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SmartFinancial, Inc. (SMBK -0.53%)
Q2 2020 Earnings Call
Jul 22, 2020, 10:00 a.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Good morning, and welcome the SmartFinancial Second Quarter 2020 Earnings Call. [Operator Instructions] Please note that this event is being recorded.
Now I'd like to turn the conference over to Mr. Miller Welborn, Chairman. Please go ahead.
Miller Welborn -- Chairman
Thanks, Nick. Good morning, and thanks for joining us this morning for our Q2 2020 earnings call. Joining me today are Billy Carroll, our President and CEO; Ron Gorczynski, our CFO; and Rhett Jordan, our Chief Credit Officer.
Before we get started, I'd like to refer you all to Page 2 of our deck this morning for the normal and customary disclaimers and forward-looking statements. Hopefully, you will take a minute and review these.
First, I'd like to say that I hope each of you are healthy and safe. This is a very challenging time for all of our families, our communities and our businesses, but this industry and our bank are doing an incredible job of being intelligent, diligent and flexible as we continue to learn how to serve our clients in these uncertain times. We did just finished another really good quarter for SmartBank. I can't say enough about how proud we are of the team here at the bank as we continue our progression and execution of our strategic plan.
A few highlights from the second quarter. We did complete the integration of Progressive Financial Group and we're glad they are now fully rebranded and integrated into our SmartBank family. Glad to have them. Net income for the quarter were $6.2 million, a really strong quarter for us. Our diluted EPS increased 115% over Q1, and our diluted operating earnings per share non-GAAP increased 60% over the quarter. We passed the $3 billion mark in asset size, which is a big milestone for us.
Tangible book value stands at $16.90, which is a 6.6% improvement year-over-year, and also our PPP numbers are very impressive for our bank currently to date $292-plus million of loans booked. We feel very good about where we are in all parts of our bank. Our historically conservative credit culture serving us very well right now.
With that, I will turn it over to Billy and let him jump into some of the details of the quarter.
Billy Carrol -- President and Chief Executive Officer
Thanks, Miller. And really, just to start out, not to bury the lead as Miller alluded to, we really had a nice quarter, and I'll hit on a couple of areas and then turn it over to Ron to dive into our financials and then on to Rhett to dive into credit a little bit. First, obviously, we've continued dealing with the pandemic and navigating this current situation has been challenging for all of us. But again, our team has continued to work diligently to execute our plan while staying safe and healthy.
I won't spend a lot of time on it, but it's noted in the slide deck on Page 5, we continue to keep this situation front of mind and we'll do so until we see these cases subside. Even through this challenging time, we've got a company to run and our team has done some great things over the last few months. A few of those highlights. We did cross the $3 billion mark in assets, jumped over that $3 billion mark and as Miller said, a great milestone. We have record deposit growth of $198 million for the quarter, assisted some by PPP deposits, but nonetheless some very nice numbers.
Speaking of PPP, Rhett's going to report on this in just a moment, but we've continued some nice warfare and now have done over 2,800 loans, resulting in over $290 million in production. Just outstanding work from our team on this project, definitely punching above our weight class on this effort. After closing our progressive financial deal at the end of the first quarter, we've now got the bank integrated and converted. That went very well and we've now rebranded all those offices growing our footprint down the I 40 Corridor West toward Nashville. Most all [Phonetic] cost saves realized by the end of June on this deal and we look forward to seeing it really generate some nice benefits moving forward.
Jumping into the financials, you'll see the quarterly highlights on Page 7 of our deck. Net income for the quarter, $6.2 million from a GAAP standpoint and operating net income of $7.3 million, that's a solid $0.48 quarter -- operating quarter even with, and I emphasize with continued reserve build of $2.8 million for the last three months due to the market uncertainty. Margin did tighten as we expected and loans did contract a little bit outside of the PPP lending, but that was expected as well with a few larger project pay offs that move to permanent financing, but we were able to mitigate those areas with some other pickups.
We reported, I believe, our strongest pre-tax pre-provision ROA quarter at 1.53% annualized, coming in at $11.9 million as shown on Slide 8. This is a great slide, slide 8 to draw your attention to it shows our outstanding revenue growth and our overall growth trend line. Record net interest income with continued balance sheet growth, record non-interest income with a great mortgage quarter as well as a full quarter of our new -- from our new insurance subsidiary and probably one of the most important things to note, doing all this, we kept our expenses in check with really nice trends in our efficiency ratio.
I've got some other comments as to what I expect as we move into the second half, but overall, very solid results from our SMBK team this quarter. So now, I'm going to turn it over to Ron to dive into the financials and he'll pass it to Rhett to dive into portfolio and credit. So, I'll close with some additional comments after that. So Ron, let me give you the mic.
Ron Gorczynski -- Executive Vice President, Chief Financial Officer
Yeah. Thanks, Billy, and good morning, everyone. We have gone through yet another eventful quarter. I want to take this opportunity to say thanks to all our associates for all their hard work. Through the ups and downs of this pandemic, our associates work together and remain focused on soundness, profitability and growth of our company.
Let's start with Slide 9, balance sheet performance trends. On the asset side, loans grew 50% annualized on a linked-quarter basis and grew over 31% year-over-year. Our growth for the quarter was primarily driven by $293 million in PPP loans. On the liability side, deposits grew over 33% annualized on a linked-quarter basis and grew over 26% year-over-year. We continue to remain focused on steady consistent growth.
Turning to Slide 10, our operating return on average assets for the quarter was at 93 basis points, an increase from the 67 basis points reported from the prior linked-quarter. In addition, we also continue to produce strong operating pre-tax pre-provision earnings in the amount of $11.9 million or 1.53% of average assets, an increase from the 1.37% reported in the prior linked-quarter. Our operating return on average tangible common equity for the quarter returned back to a more normal level at 11.5%.
Turning to Slide 12 -- excuse me, turning to Slide 11, we continued our consistent trends with our book value and tangible book value growth. At June 30, our tangible book value was at $16.90 per share. On the lower graph, our operating efficiency ratio was approximately 59%, an improvement from the over 65% from the prior linked-quarter.
