Horizon Bancorp Inc /In/ Q4 FY2020 Earnings Call

Good morning everyone. And welcome to the Horizon Bancorp Conference Call to discuss financial results for the third month ending December 31, 2020. All participants are in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please limit yourself to one question and one follow-up. If you have further questions, you may re-enter the question queue. Please note this event is being recorded. Before turning the call over to management, please remember that today's call may contain statements that are forward-looking in nature. These statements are subject to risks, uncertainties and other factors that could cause actual results to differ materially from those discussed including those factors noted in the slide presentation. Additional information about factors that could cause actual results to differ materially is contained in Horizon’s current 10-K and related filings. In addition, the management may discuss certain non-GAAP financial measures that are intended to help investors understand Horizon’s business. Reconciliations for these measures are contained in the presentation. The Company assumes no obligation to update any forward-looking statements made during the call. If anyone does not already have a copy of the press release and supplemental presentation issued by Horizon yesterday, you can access it at the company’s website www.horizonbank.com. Representing Horizon today are Chairman and Chief Executive Officer, Craig Dwight; and Executive Vice President and Chief Financial Officer, Mark Secor. They will be joined by 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 call over to Horizon’s Chairman and CEO Craig Dwight. Please go ahead.

Thank you, Anita, and good morning. And thank you for participating in Horizon Bancorp's fourth quarter earnings conference call. Our comments today will follow the investor presentation we published yesterday January 27. Starting on Slide 4, you'll find highlights that summarize Horizon’s excellent year, as evidenced by net income for 2020 increased by 3% over the prior year. Given all the obstacles that we had to confront, it was an impressive year and a true testament to the quality of our employees. Key drivers during the year were record one to four family mortgage loan production and mortgage warehouse volume, good expense control, and our ability to maintain a stable net interest margin. In addition, we maintained solid asset quality as evidenced by low NPAs to total assets at 49 basis points in that chart drops to five basis points of total loans. We're also proud to state that for over 30 years, we have made uninterrupted dividend payments to our shareholders, and we have approximately 18 quarters of cash on hand at the holding company to cover fixed costs, including future dividends. Next slide 5 titled seasoned management team, you will observe that we are a seasoned leadership team. We have managed through multiple recessions and have overseen a history of strong financial performance over the past 18 years. Of special note in December 2020, we promoted senior commercial credit administration officer Lynn Kerber and our General Counsel, Todd Etzler as our newest Executive Vice Presidents. As you'll see on Slide 6, we've completed 11 new organic market expansions and 14 mergers and acquisitions during this time. We're a company on the move and we continue to look for new opportunities in our current and adjacent Indiana and Michigan markets. With our proven track record as a successful consolidator, and the pressures that other banks are facing related to low interest rates in the challenging operating environment, we believe M&A opportunities will once again be available in 2021. Slide 7 clearly demonstrates