Wintrust Financial Corp Q2 FY2020 Earnings Call

Welcome to Wintrust Financial Corporation's Second Quarter and Year-to-Date 2020 Earnings Conference Call. Following a review of the results by Edward Wehmer, Founder and Chief Executive Officer, and David Dykstra, Vice Chairman and Chief Operating Officer, there will be a formal question-and-answer session. During the course of today's call, Wintrust's management may make statements that constitute projections, expectations, beliefs or similar forward-looking statements. Actual results could differ materially from the results anticipated or projected in any such forward-looking statements. The company's forward-looking assumptions that could cause the actual results to differ materially from the information discussed during this call are detailed in our earnings press release and in the company's most recent Form 10-K and any subsequent filings on file with the SEC. Also, our remarks may reference certain non-GAAP financial measures. Our earnings press release and slide presentation include a reconciliation of each non-GAAP financial measure to the nearest comparable GAAP financial measure. As a reminder, this conference call is being recorded. I would now like to turn the conference call over to Mr. Edward Wehmer.

Thank you very much and welcome to our second quarter earnings call. With me is always Dave Dykstra, our Vice Chairman and Chief Operating Officer; Dave Stoehr, our CFO; Kate Boege, our General Counsel; Tim Crane, President of Wintrust; and Rich Murphy, Vice Chairman and Chief Lending Officer. As the same format as usual, I'm going to — I'm talking funny because I had a one, two moved. It's not because I have a mask on I'm wearing. But I'm going to give some general comments regarding our results, turn over to Dave Dykstra for a detailed analysis of other income, other expense and taxes, and then provide some summary comments and thoughts about the future and then as always we'll have questions. In my 45 years being associated with the banking industry, I thought I'd seen it all. I was arrogant enough to think that. The COVID pandemic, resulting unprecedented government economic intervention, interest rate falls to basically nothing, a remote work environment for practically our entire staff, the implementation of CECL's latest pronouncement on how to determine loan loss provisioning, certainly made life interesting. To add to that, social unrest and the presidential election have made this a very spicy part of chili we're working in, along with volcanoes, earthquakes and floods to make this more difficult. In times like this when a high-tech, high-touch, relationship-based distribution model combined with conservative underwriting, strong credit and liquidity and a diversified asset base actually shine, and the strategic agility born out of our structure and culture we look forward to whatever the current environment throws at us. Sticking to the basics we know is more important. Now, the results of the quarter can be summarized in a couple of bullet points. Great asset and deposit growth, spearheaded by 11,000 PPP loans totaling $3.4 billion, resulting in a halo effect. Even better margin results despite approximately $15 million of one-time expenses — first, a $7.4 million MSR valuation adjustment and certain valuation adjustments; second, $7.3 million in additional contingent consideration related to an acquired mortgage company where we set up a liability for contingent consideration. With the moves in the mortgage market outperforming our targets, we've projected out where we think performance will be for the duration of the contingent period, so that contingent consideration accrual is a one-time item. Outside of that, we had an outsized provision expense of $135 million despite traditional, consistent credit metrics. Loan modifications appear to be decreasing, net interest margin increased due to the low rate environment's effect on liquidity which increased NII from our overall asset growth, and net overhead ratio benefited from balance sheet growth, though there were ins and outs including $5 million of one-time conversion expense related to acquisition-driven data processing conversion. Pretax, pre-provision, pre-MSR earnings were $173.1 million, up approximately $23 million not including the organic expenses previously financed and including the one-time expenses I referenced. We completed our preferred stock offering of $278 million of new capital to support growth, taking advantage of dislocation in the current market and to provide support for any further contingencies. Net income for the quarter was $21.7 million, down 66%, and earnings per diluted share of $0.34, down 67%. Our net interest margin dropped 39 basis points due to the low interest rate environment and excess liquidity. Margin compression was significant due to the rate environment going to basically zero and excess overnight liquidity held on our balance sheet. Liquidity totaled $4 billion, up $2 billion from Q1, which resulted in an overall liquidity portfolio duration of 1.7 years compared to 6.1 years since 2019. We prioritized liquidity coming into the crisis as the prudent thing to do given uncertainty of PPP funding timing. Now that things have settled down a bit, we'll be returning some of the excess liquidity in Q3, knowing there are alternative funding sources for PPP which we have not fully utilized at the holding company level. Today in the third quarter, we've started deleveraging about $1 billion, much of which is held at zero spread and will impact margin going forward. On the deposit side, approximately $133 million of CD deposits with average about 1.6% are scheduled to mature