Bank of N.T. Butterfield & Son Ltd Q1 FY2020 Earnings Call

Good morning, and welcome to the Butterfield First Quarter 2020 Earnings Call. Please note, this event is being recorded. I would now like to turn the conference over to Noah Fields, Butterfield's Head of Investor Relations. Please go ahead.

Thank you. Good morning, everyone, and thank you for joining us. Today, we will be reviewing Butterfield's first quarter 2020 financial results and providing an update regarding how Butterfield is addressing the COVID-19 health crisis. On the call, I am joined by Butterfield's Chairman and Chief Executive Officer, Michael Collins; and Chief Financial Officer, Michael Schrum. Following their prepared remarks, we will open the call up for a question-and-answer session. Yesterday afternoon, we issued a press release announcing our first quarter results. The press release, along with a slide presentation that we will refer to during our remarks on this call, are available on the Investor Relations section of our website at www.butterfieldgroup.com. Before I turn the call over to Michael Collins, I would like to remind everyone that today's discussions will refer to certain non-GAAP measures, which we believe are important in evaluating the company's performance. For a reconciliation of these measures to U.S. GAAP, please refer to the earnings press release and slide presentation. Today's call and associated materials may also contain certain forward-looking statements, which are subject to risks, uncertainties, and other factors that may cause actual results to differ materially from those contemplated by these statements. On Slide 23 of the presentation, we have also included a list of potential factors relevant to the implications of COVID-19 for the bank. Additional information regarding risks can be found in our SEC filings. I will now turn the call over to Michael Collins.

Thank you, Noah, and thanks to everyone joining the call today. While we are pleased with the bank's results in the first quarter, our current focus is on addressing the new realities developing from the COVID-19 health crisis. I will begin today's discussion with a quick review of the highlights from the first quarter and then provide an update regarding the bank's COVID-19-related actions and potential exposures. Turning now to Slide 4 of the earnings deck. We reported net income of $40.3 million or $0.77 per share and core net income of $40.8 million and $0.78 per share. In the first quarter, net income was 8% lower than the previous quarter due to seasonal fee income and a $5.2 million CECL reserve build for future expected credit losses. Our core return on average tangible common equity was 18.6%, down from 21.1% in the prior quarter. Net interest margin was up 4 basis points to 2.63% compared to the last quarter, and our cost of deposits dropped 8 basis points to 42 basis points. Turning now to Slide 5. As we operate across small Island communities, Butterfield has an important role to play as an essential service provider, a domestic systemically important bank, an employer, a source of working capital for companies in need, and an active corporate citizen supporting our communities. We have a particularly strong sense of responsibility to balance the needs of all stakeholders during this time. The COVID-19 virus is evident in and impacting all of our operating jurisdictions. The number of infections and deaths in our various locations have been consistent with the statistics we're seeing globally. For Bermuda, there have been over 100 cases identified and sadly, 6 deaths. The Cayman Islands have identified over 70 cases with 1 known death. And between Guernsey and Jersey, there have been hundreds of confirmed cases with known death as well. At this point, we only have 1 confirmed employee case in our Swiss office, who is expected to make a full recovery. We would like to express our deepest sympathies to anyone who has been directly affected or lost a loved one to the virus. We remain hopeful that the current shelter-in-place and social distancing practices will continue to slow the spread of the virus so that local economies and tourism can start to recover. When the severity of the crisis and health implications became known, the bank's initial focus was on the well-being of our customers and employees, including our ability to continue providing essential banking services. We quickly began mandating social distancing, providing protective equipment for staff, implementing split team and building strategies, and establishing broad remote working conditions through our virtual desktop interface. We have remained operational as permitted, with just over 70% of employees working from home and providing all necessary equipment and services to support our employees and customers. To help ease the financial impact on the communities, we have temporarily deferred residential mortgage payments, reduced fees, and increased our direct contributions to urgent care programs supporting the most vulnerable people. In the short term, we are working with clients to assess their needs and provide support. In Bermuda and Cayman, where tourism is an important contributor to local activity as well as exports, we are closely monitoring the situation and maintaining frequent engagement with clients. In our estimation, the duration of the temporary shelter-in-place lockdown conditions is one of the most critical factors that will determine the return of economic activity and ultimately, the future impact on Butterfield. The bank keeps a significant source of liquidity available, primarily $3 billion of cash and short-term securities as well as $4.5 billion of U.S. agency MBS. Together, this represents just under two-thirds of all customer deposits. The current interest rate environment will impact our interest earnings from short-term securities as well as our variable rate loans, and while lower deposit rates are unlikely to entirely offset the lost interest income. We also are seeing significantly decreased card services fees with no tourism and subdued domestic economic activity. Over the coming periods, we may also see increased prepayment speeds in our investment portfolio as U.S. home borrowers seek to refinance home loans in a lower interest rate environment. As we think about the medium and longer-term implications in the 3- to 5-year time frames, a sustained long-term ultra-low interest rate environment could likely erode profitability over time. The bank has historically benefited from lower-cost deposit funding. However, in an ultra-low interest rate environment, the value of those deposits reduces significantly and lower agency reinvestment rates would combine to compress NIM. This could ultimately alter the earnings profile of the bank and would result in increased reliance on fee businesses. If interest rates fall further to negative rates, we could be in a position to charge negative interest rates on deposits, as we have witnessed in Europe. We would also need to become more efficient through accelerated cost reductions. On the capital side, we are pleased to continue at the current quarterly dividend rate of $0.44 per share, which represents a strong yield at recent share prices, and remain active on share repurchases. We continue to believe the dividend rate is sustainable and continues to be a capital management priority. It is possible that M&A opportunities could become available as larger onshore financial institutions with banking and trust operations in our current operating jurisdictions may decide to focus on their core businesses and may want to sell less strategically important assets. I'll now turn the call over to Michael Schrum to provide additional information on the bank's credit portfolio and potential COVID-exposed areas, and then add some additional details regarding the first quarter results, including a discussion on the bank's capital position and management.

