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Western Alliance Bancorp (NYSE:WAL)
Q3 2020 Earnings Call
Oct 23, 2020, 12:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, everyone and welcome to the earnings call for Western Alliance Bancorporation for the Third Quarter 2020. Our speakers today are Ken Vecchione, President and Chief Executive Officer; and Dale Gibbons, Chief Financial Officer. You may also view the presentation today via webcast through the company's website at www.westernalliancebancorporation.com. The call will be recorded and made available for replay after 2:00 PM Eastern Time, October 23, 2020 through November 23, 2020 at 9:00 AM Eastern Time by dialing 1-877-344-7529 and entering passcode 10148637.

The discussion during this call may contain forward-looking statements that relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. The forward-looking statements contained herein reflect our current views about future events and financial performance and are subject to risks, uncertainties, assumptions and changes in circumstances that may cause our actual results to differ significantly from historical results and those expressed in any forward-looking statements. Some factors that could cause actual results to differ materially from historical or expected results include those listed in the filings with the Securities and Exchange Commission. Except as required by law, the company does not undertake any obligation to update any forward-looking statements.

Now, for the opening remarks, I would now like to turn the call over to Ken Vecchione. Please go ahead.

Kenneth A. Vecchione -- President and Chief Executive Officer

Thanks, operator. Good afternoon and welcome to Western Alliance's third quarter earnings call. Joining me on the call today are Dale Gibbons and Tim Bruckner, our Chief Financial Officer and Chief Credit Officer. I will provide an overview of our quarterly results and how we are managing the business in this current economic environment and then Dale, will walk you through the Bank's financial performance. Afterwards, we will open the line to take your questions.

I like to focus on three trends that define our third quarter results and will continue into the future; robust balance sheet growth, provision reflecting asset quality and consensus outlook and strong net interest income and PPNR that continue to build capital. The combination of these variables generated record net income of $135.8 million and EPS of $1.36, each up more than 45% versus the prior quarter and exceeding our pre-pandemic performance in 2019. The flexibility of Western Alliance's diversified business model was again demonstrated this quarter as our deep segment and product expertise enable us to actively adapt our business in response to the changing environment and continue to achieve industry-leading profitability and growth, while maintaining prudent credit risk management.

Total loans grew $985 million for the quarter to $26 billion and deposits increased $1.3 billion to $29 billion, reducing our loan to deposit ratio to 90.2%. Our loan growth continues to be concentrated in low-loss asset classes such as warehousing lending, which accounted for over 100% of the loan growth and 56% of the deposit growth and $267 million in capital call lines where the risk-reward equation is heavily skewed in our favor. The impact of this strategy will be seen near term in our reduced provisioning expense and longer term in lower net charge-offs. We are encouraged by our expanding pipeline as clients have applied lessons learned from prior recessions to right-size cost structures and to begin to plan for future opportunities.

In the quarter, high average interest earning assets of $1.9 billion were offset by lower rates, substantial liquidity build and a one-time adjustment to PPP loan fee recognition to reflect modification and extension of the CARES Act forgiveness timeframe, which pushed our net interest margin downward to 3.71%, as net interest income declined $13.7 million from the second quarter to $285 million, but improved $18.3 million from a year ago period. Excluding the impact of PPP loans, net interest income would have only fallen by $4 million, which was largely the impact of interest expense on our new subordinated debt issued in middle of the second quarter.

We believe approximately 21 basis points of this compression is transitory in nature and NIM is expected to rise as excess liquidities put to work through balance sheet growth, deposit seasonality and warehouse lending, driving balances lower and PPP loan forgiveness assumptions normalize. Given these margin trends and balance sheet growth, we believe Q4's net interest income performance returns to Q2 levels and PPNR rises above Q3. Provision for credit losses was $14.7 million in the third quarter considerably less than the $92 million in the second quarter, which was primarily attributable to stable to modest improvements in macroeconomic forecast assumptions, loan growth in low-risk asset classes and limited net charge-offs of $8.2 million or 13 basis points of average assets. Dale, will go into more detail on the specific drivers of our provision but our total loan ACL to funded loans ratio now stands at 1.37% or $355 million and 1.46%, excluding PPP loans, which are guaranteed by the CARES Act. If macroeconomic trends remain stable or begin to improve, future provision expense will likely mirror net charge-offs and reserve levels could decline.

Loan deferrals trended lower for the quarter as many of our clients have returned to paying as agreed following their deferral period. As of Q3, $1.3 billion of loans are on deferral or 5% of the total portfolio, which represents a 55% decline from Q2. We expect $1.1 billion of loan deferrals will expire next quarter, which will continue to drive down our outstanding modifications. Our quarterly efficiency ratio improved to 39.7% compared to 43.2% from the year ago period, becoming more efficient during the economic uncertainty provides the incremental flexibility to maintain PPNR. Finally, Western Alliance continues to generate significant excess capital, which grew tangible book value per share to $29.03, or 4.3% over the previous quarter and 13.4% year-over-year. Supported by our robust PPNR generation, capital rose $121.6 million with a CET1 ratio of 10%, supporting 15.6% annualized loan growth.