and be repriced in the next six months. Also in July and August, an additional $1.3 billion at approximately 2.23% were repriced. We expect the majority of PPP loans to be forgiven in the third and fourth quarters of this year based on surveys we did with our PPP borrowers. If Congress approves automatic forgiveness of loans under $150,000, that should expedite the process; two-thirds of outstanding loans could be covered by such a mandate, and that will help margin in the short term. As discussed, our commercial and CRE pipelines remain strong and momentum is building in our niche businesses, specifically premium finance and leasing. We still expect margin, notwithstanding the effect of PPP loans, to settle in the 2.7% to 2.8% range as the dust clears. Net interest income should also increase over time. Other income and other expense we will cover in detail, but needless to say our mortgage company did very well, generating $2.2 billion in production and over $102 million in gross income, almost double the previous quarter. Margins were strong in the mortgage business but we did take a $7.4 million MSR valuation decrease, offset by a $7.3 million contingent consideration expense I mentioned earlier. Ironically, the strong mortgage results are a good thing because we expect above-normal mortgage-related credit tails for the foreseeable future. Wealth management fees were down around $3 million due to the market fluctuations, as most fees are based on prior-quarter-end asset levels. Assets under administration of $63 billion grew $2.9 billion quarter-over-quarter, so we expect a rebound in fee income in Q3 unless there are other market shocks. On to the provision: the provision for the quarter totaled $135.1 million versus $53 million in Q1 and $25 million in Q2 of last year. Approximately 20% of that provision can be attributed to portfolio changes, the majority of which are a result of loan modifications. The remainder of the provision reflects economic assumptions in our models. All traditional credit metrics are relatively stable; charge-offs totaled $15.4 million or 20 basis points, and $9.2 million of those charge-offs were related to credits that had specific reserves assigned in previous quarters. NPAs were $198.5 million, or 0.39% of total assets, compared to $190 million or 0.4% at March 31. The majority of the increase related to premium finance; a portion of the premium finance loans we'll discuss later. The ticket size of our premium finance loans was up, and accordingly the amount of nonperforming premium finance increased. You should know, however, that essentially 99% of those losses are covered earlier because premiums are returned; they are confirmed to return premiums. GAAP requires us to present them as nonperforming but economically they are largely addressed. Loan modifications in the quarter totaled $1.7 billion, representing 9.2% of total loans. The growth curve for loan amounts flattened in Q3. We've included detailed information on our exposure to affected industries and loan modifications in the earnings release, rather than regurgitate all of it now; Rich Murphy, our Chief Lending Officer, can handle inquiries in the Q&A. Total credit reserves on the core loan portfolio stood at 1.85% of balances; premium finance loans carried a 14-basis-point reserve, which is appropriate given about $7 billion of those in the live portfolio that has never, knock on wood, had a loss historically. Purchased loans carried 230 basis points of reserve. Needless to say, we've increased reserves and provisions given current uncertainty. We may be naïve to think extraordinary events will not result in credit losses, but we've made a deliberate decision to reserve prudently. The balance sheet side: we had great growth of $4.7 billion in assets; loans grew $3.5 billion. Average loans were higher than period-end loans, which should help going forward. Our loan-to-deposit ratio was 87.8% and would have been in the high 70s without PPP loans. We have liquidity and room to invest back into loans. Loan growth did include the $3.4 billion of PPP loans and was driven by growth in our premium finance portfolio. Commercial premium finance grew $535 million, driven by higher average ticket sizes — $38,400 this quarter versus $31,500 in Q1 and $30,200 a year ago. The life insurance portfolio also grew almost $180 million. Commercial real estate loans were basically flat for the quarter, and our core commercial loans were down $502 million, approximately $300 million of which was related to line usage returning to normal levels; at the end of Q1 we had 56% line usage, down to 49% at the end of Q2 as clients drew on lines in Q1 for liquidity. We estimate another $300 million, plus or minus, of PPP proceeds will be used to pay down debt and those amounts will show as growth in the coming quarter. Speaking of PPP loans, today we have 11,632 loans totaling $3.41 billion. We could not be prouder of our team for satisfying our clients with great service. We're currently working on bringing relationships with over 450 new prospects who could not be served by other competitors. This represents an important source of new client acquisition and a halo effect. As a result, new pipelines are very full. Deposits grew nicely in the quarter as mentioned. We completed our preferred offering gaining $278 million of Tier 1 capital which will support growth. We also took advantage of asset dislocations that may result from the uncertain times and provide a cushion for unexpected contingencies. Tier 1 and total capital ratios were 10.1% and 12.8% respectively. I'll turn the call over to Dave to provide some additional details on noninterest income and expense.

