First Internet Bancorp Q2 FY2022 Earnings Call

Good day, everyone, and welcome to the First Internet Bancorp Earnings Conference Call for the Second Quarter of 2022. And please note that today's event is being recorded. I would now like to turn the conference over to your host, Larry Clark from Financial Profiles. Please go ahead, Mr. Clark.

Thank you. Good day, everyone, and thank you for joining us to discuss First Internet Bancorp's financial results for the second quarter of 2022. The company issued its earnings press release yesterday afternoon and is available on the company's website at www.firstinternetbancorp.com. In addition, the company has included a slide presentation that you can refer to during the call. You can also access these slides on the website. Joining us today from the management team are Chairman and CEO, David Becker, and Executive Vice President and CFO, Ken Lovik. David will provide an overview and Ken will discuss the financial results. Then we'll open the call up to your questions. Before we begin, I'd like to remind you that this conference call contains forward-looking statements with respect to the future performance and financial condition of First Internet Bancorp that involve risks and uncertainties. Various factors could cause actual results to materially differ from any future results expressed or implied by such forward-looking statements. These factors are discussed in the company's SEC filings, which are available on the company's website. The company disclaims any obligation to update any forward-looking statements made during the call. Additionally, management may refer to non-GAAP measures, which are intended to supplement but not substitute the most directly comparable GAAP measures. The press release available on the website contains the financial and other quantitative information to be discussed today, as well as a reconciliation of the GAAP to non-GAAP measures. At this time, I'd like to turn the call over to David.

Thank you, Larry. Good afternoon, everyone, and thanks for joining us today. The First Internet team delivered another strong quarter, highlighted by robust commercial and consumer loan production while maintaining excellent credit quality. Through the first half of 2022, yields on new loan originations were up over 100 basis points compared to this point in time last year. We benefited from the rising rate environment and deployed existing on-balance sheet liquidity to drive growth in net interest margin. Fully taxable equivalent net interest margin increased 5 basis points to 2.74%. For the second quarter, we are reporting net income of $9.5 million and diluted earnings per share of $0.99. Excluding non-recurring expenses, which we will cover in just a moment, we recorded adjusted net income of $10.3 million or $1.06 per diluted share. Adjusted for the non-recurring items, we generated a return on assets of 1% and a return on average tangible common equity of 11.15%, and both tangible book value per share and tangible common equity to tangible assets increased even as we repurchased over $11 million of our common stock during the quarter. Loan production was the highlight of the quarter. Total loan balances increased $201.3 million or 7% from the prior quarter and now stand at an all-time high of $3.1 billion. Total portfolio originations for the quarter were $333.5 million, up almost 115% over origination volume in the first quarter. Nearly $250 million of that came from our commercial lending lines. Our partnership with ApplePie Capital, the fintech-oriented specialty lender that focuses on lending to the franchise industry, will continue to be a standout performer in the second quarter. Together, we are providing credit to proven entrepreneurs throughout the country. We funded over $63 million of attractively priced franchise loans during the quarter and now hold nearly $170 million in this portfolio. Our public finance team had an outstanding quarter as well with over $37 million of funded originations during the quarter. The team has intentionally focused on shorter-duration loans and with the rise in interest rates has capitalized on a number of opportunities from 12 to 18-month term loans at tax-exempt spreads well above treasury yields. Single-tenant lease financing also had a fantastic quarter as we funded over $50 million of new loans during the period. The single-tenant pipeline is approaching an all-time high, and as we near the end of the quarter, the majority of the new production came in at interest rates north of 5%. Construction lending continues to be another key line of business for us. Our team sourced over $65 million of new originations during the quarter, which included almost $17 million of funded balances. At the close of the second quarter, unfunded commitments in our construction line of business totaled $211 million, up 15% over the levels at March 31. Despite the fact that gain on sale revenue was down in the second quarter, we remain very bullish on our SBA platform. We finished the quarter on a great note. June production was a year-to-date high for us, and that momentum has carried into July. The second half of the year is seasonally stronger for small business lending. Our pipeline is continuing to grow and we expect strong originations in the third quarter. That said, the secondary market for the guaranteed portion of these loans has reverted to historical averages following the conclusion of government programs that inflated these premiums over the last few years. Because we have balance sheet capacity, we can and have added SBA loans to our portfolio rather than sell them when the market premiums are soft. After taking into account the lower amount of loan sales in the second quarter, as well as lower gain on sale premium expectations, we now forecast SBA gain on sale revenue to be in the range of $10.5 million to $11.5 million for the year. Overall, our commercial loan businesses are performing extremely well. The pipeline is up 28% from the end of the first quarter, which leaves us well positioned to capitalize on growth opportunities for the remainder of the year. And as we mentioned on the call in early May, we have additional opportunities in the commercial finance space. We are confident to have substantial upside as we pair our balance sheet capital and nationwide lending expertise with specialized asset generation platforms. Our consumer lines of business also performed well during the quarter with higher balances in residential mortgage, recreational vehicle, and trailer loan portfolios. While rising interest rates and inflationary pressures may evidently impact consumer demand, particularly in the residential mortgage, we experienced strong origination growth in our specialty consumer lines, which were up 72% over the first quarter. Our credit quality remains excellent and among the best in the industry. During the quarter, our ratio of non-performing loans to total loans improved by 10 basis points and stood at just 0.15% as we continue to resolve problem credits in a very positive manner. The last line of business I want to discuss is our ongoing strategy around fintech partnerships and Banking-as-a-Service. We have spent the last twelve months building out a robust risk management and compliance infrastructure to support this strategy. In my 40-year career, most of that in technology and software-as-a-service, I have seen time and time again that you have to have the back of the house ready before you turn on the sales bucket. We have brought on new talent with deep risk management experience in the Banking-as-a-Service space. We have re-allocated internal resources to ensure that we are building the appropriate policies and procedures to review, onboard, and monitor fintech partners in a scalable manner. As fintechs and bank partnerships with fintechs are coming under increasing scrutiny from the regulatory world, our goal is to ensure that we have a best-in-class risk management platform to support our Banking-as-a-Service strategy. Furthermore, as many of you are aware, the fintech space has currently experienced some upheaval. Venture capital firms are focusing more on long-term viability and profitability as opposed to simply customer or revenue growth. We have a similar view and are approaching these potential partnerships methodically with rigorous due diligence to ensure that they have compelling unit economics, which will be accretive to earnings and are scalable across our platform. With these objectives in mind, we do have a number of initiatives in motion to help drive higher financial performance over the next several years. We are currently working towards finalizing agreements with two leading Banking-as-a-Service platforms that are expected to both increase the number of fintech partnership opportunities and make it easier for us to bring the partnerships to market faster. We are also actively sourcing and evaluating our own direct fintech partnership opportunities. Since launching our fintech partnership effort, we have reviewed over 100 opportunities. However, to my comments earlier on the long-term viability of fintechs, the funnel is very steep. Most of them have been of low or average quality that do not meet our organizational objectives or quality standards. In just the last two quarters alone, we have evaluated over 80 opportunities. While we are in various stages of valuation with several of these fintechs, we have only moved on to further due diligence with three of them, and with only one have we elected to move on to implementation. We went into this with our eyes open about the state of the fintech space and the patience to search for the right partnership. So to wrap up the fintech discussion, we remain committed to building a strong presence in the Banking-as-a-Service and fintech partnership space and remain optimistic that over the long run, it will provide new channels for lower-cost deposits, fee revenue, and lending capabilities. However, we only do so in a manner that has a rigorous risk management framework and with partnerships that meet our organizational and financial objectives. Before I turn it over to Ken, I would like to recognize the entire First Internet team for their commitment to our customers and the company's success. In the second quarter, we said goodbye to three senior leaders who retired. Associated with their departures, we incurred an expense of $300,000 and accelerated equity compensation. Of expenses one-time, their legacy will be long-lasting, I wouldn't be surprised if they're listening to this presentation, and so I thank each of them for their enduring contribution to our organization. I hope the fish are biting and the fairways are rising up to meet them. I believe First Internet has been able to attract and retain talent of their caliber because we foster a workplace culture that encourages innovation, collaboration, and customer focus while supporting work-life balance. We also champion diversity as evidenced by the composition of new hires we brought on board in the first half of 2022. A broader spectrum of backgrounds and experiences produces more ideas and creativity and ultimately better results for all of our stakeholders. It was gratifying to see these attributes recognized when our employees voted us one of the top workplaces in Central Indiana by the Indy Star for the ninth consecutive year. As an Employer of Choice, we felt the responsibility to address the rapid rise in transportation, housing, and food costs in order to allow our employees to devote their best mental energy to serving our customers. In the second quarter, we implemented a $20 minimum hourly wage for full-time employees across the company. Additionally, we paid a bonus to those employees most impacted by the current inflationary environment. The bonus amounted to $500,000 as a one-time expense, one I was very proud to support. For more than two years, we have been living in extraordinary times. We intend to stand behind our professionals, who have stood with us and our customers through it all. I would like to thank the entire First Internet Bank team for their consistent execution of our strategies and for delivering solid operating and financial performance while providing an exceptional experience for our customers. With that, I'd like to turn the call over to Ken to discuss our financial results for the quarter.

