Ladies and gentlemen, thank you for standing by, and Welcome to the M&T Bank third quarter 2020 earnings conference call. At this time, all participants have been placed in a listen-only mode, and later we will open the floor for your questions. To ask a question at that time, simply press star and the number one on your telephone keypad. To withdraw your question, please press pound key. If any time you need operator assistance, please press star zero. Thank you. I will now turn the call over to Don MacLeod, Director of Investor Relations. Please go ahead.
Thank you, Marianne. Good morning. I'd like to thank everyone for participating in M&T's third quarter 2020 earnings conference call, both by telephone and through the webcast. If you have not read the earnings release we issued this morning, you may access it along with the financial tables and schedules from our website, www.mtb.com, by clicking on the Investor Relations link and then on the Events and Presentations link. Before we start, I'd like to mention that comments made during this call might contain forward-looking statements relating to the banking industry and to M&T Bank Corporation.
Actual results could differ from what is described in those forward-looking statements. M&T encourages participants to refer to our SEC filings on Forms 8-K, 10-K, and 10-Q, including the Form 8-K filed today in connection with our earnings release for a complete discussion of forward-looking statements and risk factors. I'd like to introduce our Chief Financial Officer, Darren King.
Thanks, Don, and good morning, everyone. As noted in this morning's press release, we were pleased with the improving level of economic activity our markets experienced in the third quarter, particularly in terms of consumer and business spending. Specifically, we saw strong debit and credit card usage both by consumers and business, which also manifested in an increase in merchant volumes. The mortgage market was robust in the third quarter, where we witnessed an uptick in both residential origination volumes and margins. Our trust business experienced the increase in money fund fee waivers we had been anticipating, but those were offset by strong equity and debt markets during the quarter. Expense trends were in line with our expectations as we continue to exercise diligence in a particularly difficult revenue environment.
Also encouraging are the trends for commercial customers granted some form of COVID-19 forbearance and for which have reached its endpoint. Approximately 10% have asked for additional relief. The common equity Tier 1 ratio improved by 31 basis points to 9.81%. At the same time, the allowance for loan losses grew to 1.79% of loans, positioning M&T to meet the needs of our customers and communities. Let's review our results for the quarter. Diluted GAAP earnings per common share were $2.75 for the third quarter of 2020, compared with $1.74 in the second quarter of 2020 and $3.47 in the third quarter of 2019. Net income for the quarter was $372 million, compared with $241 million in the linked quarter and $480 million in the year-ago quarter.
On a GAAP basis, M&T's third quarter results produced an annualized rate of return on average assets of 1.06% and an annualized return on average common equity of 9.53%. This compares with rates of 0.71% and 6.13%, respectively, in the previous quarter. Included in GAAP results in the recent quarter were after-tax expenses from the amortization of intangible assets amounting to $3 million, or $0.02 per common share, little change from the prior quarter. Consistent with our long-term practice, M&T provides supplemental reporting of its results on a net operating or tangible basis from which we have only ever excluded the after-tax effect of amortization of intangible assets, as well as any gains or expenses associated with mergers and acquisitions when they occur.
M&T's net operating income for the third quarter, which excludes intangible amortization, was $375 million, compared with $244 million in the linked quarter and $484 million in last year's third quarter. Diluted net operating earnings per common share were $2.77 for the recent quarter, compared with $1.76 in 2020 second quarter and $3.50 in the third quarter of 2019. Net operating income yielded annualized rates of return on average tangible assets and average tangible common shareholders' equity of 1.1% and 13.94% for the recent quarter. The comparable returns were 0.74% and 9.04% in the second quarter of 2020. In accordance with the SEC's guidelines, this morning's press release contains a tabular reconciliation of GAAP and non-GAAP results, including tangible assets and equity. Turning to the balance sheet and income statement.
Taxable equivalent net interest income was $947 million in the third quarter of 2020, marking a decline of $14 million, or 1% from the linked quarter. That decrease primarily reflects the impact on loan yields from the 20 basis point decline in average one-month LIBOR compared to the second quarter. Higher premium amortization on residential mortgage loans and mortgage-backed securities was also a factor. The net interest margin declined by 18 basis points to 2.95% compared 3.13% in the linked quarter. Average interest earning assets increased by $4 billion to $128 billion for the third quarter, primarily reflecting a $4.4 billion increase in funds invested with either the Federal Reserve Bank of New York or into resale agreements. Those investments were funded by a similar increase in deposits, approximately evenly divided between interest and non-interest bearing DDA.
The increase in cash equivalent investments caused an estimated 10 basis points of pressure on the net interest margin while having little effect on net interest income. The lower interest rate environment, primarily the lower average rate on one-month LIBOR that I mentioned previously, contributed to approximately four basis points of the margin decline. The net impact of lower loan yields was somewhat mitigated by a six basis point decrease in the cost of interest-bearing deposits. The accelerated premium amortization on both residential mortgage loans and on mortgage-backed securities contributed some three basis points of margin pressure. All other factors contributed to an additional one basis point of the decline.
