Oceanfirst Financial Corp Q2 FY2020 Earnings Call

Good day, and welcome to the OceanFirst Financial Corp. Earnings Conference Call. All participants will be in listen-only mode. I would now like to turn the conference over to Jill Hewitt. Please go ahead.

Good morning and thank you all for joining us. I'm Jill Hewitt, Senior Vice President and Investor Relations Officer at OceanFirst Financial Corp. We will begin this morning's call with our forward-looking statement disclosure. Please remember that many of our remarks today contain forward-looking statements based on current expectations. Refer to our press release and other public filings included in the Risk Factors in our 10-K, where you will find factors that could cause results to differ materially from these forward-looking statements. Thank you. And now I will turn the call over to our host this morning, Chairman and Chief Executive Officer, Christopher Maher.

Thank you, Jill, and good morning to all who've been able to join our second quarter 2020 earnings conference call today. This morning, I'm joined by our Chief Operating Officer, Joe Lebel; Chief Risk Officer, Grace Vallacchi; and Chief Financial Officer, Mike Fitzpatrick. As always, we appreciate your interest in our performance and are pleased to be able to discuss our operating results with you. This morning, we'll cover our financial and operating performance for the quarter and provide updates regarding pandemic conditions in our markets and the progress we are making to return to more normal operations. Please note that our earnings release was accompanied by a set of supplemental slides that are available on the company's website. We may refer to those slides during this call. After our discussion, we look forward to taking your questions. In terms of financial results for the second quarter, GAAP diluted earnings per share were $0.31. Quarterly reported earnings were impacted by merger-related expenses and branch consolidation expenses totaled $3 million, net of income tax. As a result, we pegged core earnings of $0.36 a share. Given the headwind of our COVID-related credit provisions and operating expenses, we were pleased with the quarter and have positioned the company to improve a number of financial metrics in the next few reporting periods. Regarding capital management, the Board declared a quarterly cash dividend of $0.17, the company's 94th consecutive quarterly cash dividend. The $0.17 dividend remains a conservative payout of core earnings. There are no plans to reduce or eliminate the per common dividend at the present time. Capital levels remain strong with tangible common equity to total assets of 8.8%. Please note that this ratio was negatively impacted by the PPP loan growth, which decreased the ratio by 37 basis points. The TCE ratio, excluding PPP loans, would have exceeded 9%. At the current earnings rate, we expect to continue to build capital levels for the duration of 2020. During the first quarter, the company was able to repurchase 648,851 shares of common stock, but suspended the repurchases on February 28. Share repurchases are possible in the future, but we will preserve capital until the full impact of the pandemic is well understood. The company has slightly more than 2 million shares remaining in the current share repurchase program. Given the capital issuances earlier this year, we maintain approximately $200 million of liquidity at the holding company, which provides the capacity to take advantage of opportunities that may arise as the pandemic eases and the economy returns to a more steady state. Given the environment we faced in the second quarter and the uncertainty regarding the pandemic and the economic recovery, we will do our best to convey our views on the operating environment, as well as the company's performance and risk position. The current crisis will unfold over the next few quarters and impacts may extend well beyond that. At present, our markets are experiencing a much better public health situation than they were just a few months ago. The economy has begun to rebound and our loan portfolio is holding up well. However, all of those conditions are fragile and any setback in regional public health conditions, faltering in fiscal support programs for business conditions, could rapidly erase the gains made to date. It is far too soon to be optimistic, although progress has been made and we continue to be confident that the company is well positioned to weather the storm. Let's spend a minute reviewing market conditions in our area of operation. When we last spoke in April this year, New York and New Jersey were the epicenter of the crisis in the United States. I'm pleased to report that substantial progress has been made to address both the public health crisis and to begin the economic restart in a prudent, sustainable manner. Daily new COVID cases in our primary markets have decreased substantially, with the current seven-day average running 70% lower than our peak experience in April. New case reports are stable and have not increased despite several phases of reopening. Of course, we must remain vigilant. Great progress has been made and infection rates are relatively flat. In terms of economic reopening, the regional approach has been cautious and thus far that approach is working. Our clients are reopening their businesses in a safe manner and rebuilding operationally and financially. The stimulus programs, in particular, the PPP program and the $600 unemployment supplement, have hit their mark. We see direct evidence that the majority of our clients, both commercial and consumer, have built a liquidity surplus. Among other positive measures, average checking account balances have increased measurably and debit card spending now comfortably exceeds pre-pandemic levels. In addition, the seasonal Jersey Shore markets are very active with high volumes of visitors from across the region. The experience is different, but seasonal rentals are exceptionally strong, residential sales are well ahead of last year and even hospitality is managing to make the most of the new operating models. We saw similar patterns in the aftermath of 9/11 and the great recession as driving vacations increased dramatically as more cost effective and safer travel alternatives. We have significant concerns that there will be setbacks ahead, but our clients have been resourceful, innovative and resilient. Over the first six months of 2020, just two OceanFirst clients have filed bankruptcy, a figure that is considerably more favorable than our historic experience and better than national or state trends. On a cautionary note, conditions in our New York City market raise some concern, as many commuters have yet to return to Manhattan office space. The lack of office occupancy will continue to weigh on recovery efforts in that market. Given our franchise distribution, the suburban and Jersey Shore markets are a much larger component of our business than the urban centers in New York and Philadelphia. So, we expect the impact of OceanFirst to be muted. As Grace will outline later, our approach to forbearance management is working as intended. Our non-forbearance loan portfolio continues to perform with negligible delinquencies, net credit recoveries and very little migration to classified. Even OREO levels are a rounding error on our balance sheet. As a result, we are confident that the forbearance pools have identified the loans that present the most significant potential credit risk on our balance sheet. Also positive: a significant portion of the forbearance borrowers have indicated their intention to return to regular monthly payments at the conclusion of their first 90-day forbearance period. Of course, we are not out of the woods and the next few months are critical in this effort. Provided we have no major setback in the reopening process, the forbearance period for most loans will expire in the fourth quarter. At that time, we expect to have the information to adjust risk ratings as appropriate. Turning to our financials. There are several unusual items to discuss. The first is our liquidity position. Maintaining a surplus liquidity position is critically important during the crisis. We overshot our goals in this regard as a result of decisions made early in the second quarter and deposit performance that exceeded our expectations. As the PPP program was launched and our application portal began accepting requests for funding on April 3, it was immediately clear that the demand for loans would be very significant. We made a public commitment to the program and immediately moved to secure funding to meet that commitment by issuing $281 million of brokered CDs. These CDs are laddered and will come due in the next few quarters. The decision to issue these CDs was made prior to the announcement of the Federal Reserve PPP Loan Funding Program. In addition, we made a practice of funding PPP loans directly into OceanFirst operating accounts. That decision and our clients' careful liquidity management resulted in a $500 million deposit inflow, a good portion of which remained at the bank as of June 30. Finally, despite significant interest rate reductions, ordinary course deposit growth totaled $291 million. This growth was driven by the addition of some well-priced treasury accounts in New York and certainly included some elements of government stimulus. Considering our excess liquidity position, we paid off every Federal Home Loan Bank borrowing due to mature in 2020 and in 2021, and still managed to end the quarter with $720 million in cash. Obviously, that weighed on returns and on our leverage ratio. Bill will walk you through our plans to address the excess liquidity position in future quarters. In addition to the excess liquidity, the PPP loan portfolio expanded our balance sheet and negatively impacted margins and return. As these loans repay in the coming quarters, the negative NIM impact will be mitigated and capital ratios should normalize. Recall that PPP loans that are not pledged to the Federal Reserve PPP liquidity facility are included in the leverage ratio, although they are excluded from the risk-based capital ratio. In addition, due to the U.S. government guarantee, we have not allocated any credit reserve for the PPP portfolio. Joe and Grace will discuss a number of topics in more detail. But let me outline the areas of focus for us in the third and fourth quarters. During the third quarter, we are focusing on forbearance wind-down and further deposit cost reductions. Clients are indicating that a significant portion of the forbearance loan portfolio will return to monthly payments this quarter, but the monitoring of that process will be critical. As loan officers navigate the process, they collect the operating data that will be needed to determine the appropriate risk rating of any loans that are unable to return to monthly payments after the 180-day forbearance period completes. Many of these businesses have only reopened in late June and July, so it will take several months of operation to establish the data we need to evaluate credit risks. Based on the calendar, risk rating changes are likely to be concentrated in the fourth quarter. In addition, we will use our excess liquidity position to further reduce deposit costs and do our best to stabilize and recover some ground in the net interest margin. As Joe will point out later, repricing the deposit portfolio, especially in the midst of integrating two acquisitions, requires some patience. But progress has been made and will continue. During the fourth quarter, we plan to address the forbearance loan portfolio and expect to be making a number of risk rating adjustments at that time. As long as interest rates remain stable, we should achieve further deposit cost reductions. Finally, by the fourth quarter, we should have the customer transaction data to support additional expense reduction initiatives. Given the importance of credit risk management, I'll turn the call over to Grace who will outline how we view our credit risk position.