Now, moving on to Slide 12, net interest income. For the quarter, our net interest income increased $3.1 million to $25.7 million when compared to the prior linked-quarter with higher earning asset balances and lower funding costs offsetting lower yields. During the quarter, we digested the full effects of 150 basis point rate cut and dealt with the many moving pieces associated with our participation in the PPP program. During the quarter, our average interest earning assets increased $532 million, which was primarily attributable to: one, the full quarter effects of the progressive acquisition; two, participation in the PPP program; and three, overall increases in our liquidity position.
Our increases in average interest bearing liabilities was primarily driven by an increase of $169 million in average interest-bearing deposits stemming from the full quarter effects of progressive, increased deposit growth and increases of $185 million in borrowings. This increase in borrowings is primarily from the utilization of the PPPLF facility.
At this point, let me give you some backfill on the PPP program. Our participation in the program provided us with $293 million of loans with an outstanding average balance during the quarter of $209 million. We recorded $10.5 million in deferred loan fees, net of origination costs and had $1.9 million of these loan fees accreted into income during the current quarter. We funded $238 million or over 80% of the loans utilizing the Fed's PPPLF facility with an outstanding average balance during the quarter of $108 million. We view this funding as an ideal match for the loans and it also provides us favorable regulatory treatment.
Our tax equivalent net interest margin for the quarter was 3.63%, a decline of 27 basis points when compared to the prior linked-quarter. This decline was within our expectations. Additionally, our yield on interest earning assets decreased by 61 basis points, which was offset by a 43 basis point decrease at our interest-bearing liabilities.
Moving on to loans. The yield on loans for the current quarter was 4.87%, compared to 5.35% for the prior linked-quarter. Included in the loan yield for the current quarter was $888,000 of loan discount accretion, which was a decrease of $1.1 million from the prior linked-quarter. And the current quarter also include the previously mentioned $1.9 million of PPP loan fees.
We have also continued to add liquidity to our balance sheet as shown on the lower right portion of the slide. This liquidity build had resulted in some NIM compression as these increased liquidity balances have significantly lower rates. This negatively impacted our margin approximately 7 basis points. We have chosen to keep an increased liquidity position during this time to ensure we meet the needs of our clients.
Moving on to interest-bearing liabilities. When compared to the prior linked-quarter, our interest-bearing deposit cost decreased 39 basis points to 0.17%, and our overall cost of total deposits decreased 37 basis points to 0.54%. We still see some opportunities for further rate reductions in our interest-bearing deposits with over 10% of our time deposits maturing and repricing during the third quarter. The PPP program also affect the changes in some of our other interest-bearing liabilities during the quarter, such as a $91 million reduction in our broker deposit accounts, a $50 million reduction in our Fed discount window borrowings and an increase of $238 million from the utilization of the Fed's PPPLF facility.
Looking forward, we are forecasting a third quarter margin in the 3.45% range, a contraction from the second quarter, primarily due to loan rate resets and the effects of the PPP program. This forecast includes estimated loan accretion of 10 basis points to 15 basis points or approximately $860,000 and estimated PPP loan fee accretion of 15 basis points to 20 basis points, approximately $1.2 million.
Moving on to Slide 13, operating non-interest income. We had another great quarter for operating non-interest income. Over the past several quarters, our associates have been focused on building this revenue. For the current quarter, we experienced an over 24% increase from the prior linked-quarter and over 61% increase when compared to the second quarter of 2019. Our operating non-interest income to average asset ratio was at 45 basis points, consistent with our prior linked-quarter. During the quarter, service charges on deposits accounts decreased $61,000, primarily due to lower consumer activity and fee waivers. Offsetting this was a $232.000 increase in interchange fees, which was primarily from having a full quarter of activity from Progressive.
Insurance commissions, which is our newest non-interest income component, reported its first full quarter revenue of $473,000, an increase from the $269,000 reported last quarter. During the quarter, our mortgage team did an amazing job with reporting all-time high production levels of $931,000, an increase of almost 60% from the prior linked quarter. We continue to see a strong pipeline coming into Q3 due to the current low rate environment. We are anticipating slightly lower levels of revenues looking forward into Q3.
And lastly, our investment services income decreased by $74,000 in the current quarter due to current market conditions. Looking forward, our forecast for the third quarter is having non-interest income at 42 basis points of average assets or $3.3 million.
Turning to Slide 14, you'll find our operating non-interest expenses. During the quarter, our non-interest expenses reflected expected increases in the majority of the components, which was primarily from the full quarter effects of Progressive. During the quarter, as Billy had mentioned, we fully integrated Progressive and are achieving 90% of our targeted cost saves. We expect that during the third quarter we should hit our cost save target. Overall, our non-interest expenses were in line with our internal expectations. Looking forward, our forecast for the third quarter is having non-interest expenses around $18 million to $18.5 million with salary and benefit expense approximately $11.1 million to $11.3 million.
Before we move forward to the next slide, let's touch based on income taxes. For the current quarter, our effective tax rate was 18.8%, which included an additional tax benefit from our overall reconciliation of our tax rates from operations and the final effects of the CARES Act legislation. Looking forward, our forecast for the third quarter is for our effective tax rate to be 22.5% to 23%.
Our next Slide 15 gives details in our deposits. On the bar chart to the right, you will see that our deposits have experienced outstanding growth over the last two quarters. During the first quarter, our acquisition of Progressive was a primary driver of growth. During the second quarter, we experienced almost $200 million in deposit growth from both our participation in PPP program as loan proceeds were deposited into SmartBank accounts, as well as overall deposit growth. With our non-interest bearing deposits increasing $213 million during the current quarter coupled with the excess deposits from our transactional account growth and the PPPLF facility, we let $83 million of time deposits roll off with 85% of them being wholesale CDs. At June 30, our non-interest bearing deposits increased to 25% of our deposit portfolio and our time deposits decreased to 26%, our money market, savings and interest-bearing demand accounts remained at consistent levels with our overall deposit growth.
