Earnings Call Transcript - WTFC Q1 2020

Operator, Operator

Welcome to Wintrust Financial Corporation's First Quarter 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 actual results to differ materially from the information discussed during the 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.

Edward Wehmer, Founder and Chief Executive Officer

Thank you. Welcome everybody to our first quarter earnings call. Hope you are all isolated and well. With me obviously are Dave Dykstra; Tim Crane, our Wintrust President; Rich Murphy, Vice Chair and Senior Lending Officer; Kate Boege, our General Counsel; and Dave Stoehr, our Chief Financial Officer. Kate Boege is very worried because we're all at different places and our shot-caller doesn’t come that far at me. So, Kate I will behave, I promise. As you can see, we do have some additional Wintrust executives on the call; I think it's important to get to know them better. And I think there'll be a lot of questions arising just because of the times and what's going on. So, I thought it's better to have more reinforcements around. The format will be for the most part as usual. However, I'm going to try not to parrot what's already in the release, which should leave more time for the questions as I said, as I'm sure you'll have a number of them. I'm going to give some general comments regarding our results, Dave Dykstra will provide a more detailed analysis of other income, other expenses, and taxes; back to me for a summary of comments and thoughts about the future, then we'll have time for questions. Before I get into the details, I'd like to do a heartfelt shout-out to what I believe is the absolute best crew in the banking business. Case in point, a couple of examples: our crew has moved seamlessly to remote locations, also being able to grow the bank and take care of our clients. It's worked extremely well. Our technology crew has done a wonderful job. Also, in seven days, we stood up a front-end portal for PPP from scratch. We opened the portal, one of the only ones opened on the evening of April 3rd, freshly available and actually worked flawlessly. The two weeks thereafter, with all working from remote locations, we processed 8,900 applications for $3.3 billion. That put us in the top 15 of banks in the country in terms of total volume. Median loan size was $85,000, generating fees to Wintrust. Before round two, approximately $85 million. Our debts are cleared for round two. We already have close to 2,000 applications, another $8 million to $9 million in fees in there. The applications, again, are in the lower-end area. So, we know we're taking care of all of our customers across the board. I couldn't be prouder of the team that's been able to do this. At one point in time we had a need for more quality control people; we had 300 people volunteer, people worked tirelessly all night. We're one lone guy they call the closer; after Paul got involved, he could clean up other banks' messes so quickly, it was unbelievable. And now on to our first quarter earnings, as you can see, we made close to $63 million, down 27% from the fourth quarter, but for obvious reasons, our earnings per share were $1.04. You take our pretax pre-provision pre-MSR valuation income, it's over $150 million, which is almost a record for us. It's pretty good in terms of core earnings. And that's before really any recognition of the probably close to $100 million we'll have in PPP income, which will act as a reserve for us — a cushion for us we believe, for any eventuality that may come along. Net interest margin held up pretty well as we were able to drop our deposit costs rapidly. You still have room to go there as indicated on page 18 of the press release. The five basis point margin decrease was due to — really a four basis point drop in the free funds ratio as you would expect as the overall rate environment goes down and one basis point difference between the 12 basis point drop in earning asset yield, another basis point drop in liabilities. Net interest income was essentially flat. Really, one less day was offset by $925 million in average earning asset growth. We expect core NIM, that being net interest margin without PPP effect, to drop in levels previously disclosed for future quarters. However, the amortization of PPP fees, which are in question, but no longer than two years and expected to be much shorter, will have a material positive effect on both the margin and the net interest income, even in worst-case scenarios. Under the provision for credit, we adopted CECL. It's early. I think FASB certainly picked the wrong quarter to put CECL in effect. We adopted CECL with a day one adjustment of $47 million, our first quarter provision of $53 million, which exceeded the fourth quarter provision by $45.2 million. Our reserves are up $95 million from year end to now to $253 million. I'll leave it from here, as I'm sure you have a number of questions on the CECL calculations; I'll leave that to our CECL experts who are here to answer your questions. Net charge offs were eight basis points or $5.3 million in Q1. Credit quality remained relatively in good shape on an apples-to-apples basis. NPLs increased due to three factors; first, the pool of accounting for acquired loans went away with the adoption of CECL and about $35.5 million in the total. Second, approximately $21 million of new non-accruals were added in the normal course of business, largely these being SBA loans, where we should get good recoveries when we start to put them on non-accrual. These assets have been marked appropriately and will be resolved relatively quickly. Finally, commercial premium finance loans over 90 days delinquent are still recording about $5 million due to state-imposed restrictions on canceling policies during the current crisis. As you know, our commercial premium finance portfolio is regulated individually by all 50 states. In the case of crises like we have now, many of them preclude you from canceling policies. However, in the past, we've only seen minor tick-ups because they will go back and honor the actual cancellation date; in most states they are required to go back and honor that, so really the insurance companies take the hit on that. But we do expect a minor tick-up in charge-offs, but not as much as you would imagine. That's at least been the case in the past, with hurricanes, fires, 9/11, etc. We are yet to see the material effects of the current crisis on our credit quality. PPP loans coupled with interest and principal deferrals have been granted to our borrowers and customers. Regulators are really cooperating on this and we believe that our borrowers should be able to weather the storm; at least buy time for our borrowers, coupled with our highly diversified portfolio and history of loan loss performance in troubled times vis-à-vis the peer group. We're cautiously optimistic; however, at this point, it's a tossup as to if and when stress will appear in the portfolio. With our expected core earnings augmented by PPP earnings and reserves and capital, we feel adequately situated to take on whatever comes our way. Look forward to your questions in this area. Dave is going to cover other income, other expense, and taxes in detail, but I'd like to suffice it to say that we had a great mortgage quarter notwithstanding a $10.4 million mortgage servicing valuation expense. I might be jinxing this, but I think they can't go down much more. We have to be close on mortgage servicing. And our net overhead ratio was 1.33%, down 20 basis points from fourth quarter 2019, more than made up for the drop in the net interest margin. On the balance sheet front, we grew total assets to $22.2 billion and average earning assets were up $925 million. Our loans were up about $1 billion, which Murph will take you into the core of that, but half of that was probably related to the line draws which happened very quickly, seeing the panic; the initial fear of everybody drawing their lines kind of abated a little with the work of the government and other opportunities. The rest is across the board and we're happy to break it out for you a little bit later. We started the quarter with $870 million of loans where period-end balances exceeded the average, so we're going to start the second quarter with a head start that doesn't include the PPP loans, which, with round two coming on, would be closer to — we funded about $3.3 billion and we will have about $3.7 billion up to $4 billion depending on how quickly the window closes in round two. Deposits grew $1.03 billion in the quarter. We're very good about our liquidity position right now. We will be able to take advantage of — we had good liquidity to begin with. We had bulked up in anticipation of what was going on with our MaxSafe accounts where we offer substantially more FDIC coverage because of our 15 charters and other wealth management opportunities, including CDARS, which we expect to slow down a little bit, but some $1 billion came to CDARS — different exchange money at the end of the quarter. So, we feel very good about where we are. Our loan-to-deposit ratio is 90%. And we'll obviously go up with PPP loans, but between our liquidity and our ability to take advantage of the Fed's lines related to PPP, we feel very good about our liquidity and where we stand right now. All-in-all, we feel comfortable with our balance sheet. Our loan pipelines, believe it or not, remained very strong, a bit of a halo effect coming on because other banks dropped the ball on PPP; we were able to pick up a number of prospects and customers and just by word of mouth — Wintrust came through and our relationship-style banking really works. So, our pipelines are good and we have to remember that good loans are made in bad times. So, we feel very good about where we are. Right now, on the balance sheet side, we think we're well-prepared. I'm going to turn over to Dave who's going to provide some detail on other income, other expenses, and taxes. Dave?

