Webster Financial Corp Q2 FY2020 Earnings Call

Good morning, and welcome to the Webster Financial Corporation's Second Quarter 2020 Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce Webster's Director of Investor Relations, Terry Mangan. Thank you. Please go ahead.

Thank you, Donna. Welcome to Webster. This presentation includes forward-looking statements within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to Webster's financial condition, results of operations, and business and financial performance. Webster has based these forward-looking statements on current expectations and projections about future events. Actual results might differ materially from those projected in the forward-looking statements. Additional information concerning risks, uncertainties, assumptions, and other factors that could cause actual results to materially differ from those in the forward-looking statements is contained in Webster Financial's public filings with the Securities and Exchange Commission, including our Form 8-K containing our earnings release for the second quarter of 2020. I'll now introduce Webster's Chairman and CEO, John Ciulla.

Thanks, Terry. Good morning, everyone. Thank you for joining Webster's second quarter earnings call. I hope that all of you and your loved ones are healthy and safe. CFO, Glenn MacInnes, will review business and financial performance for the quarter. I'll provide updates on our COVID-19 related activities and line of business performance. I'll also report on key credit metrics and trends, including our exposure to industries most directly impacted by the pandemic, and provide an update on loan modification and payment deferral activities. The portfolio specific credit slides that we walked you through in Q1 have been updated for Q2 and are included in the supplemental slides. After Glenn provides additional information on Q2 financial performance, HSA Bank President, Chad Wilkins; and Jason Soto, our Chief Credit Officer, will join us for Q&A. While we have seen a dramatic improvement in the healthcare data across our 4 straight retail banking footprint over the last month, we know that rising cases of COVID-19 continue to challenge parts of the U.S. and that economic activity, including consumer and business demand and confidence will continue to be muted by the uncertainty surrounding the pandemic. Glenn and I, along with the rest of the executive team, continue to focus on prudently managing capital, credit, and liquidity, considering all of the potential macroeconomic scenarios. Webster bankers continue to show great energy, engagement, and compassion as they take care of each other, our customers, and our communities. I want to thank each and every one of them for their remarkable contributions during this challenging time. I'm incredibly proud of the entire team. On Slide 2, you can see some examples of the way our bankers have responded over the last several months. I'm pleased with the way our employees have adjusted to remote working environments, and our organization continues to focus on employee safety and support. We've worked tirelessly to help our consumer and business customers through loan modifications, flexible products and pricing, and through participation in the PPP and Main Street lending programs. To date, we have processed, approved, and funded more than 10,000 PPP loans, totaling $1.4 billion for both existing and new customers. We funded every qualified applicant that completed the loan process. Our philanthropic activities continue to be focused on making an immediate and direct impact on those most affected by COVID-19. Additionally, we are now helping organizations that are poised to make a difference at the inflection point to racial equality and economic opportunity. I'll now turn to financial highlights on Slide 3. Webster's second quarter results demonstrate our ongoing commitment to strong execution on our strategic priorities. We feel good about our performance in the quarter, particularly in light of the challenging operating environment. Pre-provision net revenue of $107.9 million was down approximately 14% from Q1, driven by lower total revenue, partially offset by a decline in expenses. Earnings per share in the quarter were $0.57 or $0.61 when adjusted for a $5.5 million valuation adjustment that Glenn will discuss in his remarks. This compares to $0.39 in Q1 and $1.05 in the prior year's second quarter. Consistent with last quarter, Glenn will walk you through the assumptions underlying the CECL process and resulting provision for the quarter. Our $40 million provision results in a $23.6 million reserve build. Our second quarter return on common equity was 6.8% and return on tangible common equity was 8.5%. On Slide 4, loan growth was solid as loans grew 13% from a year ago or 6% when excluding $1.4 billion in PPP loans. Commercial loans grew almost 10% from a year ago or by more than $1.1 billion. Linked quarter non-PPP commercial loan balances declined modestly, but the decline was driven almost entirely by a reduction in line utilization. In fact, commercial banking non-PPP origination and payoff activity was largely in line with the prior year's second quarter. The decline in floating and periodic rate loans to total loans reflects fixed-rate PPP loans added in the quarter. Deposits grew 16.6% year-over-year, driven across all business lines. Transactional and HSA deposits now represent 62% of total deposits, up from 58% a year ago. Slide 5 through 7 set forth key performance statistics for our 3 lines of business. On Slide 5 in Commercial Banking, excluding PPP loans, balances were up 9.4% from a year ago. CRE was the primary driver of year-over-year growth. As I mentioned earlier, loan balances in the quarter were materially impacted by lower line utilization. A significant amount of the Q1 defensive line draws were repaid, and our asset-based lending group saw a 20% reduction in outstanding loan balances as slower economic activity reduced our customers' need for receivables and inventory support. Deposits were up sharply in commercial banking due to a cash build in our clients' balance sheets. Commercial deposits were up 12.4% linked quarter and 54% from a year ago, marking an all-time high for that line of business. Higher loan and deposit volumes drove a 5% year-over-year increase in net interest income in commercial banking, while expenses were down 3.3%. Commercial PPNR was up 9.1% compared to prior year due to the net interest income increase and strong expense discipline. On Slide 6, you will notice that we have modified our slide presentation slightly for HSA Bank. Our slide now shows our core accounts and deposits as well as those associated