Horizon Bancorp Inc /In/ Q3 FY2020 Earnings Call

Good morning, everyone, and welcome to the Horizon Bancorp conference call to discuss financial results for the 3 months ended September 30, 2020. Please note that this event is being recorded. Before turning the call over to management, I would like to remind everyone that today's call may contain forward-looking statements related to Horizon that may generally be identified as describing the company's future plans, objectives, or goals. Such forward-looking statements are subject to risks and uncertainties that could cause actual results or outcomes to differ materially from those currently anticipated. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. For further information about the factors that could affect Horizon's future results, please see the company's most recent annual and quarterly reports filed on Form 10-K and 10-Q. You should keep in mind that any forward-looking statements made by Horizon speak only as of the date on which they were made. New risks and uncertainties come up from time to time and management cannot predict these events or how they may affect the company. Horizon has no duty or does not intend to update or revise forward-looking statements after the date on which they were made. To the extent non-GAAP financial measures are discussed in this call, comparable GAAP measures and reconciliations can be found in Horizon’s October 28 news release, which is available on its website at horizonbank.com. Horizon also published an investor presentation on Wednesday afternoon, and it is available on the company's website with information that will be addressed this morning. Representing today from Horizon are Chairman and CEO, Craig Dwight; as well as Executive Vice President and CFO, Mark Secor. They are joined by President, Jim Neff; and Executive Vice President and Chief Commercial Banking Officer, Dennis Kuhn, for the question-and-answer session. At this time, I would like to turn the conference over to Mr. Dwight. Thank you. And over to you, sir.

