Wintrust Financial Corp Q3 FY2020 Earnings Call

Welcome to Wintrust Financial Corporation’s Third 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 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 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 will now turn the conference call over to Mr. Edward Wehmer. Please go ahead.

Thank you very much. Welcome, everybody, to our third quarter earnings call. With me, as always, are David Dykstra, our Chief Operating Officer; Dave Stoehr, CFO; Kate Boege, our General Counsel; Tim Crane, President; and Rich Murphy, our Credit Guru. We have the same format as usual. I’m going to give some general comments regarding the results; I’m going to turn it over to Dave for a more detailed analysis of other income, other expenses and taxes; I’ll return for a summary; and then we’ll open it up for questions. First of all, 2020 continues to be full of surprises and unpredictable events. Were it not for CECL, COVID and their effects on interest rates, I think we’d be having a gangbuster year. In that regard, it’s nice to record earnings again. Earnings were $107 million for the period, or $1.67 a share. Year-to-date earnings were $191 million, or $3.06 a share. Pretax, pre-provision, pre-MSR earnings were $165 million compared to $173 million in Q2. The net interest margin was down 17 basis points. Return on assets was 0.99% and return on tangible equity was 13.43%. Our net overhead ratio was 0.87, or 87 basis points — so pretty good on all fronts from that standpoint. Net interest income and the margin: net interest income was down approximately $7 million, primarily due to a reduction in PPP fee recognition of $8 million resulting from slower-than-expected forgiveness estimates and the bank’s elevated liquidity balances. The former relates to PPP amortization in the first part of 2021; the latter to liquidity we discussed in Q2. The NIM decreased 17 basis points to 2.57%. Earning asset yields decreased 18 basis points and were offset by a 19-basis-point decrease in paying liabilities. Free funds contribution decreased by 4 basis points due to the lower cost of funds. The remainder of the decrease, related to the correction of the PPP fee accrual, was 14 basis points. Our current PPP yield going forward is about 3.85%. If you look at the margin excluding PPP — taking out PPP balances, related interest income and fees less cost of funds — our core net interest margin was relatively constant at 2.37%. We believe we can build off this going forward and think this is the low point. Through investing our liquidity and supporting loan demand, we believe at least 10 to 25 basis points of improvement is achievable, bringing us back toward the 2.7% to 2.75% range we previously indicated we would bottom out at. We are currently carrying over $3.8 billion of overnight balances at negligible yields. The overall duration of our liquidity portfolio is 1.44 years, down from 1.7 years in Q2 and 4.2 years at last year-end. For reference, we usually try to keep duration in the 4- to 5-year range. Redeploying these assets into loans and other earning assets and reducing institutional funding we brought on to support PPP, as that funding runs off, should be helpful to the extent of 10 to 25 basis points over time. As I said, that would bring us back in line with a roughly 2.75% margin. It’s a very fluid situation and optimization will take a few quarters depending on actual PPP runoff and other factors. I’ll touch on this a bit more later. Credit quality, by conventional metrics, is remarkably good — you wouldn’t think there was a pandemic going on. Nonperforming loans decreased by $15 million from Q2 to $173 million, or 54 basis points, compared to 60 basis points at the end of Q2. Nonperforming assets decreased $16 million to $182 million, or 42 basis points, compared to 46 basis points at the end of Q2. COVID-related loan modifications fell to $413 million from $1.7 billion on June 30, representing 1.4% of total loans net of PPP loans. Net charge-offs in the quarter totaled $9.3 million, or 12 basis points. The charge-offs include $6.4 million of specific reserves on individual loans that were in place since June 30. Provision for the quarter totaled $25 million, compared to $135 million in Q2; the majority of the provision relates to portfolio growth moving forward. Portfolio ratings remain relatively constant with prior quarters; details of ratings migration are included in our earnings release and slide deck. The allowance stands at $389 million, or 1.35% of loans excluding PPP loans. On a core basis, excluding premium finance loans and PPP loans, the allowance ratio is 1.88%. It’s hard to believe credit is this good given the environment, but be assured we’re not letting our guard down and we’re not naïve about potential bumps in the road. On one-time items for the quarter, net one-timers included $3.1 million to settle a mortgage banking dispute dating back to 2008, $6.3 million of contingent consideration related to a prior acquisition, and $13.2 million of acquisition expenses. We believe the $6.3 million of additional consideration will cover the fourth quarter and the next year; subsequent amounts would be negligible. So we think we’ve got it covered now — if we need more, it would mean the mortgage business is still strong. We also recorded a $3 million decrease in MSR valuations due to continuing falling mortgage rates. We now have close to $10 billion of MSR servicing portfolio, so any rise in rates would be a significant benefit to us. On the positive side, we recorded a $9 million pretax settlement on an uncertain state tax position. Other than the $3 million MSR valuation decrease, the one-timers basically washed. Quick comments on other income and other expense: Dave will cover the details, but a couple of general points. The mortgage business was extremely strong this quarter and it appears that strength will continue at least another quarter based on pipelines, and hopefully longer, always dependent on interest rates. The mortgage business is an integral part of our overall strategy. When rates go down, the mortgage business kicks in and helps while we readjust the balance sheet to optimize earnings. We maintain a positive interest rate gap at all times, and the mortgage business is an offset to that. You cannot look at the mortgage business separately and try to break it out, because it has given us the time and earnings to work on the margin, and it serves as an internal hedge to optimize earnings in any rate environment. One reason we maintain a positive gap is we know this business can cover during periods of falling rates, so treating it as entirely separate doesn’t make much sense. I know we’ll get a question on stock buybacks during the Q&A. We are considering buybacks as we always do. Right now we ran the numbers and it might make sense because it’s accretive to both earnings and tangible book value. We have about $400 million to $500 million of cash at the holding company that’s available. We’d like to keep cash at the holding company, but we do have the opportunity to repurchase shares if the Board chooses to do so. On the wealth management front, wealth management revenue continued to track back to target at $25 million. Assets under administration were $28.2 billion, up $1.2 billion or 4.3%. Growth occurred across trust, the broker-dealer, and asset management, with the majority of growth in asset management as new institutional accounts accounted for $0.9 billion of that growth. That should be good recurring revenue going forward. Again, our net overhead ratio of 85 to 87 basis points is well below our 1.5% target, largely helped by the mortgage business, and that helps offset the margin decline we hope to recover. On the balance sheet, total assets grew $200 million to $43.7 billion. Earning assets were up $1 billion; average earning assets rose from $38.7 billion to $39.8 billion. Loans grew $700 million during a period when many competitors did not have loan growth. Our loan growth is very good and our pipelines are stronger than ever. We have a $500 million head start given the average ending balance, and we expect very good core loan growth in the quarter. PPP loans increased by $44 million in the quarter to $3.38 billion. Currently $1.25 billion is in the forgiveness process, with 4,000 loans in that process — about a third of the portfolio is in the hopper for forgiveness. On deposits, they grew $192 million quarter-over-quarter, but there’s a story within a story. As mentioned on the last call, deposits were about $1 billion lower at the end of the second quarter, which means we had $1.2 billion of core low-cost deposits added as other deposits ran off or re-priced. The $1.2 billion is more core and is a result of our business development, the halo effect from PPP, and continued franchise growth. In Q4, we plan to return approximately $600 million of institutional deposits that we brought on to fund PPP loans and provide general liquidity when conditions were uncertain. Core deposit growth has remained strong, and we expect core deposits to grow to offset that decrease, but generally at lower costs. Now I’ll turn it over to Dave, who will discuss other income and other expense.