Thank you very much. I touched a little bit on some of the noninterest income and expense sections, but I'll give a bit more detail. In the noninterest income section, our wealth management revenues decreased $3.3 million to $22.6 million in the second quarter compared to $25.9 million in the first quarter of the year, and down 6% from $24.1 million recorded in the year-ago quarter. The decline was impacted by volatile equity valuations during the first half of the year, which impacts pricing on a portion of our managed asset accounts and also due to some lower trading in brokerage accounts. Given current market conditions, we would expect those revenues to rebound in the third quarter. Mortgage banking revenue increased by 112% or $54 million to $102.3 million in the second quarter from $48.3 million in the prior quarter and was also up 174% from $37.4 million in the second quarter of last year. The company originated $2.2 billion of mortgage loans for sale in the second quarter compared to $1.2 billion of originations in the first quarter of the year and the second quarter of last year — so up about $1 billion versus last quarter and the year-ago quarter in production. The increase in the category's revenue from the prior quarter resulted primarily from increased volume as well as expanding production margins, which led to an increase in production revenue of $44.1 million. Capitalized mortgage servicing revenue also positively impacted mortgage revenue as capitalized MSRs net of payoffs and paydowns activity was approximately $9.3 million higher than the prior quarter. These positive revenue measures were offset by a negative MSR adjustment net of the hedging contracts during the second quarter of approximately $7.4 million compared to a negative MSR adjustment of $10.4 million in the prior quarter. The mix of originated-for-sale loan volume related to refinance activity was approximately 70% compared to 63% in the prior quarter — so refinance volume increased slightly during the quarter and the pipeline is predominantly refinance applications as of now. We expect another strong third quarter as Ed indicated, as refinance activity is represented in a strong commitment pipeline at this time. However, production margins may compress a bit from recent lofty levels. They topped over 4% and we expect them to maybe drop back down into the 3% range, we'll see. Table 16 of our earnings release provides a detailed compilation of the components of mortgage servicing revenue and MSR activity and levels. Other noninterest income totaled $14.7 million in the second quarter, down approximately $3.6 million from $18.2 million in the prior quarter. The lower revenue in this category was due to lower capital markets activity from loan sales and syndication, lower card and merchant service revenue due to lower card activity and losses on certain investment partnerships. These decreases were partially offset by $3.2 million of higher BOLI income. The BOLI investment that supports deferred compensation plans was positively impacted by equity market returns during the quarter. Note that the BOLI income in the second quarter resulted in a similar increase in compensation expense, as deferred compensation and BOLI investments move in tandem. Turning to noninterest expense categories, noninterest expense totaled $259.4 million in the second quarter, up approximately $24.7 million or 11% from $234.6 million in the prior quarter. Relative to the prior quarter, there were three main factors contributing to the increase. First, approximately $6.9 million of additional contingent purchase price consideration related to acquired mortgage banking operations. Second, approximately $14.6 million of additional commissions and incentive compensation during this quarter relative to the last quarter, primarily due to mortgage business. Third, approximately $2.9 million of additional FDIC insurance assessment recorded due to balance sheet growth and impact of PPP loans on our leverage ratio. Those three items combine to $24.5 million of the $24.7 million increase, so essentially all of the increase was related to those items. Salaries and employee benefits increased by $17.4 million in the second quarter from the prior quarter. The majority of the increase related to incentive compensation accruals, which were approximately $14.6 million higher than the prior quarter, driven by additional commissions from significantly higher mortgage loan production. Additionally, salaries expense was up $5.8 million from the first quarter. The primary causes were $3 million of deferred compensation costs tied to BOLI investment gains, approximately $1.6 million of overtime and temporary help expense to support significant mortgage volume, and approximately $2.6 million of elevated COVID-related compensation matters. Offsetting these increases was a higher level of deferred salary cost recorded as significant loan volume in the quarter — primarily related to PPP loan activity. Employee benefit expense was approximately $3 million lower in the current quarter than the prior quarter, primarily due to reduced employee insurance claims as employees are making fewer discretionary doctor visits during pandemic work-from-home and social distancing periods. Data processing expense increased approximately $2 million in the second quarter compared to the prior quarter due primarily to a $4.5 million conversion charge related to the Countryside Bank acquisition versus $1.4 million of de-conversion charges incurred in the prior quarter, so a delta of $3.1 million. Note that all acquisition-related conversion and de-conversion costs are behind us for completed acquisitions and accordingly the third quarter should be void of such charges. FDIC insurance expense was up $2.9 million in the second quarter compared to the prior quarter. The increase was primarily due to increased assessment rates at our subsidiary banks as a result of balance sheet growth and lower leverage ratios. Although relief was provided for FDIC insurance premiums related to increases in assets from PPP loans for the asset size component of the assessment, relief was not provided for the leverage ratio unless the bank utilizes the Federal Reserve's PPP Liquidity Facility. Because we did not need the PPP LF funding program to fund our PPP loans, we did not receive FDIC insurance relief on the leverage ratio component. So our assessment rates were higher for that reason and also due to other balance sheet growth. Professional fees increased to $7.7 million in the second quarter compared to $6.7 million in the prior quarter; this category averaged approximately $7.3 million over the last five quarters, so is in line with our average and relates to legal services, consulting, workout matters and acquisition-related legal services. Advertising and marketing expenses decreased by $3.2 million versus the first quarter, primarily due to reduced sponsorship spending, including major and minor league baseball team sponsorships that have not been active, and cancellation of summer event-related sponsorships due to the pandemic. OREO expenses increased by approximately $1.1 million in the second quarter as the company recorded a gain of approximately $1.3 million on a sale of an OREO property during the prior quarter and only small OREO losses in the current quarter, so the net impact was small. The miscellaneous expense category totaled $24.9 million in the second quarter compared to $21.3 million in the first quarter, an increase of $3.6 million. This increase was caused by the $6.9 million of additional contingent consideration related to previously acquired mortgage banking operations. The increase is a result of higher anticipated contingent purchase price payments resulting from both current volume closed so far in 2020 as well as forecasted revenues out through the end of the respective earn-out periods. Offsetting that charge was a lower level of travel and entertainment expense and a variety of smaller fluctuations. So without the contingent consideration accrual, the miscellaneous expense category would have declined during the quarter. As Ed mentioned, we believe the contingent consideration accrual reflects current mortgage volume projections and should not recur at higher levels. Other expense categories were down on aggregate by approximately $169,000 from the first quarter. Ed mentioned the net overhead ratio stood at 0.93%, down 40 basis points from 1.33% recorded in the first quarter, aided by balance sheet growth and a strong mortgage quarter. On a year-to-date basis, the overhead ratio was 1.12%, also aided by balance sheet growth and mortgage results. Briefly on the tax rate: we generally think the tax rate is in the 26% to 27% range. This quarter it was 29.46%, primarily as a result of the increase in FDIC insurance expense which is not fully tax-deductible — that caused the increase because the increased expense and lower pretax earnings from the provision compressed the denominator. With that, I'll wrap up my remarks and turn it back over to Ed.

