Sb Financial Group, Inc. Q2 FY2020 Earnings Call

Good morning, and welcome to the SB Financial Group's second quarter 2020 conference call and webcast. I would like to inform you that this conference call is being recorded, and that all participants are in a listen-only mode. We will begin with remarks by management and then open the conference up to the investment community for questions and answers. I will now turn the conference over to Sara Mykus with SB Financial. Please go ahead.

Good morning, everyone. I would like to remind you that this conference call is being broadcast live over the Internet and will be archived and available on our website at ir.yourstatebank.com. Joining me today are Mark Klein, Chairman, President and CEO; Tony Cosentino, Chief Financial Officer; Ernesto Gaytan, Chief Technology Innovation and Operations Officer; and Jon Gathman, Senior Lending Officer. This call may contain forward-looking statements regarding SB Financial's performance, anticipated plans, operational results, and objectives. Forward-looking statements are based on management's expectations and are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied on our call today. We have identified a number of different factors within the forward-looking statements at the end of our earnings release, which you are encouraged to review. SB Financial undertakes no obligation to update any forward-looking statements except as required by law after the date of this call. In addition to the financial results presented in accordance with GAAP, this call will also contain non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release. I will now turn the call over to Mr. Klein.

Thank you, Sara, and good morning, everyone. Great to have you all with us. Welcome to our second quarter 2020 conference call and webcast. Once again, our comments today, as with prior quarters, supplement our earnings release we filed yesterday. It certainly has been a challenge this past quarter for our company as we've navigated this pandemic. Even as we were able to close over $224 million in residential mortgage loans, processing $83 million in PPP loans that helped save nearly 9,000 local jobs while successfully closing our first acquisition in over 12 years. By all measures, it was a great quarter. Ensuring that all of our customers could have their financial needs met in a safe and efficient manner required the dedication of each of our staff members, and I must say they've responded quite well. Highlights for this quarter include a $1.1 million pretax mortgage servicing rights impairment and $1.2 million in merger-related costs. These include net income of $3.7 million, up $1.1 million or a 39% increase over the prior year quarter. When adjusted for non-GAAP items, net income was $5.5 million, up $2.3 million or 73%. Adjusted return on average assets was a robust 188 basis points, up from the prior year quarter of just 109. Net interest income of $8.9 million was flat to the prior year as our 5% reduction in interest income was offset by a 26% reduction in interest expense. Loan balances for the quarter grew by $71 million, improving our year-over-year growth to over $87 million or just over 10%. This included PPP balances of $83 million and Edon loan balances of $16 million. Excluding these items, year-over-year loan balances were down $12 million. Deposits from the prior year increased by $151 million or 18% year-over-year, again, the Edon balances of $52 million, and retention of PPP funding and business DDAs increased growth beyond traditional core levels. Expenses were up $2.6 million due to higher mortgage commissions and the $1.2 million in Edon merger costs I just mentioned. Mortgage origination volume increased this quarter to $224 million, up over $125 million or 127% year-over-year. Asset quality metrics were elevated from the prior year, although our level of 64 basis points of nonperforming assets remained strong. We set aside $1.3 million in provision in the quarter, about $1 million of which was related to COVID-19 reserves. We continue to assist our clients, as needed, with payment deferrals in the quarter. Although of the 510 clients that had requested forbearance in April, 38% made a full contractual principal and interest payment in July. We remain committed to our 5 key initiatives we've communicated over several quarters: growing and diversifying our revenue stream, organic growth for scale, deeper product set in each household for scope, operational excellence in everything we do for our clients, and lastly, asset quality. Revenue diversity this quarter, mortgage volume and loan sale gains were up from the prior year, 127% on volume and 384% on loan sale gains. Noninterest income increased to $8.6 million from the prior year of $3.7 million, despite