For context, since the fourth quarter of 2019, the combination of short-term liquidity investments primarily placed at the Fed and investment securities has increased by $9.1 billion, reducing the net interest margin by approximately 25 basis points while incrementally benefiting net interest income. Average total loans increased by $413 million or a little less than one-half percent compared with the previous quarter. Looking at loans by category on an average basis compared with the linked quarter, commercial and industrial loans declined by $1.4 billion or 5%, primarily the results of a $1.2 billion decline in vehicle dealer floor plan loans. That reflects the usual seasonal softness, as well as the delays some dealers are having in replacing inventory being sold. PPP loans were effectively unchanged from the end of the second quarter at $6.5 billion. Commercial real estate loans grew by less than 1% compared with the second quarter.
Residential real estate loans increased by just under $1 billion or 6%, reflecting loans purchased from Ginnie Mae servicing pools pending resolution, partially offset by repayments. Consumer loans were up by 4%, reflecting higher indirect recreation finance loans, partially offset by lower auto loans and home equity lines of credit. Average core customer deposits, which exclude deposits received at M&T's Cayman Islands office and CDs over $250,000, grew by $4 billion, primarily in interest and non-interest checking, or about 4% compared with the second quarter. Turning to non-interest income. Non-interest income totaled $521 million in the third quarter, compared with $487 million in the prior quarter. The recent quarter included $3 million of valuation gains on equity securities, largely on our remaining holdings of GSE preferred stock, while the second quarter included $7 million of such gains.
Mortgage banking revenues were $153 million in the recent quarter, improving from $145 million in the linked quarter. Residential mortgage loans originated for sale were $1.2 billion in the quarter, up 7% from $1.1 billion in the second quarter. Total residential mortgage banking revenues, including origination and servicing activities, were $119 million in the third quarter, improved from $111 million in the prior quarter. The increase reflects the higher volume of loans originated for sale, combined with strong gain on sale margins. Residential servicing revenues declined very slightly. Commercial mortgage banking revenues totaled $34 million, encompassing both originations and servicing, and which was little changed from the second quarter. Trust income was $150 million in the recent quarter, down slightly from $152 million in the previous quarter. Recall that second quarter figures included $5 million of seasonal tax preparation fees.
Aside from that, business remained solid with slightly higher money market fund fee waivers offset by continued strong debt capital markets activity. Service charges on deposit accounts were $91 million, improved sharply from $77 million in the second quarter. The improvement comes primarily from some of the COVID-19 impacted categories on the consumer side, the result of higher levels of spending compared with the prior quarter. Similarly, the $20 million improvement in other revenues from operations compared with the linked quarter reflects a rebound in COVID-19 impacted payments revenues that are not included in service charges such as credit card interchange and merchant discount, with a slight improvement in loan-related fees, including syndications. Turning to expenses.
Operating expenses for the third quarter, which exclude the amortization of intangible assets, were $823 million compared with $803 million in the second quarter. The $20 million linked quarter increase in salaries and benefits reflect the impact of one additional workday during the quarter and higher compensation tied to the uptick in both mortgage banking and trust-related activity compared with the prior quarter. Recall that other costs of operations for each of the first and second quarters included a $10 million addition to the valuation allowance on our capitalized mortgage servicing rights.
There was neither an addition nor release from the valuation allowance during the third quarter. The efficiency ratio, which excludes intangible amortization from the numerator and securities gains or losses from the denominator, was 56.2% in the recent quarter, compared with 55.7% in the second quarter and 56.0% in the third quarter of 2019. Next, let's turn to credit.
Net charge-offs for the recent quarter amounted to $30 million. Annualized net charge-offs as a percentage of total loans were 12 basis points for the third quarter, compared with 29 basis points in the second quarter. The provision for loan losses in the third quarter amounted to $150 million, exceeding net charge-offs by $120 million, and increasing the allowance for credit losses to $1.8 billion, or 1.79% of loans. The allowance at the end of the third quarter reflects an updated macroeconomic scenario that is different and modestly less severe than those used at the end of the first and second quarters, which modeled the uncertainty of the COVID-19 driven damage to the economy.
The allowance and the related provision in the recent quarter reflect the ongoing impacts of the COVID-19 pandemic on economic activity in the hospitality and retail sectors, the uncertainty over additional economic stimulus, and the ultimate collectibility of commercial real estate loans where borrowers are requesting repayment forbearance. Our current macroeconomic forecast uses a number of economic variables, with the largest drivers being the unemployment rate and GDP. Our forecast assumes the quarterly unemployment rate increases to 9% in the fourth quarter of this year, followed by a sustained high single-digit unemployment rate through 2022. The forecast assumes GDP contracts 5.1% during 2020 and recovers to pre-recession peak levels by the third quarter of 2022. Our forecast assumes no additional government stimulus. Non-accrual loans as of September 30 amounted to $1.2 billion, an increase of $83 million from the end of June.
At the end of the quarter, non-accrual loans as a percentage of loans was 1.26%. It is important to keep in mind that some of the usual credit metrics have been affected by the PPP loans on the balance sheet, which are zero risk-weighted and carry little or no credit risk. Excluding the impact of PPP loans, the ratio of the allowance for credit losses to loans would be 1.91%. Similarly, the ratio of non-accrual loans to total loans would be 1.35%, and annualized net charge-offs as a percentage of total loans would be 13 basis points. Loans 90 days past due, on which we continue to accrue interest, were $527 million at the end of the recent quarter. Of these loans, $505 million or 96% were guaranteed by government-related entities.
