Logo of jester cap with thought bubble.

Image source: The Motley Fool.

First Merchants Corp (NASDAQ:FRME)
Q2 2020 Earnings Call
Jul 23, 2020, 2:30 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, everyone, and welcome to the First Merchants' Second Quarter 2020 Earnings Conference Call. [Operator Instructions].

This presentation contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act. Such forward-looking statements can often be identified by the use of words like believes, expects or may, and include statements relating to First Merchants' goals, business plan, growth strategies, loan and investment portfolio, asset quality, risks and future costs and benefits.

These statements are subject to significant uncertainties that may cause results to differ materially from those set forth in such statements, including changes in economic and business conditions; the ability of First Merchants to integrate recent acquisitions and attract new customers; changes in laws, regulations and requirements of the company's regulators; the cost and other effects of legal and administrative cases; changes in the creditworthiness of customers and the impairment of collectability of loans; fluctuations in market rates of interest; and other risks and factors identified in First Merchants' filings with the Securities and Exchange Commission. First Merchants undertakes no obligation to update any forward-looking statement, whether written or oral, relating to the matters discussed in this presentation or press release. In addition, the company's past results of operations do not necessarily indicate its anticipated future results.

After today's presentation there will be an opportunity to ask questions. [Operator Instructions].

And at this time, I'd like to turn the conference call over to Mr. Mike Rechin, President and CEO. Sir, please go ahead.

Michael C. Rechin -- President, Chief Executive Officer and Director

Thank you, Jamie. And good afternoon, everyone. Welcome to our earnings conference call and webcast for the second quarter ending June 30, 2020.

Joining me today for presentation are Mark Hardwick, our Chief Financial Officer and Chief Operating Officer; John Martin, our Chief Credit Officer; and Michele Kawiecki, our Senior Vice President and Director of Finance.

We released our earnings in a press release this morning at approximately 8:00 a.m. Eastern Time, and our presentation speaks the material from that release. The directions that point to the webcast are also contained at the back of the release, and my comments begin on page four, a slide titled Second Quarter 2020 Highlights.

So on that page up top, First Merchants reported net income of $33 million for the quarter or earnings per share of $0.62. The earnings compare to $41.1 million during the same period in 2019, whereas the $0.62 in the second quarter earnings compare to $0.83 earned in the second quarter of 2019, produced a return on assets of 97 basis points. Considered in a related context, the earnings provide pre-tax provision ROA of 1.73% or pre-tax provision return on equity of 13.18%.

Balance sheet grew, total assets grew 13 -- grew to $13.8 billion, $3.1 billion or 28.7% over the second quarter of 2019. And as Mark will highlight later, it was a combination of our September 1, 2019, closing of Monroe Bank & Trust, organic growth through the period. And then as the sub bullet point says, total loans were helped by approximately $900 million of PPP volume in a program that's set up very well for our client base.

John will be on, obviously, to talk about asset quality. But in consideration of our second quarter provision, our allowance in fair value marks totaled 1.62% of loans. Michele is going to provide additional comments as well in her remarks. I'm down in the deposit section, a meaningful part of the margin equation. I feel like we made great progress in the quarter. Deposit volume's up, as Mark is going to detail. Steady progress in cost reductions. In fact, our 47 basis point cost for the second quarter, down 50 basis points from year-end's number of 97 basis points. As you look at the detail in our deposit mix, you'll see, a close review will show that our deposit structure has management anticipating additional interest rate in dollars and expense savings linked to our remaining and laddered CD volumes and maturities.

Capital levels stayed very high. TCE of -- to assets of 9.31%. And as the press release notes that without PPP loans, our TCE level is actually 9.93%. A $23.04 tangible book value per share grows 9.7% increase over the second quarter of last year and a similar compounded growth rate over time.

Moving to page five. Very busy second quarter. As a provider of all elements of the CARES Act, most notably PPP, I alluded to it a moment ago. More than 5,000 applications really readily received both by our bankers and by the marketplace. I think I saw an article this week that said we produced the third most PPP loans in the entire state of Indiana of all banks. John Martin and our banker team recently negotiated with an outside partner that will be helping us through the forgiveness process, the forgiveness phase, using our own folks, along with a partner, as we continue to understand what will be the preparedness by the SBA to take the forgiveness applications.

We're also a registered Main Street lender, and we're assessing the fits of that program as it evolves. The listeners might know that there's new features announced weekly for that. And we look forward to seeing if that's a good fit for any of the clients in our marketplace.

On the big impacts coming up out of the resolution of the loan modifications. And so John remarks go deep into that. $1.25 billion in modifications, approximately 12% of the portfolio. When I use the term robust process in the middle bullet point, what I'm really talking about is direct client dialogue. Working with interim financials, CFO forecasts, business owner views of their needs for additional help. And as the last bullet point says, really a modest amount if none by the end of the second quarter. And I think a trickle of them that John will speak to about second requests on the back of the help that we provided through the second quarter.

The balance sheet loaded with liquidity with a loan-to-deposit ratio of just under 85% and deposit growth from all sources. Liquidity of our consumer and commercial clients held at First Merchants to include some of the PPP balances. And then as Mark will highlight, some really strong cash balances that we're looking for the highest yield that we can possibly attain in this period of really significant liquidity.