Thanks, David. Looking at Slide 4, total loans at the end of the second quarter were $3.1 billion, up 7% from the first quarter and up 4.2% from June 30 of 2021. David covered the highlights for the quarter from a lending perspective, including the growth pretty much across the board in our commercial segments, as well as strong growth in our specialty consumer lines. This activity was offset by decreases in healthcare finance, which has been in a run-off mode for several quarters, and in construction lending, where we had about $34 million of loans convert to permanent financing and another $8 million payoff. Moving on to deposits on Slide 5, overall deposit balances were down modestly from the end of the first quarter, but we continue to see notable improvement in the composition of our deposit base. During the quarter, non-maturity deposits increased by $53.5 million, due primarily to a $144 million increase in Banking-as-a-Service deposits from a relationship that we developed in the first quarter. However, this was partially offset by a $112 million decline in money market accounts due mainly to some customer activity that can be uneven from quarter to quarter. Additionally, CDs and brokered deposits continued their downward trend decreasing $119 million or 10.2%. Compared to the first quarter, the cost of interest-bearing deposits increased 4 basis points. Turning to Slide 6 and 7, net interest income for the quarter was $25.7 million and $27.1 million on a fully taxable equivalent basis. Both were relatively stable with the first quarter. With the strong loan production during the quarter, we capitalized on the opportunity to further optimize the balance sheet by deploying excess liquidity to fund higher yielding originations, as well as support continued CD and brokered deposit maturities. We were especially thrilled that we were able to effectively offset the expected decline in net interest income from revenue on tax refund advance loans, which totaled $2.9 million in the first quarter. The yield on average earning assets increased to 3.65% from 3.58% in the first quarter due primarily to a 33 basis point increase in the yield earned on securities and a 66 basis point increase in the yield earned on other earning assets. While the reported yield on average loans was down 21 basis points from the first quarter, if you exclude the effect of the revenue we received on tax refund advance loans, the yield on the loan portfolio increased 7 basis points to 4.29%, again reflecting strong growth and higher pricing on new originations. We recorded a net interest margin of 2.60% in the second quarter, an increase of 4 basis points from 2.56% in the first quarter and fully taxable equivalent net interest margin increased 5 basis points to 2.74%. As you can see on Slide 7, the 5 basis point improvement was driven by a 5 basis point contribution from securities and a 4 basis point contribution from cash, partially offset by modestly higher deposit costs and the impact of lower reported loan yields, which again included the effect of tax refund advance lending in the first quarter. As you can see on the graph on Slide 7, thus far in this rate tightening cycle, we have been able to keep deposit costs relatively constrained in comparison to the increase in the Fed funds rate. As we noted in the earnings release, given the 150 basis point increase in the Fed funds rate beginning in March and through June 30, we have not increased the rate paid on consumer, small business, and commercial interest-bearing demand deposits. Related to money market products during this period, the rate paid on consumer money market balances increased 50 basis points, resulting in the cycle-to-date deposit beta of 33%, and the rate paid on small business and commercial money market balances increased 30 basis points, resulting in a cycle-to-date deposit beta of 20%. With small business and commercial balances now representing 62% of total money market balances, the all-in cycle-to-date deposit beta on money market products is 25%. With regard to our outlook on net interest income and net interest margin for the remainder of the year, I would like to highlight a couple of observations. First, this is one of the few times in the history of the bank that money market rates have been lower than the Fed funds rate. So we are effectively making a positive spread on our cash balances at the Federal Reserve. Second, during the last cycle, we relied on higher cost, higher beta CDs to support balance sheet growth. As we entered the current cycle, the improved composition of our deposits means we are funding growth with lower cost and lower beta non-maturity deposits. As far as top-line interest income goes for the second half of the year, we feel confident that the combination of continued loan growth and higher yields on new production, as well as variable-rate assets repricing higher will drive strong growth in total interest income. On the funding side, with higher forward rate expectations, we do expect deposit costs to increase as well. However, we also expect that the pace of increase in total interest-bearing deposit costs will be somewhat lower than the increase in interest earning asset yields. As a result, we forecast continued growth in net interest income with modest net interest margin expansion. Turning to non-interest income on Slide 8, non-interest income for the quarter was $4.3 million, down from $6.8 million in the first quarter. The decrease was a result of the decline in the gain on sale of loans, lower other income, and lower revenues for mortgage banking activities. David covered the activity and the outlook for our SBA line of business, so beyond that other income declined $300,000, due primarily to a decline in the value of fund investments carried at fair market value, and consistent with other mortgage originators, we saw a decline in mortgage revenue due to a decrease in interest rate locks and sold loan volume driven by the higher rate environment and its impact on both the purchase and refinance markets. In terms of mortgage banking revenue going forward, given the broader negative outlook for the mortgage industry, we are now decreasing our forecast for the remainder of the year. We now expect mortgage revenue to be in the range of $5.5 million to $6.5 million for the full year of 2022. This forecast represents the outlook for our existing digital direct-to-consumer and central Indiana-based mortgage businesses. With the current challenges in the mortgage market, we are in the earlier stages of evaluating a couple of innovative partnerships that could potentially open up new origination channels for us. More to come on these opportunities on future calls. Moving to Slide 9, non-interest expense for the second quarter was $18 million, down $800,000 from the first quarter. The decrease was due primarily to lower loan expenses, consulting, and professional fees, and other expenses, partially offset by increases in salaries and employee benefits and marketing costs. The decrease in loan expenses was driven primarily by lower service and fees as $900,000 of fees related to the tax refund advance loans were incurred in the first quarter as opposed to a nominal amount of such fees in the second quarter. The decrease in consulting and professional fees was due primarily to $900,000 of non-recurring consulting fees that were incurred in the linked quarter. Additionally, we incurred $100,000 of acquisition-related expenses in the second quarter as opposed to $200,000 of these costs in the first quarter. The higher salaries and employee benefits expense was due mainly to a $500,000 discretionary inflation bonus and $300,000 of accelerated equity compensation that David mentioned in his comments, partially offset by lower incentive compensation in the company's small business lending and mortgage banking divisions. The increase in marketing costs was due to higher media costs, mortgage lead generation costs, and sponsorships. Now let's turn to asset quality on Slide 10. As David mentioned earlier, credit quality remains excellent and even improved during the quarter as non-performing loans and non-performing asset ratios continued to decline. Net charge-offs of $283,000 were recognized during the second quarter, resulting in net charge-offs to average loans of 4 basis points. Excluding net charge-off activity related to the final balance of tax refund advance loans, we recognized net recoveries of $100,000, resulting in net recoveries to average loans of 1 basis point during the quarter, our second straight quarter of net recoveries. The provision for loan losses in the second quarter was $1.2 million, compared to $791,000 for the first quarter. The linked quarter change was driven primarily by the growth in the loan portfolio. The allowance for loan losses increased $900,000 or 3.2% to $29.2 million as of June 30, 2022, compared to $28.3 million as of March 31, 2022. And the ratio of the allowance for total loans decreased 3 basis points to 0.95% as of June 30, 2022. The ratio of the allowance to non-performing loans increased to 644% at quarter end, compared to 399% as of March 31, due to the increase in the allowance and a decrease of $2.6 million or 36% in non-performing loans. The decrease in non-performing loans was due primarily to the upgrade of the C&I relationship and the full payoff of a single tenant lease financing loan. With respect to capital, as shown on Slide 11, our overall capital levels at both the company and the bank remain strong. Our tangible common equity to tangible assets ratio increased 4 basis points to 8.81%, which is the highest it has been in recent history. Additionally, while many banks are experiencing a decline in tangible book value per share, ours increased during the quarter to $38.35, up from $38.21 in the first quarter and up almost 7% year-over-year. During the second quarter, we repurchased 294,464 shares of our common stock at an average price of $37.77 per share as part of our authorized stock-repurchase program. Including shares repurchased in the fourth quarter of 2021 and the first quarter of 2022, we have repurchased 498,167 shares at an average price of $41.50 per share through June 30. In total, we have repurchased $20.7 million of stock under the total authorization of $30 million. With regard to capital management going forward, we enjoy being in the position of having excess capital as it provides tremendous flexibility. As David mentioned earlier, our lines of business have strong pipelines and we continue to explore new opportunities in both the commercial finance space and through Banking-as-a-Service and fintech partnerships. We want to be able to capitalize on these opportunities as they arise as these are what will drive outsized earnings growth in the years to come. However, that flexibility also allows us to remain in the market for our stock, supporting our shareholders when the price is not reflective of our franchise value. And now turning to Slide 12. We continue to feel we are much better positioned for a rising rate environment than we were at the beginning of the last rate tightening cycle. Over the last two years, we have improved our deposit composition with a larger percentage of non-maturity deposits. And as I mentioned earlier, during the last cycle, we were much more reliant on CDs to support balance sheet growth, which experienced deposit betas at or in excess of 100%. Furthermore, cycle-to-date, we are experiencing much lower betas in our non-maturity deposits than in previous cycles. And even within money market balances, our ability to grow small-business accounts, which are much less rate-sensitive than consumer balances has muted the impact of price competition on our all-in cost of deposits. We also continue to remain focused on originating higher yield in variable rate in short-duration loans, notably through both SBA and construction lending. And while we are still originating longer fixed-rate loans, areas of growth notably franchise finance and single-tenant lease financing, new originations are coming on at much higher yields. And finally, while mortgage revenue is expected to pull back from the historic highs we have seen over the last two years, our long-term investment in SBA lending has added greater diversification to non-interest income, which we expect will be further diversified as we onboard fintech and Banking-as-a-Service partnerships, providing revenue stability regardless of the interest rate environment. With that I will turn it back to the operator so we can take your questions.

