Oceanfirst Financial Corp Q3 FY2020 Earnings Call

Good day, and welcome to the OceanFirst Financial Corp. Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Jill Hewitt, Investor Relations Officer. Please go ahead.

Great. Thank you. 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, including the risk factors in our 10-K, where you will find factors that could cause actual 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. Chris?

Thank you, Jill, and good morning to everyone joining our third quarter 2020 earnings conference call. I'm here with our Chief Operating Officer, Joe Lebel; Chief Risk Officer, Grace Vallacchi; and Chief Financial Officer, Mike Fitzpatrick. We appreciate your interest in our performance and are glad to discuss our operating results today. We'll review our financial and operational performance for the quarter, discuss our strategy for the liquidation of certain loans, and outline our plans to navigate the next phase of the pandemic economy. As in the second quarter, our earnings release includes supplemental slides available on the company's website, which we may reference during the call. After our discussion, we welcome your questions. In terms of our financial results for the third quarter, GAAP diluted earnings per share reflected a loss of $0.10. This loss was primarily due to a $35.7 million provision for credit losses during the quarter. The provision comprised a reserve build of $20.7 million, net charge-offs totaling $14.2 million related to loans held for sale, and ordinary course charge-offs of $800,000. The reserve build stemmed from changes in commercial loan risk ratings related to pandemic forbearance loans and other qualitative factors stemming from weak economic conditions. The significant provision this quarter arises from a thorough review of the risk ratings in the commercial forbearance portfolio and reflects our best estimate of the credit risk associated with the pandemic. It is essential to note that our reserve estimate does not depend on additional fiscal stimulus and does not presume an overly optimistic view of the pandemic's resolution timeline. Reported earnings were also impacted by merger-related expenses, branch consolidation costs, and a net unrealized loss on equity investments totaling $5.8 million after income tax. Consequently, we estimate the core results for the quarter to be a $266,000 loss, or less than $0.01 per share. Regarding capital management, the Board has declared a quarterly cash dividend of $0.17 per common share and about $0.44 per depository share of preferred stock. This common share dividend marks the company’s 95th consecutive quarterly cash dividend and reflects our belief that earnings will recover in the fourth quarter and into 2021. We currently have no plans to reduce or eliminate our common dividend. Our capital levels remain robust, with a tangible equity to total assets ratio of 8.4%. This ratio was negatively affected by PPP loans, reducing it by 37 basis points. Excluding PPP loans, the TCE ratio would have been 8.8%. As mentioned in our earnings release, a considerable portion of our PPP loan portfolio was moved to held for sale at the quarter's end, and the sale of those loans was completed this week at a net gain of about $5.3 million. This combination of loan sales and anticipated improvement in profitability in Q4 will enable us to generate capital at a healthy rate. The company suspended common share repurchases on February 28. Since then, we have engaged with our clients to understand how the pandemic has impacted their businesses, enabling us to address our credit risk position, as seen through our sale of high-risk loans and the reserve build. This data also guides our annual stress test process currently in progress. After completing the stress test in early November, we will evaluate the possibility of reactivating our share repurchase program, which could potentially start as early as the fourth quarter. We have just over 2 million shares remaining in the current repurchase program, and if our surplus capital levels allow, the Board will consider expanding the current authorization. Before discussing our business outlook, I want to briefly review market conditions in our operational areas. When we last spoke in July, our core market of Central New Jersey and the New Jersey Shore was beginning to reopen, fostering a sense of optimism that continued into the fall, as many people chose to spend the summer away from urban centers. This trend has led to a mini-boom in residential real estate, with median single-family home prices rising over 10% compared to 2019. The growth in population and strong housing market helped many of our clients enjoy a successful summer season. Recent unemployment figures show New Jersey's rate has dropped to 6.7%, down from a high of 16.3% in April, which is notably lower than the rates seen in New York and Philadelphia. Although COVID-19 cases are rising nationally, they remain manageable in most of our markets, and there are no immediate signs of a widespread economic shutdown. While we recognize the uncertainty we face, and the potential for worsening conditions, the recovery remains uneven, and many continue to suffer economically. We believe additional targeted stimulus is necessary, yet our forecasts do not depend on it. Turning to the bank, our approach is straightforward and conservative. We followed our crisis management playbook: first, we secured liquidity by increasing deposits by $1.4 billion this year. Secondly, we enhanced capital through $181 million in subordinated debt and perpetual stock issuances. Our third step involved managing credit risk on our balance sheet by disposing of high-risk assets, and fourth, we aim to rebuild margins and improve profitability. The measures we took this quarter targeted downside risk and empowered us to focus on earnings and capital management. Although we regret announcing a GAAP loss, OceanFirst has a history of responding promptly to mitigate risk in challenging times. Our swift actions in earlier economic downturns positioned us well for recovery long before others. We hope the current situation won't escalate to the same level as the 2008 crisis, remembering that early interventions can lead to smaller losses. These actions free up resources to focus on growth. Our strategy to enhance margins and profitability includes shifting from cash to a combination of liquid securities and loans. During the third quarter, our average cash balances exceeded $800 million, with an additional $300 million in deposit growth, despite a reduction of $80 million in certificates. The strong deposit growth has lowered our loan-to-deposit ratio to under 90%, which will decrease further with additional cash proceeds from planned loan sales. Although this influx of deposits isn’t immediately profitable, it presents opportunities to cultivate new relationships, which we'll strategically deploy over time. Our organic growth will be our top focus as we head into the fourth quarter, though prudently utilizing the cash on hand will take time, and we anticipate traditional profitability metrics might remain under pressure until we complete the necessary adjustments. Addressing pandemic-related credit risks also paves the way for further capital management strategies, including share buybacks and acquisitions. While conditions this year have limited our ability to consider acquisitions, we anticipate that opportunities may arise as we approach 2021. Analyzing third quarter results, many banks appear to have moved past peak credit provisions, with net interest margin pressure now becoming a central concern that may persist in the coming quarters. Enhancing operating leverage and realizing expense reductions through increased scale will be key strategies moving forward. I will now hand the call over to Joe Lebel.

