Preferred Bank Q2 FY2020 Earnings Call

Good day, everyone and welcome to the Preferred Bank’s Second Quarter 2020 Earnings Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note that today's event is being recorded. At this time, I'd like to turn the conference call over to Mr. Jeff Haas of Financial Profiles. Sir, please go ahead.

Thank you, Jamie. Hello everyone. And thank you for joining us to discuss Preferred Bank’s financial results for the second quarter ended June 30, 2020. With me today from management are Chairman and CEO, Li Yu; President and Chief Operating Officer, Wellington Chen; Chief Financial Officer, Edward Czajka; Chief Credit Officer, Nick Pi; and Deputy Chief Operating Officer, Johnny Hsu. Management will provide a brief summary of the results. And then, we will open up the call to your questions. During the course of this conference call, statements made by management may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based upon specific assumptions that may or may not prove correct. Forward-looking statements are also subject to known and unknown risks, uncertainties and other factors relating to Preferred Bank's operations and business environment, all of which are difficult to predict and many of which are beyond the control of Preferred Bank. For a detailed description of these risks and uncertainties, please refer to the SEC required documents the Bank files with the Federal Deposit Insurance Corporation or FDIC. If any of these uncertainties materialize or any of these assumptions prove incorrect, Preferred Bank's results could differ materially from its expectations as set forth in these statements. Preferred Bank assumes no obligation to update such forward-looking statements. At this time, I'd like to turn the call over to Mr. Li Yu. Please go ahead.

Good morning. Thank you for attending our conference. For the second quarter 2020, Preferred Bank's net income was $15.3 million or $1.03 per share, compared to last quarter and the same period of last year. This quarter’s earnings are a little light. That was mainly due to a large $7.5 million loan loss provision that we recorded during the quarter. On a pre-provision net revenue basis and pre-provision pretax net income basis, we are performing a little better than those comparing periods even under the current interest rate environment. For the quarter, return on assets was 1.26% and return on equity was 12.65%. As of June 30th, total PPP loans made amounted to $74 million. We have earned approximately $1.94 million in fees, and the fees will be amortized over the life of the PPP loans. This loan does carry an interest rate of 1%. Obviously, PPP loans will have a negative effect on the net interest margin. Deposit growth in the second quarter was $264 million, and loan growth was $70 million. Both numbers include the PPP loans. We actually have a net organic origination of loans. We made $211 million of new loans and had $161 million of payoffs, which netted our net organic origination of $50 million. However, this large difference between loan and deposit growth has created a leveraging of the balance sheet, negatively affecting the net interest margin. The net interest margin for the second quarter was 3.53%, or 17 basis points lower than the first quarter. Other than the PPP factor and the aforementioned leveraging, there was over $500,000 of interest income reversal that also affected the margin. Compared to the first quarter, our loan yield decreased by 47 basis points, and our deposit cost decreased by 43 basis points. We expect that going forward, deposit costs will continue to decline because of the maturity and repricing of our certificate of deposit portfolio. As of June 30th, total modified loans amounted to $467 million. Toward the later part of the quarter, activities for new modifications have greatly slowed down or moderated. In fact, as of June 30th, there were only $4 million in new requests in process. During the quarter, many loans were returned to normal status. Between July 1st and July 20th, an additional $25 million were reinstated. The deferral modifications generally last three months. 40% of the modified loans are for partial modifications, which involve interest-only or principal-only payments, while 60% are for the full principal and interest modification. Our reserve build will continue; however, the magnitude of the new provisions will depend on quarter-by-quarter evaluations of the economic conditions, the status of the virus, and the development of our loan portfolio. The significant increase in deposits has pushed our total assets to exceed $5 billion. This increase provides us with great liquidity but penalizes our return on assets and capital ratio. With our current efficiency ratio at less than 33%, the declining trend of deposit costs, and all of our floating-rate loans operating at their floors, we feel very comfortable with our operating metrics. Thank you very much, and I am now ready for your questions.

Our first question comes from Timothy Coffey from Janney. Please go ahead with your question.

I just want to start first with the non-accrual loans in the quarter. Can you provide some color on those?

Okay. I would obviously ask Nick Pi to give you more details about that.

Yes. The non-classified loans are mainly classified top of the loans, which we have recently downgraded to classified non-accrual. The first loan is fully secured by real estate, and during the past couple of months, the borrower has been trying to sell the property to pay back the loan. However, the sale has not been successful due to the COVID-19 pandemic, which has caused delays. We’re continuously working with the borrower to resolve the issue. The second loan has been further downgraded due to the borrower filing for Chapter 11 recently, and their cash flow was negatively impacted by the COVID-19 pandemic. The third loan is around $1.4 million in our New York area, and it is also fully secured. The borrower is working with the Bank for refinancing and providing additional collateral to cover the risk.

