Earnings Call Transcript - OCFC Q1 2020

Operator, Operator

Good morning and welcome to the OceanFirst Financial Corp. Earnings Conference Call. All participants will be in listen-only mode. Operator instructions: After today’s presentation, there will be an opportunity to ask questions. Operator instructions: 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.

Jill Hewitt, Senior Vice President and Investor Relations Officer

Good morning and thank you all for joining us this morning. I'm Jill Hewitt, Senior Vice President and Investor Relations Officer at OceanFirst Financial Corp. We will begin today’s call with our forward-looking statements disclosure. Please remember that many of our remarks today contain forward-looking statements based on current expectations. Please refer to our press release and supplemental presentation for our forward-looking statement disclaimer. Our investor presentation and other filings with the Securities and Exchange Commission contain risk 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 today, Chairman and Chief Executive Officer, Christopher Maher.

Christopher Maher, Chairman and Chief Executive Officer

Thank you, Jill, and good morning to all who have been able to join our first 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 have a number of topics to cover that relate to the quarter, our recent acquisitions, and of course updates regarding the impact of the pandemic on our business. After that, we look forward to taking your questions. In terms of financial results for the first quarter, GAAP diluted earnings per share were $0.27. Quarterly reported earnings were impacted by a number of unusual items that total $10.4 million net of income tax. These items related primarily to the adoption of the CECL loan loss standard and the dual acquisitions completed on January 1. As a result, we pegged core earnings at $0.45 a share. Looking past some of the unusual items for the quarter, underlying financial performance was strong as demonstrated by expanding margins, an increase in non-interest income, and well-controlled operating expenses. The earnings strength of the franchise is critically important as we move into an environment of substantial economic uncertainty. Regarding capital management for the quarter, the board declared a quarterly cash dividend of $0.17, the company’s 93rd consecutive quarterly cash dividend. The $0.17 dividend represents a conservative 38% payout of core earnings. As you will recall, we maintained a relatively low payout ratio over the past few years to prepare our balance sheet for a shift in the credit cycle. This allows us to maintain the common dividend while continuing to provide a degree of capital flexibility. There are no plans to reduce or eliminate our common dividend at the present time. Capital levels remain strong with tangible common equity to total assets of 8.9%. At the current earnings rate, we expect to build capital levels for the duration of 2020. Early in the year, the company was able to repurchase 648,851 shares of common stock, but suspended repurchases on February 28 as the global impact of the pandemic became apparent. 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. Just a quick note regarding tangible book value per share, which now reflects the impact of the Two River and Country Bank acquisitions. Tangible book value per share decreased by about 3%, primarily driven by the consideration paid for the dual acquisitions completed in January. The book value dilution is slightly more favorable than the estimate provided when these transactions were announced in August of last year and should accelerate the tangible book value per share in the subsequent period. Turning to the income statement, the first quarter demonstrated strong performance in net interest income, healthy fee income driven by swaps, and well-managed expenses. Included in the core operating expense number is $1 million of expenses related to the pandemic. These pandemic-related expenses should moderate in future quarters. Even without fully realizing the efficiencies from the twin acquisition, the core efficiency ratio remained close to 55%. Joe will provide more detail regarding funding costs, but the stabilization of net interest margins also bodes well for future quarters. Later in the call, Grace will walk you through credit provisioning and the impact of CECL and the pandemic. Our decision to implement CECL requires some additional discussion. As you may recall, I’ve been vocal regarding the pitfalls related to CECL and strongly advocated that the new standard be set aside given the unprecedented economic shock the world is facing. Unfortunately, the policy action taken regarding CECL has made things even worse. By offering an optional deferment, we have created a few new issues. First, banks deferring CECL may be considered to have more precarious balance sheets. Second, securities guidelines require the disclosure of impacts related to upcoming accounting changes. The banks electing to defer CECL have some responsibility to share the CECL estimates anyway. And finally, the idea that the deferral would require a future restatement of prior period financials is the icing on the CECL cake. We have a high quality loan portfolio and a strong capital position and determined that it would be best to just move forward as planned. I guess every crisis experiences an accounting issue and 2008 was the application of mark-to-market and for the pandemic it will be CECL. Asset quality is especially important as we move into unfamiliar economic environments. As discussed on previous calls, we've been pruning the balance sheet of higher risk loans for quite some time and we continue to sell higher risk loans in the first quarter. First quarter loan sales were responsible for 82% of our net charge-offs for the quarter, helping drive down the level of non-performing assets to just $16.6 million or a mere 16 basis points of non-performing assets to total assets. In fact, other real estate owned amounted to less than $500,000 at quarter-end. Given economic conditions, we expect these figures to grow in the upcoming quarters, but our balance sheet provides the critical room to work with our clients during this challenging time. Regarding the pandemic, we’ve provided several supplemental slides to our quarterly earnings release. These slides include important details regarding forbearance programs and our efforts to serve as a conduit for the SBA’s PPP program. I won’t repeat the discussion from our March 24 pandemic investor call. However, I will assure you that the bank was early to respond to the pandemic. We continue to address operating conditions in a wide variety of ways. We remained open for business, are assisting customers, and are prepared to operate in a socially distanced world for an extended period of time. Our operating discipline and strong digital solutions allowed OceanFirst to address forbearance and crisis response quickly and effectively. By applying our forbearance experience in Hurricane Sandy, we've been working with clients to address forbearance requests since March 16. Over the past several weeks, we have had thousands of conversations with businesses and consumers that have resulted in requests to defer payments on $1.1 billion worth of loans. Our deferral experience indicates that forbearance loans perform quite well when their pre-crisis credit risk attributes are conservative. Grace will talk you through our supplemental slides, which demonstrate the quality of the loans requesting temporary forbearance. Joe will discuss lending activities, including our participation in the SBA PPP program. However, I want to quickly highlight the importance of having dedicated substantial resources over the past several years to build out our digital banking platform. To put our efforts in perspective, OceanFirst was not an active SBA lender when the CARES Act was signed on March 27, less than one month ago. I’ll say that again: OceanFirst did not have an SBA department nor had we originated an SBA loan. Our SBA portfolio related exclusively to loans acquired for the purchase of other banks. In recognizing the critical importance of this program for our clients, we responded quickly by simultaneously building a digital application interface and working with the SBA to activate the SBA license we acquired on January 1 as a result of the Two River acquisition. By April 3, we were channeling hundreds of digital PPP applications from our clients into our nCino commercial loan system for processing. Our first successful submission to the SBA generated SBA approvals on Sunday, April 5. The week of April 6 was dedicated to developing a custom-built electronic closing package that would comply with somewhat fluid SBA guidance. On April 14, we began closing these loans electronically, becoming among the first banks in our market to disperse funds. Through today, we have secured SBA approval for 1,568 loans totaling $350 million, which will fund over 36,000 jobs in our communities. Delivering for our clients was possible because of our extraordinary commercial lending team. Of course, they were supported by amazing information technology professionals with the tools, skills, and experience to respond promptly. Before I turn the call over to Joe and Grace, I want to acknowledge the recent decrease in our share price. We know the entire banking industry has been impacted, but every OceanFirst employee is also a shareholder. We share a common goal to create shareholder value and know that the decisions we make in times of crisis are especially important. Our efforts in the upcoming quarters will focus on helping our customers through an incredibly challenging time. Assisting our customers in their recovery will protect and preserve the assets of the bank and build the bank’s reputation in our communities. The combination of the strong balance sheet and stellar community reputation represent the path to building shareholder value over time. At this point, I’ll turn the discussion over to Joe to provide more details regarding operating conditions and some additional color regarding many of the initiatives I’ve outlined.

