Welcome to the Independent Bank Corporation First Quarter 2020 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Brad Kessel, President and CEO. Please go ahead..

real estate, rental and leasing, including all investor real estate, $49.9 million or 30% of our deferrals and only $2.6 million or 2% of our PPP loans; manufacturing, $29.2 million or 18% of our deferrals and $30.2 million or 18% of our PPP loans; accommodation and foodservices, $26.5 million or 16% of deferrals and $10.6 million or 6% of our PPP loans; retail, $10.3 million or 6% of deferrals and $9.4 million or 6% of our PPP loans; construction, $5.6 million or 3% of deferrals and $29.5 million or 17% of our PPP loans; and health care, $1.3 million or 1% of deferrals and $12.9 million or 8% of the PPP loans.

In general, the industries where we see the most risk or have the highest exposure are also the industries where we've deployed resources to assist during this difficult time.

The total principal amount outstanding for those customers in those six industries that have received deferrals is $122.9 million or 13.1% of the total principal exposure of $936 million. For PPP, the total loans to these industries is about $95.2 million or 10%.

Investment securities available for sale increased $75.9 million during the first quarter 2020. Page 13 provides an overview of our investments at quarter end. Approximately 72% of the portfolio is AAA-rated or backed by the U.S. government.

In terms of capital management, our capital levels continue to be strong with tangible common equity to tangible assets of 8.4% at March 31, 2020.

This is slightly below our the bottom end of our targeted range of 8.5% to 9.5% as a result of larger than previously planned investment purchases during the first quarter combined with our planned share repurchase activity. We anticipate moving back into our targeted TCE range in the second quarter of 2020.

We paid a quarterly cash dividend of $0.20 per share on February 14, 2020, and recently declared a $0.20 dividend on April 21 as we believe that our capital levels currently support the continuation of our dividend program.

During the first quarter of 2020, we repurchased 678,929 shares through March 16, before suspending the buyback in response to the uncertain economic environment. At this time, I would like to turn the presentation over to Steve to share a few comments on our financials, credit quality, CECL and the outlook for the balance of 2020.

Steve?.

Thank you, Brad, and good morning, everybody. I'm starting at Page 15 of our presentation. First quarter 2020, net interest income declined by approximately $500,000 or 1.7% compared to the fourth quarter of 2019 due primarily to a decline in our net interest margin.

The decline in margin was partially offset by a $30.1 million increase in average earning assets. Our tax equivalent net interest margin was 3.63% during the first quarter of 2020, which is down seven basis points from the fourth quarter of 2019 and down 26 basis points from the year ago quarter.

Average interest-earning assets were $3.35 billion in the first quarter of 2020 compared to $3.32 billion in the fourth quarter of 2019 and $3.15 billion in the year ago quarter. Turning to Page 16. We have a bit more detail on the impacts to margin on a linked-quarter basis.

The primary factor in our margin change was the yield on average earning assets, which fell 14 basis points driven primarily by changes in yields on our commercial portfolio. That portfolio is 49% variable with a reset frequency of one month for the majority of the variable rate notes.

The decline in asset yields was partially offset by improved funding costs as we responded quickly to the rate declines in the first quarter. Moving on to Page 17, non-interest income totaled $11 million in the first quarter of 2020 as compared to $10 million in the year ago quarter and $15.6 million in the fourth quarter of 2019.

The comparative quarterly changes were driven primarily by mortgage banking-related activity, namely change in net gains on mortgage loans and mortgage loan servicing income. First quarter 2020 net gains on mortgage loans increased to $8.8 million compared to $3.6 million in the year ago quarter and $6.4 million in the fourth quarter of 2020.

The increase in these gains was due to increases in mortgage loan sales volume, the mortgage loan pipeline and our profit margin. Mortgage loan application volume continues to be very strong with lower rates driving significant refinancing activity.

The application mix in the first quarter was 32% purchase and 68% refinance compared to all of 2019 where our mix was 70% purchase and 30% refinance. Brad already discussed the changes in the fair value due to price of capitalized mortgage loan servicing rights.

Our capitalized mortgage loan servicing rights asset of $14.8 million at March 31, 2020, represented a value of just 55 basis points on our $2.68 billion of mortgage loan servicing.