At the lower level portion of the slide, we had another great quarter in reducing our deposit costs and are trending downward toward the Fed funds target rate. This graph gives a good depiction of our continuous efforts on lowering deposit costs.
With that said, I'm handing over the slides to Rhett -- Rhett Jordan, our Chief Credit Officer, to go over loan and credit-related info. Rhett?
Rhett Jordan -- Executive Vice President, Chief Credit Officer
Thank you, Ron. Beginning on Slide 16, you can see our portfolio distribution profile did not change considerably from first quarter to second quarter, excluding the impact of PPP loans on the whole. We saw approximately $269 million in total balance growth for the period, while holding a consistent profile in our portfolio mix with the exception of the impact of the PPP loans on our C&I portfolio. We'll further discuss those PPP shortly.
As we stated in our first quarter call, our bank's loan mix stayed relatively consistent after the Progressive Savings merger, with roughly 80% of the portfolio being real estate secured loans, and for second quarter, that mix excluding PPP loans did not swing considerably, with real estate secured still holding at approximately 83%. We ended the quarter with CRE capital ratios of 91% and 273% in the respective regulatory guidance segments, still below the target levels and very manageable as we move forward through the remainder of 2020. Collectively, our second quarter results demonstrated consistent portfolio diversity and development while being strongly boosted by nearly $293 million in PPP loan fundings.
Moving on to Slide 17, our overall credit quality metrics continued to perform very well through the quarter. Our NPA ratio was 0.28% of total assets at quarter end. As you may recall, we've seen a slight tick higher in Q1 due to the inclusion of ORE [Phonetic] assets from the Progressive merger. A similar spike in classified loans and delinquencies in Q1 also the result of the Progressive merger impacts were both managed down to more historical levels during this quarter. Net charge-offs for the period were 0% and below peer group averages. Overall, asset quality continued to hold consistently for quarter and our outlook for solid credit performance for the balance of the year is cautiously optimistic. We believe our historical conservative credit culture as well as additional post-COVID credit extension directives that we communicated to our lending teams early on in the pandemic will continue to generate solid results in portfolio performance and our footprint, and portfolio diversification will add stability and support a continued strong performance in this area.
Slide 18 updates you on our positioning of COVID-19 related payment modifications in the loan portfolio. At the end of the second quarter, approximately 25% of our overall loan portfolio had received and were in some stage of a modified payment structure due to the COVID event. This was slightly higher than our 21% positioning at the end of Q1 and was due primarily to some continued demand through April and early May for clients that elected to analyze the duration of the initial closure events before seeking some form of assistance.
Hospitality, overnight or vacation rental properties, and restaurant and food service industry clients have led the way in modifications, representing nearly 47% of total modified loans in those segments. This was in line with our expectations as the impact of closures on gathering places and accommodation space, as well as closures of beaches and similar vacation destination-style areas continued through much of the quarter, ending only in the latter portion of May for most of our footprint. Totaling just over $600 million of balances that received COVID modifications, this was a challenging task to administer, but our relationship teams did a phenomenal job reaching out to our clients early and often through this period, inquiring how SmartBank could assist them during this historic time.
Our associates worked hard to ensure that we assisted clients wherever possible in order to create a stronger sense of security and peace of mind as we could until circumstances allowed them to regain some degree of normality in their operations. As I mentioned, this came in late May for many clients as restrictions began to ease and we've been encouraged by the feedback from those clients that June was a much stronger month than they anticipated due primarily to continued relaxation of closures and restricted access to public venues.
As we look at the mix of our modified portfolio in the bar chart at the bottom of the page, we are encouraged by the number of clients that are already back on the normalized payment structures thus far into the month of July. As of Friday, July 17, roughly 34% of our initiated modification loan count and approximately 37% of the initiated modified loan balances had already expired and converted back to their original payment structures. By the end of July, nearly 50% of all modifications will have expired. When coupled with the feedback from most clients that there is a little concern going back on the regular payment schedules at maturity of their COVID assistance and a very small portion of request to date for any longer extensions of those modifications. We anticipate this trend to continue and such that we will be at approximately 15% of the portfolio modified by the end of this month, and we will continue to see that number of track down as long as reduced restrictions are in order and COVID cases remain controlled and manageable through reasonable local and federal government mandates.
As I mentioned earlier, hospitality and restaurant bar exposures continue to be larger segments of our portfolio having sought and continued to leverage COVID mods. As expected from the beginning, these segments have been substantial -- have seen substantial impact due to the profile of this event. Slides 19 and 20 give you some general portfolio summary data about the overall mix, health and geographical representation of SmartBank's portfolio in these two areas. With an average LTV of 42% going into the COVID modification cycle along with a well-diversified portfolio both regionally and in product mix, our modified hospitality portfolio was poised to be able to sustain a considerable impact to its operations and our client base has shown remarkable management capability to modify their operations, their marketing and other key factors to help them work through this process successfully.
While the majority of clients in this particular segment opted for the six-month modification term structure, the feedback we are receiving from many of them is they are optimistic about their ability to go back to making regular payments by maturity of their short-term relief structures, some having up to do so already in advance of their original modification explorations. Similarly in our restaurant space, as seen on Slide 20, many of our clients in this segment saw our six-month modification options as well as most were closed to the public initially and many are still operational only through drive-throughs, take out and with minimized capacity in their dining basis. But just as with hospitality costs [Phonetic], our restaurants demonstrated a remarkable ability to modify their operations to accommodate take out at a much larger volume to manage their staffing needs despite difficult rehire environments and provide quick, compliant and consistent delivery of their product to their customers through unprecedented challenges.
While our portfolio did have a higher concentration in full service restaurant operations in our tourism market areas of the Gulf Coast and the Smoky Mountain zones, these operators proved themselves incredibly resourceful through the first part of the quarter and developed tremendous game plans for the point when partial and expanded openings unfolded. Leveraging the benefits of the PPP program and supported by relaxed restrictions beginning late May and expanding throughout the month of June, operators have given us indications that while still not back to pre-COVID levels of volume and profitability, they're positive in their outlook to continue to generate adequate business activity and cash flows to successfully reestablish their loan structures and work through the balance of the year assuming no resurgence of restriction mandates.
By the end of the third quarter, nearly half of our restaurants will be back on their normal payment arrangements and over 90% will achieve that position by October of 2020. So far, our client base is optimistic and hopeful that the balance of this year will trend positively and they will continue to improve as the year goes forward. As I mentioned in our restaurant segment, the tremendously positive impact of the CARES Act, primarily the Paycheck Protection Program has enabled many of our clients to financially endure some of the toughest months of their business history. Thankfully, SmartBank was able to be there to assist them with this process and provide a resource to help them take advantage of the available loan program that Congress provided to our small business community.
Looking at Slide 21, as of July 14, with the second round of PPP commitment still not fully funded by the SBA, SmartBank had assisted more than 2,800 borrowers with access to more than $293 million in PPP funds across every industry segment tracked by NAICS. SmartBank provided more than $210 million or 72% of these loan balances to its existing client base, but was also able to provide nearly $84 million or 28% of the total to prospects across our footprint. Generating more than $11 million in fee revenue to the bank, this process due to some incredible man hours and dedication shown by our SmartBank associates has been both a tremendous fee generating success and a prospecting resource for the company, but it also did exactly what it was intended to do. It placed directly into the hands of some phenomenal small business clientele, they badly needed capital to help them manage through a timeframe that none of us will ever forget. And we're grateful that we were able to be part of that assistance and support chain.
Now, I'll turn it back over to Ron to walk you through our allowance methodology and those results for the quarter. Ron?
Ron Gorczynski -- Executive Vice President, Chief Financial Officer
Thanks, Rhett, for all the detail on our loan portfolio. Let's move forward to Slide 22, our loan loss reserve. We continued our reserve build during the quarter with our allowance for loan losses increasing by $2.8 million or 21% from the prior linked-quarter. Since year-end, our allowance had increased almost 60% or $6 million with over $5 million of the increase is directly associated with the economic qualitative factors caused by the COVID-19 pandemic. You'll see in this slide that we have made reference to the PPP loans and have removed them from some of the ratios since we are not currently providing a loan loss reserve on these loans as they are guaranteed by the SBA.
Let me direct your attention to the shaded areas of this slide. I want to point out on the right hand column that for the second quarter of 2020, one, our allowance to originated loans less PPP loans increased to 0.89% and two, our total reserves to total loans less PPP loans increased to 1.53% at quarter-end. At June 30, we feel our overall allowance reserve coverage is at reasonable levels. We will continue to assess the allowance and the adequacy thereof as credit conditions change and we will expect to record similar amounts of provision as or if needed going forward.
Moving on to Slide 23, gives us some information on our current capital position. Very good trending information here. Our first quarter ratios were impacted by the Progressive acquisition. During the second quarter, our tangible common equity, tangible asset ratio and our leverage ratio were slightly impacted primarily by our participation in the PPP program. We anticipate these ratios will trend back to prior levels over the next few quarters. Events that will assist the upward trending will be: one, the PPP forgiveness process is solidified and settlement occurs; two, having our elevated liquidity position subside; and three, having a better timing match with the PPP loans and the PPPLF funding, as during the second quarter, the funding was finalized a period of time after loan originations were done. As of June 30, 2020, our current capital position remained strong and well above the well-capitalized benchmark.
With that said, I hand it back over to Billy.
Billy Carrol -- President and Chief Executive Officer
Thanks, Ron. Thanks, guys. Really some great summary on finance and on credit in the portfolio. And so as we close out, let me just add a little bit of color from my standpoint on kind of the next half year. As we heard from Rhett, we understand our loan book really well. And as he spoke to, we've had a lot of really good one on ones with our client -- larger exposures and feel really good about where we stand from a portfolio standpoint. I've asked Rhett and our Chief Lending Officer, Greg Davis, I just -- I'm asking them daily to continually dig for potential exposures. And we just don't see any major concerns right now. Not that we couldn't get surprised by something, but our focus has been and will continue to be on helping our clients through this uncertain time and we believe as long as markets regain some momentum in 2021, we're going to be fine.
Yeah, I do think there has been -- in our industry, there has been this correlation between COVID modifications and potential credit exposure. I just don't think that's the case with us. As Rhett alluded to, we've done a really nice job tracking these. We were a little -- we were aggressive and granting deferrals early on. We did that on purpose to help our clients through this. We're seeing them come through it and we really feel like we're going to be in a great shape and as Rhett said, we're going to be at 15% modified totals by the end of July, and we may have some opportunities and we might want to help some folks even past those November dates if we need to, but just to summarize it all, we feel really good about our loan book right now. And while, sure, there could be some issues that bubble up, we're well prepared.
To that point, you also see us building few really nice reserve just in case we have some of those issues, and we've got some nice income tailwinds with PPP anticipated in the second half that will help us bolster that reserve in the event that we need to. So, from the loan side, reserve side, we feel very, very good about where we sit as a company. Our markets are all performing well given the current environment. Our smaller MSA model is very well positioned for these current challenges.
While we see and continue to see some COVID case increases in the Southeast, our markets for the most part have been open and business has been moving forward. There could be some step-backs and if we see continued spikes, we may have a few of those, but I do remain optimistic that most all of our communities are really pushing hard now for the masks in public and hopefully, that will slow the spread and will enable us to normalize quickly.
From a growth standpoint, we are remaining very disciplined right now. I don't think it's a time for us to really get out and push our sales group to go find deals. We are working with our core base of clients that we know well and also working to leverage a lot of these new clients that have come to us through PPP. So we've got a really nice pipeline. It is a little bit softer than it traditionally would be at this time of the year, but I do feel confident that we can continue to generate some really solid production. But that said, I would expect us to be a little bit softer on the organic side, I would expect a flat to low single-digit loan growth in the second half, just from a pure organic standpoint. We've got a great sales team and we're really ready to put our foot back on the accelerator at the appropriate time, but we all remaining a little bit cautious right now.
