Earnings Call Transcript - WAL Q2 2020

Operator, Operator

Good day, everyone. Welcome to the earnings call for Western Alliance Bancorporation for the Second Quarter 2020. Our speakers today are Ken Vecchione, President and Chief Executive Officer; and Dale Gibbons, Chief Financial Officer. You may also view the presentation today via webcast through the Company’s website at www.westernalliancebancorporation.com. The call will be recorded and made available for replay after 2:00 p.m. Eastern, July 17, 2020, through August 17, 2020, at 9 a.m. Eastern by dialing 1-877-344-7529 using the passcode 10146019. The discussion during this call may contain forward-looking statements that relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. The forward-looking statements contained herein reflect our current views about future events and financial performance and are subject to risks, uncertainties, assumptions and changes in circumstances that may cause our actual results to differ significantly from historical results and those expressed in any forward-looking statements. Factors that could cause actual results to differ materially from historical or expected results are included in this presentation, the related earnings release and our filings with the Securities and Exchange Commission. Except as required by law, the Company does not undertake any obligation to update any forward-looking statements. Now for the opening remarks, I would like to now turn the call over to Ken Vecchione. Please go ahead.

Ken Vecchione, President and Chief Executive Officer

Good afternoon, and welcome to Western Alliance’s second quarter earnings call. Joining me on the call today are Dale Gibbons and Tim Bruckner, our Chief Financial Officer and Chief Credit Officer. I will first provide an overview of our quarterly results and how we are managing the business in this current economic environment. And then, Dale will walk you through the Bank’s financial performance. Afterwards, we will open the line to take your questions. I’d like to focus on three trends that were present this quarter and will continue throughout the year: PPNR strength; credit provisioning expense; and balance sheet growth. Combined, these trends will support earnings and capital growth and dividend distribution throughout 2020 and 2021. Starting with our second quarter results. Western Alliance generated net income of $93.3 million and EPS of $0.93, which was up 12% over the previous quarter. Tangible book value per share of $27.84 was an increase of 4.2% over the previous quarter and 12.9% year-over-year. Driving these results was record operating pre-provision net revenue of $194.7 million, up 27.7% year-over-year and 19.1% quarter-over-quarter, with operating PPNR ROA growth of 18 basis points to 2.56%, which benefited from recognition of $13.9 million of payment protection program net fees. These results demonstrate that the long-term earnings power of Western Alliance core business remains strong under the current economic and market volatility and will support significant ongoing capital accumulation, provide financial flexibility to fund balance sheet growth and accommodate changes to the allowance for credit losses for revisions to the economic outlook. In the quarter, we recorded provision for credit losses of $92 million versus $51.2 million in Q1, which was primarily attributable to changes in macroeconomic forecast assumptions and net charge-offs of $5.5 million. Dale will go into more detail in a bit on the specific drivers of our provisions. But, our total loan ACL to funded loan ratio now stands at 1.39% or $347 million. Continuing our strong balance sheet momentum from 2019, loans increased $1.9 billion this quarter to $25 billion and deposits grew $2.7 billion to $27.5 million. Without the inclusion of PPP, loans grew a more modest $117 million and deposits demonstrated strong growth of approximately $1.6 billion. The lower adjusted loan growth reflects muted demand for which we held back on marketing activities and directed our focus to low-loss, high-quality loan segments in addition to assisting our clients with their PPP applications. We are encouraged by our pipeline and opportunity to continue to grow in low-risk asset classes. Throughout the crisis, we have continued to attract new, high-quality relationships to our Bank at pricing and terms that would not have been available to us in other circumstances. Furthermore, this quarter is positive operating leverage supported our expanding PPNR as our strong efficiency ratio improved sharply to 36.3% compared to prior year. Becoming more efficient during this economic uncertainty provides the incremental flexibility to maintain PPNR. Looking ahead, we will continue to invest in new product offerings and infrastructure to maintain operational efficiency, but Q2 levels are temporary and will eventually rise back to a sustainable level in the low-40s. However, our branch-light business model and our National Business Lines strategy continue to give us a competitive advantage. Finally, supported by our healthy PPNR generation, Western Alliance remains well-capitalized with the CET1 ratio of 10.2%, which puts us in position of strength, uniquely prepared to address what’s ahead in this uncertain environment. Now, let’s take a moment to provide an update on Western Alliance’s response to the COVID pandemic. First and foremost, I want to acknowledge the health and safety of our people and clients of our utmost concern. We continue to follow CDC protocol and state-by-state return to work guidance as our organization returns to the office. Our business continuity plans have been working as anticipated. And I want to thank all of our people who continue to go above the call of duty to get the job done and serve our clients in this unique environment. As I initially described on our Q1 earnings call, WAL’s unique credit risk management strategy is focused on establishing individual borrower level strategies and direct customer dialogue to develop long-term financial plans. Our approach to payment deferral requests is to look for resourceful ways to partner with our clients along with assessing their willingness and capacity to support their business interests. We asked our clients to work hand in hand with us, whereby all clients contribute liquidity, capital or equity as an integral component to modify payment plans. Our approach collectively uses the resources of the borrowers, governments and Bank’s balance sheet to develop solutions that extend beyond the six-month window provided for the CARES Act. Since April 1, WAL has funded $1.9 billion PPP loans, which provided an expedient liquidity to over 4,700 clients and benefitted more than 150,000 employees. At quarter end, $2.9 billion or 11.5% of loans have been modified with the bulk of these loans receiving principal and interest deferrals. Excluding the Hotel Franchise Finance segment, which we executed a unique sector deferral strategy, the Bank-wide deferral rate is approximately 5%. The vast majority of our borrowers elect to utilize their own resources or PPP funds to preserve their business through the COVID crisis. I will provide an update on the portfolios most impacted by COVID later on, but I do want to highlight in our Hotel Franchise Finance portfolio, our sophisticated hotel sponsors continue to see value in and support their properties with 92% of deferrals achieved by posting additional liquidity as component of future payments deferrals. Our differentiated deferral strategy provides our customers the runway to resolve their liquidity issues and allow the appropriate time to recover. Unlike the cookie-cutter big bank approach, we established the expectation that the burden of responsibility of solving the long-term cash flow problems remains with our client base. In our gaming book, all borrowers continue to make interest payments as 90-day principal-only deferrals were approved for 37% of the portfolio. Today, 95% of our clients are open for business and are experiencing a strong rebound of demand. These facts and the daily conversations with our people and clients help me feel confident that our credit mitigation strategy and early approach to proactively managing our risk segments is bearing fruit and puts Western Alliance in a strong position to come out on the other side of the pandemic in better shape than our peers. Dale will now take you through our financial performance.

