Good day, ladies and gentlemen, and welcome to the BankFinancial Corp. Q2 2019 Earnings Conference Call. [Operator Instructions].

As a reminder, today's conference is being recorded. I would now like to introduce your host for this conference call, Mr. F. Morgan Gasior, Chairman and CEO. You may begin. .

Good morning and welcome to the second quarter 2019 investor conference call. At this time, I'd like to have our forward-looking statement read. .

The remarks made in 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 declaration 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, our 5-quarter supplements and press release are on file. We'll file the 10-quarter SEC Form 10-Q on schedule later this -- in August. .

So at this time, we are ready with current filings and ready for questions. .

[Operator Instructions] Our first question comes from Kevin Reevey with D.A. Davidson. .

So my first question is on the $4.4 million loss on the nonrecourse sale. Could you provide us some color on the type of credit that was and the collateral supporting that credit and if there have been any changes to the way -- to your underwriting policies and procedures as a result of this? I would characterize this as a one-off credit event. .

Well, we'd certainly agree with you that at this point, it's a one-off credit event. It was unique to our portfolio. We're going to put more information in the Form 10-Q so we don't spend too much time on it today. But it was a local Chicago commercial credit primarily secured by accounts receivable.

There was a small exposure to owner-occupied commercial real estate for the borrower's offices, and they were engaged in the wholesale fuel distribution business. So the business was relatively simple. They purchase fuel from the refiner, and they sell it to retailers.

Straightforward business, high volume, relatively low margin, kind of like your grocery store that way. And quite simply, the -- we had the credit for a few years. Started strong. Good operations in '16, good operations in '17. But in '18, we saw some issues with their financial statements and put them on special mention. There were 2 related entities.

One was on special mention. And in '19, we saw the first-- or one of the problems being the failure to pay the state in violation of their agreements with the state.

That caused a potential issue with their performance bond insurer, which is required to do business in the State of Illinois, and we saw them starting to divert proceeds into other payments and indeed in other banks. And that situation was just not tolerable. You needed to get control of both the collections and the payments.

And when we reviewed the legal remedies, specifically a judicial receivership under Illinois state law, that process was uncertain at best in terms of both timing and result. .

And so our conclusion at that moment in time was it's better to get this asset in the hands of an investor who can get firm control of the borrowers and their handling of cash, manage the financial statements and the payments correctly. And ultimately, they may need to recapitalize the business.

The week after we sold the notes, we saw the investor put in $200,000 in the company just to meet vendor payments. .

So felt good about the action. It was the right decision. Obviously, we would not take a loss of this magnitude if we weren't absolutely convinced that this was the right action and it no longer poses a threat to earnings or capital. It's behind us, and we're moving forward. .

And so Morgan, you don't anticipate taking any additional losses on this.

Everything is much behind you, and it's kind of done at this point?.

Yes, it was a nonrecourse sale. It's 100% done. And that was one of the main reasons for proceeding down this as we thought that this was going to be the best result considering everything that was a factor that could affect us going forward. .

And then lastly and then I'll jump off, how should we think about loan growth for the remainder of the year given loan balances were down sequentially on an all-in quarter basis?.

Yes. It's more of a puzzle than it was certainly 6 months ago given the changes in the yield curve.

So I would say at this point in time, if you were to look at our 12/31/18 portfolio, that portfolio was around $1.330 million (sic) [ $1.330 billion ] and right now, given the prepayments we're seeing from property sales in the real estate portfolio, we've had actually one customer in the leasing side be sold to a competitor.

There may be another customer in the commercial portfolio that was sold where we feel that if we get somewhere between $1.3 billion and $1.325 billion in the loan portfolio, maybe $1.330 billion, that's probably a good place for us to end the year. The yield curve has given a significant boost to external refinances. It's far more economic to do it.

We had a payoff recently where the borrowers sold a property for cash and paid us a $136,000 prepayment penalty. But they made so much building on the offer. There was another investor out there that had a 1031 exchange that they moved. They got the deal done, and they wrote a check for the prepayment. .

So I'd say at this point from a portfolio perspective, we'll see. There's a good pipeline in the health care space, there's a reasonably good pipeline in the national commercial leasing space. We may be supplementing that a little bit by going back into investment grade.

There are some lessors that want to do some investment grade with some residual equity financing so doing it as a combination might make sense for us.

But as I said, if we get the portfolio with the configuration of credits that we want somewhere between $1.3 billion and $1.330 billion, so essentially the 12/31/18 balances, we'll be pretty happy with the year because that meant we got the credits we wanted at approximately the yield we wanted with the right risk profile. .