Dale, will now take you through our financial performance. Thanks, Ken. Over the last three months Western Alliance generated record net income of $135.8 million or $1.36 per share, which was up 46% on a linked-quarter basis. As Ken mentioned, net income benefited reduction in provision expense for credit losses to $14.7 million, primarily driven by stability and the economic outlook during the quarter in a release of specific reserves associated with the fully resolved credit. Net interest income grew 1$8.3 million year-over-year to $284.7 million but declined $13.7 million during the quarter, primarily result of changes in prepayment assumptions on PPP loans that impacted fee accretion recognition. The SBA's interim final rule published in August more than doubled the amount of time that people have to receive forgiveness on their loans and coupled with the systems delay in forgiving -- forgiveness request processing, we now expect that forgiveness processes to be elongated and the average time the loans will be outstanding is projected to double as well. As a result, using the effective interest method, we reversed out $6.4 million of the fees recognized in Q2 and overall PPP fee recognition has been extended. This is purely a change in timing, impacting NIM but with no change to cumulative fee revenue ultimately recognized from this program. The $43 million, we are to receive will be simply be booked to income more slowly than our original expectations. Net interest income was impacted in Q3, as a result of this timing change by $10.6 million. Non-interest income fell $700,000 to $20.6 million from the prior quarter. We benefited from a recovery of an additional $5 million mark-to-market loss on preferred stocks that we recognized in the first quarter. Over the last two quarters, we recovered 80% of that $11 million original loss. Finally, non-interest expense increased $9.3 million, as the deferral of loan origination cost fell, as PPP loan originations dropped, as well as an increase in incentive accruals as our third quarter pandemic -- as our third quarter performance exceeded our original third quarter budget, which was established before the pandemic. Strong ongoing balance sheet momentum coupled with diligent expense management drove pre-provision net revenue to $181.3 million, up 13.5% year-over-year and consistent with our overall growth trend from the first quarter, as the second quarter benefited from one-time PPP recognition of BOLI restructuring in FAS 91 loan cost deferrals. Turning now to net interest drivers. Investment yields decreased 23 basis points from the prior quarter to 2.79% and fell 29 basis points from the prior year due to the lower rate environment. Loan yields decreased 35 basis points following declines across most loan types, mainly driven by changing loan mix and in the reduction of PPP loan fees, resulted in lower PPP loan yield during the quarter. Notably, for both investments and loans, spot rates as of September 30, are higher than the third quarter average yields. Costs of interest bearing deposits was reduced by 9 basis points in Q3 to 31 basis points with an end of quarter spot rate of 0.27% [Phonetic], as we continue to lower posted deposit rates and push out higher cost exception price funds. The spot rate for total deposits, which includes non-interest bearing deposits was 15 basis points. When all of the company's funding sources are considered, total funding costs declined by 2 basis points with an end of quarter spot rate of 0.25%. Unlike last quarter where spot rates indicated a likely margin compression in the third quarter, these rates appear to demonstrate that the margin will improve as both earning asset yields will rise and funding cost will fall in the fourth quarter. Additionally, in October, we called $75 million of subordinated debt that has diminishing capital treatment with the current rate of 3.4%. Despite the transition to a substantially lower rate environment during 2020, net interest income increased 6.9% year-over-year to $284.7 million. As mentioned earlier, during Q3, our extraordinary build and liquidity and adjustments to PPP loan fee recognition compressed our net interest margin of 3.71%, as net interest income declined $13.7 million. However, the majority of these reduction drivers are transitory. PPP loans reduced our NIM during the quarter by 13 basis points. This changes to prepayment assumptions, reduced SBA fees recognized resulting in PPP loan yield of 1.76%. Excluding this timing difference, net interest income declined only $4 million quarter-over-quarter, primarily due to interest expense on the new subordinated debt that we issued last May, resulting in a net interest margin of 3.84%. Referring to the bar chart on the lower left section of the page, of the $43 million in total PPP loan fees net origination costs that we received, only $3.3 million was recognized in the third quarter. The recognized reversal of PPP was $6.1 million in Q3 and expect fee recognition to be approximately $6.9 million in the fourth quarter and taper off as prepayments and forgiveness are realized. In reality, these assumptions are dependent on actual forgiveness from the SBA. Additionally, average excess liquidity relative to loans increased $1.3 million in the quarter, the majority of which are held at the Federal Reserve Bank earning minimal returns, which impacted NIM by approximately 21 basis points in aggregate. Given our healthy loan pipeline and ability to deploy these funds to higher yielding earning assets, we expect this margin drag to dissipate in the coming quarters. Regarding efficiency, on a linked-quarter basis, our efficiency ratio increased to 39.7%, as we continue to invest in our business to support future growth opportunities. As described earlier, the non-interest expense increase was largely related to a net increase in compensation costs, as we now have greater confidence in our ability to execute on our pre-pandemic budget and are no longer benefiting from deferred costs for PPP loan originations. Excluding PPP, net loan fees and interest, the efficiency ratio for the quarter would have been 40.7%, which as we indicated last quarter should be moving closer to our historical levels in the low-40s. Return on assets increased 44 basis points from the prior quarter to 1.66%, while provisions fell. PPNR ROA decreased 47 basis points to 2.22%, as attractive decline in margin from the prior quarter. This continued strong performance in capital generation provides us significant flexibility to fund ongoing balance sheet growth, capital management actions or meet our credit demands. Our strong balance sheet momentum continued during the quarter as loans increased $985 million to $26 billion and deposit growth of $1.3 billion brought our deposit balance to $22.8 billion at quarter-end. Inclusive of PPP, both loans and deposits grew approximately 29% year-over-year with our focus on loan loss segments and DDA. The loan to deposit ratio decreased to 90.2% from 90.9% in Q2, as our strong liquidity position continues to provide us with balance sheet capacity to meet funding needs. Our cash position remains elevated at $1.4 billion at quarter-end compared to $2.1 billion quarterly average, as deposit growth continues to outpace loan originations. While this does impair margin near term, we believe it provides us inventory for selective credit growth this demand resumes. Finally, tangible book value per share increased to $1.19 over the prior quarter to $29.03, an increase of $3.43, or 13.4% over the past 12 months. The vast majority of the $985 million in loan growth was driven by increases in C&I loans of $892 million, supplemented by construction loan increases of $103 million. Residential and consumer loans now comprise 9.3% of our portfolio, while construction loan concentration remains flat at 8.8% of total loans. Within the C&I growth for the quarter and highlighting our focus on low-risk assets that Ken mentioned, capital call lines grew $267 million, mortgage warehouse loans grew over $1 billion and corporate finance loans decreased $141 million this quarter. Residential loan originations were offset by higher prepayment activity leaving the balanced fairly flat. We continue to believe our ability to profitably grow deposits as both a key differentiator and a core value driver to our firm's long-term value creation. Notably, year-over-year deposit growth of $6.4 million is higher than the annual deposit growth in any previous calendar year. Deposits grew $1.3 billion or 4.7% in the third quarter, driven by increases in non-interest bearing DDA of $777 million, which now comprise over 45% of our deposit base plus growth in savings in money market accounts of $752 million. Market share gains and mortgage warehouse and robust activity in tech and innovation continue to be significant drivers of deposit growth. As we initially described on our Q1 earnings call, while unique credit risk management strategy is focused on establishing individual borrower level strategies and direct customer dialog to develop long-term financial plans. Our approach to payment deferral requests is to look for resourceful ways to partner with our clients along with assessing their willingness in capacity to support their business interests. We ask our clients to work with us hand-in-hand whereby our clients contribute liquidity, capital or equity as an inaugural component to modified prepayment plans. Our approach collectively uses the resources of the borrower, government and the bank's balance sheet to develop solutions that extend beyond the six-month window provided for in the CARES Act. By quarter-end, deferrals had declined by $1.6 billion or 55%, reducing total loan deferrals from 11.5% in Q2 to 5%. Excluding the hotel franchise finance segment in which we executed a unique sector specific to hurdle strategy, the bank wide deferral rate is approximately 1.6%. We have received minimal additional request for further deferrals and 98% of clients with expired deferrals are now current in payments. We expect $1.1 billion of loan deferrals will expire in the current