Earnings Call: Q3 2020

Oct 30, 2020

Good day, and welcome to the South State Corporation Third Quarter Earnings Call. All participants will be in listen only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Will Matthews. Please go ahead. Good morning and welcome to South State's 3rd quarter earnings call. This is Will Matthews and joining me on this call are Robert Hill, John Corbett, Steve Young and Dan Bockhorst. The format for this call will be that we will provide prepared remarks and we will then open it up for questions. Yesterday evening, we issued a press release to announce earnings for Q3 of 2020. We've also posted presentation slides that we will refer to on today's call on our Investor Relations website. Before we begin our remarks, I want to remind you that comments we make may include forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Any such forward looking statements we may make are subject to the Safe Harbor rules. Please review the forward looking disclaimer and Safe Harbor language in the press release and presentation for more information about risks and uncertainties, which may affect us. Now, I will turn the call over to Robert Hill, Executive Chairman. Good morning and thank you for being with us. I'm excited to be with you today and excited for you to hear from John and Will about the progress the team is making in building South State. The Center State South State partnership was about the long term, but you can clearly see the progress being made in the short term. Progress with technology, products, efficiency, all which have us uniquely positioned for the long term. But most importantly, it's about having a great team, which we to have and are continuing to build. Our Board and our management team are united around the opportunities that are ahead of us and our culture is growing in a healthy way that will only make us stronger in years to come. John Corbett's leadership along this journey has been excellent. And I will now turn the call over to John for more insight into the quarter. Thanks, Robert. Good morning, everyone. I hope you and your families are doing well. In light of the challenging environment, I couldn't be happier with the progress our team is making and the financial results that we're producing. It was a solid quarter. Adjusting for merger costs, the company produced diluted earnings per share of $1.58 for a 17% return on tangible equity. Our pre provision net revenue grew to $170,000,000 for a pre provision return on assets of 1.8 percent and tangible book value per share grew at an annualized rate over 15%. The highlight for the quarter was clearly the profitability of our mortgage and correspondent banking units. We heavily invested in these fee based businesses when treasury rates fell after the 2016 Brexit vote. And now 4 years later, these non interest income lines of businesses are producing a healthy return on investment. 2 weeks ago, we announced another investment into our correspondent banking division with the acquisition of a broker dealer based in Memphis, Tennessee. Duncan Williams is a 51 year old family firm led by the son of the founder and it's the perfect complement to the fixed income line of business that we've been building for over a decade. South State currently serves nearly 700 community banks nationwide and Duncan Williams adds an additional 250 financial institutions to our coverage universe. This was a negotiated transaction that Steve Young and Brad Jones have been pursuing for a year and a half and we're very excited to welcome Duncan and his team to South State. While fee income has been remarkably strong, we continue to be faced with industry wide loan growth and margin headwinds as we navigate through the pandemic. The good news is that our loan pipeline bottomed out in August and is steadily rising every week. The pipeline is now 24% higher than the low in August and it continues to grow as our clients become more confident in the future. Asset quality metrics improved considerably during the quarter with loan deferrals declining to just 2% of loans. Of the 2% of loans currently on deferral, half of those are in fact making their interest payments. So really only 1% of loans are at full principal and interest deferral. And this is the 2nd quarter in a row that we recorded only 1 basis point in charge offs. As for the merger integration, it's proceeding on time and on budget. And the encouraging thing to me is that the merger integration isn't slowing our forward momentum in the rest of the bank. I can definitely feel the South State team leaning forward and eager to go on offense to prove what this new franchise is capable of. One area where we continue to improve is the South State digital experience. This month under the leadership of Renee Brooks, we rolled out our new website and next month we roll out a new mobile banking app that has been in the works for over a year. Our team is excited to offer a mobile app that rivals the largest banks in the country for customer functionality and convenience. To pay for these digital investments, we will be downsizing our branch network by 20 branches this quarter, which reduces our branch footprint from 305 branches currently to 285 by year end, which also increases our average deposits per branch to over $100,000,000 and that's up from $40,000,000 a decade ago. We're also excited about the huge opportunities that are presenting themselves to recruit the very best relationship managers from the largest banks in the Southeast. South State now has the scale, technology and capital markets platform to be the logical alternative for middle market bankers looking to make a change away from the turmoil at the largest banks. So when I step back and I think about our positioning and the environment that we're operating in, there are things that we can control and there are things that we cannot control. We can't control the path or duration of the COVID virus and we can't control the shape of the yield curve. What we can control is the $80,000,000 of cost savings to be achieved through our merger and branch consolidation initiatives. We can also control our investments into the future, investments in technology, investments in our mortgage and correspondent banking teams that are not dependent on the interest spread. And finally, we can make investments in top notch relationship managers in the best growth markets in the country. So as I think about where this franchise is headed, I'm confident we're making the right strategic moves to create value for our owners, our team and our communities over the next decade. And finally, along those lines, I'm happy to share the news that South State has created a new executive level position of Director of Corporate Stewardship. LaDon Jones, a 21 year veteran of our company has accepted the invitation to lead our company's diversity initiatives, our college recruiting and management training as well as our ESG community development and employee assistance programs. Everyone at South State is excited for Ladon and his new role and eager to support his leadership as we create a company culture that will be a source of pride for all of us in the years ahead. With that, I will turn the call over to Will to provide more color on the numbers. Thanks, John. Our net interest margin was 3.22 equivalent basis, down 2 basis points from Q2. Given the June merger closing date and associated purchase accounting marks and pre closing securities sales on the legacy CenterState side, the 2nd quarter NIM is not entirely an apples to apples comparison, nor is the combined business basis margin of 3.38% from Q2 as it includes the unmarked Interstate balance sheet and income statement for the 68 days of the Q2 prior to closing. Our margin continues to be negatively impacted by the significant liquidity we're carrying, $4,400,000,000 average for the Q3. If you were to reduce our balance sheet cash and Fed funds sold to 1,000,000,000 reducing deposit funding accordingly, our NIM would be approximately 24 basis points higher. Loan yields of 4.35 were up 10 basis points from Q2, reflecting a full quarter of the CenterState loan portfolio in the company. Accretion was $22,000,000 for the quarter and core NIM excluding loan accretion was $295,000,000 As noted on Page 6 of the release, we had some measurement period adjustments as we finalized purchase accounting marks, including a reduction in the loan discount of $29,000,000 While this improved capital, I'll remind you that it will reduce future accretion accordingly. Our loan repricing mix is 55% fixed, 25% floating and 20% adjustable. Our total cost of deposits continues to improve down to 20 basis points for the quarter. Our CDs are relatively short with 19% coming due in Q4, another 32% in the first half of 'twenty one and 26% in the second half of twenty twenty one. On non interest income, we had a record $115,000,000 quarterly non interest income led by our mortgage and correspondent banking capital markets. Our mortgage team has done a really outstanding job in the midst of a merger of 2 mortgage teams as well as a pandemic with record volume of $1,570,000,000 60 percent of which was purchased and strong margins resulting in $48,000,000 in revenue. Our correspondent banking division continues to show strong results with a $26,000,000 quarter. And on that note, I'd like to echo John's welcome to the Duncan Williams team. We're not disclosing transaction terms due to the size of this acquisition, but we are excited about Duncan and his group joining Brad Jones and his team and helping us grow this business, as well as the help it should provide a very low interest rate environment. Steve has responsibility for these non interest income businesses and is available to answer questions on them during the Q and A session. On expenses, our NIE for the quarter was $237,000,000 including $22,000,000 in merger related expenses for an operating NIE of $215,000,000 Our efficiency ratio was 55.8%, excluding the merger related expenses. Our expenses for the quarter came in a little better than we expected, in part because we have begun to realize some of the merger cost saves thus far a little faster than expected through normal employee turnover and some departure of employees who will not be retained as well as certain vendor savings. We expect that this cost save realization number will continue to increase each quarter with the bulk of the savings coming in 2021, particularly Q3 after system conversion. Additionally, our expenses for a number of items were down in Q3 due to COVID. Business development, loan related and ORE expenses, travel expenses, and to some extent health insurance costs were all down due to COVID, but we would expect many of these to normalize once we are beyond the health crisis. So, the Q3 run rate for several areas is lower than we would expect in a normal non COVID environment. On merger related expenses, we've recognized approximately half of the estimated $205,000,000 to date, some of which occurred on the CenterState side pre closing. Turning to credit, our net charge offs remained very low at $594,000 for the quarter or 1 basis point annualized. Ending NPAs were 33 basis points of assets, down 5 basis points from Q2 due to a combination of payoffs and upgrades. Our provision for credit losses was $29,800,000 for the quarter, $22,100,000 of which was for the reserve for unfunded commitments liability. After running 2 separate legacy bank CECL models and combining the results in Q2, we consolidated onto one model in the Q3 and this consolidation of the legacy South State loans onto a different model resulted in the increase in the reserve for unfunded commitments. For economic assumptions, we used the Moody's baseline forecast. That forecast has the unemployment rate for the South Atlantic region holding at 8.2% for Q3 and Q4 of this year before starting to decrease in 2021 with a forecast of 7.4% at year end 2021 and 5 point 4% at year end 'twenty two. With a provision expense of almost $30,000,000 and net charge offs of less than $1,000,000 dollars our reserve coverage excluding PPP loans grew to 211 basis points, including the reserve for unfunded commitments or 192 basis points just including the reserve for funded loans. This brings the allowance to NPLs to just under 4 times. Slide 8 outlines our loss absorption capacity ratio, which ended the quarter at 258 basis points. As John said, our deferrals reduced significantly since our last update, dropping below 2% at October 23. Additionally, our full P and I deferrals were only 1% at that date as almost half of the deferrals are paying interest. For the effective tax rate, our return to profitability in Q3 after the impact of the double count provision and other merger expenses in Q2 caused our effective tax rate to decline in the 3rd quarter to 19.6% from the 2nd quarter's 22.6%. Turning to capital, with good profitability and a flat though still somewhat inflated balance sheet, our capital ratios grew during the quarter. Our TCE ratio grew 27 basis points ending at 7.83. Our CET1 and total risk based ratios grew by approximately 80 basis points and 100 basis points respectively ending at 11.5% and 13.9%. Our ending tangible book value per share was just shy of $40 at $39.83 up $1.50 from Q2 and up $1.63 from the year ago quarter. I'll turn