Let me speak a quick second to some of the technology items that we've got going on as well. I'm probably as excited about this as much as anything we've got going in the company right now. First, we've added an outstanding new Chief Information Officer, comes to us -- he comes to us with experience at $5-plus billion banks and his skill sets and ideas, we think, will take us to the next level from a tax standpoint, and we've got a number of great projects on the Board as we move to help -- really help move us into a stronger digital positioning for the bank. So thrilled about that. More to come about that in future quarters, but now as a company, we are really working hard on the tech side and have got some great things in place and some great people in place now.
I believe we're sitting in a really nice position given the current environment. We've built this $3 billion platform with a really nice loan book. We're continuing to build our reserves in case of uncertainty. And we're gaining efficiency every quarter and building capital through our earnings stream every quarter. So, it's a really exciting time to be part of this company and we are well positioned to be opportunistic as we move forward.
So let me stop there and we'll open it up for questions.
Questions and Answers:
Operator
[Operator Instructions] First question comes from Kevin Fitzsimmons of DA Davidson. Please go ahead.
Kevin Fitzsimmons -- D.A. Davidson -- Analyst
Hey, good morning, guys.
Billy Carrol -- President and Chief Executive Officer
Good morning, Kevin.
Kevin Fitzsimmons -- D.A. Davidson -- Analyst
Hey. So, I really appreciate this detail you're laying out on Slide 22 with the reserves and those adjustments to it. I'm curious to -- in your experience, I know the regulators and the examiners love doing how you screen versus peers, did they buy into and fully recognized these adjusted ratios or once you explain it to them as far as that goes?
Billy Carrol -- President and Chief Executive Officer
I'll take that, Rhett, and you can comment. I think for the most part -- I think they understand, they've seen enough acquisition accounting now that they understand the discounts and how those work. So I don't know it's really a buy-in, but they are comfortable with those reserves kind of being built into some of that numbers as well. So yes, we've not had really any issues in discussing that with regulators. Rhett, any color?
Rhett Jordan -- Executive Vice President, Chief Credit Officer
No. You're right, Bill, I mean, it's each time we go over this with them, that's always part of the conversation and once we kind of lay out the accounting treatments, they totally understand the perspective.
Kevin Fitzsimmons -- D.A. Davidson -- Analyst
Okay. And I think we talked about this last call a little bit too, just that. And this time this quarter, extremely strong pre-tax pre-provision quarter. I'm just curious, was it -- did you guys internally discuss and debate about whether to take more of that bottom line pre-tax pre-provision and steer it toward the reserve. And again, I recognize all the adjustments and that ratio looks a lot better at 1.53%, but you guys probably get that question a lot, I would assume in terms of just the GAAP ratio screens where it is? And why not take it up, given all the uncertainty? I'm just curious the puts and takes on that issue.
Billy Carrol -- President and Chief Executive Officer
Ron, I'll let you to that. Obviously, as we look kind of with our incurred loss model, I think we've tried to be reasonable in those builds and have the capacity as I made comment to bolster that if needed here in the second half. Ron, do you want to speak to kind of that component of the calculation?
Ron Gorczynski -- Executive Vice President, Chief Financial Officer
Yeah, Kevin, they are separated. The income is really not taken into account of where the expense is going to go. We did refine some of our qualitative factors being on the incurred loss model. I'm not saying we're at a disadvantage, but we have to make sure that our auditors are very -- the oversight on our model has to be there. And so we've -- all of our movement in the allowance has been supported by our qualitative factors at this point. Are we getting to the end of the road with that? We're getting close until we start seeing some portfolio movement. So, we're uncertain where we're going to go with Q3 with this, but we're ready to fund the reserve as needed.
Billy Carrol -- President and Chief Executive Officer
Kevin, I also -- I mentioned in my comments, I mean -- I'm not -- and I'm not just -- I mean we feel really good about our loan book right now. I mean, we've got it -- I mean, we are scrubbing the portfolio, digging for loss potential out there, not -- and again, I said it not that we could have a surprise. I mean, obviously, this pandemic could impact a business in a way that we just -- we don't have on our radar right now. But on the whole, we feel really good about where we are and we think the build -- we think our build right now is fair and as Ron said, we'll continue to evaluate the second half. And we talk -- we need to add a little bit more -- a little more in, we've got the ability to do it.
Kevin Fitzsimmons -- D.A. Davidson -- Analyst
And I guess on a related question, as it relates to the PPP fees, if we assume the SBA gets the rock [Phonetic] together and gets a process in place for forgiveness to take place, and that all happens effectively before year-end, are you like a lot of banks situated to get a lumpsum fee -- PPP origination fee flowing through the margin in fourth quarter that you could steer a large part toward the reserve, if you chose to?
Rhett Jordan -- Executive Vice President, Chief Credit Officer
Yes, the answer is yes. What we're anticipating, Kevin, is probably about 60% of the forgiveness we're estimating that come through the fourth quarter that will give us another $4.7 million estimated. If that were to happen, that will go to the margin in fourth quarter. At that point, probably good timing, if the reserve is needed, we will have funding our income to offset it.
Kevin Fitzsimmons -- D.A. Davidson -- Analyst
Okay, great. And Ron, just I -- I think I missed it when you were going through the numbers. So the 25.6% of balances that are on modification as of June 30, what was that as of July 17?
Ron Gorczynski -- Executive Vice President, Chief Financial Officer
[Speech Overlap] Yeah. As of July 17, roughly 37% of the original balances had come off of modification. So by the end of the month of July based on the normal progression of these maturities, that 25% will be down to about 15%.
Kevin Fitzsimmons -- D.A. Davidson -- Analyst
Okay. That's all my questions. Thanks, guys.
Billy Carrol -- President and Chief Executive Officer
Thanks, Kevin.
Ron Gorczynski -- Executive Vice President, Chief Financial Officer
Thanks, Kevin.
