BFIN - NASDAQ

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the BankFinancial Corporation Second Quarter 2020 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. [Operator Instructions] I would now like to hand the conference over to your host for today's call, Mr. F. Morgan Gasior, Chairman and CEO. Sir, please begin.

Thank you, and good morning. Welcome to our second quarter 2020 investor conference call. At this time, I'd like to have our forward-looking statement read.

The remarks made at this conference may include forward-looking statements within the meaning of section 21E of the Securities Exchange Act of 1934. We intend all forward-looking statements to be covered by the safe harbor provisions contained in the Private Securities Litigation Reform Act of 1995 and are including this statement for purposes of invoking these safe harbor provisions. Forward-looking statements involve significant risks and uncertainties and are based on assumptions that may or may not occur. They are often identifiable by use of the words believe, expect, intend, anticipate, estimate, project, plan or similar expressions. Our ability to predict results or the actual effect of our plans and strategies is inherently uncertain, and actual results may differ significantly from those predicted. For further details on the risks and uncertainties that could impact our financial condition and results of operation, please consult the forward-looking statements declarations and the risk factors we have included in our reports to the SEC. These risks and uncertainties should be considered in evaluating forward-looking statements. We do not undertake any obligation to update any forward-looking statement in the future. And now I'll turn the call over to Chairman and CEO, F. Morgan Gasior.

Thank you. At this time, all filings are complete. We have our 10-Q on file. We have our 5-quarter supplement, and we would be pleased to take any questions.

[Operator Instructions] Our first question or comment comes from the line of David Konrad from D.A. Davidson.

Just want to talk a little bit about the balance sheet and your NII outlook. The loans have been declining here. Just wondering how much of that is on the demand side versus maybe being risk adverse on your side given the current environment? So just wondering on the outlook on the loans. And then on the NIM, absent of all the liquidity build, you probably have some back book pressure, but your CDs look like you have a little bit of room to reprice there, just looking at your core NIM as well.