with our TPA partners. We've done this to provide more clarity regarding the decision of 2 TPA partners to transition accounts and balances to their internal solutions. This is what we promised we would do when we communicated the TPA transition to the market late last year. COVID-19 had a mixed impact on the overall HSA business in Q2, and account openings were modestly lower than the prior year due to slower hiring trends across our employer customers. While outside the TPA channel, deposit balance growth remained strong at 11.7% year-over-year, due in part to reduced consumer spending in the period. Therefore, higher balances helped NII, while the spending decline had a negative impact on our interchange revenue. HSA consumer spending did begin to pick up late in the quarter, a trend we see continuing as elective medical services continue to open up across the country. We saw a strong increase in new business opportunities late in the quarter, winning more new HSA RFPs than we did last year, specifically in the large employer space. This is a positive early sign for 2021 in our DTE channel. In the quarter, TPA accounts and balances declined $68,000 and $89 million, respectively, representing the beginning of the anticipated loss of accounts in that channel. As we have mentioned several times in the past, the TPA channel has materially lower average account balances than our core accounts, due to our limited interaction with the account holders. The accounts that left in Q2 had an average deposit balance of $1,442 per account compared to $2,369 for our core customer accounts. As disclosed last quarter, we are on track to close and onboard 23,000 new account holders from State Farm Bank early in the third quarter. The related deposit balances approximate $136 million or about $5,900 per account. Although the pandemic has introduced some volatility into HSA Bank performance metrics, the fundamentals of HSA Bank and the broader HSA market remain strong with ample opportunity for continued growth. I'm now on Page 7. Community banking loans grew by 13% year-over-year and by 2%, excluding PPP loans. Mortgage originations were strong, and the pipeline remains robust. Lending club balances totaled just $163 million at June 30, down another $13 million from March 31 as that portfolio continues to be in runoff mode. Community banking deposits grew by 14% year-over-year, with consumer and business deposits growing by 6% and 40%, respectively. Our total cost of community banking deposits was 38 basis points in the quarter compared to 71 basis points a year ago. Noninterest income was down 15%, primarily driven by lower deposit service charges, resulting from higher average balances and lower retail spend due to COVID-19. Mortgage banking and business banking swap fees saw meaningful year-over-year growth. Reflecting the continued shift in consumer preferences, 77% of total transactions in the quarter were self-service and mobile banking households grew by 13% year-over-year. Turning to the next 2 slides, I'll talk about credit. Our June 30 reported credit metrics remained relatively stable, reflecting the increased level of economic stress, partially offset by the impact of government stimulus and loan modification and deferral programs. We expect to see continued pressure on credit as our forward forecast of economic conditions remains less favorable, and we anticipate the continuation of a challenging business environment due to the pandemic. Overall, delinquencies, classified assets, nonaccrual loans, and net charge-offs modestly deteriorated from the prior quarter but remained within recent ranges. Glenn will talk specifically about these metrics in a moment. On Slide 8, with respect to commercial loans, we have updated our disclosure on the sectors most directly impacted by COVID and included updated modification information. Key takeaways are that overall exposure to these sectors have declined, defensive line draws in these sectors and across the commercial bank have largely been repaid, new modification requests have slowed dramatically, and the absolute number of loan modifications in force has declined from its peak. On Slide 9, we provide more detail across our entire $20 billion commercial and consumer loan portfolio. At the end of the second quarter, approximately $2.29 billion or 11% of our funded loan portfolio was under some sort of modification. On May 8, when we filed our first quarter 10-Q, modified loans represented just under $2.9 billion or 14% of our portfolio. Our modified loans have come down materially. Almost half of the commercial loan modifications in effect at June 30 are not related to modification of payment terms, meaning the borrower is still paying principal and interest as originally contracted. In these instances, we've provided covenant relief, borrowing base adjustments, additional liquidity, or other concessions. With respect to payment-related modifications, we have seen more than an $800 million or 38% decline in modified loan dollars since May 8. While it's too early to declare victory, overall modification trending is encouraging. The overall portfolio weighted average risk rating has deteriorated modestly as a result of the economic stress. However, the vast majority of our risk rating downgrades have occurred within the pass rating categories. We are actively monitoring risk, making real-time credit rating decisions, and addressing potential credit issues proactively. The path of the virus, the pace of reopening, or reclosing the economy across geographies, and the potential for additional government stimulus actions will all help determine the ultimate outcome of credit performance, not only for us but for the rest of our industry. We continue to feel good about the quality of our underwriting, our portfolio management capabilities, and our capital position. Finally, before I turn it over to Glenn, I'd like to comment on capital management. First, we remained completely focused on internal execution. We have a strong capital position, enabling us to continue to support our customers and assist in the broader financial recovery. As we announced Tuesday, our Board has approved a quarterly dividend of $0.40 per share. Given our current economic baseline forecast, anticipated earnings, and capital position, we anticipate continuation of the dividend at its current level. If conditions deteriorate significantly, we will make the appropriate decisions regarding our dividend as we will always ensure we can take care of our customers, bankers, communities, and shareholders. We will not repurchase our stock until the pandemic is behind us. I'll now turn it over to Glenn for the financial review.