David Dykstra, Vice Chairman and Chief Operating Officer

All right. Thanks Ed. As normal, I'll just briefly touch on the non-interest income and non-interest expense sections. In the non-interest income section, our wealth management revenue increased $942,000 to a record $25.9 million in the first quarter compared to $25.0 million in the fourth quarter of last year and it's up 8% from the $24 million recorded in the year-ago quarter. Overall, we believe the first quarter was another solid quarter for our wealth management unit. Asset valuations declining towards the end of the quarter may create some headwinds in the second quarter, but trading volume is also fairly solid right now. So, we'll see how that comes out in the second quarter, but the first quarter was a solid quarter for us. Mortgage banking revenue increased by 1% or $466,000 to $48.3 million in the first quarter from the $47.9 million recorded in the prior quarter and was up a strong 166% from the $18.2 million recorded in the first quarter of last year. The company originated approximately $1.2 billion of mortgage loans for sale in the first quarter of 2020. This compares to a similar $1.2 billion of originations in the prior quarter and $678 million in the first quarter of last year. The increase in revenue from the prior quarter results primarily from $17.4 million of derivative income associated with the mandatory commitments to fund mortgage originations compared to a $1 million derivative loss in the prior quarter and similar activity in the prior quarter; that was offset by a negative MSR adjustment net of the hedging contract during the first quarter of approximately $10.4 million and that compares to a $1.8 million positive MSR adjustment in the fourth quarter of 2019. We also had $5.1 million less of capitalized mortgage servicing revenue compared to the prior quarter; I think we had one fewer sale of our loans during the quarter, so there might be a timing difference there. The derivative income that I talked about earlier is associated with the surge of refinancing activity, where we had mandatory commitments to fund approximately $1.4 billion of mortgage loans at March 31st, 2020. That's roughly $1 billion more in mandatory commitments to fund than we've averaged over the past four quarters. So, it's positive momentum in the mortgage business and obviously that pipeline bodes well for closings in future quarters. The mix of loans originated for sale that were related to the refinance activity was approximately 63% in the first quarter compared to 60% in the prior quarter. So, the refinance volume increased slightly during the quarter and the pipeline is still predominantly filled with refinance applications. We currently expect second quarter originations to be stronger than the first quarter. And that's a result of the continuation of the refinance activity in the strong pipeline. Table 15 of our earnings release provides the detailed compilation of the components of the origination volumes and the production revenue and MSR capitalizations, paydowns, and valuation activity. The company recorded losses on investment securities of approximately $4.4 million during the first quarter, primarily related to unrealized losses associated with equity funds that the holding company has investments in, which were initially used to seed proprietary mutual funds. As you all know, equities have significant declines at the end of the first quarter, so those valuations declined. Other non-interest income totaled $18.2 million in the first quarter, up approximately $4.2 million from the $14 million recorded in the prior quarter. Primary reasons for the higher revenue in this category include $3.9 million of higher swap fee revenue and $2.1 million of net gains related to sales of certain loans and leases. This was offset by $2.7 million of lower BOLI income as BOLI investments that supported deferred compensation plans were negatively impacted by equity market returns. But I should note that the decrease in BOLI income in the first quarter resulted in a similar decrease in compensation expense during the quarter. So, the net effect of that is largely washed out in total. Turning to the non-interest expense categories, non-interest expense totaled $234.6 million in the first quarter, down approximately $15 million or 6% from the prior quarter. A number of factors contributed to the decrease; salaries and employee benefits expense were down $9.2 million from the prior quarter, lower levels of advertising and marketing expenses of $1.7 million compared to the prior quarter, we had $1.4 million less of OREO expenses, and we had $3.1 million of charges in the fourth quarter of last year that didn't recur related to legal settlement charges, contingent purchase price payments and costs, and terminating small pension plans. Those aforementioned changes were offset by $2.8 million of higher FDIC insurance assessments due to the rebates from the FDIC substantially subsiding in the current quarter compared to the prior quarter. I'll talk in more detail about the major categories now. The salaries and employee benefit expense category declined by $9.2 million from the prior quarter. The majority of the decline in that expense category related to reduced incentive compensation accruals, which were approximately $8.7 million lower than the prior quarter, with that change being driven largely by long-term incentive compensation programs which are forecasted to be negatively affected by the impacts of the current economic conditions brought on by the pandemic. Additionally, salaries expense were down by $1.6 million from the fourth quarter. The primary cause of the decline was a $2.2 million reduction in deferred compensation costs that were related to the BOLI investments that I previously discussed. Offsetting those decreases were employee benefit expenses which were up approximately $1.1 million during the quarter due to higher amounts of payroll taxes, which tend to be elevated in