Okay. Well, one, thanks for the question and good morning. Let's work the loan portfolio first. Probably the most significant development in the quarter, as far as the loan portfolio, was the reduction in the commercial and industrial lines and specifically with respect to health care. The various stimuli programs that were available to health care providers, whether it was PPP or Medicare advance payments, created an enormous amount of liquidity into that channel. So you saw in our disclosures, where $42 million worth of lines paid down, and those borrowers are, in fact, sitting on an additional $30 million of liquidity in deposit accounts here at the bank. So that was the most significant development. And if you say it's a factor of demand, I would just say they have an unexpected source of liquidity. And obviously, with that infusion of liquidity, they'll reduce their interest expense until such time as they have to repay the Medicare advances. But over time, that trend will reverse itself. So we do expect those lines to redraw over time. The liquidity dissipates or is repaid. That will have a couple of important factors. Certainly, that will be a material positive benefit to net interest margin. Annualized, the reduction in that portfolio cost us about $2.5 million in net interest income. So right off the bat, just recovering back to the original balances will be a material positive benefit in future quarters. It would also increase the loan loss reserve requirement probably by around $0.25 million. So that was one of the reasons why our provision in the second quarter was lower because the balance is simply paid down and you had no exposure to the portfolio at that point in time. So I would say on the -- this was the single biggest change there. We believe it to be temporary and transitory. The pace of recovery is an open question. Will there be more stimulus provided with future congressional action? It's certainly a possibility. Will hospital demand and provider demand shift from COVID care back to elective surgeries and more normal operations? Certainly, those trends have started. But in certain markets, they have been interrupted and they're back to COVID care. So I think it's going to be an uneven path there. But we haven't lost any customers. They just have a tremendous amount of liquidity they're working with now, which is certainly beneficial to their operations, a little bit less so to us, but we would expect it to recover over time. On the equipment finance side, it was just a slow quarter getting things closed. We've already had some higher activity now in the third quarter on the corporate side and on the governmental side. So we expect to have a stronger quarter here in the third quarter on corporate governmental. And we also have launched the middle market and are launching the small ticket this quarter. So we'll have some activity in that portfolio. Hard to say on the small ticket side. We're going to have a very careful rollout for the third quarter. Obviously, small businesses are taking some significant impacts due to COVID, and we're going to work our way through the opportunities we've seen. The intention was always to stay on the stronger side of the market, but we have to just kind of walk through that market and see what happens to us. We believe there is demand. We've been getting calls. The quality of that demand is what's an issue here. But we will probably see $2 million to $4 million worth of volume in the third quarter on small ticket; average transaction probably around $50,000 or so, could be bigger, could be smaller. But we're just going to take it very easy on that and have a very soft rollout, and we'll see what we see in the underwriting and what we see in demand. The middle market side, we launched that with a soft launch in the second quarter. We've got a good portfolio -- good pipeline going now. We have our initial staff set up in the middle market department, and they are actually starting their outreach next week as a matter of fact. So we feel pretty good about the demand there. A lot of that is replacement equipment. We're not seeing very much in the way of new investment right now, but there is a pretty good demand of replacement equipment. Some people are buying one piece of equipment and getting rid of 2 old ones because the new stuff is more productive. So we are feeling more optimistic about the middle market side. That part of the economy, especially in the replacement market, seems to be doing fairly well. On the real estate side, obviously, there's going to be demand for refinances, both internal and external. Our focus there is on the stronger part of the multifamily market, what we would consider are 50% risk-weighted loans. Yields have declined. We've seen them as low. We've seen some markets with under 3%. We're right around the 3.25%, 3.5% range for the very best credits. And we will continue to pursue those as the opportunities arise. We're not seeing that much in the way of purchases on the portfolio side. We are seeing more activity on the capital markets side for purchases. But really, those are transactions that have just taken a long time to come together because of the disruption in the second quarter. So net-net, we hope to get some improvement in yields and balances as health care recovers, that could be a slower process. Two, we'll see some improvements in balances for middle market, governmental and equipment finance. Corporate seems to be lagging, but it's [indiscernible] slower. And then three, real estate. I would say that we'll see some additional originations. I will also say we'll see some payoffs on that. So I would not expect a tremendous amount of growth out of real estate and it could, in fact, shrink. One thing we are not going to be doing is working through high-LTV cash-out refinances. If we can't get those transactions to go to capital markets, then we will simply pass on them and take the refinance -- take the payoff. Right now, you really, really have to think carefully about what could happen in multifamily. And we think that if people are trying to time the market at peak valuation and get every dollar out that they can, that's probably not a portfolio asset that we would prefer to book right now.

Great. And then growing on the leasing side might be a little bit challenging with this yield curve, just absent of liquidity changes just on the NIM. The roll-forward of the book coupled with maybe your CD repricing, it looks like you maybe cut that in half in the next couple of quarters?

Yes, I think that's a fair -- let's talk about the deposit side, and then I'll circle back to equipment finance in a minute. Yes, I think your perception on deposits is accurate. We'll see a steady reduction in cost of funds here in the next 2 quarters. Certainly, get under 50 points, I believe, in the third quarter. Probably under 40 points, 35, 40 points in the fourth quarter. We have some of the remaining wholesale that matures here in the third quarter that will certainly help on that, also take some of the excess liquidity out of the balance sheet. So we will get some help on the cost of funds here in the next 2 quarters. On the equipment finance side, the average yield in the middle market and small-ticket space is right around 6% to 6.25%. So it is -- it's one of the reasons why we wanted to have a full-service equipment finance division. And so it is helpful to us as we continue to grow that. The average deal size in middle market is usually $500,000 to $600,000. And obviously, we already covered small ticket. On the governmental side, those yields are in the high 3s, mid- to high 3s. The corporate stuff can be under 2.5%. So it's another reason why we're not going to focus as much on corporate unless we're very comfortable with the transaction, maybe the less -- the lessees taking out an equity loan behind it and the overall yield makes sense. So we will see some downward pressure on yields on new corporate transactions, but governmental, middle market and small ticket should provide some support.