Let me go to page six. A lot of efforts over the last five months, really throughout the bullet points here. Making sure that anyone that's doing business with us or doing business on our behalf, our employees feel safe. And so while all of the banking centers were opened by July 1. We're doing it in a way through modifications and protective barriers that are welcoming to our clients and put our bankers in a position to be the best banker that they can be. That environment would include required mask, and this is even ahead of some of the governors that have done that. But just a feeling on our part that it makes for a better environment to continue to be the advisor that our clients expect.

I think we touched on at our last call, some of the enhancements we made to capacity levels so that bankers that were more accustomed to using face-to-face banking and lobbies, to the extent that they couldn't, they still had mobile and online limits materially higher as well as a lot of one-on-one coaching for those folks that hadn't been digital bank users in the past to take advantage of our investments over the last several years.

Towards the bottom, a bullet point they call, Return to Office. It's an HR-driven framework that we use that flexes to the environment. All parts of the country have kind of had fits and starts, and it allows us to react to our company experience specifically and the government pronouncements as they come about. We have a fully armed pandemic team that digests information and then communicates it out to the rest of the company.

Bottom of the page, the community support. The efforts listed here have really served as a rallying point for our colleagues through this difficult period of time. Top bullet point, we had a commitment of $1 million in donations distributed to not for profits. I think Mike Stewart, our Chief Banking Officer, quarter backed that effort. It included our regional presidents, obviously. I think we were able to get funds to over 200 frontline organizations. And so that investment, I'll call it, call it an expense, reflects itself in our second quarter marketing expense, which you might have noticed. We captioned it internally as the right thing to do.

Bottom bullet point talks about an announcement we made that we're excited about. We've named our first ever Director of Corporate Social Responsibility, and it links to the middle point. But the Director of Corporate Social Responsibility is really combining a lot of efforts that had existed heretofore with a little bit more muscle on them. It's an internal leader within our company previously, the Market President of our Muncie market, which is our headquarters market. Scott McKee it is by name. He's going to lead several prior efforts as one larger, more impactful effort. With the Region Presidents, Scott's going to lead the community benefit agreement execution among all of his responsibilities. And that's the middle point on the page, a five year $1.4 billion agreement that we announced in conjunction with the NCRC, but really with community groups throughout the larger markets within the markets that First Merchants serves. And what it references credit on here, it really is going to be directed toward low and moderate-income needs in mortgages, small business, affordable housing, and then on top of those, credit-related answers and solutions to the needs of our communities, philanthropy and banking center access. So we're excited about it.

Page seven, just a snapshot that might give you some context for some of the answers or material provided by either Mark, Michele or John throughout the balance of our call today. It's a map of our franchise. Again, page seven, tried to just show you some of the progress that's been made. And prior to hearing from Mark, just a summarizing look at our marketplaces. The Midwest, in our view, is on the early end of reopening. And so you see some of the improvement in unemployment. There are no guarantees from me as to where we go from here, yet there are no notable COVID hotspots on a full country basis that exist in the Midwest or in our franchise.

And so we're just working our way at it, a week at a time, trying to take advantage of this situation. And as you can see by the unemployment numbers, the workers are finding opportunities, which ought to give rise to a healthy First Merchants and a healthy Midwest, paying close attention to what the governors of those states have to say. So as we try and move forward, we're doing it in a really balanced way.

And at this point, I'm going to turn it over to Mark, so we can get a little bit deeper into the results themselves.

Mark K. Hardwick -- Executive Vice President, Chief Financial Officer, Chief Operating Officer and Principal Accounting

Thanks, Mike. Yes, I have a real sense of pride around that communities -- those community support comments you just made, and I'm excited about our ability to just enhance the financial wellness of the diverse communities we serve. So those initiatives are exciting and important.

If you turn to slide nine, total assets on line seven increased by $1.4 billion or 21.9% annualized since year-end 2019. Our investments on line one increased by $193 million or an annualized 15%, following up a strong 2019 where investments increased by 59% over 2018, providing really strong liquidity for the company. Loans on line two have increased by $831 million since year-end. Of that increase, the PPP loans accounted for $883 million, net of deferred fees and cost. Additionally, on line three, the allowance for loan losses increased by $41 million or 51% year-to-date, primarily due to COVID-related economic challenges.

The composition of our $9.3 billion loan portfolio, shown on the upper right side of slide 10, produced a second quarter 2020 yield of 4.10%, down from the first quarter of 2020 yield of 4.85%. An 83 basis point decline in LIBOR during the quarter was the primary driver of the decrease in loan yields, and PPP loans accounted for about six basis points of the decline.

On slide 11, our investment portfolio has a longer duration than our peer group, which is a nice offset to the variable rate loan portfolio that we have. And as of June 30, 2020, our unrealized gain totaled $139.1 million, a $66.6 million increase since year-end. Our yields are stable, totaling 3.02%, with remaining maturities in 2020 totaling $253 million with an average yield of 2.56%; and 2021 maturities totaling $429 million with a yield of 2.25%.

On slide 12, total deposits increased by $1.1 billion or 22.9% annualized over year-end 2019. Obviously, some portion of the increase is due to PPP loans that have remained on deposit, which we estimate to be about one-half of the 2020 growth that we've experienced. We believe that our loan-to-deposit ratio of 85% and our loan to asset ratio of 67%, again, provides the bank with strong liquidity levels.

The mix of our deposits on slide 13 is the key to both liquidity and strength and low cost -- our liquidity strength and low-cost funding. Second quarter interest expense on deposits totaled 47 basis points, down from the first quarter of 2020 of 88 basis points. This 41 -- or this reduction of 41 basis points helped us offset what was an unusually challenging decline in loan yields during the quarter. As we move through the remainder of 2020 and into 2021, we have time deposits -- time deposit maturities that should bring down interest expense even further. In the remainder of just 2020, we have nearly $900 million of CDs that will mature with an average rate of 1.77%. And we're anticipating about 140 basis points of savings as those CDs mature throughout the rest of this year.