the first quarter of the year. Data processing expense increased by $804,000 in the first quarter, compared to the fourth quarter of 2019. This was due primarily to approximately $1.4 million of de-conversion charges related to the Countryside acquisition, versus only $558,000 of conversion charges related to the STC Capital Bank system conversion that happened in the prior quarter. The additional operating costs of data processing related to the franchise also contributed to the increase. For your information, we also expect to incur slightly more than $3 million of additional conversion-related charges in the second quarter related to the just-completed conversion of the Countryside Bank transaction. By the way, our teams did a terrific job of completing that this past weekend, given they were working in a remote environment and social distancing requirements, etc. So, our first virtual conversion went off well. FDIC insurance expense, as I mentioned, was up $2.8 million in the first quarter as a result of the assessment credits substantially going away. We had roughly $200,000 of assessment credits left in the first quarter of 2020, but we are essentially done with those. I think we have a little less than $100,000 that could still be credited. Professional fees decreased to $6.7 million in the first quarter compared to $7.6 million in the prior quarter. Professional fees, as you know, can fluctuate on a quarterly basis based on the level of legal services for acquisitions, litigation, problem loan workouts, as well as any consulting services. This category of expenses came down from the prior quarter due to a decline in legal fees associated with litigation, collections and acquisitions. The category also experienced a slightly lower level of consulting engagement costs. If you look at the professional fees over the past five quarters, they average $6.8 million. So, the $6.7 million we incurred this quarter is relatively in line with our typical amount. Advertising and marketing expenses in the first quarter decreased by $1.7 million when compared to the prior quarter. The decline was primarily related to lower mass media advertising costs, which tend to be lower in the first quarter of the year. We also had some media spending that was associated with various sporting events that did not occur due to cancellations later in the quarter. OREO expenses were actually negative by approximately $876,000 in the first quarter as the company recorded a gain of $1.3 million on the sale of a piece of OREO property and that gain exceeded the aggregate costs of OREO expenses and negative valuation charges on the other pieces of OREO. The miscellaneous expense category totaled $21.3 million in the first quarter compared to $26.7 million in the fourth quarter of 2019, a decrease of approximately $5.3 million. The decrease was impacted by approximately $2.7 million of charges in the prior quarter for legal settlement charges and additional expense accrued with contingent purchase price payments that did not occur in the current quarter. The current quarter also had a lower level of travel and entertainment expenses, as you can imagine, and a variety of other smaller fluctuations. So, other than those categories I just discussed, all other categories of non-interest expense were down on an aggregate basis by $19,000 from the fourth quarter of 2019, and so they were essentially flat. The net overhead ratio as I mentioned sits at 1.33%, which is down 20 basis points from the 1.53% recorded in the prior quarter. The ratio benefited from current balance sheet growth, strong mortgage banking results, and lower non-interest expenses. And we would expect that net overhead ratio to stay well below 1.4% in the near term due to the continuing strong mortgage market, the strong balance sheet growth including lending related to PPP, and focus on expense control. So, with that, I will turn it back over to Ed.

Edward Wehmer, Founder and Chief Executive Officer

Thank you, Dave. You remind me of the guy at the end of a mortgage commercial who talks really fast. Anyhow back to me for some summary thoughts and thinking about the future. These are really crazy times. I kind of feel like Bill Murray in Groundhog Day; in fact, my alarm clock which is Alexa will play — I shouldn’t have turned it on — Sonny and Cher's 'I Got You Babe' every morning when I get up on purpose. The quarter was really a pretty good quarter given the current environment. As I said the FASB picked out a quarter to adopt CECL. I think that we adapted well to the current environment as well as can be. I think our crew is working extremely well. Our ability to service our clients' needs as it relates to PPP loans, credit modifications, and new credit will hopefully abate credit issues going forward, or at least the financial effects of those will. We're not naïve enough to think that there will not be some credit ramifications to this situation. Based on our history, we would say these should affect us less than our peers due to our portfolio diversification and our conservative underwriting culture. Surely these losses will be a function of how fast we get back to work. Our earnings from PPP loans will provide a cushioning effect against these unknowns. Time will tell, but we feel pretty good about where we're at. We said before the crisis we need to grow through this low rate environment, which is exactly what we're doing. Some of it we didn't anticipate, but our core growth we anticipate to be very good. We think our expenses will be in check — the same about entertainment and no baseball season will save a lot of money there. But again, I can't say enough about the Wintrust crew and our ability to ride this out and do it for our shareholders, our customers, our employees, and the communities that we serve. You can be assured of our best efforts in getting through this crisis and continuing to grow Wintrust in the solid way we've always done it. With that, I'll turn it over to questions.