Operator
Thank you. Our next question comes from Ammar Samma of Raymond James. Please go ahead.
Ammar Samma -- Raymond James -- Analyst
Hey, good morning.
Billy Carrol -- President and Chief Executive Officer
Good morning, Ammar.
Ammar Samma -- Raymond James -- Analyst
I really appreciate the guidance in the commentary, it really helps with the model. I just had a couple of clarification questions. Ron, does the 3.45% in margin, is that kind of all-in with PPP and accretion. So is that comparable with the 3.63% reported number this quarter?
Ron Gorczynski -- Executive Vice President, Chief Financial Officer
Yes, it is.
Ammar Samma -- Raymond James -- Analyst
Okay, great. And then on deferrals, I like the maturities kind of flow chart you guys have. I guess the question is, of that 25.6%, you've seen a good chunk expire now. Have any of those requested a second round deferral? And what kind of gives you comfort that that number will move down below 16% by the end of the month?
Billy Carrol -- President and Chief Executive Officer
Yeah. Rhett, I'll let you speak to that.
Rhett Jordan -- Executive Vice President, Chief Credit Officer
Yeah, Ammar, we've only had about 10 clients that we've had conversations with on potential extensions of their modification structures, not all of them after the conversations elected to proceed with this. They were, I think, more so just sort of reaching out to inquire. So at this stage, we feel very confident that those numbers will continue to trend downward as shown on the graph. We are doing a ongoing monthly check-in with all of our clients that took one of our COVID-related modification structures. Our relationship manager teams reach out to each one of those clients each month and discuss with them, where they are, what their outlook is? And as I said, the feedback we've gotten from clients through the first two check-in periods from May and June is on a super majority scale that they intend to go right back on the regular payment structures as those mature over the next few months.
So we really do at this point in time foresee that these extensions will continue. As Billy said, we probably will have a handful here or there that may seek some additional guidance at later points. But at this stage of the game, we feel confident in these directions.
Billy Carrol -- President and Chief Executive Officer
Yeah. And I'll add, Ammar, one of the things when you look at the COVID modification maturities on Slide 18, I like that as well is one of the reasons we wanted to show it graphically this quarter. As Rhett said, and obviously, this COVID situation as it ebbs and flows, what we're seeing is, to Rhett's point, we've got a lot of folks that really feel very good about where business sits today, but they also know that it could be -- fall might be a little bit softer than anticipated. So you might get a little bit of a W out there. And so we are positioned. So next quarter even though it looks like this, you might see some deferral maturities on into some latter months, but those should be pretty minimal and would only be with some of our stronger core clients. It's really more just to help them kind of build some reserves and cash reserves during this time to kind of get through the winter. And so we're working with everybody individual and kind of customizing some of that is needed, but I think you will see that trend line continue to move down pretty aggressively.
Ammar Samma -- Raymond James -- Analyst
Great, thank you. I appreciate the commentary. Last one for me, Billy, just kind of bigger picture. You're at $3 billion now, you've got the progressive deal behind you. Understanding that organic growth will be pressured here in the near-term. How do you just think about the overall growth strategy of the bank now with $3 billion organic over the next couple of years, but also the specter of M&A? Thank you.
Billy Carrol -- President and Chief Executive Officer
Yeah, I'll start and Miller, you kind of give some color on M&A. From that point, Ammar, I do think -- I really feel like we will get back on a nice organic pace with the sales teams that we've built. I think we'll get through that relatively quickly. We just want a little more certainty coming out of our markets over the next quarter or two. Obviously, our focus now has been -- has shifted that we've kind of gotten up to this $3 billion platform. We're really starting to generate some nice revenue growth, some of our ancillary products, whether it's investments, insurance, mortgage, those are starting to hit on a little bit better clip. So I think we can continue to refine to continue to improve our financial metrics, just really kind of just organically stand-alone. That said, we are pretty opportunistic and I know Miller, we talk about that a lot. I'll let you make some comments on softer and future M&A growth.
Miller Welborn -- Chairman
Ammar, we do consider M&A kind of a line of business and we've proven we understand it and can execute transactions. But as we've said before, we're not mandated by our Board or by investors to go out and do any deal. We have continued, through this COVID, as we always have to build relationships with a few banks and a few bankers and we're continuing those discussions and those relationship builds. And we are open for business, we are absolutely open for business and at the right time, we will hopefully execute another transaction. But diligence will become a little bit more clear in the months ahead and in the quarters ahead. So I think you'll see activity with us and with the industry in general pickup.
Billy Carrol -- President and Chief Executive Officer
Ammar, we more we always keep some lines in the water and while everything has really been on a little bit of a pause for these summer -- for these kind of the spring and summer months here. I'm hopeful and I think very optimistic that we can kind of -- as we get more clarity around loan portfolios that we can rekindle some conversations and looking forward to that. But even absent that, I think you'll continue to see improvement in a lot of areas as we move forward.
Ammar Samma -- Raymond James -- Analyst
Thank you. I appreciate that. That's it for me. Congrats on a good quarter and thanks for the time.
Billy Carrol -- President and Chief Executive Officer
Thanks, Ammar.
Operator
Thank you. Our next question is from Feddie Strickland, Janney Montgomery Scott. Please go ahead.
Feddie Strickland -- Janney Montgomery Scott -- Analyst
Hey, good morning, guys.
Billy Carrol -- President and Chief Executive Officer
Good morning.
Feddie Strickland -- Janney Montgomery Scott -- Analyst
I was just wondering, given the recent talk about automatic forgiveness for PPP loans below $150,000 just kind of floating around. I was wondering what was the percentage of your PPP loans that are below that threshold? I know you guys have a fee break out in the slides, but I didn't see a loan balance piece.
Billy Carrol -- President and Chief Executive Officer
Yeah. Rhett, have yo got that?
Rhett Jordan -- Executive Vice President, Chief Credit Officer
I'm working on getting that number, really.
Billy Carrol -- President and Chief Executive Officer
Its vast majority [Speech Overlap]. We've got a bunch of them obviously that would hit that threshold. So optimistic that we'll get some of that guidance here pretty quick. That will take a lot of pressure off our group.