Thanks, Chris. As you mentioned, our credit metrics remained strong and stable through the second quarter. We had record low loan 30- to 89-day delinquencies, as well as continued low non-performing loans relative to total loans. TDRs and classified balances remained stable and low, and even OREO balances were nominal at $248,000. We had net recoveries of about $230,000 this quarter, and our loss rates continue to decline. As a result, we feel confident that those customers experiencing pandemic-driven distress are in our forbearance pool, and that our forecast for forbearance balances in the third quarter effectively captures our near-term risk position. Being highly accommodative to our borrowers has not only helped our clients and our community, but it's also helped us better assess our near-term risk position. Although, as Chris mentioned, any setbacks in regional public health conditions, any faltering in fiscal support programs or other stresses on business conditions could change this assessment. Earlier in the quarter, the forbearance pool peaked at $1.6 billion, including $1.240 billion in commercial and $329 million in residential loans. Since that time, the balance has declined, as only a portion of these borrowers require an additional forbearance period and new forbearance requests have been near-zero for several weeks. We expect almost two-thirds of our commercial customers on forbearance to return to regular monthly payments in the third quarter. This estimate is based on conversations with 90% of our commercial forbearance pool. Currently, our identified second commercial forbearance pool totaled $386 million. These loans have a weighted average LTV of just 53%, a weighted average debt service coverage ratio of 1.9 and an average deal size of just $2.1 million. Within our forecast peak exposure, the restaurant and hospitality industry represents the largest component at approximately $200 million. These credits have a weighted average LTV at just 50%, and a weighted average debt service coverage ratio of 1.9. Included in these figures is the $68 million Irish bar portfolio in New York City, which are generally secured by mixed-use properties and have a weighted average LTV of 44%. Our forecast peak exposure secured by retail properties is $77 million. This portfolio has a weighted average LTV of 56% and a weighted average debt service coverage ratio of 1.4. The average deal size is just $2 million. Moving on to residential forbearance. This pool peaked at $329 million, and we expect one-third of this to return to regular monthly payments in the third quarter, leaving a projected peak residential second forbearance pool of $237 million to be addressed in the fourth quarter. To date, $161 million has formally requested a second forbearance period and the risk profile of these borrowers is consistent with those of the initial pool, including a weighted average LTV of 70% and a strong weighted average FICO score of 734. A full 82% of these credits have never been delinquent over the life of the loan. The strong weighted average LTVs in both commercial and residential forbearance loans demonstrate the conservative underwriting practices I mentioned last quarter. And while the full extent of the impact of the pandemic on property values remains unknown, LTVs at these levels provide significant downside protection. We feel our exposure to loss is modest, should the pandemic recession extend multiple quarters. As I emphasized last quarter, our loan portfolio's risk profile was fairly conservative, given our long-standing emphasis on diversification and sound underwriting practices, including strong collateral support. The portfolio is overwhelmingly secured by real estate and underwritten with conservative loan-to-values. Our commercial portfolio is diverse in industry exposures and property types, with no single industry exceeding 5% and no individual property type exceeding 10% of total loans. C&I lending is a modest 10% of the portfolio. Repeating from last quarter's call, we have no energy, auto, equipment finance, credit card or leveraged loan exposure. Notably, none of our 10 largest commercial relationships are on forbearance, and only two of the top 20 require some degree of forbearance into the third quarter. And only a single commercial client has informed us that they plan to go into liquidation this year. This credit risk profile has a direct effect on our charge-offs and subsequently the required level of loan loss reserves. The allowance for loan losses increased $8.9 million this quarter to $38.5 million, or 0.46% of total loans. Covered non-performing loans coverage is 1.8 times. This balance together with unamortized credit marks of $35 million totaled 93 basis points of total loans, exclusive of PPP loans, on which there is no reserve given the U.S. government guarantee. Total allowance for credit losses growth was driven by a $6.7 million increase in quantitative reserves. This shift toward quantitative reserves when compared to the prior quarter reflects a much weaker economic forecast issued on June 17 by Oxford Economics. This forecast more closely aligned with other sources at that time such as S&P and Moody's, and thus did not require a qualitative adjustment to account for forecast differences. Even with that shift, qualitative reserves comprised 40% of the allowance for loan losses. That's appropriate in such an uncertain time, but it does illustrate the conservative product mix and long history of strong credit metrics. We need qualitative factor adjustments to address the COVID-19 impacts, including the impact on our forbearance portfolio, adding another $3.3 million to the allowance this quarter. In most cases, it's premature to set individual borrower ratings, as the breadth and impact of government support actions remain uncertain and fluid. As discussed in last quarter's call, we expect risk rating migration as the CARES Act forbearance period ends. As such, we expect qualitative reserves may further decrease, as this risk rating migration is reflected in the quantitative reserve. Our focus over the next 12 weeks will be to continue winding down the forbearance pool, identify TDRs and non-accruals as appropriate and liquidate risk positions that can be exited at acceptable economics. Our credit metrics excluding forbearance loans are exceptionally strong. This indicates that the forbearance loans accurately identify the near-term credit risk pool. Forbearance loans are carrying rapidly and our best estimate of the fourth quarter peak is $500 million in commercial and $237 million in residential, or 9% of the total loan portfolio. As only a portion of these will transition to TDRs or non-accrual status, the number appears very manageable in terms of our earnings, total balance sheet and our capital position. Our $181 million capital raise provides additional support in this environment. While these funds remain at the holding company and we have no immediate plans to downstream these funds to the bank, they are available should circumstances warrant. On a final note, I will reiterate that we are a conservative lender that is focused on well-secured credit in low-risk segments. However, we will be impacted by regional economic trends. For now, the regional reopening appears to have struck a balance between returning to work while maintaining effective public health protocols. But this balance is delicate and may be tested in September as the school year begins. With that, let me turn the call over to Joe for some comments on the business.