Thanks, John. I'll begin with our average balance sheet on Slide 10. Average loans grew almost $1.3 billion or 6.3% linked quarter. Our commercial portfolio grew by $1.4 billion, driven primarily by $940 million in PPP loans. In the second quarter, we funded over 10,000 PPP loans. The loans had an average balance of $135,000, with a median balance of $34,000. Over 80% of the loans were less than $150,000. The PPP loans include around $70 million to new customers with the remainder going to the existing Webster customer base. We expect 75% of the loans will be forgiven over the second half of 2020, but timing will depend on final SBA guidelines and customer preferences. We believe that approximately two-thirds of the PPP funds remained in customer deposits accounts at quarter end. Outside of PPP loans, commercial loans grew $458 million. C&I loans grew by $319 million, reflective of line draws, which began late in the first quarter, along with growth in public sector finance. In addition, commercial real estate loans grew $139 million as a result of higher activity in our Investor CRE and middle market businesses. On a year-over-year basis, commercial real estate loans have grown by more than $1 billion. The $114 million decline in consumer loans is the result of reductions of $67 million in residential mortgages and $41 million in home equity. Deposits increased $1.9 billion linked quarter, reflecting substantial pandemic-related commercial and consumer liquidity. Demand deposits represented $1.3 billion of this increase. Commercial and business banking demand deposits grew $1.1 billion or 31%. The average consumer demand deposit increased over $1,000 per account or 13.2%, representing $161 million of growth. As a result, borrowings declined by $186 million with FHLB advances representing the majority of the reduction. Borrowings included $373 million of balances from the utilization of the PPP liquidity facility. Regulatory risk-weighted capital ratios increased due to growth in equity and a decrease in risk-weighted assets. Risk-weighted assets decreased as a result of the addition of 0% risk-weighted PPP loans as well as a decline in 100% risk-weighted commercial loans. The increase in asset balances impacted our tangible common equity ratio by 27 basis points, which was more than offset by retained earnings and an increase in the net unrealized gain in our AFS portfolio. Tangible book value per share at quarter end was $27.4, an increase of 3.6% from March 31 and 6.9% from the prior year. Slide 11 summarizes our income statement and drivers of quarterly earnings. Net interest income declined $6.4 million from the prior quarter. Lower rates resulted in a quarter-over-quarter decline of $30 million in revenue from earning assets. This was partially offset by $8 million due to balance growth and $16 million due to lower deposit and borrowing costs. As a result, our net interest margin was 24 basis points lower quarter-over-quarter. A 40 basis point decline was the result of earning asset yield, partially offset by 12 basis points from lower deposit costs and 7 basis points from lower borrowing costs. In addition, PPP loans represented another 2 basis points of the linked quarter NIM decline. Versus prior year, net interest income declined $17.4 million. $44 million of the decline was the net result of lower market rates, with a partial offset of $29 million from earning asset growth. Noninterest income decreased $13.3 million linked quarter and $15.8 million from the prior year. Deposit service fees declined $6.7 million quarter-over-quarter, with overdraft fees declining $3 million. HSA deposit fees decreased $3.3 million linked quarter, with interchange representing $2.4 million of the decline as a result of lower spend. We also saw quarter-over-quarter pressure on wealth management related fees which was partially offset by higher mortgage banking activity. Another $5.5 million of the quarter-over-quarter reduction in noninterest income was due to a discrete fair value adjustment on our customer hedging book. The decrease in noninterest income from the prior year reflects the lower level of deposit service fees, the fair value adjustment, with a partial offset from higher mortgage banking revenue. Reported noninterest expense of $177 million declined both linked quarter and from the prior year and is reflective of continued expense discipline. Pre-provision net revenue was $108 million in Q2. This compares to $125 million in Q1 and $137 million in the prior year. The provision for credit loss for the quarter was $40 million, which I will discuss in more detail shortly. The efficiency ratio of 60% compares to 58% in Q1, reflecting lower quarter-over-quarter revenue with an offset from lower expense. Our effective tax rate was 21.8% compared to 22.6% in Q1. Turning to Slide 12, I will review the results of our second-quarter allowance for loan losses under CECL. The allowance for credit losses to loans increased to 1.64% or 1.75%, excluding PPP loans. For the quarter, net charge-offs were $16.4 million. Our loan loss provision of $40 million consisted of 2 components: first, a reduction of $8 million, driven by lower loan balances, primarily due to lower commercial credit utilization at quarter end and second, an increase of $48 million, which is reflective of our updated economic forecast. The provision reflects the Moody's June economic forecast. The forecast has unemployment peaking at 14% in Q2, declining to 9.5% in Q4 and 9.3% on average for 2021. GDP is forecasted to decline on a full-year basis by 5.6% in 2020. Annualized year-over-year GDP growth will not turn positive until mid-2021. Key drivers for the provision were changes in the economic forecast, risk rating migration, loan modification and deferral trends, as well as the impact of the Fed stimulus programs. The $359 million allowance reflects our best estimate of life of loan losses as of June 30. We will continue to assess the macroeconomic environment and the impact on our credit quality as we move through the pandemic. In addition to our quarterly CECL process, we continue to run several stress scenarios, reviewing the results with management, the Board, and regulators. The results inform our thinking on future performance, liquidity, and operating capital, which remains strong and in excess of well-capitalized levels. Slide 13 highlights our key asset quality metrics as of June 30. Nonperforming loans in the upper left increased $11 million from Q1, and residential mortgage and consumer loans represented $7 million of the increase, with $4 million driven by smaller exposures in CRE and middle market. Net charge-offs in the upper right increased from Q1 and totaled $16.4 million in the quarter. C&I increased $10 million, primarily reflecting 2 restaurant chains in our sponsored portfolio that were experiencing difficulty prior to the onset of the pandemic. Commercial classified loans in the lower left represented 295 basis points of total commercial loans. This compares to a 20 quarter average of 314 basis points. The allowance for credit loss increased to $359 million, as discussed on the prior slide. Slide 14 highlights our liquidity metrics. Our diverse deposit gathering sources continue to provide us with a strong base for loan growth. More than $1.8 billion of deposit growth in Q2 funded more than $900 million in loan growth and lowered the loan-to-deposit ratio to 83%. We are predominantly core deposit funded with no brokered CDs at June 30. In addition, our sources of secured borrowing capacity totaled $11.2 billion at June 30. The increase of almost $2.2 billion from March 31 reflects $1 billion of unused PPP collateral at the Fed and the pay down of FHLB advances. Slide 15 highlights our strong capital metrics. Our regulatory capital ratios exceed well-capitalized levels by substantial amounts. Our common equity Tier 1 ratio of 11.2% exceeds well-capitalized by more than $1 billion. Likewise, Tier 1 risk-based capital exceeds well-capitalized levels by $853 million. With respect to our outlook, the impact of the pandemic on the economy continues to present near-term challenges. Average earning asset growth, net interest income, and NIM will be influenced by the timing and amount of PPP forgiveness and repayment activity. Assuming market rates do not go below zero, PPNR has modest risk to further declines in short-term rates. Noninterest income will be influenced by the pace of deposit service fees in HSA Bank and community banking. We will continue to remain disciplined on our expense management and our share count should remain relatively flat as we do not anticipate any near share repurchases.