Thank you, Ed. Ed touched on the wealth management revenue a bit. But, in the non-interest section, that wealth management revenue increased $2.3 million to $25.0 million in the third quarter compared to $22.6 million in the second quarter, and it was up 4% from the $24.0 million recorded in the year-ago quarter. The revenue source has been positively impacted by higher equity valuations, which impact the pricing on a portion of our managed asset accounts and also due to a higher level of trading in our brokerage accounts from the depressed levels that we saw in the second quarter of this year. On the mortgage banking revenue front, it increased by 6% or $6.2 million to $108.5 million in the third quarter from $102.3 million recorded in the prior quarter, and was up a strong 113% from the $50.9 million recorded in the third quarter of last year. The Company originated $2.2 billion of mortgage loans for sale in the third quarter, essentially the same as the originations that we had in the prior quarter, and was up from the $1.4 billion of originations in the third quarter of last year. The increase in this category’s revenue from the prior quarter resulted primarily from an increase in mortgage servicing revenue as a result of the larger servicing portfolio, a higher level of capitalization of MSRs and a smaller negative MSR valuation adjustment during the third quarter relative to the second quarter. Production revenue was relatively stable but up slightly as the production margin on similar volume was steady with the prior quarter. These aforementioned increases in mortgage revenue were offset somewhat by an additional expense accrual of approximately $3.1 million in the third quarter for the settlement of a longstanding recourse obligation dispute. That puts that dispute to rest; it’s been out there related to loans that were basically a decade old, and we felt it was appropriate just to put that dispute behind us. We currently expect originations in the fourth quarter of 2020 to be strong, although there may be some seasonality. The winter months tend to slow the purchase business a little bit, and there are holidays involved in November and December. But the pipeline is very strong. We expect it to be a strong fourth quarter. Margins may come down a little bit, depending on that volume. We’ll see how it works out. For the fourth quarter of the year, we expect it to be extraordinarily strong. Table 16 of our earnings release provides the detail of all the mortgage banking revenue components, if you want to dig into that further. Other non-interest income totaled $13.3 million in the third quarter, down approximately $1.4 million from the $14.7 million recorded in the prior quarter. The largest decline of revenue in this category related to lower swap fee income of approximately $1.7 million. There were a variety of other smaller positive and negative variances in this category that essentially offset each other. Turning to the non-interest expense categories: Non-interest expense totaled $264.2 million in the third quarter, up approximately $4.9 million or 2% from the $259.4 million recorded in the prior quarter. Turning to the more significant changes quarter-over-quarter: The salaries and employee benefit category increased approximately $9.9 million in the third quarter from the second quarter of this year. The biggest portions of that are the employee benefit expense, which accounted for about half of the total increase, and it was up approximately $4.8 million from the prior quarter. That was due primarily to substantial increases in employee insurance claims as employees have begun to return to a more normal pattern of seeking health care, and they also were catching up on services such as discretionary doctor visits and surgeries, which were deferred during the early stages of the coronavirus pandemic. Accordingly, the second quarter expense was unusually low, and the third quarter expense was unusually high. However, the average of the two quarters is generally in line with the prior quarter run rates and our expectations. Additionally, salaries expense was up approximately $2.8 million from the second quarter. The primary cause of the increase was approximately $1.6 million of lower deferred salary costs relative to the prior quarter, which had higher deferred costs related to the PPP loan volumes that we had in Q2. So less salary deferrals in the third quarter, because we didn’t do the substantial amount of PPP loans in the third quarter. Additionally, the Company incurred a bit more expense to support the significant mortgage volume being processed through the system. Commissions and incentive compensation expense increased approximately $2.3 million in the third quarter. That change was driven largely by additional commissions related to wealth management brokerage trading activity as well as higher incentive compensation expense recorded during the third quarter relative to the second quarter. Data processing expense decreased approximately $4.7 million in the third quarter compared to the second quarter due primarily to approximately $4.5 million of conversion charges incurred related to the Countryside acquisition in the second quarter, whereas the third quarter was void of any such acquisition-related conversion charges. Professional fees declined by $1.2 million to $6.5 million in the third quarter compared to the $7.7 million recorded in the prior quarter. These professional fees can fluctuate on a quarterly basis based upon the level of legal services related to acquisitions, litigation, problem loan workout, as well as consulting services. This category of expenses was down slightly from the prior quarter due to small declines in a variety of expense types, but nothing of any significance related to any particular category. The professional fees category averaged about $7.3 million over the past five quarters. So, the current $6.5 million is a little less than that but within what we think is a normal range. Equipment expense totaled $17.3 million in the third quarter. It’s an increase of $1.4 million as compared to the second quarter. The increase is due to increased software licensing expenses, including some increases related to increased online mortgage usage, PPP loan servicing enhancements, network upgrades to support our growth in digital enhancements and various other software upgrades. We continue to invest in software and technology to enhance our customer delivery systems and products as well as investment systems to support our continued growth. Other than those expenses that I just discussed, all other expense categories were actually down on an aggregate basis by approximately $524,000 from the second quarter. Ed mentioned the net overhead ratio stood at 87 basis points, which was down 6 basis points from the 93 basis points recorded in the second quarter. And on a year-to-date basis, the net overhead ratio was 1.03%. The ratio continues to benefit from strong balance sheet growth and strong mortgage banking results. Moving onto income tax expense: The effective tax rate in the third quarter of this year was approximately 21.8%, which is well below the 26% to 27% range that we would normally expect. The reason for the lower tax rate in the third quarter related to a $7.1 million net income tax benefit recorded during the third quarter related to the settlement of an uncertain tax position with taxing authorities. We’d anticipate the effective rate to return to the expected rate of 26% to 27% in future quarters, barring any unanticipated events. I’d also like to take a few seconds to address the preferred stock dividends. There seems to be some confusion out there, if I look at some of the analyst estimates on what the preferred stock dividend should be on a going-forward basis. The Company recorded $10.3 million of preferred stock dividends in the third quarter. However, on a going-forward basis, given the existing outstanding issuances and dividend rates and if declared by the Board of Directors, the amount of preferred dividends recorded should approximate $7.0 million. The reason for the higher amount in the third quarter was that the first dividend period included a five-month period. There was really a two-month stub period in May and June, and then the normal quarterly period for the third quarter. So, in the first period, the dividend declaration included five months, but in all subsequent periods, the dividend should be a three-month period. So slightly high in the third quarter here at $10.3 million. But going forward, given the existing issuances, rates, et cetera, that amount should be approximately $7.0 million. I just wanted to clear that up as there seemed to be some confusion about that. And with that, I will turn my comments back over to Ed.