a mortgage servicing impairment of $1.1 million. Adjusting for that impact, noninterest income was up from the prior year of $5.3 million or 121%. Noninterest income as a percentage of total revenue increased to 49%, and would have improved to 52% when accounting for the impairment. Our current mortgage pipeline continues to be near capacity, with over 400 loans in process for another $93 million. We are on pace to deliver our biggest production year ever, with total volume now likely to exceed the $600 million mark. Peak Title, as we reported in prior quarters, joined our company in March of '19, and the results for this quarter were reflective of that increased mortgage volume. Abby Waters and her team achieved a new record for transactions and revenue in June. For the quarter, we delivered revenue of $609,000 compared to just $309,000 for the prior quarter. We continue to introduce Peak to our state bank lenders and clients as we expand their presence outside of the Columbus metropolitan market. Our SBA 7(a) production came in at less than $400,000 for the quarter as our efforts were clearly focused on new PPP initiatives. We processed over 670 PPP loans for $83 million in balances to small business owners in all of our markets, with 70% of our commitments to existing clients. Our focus and commitment were to the small business owner, and the detail on our production reflects that commitment. In fact, 97% of the loans were below $350,000, and only 15 of these loans exceeded the $1 million mark. The average balance on our loans was $124,000, with the median level just $42,000. Our intention now is to retain these loans with existing clients, certainly pending loan forgiveness, and to expand our relationship with each of our 216 new commercial clients. The team is ready to serve small businesses again with the expected next phase of the PPP lending program. We had an LPO in the Indianapolis market for just over a year now, and this quarter showed the potential of that market with a focused and motivated leader and staff to serve a new market with residential and consumer lending products. In the quarter, we closed $16 million in volume and have originated $23 million through the first 6 months. We are on pace to deliver our short-term goal of generating $50 million in residential loan volume annually. Wealth management assets under our care rebounded in the quarter, with the overall market improvement as our total assets under management have nearly recovered to the prior year-end level of $500 million or now at $495 million at quarter end. This pandemic has added unique challenges in this business line, but we currently look forward to engaging all of our new PPP clients with potential wealth solutions here in the coming months. Our second key initiative is more scale; loan and asset levels were elevated in the quarter due to the PPP efforts I just mentioned, as well as our clients' deposit levels surging as they focused on personal and business liquidity with discretionary spending levels declining. Most importantly, regarding scale, was our successful closing of the Edon transaction in the quarter. While we have been focused on organic growth to improve financial performance nearly the entire last decade, the opportunity to grow our company via M&A after a few near misses is certainly refreshing. Our conversion team is very engaged as we integrated the Edon acquisition financially in June with operational integration now scheduled for later this year, the last quarter. We believe we are well positioned from a capital and operational standpoint to pursue a new and likely larger transaction here in the near future. We feel our business model and growth potential is an attractive selling point to any new potential partner. Loan growth from the prior year quarter was inflated by PPP and the Edon expansion, as we discussed. But we are starting to see some improvement in our loan pipelines as business activity is improving in our markets. As such, we remain optimistic about our ability to grow loan balances organically once again in the second half of this year. Edon was predominantly an agricultural lender, which will supplement our current ag team with not only more balances but with another seasoned ag lender, Adrian Fritch. Naturally, we are also focused on introducing our full slate of lending and deposit products to these new Edon clients as well. Our deposit base expanded to $991 million, up $151 million or 18%. Included in that growth are $52 million in Edon deposits and our estimate that 75% of the PPP funding remains in our clients' operating accounts. This program and the pandemic environment we've encountered this past quarter have increased the need for us to provide more options by which our clients can access our services and their financial assets everywhere and anytime. To this end, we have become and are becoming more flexible in how we engage with our clients. The electronic aspect of client servicing, engagement, and delivery continues to accelerate, and we are preparing to participate fully. Our third key initiative is for deeper relationships, more scope, and more services per household. This quarter, outside client calling continued to be rechanneled to phone calls and digital communications. Our commitment this quarter was to proactively contact each of our commercial clients and assure them that we were prepared to provide for their liquidity requirements when called upon. This proactive calling effort to 100% of our clients was directly responsible for our successful participation in the PPP lending program and prepared us for the likely next phase of small business lending programs. Notably, with our clients' liquidity needs at the forefront, over $94 million in working capital lines or 63% of $150 million in revolving lines remains available for our clients' commercial operations. Finally, our dynamic referral process continues to be a focus for our company. This quarter, we added over $31 million in new related business from 213 closed referrals, quite an accomplishment that we feel given the distraction and headwinds in the market from this pandemic. Operational excellence is our core theme. We have traditionally had a nearly 6:1 split of residential mortgage originations between external originations and internal refinances. However, 2020 has seen a fairly dramatic shift in volume as this year, we have done 1/3 of our originations from internal refinances, 1/3 from external refinances, and 1/3 in the purchase and construction business. While refinancing internal mortgages is necessary, the ongoing longer-term relationship with local realtors remains a critical ingredient to the business line and to the purchase market. This quarter, the level of internal refinance has elevated our amortization and caused significant impairment to our mortgage servicing rights. We did see a gradual shift to purchase business late in the quarter, and our pipeline is much more weighted to purchase activity away from refinance today. Capacity optimization continues to be a key driver in both of our processing centers, and we intend to seek opportunities to improve not only front-end but back-end capacity in the second half of 2020. We have increased our servicing portfolio now to over 8,400 loans with principal balances of $1.26 billion. Households were up 9%, balances up 13% over the prior year quarter. Expense levels for the quarter were up from the prior year. But when adjusted for the additional $125 million in mortgage volume commission expense and the Edon merger cost I just mentioned, growth drops from 28% to just 6%. We continue to limit spending in our offices and among our staff with the cost containment measures we put in place in the first quarter to shore up declining net interest margin. Included were a hiring freeze, limited travel expense, and reduced employee gatherings, to name a few. The fifth and final initiative is asset quality. Client forbearance requests were prevalent at the beginning of the quarter. At its peak, we had 510 loans with $195 million on payment deferral. As a majority of our forbearance approvals were for 3 months, we are evaluating the requests of a smaller number of clients currently requesting extensions for a second 3-month period. However, as I stated earlier, we have had a number of clients returning to full payment status here in July. Specifically, 86 of 200 commercial loans have returned to contractual terms or 43%, 31 of 62 consumer loans or 50%, and 77 of our 248 full mortgage loans or 31% have all returned to contractual payment terms. We had provision expense for the quarter of $1.3 million and now for the year, $1.9 million. Our loan loss reserve is now above $10 million, and the reserve ratio was up 9 basis points from the prior year to 1.1%. If we adjust for the PPP balances, this reserve would increase to 1.22%. Our coverage of nonperforming loans now stands at 136% and is still above the median of our peer group. We remain optimistic that our past conservative loan underwriting, which has led to median peer level loan growth the last few years, will pay dividends as this pandemic dissipates. That said, we do anticipate some stress in our loan portfolio in the second half of the year, as liquidity and business activity levels tighten a bit. In the quarter, we set aside $1 million in reserve for COVID-19 related credit losses, and now for the year, $1.2 million. We expect to identify additional provision expense in the coming quarters, but we also expect to offset this with fees from the PPP loans I mentioned earlier.

Thanks, Mark, and good morning, everyone. For the quarter, we had GAAP net income of $3.7 million or $0.47 per diluted earnings per share. As noted by Mark, our earnings were impacted by a $1.1 million impairment on our mortgage servicing rights, and $1.2 million in Edon merger costs. Absent those items, net income would have been $5.5 million, up $2.3 million, which is a 73% increase. Highlights for the quarter include: total operating revenue, up 39.6% from the prior year and up 48.3% when we adjust for the OMSR impairment; operating expense, up 28% from the prior year, but up 14.4% when we adjust for the merger costs; loan sales delivered gains of $8.2 million from mortgage, small business, and agriculture, up $6.3 million from the prior year; and margin revenue, as we indicated, was flat. As we break down the second quarter income statement, starting with our margin, the interest income was flat from the prior year but up 3.8% to the linked quarter. Our average loan yield for the quarter of 4.46% decreased by 64 basis points from the prior year. Overall earning asset yield was down 93 basis points to the prior year. Clearly, the PPP loans depressed our loan yield overall, and the higher levels of cash balances were not as expected. As our clients' PPP fundings are utilized in the coming quarters, cash levels will decrease, and we are starting to see some improvement in our loan pipelines. On the funding side, as expected, we reduced the cost of our interest-bearing liabilities from the prior year. For the quarter, the rate on our interest-bearing liabilities was 0.89%, down from the prior year by 39 basis points and down from the linked quarter by 23 basis points. Net interest margin for the quarter at 3.32% was down 56 basis points from the prior year as the impact of PPP, excess cash, and Edon were headwinds to our margin. Total interest expense costs are down by 26% from the prior year and down 18% from the linked quarter. We continue to look for opportunities to improve margin in the coming quarters with an expanding loan pipeline, further declines in funding costs and higher loan origination fees. Total noninterest income of $8.6 million was up $4.9 million or 133% from the prior year, reflecting the higher mortgage origination volume. We did have a $1.1 million servicing rights impairment in the quarter. When we adjust for that impairment, noninterest income would have been up $5.3 million or 121%. In the SBA arena, our originations were down from the prior year with a volume of $0.1 million compared to $4.1 million in the prior year quarter. Our title agency had a very strong quarter, closing a record number of transactions and delivering revenue of $0.6 million, which was double the revenue in the second quarter of 2019. Second quarter mortgage projections of production and yields eclipsed all records for our company. We anticipate that mortgage volume in the third quarter and the second half of 2020 will remain strong. The shift to refinance volume, as Mark indicated, continued in the second quarter. Purchase volume did, however, pick up late in the quarter, and our current pipeline has a higher share of purchase volume. Total gains came in at $8.1 million, which was 4.0% on our sold volume of $205 million. Our servicing portfolio of $1.26 billion provided revenues for the quarter of $783,000 and is on pace to deliver $3.2 million in total revenue in 2020. Not surprisingly, the market value of our mortgage servicing rights declined again this past quarter, as our calculated fair value of 65 basis points was down 33 and 9 basis points from the prior year and linked quarters, respectively, and did result, as we said, in that $1.1 million impairment. At June 30, 2020, our mortgage servicing rights were $8.2 million, which is down 20% from the second quarter of 2019 and down 9% from the linked quarter. Our total impairment on the balance sheet now remaining is $4.6 million. Total operating expenses this quarter were $11.7 million, which is up $2.6 million or 28% from the prior year and up 24% compared to the linked quarter. A higher level of mortgage volume drove compensation higher. And as mentioned earlier, we had $1.2 million in merger costs for Edon. For the year, operating expenses are up $3.3 million or 19%. However, if we normalize for a similar mortgage volume, the Peak Title acquisition and merger costs, the year-to-date growth is $1.3 million or 7.6%. If we adjust our year-to-date operating leverage for the OMSR impairment and the Edon merger costs, operating leverage goes from 1.0 on a GAAP basis to 2.1 on an adjusted basis. Now as we turn to the balance sheet, loan outstandings at June 30, 2020, stood at $901.5 million, which was 75% of the total assets of the company. We had loan growth of $87 million and asset growth of $174 million from the prior year and were up $71 million and $115 million, respectively, from the linked quarter. PPP loans of $83 million and Edon loans of $16 million have inflated our year-over-year growth levels. Adjusting for these two factors, loan balances declined from the prior year by $12.2 million, as our loan pipelines contracted due to the pandemic. Deposit levels are up $151 million or 18% from the prior year, as clients are maintaining higher levels of liquidity. A large percentage of our dispersed PPP loans have been retained in our clients' operating accounts, and the Edon acquisition added $52.3 million in deposits in the quarter. Looking at our capital position, we finished the quarter at $137.9 million in equity, which is up $3.9 million or 2.9% from June 30, 2019. Our equity-to-asset ratio stands at 11.5% or 12.3% when we exclude the PPP balances. On a per share basis, tangible book is up $0.36 per share from the second quarter of 2019. We've been able to buy back a number of shares below book value this year. We recently announced a new buyback authorization of 500,000 shares. Regarding asset quality, total nonperforming assets of $7.7 million or 64 basis points are up $3.3 million from the prior year and up $1 million from the linked quarter. Included in our numbers are $0.8 million in accrued restructured credits. These restructured loans elevate our nonperforming levels by 7 basis points. Absent these accrued restructured credits, our total nonperforming asset ratio would be reduced to 57 basis points. We continue to monitor the at-risk segments of our loan portfolio. Thus far, those clients have remained stable since March 31 of this year. Provision expense for the quarter was $1.3 million, up from both the prior year and the linked quarter. Our absolute level of loan loss allowance of $10 million is up from the prior year by 20.6%, and our allowance to total loans percentage has increased from 1.02% at June 30, 2019, to 1.11%, currently. So in summary, year-to-date net income on a GAAP basis of $4.3 million is down $0.5 million or 11% from the prior year. However, adjusted year-to-date net income of $7.9 million is up $2 million or 33%. On a pretax pre-provision comparison, year-to-date GAAP earnings are up $1 million or 16.3%. When adjusted for OMSR and merger costs, these pretax earnings are up $4.1 million or 55%. I'll now turn the call back over to Mark.

