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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning, everyone, and welcome to the Citizens Financial Group Third Quarter 2020 Earnings Conference Call.
My name is Greg, and I’ll be your operator today. Currently, all participants are in a listen-only mode. Following the presentation, we will conduct a brief question-and-answer session. [Operator Instructions] As a reminder, this event is being recorded.
Now, I’ll turn the call over to Kristin Silberberg, Executive Vice President, Investor Relations. Kristin, you may now begin.
Thank you, Greg. Good morning, everyone, and thank you for joining us. First, this morning, our Chairman and CEO, Bruce Van Saun, and CFO, John Woods, will provide an overview of third quarter results referencing our presentation, which you can find on our Investor Relations website. After the presentation, we’ll be happy to take questions. Brendan Coughlin, Head of Consumer Banking, and Don McCree, Head of Commercial Banking, are also here to provide color.
Our comments today will include forward-looking statements, which are subject to risks and uncertainties that may cause our results to differ material from expectations outlined for your review on page 2 of the presentation. We also referenced non-GAAP financial measures so it’s important to review our GAAP results on page 3 of the presentation and the reconciliation in the appendix.
With that, I’ll hand it over to Bruce.
Thank you, Kristin, and good day to you. Good to have you on the team.
Thank you.
Okay. Good morning, everyone, and thanks for joining our call. We feel really positive about how Citizens continues to rise to the occasion and meet the unprecedented challenges of 2020. We're taking great care of customers, colleagues, and communities, while posting strong results that demonstrate the diversification and resilience of our business model.
We are delivering record levels of pre-provision profit and we're managing risks on our balance sheet well in the near term while also preserving and making the strategic investments to position us for growth and success in the long term.
Financial performance in Q3 featured record revenue, fee income and mortgage results. The low rate and flat yield curve environment puts pressure on NIM, but our well-positioned mortgage business has performed exceptionally well capturing the refi opportunity, gaining market share and providing a natural offset to low rates. We included a page on this business in our investor deck. In short, we believe the mortgage business has room to run given a positive market environment plus our own strong positioning and capabilities.
In addition to mortgage, we saw a solid quarter in capital markets revenue given strong advisory and underwriting performance, and a nice rebound in wealth fees. Consumer fees also continue to move higher off of the COVID-related lockdown lows, which should continue as the economy further reopens and consumer behavior normalizes.
These factors drove non-interest income growth of 11% sequential quarter and 33% year-on-year. Combined with a modest decline in NII and broadly stable expenses, we delivered underlying positive operating leverage of 2.6% sequential quarter and 9% year-on-year. Our pre-provision net revenue grew by 22% year-on-year and it's up 14% on a year-to-date basis.
Now, this capital generation ranks near the top of peers and has allowed us to grow loans to support customers build a prudent level of credit reserves given the uncertainty of the environment, maintain an attractive dividend payout while delivering a 9.8% CET1 ratio, which is within our targeted range of 9.75% to 10%. This capital and reserve strength gives us tremendous financial flexibility going forward from a strategic and an operational perspective.
Our view on the economy continues to be cautiously optimistic. Our consumer credit book is tracking favorable to expectations, given past stimulus, economic reopening and forbearance. On the commercial side, we are seeing some selective credit spreads and industry segments that are most impacted by COVID-19 and the lockdown's. We took sizable charge-offs on two credit during the quarter as loss recognition can be a little lumpy.
With that said, we feel we are near peak charge-offs in commercial, assuming the macro environment stays on the current trajectory. Our work on TOP and BSO continues to make solid progress. We are adding material work streams to TOP 6 largely centered on digitization and we will provide a full expense guide on our year-end call.
On BSO, we completed a student loan sale as we develop an originate-to-distribute model and we executed an attractive sub debt exchange that delivered both financial and regulatory capital benefits. It's been quite a remarkable year and we feel we've handled the challenges well and we're poised for success as the economy recovers.
With that, let me turn it over to John for a thorough review of our financials, John?
Thanks, Bruce, and good morning, everyone. Let's start with a brief overview of our headlines for the quarter starting on page 5. This was an outstanding quarter for Citizens despite the ongoing challenges in the operating environment. We have generated record revenue in PPNR in last two quarters with an excellent balance sheet position at September 30.
For the third quarter, we reported underlying net income of $338 million, EPS of $0.73 and record revenue of $1.8 billion. Our underlying ROTCE was 9%. PPNR increased 6% linked quarter to another record level and was up 22% year-over-year. We posted record fee income for the quarter, [faced] [ph] by record mortgage fees and strong results in capital markets and wealth. Also, we delivered positive operating leverage of 2.6% linked quarter and 9% year-over-year, as we continued our strong expense discipline.
Net interest income was down 2% linked quarter, due to a 3% decline in loans, given line draw pay downs and a five-basis point reduction in NIM due to rates and elevated cash. This was mitigated by excellent results in interest bearing deposit costs, which fell 13 basis points linked quarter to 35 basis points. I should note that on a normalized basis, which adjusts for PPP loans, commercial line repayments and the education loan sale completed in the quarter, average loans were up slightly linked quarter.
We increased our allowance for credit losses to $2.7 billion, which translates to a prudent ACL coverage ratio of 2.29% excluding PPP loans, up from 2.09% last quarter. Note that the reserve build during the quarter of $209 million impacted EPS by $0.40 and ROTCE by 5 percentage points. We believe charge-offs should be stable in Q4 and barring a deterioration in economic outlook, we should start to see reserve releases beginning in the fourth quarter.
Even with a significant reserve build, we demonstrated an excellent balance sheet strength, ending the quarter with a CET1 ratio of 9.8%, up 20 basis points linked quarter and back within our pre-COVID operating level of approximately 9.75% to 10%. And liquidity ratio has also improved as we ended the quarter with an LDR of 87%, and we remain in compliance with the LCR. Our tangible book value per share is $32.24 at quarter end, up 2% compared with a year ago.
