Good day, ladies and gentleman. And welcome to the BankFinancial Corp Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time [Operator Instructions]. As a reminder, today's program is being recorded.

And now I'd like to introduce your host for today's program, F. Morgan Gasior, Chairman and CEO. Please go ahead..

Good morning, and welcome to our investor conference call reporting results for second quarter of 2018. 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 provision 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. As all filings are complete, we are ready for any questions..

[Operator Instructions] Our first question comes from the line of Kevin Reevey from D.A. Davidson. Your question please..

My first question is around the margin. It looks like your deposit cost came in a lot higher than what we were expecting.

How should we think about the margin going forward as we look into the third and fourth quarters?.

Well, let's divide it into 2. I'll talk about interest income a little bit and then Paul Cloutier will talk about deposit cost a little bit. Let's just talk about interest income. As we said in the previous call, we expected that the margin would flow with better range depending on the mix of assets.

And in this quarter, as I had said in previous calls, if we had a mix which was a little less on C&I utilization, a little more on either multifamily or commercial lease origination, we'd see a little bit of a drop in interest income and that's pretty much what happened in second quarter.

We had less C&I utilization than we did in first quarter, even though the commitments increased and continue to increase. So going forward, we think on the interest income side there is a good possibility of continued improvement in utilization for C&I, especially as we get into the fourth quarter. There are some seasonal factors in play here.

And also in the health care side, there are some upcoming changes in the payment practices for Medicaid that will tend to extend out receivables and therefore extend out utilization. But those won't really be taking place until late third quarter, early fourth.

So we will have somewhat more volatility in the third quarter similar to second quarter and then it'll start to smooth out in fourth quarter. The second big thing on interest income is the level of interest-earning assets.

One of the things that we're facing here is considerably elevated payoff level compared to what we thought we were going to see at the beginning of the year. Real estate assets are -- if you looked at the payoffs from the first half of '17 or the first half of '18, for example, there's something in the neighborhood of $30 million higher.

So we have to replace that $30 million. The good news is we have a little bit of pricing room in our markets to change refinance business. It's a little hard to work on purchases now because of market conditions.

So we do have some opportunity to get a little more aggressive on pricing for refinance opportunities as those loans come up for refinance, take a little market share. And even at these current pricing levels, the yields on the '18 originations would exceed the yields on the pay-offs.

But we really need to reestablish that $30 million of asset base that we do not have at the present time and that's going to be the focus for third and fourth quarter. Given the lag time, we would expect more of an impact in fourth quarter than third quarter. So little -- I would say C&I will trend up a little bit in third quarter.

We had the benefit from getting a nice quarter of lease originations that will help in the third quarter, and we'll see a little more strength from real estate in the fourth quarter, we'll see a little more strength from C&I utilization in the fourth quarter.

And traditionally fourth quarter is also our strongest quarter for leases, but it's just a little too soon to predict just how strong it'll be.

And Paul, why don't you cover the deposit side?.

Yes, Kevin, the main driver on the deposit beta was, we had $86.5 million in CDs that were maturing in the second quarter and we thought they would price out somewhere in the high 1s, low 2s, but the market drove that repricing up a little higher than what we had projected. But going forward into the third and fourth quarter that moderates.

We only have about $50 million of CDs maturing in the third quarter. So the big driver of the deposit beta was the maturity of the CDs and the rollover at much higher rates. They were coming off at rates in a lot of cases below 1%. So with the repricing that drove the deposit beta in the second quarter..

And then, Morgan, given what you had mentioned, you expect C&I to trend higher, do you expect to see full year mid- to high single-digit loan growth this year? Or do you think it'll be in kind of in the mid-area and the mid-to-high area?.

I think what we'll probably end up seeing from here is, if we can get to a loan portfolio somewhere in the $1.3 billion range from where we were at $12.31, we were at $1.3 billion, so if we can get somewhere in the $1.350 billion to $1.375 billion range, that's a good result.

And obviously, if we do better than that, that's an even better result giving the starting point..

Thank you..

Thank you. Our next question comes from the line of Brian Martin from FIG Partners. Your question please..

Say, one thought or maybe for yourself or for Paul, it's just on the expense side.

And I think you guys had kind of outline last quarter kind of the -- some of the things that happened here, the 401(k), obviously and the -- and then on the fee income side the [indiscernible], but just kind of on the expense side, maybe just if you could talk a little bit about the new hires.