Dale Gibbons, Chief Financial Officer

Thanks, Ken. Over the last three months, Western Alliance generated net income of $93.3 million or $0.93 per share. As mentioned, net income was impacted by elevated provision expense for credit losses, driven by the adoption of CECL in Q1, and changes in the economic outlook during the quarter. Net interest income increased $29.4 million, primarily as a result of loan growth and lower rates and liabilities as interest expense was cut in half. Operating non-interest income fell $5.2 million to $11.1 million from the prior quarter as lower levels of financial activity generated fewer fees. We also benefited from several non-operating items during the period, including a recovery of approximately 40% or $4.4 million of the mark-to-market loss on preferred stock holdings we recognized in Q1. Additionally, bank owned life insurance was restructured, resulting in an increase of $5.6 million as we surrendered and reinvested lower-yielding policies. In addition to this gain, this should moderately increase BOLI revenue prospectively. Finally, non-interest expense declined $5.7 million, primarily from a decrease in deferred compensation expense of $3.3 million related to PPP loan originations, plus a 52% decrease in deposit costs and a 64% decline in business development and travel expenses. Strong ongoing balance sheet momentum, coupled with diligent expense management drove operating pre-provision net revenue of $194.7 million, which was up 27.7% year-over-year. We believe it’s the most relevant metric to evaluate the ongoing earnings power of the bank. Our strong PPNR covered an 80% increase in provision costs from Q1 to $92 million, while driving EPS, up 12% to $0.93 on a linked quarter basis. Turning now to our interest drivers. Investment yields increased 4 basis points from the prior quarter to 3.02%. However, the overall quarterly portfolio yield decreased by 32 basis points from the prior year, due to the lower rate environment. Loan yields decreased 45 basis points, following declines across most loan types, mainly driven by the 83 basis-point reduction in one-month LIBOR during the quarter. Yield reductions were partly offset by an average yield on our PPP loans of 5.02%. Prospectively, we expect loan yields to trend toward the end of quarter spot rate shown of 4.66%. Interest-bearing deposit costs fell by 50 basis points in Q2 to 40 basis points as this quarter received a full benefit of our proactive steps taken to reduce deposit rates immediately after the FOMC cut rates twice in March. The spot rate of total deposits at quarter end was 20 basis points. Total funding costs declined by 34 basis points when all of the Company’s funding sources are considered, including non-interest-bearing deposits and borrowings. The spot rate on total funding costs of 31 basis points is higher than the quarterly average, due to the issuance of subordinated debt mid-quarter at 5.25%. We expect funding costs to have stabilized at these levels as no further debt actions are anticipated. Demonstrating the flexibility of our business model, despite a transition to a substantially lower rate environment during the quarter, net interest income rose 10.9% or $29 million during Q2 to $298.4 million, up 17% year-over-year. Our origination of PPP loans, coupled with strong balance sheet growth and immediate steps taken to reduce the cost of interest bearing deposits counteracted the decline in prime and LIBOR. PPP lending supported our net interest margin during Q2 as SBA fees were recognized, resulting in a loan yield of 5.02% in this sector. We estimate most of PPP loans will be forgiven within eight months from origination. Of the $43 million in PPP loan fees we received from the SBA net of origination costs, one-third or $13.9 million was recognized in the second quarter. Net interest margin contracted 3 basis points to 4.19% during the quarter, as our earning asset yield fell 34 basis points, but was offset by an equal improvement in funding costs. Our outsize deposit growth and mounting cash reserves will continue to place downward pressure on the NIM until excess liquidity can be deployed, which we expect will take two to three quarters. With regards to our asset sensitivity, our rate risk profile has declined notably over the last year, and we are now asymmetrically positioned to benefit from any future rate increases as 78% of our loan portfolio is behaving as a fixed rate since floors on variable loans have largely been triggered. Our estimated net change of net interest income in a 100 basis-point parallel shock higher is 4.2% over the next year, and we now project zero net interest income at risk if rates move lower. Turning now to operating efficiency. On a linked-quarter basis, our efficiency ratio improved 550 basis points to 36.3%, which continues to demonstrate our industry-leading operating leverage. As mentioned earlier, the noninterest expense improvement is related to an increase in deferred compensation expense of $3.3 million on related PPP loan originations, plus a 52% reduction in deposit costs and a 64% decrease in development and travel costs. Normalizing for PPP net loan fees and interest, the efficiency ratio for Q2 would have been 38.4%. Additionally, our branch-light model has given us flexibility to identify two locations that we are transitioning from full service offices to loan production facilities. Our core underlying earning power remains strong as pre-provision net revenue ROA increased 18 basis points from the prior quarter to 2.56% and return on assets was flat at 1.22%. While we expect the 2.56% is a high watermark as elevated liquidity will hold down the margin, we believe we will continue to maintain industry-leading performance. This provides significant flexibility to fund ongoing balance sheet growth, capital management actions or any credit demands. Our balance sheet momentum continued during the