Thank you, Dave. Interesting times as they say, but we're well prepared for whatever comes our way. Our capital levels are robust, forgiveness of PPP loans should accelerate recognition of fees and we're prepared for a second round if and when the government approves it. The halo effect from that effort should provide additional core loan and deposit growth. Our loan pipelines, as mentioned, remain very strong. Commercial premium finance continues to benefit from higher average ticket sizes. Tailwinds in the mortgage business should allow for strong business for the rest of the year. Credit metrics remain strong as reserves were at the highest level in company history, and as I said earlier we are well reserved in the current situation. Credit losses will continue to be managed as we practice early identification of issues in our loan portfolio. Historically, we've operated with credit metrics that have been stronger than our peer group due to conservative lending practices, product mix and a diversified portfolio. We expect that to continue. Loan deferrals, which were below peer metrics to begin with, are declining. Managing liquidity and earnings will be challenging in the short term with elevated asset levels given the uncertain future. We believe there will be dislocations as a result of the current state of the world, which can create acquisition opportunities when the market stabilizes. Right now the market has given us organic growth opportunities. We're preparing our balance sheet for a future where interest rates may be higher — it feels to me like cycles reminiscent of the 1970s and higher rates could be on the horizon based on government fiscal activity, so we're preparing for the possibility of higher rates. With that, we'll open the call for questions — we appreciate your support and now it's time for Q&A.