it back to you, John. All right. As a reminder, we have conducted this call from different locations, so it's going to be helpful if you direct your questions to the person that you'd like to respond. This concludes our prepared remarks and I'd like to ask the operator to open the call for questions. Thank you. We will now begin the question and answer session. Our first question comes from Michael Rose with Raymond James. Please go ahead. I wanted to just circle back to expenses, Will. You guys had obviously some really good revenue generation this quarter and the expense were down. I understand some of it is COVID related. But can you just help us from a run rate perspective as the economy continues to reopen, hopefully, what are some of the specific add backs we should think about? And you can just remind us how much of the cost saves I'm sorry if I missed it, how much of the cost saves so far you've actually realized? Thanks. Sure, Michael. We would on the latter part of the question, we would estimate that thus far we have recognized on an annualized basis run rate about 12% to 13% of the $80,000,000 cost, so call that $2,500,000 for a quarter. In the quarter, like I said, we had we don't have people out there doing business development efforts. There's a lot less travel going There's not much real estate foreclosure activity in those related expenses and professional expenses associated with that. Those areas are all down. And I think for a lot of us are not going to the doctor like we as often as we had. So we're seeing a little bit of decline in health insurance. And I'd say all of those items combined relative to a more normalized quarter might be $5,000,000 or so in a quarter roughly. And then, so that's why we just wanted to be clear that while we're pleased that NIA was down to 215,000,000 dollars this is an unusual environment and didn't want to have people over interpret that as they look forward. That's very helpful. And then maybe just switching to the core margin, 295,000,000 I know there's some moving parts in there 1st full quarter post integration. As we think about going forward, I mean, are there other areas that you guys are working on to kind of optimize the balance sheet? And then how does that relate to the ability to prevent or limit NIM compression from here? Thanks. Sure, Michael. It's Steve. Let me just kind of talk about a little bit in the broader context around revenue. We talked about on Page 18, we have a slide in the deck that talks about our revenue composition over the past 4 quarters. And what you see in there is the revenue composition has changed. A year ago, we were about 77% NIM, 23% fees. Now we're 30% fees, 70% NIM. So just wanted to draw your attention to that. Our reported margin, as Will mentioned, was 3.22%, our core margin at 2.95%. Just a couple of things on that. We are core deposit funded bank in great markets. Our checking accounts make up 54% of deposits and our total cost of deposits this quarter was actually 20 basis points. So we continue to grow low cost deposits on our retail, our small business and our treasury platform. But from a margin perspective, we don't have a lot of room to reduce costs, but we will go as low as we can without cutting at the core. Let me kind of speak through the components of margin. First, on the yield on the loan portfolio ex PPP and accretion this quarter was 4.16. We're putting new loan production yields this quarter in at 3.53. So that continues to be a headwind. As it relates to Will's comment on the excess liquidity, so we have about $4,400,000,000 of average bets on sold, probably about $3,000,000,000 over a target. It weighed on our margin about 24 basis points this quarter. If you look at our pre merger, our total investment portfolio was right about $4,000,000,000 or around 12% of assets. Right prior to close, we sold $1,000,000,000 of the CenterState portfolio because it was going to be mark to market around 1.25%. So, as we think about the future of that excess liquidity, we invested about $500,000,000 this quarter to get us to around $3,500,000,000 We're likely on a path to get it closer to $4,000,000,000 by the end of the year. And then medium term, our target for the investment portfolio is around 12% of assets. That will depend upon liquidity, it will depend on yield curve, but we also want to make sure that we're not investing a bunch of capital in the lowest rate environment we've seen. So we are cautious on that, particularly as the non interest income businesses have been performing. One last comment on the securities portfolio, it was at 1.63% this quarter and we're adding purchases somewhere around 1.25%. So that would be the core margin comments. The only other comment was on accretion. I think we had $22,400,000 this quarter. Of course, that was elevated. We'd expect that to decrease from here. We have a disclosure in the earnings release that shows there's about 100 and $10,000,000 of discount left on the acquired loans. So with that, why don't I turn it over to Will if you have any other comments there? Yes, I think I just would reiterate a couple of things to make sure that we emphasize them. One is just the reminder Steve gave about the marking of this Interstate portfolio in Q2 and the impact we had. So you basically had a couple of $1,000,000,000 bond that's the impact. But the second is probably more important and that is just our long term focus and trying to make sure the decisions we make are ones that we're going to like for the long term. And it would certainly be easy to goose earnings a bit if we took that excess cash of $3,000,000,000 and invested it to pick up 110, 120 basis points over where we are earning today at the Fed. But we want to be thoughtful and do that over time and not get aggressive and then regret that 9 months or a year down the road if rates have moved back up. So we'll be thoughtful about pulling that lever, although it does exist. Okay. All that color is helpful. So I think the way to read that is maybe core margin ex PPP and ex accretion income, probably going to see some pressure here, but you guys are making some investments, the loan portfolio and the pipelines that you mentioned will continue to grow. So maybe we get to a point where NII actually troughs on a core basis ex PPP and accretion sometime next year and then starts to build from there. Is that the kind of the messaging and the way to think about it? Michael, it's Steve. I think that's a fair way. I think the tailwind will be any of our investment purchases. The headwind is the loan book until it gets closer to par. And with elections and COVID and all those, the yield curve is going to move around a lot, but that's how we're thinking about it. Our next question comes from Stephen Scouten with Piper Sandler. Please go ahead. Hey, good morning, everyone. Hi, Stephen. Good morning. So maybe just want to get some clarification on the expenses. I want to make sure I heard it correctly. On the branch reductions, it sounds as though that's incremental to the cost saves related to the deal, but that more or less it's going to get we won't see net savings due to investments in digital and other technology investments. Is that correct? I kind of interpret that, Rick? Yes, Steve. And I think, and John can elaborate further, but our it's hard to separate out between the merger cost saves we have as well as the additional investments we're making in digital and the branch reduction. And so we our $80,000,000 goal includes all three of those, both the reduction in expenses from the branch reductions as well as the additional investments we're making in improving our technology. And really, it's more of a reallocation of the branch rationalization into the digital spend would be the way I would probably describe it. John, you may have some better comments. I think you nailed it, Will. I don't have anything to add. Perfect. Perfect. And then how do how would we think about maybe, I don't know, a variable comp percentage on mortgage with mortgage being so elevated, how do we think about maybe how that's represented in salaries kind of in this quarter and the quarters to come assuming that does kind of trickle down maybe with MBA forecast next year, how we can think about the impact on salaries or maybe efficiency ratio that you think about in that business on a variable basis? Yes. Why don't I start and then Steve maybe can comment on the efficiency ratio side. So, 2 components to compensation expense and mortgage, obviously. 1 is the staff to get all of the loans through the system and that is obviously, the need for support staff in an environment like this is greater than in a lower volume environment. With respect to the variable comp associated with mortgages, accounting guidance dictates that you offset against the revenue. So it's FAS 91. So the cost of originating that loan, I. E. The commission is a revenue offset and again on sale margin. Now I will admit to you that not we've looked at all our peers, not everyone does it the exact same way, but we do it that way and that's the way we understand the accounting guidance from the time we spent discussing with a number of accounting firms. So that's a component that probably lacks some comparability when you look at other companies some other companies, I should say. Yes. And Stephen, I'd just to your point, mortgage for the industry had a great quarter. We are really super proud of our group. The integration of those teams, Tom Britton and Steven's leadership, they're just doing a great job integrating those teams. So, the production was very large, but the gain on sales, very large. So, if you think about efficiency ratios, I would expect that, over time that margin, which are record at every company right now, would move back toward 3%, even though the production, as we think about these historical levels, may move back 20%, 25% over time. Hopefully, that kind of helps guide you through. The efficiency, obviously, is really good right now because the margins are so large. The margins will come in, but our and our volume will come down a little bit. Got it. Okay. And then, just maybe last one for me as it pertains to growth and maybe this is kind of a John question, but maybe also someone else. It looks like there was maybe a big migration from the acquired book into the non acquired book. I'm just or maybe not. And maybe if you can comment on that, the big reduction in acquired non credit impaired? And then just kind of with the pipelines building, how you think about net growth in this environment, which obviously is a little tenuous still at best, I guess, I should say. So just kind of commentary there would be helpful. Yes. I'll comment on the first question and we'll chime in to clean up my accounting knowledge. But I think, Stephen, you talked about a decline in the acquired book and a rise in the non acquired book. I mean, you remember how this works. The acquired book only runs off. You never add to it. So all of the CenterState loans that came in under the fair market value accounting, they only decline. And all of the loans that are being generated by both South State and Legacy Center State, all of that goes into non acquired. So I think you'll continue to see that mix where one portfolio is going down, the other one is going to have to see outsized growth because now it's got double the production. But from a growth standpoint, we've had a pretty volatile 2 quarters here. So hard to be precise in forecasting. But let me see if I can unpack the components for you a little bit here. And I think it's important to separate the commercial portfolio from the residential portfolio. And I'll start with the residential. If you looked at our residential and home equity book at the end of the second quarter, we saw $150,000,000 decline. So it annualized out of like 10%. Well, on the same token, we had a record residential production of $1,600,000,000 So we had $150,000,000 runoff, but yet we produced $1,600,000,000 Well, the economics, as Steve mentioned, of this gain on sale being at 4% is just unprecedented. So it really doesn't make sense for us from an ALCO perspective to put on 30 year fixed rate loans on our books at 2 point 7 5%. The right thing to do from an ALCO standpoint, the right thing to do for our clients is to move those loans to the secondary market. So that has been a headwind residential to our loan portfolio, but it's not been a headwind to the income statement in totality. On the commercial side, the way I'd have you think about that is recognize that a commercial loan pipeline is a 90 day pipeline. So loans you close in the Q3 are typically loans where they enter the pipeline in the Q2. So what was the pipeline in the Q2? It was dead. So it's not it doesn't surprise us that total commercial portfolio would be down in the 3rd quarter. But having said that, within the commercial portfolio, we were encouraged that we were up. The C and I portfolio was up during the quarter and owner occupied commercial real estate was up in the quarter. So, it's important to think about those components. But as you think forward about the pipeline, the pipeline is climbing now between $100,000,000 $200,000,000 a week. And let me step back and put it in perspective for you. Pre COVID, at the end of the Q1, the pipeline was $3,400,000,000 We hit a low in August at $2,400,000,000 Since that low in August, the pipeline is back up to $3,000,000,000 So a 24% increase in the pipeline and we're feeling good that that's going to translate into the Q4 and the Q1 of next year into increased production. Don't think it's going to be any kind of rapid growth in the loan portfolio, I think we will turn the corner and start seeing some modest growth. Our next question comes from Kevin Fitzsimmons with D. A. Davidson. Please go ahead. Hey, good morning, everyone. Hey, Kevin. Good morning. Just wondering on correspondent banking, given the strength, the full quarter impact of that coming in the business doing well, but also the acquisition that you guys announced. Just curious what how sustainable you view that pace of revenues going forward? Just any kind of seasonal or cyclical forces we should be aware of? But also with the deal, are there other bolt on deals like this you guys are looking at in that area? Thanks. Sure. Thank you, Kevin. This is Steve. One of the things I'd just remind us, I mean, that we really like the diversification of these fee income businesses. If you think about mortgage, correspondent, capital market and wealth, none of those businesses make over more than 10% or more than 12% of our total revenue. So, we like the diversification within each line. As it relates to the correspondent group, if you look at the trailing 12 months under Brad's leadership, the division has done about $105,000,000 or so of revenue. If you look at the components of that, about $20,000,000 of it is in fixed income, about $80,000,000 in our capital markets product and about $5,000,000 in payments. So as you think about the future, I would think that the record year of $80,000,000 in our capital markets business likely with loan volume in the industry being where it probably will be next year, we'd expect that to come off a little bit, call it 20%, 25 just like mortgage probably will. But just to go into Duncan Williams, as we talked about already, Duncan Williams has about 250 Financial Institution clients. You put that with our 700, that's about 1,000 financial institutions. Last year in 2019, Duncan reported about $27,000,000 in revenue. And just from a modeling perspective, as we model the deal, we typically try to run these non capital incentive businesses around a 75% efficiency ratio business. So hopefully that's helpful in your modeling. So as you think about the pluses and minuses going into next year, I think you're going to see some of the capital markets activity likely decline a little bit. But with the opportunity to increase relative to our fixed income opportunity with our own group as well as Duncan Williams and the replacement of revenue there. And then I think long term, I think we're just excited to see the synergies between the two teams as we have products and services from both groups that eventually we can cross sell into. Clearly, that's not going to happen in the next 6 months, but that's the long term approach. So hopefully that's helpful for you. That's great, Steve. Thanks. Appreciate that color. Just one other broader question about reserve build. I appreciate all the detail, the level you've taken the reserve ratio to and then more broadly when you look at loss absorption as you guys are describing it. So that being said, if net charge offs are staying low as they are and we don't get any real big change in some of the economic indicators for your CECL models. Should we assume reserve build mostly in the rearview for you guys? Or is it if we still think there are losses coming, it's just they're not coming yet, maybe it will be later next year, it still may make sense for you all to incrementally build in the next few quarters? Thanks. Yes. Kevin, I'll start and if Dan or anybody else wants to jump in and they can certainly do so. But the thing about CECL, of course, and it's interesting that we all implemented this new life of loan model, life of shortly before hitting this pandemic. But the theory behind it is that we reserve fully for the economic forecast, the losses that would be, driven by these economic forecasts and loss drivers in your model over that forecast period, in which case that theory would tell you that today you've got every dollar in your reserve that you need and that should be true of everyone who adopted CECL, absent a change in that forecast. So forecasting from there, if the economic forecasts don't worsen, then our reserves should be adequate. Now there's a lot of cloudy, guidance to the crystal ball right now with what appears to be increases in COVID cases and who knows what that's going to do to some of the forecasts of unemployment and other loss drivers going forward. But sitting here today, the way the CECL model is supposed to work, we should be fine. I mentioned in my comments the model change. So given the timing of our closing, we had to do really a sum of the parts methodology for June 30. You couldn't really convert over to a new model and go through the model validation process before then. And so when we did consolidate this quarter, that's what drove the majority of the provision expense, the $22,000,000 of it was based on the different methodologies for the reserve unfunded commitments. So absent that, the quarter's provision expense would have been $6,000,000 or $7,000,000 In terms of loss realization, Dan, you might want to comment sort of on Kevin's question about where we think losses in the industry are heading in the future. Yes. Just from a future loss perspective, the last two quarters have been very good from a charge off perspective. I don't anticipate any material change in that here in the Q4. It's more 1st, 2nd, 3rd quarter depending upon how the pandemic plays out and what impact that may have in the future on credit. But right now, NPAs, charge offs, etcetera, credit looks strong. Okay. Thank you, guys. Our next question comes from Catherine Mealor with KBW. Please go ahead. Thanks. Good morning. Good morning. Good morning. One follow-up on the asset quality. You mentioned in your slide deck that classifieds increased this quarter. Can you just give us a little bit of color around the categories that drove that increase this quarter? Dan, do you want to take that? Yes. Dan Bockers, I'll take that question. The pandemic created economic headwinds that put a lot of loans on deferral in Q2 and Q3. As good risk managers, we did a comprehensive review with the credit administrators and market presidents. In August, of all of our loans, over $1,000,000 that were either in high risk categories or were on deferral. As a result of this review, we made changes to the risk rating grades, so that we could