Thanks, Dave. I have to say, we’re very pleased with the quarter. I couldn’t be prouder of the Wintrust team and the strategic agility they have displayed throughout these unusual times. Rich Murphy put it once, he said, this is a miracle. We’re able to operate from home and put up these numbers and grow like we are and keep credit where it is. It’s really hats off to the entire Wintrust team. Our approach going forward is really very simple. We need to grow through this part of the cycle by taking what the market gives us. Right now, that means organic growth. The acquisition market is currently non-existent in terms of valuations. Uncertainty is high around target credit. We believe there’ll be opportunities as we get closer to the end of the pandemic, but as of now, there isn’t a lot going on. We need to monitor the balance sheet in order to optimize net interest income and the NIM as PPP loans continue through the forgiveness pipeline. Given our asset-sensitive position, we do have room for some fixed-rate exposure, and we’re looking for opportunities in this area. Although I’m not really excited about what happens to our mortgage backs, there are some opportunities and some things we’ll be doing in the future that will help earning asset yields and help the margin. Our pipelines are stronger than ever, and we’re ready for PPP too, if that occurs. We continue to monitor credit very, very closely. As you know, there will be some cracks coming. All our reserves are robust. Our current metrics are off the charts good. We’re comfortable that our current reserve levels are appropriate. Know that we will not change our conservative, consistent underwriting parameters and policies for any reason whatsoever. I’d like to go back to the core net interest margin concept I drew out before. The $237 million June through September, we believe that’s a low point, barring additional lowering of rates in the overall rate environment. Our pipeline is strong. If we believe that we can add $1 billion of loans this quarter and $0.5 billion in investments and put the spreads out, that’s a $9 million to $10 million quarterly impact for us. That’s what we’re doing. We’ve got a lot of liquidity. We put a lot of liquidity out at the beginning of the period, really in the second quarter, because of the unusual times and draws on their lines; they knew they were going to continue with PPP loans. We’re letting some of that expensive liquidity run off. It’s being replaced by core deposits at cheaper rates. And so, that’s the plan going forward: to grow without a commensurate increase in expenses. And we’ve been able to do so, as indicated by this quarter, another $1.2 billion of regular deposit growth and $700 million worth of loans. We expect that to continue going forward. It’s going to take some time to work through this. The PPP has been a funding source, as far as I’m concerned. And the mortgage business is going to continue to support us until such time as we can continue to build the earning asset base up and get a little bit more certainty in the market as to where we’re going. Our net interest rate sensitivity position right now is around 12% to 13% on a GAAP basis. As PPP runs off, that was about 18%, which is above our preferred range of 10% to 12%. PPP loans are on a two-year average life in our GAAP calculations. So, we do have room there to add some fixed rate assets on both sides of the equation and still maintain a very positive GAAP sensitivity. Again, you have to look at Wintrust in total. You have to look at our margin. You have to look at our mortgage business. All of these are internal hedges to help in various interest rate times. So to pull one out and say that’s not going to continue without giving credit to the other side of the equation doesn’t make a lot of sense. I know we’ll get a question on stock buybacks as you go forward in the question-and-answer period. I’ll say we are considering it as we always do. Right now, we just ran the numbers and it might make some sense to do it because it’s accretive to both earnings and tangible book value. But there aren’t any acquisitions to do. And we’re sitting at about $400 million to $500 million worth of cash at the holding company that’s available. We’d like to keep cash at the holding company, but we do have that opportunity if the Board still wants to go that way. So, with that, thank you for your support. We really appreciate it. Have faith in Wintrust. We’ve pulled through the management team. We have your best interest at heart because your interest is the same as ours. So, with that, we’ll turn it over to questions. Thank you.

Our first question is from Jon Arfstrom with RBC Capital Markets. Please go ahead.

I thought it was a pretty good quarter, but obviously, people have questions about the outlook. And I guess maybe I’ll talk about growth and the margin. But in terms of growth, it’s unusual to see the kind of growth that you saw and maybe you could touch on big picture, what you think is different and whether you think you can offset the PPP runoff and actually show stable to maybe higher loans?

Well, I think, based on the pipeline, the commercial and commercial real estate pipeline, yes. It’s higher than it’s been in a long time right now. Our pull-through rates are consistent. Our premium finance business continues. The life insurance business continues to grow nicely. And the commercial business continues to grow nicely. The average ticket size is relatively constant, around $38,000 to $39,000 on the commercial side. We believe that we’ll continue to have really good core loan growth, at least for the foreseeable future on our terms, though. So, we’re not bending credit to get there. I’m telling you, a lot of it is the PPP halo effect pull-through. And we’re seeing an echo effect of that because the people who were pulling through are referring us to other people. These are good accounts taken from the larger banks in town. Nobody in particular— it’s everybody in proportion. But it seems like we’ve got very good momentum and reputational momentum and our name is out there. So, we feel very good about our growth prospects. That’s an integral part of what we have to do here: grow through this. That being said, if in fact we saw things turn and you couldn’t get paid for your risk, or saw lots of exceptions coming through, we wouldn’t be afraid to shut it down right away like we did in the past and wait for the other shoe to fall. But we’re not seeing that now. Rich, you agree?