And then just kind of the incentive comp accruals that was in there this quarter. I mean, some of the comps as of may not be in the run rate going forward, but just, kind of, in the context of how you're thinking about expenses here over the next 4 to 6 quarters. If you could give a little thought, that'd be helpful..

Sure. Well, for starters, the 401(k) is a 2018 single event. We saw -- you obviously saw the -- at end of '17, early '18, many companies did one-time compensation moves for their associates.

We gave that some thought, the board gave considerable thought to that and they determined that a -- doing something in the retirement plans would probably be the better move, but it took a quarter to get the plan amendments done and so wound up happening in second quarter.

We look at that for '18 as a one-time event, not really a core run rate at all. On the incentives, we had a pretty good quarter for originations, especially compared to first quarter. So we had to do some catch ups there. But now we're fully funded on the incentives and all incentives at second quarter.

So I would think that on the comp side, we will start going down to somewhere between $5.35 million, maybe as low as $5.25 million, depending on staffing levels. This time of year, we had a number of summer associates to do special projects or seasonal projects. And as we've said in the 5-quarter footnote, those usually run from May to August.

So they will be rolling off here soon. Some of them do marketing, some of them do credit operations, some of them do compliance, some of them do support functions, but they'll be rolling off.

So I would say that you add anywhere between $350,000 on the low side and $500,000 on the high side, maybe a little bit more of unusual expense in the second quarter that will fade over time.

Now if you get into a groove on loan originations, and similarly if we get into a groove on deposit originations and the commercial side, then they'll -- those incentives could roll up a little bit, but that would be happy news for everybody.

So I would say, $5.25 to $5.35 is a reasonable range because the temporary staff we have are going to roll off and we had some one-time expenses that had to get -- that got done in second quarter. Paul, on the rest of the expenses….

Overall, the expense run rate going forward for the next couple of quarters -- the 2 to 4 quarters should be in the $96 million to $97 million range. What we're seeing is a lot of vendors are starting to pass on cost increases. So I've taken a look at a lot of invoices and I'm starting to see that creep up.

But there's some things we can do to kind of moderate that. So I think a reasonable run rate for expenses for at least the last 2 quarters of the year, $96 million to $97 million. And then looking out into 2019, it's how good a job can we do on moderating those cost increases that are being passed on..

And I'd add one thing. We've been working on some new marketing for both commercial deposits and for real estate loans, especially trying the opportunity to sell the portfolio loan versus the capital markets. We will know in the next 4 weeks or so just how deep that campaign will go.

But especially given the need to put the interest-earning assets back on the real estate portfolio and to continue to push the capital markets forward, it wouldn't surprise me to find out that our run rate on advertising is a little bit harder than we might otherwise think, given the last couple of quarters.

We will get that word out and we will get the, get in front of those borrowers to the maximum extent possible. The other thing I'll add is, we're early days in discussions, but given some of the changes in the Chicago banking market, we started dialoguing with few people in a couple of different of the commercial disciplines.

So if it all works out, we might do some add to staff on the commercial banking side and that obviously would trend the comp side a little higher, but again to the purpose of growing the interest-earning assets..

And just, I mean, I guess your comments about being opportunistic here if you got the hiring. Certainly, I understand the expense add. I mean, I guess the expectation would be that the, there's still positive operating leverage in your growing the, improving the profitability as you do this.

Is that fair to think? I mean, on the, the revenue side would be a little bit greater uptick than what we've seen on the funding, the expense side?.

Yes, we would absolutely hope that, but there's obviously a lag. And one of the things we'll have to look at when we talk to people is what the ramp up would be? We are in an interesting position in some cases.

For certain bankers who have loans maturing, either now or in the very near future, there may be an opportunity to take advantage of that where you're not dealing with very large prepayment penalties and things like that. We may have to be opportunistic not only on the credit but also on the pricing.

And they get very, very easy and pain-free to change and not prematurely reprice the assets, for example. So we're prepared to do that if we see the right opportunities. Because, again, the point here is, let us do everything we can to increase the base of interest-earning assets and everything is pointed towards that goal.

How well we do it? That is going to be a function of markets and timing and everything else. C&I is a good example. We have, we've had a continuing good pipeline, but we probably didn't close at least $10 million of loans in second quarter that we're supposed close because of one delay or another.

And hopefully in August we will close the one that was supposed to close in June. We have another one for $11 million dollars that depending on HUD may close in third quarter, but it may close in fourth quarter. We're working on another one for $8 million that was supposed to close in September and now it's going to close in October.