Thank you, Michael, and good morning, everyone. Before I give an overview of the first quarter results, I wanted to provide some information on some specific credit exposures. As you can see on the bottom left of Slide 5, we have fairly limited direct credit exposure to hotel and restaurant lending sectors, which is primarily in Bermuda and Cayman. Hotel operators and construction loans represent our biggest direct commercial COVID-related credit risk. However, given the structure of the deals, generally at below 50% pre-crisis LTVs and the underlying financial strength of the borrowers, we are not currently expecting significant losses from this area. If the crisis lingers several more quarters, one of the emerging areas where customers could start to see challenges may be in the part of the residential book with borrowers who currently work in tourism-related businesses. Finally, we do not have any direct exposure to the oil exploration or production sector. Turning now to Slide 7 and some details regarding the first quarter results. On Slide 7, we provide a summary of net interest income and NIM. In the first quarter, NIM of 2.63% increased 4 basis points as the cost of deposits, particularly home deposits, decreased from rollovers, which more than offset the decrease in interest income. Lower rates were partially passed along to borrowers, with yields on variable rate loans being 15 basis points lower in the quarter. Average loans increased during the first quarter as we had the benefit of a full quarter of lending to the Bermuda and Cayman governments, which were drawn late in the fourth quarter. On Slide 8, we provide an overview of average customer deposit balances by location, currency, and contractual nature. Deposits at March 31, 2020, were $11.8 billion, a decrease of 5.5% from the end of the year. The decrease is the result of the expected attrition of euro balances in the Channel Islands, which is consistent with previous guidance on the ABN deal. Overall, the cost of deposits is down 8 basis points due to lower term deposit pricing on rollovers. It is also worth noting that during the '08, '09 financial crisis, overall customer deposit levels did not reduce significantly, and at this point, we continue to see stability in deposit levels. Looking now at Slide 9. Noninterest income was down 4.3% compared to the prior quarter due primarily to lower card services fees, which were negatively impacted by reduced volumes as economic activity stalled in March due to government lockdowns. On Slide 10, we provide an overview of core noninterest expense. As we discussed last quarter, first quarter expenses returned to the expected range after being elevated in the fourth quarter. The improvement was due to reduced headcount in the Channel Islands, lower marketing expenses, travel expenses, and client event costs. We continue to target a true cycle efficiency ratio of 60%. Looking now at Slide 11, we provide a summary of regulatory and leverage capital levels. Butterfield continues with our conservative capital management philosophy that balances regulatory requirements with shareholder returns. Tangible book value per share increased 4.6% in the first quarter due to contributions from earnings and OCI related to the unrealized gains in the investment portfolio. We continue to view the dividend as the most direct and efficient way to translate the high ROE of the business to investor return. The dividend coverage ratio remains around 2x, and we believe the current dividend rate is sustainable. Our capital management priorities have not changed and continue to support the dividend, organic loan growth, share repurchases in appropriate market conditions, and maintaining flexibility to pursue M&A deals when the right opportunities arise. Turning now to Slide 12. During the first quarter, the balance sheet was broadly stable, except for the continued decline in the euro-denominated deposits in the Channel Islands, as expected. End-of-period loan balances were down almost 3% due to the lower dollar value of pound sterling-denominated loans in the Channel Islands and the U.K. With the significant fall in U.S. interest rates, total net unrealized gains in the investment portfolio were $155 million at the end of the first quarter compared to $61 million at year-end. On Slide 13, we continue to emphasize low credit risk in our investment portfolio, with the majority of investments in AAA-rated U.S. government-guaranteed agency securities. Loans are mostly residential and full recourse with 75% of the portfolio in the below 70% LTV bucket. In light of COVID-19 and its potential future impact on particularly unsecured loans, we have increased our reserve estimate by $5.2 million, and the total reserve under CECL is now 72 basis points of gross loans, reflective of the collateral-backed residential lending platforms built over the last decade. On Slide 14, we discuss the average cash and securities balance sheet with a summary interest rate sensitivity analysis. The structural asset sensitivity of the balance sheet has now been entirely realized by the reduction in front-end rates. Therefore, the downside 100 basis points scenario would start to increase NII if the bank passes negative rates on to customers by increasing spread on demand deposits. The assumption on negative U.S. dollar deposit rates would be similar to what we've seen in Europe. In the upside 100 basis point scenario, the bank starts to increase net interest income with a positive differential between deposit and market rates. Additionally, reinvestment rates would improve, thereby improving net interest income as well.

Thank you, Michael. Butterfield's integration in the Channel Island is progressing well and into its final stages. We now expect the full operational integration to be completed in the third quarter of 2020 as most clients are also working remotely, and it is practically much safer to upgrade their banking systems once customers are back in their offices sometime in the second quarter of 2020. Following the success of the Channel Islands, we remain committed to exploring potential acquisitions in banking and trust, with most opportunities in the Channel Islands for banking and trust. For the trust network, we would also seek to build on the potential in Asia with a larger trust presence in Singapore. While we do not have any specific communications on this at the moment, these discussions are still continuing. The effect of this health crisis on Butterfield will depend on uncertain factors, including the length and depth of the pandemic and associated government lockdowns, how that impacts domestic economic activity and tourism, how quickly these can recover, as well as the interest rate environment. Our communications with the regulators, rating agencies, and governments remain constructive and supportive. The bank continues to have a strong and flexible capital position with a very liquid balance sheet. Learning from the financial crisis a decade ago, Butterfield's credit underwriting has been conservative, and as a result, our exposure to potentially problematic sectors is limited and should place the bank in a strong position to emerge from the current crisis. As a final note, I would like to take this opportunity again to thank our employees, particularly those in the front line and retail branches, continuing to welcome customers and helping them and us through a difficult period. Thank you. And with that, we'd be happy to take your questions.

Our first question comes from Timur Braziler with Wells Fargo.

Starting with broader CECL assumptions, many U.S. banks utilize the Moody's model to establish their CECL assumptions. I'm curious if you use a third-party to assist in determining your CECL impact. Additionally, could you elaborate on the economic assumptions that informed your CECL impact?