On page 6, I’ll cover net interest income. Net interest income was down 2% linked quarter given the impact of lower rates and a 3% decrease in loans as line draws were repaid partly offset by lower interest bearing deposit costs and improved deposit mix.
Despite the challenging rate environment, net interest margin held up well down 5 basis points this quarter. Rates drove a 7 basis point decrease through lower asset yields and higher cash balances were a two basis point impact. These were partially offset by lower interest bearing deposit costs and outsized growth in DDA.
Moving to page 7; we delivered record results again this quarter in fees reflecting our ongoing efforts to invest in and diversify our revenue streams. Underlying noninterest income was up 11% linked quarter and 33% year-over-year as our fee income ratio improved to 37%.
Mortgage banking delivered record results again this quarter on continued strength in originations more than offsetting the modest decline in margins compared to last quarter’s all-time high. The mortgage business continues to provide an excellent natural hedge as intended against low rate pressure on NII.
The wealth business rebounded nicely in the quarter with revenues rebounding to record levels. This was driven by a strong increase in transaction volume and a solid increase in AUM. Service charges and card fees continue to trend back to pre-COVID levels. Key consumer drivers were increases in credit card purchase volume and debit card transaction volume each of which is nearing pre-COVID levels.
Capital market fees were down linked quarter driven primarily by a recovery in trading values in the prior quarter. Excluding this, capital market fees were up 11%, driven by accelerating activity in loan syndications and M&A advisory.
Turning to page 8. Let's take a closer look at the mortgage business. The strong performance of the mortgage business again this quarter has really boosted our overall performance, providing diversification in this low-rate environment. The business continues to demonstrate the benefits of the scale and diversity of our origination channels off the back of our 2018 acquisition of Franklin American.
We've made significant investments in the business over the last few years, upgrading our customer-facing technology with our focus on innovating the customer experience. Over 60% of retail applications are now completed through our digital app.
The strength of our multi-channel distribution capabilities has enabled us to meet the extraordinary increase in demand in the market, with 2020, the largest year for mortgage originations in US history. We expect volumes to remain elevated through 2021 at today's rates. And we expect to make market share gains even as rates rise as we transition to a more purchase-driven market given our strength and execution consistency and leveraging our scale and channel diversification across our retail correspondent and wholesale channels.
Turning to page 9 on expenses. Underlying noninterest expense was down slightly in this quarter, reflecting continued strong expense discipline that generated robust positive operating leverage in the quarter. This continued expense discipline has contributed to the year-over-year and linked quarter improvement in the efficiency ratio, now at 53%. Salaries and employee benefits were relatively stable in the quarter and up 3% year-over-year due to expenses connected to strong mortgage banking production volumes.
Next on page 10; average core loans were down 3% in this quarter and up slightly after normalizing for the impact of PPP loans, commercial line repayments, and loan sales. We saw growth in consumer lending in both mortgage and student.
Moving to page 11; average deposits were broadly stable in the quarter and up 14% year-over-year as consumers and small businesses benefited from government stimulus and clients build liquidity. We were especially pleased with our progress on deposit costs, which declined 29% or 10 basis points to 25 basis points during the quarter. Interest-bearing deposit costs were down 13 basis points to 35 basis points.
We executed our deposit playbook to manage down deposit costs across all channels while improving our overall funding mix. We brought interest-bearing deposit costs down significantly by leveraging data and analytics to personal life offers and optimized pricing for our affluent and mass affluent customers.
We continue to see a shift towards lower-cost categories with average GDA growth of 8% on a linked quarter basis and 40% year-over-year. This continues the peer-leading momentum we have demonstrated in growing low-cost deposits over the last three years.
Turning to page 12 to discuss our CECL methodology and reserves. We have summarized the key aspects of our macroeconomic scenario, which is a foundational element of the CECL reserve estimate. These scenarios improved slightly on that used in Q2. Nonetheless, we use management overlays and qualitative factors to build reserves, focusing on expected performance trends in specific commercial sector portfolios most impacted by COVID-related not lockdowns, namely retail and hospitality-related group, and casual dining, as well as in selected retail products.
We feel we are well-reserved at this point for extended pandemic and lockdown impacts to new sectors. Notwithstanding, the sizeable reserve bill, our CET1 ratio improved 20 basis points to 9.8% given our robust PPNR growth and lower RWAs.
On page 13, we provide detail on our customer forbearance programs. In commercial, loans with payment deferrals declined to 1.4% of our commercial loan book down from 5.2% at June 30, and this is further decreased to 1.2% as of October 13. For retail, loans in forbearance have declined to 3.8% compared to 6% at June 30 and have further declined to 3.4% as of October 13.
This would be approximately 2% if we reported forbearance ending immediately after the last deferred payment. The performance of customers that have exited forbearance is trending well with approximately 95% in current status. Also, for customers that have not taken any forbearance, the delinquency status is trending favorably.
Deferrals in business banking were 8.1% and are expected to do decrease to approximately 1% by the end of October with about 40% of our customers having received PPP funds and reopenings alleviating some of the stress.
Turning to page 14 on credit. Non-accrual loans increased 29% linked quarter given a $254 million increase in commercial, which was driven by two credits to mall REITs impacted by COVID-related lockdowns and as well as a $33 million increase in retail. Note that our total of mall REIT exposure is approximately $400 million with two credits now in NPA status and the other performing okay.
Net charge-offs were 70 basis points this quarter driven by two large credits in commercial, one to a mall REIT and one in metals and mining. The increase in commercial was partially offset by an improvement in retail, reflecting the impact of forbearance and the improving economic backdrop in Q3.