Our next question or comment comes from the line of Ross Haberman from RLH Investments.

Could you just go over what you see in terms of payback schedule and your second-tier deferrals? Are you charging any additional fees? Are you taking more collateral? What are you doing on the second round deferrals, please?

Ross, well, as far as deferrals are concerned, let's take a step back and say that we offered 2 forbearance programs. The primary program was interest-only plus escrow, so no principal payment. And that ran for 4 months and it ended in July. We're pleased to report that all those borrowers made those payments. So we're current on that. And now borrowers are returning to standard payments. We also offered a program for the smaller apartment building owners, smaller commercial real estate investors, where 1 or 2 units that were slow pay could have a bigger impact. And they could skip one payment, typically, it was May. And because, again, the shutdown, particularly in Chicago, had everything pretty much down in April. But again, all those loans are current as well, and they are back to full payment schedules. So all told, we had about -- we had 140 real estate customers with about $108 million subject to some form of forbearance agreement. Right now, we think there's probably going to be about 4 to 6 customers that are going to be somewhere between $4 million and $6 million that might need some form of extension of the interest-only escrow program for a couple of months. One reason for that is the eviction moratoria in the city of Chicago. We will add all of these -- all 6 of these are in the Chicago MSA. But one reason is the eviction moratoria, there are people who actually got unemployment checks, got stimulus checks, and they're just not paying the rent because nobody can make them pay the rent right now, a frustrating situation for the landlord to be sure. So when we encounter that type of a situation, we're pleased to work with somebody for a limited amount of time. And then there's 1 or 2 of the smaller commercial estate customers that have lost a tenant, the tenant shutdown, is not coming back. They need some time to reconfigure the space, get it out in the market, and we're pleased to work with them as well. So at the moment, the -- it's clear that the various stimuli program had a material positive impact. We collected all the interest that expect -- that's essentially all the interest that was scheduled for the second quarter. And we entered the third quarter in pretty good shape. So right now, today, it seems like we'll have a very, very low level of "second deferral" or extended forbearances. But at the same time, we have to take note of the fact that the unemployment checks have ended, and there's no assurance that a second form of stimuli could happen. I think it's quite possible, but obviously, it's not yet for sure. So those numbers could change if we get into August and September. And we're very mindful of that. We entered the quarter in good shape, but we still have to keep an eye on what's going to happen next. So the numbers I gave you could change between now and the end of the quarter to be sure. We hope not, we think not, but it is certainly a possibility.

So if I'm understanding it, the total deferrals as of the end of July is about $108 million, is that the correct number?

For real estate, that's correct. We had a handful of commercial equipment leases that wanted to reorganize their payment schedules a little bit and have a little bit smaller payment in the next 3 or 4 months and then redo the payments in the remaining part of the lease. So we did some of those. There was nothing on commercial, but the real estate side was about $108 million of forbearance agreements.

Our next question or comment comes from the line of Brian Martin from Janney Montgomery. Mr. Montgomery, you may need to unmute your phone.

I'm off mute. Can you hear me?

Good morning, Brian.

Sorry. Good morning, Morgan. So the -- I appreciate the comments you made, Morgan. Just to be clear, on the deferrals, it sounds like come third quarter or fourth quarter, you would expect the deferrals, in general, to be pretty minimal relative to where they were this quarter given the positive migration you're expecting. Is that what I heard?

I agree with that subject to a very large caveat that the results so far had the benefit of the various stimuli programs. And if there are -- we'll just have to see what happens if there is no further stimulus. You also have continued eviction moratoria here in Chicago. So I think the probability is that we'll have a relatively small de minimis amount of extensions of the forbearance agreements. But I cannot tell you for sure that that's the way it's going to come out.

Okay. And most of yours, if you said this, I apologize, 90 days, so I guess you would kind of know getting through the processing by next quarter kind of whether they're requesting -- whether you are getting more requests or not, correct?