Thank you, Tony. I want to conclude my remarks today with a clear call out of appreciation to all of our employees and clients that have endured a fairly challenging past 3 months. We have, for the most part, opened all of our offices currently but certainly under different conditions in all of our varied markets. The efforts of our staff to aid small businesses and home buyers, as we mentioned, the new clients at Edon State Bank in the quarter were both noticed and well appreciated. I'll now turn the call back over to Sara for questions.

Thank you. And while we're waiting for questions, I would like to remind you that today's call will be accessible on our website at ir.yourstatebank.com. We are now ready for our first question.

The first question is from Brian Martin of Janney Montgomery.

Nice quarter. Yes. So Mark, I appreciate the disclosure, the added color this quarter from you in your prepared remarks on the modifications. Just kind of curious with the positive migration you've seen so far, where do the total deferrals stand today in July? If you can just give a little color on where that is? Or maybe I just couldn't back into the numbers, you were giving the details there.

Yes. I know I threw a lot of numbers around there, Brian. We have a number of loans that are in deferral. As I mentioned, whether it's consumer, commercial, or mortgage. Mortgage would all be Freddie Fannie loans, which again, have begun to return to full principal and interest payments. Jon Gathman is with us here this morning. I know he's been deep into the forbearance world, particularly on commercial and the consumer. As I mentioned, Freddie Fannie, we're following generally the spirit of the nationwide program offered through Freddie Fannie. But if I might, I'd like to ask Jon to give us a little bit of color on the forbearance positioning. Jon?

Yes. I would just add that we're currently entering a second round of forbearance processing. The initial program we adopted offered three months, which just expired in July. We're in the early stages of this second round, currently handling a small number of commercial loans under Freddie and Fannie—perhaps a half dozen. They are eligible for up to twelve months, but we're offering it in three-month increments, following their guidelines. While we are beginning to see more requests for this second round, the numbers are significantly smaller this time. Our updated approach is based on a needs analysis, as opposed to the first round, which was more proactive based on set thresholds. Now, customers must provide financial documents and other records for us to assess on an individual loan basis.

Does that answer work, Brian?

Okay. Yes. Jon, what is the current status of the deferrals? As of July, is there any difference compared to June 30, considering what you've observed so far? Or are you still in the process of evaluating that?

Well, in the first round, there were no additional forbearances in the month of July. So those first round numbers that Mark gave you were accurate as of today. The second round, we're right in the midst of. Again, I don't have the exact number, but totally 20, 30 maybe that are in process as we speak.

I understand. Are there any patterns among the requests for second deferrals? It's too small a number to really analyze at this point.

Yes, I think that's accurate. If there's any pattern emerging, it's certainly in the retail sector and the commercial real estate sector. We're starting to see some of those second forbearance requests come in. We had a few just this week. But again, it's very early and very small numbers.

And Brian, just one follow-up comment. As I mentioned, we've certainly seen a large increase in those DDA balances because, generally speaking, when you add forbearances in addition to PPP and the decline in discretionary spending on the business side, liquidity has improved dramatically, and we've noticed that in our balances.

And I'm sorry, this is Jon again. I would just point out, I guess the other sector, now that I think about it, would be maybe hotels. As you might imagine, we have a couple of those that have requested a second forbearance.

Okay.

And that number, Brian, has stayed consistent at that $35 million level that we disclosed at the end of Q1. We've not had any additional or any downgrades of that portfolio.

Portfolio. Okay. Yes. Because remind me what the at-risk exposure is? I guess, if you guys kind of, in your mind, as you kind of segregate the pieces that are more at-risk today, where do those stand today?

Yes, the at-risk number is a manually adjusted figure. We focus on around 109 loans, examining those in specific industries and refining our assessment from there. Our internal analysis has determined that this number is $71.2 million, which represents 6.71% of our portfolio.

Okay. What are the biggest components of that? If you could share from a sector standpoint, would it be hotels or restaurants?

Yes. As Tony mentioned, it's hotels, which are presently just right around $33 million.