Thanks, Chris. I'll discuss our loan business including PPP, as well as some comments on the net interest margin, deposits, expenses and operations. Loan originations of $975 million drove record loan growth of $450 million for the quarter, after $105 million in performing residential loan sales. PPP loans totaled $504 million of the total originations and $479 million in outstanding at quarter end. Our team did a remarkable job in quick fashion in building the capacity to do these loans and automating the documentation to close efficiently in the face of the pandemic. We've now built an automated system to take our client applications for forgiveness and eagerly await the opening of the SBA portal for delivery of those requests. In regard to the fee to be earned on these PPP loans, we expect to recognize over $15.5 million in the coming 12 to 18 months as loans are forgiven or repaid. To date, we've recognized roughly $1.7 million in fees from PPP loans through June 30, which is reflected in net interest income. Loan originations from the commercial team were strong at $217 million, as the bank experienced very little pipeline fallout despite current economic conditions. The commercial pipeline is off its highs from last quarter, but still 20% better than a year ago. Residential business is very strong, as we experienced record originations for the quarter at $242 million and the pipeline remains at elevated levels. I'll echo Chris' earlier comments and add that the local real estate market is benefiting from limited inventory, motivated buyers and all-time low rates. We're taking the opportunity to sell many of our 30-year conforming originations with solid gains to generate some mortgage banking income while managing balance sheet exposures. In this rate environment with solid gains available from loan sales and the ability to manage interest rate duration risk, sales occurred on a flow basis monthly as well as the bulk sale of $45.7 million. Our swap fee income was lower than Q1, but it was still a solid quarter with almost $2.5 million in revenue. Year-to-date, we are well ahead of last year as customer acceptance of the product remains brisk. Originating these loans at floating rates with the synthetic fixed rate swap product has had some adverse effect on net interest margin as rates have crept to all-time lows. It provides flexibility for the balance sheet and asset liability management and we generate that fee income upfront. We are avoiding the temptation to build margins by sacrificing on neutral interest rate risk position. I'll add some comments on fee income generally, which was down over $2 million quarter-over-quarter due to the decrease in swap fees from an outsized first quarter and reduced fees and service charges on deposit accounts. The reduced service charges were from an active waiver or rebate of fees to our customers affected by COVID-19, and to a lesser extent, fewer non-sufficient fund fees as the savings rate across the client base increased measurably. Year-over-year, we're almost $6 million ahead in fee income and positively, bank card income is up in the quarter and year-to-date as consumers adopted the use of their cards for digital purchases. Moving to the net interest margin. Core NIM declined by 28 basis points due to a few factors. These include the new loan activity at lower market rates, which was dominated by the PPP loans, the interest cost on our recent subordinated debt issuance and our balance sheet liquidity position during the quarter. I'll discuss each of these briefly. Loan originations of $471 million, excluding PPP, offered rates competitive in the market, including as noted earlier, swap loans with floating rate LIBOR spreads that adversely affected margin and residential rates among the lowest on record. The PPP loan originations yielded 2.81%, and were comprised of a 1% interest rate and 1.8% in fee income recognized in the quarter as part of the effective yield. Together, the new loans and PPP originations reduced NIM by seven basis points and two basis points, respectively. Subordinated debt issuance impacted NIM by 6 basis points and our decision early in the pandemic to keep some additional liquidity on the balance sheet by raising $281 million of brokered CDs for risk mitigation impacted the margin by 13 basis points. $100 million of the brokered CDs at an average rate of 1.07% run off in October, with another $75 million tranche at 1.15% maturing in January of '21. Fortunately for us, we didn't need the additional liquidity, given the deposit growth from not only the PPP loan proceeds, but also our own organic deposit build from new and existing corporate treasury clients and retail core growth. Our cost of deposits for the quarter decreased 13 basis points to 57 basis points, as deposit rates from all areas of the bank were cut. The Country Bank deposit book saw a decrease of 57 basis points for the quarter. And since the Country acquisition on January 1, we've seen deposit costs decrease by 73 basis points in that book. Two River Community Bank has seen a year-to-date decrease of 46 basis points and the OceanFirst legacy books down by 11 basis points. We still expect further reductions as time deposits at Country and Two River Community Bank continue to mature and are re-priced lower, and the aforementioned brokered CDs run off. I hope you can appreciate our pacing of the changes at Country and Two River. We're being very careful to preserve the client relationships that were central to both acquisitions. Our loan-to-deposit ratio of 93% as of June 30 provides plenty of room for loan growth and disciplined deposit repricing. Expenses were well managed and include $1.1 million in discrete COVID-19-related expenditures for the quarter and $2.1 million year-to-date. We remain confident in our quarterly expense run rate and will recognize savings from the branch consolidations completed in May, while spending wisely on digital account acquisition and continued employee and customer safety. We are actively managing headcount in the current environment. From March 31 through year-end, we expect the number of employees to be reduced by approximately 9%, comprised of Two River Community Bank consolidations, some Country Bank and Two River back office personnel, normal attrition and a recently completed voluntary retirement plan program. The merger integration for Two River Community Bank was completed mid-May as scheduled and converted the core system and consolidated eight branches into Two River markets, as well as five legacy OceanFirst branches. Country Bank will be integrated in two stages. Country branches will be rebranded OceanFirst in the fourth quarter, and the final systems integration will be completed in early 2021. In regard to daily branch operations, you may recall that we were one of the first banks to close branch lobbies and limit activity to drive-through teller transactions only. We reopened our branches for full service in-person transactions in stages beginning June 15, and are operating at normal capacity, utilizing appropriate safety protocols, including the use of personal protection equipment and limitations on the number of customers in the branch at any one time. Activity has been about 80% of pre-COVID levels, but it's too early to determine any long-term trends. I will finish up with some comments about the markets we serve and second half expectations for loan growth. We expect loan growth for the remainder of the year to be modest or flat with dependence on the economic recovery, business reopenings and people returning to work. We continue to see opportunistic borrowers with liquidity looking for deals while many others struggle to reopen. Seasonal businesses have benefited by good weather and pent-up demand or drive-to-vacation or long weekend. Construction has resumed and wholesalers of building, industrial supplies and other trades are very busy and profitable. While restaurants in our markets are adapting, they are breaking even at best. Hospitality remains well off breakeven occupancy levels, other than seasonal shore hotels and extended stay properties. Retail is spotty based on geography and certain retailers, such as car dealers and the larger big box stores seeing pent-up demand. Some clients report difficulty in attracting workers back to the workforce. In CRE, urban areas, New York City and Philadelphia are soft. Suburban office is surprisingly unaffected and warehouse distribution and other transportation logistics are strong, while retail other than discount stores and shopping centers anchored by grocery are seeing inconsistent performance. With that, I'll turn it back to Chris.