As detailed on Page 18, our non-interest expenses totaled $28.7 million in the first quarter of 2020 as compared to $28 million in the year ago quarter and $29.3 million in the fourth quarter of 2019. First quarter non-interest expenses were just above the high end of our projected range of $27.5 to $28.5 million.

Similar to the rest of the industry, as we have expanded our suite of electronic banking products, we have experienced lower transaction counts across our branch network. As we analyze the change in branch traffic, deposit growth and the needs of the communities we serve, we made the decision to consolidate eight branches.

As a community bank, it was important to us to make sure we consider the needs of our customers to still have physical access to a branch if they needed it.

In all cases, we have alternative branches very close to the closing facility with an average distance to the nearest alternative branch of less than five miles, while the furthest alternative branch is just over eight miles away.

The cost savings are anticipated to be in excess of $1.3 million annually and onetime closing costs are anticipated to be approximately $800,000, with the majority of those expenses being realized in the second or third quarter.

Moving forward, we will continue to be focused on expenses as opportunities exist to gain additional efficiencies as we optimize our delivery channels and focus on improving internal processes. Page 19 provides data on non-performing loans, other real estate early stage delinquencies and non-performing assets.

Total non-performing assets were $18.3 million or 0.5% of total assets at March 31, 2020. Non-performing loans increased by $7.2 million during the first quarter of 2020 driven primarily by the impact of one specific commercial loan relationship. This was a watch credit at year-end.

The migration from watch to non-performing was not directly related to COVID-19, and we believe that we have booked sufficient specific reserves related to this credit. Post quarter end, we did receive full pay off on a retail relationship in non-accrual status of $1.2 million.

At March 31, 2020, 30 to 89-day commercial loan delinquencies were four basis points, and mortgage and consumer loan delinquencies were 52 basis points. It's clear from the credit statistics at March 31 that we haven't begun to see the credit impact of COVID-19 on our portfolio. We'll discuss our approach to provision and ALLL shortly.

Page 20 provides some additional asset quality data, including information on new loan defaults and unclassified assets. New loan defaults are $9.5 million year-to-date during 2020 driven primarily by the commercial loan relationship mentioned earlier.

Page 21 provides information on our TDR portfolio that totaled $50.5 million at March 31, 2020, a decrease of $200,000 during the first quarter. This portfolio continues to perform very well with 95.3% of these loans performing and 93.2% of these loans being current at March 31, 2020. Moving on to Page 22.

We reported a provision for loan losses of $6.7 million in the first quarter of 2020 compared to $664,000 a year ago and a credit provision for loan losses of $221,000 in the fourth quarter of 2019. In addition, we reported net loan charge-offs of $374,000 and $298,000 in the first quarters of 2020 and 2019, respectively.

The allowance for loan losses totaled $32.5 million or 1.2% of portfolio loans at March 31, 2020. Both the provision and the allowance for loan losses were calculated using our incurred loss model.

Page 23 discusses our decision to stay with incurred and to delay our adoption of CECL until the end of the national emergency or 12/31/2020, whichever is earlier.

Our decision was driven primarily based on the lack of visibility into the impact of COVID-19 stay-at-home executive orders, increased employment unemployment eligibility and supplemental unemployment benefits on the economy. Our CECL discounted cash flow model relies heavily upon a 2-year unemployment forecast.

And currently, there's a wide range between the forecasts that have been published by various economic sources. In addition, the relationship between unemployment and its impact on credit is uncertain at this point.

Unlike past economic cycles, in this event, unemployment has been driven by stay-at-home executive orders, unemployment benefits have been increased and the pool recipients broadened.

This page discloses information about both our incurred model and the assumptions that impact our allowance for loan loss calculation as well as our CECL model, its structure and the assumptions that would have driven our allowance for credit losses. There's a considerable consistency in the assumptions between our incurred and CECL models.

That said, it's prudent that we share some details of our CECL model so you can better understand our approach. In our CECL model, we're using a discounted cash flow methodology with 14 loan segments. Our regression model uses a two year forecast period with a two year reversion to the long-term mean and unemployment is the primary driver.

Given the broad range of unemployment forecast, as mentioned earlier, we chose to use the median national unemployment rates from a collection of 55 analyst forecasts compiled by Bloomberg for our first quarter 2020 CECL calculation.

