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MidWestOne Financial Group Inc (NASDAQ:MOFG)
Q1 2020 Earnings Call
May 1, 2020, 12:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning, and welcome to the MidWestOne Financial Group, Inc. First Quarter 2020 Earnings Call. [Operator Instructions]

This presentation contains forward-looking statements relating to the financial condition, results of operations and business of MidWestOne Financial Group, Inc. Forward-looking statements generally include words such as believes, expects, anticipates and other similar expressions. Actual results could differ materially from those indicated. Among the important factors that could cause actual results to differ materially are interest rates, changes in the mix and company's business, competitive pressures, general economic conditions and the risk factors detailed in the company's periodic reports and registration statements filed with the Securities and Exchange Commission. MidWestOne Financial Group, Inc. undertakes no obligation to publicly revise or update these forward-looking statements to reflect events of circumstance or circumstances after the date of this presentation. [Operator Instructions]

I would now like to turn the conference over to President and CEO, Charlie Funk. Please go ahead.

Charles N. Funk -- President and Chief Executive Officer

Thank you very much, Ian, and welcome to everyone, and thank you for joining us on the call this morning. I am joined in Iowa City by Barry Ray, our Chief Financial Officer; Jim Cantrell, our Treasurer and Chief Investment Officer; and Gary Sims, who's our Chief Credit Officer. And I would begin by acknowledging what we all know that we do live in unprecedented times, and for years at MidWestOne, and I'm sure at other institutions, we've developed and tweaked various disaster recovery plans, wondering if they would ever be put into practice. We're very pleased that MidWestOne with the response we've had from our team, the entire team has worked long and hard and with little complaining, and I would add with significant success.

We've had three primary constituencies at the forefront of our planning during this time, our employees, our customers and our communities. And as I know, many other banks around the country have done they've done we've all done many things to help these constituencies. So taking an order and going through these briefly, our employees. We've limited our lobbies to appointment only, and there has been very low traffic in lobbies throughout our footprint. Our drive ups have remained open and busy. Our total transactions are down about 10% since the pandemic started. Social distancing continues to be observed. Right now, we have 1/3 of our workforce working from home. We are capable in more dire circumstances of up to 70% of our workforce working remotely. We've increased cleaning services throughout our footprint.

Business travel restrictions have been placed, and basically, that means no travel. We've rigorously adhered to CDC guidelines. We've made special accommodations to those with preexisting conditions, and we've had pandemic pay benefits for those directly affected by COVID-19. For our customers, we've promoted digital banking capabilities, and I'm happy to report that our online banking sessions are up about 26% since we closed our lobbies. Online account opening was up 34% in March. It's even higher than that in April, although I don't have final numbers at this time. Our call center was staffed up. We responded to increased volume of calls from our customers due to the government payments, both PPP and EIP payments, and we've had minimal wait times.

We did send a deck out with this quarter's earnings release, and you can refer to the deck, but I would just report a few things. Payment deferrals have been approved for 755 customers, which represents $346 million in loans outstanding or roughly 10.1% of the March 31 portfolio. Six-month payment forgiveness, there has not been a lot of that so far, 120 loans representing $600,000. We do get a fair amount of questions on one-four family real estate loans. As of our most recent reporting date, we've had 34 requesting deferrals, representing $7.3 million. Those are all on in-house loans and a relatively low number.

As for the PPP program, very pleased with our company's success. We were on this early, and as you have seen with other banks around the country, we delivered for our customers. The most recent totals we have completed loans for 20 we have completed 2,190 loans, representing $332 million in loans outstanding or an average of roughly $151,600 per loan. We have many associates working 12- to 18-hour a day to serve our customers and communities. We've had very few delays in getting our loans approved and funded. And right now, I would say we're caught up and working the applications as they come to us.

So and we also would want to talk about our communities. In our communities, pain is real and communities large and small throughout our footprint. We did make an unbudgeted pledge of $150,000 in additional giving to organizations throughout the footprint, and the specific giving decisions were left up to the local leaders in our markets. We've also encouraged shop local in our media outreach, and we've supported local restaurants throughout our footprint by purchasing recognition lunches for employees, who are still coming to work each day.

And with that, let's move on to the quarter as well as what lies ahead of us. The loan loss provision or our credit loss expense of $21.7 million was the dominant line item in this quarter's income statement. We did adopt CECL. After much discussion, we opted to move forward, and we thought that was the right thing to do for our company. And frankly, we believe we took an aggressive approach to this line item as we believe the future is very unclear at this time.

At quarter end, we showed a loan loss reserve to total loans of 1.49%. If you add in the purchase discount that we have, that number goes up to 2.11%. So when you add in the purchase discount, we believe that a 2% plus allowance allows us to provide the loss content in our portfolio. And of course, we hope that we're wrong and it doesn't come to that.

Looking back, as of 3/31, our total nonperforming assets were virtually unchanged from year-end at $49.6 million. Net charge-offs of 14 basis points, very acceptable. And as was noted in the release, it's my opinion that we did make progress in our collection efforts, but the progress now has been stalled as our court system is in recess. All things considered, I would characterize the asset quality as of 3/31 showing modest progress.

So now I'll talk about the current environment, what's happened since the end of the quarter. We also included in the deck a listing of vulnerable industries. And really, when we speak of vulnerable industries related to COVID-19, one could concoct a scenario where just about any vulnerable any borrower is vulnerable. With that said, in our deck, we identified six industries that comprise 20% of the portfolio as vulnerable. We continue to reach out to many customers during this time, and it will be very important that we continue to do so in the weeks and months ahead because we know that consistent communication is very important during this time. It will be a few months before we know which borrowers are most affected and showing undue stress, but we'll continue to ask our customers and talk to our customers and work with our customers.

I do want to give the quarterly ag update as we've done for the past couple of years. And with ag, I think we should talk about what happened up to 3/31 and then what's happened afterwards. Through the renewal season, we did renew some operating lines. These customers either found financing elsewhere or chose not to plant a crop this year. As of 3/31, the ag portfolio represented 9.2% of our total loan portfolio or $314.3 million. In the ag portfolio, as of 3/31, 9.6% was substandard rated substandard, that is down slightly from year-end. Our watch credits also declined slightly from year-end and were 9% of the portfolio. So if you add watch and substandard, that's 18.6% of our ag portfolio was rated either watch or substandard. I do think it's wise to step back and have some perspective on this.

Two years ago, as of 3/31/2018, this number was 23.6%, and it was 19.8% at year-end 2019, again, at 3/31/2020, 18.6% of the ag portfolio rated watch or substandard. Progress is being made in the portfolio, but now we have to look forward. And since the pandemic, prices have got what we thought were already poor prices, have gotten worse. In the MidWestOne footprint, what we most follow are soybeans, corn and dairy, pork to a lesser degree, but in all four of these instances, we've seen erosion in prices. Land prices are down from their highs of about in 2013 of roughly 13% to 15%. The most recent reading that we got on land prices for the last six months was down 2%. So not a huge fall off of the cliff, but certainly continued modest erosion in land prices.

So in summary, on our ag portfolio, we think it has stabilized as of 3/31. We're very confident in our portfolio monitoring and management. But as but prices do need to improve because our borrowers will continue to face increasing headwinds if they don't. Gary Sims will be available to answer more specific questions on asset quality, portfolio composition and other credit items in the Q&A.

Turning to the balance sheet. The highlight for the quarter was that we had very good deposit growth, which adds to already excellent liquidity in our company. Also, there was a four-day period of market illiquidity in late March, and we used that period to make some very good fixed income purchases, all investment-grade securities at what we thought were wide spreads. And as I said, this only lasted a few days, and we were able to take advantage of that. We think that bodes well for the margin going forward.

We also saw a roughly $25 million reduction in our loan portfolio. If you look at it, you could say that's entirely accounted for in the one-four family reduction of $28 million. Much of that was due to refinancing activity into the secondary market. We had a $16 million decline in C&D, construction and development loans, and a $10 million reduction in multifamily CRE, which is primarily payoffs. C&I loans were up 29 more than $29 million. Ag was up slightly and will continue to go up as operating lines are utilized during the planting season. We also continue to read many headlines about credit line usage line of credit usage nationally. We did not see that trend at MidWestOne. And to give you a little bit of color on that, at 12/31/2019, our line usage was about 46%. That had declined to 43% on March 31. So we did not follow the national trend there.

Turning to the margin, the net interest margin. My comments on the margin will focus on our core margin, which declined from 3.42% to 3.31%. My personal opinion is that our past management of the core margin has been pretty good in our company. I don't think it was quite that good in quarter one for several reasons, which I will highlight. The 150 basis point decline in short-term rates in March was too fast for our ability to reprice our liability rates. That should catch up somewhat in April. We also had an unfavorable mix change.

As previously noted, the nice increase in deposits, combined with a slight decline in loans, was not helpful to the margin. And more specifically, on the liability side, we believe we have roughly $600 million in liabilities that reprice lower in early April. And we also note a shift that continues to occur from CDs back to nonmaturity deposit. This is somewhat reminisce of what we saw in the 2008 to 2015 period. That should modestly help the margin as well. So we do expect improvement in the quarter two core margin, but would also acknowledge there will be much noise around the margin as the PPP program comes and goes.

Noninterest income was generally a good quarter in our company. Excellent progress, I would say, in almost every segment. Trust and investment services was up 4% from the fourth quarter. They also had a good April, only slightly behind budget, but this unit does face headwinds due to the market conditions. Nevertheless, good progress in Trust and investment services.

We had good mortgage activity, roughly the same amount of loans closed in the first quarter of 2020 as the fourth quarter of 2019 at $1,261,000. The headwind, of course, was the MSR adjustment of $447,000. Commercial loan swap activity, by far, the best number in our company's history, that's reflected in other noninterest income. And so you add all those up, and overall, our noninterest income was up roughly 10% from the fourth quarter. Noninterest expense will be important going forward.

Very pleased to report that despite the drop in the net interest margin, our efficiency ratio held in at 57.7%. We will continue to keep an eye on this as we've been very focused on this for the last 12 to 15 months. Notably on noninterest expense, we do not have any plans to reduce technology spending because we think that's our future, and we will continue to give generously in our charitable contributions to our communities, which are in need.

Turning to capital and liquidity. We did include a slide on the liquidity position. We believe we have a strong liquidity position. We have significant liquidity in the investment portfolio. We've listed many other sources of liquidity in the deck. But if you add all of those up, you come to $1 billion pretty quickly. So we think from a liquidity point of view, our resources are ample. In terms of capital, overall capital, tangible common equity to 8.11%. That's within the 8% to 9% range that we've talked about for many years as being a target. We also included our regulatory ratios this quarter. We estimate CET1 ended the quarter at 9.25%, Tier one capital at 10.25% and Tier one leverage at 9.39%.

All above regulatory minimums, and I'd say, well above regulatory minimums. We did temporarily discontinue our share repurchase in mid-March. We do not plan to reopen this in the near future, but we will continue to monitor. We expect to maintain our current dividend, which was unchanged from the prior quarter. So in looking ahead, it will take several months to know exactly where our primary focus should be. For now, we will continue to increase our loan portfolio monitoring as well as continue to provide support encouragement and resources to our employees, customers and communities.

And with that, Ian, I will turn it back to you, and we will be happy to entertain any questions you might have.

Questions and Answers:

Operator

[Operator Instructions] Our first question today comes from Jeff Rulis of D.A. Davidson. Jeff. Please proceed.

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

Thanks.

Charles N. Funk -- President and Chief Executive Officer

Good morning. Jeff

Barry S. Ray -- Senior Executive Vice President and Chief Financial Officer

Good morning, Jeff.

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

I wanted to ask about the I think the fee income was pretty strong. Charlie, you touched on the swap side as sort of a record high. I'm trying to think about looking forward, maybe you can't count on record levels every quarter. I just want to kind of see how that line item has progressed into the second quarter. And I guess if you that's the kind of the accounting adjustment there. And you could be back, all things being equal, up in the $10.5 million range, but wanted to check in with you on how maybe mortgage and swap can carry into the second quarter?

Charles N. Funk -- President and Chief Executive Officer

I'll take yes. Thank you, Jeff, for the question. I'll take mortgage first. Mortgage in terms of fees should have a better second quarter. They've had robust activity and have kept up with the demand, which we're very pleased about. So I think the second quarter should be really strong for mortgage. What we don't know is the mortgage servicing rights adjustment, and we'll just have to see where that falls out. In terms of swap income, I would expect that to be down for a number of reasons. The market's changed a little bit. As you know, the credit spreads have changed. And so I think we will still have some swap revenue, but I doubt that it approaches what we saw in the first quarter.

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

Would those two offset? Or is that mortgage going to be in terms of is that a trade-off? I guess it's anyone's guess, but...

Charles N. Funk -- President and Chief Executive Officer

Yes. It's anyone's guess, we're just a month into the quarter. Mortgage will be higher. My guess is that swap income would be lower. And it would be I don't know how to say this. Mortgage will be up, but not up as much as the swap income will be down. How is that?

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

Fair enough. Okay. Got to work. Let's see here. And the expenses, Charlie, you also alluded to the fact that you're not going to pull back on technology spend in all, but that's a pretty good number at $30 million per quarter. Any puts and takes that we got to think about in terms of as you've responded to the health crisis, and there's some savings there. There's some added costs there. Just thoughts on kind of maintaining the level? Or is it some growth from there given the commitment to tax spend?

Barry S. Ray -- Senior Executive Vice President and Chief Financial Officer

Jeff, this is Barry. I'll take that question. I think with respect to the run rate, the experience that we had in the first quarter of $30 million is probably a good run rate. There are going to be some factors that add noise to that in the near term. For example, as you said, we're going to incur some additional expenses for cleaning from the COVID-19 pandemic, some additional software applications from the SBA PPP program. So those are going to be adds. There are going to be some near-term positives. The one that I would highlight here is the loan cost offset through compensation and benefits associated with the SBA PPP origination, and I'd take that around $1.2 million, and that's going to be a near-term adjustment, favorable adjustment. But overall, the $30 million is probably a good near-term run rate.

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

And maybe one last one. Any thoughts on have you entertained testing for goodwill impairment or had some initial discussions if that's an avenue you want to go down?

Barry S. Ray -- Senior Executive Vice President and Chief Financial Officer

We have entertained testing for goodwill impairment, Jeff. We identified that there was a triggering event in the first quarter because of the deterioration in economic conditions that occurred at the end of the quarter. And we did do an interim impairment assessment of the goodwill at quarter end or as of quarter end, and we concluded that there was no impairment of goodwill from that. But we will continue to monitor throughout each subsequent quarter, whether or not there is another triggering event in advance of our normal October one annual test date to determine if we need to do yet another interim test of goodwill impairment.

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

Okay, thank you.

Operator

Our next question comes from Andrew Liesch of Piper Sandler. Andrew. Please proceed.

Andrew Liesch -- Piper Sandler -- Analyst

Good morning, everyone. Just a question on the deferrals. Just curious what the pace of them has been and how that's transpired into April in May now?

Gary L. Sims -- Senior Vice President and Chief Credit Officer

Andrew, this is Gary Sims. The number that we have in the slide deck was fairly up-to-date number on the deferrals. So we saw a good pace as we got started. As we put the program together in mid-March, we saw a good pace in March, but it really picked up in April and a lot of the deferral activity did take place in April. As it stands right now, we do expect that deferral activity to continue into May as we continue to work with our customers and create opportunities for them to adjust their business model and for us to help them with that. So we expect that pace to continue through May.

Andrew Liesch -- Piper Sandler -- Analyst

Okay. And then just curious the provision, obviously, pretty big here. Just what were some of the economic forecasts going into that? And was that I suspect it was like more of an up-to-date number of those, and then kind of forecast from later in April rather than May. So just kind of curious what were some of the underlying something behind that?

Barry S. Ray -- Senior Executive Vice President and Chief Financial Officer

Andrew, this is Barry. I'll take that one for start. We use the for our loss estimation process, we utilize the Moody's baseline forecast. And so the specific forecast that we utilized for our March 31 allowance for credit losses was the forecast as of March 27. So that was the Moody's baseline forecast as of March 27. Some of the economic data that drives our loan credit loss experience is Midwest unemployment.

Andrew Liesch -- Piper Sandler -- Analyst

Okay, got you. That's it from me for now, thanks. I'll step back.

Operator

And our next question comes from Damon DelMonte of KBW. Damon. Please proceed.

Damon DelMonte -- KBW -- Analyst

Hey, good afternoon. Hope everybody is doing well during these times.

Charles N. Funk -- President and Chief Executive Officer

Good morning.

Damon DelMonte -- KBW -- Analyst

So my first question, just relate to the participation in PPP. What are the expected fees you intend to realize from these loans?

Barry S. Ray -- Senior Executive Vice President and Chief Financial Officer

Damon, this is Barry. Our approximate net fee is around $10 million is what we expect for the PPP.

Damon DelMonte -- KBW -- Analyst

Okay. And have you guys participated in the second round of that?

Barry S. Ray -- Senior Executive Vice President and Chief Financial Officer

Yes. We did, yes.

Gary L. Sims -- Senior Vice President and Chief Credit Officer

That includes our second round participation, Damon.

Damon DelMonte -- KBW -- Analyst

Okay.

Barry S. Ray -- Senior Executive Vice President and Chief Financial Officer

We've got yes, we estimate the gross fee is about $11.5 million. As I indicated earlier, there is some cost offset that's going to reduce that down to approximately $10 million net. And that's what I'm talking about with respect to the spread income component. There's additional expenses that we discussed related to applications and such as well as kind of what I would characterize as the unknown is the agent fees. And so $10 million is our best estimate right now of what we're expecting for PPP loan fees to run through spread income.

Damon DelMonte -- KBW -- Analyst

Got it. Okay. That's helpful. And then with respect to your vulnerable industries, that slide that you had. Could you talk a little bit about maybe some of the sizes of the loans in those different categories like specifically like hotel and restaurants? Like how chunky are those loans and maybe like the number of borrowers?

Gary L. Sims -- Senior Vice President and Chief Credit Officer

Damon, I don't have the number of borrowers for you. Our hotel relationships generally speaking, hotels tend to be larger CRE loans. So the loans are going to be $5 million to $10 million individual loans for hotels. That's pretty typical for that space. I don't have the actual number of borrowers for you. Our hotel operators, they are generally local based operators, and we bank those hotels within our footprint. So it tends to be a fairly local effort in that regard. In the restaurant space, we really span the spectrum between a relatively large McDonald's franchisee based out of Iowa City, down to mom-and-pops in our communities across our footprint.

Damon DelMonte -- KBW -- Analyst

Got it. Okay. That's helpful. And then I think that's it. I think my other questions have already been asked and answered. So thank you.

Charles N. Funk -- President and Chief Executive Officer

Thank you, Damon.

Operator

Our next question comes from Brian Martin of Janney Montgomery. Brian. Please go ahead.

Brian Martin -- Janney Montgomery -- Analyst

Hey, good morning guys.

Charles N. Funk -- President and Chief Executive Officer

How are you, Brian.

Barry S. Ray -- Senior Executive Vice President and Chief Financial Officer

Good morning, Brian.

Brian Martin -- Janney Montgomery -- Analyst

So maybe just one, going back, Charlie, to that swap income, just to get arms around that number. Just do you happen to know the differential between 4Q and 1Q? How much was the swap income in 4Q versus what it was in 1Q? Just to kind of gauge how much of a difference there was?

Charles N. Funk -- President and Chief Executive Officer

We're looking.

Brian Martin -- Janney Montgomery -- Analyst

Yes. Fine I can the other question I had was just surrounding the PPP and Damon's question. Just the revenue you expect to recognize, timing-wise, do you expect most of that to occur in based on the forgiveness you're thinking in 2Q and 3Q? Or does it extend out? Or just how are you thinking about that in general?

Charles N. Funk -- President and Chief Executive Officer

Well, the unknown is we don't know what the forgiveness process is going to look like. And I think that's something that bankers are talking about around the country. We know there is forgiveness, but there really hasn't been a whole lot of guidance in terms of process and how it's going to work. And now you've thrown this whole notion of audits for the larger ones into this. So I think we had originally thought that we would recognize some income in the second quarter, and we probably will. But I've got to think this is just a guess that there'll be it will be second and third quarter and what percentage is which we just don't know. It's really hard to say.

Brian Martin -- Janney Montgomery -- Analyst

Okay. That's helpful. Just the other thing I had on that PPP was the $10 million, what level of loans, I guess, does that entail? With Phase one and Phase two, how many loans are you guys anticipating? Or do you expect there?

Charles N. Funk -- President and Chief Executive Officer

Well, Phase one, I think we've got roughly 1,200 to 1,300 approved. And so we're probably at 800 to 900 in Phase two and still taking applications. But the applications that are coming in now in Phase two are they tend to be pretty small, and we will continue to book loans, but I don't know that it's going to add significantly to our totals.

Brian Martin -- Janney Montgomery -- Analyst

So you're just the total loans, Charlie, that you expect in just ballpark, have you I guess maybe I missed Phase two, that's why I was asking. So if I did, I apologize. But just the total loans you're thinking right now would be about?

Charles N. Funk -- President and Chief Executive Officer

I believe what we reported was 2,261 loans. I believe that's what we said. And so if it was 2,261, we'll probably be 2,300, 2,400 loans, maybe 2,500 on the top end. It depends how long the money lasts as well.

Brian Martin -- Janney Montgomery -- Analyst

Right. Just but the dollar amount of loans, Charlie, not the number of loans. I guess, did you disclose that? That's what I...

Charles N. Funk -- President and Chief Executive Officer

$335 million to $340 million.

Brian Martin -- Janney Montgomery -- Analyst

Got you. Okay. Perfect. And going back to that swap income, just the second question on fees was just the from a fee income perspective, how much of a haircut, if any, I guess, are you guys thinking, whether it be service charges or trust as we think about the impact of COVID? And how that impacts those couple fee line items going forward?

Barry S. Ray -- Senior Executive Vice President and Chief Financial Officer

Yes. This is Barry. Brian, I think I'll give you the Q1 swap income number. I don't have that in front of me. I do think there's going to be downward pressure on the investment services and trust activities line items as well as service charges and fees. And so I don't have what that number is going to be, but I think there's going to be downward pressure on it.

Brian Martin -- Janney Montgomery -- Analyst

Okay. All right. And that's from 1Q level, correct?

Barry S. Ray -- Senior Executive Vice President and Chief Financial Officer

From 1Q level, yes.

Charles N. Funk -- President and Chief Executive Officer

Yes.

Brian Martin -- Janney Montgomery -- Analyst

Okay. Just to be clear. Okay. And then just maybe last two for me. I was just I don't know who just Charlie, you made some comments about the margin the core margin. But just as far as the accretion schedule, does that change with the adoption of CECL? Or I guess the 25 to 30 basis points of benefit on that accretion number, does that change materially? Or is there something on that schedule as you kind of look out over the next several quarters?

Barry S. Ray -- Senior Executive Vice President and Chief Financial Officer

Yes. I don't think the accretion schedule won't change, Brian, as a result of CECL. So I think we were at around $3 million of benefit this quarter. Again, that is front-loaded recognition. So it will diminish over time, but will also be variable based upon repayment activity.

Brian Martin -- Janney Montgomery -- Analyst

Okay, that's all I need. I'll circle back on the commercial the swap income, but thanks for taking the question guys.

Charles N. Funk -- President and Chief Executive Officer

Thank you, Brian.

Operator

[Operator Instructions] At this time, I have no further questions. This concludes our question-and-answer session. I would now like to turn the conference back over to Charlie Funk, President and CEO.

Charles N. Funk -- President and Chief Executive Officer

Well, thank you, everyone, for joining us on the call. And we are definitely in uncharted waters in our industry and in our country, and we just wish everyone good health and safety. Thank you for joining us.

Operator

[Operator Closing Remarks]

Duration: 35 minutes

Call participants:

Charles N. Funk -- President and Chief Executive Officer

Barry S. Ray -- Senior Executive Vice President and Chief Financial Officer

Gary L. Sims -- Senior Vice President and Chief Credit Officer

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

Andrew Liesch -- Piper Sandler -- Analyst

Damon DelMonte -- KBW -- Analyst

Brian Martin -- Janney Montgomery -- Analyst

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