Thanks Joe. Before we open it up to questions, let me just close with the following summary. There was noise in the quarter in terms of excess liquidity, the PPP program, weak deposit fees due to COVID and even the Two River integration. That noise is temporary and should work itself out in the coming quarters. We have a clear handle on our current credit risk position. The vast majority of our loan book did not require forbearance and is performing well. The forbearance loan portfolio appears positioned to decrease materially over the near term. Given conditions today, we're confident that we have the earnings power and capital position to address credit risks we face in the coming quarters. Deposit costs are positioned to be reduced further, and that effort will be critical to defending our margin as we move forward. Operating expenses will benefit from the elimination of 13 branches this quarter, as well as additional cost saving strategies that will be addressed in the coming months. We're in a position to improve operating performance over time and earnings should recover as the credit cycle moderates, which may result in decreased credit provisions. Our ability to forecast either the end of the pandemic or the strength of the economic recovery is very limited. We are closely watching public health conditions in our markets. They have improved dramatically, but could turn at any moment. Fiscal stimulus, which has played a pivotal role in supporting the economy, must continue in the near term in order for additional progress to be made. Collateral values: so far residential real estate is holding or increasing in value and even CRE cash flows are remarkably steady. Our credit risk models are quite sensitive to collateral values, so we're monitoring them closely. At this point, let's move to the Q&A portion of the call. Thank you.

Our first question comes from Frank Schiraldi with Piper Sandler. Please go ahead.

I'm trying to get a sense as always about provisioning. And it seems like the model stabilized a bit. So if that's the case, is it fair to say the qualitative builds are mostly behind and from here, it's just really quantitative factors and credit migration, specific credit migration, that's going to drive the provision going forward?

