Earnings Call Transcript - FRME Q2 2020

Operator, Operator

Good day, everyone, and welcome to the First Merchants' Second Quarter 2020 Earnings Conference Call. This presentation contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act. Such forward-looking statements can often be identified by the use of words like believes, expects, or may, and include statements relating to First Merchants' goals, business plan, growth strategies, loan and investment portfolio, asset quality, risks and future costs and benefits. These statements are subject to significant uncertainties that may cause results to differ materially from those set forth in such statements, including changes in economic and business conditions; the ability of First Merchants to integrate recent acquisitions and attract new customers; changes in laws, regulations and requirements of the company's regulators; the cost and other effects of legal and administrative cases; changes in the creditworthiness of customers and the impairment of collectability of loans; fluctuations in market rates of interest; and other risks and factors identified in First Merchants' filings with the Securities and Exchange Commission. First Merchants undertakes no obligation to update any forward-looking statement, whether written or oral, relating to the matters discussed in this presentation or press release. In addition, the company's past results of operations do not necessarily indicate its anticipated future results. After today's presentation, there will be an opportunity to ask questions. And at this time, I'd like to turn the conference call over to Mr. Mike Rechin, President and CEO. Sir, please go ahead.

Mike Rechin, President and CEO

Thank you, Jamie. And good afternoon, everyone. Welcome to our earnings conference call and webcast for the second quarter ending June 30, 2020. Joining me today for presentation are Mark Hardwick, our Chief Financial Officer and Chief Operating Officer; John Martin, our Chief Credit Officer; and Michele Kawiecki, our Senior Vice President and Director of Finance. We released our earnings in a press release this morning at approximately 8:00 a.m. Eastern Time, and our presentation speaks the material from that release. The directions that point to the webcast are also contained at the back of the release, and my comments begin on page four, a slide titled Second Quarter 2020 Highlights. So on that page up top, First Merchants reported net income of $33 million for the quarter or earnings per share of $0.62. The earnings compare to $41.1 million during the same period in 2019, whereas the $0.62 in the second quarter earnings compare to $0.83 earned in the second quarter of 2019, producing a return on assets of 97 basis points. Considered in a related context, the earnings provide pre-tax provision ROA of 1.73% or pre-tax provision return on equity of 13.18%. Balance sheet grew, total assets grew to $13.8 billion, $3.1 billion or 28.7% over the second quarter of 2019. And as Mark will highlight later, it was a combination of our September 1, 2019, closing of Monroe Bank & Trust, organic growth through the period. And then as the sub bullet point says, total loans were helped by approximately $900 million of PPP volume in a program that's set up very well for our client base. John will be on, obviously, to talk about asset quality. But in consideration of our second quarter provision, our allowance in fair value marks totaled 1.62% of loans. Michele is going to provide additional comments as well in her remarks. I'm down in the deposit section, a meaningful part of the margin equation. I feel like we made great progress in the quarter. Deposit volume's up, as Mark is going to detail. Steady progress in cost reductions. In fact, our 47 basis point cost for the second quarter is down 50 basis points from year-end's number of 97 basis points. As you look at the detail in our deposit mix, you'll see, close review will show that our deposit structure has management anticipating additional interest rate in dollars and expense savings linked to our remaining and laddered CD volumes and maturities. Capital levels stayed very high. TCE to assets of 9.31%. And as the press release notes that without PPP loans, our TCE level is actually 9.93%. A $23.04 tangible book value per share grows 9.7% increase over the second quarter of last year and a similar compounded growth rate over time. Moving to page five. Very busy second quarter. As a provider of all elements of the CARES Act, most notably PPP, I alluded to it a moment ago. More than 5,000 applications were readily received both by our bankers and by the marketplace. I think I saw an article this week that said we produced the third most PPP loans in the entire state of Indiana of all banks. John Martin and our banker team recently negotiated with an outside partner that will be helping us through the forgiveness process, the forgiveness phase, using our own folks, along with a partner, as we continue to understand what will be the preparedness by the SBA to take the forgiveness applications. We're also a registered Main Street lender, and we're assessing the fits of that program as it evolves. The listeners might know that there are new features announced weekly for that. And we look forward to seeing if that's a good fit for any of the clients in our marketplace. On the big impacts coming up out of the resolution of the loan modifications. And so John remarks go deep into that. $1.25 billion in modifications, approximately 12% of the portfolio. When I use the term robust process in the middle bullet point, what I'm really talking about is direct client dialogue. Working with interim financials, CFO forecasts, business owner views of their needs for additional help. And as the last bullet point says, really a modest amount if none by the end of the second quarter. And I think a trickle of them that John will speak to about second requests on the back of the help that we provided through the second quarter. The balance sheet loaded with liquidity with a loan-to-deposit ratio of just under 85% and deposit growth from all sources. Liquidity of our consumer and commercial clients held at First Merchants to include some of the PPP balances. And then as Mark will highlight, some really strong cash balances that we're looking for the highest yield that we can possibly attain in this period of significant liquidity. Let me go to page six. A lot of efforts over the last five months, really throughout the bullet points here. Making sure that anyone that's doing business with us or doing business on our behalf, our employees feel safe. And so while all of the banking centers were opened by July 1, we're doing it in a way through modifications and protective barriers that are welcoming to our clients and put our bankers in a position to be the best banker that they can be. That environment would include required masks, and this is even ahead of some of the governors that have done that. But just a feeling on our part that it makes for a better environment to continue to be the advisor that our clients expect. I think we touched on at our last call some of the enhancements we made to capacity levels so that bankers that were more accustomed to using face-to-face banking and lobbies, to the extent that they couldn't, they still had mobile and online limits materially higher as well as a lot of one-on-one coaching for those folks that hadn't been digital bank users in the past to take advantage of our investments over the last several years. Towards the bottom, a bullet point they call, Return to Office. It's an HR-driven framework that we use that flexes to the environment. All parts of the country have kind of had fits and starts, and it allows us to react to our company experience specifically and the government pronouncements as they come about. We have a fully armed pandemic team that digests information and then communicates it out to the rest of the company. Bottom of the page, the community support. The efforts listed here have really served as a rallying point for our colleagues through this difficult period of time. Top bullet point, we had a commitment of $1 million in donations distributed to not-for-profits. I think Mike Stewart, our Chief Banking Officer, quarterbacked that effort. It included our regional presidents, obviously. I think we were able to get funds to over 200 frontline organizations. And so that investment, I'll call it, call it an expense, reflects itself in our second quarter marketing expense, which you might have noticed. We captioned it internally as the right thing to do. Bottom bullet point talks about an announcement we made that we're excited about. We've named our first ever Director of Corporate Social Responsibility, and it links to the middle point. But the Director of Corporate Social Responsibility is really combining a lot of efforts that had existed heretofore with a little bit more muscle on them. It's an internal leader within our company previously, the Market President of our Muncie market, which is our headquarters market. Scott McKee it is by name. He's going to lead several prior efforts as one larger, more impactful effort. With the Region Presidents, Scott's going to lead the community benefit agreement execution among all of his responsibilities. And that's the middle point on the page, a five-year $1.4 billion agreement that we announced in conjunction with the NCRC, but really with community groups throughout the larger markets within the markets that First Merchants serves. And what it references credit on here, it really is going to be directed toward low and moderate-income needs in mortgages, small business, affordable housing, and then on top of those, credit-related answers and solutions to the needs of our communities, philanthropy and banking center access. So we're excited about it. Page seven, just a snapshot that might give you some context for some of the answers or material provided by either Mark, Michele or John throughout the balance of our call today. It's a map of our franchise. Again, page seven, tried to just show you some of the progress that's been made. And prior to hearing from Mark, just a summarizing look at our marketplaces. The Midwest, in our view, is on the early end of reopening. And so you see some of the improvement in unemployment. There are no guarantees from me as to where we go from here, yet there are no notable COVID hotspots on a full country basis that exist in the Midwest or in our franchise. And so we're just working our way at it, a week at a time, trying to take advantage of this situation. And as you can see by the unemployment numbers, the workers are finding opportunities, which ought to give rise to a healthy First Merchants and a healthy Midwest, paying close attention to what the governors of those states have to say. So as we try and move forward, we're doing it in a really balanced way. And at this point, I'm going to turn it over to Mark, so we can get a little bit deeper into the results themselves.