All regulatory capital ratios on slide 14 are well above the regulatory definition of well-capitalized and our internal targets, which ensures the bank maintains strong levels of capital. When adjusted for PPP loans, which are 100% government-guaranteed, our tangible common equity ratio would recalculate to be 9.93%, as you can see on the slide, and as Mike previously mentioned.

Now let's turn to slide 15. The corporation's net interest margin, net of fair value, declined by an additional 27 basis points from the first quarter of 2020 to the second quarter of 2020. Of the decline, PPP loans accounted for six basis points. As mentioned during the discussion about loans and deposits, our loan yields declined more than expected as a result of LIBOR rate reductions. Our guidance only called for a 10 basis point decline as this rapidly changing environment impacted the quarter at the highest end of our modeling. During last quarter, we were anticipating the lower end of the range.

Much of our confidence was due to the aggressive deposit rate reductions deployed by our team. However, it simply wasn't enough to outrun the rapid repricing in earning assets that we experienced. From this point forward, PPP fee amortization should be the primary point of discussion. Although we don't know how quickly the SBA will process the forgiveness of PPP loans, we have clients that are eager to move forward. We're modeling for 80% of the PPP loans to be forgiven evenly over the next 12 months, although that's just an estimate. This acceleration of fee income should allow net interest income and margins to increase on a reported basis, but the core net interest margin, excluding fair value and PPP should remain stable.

Noninterest income on slide 16 totaled $26.5 million for the second quarter of 2020. The decline in fee income from the first quarter totaled $3.3 million, and fees from customers accounted for $2.5 million of the decline. Service charges on deposits on line one was the primary driver, accounting for $1.7 million of the decrease as customer average balances increased, resulting in just half of our normal NSF and OD fees for the quarter.

May was a low point for service charge income, but we did see a nice recovery in June. Wealth management fee income is down $384,000 and more than half of the decline is related to tax prep work that is directly offset in other expense. Card payment fees increased by $190,000 during the quarter. Gains on the sale of mortgage loans continues to be a bright spot in our performance as they increased by $311,000 for the quarter. And hedge income was down for the second quarter compared to the first quarter as loan closings, excluding PPP loans is less than our normal run rate.

Noninterest expense on slide 17 totaled just $60 million in the second quarter of 2020 compared to $66.1 million in the first quarter. The decline was driven by $2.3 million of deferred salary expense related to PPP, a $1.1 million reduction in bonus accruals and a $1.6 million decrease in debit card payment processing expense due to the termination of our rewards program. We also expensed nearly $1 million in the quarter based on our contribution levels that we committed to for COVID relief. We anticipate noninterest expense in the third quarter of 2020 to be closer to $64 million.

Now on slide 18. We were pleased that our bottom line totaled $33 million in net income and earnings per share totaled $0.62. We also like the strength of our pre-tax pre-provision return on assets of 1.73% and an efficiency ratio of less than 48% for the quarter.

On slide 19, you can see trends of EPS, dividends and tangible book value per share, and we chose to add a dividend payout ratio line as well. We believe that our dividend, which is still less than a 50% payout, is reasonable in this environment.

And on slide 20, you'll notice our total compound annual growth rate of tangible common equity is still 10.13%, and our dividend yield is nearly 4%.

Now, Michele Kawiecki, our Senior Vice President of Finance, will cover a couple of key items related to loan loss coverage and capital strength.

Michele M. Kawiecki -- Senior Vice President and Director of Finance

Thanks, Mark. My comments will begin on slide 22. Looking at the top right of this slide, you will see the allowance for loan loss roll forward for the quarter. We had a beginning allowance balance at the end of Q1 of $99.5 million, plus net charge-offs of just $230,000, plus the Q2 provision expense of $21.9 million. That brings the June 30 allowance for loan loss balance to $121.1 million.

I would remind you that we elected to defer the adoption of CECL. So we calculated the provision using the incurred loss method, but continue to run our CECL models parallel. We believe the provision expense this quarter materially approximates the -- what provision expense would have been under the CECL method. Moving down to line nine. The remaining fair value marks on purchased loans totaled $29.3 million. Adding those marks to the allowance balance totals $150.4 million, which is a healthy 1.62% of total loans, which Mike mentioned earlier in his remarks.

Next on slide 23. This slide is intended to show you that when considering our robust capital and allowance for loan loss levels that we have nearly $500 million in reserves to cushion us through the economic downturn. So let me start by walking you through the allowance at the top of the page. The table at the top shows a roll forward of our allowance for loan loss since December 31, 2019. The first highlighted line shows our current allowance balance of $121 million with an allowance to loans total ratio of 1.30%. When excluding the PPP loans from total loans, the allowance to loans is 1.44%.

As I said earlier, we did not adopt CECL, but in our 12/31/19 Form 10-K, we disclosed that the estimated CECL day one adoption impact, if we had adopted on January 1, was estimated to increase the allowance by 55% to 65%. Applying 65% to the 12/31/19 allowance for loan loss balance of $80.3 million creates a CECL day one adoption increase of $52.2 million. So a pro forma of the allowance with CECL adoption using these assumptions would have yielded an allowance of $173.3 million, which has a robust coverage ratio of 1.86% and 2.06% without PPP loans. The increase in the allowance for CECL adoption would lower capital on an after-tax basis.