Good morning, and thank you for participating in Horizon Bancorp's Third Quarter Earnings Conference Call. Our comments today will follow the investor presentation we published yesterday, October 28. So starting on Slide 4, you'll find the highlights that summarize Horizon's excellent third quarter results, as evidenced by a 39% increase over the second quarter's earnings per share. Continued improvement in Horizon's efficiency ratio to 55.6%, record gain on sale of mortgage loans at $8.8 million, growth in earning assets for the quarter at 2.7%, growth in deposits for the quarter at 2.5% and continued strong credit metrics. On the next slide, we exhibit Horizon's seasoned leadership team that has managed through multiple recessions and overseen a history of strong financial performance and growth over the past 17 years. As you'll see on Slide 6, we've completed 11 new or organic market expansions and 14 mergers and acquisitions during this 17-year period. Horizon Bancorp is a company on the move and we continue to look for new opportunities. Slide 7 clearly demonstrates Horizon's ability to achieve meaningful growth. Horizon's objective is to attain a balanced growth strategy with 50% organic and 50% through mergers and acquisitions. From 2009 to 2019, Horizon achieved a 14% annual growth on assets, which was 4.7x the change in gross domestic product during the same time period and 3.3x the average growth rate for the banking industry. For the last 5 years from 2014 to 2019, Horizon's results are even more impressive, evidenced by a 20% annual growth rate on average assets, which was 5.2x the change in gross domestic product and 5.2x the average growth rate for the banking industry. On Slide 8, we highlight our primary market area in dark brown and dark green. Horizon's markets represent diversified economies and excellent growth opportunities. Horizon’s expansion and growth have occurred primarily in college and university towns and in state or county governmental seats. Therefore, a majority of our footprint has an economic base that is traditionally more stable than other areas of Indiana and Michigan. As most of you know, we bank customers in a number of college towns. All major universities in both Indiana and Michigan have opened in the fall under certain safety protocols. Some universities have moved to all virtual class instruction as the number of COVID cases increases. However, these moves have been temporary. Horizon's footprint has also positioned well to take advantage of the outbound migration from Illinois, which continues to increase as consumers and businesses seek to exit dense living spaces, high taxes, and a high cost of living. It will be interesting to see if by November 3, Illinois passes the state referendum to add yet another tax increase tied to a progressive income tax model. If these tax increases pass, we fully expect Illinois outbound migration to accelerate. Both Indiana and Michigan continue to show improving economies as evidenced by a reduction in unemployment rates. As of September 30, Indiana’s unemployment rate was 6.2%, which is well below the U.S. national unemployment rate of 7.9%. Michigan's overall unemployment rate was 8.5%. The regions we serve in the western and central part of the state are reporting levels much closer to 6%. Horizon's footprint helps to geographically disperse credit risk with 61% of our loans in Indiana and 39% in Michigan. In addition, Horizon has been consistent in over a long period of time, focusing our growth in 4 revenue streams: retail banking, mortgage banking, business banking, and wealth and investment management. This strategy diversifies risk and stabilizes earnings in varying economic cycles. For example, today, our mortgage teams are doing very well, which offset slower growth in other business lines and help to fund an increase in credit loss reserves during slow economic periods. Skipping over to Slide 10, we continue to closely monitor the impacts of the COVID-19 pandemic on the communities we serve. While Indiana's number of daily reported positive COVID-19 cases appears to be moving towards a potential new record, the actual fatality rate for the state remains low at 2.6%, with our hospital intensive care units running at 62% of occupancy. 92% of Indiana's COVID fatality rates are occurring in the over 60 age group with 2/3 of the fatalities occurring in senior housing centers. There continues to be a strong effort to follow COVID safety protocols to protect our seniors. Michigan is also trending upward in the number of COVID-19 cases on October 24 at a new single-day record for the number of cases reported. The trends statewide are increasing, primarily in metropolitan areas such as the Greater Detroit and Grand Rapids regions. The safety and well-being of our employees is Horizon's first priority and we continue to adhere to strict safety protocols as we navigate reopening stages in our markets. Indiana has advanced to its fifth and final stage of opening before we return to full business as usual. Restaurants and bars have opened to 100% of capacity, major events with less than 500 attendees are permitted, and all gyms and fitness centers are now able to open. All businesses must continue to comply with social distancing, face mask, and personal hygiene requirements. Some municipalities, like Indianapolis, still have more stringent requirements than the state as a whole. As a result, nonessential businesses continue to struggle in those markets. On September 8, Michigan allowed indoor gyms and fitness centers to open subject to social distancing and limitations to the number of people of 25% of building capacity. Although Michigan's Supreme Court rescinded Governor Whitmer’s emergency powers to restrict operations, Michigan continues to operate under more restrictive COVID-19 guidelines than Indiana. Overall, we're very proud of our resilient employees and how they’re responding to serve our customers' needs during these unprecedented times. Prior to COVID-19, Horizon was well on its way to transforming its customer base to our digital platform. As evidenced by the chart on Page 11, located on the left titled active online banking users at more than 102,000 or 73% of checking accounts. As expected during this pandemic and presented on this chart to the right, Horizon's digital transactions rapidly increased and branch transactions declined due to limiting office traffic to appointment only until June 15. Even after reopening our offices, the branch transaction volumes continued to be suppressed. Fortunately, Horizon was well prepared for this increase in digital transactions. Other technology investments to enhance our customer experience this year include adding the fourth call center location to increase capacity, expanding our interactive teller machines to allow for virtual teller interactions at our 27 locations and with expanded virtual teller hours from 6 a.m. to 8 p.m., 6 days a week. The addition of chat and online account opening to improve the customer experience and provide another channel of service. Approximately 90% of Horizon's online chats are answered by bots. Now for the financial update, it's my privilege to turn it over to our CFO, Mark Secor. Mark?

Thank you, Craig. I will briefly summarize our third quarter results, which demonstrated the ability to realize our strong operating results dropped to the bottom line as we navigate this current environment. Starting with Slide 13, the third quarter's results were just shy of matching the company's record high earnings with pretax, preprovision income being the highest in the company's history. We continue to build allowance, but with a lower credit expense in the previous 2 quarters, as we believe we are appropriately reserved given the current state of our portfolio and our CECL modeling. Our profitability metrics, including pretax, preprovision earnings, benefited from growth in net interest income supported by higher average balances in interest-earning assets. Linked quarter, net interest income growth allowed us to outpace net interest margin compression of 8 basis points during the quarter. On Slide 14, the 8 basis point decline in margin during the quarter was expected with 10 basis points coming from the full 3 months of interest expense following our June subordinated debt issuance. In addition, compared to the second quarter, the impact of the lower-yielding PPP loans further impacted the margin by an additional 1 basis point. Based on these impacts, the margin performed well as a reduction to deposit costs continues to keep pace with the reduction in asset yields. On Slide 15, loan yields were reduced during the quarter as new production and adjustable-rate loans have repriced lower. PPP loans contribute approximately 3 more basis points to the reduction than they did in the last quarter. As loans continue to reprice and new products are originated at lower rates, additional down pressure on asset yield is expected, resulting in additional margin pressure as we enter into 2021 as the opportunities to lower funding costs are realized. On Slide 16, our strong core deposits continue to help reduce our funding costs. The CD portfolio saw a 31 basis point decrease in cost, leading the reduction in funding costs as the high-cost CDs matured during this quarter. Another $176 million of CDs with an average cost of 1.44% will mature in the fourth quarter to continue to reduce our cost of funds. The 8% growth in noninterest-bearing deposits and interest-bearing deposit costs down to 13 basis points also contributed to stabilizing the margin in the third quarter. Moving to Slide 17, since the first quarter of the year, we’ve maintained a conservative and strong liquidity position, which we've maintained through the end of September. We also expect additional liquidity from PPP loan forgiveness and in the longer term, warehouse loan balances returning to normal levels. Late in the third quarter and in the early weeks of the fourth quarter, we took steps to utilize this liquidity, de-leverage, and optimize returns of earning assets. During the third quarter, we allocated $100 million of this liquidity and began purchasing investment securities. Also, in October, we prepaid $83 million of FHLB advances with a weighted average cost of 2.61%, utilizing $62 million of cash and selling $21 million of investments. While our fourth quarter results will reflect a net one-time loss of $1.2 million on the prepayment, there will be less than a 1-year payback from the interest expense savings. Looking ahead, we will continue to look for additional opportunities, and we see the need to utilize excess liquidity. Slide 18 shows that record mortgage gain on sale drove the increase in noninterest income, offset by a noncash impairment charge to the mortgage servicing right in the quarter. The continued record levels of refinancing activity and strong percentage gains we are receiving on the sale of mortgage loans is providing revenue to help offset lower nonsufficient fund fees. Based on local and national refinancing activities, we expect strong top line contributions to continue from this business through the end of the year. Slide 19 notes that during the third quarter, we continued to manage operating expenses and improved the efficiency ratio to 55.6%. Last quarter, $1.1 million of deferred PPP loan origination costs helped salaries and benefit costs. Without that benefit to salaries and benefit costs, the accrual for bonuses due to achieving targets for incentive plans drove the increase in noninterest expense during the third quarter. Horizon has long sustained efficiency ratio and other operating expenses and metrics that are favorable to peer medians as we believe that continues to be the case in the third quarter. As many of you know, part of Horizon's normal operating process includes a rigorous annual branch evaluation, which led to the consolidation of 25 retail locations over the last 5 years. Looking ahead, we intend to continue our efforts to maximize the efficiency and scalability of our retail franchise while further leveraging the investments we have already made in digital, mobile, remote banking as well as our call centers. Slide 20 discusses that we adopted CECL on January 1, and the $1.2 million reserve build in the third quarter was primarily driven by allocations made from continuing to analyze factors of loans with potentially the highest risk of loss. The percentage of allowance to loans was 1.39% at September 30 or 1.51% when excluding PPP loans. A balance of $12.9 million remains for discounts on acquired loans. Slide 21 shows that Horizon continues to maintain a strong capital position in these uncertain times, supplemented by our $60 million subordinated debt raise in June. Accordingly, at September 30, the holding company had just over $126 million in cash, representing nearly 18 quarters of fixed costs, which includes interest on all debt, operating expenses at the holding company and the current shareholder dividend level, which we are committed to maintaining. Slide 22 emphasizes that we remain diligent in performing internal capital stress testing to ensure Horizon maintains adequate capital in a range of scenarios from mild to extreme. We also engaged third parties to review our capital adequacy based on their loss scenarios. For example, a recent third-party review demonstrated Horizon's ability to sustain capital in a 3 standard deviation credit and interest rate risk event. This review indicates that as an industry, there is sustainable capital in this scenario. What differentiates us from the investor is that Horizon's expected earnings during the risk event were more than adequate to cover the credit and interest rate impact without the use of excess capital. Overall, we are very pleased with our financial performance in the first 9 months of this challenging year. We believe we are well positioned from a credit, liquidity and capital perspective and look forward to refining our operating model to further improve our results in the quarters ahead. For some additional comments on our loan portfolio, I will turn it back over to Craig.

Thank you, Mark. Looking at Horizon's $4 billion in total loans on Slide 24, you'll see a diversified portfolio with 58% in commercial loans and 42% in residential mortgage and consumer loans. At Horizon, we like this loan mix. It diversifies our credit risk and provides advantages to managing our net interest margin. This slide also details granularity in our commercial portfolio, which itself is well diversified. Our single largest sector is in residential multifamily housing loans at less than 6% of total loans, which continue to perform well. Other key points to make, Horizon manages capital at risk by maintaining an in-house lending limit at $30 million, which is well below our legal lending limit of approximately $76 million. Our granularity is further enhanced by the fact that Horizon's average commercial loan is only $366,000. Moving to Slide 25, loan deferrals peaked in May and continue to rapidly decline through September 30. Deferred loans as of September 30 declined by 70% over the prior quarter to 4.1% of total loans. The majority of our dollars under a loan deferment are still in the commercial loan portfolio with consumer and mortgage loan deferral remaining low at less than 1%. Overall, Horizon's referral rates are in line with peer banks. The number of commercial loans on payment deferral totaled 61, down from the prior quarter's total of 670 loans. Horizon’s commercial lending team has been diligent in meeting with our business customers to update their financial plans and to place their loans back on a regularly scheduled payment routine. Approximately half of the commercial loans in deferral continue to make interest payments and the other half are still on full payment deferrals. Those loans on full payment deferral are primarily hotels and are expected to come off full deferral in the fourth quarter with some expected to make interest-only payments throughout 2021. Moving to Slide 26, Horizon has a seasoned team of consumer underwriters and a long history of prudent consumer loan underwriting. Our consumer loan portfolio is predominantly secured with 99% of our loans backed by collateral of some type. The vast majority of our consumer loans are made in markets. The consumer loan portfolio has excellent credit quality as evidenced by high FICO scores, low delinquency, and low nonperforming loans. On the next slide, Horizon has a seasoned team of mortgage underwriters, processors, and mortgage loan originators. We have been in this business for a long time. The majority of our mortgage production is sold in the secondary market with year-to-date loans sold running at 75% of total production. Horizon’s mortgage loan quality remains strong at quarter end as exhibited by low loan delinquency and nonperforming mortgage loans. Moving to Slide 28, Horizon has a history and culture of prudent commercial loan underwriting. We are primarily an in-market lender. We require recourse on most of our loans from the principal owners. Our loans are geographically dispersed throughout Indiana and Michigan. Commercial loan asset quality metrics continue to be favorable at quarter end. Nonperforming commercial loans were 69 basis points of total commercial loans. This does represent a slight increase over the 61 basis points at June 30. This increase in nonaccrual loans was primarily driven by one recreational sports enterprise located in Indianapolis, which still has not reopened due to COVID-19 restrictions. Commercial loan delinquency at the end of the third quarter continued to be low at 5 basis points. On Slide 29, we report on our elevated monitoring in those loan segments that exhibit the most duress as evidenced by high payment deferral. The majority of Horizon's payment deferrals were made to nonessential businesses or real estate loans that have tenants who are primarily nonessential businesses. The portfolio of segments with elevated monitoring includes hotels, restaurants, nonowner occupied retail, leisure, and hospitality. Hotel payment modifications continue to be the highest percentage of any sector. As of September 30, approximately $82 million or 58% of our total hotel loans. This is down from a high on June 30 of $105 million in modified loans or 75% of this sector. The company we keep with this portfolio is that our borrowers are longtime operators who have managed through multiple economic cycles, most have liquid resources to fall back upon, and the portfolio has a low average loan-to-value ratio at 57%. I'll touch more on hotels in just a moment. Next, restaurants. We have $22 million in full-service