quarter, which will substantially drive down outstanding modifications. Consistent with this trend, as of yesterday deferrals are down $420 million in October, bringing the current total to $880 million. Regarding asset quality, our non-performing assets and OREO to loan ratio remained flat at 47 basis points to total assets, while total classified assets increased to $28 million or 4 basis points to 98 basis points to total assets. Classified accruing loans rose by $21 million, explainable by a few loans 90 days past due as of September 30. All of these loans are now current. Special Mention loans increased $81 million during the quarter to 1.83% of funded loans, which is a result of our credit mitigation strategy to early identify, elevate and apply heightened monitoring to loans and segments impacted by the current COVID environment. Over 60% of the increase in Special Mention loans are from previously identified segments uniquely impacted by the pandemic, such as the hotel portfolio and a component of our corporate finance division credits determined to have some level of repayment dependency on travel, leisure or entertainment. As we have discussed in the past, Special Mention loans are not predictive of future migration to classified or loss, since over the past five years, less than 1% has moved through charge-offs. If borrowers do not have through cycle liquidity and cash and capital plans, we downgrade to substandard immediately to remediate. Our total allowance for credit losses rose a modest $7 million from the prior quarter due to improvement in macroeconomic forecasts and loan growth in portfolio segments with lower expected loss rates. Additionally, we covered $8.2 million of net charge-offs. The ending allowance related to loan losses was $355 million. For CECL, we are using a consensus economic forecast outlook of blue chip -- blue chip forecasters as it tracks management's view of the recession and recovery. The economic forecast improved during the quarter, which would have implied a reserve release. However, given the still unknown time horizon of COVID impacts, political uncertainty and the unknown status of further stimulus, we adjusted our scenario weightings to a less optimistic outlook. In all, total loan allowance for credit losses to funded loans declined a modest 2 basis points to 1.37% or 1.46%, when excluding PPP loans. On a more granular level, our loan loss segments account for approximately one-third of our portfolio and includes mortgage warehouse, residential and HOA lending, capital call lines and resort lending. When we exclude these segments, the ACL to funded loans on the remainder of the portfolio is 2%. Provision expense decreased to $14.7 million for Q3, driven by loan growth in lower loss segments and improved macroeconomic factors, while fully covering charge-offs. Net credit losses of $8.2 million or 13 basis points of average loans were recognized during the quarter compared to $5.5 million in Q2. Relative to other banking companies our lower consumer exposure continues to result in much lower total loan losses. We continue to generate significant capital and maintain strong regulatory capital ratios with tangible common equity to total assets of 8.9% and a Common Equity Tier 1 ratio of 10, a decrease of 20 basis points during the quarter due to our strong loan growth. Excluding PPP loans, TCE to tangible assets is 9.3%, a modest decline of 10 basis points from the first quarter. Inclusive of our quarterly cash dividend payments of $0.25 per share, our tangible book value per share rose $1.19 in the quarter to $29.03, up 13.4% in the past year. We continue to grow our tangible book value per share rapidly as it has increased three times that of the peers over the last 5.5 years. I'll now turn the call back to Ken, to conclude with comments on a few of our specific portfolios. I would now like to briefly update you on our credit risk mitigation efforts and the current status of a few exposures to industries generally considered to be the most impacted by COVID- 19 pandemic. Throughout the quarter, Tim Bruckner and the credit administration team led ongoing focus portfolio reviews by risk segments to monitor credit exposures and performance against cash budgets, operating plans through the liquidity trough. We are not waiting for deferrals to run out to make great changes or effect remediation strategies. If borrowers are non-performing against defined operating plans or determined to not have a sufficient through cycle liquidity, we downgrade them now to substandard and enact remediation strategies to ensure the best outcomes. We do not hold loans in SM, the Special Mention for a time to eventually downgrade. And as a result, Special Mention graded loans slowly migrate to classified or substandard. These facts and daily conversations with our people and our clients help me feel confident that our credit mitigation strategy and early approach to proactively manage our risk segments is bearing fruit and puts Western Alliance in a strong position to come out on the other side of the pandemic in better shape than our peers. In our $500 million gaming book focused on all strip, middle market gaming-linked companies, total deferrals were reduced from 37% of the portfolio to only 4% and as of today, it's zero, as our clients are now open for business and are performing at or above their reopening plans. The $1.3 billion investor dependent portion of our Technology and Innovation segment has continued to benefit from significant sponsor support for technology firms best positioned to succeed in this COVID environment and an active fund raising environment as well. Since March 2020, 65 of our clients have raised over $1.7 billion in capital, resulting in 87% of borrowers with greater than six months remaining liquidity, up from 77% in Q1. Our CRE retail book of $674 million focus on local personal services based retail centers with no destination mall exposure, continues to modestly exceed national trends that shows rent collections rising from 50% in May to 80% in August. Similarly, the portfolio's deferrals have fallen from $176 million to $31 million. Lastly, our $2.1 billion Hotel Franchise Finance business focused on select service hotels with greater financial flexibility and LTVs at origination of approximately 60% continues to trend toward stabilization. Occupancy rates are tracking national averages, currently around 50%, which have tripled from April lows. At approximately 55% occupancy, select service hotels are estimated to cover amortizing debt service, so a typical hotel is operating at break even. Furthermore, we have seen deferrals declined from 83% of the portfolio to 44% of the portfolio and currently, we do not anticipate granting any additional deferrals in the hotel portfolio. We are proactively engaging with hotel sponsors to validate ongoing support and hotel performance against operating plants. As mentioned earlier, we are not waiting for deferrals to end before migrating to ensure remediation options. With strong sponsor support the worst a great hotel typically receives is SM or Special Mention. Let me just finish up with our management outlook. We believe that our third quarter performance is the baseline for future balance sheet and earnings growth. With this record quarter, we beat our quarterly budget that was established pre-pandemic. Our pipelines are strong and we expect loan growth to return to previously anticipated levels of $600 million to $800 million for the next several quarters in low risk asset classes. However, there will be some offsets as PPP loans pay-off or are forgiven. Depending on the timing of the realized PPP forgiveness, organic loan growth should be -- should more than offset PPP run-off. In Q4, we expect to see the seasonal declines associated with our mortgage warehouse clients. Therefore, deposit growth will be at the lower end of the target range, reducing our excess liquidity. To supplement our residential lending initiative, we acquired Galton Funding, a residential mortgage platform that specializes in the acquisition of prime non-agency residential home loans. The acquisition is a low risk, low cost entry point to build a meaningful residential mortgage business line at an accelerated timeframe with over 100 additional mortgage originator relationships. We anticipate that the Galton team will be fully integrated by the end of October and be contributing to loan growth by the end of the year. As Dale mentioned, our current spot rates indicate that the net interest margin pressure experienced this quarter will subside and net interest margin will trend upwards toward 3.9% in Q4. We expect net interest income to rise in Q4, aided by both an increased NIM and higher end of quarter loan balances compared to the quarterly average. Additionally, it is expected that PPP fee income will pick up next quarter as forgiveness is granted. This will however, abate during 2021 PPNR is expected to increase as net interest income growth will more than offset any increase in non-interest expense. Looking ahead, we will continue to invest in new product offerings and infrastructure to maintain operational efficiency but Q2 and Q3 efficiency ratios are temporary and will eventually return to sustainable level in the low-40s. Our long-term asset quality and loan loss reserves are informed by economic consensus forecast, which is consistent going forward, could imply reserve releases in the coming quarters. We believe that the provisions in excess of charge-offs year-to-date are more than sufficient to cover charge-offs through the cycle as we do not see any indicators that imply material losses are on the horizon. Finally, Western Alliance is one of the most prolific capital generators in the industry. Our strong capital base and access to ample liquidity will allow us to take advantage of any market dislocations to maintain leading risk adjusted returns to address any future credit demands, all while maintaining flexibility to improve shareholder returns. At this time, Dale, I and Tim, will take your questions. Operator, if you want to open up the line.

Questions and Answers:

Operator

[Operator Instructions] Our first question comes from Brad Milsaps of Piper Sandler. Please go ahead.

Brad Milsaps -- Piper Sandler -- Analyst

Hey, good morning, guys.

Kenneth A. Vecchione -- President and Chief Executive Officer

Good morning, Brad.

Brad Milsaps -- Piper Sandler -- Analyst

Dale or Ken, I just wanted to make sure I understood kind of all the moving parts around the balance sheet. It sounds like a lot of the growth that you saw at the end of the quarter was mortgage warehouse related, which can obviously be very volatile end of the quarter, can vary given the average. As you go into the fourth quarter, is your expectation that you're going to be able to replace that if it does wane a little bit with other types of loan growth?

You also mentioned that you also just expect deposits from that -- from the warehouse to go down, so you'll get some liquidity bleed there as well. Just want to understand kind of what the moving parts would be within average earning assets as you go into 4Q with kind of everything you talked about?

Kenneth A. Vecchione -- President and Chief Executive Officer

Yeah. So, mortgage warehouse had a great quarter as you can see by the results. They are increasing market share simultaneously as our warehouse lending clients increase their activity or see increased activity. So, we're getting a two-for-one and that's why you saw the increase -- the large increase in loan balances this quarter. Q4 is traditionally a little lighter and so we're just sticking to our Q4 analysis or historical viewpoint that loan growth there will be less. And yes, our model is designed such that we can replace loan growth there with other loan growth around the company and that's why we're giving you the $600 million to $800 million range for Q4 loan growth, and also the same for deposits. They lose some of their deposits in Q4 as taxes are paid.

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Brad, I would also say that we have a senior loan committee that meets weekly that approves the largest credits in the company and in the activity level of loans coming in from the line to that committee, which is loans above $15 million has really stepped up significantly over the past couple of months compared to where we were, say in the second quarter. And so we're seeing -- we think we're seeing broader strength in other classes of loan credit and at the same time, on the deposit side, despite what we think may happen on -- in terms of the, the warehouse lending piece, we're seeing some increase in some of these other channels as well that I think are going to bear fruition in the fairly near-term.

Kenneth A. Vecchione -- President and Chief Executive Officer

Yeah, just to add to Dale. I mean we're seeing strength in capital call business, we're seeing strength in the CRE business certainly around the industrial side where both of them were doing a lot of deals for distribution centers and then Tech and Innovation is seeing a lot of new opportunities as well.

Brad Milsaps -- Piper Sandler -- Analyst

And maybe just a follow-up on the loan growth. Where are kind of new loan yields coming on the books. I know you mentioned the spot rate of 4.50% but kind of curious where new production is coming on? And then can you talk a little bit more about the impact of the acquisition that you made, how much you paid kind of what's the incremental benefit you kind of see over the next six to 12 months?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Sure. So in terms of, that spot rate is really spot on in terms of kind of where the numbers are. So, the actual loans that have come on have been about 5 basis points higher yielding than what the average was and I think that's kind of reflected there. Again, we have a lot of discipline at our team in terms of putting in floor. So, let's suppose somebody makes a loan at L plus 3 or L plus 3.5, we will define in loan docs that L is -- L can't go below 1% in that situation. That's a really common structure for us. So, the floor is active on the first day and that's how we're able to sustain new originations really right on top of the current -- the current yield.

Kenneth A. Vecchione -- President and Chief Executive Officer

So, I'll take the second half. Galton, first, we didn't pay much money for it at all. All right. And it's a mortgage business that specializes on buying non-QM loans from warehouse lenders and so non-QM mortgages have a slightly different feature than standard agency paper. They sometimes offer interest-only features or they have more self-employed borrowers, but they underwrite to very low LTVs in the 67%, 68% range and the paper carries higher yields than the standard agency paper.

So, standard agency paper could be like 2.25% and these yields will be 3.25% to 3.5%. The acquisition came with 12 people; four sales people and eight operations people and it provides us with a dedicated sales force and servicing operations. So, this will allow us to ramp up our residential purchase volume while improving customer service with knowledgeable experts. It provides cross-selling opportunities to the Galton customer base.

Galton has 100 warehouse lenders that they work with, 30% of which is an overlap with us but the other 70% will allow us to offer warehouse lending lines and then the remove mortgages off of the warehouse lending line onto our balance sheet if they fit our credit box. We've seen Galton in operation for a couple years. We've probably seen over 1,000 mortgages that they've underwritten. So, we have a real sense that their approach to credit mirror ours and we think the big impact here will be seen middle of next year as this thing continues to ramp up and we bring them into the fold here. So, where we were doing residential merge -- residential mortgages either bulk purchases or forward flow agreements of the side of our debt meaning other people had other responsibilities. We now have a dedicated team to do this and that's -- and knowledgeable people and that's what excites us about this opportunity.

Brad Milsaps -- Piper Sandler -- Analyst

Great. Thank you, guys. I'll hop back in queue. Thanks.

Operator

Our next question comes from Chris McGratty of KBW. Please go ahead.

Chris McGratty -- KBW -- Analyst

Great, thanks for the question. Dale, I just wanted to make sure I got the fourth quarter guide exactly, I was writing pretty quickly. The 3.90%, I believe, Ken, you said 3.90% margin, is that a -- is that a fully loaded margin with -- with the impact of the fees from the PPP?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Correct. Yeah, at the $6.9 million level that we show on that one page, so rebounding from -- from the second quarter but much lower than what we had -- we bring from the third quarter but lower than we had in the second.

Chris McGratty -- KBW -- Analyst

Okay. And based on the balance sheet, the comment was fourth quarter reported all-in net interest income higher than second quarter reported? Right.

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Yes.

Chris McGratty -- KBW -- Analyst

Okay, great. In terms of the -- the growth strategy, can you just size up how big the warehouse is and the -- and the capital call book?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Yeah, so the -- the warehouse book is $3.9 billion and capital call is $737 million.

Chris McGratty -- KBW -- Analyst

Okay.

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Getting into your question, Chris. Yeah. No, we see -- we see that we have kind of stability here. We have an opportunity to continue to sustain earning asset growth. So, we believe we can -- even if there were margin pressure in 2021, that we have, we've got the growth trajectory that we can sustain increases in net interest income.

Chris McGratty -- KBW -- Analyst

Got it, understood. And if we look -- maybe more on just the mix of the earning assets. As we look at the mix between cash and securities, it's -- call it roughly 20% of earning assets, is that the same -- is that the proportional mix you'd expect of the balance sheet going forward, maybe toggling between cash and securities 20%?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Well, I think I -- we can take our cash down to something in kind of the low-to-mid hundreds of millions. We think that's really kind of the floor for us. And so we are up at $1.9 billion that gives us a fair amount of room and the Federal Reserve, I mean, is, not a criticism but they pay 10 basis points. So, we think that the -- we know liquidity is abundant these days at banking companies, but we think that actually garnering more relationships and even if they're flat or even slightly negative in terms of, in terms of price and obviously, they crush the margin because you get a big balance at zero spread or something like that. But we think that's going to bode well in the future as we come out of this situation and Ken mentioned with Galton Funding among other channels where we've got opportunities to really grow safely on the credit side.

Chris McGratty -- KBW -- Analyst

Okay. And then the investment portfolio Dale, just -- is that just kind of you solve for that based on the deposit? I mean, how are you thinking about the size of the bond book?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Yeah, I think the bond book it actually, I know it's got a lot of room. I think we're comfortable with our loan to deposit ratio in the 90s. So, that's going to drive some of the -- some of the investment securities portfolio, but we've got a couple billion dollars, $2.5 billion of mortgage-backed securities in there that are yielding 100, 150 less than if we buy, we think similar risk credit with low LTV first mortgages. So, there is a possibility that after we swap up our current liquidity through residential and other channels that maybe we don't need to grow the MSR book anymore and that could become a smaller proportion of the balance sheet in aggregate.

Chris McGratty -- KBW -- Analyst

Got it and then -- and then last one if I could, just everyone's topic on taxes. Anything meaningfully different in your tax structure and strategy today if we got a tax -- tax increase that -- the same math opposite direction wouldn't work next year?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Yeah. So, I mean I think you could -- the proportionate holds pretty well. So, even though our tax rate may be lower than some others, basically looking, if you're going to 28% and you're at 21%, that's a 33% increase in the tax rate. If you take our tax expense, say, for the third quarter, which was $30 million and say, gosh, if that were to go into effect, our tax recognition expense would be up for this similar quarter would be about $10 million higher, about a third higher.

Chris McGratty -- KBW -- Analyst

Got it. Okay, thanks a lot.

Operator

Our next question comes from Michael Young of Truist. Please go ahead.

Michael Young -- Truist -- Analyst

Hey, thanks for taking the question. Was kind of curious, it sounds like there is an effort to grow the balance sheet, maybe with some more residential but -- or warehouse. But I was kind of curious just about the trade-off between growing the balance sheet and some of those more non-relationship oriented areas versus maybe just looking at a share buyback program in a larger proportion? So, just kind of growing balance sheet versus returning capital, how you guys are thinking about the trade off between the two?

Kenneth A. Vecchione -- President and Chief Executive Officer

Yeah, I would argue that we do have relationships and what we're doing is with each warehouse lending customer, we have a warehouse lending relationship, we could have an MSR relationship, we can have note financing relationships. They provide deposits to us and they also provide us with a go-forward flow on residential mortgages.

So, don't think about the relationship as the end customer in their home, think of it as the mortgage servicer, which controls a lot of business. And we see an opportunity now, there is dislocation in the market with a number of mergers and also I'd just say, poor performance that were coming in with higher -- a high touch customer service that were getting business that's coming to us and we're not having to struggle to bring that business in. So, that to us is very important and that's what's driving the balance sheet growth. We're not trying to buy mortgages for mortgage's sake. It's really the warehouse lenders and those relationships that we have with them.

Dale Gibbons -- Vice Chairman and Chief Financial Officer

In terms of the -- in terms of the repurchases, I mean, where we are this is, we can sustain a balance sheet growth. And while we don't have an idea of being opportunistic in terms of -- in terms of share price. We think the long-term value creation is from expanding the -- expanding the franchise.

Michael Young -- Truist -- Analyst

Okay. That's fair, appreciate it. And then maybe just on credit, have you all actually foreclosed on or liquidated any of the hotel assets or any other CRE assets that have given you any more confidence or anything, any color you could provide on those books?

Kenneth A. Vecchione -- President and Chief Executive Officer

There has been no liquidation, no foreclosures. The hotel book is given its circumstances, performing OK. 45% of the book has a debt service coverage ratio above 1%, 45% is below it and then we've got a few construction loans. So, we don't have a debt service coverage ratio on that. You can see hotel occupancy coming back to 50%, that's about where our hotels are tracking to the national averages again. When we underwrote these hotels, we underwrote good liquid sponsors that had the ability to call on capital from their LPs and they did that to enter into many of the 3 plus 3 or 6 plus 6 deferral relationships.

Tim, you want to anything else.

Tim R. Bruckner -- Chief Credit Officer

I think it's important to remember, we started this dialog, particularly with hotel in February. We brought together the segment, we put dynamic leadership, some of our senior most executives in place and we've maintained that dialog around liquidity, operating performance and forward-looking capital plans. That has allowed us to be way out ahead of problems that arise here. So, we've got strong sponsorship, we've got an active dialog and we're seeing good progress toward stabilization.

Michael Young -- Truist -- Analyst

Okay, thanks.

Operator

Our next question comes from Gary Tenner of DA Davidson. Please go ahead.

Gary Tenner -- DA Davidson -- Analyst

Thanks, good morning. I just wanted to ask on the mortgage acquisition that you talked about earlier, day one, are there any other -- is the revenue coming off that purely the mortgages that you put on balance sheet or are there any -- is there any other associated revenue or fees anything that would be related to that?

Kenneth A. Vecchione -- President and Chief Executive Officer

No, no, it comes off of the revenue -- comes off of the mortgages put on balance sheet and we've been just integrating the team over the last three weeks or so. So, we're not looking for any mortgages to begin to hit the balance sheet and maybe for another two or three weeks.

Gary Tenner -- DA Davidson -- Analyst

Okay. And Dale, you may have alluded to this when you talked about kind of balancing the investment portfolio against the resi book. You've been hanging around in the kind of 9.5% or plus or minus in terms of residential loans, where would you take that now you've got this other kind of stream of product coming out?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Well, I think it's got a lot of runway in front of it. I don't have a number for you for where it might stop. But as you know, a typical bank that number is going to be about triple that concentration level, which is even at -- even with the growth rates that we're talking about augmented with Galton and what we've been doing before. Geez, I mean, if we could take it to 20% on a growing balance sheet that's going to be a substantial increase in the balances outstanding.

So, I think we've got years for this thing to run. We think it's a strong asset class to be in. We think the rates work now. We've been, as you know, asset sensitive where we're really now kind of a symmetric and this balances that out as well. So, we think it's a good place to be to lower risk weighted asset category and we're one of the smallest out there in terms of relative exposure.

Gary Tenner -- DA Davidson -- Analyst

Okay, thanks. Other questions were already answered.

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Thanks.

Operator

Our next question comes from Brock Vandervliet of UBS. Please go ahead.

Brock Vandervliet -- UBS -- Analyst

Great, thanks for the questions. Dale, I guess if you could talk about -- you touched on this in your prepared remarks, I guess in terms of the deposits, how much of those do you think you can kind of hold on to going forward? What's the volatility of the deposit mix at this point?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Well, I think there is -- I think it's good. But there is two areas that, that -- that I want to keep my eye on. One of them is I'll call it PPP deposits. So, we -- we took $1.8 billion of loans that we made and we deposited into these accounts and we track how much money is still there. And that number is still over $1 billion and it's like -- well, that's going to get burned somehow at some point in time, maybe that's a little bit lazy because we're in this kind of no rate environment. So, we want to keep our eye on that piece of the thing. And then the second piece is kind of the mortgage warehouse area. Obviously, it's been a torrid pace of refinancing. That's going to increase volumes generally. And so I think -- is there a space for kind of take a breather in that scenario.

Now my read of what's transpiring is while maybe the refi business is going to temper to some degree, there's still a lot of people that are eligible for refi in terms of putting themselves in a lower area. So -- but is there some area that could come out of that. I think there is. What do we have. Well, we've talked about our two business lines that are deposit generating, those both did run into a little bit of a sidetrack. Because of the pandemic, they -- each of them benefits from kind of in-person contact for development of personal relationships with these enterprises that they service.