Our first question comes from the line of Chris McGratty from KBW. Your question please.

Ed or Dave, I'm interested in the outlook for net interest income. I appreciate there are a lot of moving parts with PPP. I guess the first question is, was there any of the $91 million of fees that you booked in Q2 and how should we think about the cadence of that $91 million?

The approach we took, which we think is the right way under GAAP, is we're using a level yield method on PPP loan fees. We did a survey of all our customers to get input from them as to when they thought they would submit their forgiveness application and what level of forgiveness they expected. Based on those responses and communications with customers, we think most — probably at least 80% — of the loans will be forgiven and we would receive funds from the SBA by the end of the year. The rest we assumed will amortize out over the remainder of the contractual terms of the loans, at 20%. We put that schedule together and created a level yield curve, which we can adjust as time goes on since the SBA could change rules or adopt a simpler forgiveness form that speeds processing for smaller loans. But our assumption was 80% forgiven by the end of the fourth quarter and the remaining fees recognized over the loan terms. Based upon that schedule, in the second quarter we recognized approximately $25 million of the $91 million.

That $25 million recognized represents roughly two and a half months' worth of fee recognition, not a full three months.

Okay, so $66 million in the remainder, is that right?

Yes. We continue to book loans — we're booking probably on average about $1 million a day. We didn't open the portal early, but we continue to take customers who didn't take advantage earlier. So there will be additional fees recognized as we book more loans. I wouldn't characterize the remainder as materially increasing beyond expectations, but there is still some coming in.

Okay. And I think Ed, in your remarks you mentioned once we get through the next six months you expect margin to settle in the 2.7% to 2.8% range in this rate environment. Is that the right way to think about it?

Yeah, I think that's fair. It depends on where rates go but our loan pipelines are very strong. We had a lot of liquidity on the balance sheet which we will deploy, and an 80% loan-to-deposit ratio excluding PPP loans leaves room to grow the loan book. Remember at the end of Q1 we carried an overweight liquidity position just in case; that was prudent. There are many moving parts, but we think that range is a reasonable exit margin in the current environment.

Okay. And just a housekeeping question on FDIC insurance cost, Dave: does that gradually go back to where it was as these loans pay down? How does that work?