We took a prudent $209 million reserve build this quarter which increased our coverage ratio from 2.09% in 2Q to 2.29% 3Q excluding PPP loans. Despite the somewhat lumpy increase in NPAs and charge-offs during the quarter, we’re seeing broad signs of progress in commercial credit quality as the economy recovers.
In the appendix, on page 23, we provide you with an update on our view of the commercial portfolio. In the commercial portfolio, as businesses have reopened and liquidity has improved from capital raising and federal stimulus, we have seen sectors begin to stabilize. These include accommodation and food services credits, including quick service food concepts that have performed well during the pandemic.
The retail trade sector getting our portfolio of lower risk gas stations and essential services. The less price sensitive credits and the energy and related sector. And finally, the arts, entertainment, and recreation sector as sports teams and stadiums that have further benefited from professional sports resuming.
Given these positive trends the areas we consider to be of elevated concern have dropped from 10% in 2Q to two approximately 5% of total loans. The remaining areas of concern have been particularly hit by COVID-related closures mainly across retail-related CRE and hospitality, casual dining, retail trade, educational services, and price sensitive energy.
On page 15, as I mentioned earlier, we feel well positioned to manage through the current environment with strong capital and liquidity positions. Our CET1 improved to 9.8%, up 20 basis points linked quarter given our strong PPNR generation and reduction in risk-weighted assets. We are now back in our target range of 9.75% to 10%.
PPNR as a percentage of average assets was 3.9% year-to-date on a nine quarter DFAST calculation basis and has increased steadily over the last five years, reflecting the benefits of investments and increasingly diversified revenue base. Strong deposit growth outpaced loan growth, which improved our liquidity metrics and drove the spot LDR down to 87%. During third quarter 2020, the company completed a subordinated debt exchange, that will benefit total capital going forward, by increasing the percentage of qualifying tier 2 debt.
Turning to page 16, I'll update you on TOP 6. We continue to execute on the transformational and traditional TOP program and they've clearly been instrumental in our ability to deliver positive operating leverage and drive ROTCE improvement. The initiative we launched are expected to achieve the original 2020 pretax run rate target of $225 million. And we are still on-track to hit the $300 million to $325 million by year-end 2021.
We are also adding significant work streams to TOP 6, largely focused on accelerating our digital capabilities to create increased efficiencies and frictionless customer experiences. These should deliver at least $100 million run rate by the end of 2021 and we are working to increase this. But we are also working through the cost impact of how much we'll invest or reinvest in strategic initiatives to drive future growth. We will be updating our expense outlook, including the benefit of the expanded initiatives to upscale these programs as part of our 4Q earnings call in January.
On Pages 17 and 18, I want to highlight some exciting things that are happening across the company. As we continue to strategically invest through the crisis, to position us well for the medium-term, we are focused not only on digitization, but also initiatives that positioned the franchise well for the long term.
On the consumer side, we are focused on national expansion with citizens access integrating some of our lending businesses to further develop our national value proposition. In merchant finance, we are continuing to add new merchants to our point of sale platform, launching five important new merchant finance partners with more in the pipeline.
And we are piloting a new customer-led point of sale value proposition. In commercial, we continue to expand our capital and global markets capabilities, including completing our first lead-left-high-yield fixed income issuance, and we are also seeing increased client adoption of our digital treasury solutions.
Now, let's move to page 19 for high level commentary on the outlook for the fourth quarter. We expect NII to be broadly stable with no expectation of PPP forgiveness benefits until next year. NIM is expected to be down low- to mid-single digit. Loans should be stable, security is up modestly. Fee income is expected to be down mid-teens after a record third quarter level reflecting lower mortgage banking fees. While we expect to see mortgage results come down from 3Q record levels, we do see a significant feeing opportunity that should continue into 4Q and well into 2021 at attractive margins albeit lower than recent historic highs.
Noninterest expense is expected to be up modestly reflecting seasonal factors, and we're on track for a full year operating leverage of around 4%. We expect relatively stable net charge offs in the range of 60 to 80 basis points of average loans. We also expect a reserve release in Q4 given reserve bills taken year-to-date. And we should see a decline in NPAs.
On slide 20, to sum up, we continue to navigate successfully through the COVID-19 crisis. The resilience of the franchise is again on display with record PPNR, record fee income and positive operating leverage. We remain well-positioned to continue to strategically invest and deliver on key initiatives. Our ability to execute well drives our strong profitability, capital and liquidity positions.
With that, I'll hand over to Bruce.
Okay. Thank you, John. Operator, let's open it up for the Q&A.
[Operator Instructions] Your first question comes from the line of Peter Winter from Wedbush Securities. Please go ahead.
Good morning. Thanks. I was just curious what gives you the confidence that non-performing assets are going to decline? And at this point in the cycle, there still seems a lot of uncertainty that you'd be willing to release reserves next quarter.
Yeah. Why don't I start, John, and then you could pick in. So, if you look at what drove up the NPAs this quarter, it really was isolated to just two exposures, we had to mall REITs, which frankly had been really stellar performing companies, best in class, which we've had long relationships with. But obviously, the COVID and lockdowns and changed behavior caused some stress there. And so, we've recognized that. We do a pretty careful job of forecasting the migration through criticized assets and what could go NPA. And so, we think beyond that
We don't really -- as I think John said in his prepared remarks, we're seeing some broad signs of optimism and some improvement in the overall commercial book. So we really don't think we're going to be taking a lot new in and then we'll have some charge-offs, some degree of charge-offs which will reduce the NPA. So you put that all together and I think we're feeling pretty confident on the commercial side. And then if you look at consumer as well, we've had really, really healthy trends even surprising to the point of being surprising but very solid in terms of delinquency. So we feel really good there as well. John…
Yeah. I mean, I’d just add just higher level. We have pretty good line of sight when you think about over the next 60 to 90 days about what's going to migrate on the commercial side. I mean, we've got pay downs and charge-offs that are coming through. Things are, as we mentioned in our overall areas of market concern, we're at 10% last quarter. That number has fallen to 5%.