Horizon’s track record for achieving our well-established long-term goals which include meaningfully outpacing GDP and industry growth and achieving balanced growth of 50% organic and 50% through mergers and acquisitions. In 2020, Horizon grew the balance sheet by 8%, excluding PPP loans. On Slide 8 we highlighted 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 state or county government seats. Therefore, a majority of our footprint has an economic base that is traditionally more stable than other areas of Indiana and Michigan. Horizon’s footprint is positioned well to take advantage of the outbound migration from Illinois, which continues to increase as consumers and businesses exit dense living spaces, high taxes, and the high cost of living. Both Indiana and Michigan continue to show improvement in economies as evidenced by a reduction in unemployment rates. As of December 31, Indiana's unemployment rate was 4.3%, which is below the U.S. national unemployment rate of 6.7%. While Michigan's overall unemployment rate was 7.5%, a slight increase from November 30. The regions we serve in the western and central parts of the state are reporting levels ranging from 3.7% in Grand Rapids to 4.9% in the Bay City, Midland area. Horizon's footprint helps to geographically disperse credit risk with 60% of our loans in Indiana and 40% in Michigan. Slide 9 highlights the primary markets where we are engaged in some exciting economic events that are taking place that will continue to enhance our markets. Moving to Slide 10, titled COVID-19 response, we continue to closely monitor the impacts of the COVID-19 pandemic on the communities, customers, and businesses where we operate. Indiana's numbers of daily reported positive COVID-19 cases were elevated in November and December and have started to trend downwards in January. Indiana's current restrictions are comparable versus the prior quarters and are driven by county-by-county color code risk system. Michigan's positivity rates continue to trend downward and their protocols are still more restrictive than Indiana. The safety and well-being of our employees is our first priority, and therefore we continue to adhere to safety protocols that will navigate the reopening stages in our markets. Currently, all offices are open by appointment only. Prior to COVID-19, Horizon was well on its way to transforming its customer base to our digital platform. Though the impact of the pandemic due to limited branch access has accelerated the use of digital banking. On Slide 11, looking at the chart on the right, Horizon’s average monthly transactions have shifted away from taking place in branches to the majority being processed through our digital and virtual channels. In December 2020, 73% of all transactions took place through our digital channels compared to 57% one year ago. As you'll see in the chart on the left, in December 2020, 75% of all checking accounts were active online banking users, an increase from 66% one year ago. Horizon was well prepared for this increase in digital activity. Other technology investments made in 2020 that focused on enhancing the customer experience included adding the fourth call center locations, increased service capacity and shortened wait times, expanding our interactive teller machines to allow virtual teller interactions at our over 27 locations with expanded virtual teller hours from 6 am to 8 pm, six days a week. This edition of chat and online account opening aims to improve customer experience. As of month-end in December, over 85% of Horizon's online chats were answered by bots. Now for the financial highlights, it's my privilege to introduce to you Horizon Bank's Chief Financial Officer and Executive Vice President Mark Secor. Mark?