I think that's fair, Frank. Absent a change in the environment, where we have a big change in the reopening process or something like that, that doesn't appear and present to be an issue. We have been building up qualitative reserves, knowing that as these loans come out of forbearance, some of them will become TDRs or even non-performing. At that point, the quantitative factors will take over. You'll be making risk rating changes and the quantitative portion of your reserve will probably increase. But at the same time, as you're getting that certainty, a lot of the qualitative reserves we've established are due to the uncertainty. So, you may see one category growing and the other category hopefully reducing. And there is no way to be precise about the allocation of that or the timing of that. But we're encouraged by what we've seen. Grace, you might talk a little bit about the process of the conversations you've had with clients in order to establish your comfort with where we are today in terms of those reserves.

Sure. So it's part of our monitoring of the forbearance exposures. The credit team and the lenders reached out to, I think I mentioned, 90% of our commercial borrowers. And then we had discussions with members of senior management team on both sides, credit and lending. We talk about each credit, at least the larger exposures — I think those are everything over $2.5 million. So it's a significant portion of the commercial forbearance. And it was through those conversations that we were informed on what key factor adjustments we should make to capture the risks that Chris mentioned earlier.

In terms of — it seems like then, if the risk weighting story is probably going to be more of a 4Q story, I think that's kind of what you indicated, Chris. Then it seems like, I don't want to put words in your mouth, but 3Q might be a little bit of a lull in provisioning as long as the qualitative stock holds up. But we start to see migration into lower risk weightings and NPAs perhaps, you guys gave, I think, a best guess of where — I'm not sure what, Grace, is. 9% I heard by the end of the year, I think. But what are your best guesses in terms of provisioning levels versus earlier this year versus the first quarter and second quarter? Do you think 4Q could very well be higher because CECL really is a quantitative model, right, more so than qualitative? So, could that overwhelm the qualitative improvement? I know that's tough to say here in July, but just wanted your thoughts there.

It is very tough to say, Frank, because we don't have a crystal ball. But when we have these conversations with clients, we are delving into their liquidity position. We're assessing their level of operation, whether they plan to reopen or not reopen. We're trying to evaluate the real estate values and things like that. So if we thought that we were facing a wave of additional provisions later in the year, we would be taking them now. That's the whole point of CECL. But we do recognize the uncertainty. And I think what you see in our provisioning now in the first half reflects that uncertainty. Based on the calendar today, it would appear that most of these things are going to be worked out by the fourth quarter and then we're going to be left with what is the TDR pool and the non-accrual loan pool. At that point our precision around reserve will be much better. You shouldn't be sitting on a reserve that has a big qualitative piece at that point; it should be a reserve that is, in many cases, quantitative. So, we think we are calibrating that right. But there's a lot of questions and there could be a lot of changes between now and then.

And then just finally on the loan growth. Joe, I think you mentioned maybe moderate to flattish. Just wondering if that is correct. Given your pipeline is 20% stronger than last year and I guess Two River and Country helped that out. But if we look at the loan growth graph here on Page 11, is that kind of the story? Are you going to see some decent sized loan originations and then you're seeing a decent amount of payoffs to offset that? And then just curious where those, if centered on any geography in terms of the originations. Thanks.

Interestingly, Frank, for the first half of the year, we saw pretty even growth and activity throughout all the regions. So legacy footprint of the bank probably generated 40% and then we got 30% of the growth in New York and 30% in Philly. So it's nice we're seeing activity from everybody, which is good. And I think what we're going to see is continued opportunity. We're open for business, which is good. We hear a lot of anecdotal commentary about people not entertaining opportunities for either their clients or, God forbid, you entertain something for new clients. So that's a positive for us. The pipeline is down a little bit quarter-over-quarter, year-over-year. You're right. It's up $60 million. It's up 20%. And I'll give you an example. We just did another $50 million in loan approvals this week. So, I'm bullish, but we're also selling residential loans in the secondary market. We believe for balance sheet management, we should continue to do so. So, I think that — I think that it's prudent just to recognize that there may be some fits and starts on the economy as well.

Our next question comes from Russell Gunther with D.A. Davidson. Please go ahead.

Could you guys spend a little time addressing how the customer transaction data you gather that you believe can lead to some cost reductions later in this year and into 2021? Can you just provide a little more detail in terms of how that informs your view on the expense run rate into next year?

Sure. We've been, Russell, very aggressive in closing branches and have consolidated 53 branches in the last few years. So, we have not been slow to pull the trigger when we see patterns that make sense to us. And I want to emphasize that in most of those cases, we were following our customers' preferences. As customers move to digital channels, we want to put our expenses and our people and our tools and our technology in the channels they want to be in. So when the pandemic came along and we saw a spike in use of mobile banking and digital channels, that suggests we now have a much higher number of customers who are willing to bank without a branch. It's certainly not sensitive to having a branch nearby. Given the stress of the environment and that we just closed 13 branches, we don't want to be heavy-handed and rush to make a decision today. That said, we look at the early patterns — Joe mentioned activity being about 80% of pre-pandemic — and that's not uniform for every branch. Some branches have all the customers back and some don't. We're watching this pattern to understand which of our branches might be candidates for consolidation later in the year. So, I think that's kind of the crux of it. We just don't want to — we've been a fast and early mover. So, we think we can take 90 days, 120 days, understand what the customers are telling us and then react in a way that helps the company but doesn't sacrifice our customer satisfaction.

And I appreciate that, Chris, and that's kind of what I'm wondering, given that you guys have been so ahead of the curve here, both on the digital platforms and on the branch reductions as well. I'm just trying to get a sense of how much meat this might possibly have, as it would benefit earnings next year? Or are there other franchise investments that may absorb some of that potential cost savings?

It is always net to your point about investment. There is a net save, typically, as we do this, but we do invest in other areas. We've made a lot of investments into the digital side. We're not staring at any giant capital investments in digital. I think we're very happy with what we've built and we incrementally improve those on a quarter-to-quarter basis. But it is personnel shifts where, if we consolidate a branch that might have a half dozen people in it, the save is not a half dozen people because we move people into the call center or into our video banking group that does face-to-face interactions with people via video. The early transactions after we reopened lobbies were quite strong. They appear to have fallen off pretty dramatically now in the last week or so. So it's unclear: was there a bubble of customers that missed the branch and rushed in to take care of something and they won't be back, or is this just noise? I don't think it's going to take us a long time to figure it out. But we want to be careful. The strength of our franchise has always been our funding and our funding comes from strong relationships, both commercial and retail. So you don't want to hurt that.

That makes sense. I appreciate your comments there, Chris. And then just a final question for me is really a follow-up. And I just — just to confirm what Grace was talking about and the conversation around the reserve. So kind of a pro-forma deferral around the end of the year of 9%. Now, is that captured in your reserve today and in the — it sounds like in the qualitative factor? Is that expectation currently reserved? Or is that going to show up incremental in the fourth quarter as that risk migration formalizes?

So, I would tell you that we've made an internal assumption — one we won't publicly share the exact number of — that a portion of those credits will become TDRs or non-performers, and we need a reserve to cover that. If we are spot on, then the reserve is perfectly calibrated. I don't expect that; I expect it's probably going to be a little higher or a little low. It's all going to be based on the final outcome. But Grace, you had some figures about the coverage of the deferral portfolio that I think are informative.

Sure. I thought it might be helpful to see reserves against our expected peak forbearance — another way to look at the adequacy of the allowance. So with the current ACL balance of $38.7 million, if you take out our day-one CECL reserves of $21 million, that leaves just under $18 million and that is 2.4% of our forecasted second forbearance pool. So it's helpful context. The short answer, Russell, is it's a general reserve. There are not specific credits that we are saying, 'Oh, I think that one might be downgraded' in a list that we calculate a reserve against. The conversations I was referring to before were significant and, frankly, striking to me that there weren't obvious downgrades. Companies are doing better than they thought. They have liquidity. But as Chris emphasized, those things are still in flux and could go in a variety of directions. So we are trying to capture that risk as we go along. I think 2.4% against our estimate for the second forbearance totals is pretty healthy.

And I just want to emphasize the process. If we have known bad information on a credit, we're going to downgrade. So we're not waiting to do a downgrade. What's happening is we have a lot of situations where we have no information. It's not good, it's not bad. Take a restaurant that may be open in the last week in June or the first week in July. We have no idea whether that's going to be a good story or a bad story. So we're deferring action until we have data. But as we went through during the second quarter, we had only a single liquidation issue in our commercial base and we took the action needed on that one. This process is not putting off making decisions. It's making every decision we can when we get the information we need to make that decision. And we know that most of this is going to require a few months' worth of operation for our commercial clients. We'll analyze that information. The timing will be more of a fourth quarter story than a third quarter story, but we're not deferring the decision. Where we know we have bad information, we're downgrading those loans.

Our next question comes from Christopher Marinac with JMS. Please go ahead.

Just wanted to continue on the same line of questioning. And Grace had mentioned the additional reserve angle and I was curious how we think about the acquired reserves and the additional disclosure that you gave in the last couple of quarters. Should that come down kind of slowly or quickly? And then as those loans transition, how does that play into the overall reserve coverage in the future?

You're talking about the credit marks on acquired loans?

Really the credit marks and obviously, if we add all of it in to the existing reserve and exclude PPP, you're around 1%. And I'm just kind of curious how that's going to look a couple of quarters from now? And those loans may pay off more? If there's acceleration, how does that play into kind of your reserve? Just the considerations.

So in other words, would we keep the overall level at around 1% or work to bring it down? The answer to that question is going to depend on the risk characteristics or the profile of what's in the portfolio at that time. So if the riskier of those credits were to pay off or roll off or be generally exited and that dramatically changed the overall risk profile and risk of loss, then the number as a percentage of the total portfolio would potentially come down.

Chris, it's Mike. Let me take a shot at that, too. So $35 million in unamortized credit marks, $11 million of that is specific credits that we've marked. To the extent those credits default and charge-off, we could offset those charge-offs with that specific reserve. And then another $24 million is more general and that is accreted into income over the life of the loan, generally most of that comes in over the next three to four years.

And I'm going to clarify something to that. Our forecast for peak second forbearance of just under 9% of total loans — we certainly don't expect all of that to become non-accrual or TDR loans. In fact, it's anybody's guess at the moment like Chris just described, given the conversations we are having with these borrowers. But there is enough positive stories and that's part of the difficulty in estimating the allowance. I won't venture a guess here in this environment, but it certainly will not be all of them.

And I guess my follow up is just about the LTVs that you've reinforced the last couple of presentations. Have you had any transactional evidence where you have had property sales that help confirm those values in recent months?

I think the values depend a great deal on the segment. There are some oddities about this recession — it is different than other recessions. First, residential property values are not only holding up well, they're probably understated because I think values have come up. They've come up sharply in the suburban markets we're talking about. In most of the markets we operate in, you're seeing 10% to 15% year-over-year price gains and I know that happens in some parts of the country. That usually doesn't happen in the Northeast or certainly hasn't happened since the Great Recession. So the residential pools, I think the LTVs are fine and probably conservative or understated. On the commercial side, we've not seen as many properties move, so it's really hard to get a precise valuation, but it very much depends on property type. Our assumption is that our LTVs and things like industrial warehouse, logistics, even multifamily — at least for our multifamily portfolio — have seen reasonably steady rent collections. Maybe cap rates come up a little bit, but it shouldn't be a disastrous experience. We won't know for sure until we see properties trade. Our exposures and what we're most worried about in the industry are what a restaurant property or a hotel property is worth. Fortunately, those are an even smaller portion of our forbearance portfolio.

Our next question comes from Collyn Gilbert with KBW. Please go ahead.

Chris, just to sort of segue from that last comment that you just made and it's kind of a big picture question. You always have really thoughtful answers in the way you think about all of this. So, I'm going to ask you. As you indicated obviously, OceanFirst has been very good at consolidating branches and that's maybe going to be part of the plan going forward. Do you have a thought as to in the future for what maybe OceanFirst is going to experience or what the industry could see in terms of the re-purposing of a lot of this branch real estate, as the industry looks to consolidate away from that and you guys as well? Any thoughts on what happens to that real estate? How do you think about your own branch real estate and how that gets repurposed?

It's a really good question. I think there are — well first, we're not in the camp that you shrink all the branches and have tinier branches. There's a lot of discussion over whether you change average square footage of a branch. We're more in the camp of how many branches do you need to support a geography because people are only coming in once a month or once every six weeks; they'll drive a little bit longer. Especially in our suburban market, if you're coming to a branch you got in a car. If you go an extra half mile, it really doesn't matter very much. So we're more in the camp of consolidating locations and getting really good at digital, not having a lot of smaller locations but more efficient locations. I'll tell you that branch real estate when it is no longer occupied by a bank is not particularly valuable, especially outside of urban markets. One of our first acquisitions, we took in properties at a certain value, closed branches and we did not realize the real estate value we thought. So we've been much more careful about valuing real estate and lease exit costs. One of the reasons we've been aggressive is that it can be a drag on the balance sheet. There are exceptions in urban markets where their branches are actually held below book value and have embedded gains if they exit. For a bank like us, it's more of a push. We have a disciplined group within the bank that does nothing but liquidate bank facilities. As you can tell, 53 of them; that's a lot of places to negotiate. It won't be at a gain generally. A funny story: one of the more aggressive bidders on one of our branches was a cannabis distribution company that loved the idea of both a drive-through and the vault. So maybe that's a future use.

Interesting. Okay. That's helpful. Just then two other questions. One on deposit costs. I hear you are messaging that you want to be cautious there and you have a customer base you need to preserve. But can you just give us a sense of what your current offering rates are? I'm just trying to gauge the magnitude that you could see some of those deposit rates drop.

Collyn, it's Joe. Probably a great example of where we're going is where we've been. So I'll give you a couple of thumbnail numbers. For the remainder of the year, from now to the end of the year, we have $571 million worth of CDs repricing. The average yield on those CDs today is 1.49%. In 2021, we have almost $664 million at an average yield of 1.69%. So those are going to come down markedly. I think our one-year CD today is 50 basis points and that's probably the highest bank rate we offer unless you want to go out six or seven years. So I expect to continue to reduce deposit costs and we're doing that as well in our government municipal business. That is very sticky business and we continue to reduce that quarter-over-quarter as these guarantees come due and we're not seeing any run-off. It takes a little bit longer for us because we already had such a good funding base at lower yields. But we can work it down even further.

Okay. That's helpful. And then just last — on PPP. I know it's hard to determine and hard to guess. But just for modeling purposes and how you guys are thinking about it, what's your sort of — what are you assuming in terms of forgiveness in the next few quarters? How is that trajectory going to look in terms of percentages in each quarter?

I think it all depends on how effective the SBA is with their portal. We got the portal up and running internally and we have electronic documents from our customers. In theory, when the SBA opens and we can hit send, you should see some pretty rapid forgiveness. We have not been extending the maturity of our PPP loans; almost every single loan is a two-year loan. We didn't do much of the five-year tranche. You are either going to be okay or you're not going to be okay. My guess is you'll begin to see forgiveness in the third quarter, probably the bulk in the fourth quarter. If the SBA is doing what they're supposed to, we should be able to clear a lot of it by the first quarter of 2021.

Right now, Collyn, almost every single, probably 99.5% of loans are two-year loans. The SBA indicated they expect to open their portal August 10. We've done 3,000 loans. We've set up an automated system to have customers start to provide their forgiveness applications to us in advance of the SBA portal opening. We've already got over 500 applications of the 3,000 loans and that's going to ramp up pretty quickly. I think Chris is right. We'll see the vast majority of the income we would accrete if the loans stayed open over two years coming in the next couple of quarters.

Our next question comes from Matthew Breese with Stephens, Inc. Please go ahead.

First of all, just kudos for the presentation and particularly the pages three and four. Those are really helpful. With that, we're starting to get a good sense for what the initial cure rate is on loans coming up on the end of the initial 90 days — 65% for you on the commercial side. Is there any reason to believe that that figure is a good or bad number to use for the cure rate on the second round? I mean, I can see both sides of this argument, but just wanted your thoughts.

We've had that discussion internally. I want to be careful to tell you that we don't have a number that we're using, but that doesn't sound like a crazy assumption. It really goes to the content of the conversations. As Grace described, there is a lot of liquidity out there and I think that's underappreciated. You look at the bank balance sheet and see there's a ton of liquidity. Our businesses, as we talked to them, have more cash than you would think at this point. I think the race to a vaccine will matter because many of the hardest-hit parts will benefit most from a vaccine and it's a waiting game. If businesses have liquidity and say, 'If I can hang on until there is a true reopening, maybe early 2021, I'll be in great shape' because many competitors won't be here. We did not expect the cure rate in round one that we are seeing and it's been surprising. On the consumer side, we're not concerned; the cure rate is lower than we thought in the first round, and I think that's clients being careful about their personal liquidity and deciding to defer again to build up cash reserves. Some finance experts have been telling people to go on forbearance and put the loan payments in their savings account and we're seeing some of that behavior. So I'm not overly concerned about the consumer portion. Forbearance builds liquidity, and if borrowers are not spending that cash, they'll be better able to get through the period. We've been encouraged by the conversations with 90% of our commercial borrowers, but this remains a fragile environment and we watch COVID cases daily.

And to take the conversation one step further and let's just — I'm trying to get a sense for what the transfer rate at the end of the year from things on deferral to TDR or non-performing? Is it safe to say that if the cure rate is the same that the most is still — so if it was $500 million of commercial forbearance, you apply that cure rate, you're left with $200 million at the end of the year, that would be the balance you would transfer to TDR or NPA? There would be zero in deferral, right?

It would be very low levels in deferral. The only situation where we might differ is if there is a very unique COVID issue such as a performing arts theater that cannot operate until a vaccine. If they had a good business and will remain closed for another 90 days, maybe you make an exception. But I would expect that, in our portfolio, borrowers will either come out of forbearance and return to normal or we will re-rate them. One important point about the allowance: even if loans go non-accrual and you do an impairment analysis, the vast majority of our book is real estate-secured. So we will then estimate collateral values. For warehouses or multifamily, it's straightforward; for restaurants and hotels it's much harder. If loans go non-accrual, you will see discussions and potential haircuts on valuation for those property types until we know more.

Our next question comes from William Wallace with Raymond James. Please go ahead.

A couple of follow-up questions. Sticking to this concept of the second round deferrals rolling off and then being able to figure out what to do with what's left. How would you guide us to think about the cadence of charge-offs? Will you be charging these loans if you move into non-accrual but only building reserves? If you move into TDR will charge-offs be really a first and second quarter of next year event? Help us think about that. And then on top of that, the way the CECL model worked, I'm not sure if you're using the Moody's forecast or Fed forecast or whatever. But over the forecast period, if the unemployment rate remains at that sort of high single-digit level and the GDP forecast doesn't improve, would you assume that you would have to maintain your reserves at current levels? In other words, would you have to cover your charge-offs entirely or would you be able to use reserves to cover those charge-offs?

I'll take the first one because it's easier, then I'll give Grace the second. In terms of when you'll see charge-off activity, it's certainly possible we'll have some charge-offs in the fourth quarter as we calibrate on a loan-by-loan basis what's non-accrual and then assess the real estate collateral on that non-accrual loan. If there's a deficit, there will be a charge-off. So there could be some in Q4. If the forbearance wave ends and we move into next year, you might see charge-offs when the loan is finally disposed of and you true-up the auction value of the real estate, or if appraised values sink further. Charge-off activity would happen both at the initial non-performing assessment and later when liquidating the collateral. It may be spread over a few quarters: Q4 and into early next year. One option we'll consider is bulk exiting of positions if we determine the worst is over, which could accelerate resolution.

If I understand the question correctly about the forecast and reserves: if the forecast continues to be fairly negative into early 2021, that would indicate potential further reserve build and we'd have to replenish charge-offs at that time. It would depend on how that economic forecast compares to our actual risk profile. If our non-forbearance portfolio continues to have the current credit metrics and our second forbearance gets resolved and quantified, there might be an argument for not having to maintain the reserve build despite a negative economic forecast. It really depends on conditions at that time and how they compare to our risk profile.

No, that's fair. I think the answer is, it depends. Fair enough. Okay. And then, Chris, you had mentioned collateral values and the improvement in the residential market and then not much visibility on the commercial real estate market just because of the lack of trades. But I'm curious as you guys underwrite new deals, maybe in sectors that are not directly impacted by COVID, what are you seeing in the appraisals of the properties? What are appraisers doing with cap rates and what impact is that having on collateral values?

There are two things and Joe can add specifics. Appraisers are including general COVID disclosures which are not very helpful; they often include a caveat that there are limited comps and that 'this is COVID, so I could be wrong.' In some sectors like industrial it's relatively straightforward — NOIs and cap rates are clear. Joe, maybe talk about a couple of deals we've done and how appraisals and LTVs have been handled.

Interestingly, for us, and I'll echo Chris' comments about appraisers making COVID disclosures, there's not a lot of comps. The comps you are using are pre-COVID. We've seen some adjustment to cap rates, but not meaningful. Our approach for new transactions has largely been to stick to our credit appetite, which tends to be a lower LTV perspective. For example, we financed a couple of retail properties where tenants were on deferral; we remove those cash flows from the math, discount values and look at lower LTV loans. We may invest where our internal LTV after discounting is 50%, even if the appraiser comes in a bit higher. We take a fairly heavy hand with these properties and we've continued to win transactions. That tells you you can be in the market with a certain credit appetite and still do well. We financed a substantial Amazon distribution warehouse at a very low LTV, south of 40% LTV.

And you're saying that's an LTV on a value that you're being relatively stringent on cash flow assumptions or cap rates. Is that right?

Yes.

Okay. All right. And then just one last question, just for a point of clarification. I believe it was maybe in Joe's prepared remarks. I believe you made a statement that you feel that OceanFirst is comfortable with the expense run rate. And so — and then there was a lot of commentary about cost saving initiatives and also the cost saves out of the converted acquisitions. So I'm just confused. Is $51.1 million after the one-time items the run rate that you think we'll see in the back half of the year? Or will the deal cost saves and other initiatives underway drive that lower? And can you maybe help quantify that because the moving parts have changed so much.

Yes. I'll take that. The $51.1 million includes a $924,000 prepayment penalty on Federal Home Loan Bank borrowings. So the core rate is really about $51 million. We think that going forward, we have some costs that are coming out because of the Two River conversion in May and the 13 branches that are closed. We expect that to be about $2 million coming out of the run rate in the third quarter and then maybe a little more in the fourth quarter with some of the voluntary retirements that Joe mentioned earlier.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Christopher Maher for any closing remarks.

Great. Thank you. With that, I'd like to thank everyone for their participation in the call this morning. As I said at the conclusion of the first quarter, our company has been around since 1902 for a reason. We take conservative credit risk positions. We're strongly profitable, and we maintain ample capital levels. We look forward to talking again after our third quarter results are posted in October. Thank you.

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