ensure that we have the appropriate allowance and also acknowledge the impact that the economic headwinds have had on some of the borrowers. Clearly, there is more stress in the hotel book across the entire industry. And so that's what's driving these numbers primarily to make up the majority of the classified and criticize recognizing the headwinds there. The severity of any loss is mitigated by the approximate 5% PCD mark on the legacy CS Center State Bank loans, plus the overall 55% LTV in the hotel portfolio. From where we are today, if the economy continues this rate of recovery, we don't anticipate any material change in the level of criticized or classified assets in the immediate future quarters. Okay. Great. And on the hotel book, any kind of update on what you're seeing at some of your properties in terms of occupancy rates and maybe kind of the difference between what you saw this past quarter and your coastal properties versus even just in your metro market? Yes. The hotel book is performing better than we anticipated and about 2 thirds of the portfolio is leisure segment, vacation areas, coastal waterways that are destinations within driving distance of a large segment of the Southeast population. And the summer was fairly good. Occupancy levels in those categories exceeded 60% and in some cases were greater than 80%. So when you combine that with deferrals and PPP funds, so with this improvement performance allowed a lot of these borrowers to stabilize and build some liquidity as well as they've adjusted expenses to better operate in this environment. In the low to mid-fifty percent range, some might be a little bit lower. Those are the ones that are struggling a little bit more and have a little bit more headwinds. Okay, very helpful. And then maybe one other question on just big picture capital thoughts. A lot of banks are starting to talk about buybacks. I don't think many banks of your size will start buybacks this year. But how are you thinking about what you're looking for to be able to start to think about reengaging in the buyback activity as we move into next year? Catherine, it's John. Maybe I can comment, and Will, feel free to chime in. A lot of uncertainty this summer, plus in our situation, we are putting 2 large balance sheets together. I wanted to see where these capital ratios shook out. We did raise some sub debt in the Q2 of the year to bolster the capital position. If you look at us, we look pretty good relative to our peers on CET1 and total risk based capital. The one ratio that's a little bit lower is tangible common equity. I think it ended the quarter around 7.8%. If we keep profitability somewhere where it's at today, that should exceed 8% headed into 2021. So if credit is as benign in 'twenty one as we're feeling like it might be now, that having that extra capital, getting TCE back above 8%, I feel like it gives us some optionality to look at a buyback. Right now, the dividend, I think it's yielding about 3%. We're paying back about a third of the earnings. I feel pretty good where the dividend is, but I think that the growing capital base, capital formation is going to give us some options going into 2021. Our next question comes from Brody Preston with Stephens. I just want to circle back on the expenses real quick. So appreciate the $5,000,000 or so in business development that's sort of in the quarterly run rate right now. But and correct me if I'm wrong, theoretically, that should have also been somewhat missing from the 2Q sort of pro form a run rate of 2.25, just given the world was still locked down at that point or just coming out of a lockdown. And so I guess it's still really good cost saves and you mentioned the $2,500,000 or so from the SSB, CSFL sort of cost savings. And so I guess was there anything else that you all sort of did that drove the larger sort of reduction in expenses this quarter? So, Brody, it's Will. Let me clean up a little bit just to make sure. So that $5,000,000 I mentioned, that was more than just business development. It included ORE, loan related, foreclosure related, all those kind of expenses and included professional fee reductions, not all related sort of activity levels being lighter. And I looked on the business development and that's but this is Q2 versus Q3. And I think part of it is in while Q2 you probably have some Q1 expenses, I. E, employee credit card and stuff like that, that are those bills are received and paid in Q2. So that's probably a little bit of noise there. In terms of the full $5,000,000 was not business development, just to be clear on that. We I would say Q2 had probably a little higher expenses associated with our COVID reaction, just getting things geared up in terms of responding with our facilities and things like that. So that was a little bit of a I would think that would be a decline from Q2 to Q3. But I just my comments were just to try to give you a little more clarity on. It feels to me like $215,000,000 is not a permanent run rate given the unusual environment in which we're operating. And if we move back to a more normalized environment, we're going to be out calling on customers. Greg Lapointe and his team are going to be hitting the road and spending some money on the business development side. Foreclosure activity is going to come back in the industry to some extent. We'll spend a little more money on that. So I kind of wanted to just make sure that, that idea was out there. And Will, I'd just add to that. I mean, we showed in the deck the combined business basis the expenses there. And if you think about sometimes our fee revenue businesses move these expenses up and down on the variable side, our revenue is up on the fee income by about, I think, dollars 6,500,000 a lot of that related to an MSR adjustment. So if you think about the variability of the fee income, there really wasn't from a commission outside of our cost saves would be pretty reflective of the outside of our cost saves would be pretty reflective of the run rate where we're at. So sometimes the fee income businesses move that around a little bit, but really in the Q3, it did not. So hopefully, that's helpful commentary too. Okay. All right. Understood. Thank you for that. And then on PPP, I think you've mentioned that you have $2,400,000,000 still on the balance sheet. I wanted to get a sense for the timing of that. But then also could you I don't know if you've looked at this at all, but do you have any sense for how much of those deposits are still sitting on the balance sheet? I'll start by saying, this is, Brody that our with respect to PPP, our crystal ball is probably more cloudy than some of the other commentary I've heard folks give. But what I'll tell you what we know, we have about 20% of our loans in the forgiveness process have entered the forgiveness process. During the quarter, we recognized about $8,500,000 of the net fee, PPP fee, leaving us about $53,000,000 $53,300,000 I think remaining at the end of the quarter. It is really hard to tell when that forgiveness process will really kick into gear, how quickly the SBA will respond, will there be another bill passed post election that may include some sort of forgiveness. But I would say our rough expectation with all those qualifiers is you're probably looking at a Q1 and Q2 concentration and I don't know at this point whether it's more heavily in Q1 or Q2, but that would be our best guess today. I don't have a figure for you on how much of those deposits are still in the balance sheet. That's a good question, but John or Steve may have a feel for that. Yes, Brady. This is Steve. I just point we don't know the exact answer, but I mean it's pretty obvious when you look at the picture on Page 19 of the deck, which shows the deposits from the first quarter to the second quarter. And what you see is $4,200,000,000 of deposits there. And that's when all the PPP money was going out and we're flat from there. So, the way I would characterize it is the deposits from those companies, although we don't have a specific answer, really haven't spread out yet and our deposits are flat after that big ramp in Q2. Okay. Understood. I guess I'm just trying to think about the potential deployment of excess liquidity. And so you've got $3,000,000,000 in excess liquidity like you said on the balance sheet. But I guess just thinking about the deployment of that either into loans or securities throughout 2021, I guess as those PPP deposits flow out, I guess that would sort of flow out with it or do you I guess do you estimate that you sort of have excess liquidity still on the balance sheet that can be deployed into earning assets beyond the PPP deposits? Yes, Brady. I think the answer is we don't know. I think what our target, if you looked at our companies as separate companies, we ran our investment portfolio as 12% of assets. That's how we've traditionally done it. When we had a lot of excess liquidity in the financial crisis, we probably ran it closer to 15%. But I think right now, we're in the wait and see mode. We need to build the securities book back up to that medium term 12% number and then see where the landscape is and see how those PPP funds because I do think it's uncertain and we just want to be thoughtful as we do it. And I would say, Steve, I would also just add to that that while certainly a portion of the excess liquidity is PPP, it's also just the liquidity that the Fed has bumped into the economy. And some of those PPP loan fundings have been used to pay payroll and things like that. But I think we are there is just an excess amount of liquidity that's with us right now based on the actions the Fed has taken over and above the PPP. Okay, understood. And on Duncan Williams, thanks for giving the $27,000,000 in revenue last year. Just want to get a sense for if their business has, I guess, been negatively impacted this year as a result of COVID or how they've been faring year to date? Yes. We won't give those public numbers, but just I'll talk about our fixed income business. Our fixed income business is up this year, and it's really primarily because there's just more excess liquidity sitting in the financial space. So as you think about all the excess liquidity we're talking about, it needs to be invested at some point, so do our clients. And so I think even though financial institutions like ours have been pretty hesitant to go too fast on this, at some point next year or the year after, you'll start seeing that deployed. So I think this is another good business to be in the hedging with because I think the fixed income revenue will probably be a little stronger than that. But it's probably too early to tell. Okay. And then the 110 or so in loan discounts, is that total discount or is there something else beyond that? That's the total. Okay. And so just wanted to ask, so it was $22,400,000 in PAA loan accretion income this quarter. I guess just thinking about the quarterly run rate moving forward, understood that it's supposed to step down, but what should the quarterly run rate on PAA look like perhaps for 4Q? And when do you sort of expect those loan discounts to be fully accreted into income? Will, you want to take that? Well, I was hoping you would, Steve. I'm chuckling, really. I hope you understand why. If you'd asked me 3 months ago, I would not have come I would not have guessed $22,000,000 It's just a hard number to predict based upon when payoffs occur, paydowns occur and things like that. But it's clearly going to it should decline from here. And you model it over the weighted average life of that portfolio, but then the weighted average life ends up being, in my experience over years of acquisitions, always ends up being shorter than what you had modeled. But if I were to throw out a number for you, I would worry that I would be viewing that number with more precision than would be appropriate given the difficulty. But if you the best way to do is just model up whatever you think a weight hours life would be for that acquired portfolio and that would sort of guide you to a number. But I wish I could give you a better number, but I really don't feel comfortable doing so. Okay. Do you have do you know the weighted average life off the top of your head? I do not actually, I don't. But the type of lending we do, and again this would be from origination base, the type of lending we do, you generally think about it being in that 3 to 5 year range. But Yes. Will, I'd say for the CenterState book prior to merger, it was around 3.3 years with the average life. So, I think that is probably a decent point. Our next question comes from Christopher Marinac with Janney Montgomery Scott. Please go ahead. Hey, thanks. Good morning. Thank you for the color on the problem assets on the prior calls. I just want to drill down to the kind of classified and criticized trends just to understand, do you see a path where those loans get upgraded in the next couple of quarters? Or do you think it's going to be more sort of stagnant for a while, get more visibility on the recession, COVID, etcetera, and then those will migrate back later? Dan? Yes, this is Dan Bockhorst. I think a little bit of combination of both. I do think there's an opportunity for some of those classified loans to get upgraded sooner than later. And then the ones that are in the criticized category, probably