Joe Lebel, Chief Operating Officer

Thanks, Chris. Loan originations of $426 million drove loan growth of $158 million for the quarter. Year-over-year originations were up 63%. Commercial lending closings were strong at $267 million with quarterly commercial growth of $165 million. New York and Philadelphia continued to perform as they closed $170 million in the quarter. I’ll note that the quarter had very little loan originations from Country and Two River as expected after an acquisition. The closings have occurred in April and their pipelines are building. Our swap fee income had a strong quarter with over $4 million in revenue and while we expect revenue to be bumpy due to volume and economic conditions, we anticipate a solid year in swaps to offset reductions in other fee business. Our residential real estate continued its solid performance with $149 million in closings. The total pipeline at $525 million at quarter-end was at an all-time high with record commercial and residential activity. We anticipate a solid second quarter in loan activity and while there could be some fallout due to the uncertain economic environment, we remain confident in our underwriting risk appetite. While Grace will provide much more detail on credit metrics in her comments to follow, I’ll note that we are re-underwriting every commercial pipeline transaction as we approach closing to be sure the underlying business is healthy and cash flows are intact. In the residential business, we have also gone back a second time and re-verified income and job status prior to closing. We’ve also increased minimum down payments for purchases and eliminated cash-out refinances for vacation homes and investment properties, also reducing loan-to-value limits on equity lines and loans. Moving to the net interest margin, we saw our core net interest margin improvement of 1 basis point and a reported net interest margin expansion of 4 basis points. The reported figure includes purchase accounting accretion and modest pre-payment fees. The additions of Country Bank and Two River Community Bank loan portfolios help to keep margins stable despite the effect of prior rate cuts and lower weighted average originations. Our cost of deposits increased 6 basis points to 70 basis points due to deposit cost from the acquired Country Bank and Two River Community Bank. OceanFirst legacy saw a reduced weighted average cost of deposits of 2 basis points in the quarter to 60 basis points, while the weighted average cost of deposits at Two River was 87 basis points and the Country Bank deposits 146 basis points. We expect the cost of deposits in all portfolios to decrease in the second quarter due to continued re-pricing. Expenses were well managed and as Chris noted, included approximately $1 million in COVID-19 related expenditures, most of which represents pandemic bonuses paid to branch staff and back office personnel. We remain confident in our quarterly expense run rate, but cautious given the economic outlook. We expect to spend as necessary in digital acquisition, cyber security, and other important initiatives, including in the safety and protection of employees, customers, and visitors to our facilities. While we will be vigilant with our management of expenses, now is not the time to save a few dollars at the expense of the health and safety of our staff, our customers, and our community. Merger integration for two of our community banks remains on track with a mid-May systems conversion and branch consolidation as scheduled. As previously noted, we will be closing five legacy OceanFirst branches the same weekend. I will note that the majority of the closure expenses related to the branch consolidation are in the first quarter expense number. Closings will occur in Q2 and we will see the financial efficiencies beginning in Q4. In regard to Country Bank, we’ve elected to delay their systems integration date and will not make a decision on our revised date until mid-year. Since there are no branch consolidations involved in Country Bank, the run rate and upcoming cost savings are not as significant. In regard to daily branch operations, you may recall we were one of the first banks to close branches and limit activity to drive-through teller transactions only. As we now begin to focus on the return to work in a new normal environment, we expect to begin by focusing on the return of full-service banking utilizing a hub-and-spoke methodology. Full service would be available at certain geographically specific hub-branches, which surround the export branches limited in hours or closed inside traffic while remaining open at the drive-throughs. We are exploring abbreviated schedules as well using both customers and employees back into a safe environment over time. We will employ safety protocols, which will include the use of personal protective equipment. Chris provided some overview comments on the paycheck protection program, commonly referred to as PPP. Let me provide you a few more details to date. We’ve electronically distributed over 3,000 applications for assistance, receiving back more than 2,500, and were able to secure SBA approval for almost 1,600 prior to the first round of funding being exhausted. These approved loans represent $349 million in loans to businesses employing over 36,000 workers. We remain driven to approve the remaining requests in our queue when the SBA program is reloaded with the goal of supporting loans approaching $500 million and over 53,000 jobs between the loans we’ve done so far and the requests we have announced. And just to note on funding of the short-term loans, if needed, we will utilize borrowings from the Federal Reserve allocated to PPP pledged loans at a cost of 35 basis points, which will help to offset any funding cost of liquidity needs and has the added benefit of capital protection. With that, I’ll turn the call over to Grace.