Yes, thanks, Timur. It's Michael Schrum. Good question. A lot of work has gone into CECL over the last year, particularly in building the model. We don't rely on a third-party service provider for data since all of our loans are primarily manually underwritten. We utilize our own repayment history and local market conditions. We do incorporate external data into the model, mainly unemployment forecasts and GDP forecasts, using a mix of service providers like Moody's and Bloomberg. The assumptions for the model have changed significantly this year compared to the end of last year, which is contributing to the additional reserve build this quarter. Overall, we've established a negative 3 GDP forecast for the U.S. this year, which is a central assumption. This leads to a substantial shock in the second quarter, with double-digit impacts on economic activity, followed by a U-shaped recovery into Q4. The model is somewhat sensitive to external variables, but since most of the loan book consists of residential loans and is manually underwritten, we have a clearer path to realizing collateral in difficult situations. This primarily affects the loan buckets where debt service coverage is based on cash flow, like the C&I book and credit card book, though these are relatively small in the grand scheme of things. Hopefully, that clarifies things a bit.

Okay. That's good color. And then just your commentary around mortgage deferrals, are you deferring payments on the entire book? Or I guess, what portion of the mortgage book is currently in deferral status?

We are deferring both principal and interest payments on the residential mortgage portfolio. This primarily affects customers who are in default or have faced challenges in the past, and we are making exceptions for them. We implemented this process automatically, but those who wish to continue making payments during this 90-day period can opt to do so. Some customers prefer not to extend the term of their mortgage, which we are accommodating across our residential accounts. On the commercial side, we are engaging with our commercial clients daily to assess their situations and identify ways to assist them, which leads to more personalized discussions rather than a general program. We plan to review the residential situation in three months to determine our next steps, with the possibility of extending the deferral period. However, given the current fluid circumstances, we will wait to see how things develop. In Bermuda and Cayman, the response has been positive, as this initiative has funneled money back into the economy, which is a priority for us all.

Yes. I would say just in terms of the portion, there was about $1.4 billion between Bermuda and Cayman on the residential side that was included. So these are obviously customers in good standing. And about 10% to 15% of them opted out of the automatic deferral, so they're continuing on existing payment terms.

Yes. And we were very careful from a truth and lending perspective to make it very clear that this was extending the term of the mortgage, so you're going to pay more interest over the life of the mortgage. And so I think people understood that.

Okay. And then just lastly for me, just looking at your hotel exposure. Appreciate the color that at origination or pre-crisis, it's 50%-ish LTVs. If I remember correctly, I think a portion of that is backed by the Bermuda government as well, I think, $25 million on the St. George's project. Is that still the right number? Has that guaranteed portion been reduced? And maybe you can just talk through some of the guarantees on that hotel portfolio.

Yes. So as you can see on Page 5, we have a total of $214 million of hotel and restaurant exposure out of $5.2 billion book, so only about 4%. I mean, interestingly, restaurants are about $7 million, which is obviously really contained. In terms of the hotel book, we have a couple of big hotel loans that are currently in operation, 2 or 3. We think they're well underwritten. And they have sort of broader context. So one of them, as an example, has a large condominium project that's been running for years associated with it. So a big part of our repayment actually comes from expats in these condos as opposed to the hotel itself. One of the other operating loans is a wealthy relationship that we have a far broader deeper relationship and have real clear a lot of sight in terms of the family's wealth. So it's a hotel, it's secured by a hotel, but it's really a much, much broader relationship than that. And then on the hotel construction, you hit it on the head. I mean, we have the St. George's hotel that's really being built and is well on its way. The plan is to open up next year, which is hopefully not too bad timing given the fact it will be summer next year. We'll have some time to see how this all plays out. And on that loan, the Bermuda government has guaranteed $25 million out of our $60 million commitment. And lots of equity, lots of equity upfront, completely different underwriting than the bank did pre-financial crisis. So we feel pretty comfortable about both the total size relative to our total credit portfolio and also the individual credits within it. So we think it's pretty contained.

Our next question comes from Alex Twerdahl with Piper Sandler.

I was wondering if you could provide some information on the stimulus programs in Bermuda, Cayman, the Channel Islands, and possibly the U.K. This would help us make more accurate comparisons.

Sure. Let me provide an overview of the GDP projections for 2020 across different governments. Bermuda is projecting a decline of between 7.5% and 12.5%, while the Cayman Islands forecast a drop of 15%, based on a Chamber of Commerce estimate rather than a government projection. Guernsey is also forecasting a 15% decline, and Jersey's estimate stands at a 6% drop. It's clear that everyone is trying to navigate these uncertainties. The Cayman Islands, with a greater reliance on tourism accounting for 25% of their GDP compared to Bermuda's 17% and minimal impacts in the Channel Islands, face some specific challenges. I would suggest that we're looking at double-digit declines for 2020, likely in the lower to mid double-digit range. However, given the unique circumstances, it's difficult to determine exactly how things will unfold. In Bermuda, there have been a few small stimulus efforts initiated, including a $12 million government-guaranteed program for small businesses. For the first time, Bermuda has established unemployment insurance and allocated nearly $20 million for this purpose, with thousands of individuals receiving weekly checks directly through banks. This represents a significant step in providing economic support. The Ministry of Finance is expected to announce a more comprehensive program soon, although specific details about the broader stimulus have not yet been disclosed. We do anticipate that Bermuda will have to engage in further borrowing to facilitate this support. Cayman currently has a surplus and some reserves they can tap into, while discussions are ongoing about the possibility of borrowing a few hundred million in Guernsey and Jersey. Each of these islands are at different points in their planning regarding the use of their reserves and deciding on borrowing amounts, which may average around 10% of GDP for each, amounting to several hundred million, potentially reaching $500 million. Our goal is to provide as much credit support as we can across all jurisdictions, given our deep understanding of these economies. Thus, while there are mixed stimulus efforts evolving, the U.K. has broader programs in place. However, the islands are likely to be more restrained in their financial responses. That's the current situation.

No. That's very helpful. And then just in terms of the deposit balances and cash balances, I know a lot of those are part of the planned rundown of the book acquired with ABN AMRO. Where are you in that process of running off deposits? And kind of how much more could we expect to potentially leave the bank, is there a way to sort of ring-fence that?

Yes, Alex, it's Michael Schrum. The rate environment has changed quite significantly over the past quarter. We are continuing with the ABM repricing while being aggressive on deposit pricing, especially for term rollovers. If you look at the euro and other currency balances mentioned, you'll notice that most of the attrition is coming from there, and this trend is expected to continue for another quarter. I aim to maintain strategically important relationships, even with clients having euro balances, as long as they conduct other business with us. However, we are unable to activate these euro balances as loans, so they need to be priced at market rates. The remaining balances in that category are estimated to be around $200 million to $300 million, primarily from ABN. We have not seen significant changes elsewhere, with stability across other platforms, and in Cayman, deposit levels have actually increased since year-end. Overall, the rest of the bank remains stable, although there is still some work to do regarding the euro balances in the Channel Islands.

Great. And then just final question back to the loan modifications. Is the BMA and other regulators, do they have a similar view in terms of these loan modifications in the time of crisis, such that you're able to modify them, they don't become TDR, you have a lot of flexibility to work with your borrowers, et cetera?

Yes. We have ongoing discussions with all the regulators, who are supportive of the measures the bank has implemented to help put money back into people's pockets. This assistance may ultimately impact rents and alleviate some pressures from unemployment or temporary unemployment in various regions. The treatment of Troubled Debt Restructurings (TDRs) is primarily an accounting issue that relates to U.S. GAAP rather than prudential considerations. We follow the guidance from the Financial Accounting Standards Board (FASB), which indicates that if a customer remains in good standing, a forbearance granted for up to six months shouldn't automatically qualify as a TDR or loan modification. This is the approach we are also following with PricewaterhouseCoopers.

Our next question comes from Michael Perito with KBW.

I wanted to spend a few minutes on a couple of items here. First, regarding the residential mortgage book, I was curious if you could provide any additional context. I believe the historical loss rates in that book are quite low. However, during periods of stress on tourism on the island, have you seen any increase in mortgage loss rates? Is this something that has been observed in the past, or not yet?

