F. Morgan Gasior - Chairman & CEO Paul Cloutier - CFO.

Kevin Reevey - D. A. Davidson Brian Martin - FIG Partners.

Good day, ladies and gentlemen, and welcome to the BankFinancial Corporation Third Quarter 2017 Earnings Conference Call. And at this time, all participants are in a listen-only mode. Later we'll conduct a question-and-answer session and instructions will follow at that time [Operator instructions] As a reminder, this conference is being recorded.

I'd like to introduce your host for today's conference, F. Morgan Gasior, Chairman and CEO. Please proceed..

Good morning. Welcome to the third quarter 2017 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 report 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 will turn the call over to Chairman and CEO, F. Morgan Gasior..

Thank you. As all filings are complete, we're ready for any questions..

[Operator instructions] And our first question comes from Kevin Reevey from D.A. Davidson. Your line is open..

Good morning, Morgan.

How are you?.

We're well.

And you?.

Doing well, thanks. So, first question, just wanted to focus in on the margin. Looks like your margin expanded about -- looks like, it was up about a basis point, and I would've expected it to be just a little bit high.

Can you kind of talk about the moving parts there? And what prevented it from going up? I know, it looks like your loan yields were up four basis points, and I would've expected it to be a little bit more. And then kind of your margin outlook going into the fourth quarter..

Well, let's take it on both sides of the balance sheet. First, the loan side, we did have some respectable strength in originations. If you look at the originations, the yields were 4.77% against payouts of 4.30%.

So, if you look at just the net margin of what's going on in the books in a given period that actually has continued to improve from earlier this year. But when you have payoffs coming in, the mix of payoffs can change.

Also on the right side of the balance sheet, we're seeing a little bit of repricing in the CD portfolio, so that's causing us a little bit of money.

But I'd say the main contributor of margin compression was we had a little bit more payoffs in the portfolio and, therefore, the total amount of interest income dropped a little bit more than we were expecting..

Okay.

And then, how should we think about the margin going into the fourth quarter? And then if you look into your crystal ball, how should we think about it going into 2018?.

Well, it's going to be winter. So, the crystal ball is more like a snow globe. But we continue to like what we see in the loan pipelines. The trick is always going to be the timing of the closings. We actually had a few closings roll into the fourth quarter from the third quarter.

We were actually hoping for s slightly stronger originations in the third quarter by about $10 million to $12 million than we had. But yields on the originations look fairly favorable right now. The absolute level of rates is picking up. We're actually seeing a little bit of help on some aspects of credit spreads in some cases. That's not yet universal.

So, I think when we thought that we'd get to the 3.30%, 3.40% range by the end of the year on the net interest margin, I'd say the 3.30% is more likely than 3.40% right now. But we still see the trend is upwardly biased.

And we can manage our cash position and our liquidity position with the CD portfolio in such a way that if we are sitting on excess cash, we can just get rid of that cash and trim the interest expense down and still get the benefit of the repricing on the loans..

And then my last question, and then I'll let somebody jump on.

How should we think about the tax rate going into the fourth quarter and then for 2018?.

Yes, Kevin. The tax rate was impacted in the third quarter because of the revaluation of the deferred tax asset due to the change in the Illinois tax rates, effective in the beginning of the quarter. But going forward, from an effective tax rate perspective, we should probably normalize somewhere in the 38% to 39% tax range.

And that would be for fourth quarter and into 2018 at this point..

Great. Thanks Paul. That was helpful. I'll let somebody jump on..

And our next question comes from Brian Martin from FIG Partners. Your line is open..

Hi Morgan.

How are you doing?.

Well, and you?.

Good. Thanks. So, I've got a couple of questions, and I'm trying to balance your policy. So, let me run the first one by and maybe you can just give us a little bit of color on your outlook for the loan growth and just kind of by category.

If you think about 2018 and maybe just if you could talk a little bit in the Q about the sustainability of the C&I portfolio and kind of leasing. But just kind of how you expect each of the individual components to play out in 2018 would be helpful..