We were 120 days starting with April, generally speaking. So 4 months of interest-only payments plus the escrow payments for taxes. And as I said, all of those have ended now. So as of August 1, we're back on normal payments. And as I also said, we're talking to maybe 5 or 6 customers now for about $5 million, $6 million of total principal balance where the individuals are working through one specific situation or another. So at the moment, you're talking about what a very, very low level of additional forbearance as necessary. I think our concern, though, is what happens in the next 60 to 90 days based on eviction moratoria? What happens when there is no stimulus coming back into the economy? In particular, in Chicago, as you know, Brian, there's a lot of uncertainty about business activity, closures. We have cases. Now we're going to roll back things. It's hard for business owners to figure out what they're allowed to do or not allowed to do in any given time, particularly in the city. So I think that uncertainty is what causes concerns, and especially in the rent-by-necessity category, people who are working in restaurants, hospitality, it's not clear what hours they're going to get and tip income and so forth. And so I think those are the kind of things that we're concerned about as far as people requesting additional forbearances. You just don't know how the incomes are going to flow in the third quarter, absent stimuli.

Yes. Okay. No, that's helpful. And how about just your earlier comment about the commercial paydowns this quarter and kind of the, I guess, your hope would be that over time, that comes back. I mean if we do get another round of stimulus, does that just push that out even further? I guess if -- is that what I heard from you? I guess it sounds like if that stimulus comes, then they'll still have the liquidity that it might get pushed out? Or if they don't get it, maybe there's a higher likelihood it comes back sooner?

Yes. I think that's probably the right way to look at it. It ultimately, I think, resets. So when are the Medicare advances required to be repaid? Are those extension -- are those repayment dates extended? Are there additional funds that are provided to the health care providers given that there's flare-ups of cases that require emergency care and ICU care instead of elective surgeries? So that is the big wild card. Eventually, it rebalances. We have started to see some draws on the lines in the last 2 to 3 weeks. So there does appear to be some movement towards normalization. But obviously, if they do get additional stimuli or there are changes in the legislation or Medicare advance rules, then, obviously, that prediction could wind up getting extended. I think it balances over time, but how much time and what happens next? But right now, the portfolio is at almost 0. So there is pretty much only upside for us at this point.

Okay. All right. And it sounds -- back to your comments on the margin -- net interest margin. I guess, it sounds as if that's -- if those commercial loans take a little bit of time to come back given the liquidity you're sitting on today that the margin should trend lower in the next couple of quarters, does that seem the way you're thinking about the world today?

I think for third quarter, there is -- it's almost certainly the case that that's going to happen. It would have to take a remarkable recovery in the line demand on the health care side to provide meaningful support. I mean it could happen, but every day that goes by is one more day that it didn't help the average yield. Therefore, I would say fourth quarter is more likely to see some help from that. At the same time, we are also starting to bring in some new lessors for lessor credit facilities, bridge facilities, warehouse facilities, residual equity facilities, and we're starting to put those in place now. Typically, fourth quarter is the stronger period for that traditionally. And there might be some pent-up demand because of second quarter COVID impacts on top of that. So again, I think fourth quarter, we have a much better chance of seeing line demand, both on the equipment finance side and on the health care side. So I would probably say third quarter is likely to be weaker, but we have a much better chance of some significant improvements in the fourth quarter compared to third quarter.

Got you. Okay. And how about just capital for a minute, given, I guess, how are you thinking about the buyback or other opportunities to utilize the excess capital today, I guess, given maybe a little bit less growth in the short term?

Well, I think most people and including every regulator on the planet would say you don't have -- nobody has too much capital right now. So we're in very strong capital shape, but I will tell you that there are still quite a bit of uncertainties facing us in a -- especially if we go forward in an economy that still has some significant impacts from COVID-19, and especially if Congress cannot agree on a second PPP extension program, especially if smaller businesses cannot get a second PPP loan, if there is not another stimulus check, if there's not an extension of unemployment benefits, nobody really knows what the economy looks like, retail sales, demand in that environment. So I think our position right now is the share repurchase program will likely have relatively minimal activity in third quarter. There's a clear public policy preference on the behalf of the regulators that are not in favor of share repurchases. We have some activity as a result of the 10b-18 program during blackout. But I think we're just going to pause that for third quarter. It's not -- it's certainly compelling right now as it has been in the second quarter, but I think we're going to just pause on that for the third quarter and see how the economy develops. Back to the earlier question about how deferrals work, we're not expecting a lot of activity, but that certainly could change. So given all the uncertainties, I think share repurchases will probably have a pause for the third quarter. On the other hand, if we get later into the quarter, we see quite a bit of positive momentum in a variety of context, I'm sure the Board would take another look at that. But right now, today, I would not expect a material amount of activity in share repurchases for the remainder of the third quarter. Dividend. We published the dividend yesterday. That continues to be a priority for the Board. And if anything, right now, that will be the focus going forward in terms of managing cash from the holding company. And then finally, M&A activity. We have had a couple of calls on it, interestingly enough. And so there are some opportunities out there, smaller institutions. I think potentially looking at their loan originations and a variety of factors, thinking maybe this is time to partner with somebody else. So we have started to look at some things. Nothing is imminent at the moment. I would say there are some things we're looking at, but I can't say if anything would happen. And we'll just have to work through those and see what happens. But we would like that opportunity if there's a way to use cost savings and a smaller asset base to improve earnings for next year, give us a little growth, good deployment of capital, potentially some good locations. Eventually, the excess liquidity that we gained in the second quarter will dissipate as people use it for household and business purposes. And therefore, we'll still be looking for good quality deposits in due course. And if we see those opportunities, we certainly want to evaluate them.

Got you. Okay. And just the last 2 for me. Just the -- given your, I guess, limited exposure to kind of the -- what a lot of banks have called the COVID-sensitive industries and just the material differences in your loan portfolio versus your peers, I mean, I guess, where do you guys -- where are you seeing -- where are you spending the most attention today in the portfolio as far as where you view the risks are, the greater risks or potential risks that could come from some of what you outlined here if the cases get worse and whatnot? Just...

Well, I guess the first thing I'll say is we're actually spending quite a bit of time developing the new capabilities. So middle-market equipment finance, small ticket equipment finance, enhancing the lessor credit products in equipment finance and building out the commercial finance asset-based lending is where quite a bit of attention is going on right now. So to me, those are all positive attention. Asset loan portfolio growth projects that we've made quite a bit of progress on even in second quarter, and we're hoping to capitalize that -- on that in the third quarter and fourth quarter. So one of the good news is about the quality of the portfolio that allows us to focus on new things that are almost ideal for this particular environment. As far as the risks in the existing portfolio, I think we'd have to say that the -- that portion of the commercial real estate portfolio that's exposed to retail storefronts of one kind or another would be the concern. We put it in the 10-Q in the overview. But if you think about it, landlords over the last couple of years were trying to make their properties Amazon and e-commerce proof. So instead of storefronts that were selling retail goods that could be poached by e-commerce, they looked more towards restaurants, bars, entertainment, personal services, the things that could not be delivered -- fitness, the things that could not be delivered by Amazon or e-commerce. And of course, COVID managed to attack precisely those segments. Some of them are working through it with curbside and delivery and things of that sort. But there's no question that even in those businesses where margins were thin and you really needed to maximize your occupancy, you needed to maximize your turn of the tables that this environment is certainly not conducive. So now they've had the double whammy. E-commerce is still out there, and you now have the loss of the personal services businesses, the hits to the entertainment and the other in-person services. So those are obviously things that we have to watch. Finally, the replacement tenants, who is starting a new business or expanding a new business now. So if one goes down, who has got the capital and the ability to expand. So right off the bat, this is why, by the way, we have emphasized multifamily lending over commercial estate all these years. And we will continue to -- and we try to optimize, retain the best part -- the best possible borrowers in the retail space. So I would say if there's continuing risk in the portfolio, it's in the retail shopping space, and we have a good position in that. We had very strong debt service going into it. We had good loan to values going into it, but still, sales are sales and sales drive rents, and that would be the concern going forward.

Got you. Okay. And last one for me is just really on the expenses, Morgan. I guess you guys have done a great job on improving the efficiency -- the operating efficiency, at least doing what you can to maintain that. But the -- if you -- if revenues don't materialize or the margins stay down, I guess, are there initiatives you guys -- anything further you could do on the expense side or -- we should be thinking about?

Well, in the very short term, say, the next 6 months or so, there are some modest improvements we can make in expenses. I would expect us to run somewhere between $9.25 million on the low side and maybe $9.625 million on the high side. If we really got going in fourth quarter with originations and we have to put some money away for incentives, maybe $9.75 million, but for the remainder of '20, I'd say that quarterly range, that's probably about right. We have managed to increase the staffing for equipment finance, for treasury services and still stay pretty efficient for the quarter. So some of the investments we needed to make for asset generation have already been made. But there are some more expenses there to be made as we build out those areas. Longer term, we have now restored the branches to limited walk-in services effective this week, and we started to see some customers coming in. So we're going to monitor that demand, and we'll get a feel from the customers from what they really want to see and when they want to see it. And I think as we get that data in and we get a better sense of customer preferences and what the new normal is for customer service, we very well may see opportunities for some greater efficiencies in service delivery. More likely, those would take place in the early part of '21 as we gather more data and we think through what would make the most sense. So that is likely to be an issue whether there is recovery in the net interest margin or not. It will just make us a more efficient organization. And as long as customers are satisfied with the level and amount of service they can get and the convenience, I think we'll try to take advantage of that as we can. And finally, we're putting in a new business banking software capability in the third quarter. Our new treasury services department has its leader aboard and she is bringing on some new staffing. That provides some noninterest income support to us in cash management services for specific industries; the equipment finance industry, the property management homeowners association, which lines up with our real estate division very nicely, and lockbox for commercial finance and health care. So all 3 of those things align with what our business plan on the asset side is and the people we've brought aboard are hear from a Chicago bank that was recently acquired by a Cincinnati bank. And we are working towards building that team out so that we can capture more market share. And so that will also create some improvements in the efficiency ratio. We'll start seeing fee income. We'll start seeing greater amounts of business deposits on that. And therefore, the mix from retail deposits to commercial deposits could accelerate over time. That would also require less exposure to retail deliveries facilities.

Got you. Okay. And just one simple one. The paydowns you saw this quarter, Morgan, on the commercial side, which was obviously material, I mean are there other potential paydowns of that size, I guess, you could foresee potentially happening, depending on how things play out here? Or was it kind of more of a one-off where that -- given what those health care -- kind of what's trending in health care today that drove that with the health care people?

Well, let's put it this way. One, we certainly hope not. But two, I think right now, the -- if you asked us at the very beginning of the quarter, I think we might have mentioned that we thought it was more likely that the line facilities would have to expand because the cash flows to the health care providers were disrupted. Hospitals make money on elective surgeries and they weren't getting it. So those revenues weren't coming in. So we -- this actually worked out exactly opposite. Once the government jumped in with the support payments, it created an entirely new paradigm. That wasn't really the case in other industries, of course. PPP certainly helped. And therefore, if people did have credit facilities, they were more likely to use the PPP money, less draw on the commercial facilities, but we really didn't see that much demand. We didn't see a lot of big draws in the first quarter on a preventative basis. And then a bunch of repayments in the second quarter has happened to other people. If equipment finance continues to recover and we've seen continued demand on those facilities, if that were to falter and we saw payoffs as leases concluded and there wasn't any replacement volume for new orders and new customers, I would say the equipment finance lessor credit side would be the next one that could see some weakness there. But we haven't seen any sign of that yet. And in fact, we're getting calls from new lessors wanting to set up new facilities. So to me, it sounds like there's more upside than downside to that portfolio. But you just really don't know what's going to happen. Some of our customers are in California. California is rolling back. Hard to say how that kind of disruption will affect things going forward.

[Operator Instructions]

Well, thank you, everyone, for your calls and questions. We appreciate your interest in BankFinancial. We wish you a safe and healthy remainder of the summer, and we look forward to talking to you in the fall.