Thousand.

Yes. No, I’d say, Jon, you know our business model well. And one of the things we always say is we will take what the market gives us. Last year, CRE was a big contributor to growth; C&I less so because of some of the things Ed talked about. We weren’t getting paid for the risk and structure got a little crazy. One of the things that’s really encouraging so far this year is the way that growth is coming in. It’s very balanced. CRE is still a contributor, but we’re seeing good C&I growth, as Ed pointed out, and good growth out of the niches. We’re seeing good growth out of the premium finance area. One of the things that keeps me confident is just that—all those engines are running pretty well. If you took the first three quarters, netting out mortgage and netting out PPP loans, we’re on an annualized track of about 8%. That really requires everybody to be getting their work done. Based on what we’re seeing in the pipelines for all of those, we continue to feel pretty good about loan growth.

Well, the amazing thing to me is, and we’ll talk about this a lot, is a lot of the old-time, really old names in Chicago—names you would recognize—are now doing business with us. They’ve had long-term relationships with the larger banks in town, and they’re getting kind of fed up. You’d be amazed at some of the names we’re dealing with, and they tell their friends. So, a little bit of a pyramid effect going on here, which we’re very happy to be a recipient of.

Okay. All right. That’s good. And then, in terms of the margin, getting the margin back to that 2.70-plus type level, I understand the strategy. But just talk a little bit about the cadence—how long do you think that will take to get back to those levels?

Well, PPP is going to run off and leave us with liquidity. We’ve got to be able to put that liquidity to work, plus we have to take the $3 billion we have of overnight money and put that to work. We’re currently at 80% loan-to-deposit on a core basis and about 90% with the PPP loans included. We’ve got to run about 90%. If you factor the growth that will occur and the run-off of certain deposits, we think it will take 2 to 3 quarters, barring anything else. I would say around two quarters if everything stays where it is and we manage the funding properly. That’s about where we think we’ll get. But a lot of things can change. Deposit growth has been incredible; we’re not going to turn it down because these are really good clients and businesses that we’re getting. That’s the raw material. I’ll take it all day at these prices, since as we bring in relationships they eventually turn into larger lending relationships. Tim, why don’t you talk about what’s going on in the treasury department right now, at least in the last quarter—what happened?

Sure, Ed. And Ed’s talked about the halo effect. One of the follow-on pieces to both the PPP opportunity and any other credit opportunity is the treasury and services revenue that comes with it. We’ve had to add staff to handle the implementations that continue to come to us, and we’ll do that probably through at least the end of the year, with the treasury revenue really just starting to show up, probably in the beginning of the fourth quarter here. We think that will be relatively significant for us.

We’ve picked up almost 140 accounts.

160, just already implemented with a number in the pipeline waiting to get set up.

Yes. And revenue on that could be over $2 million annualized. So, there is a lot going on there. We’ve got to go through this and keep our expenses under control. That’s got to be the secret here to get earnings back and be prepared for higher rates because the 'beach ball underwater' we talked about 10 years ago—I think that one is deflated. We need another one down there, but it’s bigger than it’s ever been.

Our next question is from Chris McGratty with KBW. Please go ahead.

Hey, guys. Thanks for the question. Dave, on the mortgage business, you talked I think about the potential for margins to come in a bit. Maybe you could elaborate on how meaningful, given how much they’ve expanded year-on-year.

Well, a lot of it really just depends on where the pipelines are going. Right now, they look pretty full, but if they decline the margins generally decline as the pipeline comes down because people adjust margins as they’re trying to govern the amount of flow coming in. So, you could potentially see some compression in margins next quarter. I said that last quarter, too—I said that volume would come in a little bit and margins would come down, and the application flow was just astounding to us that it stayed where it was. Purchase activity really bumped up in the third quarter, and generally second quarter is bigger. There’s still a lot of purchase activity going on in the marketplace. I could be surprised again. But the fourth quarter also has holidays where some people defer their actions or just don’t do it, and there are more holiday days in the quarter. So, that could impact it too. I’m not going to give a specific number because I tried to give that guidance last quarter, and I was wrong. But if it tails off a little bit in the winter months, margins could come down into the 3% range.

Got it. And just one more. With the prospects of taxes going up, can you remind me if anything is structurally different than when you guys got the benefit in ’16 in terms of sensitivity each point?