Thank you, Craig. Horizon’s fourth quarter results continue to demonstrate our ability to realize strong operating results and drive record earnings to the bottom line as we navigate the current environment. Starting with Slide 13, the company's fourth quarter results were the highest stated and adjusted net income, net interest income, pretax pre-provision income, non-interest income and earnings per share in the company's history. Several activities during the fourth quarter impacted these record results. We incurred prepayment expense on the retirement of high-cost long-term debt, recognized PPP forgiveness fees through net interest income, and recorded tax benefits from solar tax credit investments. We continue to build allowance with additional credit expense primarily for the stressed loan sectors that we have identified. We believe we are appropriately reserved given the current state of our portfolio, additional government stimulus, and our seasonal modeling. Slide 14, the 17 basis point increases in the adjusted margin during the quarter was positively impacted by 18 basis points from PPP lending, as net fee income was recognized for loan forgiveness, compared to four basis points of margin contraction in the third quarter. In addition, excess liquidity compressed the margin by an additional seven basis points compared to three basis points in the third quarter. Slide 15, the loan yield was also positively impacted from PPP net loan fees recognized during the quarter, adding 15 basis points to the yield compared to a 13 basis point reduction in the third quarter. Higher purchase accounting income recognized in the fourth quarter compared to the third also positively impacted the loan yield. As loans continued to reprice and new products are originated at lower rates, some additional downward pressure on asset yield is expected along with a mix of additional investments, resulting in some margin pressure during 2021 as the opportunities to lower funding costs are realized. Slide 16, our strong core deposits continue to help reduce our funding costs. The CD portfolio's 30 basis point decrease in pricing led to the reduction in total funding costs as high-cost term deposits matured during the quarter. 445 million of CDs with an average cost of 93 basis points will mature during 2021 and continue to reduce our cost of funds. The 4% growth in non-interest bearing deposits and two basis point drop in interest-bearing deposit costs also contributed to margin stabilization in the fourth quarter. Slide 17. Since the first quarter of 2020, we've maintained a conservative and strong liquidity position. We also expect additional liquidity from PPP loan forgiveness and in the longer term, warehouse loan balances returning to normal levels when long-term interest rates start to escalate. To help utilize a portion of the liquidity building up in cash, we increased the investment portfolio by over $100 million during the fourth quarter. Also, we prepaid 83 million of FHLB advances with a weighted average cost of 2.61% utilizing $62 million in cash and selling $21 million of investments. While our fourth quarter results reflected a net one-time pre-tax loss of $1.2 million on the prepayment, there will be less than a one-year payback from the interest expense savings. Looking ahead, we anticipate additional growth in the investment portfolio and are currently working on adding $200 million to the portfolio. We will continue to look for additional opportunities as we see the need to utilize our liquidity and increase earning assets. Slide 18, record mortgage revenue from the gain on sale and the mortgage related income drove our record non-interest income as we saw non-cash impairment charges to the mortgage servicing right asset flow in the quarter. The continued high level of mortgage production and strong percentage gains are the primary contributors to our solid non-interest income for the quarter. We also saw all other fee-based income increase over the third quarter. Based on local and national refinancing activity, we expect strong top-line contributions to continue from the mortgage business going into 2021. Slide 19. During the fourth quarter, we saw an increase in operating expenses, but improved the adjusted efficiency ratio to 56.5%. Increased salary and benefit costs were the primary driver of the increased expenses as our very strong fourth quarter and full year results merited higher performance-based compensation payments and accruals. There were also increases in other operating line items as investments were made for future efficiency efforts. As our increase in customer activity and the one-time write-downs to reduce the company's bank-owned real estate assets. As many of you know, part of Horizon in the normal operating process includes a rigorous annual branch evaluations which have led to the consolidation of 25 retail locations over the last five years. We're currently in the process of another rigorous branch review as customer habits change with more digital channels being used. Looking ahead, we intend to continue our record of maximizing the efficiency and scalability of our retail franchise while further leveraging investments we have already made in digital, mobile, and remote banking as well as our call centers. Slide 20, as we have discussed, we did adopt CECL at the start of 2020 and the $708,000 reserve build in the fourth quarter was primarily driven by allocations for sectors of loans with potentially higher risk of loss due to the nature and characteristics of the portfolios. The percentage of the allowance to total loans was 1.47 at December 31, or 1.55 when excluding PPP loans; a balance of $11.5 million remains for discounts on acquired loans. Slide 21. Horizon continues to maintain a strong capital position in these uncertain times, supplemented by our $60 million subordinated debt raised in June. Accordingly, at December 31, the holding company had just over $127 million in cash, representing approximately 18 quarters of fixed costs which include interest on all debt, operating expenses at the holding company, and the current shareholder dividend level, which we are committed to maintaining. Overall, we are very pleased with our financial performance for 2020 in this very challenging year. We believe we are well positioned from a credit, liquidity, and capital perspective, and look forward to refining our operating models to further improve our results in the quarters ahead. For some additional comments on our loan portfolios, I'll turn it back over to Craig.

Thank you, Mark. Looking at the chart on the left on Slide 23, Horizon’s $3.8 billion in total loans are well diversified, with 50% in commercial loans and 43% in residential and consumer loans. At Horizon, we like this loan mix as it diversifies our credit risk and provides advantages to manage our net interest margin. The chart on the right provides the granularity within our commercial loan portfolio, which itself is well diversified. Our single largest sector is in the residential multifamily housing loans at 6% of total commercial loans and this segment continues 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 $78 million. Our granularity is further enhanced by the fact that Horizon’s average commercial loan is only $304,000 excluding PPP loans. Now moving to Slide 24, as of December 31, Horizon’s loan deferrals declined to 3.3% down from its peak of 14.3% on June 30. The majority of our dollars under a loan deferment are still in the commercial loan portfolio, with the consumer and mortgage loan deferrals remaining low at less than 1%. Overall, Horizon’s deferral rates are in line with peer banks. The number of commercial loans and payment deferrals as of December 31 totaled 55, down significantly from the June 30 total of 670. Horizon’s commercial lending team has been diligent in meeting with our business customers to update their financial plans and to place loans back on regularly scheduled payments. Of the commercial loans on deferral, 95% of the dollars are making interest-only payments and only 2% or 5% of those loans in deferral are making deferred principal and interest payments. The two loans on principal and interest deferrals are the same sponsor and represent two hotels in various stages of construction or remodeling. The borrower and guarantors have an excess of $20 million in cash on their balance sheets, so this deferral has minimal credit risk and reflects more of a retention strategy. Interest payments on these loans are scheduled to resume in April of this year. Slide 25 reviews our diversified commercial loan portfolio. Horizon is a traditional regional bank offering a standard line-up of commercial loan products through an experienced and seasoned team of lenders and credit administration staff. We have a history and culture of prudent commercial loan underwriting, and commercial loan asset quality metrics continue to be favorable at quarter end. Moving to Slide 26, titled, sectors with escalated monitoring. Horizon continues its elevated monitoring in those segments that exhibit the most emphasis for high rate deferrals. As of year-end, the majority of Horizon’s payment deferrals were made to hotels, with the other non-essential businesses seeing considerable improvement in the fourth quarter. The portfolio segments that we are continuing to monitor include hotels, restaurants, leisure and hospitality. Hotel payment modifications continued to be the highest percentage of any sector, increasing from 58% of total loans outstanding as of September 30 to 72% as of December 31. This increase is due to the second COVID-19 wave starting in October and the resulting drop in occupancy rates. 19 to 20 hotel loans that are modified are making interest-only payments and two are on principal and interest deferrals. The cover we have with this portfolio is that our borrowers are long-time operators, have managed through multiple economic cycles, and 71% of the total dollars in our hotel portfolio, $101 million. The sponsors have access to liquid assets in excess of $10 million per relationship. I'll touch more on hotels in just a minute. Next, the restaurants. This portfolio continues to perform well with only $2.7 million in deferment, with all borrowers making minimum interest payments and no loans having principal and interest payment deferrals. Our confidence in this portfolio is due to the fact that the average loan amount is low at $365,000. Good current performance, long-term owner operators, and good franchises. Next, leisure and hospitality. Overall, this segment is performing well with only one loan in the amount of $130,000 under a monthly interest-only payment modification. This industry segment consists of a diverse group of borrowers including golf courses, bowling centers, movie theatres, fitness establishments, and one zoo. All entities are open with the exception of one Indianapolis business that went into non-accrual during the third quarter due to the closing of related COVID-19 restrictions. In general, we have strong, cooperative borrowers with small average loan balances of $529,000 and low loan-to-value ratios on our largest segment, which consists of golf courses. Most golf courses actually saw an increased number of rounds played in 2020. Slide 27, titled Hotel Sector locations, you'll see in the map that exhibits the locations of Horizon’s loans secured by hotels, and as you can see, the vast majority of the hotels that we financed are located along an interstate highway or resort communities. Hotels located along interstate highways are rebounding faster than those located in metropolitan areas where they are dependent upon sporting or convention venues. Our hotel loans in our portfolio are open for business, with occupancy rates dropping in October and November as a result of the COVID-19 second wave. The average decline from October to November was 50% to 38% for occupancy. Even with the stress of COVID-19, Horizon continues to report strong asset quality metrics in the fourth quarter which you can see in Slide 28. The chart in the upper left corner exhibits low total net charge-offs in the last five quarters of less than two basis points. The chart in the upper right corner shows that credit loss provision expense was low throughout 2019. And for 2020, Horizon’s provision expense was higher to build reserves due to the early adoption of CECL and primarily related to the nature of metrics and the general allocation for the nature and characteristics of our loan portfolios during this pandemic. The chart in the lower left exhibits Horizon’s total non-performing loans to total loans, which is still low and manageable as of December 31, at 69 basis points. During the fourth quarter, we experienced a slight decline in non-performing assets due primarily to payoffs received on distressed commercial loans. The chart in the lower right corner shows the allowance for credit loss exhibits Horizon at 1.4% of total loans, which is in line with the other 20 banks that have adopted CECL. Horizon’s credit loss reserves to total loans, excluding PPP loans was at 1.51%. On Slide 29, you'll see key franchise highlights. We are a seasoned management team who has managed through multiple economic cycles, excellent geographic diversification within good quality markets, strong credit culture, high-quality well-diversified balance sheet, robust capital position, and historical earnings run rate even during the Great Recession. 30 years of uninterrupted dividend payments are common shares. Overall, it's been a good year. This concludes today's fourth quarter earnings presentation and operator; please open the lines now for questions. Thank you.

Thank you. We will now begin the question and answer session. The first question today comes from Terry McEvoy with Stephens. Please go ahead.

Good morning, guys. How are you?

Good.

Hi. Good morning, Terry.

Maybe, Mark, a question for you. How should we think about expenses in 2021? I appreciate all the data on active bank users and transaction volume. And you kind of hinted at maybe some opportunities to consolidate some branches with more news to come. So, with all that said, what should expenses kind of trend and look like this year?

The fourth quarter was significantly impacted by salary and benefits expenses, as we anticipated earlier in the year. While we initially didn't have a clear outlook, we believed we would align our accruals accordingly. Overall, the salary and benefits expense for the year reflects where we should have been and will be important as we move into 2021. Additionally, we experienced some elevated expenses in the fourth quarter, including typical one-time items. In the other expense category, we had write-downs on bank-owned properties as we work to remove those from our balance sheet. Increased customer activity may lead to higher loan-related expenses in the coming year. We are evaluating branch rationalization and will share more updates on that soon, while also exploring ways to reinvest some resources in anticipation of future earnings. Although we don't provide specific forward-looking statements, the total expenses for the year should serve as a solid starting point. We will aim to maintain expense levels, but inflationary pressures may require us to adjust salary and benefits as we move into 2021.

Thanks for that. As a follow-up, it seems that the mortgage business should continue to perform well in the near term. However, there are indications that the industry may see declines throughout 2021. What are your expectations for full-year mortgage revenue, and can you provide insight on the mortgage warehouse, which ended the year with nearly $400 million?

Yes. I think as we look at it, we follow the mortgage banking direction that they were looking for about a 30% decline based on this year. Obviously, coming into the first quarter here, we still are at elevated levels, both refinancing and purchase. But I think following the guidance that we're seeing from the national industry is probably pretty good. Look at what we're anticipating, which will also impact the warehousing as we get into the rest of the year if its level slows.

Yes. Terry, this is Craig. We are directly in line with the refinance indexes that are published. So whatever trend they're taking is the same trend that we'll be taking. It has been historical norms.

Thank you.

Thank you.

Thanks.

The next question comes from Damon DelMonte with KBW. Please go ahead.

Hey, good morning, guys. How's it going today?

Morning, good morning, Damon.

Hi. Morning, good morning, Damon.

Great. So first question just on the margin. Mark, could you just elaborate a little bit more on your outlook there? I think you were saying that the core margin should probably trend a little bit lower during the course of the year. And then you talked about some of the puts and takes around that, and what could be some of those factors. Could you just kind of go back over that, please?

Yes, Damon. Our focus is on utilizing our liquidity and the excess cash we have, especially as we approach the year-end. There will naturally be some pressure on loan yields due to refinancing and the introduction of new products as rates decline. However, we are seeing loan yields beginning to stabilize, and the repricing is progressing. The greater pressure is likely to come from the asset mix. We plan to invest an additional $200 million into the portfolio at lower yields, which will impact the asset yield. We expect some benefits from the CD portfolio rolling off, which will improve our funding situation. Ultimately, the asset mix will have the most significant effect on our margin. Our goal is to grow net interest income, maximize our cash utilization, and explore ways to enhance net interest income and sustain growth. The margin will adjust based on how these assets are mixed.

Got it. Okay, that's helpful. Thank you. And then, I guess just maybe a broader question for Craig. You mentioned that you thought M&A opportunities could be arising here in 2021, could you just give us a little refresher on your geographies and some of the characteristics you look for? And then also, could you comment on market disruption and maybe follow opportunities from the HBAN's TCF transaction that was announced? Thank you.

Yes. Thank you, Damon. Some of you might be surprised that our primary focus is Michigan, Indiana, and Northwest Ohio. We are not looking at Illinois anymore, primarily because the COVID-19 pandemic has exacerbated the issues and problems in Illinois that I think will have a long-term duration. And so we're avoiding opportunities in that state. But in Indiana, Michigan, Northwest Ohio, we are hearing discussions taking place again, people are at least talking about possible M&A. We saw some recent announcements come out that I think are encouraging. So yes, I think 2021 will see a reemergence of M&A in our target footprint. Regarding the Huntington TCF acquisition, whenever there's market disruption, we pursue it vigorously. We pursue not only talent but customers through increased advertising dollars. This will be TCF's third systems change in three or four years. I can't remember the time period. That's a lot of disruption for their customers to go through. So we think there's an opportunity to pick up not only talent but as well as customers going forward. Thank you for the question.

Great. Thank you.

The next question comes from Nathan Race with Piper Sandler. Please go ahead.

Yes. Hi, guys. Good morning.

Good morning.

I was hoping to just kind of expand on just the loan growth outlook. I have PPP this year. Obviously, there are some opportunities with the M&A-related disruption in some of your geography. So just curious if there's an update from I think there was kind of a flattish outlook at PPP last quarter. Are you guys feeling more or less constructive just in terms of organic loan growth for 2021?

Yes, I'll provide some insights and then Dennis Kuhn can share his perspective on the commercial aspect. Our goal is to maintain loan levels for the year, which would be impressive given the upcoming PPP forgiveness. We anticipate that this won't occur until the third and fourth quarters. Interestingly, our commercial lines of credit have seen a significant decrease due to the PPP funds and the permanent working capital that has been invested into some strong businesses. Until those companies exhaust their cash reserves, we don't expect to see an increase in line of credit usage, which contradicts our earlier expectations of higher utilization. However, we do expect the commercial sector to recover in the third and fourth quarters. We plan to invest in commercial lenders to take advantage of the TCF Huntington deal. As for building that pipeline, we did see growth in some of our key markets. Michigan performed well last year, while there were some payoffs in Indianapolis that caused a slowdown. However, the pipelines are starting to rebuild, and I believe our growth markets will again show promise moving forward. Historically, we have reinvested profits from the mortgage sector during prosperous years into commercial lending for future growth, and that is our plan for this year. Dennis, do you have anything to add?

I think that was an excellent response. And again, as Craig said, the performance in our key growth markets, including the metrics you're hearing today on unemployment, bode well for those markets to be active. And our sense at this point is that over the fourth quarter and early 2021 here we're seeing some growth in pipelines. So there are opportunities that are starting to come to the front. It is, of course, very competitive. But we will again be looking for opportunities with regard to the Huntington TCF upheaval as well.

Got it. That's great color. And just changing gears a little bit and thinking about capital deployment. Obviously, appreciate your comments just with M&A over me and ongoing, like consideration these days and with the stock having bounced back a little bit. Just curious on your kind of updated thoughts on going back to your repurchases and just the overall upside there. And what's your remaining authorization as well, along those lines?

Well, Nathan, as we continue to grow earning assets faster than capital. I'm sorry, the vice versa, capital is growing faster than earning assets, we do have to do something with that excess capital. So we are seriously looking at our dividend as well as stock repurchases in 2021. I'm not sure when those will start, but it's definitely on our table. And the third thing is the acquisitions would also take a part of that capital. Mark, do you want to add something?

I just wanted to say that we have about 1.8 million shares remaining in our current repurchase plan.

Got you. And just as a follow-up, Craig, just curious, with the credit picture becoming a little more clear these days, is there a payout ratio that you guys are targeting this year in terms of both buybacks and common dividends relative to historical peers? I think it's been in the 30% range or so. Any updated thoughts along those lines?

Nathan, we aim to keep our payout ratio aligned with our peers to increase dividends in relation to earnings growth, and we've maintained this approach historically. I don't anticipate any changes in that direction. Previously, our payout ratio was quite low, at 25% or below, but now we are more aligned with our peers at 30% to 35%, and I don't expect that to decline. We have evolved into a more mature company compared to five or six years ago when rapid growth from mergers and acquisitions required us to retain more capital. That concern is less significant now as we operate as a much larger company.

Great. Got it. I appreciate all the color. Thanks guys.

Thank you for the questions.

The next question comes from Brian Martin with Janney Montgomery. Please go ahead.

Hey, good morning.

Good morning, Brian.

Hey, Mark, I have a follow-up question regarding margins. Can you discuss your thoughts on net interest income from a growth perspective, especially considering the impact of the PPP? I'm interested in your expectations for 2021 compared to 2020 concerning net interest income, given the changes in the balance sheet size.

Yes, I think it's just a general direction, Brian. I can't provide the specific amount. However, we discussed the margin, and hopefully as the loan yields stabilize throughout the year, alongside our repricing efforts, I believe there will be some slight pressure, but they are stabilizing. Currently, we are facing various economic indicators and issues that could change over the year. The main factor affecting net interest income will be adding liquidity to the investment portfolio. We are working on $200 million, plus additional liquidity coming from PPP forgiveness as we progress through the year. This will enable us to add more assets temporarily, but those will eventually come back. In the last round, we acquired a significant amount of cash as that capital was held in our transaction accounts, along with the liquidity we'll generate from warehousing. Our goal is to grow net interest income, but there will be some pressures due to the reduction of warehousing, PPP loans, and associated fees, which yield higher returns compared to what we can achieve with investments. Additionally, the direction of our deposits is a crucial factor. If we begin to see deposit outflows, we may need to decrease some balance sheet assets. Ultimately, the flow of deposits is driving the necessity to channel cash into earning assets.

Got you. Okay. That's helpful.

And, Brian.

Go ahead.

Brian, this is Craig, good morning. If we just maintain the dollars and margin or have a modest increase, we're going to be doing very well given I anticipate the credit provision expense should not be anywhere near that it was in 2020. And that we've built up adequate reserves. So, the strategy is to bridge this year to get to 2022 where you're going to see a return of pretty good growth numbers in the stronger net interest margins as we shrink the investment portfolio and put it back into higher earning assets. So that's our plan. We've done that before in other recessions, in other mortgage boom times. I think it's worked pretty well.

Thank you, Craig. My next question is regarding your comment on the reserve builds and the current situation. The credit quality appears to be very strong, yet there were some reserve builds in this quarter. How should we consider the reserve levels going forward, especially in a post-COVID context?