Operator, Operator

Our first question comes from Jon Arfstrom with RBC Capital Markets. Your line is now open.

Jon Arfstrom, Analyst - RBC Capital Markets

Hey thanks. Good morning everyone.

Edward Wehmer, Founder and Chief Executive Officer

You're still stiff and blue Jon?

Jon Arfstrom, Analyst - RBC Capital Markets

I hope you have your mask on Ed, you're doing that. I want to talk about credit. But I guess first Dave; you have talked about the revenue line pretax, pre-provision and on mortgage I just want to make sure I understand what you're saying. You have $17 million derivative income associated with commitments, and because of the big pipeline, I think you're saying that may or may not recur in Q2, but likely may not have the MSR headwind as well in Q2. So, it's possible to sustain that kind of revenue momentum in mortgage, is that fair?

David Dykstra, Vice Chairman and Chief Operating Officer

Yes, well, I think the pipeline is still pretty strong. So, I think we're still going to — looks like we still are building the pipeline. Purchase activity is going to fall off a little bit, but we're going to probably close more loans in the second quarter, so we'll have production gain there, but that will be offset by probably that derivative income going down a little bit. So, I think we're sort of looking at ex-MSRs as being a relatively stable revenue quarter-to-quarter.

Edward Wehmer, Founder and Chief Executive Officer

They are going to wash itself out and then we'll have the regular gains from this quarter, especially with the hangover over quarter from lock to closed.

David Dykstra, Vice Chairman and Chief Operating Officer

Yes, we expect — usually don't have that much visibility going out. But the lock terms have lengthened now because there's so much volume, so we think we'll still have a fairly decent pipeline on those loans that have mandatory commitments. At the end of the quarter, we'll have to see, but I expect that will be down a little bit, but then the actual gain — gain on sale from a higher level of production that we sold will be up a little bit, so probably offsetting to a great degree.

Jon Arfstrom, Analyst - RBC Capital Markets

Okay. And then bigger picture credit. Ed, one of your comments, I don't know if this is for you or Rich, but if and when stress shows up in the portfolio, what are your near-term, medium-term expectations for portfolio stress?

Edward Wehmer, Founder and Chief Executive Officer

Well, I'll give you the 20,000 foot level and Murph can kind of jump in I'm sure on some of the areas that you want to cover. It's kind of like time has stopped for two or three months. I mean we're giving two or three — we've given three months deferrals of principal and interest to a lot of clients; regulators are okay with that, tacking it on to the end. It doesn't become a TDR really until after two of those, really six months. The PPP loans that we've — almost $3.8 billion of those out there to our clients and others give them a little over two months of breathing room. The stimulus comes in and provides people a couple months. So, if you figure it, I don't think you're going to see the stress until — if we can get out of this in two months, the stress will be mitigated. If we don't get out of it in two months, you're going to have delayed stress that will come into the portfolio. We're fortunate we don't have a lot of credit cards or consumer debt on the books where things could get a little dicey. But you think about a consumer who has a mortgage and you give a three-month deferral, that consumer is likely okay, and especially if they got a PPP loan. It's put on the end, no problem. You think about a commercial multifamily owner needing rent abatement, or principal abatement — the whole world is stopping for two or three months. I think that any stress that comes through is going to be a hangover at the end in an event where we can't get out; it's going to take six months to get out of where we're at, then I think you'd have issues unless the government comes in and provides more support into the system, which I think they'll do. They've really caused a lot of liquidity with the shutdown. I think that they're committed to keeping this going. Then you've got to worry about rates increasing down the road, but right now QE is going to take a lot of strain out of the system. Murph, you want to get into some of the specifics on the hairier parts of the portfolio?

Richard Murphy, Vice Chair and Senior Lending Officer

Yes, I would echo Ed's comments to begin with. I think that if we can bounce out of this pretty quickly, we have programs in place here that have helped our customers, and I think they'll respond accordingly. But obviously, the longer it takes to get out of this and for customer behavior and consumer behavior to really go back to normal, I think that's the big question that everybody's asking. One of the examples I use is we have a long-time movie theater operator in Chicago that we have a reasonably sized loan to — not a big loan, but for him you just have to question how long it will be before people want to go back into a movie theater. That's a good example of where the uncertainty is pretty big. As it relates to our high-impact industries, we brought a lot of detail in the release. And obviously the one that jumps out is the franchise portfolio. Generally speaking, we think the franchise portfolio is in pretty good shape for a couple of reasons. One is that we have mostly quick-service restaurants that are 85% of that portfolio. Most of those are still open; most of those are with very strong operators and franchisors. So, we feel pretty good. We also have seen a lot of those customers take advantage of some of the deferment and PPP opportunities. So, generally speaking those are holding in pretty well. But clearly that is a large segment in the portfolio of just about $1 billion and it's obviously a very impacted industry as well. As it relates to hospitality, oil and gas and some of the other areas that are areas for concern, those are relatively small for us. We have not typically played in those spaces all that much. The oil and gas exposure is really a function of some leasing work we've done over the last couple of years. But I would really go back to Ed's comments that right now, the diversity in the portfolio gives us a lot of comfort. We generally pick very strong operators that we want to finance, but the ripple effects and the length of those ripples, we just don't know right now. So, time will tell.

Jon Arfstrom, Analyst - RBC Capital Markets

And then just one small one, premium finance non-performers just kind of keep creeping up, is that an administrative issue or is there anything new there?

Edward Wehmer, Founder and Chief Executive Officer

Yes, that's what I was saying earlier. What you have when you have these crises — and again, you're governed by state regulation. In Florida, whenever there's a hurricane, they — you cannot cancel policy. So, what you've got is policies that people haven't made their payments on would normally be canceled; you're not allowed to cancel. Most states allow you to go back and cancel them as of the date they would have been canceled retroactively, but during the crisis you can't cancel. So, you're going to see those creep up. As I said earlier, you see a minor tick-up in losses, maybe from 20 basis points to 23 basis points or something. You can look back whenever we've had those types of issues. Now, not every state has done it; I think maybe 20 states have done it so far in terms of not allowing cancellations during this period. But they always let you go back, so you get your principal back — maybe not all your interest or late fees, but you get a lot of that back anyhow. So, you're going to see those keep popping up a little bit until the crisis is over. But again, it's not usually a major situation for us.

Jon Arfstrom, Analyst - RBC Capital Markets

Okay. Okay, good. Thank you. Appreciate it.

Edward Wehmer, Founder and Chief Executive Officer

You bet.

Operator, Operator

Thank you. Our next question comes from David Long with Raymond James. Your line is now open.

David Long, Analyst - Raymond James

Good morning everyone.

Edward Wehmer, Founder and Chief Executive Officer

Hi Dave. How are you doing?

David Long, Analyst - Raymond James

Ed, as a fellow fan of Airplane!, I do have to commend you on your choice of remarks, the Lloyd Bridges quote from sniffing glue, so I get a prize for calling it out.

Edward Wehmer, Founder and Chief Executive Officer

I kind of like the Wolf one better though. I mean you ever see Pulp Fiction, The Wolf is awesome. Harvey Keitel.

David Long, Analyst - Raymond James

Indeed. So, I wanted to follow up on the premium finance business. I know we just talked a little bit about the uptick there, but the reserve levels in general are always fairly low for that business. I think you had a basis point — maybe 20 basis points of reserves. On the commercial side, maybe remind us why you can carry such a low reserve in that business and maybe give us an example of a situation absent COVID-19 where you may or may not lose money in that business?

Edward Wehmer, Founder and Chief Executive Officer

Well, life insurance, knock on wood, we never lost a dime. So, in the commercial business, I'll let Dave and Murph take you through that.

David Dykstra, Vice Chairman and Chief Operating Officer

So, Dave, on the commercial premium finance business, generally you're financing commercial insurance policies for workers' comp, building coverage, liability coverage, whatever it is, and they're generally annual policies. We finance those policies by generally taking a percent down — say 15% or 20% down as a standard down payment and you finance over generally nine to ten months; I think our average is just slightly over nine months. Your collateral is the unearned premium held by the insurance carriers, which are generally high-rated carriers that we do business with. That premium, which is your collateral, amortizes daily — one 365th per day — and amortizes away over the year. Since you took 10%, 15%, 20% down on that policy, that's your initial cushion, and since the loan pays off monthly, over nine to ten months, our loan pays off faster than the collateral deteriorates. So, that's generally why you don't have losses in that industry. Sometimes you could have losses if you take a lesser down payment and you don't have as much collateral cushion. And then if they don't make their payment, the states will require you to generally give them a notice of time to tell them that they've been delayed or defaulted on their loan. Then you can cancel the policy. That notice period may be 20 or 30 days depending on the state and so your collateral continues to deteriorate during that notice period. So, if you cut your collateral position too short, then because you took less down payment, it may eat into your collateral enough when they default that you'd have some small losses. And then there are losses sometimes from auditable policies, workers' comp, fleet auto; some of those policies are auditable, and to the extent that the estimated premium on the front end was off from the actual premium when they audit the payrolls or the fleet size, you can have some losses. Those are the general reasons for it.

Edward Wehmer, Founder and Chief Executive Officer

Potential fraud or an insurance company going bankrupt could also cause losses. In case of a bankruptcy, we monitor the carrier reports and credit limits for each insurance company; it usually takes more than nine months for an insurance company to fail. So, we can stop doing business with them and that mitigates the risk. You can't prevent agent fraud entirely, but we've developed a number of systems — in the past we've had some large ones, relatively large, maybe $6 million, $7 million, $8 million. We have not had one in a long time. I think we're doing a much better job electronically of screening for those, but knock on wood; we haven't had one recently. So, that's how you could lose money. Now, regarding cancellations, during crises they may restrict cancellations, so your collateral will run off, but regulators often allow you to backdate cancellations once the crisis is over, so you get much of your principal back. Insurance companies take much of the economic hit but not always fully. And in situations like this, claims usually aren't extreme, so historically this has been a manageable situation for us. We've averaged around 15 to 25 basis points normally on that portfolio and again, knock on wood, across our history we haven't lost material amounts, so I think we're okay.

David Long, Analyst - Raymond James

Excellent guys. Really appreciate the color there. That's helpful. And then with regards to the franchise finance side of things, you indicated that about 85% are quick-service. Are there any of the remaining exposures that you consider much riskier, anything in that remaining part of the portfolio that warrants special attention?