Yes. We were in a deferred tax liability position at the time. So, there is some benefit. We still have a deferred tax liability. There are some tax planning strategies we could do. So, if there is a change in Congress and the administration and it looks like there could be some increases in taxes, there are some elections we can take on depreciation and the timing of certain expenses that we think can mitigate some of the increased cost of that tax law change. But we are in a deferred tax liability. So, when we benefited last time when rates went down, it was a negative to us. But I think we can mitigate that substantially. So, there may be some impact, but I don’t expect it to be material.

Our next question comes from David Long with Raymond James. Please go ahead.

Good afternoon, everyone.

Hi, David. How are you?

I’m doing well. I’m sure you guys are doing well after a great report, like you put up last night. With regard to the balance sheet and the size of the balance sheet, your clients seem pretty liquid; you’ve seen nice deposit growth. Do you expect deposit balances to come down at some point, and does that hinder your ability to invest some of the cash you have?

Well, we’re kind of floating there right now. One of the reasons we haven’t redeployed everything yet is exactly that: will the money stay? We don’t know how much of it is PPP-related deposits that haven’t been spent and whether that will go out—if it does go out, where will it go? Hopefully it will go into personal accounts and into Wintrust Wealth Management. We do believe that deposit growth and market share growth remain strong based on the number of clients we’re picking up on the commercial side and the retail side as a result of the halo effect and the echo of the halo effect. So, I think we’re okay in terms of deposits. I worry about rapid outflows if they happen, but by and large, deposit growth has been durable.

Got it. Okay. And then, in your reserve today, what assumption are you using for future stimulus?

We don’t have anything substantial in there for guessing whether it’s going to be $3 trillion or $1 trillion or $500 billion. If there’s more stimulus, we think that will help us. We used Moody’s economic scenarios in our models, so what Moody’s has in there is what our models would have because we used their economic scenarios. But we aren’t putting any additional qualitative impact into the assumption to say, 'we think there’s going to be a ton of stimulus.' So, we’re essentially using Moody’s baseline scenarios that were used in our CECL modeling.

What scares me as an ex-PPP round, David, is if you do have a change in administrations, remember what happened to TARP when the administration changed the last time. They changed a lot of the rules. We’re going to have to offer support, but it may not be as simple as the first PPP was. The government is not always the best counterparty. We do have to take care of our clients. There is a need out there. I’m thinking, on our projections, if it did come it would be smaller—maybe $1 billion for us, about a third of what we had before, to our existing customers. There will be new customers as well. It would be a good thing, but I expect it to be lumpier than the first round.

Got it. And then just the last thing, on the mortgage side of things, the Fannie/Freddie 50-basis-point charge expected to start here in December—has that had any impact on volumes or spreads at this point, or do you expect it to?

We built it in last time it was announced. We’ve got it built into our pricing models now. We don’t expect that the implementation would dramatically change our volumes. It might have eaten into margins a little bit if it had been delayed, but given the current timing, we’ve pretty much built that into our pricing schedules.

Our next question comes from Brock Vandervliet with UBS. Please go ahead.

We talk about funding costs. It would seem like you may have some room to continue to move those down, particularly on the CD side. What should we be thinking about there?

Mr. Crane, do you want to answer that?

Brock, as you saw, the interest-bearing deposit costs went from 81 basis points to 61 basis points. You’re correct that we believe we continue to have some room. More than half of the CD book will reprice in the next year. That’s moving from about 170 basis points to about 60 or 65 basis points. So you will see continued progress in moving our funding costs down in the next couple of quarters. If you take the low for each category, you get into the mid-30s. An early look now would put us around the low 40s or slightly below, given a normal run rate on CD repricing. Over time, I think 35 basis points was the low we had the last time we had one of these rate environments, and we would expect to get there probably mid next year.

And most competitors are flat-to-flat in terms of loan growth. I hear you in terms of picking up new clients. Clearly, that’s driving some of it. What was your loan utilization in the quarter? I believe it was 49% last quarter. Has that picked up?

It’s about 50%.

Yes. It seems to be normal. So, the growth really wasn’t an increase in utilization. It stayed relatively flat.

Okay, it’s new clients. Okay, got it. Thank you.

Our next question is from Terry McEvoy with Stephens. Please go ahead.

Ed, you mentioned a couple of times in your prepared remarks that you’re starting to see some cracks and that there are some losses coming—I think that was the expression. I was wondering if you could expand on that. Is that the hotel portfolio, which still has higher deferrals, or are there other segments within the portfolio behind that statement?

No. It wasn’t a specific statement about any particular segment. We don’t see them now, but we’re on the lookout for them. We’ve always seen our first loss is our best loss, and if we get an issue, we’ll take care of it right away. My point was we’re not naïve enough to think that we’ll get through this unscathed. I can’t tell you where or how, but something is going to be impacted. Surprisingly, the franchise portfolio is doing pretty well. Our hotel exposure is basically nothing. Rich, do you want to talk about that?