Grace Vallacchi, Chief Risk Officer

Thank you, Joe. As Chris mentioned, I’ll discuss CECL adoption and the components of the increase in our allowance for credit losses, as well as provide an update on our customers seeking debt relief. I would like to preface these remarks however with some contextual comments regarding our preparedness for the current environment. OceanFirst has long had a conservative credit culture and strong earnings stream. This is borne out by the stress test results we shared during our investor call last month. You may recall that this stress test included a severely adverse scenario that approximated the severely adverse case in the most recent CCAR guidelines. Our model indicates an ability to absorb over $300 million of credit costs over a nine-quarter period while maintaining our profitability, our ability to pay dividends and our capital ratios well above both bank policy and regulatory minimums. We certainly hope that the level of fiscal intervention will result in a far less severe environment, but we believe the balance sheet is prepared for a shock. These results are not an accident. Over the past several years management has focused on building a fortress balance sheet in anticipation of the next credit cycle. These actions included maintaining our credit underwriting discipline, despite increasingly liberal market terms, and a focus on credit risk management practices that ensured safe and sound growth. Evidence of our efforts is the widely diversified credit portfolio, as well as our risk selection. We have not participated in the leveraged loan market, energy sector credits, credit card finance, automobile loans, or equipment finance. Even land loans are not large, totaling just $19 million or just one-quarter of 1% of total loans. While we could not predict what would trigger the next credit stress events, this management team has been through several credit cycles over the course of our careers and these experiences have taught us that preparation is the best defense for times like this. With that context, I’ll turn to the primary components of the increase in our allowance for credit losses. The components I'll discuss are outlined in more detail on the slides that accompanied last night's earnings release. In summary, our transition from the incurred loss methodology to CECL resulted in an aggregate $15.6 million or 92% increase to loan reserves between December 31 and March 31. Now, to break this change into components, our December 31, 2019 ending allowance balance was $16.9 million. We added a day one CECL mark of $4.2 million, Two River and Country acquisition CECL marks of $5.4 million, funded net charge-offs of $1.1 million, and then added to the CECL reserve to address the expected economic deterioration related to COVID-19. The COVID addition was driven by $7.2 million of qualitative factor adjustments. During the first quarter, our loan growth was centered in portfolios with historically very low loss rates. This combined with further declines in loss rates in almost all of our loan portfolios would have resulted in a net contraction of $1.2 million in Legacy OceanFirst reserve requirements despite net loan growth. These figures reflect the current risk rating distribution of our portfolio. CECL models are quantitatively driven and historical loss rates and portfolio composition are key drivers of the allowance balance. We have focused our lending activities in lower risk assets and subsequently have benefited from a very low level of credit losses for many years. These facts drive the allowance math. Acknowledging the unprecedented economic challenge ahead and the quantitative reserve limitations, we expanded the total reserve by adding qualitative reserves related to COVID that totaled $7.2 million. This $7.2 million qualitative factor adjustment is intended to set aside reserves to account for the likelihood of risk-related migration as the impact of the pandemic becomes clearer. This represents our best estimate at this time of expected future credit losses from the pandemic. It’s too soon to know the depth and duration of the economic impact. The nature and breadth of economic stimulus is not yet fully known, nor is the mitigating effect these programs will have on the economy and individual borrowers. As the impacts become clearer, we expect the risk ratings on certain loans to deteriorate. This shift may result in increased quantitative results, which could be funded by decreases in qualitative results over time. This again represents our best estimate at this time of expected future credit losses from the pandemic. I'll add what we learned from our experience during Hurricane Sandy. The forbearance loans performed reasonably well. In that case, our initial Sandy reserve was $1.8 million, yet net charge-offs related to Sandy totaled less than $500,000. Of course the pandemic is a different and much broader event, and could be more protracted or severe than Sandy. While very difficult to assess, at least now our collateral remains intact and undamaged and can return to productive use more quickly than real estate destroyed by natural disaster. Active acquirers like OceanFirst also maintain purchase accounting marks related to acquired-loan portfolios, even following the implementation of CECL. While these balance sheet marks exist outside the allowance for credit losses, they represent a different element of credit reserve. As a result of the seven whole-bank acquisitions made by OceanFirst, we maintain a net amortized credit mark of $38 million that is in addition to our $32 million allowance. We believe that these two figures should be viewed in concert. Real estate values are by far the most important indicator of future losses for us and our low loan-to-value should partially protect us, even in the event of a substantial decline in real estate values. This reality was evident during the great recession when our peak annual loss rate was just 57 basis points. Our stable earnings stream is currently sufficient to fund the level of future provisions that could be driven by risk rating migration, additional qualitative factor adjustments, and net charge-off activity. As I mentioned, our low historical loss rates are largely due to our conservative risk selection and both individual loans, as well as overall portfolio composition. Again, we have no exposure to the energy, airline, or equipment leasing industries. We’re not a credit card lender and have not participated in the leveraged loan market. We don't maintain a consumer automobile portfolio. So, it’s comforting not to have to consider lease residual valuations. Even land loans are conservative at $19 million or less than 20 basis points of total assets. Next, I want to share some information on those borrowers that are seeking forbearance. To date, our early and active outreach has resulted in $775 million of commercial loan forbearance requests. These credits have a strong pre-pandemic risk profile, with only 5% rated special mention or substandard and 93% never delinquent over the past 24 months. A full 96% of this exposure is secured by real estate with a very low weighted average loan-to-value of just 55% and strong debt service coverage of 1.9 times. In aggregate, these borrowers are well-positioned to weather the current economic conditions. Our commercial forbearance requests are centered in the accommodation and food services industry and commercial real estate secured by retail properties. No other industry comprises more than 5% of total forbearance requests or more than 5% of total capital. The largest portion of our forbearance requests are from borrowers in the accommodation and food service industry. This includes restaurants of $92 million and hotels of $110 million or 1.2% and 1.4% of total loans respectively. In aggregate, our accommodation and food services credits have a weighted average loan-to-value of 52% and weighted average debt service coverage of 2.6 times. This includes The Irish Pub portfolio at Country Bank of $69 million; our real estate collateral has a weighted average loan-to-value of just 44%. The commercial real estate requests secured by retail properties totaled $106 million. These credits have a weighted average loan-to-value of 53% and debt service coverage of 1.8 times. We've also received over 1,100 residential debt relief requests totaling $311 million. These credits also have a strong pre-pandemic risk profile. The current weighted average FICO score is 742 on these borrowers, and the weighted average LTV is 70%. Furthermore, almost 90% of these loans have never had a late payment over the life of their loan. You can see why this segment of low LTV and high FICO loans with exceptional payment histories has not caused undue concern. Returning to our credit risk profile more broadly, I’d like to point out that our allowance for credit losses now exceeds non-performing loans by a measure of 1.8 times. When compared to 2008, our starting point for this crisis includes a more diverse loan portfolio, stronger profitability, a lower dividend payout ratio, and approximately 250 basis points higher capital levels. In short, we believe we are prepared for the storm. I’ll now turn it back over to Chris.