Mark Hardwick, CFO and COO

Thanks, Mike. I feel a strong sense of pride regarding the community support you mentioned, and I'm enthusiastic about our capacity to improve the financial wellness of the various communities we serve. Turning to slide nine, total assets on line seven have risen by $1.4 billion or 21.9% annualized since the end of 2019. Our investments on line one increased by $193 million or an annualized 15%, following a robust 2019 in which investments rose by 59% compared to 2018, providing significant liquidity for the company. Loans on line two have grown by $831 million since year-end, with PPP loans making up $883 million after accounting for deferred fees and costs. Additionally, on line three, the allowance for loan losses increased by $41 million or 51% year-to-date, mainly due to economic challenges related to COVID. The composition of our $9.3 billion loan portfolio, displayed on the upper right side of slide 10, yielded 4.10% in the second quarter of 2020, down from 4.85% in the first quarter. A decrease of 83 basis points in LIBOR during the quarter was the main reason for the decline in loan yields, with PPP loans contributing approximately six basis points to this decline. On slide 11, our investment portfolio has a longer duration than our peers, providing a beneficial buffer against our variable rate loan portfolio. As of June 30, 2020, our unrealized gains amounted to $139.1 million, reflecting a $66.6 million increase since year-end. Our yields remain stable at 3.02%, with maturities in 2020 totaling $253 million at an average yield of 2.56%, and 2021 maturities at $429 million yielding 2.25%. On slide 12, total deposits rose by $1.1 billion or 22.9% annualized since the end of 2019. A portion of this increase is attributed to PPP loans remaining on deposit, which we estimate accounts for about half of the growth experienced in 2020. Our loan-to-deposit ratio is 85% and our loan to asset ratio is 67%, indicating strong liquidity levels for the bank. The deposit mix shown on slide 13 is essential for both liquidity and strength as well as low-cost funding. In the second quarter, interest expenses on deposits were at 47 basis points, down from 88 basis points in the first quarter of 2020. This 41 basis points reduction has helped counterbalance the unusual decline in loan yields this quarter. Moving through the remainder of 2020 and into 2021, we anticipate that upcoming time deposit maturities will further decrease interest expenses. We have nearly $900 million in CDs maturing this year at an average rate of 1.77%, which we expect to result in about 140 basis points of savings as these CDs mature. All regulatory capital ratios on slide 14 are well above the definitions for well-capitalized and our internal targets, ensuring that the bank maintains strong capital levels. When adjusted for 100% government-guaranteed PPP loans, our tangible common equity ratio would be 9.93%, as shown on the slide and previously mentioned by Mike. Moving to slide 15, the corporation's net interest margin, net of fair value, has declined by another 27 basis points from the first quarter to the second quarter of 2020, with PPP loans contributing six basis points to this decline. As previously discussed, our loan yields have decreased more than expected due to reductions in LIBOR rates. Our guidance estimated a decline of only 10 basis points, but the rapidly changing environment pushed the quarter to the higher end of our projection. We had aimed for the lower end last quarter based on our confidence in the aggressive deposit rate reductions our team implemented; however, it wasn't sufficient to keep pace with the quick repricing of earning assets we experienced. Moving forward, the amortization of PPP fees will be a key topic. While we don't know the speed at which the SBA will process PPP loan forgiveness, we have clients eager to proceed. We're estimating that 80% of PPP loans will be forgiven evenly over the next 12 months, though this is only an estimate. This expected acceleration in fee income should enable net interest income and margins to increase on a reported basis, although the core net interest margin, excluding fair value and PPP loans, should remain stable. Noninterest income on slide 16 reached $26.5 million for the second quarter of 2020. This reflects a decline of $3.3 million from the first quarter, with customer fees accounting for $2.5 million of this decrease. Service charges on deposits were the primary factor, dropping by $1.7 million as average customer balances rose, leading to only half of our normal NSF and OD fees for the quarter. May represented a low point for service charge income, but we noted a strong recovery in June. Wealth management fee income decreased by $384,000, largely due to tax preparation work negatively impacting other expenses. Card payment fees rose by $190,000 during the quarter. We also saw gains on the sale of mortgage loans, which increased by $311,000 for the quarter. However, hedge income decreased in the second quarter compared to the first, as loan closings, excluding PPP loans, fell below our usual rate. Noninterest expenses on slide 17 totaled $60 million in the second quarter of 2020, compared to $66.1 million in the first quarter. This decrease was driven by $2.3 million in deferred salary expenses related to PPP, a $1.1 million reduction in bonus accruals, and a $1.6 million decrease in debit card payment processing expenses due to the termination of our rewards program. We also recognized nearly $1 million in expenses during the quarter based on our COVID relief contributions. We expect noninterest expenses in the third quarter of 2020 to be around $64 million. On slide 18, we are pleased to report that our net income totaled $33 million, with earnings per share at $0.62. We are also encouraged by our pre-tax pre-provision return on assets of 1.73% and an efficiency ratio of less than 48% for the quarter. Slide 19 shows trends for EPS, dividends, and tangible book value per share, and we've added a line for the dividend payout ratio as well. We believe our dividend, which is still below a 50% payout, is appropriate in the current environment. Finally, on slide 20, our total compound annual growth rate of tangible common equity remains at 10.13%, and our dividend yield is nearly 4%. Now, Michele Kawiecki, our Senior Vice President of Finance, will address several key items related to loan loss coverage and capital strength.