a little bit maybe longer path, a 6 month to to 9 months to see those start to get upgraded as we get a little bit more visibility, but I don't anticipate those to also, I don't anticipate those to migrate and get downgraded. Got it. That's helpful. So again, the reserves build really kind of counts all that into effect now as of these downgrades? Correct. Got it. Okay. Thanks for that, Dan. And then just a follow-up for whomever. On the PPP, what are you seeing on fraud? Is that an issue to worry about? Do you need to set aside reserves for that even if it's not material at this point? The fact that it hasn't really been a conversation at any of our various risk meetings or whatnot would lead me to answer, Chris, that it's really not a factor for us and I'll knock on some wood as I say that, but I think we've built some pretty good processes and had involvement of local teams, which is strength of our company throughout that process. Hopefully, we would be less subject to that than others. I don't think we've seen much of that. John or Steve, you have a and Dan, you'll have a better answer. Will, this is John. I think I've that question. And so far, I'm receiving confidence back that they're not seeing trends of fraud. So it's still early, but that's what we're here now. Our next question comes from Jennifer Demboe with Truist. Please go ahead. Thank you. Good morning. Good morning. I think all the topics have really been covered, but I'll ask one more. You announced another 20 branches you're cutting. Can you just talk about your willingness to reduce more branches or corporate real estate that's not currently planned right now in order to offset revenue challenges, should there be any? Yes, Jennifer, it's John. With our merger, there really wasn't branch overlap. So I think both companies in the past have acquired a lot of banks with branch overlap and we've put branches together. But setting that aside, there is this secular trend. And I think you're seeing this history with both companies that each year looking to rationalize the branch network. In fact, if you go back over the last decade, there's a slide Page 20 of that deck. If you take the 2 companies, put them together, there were about 85 branches a decade ago. We've acquired 4 20 branches, but we've consolidated 212. So we've consolidated about half of everything that we've purchased. So this has been an ongoing trend and we think that that will continue to be an ongoing trend. You've heard other folks talk, Jennifer, about the COVID driving more and more digital adoption. Interesting, we opened all of our branches in the company this month. They've been closed for, I think, since March. So call it 6 months that the offices have been closed. We opened this month. I've talked to some of the Presidents and said, well, now that we're open, what's happened with the traffic inside is that remarkably slow that customers have become accustomed to doing business in the drive thru, doing business digitally and they are the traffic has not picked up considerably in the lobbies now that we're open. On the digital side, just some stats for you. Year over year, digital deposits are up 67%. A year ago, this is people taking a picture of their check on their telephone. We were doing about 15% of our deposits that way, now it's 25%. As far as actually opening new checking accounts online, that's up 170% year over year. It was 10% of our accounts a year ago, now it's 27% of our accounts. And consumer loans opening up online is up 90% year over year. A year ago, it was about 10% of our consumer loans, now it's 19%. So I think as we think about the future, we'll continue to evaluate the rotation of brick and mortar expense into digital expense. On the other corporate real estate front, when we did the merger and we analyzed our operations center space, we've got 2 major operations centers, 1 in Charleston with a few 100 people and 1 in Winter Haven, Florida with a few 100 people. But in actuality, we have 17 total operation centers. There's 15 smaller ones. Well, that's those support teams have been working from home for 6 months and it's been working fine. So I think it's very likely that as we go through this efficiency project with the merger that we may see a significant reduction in a number of those smaller operation centers. So these are secular trends you're hearing from others Definitely, there's a lever for us to continue to pull on a year by year basis. One more question, John. Do you think your revenue producers are as productive working from home as they are working from the office? Yes, good question. I mean our 2 quarters here, our loan production is down. So you've got to say, well, is that because the revenue producers aren't as productive or is that because the economy got shut down? So I'd like to believe that they're as productive. I mean, let me answer it in a different way. Go back to the PPP process, okay? The economy was shut down there. They were working from home. We did 20,000 loans in a period of about, I want to say, it was like 3 weeks. So I think that's the case study, PTP, that the ability to be productive is there at least in that kind of crisis moment. But I think our relationship managers love to get in front of their clients. So I think that's slowly starting to open up. And in the long term, you're probably going to see a mix of in person and also more digital contacts. Good news is, on the RM front, we're having a lot of success now recruiting and there's a lot of turmoil in the biggest banks. So it's a new world. We're all trying to figure out how much time to spend in front of a Zoom call and how much time to spend in person. Yes. To the prior, I just add just anecdotally on some of these key lines of business, whether it be mortgage, fixed income, capital markets, they're all working remotely and having record production. So I think the ability to get in front of the clients is a little harder. But at the same time, I think we're all figuring out that you can do some of this more remotely. So I think there's pluses and minuses out of both of them. This concludes our question and answer session. I would like to turn the conference back over to John Corbett for any closing remarks. All right. Thanks a lot. These are great questions and I hope we've been able to provide some clarity this morning. We're going to be participating in the Piper Sandler Conference in a couple of weeks. But in the meantime, if you have any questions as you update your models, please feel free to reach out to either Will or Steve. Thanks for joining us this morning, and I hope you have a great day. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.