quarter as loans increased $1.9 billion to $25 billion and this up deposit growth of $2.7 billion brought our deposit balances to $27.5 billion at quarter-end. The loan to deposit ratio fell to 90.9% from 93.3% in Q1 as our strong liquidity position continues to provide us with balance sheet capacity to meet all funding needs. Our cash position increased to $1.5 billion as deposit growth continues to outpace credit expansion. While this impairs the margin near-term, we believe that provides us with inventory for good credit growth as demand resumes. Of note, during the quarter, we issued $225 million of bank-level subordinated debt to ensure ample capacity to support our growth trajectory by bolstering our total capital ratio. Finally, tangible book value per share increased $1.11 over the prior quarter to $27.84, an increase of $3.19 or 13% over the prior year. The vast majority of the $1.9 billion in loan growth was driven by increases in C&I loans of $1.6 billion, residential loans of $154 million and construction loans of $138 million. Residential and consumer loans now comprise 9.8% of our loan portfolio, while our construction loan concentration continues to trend downward and is now at 8.8% of total loans. Excluding PPP loans, loan growth was $117 million, which was affected by line pay downs from draws during Q1 and offset by growth in residential and construction. Highlighting our continued focus on growth in low risk assets, Tech & Innovation loans were flat in total, while within the category, capital call and subscription lines grew $35 million. Mortgage warehouse loans grew $325 million and residential mortgages grew $165 million. Corporate finance loans decreased $233 million, compared to the increase we saw in Q1 as borrowers repaid their line draws, reducing utilization rates down from 38% to 17%. And our loan growth was fully funded by deposit growth. We continue to believe our ability to profitably grow deposits is both the key differentiator and the core value driver to our firm’s long-term value creation. Notably, year-to-date deposit growth of $6.1 billion is higher than the annual deposit growth of the Company in any previous calendar year. Deposits grew $2.7 billion or 10.9% in the second quarter, driven by increases in non-interest-bearing DDAs of $2.3 billion, which now comprise over 44% of our deposit base. PPP loan-related deposits grew $1.1 billion, and savings and money market accounts were up $845 million. HOAs contributed to total deposit growth by adding $136 million, and Tech & Innovation increased $262 million as capital raising activity during the quarter was active. Excluding PPP-related deposits, growth would have been $1.6 billion or 6.5%. Regarding asset quality, special mention loans increased $292 million and non-performing loans rose $53 million during the quarter. One half of the increase in SM loans are from the hotel portfolio. Generally consistent with our previously discussed Tech & Innovation rating guidelines, these loans were downgraded as we do not have clear line of sight to more than six months of remaining operating liquidity. These borrowers are current, however, as they made loan prepayments that we required for us to consent to a deferral modification. Our other borrowers in the segment are also paying as agreed or provided cash payments that when coupled with the payment deferral have no additional debt service requirement until sometime in 2021. Second, we have aggregated an event planning and leisure sub-segment in which the business models are essentially dependent on social distancing relief and in some cases, the resumption of group events. Of the $150 million total exposure to this sector, $60 million has been moved to special mention and $40 million to non-performing. While the portion moved to SM has over a year of current liquidity, it was downgraded as the revenue models have been sharply impaired. The loan moved to nonperforming has now had limited remaining liquidity. The remainder of the migration to special mention is currently granular from our client spread throughout our metropolitan markets where liquidity has been tightened. These loans are generally collateralized by an array of assets that include real property. Frequently, a loan may be downgraded to special mention because of liquidity concerns, even though collateral coverage may be considerable. For this reason, migration to special mention has a low correlation to ultimate credit losses as over the past five years less than 1% has moved through to charge-offs. Our allowance for credit losses rose $86 million during the quarter as a change in mix of the balance sheet released $4.2 million of reserves and changes to the outlook accounted for $96.2 million, including covering $5.5 million of net charge-offs. Revision to the CECL macroeconomic outlook assumptions, which have declined since March 31st but have generally stabilized since April accounted for the entire net reserve build. Our Company’s allowance related to loan losses was $347 million, excluding held-to-maturity securities or 1.39% of funded loans, an increase of 25 basis points. The current reserve build reflects our best estimate of the future economic environment as of quarter-end, including the impact of government stimulus programs and credit migration actions. We have migrated to a consensus economic outlook, a blue chip economic forecast as it tracks largely management’s view of the recession and recovery. Net credit losses of $5.5 million were recognized during the quarter, which were mainly attributable to small business and C&I borrowers. In all, total loan ACL to funded loans increased 25 basis points to 1.39% in Q2 as provision expense for loan losses of $87.3 million significantly outpaced net loan charge-offs. Relative to most other banking companies, our lower consumer exposure continues to result in lower total loan losses. I’ll now turn the call back to Ken.