I'll begin. After the financial crisis, we did face some challenges in our residential mortgage portfolio and invested significantly in enhancing our debt collection capabilities. Looking back to around 2011 and 2012, we didn't have much of a focus on that area since we hadn't experienced any losses, and property values in Bermuda and Cayman had remained stable. However, property prices did decline, varying between 20% to 40% depending on the type of property, which did create some pressure. Nevertheless, as you can see, the net charge-off rates, both now and back then, never reached significant levels. We have gained valuable experience, and I can assert confidently that our debt collection capabilities are now quite robust compared to ten years ago. We have learned how to manage this process effectively.

One characteristic of small island property markets during stressful periods is that supply tends to decrease due to very low loan-to-value ratios. This results in fewer transactions for a while until prices begin to recover. Additionally, there is strong social cohesion, as buyers in places like Bermuda are reluctant to lose their properties, leading to support from family members during tough times to help share the financial burden. This has been beneficial in maintaining the mortgage book and minimizing troubled debt restructurings following the financial crisis.

If you look back at 2007 and 2008, Bermuda had around 700 property transactions each year. This number has been about 200 for the past 5 to 7 years, partly because there is still a significant amount of indigenous wealth on the island. When property prices drop, families tend to hold onto their properties rather than trying to regain some equity, which slows down the market. We have limited direct exposure to tourism, but we do have indirect exposure through mortgages, and we need to monitor that closely.

That's helpful. And then on the deposit side, it seems like a bit of the quarter-over-quarter drop was in term deposits, which I imagine was kind of pricing-related. But just on the transactional reduction, I mean, can you provide us a little bit more color on the drivers there? And it seems like based on your prepared remarks that deposits are pretty stable at this point. I mean, is that something you expect on the business side as well if volatility kind of persists globally from the COVID-19 pandemic?

Yes. So maybe I'll start. I mean the other piece of this is, obviously, if you look at average deposit balance versus this period end, there's that sterling weakness that's causing the translation difference of about $150 million in deposits.

Was that the entire piece, Michael, on the transactional side or was there any other kind of else...

Sorry?

Was that the entire piece on the transactional deposits, or was there anything else included in that?

There were normal commercial movements, though I wouldn't highlight anything specific. Cayman actually experienced a slight increase during the quarter. We have a cycle with captive insurance companies receiving premiums and paying out claims. Additionally, hedge funds in Cayman saw redemptions and an increase in cash balances following the financial crisis about ten years ago, before those funds were distributed to investors. We're aware of the movements on the balance sheet, but overall, it's been typical commercial activity at this time.

Okay. Helpful. And then lastly, on noninterest income, I believe the vast majority of your trust fees really are not impacted by the market at all. I guess, one, can you just confirm that? And two, maybe provide a little bit more context about how you expect some of the fee items to be impacted next quarter, whether it's by lower global market values or kind of less transactional volume.

Yes, I can confirm that all trust fees are billed as part of an annual fee. There are also activity fees when trusts restructure and for enhanced tax reporting required by common reporting standards or FATCA. These fees are primarily based on time spent rather than market drivers, making them stable and capital-efficient. Since going public, the only changes in fee amounts have been due to acquisitions or adjustments in trust structures after beneficiaries have passed away. Asset management fees are influenced by underlying valuations, so they have been affected and will continue to be, as seen over recent quarters. Banking fees, particularly from card services and merchant acquiring, make up about a third of our banking income. We are observing indicators that suggest a significant drop in economic activity related to debit card transactions due to government lockdowns and restrictions in Bermuda and the Cayman Islands. This situation has led to a reduction in transaction values. In the short term, we expect to see a notable impact. On the other hand, foreign exchange activity has increased because of currency volatility, especially involving the dollar and sterling. The Channel Islands experienced a record quarter in foreign exchange activity, driven by this volatility rather than proprietary positions. The overall performance will depend on developments in the FX markets. Other income sources, such as custody fees, remain stable at a couple of basis points, as expected.

So net-net, there could be some near-term pressure on the $47.5 million of core noninterest income in the first quarter? It sounds like that's reasonable.

I would expect asset management fees to be affected by lower valuations and market values of underlying assets under management, and I anticipate that banking fees will also be impacted in the short term due to fluctuations in merchant acquiring card services volumes. However, as we move forward and with Bermuda and Cayman emerging from a full lockdown over the weekend, we should see an increase, particularly in domestic economic activity, which will depend on consumer responses at that time.