We will now begin the Q&A session. The first question is from Michael Perito with KBW. You may proceed.

Hey, good afternoon, guys.

Hey, Mike.

Hi, Mike.

So thanks for the prepared remarks, a lot of helpful commentary in there. There are a couple of things I wanted to expand on. First just Ken on the OpEx side, I wanted to hit this before I kind of dig into some of the growth opportunities. But you talked about some of the pressure, some one-time items, but obviously the run rate was a little lower? I mean, is there any more specifics you can give kind of on the back half of the year understanding it's kind of a difficult OpEx prediction environment. But just any kind of range you guys are thinking of, especially with the mortgage run rate stepping down to the range you guys disclosed the $5.5 million to $6.5 million what the OpEx could look like here?

Yes, it came in a bit lower than our forecast when excluding the one-time charges. Some of this was due to a decrease in mortgage and SBA commissions, and also the timing of new hires and planned technology investments played a role. For the rest of the year, I believe we are looking at a range of low to high 18s over the next few quarters, probably increasing gradually. As David mentioned regarding taxes, we are continuing to invest in our team, and we have some scheduled investments coming up. This will lead to a slight increase, but I believe it will align with what many of you have in your models already.

Got it. Helpful, Ken, thank you. And then, secondly here on some of the fintech partnership initiatives. It sounds like you guys are being highly selective, which I think makes a lot of sense, because obviously it's an interesting market in the realm of fintech right now. But I was wondering if you could maybe bifurcate for us a little bit more, how are you viewing these opportunities in terms of lending deposits and fees and where the pipeline sits today? And maybe what opportunities you think could be the most meaningful near-term? Could we see some fee acceleration? Are there largely deposit opportunities that we've seen you guys had success with already? I know you mentioned a couple of lending. Just spending a little bit more time there, I think it’d be helpful.

Mike, we have a lending opportunity coming up in the next 30 to 45 days. We should be live on deposits, as Ken mentioned from the fintech perspective. There’s another significant relationship expected in the next 45 to 60 days that offers a mix of service fee income potential. It has been a bit frustrating; I've said before, we've had to explore many options before finding the right ones. However, as we've navigated the marketplace, we are gaining visibility and connecting with reputable partners who have been involved in this space for years. In the last three weeks, we’ve encountered three deals that are likely the best we've seen all year. It’s a matter of persistence, and eventually, one of them will come through. We have a couple of prospects in the pipeline that could accelerate. During a conversation on Monday, the gentleman expressed frustration about the typical six-month process for fintechs to establish partnerships and another six months to make those partnerships operational. I believe we can reduce that timeline from 12 months to a 90-day to six-month process. This is what we've organized internally, and I think we are well-positioned to make this work, creating good opportunities. We have strong partners in legal and accounting who have experience with fintechs. Some fintechs are currently seeking new banks due to issues with their existing banks and regulators. Therefore, there are potential opportunities for bringing in ready volume. There are still many exciting possibilities that we will have a great chance to pursue. It’s been frustrating internally, but we have also managed to establish a solid system for onboarding, and hopefully, we will have more than enough support from our compliance and back-office teams. We want to ensure we align with regulatory requirements as we onboard these new clients, unlike some of our peers.

Got it, David. Thank you, very helpful. And just last for me, maybe question back to Ken, and I apologize if I missed this, I heard some of the micro NIM commentary and whatever, but it's just as we think about your overall positioning, the rate environment as it stands today, the balance sheet positioning as it stands today. I mean, you guys have kind of been flat at about $27 million on the NII for the last two quarters. I mean, are you guys hopeful you'll be able to hold the line there within a reasonable range? Or do you think there will be some downward pressure that starts to manifest, particularly if we get another 75 basis point hike next week and the rate of hikes remains accelerated?