Ken Vecchione, President and Chief Executive Officer

Thanks, Dale. I would now like to briefly update you on the current status of a few exposures to the industries generally considered to be the most impacted by the COVID-19 pandemic. During the last two weeks of the quarter, Tim Bruckner, the credit administration team and I conducted the most extensive quarterly portfolio review process in the Bank’s history. The review covered 95% of WAL’s outstanding loan balances, excluding purchased residential mortgages. Our $2 billion Hotel Franchise Finance business focused on select service hotels represents approximately 8.2% of the loan portfolio. The financial flexibility of these borrowers is maximized by working with financially strong institutional operating offers, deep industry experience expertise and conservative underwriting structures focused on loan-to-cost. Occupancy rates are tracking national averages currently around 46%, which have tripled compared to the lows in April of around 15% and are now only a few percentage points short of fully covering estimated operating expenses. At approximately 55% occupancy, select service hotels are also estimated to cover amortizing debt service. As a testament to the operating models of the select service hotels, revenue per available room has fallen 55%, but they have been able to shrink their cost structure by over 40%. As a result, the typical hotel is operating at breakeven. Nearly 85% of our hotel portfolio is either paying as originally agreed or on a proactive payment deferral plans that bridge into 2021. We feel positive about the trajectory of the portfolio and that our proactive deferral strategy will produce relatively stronger credit performance given the active support of our sponsors have demonstrated through the material upfront payments made to receive deferral plans. To augment the strategy, we nearly doubled the reserve of the portfolio this quarter and increased the ACL to loans ratio by 93 basis points to 1.95%. The investor-dependent portion of our Technology & Innovation segment is primarily focused on lending to established growth companies with successful products and strong investor support, which provides greater operating and financial flexibility in this environment. Overall, significant sponsor support and an active fundraising environment continued for these growth firms. 81% of loans have greater than six months remaining liquidity, up from 77% in Q1. Additionally, we had over 50 clients successfully raise over $1.4 billion in new capital since March 1st. Our $509 million gaming book is focused on off-strip middle market gaming-linked companies whose revenue is driven by local demand factors. 37% of the portfolio is on 90-day principal-only payment deferral as they continue to cover interest payments. Additionally, these clients benefited from $28.4 million of PPP loans. Inclusive of our recent closure mandates in Nevada to limit certain business activities, businesses representing 95% of the portfolio are open for operations. Upon reopening all casinos, bars are performing at or above their COVID operating plan and no loans were downgraded to criticized or classified at quarter end. Lastly, our commercial real estate portfolio continues to perform as 99% of our industrial leases are current. 90% of our office rents are paid on par with the national average. The subsegment of CRE showing signs of stress for the industry is retail. WAL CRE retail exposure of $676 million is focused on local, personal service-based retail strip centers with limited merchandise retail exposure. Similar to HFF, we are utilizing deferrals to support a path to recovery for these borrowers, while requiring demonstrated sponsor support with high level of additional payment reserves. Of note, 67% of WAL’s investor CRE retail tenants paid May’s rent payments compared to 50% nationally. We continue to generate significant capital and maintain strong regulatory capital ratios with tangible common equity to total assets of 8.9% and a common Tier 1 ratio of 10.2%, an increase of 20 basis points during the quarter. Excluding PPP loans TCE to intangible assets is flat from Q1 at 9.4%. Inclusive of our quarterly cash dividend payment of $0.25 per share, our tangible book value per share rose $1.11 in the quarter to $27.84, an increase of 12.9% in the past year. We continue to grow our tangible book value per share at a rate significantly better than our peers, as it has increased three times that of our peers over the last five and a half years. In conclusion, we expect loan growth to be fairly flat in Q3 as PPP payoff and forgivenesses are largely offset by the organic growth in low-risk asset classes. Depending on the timing of the realized PPP forgiveness, organic loan growth should offset PPP runoff resulting in net loan growth being relatively stable. We anticipate another strong quarter of deposit growth in Q3, primarily by executing on our deposit initiatives and achieving our market share gains in mortgage warehouse. The anticipated deposit growth and resulting liquidity will primarily be deployed to residential mortgage assets to improve returns on cash over the next several quarters. However, as PPP loans roll off and liquidity continues to rise, pressure on NIM will also continue. The anticipated deposit growth and resulting liquidity will be fully deployed into productive assets. While we are pleased with our deposit growth, the pace is exceeding loan growth, and as Dale mentioned, it will take several quarters to redeploy this liquidity into low risk loans or assets providing yields greater than the Fed’s current offering. Operating PPNR is expected to decline modestly as PPP income begins to abate, loan balances growth begins to reignite, and the deployment of excess liquidity continues, and deferral loan origination costs return to normal levels. Our long-term asset quality and loan loss reserves are informed by the economic consensus forecast, which if consistent going forward, should preclude material increases in reserve levels from this point. The pace, timing and size of future net charge-offs are uncertain to us as we have not seen a material increase in delinquencies or substandard migration. Finally, our strong capital base and access to ample liquidity will allow us to both take advantage of any market dislocations to grow in low-risk areas and to address any credit demands in the future. At this time, Dale, Tim and I are happy to take your questions.

Operator, Operator

We will now begin the question-and-answer session. The first question today comes from Casey Haire of Jefferies.

Casey Haire, Analyst (Jefferies)

First question on the hotel book. The deferral strategy appears to be for more than six months. Can you give us some color on the average term and how far in advance these deferrals were made? Also, occupancy sounds like it is near breakeven levels. What is your reserve build forecast going forward, and do you expect it to reach 55%? Some color on this would be helpful given the concern.

Ken Vecchione, President and Chief Executive Officer

Yes. I think the hotel franchise finance book of business is the most misunderstood, and our approach is not fully understood as well. So, let me take a step backwards and give you a larger picture as to what we’re doing and why we’re doing it and then get directly to your questions there, Casey. One, first misconception is deferrals are a good thing. Payment deferrals require cash collateral or paid out of debt upfront. They provide liquidity to the project. They show from the borrower’s point of view project commitment, which is very important, or they flush out any early problems we need to deal with. So, when we say we have a six-plus-six program, what that means is our borrower gave us six months of payments upfront that we deposited into a bank account, which we pull out on a monthly basis as debt service, principal and interest, is due. And they don’t get to their six-month deferral period until six months from today. So, that’s what six-plus-six means. And what we’re trying to do here is look for people who provide the liquidity and commit to the projects. Again, it helps us understand if they do not want to do those things, then we need to take fast action to preserve the 40% of equity that’s sitting in front of our debt. That is the philosophy around our approach. A specific answer to your question today: about 51% of our portfolio is in the six-plus-six deferral bucket, 19% is in the three-plus-three bucket, about 9% is paying as agreed, and another 3% is in the three-plus-six buckets. And then, we’ve got a whole bunch of other plans—five-plus-five, two-plus-two—all those types of plans depending on the particular borrower. And that amounts to about 10%. So all-in, about 92% of our hotel book is paying as agreed or is on a deferral program. Now, we still have about 6% that we’re in the process of documenting, and we expect that to fall into any one of the buckets I just described. But all in, overall, 99% of our hotel book is paying as agreed, even if they’re on a deferral because we are attaching those funds that are sitting in a bank account where they provided the liquidity upfront. The other specific question you asked is—let me just give you some of the numbers here. For us, the current occupancy is about 43%–44%, that is three times higher than the lows in March. The ADR is $44. That too is three times higher than March. We did say, at 45%, based on our book of business here the Company is breakeven on an operating basis. And at 55%, the book of business does begin to cash flow on a 1-to-1 ratio, inclusive of amortization. I think that addressed all of your questions.

