Earnings Call Transcript - WBS Q4 2020

Operator, Operator

Good morning, and welcome to Webster Financial Corporation’s Fourth Quarter 2020 Earnings Call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded. I would now like to introduce Webster’s Director of Investor Relations, Terry Mangan to introduce the call. Please go ahead, sir.

Terry Mangan, Director of Investor Relations

Thank you, Darrel. Welcome to Webster. This conference is being recorded. Also, this presentation includes forward-looking statements within the safe harbor provision of the Private Securities Litigation Reform Act of 1995 with respect to Webster’s financial condition, results of operation, 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 fourth quarter of 2020. I’ll now introduce Webster’s Chairman and CEO, John Ciulla.

John Ciulla, CEO

Thanks, Terry. Good morning, everyone. I appreciate you joining Webster’s fourth quarter earnings call. Glenn MacInnes, our CFO, and I will discuss our business, financial, and credit performance for the quarter. After that, HSA Bank President Chad Wilkins and our Chief Credit Officer Jason Soto will be available for Q&A. Reflecting on 2020, a year filled with challenges in many ways, I want to express how proud I am of Webster bankers for their commitment to each other, our customers, communities, and shareholders. Although rising COVID cases continue to pose challenges, we are hopeful that 2021 will bring some normalization as vaccine distribution significantly alters the pandemic's trajectory. The broader economy, including sectors affected by COVID, continues to recover, and the recent peaceful transition of power may signal the start of a less divisive political climate. We remain dedicated to carefully managing our capital, credit, and liquidity while preparing for growth and strong performance as the macro environment improves in 2021 and beyond. Moving on to our performance in the quarter, I am very pleased. We originated $1.9 billion in loans, generated strong fees from loans, maintained deposit growth, and HSA total footings approached $10 billion. Credit trends are positive, and our net interest margin has stabilized. Our adjusted earnings per share for Q4 were $0.99, an increase from $0.96 the previous year. This quarter included $42 million in pretax charges associated with the strategic initiatives we discussed last quarter, which Glenn will elaborate on. An improved economic outlook, despite ongoing uncertainty, combined with a flat loan portfolio, led to a $1 million release from our CECL allowance this quarter. Our adjusted return on common equity was 11.5%, and the adjusted return on tangible common equity was 14.2%. Loans grew by 8% from a year ago, or 2% when excluding $1.3 billion in PPP loans. Commercial loans increased by 6% year-over-year, translating to more than $800 million. Deposits surged by 17% compared to the previous year, driven by growth across all business lines. The loan yield saw a rise of 4 basis points quarter-over-quarter, while deposit costs continued to decline. We reported a very strong quarter in Commercial Banking, with over $1.2 billion in loan originations, an increase from Q3 and only slightly below a strong Q4 2019. Loan fundings of $825 million also showed solid growth from Q3. We benefited from our expertise and deep relationships in specific sectors, including technology, which remained unaffected during the pandemic. Commercial bank deposits reached record levels, rising over 35% compared to the fourth quarter of last year. The yield on our Commercial Banking loan portfolio increased by 9 basis points this quarter, driven by better spreads and a higher pace of deferred fee acceleration as we returned to more normalized payoff activity. Noninterest income in Commercial Banking improved, reflecting higher fees tied to strong origination activity. Regarding HSA Bank, total footings increased 17% year-over-year, nearing $10 billion. Core deposits rose by 15%, and 13% when excluding the State Farm acquisition that occurred in 2020. The year-over-year rise in balances was due to ongoing contributions and decreased account holder spending as a result of COVID-19 restrictions. We did see a decrease in TPA accounts from last year, corresponding to anticipated departures in Q3. In 2020, we added 668,000 accounts, which is 10% fewer than the previous year, consistent with industry trends primarily due to lower enrollments with existing employers as COVID-19 affected overall employment. We expect this trend to persist into the first half of the New Year. HSA deposit costs continued to decline in this low interest rate environment, totaling 9 basis points in the quarter. Turning to Community Banking, loans grew by 5% year-over-year but saw a decline of 5% when excluding PPP. As noted, PPP loans decreased by $63 million as repayment and forgiveness activities began this quarter. Community Banking deposits grew by 14% year-over-year, with consumer and business deposits increasing by 9% and 31%, respectively. Deposit costs continued to decline, totaling 16 basis points this quarter. Net interest income rose by $8.3 million from a year ago, driven by loan and deposit growth. The next two slides provide details on credit metrics and trends that have remained surprisingly stable despite the macroeconomic challenges. Our commercial loan sectors most impacted by COVID have shown a decrease in overall loan outstandings from September 30th by 10%, and payment deferrals have dropped by $64 million, or 31%. We also saw payment deferrals decline by 35% to $315 million at December 31st, now representing 1.6% of total loans, down from 2.4% at September 30th. At the end of the year, $100 million, or 32% of the $315 million in payment deferrals, were first-time deferrals. Payment deferrals defined under the CARES Act also decreased by 29% from September 30th, now at $201 million. Although we continue to face challenges from the pandemic and the economy, I am proud of the support we have provided to our customers during these tough times. We are actively monitoring risk, making real-time credit rating decisions, and addressing potential credit concerns proactively. We have confidence in our risk selection, underwriting processes, portfolio management capabilities, and capital position. Now, I will hand it over to Glenn for the financial review.

Glenn MacInnes, CFO

Thanks, John. I will focus on the key aspects of performance in the quarter, including stable adjusted net interest margin, an increase in noninterest income, ongoing expense control and a favorable credit profile. I’ll begin with our average balance sheet on slide 9. Average securities grew $160 million or 1.8% linked quarter. Securities represented 27% of total assets at December 31st. Average loans declined $142 million or 0.6% linked quarter, primarily driven by a $176 million decline in consumer loans, reflecting higher pay-down rates in mortgage and home equity portfolios. Prepayment and forgiveness on PPP loans during the quarter totaled $98 million. In Q4, we recognized $7.3 million of PPP deferred fee accretion, and the remaining deferred fee balance totaled $27 million at December 31st. Deposits increased $276 million linked quarter, primarily driven by growth in Community Banking and HSA. This was partially offset by a reduction in CDs. The strong growth in deposits allowed us to pay down borrowings, which were lower by $289 million from Q3. At $1.9 billion, borrowings represent 5.2% of total assets compared to 7% at September 30th and 11.6% in prior year. The tangible common equity ratio increased to 7.9% and will be 32 basis points higher, excluding the $1.3 billion and 0% risk weighted PPP loans. Tangible book value per share at quarter-end was $28.04, an increase of about 1% from September 30th and 3% from prior year. Slide 10 highlights adjustments to reported net income. Aggregate adjustments totaled $42 million pretax, or $31.2 million after tax, representing $0.35 per share. Of the $42 million in adjustments, $38 million is related to our strategic initiatives, which John will discuss further. The remaining $4.1 million is associated with the debt prepayment. The prepayment expense adversely impacted current quarter net interest income and impacted net interest margin by 5 basis points. However, we will benefit by approximately $1.3 million in net interest income per quarter, and NIM will benefit by 2 basis points. On slide 11, we provide our reported and adjusted income statement. As highlighted on the previous page, the adjustments total $42 million pretax. On an adjusted basis, net interest income increased by $1.3 million from prior quarter. This was a result of a $4.5 million reduction in deposit and borrowing costs, along with $1 million in additional loan income, which was partially offset by a $4 million decline in securities income, primarily as a result of elevated prepayments. Taken together, our adjusted net interest margin of 2.8% was flat to third quarter. As compared to prior year, net interest income declined by $11 million. $47 million of the decline was the net result of lower market rates and was partially offset by interest income of $29 million from earning asset growth and $8 million from a reduction in borrowings. Noninterest income increased $1.7 million linked quarter and $5.9 million from prior year. Loan fees increased $2.5 million from prior quarter as a result of higher syndication, prepayment and line usage fees. Other income increased $4.4 million, reflecting higher direct investment income and swap fees. HSA fee income decreased $3.1 million linked quarter as Q3 included $3.2 million of exit fees on TPA accounts. Mortgage Banking revenues decreased $3 million linked quarter as a result of lower volume on loans originated for sale. The $5.9 million increase in noninterest income from prior year reflects additional loan fees, higher mortgage banking revenue and HSA fee income, partially offset by lower deposit service fees. Noninterest expense of $181 million reflects an increase of $2 million, primarily due to technology and seasonal increases in temporary staffing to support the HSA annual enrollment. Noninterest expense decreased $1.5 million or 1% from prior year, and our efficiency ratio was 60% in the quarter. Pre-provision net revenue was $116 million in Q4. This compares to $115 million in Q3 and $122 million in prior year. Our CECL provision in the quarter reflects a credit of $1 million, which I’ll discuss in more detail on the next slide. And our adjusted tax rate was 22.1%. Turning to slide 12, I will review the results of our fourth quarter allowance for loan losses under CECL. The allowance coverage ratio, excluding PPP loans declined from 1.8% to 1.76% with total reserves of $359 million. The reserve balance reflects our lifetime estimate of credit losses. The small decline from prior quarter is the net effect of an improvement in the macroeconomic forecast partially offset by additional qualitative reserves. The increase in qualitative reserves is driven by uncertainty around the resolution of the pandemic and the pace of the recovery. The total reserves provide a more adverse scenario than shown in the baseline assumptions at the bottom of the page. Slide 13 highlights our key asset quality metrics as of December 31st. Nonperforming loans, in the upper left, increased $3 million from Q3. Commercial, residential mortgage and consumer each saw linked quarter declines, while commercial real estate increased. Net charge-offs, in the upper right, decreased from the third quarter and totaled $9.4 million after $1.9 million in recoveries. The net charge-off rate was 17 basis points in the quarter. Commercial classified loans, in the lower left, increased $30 million from Q3 and represented 352 basis points of total commercial loans. Slide 14 highlights our liquidity metrics. Our diverse deposit gathering sources continue to provide us with considerable flexibility. Deposit growth of $414 million exceeded total asset growth and lowered the loan-to-deposit ratio to 79%. Our sources of secured borrowing capacity increased further and totaled $12 billion at December 31st. Slide 15 highlights our strong capital metrics. Regulatory capital ratios exceed well capitalized levels by substantial amounts. Our common equity Tier 1 ratio of 11.35% exceeds well capitalized by $1.1 billion. Likewise, Tier 1 risk-based capital of 11.99% exceeds well capitalized levels by $895 million. Our guidance will continue to be impacted by the pace and duration of the pandemic over the next few quarters. That being said, we anticipate modest loan growth, excluding the timing of PPP forgiveness and round two originations. NIM will also be influenced by the rate environment and PPP forgiveness. Assuming today’s rates, we would expect net interest income to be around Q4’s level. Noninterest income will be modestly lower linked quarter, driven by lower loan-related and mortgage banking fees. The provision for credit losses will continue to be impacted by credit trends, the macroeconomic environment, government stimulus and the duration of the pandemic. Core operating expenses will be lower as we begin to recognize the benefits of our strategic initiatives. And our tax rate will be approximately 21% to 22%. With that, I’ll turn things back over to John for a review of our strategic initiatives.

John Ciulla, CEO

Thanks, Glenn. I’m on slide 16. As we discussed on the October earnings call, we’ve been working through a comprehensive strategic and organizational review since before the onset of the pandemic. And while today we’ll provide more detail on our progress and some shorter-term financial targets, I want to stress that the work we have done over the last year and the actions we are taking are transforming our Company and the way we do business. We believe that we will continue delivering incremental value to our customers and shareholders for years to come, consistent with our overarching objectives of maximizing economic profits and creating long-term franchise value. Importantly, these actions afford us the capacity to invest in the future and provide better customer experiences through improved products, services and digital offerings, all in the furtherance of our mission to help individuals, families and businesses achieve their financial goals. We are investing in revenue growth drivers that leverage our differentiated businesses. These include accelerating growth in new and existing Commercial Banking segments, improving sales productivity, enhancing noninterest income through treasury and commercial card products and driving deeper relationships across all lines of business. While we anticipate short-term benefits from these initiatives, they will contribute meaningfully to our financial performance in 2022 and beyond. Additionally, we continue to invest in technology to provide better digital experiences for our customers and bankers to further improve customer acquisition and retention rates. As shown on slide 17, we have made significant progress on our efficiency opportunities. We remain on track to deliver an 8% to 10% reduction in core noninterest expense. We expect this to be fully realized on a run rate basis by the end of the fourth quarter of 2021. Our efficiency initiatives fall into three areas of focus that we discussed last quarter: rationalizing retail and commercial real estate; simplifying the structure of the organization; and optimizing our ancillary spend. We’ve taken actions to simplify our organizational structure, including combining like functions, automating manual processes and selectively outsourcing commoditized activities. A portion of the project-related expense adjustments that Glenn discussed relate to these actions and the associated severance costs result from a targeted reduction in the overall workforce. We announced in December the consolidation of 27 banking centers and we have targeted actions aimed at reducing corporate office square footage over time. The real estate optimization plan reflects our response to changes in customer preferences and the shift in workplace dynamics that have only accelerated during the pandemic. The remaining quarterly cost benefits will be driven by a more disciplined approach to ancillary spend, redesigning and automating internal critical processes and leveraging back office synergies. Slide 18 provides an overview of the cost savings and an expense walk to our fourth quarter target run rate. Achieving these efficiencies will allow us to continue to invest in our franchise and improve the customer experience. The last slide for me is an important one. We’ve updated it from prior quarters. It aggregates our activities during 2020 related to helping our employees, our consumer and business customers and the communities we serve navigate an extraordinarily challenging time. This is what the Webster way is all about. I have to thank each of our bankers for their dedication, perseverance and hard work during the pandemic and through a period of transformation. The commitment to our customers, our shareholders and to each other has enabled Webster to continue to differentiate itself. And before we go to Q&A, I’d like to take a moment to share with you all that today is Terry Mangan’s last earnings call as he will be retiring on March 31st. Many of us and many of you have had the pleasure of working with Terry over his 18-year career at Webster. Terry’s efforts have been recognized at the national level by Institutional Investor as a top Investor Relations professional. I want to thank Terry personally for his significant and long-lasting contributions that have helped our organization navigate through exciting, fun and challenging times. With that, Darrel, Glenn, Chad, Jason and I are prepared to take questions.

Operator, Operator

Thank you. Our first question has come from Steven Alexopoulos of JP Morgan. Please proceed with your questions.

Steven Alexopoulos, Analyst

Hey. Good morning, everybody. I wanted to start on the strategic plan. And I appreciate the $18 million of projected cost saves being called out by 4Q. John, can you give us an idea or maybe Glenn, in terms of the timing of that recognition through the year? I’m just trying to get a better sense of when these cost saves will work into the run rate through the year.