The reason we were deemed was not because of the size of the balance sheet — they allowed exclusion of PPP loans for the asset component of that calculation — but where we were impacted was the leverage ratio. As the leverage ratio improves, our FDIC insurance rate can come down. So as we generate more earnings and the leverage ratio improves, or if we downstream some capital into the banks, we could reduce the rate. I would suspect the rate will be similar in the third quarter because the leverage ratio isn't going to swing dramatically even if some PPP loans pay off — they'll still be in average assets and could switch from loans to liquidity.

Back in March, nobody knew what was going on. We made the decision to pull some dividends to the holding company because we hadn't completed our capital offering yet and wanted liquidity at the holding company, which was prudent. That temporarily reduced capital at the bank level. We'll consider where to allocate capital going forward; it was a precautionary decision and I think the right one.

And so that will steady, but that $7 million contingent number will come out next quarter, Dave, right?

That's correct, unless mortgage volumes materially exceed our current forecasts. We're projecting these contingent payments over a multi-year period based on expected volumes, so we think the accrual is appropriate. It could be tweaked slightly up or down as volumes change, but we don't expect it to recur at a materially higher level.

Our next question comes from the line of Jon Arfstrom from RBC Capital Markets. Your question please.

I wanted to ask about the reserve build, especially the $96 million for economic factors — were you surprised by that amount relative to last quarter? When you look at your qualitative overlays, what would need to change for you to have another build in that economic factor?

I was a little surprised by the magnitude, but the models produced it. The main drivers are macroeconomic inputs, especially the commercial real estate price index, which drove most of it; that projection was down significantly at the end of Q2 versus Q1. BAA credit spreads and GDP also impact the models. If the commercial real estate price index deteriorates further you could see additional provision, but as of June 30 those assumptions were appropriate. If conditions are relatively stable going forward you shouldn't see more provision unless the balance sheet grows or macroeconomic assumptions worsen. If commercial real estate prices improve in forecasts, you could see relief. Given current charge-offs, past dues, NPAs and declining new deferral requests, we don't feel right now that another build is necessary unless the economy deteriorates more materially. Roughly 80% of the increase was related to GDP and the CRE price index.

If you look at the other 20% of the increase that was related to portfolio changes, that was largely downgrades in specific loans as those loans exhibited stress at the time of the quarter-end.

As we discussed last quarter and we track by highly affected industries, much of the stress really occurred in the first weeks of April, particularly in our franchise base. We track these segments closely and what we're seeing now as we move through the first 90 days into the second 90 days is a steep decline in customers asking for additional relief. New deferral requests are slow. We're starting to see the percentage of customers in deferral drop dramatically. Those risk ratings that correlate with the modifications are starting to improve as cash flows improve, particularly in the franchise portfolio, so we're mildly encouraged.

It seems like things may improve in Q3. Dave you backed off a bit on mortgage banking margin in your prepared remarks and I understand that, but what about mortgage volumes? It sounds like your pipeline is strong and you're suggesting continued strength. Is that right?

We don't have perfect visibility through the end of the quarter, but we had a strong pipeline — about $1.9 billion of locked loans in the pipeline. Given current application flow, I would expect roughly another $2 billion plus or minus in production if applications continue at current levels. Production margins may compress a bit, but given the pipeline and application flow, the third quarter should be strong. We didn't see many people walk away from their deals in Q2 even as rates fell, so I expect a solid pull-through.

Applications through July and August already provide visibility into September and they remain at a healthy level, which gives us a good feeling about Q3.

Our next question comes from the line of David Long from Raymond James. Your question please.

Thanks. Did you say in quarter-to-date in the third quarter that deleveraging has already been about $1 billion on the balance sheet?

Yes.

Okay. And I didn't see it in the release but can you disclose what purchased loan marks you still have on the books at this point?

Our purchased loan reserve was 2.30% relative to those balances. Specific reserves on purchased loans are very small; I don't have the exact number in front of me but it's immaterial.

You talked about marketing dollars and sponsorships with major league baseball kicking in — what type of increase should we expect in marketing spend in Q3 versus Q2 from those sponsorships?