Tim Bruckner, Chief Credit Officer

I would add a couple of things. First, I’d say, this was not the easiest thing to execute. I don’t want to downplay that. This took a concerted effort of our people. Initial discussions with borrowers were difficult, because we’re solving for a period significantly longer than most viewed COVID in the first 90 days of the crisis. And so, we went out from the start and said, let’s solve for periods sufficient to return to stabilization. And that’s what we did. And we solved that not just with our money and our deferral, but with contributions from our very significant sponsorship in the space. We did it because it was the right thing to do. Our borrowers did it because they could do it. And I think, that’s a very important point on this. And we have so many now that come back and say, I’m so glad that we took this approach.

Ken Vecchione, President and Chief Executive Officer

So, 50% of our portfolio, slightly more, we’ll have to deal with these issues again in middle of 2021. Another 20% or so, we’ll deal with towards the end of the year. We’ve given enough of a runway here. This was the most important thing that we could do to help our clients is to give them a long runway to come back to us at the operating levels that they previously experienced. Additionally, as Tim said, they resisted at first. But once they talked to us and once they saw what was happening, they saw some of the wisdom in the approach that we deployed.

Casey Haire, Analyst (Jefferies)

Yes, yes, yes. No, that was pretty comprehensive. I’ll have to go back and read it myself, but that was very good. Dale, a question for you on the NIM. On Slide 6, by my math on the spot rates, it looks like it exited the quarter at 3.90. Does that sound about right? And then, what is that loan yield spot rate of 4.66% assuming for the PPP loans? It was 5.02 in the second quarter, which is a lot higher than what we’ve seen from peers. Could you give us some color?

Dale Gibbons, Chief Financial Officer

Yes. So, that assumes 5.02% for the quarter as well. So, what we did in terms of recognizing PPP revenue is, we’ve estimated using the effective interest method in GAAP how long these loans are going to last. From information we have and how our borrowers are behaving, we think that the average life of these is going to be about eight months. And so, we’re recognizing two-thirds of that PPP average loan fee, which is about 2.7%, over the eight months and then there’s a tail for the part that might not pay off. So, you should expect us to show something of a level low yield on the PPP that I think some others are doing maybe a little different approach. I would hope that our number would be on the higher side of where you are in the higher 3s for the quarter. But frankly, it remains to be seen a bit. We’ve had this massive increase in core deposit. We think that we’re on track for another strong quarter of core deposit growth in the third quarter, while the low balances won’t be moving as much, because we’re dealing with the pay-downs on PPP as we originate credit in other high-quality categories. So, that’s going to help us in terms of inventory build, but it doesn’t help us in terms of the NIM, but we think that’s going to be really important in 2021.

Casey Haire, Analyst (Jefferies)

Great. Thank you. I’ll step back.

Operator, Operator

The next question comes from Brad Milsaps of Piper Sandler. Please go ahead.

Brad Milsaps, Analyst (Piper Sandler)

Hey. Good morning, guys.

Ken Vecchione, President and Chief Executive Officer

Good morning.

Brad Milsaps, Analyst (Piper Sandler)

Dale, I just wanted to make sure I understand the PPP fees on a go-forward basis. $1.9 billion of loans should imply $57 million in gross fees. I think you mentioned that. Net of origination costs, you had about $43 left, you recognized about $14 this quarter. Can you help me understand for the geography of where some of those fees will show up in terms of NII versus the reduction in operating expenses going forward? I mean, I think you’d get to the same place overall, but maybe starting from a little lower point than I thought.

Dale Gibbons, Chief Financial Officer

Yes. So, we did $1.86 billion in loans. We had some people surrender at a couple of early pays, and so that number is down to about $1.7 billion today. We’ve received fees of $49 million from the SBA, not $57 million. And then, we netted certain costs against that. And that’s how we get to the $43 million. Going forward, I’m not looking for any cost relief obviously, because the origination process has ended. The $3.3 million that we’ve highlighted in the release was an increase in deferred compensation related to PPP originations; that is likely to normalize. So, the $3.3 million that we’ve highlighted in the release, yes, I think that’s going to come back up in compensation expense. So, that is going to rise again. The remaining net $43 million, of that we took a third in the second quarter; we’re probably going to take another third of that in the third quarter; and then, we’re going to have a tail into the fourth and maybe dribble into the first of next year in terms of recognition. So, I think the two things, one is maybe that dollar amount was a little bit higher because some of these were very short term or refunded; and then, two, the average loan fee was shy of 3%, it was about 2.7%.

Brad Milsaps, Analyst (Piper Sandler)

So, bottom line you’ve still got $29 million to recognize, most of that’s going to come through net interest income?

Dale Gibbons, Chief Financial Officer

Yes. That will come through net interest income.