No, I think the way that we look at it is if you back out the tax revenue, the revenue from tax refund advance lending last quarter, which was about $2.9 million and you're familiar with that business, Mike, that's predominantly this quarter's event. When you back that out, I think what we were really, really happy about is that we made up that difference, right? So if you want to back that out or call that a core number for lack of a better term, I mean, we picked up almost $3 million of NII. And I think with the way looking at what the forward rate curves look like with our production, our loan production focused on higher yielding products, things repricing higher, and where betas we’ve been on deposits and we are going to do everything we can and we're not really getting pressure to go above these betas on the deposit side. So with that, I mean, we continue to expect to see, as far as net interest income goes, continue to grow. If I think one thing this quarter is we did put a lot of cash to use and we try to expect that, you know, call it a 30 basis point bump in net interest margin is probably unrealistic, because of our deployment of cash. But I think in terms of being able to creep net interest margin up, as well as grow NII dollars, we see a clear pathway to being able to do that.

Great. Yes, it's clear that the balance sheet appears to be positioned quite differently this time, which is positive. Thank you for addressing my questions.

Yes. Thanks, Mike.

Thank you. The next question is from the line of Nathan Race with Piper Sandler. You may proceed.

Yes. Hi, guys. Good afternoon.

Hey, Nate.

Hi, Nate.

Question maybe just drill into the margin outlook a little bit more. I know you guys indicated in the deck that rates on new loan originations are 100 basis points above what we saw last year. So I was hoping you could just kind of quantify where you guys have put loans on the portfolio today relative to, I believe, the portfolio yield at 431 or so in the quarter?

Yes, we have a blended yield, but on the commercial and consumer side, keep in mind that some of the deals funded in May and June were priced in April. New production during the quarter averaged over 4.5%. What excites us is that new deals in the single-tenant sector are now quoted above 5%. Our partnership with ApplePie has deals priced close to 6%. As we've experienced a rate increase, yields on variable loans and construction and SBA have risen; our SBA portfolio averages around prime plus 2.50%. This trend is expected to continue, leading to an increase in overall yield. However, it's somewhat like turning a battleship, given we have a $3 billion portfolio. As older loans amortize and new loans come in at higher rates, the core portfolio yield is around 4.30%. We anticipate continued growth in the overall yield of the loan book.

Okay, great. And then just maybe thinking about the right side of balance sheet. Deposit growth lagged relative to loans this quarter. I know you guys spoke about Banking-as-a-Service deposit wins. So just curious, kind of what rates you're paying on those deposits? And just the opportunity to fund deposit growth commensurate with that of loans, which it sounds like you guys are still comfortable with kind of 10% to 12% loan growth going forward?

Yes, our goal is to fund loans using deposits. We have noticed some volatility in our money market balances at the end of the quarter, but we are still seeing growth in small business money markets. The deposits from Banking-as-a-Service are priced closely to the Federal funds rate. These rates will increase, and a key advantage is that they are roughly 200 basis points lower than funding through certificates of deposit.

Another way to look at this is that while we don't intend to borrow solely to make loans, we can secure a five to seven year loan from the Federal Home Loan Bank at a lower cost than obtaining six to nine month commercial CDs. The market is quite unusual, with long-term rates remaining stable while short-term rates are rising. If the Federal Reserve raises rates by 75 basis points next week, the cost of short-term money could increase by 100 to 125 basis points compared to five-year rates. We are considering all options. Ken's team is closely monitoring rate curves and market activity almost continuously. There is significant volatility in the market that could be both advantageous and risky. We believe Ken has developed a solid strategy, and we see opportunities to attract deposits. As I explained to Mike earlier, we are evaluating these on a daily basis, looking at fintech companies and other players offering rates between 1% and the Fed funds rate. We are actively pursuing these opportunities and adapting as the situation evolves.

Yes. We are preparing to launch a partnership with a commercial finance company that will provide both lending and deposit services. The deposit opportunities involve operating accounts for their client base, which is exciting because it includes small business checking accounts for which we are offering a 40 basis point interest rate.

Okay, got you. So just trying to put those pieces together, it sounds like you're still comfortable with kind of 10% to 12% loan growth and maybe a moderate lag in deposit gathering?

Yes.

Okay, great. And just kind of thinking about the loan growth outlook, obviously you guys have provided for really strong growth in the quarter. And assuming growth reverses that 10% to 12% range? How are you guys thinking about providing better growth relative to where the reserve stands today?

It will probably be in line with that. Obviously, we reserved a little heavier on the commercial side than the consumer, but some of that is offset as we continue to put some short-term money to use in public finance. So I would say just kind of model the reserve where it is today.

Okay, perfect. I appreciate all the color. Thanks for taking the questions.

Thanks, Nate.

Thanks, Nate.

Thank you. The next question is from the line of Brett Rabatin with Hovde Group. You may proceed.

