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Good afternoon, everyone, and welcome to Associated Banc-Corp Third Quarter 2020 Earnings Conference Call. My name is Diego and I will be your operator today. At this time, all participants are in a listen-only mode. We will be conducting a question-and-answer session at the end of this conference. Copies of the slides that will be referenced during today's call are available on the company's website at investor.associatedbank.com. As a reminder, this conference call is being recorded.
As outlined on slide one, during the course of the discussion today, management may make statements that constitute projections, expectations, beliefs or similar forward-looking statements. Associated’s actual results could differ materially from the results anticipated or projected in any forward-looking statements. Additional detailed information concerning the important factors that could cause Associated's actual results to differ materially from the information discussed today is readily available on the SEC website and the Risk Factors section of Associated's most recent Form 10-K and subsequent SEC filings. These factors are incorporated herein by reference.
For a reconciliation of the non-GAAP financial measures to the GAAP financial measures mentioned in this conference call, please refer to pages 21 and 22 of the slide presentation and to pages 10 and 11 of the press release financial table. Following today's presentation instructions will be given for the question-and-answer session.
At this time, I would like to turn the conference over to Philip Flynn, President and CEO, for opening remarks. Please, go ahead, sir.
Thank you and welcome to our third quarter 2020 earnings call. Joining me today are Chris Niles, our Chief Financial Officer; and Pat Ahern our Chief Credit Officer. Goes without saying that this has been a challenging and unusual year. We pivoted in March in response to the pandemic and have been retooling our delivery channel since to best meet our customers' needs.
We deployed ourselves to seamlessly interact through virtual channels and have seen an accelerating shift to mobile and online banking. With a likely very low interest rate environment facing us for an extended period, it became critical to respond in areas we can control. Let's start with the actions we took during the third quarter.
On slide two, we have detailed our optimization efforts and the restructuring of our securities and real estate lending subsidiaries. During the third quarter we announced the sale and planned consolidation of 22 of our branches. We also announced the strategic streamlining of several corporate managerial and back-office functions. As a result of these actions, we incurred $16 million of pre-tax charges in Q3, but we expect these changes to drive a $40 million per year reduction in our run rate expenses, as we move into this quarter and 2021.
We also deployed about half of our excess liquidity position to repay $950 million of FHLB advances. This prepayment resulted in a $45 million Q3 pre-tax expense. However, we expect this to improve annualized net interest income by $20 million, beginning in Q4 2020, continuing through 2021, with diminishing but continuing savings through 2022 and into 2023. Finally, we were able to unlock capital losses through the restructuring of our securities and real estate lending subsidiaries and this resulted in a $49 million after-tax benefit during the quarter.
Turning to slide three. We've highlighted the impact of our Q3 initiatives on our pre-tax pre-provision income. Adjusting for the $60 million of restructuring and prepayment costs, third quarter PTPP would have been $90 million. On slide four, we've provided a walk forward of EPS, which breaks down the various initiatives executed during the quarter.
You'll notice when tax affected, the one-time costs of our efficiency initiatives were more than covered by the tax benefits we realized from the reorganization of our subsidiaries. If you were to exclude both the restructuring charges and the tax benefits from our EPS for the third quarter, the adjusted $0.24 result is within $0.02 of our reported GAAP EPS of $0.26. So in effect, the items largely offset each other. The actions this quarter were net additive to our tangible book value.
Turning to slide five. Average loan balance trends are shown. Total average loans came in at $25 billion, down slightly from the prior quarter's average. Commercial real estate grew $312 million, driven by the continuing funding of construction loans. And at September 30, we still had $1.9 billion of unfunded commercial real estate commitments. Commercial and business lending on the other hand declined by $271 million on average, as our general commercial customers largely used their increased excess liquidity balances to pay down open lines of credit.
Turning to slide six. We highlight changes in the end-of-period loan balances. Period-end loans were up $171 million or 1% for the quarter, driven again by strong growth in commercial real estate lending which was up $298 million. Mortgage activity remained strong, which was reflected in our elevated mortgage warehouse lending balances at quarter end.
Power and utilities lending, along with commercial real estate construction and investor loans, have continued to grow throughout 2020. I'll also call out oil and gas, which declined nearly $100 million during Q3 and now represents only 1.3% of our total loan portfolio. Consumer lending balances came down during the quarter driven by refinancing activity and our decision to sell $70 million of prepayment susceptible mortgages.
Now let me provide an update on our deferral programs. On slide 7, you can see our commercial deferrals have continued to steadily decline. As of October 19, and we have approximately $227 million of active commercial loan deferrals, down 73% from June. Our commercial deferrals have largely rolled off their initial 90-day terms and the remaining deferrals are primarily related to COVID-impacted portfolios.