Okay. Well, let's wrap up '17 and say that the residential -- look, we'll go through '17, '18. The residential portfolio will continue to pay down. You know, we paid down by something like $15 million in the third quarter. That trend will continue. Whether we get below $100 million at the end of the quarter, I think that's entirely possible.

It's possible that refinances could slow down a little bit, but with rates finally starting to move, I think that last gasp for refinance activity might start to accelerate into fixed-rate mortgages that are sold to the secondary market. So, I would say that the trend of residential going down at somewhere in the 10% to 15% range should continue.

On the multifamily side, we seem to consistently do about high single digits, 6% to 8%. I would say that's still an intact scenario for now. Some markets are getting very, very well priced and even the investors who are selling buildings aren't necessarily sure they want to reinvest that at the types of levels they're talking about right now.

So, I'd say that, that -- maybe that range should be 5% to 8%. We might not go quite as fast, because buildings that are sold at very, very, very nice valuations, those loan volumes may not get replaced. Also, on capital market side, the availability of credit for multifamily is very broad.

And if borrowers want to get in that recourse financing, if they need particularly aggressive underwriting or terms, long-duration interest only, 80% cash out refinancing. These are things that Fannie and Freddie offer, and we have set up a channel to make that available to the customers.

So, our noninterest income would go up, but the balance growth in the portfolio might not be as strong. Commercial Real Estate will probably stay flat. We're being, as we said before, opportunistic in that, not being particularly aggressive.

You really have to look at each one of those properties and decide what the future's going to be as far as rentals and lease turnovers. And in our market like Chicago, that can be a very different thing depending on where the property is and what the tenant base looks like. Commercial -- C&I, the three components of the retail commercial banking.

That continues to grow at a 5% to 10% clip. We would expect it to continue to do so. The National Health Care platform continues to enjoy a pretty broad pipeline. That's the one where the closing timing is always uncertain. And from some time to time, you'll have a little bit of volatility in usage.

But I would say that this portfolio has got a good chance of growing between 10% and 20% over the next 12 to 15 months. And we may be pleasantly surprised that from time to time we get some larger deals there and some larger opportunities that actually exceed the 20% range. But, obviously, those are a little harder to predict.

And on the commercial leasing side for the direct lessor credit side, that again continues to grow pretty nicely in the 10% to 15% range. Again, we get some opportunities from time to time that can push that higher. But that area probably more than anyone else, any other single segment, has the most volatility in terms of usage.

We might see a draw, and you might see 10%, 15% growth in a quarter and all of a sudden, especially when you get right to period end, the lines pay back down as the leases are -- as the loans are converted to leases, either ours or somebody else's. So, you get intraperiod growth, but the balance, the period and balances might not move very much.

And since people are trying to get their deals booked and closed right at the end of each quarter or especially each year, it's kind of hard to look at the period and balances and say, you saw the growth, but you saw it during the period.

So, the thing we've been looking at consistently over the last few years is our commercial side portfolio has been growing somewhere in the low double digits for quite some time now on the compound annual growth rate, and we would expect that to continue.

The lease portfolio itself is as a result of its structure, particularly of the portfolio acquisition, it's got some heavy cash flows coming in from it for the next several quarters. And as we said at the beginning of this year, we were perfectly fine with that.

It's a good thing to have in a rising rate environment, which apparently is finally upon us. So, to the extent that we can pick up volumes and redeploy it, we're redeploying it at 150, 200 points above what's coming off the portfolio. Third quarter was a very, very quiet quarter, particularly in the investment grade and the high middle-market space.

It -- we do see some better opportunities, lots of bids going out the door. So that's why we are pretty comfortable saying our origination volumes will return to the $30 million, $35 million, $40 million range. And again, there's a couple of larger transactions out there that might pick that up. So, we'd like to see leasing grow.

Originations should do somewhere in the neighborhood of $200 million next year. But we might not see more than 5% to 10% growth in the portfolio, because the cash flow's coming back at it..