Okay. What were the book values of the first two loans?

It’s in LA.

Book value?

Dollar amount.

Book value? The first one is $16.8 million, the second one is $6.32 million, and the third one is $1.13 million.

And the first one you say was in Los Angeles area?

Yes.

And where’s the second one?

The second one is also in the LA area.

Are you expecting additional write-downs on these?

I'm sorry?

Are you expecting to write down the values of these loans still?

We have provided sufficiently - you have provided sufficiently…

Yes.

For the second loan. The first one doesn't need any.

The first and third loan, based on our SB 114 analysis, they are fully secured and we don't expect any loss for those two loans.

Okay. I was kind of wondering if that’s the commentary that you had provided earlier on provisions, were not related to these loans. Okay. Ed, what was the spot rate on your deposits in the quarter?

When you say spot rate, Tim, do you mean the ending rate as of June 30th or during the quarter?

As of June 30th.

As of June 30th, the cost of deposits was down to 74 basis points.

And in the comp line item, did you include any deferrals of loan origination expenses?

Yes. That's always in there. But that was one of the reasons for salary expense going up over last year's levels, Tim. One of the reasons is that loan origination activity, as Mr. Yu talked about, was there, but it was significantly down from where we were a year ago. So, those credits to salary expense that we defer over the life of the loan, those are way down as well.

And then, just Mr. Yu, the debt payoff of $161 million, were those properties refinanced to other institutions or why were those so elevated?

Some of them are construction loan payoffs, okay? Some of them are being refinanced by other institutions at a relatively low rate. Some of them are outright sales; customers sold properties.

In this current environment, do you expect that number to stay the same or change either way in the coming quarters?

I will give you my thoughts after Wellington gives you his thoughts about what he expects, because we sometimes think slightly differently.

Hi, Tim. This is Wellington. For the third quarter, the payoff, no, it's not really, because it's so many moving parts. As I mentioned in the past, every quarter, we have projections of the pipeline, what's in the pipeline, and we try to project as accurately as possible on the payoff. It's not a factor right now.

Well, Tim, my thought is that we will see declining levels in the third quarter both in origination and payoffs. One reason is judging from the activity at the tail end of the second quarter. Another reason is that due to the ongoing virus, many individuals are simply not making any movement.

Our next question comes from Nick Cucharale from Piper Sandler.

So, just a follow-up on the NPAs. The first one you mentioned, the $16.8 million loan, you mentioned the delayed sale process. Is that looking optimistic at this point? It sounds like it could be resolved quickly given the status of the sale?

Actually, this question is kind of optimistic. From a normal sales point of view, it should have happened much earlier. But, we have a borrower who is somewhat hesitant. Every time a deal is set, it seems to fall through due to some parties backing off. This property qualifies for a deferment, but since it was delayed before the guidelines were issued, we cannot provide them with further deferment. We are putting in our utmost effort to encourage them to sell the property.

That's very helpful. I know there were a few moving pieces with respect to the NIM this quarter. But, I was hoping you could help us think about the forward trajectory in light of PPP forgiveness on the asset side and continued repricing on the liability side?

Yes. Ed can provide that information. Ed, he has it already for you.

Well, I don't have a crystal ball, Nick. But just a few things. You mentioned moving parts in the NIM this quarter. As Mr. Yu mentioned, there was a significant deleveraging of the balance sheet during the quarter where we’ve taken out a lot of deposits and taken on a lot of cash yielding only 10 basis points, and loans are not growing. This certainly had a negative effect during the quarter. The reversal of non-accrual interest had an effect of about 3 basis points. So, without that, we would have reported about 3.60 for a NIM instead of 3.53. I think that was the quarter before. Going forward, if we get PPP forgiveness on the $74 million, it will certainly help, especially into 2021. I don't anticipate much movement on that forgiveness piece prior to the end of the year or in the third quarter. We will have $426 million maturing during Q3 at an average rate of about 161; those will come back at an average rate around 70 to 75 basis points, which will certainly help moving forward. As Mr. Yu noted, many of our adjustable rate loans are already at their floors, so we do not foresee much more pressure on yields. We hope this quarter's results represent the nadir of our margin.

Our next question comes from Steve Moss from B. Riley FBR. Please go ahead with your question.

I guess just following up on the margin here in terms of the incremental securities purchases in the quarter. What's your appetite at this point for anything or any structures out there?

Regarding the bond portfolio, there isn't much to report. We aim to operate with a cautious approach since there are no major gains or even modest successes. We're attempting to invest some capital, but it's a tough environment as you know, with a lot of people chasing yield. We've tried to allocate more funds with our correspondent banks to achieve better returns than the minimal interest we earn on cash. Additionally, we've gradually increased our bond holdings as we identify small opportunities.

And then, in terms of going back to non-accruals, kind of curious about the property types for the $16 million — $16.8 million non-performer and the third loan. Are those just commercial real estate? Any color there?

Nick, why don’t you answer that?

Yes. The loan is actually covered by field properties, which are in high-end residential areas.

Okay. And then, in terms of your hotel exposure, just curious — can you give any color around what you're seeing for occupancy at those hotels, whether they're located in urban or resort areas, and what your approach will be for restructuring those loans?

I’m going to provide a longer explanation on that. We have some hotels that have closed, and others that have decided to keep open. For those that are operating, the reports we receive indicate occupancy is ranging from 35% to 50%. Some hotels in special locations have contracts with the government, such as those in New York for first responders, and these are fully occupied. With our hotels, essentially, there are two categories. One is in metropolitan areas like New York City, San Francisco, and Los Angeles, primarily flag hotels. The other segment includes boutique hotels in waterfront locations. We have one boutique hotel in Newport Beach, another one in Redondo Beach, and several others located in prime areas. We believe the property value of these hotels is holding up well due to their locations. I must also point out that nearly all the hotels have recourse, and we consider these recourses to be adequate. We are optimistic that once the situation improves, owners will have the resources to reboot their hotels and resume operations. However, there will likely be one or two exceptions, but we do not foresee any serious issues here, at least as of now.

That's helpful. One more question regarding your hotels — what percentage are in metro locations versus boutique hotels on the beach?

Well, in terms of total value, I would estimate it's around 80% in metropolitan areas and 20% in boutique beach locations.

That's helpful. And in terms of expenses for the quarter, just curious, they came in lower than expectations. Any update on what to expect in the third quarter?

Yes. The second quarter was pretty good regarding holding expenses down; there's no question about it. I think moving forward, Steve, we can expect expenses to be somewhere between where they came in for Q2, which was roughly $14.5 million to $15 million, within that range.

I would also like to add to that, Ed, a bit. First of all, you may have noticed that we have substantially exceeded all forecasts in terms of pre-tax, pre-provision income and revenue forecasts put out by valued analysts. Secondly, looking ahead, we have a low efficiency ratio, and the important factor is that deposit costs are on a declining trend. Apart from the repricing of certain loans, we anticipate relative stability in loan yields. Given these three factors, I feel confident about our operating metrics.

One more thing, I meant to ask is regarding your assumptions for CECL. What are your expectations for GDP, unemployment, and if there are any overlays this quarter?

Currently, we forecast the unemployment rate to be around 11% to 12%. This number could escalate significantly, considering that some major employment centers may face re-closures in response to the pandemic. Additionally, we forecast a GDP contraction of 5% to 6%. We will closely monitor these two metrics and will make adequate reserves in Q3 and Q4.

Our next question comes from David Feaster from Raymond James.

I just wanted to start on deposits. I mean $264 million of core growth, even with just a modest benefit from the PPP side, that's real strong organic growth. Just curious about how much of that you think will remain on the balance sheet, how deposits have trended in the third quarter, and any thoughts on the deposit front?

At this time, I can only say that deposits are probably the most challenging aspect to forecast. It largely depends on customer usage. However, for the third quarter, we’ve seen a slight increase as of July 21st compared to quarter-end. We must moderate any significant increases and balance paying less interest to slow down deposit growth. The more we deposit, the more we lose money unless it's attributed to DDA, where we do have growth. So, forecasting deposits is quite fluid.

That's great. Incredible. Regarding deposit growth, decreasing deposit costs, and the floors in place for loans offset by lower-yielding new originations, how effective do you believe those floors will be in ensuring that deposits reprice faster than loans? Could we see a core NIM expansion from this point, or should we anticipate more modest contractions?

Setting the leveraging factor aside, the discussion around one-time items, which involve interest reversals, is worth noting. Unless we face additional situations that could push rates down significantly, we should expect NIM to remain relatively stable. As mentioned earlier, deposits costs are improving, and loan yields will generally remain steady. Loan yields always depend on payoffs; the rates on existing loans tend to be higher than those on newly issued loans. Additionally, we frequently receive inquiries from clients requesting lower rates, and selectively, we might match those requests. These two factors slightly adjust our margins. However, during the ongoing pandemic, we believe stability will be maintained.

Just following up on the discussions about deferrals, it's great to hear that you've already had about $25 million return. Despite the two to four-month terms, many of those should be ending in the third quarter. What are your expectations for re-deferral rates as we progress through the third quarter?

As you mentioned, we have three months for the deferral. What we’re observing are requests primarily involving small amounts around $4 million. If clients come in with requests, we know we have to address those under safety and soundness guidelines. For hotels that are not opening, we provide full deferral. For those that are operating and show some cash flow activity, we grant only partial deferrals, either interest-only or principal-only. We anticipate that loans currently under partial deferment, particularly those that are interest-only, will return to normal status in the third quarter. Thankfully, we haven’t seen many new requests. We maintain that the existing deferral structure is holding in place.

As a strategic question amidst a pandemic that alters customer behavior and increases remote work, how might your strategy change? Are there additional opportunities for expense rationalization, or are there areas for further investment to keep up with evolving client behavior?

We just had a Board meeting yesterday, discussing these points. The first quarter coincided with the start of lockdowns, so we observed just one quarter of activity following the pandemic's onset. During this period, we managed a number of PPP loans, deferments, new loans, and adjustments to branch operations due to COVID-19 cases. Consequently, we were quite busy simply to stay operational. Moving forward, if everyone continues to work from home, staff realignment will be an issue we need to consider, as we must maintain our origination activity, and also reassess our operational activities in response to the changing environment. I must emphasize that as a small institution, we have not had the opportunity to engage deeply in strategic adjustments yet. Sooner or later, every institution will have to address this.

And our next question comes from an unidentified analyst. Please go ahead with your question.

We saw that you've added $23 million to the troubled debt restructurings in the multifamily category. Could you share details on this situation? What type of modifications and in what geography?

That's one of the loans in LA in a prestigious real estate area; our loan-to-value ratio is less than 50%. Due to cash flow issues at the outset, they worked with the bank, and under a forbearance agreement, they complied with additional interest payments. However, since this happened before the agency’s guidelines were issued, we classified it as TDR for now.

That's very helpful. Thank you. Can you clarify how much of your loan portfolio is in California versus the New York area?

In New York, it’s only around $350 million. The remainder is in either Northern or Southern California.

And our next question is a follow-up from Timothy Coffey from Janney.

I just had a question about the PPP loans. Can you quantify what amount or percentage are less than $150,000?

I’ll have Johnny answer that, okay? Do you have the information readily available?

Under $150,000, I would estimate it's approximately 60% to 70%.

Did you hear that, Tim?

I did; 60% to 70%?

Yes.

Okay. And just kind of — I mean, I don’t know if you're able to share this. What are your internal expectations for when those might be forgiven — by year-end or early next year? What are your thoughts?

I think our expectation is that most of them will be forgiven. We're encouraged by reports from the Fed and others promoting automatic forgiveness for loans below a certain threshold. We are fortunate to have many loans under that limit. By the end of the year or when we've received more definitive guidance, that is when we foresee this process will conclude.

These loans are primarily to our own customers, so on a KYC basis, we have strong confidence that the information provided will result in forgiveness.

And our next question comes from Gary Tenner from D.A. Davidson.

I wonder if you could provide thoughts on what you're seeing in terms of general credit risk rating migration in the portfolio, separate from the downgrade to those loans that have previously been classified into non-accrual status?

Other than those few loans, we don't see deterioration in overall credit quality at this time. We will need to monitor this closely after deferment periods, especially in Q3 or Q4. However, up to now, we haven't observed any significant issues within our credit portfolio.

Putting a loan on deferral or modifications doesn't necessarily halt the process of reviewing and assessing internal risk ratings. Are you indicating that you’re holding the risk evaluation until after the deferment period ends?

In fact, every loan under deferment has undergone our evaluation procedures to ensure compliance with the guidelines. We're also conducting comprehensive reviews on all loans, especially those that we feel require a deeper dive, including those influenced by the ongoing China trade situation.

And ladies and gentlemen, at this time I’m showing no additional questions. I'd like to turn the conference call back over to Mr. Yu for any closing remarks.

Thank you very much for your interest. I know that in this quarter, there's slightly more noise compared to previous quarters. However, we all hope that the virus will be eradicated soon and that a vaccine can be developed promptly, so we can return to a normal life. Most importantly, we hope that our good customers will recover well, as their financial health was generally stable prior to this situation. We wish not to see any deterioration in credit due to circumstances beyond their control, such as the virus disrupting livelihoods and wealth. Let's keep our fingers crossed and pray together. Thank you.

Ladies and gentlemen, with that we’ll conclude today's conference call. We thank you for joining. You may now disconnect your lines.