John Ciulla, CEO

Yes. Steve, I’ll take a shot at it and then Glenn can add some more context. As you said, first quarter, expenses should show the beginning of our expense moves. The second quarter, when the banking center consolidations are complete and many of the employee actions will be complete, will be the real time where we’ll see a more dramatic shift in expenses. And then, we see more savings in the third and fourth quarter. So, without giving you kind of a specific scorecard, I’d say first quarter will be modest. You’ll see a bigger drop in the second and third quarters, getting to that final run rate target.

Steven Alexopoulos, Analyst

Okay. That’s helpful. And then, maybe for Glenn, I appreciate the NII guidance for the first quarter. But, if we think about the forward curve, how are you thinking about the trajectory of margin through the year? And specifically, I’m hoping you could comment on the additional opportunity maybe to pay down additional borrowings.

Glenn MacInnes, CFO

Thank you, Steve, and good morning. I want to highlight two points. First, we noticed an increase in prepayment speeds, especially in the CMBS portfolio, which is also evident in the treasury portfolio's yield. This shift is part of a broader industry trend, putting some pressure on our core net interest margin. Second, regarding borrowings, we have the chance to reduce around $500 million in short-term, low-rate borrowings, with a weighted cost of approximately 8 basis points. On the funding side, we have about $900 million in CDs maturing in the first quarter at 81 basis points, which will typically reprice to around 25 to 27 basis points. For the entire year, we have about $2 billion in CDs maturing at 66 basis points, and we could gain another 30 basis points there. Therefore, for core net interest margin, I expect it to fluctuate between 2.85% and 2.87%. However, the variable to consider is liquidity and stimulus; as more funds enter the market, depending on the final legislation, municipalities and businesses could end up with significant liquidity. If we don’t see corresponding loan growth, we may have to place that money at the Fed or invest it elsewhere. We are continuously evaluating those options.

Steven Alexopoulos, Analyst

Okay. That’s helpful. Then maybe one final one, assuming Chad’s there. So, HSA account growth was a bit soft in 2020. Can you talk about the outlook for 2021 and maybe any early reads, given the enrollment season that wrapped? Thanks.

John Ciulla, CEO

Sure. Chad, I’ll throw that directly over to you, if that’s okay.

Chad Wilkins, HSA Bank President

Thanks, John. Thanks, Steve. Steve, if you've been monitoring our account growth over the last three quarters, we've experienced a decline of about 15% to 20% compared to previous periods due to the pandemic's effect on the economy and labor markets. We're seeing similar patterns in our one-on-one enrollments, as core new accounts for January and the trend into Q1 are approximately 20% lower than last year at this stage. The weakness is predominantly in our new accounts from existing employers, which we’ve mentioned before, account for about 80% of our account generation. Currently, new accounts and HSA accounts from existing employees are down around 30%. However, as we've noted in previous calls, we are having a successful new employer sales season, with enrollments from new employers increasing by about 25%. Overall, we're down about 20%, which aligns with the declines we've observed since the pandemic began in Q2 and appears consistent across the industry.

Steven Alexopoulos, Analyst

Okay. That’s helpful. And before I sign off, congrats to Terry. I can’t wait to get a copy of your book. Thanks, everybody.

Terry Mangan, Director of Investor Relations

Thanks, Steve.

Operator, Operator

Our next questions come from the line of Chris O’Connell with KBW. Please proceed with your questions.

Chris O’Connell, Analyst

Congratulations to Terry on your retirement.

Terry Mangan, Director of Investor Relations

Thanks, Chris. It’s good to hear from you. Strange to see a different name than Collyn’s since before the financial crisis, quite a long street, but we’re glad to have you on the call.

Chris O’Connell, Analyst

Absolutely. So, just circling back to Chad in response to the previous question. Were those percentages specifically referring to account growth? If so, do you have any insights on what the deposit balances might be doing with the enrollment season in the first quarter?

John Ciulla, CEO

Yes. We mentioned that deposits haven't aligned with account growth due to the gradual seasoning of accounts and the impact of the pandemic in 2020, which significantly reduced spending from the accounts. While I hesitate to say they are artificially higher, it's true that the lack of spending contributes to this. Chad, could you clarify what one-to-one looks like or how the year will shape up regarding deposits? Chad has unfortunately left the call. Chris, we stated that deposits increased by about 13% and 15%, respectively. Excluding the State Farm acquisition, the figures remain at 13% and 15%. Although account growth was relatively flat, adding in the TPA accounts, our new account growth was around 20% lower compared to last year. Nonetheless, we experienced substantial growth in deposits, and we are also seeing significant deposit growth in the first quarter, similar to the previous year. Glenn can provide the dollar amount, but it's worth noting that the disconnect between accounts and deposits may be due to fewer transactions from individual accounts, as people are not utilizing as many elective medical services as they did before the pandemic.