Hey guys, good afternoon.

Hey, Brett.

Hey, Brett.

I wanted to talk about fintech for a second. And on the call with the First Century transaction cancellation, you indicated that the things that were in progress could add about $0.35 a share to the ‘23 earnings. Can you give us an update on that? And then also wanted to ask about these from a lending perspective opportunity these credits that you're putting on. Are there any credit enhancements, or generally speaking, what is the framework on the loans that are going to come from fintech players?

Maybe I'll address the EPS buildup first. I mean, I think when we look at those opportunities going forward, I think the kind of the guidance we gave them, I would say is probably on the low side when we talked about existing opportunities with $0.35 of additional EPS on that. Some of those players, some of those things that we're working on, again, the thing I mentioned before with the loans and deposits thing, that is one of the items and we're getting closer to launching on that and that probably to be honest has more earnings upside than we initially modeled out. And we continue to work on some of these other projects as well. I mean, I know like one of the things we were moving towards was more of a consumer lending opportunity, we’re probably slowing that down a bit, just kind of in the wake of potential recessionary period and just kind of making sure we got our arms around that. But we've had a couple of other things slide in as well that as David alluded to on projects we're working on in the fintech space. So I think a couple of moving parts, but I think we feel, still feel pretty good about the upside earnings contribution which quite frankly could be conservative in the long run.

In response to your question about credit enhancement, I didn't quite...

Yes, so David what I was just trying to figure out is on these fintech loans that you add to the balance sheet, is there any structure where they have to set up a reserve for the loans that you're putting on your balance sheet or it's just straight amortization and there is no credit enhancement? What kind of terms are you doing on these loans?

It's a combination of various factors. Some of the funds we receive are on a percentage basis related to specific loan deals, and some come from the commercial segment. However, the majority is straightforward credit, and the yields are sufficient to cover our reserves. The overall impact of loan yields will balance out the increased reserves needed for some consumer-oriented products. As Ken mentioned, we’ve taken a step back from certain consumer opportunities due to risk, and while some of our peers may talk about potential hurricanes, I believe we might just encounter occasional localized issues. So far, consumer activity hasn’t shown significant fluctuations. Our RV portfolio remains stable and continues to grow significantly despite rising gas prices. Consumers are in a better position now compared to the past, but we remain cautious. Currently, a major challenge in the fintech sector is that many companies are trying to finalize their B, C, and D financing rounds to advance their growth. Promised funding timelines have shifted, which has caused delays. Investors are now more focused on establishing paths to profitability. Articles indicate that around 95% of fintech companies currently lack a clear route to profitability. If these companies fail to secure their next funding round, it won't directly affect us since they are accountable to their customers, but it could harm our reputation since we're indirectly associated. We aim to be careful and methodical in our approach, which might frustrate some team members. With 40 years in the software industry, I’ve seen the warning signs. There are robust fintech players with strong capital, but public companies have faced significant declines, such as Upstart’s drop from around $400 to $26. We want to ensure we make sound decisions before proceeding.

And Brett, to address the question on credit enhancement, I associate that with lending opportunities that are a bit further out on the risk spectrum. However, that's not the kind of lending we are pursuing. The lending opportunities we are focused on are primarily on the consumer side, targeting prime and super-prime borrowers, the types we are accustomed to underwriting and feel comfortable with. On the commercial side, we are looking at more established types of credits rather than lending to start-ups or similar ventures. Therefore, we are not venturing out on the risk spectrum when considering fintech lending opportunities.

Okay. That's really helpful. And then wanted to make sure I understood the discussion around the deposit betas from here? And just thinking about money market in particular. I know money market didn't really move much in 2Q. When I look online, I see a lot of pretty high rates and I see it posted rate of 1.16 for you guys and some higher rates even than that. Can you explain to me if you can, kind of the thought process on the deposit betas from here and specifically in the money market account?

What we've observed so far is that pricing has remained fairly stable, particularly in the consumer sector, where competition has intensified but is behaving better compared to the last rate tightening cycle. During the previous cycle, we saw a frantic race to raise rates. Currently, it appears that money is not flowing out, leading us to believe that over the next several quarters, deposit betas should stay reasonably constrained. It's also important to note that since the last cycle, when our money markets were primarily consumer-focused, we've expanded significantly into small business. Now, nearly two-thirds of our money market base consists of small business or commercial deposits, which are less sensitive to rate changes. This shift means that the pricing for these accounts has been much less impacted by rates than before. Therefore, we believe that the betas on our money market accounts will remain significantly lower than they were during the last cycle.

Okay, that's helpful. Great, congrats on the strong loan growth in the quarter.

