Community Bank System Inc

NYSE:CBU

Earnings Call Transcript 2020-Q2

[Operator]

Welcome to Community Bank System Quarter -- Second Quarter 2020 Earnings Conference Call. Please note that this presentation contains forward-looking statements within the provisions of the Private Securities Litigation Reform Act of 1995 that are based on current expectations, estimates and projection about the industry, markets and economic environment in which the company operates.

Such statements involve risk 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 all be joined by Joseph Serbun, Executive Vice President and Chief Banking Officer for the question-and-answer session.

Gentlemen, you may begin.

[Mark Tryniski, President and Chief Executive Officer]

Thank you, Cole. Good morning everyone and thank you all for joining our Q2 conference call. We hoped 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 of deferrals. One of the most significant impacts for 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 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 15, with the conversion and integration going nearly flawlessly. We were excited about this in-market transaction and the further strengthening of our Western New York footprint. Loan and deposit retention have both been almost 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 severity, but more 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 Sutaris]

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 effected $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 pretax pre-provision net revenue increased $0.05 per share or 4.9% between comparable annual quarters and $0.03 or 2.9% on the 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 12, 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 of 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 of 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 $11.1 billion was up $1.07 billion or 10.6% from the linked quarter of 2020 and up $1.68 billion or 17.8% for one year prior. Ending loans at June 30, 2020, were $7.53 billion. This was up $661.9 million or 9.6% from the end of the first quarter and up $1.24 billion or 19.8% when compare to June 30, 2019.

The company acquired $339.7 million 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 slowdown in business activity and the pandemic related shutdown of non-essential businesses in the company's Northeast markets.

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

The company maintained average cash equivalents during the second quarter of 2020 of $823 million. This is up $708.3 million or 618% 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 and an average yield of 10 basis points during the quarter. The very large increase in cash equivalents during the quarter place 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 diversifying revenue streams, a strong credit record and experienced management team leads us well prepared to endure the impacts of the COVID-19 pandemic.

The company's net tangible equity to the net tangible assets ratio was 10.08% at June 30, 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 two 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%, respectably reflective of the company's lower risk asset based and high levels of regulatory capital.

The company has an abundance of liquidity and resources and extremely well-positioned to fund future loan growth. Company's funding base is largely comprised of low cost for deposits at June 30, 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 30. 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. 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 $4.9 billion.

The company recorded 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 non-interest revenues and a slight decrease in financial service 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 for 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 $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 and fee income partially offset by 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 second quarter, driven by a nine 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 significant increases in non-interest 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 continued financial hardship experienced by certain segments of the company’s loan customers.

The company recorded $52.9 million in non-interest 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 security gains. This represents a $2.8 million or 5.2% decrease in non-interest revenues between the periods, $2.7 million of which is attributable to a decrease in banking related non-interest revenues.

The significant decrease in banking non-interest 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 a company's northeast markets during the quarter.

Employee benefits 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 record keeping and actuarial services. Insurance services and wealth management revenues were down $0.4 million or 2.4% from the same quarter last year.

Total non-interest revenues 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 benefit service revenues and a $0.7 million or 10.8% decrease in wealth management revenues partially offset by $0.5 million or 50% increase in mortgage banking revenue and a slight increase in insurance service 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 decrease 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 the reduced provider utilization.

On a combined basis, data processing and communications expenses, legal and professional expenses and occupancy and equipment expense 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, $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. 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 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 hardship due to COVID-19 related challenges. At June 30, 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 balance under active forbearance drop 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 30, 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 comparison to 0.87% at the end of the second quarter of 2019 and 1.1% at the end of the linked first quarter of 2020. The delinquency status for loans on 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 and less subsequent to March 31, 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 31, 2020, to $64.4 million or 0.86% of total loans outstanding at June 30, 2020. The $8.7 million increase the allowance for credit losses included $3.6 million in additional reserves due to the Steuben acquisition and $5.1 million due to -- primarily to expect that COVID-19 pandemic related losses. The allowance for credit losses at June 30, 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 to feed borrowers with forgiveness requests during the third and fourth quarters of 2020, the eligibility of the borrower's forgiveness requests and the SBAs ability to provide loan forgiveness in a timely manner and 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 PPPs 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 will be maintained, 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 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 remains strong.