Christopher Maher, Chairman and Chief Executive Officer

Thanks, Grace. At this point, Mike, Joe, Grace, and I would be pleased to take some questions.

Operator, Operator

Operator instructions: Our first question will come from Frank Schiraldi with Piper Sandler. Please go ahead.

Frank Schiraldi, Analyst

Good morning and hope everyone is well.

Christopher Maher, Chairman and Chief Executive Officer

Thanks Frank. You too.

Frank Schiraldi, Analyst

Just on the reserves, you know, even if you adjust for the marks on the purchase book and the reserves for loan ratio, still, you know, I’d argue well below where some of your community bank peers have built their reserves, Joe, and I know Grace spoke to the confidence in the portfolio and the low expected loss, but I wonder if partially it also reflects maybe a difference in opinion on how provisioning is likely to play out. You know, it seems like a lot of the calls that the management teams are talking about are very frontloaded provision where I’ve gotten the sense in the past Chris that – you know you look at the potential for CECL provisioning as being a bit more stable through the year maybe as, you know, later in the year some quantitative factors maybe take over for the qualitative factors currently, so wondered if you could just speak to that? Thanks.

Christopher Maher, Chairman and Chief Executive Officer

Thank you, Frank. It’s a difficult time for all of us and our peers to estimate what the impact of this pandemic might be. Look, if we thought that we could put aside more reserves and responsibly do that, we would have done that and I’m very cautious not to send a message that, hey, we’ve taken some giant reserve now; don't worry about it for the rest of the crisis. I don’t think any of us know exactly what the duration and the depth of the crisis will be. I think the important point that I would stress is that taking a really healthy provision as large as we’ve taken, almost $10 million for the quarter, we still maintain our core ROA over 1%, so we can continue to fund provisions as needed. It’s very hard to tell what we will need, so we do look at this as the data comes. We’re going to be data-driven. So, I will say that while the aggregate number of forbearances is something that gives you pause, as we've had conversations with our borrowers, I think they’ve been very productive discussions about how their businesses will fare. We went into this and I think like many banks, our clients got through 2008. They have very low levels of leverage, they put cash aside; in many cases, their request for forbearance is a precaution. It’s not that they don't have any cash to pay us, it’s that they are trying to preserve their liquidity because they know they’ve got to restart their businesses in hopefully 90 days or somewhere in that time frame. So I think, Frank, you characterized it reasonably well. I would expect elevated provisions during the course of the pandemic, but I don't think there is anything that should overly concern us given our earnings stream and our starting position. I’ll also point out that our composition of loans is different than many peers and we really have avoided a lot of asset classes that carry higher provisioning. If you think about credit cards, they typically run very high loss rates. So, if you have any of those on your balance sheet that’s going to drive more significant reserve. Almost everything we have is real estate secured and the LTVs are quite low, so we could have non-performers, but the actual charge-offs over the course of the pandemic may be lower than you think.

Frank Schiraldi, Analyst

Great. Okay, that’s appreciated. And then, just a follow-up, obviously, Joe, you spoke to the strong pipeline, can you maybe just talk a little bit more about growing the loan book in this environment and maybe if the focus has changed at all and how you get comfortable with things like collateral values here? Thanks.

Joe Lebel, Chief Operating Officer

Yes. Good morning, Frank. I tried to refer to some of that in my comments in the sense that we’re looking at everyone a little differently as you would expect. We’re making sure that the underlying criteria still meet what was our credit standard and maybe even a little tighter credit standard at the moment. From the loan growth perspective, we’re focusing on big strong commercial real estate-type credits. We’ve recently financed and approved two financings for Amazon warehouses. We’re in the process of doing some other credit tenants such as Walgreens and CVS. The kind of stuff where you’re not going to make a killing on spread, but you know that you’re putting assets on that are in the right position with bonafide strong historical cash flows. As you go forward, I mentioned I think the second quarter will be fine just because of what’s in the pipeline. I think we’ll see some fallout, but I do think the second quarter will be okay. It’s hard to forecast going forward. It really just depends on how the pandemic plays out and not only consumer, but also our commercial customer confidence.