Rhett Jordan -- Executive Vice President, Chief Credit Officer
We will have that report in front of Billy, but I'm going off memory, it's about 90%.
Billy Carrol -- President and Chief Executive Officer
Yeah, you always said that 90%.
Rhett Jordan -- Executive Vice President, Chief Credit Officer
Yeah, I think you were at around 90%, Feddie.
Feddie Strickland -- Janney Montgomery Scott -- Analyst
Got you. Thank you so much. And one other follow-up, just wanted to ask about kind of watch grade at loans or hotels, are there any hotels and restaurants that are still rated pass? And kind of what do you guys thinking are going to happen with these ratings in October? Obviously, we don't know exactly how the virus and everything is going to play out, but just kind of curious what your thoughts are there?
Billy Carrol -- President and Chief Executive Officer
Rhett, can you speak to that?
Rhett Jordan -- Executive Vice President, Chief Credit Officer
Sure, I will. I guess just to clarify from the standpoint of terminology you used the term pass. Again, our watch grade technically is a pass grade, it's not a classified grade asset, but as I mentioned, I think last quarter and can restate our practice was as we identified clients that took a COVID modification, we did move those into our watch list. As I mentioned, we're checking in on those on a monthly basis. Our process thus far has been, as clients come off of their modification structures based on the conversation that our relationship managers are having with them, the information they're providing us on their year-to-date performance and their forecasts, we're making case by case decisions on whether to go ahead and transition them back to their pre-modification internal grade or keep them on the watch list for any additional period, just to ensure.
So the answer to your question is that, yes, we certainly anticipate a significant portion of those that are sitting in a watch grade today to transition off over the next few months. That for the hospitality portfolio will be a slower progression solely because most of those clients took the six-month option. So as long as they are under their COVID modification terms, we're going to keep them in a watch grade until they get back to making the regular payment. So you won't see that portfolio transition back until likely end of the third quarter really going into the October month. But based on the feedback we're getting right now, fairly been talking to clients, the vast majority do anticipate based on their current performance that they will transition back to their regular payments and we have had a handful of that have elected to go ahead and do so early. So we're optimistic that that number will trend back to where it was pre-COVID as they come off the deferrals. But for the next few months, it will definitely, at least for the next quarter, you will likely see that particular portion of the portfolio be a higher percentage in the watch category.
Feddie Strickland -- Janney Montgomery Scott -- Analyst
Got you. Thanks so much. I guess just one more for me. I'm just curious, I've heard some banks, as they're doing some of these modifications have been putting loan floors and some loans that might not have had them before. Are you guys doing that at all with any of your modifications or is that kind of case by case?
Billy Carrol -- President and Chief Executive Officer
It's really more case by case. I don't think we've really going in to try to make some term changes or any real changes to the loans during this period. Now, we have discussed if we need to come in and do some other types of modifications, or if you need to do a second phase, then maybe we get in there and make some adjustments from that standpoint, but really nothing to go in that's changing the structure or rates on notes at this point.
Rhett Jordan -- Executive Vice President, Chief Credit Officer
No, I would agree with Billy on that one, Feddie. We haven't done any kind of -- I haven't across the Board by any means. But the standard process was -- this was solely a adjustment to their existing loan structure. We didn't do any type of pricing adjustments. I guess for the positive, we didn't have a lot of our client base at the time that we felt like needed such. We felt like those portfolios were priced pretty well at that point and in many instances, we didn't want to change the rate because they had very attractive rates at that point in time for us.
So that's been the procedure and as Billy mentioned, and the prior question earlier about second round of COVID request, we have -- we are implementing some discussion with clients that they're requesting second rounds about some additional factors that we will ask them to abide by before we will consider a second round of modification. So we anticipate that that will be handled on a case by case basis as well.
Feddie Strickland -- Janney Montgomery Scott -- Analyst
Got you. Thank you so much. It's very helpful, guys, thanks for taking my questions and congrats on a great quarter.
Rhett Jordan -- Executive Vice President, Chief Credit Officer
Thank you.
Billy Carrol -- President and Chief Executive Officer
Thanks.
Operator
Thank you. Our next question is from Stuart Lotz of KBW. Please go ahead.
Stuart Lotz -- KBW -- Analyst
Hey, guys. Good morning.
Billy Carrol -- President and Chief Executive Officer
Good morning, Stuart.
Stuart Lotz -- KBW -- Analyst
I hope everyone is doing well. Most of my questions have been asked, but Ron, I just wanted to follow up on your expense guidance. I think you mentioned $18 million to $18.5 million run rate next quarter. And if we back out the merger charges from this quarter and I think we are at $17.8 million [Phonetic]. So help me fill in the gap, kind of where that expense creep is coming next quarter. Are there any remaining merger charges or kind of any ancillary items may you expect to be in that run rate?
Ron Gorczynski -- Executive Vice President, Chief Financial Officer
Yeah, I think it's a fluent amount. I think the commissions that we're anticipating from the commission-based compensation will probably be part of that. Other than that's some new hires, some salaries, as you saw the salaries trended upward. But there is no really -- I don't think there is any line item that's really pointing to the definitely increase. And its overall -- our franchise growth is going to be the compensate the difference.
Stuart Lotz -- KBW -- Analyst
Got it. Thanks for the color. And then looking at your branch footprint and just given how -- I mean, you guys are dense in Chattanooga, pretty dense in Knoxville, are you guys looking at any potential branch optimization, as COVID and kind of the work-from-home policy is that made you guys kind of look at your branch footprint and evaluate any potential branch closures this year or next?
Billy Carrol -- President and Chief Executive Officer
Yeah. Stuart, we have. I think we always evaluate the branches and while we do have, we've got some density in a few markets. In most of Arizona, we're pretty well positioned to where it would be a little bit -- probably a little bit more challenging to cut back. There are some opportunities though. We are evaluating a couple of options there and we'll continue to do so. So probably nothing on the major side, but we've got a couple of opportunities there that we're going to take a look at over the next quarter or two.