The median unemployment rates from the survey started at 12.8% in Q2, fall to 8.3% by the end of the year and reached 6% by the end of our projection period then gradually fall to our long-term average of 5.9% over the reversion period. Please look at the chart on the lower left corner of the page for this following discussion.

Under our incurred model, on the left-hand side of the chart, our allowance increased by $6.3 million to $32.5 million as of March 31, 2020. This represented 1.2% of total loans. While there was some significant movement in commercial-related specific reserves, the $4.9 million of growth in the subjective allocation drove the majority of that change.

If we had adopted CECL, our day one adjustment, as previously calculated and disclosed as of December 31, 2019, would have been between $8 million and $10 million.

Using the midpoint of the CECL range, adoption would have increased our allowance at January 1, 2020, by approximately 34.4%, and total allowance for credit losses would have been 1.29% of total loans.

At March 31, 2020, our CECL allowance for credit losses would have been between $42 million and $45 million, implying an additional reserve build under CECL of between $1.5 million to $2.5 million, again, using the midpoint of that range.

In that instance, the CECL ACL would have been 33.9% higher than our incurred allowance, and the total CECL allowance for credit losses would have been $43.5 million or 1.6% of loans. Transitioning to Page 25; I'd like to share a few comments on our outlook update for first quarter of 2020.

Staying with the theme of the day, this is a very difficult page due to the uncertainty surrounding the economic and social toll that the COVID-19 pandemic has created.

I'm sure you'll all understand that we caveat these comments and really the entire presentation with a reminder that these are estimates based on what we know today, and ultimately, all of these outcomes discussed may be greatly impacted depending upon the depth and duration of the COVID-19 event. The first section is loan growth.

While we had modest loan growth of 3.2% annualized, excluding loan securitizations and sales, we can no longer be certain of continued portfolio growth. Excluding loans related to the PPP program, we believe that loan growth will be flat to low single digits.

For net interest income, we were targeting a full year 2020 increase of approximately 1% to 2% over 2019. Obviously, we're in a very different interest rate environment than we were when we initially provided this guidance. Our net interest margin for the first quarter of 2020 was 3.63%.

We would anticipate, excluding again the impact of PPP and given the current interest rate environment, that margin will be relatively stable to a slight decline from our first quarter level for the rest of the year. For provision, our outlook is based on our incurred model instead of CECL.

This line item more than most, will depend on the depth and duration of the COVID-19 event. We'll be watching the economic environment and the portfolio very closely to ensure that we provide appropriate allowance levels. For non-interest income, we estimated a quarterly range of $11 million to $13.5 million. We will keep that range in place for now.

Higher volumes of mortgage loan refinance activity is boosting gains on mortgage loans in the near term, which should offset slowing point of sales volumes on debit cards as stay-at-home orders persist as well as lower-than-expected home purchase activity as economic uncertainty and unemployment potentially weigh on home sales.

This is also caveated by an assumption that we don't experience additional significant changes in the value of MSRs due to price. Net interest expense for the first quarter of 2020 was just outside of the top end of our range at $28.7 million.

We're still comfortable with this original range, and believe that expenses will fall closer to the bottom end of the range due specifically to the branch closures impacting the second half of the year as well as select expense reductions in marketing and travel given the new economic environment that we're in.

Our outlook for income tax remains unchanged. And lastly, we repurchased 678,929 shares of the $1.12 million or 1.12 million share authorization and additional repurchases are on hold at this time. That concludes my remarks for today, and I'd like to turn the call back over to Brad.

Brad?.

Okay. Turning to Page 26. Thanks, Steve. As we began 2020, our team was focused on continuing to execute on the initiatives reflected on this page. We will continue to move forward on these initiatives. In addition, we will continue to work to protect the health and well-being of our employees, our customers and our community.

At this point, we would now like to open up the call for questions..

[Operator Instructions] The first question is from Brendan Nosal of Piper Sandler..

First of all, thank you for all the detail that you provided. It's definitely been more than I've seen from most and was certainly helpful. So just to start off here, curious on the installment portfolios, how do you guys expect that to perform through this cycle? I get that it's a higher FICO book, so it should hold up relatively well.