Okay. And the -- maybe one other thing, just I think, there is a question I didn't hear it to begin with on the call about the margin. But just one question on the margin. I know you gave a little bit of color in the 10-Q regarding your outlook, some of the near-term outlook here.

But just as far as, I think last quarter we talked about kind of redeploying -- or you talked about redeploying kind of the cash flows and just kind of the pickup in yield you're getting versus kind of where the weighted average yield is today.

Can you just give a little update on that, what you're seeing there trend-wise, so we kind of know how to think about 2018 as far as those cash flows?.

Well, the key on the loan portfolio is we would expect the yield to continue to drive higher, and I think we have a better opportunity than most given the fact that, for example, we just had a multifamily building sell, the borrowers redeploying the proceeds here in Chicago. But the coupon on that loan was 3.25%.

So, we are easily picking up 75 points or better on that. As I said before, the next big source of cash flows will be from the residential portfolio. The next big source of cash flows after that will be leasing. The leasing portfolios are going to come off in the 3% -- low-3% range, and we'll pick up 100 points there.

So just on the loan portfolio itself, we feel pretty good about margin expansion. The wildcard as most institutions are looking at is what's going to happen on cost of funds. On our transaction account side, we are in good shape on that. I think our bases are good.

I will think that in '18, especially if we get 2 more rate hikes, we'll see some more activity in the transaction side, particularly in the money markets. Hard to predict what that's going to look like. So, we have said before that we were thinking 3.30% to 3.40%, we still think that's feasible.

We don't see tremendous pressure on the cost of funds, and we see some pretty good opportunities to improve the overall loan yields that we think that's intact. And we may, may, may get a little bit lucky where if we have enough loan growth at the higher end of the spectrum on yields that we could actually outperform that.

But I'd say 3.30% to 3.40% is a good safe estimate for now..

Okay. I mean, do you feel like that's a longer-term type of margin you can sustain, Morgan? Or do you think it ultimately goes higher than that? It's kind of with this remix and the change in the charter, it feels as though it ought to be higher over time.

If next year is more in that 3.30%, 3.40% range, with maybe some upside as you just elaborated, should we be thinking as you get further out that you can continue to move that number higher?.

Yes, I think so. It'll really be a function of what happens in two places, what happens with lease originations against the cash flows that we get in. If we can grow that portfolio, then we have a better chance at margin expansion.

Two, if we get some better growth on the multifamily side and then especially against the cash flows that runoff, then, again, I think we have some opportunities. Because we're seeing multifamily yields in the 4%, 4.25%, 4.5% range pretty comfortably. The 10-year -- the five-year and the 10-year continue to move up.

So, we've even seen quite of a few deals recently in the high 4s. And we seem to be winning those deals.

So that's why I think that if we get a little bit help -- a little bit of help on the loan origination front, we're able to put that excess leasing cash to work more effectively, and we can continue our 6% to 8% growth in multifamily, we'll do well with that.

The other part of the C&I portfolio contributes a lot, but it's really just a question of when those deals close.

And as I said, if we have nominal pressure on the cost of funds, it could conceive a little higher, but I don't really want to make too many predictions about that other than if the trends were to continue, and we get to 3.30%, 3.40% by the end of the first six months, then from that point forward, assuming that there's not a -- outward or excessive pressure on cost of funds in the second half of '18, then we should be able to make further progress from there..

Okay. That's perfect. That's help. And just as it relates to the expenses in the quarter, and maybe if you touched on this, I apologize, just the -- I know, Paul, you talked a little bit in the last quarter about kind of where you think you're trending as you go into '18.

And you mentioned, Morgan, on the last quarter's call about taking some steps to accelerate the OREO, which you guys did this quarter.

I guess is -- are you largely done with the OREO resolutions that, I guess, you anticipated last quarter? And is there any update on, I guess, just kind of sustaining the level of expenses that Paul talked -- elaborated about last quarter, I think, it was kind of a $36 million to $37 million type of range, as you look forward?.

I'll take the OREO question. Yes, we think we're just about done with that. And we have a good pipeline of disposition for the remainder of the portfolio. We would hope that the OREO balances are in the $2 million range plus or minus at the end of the year, and we think we can pretty much keep it at those levels with a lot of surprises and expenses.

So that provides a pretty good upside to the '18 expense run because that's been the -- kind of like stubbornly sticky expense that continues to seem to just be there. So that's why we took that affirmative move, and I think we're pretty comfortable with that.

As for the rest of the expenses, Paul, why don't you touch on that?.

Yes, for third quarter, we had a few expenses that were higher than expected. We put away a little extra in incentive comp for loan originations. We had some real estate tax bills go up with the triannual assessment here in Cook County.

And there was some compliance costs related to catching up on some state taxes and the reallocation of taxes from tax provision to actual G&A, because they're based on capital, not income. But that all flushed through in the third quarter.

So, looking out fourth quarter and 2018, Brian, I think we're still on pace to normalize somewhere around $37 million annualized in terms of expense. We have some favorable things happening with IT expense going down. As I mentioned in the last quarter, the CDI amortization will start to run off or drop significantly after first quarter 2018.

So, there is some positive trends, but we have some onetime items that flowed through in third quarter. So, looking out into the future, fourth quarter in 2018, as I say, I think will normalize back to about a $37 million annualized expense rate..

Okay. Paul, that's helpful. I think the -- maybe one of the last one or two last things for me would be just as it relates to kind of the capital outlook. You guys -- maybe just update us. I think, you guys gave the shares repurchases. Just kind of your outlook on share repurchases.

And I guess more, I guess, bigger picture, how you manage the capital from there to continue to be as you prioritized growth or share repurchases or potential M&A. Just any interests you have on managing that as you look into '18..

Well, let's talk about the -- each element in turn. Obviously, the board is -- continues to be comfortable with earnings and earnings growth and, therefore, the dividend was increased last night. And we continue to think that dividends -- dividend returns are important to shareholders. So, we will continue to use capital towards dividends.

I don't think we're thinking about a special dividend at the moment, but continued growth in dividends continues to be a priority. We'll probably finish up the year at this rate, and then we'll reevaluate on '18 earnings and see if we can continue to improve the dividend payout.

On share repurchases, we are getting to the point where the accretion is getting to be smaller and smaller as time goes on. When we take our next leg up on earnings growth, the accretion gets a little bit more favorable, but not much more favorable. So, I think the share repurchase program, obviously, it's going to continue. We have plenty of capacity.

I would not necessarily expect it to be very, very active going forward. It will be more of a steady state at or around the levels that we've had over the last two to three to four months. I wouldn't expect a great outburst in volume, absent any other developments. And on the M&A front, we continue to be open to opportunities.

Our priorities would be adding good-quality franchises that present little or no risk on the credit side so that we can continue to focus on executing the loan growth mission on the organic side. Obviously, strengthening a core deposit base is always of interest, particularly now, when -- given our loan to deposit ratio and the movement of rates.

If we can redeploy a lower-yielding portfolio into higher yields, then we can take a stable deposit base and add it to our mix. That will be positive across the board. And it will present very little downside risk in terms of having to work out the credit portfolio.

So, to the extent that those opportunities are out there, we're very interested in them, and we'll stay focused on them as they arise..

Okay. That's helpful. And maybe just one last one. Just as it relates to your outlook on kind of provisioning and charge-offs. Just with the loan growth you're expecting in some of the categories, you're expecting, it may be kind of feels like you're at the bottom as far as maybe where the reserve levels are today.

And just -- is that fair? And just as you guys think about growth in 2018, is it just provisions are -- appear to be likely heading higher in '18 versus '17.

But just reserving for growth in charge-offs, is that a fair way to think about the expectations for the reserve in 2018?.

Yes. We would think that almost all of our provisioning would be -- the fund growth in the reserve due to loan growth. Obviously, it depends on the mix. But if you thought that provisioning at a rate of 60 -- 50 basis points on the low side, 75 basis points on the high side, call it 60, 65, 70 right in there, that's probably a good run rate.