Government-guaranteed loans under COVID forbearance in which we have purchased from servicing pools are generally not reflected in these figures. Consistent with regulatory and CARES Act provisions, loans that have received some sort of forbearance, whether payment deferrals, covenant modifications, or other form of relief as a result of COVID-19 related stress, for the most part, are not yet reflected in our non-accrual or delinquency numbers. A significant majority of commercial loans that were granted COVID-19 payment relief were for 90 days, with the ability for clients to request a second 90 days. For example, substantially all of the $4.2 billion of forbearance as of June 30th given to vehicle dealers was for 90 days, and less than $100 million are under some form of forbearance relief at the end of the third quarter.
For the total commercial and industrial portfolio, including the aforementioned dealer portfolio, loans under COVID-19 forbearance have declined by 85% to slightly higher than $800 million, or about 3% as of September 30th. Customers in the commercial real estate portfolio generally received 180-day COVID-19 deferrals. In total, deferrals in the CRE portfolio have declined by 41% to $5.1 billion. Over two-thirds of the loans on active forbearance as of September 30th that have not reached their endpoint relate to the CRE portfolio segments most impacted by COVID-19, notably hotels and retail CRE. We'll know more over the next 60 days or so as the 180-day deferrals reach their end of term. For the consumer portfolios, deferrals declined from just under $700 million at June 30th to under $150 million, or less than 1% at the end of September.
For residential mortgage loans we own, non-government guaranteed loans under deferral amount to $1.6 billion, down about 19% from the second quarter. Total deferrals have increased to $3.3 billion from $2.3 billion 90 days ago. All of that increase reflects government-guaranteed loans purchased from servicing pools that represent no credit risk to M&T. All of these figures do not include approximately $10 billion of forbearance on residential mortgage loans we service for others. Turning to capital. M&T's Common Equity Tier 1 capital ratio was an estimated 9.81% as of September 30th, compared to 9.5% at the end of the second quarter. This reflects the impact of earnings in excess of dividends paid and slightly lower risk-weighted assets. M&T did not repurchase shares during the third quarter and will not be doing so in the fourth quarter.
M&T's net income comfortably exceeded its common stock dividend both for the quarter and under the trailing four-quarter calculation outlined by the Federal Reserve. Turning to the outlook. Our usual practice is to offer thoughts on the coming year in a January earnings call after we've completed our planning process. My remarks today will be somewhat brief. We're all pleased to see that the economy has improved while recognizing that we're still a long way from conditions we saw in January and February. Core commercial loan growth, excluding PPP loans, has slowed, and we expect those balances to remain flat to slightly down over the remainder of 2020 compared to where we ended the quarter. Given that the auto manufacturers are still not running at normal levels, we don't expect the normal seasonal rebound in dealer floor plan loans during the fourth quarter.
Our portal for receiving forgiveness requests of PPP loans is open, and applications are being processed and sent on to the SBA. Most of the activity so far is on the smaller loans on which the SBA is expediting relief. The residential mortgage loans we purchased from servicing pools aren't fully reflected in the third-quarter average. Combined with the potential for further buyouts, we should see modest growth in average residential mortgage loans for the current quarter. All in, we expect modest linked-quarter growth in total loans. More difficult to forecast has been our liquidity assets or short-term investments and the deposits with the Fed, which continued to rise over the past quarter, although at a much slower pace. As I noted earlier, this was primarily the result of further deposit inflows. Although uncertain at present, we may be approaching the peak and may see declines in the current quarter.
As those deposits and associated short-term investments decline, we'd expect that the net interest margin would benefit by about 2-3 basis points per billion-dollar decline, with limited impact on net interest income. With LIBOR having reached a steady state and our expectation for additional modest downward trends in deposit costs, we expect net interest income to be slightly higher in the final quarter of 2020. If a significant balance of PPP loans are forgiven, the accelerated recognition of the PPP loan fees would be a further benefit. We've previously mentioned that the size of the active cash flow hedge position on our floating-rate loan portfolio will step up during this quarter. To be more specific, the $13.4 billion notional amount of active cash flow hedges will step up to $17.4 billion this quarter and then remain at those levels for about one year.
The benefit to net interest income is less substantive as the older swaps with higher fixed receive rates mature and forward-starting swaps with lower receive rates become active. Turning to fees. Residential mortgage applications continue to be strong with rates as low as they are. We expect continued solid origination volumes this quarter, but likely with some pressure on margin. For trust income, we have seen the increase in waivers of money market mutual fund management be somewhat offset by strong debt capital markets activity. We expect those waivers will reach a steady state shortly and will persist while the zero rate environment endures. Service charge income was boosted by higher levels of customer activity, notably in payments. With some volumes at or even better than pre-COVID levels, further upside from the current levels appears unlikely. We have no change to our expense guidance for the remainder of 2020.
We continue to expect expenses for the second half of the year to be in line with the first half, excluding the seasonal factors in this year's first quarter. Any additional loan loss provisioning will be determined by changes to the macroeconomic variables that we see at the end of the year and by the portfolio composition. Lastly, turning to capital. We are continuing to build capital levels as limited loan growth and profits in excess of the dividend bolster our capital ratios. Consistent with the guidance from our regulators, we won't repurchase stock or recommend that the board consider a change to the dividend during the fourth quarter.