Thanks a lot, Glenn. I'd like to provide some perspective on our longer-term operating goals and execution strategies before we open it up to questions. As you know, our goal is to allocate capital and focus business strategies for the purpose of maximizing economic profits over time. For 40 consecutive quarters, we were able to grow revenue period-over-period, distinguishing ourselves from our peers. The differentiated strength of our company has been deploying low cost, high-growth HSA and core consumer deposits into market-leading, specialized, and sophisticated C&I and CRE commercial loan growth across an expanding set of industry verticals and geographies. Our view of the macroeconomic environment over the next several years is that rates will be lower for longer, and economic growth will be modest. As I mentioned beginning in our January earnings call, we believe we have meaningful opportunities to change the cost structure supporting our delivery of products and services to our customers across all business lines, without limiting the effectiveness or growth or value of our differentiated businesses. We have been and remain focused on operational efficiencies and revenue enhancements across the organization, well before the onset of the pandemic. With the pandemic accelerating changes in customer preferences and shifting workplace dynamics, opportunities to fully align expenses with our business line execution will only get broader. Our goal continues to be generating returns in excess of our estimated 10% cost of capital over the medium and long-term, and we'll work diligently to achieve that goal. Donna, with that, Glenn, Chad, Jason, and I are prepared to take questions.

Our first question is from Steve Alexopoulos of JPMorgan.

I can start on credit. So if you look at the deferral slide, most of the trends were favorable, but the one that does stand out is leverage lending, which saw modifications rise since May 8. Could you give color on what you're seeing there? And should we translate higher deferrals into eventual higher losses in that bucket?

Yes, the main concern is how to interpret the embedded loss from the modifications. We are carefully assessing if customers require modifications that may indicate potential weaknesses. I'll let Jason share his insights on this matter. Regarding the leveraged portfolio, not all modifications relate to payments. In both our general sponsor book and the leveraged loans within that group, we're encouraged by the modifications we are making, which are often aimed at providing customers with increased flexibility regarding covenants or liquidity. We have strong sponsors supporting the majority of these deals, who have substantial equity invested and are collaborating closely with us. Therefore, I am not particularly alarmed that this is one of the higher categories. It is expected that companies in leveraged situations may need more modifications and flexibility, but we are not observing any systemic weaknesses in that portfolio. Jason, would you like to share your perspective?

Yes. No, happy to, John. I think you're right. If you look at the amount of the slide, 70% of it is not payment related, right? And so the other 30% is and if you even break down that 30% further, there is a portion of that, that's just the principal deferral, but they continue to pay interest. Ultimately, we worry a little bit less about the covenant modifications versus the payment modifications. What I'll also tell you is that a lot of sponsors have indicated that they're willing to support these companies even in some of the most impacted sectors, right? But they want sort of a short window to assess the situation and environment and how quickly the borrowers will recover before they decide to cut a check and figure out what the long-term solution is. So right now, I'm cautiously encouraged by the conversations we're having with these sponsors. I think the right point is that only 30% of them are actually payment related.

Okay. That's actually helpful. Can you walk us through the reviews you've conducted on the updated COVID-19 exposures in those portfolios? Now that you've had more time to assess the risk, how do you view the risk in those categories?

Jason, why don't you take that one directly?

So you're talking specifically about the sectors or...

The slide that calls out restaurant, hotel, leisure, et cetera. Yes, all those impacted sectors.

The rigor review around these sectors is, I'll call it, significant, all right? We have a normal course review of problem assets. We've had separate special reviews focusing on just things like restaurants, travel, leisure, hotel, and motel. We've required an escalation of decision-making modifications on any deals that carry a certain risk rating, which in the past would have been done without coming to my level. We've been very proactive in looking at all these exposures and challenging ourselves to make sure we don't have any blind spots of future problems in these sectors. Most of my comments are around our larger structure businesses, which carry the higher exposure. But I will tell you that also on some of our smaller flow businesses, we've also taken an approach on things like restaurants that if over 50% of your revenue has gone as a result of the situation, we just concentrated to a downgrade because we can't have the same level of review and rigor on a $200,000 loan as we can on a $20 million loan. I feel really good about the week we rely on all these accounts and all the controls in place to make sure that we don't have blind spots.