Thank you.

Thanks.

Thank you. The next question is from the line of John Rodis with Janney. You may proceed.

Hey, good afternoon guys.

Hey, John.

Hey, John.

Hey. Hey Ken, just on the tax rate dropped down some this quarter. What sort of rate should we use going forward?

Yes. What's really driven the rate down is the significant decline in mortgage and SBA, along with growth in public finance, which has slightly increased the proportion of tax-exempt income. As we continue to achieve success with commercial loan growth in sectors like single-tenant and franchise, and hopefully see a rebound in SBA, I believe using a tax rate of 13% to 13.5% would be appropriate.

Okay and then Ken, just one more question on your comments on the margin. I think you said modest expansion from the second quarter level. And if you look at the reported margin from the first quarter, the second quarter, it was up 5 basis points on an FTE basis from 2.69% to 2.74%. Is a 5 basis point increase, is that modest? How should we think about this?

Yes. That's in the range.

Okay, Okay. Just wanted to check. Thanks.

Thanks, John.

The next question is from the line of George Sutton with Craig-Hallum. You may proceed.

So guys, relative to the gain on sale spreads having come down, I'm curious how you're now going to market with your SBA offering? You were fairly active in the market, at times many were not, and that I think at the end of the day was related to the high spreads. How are you going to market now given that it's more on your balance sheet? Just curious about the total volume opportunity?

Actually, George, we're probably as active or more active than we have been historically for the reasons you just outlined. Many people are starting to pull back on the SBA side of things. From our balance sheet perspective, if we can put a 75% guaranteed loan on the books at a 7% or 8% rate, we will do it continuously. We finished the quarter with what we refer to internally as about a $28 million bubble, which consists of loans that have been done, approved, and are ready to go. As you know, the SBA has a variety of standard operating procedures that must be followed. This means the loans have passed through credit and underwriting, and now we're just waiting for a specific document, a piece of paper, or a signature to bring it across the finish line. Therefore, we have $28 million pending that is ready to close, in addition to another $34 million in the pipeline. The SBA sector is stronger than ever. We aimed to reach $200 million this year; however, due to market activity and rising rates, some participants are being impacted. The housing market is starting to shrink, and the refinancing opportunity has diminished because of higher rates. I anticipate that overall SBA activity will slow down in the fourth quarter due to rates of 7%, 7.5%, and 8%, along with the Fed's policy of an additional 75 basis points. But in terms of our market activity and pursuit of SBAs, we are still actively engaged.

Thank you for that clarification. I wanted to revisit an earlier question regarding the First Century call. Previously, you mentioned the potential to enhance the core business and execute buybacks, leading to a target of around $6 for 2023. Are you still indicating that this is a feasible opportunity, or has there been a shift in that outlook?

I would say, George, probably the one if you wanted to take the most conservative look at that possible, I would think about mortgage, because obviously mortgage, our forecast for 2022 mortgage was coming down, right? It was down and we were kind of forecasting consistent with for '23 with what we had for '22. We’ll now obviously, as we mentioned earlier and what's going on, we've revised mortgage down a bit. One conservative way to look at that is you could probably take $4 million or call it roughly $0.40 of EPS away due to mortgage and look at it that way as the most conservative sense. On the other side of it, I would say that some of these other opportunities we had, or maybe we were saying $0.35 of opportunities that could be north of $0.50 or $0.60, where we have to let some of those play out. But I think we have some tremendous opportunity with some of these others. So on the low end, you could cut, but I think on the high end and some of the things we're looking at, I think we feel that we could get back to that number anyway.

The big play too will be, George, depending on what the Fed does for the balance of the year and the forward curves are showing that by the first quarter next year they're going to be back in a position and to lower them a little bit, if they keep going up at 50, 75 every time they need. So that could bring mortgage back mid-year. I think if mortgages got back into a mid-four handle then it's going to pop right back to where it was, at least on the purchase side of things. Re-fi, maybe not so much, although there are some people that are out there now getting 5.50%, 5.75%, 6% mortgages that in the mid-four could open up a refi business second half of the year. So I agree with Ken 100% that the biggest wildcard we have, we think SBA will be strong. We think all of the other lending verticals we've got are strong, a couple of verticals and new opportunities we’ll bring it on have tremendous potential that we're going to hit it all across the line. The real, real wildcard for this mortgage.

Perfect. Thanks, guys.

Thank you. There are no additional questions at this time. I will pass it back to David Becker for any closing remarks.

Again, we appreciate all of you joining us today. We hope you have a great day and look forward to speaking with you all again soon. Thank you very much.

That concludes today's conference call. Thank you. You may now disconnect your line.