So in the bottom left corner, I have provided a pro forma of the total risk-based capital ratio. Our current total risk-based capital ratio is currently 14.18%. When reduced for the impact of a CECL adoption, the ratio would be reduced to 13.68%. That still leaves $316 million of excess capital above the well-capitalized level. This excess capital added to the $173 million of allowance, both shown post CECL, gives you nearly $500 million in reserves. That's enough to cover a 6% to 7% non-PPP loan charge-off ratio, depending on whether you're looking at it before or after tax.

Now it's important to keep in mind that this does not consider our strong pre-tax pre-provision earnings levels that would continue to contribute to capital over the quarters to come, as well as the $29 million in fair value marks that I just mentioned on the previous slide.

I hope that this gives you a clear picture of our balance sheet strength. Now I will turn it over to our Chief Credit Officer, John Martin.

John J. Martin -- Executive Vice President and Chief Credit Officer

All right. Thanks, Michele, and good afternoon. I'll begin my comments on slide 25 with a detailed look at changes in the portfolio, provide an update on modifications, discuss the PPP loan program further, discuss some of the specific COVID-sensitive loan portfolios, cover some mortgage lending highlights and then review first quarter asset quality.

So turning to slide 25. C&I loans grew on line one by $718 million during the quarter, resulting from the origination of roughly $908 million in PPP loans, offset somewhat by decline in line of credit utilization. Dropping down to line 10, mortgage loans grew by $19 million, while home equity loans on line 11 declined by $38 million. The active refinance market helped to maintain and grow the mortgage portfolio, while second mortgages were likely included in refinances, which caused our second mortgage balances to decline.

Slide 26. This shows a diversified loan portfolio, grouped by bank call reporting, which is tied to collateral. And yet, as one would expect, concentrated in the states we are located. There have been 2,548 cumulative payment deferral modifications granted to roughly $1.124 billion with roughly 1,869 commercial modifications. At quarter end, there were no commercial second deferrals or modifications granted. And I checked yesterday, and we had less than $5 million of second commercial deferrals to date.

It is difficult, if not impossible, to determine the number or the amount of second payment deferral modifications that will be requested, but I've been pleasantly surprised by the low number of requests and grants thus far. We have established processes for a second modification request to analyze and work with borrowers depending on individual circumstances. These include reviewing need and expected repayment in a COVID environment with financial analysis and financial information determining the borrower's ability to repay.

Drilling into modifications further on slide 28 by NAICS or industry segments. This slide is intended to help provide a clearer picture of the modification data. Here, you can see the modifications concentrated around hotels, restaurants and food services, dental and lessors of real estate. Hotels were not as fast to request modifications in the first quarter, but grew to be the portfolio at the highest percentage modification, while lessors of real estate became the portfolio with the largest dollar modifications. All but 28 loans representing roughly $80 million were granted 90-day deferrals, while the remainder were extended for a full six months. These longer-term modifications were granted primarily to hotels. Of the 1,863 modifications mentioned earlier, roughly 1,250 or roughly 67% have returned or are in the process of returning to their regular payment schedule.

Moving on to slide 28. As I mentioned, on the loan portfolio trend slide, we originated $908 million of PPP loans to roughly 5,100 borrowers. The effort utilized existing resources and systems and generated almost $27 million in deferred PPP loan fees. Because of the high demand in the first round and the streamlined process that the initial -- streamlined process that we implemented, the initial focus for fulfillment and delivery was to our existing customers. Looking forward, the PPP forgiveness planning process is well under way, as Mike had mentioned, and we intend to use a third-party system with a blend of internal and external resources on a flex basis as necessary.

Turning to slide 29. This shows the industry concentrations for our C&I portfolio. Our largest concentration is manufacturing, which aligns closely with the concentration of manufacturing in our geography. Line utilization dropped for the quarter from 47.5% to 40.8%, which reduced loans by $138 million, as I referenced on the third slide, partially offsetting the growth in PPP loans. Receipt of PPP funds, combined with reductions in working capital assets and the repayment of isolated defensive draws are potential causes for the reduction of line borrowings.

Turning to slide 30. I've broken out and expanded on prior discussions of our sponsor finance business and clarified how it fits into the definition of leveraged lending on the right. Our sponsor business lends to the portfolio companies managed by private equity firms. While most all of the businesses we lend to in the sponsor finance space rely on enterprise value as a secondary source of repayment, we generally structure loans with lower leverage of senior funded debt. This means that not all of the sponsor finance business is definitionally leveraged. We also have relationships outside of the sponsor finance business which may be leveraged, including regional or middle-market businesses or leveraged shared national credits in our geographies where we are a participant. The table at the bottom of the page provides a breakout of our leveraged loans by business lines, which includes modifications.

Moving to slide 31. I've included a breakout of the investment real estate portfolio by multifamily and commercial real estate. Commercial real estate includes some of the more COVID-sensitive categories, including hotel and some -- or some hotel and some retail, which are shown on slides 32 and 33.

I've included on slide 34 mortgage and consumer for reference as well. These slides are intended to provide a deeper view into the areas where modifications have been higher or where we've seen issues. I'm happy to answer questions, but suffice it to say, we continue to monitor these portfolios closely.

Then moving to slide 36. Nonperforming assets increased $34.5 million due to two names in the senior living space and one in the university logo apparel industry. All three have been experiencing some level of issue prior to the pandemic and now need either a restructure or some other form of work out. Dropping down to line four, 90-plus days delinquent increased mostly as a result of a $3.5 million relationship, which is in the process of a refinance but decided to let the payments at the end of the quarter go past due. We believe that we are well secured and in the process of collection, and this relationship should be resolved by quarter's end -- third quarter's end.

Then moving to slide 37. We reconcile nonperforming assets. We added the $35.6 million of nonaccruals on line one, reduced nonaccruals by $1.1 million through $600,000 of payoffs and return to accrual or restructure on line two with gross charge-offs of $500,000 on line five. We had a $600,000 reduction in OREO through sales and writedowns on line eight and nine with a $4.7 million, as I just mentioned, in 90 days past due. That leaves us with a $39 million increase in NPAs and loans, 90-plus days delinquent at the end of the quarter at $63.6 million.

So to close out my remarks, we are paying close attention to the modifications and the second deferral requests. I believe we have a long way to go before we will know or understand the impact of the economy being shut down. The economy is presently being buoyed by stimulus that will eventually end. But for now, we are proactively engaging our COVID-impacted customers and balancing between the best short-term and long-term solutions, such as deferrals and nonconcessionary restructures. We continue to maintain our underwriting standards and look for opportunistic portfolio growth in non-COVID-sensitive industries to borrowers who are well positioned to grow in the current environment and beyond. We are beginning the cycle with a stronger credit and capital profile, and this should give us strength to bridge through.

All right. I'll turn the call back over to you now, Mike.

Michael C. Rechin -- President, Chief Executive Officer and Director

Thank you, John. I'm going to move to page 40, we have some -- offer a couple of comments, and then we'll take questions.

So we aspire to demonstrate many of the needed ingredients to be a true high-performance banking company and often do. I would submit there's some of that in our second quarter, and they're highlighted specific bullet points on 40, whether it's a earnings stream, pre-tax provision of nearly $60 million, it will help to continue to build capital and cushion. TCE that already stands just under 10%, absent the effects of the PPP loans. Liquidity for all purposes. The diversified loan portfolio that John just covered in the slides I thought were insightful. But maybe most of all, experience and talent in working through a recession. And so -- and John Martin; and Mike Stewart, our Chief Banking Officer; and then dozens and dozens of other bankers charged with monitoring their portfolio and the health of their borrowers. I feel like that as what comes, whether it's next quarter's modifications or the entirety of the portfolio to include new requests in less certain times, I'm very confident that our commercial backbone will be up to the test.

This corporate social responsibility, which is two-thirds of the way down the bullet points, really gives us a chance to invest in the staying power of our marketplace and it will do so. We got nearly 2,000 teammates on board with that set of opportunities under Scott McKee's leadership.

Going to take a deep look at our channel of deliveries. We've always been looking toward platform work in the consumer bank. I think we're going to widen that out and see if customer experience has had them change the way they'd like to use our company. And there's a lot of technology that we've been evaluating for quarters now and look to make an investment on when the time is right, sooner rather than later. So we're excited about that.

I'm going to finish by referring to a page that we looked at not that long ago, page seven, the unemployment rate decline and how it feels. While our loan demand might be less than it was historically prior to the COVID period, it's very much out there, and it's a function of our dialogue with our clients. So while overall loan demand might be beneath where we'd like it to have that 8%, 9% organic growth. There's industry pockets that are really running hard, and there are pockets that we participate in. So we know we'll get our share there. I'm encouraged by the sticktuitiveness of our entrepreneurial middle-market client base and look forward to watching their recovery as I watch the strength of our company.

So at this point, Jamie, if there's folks that have questions, we're ready to address them.

Questions and Answers:

Operator

[Operator Instructions] And our first question today comes from Scott Siefers from Piper Sandler. Please go ahead with your question.

Scott Siefers -- Piper Sandler -- Analyst

Good afternoon, guys. Thanks for taking the question.

Michael C. Rechin -- President, Chief Executive Officer and Director

Sure, Scott.

Scott Siefers -- Piper Sandler -- Analyst

I was hoping, John, that you might be able to provide a little more detail on those three credits that you mentioned that drove the increase in nonperformers, the two senior living ones and the logo company. I'm guessing given that there were virtually no net charge-offs, you probably haven't necessarily charged those down. But just -- I'm curious for what kind of loss potential you might see, if you have charged them down, kind of where they're charged down to, etc?

John J. Martin -- Executive Vice President and Chief Credit Officer

Yeah. Hey, Scott. We haven't charged those names down. A little bit of background, essentially, what we had were two specific nursing homes that were in the process of lease-up, and both of them were hit with the coronavirus. They were a little slow to lease-up initially anyway. With the coronavirus, they experienced issues, and as a result, really fell backwards in terms of their occupancy. There hasn't been any charge at this point. We're in the process of getting updated appraisals, and we have laid -- or put in place a specific reserve.

Scott Siefers -- Piper Sandler -- Analyst

Okay. Perfect. And did any of those -- had they received any forbearance? Or just given that they were experiencing some trouble or slowdown before COVID, were they just sort of not eligible?

John J. Martin -- Executive Vice President and Chief Credit Officer

Well, they probably could have been eligible for COVID. But given the issues that they were experience -- experiencing, we thought it best to recognize the nonaccrual status rather than try to mask it, if you will, for someone who is potentially not going to be able to pay even without the deferral. So it was transparency more than anything, Scott.