So we just run into timing issues on somewhat consistent yet frustrating basis. And that's why I think maybe fourth quarter is a stronger opportunity for growth than third quarter, just given the things we see.

But if we can move those assets forward either from new people or from different opportunities, we will certainly do so to make up lost ground..

More focus on, you're willing to give up a little margin percentage, you get the volume and take the net dollars of interest income higher..

Especially on the real estate side to replace the lost volume, because that was the foundation we were building everything else on..

And just leases you brought on this quarter, when we look at next quarter for the margin, what was the rate that you brought these leases on this quarter.

Can you just -- is there kind of an average rate you can think about relative -- and I know the C&I yields are a bit higher, just not sure how the lease yields are and especially what you brought on and the impact to third quarter margin from that..

This quarter, we did probably mid-4s in the leases. The third quarter pipeline looks to be in the high 4s to low 5s. It's kind of early yet to see. We are continuing to have dialogues with people. And being -- it really comes down to the mix of the lease quality.

For example, you're still seeing some credit spread compression out there, especially in investment grade. So we tend to want to focus on the BBB space of the investment grade and then the BB space of the noninvestment grade. We're pretty tightly there. So I would say, second quarter was, call it, mid-4s -- between 4 quarter, 4.5% on average.

I would think third quarter would be more like 4.75% to 5%. And then depending on what happens in fourth quarter with volumes, that could go a little bit higher, it could stay about the same. It really depends on the mix. But I'd say, we should at least pick up 50 basis points on the lease originations for third and fourth quarter.

We might pick up as much as 75 or even a 100 depending on the mix..

And just in the context of, kind of, origination and payoffs, Morgan.

I mean, this quarter -- I mean, I guess -- how would you -- do you -- can you give some color on what the -- just what the payoffs were versus the origination? I mean, some of that I think you've given the release, but just relative to high or low, I guess, how would you characterize this quarter from both the [indiscernible].

It was high. First and second quarter were both high. So the ones I draw your attention to, the 3, real estate was $52 million for the first half of '18 compared to $36 million for the first half of '17. Commercial real estate was $17 million versus $7.5 million. Now on the real -- commercial real estate side, some of those we let go for credit reasons.

Borrowers who didn't want to ask for their tax payments, even though the debt service wasn't particularly strong. Borrowers who didn't have stabilized net operating income. Borrowers who wanted to do a big cash-out refinance. Some of those just had to go because we're not going to -- they're not going to meet the credit parameters.

But the thing that probably drove it more than anything else is, if you look at commercial loans, we had payoffs of approximately $140 million in the first quarter and then we had payoffs of $163 million in the second quarter, and that reflects the drop in C&I line utilization.

And that also correlates to why the weighted average rate on payoffs went from 4.97% to 5.28%. So that's why C&I is a double-edge sword. It's great opportunities for us, it fits a lot of parameters, but borrowers are very, very careful in how they manage their credit exposure, especially with rates rising. So if they can pay down, they will.

And as I said, we expect that to moderate over time due to some of the payment practices we're seeing and the changes in the mix a little bit.

But if I had to point to one thing in the second quarter that drove the difference, it was, first of all, C&I utilization and secondarily the higher payoffs and the multifamily and to a lesser extent commercial real estate. Those were the things that drove the difference..

Okay, then maybe last one or two things. Paul, you talked on the CD side, the renewals.

Were you guys -- I guess, have you guys been extending out a bit to kind of lock-in, even if it costs a little bit more today to go out 18 months or I guess what's kind of the thought on? Maybe if you get a couple more increases, you are extending then obviously it pays dividends down the road, but you have low cost upfront.

It's that kind of what you guys have been doing? Or is it more 12-month-type-of-money and kind of what rates are those CDs coming out at?.

No. We try to extend out. It looks like the sweet spot for retail customers is more the 18-month maturity, so you move them out a little bit. And then on the wholesale side, you can pick your maturities to the extent we can extend out before additional rate hikes occur that help for locking in rates for the future..

Okay fair. And just on….

And we like to move those rates out a little bit if we can. So exactly for your point is, depending on what the Fed might do, we're getting a little bit of term protection. It also helps match out the interest rate risk and keep us balanced. And you can't really do that in the money markets and the core accounts.

So again, if the mix is skewed more towards floating rate, then the commercial deposits make -- grow and it makes more sense if the mix is more leases and real estate, then the term CDs make more sense. So that's the -- those are all the factors, but to the extent we can get term protection, we will and that's why we like working in the CD market..