Of course, as you're aware, our projections are subject to a number of uncertainties and various assumptions regarding national and regional economic growth, changes in interest rates, political events, and other macroeconomic factors, which may differ materially from what actually unfolds in the future. Now let's open the call up to questions, before which Maria will briefly review the instructions.
Thank you. The floor is now open for your questions. If you wish to ask a question at this time, simply press star then the number one on your telephone keypad. In the interest of time, we do ask that you please limit yourself to one question. You may reenter the queue for any follow-up questions. Our first question comes from the line of John Pancari of Evercore ISI.
Morning.
Morning, John.
On the credit side, wondered if you could give us a little bit more color behind the rationale for the reserve build in the quarter. I know you mentioned some of the ongoing uncertainty in the backdrop and around stimulus. Just curious, was there an overlay that you applied or are you seeing something specific there to justify the addition? Thanks.
Yeah, sure, John. I guess if you break down some of the components, the big driver obviously is the macroeconomic variables that you run through the model. While they were modestly better, the out quarters really haven't changed much from what we were looking at in the third quarter. Those really drive the magnitude of the allowance at its core. There was really no change there. When you look underneath, you see some growth in certain segments of the portfolio. Growth in the consumer book and some growth in CRE. Much of the addition was for that. The other just reflects the uncertainty, I guess is the way to put it, or some conservatism in the forbearance portfolio and what that ultimately might look like.
Okay. All right. That's helpful. Thanks. Separately on the credit front, can you give us an update on the performance trends that you're seeing in your commercial real estate portfolio from a credit perspective? How are you seeing your borrowers impacted amid the backdrop, and are you seeing some stress there in terms of credit performance? Thanks.
I guess, looking at the commercial real estate portfolio, the ones that we are most focused on right now, the segments we're most focused on are the hotel segment and the retail segment. Those are ones where there has been a significant amount of forbearance in those portfolios. For the most part, those portfolios received 180-day forbearance. They will start to show themselves over the next 90 days. The hotel business continues to be challenged, particularly in some of the larger cities, where you have a hotel that maybe relies on conferences or food and beverage as part of their business. Those ones are probably the most challenged. When you get into other segments of the hotel portfolio where you're able to get there by car and able to drive up, we've seen some return of revenue.
Not all the way back, obviously, to where things were, but able to cash flow. We're watching those portfolios as we go through this quarter. We're pleased by the reaction we've seen from the customers so far and their ability to manage their expenses down, to try and keep their cash flow at least as close to breakeven as possible. We continue to feel very positive about the loan to values in the portfolio, and that in particular in New York City, which I know gets a lot of attention. I think the average loan to value is less than 50%. When I look at in New York City, we have about $42 million of loans outstanding, which are two loans that are between 60% and 70% LTV, and five loans and $152 million between 50% and 60%.
Then the vast majority is less than 50% LTV. So when you look at those properties and the values, there's a lot invested by the client already in those properties, and they have a real strong incentive to figure out how to maintain it. On the retail side, it's a similar space. I think retail has been a bit of a challenged industry, much before COVID hit and that watching things go online, we were seeing challenges on pricing and rents, and COVID just accelerated that. Again, when we look at our portfolio and the distribution of the LTVs, again, skews very low, and in particular in New York City skews also below 50%.
When we look at some of our larger relationships, they have some LTVs where they're multi-generational ownership of properties, and their cost basis in some cases is down in the 25% of current values. The tax basis that they have is very low. They also have a very vested interest in protecting those properties. It's long-winded way of saying there's certainly stress out there. The clients have been active in adjusting their operations to the environment. Many of them have outside resources and liquidity to help carry the properties while things try and come back to normal. We'll know a little bit more in 90 days. We're very pleased by the actions that our clients have taken so far to protect their investments.
Our next question comes from the line of Steven Alexopoulos of JP Morgan.
Hey, good morning, Darren.
Morning, Steven.
The loans that you purchased out of the Ginnie Mae pools, what's the yield on those? Are you likely to purchase again at a similar level in 4Q?
Yeah. In round numbers, the yield on those Ginnies is about 4%. Each one will be slightly different, but it's right around there, ±5 basis points. It's something that we will continue to do, just because it makes economic sense to take some of these loans that are being serviced and buy them out so that we only have the carry cost, and we don't have to advance the principal and interest to the investors.
I think what you saw in this quarter was a larger than what would be normal uptick in those balances because there was some residual hangover from the second quarter where there hadn't been active buyouts happening. The run rate is probably more in like the $250 million-$300 million a month range, give or take. There was just a larger uptick this quarter because that hadn't happened very much in the second quarter.
Okay. That's helpful. I think you also said the purchases were late in the quarter, so we'll see the benefit flow through into 4Q from this quarter?
Yeah. It continued through the quarter. There'll be a little bit of an uptick in the fourth quarter. Not as big as what we saw this quarter.
Okay. All right. Thanks for taking my question.
Sure.
Our next question comes from the line of Erika Najarian of Bank of America.
Hi, good morning, Darren.
Morning, Erika.
My one question is on the contribution from the swap portfolio. I heard you loud and clear in terms of the notional stepping up to $17 billion. I'm wondering if you could give us a sense on what the distribution was to net interest income from your derivative book in the third quarter, and how that progresses either on an annual or quarterly basis, however you want to give it, in 2021.
Sure. I think we talked last quarter about the hedging adding about 26 basis points to the net interest margin for the quarter. Was up slightly in the third quarter to about 30. What you'll see going forward, as we mentioned earlier, as the notional goes up, but the coupon, the received fix comes down, the impact's about the same. We think in the fourth quarter and the first quarter of next year. Over time, as the swaps that become active have a lower coupon, the benefit will start to trickle down as we go through 2021. Probably a good assumption would be after you get through the second quarter, three basis points a quarter decrease in the benefit of the hedge based on our forecast of what the balance sheet looks like.
Got it. Thank you.
Our next question comes from the line of Matt O'Connor of Deutsche Bank.
Good morning. I want to follow up on expenses. The cost controls have been very good this year. The guidance for 4Q is in line with what you said three months ago. How sustainable is the expense management? Is it kind of just a one-time pulling in on some things that isn't all that sustainable? Is it kind of some structural changes or a combination of two of them?
Yeah, Matt. It's a good question. I guess some of the things that I think are sustainable that you really see illuminated in the third quarter results is if you look at the salaries and benefits and you compare them to where they were in the third quarter of last year, you can see they're basically flat. They're up, I think, about $2 million. If you look at the other cost of operations, which is where the professional services shows up, you can see the drop there. Now, some of the drop obviously is because there was impairment that we took in the third quarter of last year that didn't repeat itself this year. Outside of that, we've seen a decrease in the professional services line.
We've been talking for a number of quarters about the path we've been on to build technology skills and insource those, which would impact the salary and benefit line. It took a while for the professional services to come out. You've seen that remixing. We've got a little bit more to do. I think there's some evidence that is working. We can continue to do that, which I would say is more structural. A couple of the other big items obviously are travel and entertainment and advertising and promotion. I think what we're seeing in the advertising and promotion line item is that obviously, you need to be competitive in the markets that you're advertising in. Also, we're learning that there's different ways that you can reach customers and prospects that might be more cost-effective than traditional means.
We'll be continuing to look at that as we go forward and being smarter about that, and also thinking a lot harder about how much travel we need both internally, for sure, and then oftentimes with clients. I don't think you can get away from face-to-face interactions in banking, but maybe we don't need quite as much as we've had in the past. We're looking at how we're doing our business. I think the last thing you see is through the PPP process. We were able to handle such a massive amount of loan volume in a short period of time. We literally did about three years' worth of SBA loans in a week, and we did that through changing the process and using more digitization.
We think that there's opportunity to take that thought process beyond just business loans into other lending and deposit opening and other operations to drive expenses down. I guess long story short, I think there's been some things that were gifts, so to speak, from the pandemic. It's also really got us to rethink and continue on the path of rethinking how we do the work. That offers continuous improvement. I don't know that there's a step change down, but we continue to chisel away, and I think that allows us to slow expense growth, and to get close to positive operating leverage. To me, to be in this environment where we've had challenges in revenue, and the efficiency ratio this quarter was the same as last year, I think just speaks to the ability of the team to be disciplined on expenses, which is kind of classic M&T.
That's helpful. I'm going to guess you don't want to give explicit 2021 guidance on cost, but you just said, no step down, but also kind of described an implication that there wouldn't be a step up as well. If I had to guess, I would think it seems like you're trying to keep costs relatively flat by parsing some of the comments together there.
I think that's a safe assumption. Well, like I said, we'll be back with more detail in January, but that's certainly a safe assumption.
Okay. Thank you.
Our next question comes from the line of Ken Usdin of Jefferies.
Hey, thanks. Good morning. Hey, Darren.
Hey, Ken.
How are you? Can I ask you further on the trust income? You said that the fee waivers would be run rated I think going forward. Can you just help us understand what was in the third and what the step up, if any, is going to be into the fourth?
I think we talked before about maybe $10 million a quarter impact from those fee waivers. I think this quarter we saw about $7 million. It was offset by an uptick in some of the loan agency fees that we get because you've been watching the debt markets. I think they hit a record for issuance at the end of September, and they still had three months to go. That activity, our participation in that market you saw reflected in some of the agency fees that show up in that trust income line. It masked the impact of those fee waivers on the money fund accounts.
We continue to have strong equity markets, and that's impacting AUM positively, maybe a little bit better than we might have thought going into the quarter. That also was a positive that was an offset. The money fund waivers that we had talked about are basically in there. There might be a little bit more to go. The question will be what happens with some of those other parts of the trust business and how robust those markets are as we go through the fourth quarter.
Understood. Thank you. Just a follow up on mortgage. Can you give a little bit more discussion of just the differences between resi and commercial origination activity? Also, are you still seeing opportunities to buy additional servicing assets as you guys have been pretty frequent opportunistic buyers there? Thanks.