Stuart Lotz -- KBW -- Analyst
Thanks, Billy. And guys, just one more from me. Sorry, back to Ron, on the fee side, it looked like service charges were a little bit higher this quarter, which is a little different than peers, given kind of cutting breaks on fees. Could we expect that the run rate, that $573,000 is that a good kind of guide for going forward?
Ron Gorczynski -- Executive Vice President, Chief Financial Officer
Well, I think it went higher because we had the full effects of the acquisition. So the guidance we gave you will -- so comparing one quarter to the other, I think it's hard to do. We have seen -- in the service charges alone, we have seen a little bit of a decrease because of the activity and the waves, but the overall -- no, our guidance is reasonable.
Hey, getting back to your non-interest expense question, it just dawned on me. The big delta between quarters is because we booked the loan origination fees for the PPP program, which came out of salaries. So that's a best part of the delta also. So I apologize for missing that.
Stuart Lotz -- KBW -- Analyst
Okay. What's that number, if you don't mind?
Ron Gorczynski -- Executive Vice President, Chief Financial Officer
$600,000.
Stuart Lotz -- KBW -- Analyst
Okay. got it. Awesome. Thanks for taking my questions and congrats on a great quarter, guys.
Billy Carrol -- President and Chief Executive Officer
Thank you, Stuart.
Operator
[Operator Instructions] Our next question comes from Stephen Scouten of Piper Sandler. Please go ahead.
Stephen Scouten -- Piper Sandler -- Analyst
Hey, guys. Good morning.
Billy Carrol -- President and Chief Executive Officer
Good morning, Stephen.
Stephen Scouten -- Piper Sandler -- Analyst
I hopped on a little late, so forgive me if you've covered this at length, but I was listening to your comments about the hospitality credits in particular and about second deferral process. And I'm wondering what the thoughts are around more of a true kind of restructuring or modification of those loans within the CARES Act as opposed to an additional 90-day deferral and things where you might kind of bridge the gap in to weakness into '21 from a revenue perspective for those kind of hospitality credits or if it is largely just a plan to keep the loans in tact and push out the deferrals a little longer?
Billy Carrol -- President and Chief Executive Officer
Rhett, you want to take that first and give some comments.
Rhett Jordan -- Executive Vice President, Chief Credit Officer
I can, Billy. Stephen, we -- actually, it's interesting. Yes, that we've had a number of conversations internally about the possibility of that especially in the hospitality sector. The positive for us if you look at our portfolio, I think as we mentioned kind of going into the cycle here, our loan to value positions on a lot of these relationships were very attractive and it does give us a good bit of flexibility to be able to work with clients, and we've talked about the possibility when and where needed by our specific clients in specific areas about the possibility of doing some -- just some adjusted repayment structures, potentially looking at, maybe modifying some longer amortization periods for a short-term within the full scale of the loan maturity. So for example, if you've got a loan that's got another 10, 12 years of maturity, perhaps we let that borrower make P&I payments based on a longer amortization for another 18 months or something to that effect and then they go back to a payment that would keep them in their original amortization schedule.
To your point, given them a little bit of a relaxation or a little bit of breathing room over the next short run just until this whole virus event has kind of run its course, that's been some -- we've had that conversation. We haven't settled on any one specific solution at this point, frankly, because we haven't had a tremendous amount of demand for it at this point. Most of our clients as we talk with them are giving us the indication that they still feel very comfortable that as they work through the balance of their remaining modification period based on their outlook that they expect to be able to go back to their pre-COVID payment structure and of course, that's optimal for us and that's ideally what we would like to see happen as often as possible.
I don't know if that answers your question, but we definitely have had some conversation about it, but we haven't really said on any specific offer at this point in time.
Billy Carrol -- President and Chief Executive Officer
And I'll just add, Stephen, to Rhett's point, and he said it, we've really not had a lot of folks asking for that. I think there is still some yet to be determined with this, if we get a little bit of a W shape and if there is a little bit of a slowdown, but as we go through and we've looked at every logic property in our book. And as we sit down and go through it and we look at occupancy trends in RevPAR trends and all of that. For the most part, most -- just about all of our properties have had some nice uptick over the last month. And so for us, we're optimistic. We will do if we've got the ability to do some restructures or some readjust, we'll be glad to do that but we've just not had a lot of demand or request for that at this point.
Rhett Jordan -- Executive Vice President, Chief Credit Officer
But we've very strong LTVs, it gives us the ability to do that.
Billy Carrol -- President and Chief Executive Officer
Yeah, that's a great point. And I think that's -- our hotel book, Stephen, compared to maybe some others, I mean, when you look -- and that's the reason we put the loan to values in there. We've got some really nice space to be able to do some of that. So again, I just don't think -- I don't think we'll have too much trouble kind of helping some of these folks along this process if we need to.
Stephen Scouten -- Piper Sandler -- Analyst
Okay, great. That's great color and encouraging the information here. Thanks. Thanks, guys. Appreciate it.
Billy Carrol -- President and Chief Executive Officer
Thank you.
Operator
This concludes our question-and-answer session. Now I'd like to turn the conference back over to Mr. Miller Welborn. Please go ahead.
Miller Welborn -- Chairman
Thanks, Nick, In closing, I'd just say thanks again to all of you for joining us today. We're excited about this bank and our opportunities in the future, and hope you all have a great day. Thanks.
Operator
[Operator Closing Remarks]
Duration: 61 minutes
Call participants:
Miller Welborn -- Chairman
Billy Carrol -- President and Chief Executive Officer
Ron Gorczynski -- Executive Vice President, Chief Financial Officer
Rhett Jordan -- Executive Vice President, Chief Credit Officer
Kevin Fitzsimmons -- D.A. Davidson -- Analyst
Ammar Samma -- Raymond James -- Analyst
Feddie Strickland -- Janney Montgomery Scott -- Analyst
Stuart Lotz -- KBW -- Analyst
Stephen Scouten -- Piper Sandler -- Analyst