Thanks, Chris. I'll discuss deposit activity and loan originations and their impact on net interest income and margin before making some brief comments on expenses and our 2021 loan growth plans. We continue to see relationship deposits increase, with quarterly growth of $316 million and year-to-date growth of $1.4 billion, exceeding our expectations. Notably, this growth has included several significant relationship wins. Since most PPP loans have been utilized by borrowers, a considerable portion of the excess liquidity is now ready to be invested in higher-yielding options and loans. These new deposits stem from the growth in our corporate cash management business, which has risen by 33% year-over-year as we've doubled our staff to support this growth. Previously, we talked about maintaining a high loan-to-deposit ratio and strategies to increase deposits for loan growth. Currently, our loan-to-deposit ratio stands at 86% and is decreasing as we finalize earlier-mentioned loan sales. We believe we have established a strong competitive suite of treasury talent and products that will allow us to continue accelerating deposit growth in 2021 and beyond. Simultaneously, we've been adjusting existing deposit account rates, lowering our deposit costs from 57 basis points to 49 basis points quarter-over-quarter. Deposit costs are continuing to decrease, evident from the quarter-end weighted average deposit rate of 46 basis points. In the fourth quarter of 2020 and the first quarter of 2021, over $705 million of CDs with an average rate of 157 basis points will mature, presenting further opportunities to reduce deposit costs. Loan originations reached $418 million for the quarter, showing strong residential closings and solid commercial activity despite the economic climate. Excluding PPP originations, loan volume of $1.3 billion year-to-date is 30% ahead of 2019 figures. Loan growth is somewhat subdued as we exit weaker acquired loans in line with our ongoing strategy. We continue to sell most newly originated conforming residential loans, totaling $169 million through the first nine months of 2020. The commercial team's loan originations reached $188 million, and while our overall pipeline remains stable quarter-over-quarter, the pandemic has impacted what we initially expected to be a robust year in commercial lending, particularly in the Philadelphia and New York sectors after a promising start. The residential segment has recently helped drive activity, fueled by record low rates, a shift towards suburban living, and limited inventory, resulting in unprecedented activity in 2020 and a strong near-record pipeline. Given the current interest rates, we have opted to continue generating mortgage banking income while managing balance sheet risks. We anticipate modest or flat loan growth for the rest of the year as individual borrowers and businesses find their footing during the economic recovery from the pandemic. Following the election, we hope to gain more insights from our customers. The uncertainty surrounding future public policy and the need for additional data on public health trends continue to hinder commercial investment and lending opportunities. Regarding net interest margin, we experienced a reduction of 27 basis points, with core NIM down by 19 basis points due to several factors, mainly the excess liquidity on our balance sheet, which accounted for 13 basis points, and 6 basis points related to the lower interest rate environment. Additionally, purchase accounting contributed a decrease of 6 basis points to the overall NIM. New loans are being originated at reduced market rates, with average yields on interest-earning assets down 34 basis points quarter-over-quarter. The commercial segment includes swap loans with floating rate LIBOR spreads that affect margin while offering protection for our balance sheet. Regarding expenses, excluding merger-related and branch consolidation expenses, our operating expenses rose by $802,000 mainly due to COVID-related expenses totaling $1.7 million, which is an increase of $600,000 from the previous quarter. We have also seen an uptick in employee benefits costs and higher professional fees. No branches were consolidated in the quarter, but we anticipate some branch consolidations in 2021 and will provide more details next quarter. I will conclude with remarks about the markets we serve and our loan growth outlook. Despite COVID, we remain optimistic about loan and deposit prospects in 2021. Our newer market areas in the New York City and Philadelphia metros have outperformed expectations. While I foresee flat or modest growth for the remainder of the year, excluding sales of underperforming loans, we are investing in attracting commercial banking talent and will be ready for a rebound in loan growth in 2021. However, the pandemic may limit growth in the first and second quarters. The interest rate environment is challenging and will necessitate additional investment in commercial lenders and teams to enhance NIM and generate earnings progress in 2021 and beyond. We have a successful history of establishing commercial loan production offices in new markets and attracting elite talent, and we plan to accelerate similar investments in 2021. I expect several new loan production offices during the 21 fiscal year, along with a deeper focus on our current markets. Now, I'll hand the call over to Grace.

Thank you, Joe. As Chris mentioned, OceanFirst has a long history of proactive identification and recognition of risk. We believe this philosophy enables a more effective management of risk and leads to the best outcome concerning credit risk, which typically means the minimization of losses. It is simply good risk management and, I believe, is a key factor in our low loan loss history relative to our peers over a variety of economic cycles. This includes cumulative losses since 2007 that are 43% lower than our proxy peers and 70% lower than our UBPR peers. Specifically, we have been and remain, through the pandemic, quick to downgrade credit where appropriate and take active measures to work out problem loans. Chris mentioned our proactive approach to the developing recession in the first quarter of 2007. More recently, we actively derisked the Sun and Cape Bank portfolios shortly after acquisition, exiting several hundred million dollars of exposure that was inconsistent with our credit risk appetite and incurred zero loss through this process. We've maintained this philosophy of proactive risk identification during the pandemic. While the CARES Act provides exemption from nonaccrual and troubled debt restructuring status, it doesn't absolve banks from appropriately identifying the risk in their portfolios. We mentioned in the first and second quarter calls that we expected risk-weighted migration in the third quarter as forbearance periods began to end. Over the course of the third quarter, we continue to stay in close contact with our borrowers and monitor their financial condition and repayment capacity. This means we've talked with our borrowers, discussed their financial condition, verified their liquidity, and have a reasonable basis for assessing their ability to continue or resume payments. As a result, we've updated risk ratings for a significant portion of the commercial portfolio, including all of the commercial loans that received forbearance. During this process, we made no assumptions about additional stimulus funding, the timing of a potential vaccine, or any other factors that may impact economic recovery. Given our close contact with our borrowers and these proactive efforts to measure and monitor credit risk, we are optimistic that we've identified and quantified all current material credit risk in the portfolio. Through this process, we identified $81 million in higher-risk commercial forbearance exposure and chose to accelerate resolution of these credits through loan sales. This includes $30 million in New York exposure and $51 million in New Jersey and Pennsylvania at recovery rates of 85% and 82%, respectively. These sales include $15 million in hotel exposure, $12 million in restaurant and food-related exposure, and over $4 million in gym and fitness exposure. $18 million are substandard rate credits, and $32 million are special mention. Net of these loan sales but inclusive of all other risk rating migration this quarter, total classified balances, including residential and consumer loans, remain very manageable at just 2.2% of total held-for-investment loans. Both commercial- and residential-classified credits are well secured with low weighted average loan-to-value. Overall, the loan portfolio continues to perform well over 6 months after the pandemic-driven shutdown across our market areas. $4.1 billion or 77% of our $5.2 billion commercial loan portfolio never received forbearance. As of October 23, $1 billion or 91% of the $1.1 billion in commercial exposure that received forbearance has returned to payment. This leaves $88 million in commercial loans remaining on full forbearance as of October 23, all of which are expected to resume payments by December 31. In the residential portfolio, $207 million or 63% of the $329 million that received forbearance has returned to payment. This leaves $122 million in residential loans remaining on forbearance as of October 23. Inclusive of these forbearance loans that have returned to payment, total loan portfolio delinquencies are just 17 basis points, and nonperforming loans held for investment are 37 basis points as of September 30. Total TDRs should be low and essentially unchanged at $23 million. Net charge-offs, exclusive of the discount on loan sales, were just $800,000 in the third quarter, and OREO balances remain negligible at $106,000. Within the residential portfolio, we have just $9 million remaining in the first 90-day forbearance period and $113 million remaining in the second 90-day forbearance period exposure. The weighted average LTVs are just 61% and 68%, respectively, and weighted average FICO scores are 724 and 741, respectively. I'll point out that over 75% of our residential forbearance portfolio is located in Ocean, Cape May, Monmouth and Atlantic counties, where annual median home prices have increased substantially over the past year. It's quite reasonable to conclude that current loan-to-values, and thus, our risk of loss is even lower than these LTV figures indicate. The third quarter provision includes a qualitative credit reserve associated with residential forbearances. Depending on the final resolution of this portfolio, we may choose to sell a pool of residential loans in the fourth quarter. As with the commercial loan sale decision, residential collateral valuations remain strong, and it may be economical to accelerate the final disposition of any remaining loans that demonstrate high-risk characteristics. The existing reserve should support that approach if necessary. Inclusive of both commercial and residential loans and exclusive of loans held for sale, forbearance loans totaled just $210 million or 2.6% of total loans as of October 23. Our allowance for credit losses build of $20.7 million brings the funded loan loss reserve balance to $56.4 million or 70 basis points of total held-for-investment loans. This coverage increases to 1.10% with the addition of $31.6 million in unamortized credit marks. As Chris noted earlier, the allowance for credit loss increase was driven by commercial loan rating changes related to pandemic forbearance loans as well as qualitative factors related to generally weak economic conditions. The allowance for credit losses currently represents our best estimate of the credit risk related to the pandemic. We expected some third quarter risk rating migration as CARES Act forbearance periods ended and the impact of the economic shutdown and recession on individual borrowers became clear and the migration would drive an increase in quantitative reserves. Qualitative adjustments were made to account for the potential for further impact to our borrowers' repayment capacity, both within the commercial portfolio and as residential forbearance periods come to an end this quarter. To conclude, I'll reiterate that our credit risk position is modest and manageable. We're confident that we have a comprehensive understanding of our current credit risk profile given our thorough assessment of individual borrowers' capacity to repay, that we have identified the current risk of loss in our portfolio in light of today's economic conditions and that these losses are reflected in the ACL build and the loan sales. We've elected to settle a portion of higher-risk commercial credits to derisk the balance sheet and redirect our resources toward growth initiatives and reserve for risk associated with the end of residential forbearance periods during this fourth quarter. We're currently updating our stress test, which will include the Federal Reserve's latest adverse and severely adverse scenarios. Excess capital at the holding company further strengthens our position and provides ample growth capacity. I'll now turn it back to Chris for his concluding remarks.