Frank Schiraldi, Analyst

I think you might have mentioned loan-to-values, has that underwriting standard in terms of the loan-to-values you’re willing to go up to changed meaningfully?

Joe Lebel, Chief Operating Officer

I wouldn’t call it meaningfully. Some adjustments have been made. For example, our home equity book has largely been for customers; it’s a reactive portfolio with very low LTVs in the mid-50s typically. We’re still doing them. We’ve cut back on the maximum LTV, but we’re not going to say we’re not going to be there for a client that needs our support. We absolutely are looking at underwriting criteria and scaling back a bit, yes.

Frank Schiraldi, Analyst

Right, okay. Thank you.

Operator, Operator

Our next question will come from Matthew Breese with Stephens. Please go ahead.

Matthew Breese, Analyst

Hey, good morning.

Christopher Maher, Chairman and Chief Executive Officer

Good morning, Matt.

Matthew Breese, Analyst

I was hoping you could maybe walk me through the process of actually getting a forbearance, what’s the bar for approval? And are there any cases where you deny a forbearance?

Christopher Maher, Chairman and Chief Executive Officer

Yes. So they’re very different processes on the consumer and the commercial side. When we had this experience during Sandy as well, on the consumer side, you’re dealing with lower dollar amounts and the burden for someone to provide paperwork in the middle of whatever crisis they’re going through is pretty rough. You can’t take someone who may have a family tragedy playing out in front of them and say, hey, we’d like tax returns. On the consumer side, our rule is very clear. If you're willing to certify that you have a COVID-19 issue and you need forbearance you’ll get it and we’ll put you on forbearance, and then as we re-look at those in 90 days, we’ll have a deeper conversation about the reasons that you might need forbearance. I think that is appropriate. If you consider the kinds of folks that have been impacted we just don't feel that re-underwriting those is appropriate. However, so that we understand the risk profile of what we’re doing, we are capturing information like the FICO score at the point the forbearance is granted so that we can understand the degree of deterioration that might hit this segment and make sure we’re reserving appropriately as time goes on. So we’re collecting information, but a consumer forbearance request is reasonably automatic. It’s a little different when you shift to commercial, and we also want to be accommodating. We want to make sure that people have been impacted by COVID, but you’ll also recognize that there are a lot of commercial borrowers who jump at the chance to go interest-only for a period of time and they may or may not have had a significant impact to their business. In that case, we are asking for minimal but reasonable documentation about what's going on in the business. This is about making sure that our forbearances are thoughtful and prudent. So, let’s take the case of commercial real estate. We’re asking for new rent rolls so we understand how much deterioration there has been in the rent roll. We have cases where if you’re covering at two times your debt service and now you're covering at 1.5 times your debt service, we’re probably having a conversation saying that a forbearance is not appropriate. But if your rents are down and you can pay principal but not interest, we may put you on interest-only, etc. This has a dual purpose as well. First, we want to throttle the amount of forbearances we grant so there is a credit approval required. Second, this is the kind of data we will need during the course of the year to understand how much credit risk we’re facing. The $775 million worth of requests that we noted earlier, there’s a few hundred million that we’ve been able to take action on in forbearance. I would expect to get through the rest of it in the coming weeks and make those decisions, but we’re just getting rent rolls for April for many of the commercial real estate. So, it’s two different analyses and hopefully that helps.

Matthew Breese, Analyst

Very helpful. The million-dollar question on our end is how many and how fast are these modified or forborne loans going to grow and to what extent are they going to transition to non-performers, and any detail you have in terms of on the consumer side whether or not if it’s a residential loan, homeowners are unemployed or if it's commercial loans and these companies are shut down, do you have those types of metrics at your fingertips?

Christopher Maher, Chairman and Chief Executive Officer

So look, I can share some of what we've disclosed to date. If you take a look at the consumer book, the fact that the FICOs are in the 740s is extremely encouraging and the reason for that is FICO is driven not just by late payments but also by credit utilization. You don’t wind up at a 740 FICO score if you're tapped out. These are customers with liquidity who are probably frightened about what's going on in the economic environment and trying to preserve cash. They don't understand how long they’re going to be out of work, so any piece of help they can get. So, I’m not terribly concerned on the consumer side although the duration of time that people are out of work will play into this. On the commercial side, it's too early to tell. We’re collecting information, but I think it will be too early to make broad statements. When you think about how to assess the risk, if you go back to our March 24 call, we disclosed our concentrations in sectors where there could be a risk. Now it’s much more important to look at who's requesting forbearance and where they are coming from. We proactively called our commercial clients in high-risk segments and said, what’s going on, do you need help? Talk to us; tell us what’s going on. We wanted to pull those forbearances out quickly. I don’t want to wait until someone misses a payment to start a forbearance conversation. If you look in the supplement slides, we showed the unit trend in requests for forbearance and at least for this wave, it appears to be moderating for both consumer and commercial. We don’t know how long the pandemic is going to last and how the restart efforts are going to go, but we think we have the majority of the forbearance requests reflected in the numbers we’re sharing with you today and there’s not going to be another $1 billion coming toward us in the next 30 days. We think we’ve got a good handle on the tempo.

Matthew Breese, Analyst

Understood, okay. And then, on the provision, I understand that it's very hard to predict what can happen here, but maybe you can just set the stage in terms of the framework. As we think about the underlying assumptions, if we go from an unemployment forecast and take it from 5% to 10%, is the next incremental 5% as painful as the first? Or does this soften as you go higher? Or is there any way you could frame that for us?