We delineated where the puts and takes are with respect to that in our slide deck. And so we've done a bottoms-up cash burn analysis which Don can comment on. So we feel reasonably comfortable with that guide from nonaccruals on the nonaccrual space.
Just on the reserve levels with releasing reserves, just I feel like there's still enough uncertainty in the economy. What gives you the confi - the decision to release, possibly release reserves next quarter?
Yeah. I mean, I’ll go ahead and take that one. I think this comes back to the methodology of CECL in the first place. I mean, we've been -- over time, there's been significant uncertainty with respect to the scenario and you saw how that trajectory played out over the first and second quarter where we built in both quarters. In this quarter, the scenario actually got a little better.
And I think at least from what we can see, the level of uncertainty have started to shape into something that we feel comfortable with our outlook. I think the difference this quarter in terms of our build is we've been spending a lot of time with individual sector reviews and that really was those management overlays and the qualitative factors and what drove our build this quarter.
After we've gotten through all of that, when we -- if the scenario barring a deterioration in the environment, we feel like after analyzing what we would expect the loss content to be in these in these categories that reserving requirements have been satisfied. And so therefore, the lost content has been provided for.
And therefore, on an on a go-forward basis the way CECL works is that you would charge off against that reserves that you’ve already built and the provisions would be driven by your origination and go forward activities. So, from our standpoint, that would -- that would mean reserve releases with provisions less than charge-offs.
Thanks for taking my question.
Sure.
Your next question comes from the line of Erika Najarian from Bank of America. Please go ahead.
As we take a step back, obviously unfortunately given the timing of where we are in the year, I'm sure you'll get a lot of questions on 2021, and I know you'll defer us to January for details. But as we take a step back and we think about all the work that you've done either through, you know, the top programs and building your fee income generating capabilities and weigh that against, obviously, the interest rate challenges and the swap income roll off.
As we think about normalized return sort of post the spike in credit that we all expect for 2021, as they think about normalized ROTCE for citizens sort of in a post-COVID recovery world with no help with rates, do you think that you have enough in the tail with top or fee generation to achieve, you know, like a 10% or low-double digit ROTCE on the other side?
Yeah. I’ll start then, again, John you can add your perspective. But I think that's certainly the case, Erika. So, if you look at what we deliver just this quarter was 9% with a huge reserve build, which the build basically cost us 5% of ROTCE. So you can do the math on that. But we'll I think going forward have lower credit costs.
We'll have some NIM headwinds but, again, we consider hedges as part of the strategy in managing a low rate environment. But our mortgage business was also part of that strategy as well. And so, there seems to be a great fixation on hedging and some folks have put hedges on. I think we've done a nice job there with some folks may have some longer duration or more hedges, but they don't have the sized mortgage business that we have.
And so, I think if you look at our PPNR generation through this year we're really top of the class in terms of how we've been performing. So, we expect there to be linked to run in the mortgage business through next year. 60% of the households in the country would benefit, I'd say, by more than 50 basis points in terms of the math if they refinance their mortgage. So there's going to be continued demand on the refi side.
As the market goes back to a purchase market, we also are very well positioned. We probably have the most diversified origination channels of any bank owned mortgage company with exposure to retail to correspondent and wholesale.
We've worked really hard to digitize that business and gain market share and be able to handle volumes efficiently. So, feel really good about that. So, you know, I'd say, we're kind of on the doorstep of crashing through double-digit ROTCE. I think we can get there and certainly sustain it. But it's going to take all the levers of, you know, the fee investments that we've made doing more top and continuing to focus on driving efficiencies, looking for volume in terms of loan growth. And we see -- we think there's going to be some opportunities.
We think we uniquely have some niches on the consumer side that some of our peers don't have. And I think also in commercial we've been able to achieve nice growth through the build out of some of our regional geographies. So, we know what we have to do. We know what the objective is and we're going to keep driving towards that, you know, original medium term targets. I think you probably need a little help from rates to get all the way there. But certainly double digits seems like a bar we can hurdle. John?
Yeah. I think I’ve not too much to add other than, I think it's -- I think that we have been a self-help story in the past and I think we absolutely remain so going forward. In the NII space, our BSO actions, and with interest bearing deposit costs at around 35 basis points, there's a lot of opportunity there for us. We are complete -- we are completely different bank than we -- this reserve versus last. And so, you can expect that our interest bearing deposit costs are going to find new lows for the bank compared to what we were at the end of the last reserve.
On fees, like night -- it’s night and day with respect to our diversification. A combination of the organic investments that we've made and the inorganic acquisitions that we've made have been extremely powerful in the fee generation space, as you're seeing in mortgage. But we shouldn't forget about wealth, which is hovering around record levels on its own but sometimes it gets overshadowed by the eye popping numbers in mortgage. But the diversification there is great and the capital markets business has never been more diversified.
And then finally, expenses. We've had a history of our top six programs that will continue. That will be a hallmark of what we do and we have a lot more opportunity there as well. So those are the final points, I think.
Okay. Thanks.
Your next question comes from the line of Scott Siefers from Piper Sandler. Please go ahead.
Morning, guys. Thank you for taking the question. I just wanted to ask on credit broadly. What is your sense for when lost content will really begin to materialize? I think it kind of feels like it keeps getting pushed back and the consensus now seems to be sort of mid to even late 2021 so just curious to hear your thoughts.
And then just a very top level, what kind of cycle do you really think you're sort of setting yourselves up for? It seems like with current info, most the economy sort of slog through and it's just these isolated areas that we'll see the real pain. Is this something where we could really resolve most of the credit cycle next year or do we see this sort of bleeding on for a couple of years from here?