Glenn MacInnes, CFO

Yes. And I would just add. I mean, our forecast and it’s still relatively early, our forecast for deposits quarter-over-quarter, so fourth quarter to the end of the first quarter is somewhere between $350 million to $400 million at this point.

John Ciulla, CEO

I think, we have Chad back. I don’t know, Chad, if you heard us. Anything you else you wanted to say about kind of deposits? I talked about them kind of splitting off from account growth because of certain pandemic related trends. Okay. He’s not on. We’ll move on. Chris, does that answer your question?

Chris O’Connell, Analyst

Yes. No, that’s fine. That’s great. The $350 million to $400 million I think is a good starting point. And then, you guys have mentioned I think kind of modest loan growth outlook, at least near term. As you kind of go through the course of 2021, and obviously the environment is kind of constantly changing at this point, but where are you guys seeing loan growth demand, and where are you most comfortable growing loans at this point?

John Ciulla, CEO

Yes, Chris, that's a great question. I often say that each quarter we observe notable fluctuations in payoffs, whether that's significant increases or decreases, as well as substantial spikes in originations. Even during a pandemic year, commercial loan growth is nearing the 8% to 10% range we typically achieve annually. I always mention the various strategies we have, both regionally and across different sectors and asset classes. The fourth quarter was quite interesting. We didn't experience overall loan growth on the balance sheet, but we did see an outflow in mortgage refinancing, despite our activity being relatively high. Although our originations were robust for what we expected to be a subdued fourth quarter due to the pandemic, we also had considerable payoffs. In contrast to the fourth quarter of 2019, which was propelled by strong commercial real estate growth, the fourth quarter of 2020 was driven by significant growth in sponsor and specialty areas, especially in technology and healthcare. Looking ahead, there may still be some uncertainty in the real estate market. Certain property types, like retail, do not present many opportunities at the moment, and there is substantial uncertainty in the hotel sector. When considering mixed-use, industrial, and office spaces, many of our key, highly regarded real estate investors seem to be taking a pause. Therefore, I would say the pipelines are decent but not exceptional. However, I believe technology and healthcare will contribute a considerable amount to growth. Our middle market, municipal, and institutional sectors have performed well in this rate environment, and we expect that to continue. Thus, I would recommend focusing more on commercial and industrial lending rather than commercial real estate. Additionally, one reason Glenn describes the outlook as modest is that while we do have some pipeline, we also anticipate some payoffs, which could be a significant factor in whether we can grow the loan book significantly.

Chad Wilkins, HSA Bank President

Hey John, I’m back on, by the way. I’m sorry. I got kicked off here.

Operator, Operator

Thank you so much. Our next questions come from the line of Brock Vandervliet with UBS. Please proceed with your questions.

Brock Vandervliet, Analyst

Just going back to the earlier question on HSA business, it seems like, just stepping back a bit, much of the slower growth is COVID-related in one way or another. What’s your sense of, for example, if we were to get vaccine efficacy mid-year, when does the HSA business kind of shake off this hangover?

John Ciulla, CEO

Yes. I’ll take a shot and then I’ll give it to Chad. I think, again, let me put a high perspective on it. We are still so bullish on the business. Our trends are consistent with what we can read, at least through the periodic Devenir reports and what our pure-play competitors report in conferences. It does seem to be an industry sector experience that we’re seeing. I think, I want to put a finer point on what Chad said before that really the slowdown in account growth was almost entirely related to existing customers we have, not signing up as many new accounts and new employers because of the employment market, right? Many companies aren’t hiring. Some companies are shedding employees. And so, I do think that the good news for us is that during the pandemic, we actually had our best year in terms of driving new large employer wins. And so, while accounts per employer are down, we’re adding customers. And so, as the economy rebounds, as the employment market changes, as confidence gets out there and there is more activity, we feel like we’ll naturally be able to capture new accounts through the new employers we’ve gotten. I think, our best guess, my best guess would be, like everything else, we look to the second half of 2021 when there is a little bit more activity. And then, as we recall, there may be some pent-up demand for medical procedures, which could also mute deposit growth over time. But, we think that’s when we might get more activity in the market. Chad, I don’t know if you disagree or if you have anything further to provide there.

Chad Wilkins, HSA Bank President

That’s right, John. We believe that everything will return to pre-pandemic levels as the economy reopens and we move past the pandemic. You covered all the key points. To add to what you said, yes, we're experiencing similar deposit growth in the first quarter compared to last year, so we anticipate the first quarter will be about the same. However, we need to remember that for TPA accounts, we expect around 60% of the deposits and accounts to roll off throughout the year, mostly not in the first quarter, but in the later months.

Brock Vandervliet, Analyst

Okay. And a quick accounting kind of follow-up for Glenn. The loss on hedge terminations, $3.7 million, did that flow through NII, or was that...

Glenn MacInnes, CFO

Yes.

Brock Vandervliet, Analyst

It did.

Glenn MacInnes, CFO

There are two components. One is a break fee of $400,000 that impacts income. The other part contributes to net interest income, which was approximately 5 basis points on margin.

Brock Vandervliet, Analyst

Okay, great. I wanted to clarify that. I think that’s important. Okay. Thank you.

John Ciulla, CEO

Thanks, Brock.

Operator, Operator

Thank you. Our next questions come from the line of Mark Fitzgibbon with Piper Sandler. Please proceed with your questions.

Mark Fitzgibbon, Analyst

Good morning, everyone, and congratulations, Terry. John, my first question is about the expense initiatives. Do you think there’s still more potential to reduce costs and improve efficiency ratios, especially with the ongoing digitization of the business after the optimization program is complete? Can you achieve even greater efficiencies?

John Ciulla, CEO

We do think there is potential for improvement, Mark. On page 18, you'll see it reflects the lower end of the 8% to 10% growth range. We are optimistic about reaching the full 10% as we progress into 2022, focusing on enhancing efficiency and reducing delivery costs. I want to clarify that our aim is not to generate shareholder value through cost reductions alone. We intend to continue advancing our distinct Commercial Banking, HSA, and Community Bank businesses for long-term growth. Our target is to improve efficiency in unit costs over time. If interest rates rise and loan growth significantly increases, we want to be ready to expand our Commercial Banking sector, hire new bankers, and invest in technology. While our overall cost in dollars may increase, our goal is to achieve operating leverage, substantially reduce our cost structure, and continually enhance efficiencies by generating more revenue.

Mark Fitzgibbon, Analyst

Great. And then, secondly, can you update us on how you’re thinking about geographic expansion and maybe share some thoughts on whether your view with respect to M&A has changed? Obviously, you have a strong currency now. I’m curious how you’re thinking about M&A.

John Ciulla, CEO

Yes. It’s interesting. I think from a geographic expansion perspective, it’s always on our drawing board. And we have paused obviously in this unique environment over the last few years in kind of a credit frenzy first, a lot of competition and now obviously the pandemic. I could see us expanding in contiguous geographic metro markets to go into middle market. As you know, we have a significant national presence in our key industry sector specialties, which I think we’ve proven over time. We know how to select risks and we have really deep knowledge there. So, we’ve been able to maintain good growth and expansion without planting flags in other cities. But, we do see that as part of the tool of expanding Commercial Banking over time. With respect to M&A, it’s interesting, I got a lot of feedback from the last call that I had pivoted and I certainly didn’t mean to. I mean, I think, the answer for us is always, as you know, we’re very confident in the fact that we believe we’ve got differentiated businesses that we need to exploit over time and we need to continue to invest in. And so, we think we can grow organically over time. We’ve also said that scale matters and that if there were a really, really compelling opportunity in HSA or from a whole bank perspective that had great strategic and financial merits to it, obviously, we would look at it. But I will tell you that this bank right now, particularly, Mark, as you can imagine, undergoing the transformation we’re going through right now is completely focused internally at making sure that we drive value, that we take care of our customers and take care of our own business. And then, we’ll look at opportunities if they arise.

Operator, Operator

Our next question comes from the line of Jared Shaw of Wells Fargo. Please proceed with your questions.

Timur Braziler, Analyst

Hi. Good morning, everyone. This is Timur Braziler filling in for Jared. Maybe starting first on the allowance, just wondering how heavy did you guys lean on the qualitative overlays in keeping the allowance at somewhat of an artificially elevated level. And as we go forward, how should we think about applying these qualitative overlays and what type of pace of reserve release could we see if the economic backdrop and credit picture remains unchanged?

Glenn MacInnes, CFO

Hey, Timur. Good morning. It’s Glenn. Let me address that first and then John can provide further insights. First, it's important to note that the quantitative methods still make up a significant majority of our total allowance. Regarding qualitative adjustments, given the current environment with its heightened uncertainty, it's likely that we will see a higher percentage of qualitative factors compared to quantitative ones to address the unknowns. Additionally, during the ten months of the pandemic, our customer performance has shown significant differences compared to previous recessions, and the qualitative factors are essential for managing risks not accounted for by the model. While we don't specifically disclose the qualitative reserve, as noted in our K, it is influenced by factors such as credit concentration, credit quality trends, the quality of internal loan reviews, the nature and volume of the portfolio, staffing letters, underwriting exceptions, and other economic considerations not included in the base.

John Ciulla, CEO

I think that’s great. Timur, you should observe the processes we’ve developed to leverage a lot of data and models. It's mostly driven by quantitative analysis. Stepping back from an industry perspective, after the significant shock to GDP in the second quarter, all our models overestimated losses because they were based on projections from sources like Moody’s, GDP, and unemployment. Historically, those models did not forecast significant short-term losses that ended up not materializing. Now, we’re seeing the opposite trend with a more optimistic economic outlook, although there isn't much loan growth. Most banks maintain consistent portfolios and don't need to provision significantly for new loans. The models may also predict too much of a release due to ongoing uncertainties like new virus strains, vaccine distribution and efficacy, and whether the government stimulus will effectively target the right areas. There’s still substantial uncertainty present. However, Glenn is correct that the core process for all banks remains having a reliable, repeatable, quantitative-driven approach, using relevant quantitative factors to ensure that actual conditions align with predictive models regarding future losses. I’ve been surprised to observe among our peers in the mid-cap sector a general theme of minimal provisions and small releases within that margin, indicating we align with many of our peers.

Timur Braziler, Analyst

Right. And could that accelerate if loan growth doesn’t reengage in, let’s say, the next two quarters? Can we see an acceleration of reserve releases as some of that uncertainty rolls off, or are you going to try and maintain some of those balances and incorporate future loan growth into that amount?

Glenn MacInnes, CFO

Loan growth is one factor we consider, along with economic conditions, credit quality, and risk migration. Additionally, we take into account factors such as government stimulus that may arise in the future. It's difficult to predict, but I believe the $359 million total allowance we completed the year with is our best estimate. This figure is mainly based on quantitative methods, complemented by qualitative methods to address uncertainty.

John Ciulla, CEO

Okay, that’s good color. Thank you. And then, last one for me. Just on the second round of PPP, any kind of guidance you guys can provide for us on what kind of magnitude we should be expecting out of the second round, or is it still too early to tell?

Jason Soto, Chief Credit Officer

Yes. So, in the first couple of days here, we’ve received over 2,000 applications, about $250 million in total volume. We’ve processed a good portion of those and ready to start submitting to the SBA. So, I think, overall, I would say, we probably don’t expect the same level of activity as we had last time around, but the early start has been pretty good.

Operator, Operator

Our next questions come from the line of Laurie Hunsicker with Compass Point. Please proceed with your questions.

Laurie Hunsicker, Analyst

I just want to say, Terry, it’s been a great, great pleasure working with you over the years. Glenn, first question for you on the deferrals and I love the detail you give. Can you just help us understand a little bit maybe more broadly and any color you can give around the hotel book. It seems like we’ve only seen sort of two categories where we’ve seen the upticks understandably. But just if you can help us with any details on that $123 million book, what the LTV is, where they’re located, what’s flagged, any color you can share with us around that? And just maybe the uptick, going from $28 million to $45 million.

Glenn MacInnes, CFO

Sure. Jason, I’ll throw that right to you, if that’s okay.

Jason Soto, Chief Credit Officer

Yes. Looking at the book, right, if you step back, it’s really six or seven deals that make up that population. And there is really only two deals that are in active deferral in that population. And both of those are paying interest, right? They’re not paying principal. We’ve given that deferral. And the recovery, we expect it to be slow. But we’ve seen some support of willingness by the sponsors or the owners to put some money into those just to keep it going. And time will tell. Right? And so, it’s not a huge exposure. We’re not overly concerned about it. But, we are obviously monitoring it closely. And just to answer your question, the LTV going into the cycle, and obviously, we all acknowledge there’s been some impact here, but going into is about 60%.

Laurie Hunsicker, Analyst

Okay. And then, of your hotel book, the $123 million, how much of that is CRE versus C&I?

Glenn MacInnes, CFO

It’s all CRE.

Laurie Hunsicker, Analyst

Okay, perfect. Okay, thanks. And then, Jason and Glenn, maybe the same question on the $1.4 billion of leverage. Again, that was the only other uptick that we saw in deferrals, and that’s still very, very, very small, obviously, 4.3% deferral rate. But any color you can give around that.

Jason Soto, Chief Credit Officer

Yes, I’ll address that. It was primarily influenced by one credit that shifted, resulting in an active deferral, which was off set by several others that matured. We are not particularly worried about that one credit, as we have a position in the capital structure at a first out level with less than 20% loan-to-value. It is in the leisure sector, and there is five times the amount of junior equity and debt behind us in that transaction. Additionally, in return for us granting a deferral, the sponsor contributed some equity.

Laurie Hunsicker, Analyst

Okay, great. Super helpful. Okay. And then, I just wondered if maybe more broadly, John, just going back to where Mark was going in terms of the M&A question, because again, to his point, your stock is exponentially outperformed here, certainly even recently. And so, that’s very, very strong currency. Can you help us think more generally if you were to consider full bank M&A, what’s the smallest deal that makes sense? What’s the largest deal that makes sense? What’s your sweet spot? Just how you’re approaching that? And I realize you’ve got a lot going on here in the next couple of quarters, but just sort of thinking a little bit further out. Thanks.

John Ciulla, CEO

Yes. I think, Laurie, it’s hard for me to provide a detailed perspective there. I think, it’s consistent with what I’ve said before. And what we’ve said is that it’s a pretty high bar for us from a financial perspective because we think we’ve got a lot of organic running room and we certainly don’t want to kind of dilute that as we move forward. I would say, if a transaction was really financially compelling, obviously, that would be one of the gating elements. But more importantly for us, it’s around strategy. And you’ve seen the makeup of our earnings streams shift more commercial over time and more wholesale over time and you’ve seen us try and aggressively grow HSA Bank. So, kind of tuck-in acquisitions that are basically branch-based are not particularly interesting to us. So, if something came along that enabled us to gain scale, was financially compelling and was consistent with our strategic view of expanding our Commercial Banking capabilities and enhancing the value of our HSA franchise, that would be something we would look at. So, I would say larger rather than smaller and not really focused on contiguous branch acquisition.

Operator, Operator

Our next question comes from the line of Jared Shaw of Wells Fargo. Please proceed with your questions.

Timur Braziler, Analyst

Glenn MacInnes, CFO

Hey, Timur, good morning. It’s Glenn. Let me address that, and then John can provide additional insights. First, I want to emphasize that quantitative methods still make up a significant majority of our total allowance. In light of the current environment, which presents a heightened level of uncertainty, it’s reasonable to expect a larger proportion of qualitative adjustments compared to quantitative ones to account for the unknowns. Additionally, during the 10 months of the pandemic, our customer performance has differed markedly from past recessions, and qualitative factors help us manage risks that the model does not capture. While we don't disclose the qualitative reserve specifically, as noted in our K, it is influenced by factors like credit concentration, trends in credit quality, internal loan review quality, the nature and volume of the portfolio, staffing concerns, underwriting exceptions, and economic elements not reflected in the baseline.

John Ciulla, CEO

I think that’s great. Timur, you should definitely be exploring how these banks are leveraging data and models. It's largely driven by quantitative analysis. If I take a step back from an industry perspective, after experiencing a significant shock in GDP during the second quarter, all the models overestimated losses. They incorporated factors like the Moody’s model, GDP, and unemployment rates. However, we hadn't encountered such drastic short-term losses predicted by these models before. Now, on the flip side, we see an improved economic outlook, though there's not much loan growth. Most banks have consistent portfolios without a need for substantial new loan provisions. The models might be overly optimistic regarding the release of provisions due to lingering uncertainties related to new virus strains, vaccine distribution and effectiveness, and whether government stimulus will be appropriately targeted. There's still considerable uncertainty. However, Glenn is correct that it's crucial for all banks to maintain a reliable, repeatable, and model-based quantitative process. They must ensure that what they observe aligns accurately with actual events to prevent errors in predicting future losses. I have been surprised to see that among our peers, particularly in the mid-cap space, there is a trend of minimal provisions and small releases within that margin. So, we appear to be in line with many peers.

Timur Braziler, Analyst

Glenn MacInnes, CFO

Loan growth is one factor we consider, along with economic conditions, credit quality, and risk migration. There are also other elements like potential government stimulus that could come into play later. It's difficult to predict. However, I believe that the $359 million total allowance we ended the year with is our best estimate. This figure is based largely on quantitative methods, complemented by qualitative methods to address uncertainties.

Jason Soto, Chief Credit Officer

Yes, we have about $1.3 billion at year-end, maybe just a little under that. I would estimate about 40% in the first quarter, 40% in the second quarter, and then 10% and 10% in the following quarters, if you consider it that way. That can change, but that’s our current forecast.

Operator, Operator

Our next questions come from the line of Laurie Hunsicker with Compass Point. Please proceed with your questions.

Laurie Hunsicker, Analyst

Glenn MacInnes, CFO

Sure. Jason, I’ll throw that right to you, if that’s okay.

Jason Soto, Chief Credit Officer

Laurie Hunsicker, Analyst

Okay. And then, of your hotel book, the $123 million, how much of that is CRE versus C&I?

Glenn MacInnes, CFO

It’s all CRE.

Laurie Hunsicker, Analyst

Jason Soto, Chief Credit Officer

Yes, I'll take that one. It was mainly influenced by one credit that transitioned and resulted in an active deferral, which was somewhat balanced by a few others that came off. We're not particularly worried about that one credit. We have a first-out position in the capital structure with less than 20% loan-to-value. It is in the leisure sector, by the way. Additionally, there is five times the amount of junior equity and debt backing us in that deal. In return for granting a deferral, the sponsor actually contributed some equity.

Laurie Hunsicker, Analyst

John Ciulla, CEO

Operator, Operator

Our next questions come from the line of Jared Shaw of Wells Fargo. Please proceed with your questions.

Timur Braziler, Analyst

Glenn MacInnes, CFO

Hey, Timur, good morning. It’s Glenn. Let me address that and then John can provide additional insights. First, I want to emphasize that quantitative methods still constitute a significant majority of our total allowance. In light of the current environment, marked by greater uncertainty, it is reasonable to anticipate a higher proportion of qualitative adjustments compared to quantitative ones to account for unknown factors. Additionally, it's important to note that during the 10 months of the pandemic, our customer performance has differed significantly from previous recessions, and the qualitative factors help mitigate risks that are outside the model. While we don’t specifically disclose the qualitative reserve, as you may have seen in our K, it is influenced by factors such as credit concentration, credit quality trends, the quality of internal loan reviews, the nature and volume of the portfolio, staffing letters, underwriting exceptions, and economic considerations that aren't reflected in the base.