Michele Kawiecki, SVP and Director of Finance

Thanks, Mark. My comments will begin on slide 22. Looking at the top right of this slide, you will see the allowance for loan loss roll forward for the quarter. We had a beginning allowance balance at the end of Q1 of $99.5 million, plus net charge-offs of just $230,000, plus the Q2 provision expense of $21.9 million. That brings the June 30 allowance for loan loss balance to $121.1 million. I would remind you that we elected to defer the adoption of CECL. So we calculated the provision using the incurred loss method, but continue to run our CECL models parallel. We believe the provision expense this quarter materially approximates what provision expense would have been under the CECL method. Moving down to line nine. The remaining fair value marks on purchased loans totaled $29.3 million. Adding those marks to the allowance balance totals $150.4 million, which is a healthy 1.62% of total loans, which Mike mentioned earlier in his remarks. Next on slide 23. This slide is intended to show you that when considering our robust capital and allowance for loan loss levels, we have nearly $500 million in reserves to cushion us through the economic downturn. So let me start by walking you through the allowance at the top of the page. The table at the top shows a roll forward of our allowance for loan loss since December 31, 2019. The first highlighted line shows our current allowance balance of $121 million with an allowance to loans total ratio of 1.30%. When excluding the PPP loans from total loans, the allowance to loans is 1.44%. As I said earlier, we did not adopt CECL, but in our 12/31/19 Form 10-K, we disclosed that the estimated CECL day one adoption impact, if we had adopted on January 1, was estimated to increase the allowance by 55% to 65%. Applying 65% to the 12/31/19 allowance for loan loss balance of $80.3 million creates a CECL day one adoption increase of $52.2 million. So a pro forma of the allowance with CECL adoption using these assumptions would have yielded an allowance of $173.3 million, which has a robust coverage ratio of 1.86% and 2.06% without PPP loans. The increase in the allowance for CECL adoption would lower capital on an after-tax basis. So in the bottom left corner, I have provided a pro forma of the total risk-based capital ratio. Our current total risk-based capital ratio is currently 14.18%. When reduced for the impact of a CECL adoption, the ratio would be reduced to 13.68%. That still leaves $316 million of excess capital above the well-capitalized level. This excess capital added to the $173 million of allowance, both shown post CECL, gives you nearly $500 million in reserves. That's enough to cover a 6% to 7% non-PPP loan charge-off ratio, depending on whether you're looking at it before or after tax. Now it's important to keep in mind that this does not consider our strong pre-tax pre-provision earnings levels that would continue to contribute to capital over the quarters to come, as well as the $29 million in fair value marks that I just mentioned on the previous slide. I hope that this gives you a clear picture of our balance sheet strength. Now I will turn it over to our Chief Credit Officer, John Martin.

John Martin, Chief Credit Officer

All right. Thanks, Michele, and good afternoon. I'll begin my comments on slide 25 with a detailed look at changes in the portfolio, provide an update on modifications, discuss the PPP loan program further, discuss some of the specific COVID-sensitive loan portfolios, cover some mortgage lending highlights, and then review first quarter asset quality. So turning to slide 25. C&I loans grew on line one by $718 million during the quarter, resulting from the origination of roughly $908 million in PPP loans, offset somewhat by a decline in line of credit utilization. Dropping down to line 10, mortgage loans grew by $19 million, while home equity loans on line 11 declined by $38 million. The active refinance market helped to maintain and grow the mortgage portfolio, while second mortgages were likely included in refinances, which caused our second mortgage balances to decline. Slide 26. This shows a diversified loan portfolio, grouped by bank call reporting, which is tied to collateral. And yet, as one would expect, concentrated in the states we are located. There have been 2,548 cumulative payment deferral modifications granted to roughly $1.124 billion with roughly 1,869 commercial modifications. At quarter end, there were no commercial second deferrals or modifications granted. And I checked yesterday, and we had less than $5 million of second commercial deferrals to date. It is difficult, if not impossible, to determine the number or the amount of second payment deferral modifications that will be requested, but I've been pleasantly surprised by the low number of requests and grants thus far. We have established processes for a second modification request to analyze and work with borrowers depending on individual circumstances. These include reviewing need and expected repayment in a COVID environment with financial analysis and financial information determining the borrower's ability to repay. Drilling into modifications further on slide 28 by NAICS or industry segments. This slide is intended to help provide a clearer picture of the modification data. Here, you can see the modifications concentrated around hotels, restaurants and food services, dental, and lessors of real estate. Hotels were not as fast to request modifications in the first quarter but grew to be the portfolio at the highest percentage modification, while lessors of real estate became the portfolio with the largest dollar modifications. All but 28 loans representing roughly $80 million were granted 90-day deferrals, while the remainder were extended for a full six months. These longer-term modifications were granted primarily to hotels. Of the 1,863 modifications mentioned earlier, roughly 1,250 or roughly 67% have returned or are in the process of returning to their regular payment schedule. Moving on to slide 28. As I mentioned, on the loan portfolio trend slide, we originated $908 million of PPP loans to roughly 5,100 borrowers. The effort utilized existing resources and systems and generated almost $27 million in deferred PPP loan fees. Because of the high demand in the first round and the streamlined process that we implemented, the initial focus for fulfillment and delivery was to our existing customers. Looking forward, the PPP forgiveness planning process is well underway, as Mike had mentioned, and we intend to use a third-party system with a blend of internal and external resources on a flex basis as necessary. Turning to slide 29. This shows the industry concentrations for our C&I portfolio. Our largest concentration is manufacturing, which aligns closely with the concentration of manufacturing in our geography. Line utilization dropped for the quarter from 47.5% to 40.8%, which reduced loans by $138 million, as I referenced on the third slide, partially offsetting the growth in PPP loans. Receipt of PPP funds, combined with reductions in working capital assets and the repayment of isolated defensive draws are potential causes for the reduction in line borrowings. Turning to slide 30. I've broken out and expanded on prior discussions of our sponsor finance business and clarified how it fits into the definition of leveraged lending on the right. Our sponsor business lends to the portfolio companies managed by private equity firms. While most all of the businesses we lend to in the sponsor finance space rely on enterprise value as a secondary source of repayment, we generally structure loans with lower leverage of senior funded debt. This means that not all of the sponsor finance business is definitionally leveraged. We also have relationships outside of the sponsor finance business which may be leveraged, including regional or middle-market businesses or leveraged shared national credits in our geographies where we are a participant. The table at the bottom of the page provides a breakout of our leveraged loans by business lines, which includes modifications. Moving to slide 31. I've included a breakout of the investment real estate portfolio by multifamily and commercial real estate. Commercial real estate includes some of the more COVID-sensitive categories, including hotel and retail, which are shown on slides 32 and 33. I've included on slide 34 mortgage and consumer for reference as well. These slides are intended to provide a deeper view into the areas where modifications have been higher or where we've seen issues. I'm happy to answer questions, but suffice it to say, we continue to monitor these portfolios closely. Then moving to slide 36. Nonperforming assets increased $34.5 million due to two names in the senior living space and one in the university logo apparel industry. All three have been experiencing some level of issue prior to the pandemic and now need either a restructure or some other form of work out. Dropping down to line four, 90-plus days delinquent increased mostly as a result of a $3.5 million relationship, which is in the process of a refinance but decided to let the payments at the end of the quarter go past due. We believe that we are well secured and in the process of collection, and this relationship should be resolved by the third quarter's end. Then moving to slide 37. We reconcile nonperforming assets. We added the $35.6 million of nonaccruals on line one, reduced nonaccruals by $1.1 million through $600,000 of payoffs and return to accrual or restructure on line two with gross charge-offs of $500,000 on line five. We had a $600,000 reduction in OREO through sales and writedowns on line eight and nine with a $4.7 million, as I just mentioned, in 90 days past due. That leaves us with a $39 million increase in NPAs and loans, 90-plus days delinquent at the end of the quarter at $63.6 million. So to close out my remarks, we are paying close attention to the modifications and the second deferral requests. I believe we have a long way to go before we will know or understand the impact of the economy being shut down. The economy is presently being buoyed by stimulus that will eventually end. But for now, we are proactively engaging our COVID-impacted customers and balancing between the best short-term and long-term solutions, such as deferrals and nonconcessionary restructures. We continue to maintain our underwriting standards and look for opportunistic portfolio growth in non-COVID-sensitive industries to borrowers who are well-positioned to grow in the current environment and beyond. We are beginning the cycle with a stronger credit and capital profile, and this should give us strength to bridge through. All right. I'll turn the call back over to you now, Mike.

Mike Rechin, President and CEO

Thank you, John. I'm going to move to page 40 to offer a few comments before we take questions. We aim to show many of the essential qualities needed to be a high-performance banking company, and we often do. I believe we demonstrated some of that in the second quarter, highlighted by specific points on page 40, including a pre-tax provision of nearly $60 million, which will aid in building capital and cushioning. Our tangible common equity stands just under 10%, excluding the effects of the PPP loans. We have liquidity for all purposes and a diversified loan portfolio that John covered, which I found insightful. Most importantly, we have the experience and talent to navigate through a recession. John Martin, Mike Stewart, our Chief Banking Officer, and many other bankers are focused on monitoring their portfolios and the health of their borrowers. I am confident that our commercial backbone will meet the challenges of the upcoming quarters, including modifications and new requests during uncertain times. The corporate social responsibility initiatives, mentioned two-thirds down the bullet points, allow us to invest in the longevity of our market, and we have nearly 2,000 teammates engaged in these opportunities under Scott McKee's leadership. We are conducting a thorough examination of our delivery channels. We have always aimed to enhance our platform work in the consumer bank, and we intend to broaden that focus to improve customer experience. We've been evaluating various technologies for several quarters and plan to invest when the opportunity arises, ideally sooner rather than later. So we are excited about that. I want to point out a previously examined page, page seven, which shows the decline in the unemployment rate and its implications. While our loan demand is currently lower than historical levels prior to COVID, it remains present and is driven by our ongoing dialogue with clients. Although overall loan demand may be below our desired 8% to 9% organic growth, there are certain industry sectors that are thriving, and we are involved in those areas. I am encouraged by the loyalty of our entrepreneurial middle-market clients and look forward to witnessing their recovery alongside the strength of our company. At this point, Jamie, if there are any questions, we are ready to address them.

Operator, Operator

Operator instructions. And our first question today comes from Scott Siefers from Piper Sandler. Please go ahead with your question.

Scott Siefers, Analyst

Good afternoon, guys. Thanks for taking the question.

Mike Rechin, President and CEO

Sure, Scott.

Scott Siefers, Analyst

I was hoping you could provide more detail on the three credits you mentioned that contributed to the increase in nonperformers, specifically the two related to senior living and the logo company. Given that there have been virtually no net charge-offs, I'm assuming you haven't necessarily charged those down. I'm curious about the potential loss you might see, whether you have charged them down, and to what extent they have been charged down.

John Martin, Chief Credit Officer

We haven't charged those names down. Essentially, we had two specific nursing homes that were in the process of lease-up, and both were affected by the coronavirus. They were already slow to lease-up initially, and the coronavirus caused additional issues, resulting in a significant decline in their occupancy. There hasn't been any charge at this point. We are currently obtaining updated appraisals and have established a specific reserve.

Scott Siefers, Analyst

Okay. Perfect. Did any of those receive forbearance? Or given that they were experiencing some trouble or slowdown before COVID, were they just not eligible?

John Martin, Chief Credit Officer

Well, they probably could have been eligible for COVID. But given the issues that they were experiencing, we thought it best to recognize the nonaccrual status rather than try to mask it, if you will, for someone who is potentially not going to be able to pay even without the deferral. So it was transparency more than anything, Scott.

Scott Siefers, Analyst

Okay. Perfect. All right. Thank you. And then, Mark, maybe one for you, just on the cost base. A really good cost control quarter. It sounded like things might elevate a little in the 3Q. I was hoping you could maybe just provide a little color on what would cause the upward pressure on costs in the third quarter.

Mark Hardwick, CFO and COO

There are a couple of items that I highlighted. The $2.3 million of deferred salary expense was all related to our PPP origination, so we won't have that deferral going forward. That's where the $2.1 million or $2.3 million increase comes from. Additionally, we had a reversal of an accrual related to the termination of a rewards program that was $1.6 million. The contribution level and bonus accruals offset each other, which is how I moved from $60 million up to $64 million for the third quarter.

Scott Siefers, Analyst

Okay. Got it. Thank you very much. Appreciate you guys taking the question.

Mike Rechin, President and CEO

Sure. You're welcome.

Operator, Operator

And our next question comes from Terry McEvoy from Stephens. Please go ahead with your questions.

Terry McEvoy, Analyst

Hi. Good afternoon.

Mike Rechin, President and CEO

Hi, Terry.

Terry McEvoy, Analyst

I'm just curious on the accounting for the salary expenses that were deferred, will that flow through expenses, future expenses? Or is that netted against the yield or the fee that will come through net interest income?

Michele Kawiecki, SVP and Director of Finance

Terry, this is Michele. That actually will come through the salaries line. And so we deferred a total of $2.5 million that will be amortized over 24 months. So you could expect to see an impact of about $300,000, $320,000 each quarter coming through salaries expense.

Terry McEvoy, Analyst

Thank you for that. And then a question for Mark. Thanks for pointing out that there was a 6 basis points impact to the margin from PPP and running through some of the repricing opportunities on the CD side. What are your thoughts on the core margin, call it, in the third quarter? Will there continue to be some incremental asset yield pressure? And do you see that coming down?

Mark Hardwick, CFO and COO

We anticipate some additional pressure on asset yields, so I expect a slight decrease in loan yields. However, we believe that our ability to reprice the CD book and continue tightening our pricing on the deposit side can balance out any reductions we may experience in the third or fourth quarter. We feel confident that we have established a sustainable level moving forward. That said, this quarter has been quite volatile, and we are keeping a close eye on it and managing the situation as best we can.

Terry McEvoy, Analyst

Thanks. And then maybe a question...

Mike Rechin, President and CEO

This is Mike. A tactic that should offer some help relative to asset yields, particularly with the LIBOR decline that Mark covered earlier in his comments, is the implementation of a LIBOR floor that we've put in place probably 90 days ago, but we didn't have the ability nor the appetite to just unilaterally deploy it against all of our LIBOR-based loans, but are deploying it in every new loan situation or rewrite situation to include the majority of the modifications that John's team evaluates. So with the floor that we have in place over the book of business that's LIBOR-based, I think it's going to provide a nice net, if you will, beneath erosion on loan yield.

Mark Hardwick, CFO and COO

I think the key is that those floors weren't established as rates decreased. Now that we're in a lower rate environment, we are implementing new floors with every loan renewal opportunity.

Terry McEvoy, Analyst

Thanks for that. And then just a quick last one for John. Any of the four nonperforming loans or nonaccrual loans and then the 90 days past due, any of them connected to the sponsor finance portfolio?

John Martin, Chief Credit Officer

The logo name was indeed linked to the sponsor book.

Terry McEvoy, Analyst

Okay. Thanks, everyone.

Mike Rechin, President and CEO

Thanks, Terry.

Operator, Operator

And our next question comes from Damon DelMonte from KBW. Please go ahead with your question.

Damon DelMonte, Analyst

Hey, good afternoon, guys. How is it going today?

Mike Rechin, President and CEO

Good, well, Damon.

Damon DelMonte, Analyst

Great. So just to kind of circle back on the margin outlook. Mark, where would you put the core margin at this quarter when you take out the fair value accretion that was recorded?

Mark Hardwick, CFO and COO

Yes. So if you go to slide 15, the reported margin was 3.19%, you back out 12 basis points for fair value, gets you to 3.07%. And then you can add back six related to PPP to get to the core. So you're at 3.13% on a core basis, ex PPP and fair value.

Damon DelMonte, Analyst

Got it. Okay. And then the fair value the first two quarters of this year were around $3.5 million or so. Do you expect that to start to trail off in the back half of the year?

Mark Hardwick, CFO and COO

That feels like a pretty stable number based on how much we still have outstanding. And so as we're building our models through the rest of 2020 and even into 2021, that's a pretty stable number.

Damon DelMonte, Analyst

Okay. And could you just repeat again how much in the way of CDs you have repricing again throughout the second half of the year?

Mark Hardwick, CFO and COO

Yes. We have $900 million that we should pick up about 140 basis points of savings as those reprice through the remainder of the year. They're currently on the books at an average rate of 1.77.

Damon DelMonte, Analyst

Got it. Okay. And then just the last question. As you guys clearly pointed out, pretty healthy provisioning and reserve building in the first half of the year. How do we kind of think about that as we go through the second half? Do you think you kind of retreat a little bit from that $20 million quarterly level? Or do you think that given what you're seeing across your footprint, it's going to be prudent to keep that level up there?

Mike Rechin, President and CEO

John, I know, is looking at his materials, getting ready to answer. I know that the quarter's $21.9 million was really an 80-day assessment of where we are under the incurred loss model. That obviously plays into it. And then we do a really deep environmental scan. So it's kind of pulled together, as you might guess, toward the back end of the quarter. And I'm not going to predict anything. We're going to do the exact same thing. We're going to look at our incurred losses through the first 70, 75 days of the quarter and kind of assess where we are and look at John's team for what else we might see. John, do you have any addition to that?

John Martin, Chief Credit Officer

Yes. No. As long as the asset quality holds up and continues, it should be consistent with what we've seen in the past. And on any individual name, those will be added as specific as necessary.

Mike Rechin, President and CEO

We believe that the work Michele discussed earlier involves many aspects with the PPP. However, as she mentioned, when we project a number into the future after CECL, and it starts with a two, we consider that a healthy level. Nevertheless, the economy continues to surprise us, and we will remain vigilant.

Damon DelMonte, Analyst

Very good color. Thank you very much, guys. Have a great rest of the day.

Mike Rechin, President and CEO

Thanks, Damon.

Operator, Operator

Our next question comes from Daniel Tamayo from Raymond James. Please go ahead with your question.

Daniel Tamayo, Analyst

Hi, good afternoon. So just at the end of your comments, Mike, you mentioned that some industries are running hard, and you might see some growth there on the balance sheet. Wondering if you could go into a little bit more detail on which industries you're referring to.

Mike Rechin, President and CEO

Sure. It's somewhat anecdotal, and John might have more insights, but it's about both the internal and external situations. Companies involved in external services are experiencing higher backlogs and a greater demand for employees than they can find to fulfill that need. I'm referring to areas like trailers, RVs, camps, campers, and tractor suppliers. Consumers are investing in their homes, which also boosts demand for pool installers, home contractors, painters, and roofers.

Mark Hardwick, CFO and COO

Construction.

Mike Rechin, President and CEO

Construction, maybe not so much new construction, certainly not office construction, but yes, building out heretofore announced construction projects are swamped. You drive to the office in the morning, as we've been doing, I eyeball my way through who's parked on the side of the road. And then in direct contact with our clients, the ones that are really just trying to cajole their workers back into the workforce. So there's some real points of strength, and they've been even kind of growing as the months have turned from May into June into July. So there's reason for optimism. And yet at the same time, we still got, on balance, 12% unemployment, so there are people that haven't seen fit to call everybody back yet. But reasons to be optimistic.

Daniel Tamayo, Analyst

Thank you for the information. I'm curious about the geographic aspects of the portfolios. You shared some valuable economic metrics by state, but I'm interested in how the different markets are performing. Specifically, is there any noticeable difference between the Indy market and others? How do you anticipate this will evolve as states and markets operate differently on the path to recovery from this recession?

Mike Rechin, President and CEO

Yes. I think it's somewhat even. Mike Stewart lives that on a daily basis. But I know that there is a parallel, I think I heard it in your question, with the, you want to call it, aggression that any particular governor chose to deploy relative to their unique reopening. I would say, of the four states we do business in. Michigan has probably been the slowest to approach normalcy, if you want to call it that. And so I think our backlog there might be a little bit light. And in addition to which the Monroe franchise is newest into our company and probably has undertaken the most change, and yet it's got awesome upside. Ohio and Indiana, really kind of throughout doing relatively well. And so that's where I see the majority of the backlog that's beginning to replenish itself.

Daniel Tamayo, Analyst

Thank you very much. Appreciate it. That's all I have.

Operator, Operator

And our next question comes from Brian Martin from Janney Montgomery. Please go ahead with your question.

Brian Martin, Analyst

Hi, guys. Thanks for taking the question. Just two for me. Mark, I appreciate the color on the expenses next quarter. Just any thoughts on whether you guys have any initiatives in place, expense initiatives, looking out now that we've kind of entered this period of the pandemic as you look at branches and whatnot going forward, anything like that on the horizon you're anticipating?

Mark Hardwick, CFO and COO

Yes. I think every department of our company is looking closely at expense levels and trying to identify ways to, in some cases, take advantage of a new operating environment, like in the case of retail, or just looking for ways to be more effective and efficient. So as we are moving our way into planning for 2021, which really starts in earnest here in about another month, we have teams across the company that are already putting together their tactics and their recommendations, some based on how they view they could improve the efficiency and performance of the company and some based on the direction that executive management has given them. So we think we have opportunities to continue to create efficiency from end-to-end, from the customer all the way through the back office, and we're going to have to look really closely at them as we work our way through this 2020 budget season or for the rest of 2020 for our 2021 plan.

Mike Rechin, President and CEO

Brian, it's Mike Rechin, just going to add to Mark's thoughts. As you've watched, we have looked at our retail and banking center optimization over the years. That will continue. We think it's a tiny bit early to draw transaction counts, which really dove low in the March, April time period. We're going to give a full chance to see how that's getting used, but it's clearly front and center for what we look at. We've also, in 2019, made a technology investment that allows us to see fintech companies that have really strong innovation around the back office of a bank. So while consumer optimization is a tool we've used in the past and we'll continue to, we think there's even more upside for some of the operational areas of the bank.

Brian Martin, Analyst

Got you. I appreciate the additional details. I have another question regarding the fee income, particularly two areas that declined this quarter: service charges and derivatives. Can you provide insight on when we might see service charges start to recover? Mark, I thought you mentioned they might begin to improve, but I may have missed that. If you could reiterate your comments...

Mike Rechin, President and CEO

Mark is looking for a note, I think, because we did see a nice lift in June relative to the earlier part of the quarter. But clearly, our consumer banking leadership wanted to make full offering to our consumer customers of the CARES Act features about protecting folks through the time. So all of those numbers, overdrafts and any other fees, were really held back or eliminated for a certain period of time. So that ought to have a natural lift to it. The derivative, the hedge that you talk about, kind of speaks to my comment, Brian, about loan volume being a little bit down because those are origination fees around commercial borrowers locking in rates. And so as you can see the number clearly didn't go to zero. It had been on a really steady ascent based on the interest rate environment. I've already seen a little bit of volume pickup there. So that will be a live item for us. I fully expected it based on the hunker-down approach that many of our customers had trying to get through. If you're using PPP, you're trying to keep employees, not necessarily originate new loans. So yes, down. And Mark made the comment about the other customer-driven fee activity in the wealth business. Wealth business fee generation is one month in arrears. And so the figures shared with you in the wealth business would capture the March, April, May 90-day time period, which really bore the biggest brunt of the market declines. And so I think we were probably 4% or 5% lower in fees than we otherwise would have been. And so starting with June into July, we'll see where the market goes, but it's had a little bit more life to it.

Brian Martin, Analyst

Yes, I appreciate that insight. I have a modeling question. Do you have the average balance of PPP for the quarter or just the dollar contributions for the quarter?

Mike Rechin, President and CEO

Yes, I bet you will be able to pick that up quickly here. I see some keyboarding, Brian.

Daniel Tamayo, Analyst

Okay. If not, I can follow-up.

Mike Rechin, President and CEO

Yes, we'll send you an email with it. The 883 is the period end. Do you have it, Michele?

Michele Kawiecki, SVP and Director of Finance

Yes, I do. Actually, Brian, the average balance for the quarter was $703 million.

Brian Martin, Analyst

Okay. Okay. And I guess I'll just back into the yield, you gave the other piece. So, okay, thank you so much.

Mike Rechin, President and CEO

Thanks, Brian.

Operator, Operator

And ladies and gentlemen, at this time, I'm showing no additional questions. I'd like to turn the conference call back over to management for any closing remarks.

Mike Rechin, President and CEO

Thanks, Jamie. I have none. I appreciate the questions. I know it was a longer call than normal. We were trying not only to make sure we convey what we know about the business, but kind of having some intuition for what allows folks to get the best feel for how First Merchants is doing through this period of time. We look forward to your continued interest. If you have any follow-up questions from material we weren't able to get to, I'd ask you to give us a call, and we'll see if we can't provide that. Appreciate your interest. Talk to you soon.

Operator, Operator

Ladies and gentlemen, this does conclude today’s conference call, we thank you for attending, you may now disconnect your lines.