Okay. And any other sectors, I guess, you'd call out, whether it be restaurants or whatnot in there, the retail piece as you break them out?

Yes. We don't have that number. We don't have our commercial real estate portfolio. We're starting to see some stress, as I mentioned, on retail and even office space. So that's not in that number. But inside that $71 million, I don't think there's anything additional to hotels. Our restaurant portfolio, while it is concerning, is small and primarily backed by SBA. So our exposure there is minimal. Our biggest exposure, there is 1 in the net in that hotel sector just because of the pure volume and pure number of that.

Thank you for the information. I would like to hear your thoughts on the mortgage market, particularly regarding your outlook for the third quarter and the second half of the year. Additionally, could you provide some insights on the gain on sale margin, which has seen a significant increase? It would be helpful to understand your perspective as we move into the latter part of the year.

Yes, we've been dedicated to this business line for about 12 to 13 years. Columbus is performing exceptionally well and is expected to handle over 50 percent of our volume. We are gradually increasing our staff, focusing more on the middle of the value chain, such as underwriters and processors, as well as on the back end to ensure quality, as we need our portfolio to be top-notch. We are optimistic about this business line, and Tony and Matt Booms have done a remarkable job hedging the volume. At one point, we were comfortable with around $20 million in fixed-rate mortgage volume but decided not to proceed deeper due to the associated risks. The hedging strategy has enabled us to expand our pipeline effectively while balancing the risk involved. Our Encompass platform is widely accessible for all our producers, whether they're working on-site or remotely, and Ernesto and his team have excelled in this. We've recently communicated to our Board about enhancing the management of this business line to provide clearer guidance. David Homoelle will be taking on additional responsibilities for approving mortgages and exceptions on our books. We're refining our approach to achieve our goal of $1 billion in annual mortgage originations. Given the flat yield curve with no anticipated increases in the near term, we remain confident in this business line, which has strengthened our operations. Until the yield curve changes, we are committed to it and will continue to build deeper relationships in all markets. We're pleased to see Brian Indy contributing towards the $50 million we projected during our initial discussions in Indianapolis. Overall, we're enthusiastic and plan to keep expanding this business line.

Yes, sure, Brian. We went into the quarter kind of anticipating a $150 million type quarter in terms of volume, and that's what it was looking like as we were getting there to the quarter. We weren't sure what was going to happen with the pandemic. I think early on, it started to really accelerate. Pricing became very profitable as the yield curve kind of moved down, the bifurcation of pricing between purchase and refinance. The general market was fine with maintaining a little extra yield because we weren't sure what was going to happen in the future on defaults, et cetera. So that for the most part added to the ability to really expand the spread on each one we sold. I think hedging, we did some nice things there, and we were in place to do some nice things to take care of our pipeline and portfolio, which allowed, really, our yields to be really spectacular relative to anything we've seen for some time. The combination of $224 million of volume and yields probably 140% higher than we traditionally have led to the quarter that we had.

Yes. And I guess in thinking going forward, Tony, I mean, those yields that you're, I guess, anticipating, let's say, in the back half of the year, do you expect that to trend a little lower in the near term or kind of hold that and then trend down into '21? But just more big picture?

Yes. I think knock on wood, the yield picture is going to stay where it is, probably for the rest of 2020 because I think pricing and the yield curve is going to stay right where it is. So we're not going to have as much volatility. Our hedge is going to perform a little bit better. As Mark has said before, we really have to applaud our MLOs who deliver to us great clients that we know are going to close. So we were able to hedge at a much higher percentage, which enables us to improve yields on the back end. It’s kind of worked from front-end to back-end. I think as we look at volume, we would expect probably $180 million to $200 million in Q3 if things continue the way they are. We’ll see what happens in Q4 as seasonality comes into play. But we feel very good about $600 million for the year.

And Brian, just one comment. We all know it's all about pull-through, and that's exactly what Tony just talked about, which is the quality of MLOs we have that when we take an application, we have a high probability it's going to make it to the other end. When you get into 80% and 90%, you can obviously make a good forecast on what it is we can do on the hedging side. So kudos to Tony and Matt and all that group for not only accepting all that volume but improving the margins on the way out. So it's all good.

Yes, I appreciate it. Can we take a moment to discuss the margin? It seems that cash levels and liquidity might decrease slightly. However, if loan growth continues, that sounds positive, along with some progress in reducing funding costs. How are you viewing the margin directionally? Additionally, Tony, what was the impact of PPP on the margin in Q2? As you consider the margin excluding PPP moving forward, taking into account what was mentioned on the call, how are you assessing that core aspect?

Sure. As we've talked about, Brian, we came into the quarter with a pretty robust pipeline, which made the Edon acquisition just perfect for us because it provided extraordinarily low funding costs for us to fund that pipeline. Obviously, with everything going on in the marketplace, the pipeline kind of went into a stall pattern and the bond markets went away. So we didn't have a ready use really of that cash to deploy. We think loan pipelines are coming back and will come back. I think Jon nods his head that it's starting to improve a little bit. We'll see some maneuver here in Q3 as cash starts to move a little bit out of the bank and do some things. For PPP, we took $300,000 on the fee side on amortization in Q2. Our interest income for the 3 months on the portfolio was about $160,000, so just a shade under $500,000 between the two, which leaves us $2.7 million of unrealized fees. Going forward, we've talked about the utilization of that, obviously, keeping in mind higher provision levels for the second half of the year, which is kind of our intention right now because we think mortgage is going to be able to provide significant income levels for us for the second half of the year, and we won't need to rely on the PPP funds for tangible book value growth necessarily.

Okay. That's helpful. So you're expecting the total fees from the PPP to be about $3 million?

Yes, $3.1 million.

Okay, perfect. And regarding the forgiveness you anticipate, given the small loan sizes, it seems reasonable to expect a high level of forgiveness. Is that accurate? Additionally, what is your current thinking on the timing? Are you expecting this to happen in the fourth quarter or the first quarter? Or is it expected to play out differently?

We currently anticipate that this will take place in the fourth quarter. There has been considerable discussion about minimal forgiveness levels ranging from $150,000 to $1 million, which would cover approximately 86% of our volume at the lower end and 97% at the higher end based on the number of loans. We believe that the forgiveness, along with payments and the SBA covering the interest due, will conclude in the fourth quarter. We expect the SBA will provide guidance during this period. They recently launched their forgiveness system last week, and we expect updates soon.

Portal.

Online system, which is a portal, yes, thank you, which is different than the regular 7a portal. Yes, we fully expect a lot of that to happen here in the fourth quarter of this year.

Okay, that's helpful. Tony, you mentioned the dollar amount in relation to the impact of the PPP for the quarter, which allows me to calculate its basis point effect. However, regarding reserve building, you indicated there might be further reserve accumulation expected in the latter half of the year due to economic uncertainty. Is that correct?

Yes, we've allocated $1.9 million over the first six months, with $650,000 in charge-offs and minimal loan growth. This brings us to the $1.2 million set aside for COVID. Looking ahead to the second half of the year, we expect provision levels to remain similar to the first half. While we acknowledge the potential for credit card and consumer lending charge-offs, we haven't seen significant impacts from COVID on the consumer side so far. The focus is more on the commercial side, as Jon mentioned, and we anticipate further reserves of about $1.5 million to $2 million in the latter half of the year, balanced by an expected $2.5 million to $3 million in additional PPP fees to support that.

Got you. Okay. No, that's helpful, Tony. And how about just the loan growth? It sounds like it's slowly picking back up. So I guess, from that standpoint, the pipelines are building today. So you'd expect some net growth in the second half of the year, kind of excluding what goes down with PPP? That's the...

I believe it's reasonable to say, as mentioned by Mark and Tony, that our pipelines are growing, and we're beginning to see a return to normalcy among borrowers. However, we will face some pressure from a few large clients who are selling. This situation will create some opposing pressure because I think these customers have concluded that now is a good time to sell, wanting to avoid any potential disruptions from COVID, despite being strong clients. It's not that we are losing these clients to competitors; rather, it's just a few businesses that have decided to sell. Nonetheless, the pipelines on the other side have developed well, and we have some positive developments ahead. I believe in the third quarter, we can expect one factor to potentially offset the other.

Yes, and Brian, one comment from where I sit. We know we're going to have to work harder to find the quality of the deals that we found before, particularly in this environment. But I think it's a testament, generally, to the quality of the clients that we have because many of those clients that we have, fortunately, have great liquidity and good balance sheets and are still expanding and doing things. And so we're happy to participate with them. Again, I think it's a function of our median level growth the last 5 or 7 years. We could have grown a lot faster, but $75 million a year was a nice number, and that's one area that we don't mind being a median performer at. I'm hopeful that our underwriting will pay dividends here as we fight our way through this next couple of quarters.

