Midland States Bancorp, Inc. Q1 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by and welcome to the First Quarter 2020 Midland States Bancorp Earnings Conference Call. At this time, all participant lines are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference may be recorded. I would now like to hand the conference over to your host today, Mr. Tony Rossi of Financial Profiles. Please go ahead, sir.

Thank you, Liz. Good morning, everyone, and thank you for joining us today for the Midland States Bancorp first quarter 2020 earnings call. Joining us from Midland's management team are Jeff Ludwig, President and Chief Executive Officer, and Eric Lemke, Chief Financial Officer. We will be using a slide presentation as part of our discussion this morning. If you've not done so already, please visit the Webcast and Presentations page of Midland's Investor Relations website to download a copy of the presentation. 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 Midland States Bancorp that involve risks and uncertainties, including those related to the impact of the COVID-19 pandemic. Various factors could cause actual results to be materially different 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 for 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 the reconciliation of the GAAP to non-GAAP measures. And with that, I'd like to turn the call over to Jeff. Jeff?

Thanks, Tony. Good morning, everyone. Welcome to the Midland States earnings call. I would like to begin by thanking the entire Midland team for the extraordinary efforts they’ve made over the past couple of months. The COVID-19 pandemic has impacted all aspects of our lives, and I’m very proud of the way our team has responded and made certain that we can continue to support our clients and communities during this challenging time. I appreciate the positive attitude of our team members throughout this crisis as well as their commitment to maintaining exceptional service levels and productivity during the unprecedented conditions that we’re dealing with. Given the extraordinary changes in the operating environment brought on by the COVID-19 pandemic, we wanted to spend most of the time on our call today providing overviews of our response and the components of our loan portfolio. Overall, we had a good quarter and we were pleased with our trends in a number of areas, most notably reducing our expense levels, maintaining good stability in our normalized net interest margin, and increasing deposits. However, the rapid decline in interest rates resulted in a large impairment to our commercial mortgage servicing rights. While our adoption of CECL resulted in a significant provision for credit losses that negatively impacted our financial results, resulting in only marginal earnings for the quarter. Obviously, the big story of the quarter was the rapid spread of COVID-19. As the quarter progressed, we took a number of steps to protect our employees and customers, as described on Slide 4. As the crisis unfolded, we moved very quickly to protect the health and safety of our employees and customers. These steps included closing our bank branch lobbies, servicing customers primarily through our drive-through facilities, rotating branch staff on a week on, week off schedule, and transitioning approximately 95% of our non-retail employees to a remote working environment. Due to the investments we have made in technology and the incredible effort of our entire team, we've been able to efficiently transition to remote working without much impact on our level of productivity, and our digital banking platform was well-prepared to handle the increased use by our customers. Moving to Slide 5, I wanted to review our response to clients since the crisis started. From a customer engagement standpoint, our relationship managers have been reaching out to customers to assist them in managing through this crisis. We were able to quickly get up and running our PPP process and have utilized that as a first option for assisting our clients. Through April 16, we had processed $263 million in PPP loans that had been approved by the SBA for almost 1,300 of our commercial clients, which assisted approximately 26,000 employees in our markets. Estimated fee income for the PPP loans is approximately $9.2 million, which will be recognized over the life of the loans. Through April 20, we have received requests for loan payment deferrals of approximately $665 million of loans. These payment deferrals are primarily from one to three months in length and the loans will continue to accrue interest during that time. Our hope is that working with our customers through payment deferrals combined with the proceeds from the PPP will allow the vast majority of our small businesses to make it through this pandemic and get to the other side. Our clients and local communities have been extremely appreciative of our efforts. We are receiving great feedback about the value of working with the community bank, which is committed to relationship banking. Looking at other trends, we have not seen significant drawdowns on credit lines the way some other banks have reported. Throughout the month of March, credit line utilization rates remained consistently in the 66% to 68% range. Despite the reduced operations in our branch network, the pace of new consumer deposit and commercial treasury management account openings has remained relatively consistent. As we would expect, debit card transactions and check processing volumes decreased quite a bit towards the end of March when Illinois imposed the stay-at-home order. And in our wealth management business, as we have done in commercial banking, we spent a lot of time talking with clients and staying in close contact throughout the crisis. To date, we've had discussions with approximately 80% of our wealth management clients, and they have indicated they plan to remain consistent in their investment strategy. And finally, interest rate locks for residential mortgage loans in the first quarter more than doubled from the prior quarter as a result of the decline in interest rates. Turning to Slide 6, we have provided a more detailed view of our loan portfolio. We feel that we have a broadly diversified portfolio with no significant concentrations in any one industry. As you know, one of our objectives over the past couple of years has been growing our equipment finance portfolio. We continue to do that in the first quarter as this portfolio increased by approximately $40 million. At the end of the first quarter, commercial loans represented 72% of our portfolio, while consumer loans, which include residential real estate loans, represented 28% of the portfolio. 88% of our consumer portfolio consists of loans that are originated by GreenSky in accordance with underwriting criteria that we have provided to them. These borrowers have an average FICO score in the 730s, and it's a very granular portfolio. We also have credit enhancements due to the way the economics of the program are structured. This has been a very successful program for Midland as we have experienced no charge-offs in this portfolio in the nearly 10 years we have been partnering with GreenSky. On Slide 7, we showed a breakout of our commercial loans by industry. This includes traditional C&I loans, commercial real estate loans, and equipment finance loans and leases. It's a broadly diversified portfolio. Among the more troubled industries, our retail trade exposure represents just 8% of commercial loans, and health care represents just 5% of commercial loans. On Slide 8, we show our commercial real estate portfolio broken down by collateral type. Our largest segment is retail, which had 18% of CRE loans, representing 6.2% of our total loan portfolio. Amongst some of the more troubled industries, our hotel, restaurant, and elder care facility exposure each represents 10% of our CRE loans.