I think we will see a significant decline in fees, especially from debit and credit card transactions in April. It should improve a bit in May as the domestic economies start reopening this weekend. However, it will remain low until the airports actually open, which is uncertain but could be late May into June and July. This is how it is expected to unfold.

Our next question comes from Will Nance from Goldman Sachs.

I appreciate the insights you've provided on credit. Could we delve deeper into the PPNR dynamics for the upcoming quarters? I found the comments about the effect of lower interest rates on the net interest margin interesting. Could you explain some of the factors at play, especially since a significant portion of the portfolio is floating rate? What actions have you taken in response to the U.S. rate cuts? Are there any factors that might help mitigate the decline in your loan yields compared to U.S. benchmark rates?

Great question, Will. It's Michael Schrum. Let’s begin with the actions we took on March 18. In Bermuda, we reduced the residential rate by 50 basis points with a 45-day lag. Therefore, you can expect to see that reduction reflected in Q2 for the floating portion of that book, which makes up 80% of it. In the U.K., we have observed a 25 basis points reduction, primarily impacting the floating rates, which have a floor of 50 basis points. We do not anticipate further decreases for the U.K. book, but we expect to see a complete quarter’s effect following the Central Bank actions there. In Cayman, most of the portfolio is floating, with about 20% fixed. We should expect the full impact of U.S. prime rates, likely around 100 basis points—most of which will be recognized in Q2, with some spillover into Q1. On the investment side, specifically regarding cash and short-term securities, those have mostly been repriced. We manage our own liquidity with a three-month T-Bill ladder set ahead of any Fed moves. We’ve already seen most of the impact in that area, but it could translate to an additional 15 to 25 basis points on cash and short-term securities. For the investment portfolio, the outcome will partially depend on reinvestment rates, and I anticipate some premium amortization. This will also be influenced by the CPT, which is uncertain at the moment. We haven't experienced accelerated prepayments yet, but we may expect around 10 basis points on the investment portfolio over the next couple of quarters. Additionally, we predict a continuing decline in the cost of deposits, particularly on the term side as we have not implemented negative rates on dollar deposits yet. However, we expect to see a rollover benefit over the next couple of quarters. Most term money is sitting in three and six-month intervals, so it will roll over to lower rates, likely resulting in a 10 to 15 basis points offset in the cost of deposits. Overall, in the coming quarters, we could experience a net interest margin compression of approximately 25 to 35 basis points. This will also hinge on loan demand in the market, influenced by government lending and the 10-year rate. Currently, reinvestment rates for MBS are in the $150 million range. We are also seeing about $150 million to $200 million in maturities each quarter from that book. If this trend continues, it could significantly affect investment yields, but we initially built that book to hedge against interest rate risks in our banking book. We currently have an unrealized position of $150 million there, which should contribute positively to coupon payments from MBS securities over the next few years, fulfilling our original purpose for holding them.

That's very helpful. On the expense side, the levels came in much lower than most were expecting this quarter. I would have thought that given the delays in some of the integration in the Channel Islands, there could have been a risk of higher expenses, but it appears you have implemented some effective cost measures in the short term. Can you walk us through your near-term expectations on expenses? What kind of impacts from the health crisis might we see on expenses? What sorts of cost reductions could we expect? Also, what impact might the integration of the Channel Islands deal have in the third quarter? I realize there are many variables at play.

Sure. Let's address the short-term situation first. Since corporate travel policies were implemented in mid-March, travel has completely stopped, significantly reducing our expenses. Operating banks across various locations normally requires a lot of travel, which is beneficial, but client entertainment has also stopped and shifted to virtual formats, leading to further savings. We noticed considerable benefits in late March and anticipate continued reductions in discretionary spending, although this will be a temporary advantage. As we exit lockdown, we'll begin ramping up operations because maintaining relationships is essential to our business. From a strategic perspective, we've temporarily deferred some capital spending, especially on buildings and brand expansion, spreading these costs over a longer timeframe while still aiming to achieve the same benefits. For instance, employees are using existing business cards rather than getting new ones, and we are gradually replacing credit and debit cards as they expire. We are still investing in frontline business initiatives, such as the branch refurbishment in Bermuda, but certain back office projects have been postponed or are under review. Regarding amortization, we previously mentioned that Butterfield invested heavily in a system a decade ago, which incurs yearly costs of $10 million that will start to decrease at the end of this quarter. Moving into Q4, we expect to see some cost savings from this, but we plan to allocate $2 million to $3 million for necessary system upgrades, resulting in a net annual saving of approximately $7 million. Depending on how long current conditions persist, we may need to reassess our operations and staffing requirements through zero-based budgeting as we reset our operational needs. I'll let Michael provide further insights on that.