Sure. So what I'd say on that is you have to look at Commercial and you have to look at Consumer. Consumer has been extremely well behaved and we've had folks on forbearance or people rolling off forbearance have actually been current and we haven't seen any uptick in charge-offs, but I think the residual focus around forbearance, there will be some charge-off content there. And I think that probably doesn't peak until sometime in the middle of next year. So, whether that's Q2 or Q3, we'll see.
I think on the commercial side we’ve got hit with two one-offs this quarter. And there's the pig is going through the python. I don't think there's significant jumps on the commercial side. I think we're probably nearing the peak charge-offs, but they'll stay elevated for a while before they move back down I think in the second half of the year.
So, you know, I'd say our outlook is that most of this should resolve over the course of next year setting us up for I think more normalized charge-off rates as we head towards 2022. Any comment there? Brendan, do you want to comment on the consumer side at all?
Yeah. Only just add a little specificity. So, you know, John, quoted a few numbers in forbearance, we’re increasingly confident that that portfolio is of high quality particularly with some portfolios that were of high interest that hadn't gone through a cycle before. Our student portfolio was holding up incredibly well so far. And the merchant finance portfolio is equally holding up incredibly well. And in fact that portfolio has almost, almost no customers in the forbearance at all. And delinquency is still flat for pre-COVID.
So, we're feeling really, really strong about consumer. As John mentioned, the customers that are firmly still in forbearance has moved from a peak of ever forbearance at 8% to now 2%. And our delinquency rates have been flat to down at the same time. So, we're seeing a lot of gearing out of the forbearance portfolio with very minimal impact to distressed consumer behavior so far. So, we're out of the woods, but surprising, yeah, but on the green -- the green shoots that we're seeing are quite positive. Yeah.
Don, maybe you want to talk about it?
Yeah. I’d echo that. I do think it's kind of elevated for next year, but we're kind of peeking out where we are right now. I think, remember, and I'll just emphasize what Bruce said, our view is based on a client-by-client liquidity analysis where we project out current rates of cash generation versus current rates of cash burn. And we're seeing really positive trends. We've taken 25% of the companies that were in the high risk category out of that category based on our last analysis.
We're also seeing record level of customer deposits. So they have heavy levels of liquidity sitting with us. And we're seeing -- on a customer by customer basis, we’re for seeing the bigger customers as everybody knows going to the public markets and grabbing any liquidity that you get in the high yield in the equity markets.
And the smaller customers, while they're having a little bit of a more difficult time, they're managing their businesses in a really conservative way for cash. So they've kind of cut expense levels and they're positioning their businesses to survive an extended slowdown if there is an extended slowdown. So, we feel good about what customers are doing on an individual basis.
Great. That's perfect color. Thank you very much. And I guess…
Sure.
I can sneak one in here. Just, Bruce, you noted the kind of emerging emphasis on things like hedging programs, which you guys have benefited from. I've noticed the same thing. I guess maybe John, as you sort of think about things into next year, when and how do we see some of those hedges that you guys put in place to roll off and sot of what is the sense? Should we just sort of recast our focus onto the key drivers such as mortgage and wealth that you alluded to earlier? Or how do we replace those benefits as they do roll off?
Yeah. I mean, basically the hedges that are in place roll off throughout 2021. By the end of 2021, most of that benefit is starting to wane. But what I’d do is take a step back on NIM overall. The levers that we're pulling and have very large opportunity to get after as what I mentioned earlier with respect to interest-bearing deposit costs sitting at 35 basis points, we expect those two decline significantly in 2021. That's on the sort of funding side of things.
We also are focusing on the asset side. So, we have broader BSO efforts, rotating our capital and allocating it into better risk return categories and profiles. And then, you've heard from Bruce earlier, the mortgage business has room to run. There are trillions of dollars of mortgages that are -- that have refinance incentive. And I think that -- I would say that we're -- we have -- that business is rate sensitive and has been part of our hedging story and has done incredibly well.
And a lot of the NIM headwinds, frankly, I guess I could say most of the headwinds, all of it in 2020 and probably on a cumulative basis through 2021, most of those rate headwinds will be offset by expected mortgage fee -- elevated mortgage fee revenues, so.
And then, of course, you heard, when you have rates falling, that's a big impact. And we'll have to look at all the levers across the self-help that we feel like is alive and well here. And that would include expenses and TOP 6 is part of that.
The last thing I would say, Scott, and I know hope is not a strategy, but if you consider that we could see real progress on the health front and you could get these treatments that are progressing nicely, vaccines are progressing, you could see another stimulus bill. It seems like the folks in Washington are getting closer on that. You could actually see a fairly decent rebound next year, which could result in a steep in the curve.
Yeah. Yeah.
…would create a lot of benefits and also opportunities to lay on some more hedges. So, anyway, we're keeping our eye on that, but I…
Yeah. When you run your scenarios, you have to consider that as a possible scenario.
That’s perfect.
Your next question comes from the line of John Pancari from Evercore ISI. Please go ahead.
Also on the credit front, I know you mentioned the -- that you’re closely tracking loss migration and that has influenced your commentary around non-performing asset levels likely to decline. Can you just give us -- do you have what your total criticized assets trends were for the third quarter? And how that may break down in terms of the special mentioned versus classified?
Yeah. I -- we published that in the Q, I would say, directionally it's up and it's mostly special mentioned. So, you'll stay tuned for the details on that.
Okay. All right. Thanks, Bruce. And then also on the credit side, the -- I wanted to see if you could just give us a little bit of update on what you're seeing in your commercial real estate portfolio? Are you beginning to see stress there? I know you mentioned the mall REITs, but just curious about other properties, how that portfolio is projecting? It looks like you added a fair amount to the reserve this quarter there.