We think that's coming out of it now. We think those pipelines look strong also. Ken mentioned the Tech and Innovation space. And one of our competitors was -- was fairly bullish in terms of what that outlook is like and we would -- we would second that assessment. So, while we may see softness in a couple of these categories that have been really powerful in 2020, we think we've got hand-off so we can make to kind of sustaining the realized performance in 2021 to these -- some of these new areas.

Brock Vandervliet -- UBS -- Analyst

Got it. And then separately, just on the Galton acquisition and the non-QM and that -- that encompasses many different flavors of mortgage origination. Is this generally paper that just doesn't quite check the agency box or is it more of the heavier credit component to it? And I guess separately, what's the step up from vanilla agency origination? What's the step up in rate with this paper?

Kenneth A. Vecchione -- President and Chief Executive Officer

Yeah, it just doesn't check the box for the agencies and the step up in paper is about 1%.

Brock Vandervliet -- UBS -- Analyst

Got it. Okay. It's pretty flat. Thank you.

Operator

Our next question comes from Timur Braziler of Wells Fargo. Please go ahead.

Timur Braziler -- Wells Fargo -- Analyst

Hi, good morning.

Kenneth A. Vecchione -- President and Chief Executive Officer

Good morning.

Timur Braziler -- Wells Fargo -- Analyst

Starting with efficiency, it seems like NII has seemingly reached a bottom here in the third quarter, should start improving in the fourth quarter. As we look ahead, should we expect a similar level of operating leverage, whether it's two to one or three to two, as we've seen in recent years, or does the current rate environment present enough challenges where it's likely they're going to be lower than that for the foreseeable future?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

I think we can sustain where we are in terms of -- in terms of the operating expense level. So yeah, we think the margin is fairly stable even if rates kind of stay at this level for maybe in perpetuity for certainly an extended period of time. And then our expense is running at around $0.40 relative to the revenue we bring in. We think that's pretty sustainable as well. So, we had some volatility in the second quarter for a variety of reasons we talked about, really it underscores that we're looking at the third quarter of 2020 as really being a pretty good baseline.

I know some of you have commented or looked at that we had these -- we had this gain from securities gains kind of recovery of about $5 million bucks in the third quarter, which of course we did. But in my view, I don't back that out in terms of what our run rate is because I'm offsetting that with the reversal we had in PPP kind of going forward. So, we think the revenue is a good base to come from. We think the expense base is -- is good base from which to grow, but again holding in at kind of the low-40s on efficiency.

Timur Braziler -- Wells Fargo -- Analyst

Okay, thanks. And then, I just want to make sure I'm thinking about deferrals correctly. So, the $1.1 billion of deferrals that are rolling off in the fourth quarter, how much of that was part of the 6 plus 6 program? And for those loans, it it now that the liquidity that was collected as part of the initial deferral processes, is that now kicking in for another six months, or is that entire balance going to be moving into performing status essentially?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Yeah, so I mean they prepaid. I mean, so before they got six months of deferral, they prepaid another six months. And this is what we recommended that they do because it takes them out until the second quarter of next year, which -- you can different assumptions in terms of when we get out of this, but with therapeutics and I think vaccines are just frankly pretty close to around the corner that I think by that point in time, what were -- these entities -- those hotels are going to be able to benefit from kind of relaxed social distancing. And so they prepaid it also. Yes, they are paying as agreed, because they are dipping into basically a control account that is making the principal and interest debt service as they've come off of deferral.

Timur Braziler -- Wells Fargo -- Analyst

Okay. And is that -- is that around 50%, that's 6 plus 6 of that or is there going to be a smaller amount -- that's about $1.1 billion?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Well, of those that are coming off in the fourth quarter, it's predominantly the 6 plus 6 because they were -- they were done. I mean, we did some that were 3 plus 3. Those typically came off mostly in in the second -- in the third quarter. Right. So, in the fourth quarter, those are 6 plus 6s that were done in the second quarter of this year.

Timur Braziler -- Wells Fargo -- Analyst

Okay. And then one last one for me. Just looking at the technology sector, another strong quarter of growth, but I noticed that the allowance for that sector declined on a linked-quarter basis. Was that the specific reserve release that you spoke of, or was there something else going on in that portfolio that the linked-quarter reduction in allowance?

Kenneth A. Vecchione -- President and Chief Executive Officer

No that was, that was part of it that drove the decline in imbalances. Was a reserve release on an asset that we were able to get off our books and we are happy to get off our books.

Timur Braziler -- Wells Fargo -- Analyst

Okay, great. Thank you very much.

Operator

Our next question comes from David Chiaverini of Wedbush Securities. Please go ahead.

David Chiaverini -- Wedbush Securities -- Analyst

Hi, thanks. Couple questions for you. And the first one is a strategic question on mortgage warehouse with it now $4 billion of loans and you addressed a little bit about this with the deposit discussion. But I was curious because some investors have expressed concern generally about seasonality and volatility around the mortgage warehouse business. Can you talk about how you're viewing that business in addressing that volatility over time as we look ahead?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Yes. So, I mean we thought this was -- again, if you look at kind of the business lines with which we can select from and which to grow, this was a great time to go into mortgage warehouse. The balance -- the demand was strong, the quality is excellent and because of the cycle where we are, our interest rates have to be after the FOMC actions, it's a robust -- it's a robust growing area. So, yeah, I mean, I don't think that what's going on there is sustainable long-term. If rates start to rise, I think it's going to -- it's going to come down significantly, although, the purchase market is pretty active still and that maybe has more legs to it and less cyclicality.

But in any event, I mean it's just -- I think it's just a good example, of hey, we can go here, because this is safe, this has activity, this is something where we can move to in the immediate timeframe that we did that basically earlier -- earlier this year. If that pulls back in 2021, which I think is a reasonable probability, like I mentioned, we are looking at our the things that are coming to our credit committee and they're strong and they're diversified and we think that that's where we can kind of pivot to as this one may wane a bit.