Scott Siefers -- Piper Sandler -- Analyst

Okay. Perfect. All right. Thank you. And then, Mark, maybe one for you, just on the cost base. A really good cost control quarter. It sounded like things might elevate a little in the 3Q. I was hoping you could maybe just provide a little color on what would cause the upward pressure on costs in the third quarter.

Mark K. Hardwick -- Executive Vice President, Chief Financial Officer, Chief Operating Officer and Principal Accounting

Yeah, Scott. The -- there are a couple of items that I highlighted. Just -- the $2.3 million of deferred salary expense, that was all related to the -- to our PPP origination. So we won't have that deferral into the future. So that is where 2.1 -- $2.3 million of the increase comes from. The reversal of an accrual that we had from the termination of a rewards program that was in place was $1.6 million. And then the contribution level and kind of the bonus accruals kind of offset one another. And that's how I kind of moved from $60 million up to $64 million for the third quarter.

Scott Siefers -- Piper Sandler -- Analyst

Okay. Got it. Thank you very much. Appreciate you guys taking the question.

Michael C. Rechin -- President, Chief Executive Officer and Director

Sure. You're welcome.

Operator

And our next question comes from Terry McEvoy from Stephens. Please go ahead with you questions.

Terry McEvoy -- Stephens -- Analyst

Hi. Good afternoon.

Michael C. Rechin -- President, Chief Executive Officer and Director

Hi, Terry.

Terry McEvoy -- Stephens -- Analyst

I'm just curious on the accounting for the salary expenses that were deferred, will that flow through expenses, future expenses? Or is that netted against the yield or the fee that will come through net interest income?

Michele M. Kawiecki -- Senior Vice President and Director of Finance

Terry, this is Michele. That actually will come through the salaries line. And so we deferred a total of $2.5 million, that will be amortized over 24 months. So you could expect to see an impact of about $300,000, $320,000 each quarter coming through salaries expense.

Terry McEvoy -- Stephens -- Analyst

Thank you for that. And then a question for Mark. Thanks for pointing out that there was 6 basis points impact to the margin from PPP and running through some of the repricing opportunities on the CD side. What are your thoughts on the core margin, call it, in the third quarter? Will there continue to be some incremental asset yield pressure? And do you see that coming down?

Mark K. Hardwick -- Executive Vice President, Chief Financial Officer, Chief Operating Officer and Principal Accounting

We think we'll have some incremental asset yield pressure, so I would expect to see a modest reduction in loan yields. But we do feel like the ability to reprice the CD book and continuing to tighten our pricing on the deposit side can offset whatever reduction we might see in the third or fourth quarter. So we kind of -- we feel like we've hit a level that we can maintain going forward. But the way this quarter played out, there was a lot of volatility, and we're monitoring it, watching it closely and managing it as well as we can.

Terry McEvoy -- Stephens -- Analyst

Thank. And then may be a question...

Michael C. Rechin -- President, Chief Executive Officer and Director

This is Mike. A tactic that should offer some help relative to asset yields, particularly with the LIBOR decline that Mark covered earlier in his comments, is the implementation of a LIBOR floor that we've put in place probably 90 days ago, but we didn't have the ability nor the appetite to just unilaterally deploy it against all of our LIBOR-based loans, but are deploying it in every new loan situation or rewrite situation to include the majority of the modifications that John's team evaluates. So with the floor that we have in place over the book of business that's LIBOR-based, I think it's going to provide a nice net, if you will, beneath erosion on loan yield.

Mark K. Hardwick -- Executive Vice President, Chief Financial Officer, Chief Operating Officer and Principal Accounting

And maybe to -- that's a good explanation. I think the key is that those floors weren't in place as rates declined. Now that we're at a lower rate environment, every chance we have to renew a loan, we're putting new floors on the books.

Terry McEvoy -- Stephens -- Analyst

Thanks for that. And then just a quick last one for John. Any of the four nonperforming loans or nonaccrual loans and then the 90 days past due, any of them connected to the sponsor finance portfolio?

John J. Martin -- Executive Vice President and Chief Credit Officer

The fashion -- the logo where name was connected to the sponsor book, yes.

Terry McEvoy -- Stephens -- Analyst

Okay. Thanks everyone.

Michael C. Rechin -- President, Chief Executive Officer and Director

Thanks, Terry.

Operator

And our next question comes from Damon DelMonte from KBW. Please go ahead with your question.

Damon DelMonte -- KBW -- Analyst

Hey, good afternoon, guys. How was it going today.

Michael C. Rechin -- President, Chief Executive Officer and Director

Good, well, Damon.

Damon DelMonte -- KBW -- Analyst

Great. So just to kind of circle back on the margin outlook. Mark, where would you put the core margin at this quarter when you take out the fair value accretion that was recorded?

Mark K. Hardwick -- Executive Vice President, Chief Financial Officer, Chief Operating Officer and Principal Accounting

Yes. So if you go to the slide 15, the reported margin was 3.19%, you back out 12 basis points for fair value, gets you to 3.07%. And then you can add back six related to PPP to get to the core. So you're at 3.13% on a core basis, ex PPP and fair value.

Damon DelMonte -- KBW -- Analyst

Got it. Okay. And then the fair value the first two quarters of this year were around $3.5 million or so. Do you expect that to start to trail off in the back half of the year?

Mark K. Hardwick -- Executive Vice President, Chief Financial Officer, Chief Operating Officer and Principal Accounting

That feels like a pretty stable number based on how much we still have outstanding. And as -- so as we're building our models through the rest of 2020 and even into 2021, that's a pretty stable number.

Damon DelMonte -- KBW -- Analyst

Okay. And could you just repeat again how much in the way of CDs you have repricing again throughout the second half of the year?

Mark K. Hardwick -- Executive Vice President, Chief Financial Officer, Chief Operating Officer and Principal Accounting

Yes. We have $900 million that we should pick up about 140 basis points of savings as those reprice through the remainder of the year. They're currently on the books at an average rate of 1.77.

Damon DelMonte -- KBW -- Analyst

Got it. Okay. And then just the last question. As you guys clearly pointed out, pretty healthy provisioning and reserve building in the first half of the year. How do we kind of think about that as we go through the second half? Do you think you kind of retreat a little bit from that $20 million quarterly level? Or do you think that given what you're seeing across your footprint, it's going to be prudent to keep that level up there?

Michael C. Rechin -- President, Chief Executive Officer and Director

John, I know, is looking at his materials, getting ready to answer. I know that the quarter's $21.9 million was really an 80-day assessment of where we are under the incurred loss model. That obviously plays into it. And then we do a really deep environmental scan. So it's kind of pulled together, as you might guess, toward the back end of the quarter. And I'm not going to predict anything. We're going to do the exact same thing. We're going to look at our incurred losses through the first 70, 75 days of the quarter and kind of assess where we are and look at John's team for what else we might see. John, do you have any addition to that?

John J. Martin -- Executive Vice President and Chief Credit Officer

Yes. No. As long as the asset quality holds up and continues, it should be consistent with what we've seen in the past. And on any individual name, that -- those will be added as specific as necessary.

Michael C. Rechin -- President, Chief Executive Officer and Director

We think that the work that Michele covered earlier, and there's a lot of moving parts with the PPP and such. But when you get to a number, as she called out, that can be pro forma-ed into the future post CECL to a number that starts with a two that -- we think that, that's a healthy level. And yet the economy is not done surprising us. We're going to keep a close eye on it.

Damon DelMonte -- KBW -- Analyst

Very good color. Thank you very much guys. Have a great rest of the day.

Michael C. Rechin -- President, Chief Executive Officer and Director

Thanks, Damon.

Operator

Our next question comes from Daniel Tamayo from Raymond James. Please go ahead with your question.

Daniel Tamayo -- Raymond James -- Analyst

Hi, good afternoon. So just at the end of your comments, Mike, you mentioned that some industries are running hard, and you might see some growth there on the balance sheet. Wondering if you could go into a little bit more detail on which industries you're referring to.

Michael C. Rechin -- President, Chief Executive Officer and Director

Sure. It's a little bit anecdotal and John might have some answers, but it's kind of an inside-outside thing. Anything that participates outside -- as we're watching commercial companies that are serving outside activities, they have more backlog and more need for employees than they can find to meet the demand. So I'm talking about trailers, RVs, camps, campers, tractor suppliers. People are spending money on their home, so pool installers, home contractors, painters, roofers.

Mark K. Hardwick -- Executive Vice President, Chief Financial Officer, Chief Operating Officer and Principal Accounting

Construction.

Michael C. Rechin -- President, Chief Executive Officer and Director

Construction, maybe not so much new construction, certainly not office construction, but yes, building out heretofore announced construction projects are swamped. You drive to the office in the morning, as we've been doing, I eyeball my way through who's parked on the side of the road. And then in direct contact with our clients, the ones that are really just trying to cajole their workers back into the workforce. So there's some real points of strength, and they've been even kind of growing as the months have turned from May into June into July. So there's reason for optimism. And yet at the same time, we still got, on balance, 12% unemployment. So there's people that haven't seen fit to call everybody back yet. But reasons to be optimistic.

Daniel Tamayo -- Raymond James -- Analyst

Yeah. That's good color. Thank you. And from a similar side, looking at the -- I guess, breaking out the portfolios, but from a geographic standpoint. You gave some good information on some economic metrics by state. But wondering what you're seeing in your different markets, if you're seeing any kind of divergence between the Indy market and others? Or how you're thinking about that start to play out as we see states kind of operate differently and markets operate differently as we come out of this -- hopefully, come out of this recession?

Michael C. Rechin -- President, Chief Executive Officer and Director

Yes. I think it's somewhat even. Mike Stewart lives that on a daily basis. But I know that there is a parallel, I think I heard it in your question, with the, you want to call it, aggression that any particular governor chose to deploy relative to their unique reopening. I would say, of the four states we do business in. Michigan has probably been the slowest to approach normalcy, if you want to call it that. And so I think our backlog there might be a little bit light. And in addition to which the Monroe franchise is newest into our company and probably has undertaken the most change, and yet it's got awesome upside. Ohio and Indiana, really kind of throughout doing relatively well. And so that's where I see the majority of the backlog that's beginning to replenish itself.

Daniel Tamayo -- Raymond James -- Analyst

Thank you very much. Appreciate it. That's all I have.

Operator

[Operator Instructions] And our next question comes from Brian Martin from Janney Montgomery. Please go ahead with your question.

Brian Martin -- Janney Montgomery -- Analyst

Hi, guys. Thanks for taking the question. Just two for me. Mark, I appreciate the color on the expenses next quarter. Just any thoughts on whether you guys have any initiatives in place, expense initiatives, looking out now that we've kind of entered this period of the pandemic as you look at branches and whatnot going forward, anything like that on the horizon you're anticipating?

Mark K. Hardwick -- Executive Vice President, Chief Financial Officer, Chief Operating Officer and Principal Accounting

Yes. I think every department of our company is looking closely at expense levels and trying to identify ways to, in some cases, take advantage of a new operating environment, like in the case of retail, or just looking for ways to be more effective and efficient. So as we are moving our way into planning for 2021, which really starts in earnest here in about another month, we have teams across the company that are already putting together their tactics and their recommendations, some based on how they view they could improve the efficiency and performance of the company and some based on the direction that executive management has given them. So we think we have opportunities to continue to create efficiency from end-to-end, from the customer all the way through the back office, and we're going to have to look really closely at them as we work our way through this 2020 budget season or for the rest of 2020 for our 2021 plan.

Michael C. Rechin -- President, Chief Executive Officer and Director

Brian, it's Mike Rechin, just going to add to Mark's thoughts. As you've watched, we have looked at our retail and banking center optimization over the years. That will continue. We think it's a tiny bit early to draw transaction counts, which really dove low in the March, April time period. We're going to give a full chance to see how that's getting used, but it's clearly front and center for what we look at. We've also, in 2019, made a technology investment that allows us to see fintech companies that have really strong innovation around the back office of a bank. So while consumer optimization is a tool we've used in the past and we'll continue to, we think there's even more upside for some of the operational areas of the bank.

Brian Martin -- Janney Montgomery -- Analyst

Got you. No, I appreciate the color. And maybe just one other one, which was just -- as it relates to the fee income, a couple of areas that really took a little bit of a turn for the -- I guess, the worst this quarter, the service charges and the derivatives. Just in general, some of those -- the timing of when you might expect, at least, on the service charges to respond -- to pick back up. Mark, I thought you said that they might start to begin to pick up. I guess maybe I just missed that. If you go back on your comments...

Michael C. Rechin -- President, Chief Executive Officer and Director

Mark is looking for a note, I think, because we did see a nice lift in June relative to the earlier part of the quarter. But clearly, our consumer banking leadership wanted to make full offering to our consumer customers of the CARES Act features about protecting folks through the time. So all of those numbers, overdrafts and any other fees, were really held back or eliminated for a certain period of time. So that ought to have a natural lift to it. The derivative, the hedge that you talk about, kind of speaks to my comment, Brian, about loan volume being a little bit down because those are origination fees around commercial borrowers locking in rates. And so as you can see the number clearly didn't go to zero. It had been on a really steady ascent based on the interest rate environment.

I've already seen a little bit of volume pickup there. So that will be a live item for us. I fully expected it based on the hunker-down approach that many of our customers had trying to get through. If you're using PPP, you're trying to keep employees, not necessarily originate new loans. So yes, down. And Mark made the comment about the other customer-driven fee activity in the wealth business. Wealth business fee generation is one month in arrears. And so the figures shared with you in the wealth business would capture the March, April, May 90-day time period, which really bore the biggest brunt of the market declines. And so I think we were probably 4% or 5% lower in fees out of that business than we other would have been. And so starting with June into July, we'll see where the market goes, but it's had a little bit more life to it.

Brian Martin -- Janney Montgomery -- Analyst

Yes. Okay. I appreciate that color. And maybe just one -- just a modeling question. I think -- do you have -- or I don't know if Michele or Mark -- wanted to see average balance of PPP in the quarter or just in the dollars of contribution in the quarter?

Michael C. Rechin -- President, Chief Executive Officer and Director

Yes, I bet you will be able to pick that up quickly here. I see some keyboarding, Brian.

Daniel Tamayo -- Raymond James -- Analyst

Okay. If not, I can follow-up.

Michael C. Rechin -- President, Chief Executive Officer and Director

Yes, we'll send you an email with it. The 883 is the period end and -- do you have it, Michele?

Michele M. Kawiecki -- Senior Vice President and Director of Finance

Yes, I do. Actually, Brian, it's $703 million -- was the average balance for the quarter.

Brian Martin -- Janney Montgomery -- Analyst

Okay. Okay. And I guess I'll just back into the yield, you gave the other piece. So, OK, thank you so much.

Michael C. Rechin -- President, Chief Executive Officer and Director

Thanks, Brian.

Operator

And ladies and gentlemen, at this time, I'm showing no additional questions. I'd like to turn the conference call back over to management for any closing remarks.

Michael C. Rechin -- President, Chief Executive Officer and Director

Thanks, Jamie. I have none. I appreciate the questions. I know it was a longer call than normal. We were trying not only to make sure we convey what we know about the business, but kind of having some intuition for what allows folks to get the best feel for how First Merchants is doing through this period of time. We look forward to your continued interest. If you have any follow-up questions from material we weren't able to get to, I'd ask you to give us a call, and we'll see if we can't provide that. Appreciate your interest. Talk to you soon.

Operator

[Operator Closing Remarks]

Duration: 61 minutes

Call participants:

Michael C. Rechin -- President, Chief Executive Officer and Director

Mark K. Hardwick -- Executive Vice President, Chief Financial Officer, Chief Operating Officer and Principal Accounting

Michele M. Kawiecki -- Senior Vice President and Director of Finance

John J. Martin -- Executive Vice President and Chief Credit Officer

Scott Siefers -- Piper Sandler -- Analyst

Terry McEvoy -- Stephens -- Analyst

Damon DelMonte -- KBW -- Analyst

Daniel Tamayo -- Raymond James -- Analyst

Brian Martin -- Janney Montgomery -- Analyst

More FRME analysis

All earnings call transcripts

AlphaStreet Logo