I guess most of the action for the last couple of quarters has really been in the consumer space, and it's just with rates where they are. There's a lot of refi activity going on. That's really what's been driving the volume there. What I think has been seen for the last two quarters, both for us and for the industry, is that there was so much volume it overwhelmed people's capacity to handle it. One of the ways the industry manages capacity is through pricing. That's why the margins were so strong this quarter and last. What we expect to see in the fourth quarter is we expect to see similar levels of volume, maybe seasonally slower just because of the fourth quarter. We'll start to see the margins come down.
We started to see that at the end of the last quarter that the gain on sale margin in September was down from what it was in July and August. We expect that trend to continue into the fourth quarter, and that's why we think we'll see a drop in the mortgage fee line item. In commercial, things have been slow really since COVID hit. There's just not a lot of activity in the commercial real estate space. Third quarter, I think for the last couple of years, has been a blowout quarter for us in the commercial real estate sector. This year was the notable exception, and we don't see that changing into the fourth quarter. It's just a slowdown in activity there.
Okay, thanks a lot.
Sure thing.
Our next question comes from the line of Saul Martinez of UBS.
Hey, guys. I wanted to parse through some of the moving parts on that interest income. I think in a response to Erika's question, you mentioned, Darren, that the protection from the hedges were about 30 basis points, which by my calculations amount to roughly $95 million. Just to clarify then, your guidance for NII in the fourth quarter, that assumes that that level of protection more or less stays flat, i.e., there's no incremental benefit, and you're also assuming no PPP forgiveness in that outlook. Is that correct?
That's right.
Okay. Just following up there. You kind of painted a picture on the outlook into 2021 for the benefits sort of trickling down gradually, especially in the latter part of the year. Your disclosures show that I think the average weighted average maturity is about 1.3 years on the swap book, or it was that in the second quarter. Which would seem to imply that there would be some more material step down in protection at some point between now and, say, year-end 2022. I guess, how should we read that and think about that? Is there going to be more of a cliff effect on the hedge protection that you get late next year into 2022? Just maybe a little bit more color in terms of how that evolves, not just during the course of 2021, but looking out over the life of those hedges.
Yeah. I guess, when you think about the hedging that we did and the way we constructed the portfolio, we were always adding a consistent level, with the exception, obviously, of this next 12 months of forward starting swaps. The idea was to keep the outstanding notional amount fairly consistent through time. Really what starts to happen is each month, one swap falls off and a new one starts, and it would be reflective of the rate environment at the time at which we entered into that agreement.
Yep.
We're in the spot now where we were entering these agreements and the curve was positively sloping and rates were higher. Over time, you saw those received fixed coupons come down. There's not really a cliff per se, but more a continual gradual decline. As each month some swaps go inactive and forward starting ones become active. That brings the average received fixed coupon that's in place in any month declining through 2021 and into 2022.
As the duration of the swap portfolio will shorten because as rates really fell down at the end of 2019 and then at the start of 2020, there wasn't a benefit that we saw in continuing to add forward starting swaps to lock in rates at 50 or 25 basis points. That we continue to believe that zero is, for all intents and purposes, the practical floor right now, and that negative rates are not a huge consideration of the Fed. We've slowed down in the hedging, and you'll see that it gradually goes away through the next 24 months.
Just a point of clarification. The weighted average maturity is not from the reporting date, but from the start date of the forward starting swap to the end of the forward starting swap.
Okay. It's not 1.3 years necessarily.
From now.
Yeah. From now. Okay. It's from when all the forward starting swaps come on board. Okay. I guess, let me just pivot quickly to second question. The CRE book 180 days forbearance, I think you mentioned $5.1 billion and 2/3 of that I guess exiting the initial deferral period. A couple questions there. Do you have any expectations as to what % of that we'll ask for a second modification, and how do you expect to account for additional modification?
Do you anticipate taking advantage of the CARES Act 4013 to not classify it as a TDR? Will you say these loans have been a modification for an extended period, and hence we think they should be treated as TDR even with some of the, I guess, the negative implications for risk-weighted assets and other things? I'm just curious what you're expecting there and how you plan to account for it?
Yeah. I guess a couple things. Obviously it's hard to predict exactly what will happen with each of these portfolios as we go, but I look at what we've seen so far. I mentioned that the C&I portfolio was going to be down to about $800 million of loans still in forbearance. The bulk of that is really folks who haven't reached the end of their current term. When I look at the dealers and the floor plan dealers that were in forbearance, basically 98% of them have gone back to paying.
When I look at the rest of the C&I portfolio, it's about 90% have gone back to paying, and there has been some decrease in the commercial real estate portfolio levels of forbearance. When I look at folks who have come up to the end of their time period so far, about 80% of them have gone back onto their normal payment schedule.
From what we've seen so far, about 20% have gone back or have asked for some extension of their forbearance. When we get to the next group that will come up, I think it's a tougher segment, and so I'm not sure I'm bold enough to say it'll be 20%. The trends that we've seen are positive, and we know that there are a number of clients that we've talked to that do actually plan to resume payments because they have outside liquidity and the wherewithal to go back and maintaining their loans. As it relates to how they'll be handled, each loan and each client will be treated individually and considered individually. We'll look at, first of all, are they looking for some kind of change to their terms? If they are we getting anything back?