But at the same time, it feels like if borrowers come under stress, that's probably one of the first areas they look to kind of alleviate their financial situation..

That's a great question. And the team that oversees that area has been in place for many years. And in fact, they go back, many of them to pre-Great Recession. And that book, while it was smaller through the Great Recession, performed very, very well.

Early again, as I said in my prepared remarks, the it's very granular, high FICOs, that's part of the business model with the dealer network that we have. We're really getting looks at only the best paper.

And then really since the COVID-19 came through here, when we look at the forbearance activity, only a very small percentage has been requested so far. So it will be interesting to see if that changes here now as we come to another month end. But for the first month end, we really just had very little forbearance requests come in.

So I feel good about that portfolio, and time will tell..

All right. Great. And then another one for me, just kind of on the reserve going forward. I get that larger provisions are quite potential in the quarters ahead. That makes complete sense to me.

But just as I think about the reserve, I mean, is one way to think about it just to bring the reserve under the incurred loss methodology up toward that CECL level over the next few quarters as all of that forward-looking CECL information in the model kind of actually comes to pass and gets baked into the incurred loss model?.

Yes. I think that's a great way to look at it. In the coming quarters, the gap between the two start to narrow. But I think that's fair..

The next question is from Damon DelMonte of KBW..

First question, just wanted to kind of circle back on the margin commentary.

Steve, could you give a little perspective as to how much of that 150 basis point rate cut has been absorbed by the margin? And what you expect that could still come through here in the second quarter?.

If you look at when rates fell from a timing point of view, much of the commercial portfolio had changed with it's reset midway through March. That being said, there still is, as you probably realize, a bit to go yet with the resetting of those rates.

On the deposit side as well, we see that we have some more potential to get better cost on that side, too. So as we look to this quarter, we may see a little bit of pressure on the asset yield side, but we will also get that additional benefit on the deposit side with the cost of funds.

And so that's why we guided to a very slight decline perhaps, but mostly flat relative to the first quarter. So we have a benefit on both sides coming down the pipeline..

Okay.

And then as we look out a couple of quarters from here, if we assume that this low rate environment continues on, is it fair to assume that asset yield is just going to kind of continue to grind lower and just put modest pressure on the margin as we look out through 2020 and into 2021?.

Yes. Obviously, excluding PPP, but yes, that's the way we're looking at it. It will be a very, very slow grind. We'll have some benefit on the cost of fund side but that'll ease up a little bit. And that's again why we're looking at a few basis points throughout the year going forward as far as potential decline..

Okay, great. And then with regards to the PPP, what are you expecting for total fees to be realized from your origination activity.

And how do you kind of see that being realized over the coming quarters once those loans are forgiven?.

So internally, the analysis we've put together obviously includes some assumptions, right? So as Brad said through this morning, we are at about $250 million of loans. The fees for that are going to be somewhere in the realm of $8 million to $10 million. Those will be accreted over the lifetime of loans.

So what really ends up happening is it depends yield on those will depend ultimately on how soon they're forgiven and how much of the loan portfolio the PPP loan portfolio is forgiven. And so in our internal analysis, we made the assumption that 80% were forgiven within a six month period.

So if we look at the fees on that, we look at the costs on that, and we say 80% are forgiven and repaid within six months, the yield on those loans are somewhere around the 5.25% to 5.5%.

If we look on the other side and say, okay, from one extreme to the other, if all of those loans end up billing to term and last the full two years, the yield will be closer to 2.6%. So it's really difficult to look at it and forecast and say, this is where it's going to end up.

But those are kind of the ranges as we're thinking from our assumptions point of view..

Got it. That's great color. I appreciate that. And then I guess just lastly, just to circle back on the increase in the non-performing loans this quarter, you referenced it was pretty much one credit that drove that $7 million increase, is that correct? Make sure I heard that right..

Yes, Damon. And actually, Jim Mack, who runs our Commercial Banking group is on the call with us today.

And Jim, can give a little bit of insight into that credit, Jim?.

Sure. So it was a movie-theater-related deal that has multiple locations to it. We had a pretty good plan in place to bridge the credit through to the summer season. COVID-19 obviously changed that plan. But we do have hard collateral on multiple locations in with very good facilities.