I'd guess about $2 million to $2.5 million in incremental spend, not including ticketing, so it won't be back to prior-year levels but it will increase modestly in Q3. You might see another $0.5 million to $1 million in Q4 versus Q3, depending on events and activity.

Okay, thanks.

Our next question comes from the line of Nathan Race from Piper Sandler. Your question please.

On the excess liquidity build in the quarter, how much of that do you think will convert to core deposits? Almost two-thirds of the increase was tied to PPP, but any sense of how much of the other deposit growth is sticky and your reinvestment plans for that excess liquidity going forward?

I'll have Tim address the utilization strategy, but to the first point we've seen inflows across deposit types. Municipal deposits were up, and about $2.5 billion of PPP-related deposits remain on the balance sheet. MaxSafe deposits increased about $0.5 billion in the quarter. I don't expect deposits to decline sharply; I'd think they remain relatively stable or even up excluding PPP movements.

From a utilization standpoint, we're not excited about locking in long durations at very low yields. Our loan pipelines are strong and premium finance loans pay back in roughly nine months, and with $10,000 increases in average ticket sizes, we're capturing more market share there. The life insurance and leasing portfolios are performing well and the CRE pipeline is robust — estimated draws of roughly $1.3 billion from an estimated $1.8 billion to $1.9 billion pipeline will create a halo effect, bringing deposits. If I had to guess, deposit levels will be generally flat and assets may be up slightly in Q3. If PPP loans are forgiven, loan-to-deposit ratios should increase as core lending activity resumes. We may selectively invest in mortgage-backed securities to earn a little more spread, but I'm focused on balance-sheet positioning given the low-rate environment and preparing for possible inflation or higher rates in the medium term.

On core loan yields, excluding PPP, how much did they decline in the second quarter and what was the magnitude?

Commercial loan yields — commercial and commercial real estate — were probably down 40 to 50 basis points from early to late in the quarter due to rate movement and repricing activity.

Our next question comes from the line of David Chiaverini from Wedbush Securities. Your question please.

You mentioned Moody's model and the CRE price index as a main driver of the provision in the quarter. Can you share what that projection is — how much are commercial real estate prices expected to come down based on the Moody's model?

The CRE price index in the Moody's baseline is projected to decline through Q4 and recover into 2021, but remain below the level at the end of Q1. The models we reference show the index declining from around the near-300 range at the end of Q1 down into the mid-240s to 250 range — roughly a 20% decline — before recovering into 2021 under baseline scenarios.

Okay. And given the moving parts and utilization changes in Q2, looking into Q3 for loan growth should we think of core loan growth as roughly flattish given PPP paydowns offsetting pipeline draws?

PPP loans in Q3 and Q4 we expect to be largely forgiven in our base, unless there's a new round of stimulus. We expect our non-PPP core portfolio to grow nicely based on niche business strength and commercial pipeline. So while PPP may decline, core loans should continue to grow.

Practically speaking, unless the SBA processes forgiveness extremely quickly, I'd expect most PPP payoffs via forgiveness to occur in Q4 given SBA turnaround times, so PPP loans will generally remain in place through Q3.

A housekeeping question on the tax rate: you noted the FDIC assessment was elevated in the second quarter and that drove the tax rate to 29.5%. Should we assume the tax rate going forward is closer to 29% to 30% given the elevated FDIC assessment, or should we still use roughly 26% to 27%?

I would still model around 26.5% to 27% as our normal tax rate. This quarter the effective rate was higher primarily because pretax income was depressed by the elevated provision and FDIC insurance expense is not fully deductible. So with normalized pretax earnings the effective rate should revert closer to our typical range.

Our next question comes from the line of Brock Vandervliet from UBS. Your question please.

Given the wash of liquidity, do you have much scope to further reduce the CD component of your funding mix? It wasn't large on a percentage basis but I'm curious if you could work it down further.

Yes, I think CDs will naturally come down as rates on other deposit options and money markets become more attractive to customers. So I do expect some reduction in CDs.