Yes. I’d say you answered the question. We look at all the material classified assets all the time. If something is really problematic, we’re going to work it and address it. But generally speaking, things are holding together pretty well. The high-risk portfolios we’ve discussed in prior quarters have performed amazingly well. The franchise portfolio is largely made up of QSRs, and I asked the group this morning whether we’re back to pre-pandemic levels in that space and we’re pretty much at or above because they have modified their business models. Hotels are very small in our portfolio—I can count our hotel deals on one hand. Energy is not a big part of our book. It’s hard to say exactly where some issues might pop up, but if this pandemic continues through much of next year, there will be real challenges in certain credits tied to tourism or non-franchise restaurants. For now, we’re feeling okay.

And I think it’s all been accounted for in the buildup of the reserve that we have right now. Just because they’re not appearing now doesn’t mean you shouldn’t be vigilant. We’ll stay on this. We don’t see material deterioration right now. As I said at the beginning, you wouldn’t think there was a pandemic looking at our credit book today.

And then, as a follow-up, maybe for Dave. I was hoping to get your initial thoughts on expenses in 2021. It looks like maybe advertising and marketing are down $5 million year-over-year. So that’s going to normalize, we hope. That’s about a $20 million increase. But what else stands out as you think about next year?

We’re going to, obviously, have a little bit of salary increase for merit pay, but we’re going to try to hold the line as much as we can on staffing. If you look at what we did this quarter, we had some one-timers. We had $6 million of contingent consideration on an earnout this quarter and had $7 million last quarter, so that’s $13 million. We had the settlement of some recourse obligations that have been going on for years; there’s probably a few million dollars difference there from what you would have. Acquisition costs were higher last quarter. Last quarter we had $4.5 million of conversion charges. I think there are some numbers here that aren’t going to happen again next year. We would hope that we can grow deposits and loans and hold the line on expenses; there will be some increases as Ed mentioned on technology and software as we build out digital platforms and customer-facing systems. But hopefully that helps on efficiencies in other areas of the business, like branches, and there are offsets. I don’t have a specific number for you but we’re trying to hold the line on expense growth.

We are going through and looking at our branch network. We’re looking at the number of people who—we have not laid anybody off or furloughed anyone during this period. We’ve been able to repurpose people for PPP and other work. I think we have developed some efficiencies through this period that can be carried forward, and through normal attrition we should be able to reduce headcount relatively through repurposing. Once we get through PPP forgiveness, which is becoming somewhat laborious, and we’re growing at the same time, a lot of people were repurposed to do that. So I think we’ll be okay in that regard, but we’ll see.

Our next question is from Nathan Race with Piper Sandler. Please go ahead.

I was hoping to follow up on your comments around office location and so forth. We’ve seen some competitors in Chicago close locations, given that branch traffic has slowed considerably with economies closing down. Just curious, what you’re seeing in terms of the magnitude of opportunities if you guys do go down a branch consolidation path?

As we mentioned in the last call, we’re seeing an increase in the use of electronic services, which is encouraging. We’re also seeing a different pattern in how clients use facilities. We’re nearing the end of analysis that I would guess will result in the closure of some number of branches. I don’t think it will be trajectory-changing, but roughly comparable to what you’re seeing with some others. The important piece though is we still think there are markets we’d like to be in, and we will selectively add locations in underserved or attractive markets. The goal is to run a more efficient network and take advantage of opportunities to add presence where strategic.

That’s helpful. Changing gears a bit, thinking about the commercial real estate growth in the quarter: I noted growth out-of-state and other parts of the country. Is that a function of following existing developers and clients to other parts of the country, or are these new client adds occurring in geographies more attractive than Illinois and surrounding states?

You anticipated my answer. We have a very good client base that we’ve dealt with for a long time. As we’ve gained expertise and expanded our Wintrust presence in CRE, we’ve built a stable of sponsors. As time has gone on, they’ve asked us to follow them to opportunities in other markets from Texas to Colorado to the East Coast and Florida. We’re generally happy to follow them; we don’t do them all, but we do business with professionals we know and trust. We try to understand those markets and get a good handle on them. It’s largely a function of following clients we’ve had for a long time.

As a general rule, our core portfolio has been tied to our Chicago nexus. Our niche portfolio can go anywhere in the country—premium finance, leasing—and the core portfolio should have a nexus to Chicago, Milwaukee and our market area.

That makes sense. I appreciate you guys taking the questions.

Our next question is from David Chiaverini with Wedbush Securities. Please go ahead.

Hi, thanks. A couple of questions, starting with mortgage banking. Clearly, this year it’s a blowout year, double the revenue of the prior year. If we go back to 2019 levels, how much expense reduction would come with that? If you were to take 2020 mortgage revenue and divide it in half looking at next year or the following year, how much expense reduction would be related to that?