Yeah. I think it's really what we mentioned, it's retail and hospitality, where we're focused. If you click through the different asset classes office, it looks like it's holding up pretty well with rents being paid. Well, multifamily, it looks like it's holding up pretty well, we've got our eye on trends there.
We don't have the big exposure to some of the cities. So, frankly they get tips like New York and San Francisco, fortunately.
Let me get into industrial and healthcare, and those are also holding up quite well so the place where focus is on the retail and hospitality. On the hospitality side, we've got exposure to business travel, which has obviously slowed but we've got very diversified sponsors and we've got some support provided by those sponsors in terms of flag change, which have overnight guarantees on some of that. So it’s really around the other areas of retail and we feel like we're in pretty good shape with the reserves we've put up at this point.
Yeah. I think what we tried to do here was really look at it for an extended period of either lockdown's or consumer behavioral shifts that goes well into 2021. That puts more stress on these narrow sectors. Let's make sure we've taken credit off the table and put up a sizeable reserve there.
And the other thing I mentioned is we are working with all of the sponsors. We all we really thank the best sponsors out there and they're working with us and they're restructuring the properties that are having temporary dislocation. So we've given some forbearance but they're also putting some money into pay interest and keep the properties upright.
Okay. Thank you. That's helpful. If I could just ask one more on the efficiency, the $100 million, just to confirm, we do not yet know how much will fall to the bottom line of that of that $100 million?
Yeah. That's a good, John. We conveyed -- we communicated appropriately. So we are going to -- we're working on launching a number of work streams. Some of those are in Brendan's area in Consumer, the big digitization push. And so far, the tally is up to at least $100 million. So that's good news and we're going to keep trying to drive that higher.
We also have a couple pages in there and some of our strategic initiatives. And so, one of our objectives here is to really keep investing for our future so that we come out of this challenging period in even better position with a stronger franchise that's positioned to grow and to continue to do well.
And so, we're working through the pacing of some of those investments and which ones to prioritize. So, we're kind of reluctant at this point to give you a full update on expense guidance until we complete that work. But I'm sure we knew there was going to be a clamoring for what you have you got so far. So, we've put the number out there. Stay tuned to January. We'll give you all of that in the context of our full-year guidance that we do every January earnings call.
Got it. All right. Thanks, Bruce.
Sure.
Your next question comes from the line of Ken Usdin from Jefferies. Please go ahead.
Hey, if I could just follow up on the last question a little bit. TOP 6 you're on track and you still have another $75 million to $100 million by year-end and then the new $100 million on top of that. I'm not looking for expense guidance, but can you help us understand of that $175 million to $200 million that you -- at minimum you expect to get next year. The approximate mix of what like comes through expenses of that and what comes through revenues of that, because you're talking about like these new revenue opportunities as you just alluded to Bruce? Thanks.
Yeah. I'll go ahead and take that. I mean, I think in -- the majority of this is an expense-driven program. There are some revenue opportunities that are there in the traditional TOP program as we have done historically. But for example the transformation piece of this is 100% expenses for the most part. And I would say that that's really the main driver of the program. But we also do use the program to fund to fund revenue opportunities as well and to drive upside on that front.
I would hasten to add that when you start doing the numbers, you’re looking at a run rate target of around 2.25% by the end of this year. That rises to as high as 3.25%. So there's hundred there. And then we also mentioned the additional hundred at least that Bruce mentioned as well. So, we wanted to make sure that we weren't losing track of those different hundreds.
Yeah. Exactly. Yeah. Okay. Very good. And then second question just, John, on the on the PPP in general. You know, many banks have thought through that forgiveness might start in the fourth quarter. It seems like you guys are conservative in terms of not at least putting it in your core, you know, your NII guide. But can you just help us understand. And I know it's more of a timing question, but just what you expect and how do you expect us to go with regard to -- with regards to forgiveness timing and also just how much was PPP in the 3Q NII as well? Thanks, guys. Appreciate it.
Yeah. Sure. I'll start off and maybe Brendan will comment on it. But, you know, in terms of process, I mean the forgiveness process can take up to five months. There's many steps that have to be made. Maybe Brendan can talk about the invitation approach that we're taking in the fourth quarter. But, you know, I think that, you know, our view is given the complexity there, that it would be appropriate to -- in the outlook to not include any acceleration with respect to forgiveness benefit.
That said, we do, as you know, the way the accounting works is that we are incorporating the expected fees on a level year basis over the life of the 24 months of these loans. And so, every quarter that goes by, we are recognizing P&L that is attributable to the PPP program. In the third quarter the yield on the program is nearing somewhere between -- nearing 3% in terms of the yield and from a pretax standpoint, if you -- maybe in the $25 million range for the third quarter.
So, that gives you a sense in all of that, and I call it pretax all of that that's really after the expenses. It's a tiny bit higher on the NII line. So -- and that number will be -- with no forgiveness, but we’ll see that again in a similar number in the fourth quarter given the way that the accounting works and if forgiveness really -- is really a 1H 2021 event as we are forecasting.
And I would say one thing on that, it’s Bruce, and then I’ll let Brendan go. But Ken, initially, we take it out over a roughly eight quarters, and I think we had $140 million and $150 million roughly to amortize on a straight line basis. But we thought that forgiveness would occur much sooner. We had thought some of that would trickle into Q3 and Q4, but now it looks like that will largely be at 2020, first half of 2021 event.
But the spike is going to be lower since the longer this goes towards the end of the period, then you won't get the same spike as if you had a massive acceleration into, say, Q3 that would have really altered the timing in a material way. But at this point since we are steadily recognizing and then there's less time remaining to accelerate, the spike shouldn't be as dramatic. Just to just make that mathematical point.