Thank you, Grace. At this point, we will open the line up for questions.

The first question today comes from Erik Zwick of Boenning and Scattergood.

I have some questions regarding the loans you chose to liquidate. I'm looking at the amount of about $67.5 million and the related charges you recognized, which are $14.2 million. I want to know if these are the correct figures to compare. How did you estimate the losses? Have you received any bids on the loans? I'm trying to understand the loss ratios involved.

Sure. So those numbers are correct. And so the New York pool has already closed post quarter. So that has realized at the figures we expected. And we have what I would classify as firm bids from multiple bidders on the New Jersey and Pennsylvania pool. So we expect to close that in the next 2 weeks, but the marks that we took at the end of the quarter are reflective of those clearing prices. So we think we've got reasonable assurance. But New York is closed and Pennsylvania and New Jersey are pending closure.

And with respect to the bids, are these coming from other banks or nonbanks? Just curious what the buyer pool looks like at this point.

That's really interesting because the markets are quite different. In the New York metropolitan area, there's a longstanding tradition of real estate investors engaging in note purchases for various reasons, one of which is that default rates tend to be more favorably upheld by the courts in New York compared to other places. For the New York credits, it was mainly about aligning specific credits and asset classes with buyers who focus on those types of assets. Over the years, we've done business with those buyers and occasionally sold loans. Prices are somewhat weaker than what you'd typically anticipate in New York; you would generally expect higher prices, but I believe that's due to the pandemic discount. Buyers in New Jersey and Pennsylvania are a different story. They are largely institutional credit fund buyers who seek distressed loan notes and price them accordingly. As a result, New York's prices have come in a bit lower than the historical average, while New Jersey's prices are actually coming in a bit better than the historical average. However, neither is very far off from what we would consider good recovery rates.

Okay. Of the loans you decided to sell, can you provide a breakdown between those acquired through your recent acquisitions and those that originated from OceanFirst?

Sure. There wasn't a significant pattern indicating that the loans came from a specific acquisition. There was no concentration of issues related to credit underwriting criteria. Some were long-term OceanFirst customers, and there might have been one or two credits from nearly every acquisition. It was a mix, which provided us with reassurance that there wasn't a troubling pattern in the loan portfolio that could pose problems in the future.

And then previously, you'd spoken favorably of the experience using forbearance following the Hurricane Sandy kind of impact. Just curious, what are you seeing this time that's different that leads you to believe that working with some of these borrowers longer would not lead to a more favorable outcome versus selling them today?

So that's a good question. So one of the things we look at is the chances that if we had held these loans, would we have recovered more than we recover today, and the answer is almost certainly yes. So if we had decided to hold on to these loans, many were paying. In fact, a good section of these were past credits. However, what we had to weigh against that was ultimate recovery, which may take us several years and the ability to kind of put these behind us and focus on other things. So we certainly took a little bit of an extra liquidity discount. I guess that's probably a few million dollars. But we bought ourselves the time and attention by accelerating those. So I think that there was a cost to accelerate this. We don't think it was a giant cost. The other thing is that there's a finality that comes with the final disposition, and we were very conscious that had we merely kept these on the books, established a risk pool, and taken, let's say, a reserve for the $14 million, that may have proven to earn us more money in the long run. But it may also have led to several quarters of discussions about valuations with a lot of stakeholders, with our regulators, with our investors, where now you'd be in a position of having to explain why you thought a fitness center or a hotel property was actually valued where you think it is. So this way, we get the final disposition. We know exactly what the answer is. We can be certain that we took those risks off the balance sheet.

Regarding the third quarter net interest margin, did it include any interest reversal due to the downgrades or the transfers to held for sale?

It did not. So there were no unusual entries in the net interest margin for the quarter.

The next question today comes from Russell Gunther of D.A. Davidson.

Just a follow-up on some of Erik's questions on the credits that you moved this quarter. Are you able to share how the loss rates translated from an asset class perspective, so discount on hotel, restaurant, and gym and fitness?

It was somewhat disorganized, and in any particular category, we had only a few loans. Grace, if you have any additional data to share on that, or Joe, if you have those figures available, please let us know.

Yes, Chris, I can provide some information. In hospitality, we're seeing about a $0.75 recovery. It varied somewhat, but as an example, food and beverage is also around $0.75. Most were in that range. Overall, it was interesting to observe how the bids came in and how everything unfolded. I also want to mention that 66% of the sale was either criticized or classified. While some were paying, we had assessed them based on our expectations for long-term health.

Okay. Were any of the $12 million in restaurant loans related to the New York City pub portfolio?

Interestingly, that portfolio seems to be performing quite well. The owner-operators have a significant amount of liquidity, including bank deposits that we can monitor. For many of these families, this portfolio is often their primary and only asset. They have shown more liquidity than typical real estate investors and are also much more protective of their collateral. During our discussions with them, we expressed our willingness to support them, but we required them to demonstrate their liquidity, which in some cases involved posting payments in advance. Overall, it was a particularly strong portfolio.

Got it. And then lastly, you mentioned that 66% of this was from the criticized and classified assets, which I believe is now at 2.2% of held for investment. I understand that these were particularly troubled assets impacted hard by the pandemic, and the classified portfolio is not exclusively made up of these types. However, can we derive any insights from the clearing rate of the criticized classified assets regarding what remains classified today?

I want to make a few comments, and I believe Grace and Joe will add their insights as well. As an active commercial bank, our perspective differs somewhat from that of a primary real estate lender. We are accustomed to managing relationships and credit risks. We have various tools at our disposal, including covenants and guarantors, which provide us with significant liquidity. Therefore, when we categorize a loan as special mention or substandard, it doesn't necessarily indicate that we are overly concerned about a loss. It simply signifies that the risk has escalated and requires our attention and management. We have dealt with similar situations in the past, particularly when we acquired banks like Cape and Sun, where we categorized several hundred million dollars in loans as special mention or substandard. In subsequent quarters, we successfully navigated those loans, often through paydowns, restructures, additional collateral, asset sales, or refinancing. I wouldn't interpret our categorization as excessive concern; rather, we are proactive in these classifications because they help us maintain transparency regarding credit risk. Joe and Grace, since you are closely involved in this process, feel free to add your thoughts.

Before I turn it to Grace, I want to add to Chris' comments. Erik mentioned earlier about Sandy, and a good example in that context is we had borrowers who were downgraded to criticized or classified but then stayed in that status for a while before returning to pass-rated credits. I believe we will see a lot of that happening again. The credits we sold were ones we felt, in the long term, would not have the ability to return to being the kind of performing assets we required.

Absolutely. I would like to add to what Chris mentioned. I hope the audio quality is better now than it was earlier. Although we have a significant amount of real estate collateral, we view ourselves as commercial lenders, so we take a more proactive approach to risk assessment and customer interactions. Rather than waiting for signs of delinquency to inform our risk ratings, we assess risk more actively. As both Joe and Chris pointed out, this doesn't necessarily indicate that these borrowers are currently facing payment issues. I can assure you that there isn't a significant concentration in the nature of the downgrades; they are quite diverse and not limited to one specific sector.

And then just switching gears, if I could, quickly on the expense side of things this quarter. You mentioned some of the moving pieces. One of the kind of COVID related expense, I think, was $1.7 million. So I'm just wondering, trying to think of what the run rate would be. Perhaps that $1.7 million moves lower over time. But could you quantify what expenses are kind of below normalized based on perhaps less travel and expense, for example? Do those 2 things kind of net each other out? Or how should we think about that?

Our current elevated expenses are largely attributed to COVID-19. This includes direct COVID-related costs and our significant investment in safeguarding our employees, clients, and community. We are incurring substantial expenses for healthcare professionals, conducting active testing for our employees, and outsourcing health management, with professionals involved in decisions about work status and return. While these expenses are considerable now, we anticipate they will decline as we progress into 2021. It's important to note that we are self-insured when it comes to healthcare, which means we share some of the risk. In the second quarter, healthcare systems were largely unavailable, hampering our employees' access to necessary procedures, which means many of those procedures were deferred to the third quarter. As we look ahead, we expect two trends: the decrease of pandemic-related expenses and potential branch consolidations next year, although these opportunities are limited compared to previous years. At the same time, we are continuing to hire commercial bankers, indicating a shift in our spending priorities. Overall, I don't expect to see significant increases or decreases in expenses; they will likely fluctuate around current levels.

Okay. I guess you got to my follow-up question already. So the last piece of it would be, given that expense outlook, some of the other moving pieces on the top line you had discussed, do you think you're going to be able to generate positive operating leverage in 2021?

We do. So the positive operating leverage really needs to come from a fair amount of organic growth. And let me be clear about organic growth. We have about just under $1 billion to deploy before the balance sheet moves by $0.05. So we have a ton of cash. We average cash balances in the third quarter of over $800 million. So the first order of business is that our balance sheet says we're an $11.6 billion bank. We're really like a $10.5 billion bank. And that's why some of those margin numbers and return on asset numbers may be difficult to compare going forward. We have to grow into the cash we have. So when I say organic growth, I mean organic growth in the loan book. So that will occur over the next several quarters. As we do that, that will produce operating leverage because you'll see NIM stabilize and then start to increase. And then we will be working at operating leverage more on the revenue side than on the expense side.

Next question comes from Zack Westerlind of Stephens.

It's Zack Westerlind filling in for Matt Breese. Regarding the deferral situation, you mentioned in the presentation that the remaining $200 million should be resolved by year-end. I'm interested in knowing what factors give you confidence that these deferrals will be cleared from the balance sheet by the end of the year.

We have conducted a comprehensive review of all borrowers in forbearance, along with a substantial portion of our commercial portfolio that is not currently in forbearance. This was more than just a quick check-in; we engaged in detailed discussions about their liquidity situations. In some instances, we required that liquidity be provided to the bank and secured before payments were made. We wanted to ensure we understood the true capacity of these borrowers—not just those who said they would resume payments. Our concern was that some borrowers, after not making payments for six months and having some cash set aside, might only cover a couple of payments and then face issues in the following months. Thus, we took a proactive approach to identify borrowers who genuinely had the ability to continue making payments and were not dependent on external factors. The review was thorough to uncover any potential risks. Additionally, the loans we sold were those for which we could not find a viable way forward; there was good collateral and responsible borrowers, but the combination of liquidity challenges and operational difficulties made it clear that their situations were unlikely to improve. Even if the effects of COVID-19 dissipate sooner than expected, we do not anticipate a significant turnaround for these borrowers.

Understood. And then just on the provisioning expense, there was a little bit of reserve build this quarter higher than the past couple of quarters. Are you comfortable with the level of reserves you have now? Or should we expect continued build going forward?

So I think we've had a lot of conversations over the last several quarters about the aggregate coverage of the loan portfolio. And if you think we've got this anomaly in unamortized credit mark, which kind of has a portion of the reserve that's not quite as apparent, if you add those together, we wind up now, as Grace said, at about 110 basis points, 111 basis points. For the credit risk profile of our institution, we think that's a pretty adequate reserve. As Grace noted, even with these charge-offs that we took this quarter, our long-term credit performance is quite favorable to our proxy peers as well as the UBPR peers. So our reserve should be a little bit lower than average. So we think we're in the ballpark of where we should be. In quarters 1 and 2, we were taking provisions not knowing exactly how the forbearances were going to fall out. We've gotten through that process now. The main concern would be what we think is a very small chance but a chance that economic conditions will deteriorate considerably from where they are today. So that would come in the form of maybe a regional very significant kind of stay-at-home order or those kinds of things. So hopefully, we avoid that. We don't see any signs of that today, but that would be something that we've not taken into account in our reserve.

Got you. That's helpful. And then just last question, moving over to the margin. We saw 27 basis points of compression this quarter. Moving into 2021, do you see that as a bottom? Or do you think that there's room to run lower there?

We're close to a bottom. I don't know. I'd be very careful about declaring things like an absolute bottom to things. But I think we're close. And what we have going on now is we'll have 2 factors in the fourth quarter, and then I'm comfortable we'll be through the bottom. The first is that, look, we're liquidating $388 million worth of loans. Now most of those were PPP loans, but they were still paying us interest last quarter. So we're not going to get that interest in. On the flip side, the $800 million we keep referring to, that was earning us 10 basis points. So even moving into mortgage-backed securities, you get a pickup. So we have some portion of the balance sheet that's at a negative carry. And Mike, maybe talk a little bit about just what that negative carry means in terms of margin to give you a sense as to what our stabilized margins will look like.

When we analyze the margin, we see that short-term cash was $805 million in Q3, compared to $40 million a year ago. This results in approximately $750 million of excess cash earning 10 basis points. If we reduce the average earning assets by this amount, it increases the margin by 24 basis points, bringing it from 2.97% to 3.21%. Additionally, if we offset the 10 basis points earned at the Fed with a 10 basis point reduction in deposit costs, we effectively manage an $11.6 billion balance sheet, which functions as a $10.5 billion balance sheet in reality. We also noted broker deposits of $250 million back in April due to liquidity concerns, which have a negative carry of 1%, impacting the margin by another 3 basis points. These broker deposits will start rolling off from October, continuing through January to April, which results in a margin reduction back to 3.24%. Therefore, the issue isn't with the margin; rather, we have excess liquidity that we must invest prudently.

Got you. That's very helpful. And then one quick last follow-up for me. The $350 million in securities that you mentioned in the deck that's coming on in Q4, could you give us a sense for what those securities are yielding?

There's a mix of securities involved, so we need to be cautious not to concentrate everything in one asset class. This will include typical mortgage-backed securities, which are not expected to yield much—perhaps around 90 basis points or a bit more. While not particularly exciting, it's certainly better than 10 basis points. We'll also engage in other investments, including subordinated debt and dividend-paying equities that we believe in, along with a few other options. Municipal bonds will represent another part of our strategy, as we have the chance to grow our municipal bond portfolio. However, we must approach this carefully, as the credit risk landscape for municipal bonds is changing, and we want to avoid entities with potentially high credit risks. Additionally, we have discussed asset quality in our loan portfolio, and we also reviewed our fixed income portfolio, which resulted in the sale of approximately $17 million in securities from CMBS pools that we consider to be at significant risk. We accomplished this in the fourth quarter with minimal gain, essentially a rounding error. Our review encompassed not just our loan portfolio but every aspect of our balance sheet. These CMBS portfolios were linked to the hotel sector, which suffers from high vacancy rates and elevated nonpayment ratios, and we managed to divest from them effectively, likely due to our timely decision.

The next question comes from Frank Schiraldi of Piper Sandler.

Just wanted to ask, Chris, about as you've gone out and marketed these loans. From a timing standpoint, I assume you had to go through the loan-by-loan review, so maybe you guys just weren't ready earlier to get something done. But was there any market earlier anyway? I'm just trying to get a sense, as you've marketed these things, if you've seen a significant pickup in interested parties and what seems like pretty palatable pricing.

No, it was very interesting timing, Frank, because we aimed to be early but not the very first. We observed a few other banks that were liquidating their portfolios. In some cases, our execution was slightly better. We wanted to see a few transactions to understand the value we were discussing. However, we didn’t want to wait until there was a rush because this is about supply and demand. We recognized there was a strong buying interest, and all the buyers were rational, so they wouldn’t act impulsively. We wanted to ensure our sales took place earlier in the fourth quarter to mitigate any rush to liquidate assets, especially after the election. Therefore, we aimed to eliminate as much election risk as possible.

That makes sense. You mentioned the completion of the loan-by-loan review. Is that across all the higher-risk categories? Does that mean that the sales that have occurred or that are in loans held for sale now represent the majority of what you're planning to move off the balance sheet?

The sales that we're talking about now are the bulk of what we expect, and we have been through both the forbearance pools in totality and a significant amount of the nonforbearance portfolio, and we've obviously focused on the higher-risk industries and geographies. I have to make a point here: the geography can be as important as the industry. So for example, we have cases where restaurants that were in resort locations near the Jersey Shore did pretty well. And they're in good shape going into next year. They're used to having kind of a tight winter season because they don't really have one. So the geography makes a big difference.

I want to clarify your comments about moving out of forbearance by the end of the year. Specifically, when you mention the $88 million in full forbearance that isn’t currently making payments, are you confident that this group will transition back to regular payments? Or might there be some that require further assistance, possibly through TDR or other means?

There will be a small number of loans that will transition to interest only, and we are confident that we have the liquidity necessary to make those payments. In many instances, we have requested that this liquidity be shifted to the bank. Most of these loans will either be repaid in full or convert to interest only. As for forbearances, we believe that by this quarter, we will have concluded activities related to pandemic forbearance, unless there is a significant resurgence of issues related to the pandemic. Our main focus now will be on returning to standard credit metrics. As we conclude this year and move into the next, we will categorize loans as performing or nonperforming, track delinquencies and troubled debt restructurings as we normally would, and present clear information about the balance sheet. We do not anticipate having a forbearance portfolio in the upcoming year, and will not report it as such. We will provide updates on delinquencies, troubled debt restructurings, and nonaccruals, ensuring full transparency regarding the loan portfolio.

The next question comes from Christopher Marinac of Janney Montgomery Scott.

Chris, you might have mentioned this earlier in the call, but the criticized loans and assets that we will report in the 10-Q can include the held-for-sale loans. However, there is a portion of those loans that are already being sold this quarter. Therefore, we need to consider that the criticized number is likely to be lower than what we will report in the upcoming quarter. Am I understanding that correctly?

Absolutely. So we have 2 events. First, the New York sale has closed, so that is done. I know it's not a criticized asset, but the PPP loan sales is also closed. And the remaining New Jersey and Pennsylvania sales will close. It's going to be tight probably around the Q. But if they close after the Q, I would imagine we will provide an 8-K just assuring people that those sales have been conducted and what the final metrics are.

Okay. The levels and ratios will clearly decrease from this point. My other question is whether you are confident that the migration of other elements beyond this quarter should be limited based on your current observations.

There are two points to address. First, we have conducted a thorough review of our loans. We have identified and addressed any issues we found. Although there is always a possibility that something may emerge in the loan portfolio, we have taken substantial qualitative adjustments into our reserves to account for potential credit issues. Secondly, we feel confident about our situation because our largest loan customers are performing well. All of our top 20 customers are making payments, with only a few cases of interest-only loans. Additionally, we have a very detailed loan portfolio relative to our size, so even if there is an issue with a specific credit or relationship, it is unlikely to have a significant impact. Beyond our top 20 clients, the relationship exposure generally falls below $25 million.

Okay, that's helpful. I have one last question that might be for Grace regarding the reserve calculation within the economic forecast. How does it compare today to March and April, and do you anticipate any significant changes in the upcoming quarter or two?

So Chris, the situation is not as severe as it was in March and April. I estimate an average unemployment rate of about 8% over the next year, which is higher now and expected to decline over time. I believe GDP will stabilize between 1% and 2% through the end of the two-year reasonable and supportable forecast. It's not great, but it's quite similar to last quarter, just slightly better.

The next question comes from William Wallace of Raymond James.

I apologize if I missed this, Chris, but I'm trying to reconcile the difference between the $51 million in New Jersey and Pennsylvania and the $30 million in loans in New York being sold with the release that states $45.5 million of loans moved to held for sale, which I assume is net of the $14.2 million in charge-offs. I'm just trying to understand why those numbers don't add up or match.

Okay. We'll let Mike explain that. You're correct that we're displaying the net amount in the earnings release. In the supplemental presentation, we are showing the principal balance.

Yes. And the $45 million was forbearance loans that were transferred into held for sale. So they were loans that were...

Okay. Please proceed.

The $45 million was forbearance loans that were transferred into held for sale. So they were loans that were...

So the difference was performing loans that were okay.

Yes. And the $45 million was forbearance loans that were transferred into held for sale.

So the difference were performing loans that were okay.

There was nothing unusual about those LTVs. They were not like an 80% LTV pool, and that was not the primary factor we considered for liquidation. The main determinant was our visibility into the liquidity and cash flow to continue servicing these loans.

Yes. No, I'm actually just kind of to your point about the first loss maybe usually being the best. I'm just kind of trying to gauge where the market might be on original value if we have banks continuing to need to sell assets.

I want to highlight that with a small increase in vacancy, such as in a multifamily building in Manhattan where vacancy has risen from historically around 2% to just under 6%, the latest data indicates an 11% decrease in rent. I calculated that if vacancy increases from 2% to 4%, rents would likely decrease by about 10%, and the cap rate would rise by 1.5%. Consequently, in an average building, this could lead to a 30% to 40% reduction in appraised value due to a decline in net operating income. As net operating income falls and vacancy rates increase, it is expected that cap rates will also rise, particularly for assets perceived as slightly riskier.

Right. Yes. And then on the PPP loans, you may have given this, but do you have the premium that you'll make on that sale?

So the net would be $5.3 million.

And does that include the fees that would need to be accelerated?

Correct. Yes. So that's the net. We actually sell them at a little discount. Then we hold on to them and accelerate the fees related to those loans. That was only about half of the portfolio. We kept the other half. The customers and loans we retained were more strategic for the bank. They also promptly provided us with the information we needed to file for forgiveness. If they were helping us, it was easy to move them through. If we thought those were going to be long-term difficult loans to get through forgiveness, we decided to part ways.

Okay. And none of that was booked in the second quarter, correct?

That's correct. That will be booked in this fourth quarter.

So what was the net interest income contribution from the PPP loans in the second quarter?

I'd say they were earning at 2.25% in the third quarter.

The next question comes from Collyn Gilbert of KBW.

This is great information and insight that you've provided. I have a couple of questions. First, regarding the PPP aspect. Can you confirm whether that gain will be recognized through net interest income or as fees from the sale?

I actually haven't thought about that yet. Mike, do you have the answer for that?

Yes, it's not fees. It's gain on sale of loan. It's not NII.

Okay. Okay. Got it. And then I know, Chris, you had indicated who the buyers were of the nonperforming loans that you're moving. But what about the buyer for the PPP slug? Who's the...

Yes, we found a robust market for that. There is a small industry emerging where people are purchasing PPP loans. I believe part of their strategy is to hope that Congress will implement a mass forgiveness, allowing them to receive the forgiveness without doing any work, which could potentially occur. If that happens, we would have gained more had we retained those loans. The company we sold to had acquired from approximately six to ten banks before transacting with us, and there were several bidders. Hence, a few entities are aggregating these pools of PPP loans.

Okay. That's helpful. And then just on the comment that you guys made in the slide deck that you were assuming that a lot of the consumer deferrals are going to drop to nearly 0 by the end of the year. Just curious, what gives you that sense of comfort? I mean I get it on the commercial side. As you've said, you're in touch with the borrowers, you're having discussions, you know the businesses. But what gives you confidence and insight into these consumer forbearance loans that they'll become current?

You're right. It's somewhat challenging to evaluate the consumer side. We consider several factors here. The most crucial aspect is that we maintain conversations with them, which provides us with some insights from our interactions. In our slides, we noted that $13.4 million of the customers who have updated their status have asked for additional accommodations. This does not necessarily mean we will grant them; we are reviewing those requests individually. We have required them to submit an application containing more recent information regarding their liquidity and related matters. We received requests totaling $13 million, and while this may slightly increase, we believe it will remain manageable. Additionally, in line with Grace's comments, we expect some of these requests to appear in the fourth quarter. Therefore, in our reserve calculations for the third quarter, we anticipated this, and the provision will help address it. For the fourth quarter, our current estimate suggests there could be $10 million to $20 million in higher-risk consumer loans. We have sufficient reserves to handle those as well, having accounted for this risk through the provision in the third quarter. It's important to note that the primary characteristic associated with default on a residential loan is not income or FICO scores, but rather the loan-to-value ratio (LTV). Our LTVs are acceptable. Looking at our lending area, which is why we included slides on median home price values, most of our loans are concentrated in coastal communities experiencing significant price increases, which seem to be continuing. Earlier in the summer, we observed some unusual trends, particularly in Cape May County, where the median home price rose 37% from June 2019 to June 2020. While that's impressive, it raises questions about sustainability. We monitored the situation through July, August, and September, and the four counties that represent the majority of our loans and forbearances all reported double-digit median home price increases over the last year. This doesn't appear to be a temporary spike from a few anxious buyers in April; it seems to indicate a lasting change. Ultimately, if people can profit from selling their homes, they are less likely to allow their properties to go into foreclosure. We are considering this as well.

Okay. That's great. Just to clarify, regarding Grace's comments about potentially selling some residential mortgage or higher-risk consumer loans in the fourth quarter, when you mentioned the $10 million to $20 million, is that the total amount you expect to do?

Correct.

Okay. And you think at this point, those credits are sufficiently reserved, so no additional provisioning would be needed.

That's correct.

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

Right. Well, I thank everybody for taking the time to join us today. Enjoy the holidays. I hope everyone will stay safe, and we look forward to talking to you with our results in January. Take care.

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