Pretty much the same percentage. We’re using a lot of contracted labor now. Our ability to scale our expense base up and down is much improved. On a run-rate basis, we’ve designed the business so you can pare expenses down fairly quickly as volume declines. Murph, do you want to add?

That’s exactly right. We have become much more nimble in our ability to step up and step down as volume dictates. It won’t be exactly one-for-one at any point in time, but it’ll be close.

Generally, the efficiency ratio in that business has been around 80% or so. One of the reasons our overall efficiency ratio is higher than some peers is the higher percentage of revenue that comes from mortgage banking. So a substantial amount of expenses would come out of that equation if mortgage revenue declines.

I think the difference between 2019 and 2021 will be our use of contract labor; our front-end automation is working well, and much of the previously manual front-end has been digitized, taking costs out of the business. Also, a lot of work that doesn’t touch the customer is being done offshore on a per-deal basis. So costs are more variable now and less fixed.

Every time I talk with our senior leadership in mortgage they say, 'congratulations on a great month—how are you going to get your cost down when the revenue goes up?' So it’s definitely a focus.

Great. Thanks for that color. Shifting to provision outlook: $25 million this quarter is substantially down from Q2. How should we think about the go-forward provision? Is $25 million a good baseline?

CECL is a life-of-loan concept. If the portfolio didn’t grow and credit quality stays the same and the economic outlook is unchanged, you could theoretically have zero provision. The drivers going forward will be portfolio growth and any migration in credit quality. If the economic scenarios improve materially, some banks could start releasing reserves, but I don’t think we’re at that point. For us, right now, provision will be driven mainly by growth in the loan portfolio.

That makes sense. Lastly, on loan growth: what types of borrowers are you seeing the most demand from? And are distressed investors swooping in and purchasing CRE at this time?

Activity is really within the Chicago market; we continue to grow our share of that pie. The halo effect of PPP is real. We’re seeing many deals come from customers that were frustrated with how larger banks handled PPP. That has changed our visibility in the market dramatically versus a couple years ago. Quality of borrowers is good. As it relates to distressed-assets, every day we see inbound interest from parties looking to buy hospitality and CRE portfolios. They send those offers to everybody because they’re trying to find assets. So, yes, there are many people looking for distressed assets.

Great. Thanks very much.

Our next question is from Michael Young with Truist Securities. Please go ahead.

Hey. Thanks. Maybe just a big picture question: any KPIs or high-level articulation of financial targets given the disruption? I know you did some management reorganization to free up bandwidth to evaluate strategy. Should we expect anything from that?

I don’t think we’re going to provide different guidance right now. The overall strategy is the same: this is a diversified business model. If we set certain KPIs, they could change dramatically based on mortgage activity vs. interest rate environment, so granular KPIs would require frequent updates. We prefer to manage the overall diversified business and adapt rather than publish granular KPIs that would change frequently.

Okay. That’s fair. On underwriting, have you shifted structure on new loans you’re pursuing to make sure there’s an appropriate safety margin on new originations—CRE or C&I?

We don’t change our loan policy significantly. This business hasn’t fundamentally changed—our underwriting remains conservative and consistent.

We’ve been consistent in underwriting and structuring deals. In CRE we’re mindful of potential vacancy rates and are being cautious. We’re not doing a lot of office deals right now; we stress scenarios for retail and other segments. Sponsor selection is critical—strong sponsors who can step up and support deals provide protection.

Our last question is from Brock Vandervliet with UBS. Please go ahead.

I just can’t get enough. I wondered if you could briefly walk through the PPP dynamics on the NIM. Was that change related to a change in assumed term from, say, two years to five, or driven by an update on the level of forgiveness that you’re seeing?

It’s really driven by the timing of forgiveness. Based on customer surveys and responses, we initially thought forgiveness would happen quicker. Then there were discussions about Congress passing a simplified form for everything under $150,000 and some borrowers decided to wait. Many accountants and lawyers advised clients to wait for a more streamlined approach. So a lot of people have held off. About a third of our portfolio has applications in now; some have completed forgiveness and we’ve received cash, others are awaiting the final process. The flow backed up a bit because of anticipation of a simplified approach, pushing some flow from the third quarter into the fourth quarter and into the first quarter. It’s a timing issue: you recalculate expected yield and how fast accretion is going to come in.

Yes. Got it. Okay. Thanks, Dave.

This concludes our Q&A session. I will now turn the call back to Ed Wehmer for his closing comments.

Thank you very much for listening. If you have other questions, feel free to call Dave, me, Tim, Kate, Rich, anybody on the call. Thanks. We’ll talk to you later. Have a great holiday season. Talk to you soon. Thanks.

Ladies and gentlemen, this concludes today’s conference call. Thank you for participating and you may now disconnect.