Commercial real estate loan deferrals were $182 million of that $227 million and are primarily related to hotel and retail borrowers. Commercial and business lending deferrals have declined to just $45 million at October 19, and they now comprise less than 1% of the commercial and business loan book.
Taken together the $227 million of active commercial and commercial real estate deferrals at October 19 make up about 1.4% of our total commercial loans outstanding. Our consumer-related COVID relief efforts are highlighted on slide 8.
In the beginning of the pandemic we granted deferrals to virtual any – virtually any customers, who asked for assistance. The deferrals granted were for six months so the bulk of those deferrals began to expire during September. At October 19, we had $269 million of active deferrals down 63% from June.
These loans now represent approximately 3% of outstanding consumer loan balances. It's important to note, however, that of the remaining $269 million of active deferrals, $263 million of that is still on their first deferral period. The bulk of those deferrals will expire during the balance of October and we expect most will not require additional assistance.
So of those loans that have come off deferral in the consumer book, at this point only $6 million have asked for additional assistance. Among consumers, whose deferrals have ended 97% are current or less than 30 days past due, the trends we're seeing is deferrals roll-off continue to be positive and we feel confident many of these borrowers will go back to their pre-COVID performance.
On slide 9, we've provided an allowance update. We utilized the Moody's September 2020 baseline forecast or our CECL forward-looking assumptions. The baseline forecast assumes additional stimulus continuing low rates and a COVID vaccine that becomes widely available in Q2 of 2021.
For Q3 of 2020, our net allowance build was only $13 million, down from $35 million in the prior quarter. I'll direct you to the top right chart, where we illustrate the ACLL trend during 2020. You can see our net reserve build has tapered off throughout the year. This reflects the overall stability of our loan portfolio and our real-time outlook for all our credit exposures at quarter end.
As you can see from the lower table on this page, during Q3 we actually released reserves in four lending categories and added reserves in three. The largest net build was in our commercial real estate investor portfolio where we added to our reserves related to shopping malls and other retailer exposures.
Reserves on our oil and gas portfolio declined $33 million as we continue to manage that portfolio down. As of September 30, our total allowance was $442 million and covered 1.8% of total loans.
Credit metrics are presented on slide 10. As a reminder, these metrics reflect our real-time risk rating and credit evaluations with the expectation that substantially all the active deferral activity will come to some conclusion of remediation this quarter. Potential problem loans decreased $14 million, primarily driven by the migration of COVID-affected loans to non-accrual.
Overall non-accrual loans increased $60 million, driven primarily by the migration of two commercial real estate mall-oriented REITs and our only sand fracking company into nonaccrual.
Loans included in our key COVID commercial exposures, made up 37% of non-accrual loans at the end of Q3. This inflow was partially offset by non-accrual oil and gas loans, which declined $42 million due to charge-offs, note sales and payoffs. Charge-offs for the quarter were $30 million. Outside of oil and gas, net charge-offs were again less than $10 million for the quarter. Reserves on the remaining oil and gas book remained over 15%.
Turning to slide 11. Average deposits were $26.8 billion, up nearly $700 million, or 3% over the second quarter. Average deposit growth again came from low-cost savings and check-in accounts this quarter. Liquidity remains high and our deposit mix continues to improve. Low-cost deposits accounted for nearly 63% of our balances at the end of the third quarter.
Turning to slide 12. Third quarter net interest income was $182 million, with a net interest margin of 2.31%. We previously guided that net interest margin would bottom out during Q3 and begin to pick up in Q4. And as we expected margin hit bottom in July and August and then rebounded up to 2.35% in September.
Asset yield stabilized during the third quarter, while our liability cost trended downward. We continue to expect to see margin expansion further into Q4 and into 2021. We expect spreads to widen on our LIBOR-based commercial loans as we continue to implement new LIBOR floors into our new and renewing loans. This will happen over time or in conjunction with other repricing or credit actions including the anticipated migration to SOFR and other indices later in 2021.
On the liability side, our time deposit levels have both been declining and repricing lower. When CDs renew or roll over today, they're generally repricing from approximately 1.2% to below 15 basis points. We expect this repricing to provide margin lift going into 2021.
Additionally, we'll see a full quarter impact during Q4 from the prepayment of our FHLB advances. We expect this will provide a $5 million benefit to net interest margin in the fourth quarter and about a $20 million improvement in '21.