David Dykstra, Vice Chairman and Chief Operating Officer

Yes, the dine-in restaurants are where I think you're going to be most impacted. For us, that's about $150 million — well-known names, but they're obviously the most profoundly impacted by this crisis.

Edward Wehmer, Founder and Chief Executive Officer

Many of them have taken PPP loans from us or other banks, because many of these are syndicated deals. They've also taken deferrals. So again, this is a situation where a couple months it will look fine, and hopefully they get out of this and people go back to eating, they'll be fine. Everything gets pushed off and it's a very logical way to look at it. However, if we don't get back to business until September or October, you're going to have some issues.

David Long, Analyst - Raymond James

Got it. And then just lastly, you hinted on marketing expenses — if no one attends Wrigley Field this summer, those are marketing expenses you would not be spending, correct?

Edward Wehmer, Founder and Chief Executive Officer

That is correct. Cubs, White Sox, you name it. We would not be spending that money. But I'd rather spend it going to ball games myself. We actually have relationships with minor league teams and other local sponsorships that would be impacted. That can be a significant amount of money.

David Long, Analyst - Raymond James

Got it. Thanks guys. Appreciate it.

Operator, Operator

Thank you. Our next question comes from Terry McEvoy with Stephens. Your line is now open.

Terry McEvoy, Analyst - Stephens

Good morning. Can't believe it took this long to ask that net interest margin question. So, I'm going to ask one. Just taking a step back as you think about the second quarter, you have the full impact of the March rate cuts, but then you have multiple work orders just lowering deposit rates. So, big picture, Dave does the net interest margin bottom out here in the second quarter and then potentially move higher in the second half of the year as deposit rates come down?

David Dykstra, Vice Chairman and Chief Operating Officer

Well, if you're talking about the core net interest margin, yes, it would go down. But remember, we're going to have almost $100 million of PPP fees we'll be bringing in over two years at the longest. The shortest, it could be much shorter depending on how quickly loans are forgiven. These loans can be forgiven once customers apply to the SBA. In a worst case scenario over two years, the margin would be okay, roughly where it is today. If many borrowers get forgiven in the near term, we could have a significant amount of PPP fee income in a compressed period, which would positively affect the margin. So, margin — the core margin is going to be in the mid to high 2.7% range — around 2.70% to 2.80% based on where we are right now. But the PPP fees are going to protect us for one to two years and help the net interest income. So between that and our growth, I would expect a bounce back from there on the core side, and the PPP loans will be very helpful from an income side to help cushion any long-term credit issues and to help the margin.

Terry McEvoy, Analyst - Stephens

Understand your thought process on PPP and how that plays into the margin. I'm just thinking about the revenue related to PPP and what that can be to the bottom line. You mentioned $85 million in the release. I just want to make sure that $9 million is what's in the pipeline. My guess is you assume that grows with round two. And then what are the expenses that we should think about related to PPP just so we can calculate a bottom-line impact that will help your capital ratios?

Edward Wehmer, Founder and Chief Executive Officer

I think the marginal expenses are basically zero. We set up the system on our own. We didn't engage much outside vendors. The work was mostly handled by people we already have on staff. So the incremental expense should be negligible. Dave or Dave Stoehr, do you want to add?

David Dykstra, Vice Chairman and Chief Operating Officer

No, I think it's generally just the people issues — our staff that we already have on board who clear up the back end. There are some minor data processing impacts with more accounts on the core systems, but it shouldn't be that much additional expense.

Terry McEvoy, Analyst - Stephens

And then just on round two of PPP, you said $9 million — that's going to be higher as we move forward?

Edward Wehmer, Founder and Chief Executive Officer

Right now what we have in the pipeline is about $350 million to $360 million that will be waiting for eTran tonight. Once you get your eTran, they're committed. That's about $9 million of fees — rough numbers, give or take. We'll know better at the end of the day. We may open the portal again once we get through that. We think this next round will be short because many of the big banks dropped the ball in round one and have backlog — they have remaining needs in their quota. We had 98% of ours fully funded in round one. The next allotment may last 48 hours at most. We'll be careful not to overextend and leave customers hanging. But we think we can get these through and plus/minus 10% is reasonable for the pipeline estimate.

Terry McEvoy, Analyst - Stephens

That's great color. Thank you.

Operator, Operator

Thank you. Our next question comes from Michael Young with SunTrust Robinson Humphrey. Your line is now open.

Michael Young, Analyst - SunTrust Robinson Humphrey

Hey, thanks. Good morning.

Edward Wehmer, Founder and Chief Executive Officer

Good morning.

Michael Young, Analyst - SunTrust Robinson Humphrey

Want to start with the CECL reserve; it’s a little lower than peers and I understand there are some mix benefits from the premium finance book, but can you talk about the economic assumptions that are underlying the adjustment you made this quarter? And any outlook going forward into Q2 on whether you need to continue to build this reserve?

David Dykstra, Vice Chairman and Chief Operating Officer

We put in the slide deck the macroeconomic scenario factors that are key drivers for our models. Those include credit spreads, commercial real estate price indices, GDP growth, etc. Those factors most impacted our portfolios and have the best historical correlation. I was reading some sell-side reports and saw a range of views. Some think we had too much, some too little, some just right. Our mix with premium finance loans helps our reserve position, and our diversity helps too. We think we're comfortable with where the CECL reserves are at. It's substantially more than our previous run rate when you look at the total reserve build. We've gone through the business lines and done a lot of the heavy lifting. There's more stimulus coming that should help. But we can't predict how long this will last. We won't make a firm prediction on Q2 reserves here; they could be higher or lower depending on how quickly the economy reopens. Our view is it's probably not a sharp V-shaped recovery, it's somewhere between V and U. We're monitoring the portfolio closely and managing it. Compared to peers, we feel we're in the middle of the pack, and we tried to take a reasonable view in our modeling with our subject matter experts.