Kenneth A. Vecchione -- President and Chief Executive Officer

Let me just add, first, remember that while we have $3.9 billion sitting out there in loans, we have almost an equal amount, $3.6 billion sitting out there in deposits. So, it's a great strength of deposit growth for us. And so I think that's important to remember. The other thing is, when we say warehouse lending, you got to remember that includes MSR lending, that includes note financing and warehouse lending and so it's a combination of all those things. So, we do have some other levers to pull when we're dealing with some of our clients.

David Chiaverini -- Wedbush Securities -- Analyst

Great, that's really helpful color. And then shifting gears, you mentioned about the potential for reserve releases looking out over the next few quarters or maybe middle or end of 2021. But nonetheless, I was curious, do you have a target reserve to loan ratio in mind?

Dale Gibbons -- Vice Chairman and Chief Financial Officer

We don't, because it's so dependent on each particular asset type. So, that number as we've grown in these categories that are about a third of our balance sheet now that are little to zero loss mortgage warehouse, public finance, capital call lines residential mortgages, resort finance. As those become -- have become a larger proportion, that number is going to fall. And so I think you need to look at it more on a category by category basis.

I mean if you look back to kind of what a standard normal situation might be, if you take -- if you take where numbers were as of 12/ 31/19 before this pandemic started, and then add in the overlay that was done at the beginning of this year for the adoption of CECL, which front-loads provisioning as everyone is well aware. That number was about a 1% number for us in terms of reserve level. I think in a more kind of benign environment and less uncertainty, I think you kind of go back to that level with that mix. If the mix is lower, I think that number could even fall further.

David Chiaverini -- Wedbush Securities -- Analyst

Great. Thanks very much.

Operator

Our next question comes from Andrew Terrell of Stephens. Please go ahead.

Andrew Terrell -- Stephens -- Analyst

Hey, good morning.

Kenneth A. Vecchione -- President and Chief Executive Officer

Morning.

Andrew Terrell -- Stephens -- Analyst

Most of my questions have been asked and answered at this point. I just want to touch on, on the increase in compensation this quarter, was there included in that number any type of catch-up from prior quarters that we would see far of the 4Q run rate?

Kenneth A. Vecchione -- President and Chief Executive Officer

Yeah, that's exactly. As we move closer to our performance targets, we caught up for the first two quarters as well.

Andrew Terrell -- Stephens -- Analyst

Okay, that's helpful. And then maybe just a bigger picture question. Fees to, I guess, overall revenue are consistently just around the mid-single digit range. If we're on a lower for longer interest rate environment, are there any thoughts to potentially growing out any specific offerings in the fee income base?

Kenneth A. Vecchione -- President and Chief Executive Officer

So, we're always looking at that, as you know, we're very low. We lead the industry in many different categories. We do not to lead the industry in fee income, and so we are working on a few things. I would say they're going to be marginal at this point. There's nothing that's going to move the needle, as we -- as we look toward 2021. So, we're a spread business and for us, it's important for that balance sheet growth to occur. Good asset quality of course, that will negate some of the raw -- some of the lower funding -- lower interest rate environment. But remember we're able to get floors on our loans and 78% of our loans have floors and so the impact to us on an in-basis will not be as great.

Andrew Terrell -- Stephens -- Analyst

That's helpful. Thanks for taking my questions.

Operator

Our next question will come from Jon Arfstrom of RBC. Please go ahead.

Jon Arfstrom -- RBC -- Analyst

Thanks, good morning, everyone.

Kenneth A. Vecchione -- President and Chief Executive Officer

Good morning.

Jon Arfstrom -- RBC -- Analyst

This is maybe I think everything is pretty much been covered, but touchy feely philosophical question for Tim or Ken. I can look at this and you are making more than you were pre-pandemic, your returns are tangible -- return on tangible is almost 20%, but stock plus 30%. So, the gap is probably credit concerns. Do you feel like we're all overreacting to that or should we expect some kind of a surge in losses over the next few quarters that it doesn't seem like you're indicating but are we missing something here?

Kenneth A. Vecchione -- President and Chief Executive Officer

The short answer is yes. I mean, if you if you piece through everything we said today. We said that the baseline of earnings for Q3, $136 million this quarter, is going to be the baseline going forward for the upcoming quarters into 2021, assuming at this point, the same provisioning of about $15 million. Now, we don't see large losses on the horizon. We don't see charge-offs rising dramatically, it's hard to find them in our book of business at this point.

So, even our provision maybe a little high and certainly would be a little high if the consensus economic forecast is changed to be more favorable for the vaccines and what have you and more states opening up after the election. So, I think that the -- a lot of investors, I'll say that way, overreacted to what they thought our losses could be. All right. Almost $10 billion of our book is in really, really low loss categories. And as I said, we don't see the losses coming our way and we're feeling good about where our net interest income is going to be in Q4, and we're feeling good that the baseline for earnings is what you see this quarter.

Jon Arfstrom -- RBC -- Analyst

Okay, that's all I had. Thank you.

Kenneth A. Vecchione -- President and Chief Executive Officer

Okay. Well, thank you all for attending the call. We look forward to speaking to you in the fourth quarter and everyone, enjoy their weekend.

Operator

[Operator Closing Remarks]

Duration: 67 minutes

Call participants:

Kenneth A. Vecchione -- President and Chief Executive Officer

Dale Gibbons -- Vice Chairman and Chief Financial Officer

Tim R. Bruckner -- Chief Credit Officer

Brad Milsaps -- Piper Sandler -- Analyst

Chris McGratty -- KBW -- Analyst

Michael Young -- Truist -- Analyst

Gary Tenner -- DA Davidson -- Analyst

Brock Vandervliet -- UBS -- Analyst

Timur Braziler -- Wells Fargo -- Analyst

David Chiaverini -- Wedbush Securities -- Analyst

Andrew Terrell -- Stephens -- Analyst

Jon Arfstrom -- RBC -- Analyst

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