restaurant loans. One relationship has more than $10 million in loan outstandings with a very strong operator, with considerable liquid assets and a very short amortization schedule on the real estate portion of their debt. Our limited-service restaurant loans totaled $29 million, most consisting of good franchises such as McDonald's, Culver's, and Burger King, and are longtime owner-operators. Horizon's borrowers are reporting that their fast food total revenues are down year-to-date between 25% and 30%, which places them close to or at breakeven point to service debt. However, some entities are actually reporting an increase in net profits over the prior year due to low overhead and good drive-through revenue. Total restaurant loans still under deferment are currently at only 3% or $2.1 million. Most of the restaurant loans in deferment are located in Indianapolis or Greater Detroit market areas, where they have more stringent COVID-19 operating restrictions. Our comfort in this portfolio is due to the fact that the average loan is low at $365,000, good year-to-date performance, longtime operators, and good franchises. The nonowner-occupied retail portfolio is holding up well due to stable markets and strong sponsors. In addition, this portfolio has a low average loan-to-value ratio of 53%, which provides Horizon cushion against any potential loan exposure. Total loans still under payment deferrals amount to $15.3 million or 11% of the portfolio. All of these loans are making at least interest payments. Our comfort in this loan portfolio is due to the fact we have good sponsors, low average loan amount, low loan-to-value ratios in diverse and stable markets. The leisure and hospitality segment consists of a diverse group of borrowers, including golf courses, bowling centers, movie theaters, fitness establishments, and a zoo. All entities are open excluding the one Indianapolis business mentioned earlier. In general, we have strong cooperative sponsors. However, we may need to increase allocations for this portfolio as the COVID-19 challenges continue and as states or municipalities add additional restrictions. Our next slide is a map that exhibits the locations of Horizon's loans secured by hotels. As you can see, the vast majority of our hotels that we finance are located along interstate highways or resort communities. Hotels located along interstate highways are rebounding faster than those hotels located in metropolitan areas where they depend on sporting or convention venues. All hotels in our portfolio are open for business, with occupancy rates ranging from 20% to 70%. We continue to see improvement in occupancy each month. Moving to Slide 31, even with the stress of COVID-19, Horizon continues to report strong asset quality metrics in the second quarter, which you can see on this slide. The chart in the upper left exhibits low total net charge-offs over the last 5 quarters of less than 2 basis points. The chart at the right corner, credit loss provision expense was low throughout 2019. For 2020, Horizon provision expense was higher to build reserves due to the early adoption of CECL and primarily related to econometrics and the general allocation of the nature and characteristics of our loan portfolios during this pandemic. The chart on the lower left exhibits Horizon’s total nonperforming loans to total loans, which is still lower and manageable at 72 basis points, a slight increase we discussed earlier. The chart on the lower right shows the allowance for credit loss reserve rising to 1.39% of total loans, which is in line with other community banks that have adopted CECL. Excluding PPP loans, the allowance for credit losses stands at 1.51% of total loans. In conclusion, our investment thesis is we have a seasoned management team who has managed through multiple economic cycles and have a history of delivering growth far exceeding the banking industry's average growth rates, excellent geographic diversification with stable less volatile markets, strong credit culture, high-quality loan diversified balance sheet, robust capital levels, and Horizon’s favorable historical earnings run rate, even during the Great Recession and now even in the early stages of this pandemic. Finally, the fact we maintain a conservative guideline to retain cash at the holding company to protect dividends to our common shareholders and to provide future optionality. Thank you. That concludes my comments for the third quarter's earnings presentation. We'll now turn it back to the operator to open the lines up for questions. Thank you.

The first question is from Terry McEvoy from Stephens.

Maybe let's start with a question on expenses. I understand the step-up in the third quarter due to the strong performance of the company in the second half of the year. But I was wondering what your thoughts were on the third quarter, whether it will move down to a more normal level? And then looking out into 2021, I know you talked about evaluating branches, which in theory should generate some cost savings. But what are your thoughts on expense growth in 2021 just incorporating inflation and other investments that you foresee across the company?

Yes. What you saw in the third quarter was what you explained, a catch-up from the first half of the year, just based on the performance through that point and the need to start to build these accruals. And, obviously, you can't predict what we're going to exactly see in the fourth quarter. We will need to continue to maintain bonus accruals we expect through the fourth quarter. Going into 2021, we're committed to continue to look for cost savings through branch rationalization, which is going to be key to that as we want to continue to leverage the network and the technology that we have. We know that we need to maintain the level of expenses to help drive the bottom line looking at what we see coming on the interest rate side into 2021 and the net interest margin.

Yes, if I can add to that. What's driving our strategy for 2021, 2022 and beyond is the fact that we're facing a shrinking net interest margin. Therefore, there's not a single line item on our expense side that's not being considered for reduction. In addition to that, we engaged a third-party consulting firm to review all 73 of our locations, to look at where we should invest for future growth and where we should reduce our costs because the market isn't supporting growth. We do have a plan in place for 2021 and more will be coming out probably in the first quarter. Thank you for the question.

And then just as my follow-up, not to be too technical, but Slide 20 on the CECL, the third quarter reserve building in consumer stands out versus some of the other banks that I've looked at this quarter. Could you just talk about what was behind that reserve build in consumer in Q3?

Yes. That's all econometrics-driven. The fact that we are running out of seamless monetary policy and so forth, the delinquency still remains low. We were basing it on the econometric trends in the consumer side. Bankruptcies are starting to increase again in our markets. So it's not tied to the portfolio performance. Jim, do you want to add anything to that all? You cover that.

We went through our portfolio and categorized them by loan to value, debt to income ratio, credit score and put them in different categories. The most at risk were at the top, and we took those loans in the most risk and applied a percentage to those to put as an overall allowance to that just to be on a conservative basis. But as Craig said, the delinquencies are holding up very well, and we don't see any specific issues.

Yes, that percentage that we have tied to that portfolio, higher risk credits, was due to the econometrics. So good point. To Jim's comment, we have an excellent data bank of information on our loans that can slice and dice multiple ways, which we've exhausted, I think, in the last 2 or 3 quarters. Thank you for the question.

The next question is from the line of Nathan Race from Piper Sandler.

Mark, I was hoping to, or Craig, get your outlook commentary on the core margin going forward. Obviously, PPP dynamics will impact the reported NIM. But I guess, away from that, I'm curious to know what the balance sheet looks like as alluded to earlier. How should we think about the core NIM kind of trajectory into this fourth quarter and into early '21 as well at this point?

Yes, in the fourth quarter, the reduction in leverage and interest costs should improve the margin. Even in the third quarter, we managed to maintain the margin on the asset side while saving on the liability side by removing the extra costs associated with subordinated debt. This will be beneficial. Looking ahead to next year, we anticipate additional savings from the CD portfolio, but those benefits are expected to taper off, and we foresee some pressure on the margin as we progress through 2021.

Okay. Got it. I'm just curious now as we kind of think about those dynamics, how we should think about loan growth. Obviously, the warehouse showed some nice growth in the quarter. Just curious if you guys are continuing to work through some price on the commercial side, if we should expect some attrition within the commercial portfolio going forward, and maybe we can expect a bottoming in loans overall, excluding the warehouse in the fourth quarter and modestly into 2021? Or just any thoughts on the overall loan growth outlook from here excluding warehouse.

Nate, this is Craig. Thank you for the question. Based on historical performance as we come out of the recession, we have about 2 quarters where we have to make up the loan shrinkage in the warehouse business, and we would expect that again going into 2021. So from a growth standpoint in 2021, we don't expect much growth because we have to offset the decline in warehouse loans. Pipelines for commercial lending are picking up. Dennis, do you want to add anything to the pipelines in commercial at all?

We have observed an increase in activity across our areas. Our growth markets are doing well, and we are receiving new opportunities with some clients that are familiar to our team.

The next question is from the line of Damon DelMonte from KBW.