So long term, we think we have a very good chance of substantial recovery on that loan. And as Steve, I think, mentioned earlier, we do think we're properly reserved at it now..

Got it. Okay. And then just one quick final one.

Did I hear you say that the line utilization on your C&I portfolio went from 41% to 48% this quarter?.

It went from 40% to 44% and it stayed. For quarter-over-quarter, I believe, and that it stayed flat to post quarter end. I think I've got that right..

Yes, yes. I'm sorry. Yes, it went from 44% to 48%. 44% to 48%. And then it stayed flat at 48%..

Stayed flat at 48%?.

Yes..

Okay..

Your next question is from John Rodis of FIG Partners Janney Montgomery Scott LLC..

I guess most of my questions have been asked and answered. But just one on the balance sheet, and maybe this is for you, Steve. Just we saw some buildup in the securities portfolio.

How should we think about the level of that portfolio going forward?.

So if you look at the movements on the balance sheet, we had some fairly significant growth in deposits without corresponding growth on the loan side. So the securities loan or the securities portfolio bulked up a bit.

That is something that excess capacity is being utilized through PPP, will be utilized through, hopefully, some additional loan growth. That being said, it is not something that we're obviously targeting. But at this point, we're kind of in a wait-and-see mode to see what happens on the deposit portfolio.

Don't know at this point what we're going to ultimately see based on both sides of the balance sheet. That level of investments is hopefully going to stay pretty stable then going forward..

The next question is from Russell Gunther of D.A. Davidson..

I wanted to follow-up on comments you guys made early in the presentation and just to make sure I understand it. So the six or seven kind of buckets you rattled off, whether it's manufacturing, accommodation, foodservices, retail, construction, et cetera.

Are those the pockets of the loan portfolio that are kind of most concerning to you within the early innings of this COVID-19 situation and lack of visibility.

And if I'm not understanding that right, perhaps you could just give us your thoughts in terms of maybe stack ranking sort of where that initial perceived risk might be?.

Sure. Yes.

And I'd like Jim to maybe take for a shot at that, Jim?.

Yes. So if you go back to Page 12 maybe in the presentation, one of the things Brad mentioned is we have a very diversified and granular portfolio in total. So that gives me some level of comfort there.

But if we look at the hotel portfolio or the foodservice industry that we have on the chart on the left, those will be high-risk industries today, certainly. And as we dug into those, we really look at how we've structured deals over the last eight or 10 years with lower loan to values, quicker amortizations.

And we also look at the sponsors and guarantors to their liquidity levels to support that. So we feel pretty good about some of these higher risk industries that we have good structures, good loan to values to start out and good guarantor and the sponsor support..

Okay, great. And then just digging into that a little bit, if possible, kind of at quarter end. Are you able to share kind of where the LTV and debt service coverage stands within those portfolios.

Or perhaps even more broadly, just maximum related criteria and then minimum as it relates to debt service?.

Yes. I mean, I don't have it very specifically in each of those categories. Overall, we did take a look at that recently, and I think it was about a 67% overall loan-to-value on our real estate portfolios. Debt service coverage when we underwrite varies by the property type. On the hotels, it would typically be a 1.4 times debt service coverage.

In foodservice and others may be closer to 1.2. And our amortizations that we look at in those industries are 15 to 20 years on the outside, we do not go longer than that.

Does that help?.

Okay, great, it does. Yes, quite a bit. I appreciate it. And then just switching gears for the final question I had.

With regard to the updated loan guidance, could you share kind of where you would expect that loan growth to come from, if, in fact, the low single digits does materialize?.

Well, I think it's like so up to this point, up to this quarter, we had 23 consecutive quarters of loan growth. And generally, through that period of time, it was fairly well balanced. And so I guess I would say at this point, it's probably the same kind of thing, Russell, it would be balanced.

I would say this, we have tightened on the portfolio of mortgage underwriting at this point. And how quickly we ease up on that as things get clearer. I don't know. So but I think it'd be fair in the modeling to just sort of spread it evenly..

This concludes our question-and-answer session. I would like to turn the conference back over to Brad Kessel for closing remarks..

Very good. I would like to thank each of you for your interest in Independent Bank Corporation and for joining us on today's call. We do wish each of you peace and good health, and have a great day..

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect..