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Heritage Financial Corporation (NASDAQ:HFWA)
Q1 2020 Earnings Call
Apr 30, 2020, 2:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

I'm here.

Jeffrey J. Deuel -- Chief Executive Officer

Thank you, Brian.

Operator

Okay, so that host and speakers, you are in the main conference and everyone is in listen -- else is in listen mode right now.

Jeffrey J. Deuel -- Chief Executive Officer

Okay, perfect. Thank you, Daniel. Welcome everybody, who called in. This is Jeff Deuel, CEO of Heritage Financial. We're very sorry for the mix-up on the phone call. Apparently, we asked for a hosted call and got a general call. Fortunately in today's environment, we're all a lot more flexible than we used to be. So hopefully, you've had some time to work on your emails, while we got streamed out on our end.

I'm going to jump into our presentation and then we will open up for questions at the end. With me in the room are Don Hinson, our Chief Financial Officer; Dave Spurling, our Chief Credit Officer; and Bryan McDonald is our Chief Operating Officer is on by extension, he is at one of our remote locations this morning. Our earnings release went out this morning pre-market and hopefully you have had the opportunity to review it prior to the call. Please refer to the forward-looking statements in the press release.

Well, it goes without saying this has been a heck of a quarter for our country, our communities and the banking industry. We started out the first two months of the quarter seeing some nice growth in our pipeline, some positive progress with credit quality as a result of our active portfolio management. We also successfully launched our new Heritage direct treasury management platform, obviously things quickly changed as the C-19 pandemic accelerated. Our pipeline began to decrease and the management team dusted off our pandemic plan.

In Washington and Oregon, we have been operating in stay at home status since the third week in March. Our robust regional economy is in a self-induced coma, and although we have managed to flatten the curve we expect the revival of our economy to take some time. Fortunately, Washington and Oregon are talking about a staged approach to a restart. As an essential service, we continue to operate the bank with very little interruption to our customers. Early in March, we opted to close our branch lobbies to most customer traffic and operate through our drive through facilities all, but nine of our 62 locations have drive through capabilities, which made the transition that much easier. This move served to keep both employees and customers safe. We continue to operate in this manner and we are now just beginning to plan for phase -- for a phased approach to reopening some lobbies in the next couple of months.

We are also able to quickly implement a remote work environment for many employees approximately 60% of our employees now have remote capabilities and we have about 325, who are fully remote at this time. It is important to note that even with the lobby's closed, people working remotely, we continue to add deposit relationships and make select new loans. In parallel we're securing our lobbies and our people, we launched a loan modification program for all loan types to provide relief to our customers and we also began a review of our underwriting parameters in light of the new conditions. After that, we became completely absorbed in the SBA PPP program and getting the stimulus money to customers, who needed it.

Fortunately, we have seen good success with our PPP program and at this point, we believe we have served the needs of our customer base. Even though we expect the banking industry will experience credit quality deterioration as a result of the C-19 impact. We believe Heritage will outperform the industry median similar to our experience in the last downturn. Our long-standing culture is focused on conservative underwriting, active portfolio management and avoidance of loan concentrations, which will pay off for us by keeping credit losses at manageable levels.

We will cover all of this in more detail as we move to Don Hinson, who will take a few minutes to cover our financial results including color on our corporate operating metrics -- our core operating metrics, there's some specific comments about credit quality and CECL.

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Thank you, Jeff. Our reported diluted earnings per share for Q1 was $0.33, which is down from $0.47 in Q4, 2019. The decreased earnings was due mostly to an increased provision for credit losses. The unfavorable impact to earnings was partially offset by much lower effective tax rate in Q1, this was due to a combination of factors; including lower pre-tax income, while increasing tax exempt income instruments; and a $1 million discrete item, due to the CARES Act, allowing us to carry back and acquired bank net operating loss to 2020. Our stable net interest margin also helped earnings this quarter, the net interest margin expanded to 4.06%, compared to 4.02% in the fourth quarter of 2019.

Moving onto the balance sheet, net loan balances increased $73 million in Q1, of that amount $30 million was due to increases in utilization rates for operating lines of credits on C&I loans. Deposits increased $35 million in Q1, while maintaining the same percentage of non-maturity to total deposits of 88.6%. We continue to maintain a very strong balance sheet liquidity. At quarter end, we maintained combined credit facilities at the Federal Home Loan Bank and Federal Reserve Bank of $972 million and for the lines other banks totaling $140 million.

In addition, we have unpledged investment securities totaling $728 million and broker deposits currently making up only 5 basis points of total deposits. Our loan deposit ratio was 83.4%, we continue our long-standing strategy of operating with the balance sheet with low leverage, which we believe will serve us well during our current economic situation. We have also been approved to use the Fed's PPP liquidity facility in conjunction with our PPP lending.

Regarding credit quality, we had a significant decrease of $10.4 million or 23% in non-accrual loan balances in Q1. This improvement was due mostly from agricultural borrowing line of $6.8 million, which exceeded the Bank. This is part of the $20 million relationship discussed at length in the Q3 and Q4 earnings calls, which we partially charged off in Q4. We still have $12.4 million in real estate loans are way to that Ag relationship, which we believe are well secured. These loans will stay on non-accrual status until we see a history of payments on those loans.

Additionally, we received payment in full on a commercial business relationship of $2.3 million, which was also on non-accrual status. Our net charge-offs for Q1 were only $417,000, this is a decrease from $1.9 million in Q4, due to the recovery in Q1 of $963,000 from that same Ag relationship that was charged off in Q4. This recovery was offset by other commercial charge-offs of $1.2 million in Q1.

Potential problem loans increased $14 million in Q1, due mostly to four loans downgraded to special mention as a result of C-19 and eight loans downgraded to provide additional oversight. Potential problem loans decreased quarter-over-quarter without the C-19 additions. We are carefully monitoring our exposure to high-risk industries during this pandemic. Our commercial exposure to high-risk categories is relatively low includes the following: restaurants $85 million or 2.2% of the total portfolio; hotels $124 million or 3.2% of the total portfolio and recreation, entertainment, which includes bowling, fitness centers and other amusement related businesses of $37 million or about 1% of the total portfolio. In addition, we are monitoring all our winning loan types carefully.

Let's turn now to COVID-19 related loan modifications. At the end of Q1, we have modified 136 commercial loans for a total of approximately $80 million, including a combination of interest-only deferrals on amortizing term loans and full payment deferrals. Almost all modifications were for 90 days. Subsequent to quarter end through April 27, we modified 615 commercial loans for a total of approximately $350 million with approximately 60% interest only and 40% full payment deferrals, while consumer loan modification the number are higher than on the commercial loan portfolio, the dollar amount of consumer loan modifications is less than 10% of commercial loan modifications. We are taking a conservative approach to risk rating and only leaving modified loans at their pre-pandemic risk rating, if it is clear that the operating entity will quickly return to its pre-pandemic performance.

As of March 31, we have downgraded 39 loans totaling $36 million in response to pandemic related issues. Most of our C-19 modifications are being downgraded to watch and are not included in potential loan numbers. Our expectation for the next round of modifications, is that we'll see deterioration of our sustainability and some downgrades substandard.

Moving on to CECL. The total Day 1 impact on allowance for credit losses was $5.5 million, $1.8 million for the allowance on loan balances and $3.7 million for the allowance of unfunded commitments. This Day 1 increase in the allowance for credit losses on loans was partially mitigated by approximately $1.9 million of previously allowance related to December 31, PCI loans that were reclassified to loan discounts to be accreted as part of the CECL implementation process. The provision for credit losses on loans in Q1 was $10 million or is 26% increase from the post Day 1 allowance for credit losses on loans. This provision was partially offset by a $2 million reversal of allowance on unfunded commitments, due to lower unfunded balances at the end of Q1.

At the end of Q1, the allowance for credit losses on loans increased to 1.23% of total loans from 0.96% as of the end of Q4. As a result of this increase in the allowance and decrease in non-accrual loans, the allowance to non-accrual loans increased to 1 point -- sorry, 139% at the end of Q1 from 81% at the end of Q4.

I'll quickly go over some CECL model assumptions we used. We used a late March Oxford Economics models for the forecast, due to the rapidly changing environment we had an additional expected losses to the allowance for certain at risk industries such as restaurants, hotels and recreation. We also reviewed the impact of Federal Reserve Bank's 2020 early stress scenario, which calls for increased US on planet rates severe global of recession and elevated stress on corporate debt market and CRE.

Although we did not use the scenario in our final CECL calculation our allowance as of March 31 was the equivalent of using a 60% likelihood of the Fed's severely stress scenario and a 40% likelihood of the late-March Oxford Economics forecast. We will continue to monitor the forecast and economic conditions. Based on what has occurred post-quarter end, we are likely to have elevated provisions for the remainder of 2020.

Moving on to net interest margin. We had an increase of 4 bps in the NIM in Q1. This occurred primarily due to a change in the mix on earning assets higher percentage of loans and lower percentage in overnight interest earning deposits. Loan yields did not decrease as much as might have been expected, due to some recapture of previously reversed interest on non-accrual loans and the funding of higher earning, commercial construction loans during the quarter. As previously expected cost as whole deposits began to decrease in Q1, dropping 2 basis points to 37 basis points in Q1. Although we didn't experience NIM compression in Q1 due to 150 basis points rate cuts in March, I expect the significant downward pressure on NIM starting in Q2, this pressure is expected to be partially mitigated this year by the yields on the PPP loans.

Non-interest expense increased $1.3 million from Q4 levels, due mostly to increases in comp and benefits and marketing expenses. Both of these expense categories tend to jump in Q1 from the prior Q4, comparing year-over-year our overhead ratio improved to 2.70% in Q1 from 2.79% in Q1, 2019. We do expect overall expense levels to increase in Q2 and Q3, due mostly to increased costs associated with the implementation of our new treasury management system and the completion of our usage of the credit for our quarterly FDIC premiums.

And finally, moving on the capital. We remained well capitalized for all regulatory capital ratios. Further our TCE ratio remains strong at 10.2% at the end of Q1. During Q1, we repurchased 796,000 shares, completing one repurchase plan and starting another one on March 12th. On March 18th, we suspended our buyback program until we better understand the impact of the current economic situation on our long-term capital levels. Yesterday, the Board declared a $0.20 dividend, which is unchanged from the prior quarter. Although we have no plans to cut or cease our dividends at this time, we will be monitoring on a quarterly basis our capital position and ability to pay future dividends.

Bryan McDonald will now have an update on loan production and the PPP status.

Bryan D. McDonald -- Executive Vice President

Thanks, Don. As Jeff mentioned in his opening remarks, we saw good momentum in the commercial loan pipeline and production levels in January and February. Before being heavily impacted in early March by C-19, which then caused us and our customers to shift our focus. For the quarter, our commercial teams closed $167 million in new loan commitments, very similar to the volume closed in the first quarter of 2019. The commercial loan pipeline ended the first quarter at $506 million, up 30%, compared to the fourth quarter, and up 13%, compared to the first quarter of 2019.

Subsequent to quarter end, we have seen many customers put capital projects, expansion plans and bank transitions on hold, and we are now anticipating the actual loan volume closed from this pipeline will be much lower. Gross loans increased to $84 million during the first quarter, a 9% annual rate due to lower levels of prepayments and payoff activity and a higher utilization rate on operating lines of credit. So utilization rate on our commercial loans increased by 6% during the quarter, contributing $30 million to the growth and loan prepayments and payouts were $68 million lower than what we experienced in the fourth quarter.

Subsequent to quarter end, the utilization rate has trended down to levels more in line with utilization rates we have been experiencing over the last few years. Consumer production during the first quarter was $47 million, the same as the fourth quarter of 2019 and up from $40 million closed in the first quarter of 2019.

Moving on to interest rates. Our first quarter interest rate for new commercial loans was 4.24%, a decrease of 19 basis points from 4.43% last quarter. In addition, the average first quarter rate for all new loans was 4.46%, up 1 basis point from 4.45% last quarter. The mortgage department closed $26 million of new loans in the first quarter of 2020, compared to $52 million last quarter and $22 million in the first quarter of 2019. The mortgage pipeline ended the quarter at $54 million versus $15 million last quarter and $27 million in the first quarter of 2019. The growth in the pipeline is due to a spike in refinance activity caused by the drop in long-term rates, refinance makes 70% of the pipeline at quarter end.

Finally, I'd like to cover the bank's participation and offering loans under the SBA paycheck protection program. At the end of the first quarter, we started preparing to launch our fulfillment of PPP loans after the President signed the CARES Act into law on March 27th. Our application package was made available to customers on Friday April 3rd, and we went live processing applications on Monday, April 6th. We are very fortunate to have a very experienced SBA team here at Heritage having been a preferred SBA 7A lender for many years. This proved critical in designing the requirements and workflow for the PPP.

In addition, we benefited from having internal IT capabilities to stand up a fulfillment and reporting system for SBA PPP lending, during the weekend of April 4th and 5th. The system allowed us to organize ourselves see in real time our volumes at each process step and shift work between several hundred staff members, many of whom are working remotely and working extended hours. This allowed us to fulfill over 2,800 applications in the first phase of funding with an average loan amount of $244,000. Most important to us, we were able to process the full backlog of customer PPP applications received during the first round of funding, being left only with a small number of unprocessed applications, when SBA funding was exhausted on the morning of April 16th.

These applications were fully processed, when the second round of funding went live on Monday, April 27th and we continue to process new applications. We process PPP applications exclusively for our customers until we are current on our backlog and processing new applications within a few hours of receipt, after achieving this level of process efficiency, we opened up the process to known prospective customers. We anticipate net many new relationships will result from our ability to help them with their SBA PPP application.

I'll now turn the call back to Jeff.

Jeffrey J. Deuel -- Chief Executive Officer

Thank you, Bryan. We feel very good about our performance in light of the overlay of C-19. We have successfully and safely address the needs of our employees, customers and the communities we serve. It was particularly important for us to be able to perform at a high level in support of PPP, as a result of adding IT development capability to the team two years ago, we were able to stand up an automated platform in a matter of days. We believe this capability provided us with a competitive advantage in our markets, while we have not seen notable deterioration in loan portfolio -- in the loan portfolio, we expect to see stay at home actions continue to take its toll on the at-risk industries.

We will need to get beyond the PPP funding and the modification deferral period to fully begin to see the damage. We agree with others that businesses will suffer two shocks back to back, an immediate and in most cases, total revenue shutdown that transitions to a recession with very slow revenue growth. This is a different set of parameters than we have ever seen before and we are not sure how it will play out as the economic resuscitation gets under way in our footprint.

We are pleased with our performance and progress in the first quarter, despite the challenges from C-19, and a rapid decrease in interest rates. We believe Heritage is well positioned to navigate these challenges and we will continue to benefit from our core deposit franchise and conservative credit culture, while maintaining our focus on net interest margin and expense management. Furthermore, the robust liquidity and capital position on our balance sheet provides us with a solid foundation to address the challenges and take advantage of opportunities. As I said earlier, we're pleased with our performance to-date and immensely proud of our team for their performance during this difficult time.

That is the conclusion of our prepared comments. So, Daniel maybe we can open up the line to answer questions.

Questions and Answers:

Operator

Yes, absolutely. [Operator Instructions] And we do have a question from the line of Jeff Rulis. Your line is now open.

Jeffrey J. Deuel -- Chief Executive Officer

Good morning, Jeff.

Jeff Rulis -- D.A. Davidson -- Analyst

Thanks, good morning, Jeff. To the margin, Don the -- how much was that -- how much did the interest recovery add to the 406, it reported and kind of, what was core I guess, if you'd quarter-to-quarter?

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Jeff, I think that's a couple of bps to that not a lot, but it did help some. But again I think that again we didn't steal the impact of the -- all the rate cuts and tell we -- because it happened so late in March that we won't feel a lot of that tell us this quarter and mostly on the loan side, obviously and because our cost deposits will not be able to drop as fast as our loan balances, our loan rates will be.

Jeff Rulis -- D.A. Davidson -- Analyst

Okay. So it's 401, 402 and you talked about I think in the release about deposit lag pricing, that's more of a, kind of, a balance of the next couple of quarters. So again, maybe an acceleration of some compression given the rate cuts didn't have a lot of time to impact the quarter's margin?

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Correct. Correct. Again, about both quarter of our loans are fully floating. So if you just think about that a 150 basis points now, some of them are -- have floors and but even them, when they get rewritten each year on their anniversary they are liable to get rewritten at lower rates. So you know, if they're on a floor now like that will changes as the loans gets renewed.

Jeff Rulis -- D.A. Davidson -- Analyst

Got it. To the credit side, the Ag and C&I credits brought out of non-accrual. I think, I recall those were somewhat one-off issues, but trying to see if there is any related hope that others hear that are similar or were they true singular credit issues?

Bryan D. McDonald -- Executive Vice President

I don't think that there is an overlay to all of those loans that's specific to the group. I think they're all individual issues, we are always working the portfolio, we talk about that all the time, Jeff. And I think that we're hopeful that we'll see progress, especially we've already seen.

Jeff Rulis -- D.A. Davidson -- Analyst

And on the -- you mentioned some C&I downgrades. I don't know, if you've got a percentage or just a broad terms the group of those that have deferrals, or PPP support any idea on that?

Bryan D. McDonald -- Executive Vice President

Well, there is clearly customers in the PPP program that we're happy to see participating. The deterioration that was related to COVID, which was a series of what I would characterize as larger loans moving into the problem loan category are obviously larger got attention sooner. And they're part of that category of that risk loans, specifically most of it is hotels and it was just an exercise on our part to start taking action on some of them sooner than later.

Jeff Rulis -- D.A. Davidson -- Analyst

Great. And one last one if I could just -- what would be the -- maybe for Don, the true-up on that reserve to loans at 123. If you were to include credit marks additionally?

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Jeff, I'm not quite understood your question.

Jeff Rulis -- D.A. Davidson -- Analyst

The acquired credit discounts that may be, so reserves to loans at 123, but did you have a -- an additional balance that would exceed that reserve level?

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Well, I think we had $1.9 million that we switched over.

Jeff Rulis -- D.A. Davidson -- Analyst

Okay, so that effectively went away, there's not [Speech Overlap]

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Yes. So went from allowance basically into discounts that will be that's one reason why, normally we see as the balances decrease the accretion percentage goes down overall to the impact on loan yields and stayed the same this quarter, and that's because we threw in another -- that amount, and then the $1.9 billion of that going to get accreted as opposed to being part of the allowance, which it was before.

Jeff Rulis -- D.A. Davidson -- Analyst

Great. Okay, thanks. I'll step back.

Jeffrey J. Deuel -- Chief Executive Officer

Thanks, Jeff.

Operator

And we have a question from the line of Mr. Matthew Clark. Your line is open.

Matthew Clark -- Piper Jaffray -- Analyst

Hi, good morning guys.

Jeffrey J. Deuel -- Chief Executive Officer

Good morning.

Matthew Clark -- Piper Jaffray -- Analyst

On the adjustment this quarter using a late-March forecast with things obviously deteriorating in April. I know that forecast was pretty dire, but is there -- is it fair to assume that we'll see some additional reserve builds here in the second quarter before, and maybe even the third too, but before you start to, kind of, use that reserve to realize the losses?

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Yes, I think, this is Don. I think that we will continue to see that again I expect to higher reserves throughout this year, and I think that Q2 and probably Q3 will be probably, I'm guessing the high points to really depending on what happens, right. It's hard to predict right now, what's going to happen long-term and how long this is all going to go on for. But right now, I would expect continued high levels of reserve for quarter -- over the next probably couple of quarters at least.

Matthew Clark -- Piper Jaffray -- Analyst

Okay. And then on the higher-risk exposures the restaurants, hotels, recreation, entertainment. Can you give us a sense for the underlying LTVs and debt service coverage ratios there? And maybe average loan size and whether or not there is any other industries that you might be concerned about that others have talked about like healthcare, senior living facilities, schools, churches, things like that?

David A. Spurling -- Executive Vice President and Chief Credit Officer

Yes, this is Dave Spurling. The high risk industries we've identified, obviously include restaurants, hotels, as Jeff mentioned recreation fitness centers. But we've also got on that list some dental, our dental borrowers and also churches if that answers your question.

Matthew Clark -- Piper Jaffray -- Analyst

How much in terms of exposure there, are those two other categories?

David A. Spurling -- Executive Vice President and Chief Credit Officer

The exposure on those other categories are fairly low. The largest exposures in hotels, restaurants behind that. And the hotel exposure was about -- was at $119 million, I believe and the restaurants is about $84 million. Those are the predominant high risk categories.

Matthew Clark -- Piper Jaffray -- Analyst

Okay. And the underlying LTVs and coverage ratio there, if you have them?

David A. Spurling -- Executive Vice President and Chief Credit Officer

On the real estate side of things. Our LTVs tend to be pretty conservative weighted average in the portfolio is about 55% to 60%.

Matthew Clark -- Piper Jaffray -- Analyst

Okay. And then -- just on the PPP program, can you give a sense for the average loan size there? How much might still be in the pipeline if you -- I'm not sure if you already mentioned that? And then how you might be modeling it whether not, you're just assuming that most of it will come and go by the end of the third quarter, or do you feel like you're going to stick around longer?

Jeffrey J. Deuel -- Chief Executive Officer

Matt, Don you want to start and then I'll follow you.

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Sure. Again through the -- through quarter end -- or not the quarter end. For the first tranche we got funded with $687 million average price -- average was $244 million and again a bulk of those were under 350 million and/or between $350 and 400. I would say, in fact, if you break it down further under 100,000 was about 9.4% 100 to 350 million was 22.5. Half of the loans in balance we're between $350 million and $2 million and then 18.5% were over $2 billion. So those are the funded piece and then we still have getting -- we're still getting other items through our applications through, they have been funded, but they've been approved and we're up to around our applications right now that we think we will get through is about $885 million worth it, and then it drops the overall average though with including all of that down about $220, so that the loan sizes are going down over time. And but that's, kind of, we're looking to putting on by another $200 in the second tranche it adds up right now. Bryan, do you want add anything to that?

Bryan D. McDonald -- Executive Vice President

No, that's right, Don.

Matthew Clark -- Piper Jaffray -- Analyst

Okay. But is it fair to assume a 3% origination fee on average not 5%?

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

I think, it's going to be higher than that, yes, because again only, again, about half of it is -- half of the loans are between the $350 million and $2 million to get the $3 million and only about 19% is over $2 million, so it will be between by $3 million and $4 million on average.

Matthew Clark -- Piper Jaffray -- Analyst

Okay. Got it. Okay and then maybe just the spot rate on deposit costs at the end of March, if you have it?

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

It was lower, I think it was closer to 35 basis points at play in toward the end spot rates. So but we keep dropping the rates and -- in this market.

Matthew Clark -- Piper Jaffray -- Analyst

Okay. And then just a good tax rate to you, just given the lower level of income going forward?

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Well, depending on our income levels as far as the effective tax rate it's similar we didn't have the discrete item it would be closer to 13%, but again, a lot of the effective tax rate itself will depend on the pre-tax income going forward. But because again or we don't, our taxes or perm tax items that are used to for that calculation actually grew a little bit and in Q1, so...

Matthew Clark -- Piper Jaffray -- Analyst

Okay, great. Thank you.

Operator

And we have a question from the of Jackie Bohlen. Your line is now open, please.

Jacquelynne Bohlen -- KBW -- Analyst

Good morning, everyone.

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Good morning, Jackie.

Jacquelynne Bohlen -- KBW -- Analyst

Good morning. One quick follow-up on the PPP in terms of the new customers, so that the additional roughly $200 million that you're processing through the second round. Is that all new customers or did you have some that carried over from the first round? I just wanted to make sure that, I was clear on that?

Bryan D. McDonald -- Executive Vice President

Hey Jackie. This is Bryan, we had just the inflow so stuff that maybe was taken after 8 o'clock the night before at around and then we had a certain number of incomplete applications that hadn't been able to be process. So, and then of course between the time it closed and the time the second round of funding opened. We had additional customers that came and applied during that period of time. So our daily flow over the last few days has been maybe somewhere in the neighborhood of 100 applications and it's a different day-to-day. But it's more of a mix of prospects, end customers versus of course all customers when we went into Phase 1. So there is still customers in there along with prospective customers that we've been calling on.

Jacquelynne Bohlen -- KBW -- Analyst

Okay, and then in terms of these new customers. What do you think the likelihood is that you could bring other pieces of their portfolio and in both loans and deposits, over to you after things begin to normalize again?

Bryan D. McDonald -- Executive Vice President

We're already seeing that, Jackie, we didn't go into it with a requirement around that, but we're seeing a number of our customers be open to talking to us about other banking services as a result of doing the PPP loan forum. It's a little early, but we're already seeing customers being open to moving additional business to us.

Jacquelynne Bohlen -- KBW -- Analyst

Okay. And were you actively marketing these customers meeting where these prospective customers. If you have been reaching out to you and hopes of obtaining their business or were these I have just customers coming in, looking for a loan?

Bryan D. McDonald -- Executive Vice President

They were predominantly prospects that our bankers had been calling on previously, so in many cases for many years, everybody has their prospect list and actively calling. So as they finished up handling the needs of their existing customers, the applications they had in hand. They then turn their attention to for the prospects, they had been calling on to see if -- to see if we can help them with the PPP.

Jacquelynne Bohlen -- KBW -- Analyst

Okay, great, thank you will recover. Just one last one and then I'll step back. In terms of the treasury management system I had light note, I think from last quarter that, that's roughly and $1 million of added expenses in the year. First off, is that still an accurate number. And second, was any of that included in 1Q or will that all flow in 2Q, realizing that, that million is an annual number?

Bryan D. McDonald -- Executive Vice President

And that -- Jackie that's gone up some implementation of cost is going to be more than we initially thought, I think we probably have another I think another million or $1.1 million left and we did about I think about $400,000 in Q1. So, but that should be done by end of Q3 in the remaining $1 million or $1.1 million.

Jeffrey J. Deuel -- Chief Executive Officer

Jackie, one of the issues we faced into was we launched in the first quarter and the first wave of customers were handled quite well actually and then C-19 hit. So what we had to do was shift our waves of customers to double up the next wave later in the year, so that we can get past what we were dealing with the last eight weeks. So that just presented additional cost, because we had to reset our arrangement with a vendor, that's helping us through that process.

Jacquelynne Bohlen -- KBW -- Analyst

Okay, that's helpful. And that $400,000 number, is that an annualized number?

Bryan D. McDonald -- Executive Vice President

No, that was the number in Q1.

Jacquelynne Bohlen -- KBW -- Analyst

Thank you.

Bryan D. McDonald -- Executive Vice President

And I like I say, we'll have another $1.1 million I think left over the next two quarters.

Jacquelynne Bohlen -- KBW -- Analyst

Okay. And that, so the $400,000 is not annualized. But the $1.1 million is?

Bryan D. McDonald -- Executive Vice President

$1.1 million -- the $1.1 million is what's left to be spent over the next two quarters.

Jacquelynne Bohlen -- KBW -- Analyst

Okay, Okay. Got it. Okay, thank you. That's all.

Bryan D. McDonald -- Executive Vice President

Thank you.

Operator

And we have a question from the line of Mr. Gordon McGuire. Your line is now.

Jeffrey J. Deuel -- Chief Executive Officer

Good morning, Gordon.

Gordon McGuire -- Stephens -- Analyst

Good morning, how are you guys?

Jeffrey J. Deuel -- Chief Executive Officer

We're better now that a phone systems working.

Gordon McGuire -- Stephens -- Analyst

Don, I wanted to clarify a comment you made earlier you for modified loans you -- you downgraded. If you did, you didn't feel like they could return to pre-Covid levels of performance, is that correct?

David A. Spurling -- Executive Vice President and Chief Credit Officer

Yes, this is Dave. We had a bias toward taking credits to watch. But in those instances where the borrower and client was more likely to return quickly to pre-pandemic performance we left those at their original risk rating.

Gordon McGuire -- Stephens -- Analyst

Okay. And do you have the ratio of watch loans at this point versus I guess March 31 versus December?

David A. Spurling -- Executive Vice President and Chief Credit Officer

I don't have those numbers handy, but I know there was in the first quarter in March, there was kind of a spike in watch credits due to the downgrades that were result of modifications.

Gordon McGuire -- Stephens -- Analyst

Okay. But those did not flow into potential problem loans. So I guess the $18 million or so COVID-related potential problem loans are there is going to be able to be subject to modifications?

David A. Spurling -- Executive Vice President and Chief Credit Officer

Those were kind of outliers, those were some credits that the two predominant ones were destination hotels and they presented more risk than we thought a normal modification would present. So we did take those down to special mention and became DPLs.

Gordon McGuire -- Stephens -- Analyst

Okay. And do you have the mix of modification or how much of the modifications, you had were related to the higher-risk portfolios that you identified?

David A. Spurling -- Executive Vice President and Chief Credit Officer

I don't have it, but as was mentioned earlier, there was, it was a kind of an even split between interest only on amortizing and full payment deferrals, but don't have the breakout by industry.

Gordon McGuire -- Stephens -- Analyst

Okay. And then, Bryan. I think I heard all new loan originations were up 1 basis point to 446 basis points, I guess what drove what drove what do you feel like drove that, was it increased credit spreads or did the construction utilization, drive that higher was that kind of abnormal?

Bryan D. McDonald -- Executive Vice President

It just, most of the quarter's production just pre-trade pre-dated the big drop off in rates, so Don mentioned the Fed rates dropping. But of course the Federal Home Loan Bank indexes that tend to mirror the jury rates of course higher we saw those fall off. So it was really the mix of loans. And then just the fact that the quarter just didn't capture most of the downward rate movement we've seen.

Gordon McGuire -- Stephens -- Analyst

Okay. And then last one for me is how you guys are thinking about funding the PPP loans that come on the balance sheet?

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Well, as I mentioned, we're all signed up with the -- the Fed to use their liquidity facility for it we haven't started doing that yet. We haven't needed it. And, but everyone think is that we got going to loans out there and going to a person's deposit account, but really nothing or not much has been spent yet to give will have pretty recently. So, but as that money gets spent and we need the funds we'll start fledge those to that facility and take those funds from that facility. And as a reminder that facility is at 35 basis points. And there are no non-recourse on borrowings.

Gordon McGuire -- Stephens -- Analyst

All right. I appreciate it. Thank you.

Bryan D. McDonald -- Executive Vice President

Thanks, Gordon.

Operator

And there are no further questions at this time.

Bryan D. McDonald -- Executive Vice President

Thank you, Daniel. I think then we're ready to wrap up this quarter's earnings call. We thank you all for your time and your patience as we got our call under way. We appreciate your support and your interest in our ongoing performance. So we look forward to talking with many of you over the coming weeks. Thank you and goodbye.

Operator

Ladies and gentlemen, this conference will be available for replay after 1:00 PM today through May 14th till midnight. You may access to AT&T replay system at any time by dialing 1-866-207-1041 and entering the access code 3443789. Those numbers again are 866-207-1041 and the access code 3443789. That does conclude our conference for today. Thank you for your participation and for using AT&T Teleconference Service. You may now disconnect.

Duration: 44 minutes

Call participants:

Jeffrey J. Deuel -- Chief Executive Officer

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Bryan D. McDonald -- Executive Vice President

David A. Spurling -- Executive Vice President and Chief Credit Officer

Jeff Rulis -- D.A. Davidson -- Analyst

Matthew Clark -- Piper Jaffray -- Analyst

Jacquelynne Bohlen -- KBW -- Analyst

Gordon McGuire -- Stephens -- Analyst

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