Brad Milsaps, Analyst (Piper Sandler)

Got it. Understood. And then, just to follow up on the margin. You noted in the deck you’ve got 78% of the loan book essentially acting as a fixed rate. Thus far, I mean, I know it’s early, but how challenging has it been to defend some of those floors? Obviously, there’s probably not a lot of loans moving from bank to bank right now. So I’m just curious — your thoughts on being able to defend those loan floors as we move through the year?

Dale Gibbons, Chief Financial Officer

Actually, it has been less challenging than it has been in other downward environments. Today that’s not the case. Today how the floors operate is usually as a LIBOR floor assumption of 1%. LIBOR is under 20 basis points today. So, when loans are priced with floors, the floor is active, and it will remain active until LIBOR moves above 1%. So out of the gate, the floor is what’s active and it’s going to be active until LIBOR gets above 1%, and then we can go back to the variable rate structure.

Ken Vecchione, President and Chief Executive Officer

Surprisingly, we’re not losing business because of the floors.

Brad Milsaps, Analyst (Piper Sandler)

Got it. One final question: looking at some of the segment data, I noticed what appeared to be a negative provision in the other national business line category this quarter, with the reserve actually decreasing. Can you provide any color on that and explain how it compares to what you did with the rest of the portfolio?

Dale Gibbons, Chief Financial Officer

It’s not so much a portfolio thing as it was a reallocation. When we updated for the CECL outlook and the migration from Mark Zandi’s analysis to a consensus forecast, it resulted in different allocations for certain sectors. C&I loans in particular came down in part in that regard.

Brad Milsaps, Analyst (Piper Sandler)

Okay, great. Thank you.

Operator, Operator

The next question today comes from Timur Braziler of Wells Fargo. Please go ahead.

Timur Braziler, Analyst (Wells Fargo)

Hi. Good morning, guys. Maybe we can start on the credit migration into special mention this quarter. It certainly didn’t seem like that was the primary reason for the second quarter provision. Looking ahead, how should we think about future credit migration relative to the current allowance? If there’s future migration into special mention, is that already pretty much included in the existing expectations? And more specifically, if there’s migration out of special mention and into classified, would that drive incremental necessity to build allowance from here?

Dale Gibbons, Chief Financial Officer

As I highlighted earlier, the loss rates from special mention loans do not have a high correlation to ultimate charge-offs. Migration to special mention is usually driven by a liquidity question. So, even if a loan has strong collateral coverage but liquidity is tight at the borrower, it may be moved to special mention even though the risk of loss is low. In terms of what could migrate to SM, we highlighted potential SM migration in the hotel book due to liquidity stress. If an asset moves from SM to classified or non-performing, then the loss assumptions generally increase. When a loan becomes classified, we look at collateral and recognize a reserve based upon whether we expect shortfall relative to expectations. That could result in a different provisioning outcome. But SM migration itself typically has minimal impact on provisioning.

Timur Braziler, Analyst (Wells Fargo)

Okay. That’s helpful. Thank you. And then, maybe switching to the technology portfolio, certainly encouraging to see that over 50 clients, over $1 billion was raised in the quarter. I’m looking specifically at the 14% of tech loans last quarter that had under six months of liquidity. Were those included in the $1.4 billion of capital raising activity? And those companies coming up to that kind of deadline, are they having as easy success raising incremental rounds, and what’s happening to the valuations, if they are?

Ken Vecchione, President and Chief Executive Officer

Yes. Some of that capital was raised for customers that were in special mention last quarter and were able to raise liquidity and move out. That number moves in and out and the Tech & Innovation segment stayed relatively flat in terms of special mention movement. That’s encouraging because it means investors remain confident in the companies and continue to deploy capital.

Tim Bruckner, Chief Credit Officer

Quarter-over-quarter, we actually saw improvements in businesses with remaining months of liquidity less than six; Q1 to Q2 improved. We’re seeing a high level of activity. In some cases, the rounds are smaller, but we’re seeing sustained sponsor support and strong activity in the sector.

Ken Vecchione, President and Chief Executive Officer

Two interesting facts about our Tech & Innovation book: the median equity invested in our portfolios is six times our loan commitments today, and it is 10.6 times the current outstanding loan balance. That gives a sense of how much equity is in the companies and that about half of our commitments are undrawn because of that equity. That explains why we have 2 to 2.5 times deposit-to-loan ratio in the Tech & Innovation business.

Timur Braziler, Analyst (Wells Fargo)

And then, in the gaming book, I guess I’m kind of surprised to see the level of allowance allocated for that portfolio relative to currently adversely graded loans. Is that an indication that things could still get choppy in the future or is that formulaic? Because it didn’t seem like there was much expected loss content from your prepared remarks?

Ken Vecchione, President and Chief Executive Officer

We have no Las Vegas Strip exposure. Our book is driven by local demand factors, and many properties are outperforming initial reopening expectations. Some properties are posting win-per-day at slot machines at multiples of normal levels. In this book, 36% had interest-only deferrals; we have not had principal deferrals. The model produces conservative results and we also apply subjective overlays where appropriate. Our gaming book has relatively low leverage—generally under 3x debt-to-EBITDA—so we are comfortable with the performance we’re seeing.

Dale Gibbons, Chief Financial Officer

Part of what you’re referring to is using formulas developed in prior crises and extrapolating them to today. This circumstance is different with different underwriting and risk profile. With 95% of our properties open and strong early results, I would put my bet that when we’re done with this pandemic, the ACL for the sector will be shown to be higher than actually needed.

Tim Bruckner, Chief Credit Officer

The pace of events is important. In late May and June we saw very robust responses, and though positive, the ACL is based on historical patterns. We’re seeing today results that outperform those historical patterns.

Timur Braziler, Analyst (Wells Fargo)

And then, just one more modeling question for Dale, just average PPP balances for the quarter?

Dale Gibbons, Chief Financial Officer

$1.8 billion.