Michael Young, Analyst - SunTrust Robinson Humphrey

Thanks for that. And maybe just following up, any high-level thoughts on commercial real estate and construction, particularly retail, and any mitigating factors you're looking at or portfolio analysis you've done so far?

Edward Wehmer, Founder and Chief Executive Officer

Go ahead, Murph.

Richard Murphy, Vice Chair and Senior Lending Officer

CRE is a bit of a wild card. We've spent time thinking through what it might mean and we're pretty well diversified in the CRE book, with multifamily being the largest segment. Multifamily is generally Chicago metro, with long-time operators; that gives me comfort. Industrial is a decent-sized portfolio for us and I feel good about that. The areas that give me the most concern are retail and office. For office, the work-from-home model we've adapted to is going to change how the office market looks over time — a year or two from now we may see differences. We tend to be granular and pick very strong operators, so I feel okay. Retail is the segment that probably concerns me most in general. Our approach over the last five years has been to reduce retail exposure, and we've been successful. Where we do have exposure, it's mostly in the downtowns and suburban community retail, not big box regional centers. I think those operations will be viable longer term, but habits like ecommerce have accelerated and I don't think there will be full reversion to past patterns. Those changes will matter for retail owners and how they adapt.

Edward Wehmer, Founder and Chief Executive Officer

Murph and I have talked about that a lot. We're diversified and we know our borrowers. We'll see how it shakes out over the next two or three months once people are back to work. We'll be very cognizant of it in underwriting and in new lending; loans are made in bad times, but you have to be careful with the collateral you take.

Michael Young, Analyst - SunTrust Robinson Humphrey

Okay. Thanks.

Operator, Operator

Thank you. Our next question comes from Chris McGratty with KBW. Your line is now open.

Chris McGratty, Analyst - KBW

Hey, good morning. Question: in the past you've talked about the rope-a-dope strategy and not the need to go there. What would it take for you to pivot? Is it just two to three months and we don't get the outcome we're looking for? I'm interested in what would pivot the bank's strategy more significantly next?

Edward Wehmer, Founder and Chief Executive Officer

Well, the rope-a-dope concept before was really brought out by two things. One is we couldn't get paid for the risks we were taking and we didn't meet our profitability models on many deals. Secondly, we were seeing too many critical exceptions to loan policy and we said we're not going to do that. Now, spreads on the lending side are moving up, which is a good thing, so we are meeting our profitability models. We are closely monitoring exceptions; if there's too many exceptions that could slow new loan production. But I think folks have pulled back enough that this may have been a timely crisis, because some lenders had been taking too much risk as yields went lower. This has led to more rational pricing. Also, we've seen a halo effect from PPP work where competitors couldn't service their clients and our team could, which opened up opportunities to add solid customers at reasonable pricing. So the landscape has shifted. We'll remain vigilant, but right now we see growth opportunities and will continue to be disciplined.

Richard Murphy, Vice Chair and Senior Lending Officer

I agree with Ed. The market had gotten aggressive in pricing and structure. This crisis has snapped back those trends and we've seen that. That said, we'll continue to be disciplined in underwriting.

Chris McGratty, Analyst - KBW

Thanks. One more on PPP. Conceptually, wouldn't the right thing be to put PPP fees back into the reserve to make people feel better about adequacy for the industry?

Edward Wehmer, Founder and Chief Executive Officer

We have to be consistent with accounting and reserve modeling. The reserve will be what it is and the PPP fees will be recognized as income per the accounting rules and timing of forgiveness and recognition. You could take qualitative actions if the situation clearly warranted additional reserves, but it's important to treat the two items independently and be consistent.

Chris McGratty, Analyst - KBW

Dave, I have one on tax. How should we think about the effective tax rate relative to Q1?

David Dykstra, Vice Chairman and Chief Operating Officer

I think you should look at a normalized tax rate of roughly 26.5% to 27%. The stock price drop impacted some first-quarter benefits we usually get from stock-based compensation, so the first quarter was a little different, but long term, that normalized tax rate is a good guide.

Edward Wehmer, Founder and Chief Executive Officer

Chris, I have a question for you: why does our stock trade at a discount to peers so often? I don't understand why we trade so much lower sometimes.

Chris McGratty, Analyst - KBW

I think the volatility lately has been somewhat technical and less fundamental, but I agree — constructive on the franchise.

Operator, Operator

Thank you. Our next question comes from Brock Vandervliet with UBS. Your line is now open.

Brock Vandervliet, Analyst - UBS

Thank you. Given your comments about the outlook and that Moody's and others are revising scenarios, could you touch on what external inputs you used for your CECL scenarios and whether you consulted third-party providers for a reality check?

Edward Wehmer, Founder and Chief Executive Officer

We look at a number of sources. We run base, severe, and adverse scenarios. We consult blue-chip economists' consensus, Moody's scenarios, and run our models against those inputs. We then compare and contrast and overlay qualitative input from our business leaders. You have to pick a scenario at quarter-end to run the numbers, but we were informed by multiple external models and internal judgment.

Brock Vandervliet, Analyst - UBS

Okay. And regarding forbearance, I saw reference in the press release with certain dollar amounts. Did you disclose the percentage of commercial and CRE deferrals granted?