Turning to slide 14. Second quarter non-interest income came in at $76 million. Non-interest income was lower in Q3 than Q2. However, this was driven by the large gain from the sale of Associated Benefits and Risk Consulting in Q2 and of course, the lack of revenue from ABRC going forward.
Service charges and deposit account fees came in at $14 million, an increase of nearly $3 million quarter-over-quarter. Card-based fees increased 15% from the second quarter up to $10 million. So the combination of COVID relief winding down as well as more normalized economic activity is driving these fee lines.
Our mortgage banking activity remained strong this quarter with nearly $600 million of mortgages sold to the agencies generating $13 million in net fee revenue. After $17 million of MSR impairment in the first half of the year impairment for the third quarter was just over $1 million. We expect positive fee trends heading into Q4.
On Slide 14, we highlight our expenses. The third quarter came in at $228 million including $60 million of restructuring costs previously mentioned. Core expenses continued to trend lower largely driven by the reduction of expense following the sale of ABRC. We expect the expense initiatives executed in Q3 to provide further savings as we move into 2021 and as you can see from the lower right chart on an adjusted or run rate basis our expenses to average assets ratio is already trending below 2%.
As shown on Slide 15, our regulatory capital levels remain strong. At the end of Q3, our regulatory capital levels were at or above where we ended the year for 2019 and our tangible common equity ratio increased 25 basis points to 7.5%. Tangible book value per share also increased to $16.37 per share up from $16.21 in the prior quarter reflecting the net additive benefit to shareholders of the actions we took during the quarter.
On Slide 16, we're updating select items for the remainder of 2020 and reiterating our expense guidance for 2021. We expect a net interest margin of 2.5% or slightly higher in the fourth quarter. We expect fee revenue to continue on a positive trend through the end of 2020. Expenses for Q4 are expected to come in at $175 million including about $3 million of remaining restructuring costs.
We reiterate our full year 2021 expenses are expected to be approximately $685 million. The full year 2020 tax rate will be in the low to mid-single digits and we expect the full year 2021 tax rate to be between 15% and 17%. Thank you.
And with that we'd be happy to answer your questions.
Thank you. [Operator Instructions] Our first question comes from Michael Young with Truist Securities. Please proceed with your question.
Thanks for taking the question. I wanted to ask about loan growth. You mentioned the commercial construction pipeline with -- I think you said $1.9 billion yet to be funded. So it sounds like that's a pretty nice tailwind or potential bridge to return to stronger loan growth. Is that the right way to think about that? Or are there some other offsets that we should be thinking of in some of the other commercial categories?
Yes. Thanks Michael. So yes, certainly commercial real estate as you've seen throughout the year will continue to provide loan growth based upon the backlog we have. And there is some amount of new business being done in that area as well. Our specialty areas Power & Utilities, the mortgage warehouse business continue to show good growth. And we expect certainly the Power & Utilities area to keep growing. Mortgage warehouse will depend upon refinance activity.
The mortgage business still has some tailwind and we may choose to retain some of our mortgage production going forward. General commercial lending probably somewhat slow. We don't have great visibility into that line item into next year yet, but we expect to have more information on that as we get through the fourth quarter and get to the January call.
So there are certain areas that continue to show good growth. There are areas that continue to have the backlog like CRE that will fund up. But general activity in the commercial lending space needs to show some more growth going forward and we'll see what happens as we go along.
Okay. And just maybe on a core basis as we're thinking about the margin for next year, is really kind of loan growth the main driving factor to upside from kind of what you've already talked about in terms of just the funding costs coming down?
So we expect our liabilities to continue to grind lower. We took the actions on the FHLB prepayment, which is a significant improvement to NII next year. We are getting decent traction on imposing floors on our LIBOR-based loans, which is the bulk of our loans. We'll continue to work on that. So the combination of winding liability costs down, the FHLB prepayment, LIBOR floors and then transitioning to new indices should provide stable to growing NIM as we look forward, but we'll have better guidance for you in January on that.
Okay. And if I could just sneak in one last one. Just on the commercial deferrals, I understand obviously those have come down a good bit. But I guess are there some that have been modified? Is there a large portion that's maybe paying interest-only or some other modification has been made that's maybe not captured in that deferral number?
Yes. So we're down to 1.4% of the total commercial and commercial [Technical Difficulty] that have requested some additional deferral. Pat, do you have a little more color on that for Michael?
Yes. I would say on the commercial book, it's really case by case how we're looking at those. There's definitely a mix where we've got clients that have moved to maybe an interest-only. We have some -- hotel industry obviously is going to need some more time. So those modifications are a little more customized to kind of bridge them for at least the next year plus. So there's a lot of nuances to kind of go with each credit from that standpoint.
Is there an amount that's just been modified? I mean, would it be -- would it closely match kind of that initial $800 million? Or is it more like $600 million? I don't know if there's any way to kind of ballpark that?
Well the modified loans Pat correct me if I'm wrong are included in the $227 million that you see Michael.
Right. The bulk of those have rolled off and don't need any further assistance or modification.
Okay. So they've fully captured that number. Thank you. Appreciate it.
Yeah.
Our next question comes from Scott Siefers with Piper Sandler. Please state your question.
Good afternoon, guys. Thanks for taking the question. First one, hopefully it's a pretty basic one. I'm just -- given all the moving parts, I just want to make sure I understand sort of what you guys think the run rate cost base is in the third quarter. So I'm just trying to square what's on slide 14 with the commentary in the text.
So, if we just take the $109 million and the $69 million that would give us somewhere around $178 million in core expenses. So you have the $50 million of restructuring costs, which I think is the FHLB as well as the real estate. Where exactly do the $10 million of severance costs -- where do we see those? Is that the first...
That $10 million is embedded in that $109 million, so you can take it out of there too Scott.
Yes. Okay. Perfect. So then we're talking about a core number of somewhere in like $167 million range. Is that a fair way -- fair approximation?
For that quarter yes.
Yes. Okay. Perfect. Yes sorry for a kind of basic one there. Just trying to get through all the moving parts.
That's okay.
All right. Perfect. And then...
Well you thought there were moving parts really?
Yes. And then more just a top level one on how the credit cycle kind of plays out. It seems like every 90 days we sort of push out the time until we see more accelerated loss migration. I guess with the benefit of at least a bit more clarity vis-à-vis say 90 days ago, Phil maybe how are you thinking about when we should expect losses to begin to accelerate at some point in 2021? Is that like a mid or even later 2021 event? Or how are you guys preparing for things?
It's always hard to tell. You can see that our reserve build is moderating to being pretty flattish at this point.
Yeah.
I think so much depends on is there more stimulus, what's the economy look like as we get into next year. But there's a -- from here there's probably -- putting aside oil and gas, but from here you're probably a couple 3 quarters out before you kind of push this lump of troubled credits through the pipeline and see what comes out. So, I think there's a lag to go.
And of course, you saw in our oil and gas that we've done I think a good job of winding that down and getting that behind us. So, we still have the fall re-determination period to come. We're about a third of the way through that without any issues. But, we're still holding significant reserves in the event that we have of additional troubled credits there.
Okay. Perfect. All right. Well, thank you guys very much. I appreciate it.
Yeah.
Thank you. Our next question comes from Terry McEvoy with Stephens. Please state your question.
Hi. Good afternoon, guys. On your capital slide, you typically prioritized your usage for excess capital. I didn't see it this quarter. I was wondering if you could kind of run through how you're thinking about excess capital, specifically the buyback just given where the share price is relative to tangible book value.
Sure. So that leaving out the chart caused a question. We haven't changed our level of priorities, but it is more than fair to say when we're trading at a discount to book, which frankly we don't understand why we are given all of our actions and given our outlook. But when we're trading at that type of level, share buybacks, certainly become interesting to us. It's probably still a little bit early, but as we get into next year, Terry, clearly as we sit with growing capital and depending on where we're trading at, share buybacks become a great interest.
Thanks. And then, just as a follow-up. The $1 billion-plus of retail and shopping centers, how much of that is just what I'll call, typical -- your typical mall, which was may have been struggling pre-COVID and we just haven't seen charge-offs at all just for the whole bank. What are your thoughts there in terms of when the deferrals run out? What's the most susceptible? Is it that traditional mall? And if so, how big is the portfolio? And do you have any kind of stats average LTV or something like that to give us some color on the portfolio?
Sure. Pat, do you want to give some color on the mall-based that we were...
Sure. In general, the stuff that we're seeing that continues to struggle is all going to be the enclosed mall kind of space, where you just -- with the social distancing, et cetera, people are struggling to get into. Our -- majority of our retailers are in that, what I'll call neighborhood strip center mall, net lease space. And those have all seen rent collections come back almost to normal levels, 85%, 90%. A lot of those have come off deferral. We feel pretty good about them. There is still a handful that we're dealing with.
And then in terms of -- we really only have a handful one or two maybe other enclosed mall exposures to public REIT that have been -- so far those remaining ones have been performing well other than the two Phil mentioned earlier with the non-accrual. So right now, we feel pretty -- we have a pretty good trajectory on the retail client base.