We might be able to get an interest reserve. We might be able to get a little bit of equity. We might get a different rate. The combination of those things will help us go through our determination of whether we think it qualifies as a TDR or needs to go on non-accrual. I think it's safe to say that there will be an uptick in those categories as we go into the fourth quarter and first quarter of next year.
Okay. It'll be treated on an individual basis then. Okay. That's helpful.
Yeah. It goes through our normal portfolio assessment and grading process.
Okay, great. Presumably you reserved for it already under CECL.
We've set aside some for that, yes.
Yeah. Okay, great. Thanks so much.
No problem.
Our next question comes from the line of Bill Carcache of Wolfe Research.
Thanks. Good morning, Darren.
Morning.
While we've seen some improvement in metrics like unemployment and GDP, and the outlook there is helpful, some of the CRE metrics have been going the other way. Can you give us a little bit more color on what your outlook is contemplating for some of those key drivers of CRE credit performance? Some of the industry forecasts have metrics like vacancy rates continuing to rise and commercial real estate prices continuing to decline as we look out to 2021. Now, I understand that shouldn't have an impact on your CECL allowance as long as it contemplates that degradation, but it would be helpful to understand a bit better what your expectations are, if possible.
Yeah. I guess one of the most important parts of this is understanding not just what's going on, but how the loan was underwritten to start. When you look at a lot of our real estate portfolio, and I'll speak to multifamily, we take into account the current rents, and we don't assume that there are rent increases when we underwrite. We take into account the current vacancy, but we underwrite to a higher level of vacancy than what exists. Another really important element is just the interest rate, and that as the interest rates drop, that creates a lot of capacity to support these properties. Those factors will also help maintain collateral values. We've seen vacancy tick up. One of the places obviously we watch a lot is in New York City.
We've seen rent collections in the 90%-95% range, feel pretty good about that. There hasn't really been much that's traded in terms of values to think about Commercial Real Estate Price Index, which the CREPI would be an important element in the CECL modeling, we haven't seen much there. Those factors, rent changes we would look at and look at the vacancy rate and the realizable rent as we forecast cash flows for each of these individual borrowers and think through whether or not they're running at a deficit or not, or they're able to adjust their expense base, what outside resources they have to maybe come in and maintain the properties. It'd be a similar viewpoint on the hotel portfolio. Obviously slightly different where you're looking at RevPAR and you're looking at the occupancy rates.
Again, we've seen, and it depends on the geography, some uptick. New York has been a little bit more of a challenge. We see that in office. Also, so far rent collections are holding up and strong and people are going back into the city. At least you're hearing announcements, particularly from the tech sector of space being under contract. I guess a little bit of a long-winded answer to say that when we look at the trends in these portfolios, we're not seeing a severe degradation. It's gradual.
What we've watched so far, we've seen the clients doing a very good job of adjusting their business to be able to manage the cash flow. Where they don't do that, they often have the outside liquidity to be able to maintain the property. I guess the question really is how much liquidity do they have and how long can they sustain it in this environment?
That's really helpful. Thanks, Darren. If I could squeeze in one last one.
Yeah.
Beyond the hedging benefits that you've discussed, can you give a bit more color on the loan and securities portfolio paydowns on your back book, perhaps by product, if possible? What's the yield differential between what's paying down and what you're deploying into today?
I guess, well, I'll take the loan book separate from the securities book. In the securities book, we've basically run it for not a lot of duration risk, and certainly not a lot of credit risk. We describe it as a barbell, where there's been a significant amount invested in one-year Treasuries or less, and then another significant amount in mortgage-backed securities. With the mortgage-backed securities, as they pay down, we haven't been buying additional securities at this point, just given where rates are. Those dollars are basically going into cash. That's part of the cash build. Interesting, when you look at the loan portfolios, what we've seen in the last 90 days, and probably started a little bit earlier, is that the margins on new business have been increasing.
When we look at the returns that are being generated on new loans over the last 120 days, they're higher than what's in the book. Between floors going into loans where the floors are actually active the day the loan starts, and some firming in the pricing, we're actually starting to see roll-on margins higher than roll-off margins in the loan book. It'll take a little while for that to start to shift the whole portfolio. As you get out into 2022 and beyond, you start to see a greater proportion of that benefit in the loan yields and the loan margin. It's encouraging to see where things are heading, at least based on the last 90 days.
Very helpful. Thanks again, Darren.
Our next question comes from the line of Brian Klock of Keefe, Bruyette & Woods.
Good morning, Darren and Don.
Hey, how you doing, Brian?
I'm good. Hey, real quick. On the fee income, you talked about the deposits service charges snapping back nicely in the quarter. When I look at the other revenues from operations, can you give us a little color on what's going on in there? It feels like the overall level is sort of back to pre-COVID if you get rid of the Bayview from the first quarter. I don't know, was there anything in there when you look at BOLI or the merchant discount, any of the insurance revenues? Was there anything in there that you can give us color to that 107 somewhat run ratable into the fourth?
Yeah, sure, Brian. By and large, when you look through the components in that category, we have seen a strong snap back in merchant discount and credit cards. They're pretty much back to pre-COVID levels. BOLI was pretty consistent, as was some of the underwriting. Loan fees were up quarter-over-quarter, but not back to pre-COVID level. Obviously that's a function of what's going on with the activity in the market. Sometimes in that line item, there's some lumpiness of things that happen. We were, I guess on that line item, close to where we average.
I've seen some quarters where it's $1 million higher than what we had before, and last quarter was particularly low. It might be a little bit high from where we might run rate in the fourth quarter. There's still some spots where there's softness in insurance and some softness still on some of the fees. We're not quite all the way back to pre-COVID levels on loan fees and merchant card.
Got it. Just quick follow-up. Same question on the other side, the other miscellaneous costs. Looks like they were down a little bit lower than the run rate over the last few quarters. Usually the fourth quarter has the professional services or the accountant accruals and stuff like that that might be in there. Should we expect that one to be kind of back up to sort of average levels versus the $165 that was in the third quarter?
I think that the spot we're at now is probably pretty reasonable for where we are in the fourth quarter. The only other thing that goes through there that creates some lumpiness is if there's been litigation costs or MSR impairment or when we took the write-down on the asset manager that we sold. That goes through that line item. Kind of holding that stuff aside, I think we're give or take a few million bucks in the right zone of where that will be for the fourth quarter.
Got it. Great. Thanks for your time. Appreciate it.
Sure, Brian.
Ladies and gentlemen, we have time for one more question. Our final question will come from the line of Gerard Cassidy of RBC
Hi, Darren.
Morning, Gerard. How you doing?
Good. Thank you for taking the question. To wrap up, can you give us a comment on what you're thinking about for next year on capital action plans? Obviously, the Fed has suspended buybacks for all the banks like your size. What are you guys thinking should the gate get lifted? Second, if it's not lifted until, let's say, the third or fourth quarter of next year and your capital really is starting to accumulate, is a Dutch auction tender offer a consideration to get all the stock at once?
I guess the first part of I'll leave the Dutch auction thing for a second. I haven't really thought much about a Dutch auction, to be honest with you. I appreciate you always got great questions. On deployment of capital, we'll obviously have to wait and see what comes from the Fed through the resubmission process that we're all going through right now, and if the Fed actually allows the SCB framework to be effective. Generally, our thought process on capital deployment really isn't changing, and that the first place we want to deploy capital is in the service of our customers and the communities that we do business in. We've got the liquidity, as you can clearly see on the balance sheet, and we keep deploying the capital so that we're in a position to be able to lend and support growth in the communities.
Hopefully we'll see some of that. As I mentioned before, I really like the returns that I'm seeing on some of the business right now. After that, we'll obviously hope that we're maintaining our income, and so we can maintain the dividend. Then we'll look at what other alternatives we have to deploy the capital. I guess, to me, the most important thing is, we'll try and return it if we've got excess and we're allowed to. Really, the key of how we've always run the bank is to make sure that we don't take the capital that we believe to be excess and consider it free. If we sit on the capital, it's inefficient, and we'd certainly rather not do that.
Investing it in low return businesses or low return loans, then you're stuck in that position, and that lowers your overall returns for the organization. You're stuck with that for the length of that asset. We do that from time to time to win new prospects and customers. We wouldn't want to make a practice out of deploying capital into low return businesses. We'll see what the alternatives are. We'll continue to manage it the way we always have, which is to be thoughtful stewards of capital and make sure we're focused on returns.
Just as a follow-up question. Clearly, you and your peers have indicated that many of your customers have built up their liquidity in their deposit accounts because of these uncertain times. Can you compare this to the 2008, 2009 time period? We had the same phenomenon of customers building up liquidity. How long did it take, do you recall, to have those customers bring those deposits down to a more normal level? What do you see for this cycle? Is it going to be as long as it was after 2008, 2009?
Well, my crystal ball is as good as yours, Gerard. I guess I look at the level of liquidity that we have this time. I think people are smarter this time than they were last time. I think the industry, not the banking industry per se, but the customers we bank have been a lot quicker to build liquidity, have been a lot quicker to adjust their business operations to the revenue environment. That's why we've seen that buildup. I think part of what you're seeing in the liquidity also is the lack of alternatives of places where they can invest their excess cash. Right? It doesn't make a lot of sense to have it in sweep right now if you're a larger middle market client.
It doesn't make sense to keep it in time and money market accounts if you're a small business or a consumer, because there's no rate there. We're seeing it all sit liquid. What I think starts to happen is as things improve, you'll see some of it get deployed in hiring, in building inventory. You'll see some of it get deployed into higher returning asset classes from the customer's perspective to the extent that they've got excess. How long that takes, I think, will be some combination of how quickly we see GDP recover and how quickly we see interest rate movement up from here.
I guess I just keep in mind that last time, it took us until we probably got to 75 or 100 basis points on Fed funds before people started to really move and pay attention to moving dollars out of savings and interest checking and checking into higher yielding types of products. We're thinking it's here for a while, kind of next 12 months. Hopefully not much longer, but we'll see how the economy goes.
Great. Appreciate all the color. Thank you.
I'd like to turn the floor back over to the management for any additional or closing remarks.
Again, thank you all for participating today. As always, if clarification at any of the items on the call or news release is necessary, please contact our investor relations department at area code 716-842-5138. Thank you and goodbye.
Thank you, ladies and gentlemen. This does conclude today's conference call. You may now disconnect.