Christopher Maher, Chairman and Chief Executive Officer

There’s two key attributes you have to remember in reserving. The first is the probability of default, and the second is the loss given default. Things like the unemployment rate affect the former. They don't necessarily affect the latter, although they may. It’s really hard to tell if there's nonlinear behavior. I don't think it's as sharp, and Grace can give you a little more information about the model. In a portfolio like ours where the vast majority of loans are real estate secured and you have some presumption that real estate values will remain in a certain range, actual losses, the charge-offs, are likely to be lower than you might expect. I think for a balance sheet like ours it would not be unusual to see an elevation in non-performing loans. Unlike the last credit cycle, our peak non-performing loans crested at much higher levels, but our worst year of charge-offs was 57 basis points. So, we may have a bunch of loans we're dealing with, but the actual risk to capital and earnings and the balance sheet may be lighter than that. Grace, you can add to the way the model works.

Grace Vallacchi, Chief Risk Officer

The only thing I would add is that what’s unusual about this situation is that many CECL models are based on historical correlations between things like unemployment and GDP going back decades, but given the measures that are being taken by the federal government—for instance, the supplemental $600 unemployment payment—we really don't know how strongly those correlations will hold. We would think that it will be mitigated somewhat by that. A lot of people are actually making more money on unemployment than they did as an hourly worker. So that all remains to be seen. That’s the only thing I would add to what Chris said.

Matthew Breese, Analyst

Understood, thank you. And then my last one, in terms of getting loans done, have some of the underlying mechanics improved yet? Local county clerk's office, notaries, areas where ink signatures are necessary, how much of a hindrance is this to business? Are municipalities catching up and making improvements?

Christopher Maher, Chairman and Chief Executive Officer

It’s getting better. We had a couple of our states—New Jersey and now Pennsylvania—move to electronic notary, which is new for them. By and large, the counties have been pretty good. Initially we were concerned that title might be a logjam for real estate transactions. They’re a little slower, but they continued to function. Probably the area where we still see significant concern is around anything related to construction. Construction has been shut down or discretionary construction in many of the areas we operate in, although there are carve-outs like residential properties with fewer than five contractors involved. The process of appraisals, inspections, and ongoing management of that segment has been more problematic. Pennsylvania will restart construction to a certain degree in a couple of weeks and New York and New Jersey may follow. Right now, that’s where we’re seeing the most friction: inspections and municipal inspectors being out on the job.

Matthew Breese, Analyst

Got it, okay. That’s all I had. Appreciate taking my questions. Thank you.

Christopher Maher, Chairman and Chief Executive Officer

Thanks Matt.

Operator, Operator

Our next question will come from Christopher Marinac with FIG Partners. Please go ahead.

Christopher Marinac, Analyst

Hey, thanks. Good morning, Chris and team. Thank you for all the background both last night and on the call this morning. So, back to the reserve level overall, I mean you’re reserving for actual loss expectations, right Chris? So, at the end of the day, your past experiences with Hurricane Sandy and other disasters really lead to what you expect on losses and you reserve for that today. So it reflects what you're expecting and until you have a different fact pattern there’s no reason to expect that the reserves would significantly change, is that fair?

Christopher Maher, Chairman and Chief Executive Officer

That’s correct. I would point out that $7 million of the allowance we took is qualitative, not quantitatively driven. We knew the model was producing a number that we thought was light compared to our expectations, so we set that aside to cover migration of loans. The model drivers and the real-world experience are different. Sandy was different in that we had destruction of collateral; the pandemic is broader and the scale of stimulus is much larger than in Sandy. Our quantitative reserves would have been about $7 million lower, and we added the qualitative reserve because we knew we needed to set funds aside given the environment.

Christopher Marinac, Analyst

And then two follow-ups: can you remind us how the fair value mark evolves over time? Does that accrete back quickly the next couple quarters or will it be slow?

Mike Fitzpatrick, Chief Financial Officer

Chris, it’s Mike. It accretes back into income over the life of the loan, but more at the front end of the loan. Over the next few years most of it accretes, with a long tail thereafter.

Christopher Marinac, Analyst

Great. So we can still use that as a sort of factor reserve almost as if you, just like you said in the slides?

Joe Lebel, Chief Operating Officer

Yes, I think if you consider the $38 million as a pool that accretes back into income, you could reallocate that to cover credit losses if needed.

Christopher Marinac, Analyst

Great. And then last question on the Fed’s upcoming mainstream lending facilities, is that something that might apply to your commercial borrowers? Any early read?

Christopher Maher, Chairman and Chief Executive Officer

There are a small number of credits that would be of the size and nature to qualify for a mainstream program. So we may have a few loans that would participate, but for us it would be a much smaller event than PPP.

Christopher Marinac, Analyst

Got it. Thanks Chris and thank you everyone.

Operator, Operator

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

Russell Gunther, Analyst

Hey, good morning, guys.

Christopher Maher, Chairman and Chief Executive Officer

Good morning, Russell.

Russell Gunther, Analyst

Chris, I know we really don’t have a great crystal ball in terms of how the current situation is going to persist, but given your footprint and sensitivity to the summer months and if beaches and boardwalks remain closed, is that type of event captured in the qualitative reserve this quarter? How might that play out within your modeling?

Christopher Maher, Chairman and Chief Executive Officer

I think that’s an area highly comparable to Sandy because even though people come to the beach while the restaurants and hotels were just unavailable for use in the season following Sandy, remember Sandy hit late October; very few businesses were able to completely reopen by the following May. We expect a weak summer season this year because of social distancing and it may be better in the second half of the season. Usually July and August are more important to these summer resort towns than May and June. I would expect we may limp through this season; we have the benefit that when people don't want to get on a plane they drive to nearby shore resorts, so there will be some support. I wouldn’t be surprised if next year, assuming improvements, could be a strong year for the shore. This year may be weak, next year could be strong. We don’t have to rebuild these places as we did in some Sandy-impacted cases. A weak year this year was factored into our qualitative adjustments for the quarter.

Russell Gunther, Analyst

Understood. So were that to play out you believe that scenario is captured in the qualitative adjustments this quarter?

Christopher Maher, Chairman and Chief Executive Officer

Yes. I’ll reiterate that reserves and charge-offs relate to net credit experience, not simply non-performing loans. With conservative real estate values, you may have a bubble of non-performing loans that does not result in the same degree of net charge-offs. The six-month forbearance program should get us through this summer. If we have further issues after that, some of these will become TDRs, but we start from a strong position with most clients.

Russell Gunther, Analyst

I appreciate the confirmation. I wanted to follow up on loan growth and Joe’s comments. What are you assuming for pull-through rates within commercial and residential? Is there enough visibility to re-commit to net organic loan growth of $50 million to $100 million, or how do you see that shaking out for the remainder of the year?

Joe Lebel, Chief Operating Officer

So I’ll take it in stages, Russell. On the residential side with our underwriting criteria and verifying income and job status, we tend to see very strong pull-through rates typically in the 90% range. The pipeline has still been very strong and we haven’t seen significant fallout; if anything we’ve continued to see volume. On the commercial side it’s harder to predict, although with the addition of Philadelphia and New York to our legacy markets it’s allowed us to see strong quarter-over-quarter performance there. We’ll have opportunities and we’ve seen good activity; the PPP program also generated more engagement and new relationships. The second quarter should see loan growth barring decisions to sell some pools for liquidity. It’s harder to forecast the third and fourth quarter.

Russell Gunther, Analyst

Understood. Last line: could you put a finer point around expenses? Any offsets from facilities being closed or lower fee lines? And last quarter you mentioned a $50 million annual run-rate savings by year-end; any update to that?

Christopher Maher, Chairman and Chief Executive Officer

I’d classify it as a potential tailwind. We will complete the Two River integration in Q2 and close five legacy branches, which will provide a tailwind into the second half of the year. We are cautious about setting specific guidance on expenses now; reopening protocols will bring additional costs for equipment and safety. Overall I expect a favorable trend, and we’ll give a better update after Q2.

Russell Gunther, Analyst

Understood. I appreciate the color. That’s it for me.

Operator, Operator

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

Collyn Gilbert, Analyst

Thanks. Good morning, everyone.

Christopher Maher, Chairman and Chief Executive Officer

Good morning, Collyn.

Collyn Gilbert, Analyst

First kudos for pulling off what you did on the PPP program without having any kind of SBA platform in place prior to that. Very impressive. One thing I don’t understand: how do you think of the relationship between borrowers that are asking for PPP participation and those that could also be asking for forbearance? How do you collaborate or isolate those two situations?

Christopher Maher, Chairman and Chief Executive Officer

One of the reasons to be good at PPP is it improves liquidity for your commercial clients. Every dollar we get out to help fund payroll strengthens their business and our long-term relationship. We also had many requests from non-customers and accommodated some. This is a reputational moment for banks. Banking is less of a commodity now; people notice performance. We had staff working around the clock to get this done because it was important for our community.

Collyn Gilbert, Analyst

Okay. In terms of those who applied for PPP, could they also apply for forbearance?

Christopher Maher, Chairman and Chief Executive Officer

Yes, and there is overlap. If a restaurant is functioning on takeout only, or a landlord has a temporarily depressed rent roll but expects it to recover, that can be a reason for forbearance. We will avoid granting forbearance to businesses that had significant weakness before the pandemic started.

Collyn Gilbert, Analyst

Do you have the number of borrowers or dollars that overlap between the two programs?

Christopher Maher, Chairman and Chief Executive Officer

I don't have that handy, but we can get that to you after the call.

Collyn Gilbert, Analyst

Okay, thanks. Last question: you indicated swap activity was strong this quarter and you expect a solid year. Can you walk through how you’re thinking about that business line going forward?

Joe Lebel, Chief Operating Officer

We adopted the product a little over a year ago and clients were excited to have it. Swap income can be choppy quarter-to-quarter depending on activity. Borrowers with strong liquidity and balance sheets want flexibility and swaps provide that. We are bullish on the swap business; it should be a good year, though choppy.

Collyn Gilbert, Analyst

Okay, that's helpful. Last question: any anecdotal differences among how borrowers in New York City, New Jersey, and Philadelphia are operating and how they might respond when the economy opens again?

Christopher Maher, Chairman and Chief Executive Officer

There are interesting patterns. The number-two category requesting PPP loans from us was healthcare, largely due to elective procedures stopping and the cash-flow impact. We had some well-prepared retailers who didn't need help. Regionally, New York City has been impacted more severely so far than Philadelphia. Across markets, our strongest and most liquid commercial clients are waiting to invest until there is more clarity. There is a lot of cash on the sidelines looking to invest at the right time, and that could create loan growth opportunities later in 2020 and into 2021 provided requests are reasonable.

Collyn Gilbert, Analyst

Okay, that’s helpful color. I’ll leave it there. Thanks guys.

Operator, Operator

Our next question will come from Erik Zwick with Boenning & Scattergood. Please go ahead.

Erik Zwick, Analyst

Good afternoon, everyone.

Christopher Maher, Chairman and Chief Executive Officer

Hi, Erik.

Erik Zwick, Analyst

First question: do you have an expectation for what percentage of the PPP loans will ultimately be forgiven? And secondly, when would you potentially record the associated accelerated fee?

Christopher Maher, Chairman and Chief Executive Officer

On forgiveness, anybody's guess, but we think it will be a pretty high percentage. Most folks accessing PPP plan to maintain payrolls and be eligible for forgiveness. One caveat: some clients have told us that after calling employees back to work, employees have declined to return because the unemployment supplement can in some cases make them financially better off staying on unemployment, and there are legitimate concerns about returning to work. That dynamic could affect forgiveness for some borrowers who cannot get employees back. Regarding the accelerated fee recognition, I think you'll see the majority of that in the next couple of quarters with a tail thereafter. Two-thirds or three-quarters in the next two quarters is a reasonable tempo.

Erik Zwick, Analyst

Thanks. Looking at trends of loan yields, residential real estate yields have held up better relative to commercial and home equity. Is that specific to you or a reflection of dislocation in the secondary market for residential mortgage loans?

Christopher Maher, Chairman and Chief Executive Officer

There has been some dislocation. Large banks have pulled back from correspondent business and there are fewer players. Many banks, including us, have instituted pricing floors because we are not willing to originate long-term loans at today's extremely low rates. The historical relationships between the 10-year treasury and mortgage rates have been disrupted and credit spreads are compressed, so you’ll see pricing that does not align to the prior yield curve relationships.

Erik Zwick, Analyst

Last question: the $949,000 charge-offs tied to high-risk residential loans—were those related to COVID developments or were they previously criticized? Any color?

Christopher Maher, Chairman and Chief Executive Officer

Those were pre-COVID issues and reflect our policy over the past few years to sell higher-risk consumer loans rather than hold them. We’d rather take a small loss now than retain loans we might have to fire-sale later in a downturn. As soon as we had a pool of loans to dispose of, we did so and cut our losses to make room on the balance sheet for better-quality loans.

Erik Zwick, Analyst

Great. Thank you for taking my questions.

Christopher Maher, Chairman and Chief Executive Officer

Alright. Thank you, Erik.

Operator, Operator

Our next question will come from Louis Feldman with Wells Fargo Asset Management. Please go ahead.

Louis Feldman, Analyst

Good day.

Christopher Maher, Chairman and Chief Executive Officer

Hi Louis, how are you?

Louis Feldman, Analyst

Pretty good. Mike, quick question: given the stock price adjustment and the current environment, have you talked with your auditors about goodwill impairment at this point?

Mike Fitzpatrick, Chief Financial Officer

We have, Louis. We ran an impairment analysis given the stock price and COVID-related considerations. We usually do that analysis annually in August, but we performed it recently. We concluded there was no impairment and our auditors agreed with that conclusion.

Christopher Maher, Chairman and Chief Executive Officer

Thanks Louis.

Operator, Operator

Our next question will come from Stan Westhoff with Walthausen & Company. Please go ahead.

Stan Westhoff, Analyst

Good morning. I guess afternoon at this point. On funding cost, you had a jump in deposit cost, and obviously a lot of that came over from the acquisitions. Where do you stand now and what are your plans to reduce some of those, particularly savings account rates which jumped up 30 basis points?

Christopher Maher, Chairman and Chief Executive Officer

That increase was driven entirely by the acquisition of Two River and Country, which had higher deposit rate structures than OceanFirst legacy. We typically reduce rates after acquisitions as we get to know the customer base and do it gradually. We began reducing rates in earnest in those two portfolios late in Q1, so you wouldn't see the full effect yet in overall deposit costs. We expect to reduce those deposit costs in the current quarter, which will help stabilize margin.

Stan Westhoff, Analyst

Okay. Regarding CECL, did the quantitative model suggest a small increase in provision and you decided to add $7 million qualitatively?

Christopher Maher, Chairman and Chief Executive Officer

Yes. After the day-one CECL mark and considering loan mix and another quarter of low loss data, the quantitative CECL result would have been lower in some respects. We did not think that was appropriate given the unprecedented economic conditions and the relative benign economic forecast inputs we had from our provider, Oxford Economics. Because we felt the quantitative model inputs were too benign relative to other forecasts and to our judgment, we added $7.2 million of qualitative reserves to reflect expected deterioration from the pandemic.

Stan Westhoff, Analyst

Can you share the unemployment input that went into the model?

Christopher Maher, Chairman and Chief Executive Officer

I’d prefer not to disclose a single input number as there are many economic inputs in the model. I will say the Oxford number was lower than most other estimates we saw, which is why we added qualitative adjustments.

Stan Westhoff, Analyst

Okay, that’s all I have. Thank you very much and be safe.

Operator, Operator

Our next question will come from Frank Schiraldi with Piper Sandler. Please go ahead.

Frank Schiraldi, Analyst

Just one quick follow-up. How should we think about the increase in delinquencies linked quarter-over-quarter—are those COVID-related and should they likely turn into deferments at some point? You have a 30-plus days past due increase; it would seem that points to February, which is early to be COVID-related, so how should we think about that?

Christopher Maher, Chairman and Chief Executive Officer

You’re exactly right, Frank. We think much of that is COVID-related and there's an overlap between delinquencies and forbearance because we only started soliciting forbearance requests on March 16 and we are credit underwriting them. There is also a small increase related to including Two River and Country in the March 31 numbers versus December 31. We would expect moderation by the end of Q2 as forbearance requests are processed.

Frank Schiraldi, Analyst

Okay, and did some people see the writing on the wall and miss the February payment as a cash preservation tactic? I’ve seen that in other banks.

Christopher Maher, Chairman and Chief Executive Officer

Yes, I think geography played a role. We operate near the epicenter of the pandemic where strong early sentiment impacted behavior. If you look at year-end delinquencies they had been trending positively. Some restaurant and hotel borrowers had very strong 2019 results but have seen a big change in sentiment and cash management choices.

Operator, Operator

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

Christopher Maher, Chairman and Chief Executive Officer

Thank you. I’d like to thank everyone for their participation in the call this morning and this afternoon. We face a very troubled economy in the coming quarters and nobody has a crystal ball, but our company has been around since 1902 for a reason. We take conservative risk positions, we’re strongly profitable, and we maintain ample capital levels. We look forward to talking again after our second quarter results are posted in July. Thanks again. Stay safe.

Operator, Operator

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