On the timing, the one thing I would just add is keep in mind the customer doesn't need to incur interest charges until October of next year. And so, there's no huge pressure point for our customers to apply for forgiveness right in the second. And so with...
They don't have to pay.
They don't have to pay. So with the various bills going through Congress that would possibly be quite positive to these customers, there’s a bit of a waiting game. And that's what we're hearing from most customers is that they'd rather wait and see what flexibility is afforded to them before they jump in and start the forgiveness process. So, we're getting a handful trickle then.
And then to John's point, once the customer provides all their documentation the SBA still has a three-month window to stamp it and say, yes, it's able to be forgiven. And that's the recognition event is what the SBA stands it. So, there's a bit of a tail on this. We expect that, as Bruce point and John pointed out to be…
There are two things. Some small business owners are being cautious here and just holding on to that cash to see what the forgiveness turns out that they might have to pay it back, which one of the reasons we still have elevated cash balances. So, they’ve slipped into their own pocket to keep the lights going in the business. And so, we’ll -- I think there's just a bit of caution generally as we said.
Understood. Hey, one just quick clarification, John. That $25 million pre-tax was at the fee part of it or was that also with the NII just with some of the loan yield?
Yeah. It’s -- that’s the fee part of it and the NII, so it’s all in. And that’s consumer and commercial.
Okay. So, that's the all in what you had from PPP. Thanks.
Your next question comes from the line of Ken Zerbe from Morgan Stanley. Please go ahead.
Great. Thanks. So just in terms of credit, it sounds like the management overlays sort of most of the reserve build this quarter. Why did your CECL model if we look at CECL by itself actually tell you to do the reserves?
I think it's hard to pars it, Ken, actually because to us the CECL model is not just a macro forecast. It's a process that involves many, many, many variables, and management judgment is one of those variables. So I think it's just hard to parse that.
Got it. Okay. Maybe just on the same topic, I guess why apply that management overlays this quarter? I mean, I'm sure you had some earlier in the year but it seems like maybe this quarter had more of the qualitative adjustments rather than…
Yeah. I think we've had overlays and qualitative factors are part of the process every quarter. I think the reason to call these out was you had a slight divergence. It looked like the macro forecast was a little better, the backdrop was a little better. But what we're seeing is that consumer behavior and the effect of lockdowns is going to be more prolonged than I think we saw when we were assessing it in the first quarter and second quarter.
We think it could be well into 2021 before we get back to life as we knew it and to normal lifestyle, which means these retail and hospitality, entertainment, travel all of that genre could still be in a difficult situation for longer. So you wouldn't necessarily pick that up from your macro forecast. I mean, that's a kind of unique aspect of certain businesses are disproportionately impacted from the new normal, about how we're living our life. And so that's why we're calling that out.
All right great. Thank you.
Your next question comes from the line of Vivek Juneja from JPMorgan. Please go ahead.
Hi. A couple of -- I’m going to just follow up on some of the themes that have been coming up. The release in reserves, Bruce and John, that you’re expecting in the fourth quarter, which loan category do you think you’re more -- that you’re expecting to see that at this point? Where is that visibility coming from?
Yeah. I mean, I'll go ahead and take that. It's -- Vivek, it's kind of like the way CECL work as you know. I mean, we provide for all of the loans that we will -- that are outstanding at September 30, both for the loss content that we see after considering our macroeconomic scenario and then our qualitative factors that we reviewed by loan category.
And if we're right, and it's very hard to say that you can be, there are so much uncertainty that, you know, a lot of that build as you know in the third quarter came through the commercial portfolios. And -- you know, as we mentioned earlier, CRE retail and hospitality. And we also mentioned casual dining, the sectors where we built reserves. So once that's done, then theoretically at least, you're just going to charge-off against those reserves going forward, assuming you were right about what the loss content is and what the scenario will be.
The rest of your provisioning then would only be focused on your front book activity and growth. So, where we're going to grow going forward, you know, let's say for example in the residential mortgage and student emergent spaces, we would provide additional reserves for those loans as they come on as well as the C&I loans that we're going to see as you get, you know, to the end of the fourth quarter.
So it really is you -- have to sort of look at it in those two buckets as waste…
And just make an assumption that the environment won’t deteriorate in a meaningful way, so that you wouldn't need to add to any further reserves around the back book. Now there could be some of that, but we don't see it -- a sufficient amount of it to result in a reserve build and a need for reserve build.
Okay. And what are you thinking about the student loan book because that, you know, forbearance rate has stayed pretty high. It hasn't come down. It’s higher than even resi mortgages. Can you comment on why that's the case? Have they just not come up for, you know, how long is the forbearance perio? Have they just not come up yet or have they -- what percentage have gone in for an extension of the deferral?
So, we're actually starting to see it gear down a little bit in the recent weeks. It was lagging a little bit principally because the majority of our student loan book is student loan refi. And a lot of those customers also have government loans which had significant forbearance periods that were kind of automatically granted.
And so, customers were triggered by the government events and they call all the private lenders and banks and raised their hand for forbearance and there sort of no reason for them to delink those, too. So, you know, we've been, you know, aggressively working with our customers to make sure we try to understand where they're at and if they have the capacity to pay.
But if they are still on the fence, we've been allowing them a little bit of leeway to land on their feet. But every underlying dynamic we see in that portfolio is quite positive. Recall it’s a super prime portfolio. The credit is $70 million, $80 million plus in that portfolio, and particularly in the refi portfolio they'll make six figure income and that's the sector that's been the least impacted by unemployment. And so, we feel quite strong that this is -- there's no significant underlying dynamic that's a different scheme than any other portfolio in consumer.
Great. Thank you.
Your next question comes from the line of Saul Martinez from UBS. Please go ahead.