On deferrals, what's the endgame? If you re-defer later, under the CARES Act some modifications are not considered TDRs. How are you thinking about re-underwriting and structuring those if customers need additional relief?

We shared the pain on the first round but we didn't hand out deferrals indiscriminately. We re-underwrote and looked at each case to determine what the borrower could sustain and we included provisos to protect the bank. If a second round is requested, we'll be more deliberate — more pain-sharing and more underwriting around how the borrower will get to the other side. We won't simply kick the can down the road without a plan.

To add, when customers request additional deferral we look at collateral, personal guarantees, and what the customer's plan is to get back to cash-flow positive operations. We're seeing deferral requests decline and many borrowers show improving operating performance. For customers who truly need additional accommodation, we'll work with them but we'll expect a credible endgame plan and appropriate enhancements to loan structure where necessary.

Our next question comes from the line of Michael Young from SunTrust. Your question please.

Quick follow-up on first-loss recognition: what areas are you being more aggressive about marking to loss now where you see less opportunity for recovery or where a sale or liquidation is a more likely path?

We don't have a wholesale approach to selling off chunks of any portfolio. We examine credits individually. Energy and hospitality are highly impacted in the market generally, but for us exposures are limited. The CRE retail portfolio is getting attention across the industry; we've done a deep dive on ours and it shows average LTVs and debt service coverage ratios that provide room to navigate stress. We also have personal recourse on many loans, which provides additional handles. We're not cutting and running on any large segment; most borrowers want to work with us and we want to work with them. We'll handle problem credits on a case-by-case basis.

On the branch footprint and technology investments: given the pandemic and changing customer behavior, are there opportunities to reduce branch costs or reconfigure physical distribution? What tech investments are required going forward?

On the technology side we continue to upgrade systems and digital offerings; those investments continue and are important. On the branch side, by year-end we'll complete a full review of smaller branches and branch locations acquired in recent years to determine whether to consolidate or relocate. Remote working has performed well for us and may change future workplace needs, so we'll assess real estate and staffing needs through the end of the year. We're not abandoning our branch footprint — branches remain an important access channel — but we will be selective and optimize where appropriate.

We believe clients will use both branches and digital services. Electronic engagement is up significantly and we're investing there, but branches remain important. We'll be selective about future branch moves and will optimize distribution over time.

One last question on mortgage variable compensation: it was up about $6 million year-over-year due to higher volumes. How should we model that going forward if production remains elevated?

Mortgage commission and incentive compensation is largely variable and tied to volume and closings. If we do another $2.2 billion quarter next quarter, you'd expect similar compensation expense. If production falls back to $1.2 billion, compensation would decline accordingly. Given current application flow and pipelines, I would expect elevated production and therefore elevated variable compensation in Q3; the compensation is a cost of producing the revenue and will move with production.

Our next question is a follow-up from the line of David Chiaverini from Wedbush Securities. Your question please.

You called out retail CRE earlier. Can you remind us what the average LTV is for the retail CRE portfolio and CRE overall?

On retail CRE, we reviewed about 75% of the portfolio in detail and the average LTV on that sample was about 55.6% based on the most recent appraisals. Keep in mind that represents appraisal-based LTVs and may not reflect the exact current LTVs, but it highlights that there's room to absorb some valuation stress. Our retail CRE loan sizes are also fairly granular, with an average loan size around $1.2 million, and we have limited exposure to big-box or regional malls. Most of our retail CRE is infill, community-oriented properties that are our bread-and-butter.

This does conclude the question-and-answer session of today's program. I'd like to hand the program back to Edward Wehmer for any further remarks.

Thank you. A couple of closing remarks: I continue to believe that in the longer term, interest rates will be higher than today's extremely low levels. It may not happen imminently but over the next several years I think it's probable. This is a cyclical business and we plan and prepare for higher rates — that has historically served us well. We're well positioned, our balance sheet and capital are strong, and we appreciate your support. If you have further questions you can contact us directly. Have a great week and stay healthy — thanks.

Thank you ladies and gentlemen for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.