Our next question comes from Brian Martin, Janney Montgomery. .

Morgan, I was wondering if you could just give a little color, just some thoughts framing around the margin and just kind of how you're thinking about that with the change in the direction of the Fed likely here and just how that plays out in the coming quarters. .

Yes. Well, obviously, we've gone through quite the sequence of expectations, right? We started the year with an expectation of the Fed increasing rates multiple times. They started and kept going starting in December. Then we get into middle second quarter. And now, well, maybe we don't need to raise rates, but we're certainly not going to lower them.

And now we're in a world of this week, we expect a 25 basis point cut. There may be -- we expect probably one more sometime later this year. That's not in the bag, but it seems a pretty good bet. And then we'll see. .

So for us, one thing is we will have to see how the deposit market reacts to this. There has been some signs of softening of competition. So in second quarter, we have been managing the cost of funds, particularly paying down any wholesale CDs that's maturing, paying borrowings down. And that helped to put a lid on interest expense.

We will continue that path going forward, and then we'll manage the cost of funds as best we can consistent with customer expectations. We will probably see a little extra liquidity coming from some of the portfolios. So therefore, we won't really need to worry about funding on the margin per se at the moment. But we'll have to see how that plays out. .

So it's -- first thing is we're going to work to try and manage the net interest income as a balance and not be quite as concerned about managing the ratios. But having said that, it's just a broad range I'm going to give you, but it could -- we could see 3.50%, 3.45% at one level. We could see 3.65%, 3.70% at another.

It really is going to depend on the mix.

But I'll have to say if the risks skew towards the lower end because we're just seeing almost extreme price sensitivity with multifamily borrowers, particularly given the competition from capital markets, you can -- we have a borrower that is looking to do a 10-year loan, and they have a quote for 3.65% 10 years, 30-year nonrecourse, that's not what we're going to chase in the portfolio, but it's an indication of what's available to the borrowers.

.

Same thing, we've seen further credit spread compression in the lease space and further price competition. The lessors incrementally make more profit as the absolute level of rates go down. So both those portfolios are pretty price sensitive, and there's just no getting around it. .

So as much as I'd like to say we would -- we could see the margins skew higher, that would be probably the best case scenario. More likely, it'll be somewhere in the 3.50%, 3.60% range.

It could skew lower if we wind up with more cash or if we wind up putting assets still, the higher-quality, lower-credit-risk assets, on the books at current market rates.

I don't think anybody around here is thinking there's going to be a big shock to the curve where the 10-year is suddenly going to be at 2.50% or 3%, and we're going to be back where we were at the third and fourth quarter of '18. .

Okay. And your sense today is, like you say, a lot to it depends on the mix in the asset side.

But the pipelines, where you sit today and kind of getting to your -- the target you mentioned earlier on loans, where is the strongest pipeline? And I guess the kind of where are rates coming out on that type of product? So is it commercially the strongest in your... .

The health care side continues to be the strongest in part because it takes the longest to close. So we've been talking about certain credits almost since my last birthday. And -- but those pipelines remain strong. I'm actually going on a sales trip here starting today. And the yields on those are still prime plus, prime plus 1, prime plus 2.

I think it's safe to say prime plus 1 is a good number. Obviously, prime is going to come down a little bit. The good news there is we tend to have floors on those credits, and so there is a certain amount of income protection associated with those loans. .

Leasing has had a good second quarter, especially given the competition in the space and also the declining level of business investment. We have a few ideas there about product development that might be useful, but that ranges the gamut. You're going to see leases that could go as low as under 3% in an investment-grade space into the 4s.

I think it'll be harder to see stuff in the 6s, but there's a big range there. It could be high 2s all the way to high 5s. Take the midpoint. And even then, it'll probably skew closer to 3.75% to 4.25% on average, whereas we were looking at 5.25% less than a year ago. .

Real estate has the thinnest pipeline for the reasons we said for a couple of different reasons. One is we're continuing to see the markets very mature in terms of valuation. More and more borrowers, I think, are acquiring properties.

If they're doing so, they're trying to do it with max debt to get the cash-on-cash return to work, and that is not working in our underwriting models. So for that reason, we're hopeful that we can convert more of those opportunities to capital markets. But for example, in multifamily in Chicago, there are competitors under 4%. Same is true in Denver.

But there's multiple competitors under 4% in Chicago. So 3.75%, 3.95%, something like that for a 5-year, 30-year -- 5-year 30-year [ M ] money. And commercial real estate is only about 0.25 point higher, so there's not that much yield pop for the inherent risk of that asset. .

So we're not going to be really doing too much with real estate lending. We'll do our best to retain the portfolio. We're going to work hard on attracting good quality refinance opportunities, and then we're going to work to build the referral base and the capital markets and strengthen the noninterest income.

Sometimes, those products are the best solution for the customer. Our mission needs to be customer market share and give them what they -- what is best for them. And if that means it's fee income on the capital markets side, then that's fine.

We'll put what belongs in the real estate portfolio at the right yield with the right risk profile, as we always have. .

Okay.

And just remind me, what percentage of the loan portfolio is variable rate today?.

I don't have that number right at the fingertips. Most of the commercial portfolio was floating rate. But remember, there is significant liquidity coming off of the leasing portfolio. And even with prepays on the multifamily portfolio plus loans that are coming up on rate reset, there's significant liquidity coming off.

So repricing assets is not really going to be the issue. If anything, we were slightly asset sensitive at the end of the last quarter, and the current environment will probably make us a little bit more so. .

Yes. Okay.

And just on the funding side, given the actions you took this quarter, and you talked about paying off some of the borrowings and maybe doing a bit more on the wholesale CDs this quarter, I mean, do you feel like -- and then the softening, I guess, within the deposit competition market, I mean, do you feel like deposit costs have peaked? Or is that still going to play out in the third quarter? But just kind of when do you think the deposit costs peak?.

I think we're either at peak or very close to peak just because of, for example, wholesale -- well, just -- I think wholesale has peaked. I would not be worried about that. On the retail front, that might be a little different story.

I think it will depend largely on how people react to the Fed cut and what the their own loan-to-deposit funding issues are. So I'm a little less comfortable in saying that retail has peaked. But I'd say we're at it or close. So wholesale, definitely. Retail, if it hasn't peaked, it probably will by the end of the third quarter.

Then it's just a question of the magnitude of the market adjustment. .

Okay. All right, perfect. Just a couple others from me just on the capital front. Just kind of maybe talk about if anything has changed and kind of your outlook on repurchasing stock or how you're thinking about that.

And then same thing maybe on M&A, kind of what you're seeing, if anything, and kind of still your appetite there, if there was something that looked opportunistic. .

Well, we will continue to look at share repurchases. That still seems, especially given where we're trading, like a good opportunity for us. Timing will be market driven and liquidity driven. Probably expect more activity later in the year than in the short run. But we're still very interested in doing that.

We think it's relatively a safe way to help earnings per share and get the most out of the performance of the franchise. .

Having said that, from an M&A perspective, we're encouraged by the fact that we're looking at a couple of opportunities.

Obviously, we'll have to watch the deal consideration, but these opportunities do seem to fit our inherent requirements of good deposit base, relatively low credit risk, an ability to integrate relatively efficiently and good geographic support here in the Chicago area.

So hard to say what's going to happen, but the fact that we're looking at multiple opportunities gives me some reason to think that we'll get at least one done, maybe more. .

And even being reasonable about cost savings, we should be able to get some relatively predictable earnings growth out of those franchises without material credit risk.

If anything, we would look at credits in the portfolio that were questionable and arrange a sale of them either right before closing or shortly after closing with an appropriate mark so as to protect the asset quality but, even more importantly, not spend money on NPA resolution.

And that could be a very helpful boost to earnings per share and franchise value in a world where there's not as much organic loan growth available to us, and you're still trying to get the maximum efficiency ratio out of the operation. .

Perfect. That's helpful. And just on the M&A, Morgan. I guess would you -- I guess your thought on -- just I guess I've not -- I don't recall kind of what your targets look like from a size perspective.

Or I guess would it be more of a -- in fact, I mean, would it be more of a market extension, if you will, kind of outside of where you're currently at or adding a new market or just kind of in market and getting a bit more on the cost savings side?.

Let me address both questions. First, we're going to look at things generally under $500 million. And so those would be integratable. We've done 3 of them at that size before. And that would allow you potentially to sequence more than one if all the timing worked out for both sides. .

Secondly, in terms of market, to your point, we're interested in both. Some opportunities give us an opportunity for greater cost saves. Even within the franchise, they might have more offices than they really need. And when you then factor in potential overlap or coverage by our franchise, it lends itself to greater cost saves. .

stable populations, maybe not growing but stable; and potentially opportunities to do more with their deposit franchise than the current managers are doing. .

So I think smaller and potentially put them in sequence if we're able -- if we're fortunate enough to be able to do that. Two, look for opportunities that you can get reasonable cost saves. And in some cases, the cost saves might be even a little bit outsized. It'll be apparent to everyone in those cases why that is.

And that will give us some good opportunities to leverage capital on a low-risk basis, issue as few shares as possible in that context to continue the improvement of earnings per share. And at the end of the day, you'll have a bigger, better and more efficient franchise with the same lower credit risk and a really strong deposit franchise. .

Perfect.

And just the -- on the buyback, maybe if you have it or if Paul has it, just the remaining shares on the repurchase plan today, are -- where are they at today? How much is left on it?.

It's a little over 600,000. .

Okay. A little over 600,000. Okay. And then maybe just the last one was just on expenses. Just any change on kind of what we talked about last quarter. Kind of this quarter was pretty much as expected.

Just anything you're seeing changing on that front? I guess we've heard a handful of competitors talk about seeing good opportunity to add talent from some of the disruption in the Chicago market. So I'm not sure if you're seeing that or if there's any change in kind of an expense run rate, if some of that is going to occur. .

Well, some of it has already occurred. We have achieved a pretty good run rate, but we have also added people over the last 6 months. We have a new leader from PNC in the commercial and industrial area running that division. Her specialty is in health care, specifically physician practices.

But she's had a broad range of health care over a 25-year period. .

Recently, we hired a banker from MB Financial. Her specialty is in the commercial real estate area but also community development. And those are some interesting opportunities for us as well. .

We're adding a third officer on the deposit side. We think that the commercial deposit side could be an opportunity for future deposit growth as well as some fee income. And this individual ran all of the cash management and treasury operations for MB.

And I think over time, that will give us a much more advanced product lineup, a good leadership in that, that not only can we do that in Chicago, but we can take that across the 3 national platforms and cause some pain to people in other places. .

So those expenses are basically factored into the run rate now. We've made adjustments in other places to facilitate that. As that evolves, I know both the commercial leasing president and the commercial lending president are going to be looking to add people, and we'll keep you posted on that.

But if there is a material change in the run rate, we're very focused on making sure that revenue growth, deposit growth and loan growth are the principal reasons why. .

Okay.

And given the change, Morgan -- last one was on the -- given the change in kind of the rate outlook and just kind of where you sit today on loan balances and relative to kind of at least initial expectations with paydowns being a factor, I guess is your sense on profitability that there's a -- is your profitability outlook or target come in a little bit based on that? Or I guess changes you're making elsewhere, you still think a -- I guess I don't know your expectation is or kind of broader target is for return on assets, but can you give any sense on if it's changed kind of where you're thinking about that as you move forward?.

I think you'd have to look at all the metrics, but it's going to come down to just where the loan portfolio is and where the net interest income is on an absolute basis. We'll have -- we should have reasonably stable, maybe a little bit improvement in noninterest income.

We'll do our very best to continue the trends, if not improve on them a little bit, in noninterest expense. But it's all going to come down to where the dollar level of net interest income is. And obviously, that's a function of the loan portfolio size, the mix, the deposits, the costs.

And in our world, the decline in the multifamily portfolio puts that at some of -- at a certain amount of risk, as you saw in the second quarter, we'll -- especially if the better solution for customers is capital markets.

We can, I believe, offset some of that in the context of leasing, in the context of health care, but I don't know that we'll be able to offset all of it. At the same time, you don't want to push a position in any asset class that is growth for growth's sake or to try to get an absolute level of dollars for very short-term perspectives.

So I think I'd have to say that because we're not going to get the repricing on the leases' cash flow, we're not going to get the pricing on the multi cash flow, as we said last quarter.

And now that there's more opportunity for multifamily customers to refinance at very low rates nonrecourse, completely contrary to what we thought, there's probably at least some risk that the overall absolute level of profitability declined somewhat, and it's going to be hard to predict all those factors if rates back up a little bit, if something else happens that might ameliorate a little bit.

But I would say the volatility in the multifamily portfolio and the price competition in leasing are the -- probably the 2 bigger threats to the original projections on profitability. .

[Operator Instructions].

Well, if there are... .

I'm not... .

No further questions, so going once, going twice, going 3 times, we thank everyone for their interest in BankFinancial, and we look forward to talking to you in the fall. Enjoy the remainder of your summer. .

Ladies and gentlemen, this concludes today's presentation. You may now disconnect and have a wonderful day..