Hey. Good morning, guys. So, good morning. A couple of questions. First, John, you mentioned that you -- the hedges should mostly roll off and the headwinds from the hedges rolling off should be pretty -- for the most part, fully realized by the end of 2021 and early 2022. And I think we've estimated that the headwind’s probably in the $200 million, $250 million dollars annualized from the hedges rolling off. Can you -- is that -- I mean, can you just give us a sense of the magnitude of the incremental headwinds if your number is more or less right? And how should we see that, those incremental headwinds sort of material in 2021 and in 2022.
Yeah. I'd give you a fraction of that. Without really getting into the numbers, it's not nearly that big. It's not -- it's nowhere near that from what we can see. How we track through 2020, I mean, you've got to think about where -- what the terms are in which we publish. And you can see what the terms are on those swaps, I believe. But it's much, much lower than that.
And I'd say, to just bring it back bigger picture to ensure those are running off. But mortgage business has been part of our hedging strategy all along. The majority of the NIM headwinds on a cumulative basis are being offset in 2020 and 2021 by the mortgage business.
And we also have a very significant lever with respect to interest-bearing deposit costs this time around given all of the investments we've made in the analytics and product capabilities and orientation of our bank across consumer and commercial with respect to the relationship-driven deposit gathering that we have embarked upon, which takes years to do but that started many years ago. So we're starting to see that bear fruit. Those are the things I think about when you're when you're trying to consider the puts and takes for next year.
Yeah. I get that but maybe we can go with the mechanics offline but there does seem to be a sense from the investment community that the headwinds are we're talking about on a static basis not factoring in some of the offsets are in the hundreds of millions of dollars. But just to be clear, you're saying that that estimate, just on a static basis, nothing else the hedge rolling off, that that number is way too high? Is that true? Is that right?
That's correct. That's correct. And we can take you through the math on that off line with some publicly available information. And we'll just make sure that you can -- you're seeing it the way we see it.
Okay. Just one other question on NII. What are you assuming for forgiveness ultimately throughout the course of the first half of next year? What percentage of loans?
So the full percentage -- so where -- there's a 15% tail that we think will be forgiven on the backend. And so the other 85% will come through mostly in 1H. So there's some little comfort for the third quarter or so.
Got it. Okay. Thanks a lot.
Okay. Is that -- is that it?
One more question. Okay. We'll take one more question.
The next question comes from the line of Dave Rochester from Compass Point. Please go ahead.
Hi. Just on your NIM guidance, was just curious how much deposit growth you're assuming that feeds into that, if any? Or you're still looking for more of that continued favorable mix shift that you've been having there, favoring the lower cost deposits?
Yeah. It's primarily a mix shift story. I mean we've got in search deposits like many other banks. You know, we think some of that may stick around for quite a while and through well into 2021. So there's that benefit. We've paid down everything you can pay down and we're sitting around with some excess cash. And so, excess cash is a drag on NIM. Call it about a two basis point drag or so in -- on a quarter-on-quarter basis in the fourth quarter. But it's getting up to near -- call it 8 basis points to 10 basis points on an absolute basis in the fourth quarter. All that excess cash.
We'll look to see that pay down over time. But as it relates to deposits, really we're seeing great, you know, mix shift into DDA. We've had, you know, I think three years running now pure leading DDA growth. And that's part of the next story. And it's just accelerating that trend that already was happening with us, that’s nice to see on the deposit side.
Yeah. Well you mentioned the cash that's sitting there. I mean are there any lumpy maturities on the borrowing side that maybe you can take advantage of and use some of that cash to pay those down, anything over the next year that we can look forward, that’s well, the question?
Yeah. I mean, it's not a lot. So you know, our flow of funds are down to zero. And then our senior debt we only have very, very modest and -- you know, maturities coming in early 2021.
We just called one issue and we did a sub debt exchange. So we're working as much as we can, but not a huge amount of opportunity there.
All right. And then, did you guys have any color on new loan yields and securities purchase yields that you guys are seeing today? I'm just trying to get a sense for where we could ultimately be going on the average earning asset yields, if we continue to see this black curve over the next couple of years?
Yeah. And you know, so for securities, I'll take and, you know, maybe, Don or Brendan want to talk about spreads. But -- I mean, on the loan side. But it's not a great story on the security side, there's a 40, 45-basis point, just call it, negative front book, back book. In terms of runoff, which comes off at around, call it, 190 basis points. And you’ve got reinvestment coming on at around 140 or 145 basis point on the front book for securities. So, that's the story there. I think in commercial, we're seeing strong, sort of, spreads are up, but rates are down. So, that's good.
In the consumer side of things, we're seeing some interesting positive trends there in auto, which has been quite good and really strong spreads there and maybe I'll just let Don or Brendan add anything else.
Yeah. I think auto has been very strong, student loan refi has also been very strong. We're seeing a significant increase in margin across, basically, all the products. So, they’ll…
We have also talked merchant, we just had a nice string of wins and…
Yeah. Apple just launched their -- is launching their new product.
Our merchant business, kind of, has a profile of a credit card business, Apple, we're gearing in. So, the new product release for them right now, with the 5G phones. So, we’re enthusiastic about that. Microsoft, All Access has geared up for this big launch right now seasonally. And we just launched, as John pointed out earlier, five new merchant partners. Really centered in home improvement, electronics and fitness, similar to our Peloton relationship with the firm.
So, we're really bullish about the growth there and we're actually getting some really decent momentum, that should really help offset some of the yield headwind from some of the other portfolios, by bringing in something about high yield.
Yeah. On commercial, we’re generally getting anywhere from 10 to 30 basis points, better spreads on new originations. And we're also putting LIBOR force and a lot of transactions, which are helping the overall yield that seems to be holding.
Okay. I think that's it for the queue. Thanks again for dialing in today, everyone. We appreciate your interest and support. Have a great day and everybody stay well.
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