So, if our reserve ratio now is 62, it would probably go incrementally higher, maybe 65, maybe 70, depending on the mix. But right in that 62 to 70 range seems pretty feasible to me. And, obviously, it's just a function of what actually hits the books at that time.

The only interesting thing we saw in terms of provisioning was in -- we have a variety of markets that we track for a variety of loans. The only interesting part was in the Illinois market in the Chicago MSA, we actually had an increase in the qualitative risks, because the unemployment rate in Chicago has been trending a little bit higher.

So, we had a little bit of an extra provision against the Illinois portfolios for that trend. But, obviously, in all of our other markets, unemployment continues to decline. And so, we actually had a little bit of a pickup, release of reserves to offset that.

So, again, given our geographic distribution of loans and leases, given the changing mix, I would say that, that 65 basis point run rate is a pretty good one. It just depends on when it happens. But we think we're in a pretty good shape, otherwise, on the credit side. Knock on wood, say a prayer. Don't tempt to cross the credit.

And having said that, I think, I'll leave it there..

Okay. And last one, Morgan. Just maybe you said this earlier, and I missed it. You talked in the Q, I thought, about the payoffs this quarter. I think you talked about the C&I growth kind of being at this 25% type of level. It felt like that was going to sustainable as you went into '18. So that was number one.

And secondly, just the payoffs that you saw this quarter.

Were they, I guess -- do you feel like this is a new elevated level for payoffs or do these just continue? What's the crystal ball if you have in your hand? And how to think about the payoffs you're seeing? Is this based on where the rates and where the market is today? Would you expect that you continue to get an elevated level of payoffs as you go into '18? Or is that likely to subside?.

Well, third quarter was a little bit unusual. And it's turning into a bit of a seasonal thing. We have a portfolio of leases to governmental entities. So, it might be the state of X or the county of Y. And those are typically done on annual payments because of appropriations.

So, it's appearing because many, many, many jurisdictions seem to have a September, October fiscal year that we will get some elevated payoffs to the annual scheduled payments in the September third quarter time frame. A little bit in October too, but especially in September and October.

So, I think in part we should probably think about that seasonally at this point. Two, we deliberately set up that portfolio acquisition last year in the '16 and '17, it was lower yielding, but it had extremely quick cash flows coming off of it. I think the weighted average was like 28 or 29 months.

So, in the first part of '18, we will continue to see that portfolio pay down. It will helpfully give us an opportunity to redeploy that cash into considerably higher-yielding assets. So that's why for us the game is, can we originate enough volume to offset that and even grow it a little bit.

And if so, that's where the margin expansion's going to happen.

So, I would say that the leasing portfolio should probably see $35 million to $40 million worth of cash flow every quarter, just coming off the scheduled payments, out probably through the end of third quarter of next year and then if some deals are early-termination deals, where they do a rewrite, we could get some prepayment income, but you'll still see the cash come back.

After that period though, after the end of third quarter, it will start to come back down to a normal run rate. We're doing more five-year deals than we're three-year deals, because of the nature of the equipment.

So, I think we're in a little bit of a, I don't want to say a bubble, but a little bit of an elevated period of payoffs for the next 3 to 4 quarters, including fourth quarter of '17. But then after that, it'll start to mellow back down. So that's why our challenge will be to redeploy that cash effectively for the next 3 to 4 quarters.

And if we're successful in doing that, we have an excellent chance at some significant margin expansion, and we will still have very good liquidity coming after that portfolio, even if we do..

Okay. And it's all pretty equal as far as by quarter.

And there's no lump in the quarter as far as that pickup in margin you'd expect?.

Yes, I would say that's correct. It's really going to be a function of what we are able to put on the books and at what rate. I would say though that the third quarter of each year will be probably a little bit more elevated in terms of payoffs because of that governmental annual payment cycle that we're into now..

Got you. Okay. I appreciate you taking the questions Morgan..

Anytime..

[Operator instructions].

Well, in the event there are no more questions, we wish everyone a good late fall and happy holiday season. And we look forward to speaking to you in the New Year. Thanks always for your interest in BankFinancial..

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Everyone, have a great day..