Our current focus is on ensuring the safety and well-being of our employees while maintaining operations. We have been effectively managing remote work, which is an important aspect of our current operations. Out of our 1,500 employees, 70% are working remotely, 15% are at home not working, and 15% are in the office. For instance, in Bermuda, we are providing full retail services with 59 people in the office out of about 500, maintaining similar ratios in other locations. We are considering what our operational model and cost structure should look like in a long-term low interest rate environment, especially as a deposit-led bank like Butterfield. While our remote work has been successful with minimal client complaints, we must acknowledge the significant drop in volumes. This situation calls for careful analysis of how we can operate moving forward. We recognize that we've entered a new working model, especially as a complex bank dealing with expensive jurisdictions, multiple currencies, and regulations. Our priority right now is to support our employees as they serve our clients while we assess potential changes to our cost structure.

Got it. That's very helpful. Lastly, on the strategic front, you mentioned that this could lead to large banks leaving offshore jurisdictions, which might create some opportunities for us. How are you viewing your position? It seems like Butterfield is relatively well positioned compared to some global peers that may face more severe credit exposures and are in a capital preservation mode right now. So, how do you see your ability to act as a strategic acquirer at a time when many global banks might be looking to exit and raise capital?

Yes, we have learned a significant amount from the financial crisis. Our approach has been focused solely on in-market lending, avoiding out-of-market lending and credit exposure in our investment portfolio. This strategy has positioned us well. While we may face some residential mortgage challenges as the economy opens up, we believe we have adequately repositioned ourselves from a credit standpoint for situations like this. We're feeling confident in that regard. Currently, due to the environment, there isn't much activity around near-term corporate development, but we anticipate that things will start to open up as markets begin to function again. We are a notable bank in Guernsey, holding around 10% to 15% market share, and about 1% to 2% in Jersey. We believe there will be opportunities as U.K. banks strategically reposition themselves. Singapore, although currently more restricted, is still a great market for us since we operate as a trust company. We need to find some scale there as well. While we expect opportunities to arise, we also recognize that in the coming months, many are focused on getting through their current challenges. However, as we head into summer, discussions may begin again. Importantly, we have a strong balance sheet and are strategically positioned to execute our long-standing strategy.

Our next question comes from Arren Cyganovich with Citi.

I was wondering if you could discuss the behavior of your global trust clients in the current environment. You mentioned that the trust fees remain relatively stable, but is there any change in the large deposits or in the typical activity they bring to the bank?

What we're observing is a significant amount of estate and financial planning taking place for clear reasons. People seem to be quite anxious. We have noticed an uptick in interest from our jurisdictions regarding estate planning, primarily influenced by a few lawyers from New York, London, and Miami. We've established some promising connections that could lead to new trusts. In terms of existing trusts, clients are focusing on ensuring that the structures are appropriate and that beneficiaries are correctly assigned. This is part of our routine operations, but it appears to be more emphasized at the moment. There may be some deposit weakness, particularly with our larger trust clients. Rather than simply pulling money out to set aside, clients seem to be identifying real investment opportunities. I believe some of these larger trust clients will invest some of their funds, but we also anticipate a fluidity with money moving in and out. While there may be minor weaknesses, it’s worth noting that our larger clients are just a small part of a generally balanced portfolio.

This concludes our question-and-answer session. I would now like to turn the call back over to management for any closing remarks.

Thank you, Brandon, and thanks to everyone for dialing in today. We look forward to speaking with you again next quarter. Have a good day.

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