Thanks, Jeff, and good morning again, everyone. Looking at Slide 9, I want to spend a couple of minutes talking about the impact of our adoption of CECL, and what it did to the level of our overall loan reserves. We've provided a walkthrough of the drivers of the change from the allowance for credit losses that we held at December 31, 2019. We had a day one adjustment of $12.8 million, which was less than our initial expectations. Our day one adjustment decreased from that initial estimate as we continued to fine-tune our model and evaluate certain economic forecasts and our methodology for incorporating those forecasts into our overall loss factors. We also charged off approximately $9 million in specific reserves that we held as of December 31. Then in terms of how the reserve was impacted by what we saw in the first quarter, the changes in our portfolio contributed $2.5 million to that overall change. This reflects the impact of new loans that we booked, changes in credit quality, the aging of the existing portfolio, and other charge-offs and recoveries that we had in the quarter. And finally, the changes in our economic factors contributed approximately $4.7 million to the reserve. That primarily reflects the downgrade in economic forecasts due to the impact of COVID-19. This resulted in an allowance for credit losses of $38.5 million at March 31, which represented 88 basis points of total loans, up from our previous allowance for loan and lease losses of 64 basis points of total loans at the end of the prior quarter. Turning to Slide 10, we want to talk about some of the factors impacting our net interest margin. As Jeff mentioned earlier, first, we were able to stabilize the normalized margin as it decreased by 1 basis point over the previous quarter. We've been successful in passing through deposit rate reductions to our customers, and our overall cost of deposits decreased 6 basis points in the first quarter. Due to the lower rate environment, the average rate on new and renewed loans declined to 4.59% compared to 4.8% in the previous quarter. We expect to continue to benefit from repricing our CD portfolio, particularly as time deposits that were previously offered at promotional rates last year continue to mature. We have approximately $194 million in CDs scheduled to mature over the second quarter of 2020 at a weighted average interest rate of 2.14%. Our current CDs are being offered at a rate from 25 to 55 basis points depending on term, so we should see a significant reduction in our costs of time deposits. On the negative side, we intend to continue to build liquidity on our balance sheet to help us manage through this crisis, and that will weigh on our margin going forward. Moreover, we continue to carry higher balances of subordinated debt, which continues to impact our net interest margin. In light of the pandemic, we expect to retain, at least in the short term, the approximately $30 million of subordinated debentures that are callable in June 2020. However, the subordinated debt will move to a quarterly floating rate in June, and that will reduce the interest rate on that debt by approximately 50 basis points. Finally, our participation in PPP is expected to positively impact our margin in the second and third quarters, with the largest impact coming in the third quarter as customers qualify for and receive debt forgiveness. Moving to Slide 11, let's take a look at our capital and liquidity positions. We've included both our bank level and consolidated capital ratios. We believe that we're in a good position from a capital standpoint, particularly at the bank level, to continue supporting our customers through the duration of this crisis, including through the additional stimulus programs approved by Congress. We're also in a strong liquidity position with nearly $1.2 billion in primary liquidity sources and $185 million in secondary liquidity sources, should we need it. We also have the ability to tap into a $250 million credit facility and add up to $500 million in brokered CDs. We also plan to utilize the PPP liquidity facility, which will provide another source of funding. We've included all of our usual slides reviewing our first quarter results in the earnings deck, but we are planning to walk through them this quarter due to the current environment. If you'd like additional color on any of those items, we'd be happy to provide it during the question-and-answer session. And then with that, I'll turn the call back over to Jeff.