David Dykstra, Vice Chairman and Chief Operating Officer

On the press release we noted that we had about $300 million of outstanding balances for commercial and commercial real estate loans that have some form of modification. That is the amount we have booked so far. There are others in process that we are evaluating that could show up over the next couple months. On our retail/residential mortgage servicing portfolio, we sell the bulk of those loans, so we do have servicing portfolio metrics and so far are tracking better than MBA averages at the times we check. Our internal numbers are a bit more current than some external aggregates.

Brock Vandervliet, Analyst - UBS

Okay. Thanks for the color.

Operator, Operator

Thank you. Our next question comes from Nathan Race with Piper Sandler. Your line is now open.

Nathan Race, Analyst - Piper Sandler

Thanks. One last question on capital, planning and priorities: with total risk-based capital down about 30 basis points sequentially, what are your updated capital deployment priorities and how do you see capital levels projecting given the uncertainty?

David Dykstra, Vice Chairman and Chief Operating Officer

We review capital continuously and run stress analyses frequently. PPP loans are generally capital-free from a risk-based perspective, so they don’t materially impact risk-based ratios. We continue to generate positive earnings and suspended share repurchases, which was prudent, while maintaining the dividend policy under Board oversight. If growth accelerates or markets present attractive instruments, we could consider preferred or subordinated debt, but it's not critical right now. Overall we view capital as adequate.

Edward Wehmer, Founder and Chief Executive Officer

We run stress tests regularly — perhaps more than most. We feel comfortable where we are. The primary items that would change our view would be accelerated growth opportunities that required additional capital or a materially worse stress scenario. Right now our focus is on disciplined growth.

Nathan Race, Analyst - Piper Sandler

Understood, that's helpful. Speaking of stress tests, when you last submitted DFAST in 2017 you indicated you could have 2.8% cumulative losses in a severe adverse scenario. Any updated thoughts on what you could see in a severe adverse scenario under current circumstances?

David Dykstra, Vice Chairman and Chief Operating Officer

We haven't disclosed updated DFAST-like stress test outputs publicly recently. We do them internally, but I don't have updated public numbers to share today. We believe with a substantial amount of stress we can manage, but we haven't provided a detailed quantified public stress estimate for this environment.

Nathan Race, Analyst - Piper Sandler

Understood. One more on PPP — you disclosed that you funded relief to about 15% of highly affected industries through PPP. Based on the pipeline, where do you expect that number to move, and how does that provide added cushion for those industries?

Edward Wehmer, Founder and Chief Executive Officer

Most of the customers in highly impacted industries applied in round one; going forward we have reached out into lower- and moderate-income communities to help those less likely to get loans. We took a brief pause on the portal to make sure we could process people who might not have been as prepared, and we've processed over 10,000 applications in total to date. We believe we've helped prevent many small business failures and preserve payrolls. For highly impacted industries, we continued to process additional applications, and Dave noted in the release that from the release date through 4/20, excluding the Phase 2 activity, we increased our exposure to highly affected industries by about 15%.

Nathan Race, Analyst - Piper Sandler

Understood. I appreciate the color. Thanks guys.

Operator, Operator

Thank you. Our next question comes from David Chiaverini with Wedbush. Your line is now open.

David Chiaverini, Analyst - Wedbush

Hi, thanks. I wanted to ask about expenses. In the past you've mentioned keeping the net overhead ratio below 1.5%. I think I heard you mention it should be well below 1.4%. Is that the new bogey now?

David Dykstra, Vice Chairman and Chief Operating Officer

Yes, I said in my remarks that with the balance sheet growth related to PPP, the strong mortgage markets, and lower travel, entertainment and sponsorship expenses, we expect to be below 1.4% in the near term. The long-term bogey hasn't changed — below 1.5% is still the general target — but for the next few quarters expect the ratio to be between 1.30% and 1.40% and potentially near 1.30% if things go well.

Edward Wehmer, Founder and Chief Executive Officer

Yes, 1.5% has always been the signaling target but given current dynamics, expect sub-1.4% in the near term. We remain committed to running the business efficiently.

David Chiaverini, Analyst - Wedbush

Great. Has your de novo outlook changed? Previously you planned about a dozen branches over the next 12 to 18 months; has the backdrop shifted your thinking?

Edward Wehmer, Founder and Chief Executive Officer

Not really, though we've slowed the timetable a bit. We're taking a couple months off and being cautious, but these de novos are still part of our long-term plan. The timing may be a bit more spread out, but the commitment remains.

David Chiaverini, Analyst - Wedbush

And on loan growth, you mentioned line draws and a surge at the end of the first quarter. Could that be a headwind if companies pay down those drawdowns as things normalize?

Richard Murphy, Vice Chair and Senior Lending Officer

Overall economic activity will be muted in the remainder of the year which will affect growth. However, the halo effect from PPP may create opportunities to win new customers and grow relationships. We also see strong mortgage warehouse line usage currently which could be pressured in the second half. We continue to monitor line utilization and the broader economy.

David Chiaverini, Analyst - Wedbush

Makes sense. Thanks very much.

Operator, Operator

Thank you. I'm not showing any further questions at this time. I would now like to turn the call back over to Edward Wehmer for any closing remarks.

Edward Wehmer, Founder and Chief Executive Officer

Thanks everybody. Stay healthy. If you have any other questions, please feel free to call me or Dave. Tim Crane got off easy; he didn't have to answer anything today, but feel free to call him. Thanks, everybody. Stay healthy and until next time. Bye-bye.

Operator, Operator

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