Hope everybody's doing well today. So my first question is related to the outlook for provision expense. Mark, just kind of wondering your thoughts on the meaningful decline this quarter from the first 2 quarters of the year. And just kind of, can you assess your CECL model when you look out for the remainder of this year and into 2021? Do you feel that reserve levels are adequate? Or do you feel that ongoing uncertainties in the global economies would require you to continue to build reserve?

Thank you, Damon. You summarized it well. We currently face uncertainties that we cannot fully grasp. As we conclude the third quarter, we feel confident about our allowance balance based on the information available to us at this point. The key factors contributing to our uncertainty revolve around the direction of the economy in the coming year. If the current situation remains stable and we do not encounter further decline, we believe we are on track. We will need to monitor charge-offs to replace, but predicting the future is challenging. With an election approaching and COVID cases rising, it's difficult even for us to make definitive statements until we observe the relevant metrics. While these metrics have been improving, that trend may change.

We've been pleasantly surprised by the dynamic management of our borrowers of their business lines. A lot of the feedback we're getting from our commercial portfolio indicates they are able to manage through this COVID-19 situation, except for some of the essential nonessential businesses, which have experienced more restrictive markets. So I think the important question is going to be after the election, what's going to happen in the business segment. Are they going to shut down again? And then, too, I have a high degree of confidence that there will be another stimulus package coming out shortly after the election, maybe after January 20, but that should help soften any blow in 2021.

Got you. Okay. And then with respect to the fee income, you guys had a loss this quarter in the mortgage servicing income net of MSR. Normalizing that, Mark, what is the reasonable expectation for fee income, taking into account the pipeline strength from mortgage banking?

Yes. I think we commented that the mortgage banking looking into the fourth quarter remains strong as we continue to see both purchase and refinancing activity strong. However, going into next year, I think sometimes the first quarter is typically a slower quarter in the Midwest. Depending on what happens with interest rates and the continued ability to lower the mortgage rate, we could continue to drive refinancing and maintain a strong gain. But yes, estimates from mortgage banking experts are predicting around a 30% decline next year in volume. So that's the outlook we're considering right now until we start to see what actually happens.

Yes. The real question is really would they stop their monetary policy from buying long-term debt. Once they exit the market, then we would expect to see that business turn downward.

The next question is from the line of Brian Martin from Janney Montgomery.

Could you comment on the strong credit performance? Were there any notable changes in your criticized or classified portfolio this quarter?

Brian, we downgraded our credits as we modified loans one downgrade. Dennis, can you give more color on that for Brian?

Yes. So as Craig mentioned, whenever we were touching a file for modification, we were downgrading by one step. Very few loans went into classified status during that exercise. We did see some increase in classified as we did move two relationships related to the hotel portfolio into that classified category substandard during the quarter. They are continuing to make payments as agreed. However, we recognized some weaknesses, obviously, in that portfolio, but some metrics for these two borrowers in particular seemed prudent for us.

Okay. So it sounds like it's pretty stable or slightly higher for the criticizing classified when we see the quarter come out?

Yes. And Brian, at this point, we haven't even been able to allocate specific reserves either for these credits; they're still in a general pool allocation within our modeling just because specific losses have not been identified yet.

Got you. Okay. And then could you just, Mark, share any thoughts on just the remaining unearned loan fees for the PPP and how you're thinking about that?

Yes. We're currently accepting applications for PPP forgiveness. We've had a small number granted so far, and only about a quarter of our customers have submitted applications. We anticipate more applications to come in during the fourth quarter. Depending on the pace of FDA approvals, which appear to be happening relatively quickly, we expect the majority to be processed in the first quarter.

Okay. And then the remaining unearned fees you expect to collect?

Yes. That would be the same as when those are forgiven. The unearned fees are just under $8 million, around $8 million. They're amortizing at a rate of about $450,000 a month when they're not being forgiven. But those fees will be the same as what I was stating. We should see some in the fourth quarter and the more — the majority of them coming into next year.

$8 million net of expenses.

And there are no further questions, so I will now turn the conference over to the management for their closing remarks.

Okay. Thank you for participating in today's earnings conference call with Horizon Bancorp. We look forward to meeting you in person someday in the near future. Have a good week. Thank you now. Bye now.

Thank you very much, members of management. Ladies and gentlemen, the conference call has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.