Yes. Given the discussion about credit, Mark, you and your team have done an excellent job. From an exposure perspective, it's relatively minimal at the $70 million level. Outside of that, where are you seeing stress? Has there been any change in risk ratings or in the levels of criticized and classified credits as you've reviewed some of these accounts in the current economic climate? Are the criticized and classified levels for the second quarter comparable? Additionally, what concerns or areas are you focusing on outside of the $71 million exposure?

Criticized and classified in the second quarter, we did see our classifieds increase, but that was a non-COVID related situation with a large borrower. We're working through going forward; we have not downgraded anything related to COVID specifically. We'll be looking at that as these forbearances roll off in the third and fourth quarter, and we'll be taking a harder look at some of those. That said, the government, as you know, Brian, flooded the economy with so much money. Many of those borrowers have continued to make payments and met kind of contractual obligations and/or under forbearance. We're working through all of that as we speak. Yes, we intend to reassess those. Your 1 question, I think I alluded to earlier, is there anything outside of that at-risk industry list that we've put together, again, manually adjusted? I remain concerned about two, in particular, sections of our commercial real estate portfolio, retail, which we don't have a huge exposure to, but also office, a lot of articles about changes in the workforce dynamic and how that will affect office space and potentially affect prices. But again, we haven't seen any softening in that per se at the moment nor have we downgraded anything specifically related to that COVID or coronavirus.

Got you. Okay. And Tony, you mentioned that capital remains very strong. What is your perspective on your willingness to continue repurchasing shares? Do you expect to remain active or take an opportunistic approach in that regard?

Yes, I believe both of those words are perfect for us. We continue to view our stock trading slightly above tangible book value as an excellent value, and in terms of execution, it represents the best use of our capital. We are mindful of our acquisitive nature and feel that we have some opportunities that will present themselves, and we are currently in discussions regarding those. I would say we are balancing both aspects.

Okay. Please proceed, Mark.

Brian, just one follow-up question for Tony. I know Tony and I have discussed this at great length. But in the last 5 years, I think we've pulled into the bottom line about $50 million. We've made somewhat of a conscious effort to attempt to drive some of that back out to our investors in the form of buybacks and dividends. I think, Tony, is probably half of that has gone back out in terms of those two general programs.

Yes. About $20 million between dividends and buybacks, so about 40% to 45% of that $50 million. We really have raised equity capital for the future and supplementing what was when Mark and I first got here, a fairly weak tangible capital scenario that we have improved dramatically since that time.

So an increasing tangible book value along the way. So...

Yes. To your point, Tony, regarding M&A, are there current opportunities, or is it on hold for a while as you evaluate your own portfolio? How would you describe the M&A opportunities you are seeing at this time?

Well, Brian, we've talked at great length. We think there's opportunities out there abound now after we've had 3 months of this COVID-19 discussion. We've worked hard to get our tangible book value up, we've worked hard to improve our capital position, and we've worked hard to grow the old-fashioned way, which is one client at a time on our organic growth. But as I mentioned, now we can jump into the M&A market and accelerate organic growth with some prudent M&A where we don't overpay, we know where we can be, and we want to be in the 3 or 3.5-year payback arena. If we got a stronger currency, we can certainly do a lot more and be a lot more. We know that there's opportunistic opportunities out there, and we have to be a bit aggressive if you will to identify those opportunities because we do feel we have a model that works, one that's decentralized, that can provide a little more inertia outside of organic growth. They're out there, and we're going to continue to pursue opportunities to improve our reach and improve our performance by gathering some more scale.

There are no other questions at this time. This concludes the question-and-answer session. I would like to turn the conference back over to Mark Klein for closing remarks.

Yes. Thank you. Once again, thanks, everyone, for joining us. We're trying to take care of all of our communities and remain safe as we attempt to improve performance, and we look forward to the next quarter and maybe an improved pandemic environment as well as GDP and financial markets as we report our third quarter earnings to you in October. So thanks again for joining us, and have a great weekend and quarter. Thank you.

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