Operator, Operator

The next question comes from Chris McGratty of KBW.

Chris McGratty, Analyst (KBW)

Dale or Ken, I just wanted to go back to loan growth for a second. Completely understand that the near-term low-risk growth strategy and PPP dynamics perhaps last couple quarters. I’m wondering kind of your thoughts on how we should be thinking about loan growth beyond maybe the next couple of quarters and remind us kind of the targets that you’re setting forth for growth?

Ken Vecchione, President and Chief Executive Officer

As I said in my prepared remarks, it’ll be somewhat stable considering PPP runoff being replaced by organic loan growth. As we emerge out of Q4, we haven’t done full planning yet, but I would think it’s going to be back to our normal run rate of $600 million to $800 million per quarter. I’m encouraged the pipeline is building—the number of loans coming into our senior loan committee are brand name companies at good terms and pricing—so we expect to be back to a normal run rate as we emerge out of Q4.

Dale Gibbons, Chief Financial Officer

This will depend on how the situation unfolds. I’m encouraged by reports of potential vaccine candidates. If that happens by the end of this year or into Q1, that would boost confidence and demand. We have the background, infrastructure and deposit capacity to take advantage of any increase in demand.

Chris McGratty, Analyst (KBW)

That’s great. Dale, in terms of deposits, so it sounds like loan growth treading water until the end of the year and then resumption. The comments about deposit growth just coming in, if I take out the PPP of $1.1 billion, you still grew $1.5 billion or so in the quarter. Could you just help us with the magnitude of what you’re likely to see in Q3 and Q4, just how big of the balance sheet is going to be? I’m trying to get my arms around it.

Dale Gibbons, Chief Financial Officer

It’s not going to replicate the first half of the year, but we’re getting traction in our specialty business lines: mortgage warehouse, homeowner associations, and Tech & Innovation, and those historically have momentum. The pipeline is active and the Q is good for what we’re seeing coming in.

Chris McGratty, Analyst (KBW)

Great. And then, if I could sneak last one. I just want to make sure I got the expense outlook right. So, the deposit costs came down to 40 basis points. Is that the right run rate that we should be using from here?

Dale Gibbons, Chief Financial Officer

I think that’s fair.

Chris McGratty, Analyst (KBW)

Okay. And then the moving pieces with the PPP’s comp, how do we think about overall expenses? You were kind of flat quarter-on-quarter, but I know you’re making some investments, any direction on expenses?

Dale Gibbons, Chief Financial Officer

We were at $115 million which included a deferred compensation related to PPP originations. We’re not doing further PPP originations. I don’t think we will be below 40% on efficiency for long. I’m not sure we’ll immediately go back to 42%, but I would look at something closer to the $120 million run rate where we were before. Travel and business development expenses that were lower this quarter will likely rise as conditions allow.

Chris McGratty, Analyst (KBW)

That’s perfect. Thanks, Dale.

Operator, Operator

The next question comes from Michael Young of SunTrust. Please go ahead.

Michael Young, Analyst (SunTrust)

Hey. Thanks for the question. I wanted to follow up first on the reserve. I think that’s gotten a lot of attention. I’m trying to get to a more comparable figure to maybe other banks, if we kind of back out mortgage warehouse and maybe the large resi mortgage purchase portfolio and PPP loans. I think you guys might be more on par with other banks. But I didn’t know if there was a way to disaggregate that where we could maybe see it on a more comparable basis.

Ken Vecchione, President and Chief Executive Officer

When you think through our loan loss reserve and compare it to other banks, first, we don’t have a consumer franchise and that’s where a lot of losses begin to mount. Second, break our book into loan categories where we’ve had no losses: resort finance for $900 million, capital call lines $500 million, HOA services $300 million, warehouse lending $2.9 billion—together about $4.5 billion that we’ve never had a loss in. Then, we have another $4 billion with limited historical loss in residential loans, consumer, municipal loans and nonprofits. That totals roughly $8 billion that have no or low losses historically. If you adjust on that basis, the reserve ratio on the remaining book looks considerably different than a headline comparison. Also, construction, land and development—about $2.2 billion—looks different in this cycle. About a third of that sits in lot banking with LTV around 55% with well-capitalized, liquid sponsors as guarantors. That business is performing well with no deferrals. When you combine these factors and the fact that we have no energy loans, limited restaurant loans, few solar loans, you get to our reserves calculation.

Michael Young, Analyst (SunTrust)

That makes sense. As we move forward, the main thing that would drive a big delta in the reserve would be losses in some of those historically low-loss categories? Is that the right way to think about it, or would it be more significant downgrades in other categories that have had historical losses in the past?

Ken Vecchione, President and Chief Executive Officer

Effectively, it’s a pay-as-you-go situation. Your ACL covers what’s still in the book. If you have a loss in a category previously considered zero-loss, that would inform the analysis and could drive higher provisioning. But for the most part, it’s pay as you go—sustain reserve levels based on outstanding balances and changes in economic outlook.

Michael Young, Analyst (SunTrust)

Okay. And maybe one last follow-up. Are there any other tangential categories that we should have on our radar screen? Maybe C&I relationships or something related to underlying categories that might warrant elevated attention?

Ken Vecchione, President and Chief Executive Officer

Inside our CRE book we have industrial, office and retail. Industrial is strong—99% of industrial leases current. Office about 90% of rents are paid. The CRE retail book of about $676 million is focused on local, personal service-based retail strip centers with limited merchandise exposure. 66% of WAL’s investor CRE retail tenants paid May rent compared to 50% nationally. We’re watching that retail subsegment closely, though it entered the downturn with a DCR of 1.8 and average LTV around 48%. We’re monitoring it, but not suggesting acute problems at this point.

Michael Young, Analyst (SunTrust)

Okay. Thanks for all the color. I appreciate it.