And to your point, Paul, I guess, you would expect, I guess, if the plan goes according to schedule that the loan betas in the third quarter and fourth quarter would exceed the deposit betas.

If you had less CDs that are repricing, you're getting the mix change you want to and it point towards higher margin and higher betas on the loan side to offset the ongoing funding cost rise..

That would be the intent. Now the question in Morgan's raises is the mix on the loan side.

Do you get the proper mix to create that beta?.

If this works the way we want, we pick up some interest-earning assets out of base, whether it's more leasing, more real estate and that drives absolute interest income higher. And then if we get better C&I utilization, then that drives the margin better. So it's a two -- it's a double-barreled approach..

Yes. Okay. Got you. And then just on the capital funds.

The repurchase program and kind of how you guys are thinking about that today? I guess, how much is left on the plan? Are you -- Is there expectations you guys would look to get that done here? Or am I -- if I missed where you guys are at on that?.

We still have some room on the plan. And obviously we did quite a bit for the ESOP here and some on ESOP, which is completely finished at this point. Given the 0.25 million shares or so that are left, we'll have to rerun the numbers, given market conditions.

But obviously, at current trading levels, we're going to be more aggressive than we were at higher trading levels. So I would think that repurchases will be a bigger factor now than they might have been, say, 45 days ago. We still think that is a good use of capital.

We have availability of the holding company to work that and I would expect that to be a factor. So if we are -- if we trade where we are now, which certainly we'd like to recover where we were before, but if we trade where now, we'll be more active.

And if we're trading at the very high end of the 52-week range that gets a little more expensive, but we will always be in the market doing something. It's really just a matter of degree..

And your new commercial real estate group, I guess, tracking kind of as you guys would, as expected and just building momentum.

I guess any updates there?.

They did, obviously, they did better in second quarter. I would say that we are still feeling our way through their process. It's summertime, I would expect that third quarter will be probably somewhere between first quarter and second quarter in terms of results. They do appear to be building a pipeline for fourth quarter.

And if we can get into triple digits for income, for the fourth quarter, that would start to get on the plateau on where we'd like to be. Right now, still getting out to know customers and funders and the process, but it's making progress. I, is it where we would like it to be, no.

But as I said, if we can get into $100,000-plus quarters on a consistent basis starting in fourth quarter and build on that for '19, that would be a better place for us to go. And to the extent that we get into the $200,000 to $250,000 a month in '19, especially if this marketing work takes off on us, that's really where we'd like to be.

So it's early days to say, they did $80,000, was that a good improvement on first quarter? But we have a ways to go..

Okay.

And last one for me, Morgan, it's just the, when you guys kind of laid out your roadmap in the shareholder meeting and plan, I mean, I guess anything changed from how you're thinking about things based on the, how loan trends and margins are trending relative to what you thought maybe back in March as far as the run rate on earnings and profitability as you look to second half of this year and into '19? Or is it still kind of tracking that plan with obviously some twists and turns along the way?.

Well, right now, I would say that we thought we would be closer to $0.25 a share, mid-20s at the end of the year. And the drop in the real estate portfolios has threatened that outlook. So right now we thought we'd look, on a core basis, if you take out the 401(k) and some things, we thought we did about $0.20, $0.21 in the second quarter.

And we want to build a floor over that for third quarter and fourth quarter. For us to get to $0.25 at the, for fourth quarter, we would really have to rebuild that real estate portfolio back to the levels we thought.

And the good news is, with rates up a little bit, we might need just a little less volume to do it than we did before just holding the portfolio. But I would say that's our biggest concern. Now the second concern for that would be what will be the funding cost? There are still pressures out there.

You still have to take care of customers and respect the customer. So I'd say the secondary issue for us, but the first and biggest issue is we need to keep their interest-earning assets going and we're about $30 million or so behind on the real estate portfolio and we need to do as much as we can to safely reestablish it.

If you do, then I would say that the '19 thought process remains largely intact. But that's probably the biggest change from the beginning of the year as we have some work to do to strengthen interest-earning assets further than we thought we would at this point..

So back half of the year maybe a little bit less than you thought, but '19 is not without an opportunity if you can kind of there any get assets where you need to. It's still possible to stay, function of better reevaluating maybe later in the year..

I absolutely agree with that statement..

Thank you [Operator Instructions]..

Going once. Going twice. Three. Thanks, everyone, for their interest and attention for BankFinancial. We look forward to talking to you in the phone..

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect..