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Community Bank System Inc (NYSE:CBU)
Q2 2020 Earnings Call
Jul 27, 2020, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Welcome to the Community Bank System Second Quarter 2020 Earnings Conference call. Please note that this presentation contains forward-looking statements within the provisions of the Private Security Litigations Reform Act of 1995 that are based on current expectations, estimates and projections about the industry, markets and economic environment in which the Company operate.

Such statements involve risks and uncertainties that could cause actual results to differ materially from the results discussed in these statements. These risks are detailed in the Company's annual report and Form 10-K filed with the Securities and Exchange Commission.

Today's call presenters are Mark Tryniski, President and Chief Executive Officer and Joseph Sutaris Executive Vice President and Chief Financial Officer. They will be joined by Joseph Serbun, Executive Vice President and Chief Banking Officer for the question-and-answer session.

Gentlemen, you may begin.

Mark E. Tryniski -- President & Chief Executive Officer

Thank you, Cole. Good morning, everyone, and thank you all for joining our Q2 conference call. We hope all of you and your families are well. Like most banks, we had a busy quarter that revolved around PPP, loan deferrals, and for us, an acquisition as well. We provided nearly $500 million of PPP loans for our customers and granted $700 million in deferrals.

One of the most significant impacts of the quarter was the change in our balance sheet, which grew by over $1.6 billion from a combination of PPP, the Steuben acquisition, and significant stimulus-induced deposit growth. Not surprisingly, organic loan growth was negative for the quarter.

Despite granting $700 million of loan deferrals over the past two quarters, total active deferrals as of Friday were down to $150 million and requests for a second deferral had been very limited, which we hope is good news for the future. We're certainly starting from a very good point, given current credit metrics but don't expect to necessarily sustain these levels as we move into the second half of the year.

Operating earnings were actually pretty good for the quarter, and as Joe will discuss in further detail, with operating PPNR up from both this last quarter and last year's Q2, encouragingly, our benefits, wealth, and insurance businesses are all up year-to-date over last year on both the revenue and in earnings basis.

The Steuben acquisition closed on June 15th, with the conversion and integration going nearly flawlessly. We are excited about this in-market transaction in the further strengthening of our Western New York footprint. Loan and deposit retention have both been almost a 100% and we got three consolidations done there already, so we're off to a very good start.

Looking forward to the remainder of the year and into 2021, it's all about three things in my view; credit, the economic environment and interest rates. It's too early to forecast this credit cycle, but we should get more visibility in the second half of the year. We're starting from a position of strength, not just with respect to credit, but also as it relates to earnings capital and liquidity.

The economic environment is equally subject to uncertainty, but we did see significant improvement in consumer activity in the last half of the quarter. The question for me is not just the near-term challenges and severe, but more of the longer-term impact on consumer and business behavior and the ultimate demand for financial products and services. And we all know, the current interest rate environment has the potential to create continued margin challenges going forward.

It's hard to predict whether stimulus or inflation will ultimately prevail, but the current rate environment will make it increasingly more difficult for banks to deliver earnings growth. Despite these forward uncertainties and challenges, I think CBSI is in extremely good stead.

As I said last quarter, there is no substitute for earnings, liquidity, capital asset quality, core deposits and revenue diversification. When I look at the fundamental financial strength of this Company, I remain highly confident that we are well prepared to manage the challenges that lie ahead and to capitalize on the opportunities that are created as a result, Joe.

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Thank you, Mark, and good morning, everyone. As Mark noted, the earnings results for the second quarter of 2020 were solid in spite of the challenges related to the COVID-19 pandemic. The Company recorded $0.66 in fully diluted GAAP earnings per share for the second quarter. Excluding $0.05 per share for acquisition-related expenses net of tax effect and $0.05 per share for acquisition-related provision for credit losses net of tax effect due to Steuben acquisition, fully diluted operating earnings per share were $0.76 for the quarter.

These results were $0.04 per share lower than the second quarter of 2019 operating earnings per share of $0.80 due largely to the COVID-19 pandemic and its related impacts on the Company's operations. The Company recorded $6.6 million in its provision for credit losses, exclusive of acquisition-related provision in the second quarter of 2020, reflective of expected credit losses due to weak economic conditions. The Company's adjusted pre-tax pre-provision net revenue increased $0.05 per share or 4.9% between comparable annual quarters and $0.03 or 2.9% on a linked-quarter basis.

I will next touch on the Steuben acquisition and the Company's balance sheet before providing additional details on the Company's earnings performance for the quarter. On June 12th, 2020 the Company acquired Steuben Trust Corporation and its banking subsidiary Steuben Trust Company for a combination of stock and cash, representing total consideration valued at approximately $98.6 million.

The acquisition extended the Company's footprint into two new counties in Western New York State and enhanced the Company's presence at four Western New York State counties in which it currently operates. In connection with the acquisition, the Company consolidate three former Steuben branch offices into existing Community Bank branch offices and added 11 additional full service offices to its current network. The Company acquired total deposits of $516.3 million and total loans of $339.7 million in connection with the transaction.

The Company closed the second quarter of 2020 with total assets of $13.44 billion. This is up $1.64 billion or 13.8% from the end of the linked first quarter and up $2.7 billion or 25.1% from a year earlier. The very large increase in total assets over the last 12 months was driven by the third quarter of 2019 acquisition of Kinderhook Bank Corp, the second quarter 2020 acquisition of Steuben, large inflows of government stimulus-related funding PPP originations, and other organic balance sheet growth.

Similarly, average interest earning assets for the second quarter of 2020 of $11.11 billion was up $1.07 billion or 10.6% from the linked-quarter of 2020 and up $1.68 billion or 17.8% from one year prior. Ending loans at June 30th, 2020 were $7.53 billion. This was up $661.9 million or 9.6% from the end of the first quarter and up to $1.24 billion or 19.8% when compared to June 30th, 2019.

The company acquired $339.7 million of loans in the Steuben acquisition and originated $492.4 million of PPP loans. Exclusive of these activities, the Company's outstanding loan balances decreased $170.2 million, or 2.5% during the quarter, due largely to a significant slow-down in business activities and the pandemic related shutdown of non-essential businesses in the Company's Northeast markets.

At June 30th, 2020, the carrying value of the Company's available for sale investment securities portfolio was $3.29 billion. This includes net unrealized gains of $163.1 million, up from $155.3 million in net unrealized gain at March 31st, 2020 and $36.3 million in net unrealized gains a year earlier. The effective duration of the Company's investment securities portfolio was 3.3 years at June 30th, 2020.

The Company maintained average cash equivalents during the second quarter of 2020 of $823 million. This is up $708.3 million, or 617.8% over the linked first quarter and $488.7 million or 146% over the second quarter of 2019. The very large increase in cash equivalent balances was due to large inflows of government stimulus funding driving up the Company's deposit liabilities which in turn were invested in overnight fed funds at an average yield of 10 basis points during the quarter.

The very large increase in cash equivalents during the quarter placed a significant drag on the Company's net interest margin and return on asset metrics in the second quarter. Average total deposits were up $1.05 billion or 11.6% on a linked-quarter basis due to Steuben and stimulus and $1.61 billion or 19% over the same quarter last year due to Steuben, stimulus, and Kinderhook.

As Mark noted, we believe the Company's capital reserves and liquidity along with diversified revenue streams, a strong credit record, and experienced management team leaves us well prepared to endure the impacts of the COVID-19 pandemic. The Company's net tangible equity to net tangible assets ratio was 10.08% at June 30th, 2020. This was down from 10.78% at the end of the first quarter and 10.56% from one year earlier due primarily to a significant increase in assets.

The Company's Tier 1 leverage ratio was 10.79% at the end of the second quarter, which remains over 2 times the well capitalized regulatory standard of 5%, while the Company's Tier 1 risk-based capital ratio -- total risk-based capital and common equity Tier 1 capital ratios were 17.1%, 18% and 16.1% respectively, reflective of the Company's lower risk asset based on high levels of regulatory capital.

The Company has an abundance of liquidity resources and extremely well positioned to fund future loan growth. Company's funding base is largely comprised of low-cost core deposits at June 30th, 2020, checking and savings accounts represented 71.7% of the Company's total deposit base.

The Company's cash and cash equivalents, net of float and reserves, totaled $1.25 billion at June 30th. Total borrowing availability at the Federal Reserve Bank was $259.8 million and total borrowing capacity at the Federal Home Loan Bank was $1.8 billion.

The available for sale investments securities portfolio was valued at $3.29 billion, $1.62 billion of which was available for pledging if needed. In total, these sources of immediate liquidity exceeded $14.9 billion. The Company reported total operating revenues of $144.9 million in the second quarter of 2020, this represents a $0.8 million or 0.5% increase over the second quarter of 2019 excluding net gains on securities of $4.9 million.

A $3.7 million or 4.1% increase in net interest income between comparable quarters were partially offset by a $2.8 million or 16.5% decrease in banking noninterest revenues and a slight decrease in financial services business revenues. The increase in net interest income was due to a $1.7 billion or 17.8% increase in average earning assets between the periods, offset in part by a 43 basis point decrease in net interest margin, a decrease in market interest rates and a significant increase in change in the composition of earning assets, including a $488.7 million increase in average cash equivalents between the periods negatively impacted the company's net interest margin.

Total revenues were down $3.8 million or 2.5% on a linked quarter basis. The Company recorded a $4.3 million or 24.7% decrease in deposit service revenues and a $1.9 million or 4.8% decrease in financial services business revenues between the linked-quarters, offset in part by a $1.9 million or 2.1% increase in net interest income and a $0.5 million or 50% increase in mortgage banking revenues.

Interest income and fees on loans was up $4.7 million or 6.3% over the comparable prior year quarter due to a $924.7 million, or 14.7%, increase in average total loans outstanding and $2.9 million of PPP related interest in fee income, partially offset by a 33 basis point net decrease in the average loan yield.

The increase in average outstanding loan balances was due to the Kinderhook acquisition in the third quarter of 2019, pre-COVID organic loan growth, the Steuben acquisition in the second quarter of 2020, as well as a significant increase in business lending due to $492.4 million of PPP loan originations during the quarter.

Interest income on investments, including cash equivalents, decreased $1.8 million or 8.9%, between the second quarter of 2019 and the second quarter of 2020. The decrease is reflective of lower market interest rates, a significant increase in the proportion of low-yield cash equivalent balances and a $0.8 million decrease in the Company's Federal Reserve Bank semi-annual dividend payment, offset in part, by a $265.2 million, or 9.5% increase in the average book value of investment securities.

Interest expense was $0.8 million or 13.4% lower than the previous year's second quarter, driven by a 9 basis point decrease in the cost on interest-bearing liabilities partially offset by a $971.9 million, or 15% increase in average interest-bearing liabilities. The average cost of deposits was 17 basis points in the second quarter of 2020 as compared to 22 basis points in the second quarter of 2019, reflective of market-driven rate decreases for deposits between the periods and the significant increases in noninterest-bearing deposits. By comparison, the average cost of deposits during the linked first quarter of 2020 was 25 basis points.

The Company recorded $9.8 million in the provision for credit losses during the second quarter of 2020. This was comprised of $3.2 million of acquisition-related provision due to the Steuben transaction, and $6.6 million of provision related to expected credit losses largely due to the COVID-19 pandemic. Net charge-offs for the quarter were $0.9 million. This compares to $1.4 million in the provision for credit losses and $1.2 million in net charge-offs recorded during the second quarter of 2019.

On a linked-quarter basis, the provision for credit losses, exclusive of the acquisition-related provision, increased $1 million due to weaker economic forecasts and the financial hardship experienced by certain segments of the Company's loan customers.

The Company recorded $52.9 million in noninterest revenues in the second quarter of 2020, as compared to $55.8 million in the second quarter of 2019, excluding $4.9 million of investment securities gains. This represents a $2.8 million, or 5.2%, decrease in noninterest revenues between the periods; $2.7 million of which is attributable to a decrease in banking-related noninterest revenues. The significant decrease in banking noninterest revenues was due to a $4 million decrease in deposit service and other banking revenues, offset, in part, by a $1.2 million increase in mortgage banking revenue.

The decrease in deposit service and other banking revenues was driven by a precipitous drop in deposit transaction activity due to mandated shutdown of non-essential businesses in the Company's Northeast markets during the quarter. Employee benefit service revenues for the second quarter of 2020 were $0.3 million or 1.2% higher than the prior year second quarter due to increases in plan administration, recordkeeping and actuarial service fees. Insurance services and wealth management revenues were down $0.4 million or 2.4% from the same quarter last year.

Total non-interest revenue decreased $5.7 million or 9.7% on a linked quarter basis. This was driven by a $4.3 million or 24.7% decrease in deposit service and other banking revenues, a $1.3 million or 5.1% decrease in employee benefits services revenues, and a $0.7 million or 10.8% decrease in wealth management revenues, partially offset by a $0.5 million or 50% increase in mortgage banking revenue and a slight increase in insurance services revenues.

Excluding acquisition expenses, operating expenses decreased $2.5 million or 2.7% from $90 million in the second quarter of 2019 to 87.5 million in the second quarter of 2020. The decrease in operating expenses between the periods was largely attributable to the decreased levels of business activities due to the COVID-19 pandemic. Business development and marketing expenses decreased $1.6 million or 52.1% between the periods.

Other expenses decreased $2.1 million or 33.6%, driven largely by decreases in employee business expenses. Salaries and employee benefits expenses increased $0.7 million or 1.3%, but benefited from a $0.8 million or 21% decrease in employee medical expenses due to reduced provider utilization. On a combined basis, data processing and communications expenses, legal and professional expenses, and occupancy and equipment expenses increased $0.9 million or 4.2% between the comparable quarterly periods. Intangible asset amortization expense decreased $0.4 million or 9.7% between the periods.

On a linked quarter basis, total operating expenses, excluding acquisition expenses, decreased $5.8 million or 6.2% primarily due to a $3.6 million or 6.1% decrease in salaries and employee benefits, a $1 million or 9.2% decrease in occupancy and equipment expense and a $1 million or 40.2% decrease in business development and marketing expenses.

The effective tax rate for the second quarter of 2020 was 20.3%, up from 20.2% in the second quarter of 2019 and 18.8% in the linked first quarter of 2020. From a credit risk and lending perspective, the Company has taken actions to identify and assess its COVID-19 related credit exposures based on asset class and borrower type.

With respect to the Company's lending activities, the Company implemented a customer forbearance program to assist with both consumer and business borrowers that may be experiencing financial hardships due to COVID-19 related challenges. At June 30th, 2020 approximately $700 million or 9.3% of the Company's outstanding loan balances were under active COVID related forbearance.

As of last week the outstanding loan balances under active forbearance dropped below $150 million. The Company anticipates at the end of the third quarter, the number of active forbearance agreements will decrease further, but the number and amount of delinquent loans will likely rise. At June 30th, 2020 non-performing loans decreased to 0.36% of total loans outstanding. This compares to 0.39% of total loans outstanding at the end of the second quarter of 2019 and 0.46% at the end of the linked first quarter of 2020.

Total delinquent loans, which includes non-performing loans and loans 30 or more days delinquent to total loans outstanding were 0.72% at the end of the second quarter of 2020. This compares to 0.87% at the end of the second quarter of 2019 and 1.11% at the end of the linked first quarter of 2020. The delinquency status for loans on a payment deferment due to the COVID-19 financial hardship were reported at June 30, 2020 based on their delinquency status at the end of the first quarter, unless subsequent to 31st, 2020 the borrower made all required past due payments to bring the loan to current status.

The Company's allowance for credit losses increased from $55.7 million or 0.81% of total loans outstanding at March 31st, 2020 or $64.4 million or 0.86% of total loans outstanding at June 30, 2020. The $8.7 million increase in allowance for credit losses included $3.6 million in additional reserves due to the Steuben acquisition and $5.1 million due to -- primarily to expected COVID-19 pandemic-related losses. The allowance for credit losses at June 30th, 2020 represented approximately 10 times the Company's trailing 12 months net charge-offs.

Looking forward; operationally, we will continue to adapt to the changing market conditions and remain very focused on asset quality and credit loss mitigation. We anticipate assisting the substantial majority of the Company's PPP borrowers with forgiveness request during the third and the fourth quarters of 2020. The eligibility of the borrower's forgiveness request and the SBA's ability to provide loan forgiveness in a timely manner is uncertain at this time.

For these reasons, it is uncertain as to the timing for which the Company's remaining $13.1 million in net deferred PPP fees will be recognized through the income statement. It seems likely that the pandemic will continue to negatively impact the level of business activity and employment. These factors will continue to adversely affect certain borrower's ability to service debt, may increase loan delinquency and credit losses levels for the remaining two quarters of 2020 and potentially beyond.

Loan demand may be impaired by weak economic conditions. We're also uncertain as to whether or not the high level of deposit liabilities we maintain, spent down or increased further by additional stimulus. We do expect the Company's deposit service revenues to increase slightly in the third quarter, barring another shutdown of non-essential businesses is in the Company's market footprint.

Although we will remain focused on containing operating expenses, it is likely that they will increase in the third quarter as the Company has resumed certain marketing and business development endeavors. The Company's dividend capacity remained strong. Accordingly, the Company expects to continue to pay a quarterly dividend consistent with past practice.

Undoubtedly, the COVID-19 crisis has changed the near-term outlook for society in general as well as the expectations around economic conditions. With this said, we will continue to support our stakeholders in a thoughtful, disciplined, and compassionate manner. I believe the Company is well prepared to endure its effects.

Thank you. I will now turn it back to our, Cole, to open the line for questions.

Questions and Answers:

Operator

Thank you. We will now begin the question-and-answer session. [Operator Instructions] And our first question today will come from Alex Twerdahl with Piper Sandler. Please go ahead.

Alexander Twerdahl -- Piper Sandler Companies -- Analyst

Hey, good morning guys.

Mark E. Tryniski -- President & Chief Executive Officer

Good morning Alex.

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Good morning Alex.

Alexander Twerdahl -- Piper Sandler Companies -- Analyst

First question, just on the additional reserve build this quarter. Was that mostly driven by just a change in the economic scenario inputs to the model or was there any portion of it that was actually related to any loan downgrades in the second quarter?

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Hey Alex, it's a good question. Most of the reserve build was really due to changing economic conditions and continued challenges with the economic forecasts as we kind of look ahead. But we also try to estimate what would happen to delinquency given the level of deferrals which is really sort of a non-economic qualitative factor. We have seen some modest migration in risk ratings, but not significant yet.

We expect that in the third and the fourth quarter, however, that we'll continue to see some -- probably some migration downward relative to the risk rating and probably higher level of delinquency, but our -- we'll continue to monitor that and monitor our customers to determine if there is additional provision requirements in the third and the fourth quarter.

Alexander Twerdahl -- Piper Sandler Companies -- Analyst

Okay, thanks. And then, appreciate all the additional color that you guys provided in this accompanying slide presentation on some of the more at-risk portfolios. But I was wondering if you can just kind of help us all on the line understand just sort of where your economies are in upstate New York in terms of reopening?

And then, kind of as you look at some of the higher categories on that list of at-risk, you know the retail and the lodging, if you have any sense for sort of what -- sort of the utilization of some of these properties are right now, so we can kind of get a better sense for whether or not kind of where the risks or the kind of things we should really be focusing on in terms of credit will be?

Mark E. Tryniski -- President & Chief Executive Officer

Hey Alex, it's Mark. I would just broadly and let Joe Serbun to maybe to comment in a little more detail, but I'll say that in our markets, we were fortunate we've had lower infection rates almost across all our markets even -- in every state essentially and a lot of that is driven by the fact that there are less non--metropolitan -- less metropolitan.

So I think that was, that's been a help for us that there hasn't been this severity of infections and lock-downs and the related impacts. Most of our markets are opened for business except for certain high risk businesses still, like gyms and bowling alleys and some other things, but most of it is open, which has been good.

Clearly, it was interesting the trend and which is really directly tied to economic activity which is -- which is debit swipes. So I mean, we can pretty clearly see when we had kind of the lock down across most of our markets in, when was that? April, I guess, I mean the debit activity took an enormous hit also overdraft as well. But then, kind of recovered pretty nicely when things started to open back up.

So it's hard to predict right now. I mean, everything looks pretty good. The credit metrics are good. The fact that we -- I mean, I was surprised that our deferrals went from $700 million to $150 million and then that we've had very few requests for second deferrals which we're going to address on kind of a case-by-case basis, in terms of either yes or no.

When you look at even something like the at-risk portfolios, like retail is a good example. A lot it's essential businesses that have reopened. So I think I'm cautiously optimistic about some of the credit. I think when you look at the lodging portfolio, it's probably one that's a little more at risk for us, what is it Joe, a couple of hundred million?

Joseph F. Serbun -- Executive Vice President & Chief Banking Officer

Yeah.

Mark E. Tryniski -- President & Chief Executive Officer

That's probably a little more risk. However, if you look at what our lending structure is like in terms of equity and you look at the occupancy, kind of rates in the hotel industry have been coming back, which is good, hopefully that continues. That's probably one of our more at-risk properties. And I think also, again Joe correct me if I'm wrong, but that's one of the sub sectors which has seen more -- a higher percentage of request for deferrals.

Joseph F. Serbun -- Executive Vice President & Chief Banking Officer

Yeah, exactly.

Mark E. Tryniski -- President & Chief Executive Officer

So, I think we're seeing -- we're doing OK. I mean my -- there's so much uncertainty around not just kind of the economic damage that's already been done and what does that look like because we don't know that yet, because there's been so much stimulus. It's just, it's very difficult to predict what's going to happen when the stimulus wears off. So I think the damage -- the economic damage is already done. It's difficult to predict. And I think the future is equally or maybe even more difficult because of the variability in terms of which way things go.

I think if you look at what they're doing with the vaccine, total fast track on that. And I wouldn't be surprised given the different vaccine platforms and the amount of money and you know that whole process around that, if there is some kind of good news, and politically speaking, I would not be surprised if it happened before the election. So I mean, it's hard to predict, but I think from where we sit right now, we're in pretty good shape. I think we had not taken the provisions that some of our peers have.

I think some of that -- we kind of follow our model and some of -- I think some of the charges that have been taken look almost, I think, Joe, this is your words, speculative to send a message that, "Hey, we have the reserves, if we need it mate" and we took kind of a different approach, which was, we'll take the provision we need to take based on what the model says and what we're seeing in our markets without kind of trying to speculate on where things might go.

But I think business -- just to circle back to your initial question, Alex. I think business is OK. We continue to have kind of a lower infection level than a lot of other places, which has been good for us and good for our customers as well. So, I think, if we get some kind of break here in terms of either the infection or a vaccine, things will be great. If we have to kind of relock down. If there's a surge in our markets, there is a relock down that will -- we'll take a step back.

So I think there's a lot of unpredictability there, but Joe, I don't know if you want to comment just on more of a kind of customer level, here's what we're seeing and feeling and maybe even comment on the lodging portfolio because that seems to be where most of the deferral requests have come from.

Joseph F. Serbun -- Executive Vice President & Chief Banking Officer

Sure. So, Alex, let me just -- I'll touch on both portfolios. So on the retail portfolio, particularly the non-owner occupied CRE, just to put some context around it. So the top 10%, the top 10 clients that make up that portfolio, approximately $60 million or 41% of the total non-owner occupied, much of that -- much of that have national or regional type tenants and they're not malls. These are -- these are large properties with multiple stores with their own -- with their own entrances.

The LTV in that portfolio, for the largest top 10, 71%; ranges from 79% at the high to an average low of 40%. So nice diversification from a loan-to-value perspective. In my two cents, what we don't know is what impact is the online shopping going to have. Is it going to continue? And therefore, you're not going to have the people go into the physical location, to physical stores to shop, still uncertain there.

And on the hospitality, as Mark said, it is our largest. Just to put numbers around that, 53% of the total impacted dollar is lodging and 25% of the impacted dollar is retail. So 75% of the impacted dollars land in those two portfolios for us. The numbers of loans that were impact 23% and 21%. So we're keenly focused on those two portfolios and I'll tell you that the -- that the deferrals; the first ones in, and the first go-around, and the first ones coming in the second-go-around, are the hospitality properties and we're taking one at a time.

I'll let you know that of the most current deferrals that we're doing, so the second round deferrals, I think this is important to understand, of the second round deferrals, 50% of them received a principal and interest deferral; 10% of them, almost 10% of them are going to be making a modified principal payment and interest payment and the remaining balance of 40% or 42% will have a -- will be making an interest payment.

So a good percentage or 50% of our portfolio is going to be making some level of payment, whether its interest or modified principal and interest payment and the other 50% -- excuse me, the other 50% are in the P&I deferral.

I mean with respect to credit quality, we approached the first round, the first deferral period, if you were a -- if you weren't a past credit, we downgraded you. We didn't move much credits on the first go around. We're looking harder and harder at the risk ratings at the second go around and we're moving the credits as we deem appropriate.

Mark E. Tryniski -- President & Chief Executive Officer

I think Joe, just to add one thing to that. If you look at the lodging portfolio, the current loan to value on that portfolio is 55%. So there is some fairly good equity coverage there in that portfolio. And these are, for the most part, good developers with good flags.

Joseph F. Serbun -- Executive Vice President & Chief Banking Officer

Yeah, excellent flags.

Mark E. Tryniski -- President & Chief Executive Officer

And, yeah. So I don't lose any sleep over where we're going to be -- where we're going to end up in our lodging portfolio.

Alexander Twerdahl -- Piper Sandler Companies -- Analyst

Great, that was very helpful answer. And then just a final question from me. Just, can you remind us what your dividend policy is? Obviously, you've got plenty of coverage today, but remind us what the policy is and your willingness to continue increasing it on an annual basis, especially if the revenue environment continues to be challenged?

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Sue. Well, we think the dividend is important. We think it's important to be balanced in that dividend. We don't want our -- and there is a balance between return to shareholders of capital and capital retention to use in the business. So I think it's important that earnings grow over time, so that you can grow that dividend because you can't just raise the dividend without growing your earnings.

And as you know and we're proud of, we've raised the dividend every year for 27 or 28 years, something like that. So that's certainly -- we're biased toward growing the dividend, but also mindful of that balance between capital retention and return to shareholders.

Alexander Twerdahl -- Piper Sandler Companies -- Analyst

But I guess, said another way, you guys would be willing to raise the dividend at least for a year or two, even in an environment where revenues and earnings could be going down, just given how comfortable your or bigger cut to your capital position is today. Is that a fair way to think about it?

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

It may be. I mean, I think it's difficult to predict Alex, because I think a lot depends on where the credit results end up, what happens at least in our estimate out into the foreseeable future with margin and the interest rate environment. What happens to tax rates? It's not inconceivable that we have a different tax structure than we currently have.

So, I mean we take all of those things into consideration before the Board makes judgments on the dividend -- the dividend policy. So all of those -- it's a little bit too complicated. I just, we don't want to get into a position where our -- we're willing to kind of let's say tolerate a near-term pay-out ratio that's either a little lower or a little higher than kind of historically. Ideally, we'd like it to kind of be in the 50% range.

We have high earnings and low organic growth, so we don't need to retain as much capital to capitalize organic growth. So that's a very good position to be in. But I would say -- you asked the question about policy, I think 40% to 60% I would say is kind of a reasonable range for us and we'd like to be in the middle of that.

Over time if things do happen for different reasons, whether it's tax rate changes or the impact of M&A or other operating things that could impact kind of your earnings, and -- so there is a lot of factors in play. I think our bias is toward continuing to raise the dividend.

But I think if we -- if we saw severe storm clouds on the horizon for some reason the pandemic gets worse, the economic outcomes get worse as a result, the tax rates go up and we find ourselves where our current dividend policy is substantially outside what our kind of preference would be and I think we would probably do that in the short term on the short-term basis, but -- so I would say pay-out ratio of 40% to 60%, give or take is where we want to be with a bias toward raising it if we can and we believe that it's sensible.

Alexander Twerdahl -- Piper Sandler Companies -- Analyst

Thank you for taking my questions.

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Thanks, Alex.

Mark E. Tryniski -- President & Chief Executive Officer

Thanks, Alex.

Operator

And our next question comes from Erik Zwick with Boenning & Scattergood. Please go ahead.

Erik Edward Zwick -- Boenning & Scattergood Inc. -- Analyst

Good morning, guys.

Joseph F. Serbun -- Executive Vice President & Chief Banking Officer

Good morning, Erik.

Mark E. Tryniski -- President & Chief Executive Officer

Good morning, Erik.

Erik Edward Zwick -- Boenning & Scattergood Inc. -- Analyst

First, I wanted to start with a couple of follow-ups on the lodging portfolio and I appreciate the detail you gave there and it seems like you're not too concerned about at this point and you mentioned the strong LTV ratios. Curious, at this point, can you give us a sense of distribution of the primary uses, either kind of business or recreation for that portfolio, and also, just any insight you might have into the current occupancy rates across the portfolio?

Joseph F. Serbun -- Executive Vice President & Chief Banking Officer

Yeah. So, Eric, the occupancy rates are picking up, but still not where they need to be. So I would say they're in the 35% to 40% occupancy, by and large. And whether it's -- whether it's business or staycation traveling. I don't have a feel for, for what might be driving the -- driving the occupancy. But I'll -- anecdotally and speaking to some of our clients, particularly in destination type marketplaces, they're seeing a pick up over the last -- over the last couple of weeks with people getting a little bit more comfortable with the pandemic and the wearing of the masks.

And so there is -- and the extent that the hoteliers are going to, to keep their properties clean and sanitized, so there is certainly those locations that are destination-like are seeing a much larger pickup in occupancy than you would in a more business environment. And remember, most businesses have locked down employees. There is not a lot to travel or hadn't been a lot of travel. Hopefully that will change here shortly and we'll see some business pick up as well.

Erik Edward Zwick -- Boenning & Scattergood Inc. -- Analyst

Thanks for the color there. And then on that smaller piece, the rooming and boarding houses. I guess, what are your sense for the universities and colleges that might support those for those reopening in the fall and what that -- how that portfolio might trend?

Joseph F. Serbun -- Executive Vice President & Chief Banking Officer

Well, as we sit here today, there is an awful lot of talk about them opening up and bringing students back on campus. Hopefully that happens because there is a population of student housing that sits in that -- that sits in that portfolio. Again, I would tell you that we pick solid sponsors with alternative cash flows and liquidity, and this portfolio, no different. And we could get some help by having them bring the students back. That would be -- that would be terrific.

Erik Edward Zwick -- Boenning & Scattergood Inc. -- Analyst

Then, switching gears to the net interest margin. In the third quarter, it seems like there is a couple of variables that could impact it. One, you'll get a full quarter impact of the Steuben's coming in, which had a higher net interest margin and then I guess there is the questions in terms of excess liquidity, how much you continue to hold and then also the impact of the PP loans -- PPP loans as well as the related deposits. Just curious, your thoughts for what we might see the net interest margin, how it might kind of move relative to 2Q at this point?

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Okay Eric, this is Joe Sutaris. I could take that question. I mean, yeah, I think you've identified all the variables that could impact us in the third quarter. We -- if you kind of peel back the excess cash and cash equivalents we had on the balance sheet in the second quarter of '20 and sort of just call that -- call that a push for the quarter.

In other words, basically a neutral effect, the core margin was down about 6 basis point or 7 basis point toward the high 3.50%s excluding all that excess liquidity in the quarter. So that -- so our core margin did erode a little bit from the first quarter to the second quarter.

With respect to the third quarter if we do recognize and I mentioned $13 million [Phonetic] of net deferred PPP income. If we'd recognize some of that, I think you'll see the posted margin or the printed mark and go up a bit in the third quarter. If you peel that back and roll in the Steuben transaction, I would probably characterize the third quarter net interest margin expectations as about a par with the second quarter.

Obviously, the continued flat and very low yield curve will present challenges as we move ahead into the fourth quarter and into the first quarter of next year. We like a little slop, obviously, as all banks would. But right now, that's going to continue to sort of put a lid on the ability to grow net interest margin even if we see -- even if we start to see some modest loan growth in the second half of the year or even if it's -- just a little bit of growth, I think will generally, it would be difficult to really grow the margin because of the -- because of the low interest rate environment.

Erik Edward Zwick -- Boenning & Scattergood Inc. -- Analyst

That's helpful. Thanks, Joe. And then, one last one, as I think about you know -- the last year or so, you've closed the Kinderhook and then Steuben and certainly the M&A environment has changed a little bit. We saw a few transactions in 2Q, but certainly down from historical standards.

You're in an advantageous situation where you still have a very strong currency relative to many other banks out there today. Just curious how you're thinking about M&A today and what the pace of discussions are relative to past quarters and how you would evaluate those targets today given the unknowns in the economic outlook?

Mark E. Tryniski -- President & Chief Executive Officer

Yeah. No, fair question. I think we -- the way we look at M&A is it's -- given we operate in low growth markets, M&A is not unimportant in terms of our ability to deliver double-digit returns to shareholders over time and the model, the formula is fairly simple. It's let's get 3% to 4% organic, let's get 3% to 4% M&A over time, and let's pay out a decent dividend to shareholders, and that's a double-digit return.

So it's a fairly simple formula. Maybe a little harder to execute in real life than the formula. But M&A is an important part of that. So we never not stop thinking about high value opportunities to our shareholders whether that's in the bank space or the financial services/non-bank space. And so we would continue to look at those opportunities.

As I said last quarter, we would certainly and are always in the process of having conversations and evaluating opportunities. I think it's kind of slowed down a little bit, obviously over the last few months. But I think there is green shoots starting to appear. I just -- I think that a lot of banks that maybe aren't starting from a position of strength, let's call it, are going to have a harder time particularly if they're -- they don't have enough capital, they -- their interest margin is probably not going to grow out into the future.

And so, I think you're going to see, they've gotten beaten down on price and multiple. And so I think there is going to be, it may -- it may take into 2021 for this dynamic to play out, but I think you're going to see a fair bit more M&A opportunity at some juncture in the future because I think you're going to see, again, banks that aren't starting from a position of strength.

Looking out into the future, you know, going forward a year or two and concluding that they're going to have a very difficult time to create incremental value to shareholders. So I think there'd be a fair bit more M&A opportunity, but it's something for us, it's ongoing, it doesn't matter, actually, in terms of the cycle. We usually have less success when the trees are growing to the sky through.

So I'm not saying I'm encouraged, but this is the environment where we seem to historically have had somewhat better opportunities than the other environments, when the trees are growing to the sky, the multiples are already high and prices go even higher, and then we don't want to play in the overpaying space.

So -- but I do think, as you mentioned our currency, even -- I mean we had a reasonably good relative advantage going into COVID. Now we have an even greater relative advantage. So, hopefully, we'll have the opportunity, Erik, for that to help us. Hopefully we get that opportunity, we'll see, but it's some that's an important element of our broader strategy as I said and something that we'll continue to dialog around and we're always -- we're always talking and we're always evaluating.

Erik Edward Zwick -- Boenning & Scattergood Inc. -- Analyst

Thanks so much for all three of you for taking my questions.

Mark E. Tryniski -- President & Chief Executive Officer

Thanks Erik.

Operator

And the next question comes from Russell Gunther with D.A. Davidson. Please go ahead.

Russell E.T. Gunther -- D.A. Davidson & Co. -- Analyst

Hey, good morning guys.

Mark E. Tryniski -- President & Chief Executive Officer

Good morning, Russell.

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Good morning, Russell.

Russell E.T. Gunther -- D.A. Davidson & Co. -- Analyst

Just a quick follow-up on -- if we think about sort of that $150 million pro forma deferral number, could you give us a sense for how that breaks down, what type of loans or exposures that is primarily consisting of?

Joseph F. Serbun -- Executive Vice President & Chief Banking Officer

Yeah, I'll take that Russell. So the -- I'll break it down between the various lines of business if you will. So the business loans, about $130 million; the consumer mortgage, home equity, consumer direct, indirect makes up the difference, in other words [Phonetic] $13 million of the $15 million. And keep in mind that our approach particularly around the consumer product is that we would participate in providing leeway round one deferral.

But when it comes to round two, we will see very few. I wouldn't say zero, but very few second round consumer deferrals being granted. We'll use other loss mitigation type approaches to handle that. So as we sit here today, a $130 million in business and the difference is in the consumer portfolio.

Russell E.T. Gunther -- D.A. Davidson & Co. -- Analyst

Okay, great. And then, of the $130 million that's in the business and if we think about it in terms of the COVID sensitive sectors that you guys identified on the slide. How would -- how would that breakdown?

Joseph F. Serbun -- Executive Vice President & Chief Banking Officer

Sure. So, you have lodging and retail, in percentage basis, 53% lodging and 25% retail. Manufacturing, then it drops drastic, manufacturing is just shy of 7.5%; then it just continue to go down, insignificant dollars, let's say after the first two. Sure.

Russell E.T. Gunther -- D.A. Davidson & Co. -- Analyst

Got it. No, that's very helpful, thank you so much. And then, just in terms of how you guys are thinking about this exposure. I mean are these credits that you believe are at risk simply because they are in a forbearance program and therefore that is captured in your current reserve or is this more of a risk migration that you referenced over the next couple of quarters and depending on that outcome, would impact future provisioning?

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Russell, this is Joe Sutaris. Regarding the future provision, I think we'd like to have a little more visibility, relative to when we come through this first round of deferrals what the second round will look like. I think also as we get toward the end of the third quarter, we'll have a better sense of true delinquency. We'll sort of unmask that if you will, by not granting deferrals in the second round.

And if we kind of run that through our model and it results in additional provisioning, we'll record that. I think Mark stated that, we wanted to be very -- want to rely on our model and create the expected losses, not the speculative losses, and quite frankly, the visibility has not been great, simply because there has been a lot of stimulus injected into the economy for that matter, into the bank accounts of our of our depositors. So we do think there is some pent up repayment capacity there.

How long that last? Time will tell, and for that matter, if we have a second round of stimulus, will there be additional ability to cover those payments? So I think if we start to see higher levels of delinquency, some additional risk migration in the third quarter, we'll provision appropriately. But we're trying to capture everything that's expected at this point, but the lack of visibility just makes that a little bit difficult to determine what the future provisions might big.

But certainly, the credit metrics at the end of the second quarter look pretty good from an NPA perspective and from a net charge-off perspective, so that was -- that was encouraging.

Russell E.T. Gunther -- D.A. Davidson & Co. -- Analyst

Great, thank you for that Joe. Last question for me would be around the kind of run rate expenses. You mentioned you'd expect them to move a bit higher for a number of reasons next quarter. But could you give us a sense in terms of where you would expect that to shake out considering just some normalized migration there, contemplating any cost saves from Steuben, just how that 3Q non-interest expense number might look.

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Yeah, that's a very fair question. So our operating -- OpEx run rate prior to COVID, we were kind of calling in the $93 million to $94 million range in a quarter, exclusive of Steuben. Obviously the world changed on us very quickly. So we were able to recognize significant savings on the operating expense line item, particularly in the second quarter. Some of that was payroll based, it was medical plan utilization, virtually all the travel, if you will, and a lot of our -- I should say employee travel and those costs came down significantly, as did our business development and marketing expenses.

So sort of going back, so we're sitting at $87.5 million this quarter, which was lower -- very low relative to what we expected our full tilt run rate to be, which was $93 million and $94 million before Steuben. But what I would expect is that in the third quarter, we're going to see a significant increase in the payroll and medical costs, we're going to have higher utilization, we have an extra payroll day. Couple other items are going to drive up the payroll costs.

We're resuming our business development activities. Relative to the second quarter, we were down about $1.5 million, I believe, over the same quarter last year. So we're basically kind of picking back up on the business development. Other expenses will start to come back. I think the travel related expenses will come back a little bit slower. As the economies open up. So our expectation for the full tilt run rate including Steuben was $95 million to $96 million.

I don't think we'll be at full tilt necessarily in the third quarter. But once we get back to full tilt, assuming there is a vaccine. I think that's a fair run rate. So I would expect us to ramp up from $87.5 million at some point in the next couple of quarters back to that $95 million, $96 million level.

Russell E.T. Gunther -- D.A. Davidson & Co. -- Analyst

Thank you, Joe. Very helpful. That's it from me guys. Thanks again.

Mark E. Tryniski -- President & Chief Executive Officer

Thanks, Russell.

Operator

Our next question comes from Matthew Breese with Stephens, Inc. Please go ahead.

Matthew M. Breese -- Stephens, Inc. -- Analyst

Good morning.

Mark E. Tryniski -- President & Chief Executive Officer

Good morning Matt.

Matthew M. Breese -- Stephens, Inc. -- Analyst

Just curious, on the deferrals down $150 million, the cure rate on that is obviously very solid. Is the decrease all attributable to resumption of payment or is there any transfer to non-accrual or TDR type categories?

Joseph F. Serbun -- Executive Vice President & Chief Banking Officer

It's -- all is resumption of payments the deferral period has come and left, it's come and gone.

Matthew M. Breese -- Stephens, Inc. -- Analyst

Understood, OK. And then, Joe, you mentioned on -- in regards to the 3Q NIM that you might be able to just hold par, all things considered. Were you referring to the reported NIM this quarter of 3.37% the whole par or the liquidity adjusted NIM the high 3.50%s.

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Yeah. No, that's very fair question. So liquidity stays where it is in the third quarter, relative to where we were in the second quarter. The NIM at 3.37% is expected to stay about there, about 3.37%. So as the core number was closer, it was a high 3.50%s about 3.57%. So the core NIM I think would also hold up very similarly in the third quarter. So, both I think would hold in the third quarter, all things considered.

Matthew M. Breese -- Stephens, Inc. -- Analyst

Okay, does that also imply net interest income expectations in this $92 million can hold for a while? And then secondly, longer term, what is your view on ultimately deploying that liquidity. How long do you think that will take?

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Well, I think the liquidity question is very uncertain at this point. I mean, I would expect that some of our -- some of that cash that's sort of pent-up on the -- in the depositors accounts will start to run off, potentially just because the activity is going to pick up, commerce will pick up. They're going to begin to make some loan payments. Conversely, if there is a second round of stimulus, they'll reload effectively on some of that liquidity. So that's a tough call to make relative to which direction it's going.

And as far as the opportunity to deploy that, at the present time, those opportunities are fairly limited. The yield curve is very flat at this point in time and there really hasn't been a great trade, if you will, on the longer end of the curve. If the Fed continues to manage the yield curve out to 10 years and keep rates very low, there will be challenges relative to deploying some of that excess liquidity. But, barring another round of stimulus, I would expect some of that to trickle out over the coming quarters as consumers start to spend that and pay down debt.

I think at 4:30 today, there is an announcement relative to some proposals on the next round of stimulus and my understanding is the parties are kind of far apart. So -- but that will help determine what the liquidity profile will look like in the coming quarters.

Matthew M. Breese -- Stephens, Inc. -- Analyst

Okay, all right. Last one, the employee benefit services line has held up really well fee-wise, much more stable than it would have expected. And I always thought this business was assets under administration driven, is that the case or the fees more contractual versus AUA? And is the $24 million to $25 million quarterly run rate, is that something we can use going forward?

Mark E. Tryniski -- President & Chief Executive Officer

I would say yes, it's much -- that business is much less dependent on market equity, market performance than the wealth management business. So we expect, I mean, that business to continue to grow modestly overtime as it has, there is a certain element of that business. I'm not sure exactly what the percentage is Joe. I don't know if you know it, but of it that's directly tied to the market, but it's not that much.

Joseph F. Serbun -- Executive Vice President & Chief Banking Officer

Right.

Mark E. Tryniski -- President & Chief Executive Officer

So -- and the business is doing OK. We continue to win opportunities and we continue to organically grow some of those core businesses that are in -- that are in good markets.

So I would expect to -- certainly the second half of the year and I think we had some, I'll call them deferred wins that we expected to book or close in the first half of the year that didn't happen because of COVID that are now expected to close in the second half of the year.

So there might be a little bit of pent-up revenue opportunity in the second half of the year as well. But we would expect those businesses to continue to do OK regardless of equity market conditions.

Matthew M. Breese -- Stephens, Inc. -- Analyst

Got it. That's all I had. Thanks for taking my questions.

Mark E. Tryniski -- President & Chief Executive Officer

Sure. Thanks, Matt.

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Thanks, Matt.

Operator

And this will conclude our question and answer session. I'd like to turn the conference back over to Mr. Tryniski for any closing remarks.

Mark E. Tryniski -- President & Chief Executive Officer

No, nothing further, thank you Cole. Thank you everyone for joining and we will talk to you again in October. Enjoy the rest of your summer. Thank you.

Operator

[Operator Closing Remarks]

Duration: 62 minutes

Call participants:

Mark E. Tryniski -- President & Chief Executive Officer

Joseph E. Sutaris -- Executive Vice President & Chief Financial Officer

Joseph F. Serbun -- Executive Vice President & Chief Banking Officer

Alexander Twerdahl -- Piper Sandler Companies -- Analyst

Erik Edward Zwick -- Boenning & Scattergood Inc. -- Analyst

Russell E.T. Gunther -- D.A. Davidson & Co. -- Analyst

Matthew M. Breese -- Stephens, Inc. -- Analyst

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