Thanks, Eric. We'll wrap up with a few additional comments on our near-term outlook and priorities. As Eric mentioned, we believe we are well positioned from a capital and liquidity standpoint to continue supporting our customers and communities through this temporary downturn in the economy. While it's hard to know how long the crisis will persist or the full impact it will have, our principal capital management priorities will be supporting the credit needs of our customers and maintaining our dividend. Given the level of uncertainty around the severity and the duration of the crisis, it's very difficult to forecast how the rest of the year is going to go. That being said, we want to provide a few general comments. We plan to continue to tightly manage expenses, and in the second quarter, we will see the full quarter benefit of the staffing level adjustments we made in the first quarter. We will also continue to manage our deposit costs down and hold the line on loan pricing. With respect to our wealth management fees in the second quarter, it seems likely we will see a decline unless the overall market moves back up to pre-COVID levels. Pipelines in our originate to sell businesses, including both commercial FHA and residential mortgage, have increased in the current rate environment. Credit, of course, continues to be the great unknown. As we wrap up, this is certainly a challenging time. But for 140 years, the communities we serve have counted on Midland to help them manage through difficult times, and this current crisis will be no different. With that, we'll be happy to answer any questions you might have. Operator, please open the call.

Our first question comes from line of Michael Perito with KBW. Your line is now open.

Hey, Jeff, Eric, good morning. Thanks for the time and for the extra added disclosure. So with everything going on in the slide deck, it's helpful. I wanted to start on the credit side. I was wondering, Jeff, if you could give us a little bit more color into the 7% of commercial loans that are a combination of food service. You know what, maybe some of the larger credits are in there and how that portfolio has looked thus far? I imagine there's probably quite a bit of deferral in there. Just curious what some of the metrics are at this point.

Yes, we are seeing the initial deferrals that started coming in around March, and we took proactive measures with those customers at that time. As we've mentioned in previous calls, we do not hold a significant amount of large loans, with fewer than 15 loans exceeding $50 million. Most of our loans are under $10 million, so the diversity of our portfolio should be beneficial in this situation. Our approach has always emphasized having a diverse portfolio to ensure that if one credit underperforms, it doesn't adversely affect us.

Okay. And the charge-offs in the quarter, I know you flagged the vast majority of it is being related to those items that have been on NPL for a year or greater. But the remainder of that, I think it was a couple of million, was any of that related to the pandemic, or was that still earlier in the quarter actions that kind of predated what's going on now?

Yes. Mike, this is Eric. So as we pointed out in the slide deck, about 10.2 of the charge-offs were related to three larger specific credits that had been in our specific reserves for some time. The remainder of those charge-offs were primarily earlier in the quarter and really unrelated to the overall impact. I think we experienced those prior to March before this current crisis kind of kicked in.

Okay. Changing the subject a bit. Regarding the PPP loans, do you have an idea if there will be another wave of them? I imagine there are many applications in the pipeline for additional funding. Can you provide an estimate of what that dollar amount might be? Additionally, what do you expect the fees related to the PPP program to look like over the next two quarters?

Our team did an excellent job processing the applications we received up until April 15. We managed to get 80% to 90% of those applications approved through the SBA. Our teams acted quickly and successfully navigated a majority of the clients through the SBA portal. We do have a pipeline, but it will likely be much smaller this time for a couple of reasons. We've addressed most of our customers' needs, though there are still a few we need to assist. I expect the process to move even more rapidly now, as larger institutions are better prepared than they were before. Smaller community banks like ours were able to quickly mobilize our teams, reach out to clients, and get many loans approved. Looking ahead, the volume will likely be lower. I can't provide a specific estimate for the fees, but I anticipate they will be significantly less than in the first round.

Do you have any idea what the fees will be related to the PPP loans that have already been approved?

Yes, I think in Eric's script, that was $9.2 million...

Yes.

Okay. All right. Sure. Thank you. And then just lastly for me on capital. You mentioned, Jeff, that the priorities kind of support the bank and support the dividend. But the bank sub-ratios are obviously quite high, but the equity ratios at the holding company are a bit lower. Do you expect those to kind of build? I mean, was that some of the moving parts with CECL and the provision in the first quarter that really weighed on that amongst other things? And do you expect those to kind of rebound going forward with most of that noise now hopefully behind you?

Yes, I believe so. During this period, we will focus on building capital. The CECL day one adjustment was $12 million, which had an approximate $8 million impact on equity. This was significant. Additionally, we repurchased some stock in the first quarter.

Are you planning to pause the repurchase program for now?

We've not suspended our program at this point. We have a Board meeting next week and we'll talk about it. But my expectation is we'll continue to keep that in play and keep our options and flexibility because this thing is pretty fluid. So I think we'll keep it out there and continue to assess our capital and the market.