Thank you, Pat. Thank you, Phil as well.
Thanks.
[Operator Instructions] Our next question comes from Jon Arfstrom with RBC Capital Markets. Please state your question.
Hey, thanks. Good afternoon.
Good afternoon.
Can you talk a little bit about the timing of the expense reductions for the branch optimization project? How we should roll that in?
Sure. So the consolidations, internal will be done this quarter. The sales in Peoria and of two branches in Southwest Wisconsin will complete this quarter. We expect them to complete this quarter. And the remaining one branch, which we're selling to a third-party, will close sometime in the first quarter. So you should expect to see everything clean starting January 1, with a very minor exception of one branch.
Okay. And so the message is similar to your commentary on net interest income with the $5 million. You're saying that it could be as simple as just putting an extra $10 million -- taking $10 million out of expenses for Q1. Is that fair?
Well, the -- Chris, what's the -- I think we have all the charges through in the fourth quarter, right?
Correct. Yes. So, as you said 2021 should be a clean from January 1. So Jon, I think you're thinking about it the right way.
Okay. Okay. Good. Thank you for that. Any comments on the service charge rebound, the magnitude of what you expect? Or is that just -- I know there's a bit of a bounce back, but any commentary there?
Yeah. So we expect to see continued growth there. As you know, at the start of the pandemic we gave quite a bit of relief to customers. That is now completely rolled-off as we get into Q4. And rightly or wrongly, economic activity has picked up, particularly in the Wisconsin footprint. And so we're seeing more activity there as well. So our guidance that we expect to see fee income continuing to grow into the fourth quarter is based on those factors.
Okay. And then one more maybe not an easy question, but you've had some really good deposit growth the last few quarters. And do you all think about how much of this might be permanent versus temporary if things return to normal?
Chris, do you have a view on that you want to express?
Yes. So, Jon, I think if you had asked us a couple of quarters ago certainly we would have said we saw it all as surge. As we sit here moving into October and the balances have stayed through the entire third quarter, they're staying as we move into the fourth quarter, we're starting to feel that the balances are a lot stickier, which is part of the reason we are comfortable repaying the $950 million of Federal Home Loan Bank advances, because we think a good portion of this is sticky.
And the dollars that we're still continuing to see come in, we think will continue to be sticky as we move forward. So as we sit here today, it feels a lot stickier than we would have expected and it feels like we have room to move things around.
Okay. All right. Thanks for the help guys.
Yes.
Our next question comes from Chris McGratty with KBW. Please state your question.
This is actually Kelly Motta in for Chris. Thanks for taking my question. I guess, you've talked a lot about what we've done on the funding side with prepaying that FHLB borrowings and you're still repricing to be lower. Just wondering if you could give us color on reinvestment yields of securities and how new loan yields compared to what you have on book right now.
Chris, do you want to handle that?
Sure. So on the reinvestment securities I think one thing to keep in mind is we're not aggressively growing the balances. And so what you're seeing is essentially relatively stable level to what you'll see reported for the third quarter averages and not a lot of net movement, because of incremental significant investment activity. So I don't expect there to see the continuing drift downward because there just isn't a lot of net new that we're expecting to put into that portfolio.
On the commercial loans, I think we've showed the trends on the slides. And again, we started to highlight monthly trends. So if you take a look at the slide, page 12, you'll notice that commercial loan yields actually bottomed in June and that's for the commercial and business lending. And we've been working with our lending business on spread and floors in order to sort of bounce that back up a few basis points and hold that line above 250 on the commercial book and as a whole over the last several quarters and that seems to have gone successfully, and that reflects the activity we're doing on new.
You can also see that commercial real estate has held steady. And again, what we're holding in portfolio is holding steady on the residential book as well. So I think those month-to-month trend lines give you a good indication of sort of where the new volume is coming in.
Great. Thank you. And then last question for me. On tax rates with potentially tax rates going up again and from Washington. Is there any differences on how we should think about it? Or is kind of looking at it what happened in 2018 so kind of a valid proxy? Thank you.
Well, your guess on what happens is as good as ours, but our best guess right now is that we've got tax rates in that 15% to 17%-ish range, but that can all change.
All right. Thank you.
Yes.
Ladies and gentlemen, there are no further questions at this time. I'll turn it back to Philip Flynn for closing remarks. Thank you.
Thanks. Well everybody please stay safe. Thanks for joining us today. We look forward to talking to you again in January. And as always if you have any questions give us a call. And thanks as always for your interest in Associated.
Thank you. This concludes today's conference. All parties may disconnect. Have a good day.