Okay. That's helpful. Could I ask Chad about HSA Bank? I'm curious about the overall impact of layoffs on contributions. Are the employees who are still working continuing to contribute as they did before? We previously discussed employers potentially considering full replacement. How is the current environment affecting that business?

Yes. Thanks, Steve. I'd say that we haven't seen a lot of impact from the furloughs and the layoffs. So really not a big uptick in closed accounts. We have seen, I guess, a slowdown in new accounts with existing employers. As employers have kind of paused on hiring as we've gone through the pandemic. John spoke to the slowdown in our spend levels that dropped down to about 60%. Currently, in June, we came back to about 80%, which conversely has added a little bit more growth to our deposits as folks aren't spending as much. Contribution levels have remained about the same, and that's why we're seeing an uptick in growth on deposits. So we really haven't seen much of an impact on the contribution level, just really the spend levels. Looking to the rest of the year, I think as the economy is still in a difficult spot, the enrollments with new employers remain a little bit depressed. We had a dip in our pipeline as we went through March and April, but it came back really strong in June and July, and we've actually had one of our best sales seasons ever in the large employer market. So it's looking good for win-win. It's too early to tell whether that's indicative of some tailwinds coming into the industry as a result of the impact on the economy. So we'll see how that unfolds as we get into 2021.

Our next question is coming from Collyn Gilbert of KBW.

I wanted to follow up on Steve's question regarding HSA. Chad, with July 1 being a significant enrollment period, are employers able to manage it? Additionally, are you noticing some employers extending the enrollment periods by about a quarter due to the current work-at-home situation, or are the plans too rigid to allow for an extension of the July 1 enrollment period?

Yes. Thanks, Collyn. We have not seen any changes in the timing of enrollments, and I don't anticipate seeing any changes to the point you made. It's a little inflexible there. We thought we were seeing a pause in folks putting their benefit packages out to bid because they were just so distracted with everything that was going on, just responding to the pandemic. However, that's just come back and I feel like we're ahead of last year's levels at this point in terms of bids and opportunities because of everything that got pushed back a little bit.

Okay. That's helpful. And then just in terms of potential M&A within the sector, are you guys seeing any other opportunities coming your way, similar to what you have closing with State Farm or how this current environment may have impacted portfolios and businesses that have come available for you in the HSA space?

Yes, Collyn, I'll take a crack and then let Chad follow up. I mean, I think we remain committed to looking at inorganic opportunities to grow this special business. So from our perspective, we're still as engaged. I will tell you, given the sort of overhang of the pandemic, lower value, perceived value of deposits and growth trajectory, I think sellers are maybe more reluctant to engage in a transaction at this time. I'd sort of say the odds of us executing on more inorganic opportunities are lower, but our desire remains just as significant as it was before. Chad, I don't know if you have a perspective there?

Yes. The only thing I'd add to that, John, because I agree 100% with everything you said, is that there may be some players in the space who are going to struggle with the lower interest rate environment as you see it sizable decrease in the revenue. That might create some opportunities, but otherwise, I absolutely agree with everything.

Okay. That's helpful. Regarding expenses, could you provide an update on the Boston franchise and how your branch network infrastructure is currently set up? Are there areas where you see potential for rationalization in both the near and long term?

Sure. Collyn, I was pretty purposeful in my final comments there. We've been working across the entire organization on things like automation, looking at whether or not our entire infrastructure and expense base is fully aligned with kind of our narrow-targeted growth opportunities in businesses. Obviously, our physical footprint, both office space and banking centers is something that we review as we talk about all the time. I do think that coming out of this pandemic, it's really put a highlight on the fact that consumer preferences are changing and that we can deliver more effectively digitally, and there's less reliance on the banking center. I do think you'll expect to see us, along with a lot of other players in the industry, be a little bit more aggressive at reducing square footage, making sure that we still can deliver our products and services to our customers. To follow-up on my earlier prepared remarks, we'll be able to quantify that a little bit more as we head into the third and fourth quarters for the market.

Okay. That's helpful. And then just lastly, just on the loan activity in the quarter and if you covered this in some of the initial comments, I apologize, I missed it. But just the declines that you saw on loan balances and maybe what your expectation is for activity in the back half of the year?

Yes, sure. It was a really interesting quarter actually. We onboarded some great new customers. One of the strengths, and it's fortunate, in terms of the people, how it reflected risk. One of the strengths in that sponsor business is that our largest concentration is around technology, infrastructure, data centers, fiber, and those kinds of transactions which are just actually benefiting from the marketplace. We've continued to onboard some really good credits. One of my comments, I did make earlier is that the non-PPP reduction in commercial balances was entirely driven by line utilization. So repayment of defensive line draws along with probably the biggest reduction I've ever seen or contraction in ABL utilization, given what's just going on with working capital. The actual stated numbers of originated dollars and payoffs were almost exactly in line in commercial banking with a year ago second quarter, which is kind of remarkable when you think about the economic slowdown. Going forward, now that we've kind of balanced out the utilization, you'll continue to see modest loan growth from us. Obviously, the economic environment impacts it, but we have a decent pipeline as we head into the third quarter. We're open for business, understanding that our underwriting criteria changes a bit with the overhang of the pandemic.

Our next question is coming from Mark Fitzgibbon of Piper Sandler.

John, given the differences between states on the COVID shutdowns, I'm curious, are the credit dynamics for business customers markedly different sort of across your footprint? And could you maybe give us some color on that?

Yes, that's a great question. I don't think there's sort of a systemic or kind of repeatable underwriting change as we go throughout our footprint. I do think, interesting dynamics, even with what's been happening lately, we've been seeing boosted real estate prices in Fairfield and Westchester because people are leaving the city. What I'd say, Mark, is I think that when we're underwriting transactions, if you think about small businesses, which are more volume-driven, I think we're looking out systemically for industries that may be more vulnerable to this economic landscape and the pandemic and some of the shifts in geography. As we get into the commercial bank underwriting, where it's really credit by credit, I think we certainly take into consideration the dynamics in the geographies. So what you've seen in our branch footprint, our 4 Massachusetts, Rhode Island, New York, and Connecticut is a consistent sort of slow march to reopening and a little bit more activity. We're seeing a little bit more loan activity. I don't think there's a differentiation between those 4 states; I think those 4 states are doing pretty well. There are areas, our national restaurant franchise business, we are not originating there now. There's just too much variability, and there's just too much uncertainty as it relates to specific geographical challenges. I can't really give you any trends. We haven't seen it in credit performance, in delinquencies in consumer. We haven't had sort of hot spots, and I hate to use that phrase because particularly the situation where we haven't seen kind of hot spots of poor credit performance in commercial or business banking based on geography, it's more sector driven.

John, can I add something?

Sure.

What I would say, if you're looking at our modification book and you look at those customers that are asking for second round accommodations, if you will. Within our business banking portfolio, we've had well over $100 million mature of the initial $350 million or so, and only $15 million of that actually asked for a second round deferral. I take that as cautious encouragement within our footprint. What we're hearing from borrowers are, 'Look, we're not quite sure how things are going to play out, but we've got some good liquidity, and so we're comfortable resuming payments at this point.' So take that for what it's worth, but I do view that as a slight indication of some of the positive trend.

Okay. Great. And then just a follow-up for Chad. Chad, I was curious if you think you still have room to push HSA deposit costs down even further or are we sort of bottoming out here at 15 basis points?

Yes. I think that we've seen some more movement in the market. We're paying really close attention to what's going on across our competitors. I think we have room to move still.

So Mark, it's Glenn, if I could just add to that. So sort of 15 basis points for the quarter, but that's reflective of changes mid-quarter. So you'll get a full quarter of that going into the third quarter. It will probably be close to around 13 basis points.

Okay. And then, Glenn, I know you're not giving guidance, but I wondered if you could help us think about some of the major moving parts on operating expenses in Q3?

So John sort of touched on the operating expenses. I would think all things considered, you would think it would probably be in the $176 million to $178 million range somewhere around there, excluding any significant investments that we make. Just going forward, obviously, if you think about guidance going forward, a lot of it is predicated on the PPP forgiveness. Our thoughts on that. I indicated 75% by year-end, but it's anyone's guess if 20% comes in the third quarter or 25%.

Our next question is coming from David Chiaverini of Wedbush.

A couple of questions. So starting on credit, commercial real estate, you see how 9% of it is shopping centers in retail. Can you talk about how you're feeling about this portfolio and modification activity or deferral activity there?

Sure. I'll give a quick overview and then let Jason drive home some points. I've always said when asked about the commercial real estate portfolio that we've been a sort of low risk, low return business. Bill Wrang that runs that business, I always mention this name on earnings calls because I think we deal with top-notch sponsors, and we have a very much of an institutional book. My view is, I feel comfortable, given the debt service coverage ratios, the sponsors, and the LTVs where we are now. But I would acknowledge as CEO, one of the long-term concerns I have is what happens with some of the commercial real estate sectors over time with changing work dynamics and retail dynamics. If anything, I mentioned earlier, you kind of have to wait and see how credit plays out with all these macro variables. I think commercial real estate is going to be the last one to kind of figure out what happens there just given some of maybe the long-term shifts. Jason, maybe you want to address that question more specifically?

Yes. No, happy to, John. You mentioned sort of the ratios and the metrics overall in that book within commercial real estate, where we have a weighted average, 60% loan-to-value, and sort of 1.7 debt service coverage going into the environment. Obviously, that will see some impact. The more important thing is 72% of our commercial real estate portfolio is nondiscretionary versus discretionary anchored by pharmacy and retail. We've seen a real difference in terms of rent collection rates in those sectors. So far, we've provided relatively modest accommodations on that portfolio, 6 loans, about $70 million in exposure. I’m never going to claim on this call that we’re out of the woods on anything; just given the environment. But so far, our performance in that book has been relatively strong.

Great. And sticking with credit, it was good to see the provision down in the second quarter versus the first quarter. How should we think about the provision for the second half of the year given all the uncertainty?

Yes. So I think with respect to CECL, you nailed it. There is a significant amount of uncertainty at this point. We'll update our models. We'll look at the macroeconomic factors, risk ratings, loan modification trends as well as we get further clarity on the impact of stimulus on the portfolio. It’s sort of hard to give a number going forward, but we'll continue to monitor that.

Yes, Dave, I mean, it's interesting, right? To simplify it as much as you can if the forward economic forecast deteriorates that leads to higher provision. Risk rating trends within your portfolio, depending on which way they go impact it, and then other more qualitative borrower behaviors like modifications and other things kind of factor in. Those are the variables, the high-level variables, and then, of course, throw in government stimulus and other customer behaviors, and that's where we go. This was a pretty simple one. As Glenn went through, we had a reduction in our forward outlook. We had some good news on modification activity, and we had some slight downtick in our risk rating. We ended up where we are here. Those are the things that will give you some directional sense as to where we might be going forward.

Okay. And then on the net interest margin, and clearly, there’s going to be a lot of noise in the near term, you mentioned about the uncertainty around when the PPP loans are forgiven. But if we were to fast forward to say the second quarter of 2021 or the third quarter of 2021, if we were to assume interest rates are flat, remaining very low here. Do you have a sense as to where the net interest margin could be close to PPP?

Sure. Within a range. I think if you look at 1-month LIBOR, we pushed that out at basically 18 basis points fed funds at 25 basis points. So maybe a slight increase in the 10-year, and you can look at the impact of that in our slides, whether you think that rate is going to come down. But if I do all that and look at our asset growth, I think you'd be modestly below where we are today. And you'd pretty much bottom out at that point. You're right about PPP; I think over the next two quarters that will create a lot of noise within NIM as well as net interest income.

And just one quick one on HSA. You mentioned about how the pipeline for RFPs heading into the 2021 season is picking up for June and July. Do you have a sense as to how that compares to the pipeline a year ago?

Chad, do you want to take that one?

Yes, absolutely. I would make two comments on that. One is the pipeline is up modestly year-over-year, and we started out much stronger. It died down for a couple of months and then snapped back right back to actually above prior levels. So a little bit above last year. It's the win rate that's really up significantly year-over-year in the large employer space, because we're in the large employer selling season right now, which has been delayed a little bit as well.

Our next question is coming from Jared Shaw of Wells Fargo Securities.

Just I guess, circling back to the provision, the allowance, and it looks like the Moody's model for July deteriorated just a little bit, incrementally, versus June. But if we assume that, broadly, the economic model doesn't change much, and you start seeing actual loan-level losses, do you think that the current allowance is enough to cover that? Or would you be inclined to continue to provide for incremental losses, sort of, given the broader continued uncertainty around the economy?

Yes. I mean right now, Jared, it's Glenn. We think the $359 million we have right now is adequate, and it's reflective of loss content in our book. It is, as John just pointed out on the last question, a matter of looking at risk ratings, loan modifications, the macroeconomic forecast, and on top of that, the stimulus. A bigger part of this is looking at the duration of the pandemic and the impact to our customer, whether it's a retail customer or a commercial customer, their liquidity profile. It's hard to give you a number, but I think where we are at the end of the second quarter is reflective of what we see right now. If Moody's stays about where it is, then you have to look internally, at your risk rating migration, your liquidity on a customer basis, and then your modification trends.

Okay. And then, I guess, how were the trends in internal credit migration during the quarter? And are all the modified loans automatically downgraded or put on the watch list? Or how are you looking, I guess, internally at dealing with those credits?

I'll let Jason take the second one, Jared. I mentioned earlier just with respect to internal risk rating migration that our weighted average risk rating deteriorated modestly in the quarter. The interesting dynamic there was the vast majority. I mean, almost all of it occurred within pass rating categories. If we're accurately risk rating, which we think we do and our regulators think we do, those are pass graded credits that we would underwrite even at their slightly deteriorated level. This has an impact on pushing the provision slightly higher. I also want the market to understand that we're not hunting forward or kicking the can on risk identification and risk rating. We're looking at our credits as information is provided to us, and we're talking to all of our big commercial customers, and we're making the appropriate assessments on a daily basis where we can get information and we take those circumstances and make the right call. Jason, do you want to talk specifically about what modification means with respect to risk rating?

Yes. No, I'll just talk a little bit about our overall approach, right? It's not an automatic downgrade if somebody is being modified. It depends on a number of factors, whether it's a payment modification, whether it's a temporary covenant modification, bridge to a broader solution, as I mentioned before. Our approach is really, of course, more forward-looking than just looking at historical metrics given the current environment. We're specifically assessing whether the borrower has adequate liquidity to make it through this environment until revenue returns to reasonable levels. As we know, overall liquidity has been enhanced by PPP deferrals. In some of our larger structure businesses where you're having a lot of these conversations on meaningful risk ratings, we're getting cash flow projections that really help influence our decisions on a rating, and we're actively tracking the true liquidity on a weekly basis versus what the companies were projecting and the revenue associated with that. In some of our smaller businesses, we're downgrading by sector. We will continue to address and adjust our ratings as we get more borrower-specific information as well as within the context of the overall economic environment. But it's not an automatic downgrade just because they've asked for a deferral.

Okay. That's great color. And then just finally for me, Glenn, you mentioned PPP forgiveness assumed to be 75% in 2020. What's your total assumption forgiveness out of the whole portfolio? I'm sorry, over the life of the portfolio.

I think we go all the way through probably the end of the first quarter of 2022. So it drops down. If you think about it this way, Jared, say, 20%, 25% in Q3 and 50%, 55% in Q4. That's 75% of it right there. Most of it trends down throughout 2021.

So I can sort of assume like a 90% total forgiveness level for the year?

Yes. By the end of 2021, I think that's a good number.

Our next question is coming from Steven Duong of RBC Capital Markets.

Most of my questions have been addressed. I just have a general question. How does the Moody's economic forecast you consider compare to your experiences during the financial crisis?

It's hard to handicap; it's a different form of economy, and that you have the sharp real GDP. You go from a negative GDP in Q1 to minus 33%. Likewise, unemployment. So it's sort of very steep and then a snapback in some respects.

That's exactly right.

I think it's interesting because, obviously, the banking industry as a whole is doing a lot more stress testing and has a lot more capabilities to forecast now than when we went through this during the Great Recession. But what's interesting is I think Glenn hit the nail on the head, we're dealing with something here that's difficult because there's a big exogenous shock right away. There's a lot of uncertainty about the path of the recovery. The financial crisis just had a longer duration, and it was kind of cumulative losses over time. I think that's what I would say is that it's a different shape of economic forecast with a lot more uncertainty going forward as to the shape of the recovery.

And Steven, I would just mention that if you examine our worst-performing four quarters during the financial crisis, specifically in 2009, our loss content was approximately 167 basis points. That’s just for those four quarters, and I think it serves as a useful reference point.

I think we're seeing a significant rebound similar to what Moody's is predicting, with a 40% drop followed by a 50% recovery from that lower point. Do you believe the overall level of economic activity is important when we consider such extreme fluctuations? Specifically, does GDP level play a role in how businesses operate and succeed in the future?

You're asking great philosophical questions. I think that the whole CECL framework is a reasonable model. There seems to be a disconnect right now between direct correlations, such as unemployment and GDP shocks. It's not immediately correlated, and we need to wait and see how things develop, especially with government stimulus somewhat softening the impacts. When examining GDP or the posted unemployment numbers, they don't truly reflect what we can expect regarding consumer credit behaviors or small business decisions. If that's your angle, we should observe how predictive some of these variables will be moving forward, particularly after the significant GDP decline in Q2 and the subsequent bounce back.

And Steven, I would just add, I mean, it is going to be, as we said a few times now, it's more duration and so you look at our numbers and you think about the PPP loans as a percentage of total loans, and it's pretty significant. Even under the modification numbers we talked about, payment modification is a significant number of PPP loans. Our consumers, and their average DDA account is up $1,000, 13%. They're feeling pretty good. Our overdrafts are down over 20% quarter-over-quarter. That can't last forever, but it's a matter of looking at duration, and how strong the liquidity profile of our clients is and can they see their way through the other side of this? That's what we're focused on.

Again, just editorial, if you're a management team, if you're our management team, you're less focused on whether all of these variables are accurately correlated to performance and the shape of the curve, you're looking at all of the potential outcomes and the duration and making sure you're making smart decisions that will help you under a wide variety of potential economic outcomes.

Our next question is coming from Matthew Breese of Stephens.

There seems to be a mixed perspective within the industry regarding the duration of deferrals. The concept of long-term deferrals has come up as it's becoming clear that certain businesses and sectors of the economy might be affected well into 2021. Do you believe you have this kind of flexibility? Additionally, will you utilize it in practice, or should we anticipate that after 180 days of deferral...

You cut out a little bit there. I think we got the gist of the question, and I'll give you a quick thought and then hand it over to Jason. We were actually talking about this yesterday internally. I think there's kind of a natural cadence given where we are, given the fact that people still view fundamentally that this is a temporary disruption that you'll have your original modifications. Jason gave you some indication that we're pleasantly surprised that there's a lower number of people who are on modification asking for a second modification. We're still under the CARES Act. We're still in a place we want to help our customers. We were talking about what would happen if we just got into what we would call the third wave of modifications. Our view institutionally is that we really have to take a strong look, to your point, at the underlying fundamental strength of the business before we just blindly grant a third wave of modification. You won't see continued modification after modification as we go into the third wave, if you will. Anything to add on that, Jason?

Yes. I think the only thing I would add is there's probably going to be a bifurcation between the types of business and products, right? If you're talking consumer, small business going to third wave, you have to start thinking about, all right, is this permanently impaired? Should we be talking about loss mitigation type stuff at that point? Whereas, I just take on the commercial side and sponsor, right? You may have a situation where we granted an additional waiver, the sponsor in the second amendment agreed to put in a few million dollars because the lion's share, the revenue they were expecting in the second half of the year is gone. Take a company that puts on events and conferences. That's just not going to happen this year, right? They put a temporary bandit on, but we all know that in early 2021, when they have their slate of events laid out, there may be a third round, which is a broader solution with some equity, maybe some incremental deferrals on payments; and that's just how it works more on the structured larger deals. The answer is different depending on what business you're talking about.

Understood. So practically speaking, you have the option to carry deferrals well into 2021, but it's a case-by-case as to whether you'll exercise it or move it to NPA.

I think that's well said.

Okay. And then just a real quick one. What was the PPP contribution to net interest income this quarter? Or what was the all-in PPP yield this quarter?

The all-in, the contribution was somewhere around $6 million, and the all-in yield is probably around $272 million. You got to be careful with that because that's not a full quarter yield.

Understood. What would it be on a full quarter? It would likely be closer to around $350 million. If you consider our average balance of a PPP loan, which is about $135,000, the all-in yield would amount to about $350 million, with a funding cost of roughly $35 million. You would end up around $350 million.

At this time, I would like to turn the floor back over to Mr. Ciulla for closing comments.

Thank you very much. Thank everyone for being with us this morning, and be well and stay safe. Thank you.

Ladies and gentlemen, thank you for your participation. This concludes today's teleconference. You may disconnect your lines at this time, and have a wonderful day.