Okay.

Okay. But from like a modeling perspective, before trying to think about your buyback appetite, I mean, if the environment stays as current, if the country stays closed for the mid to mid-May, I mean, is it safe to assume that that probably won't be heavily utilized until there's some type of clearer trajectory for recovery?

Yes, I'm not sure. We're going to sort of keep our options open. I can't imagine there's going to be a material change in what we've been doing. Again, I think I'll stick with our comments of we're going to support our clients' credit needs and support the dividend. So …

Okay. Excellent. Thank you guys for taking the questions and be well and talk more soon.

Yes. Thanks, Mike.

Our next question comes from Terry McEvoy with Stephens. Your line is now open.

Hi. Good morning, guys.

Good morning, Terry.

Good morning.

Maybe just start with the margin. It sounds like a great opportunity to reprice the CDs down, which Eric talked about. But then you've got to balance the excess liquidity and just low interest rates overall. So I guess, what are your thoughts on the core margin for the second quarter as you think about some of the puts and takes?

I'll give it a try. The situation is still very uncertain. Our goal is to support the current margin, which we previously discussed maintaining in the 330 range for the first couple of quarters. As we reach the latter part of the year, we anticipate CD repricing will occur. We also plan to pay off some subordinated debt in June, which should provide additional support. By the end of the year, we hope to increase the margin to around 350. A lot has changed since our last discussion, and we expect to provide clearer guidance on the margin going forward. We have communicated where we see the challenges and opportunities, and I remain optimistic about improving the margin. However, the end of March brought some unexpected rate cuts. We acted quickly to lower our deposit costs, and I remain hopeful for a positive trend as we enter the second quarter. The PPP loans should also contribute positively.

I have a question about the payment deferral request mentioned in the presentation. Is that for mid-April or is it a number for the end of March?

That's I think mid-April, April 20 or so. Yes, and those are requests not processed. But I think our expectation is the vast majority of those requests will get processed.

And then just the last question, what's a good run rate of expenses to think about as a starting point for modeling, specifically trying to layer in the cost saves from some of the actions you took in the first quarter and the benefits that you mentioned in the presentation?

Yes. Regarding expenses, we did not provide a specific number due to the uncertainty in the current environment. I believe the first quarter serves as a reference point for where we anticipate expenses will likely be.

Okay. That's it. Thanks so much. Stay healthy.

Yes. Thanks.

Our next question comes from Andrew Liesch with Piper Sandler. Your line is now open.

Good morning, guys.

Good morning, Andrew.

Hi. I am curious about the consumer loans that were held for sale. Were those GreenSky loans?

Yes, they were.

And I guess what is your appetite to do more of that? And really what drove the decision to just sell these?

Yes, I believe there is an opportunity to collaborate with GreenSky. They are developing additional partner relationships, and we were able to transfer $100 million to held for sale, which created some liquidity for us. We considered this a wise move. I'm not certain if this will be a recurring action, but we had the chance and believed it was a prudent decision.

Okay. And then with the CECL adjustment, part of the provision, the change in the macroeconomic variables and forecast, were those based on the March 31 economic outlook or later on in April, just trying to get a sense of the timing that you guys are using for this forecast?

Yes, Andrew, this is Eric. I can answer that. The economic forecasts we used were around the end of the quarter, specifically March 31. We utilized a base case for our forecasts and looked ahead over the next 12 months, along with a 12-month reversion to the mean. We also assessed how these factors affected our various portfolios, which should address your question unless you would like to discuss it further.

Could you share any details about the unemployment rate you are considering or the trends in GDP, as well as how long you expect the recession to last? If you have that information available.

We use Oxford Economics for our modeling. I don't recall the exact unemployment number. We consider both factors you mentioned, focusing primarily on the state of Illinois, with the exception of our equipment finance portfolio, which we assess on a national level. The modeling we conducted indicated a bounce-back and a U-shaped recovery through the fourth quarter in relation to both the unemployment rate and GDP.

Okay. And then just the $9.2 million in fees for the PPP loans. Any sort of thoughts on how quickly those could be realized in the second quarter, or do you think they will be more heavily weighted towards the third?

That's a good question. I think that's sort of a big question. I think how we're sort of thinking about it internally is we've got sort of eight weeks and then customers will start applying for that forgiveness, and then it will be another 30 to 60 days, possibly, for the SBA to actually return those funds. So I guess we're kind of thinking that we will start to receive those funds back maybe that July and August time frame.

Okay. That's very helpful. Covered my question. Thanks.

I'm showing no further questions at this time. I would like to turn the call back to management for closing remarks.

All right. Well, thanks everybody. And we will talk next quarter.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.