interest-bearing deposits given the rate moves, but it looked like the cumulative loan beta was maybe only about 20% as well. I’m just kind of curious how you’re thinking of loan betas moving forward. I know, Michael, you gave some color kind of throughout the quarter, and if I do that math, it looked like maybe 67% on the variable rate production if I break that out. I guess I’m just kind of wondering how we can think about a loan beta on the whole 50/50 fixed-floating kind of split, what you’re seeing on fixed rate loan spreads.

Michael Mettee, Chief Financial Officer

Yes Steve, that’s a great question. One of the things that we’ve experienced this first half of the year is there was a lag in competitive move-up in loan pricing, and so Chris mentioned in his part of the discussion, we expect to see higher prices on new production going forward. The fixed rate part of our portfolio in new production was relatively flat in the quarter, so I think you’d start to see as the market is now adjusting to higher rates, some of the commitments that were made 30, 60 days ago have been baked, and so the newer commitments are certainly coming on at higher rates. Competitive pressures again are still out there - you know, you’re not getting 100% beta by any means, but we are seeing a little bit more 50 and up kind of betas, is what I would expect on that going forward.

Stephen Scouten, Analyst

Okay, super. That’s very helpful. Thanks for all the color, guys, and congrats on a great quarter.

Chris Holmes, President and CEO

Thanks David.

Operator, Operator

Ladies and gentlemen, with that, we’ll be ending today’s question and answer session. I’d like to turn the floor back over to Chris Holmes for any closing comments.

Chris Holmes, President and CEO

We appreciate your interest, your questions, and your support. If anyone has further questions, we are available for telephone calls. Have a great rest of your day.

Operator, Operator

Ladies and gentlemen, with that we’ll end today’s conference call and presentation. We do thank you for joining. You may now disconnect your lines.