Operator, Operator

The next question comes from David Chiaverini with Wedbush Securities. Please go ahead.

David Chiaverini, Analyst (Wedbush Securities)

Hi, thanks. My first question is on the mechanics of the deferral program. If we use the six-plus-six program as an example, so the first six months, they’re accruing interest, you pull the P&I from the accounts that they deposited, everything’s normal. But after the first six months, as we get into 2021, what happens to those loans in terms of the treatment of it? Do they go on non-accrual or do they move to special mention or classify them? Just curious as to whether or not they’ll continue to accrue interest in the second half of the deferral period.

Dale Gibbons, Chief Financial Officer

The loan documents have been modified. Contractual payments now allow for no new payments due until around May of 2021 in many cases. We take the six months they paid up front of P&I into a custodial account and then debit it over the six months. For the next six months, principal is deferred and interest payments that otherwise would have been due are typically capitalized—added to principal or handled under modified terms and become due at maturity or a later payment schedule. We will continue to accrue income during the deferral period and increase the balance accordingly. It won’t move to classification unless new information indicates a deterioration beyond the deferral mechanics.

Tim Bruckner, Chief Credit Officer

One clarification: deferral status does not directly determine risk rating. The ongoing weekly dialogue with the borrower and verification of liquidity to work through that plan is the important calculus in our risk rating methodology. We’re in constant dialogue and will change ratings if our assessment of liquidity or performance changes.

David Chiaverini, Analyst (Wedbush Securities)

And then, shifting to the provision, as we think about the third quarter and clearly there’s a lot of uncertainty on the macro outlook, but if we assume the macro outlook is stable from here, and you mentioned about how you’re expecting flat or low loan growth, what would that translate to in terms of provisioning? Are we thinking back towards 2019 levels? What should we expect over the next couple of quarters?

Dale Gibbons, Chief Financial Officer

I wouldn’t expect us to go back to 2019 levels immediately, but the reserve build this quarter resulted entirely from deterioration in the macro outlook from late March to quarter-end. If the outlook is stable, provision expense should decline significantly and move to more of a pay-as-you-go model: recognize losses and charge-offs as they occur. If we see migration into classified or non-performing, that could increase provisioning needs. But absent realized losses, the provision should fall off considerably.

Operator, Operator

Next question will come from Brock Vandervliet of UBS. Please go ahead.

Brock Vandervliet, Analyst (UBS)

Dale, how did you kind of thread the needle with the hotel restructuring that you’re implementing, especially the longest-term ones out to mid-2021? How is that not a TDR?

Dale Gibbons, Chief Financial Officer

Regulatory guidance provided temporary relief that allowed us to extend accommodations beyond the typical 90 days without automatically classifying them as troubled debt restructurings, provided the modifications were due to the pandemic and met specific criteria. The guidance allowed up to six months in many cases, and we've structured modifications within that framework. Many borrowers prepaid six months of P&I upfront, which also affects classification. So, the modifications are within the regulatory allowances for pandemic-related relief and therefore are not automatically TDRs.

Ken Vecchione, President and Chief Executive Officer

There’s a difference between the solution to bridge the runway for the borrower and the deferral mechanics. The solution is for a year in many cases; the deferral mechanics often involve six months of prepaid payments and then structured follow-on terms.

Brock Vandervliet, Analyst (UBS)

Any more color on that negative provision? You touched on it earlier and one of the national business lines had a small negative provision.

Ken Vecchione, President and Chief Executive Officer

The HOA loan portfolio is small and was previously embedded in C&I. When we reviewed it as a standalone segment, historical loss experience is essentially nil. HOA loans have unique mechanics—the HOA lien can have priority over the first mortgage in many jurisdictions—so loss rates have been effectively negligible. Re-segmentation to reflect that characteristic produced the small reallocation and the negative provision in the segmented accounting.

Operator, Operator

The next question comes from Gary Tenner of D.A. Davidson. Please go ahead.

Gary Tenner, Analyst (D.A. Davidson)

I wanted to ask a question on the hotel deferral strategy. Ken, I think you mentioned that you had some sponsors basically coming to you and saying, I’m glad we did it this way, the six-plus-six. That said, I’m sure they all would have happily taken a six-month deferral without paying six months of accelerated cash. So, how can you be confident that post-COVID there’s not any negative fallout in terms of business or relationship versus some of the sponsors with the Bank?

Ken Vecchione, President and Chief Executive Officer

That’s a fair question. Sixty-six percent of our hotel book is with large sponsors that manage many hotels and deal with major brands like Marriott, Hilton, and Hyatt. They value working with lenders who deeply understand the industry. We’ve gained market share in some businesses because incumbent banks don’t understand the space as well. We didn’t do anything irrational: we required commitment, analyzed underwriting and debt service, and insisted on sponsor contributions. Many borrowers initially resisted but later appreciated the approach. Over time, as the economy normalizes, I think many smaller competitors who used cookie-cutter, short-term responses will lose business to institutions like ours that provided thoughtful, durable solutions. We remain open to new deals and will continue to finance good opportunities where appropriate.

Dale Gibbons, Chief Financial Officer

I call this tough love because I don’t think borrowers liked it at first, but we’ve earned some respect. The large majority of our borrowers have the resources to be here for the long haul.

Ken Vecchione, President and Chief Executive Officer

There comes a point where clients may not appreciate the approach initially, but later see the value. This differentiated strategy allowed us to have constructive dialogue earlier than many other banks and position us well going forward.

Operator, Operator

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

Ken Vecchione, President and Chief Executive Officer

Thank you all for your time today. We appreciate it. We went a little bit longer, but we were happy to do so to make sure that all of your questions were answered thoroughly. We’ll be in touch. We look forward to seeing you again in person one day. Thank you all.

Operator, Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.