Yes. I believe CECL is functioning as intended. While we could discuss its mechanics and how they vary for each bank, it's reminiscent of how we handled our reserves in the 80s by saving earnings during strong years for future losses. I'm encouraged to see that the number of loans is decreasing. Our hotel sector performed well this summer through October, with increased occupancy rates, particularly in hotels along highways and in resort areas, thanks to an influx of visitors to these communities. The second round of PPP funding should sustain them through the next summer. However, they may not achieve the same occupancy and average daily room rates as two years ago. That said, cash flow is reasonable and should provide modest returns to investors, though not at the previous exceptional levels given the demand. We are not making conventional progress, but I feel optimistic about this segment moving forward due to additional stimulus funding. This sentiment applies to our other non-essential businesses as well. The PPP program has effectively bridged the gap in terms of credit quality, helping us navigate to the other side, which we anticipate in the summer. I sense there is pent-up demand in the retail consumer sectors, although not as much on the business side where cash is being conserved. Personally, I am eager to travel again.

Yes. Help, for sure. And maybe just given your comments on the hotel, the level of credit size assets, I think you guys gave the classifications in the release. But just how the credit size levels trend this quarter?

Yes. I'll make a broad comment, and let Dennis talk about it as well. Two things that I want to state. Number one, when we gave modification, we downgraded the credit. I'm not sure all banks are doing that. Number two, our third-party independent loan review company recommended to the board which we accepted to do a deep dive into our troubled sectors. They looked at a lot of loans, over 100 loans. And came back to the board at our meeting in December and said basically, that we were perhaps one of the best banks they've seen, how we address and attack the distressed sector. So that gives me a lot of confidence in how our team manages their accounts. When I talk about their plans to cut costs, look for capital alternatives to help them get to the other side. So very proud of what we've done. But with that, we did have an increase in substandard loans in the fourth quarter. I’ll let Dennis talk about that, Dennis?

We experienced an increase of approximately $11 million, or 12%, during the fourth quarter, primarily in our commercial sector. The largest contribution came from seven relationships, with one agribusiness seed distributor accounting for about $8 million, who is undergoing recapitalization and may finalize repayment within the first or second quarter. There were several other credits, including a few from manufacturers. Overall, we are closely monitoring our loans and actively managing them, which has led to successful workout plans, as evidenced by the reduction in nonperforming loans during the fourth quarter. Two specific loans were paid off, resulting in positive outcomes for the bank without incurring additional losses. This further illustrates our history of identifying challenges, implementing plans, and minimizing charge-offs.

I was surprised that at the end of the quarter, the industry has remained consistent all year. Our asset-based loans have mostly adhered to the formula. Over the year, a few have deviated from the formula, but that is due to growth; the asset-based formula relies less on inventory. They were accumulating inventory and haven't made any sales yet. They're building up inventory, and we believe they will return to the formula in the first quarter. Despite downgrading credits in the manufacturing sector, they have actually performed quite well.

Got you. And just to be clear, Dennis, the comment on the $11 million, was that the classified level? Or was that the level of credit size, including special mention, or did you mention special mention?

That was in the substandard, so substandard category.

And how did they get inclusive of the special mention? So the credit size number, was that direction the same way? Or how is that trending this quarter?

There was significant impact. As Craig has mentioned, when we modified loans, we took a one-step downgrade. So there was certainly additional movement early in the year within the special mention. But as we've progressed, and we're getting the opportunity to review those credits again, we are seeing that they are stable, they are making payments. And we are starting to actually see some reversal of that and will over time we expect special mention will actually reduce. So there'll be of course, some level of migration. But again, what we're seeing at this point has been favorable.

Yes. Brian, by example, most of our hotels went into special mention, and some into substandard. But 71% of our hotel dollars outstanding have sponsors with $10 million plus in liquid assets, very well-healed sponsors that can support the portfolio going forward.

Got you. Okay. Thanks for taking the questions, guys.

Thanks for the questions, Brian.

This concludes our question and answer session. I would now like to turn the conference back over to Craig Dwight for any closing remarks.

Thank you, Anita, and thank you for participating in today's earnings call. We look forward to speaking to you again hopefully in person in the near future. Let's get to the other side of this pandemic. Thank you. Have a great day.

This conference has now concluded. Thank you for attending today's presentation. You may now disconnect.