According to 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 endorse effects.

Thank you. I'll turn it back to our host call to open the line for questions.

[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.

[Alex Twerdahl, Piper Sandler]

Hey, good morning guys.

[Mark Tryniski, President and Chief Executive Officer]

Good morning, Alex.

[Joseph Sutaris]

Good morning, Alex.

[Alex Twerdahl, Piper Sandler]

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 Sutaris]

Alex, it is a good question. Most of the reserve build was really due to changing economic conditions and continued challenges with the economic forecast as we kind of look ahead. But we also tried 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 or that we'll continue to see some -- probably some migration downward relative to the risk rating and probably higher levels of delinquency. But our -- we'll continue to monitor that and monitor our customers to determine there's the additional provision requirements in the third and the fourth quarters.

[Alex Twerdahl, Piper Sandler]

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 and Upstate New York in terms of reopening. And then kind of, as you look at some of the higher categories on that list of that risk, 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 Tryniski, President and Chief Executive Officer]

Alex, it's Mark. I would just broadly and ask Joe Serbun maybe to comment a little more detail, but say that our markets -- we were fortunate we've had lower infection rates, almost across all our markets, even in every state, essentially in a lot of that driven by the fact that they're less non-metropolitan or less metropolitan. So, I think that was a -- that's been a help for us that there hasn't been this severity of infections and lockdowns and the related impacts. Most of our markets are open for business, except for certain high risk businesses still like, gyms and bowling alleys and some other things. But most of it's open, which has been good. Clearly, it was interesting the trend in, which is really directly tied to economic activity, which is debit swipes. So, I mean, we can pretty clearly see when we had kind of the lockdown 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 to 150, 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 some of like the at risk portfolios, like retail's a good example, a lot of its essential businesses that have reopened. So, I think, I'm cautiously optimistic about some of the credit. I think -- 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 Sutaris]

Yeah.

[Mark Tryniski, President and Chief Executive Officer]

That's probably a little more at 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. 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 requests for deferrals.

[Joseph Sutaris]

Yeah.

[Mark Tryniski, President and Chief Executive Officer]

So, I think, we seem to be doing okay. I mean, my -- you just -- 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 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 would be surprised given the different vaccine platforms and the amount of money and that whole process run that if there isn't 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 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 word speculative, to send a message to, Hey, we have the reserves if we need them. I -- 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 seeking in our markets without kind of trying to speculate on where things might go.

But I think business -- to circle back to your initial question, Alex, I think business is okay. 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 relockdown, if there's a surge in our markets, there's a relockdown 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 Serbun]

So, let me just -- I'll touch on both portfolios, excuse me. 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 made up that portfolio, approximately $60 million or 41% of the total 900 non-owner occupied, much of that have national or regional type tenants. And they're not malls. These are large properties with multiple stores, with their own entrances. The LTV in that portfolio for the largest top 10, 71% -- ranges from 79% at the high to do an average of 40% so nice diversification from a loan devalue perspective. In my consent 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 handle the people going to the physical locations or 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 dollars, lodging; and 25% of the impacted dollars, retail. So, 75% of the impacted dollars being those two portfolios for us. The numbers of loans that were impacted, 23% and 21%. So, we're keenly focused on those two portfolios. And I'll tell you that the deferrals, the first ones in, on the first go around and the first one was coming in and 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 the second round deferrals, 50% of them received a principal 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 -- we'll be making an interest payment. So a good percentage is 50% of our portfolio is going to be making some level of payment, whether it's interest or modified principal and interest payment and the other 50% -- excuse me -- the other 50% are in the P&I deferral.

And with respect to credit quality, we approached the first round -- the first of through 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 and the second go around and we're moving. The credits is we deem appropriate.

[Mark Tryniski, President and 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 …

[Joseph Serbun]

55%.

[Mark Tryniski, President and Chief Executive Officer]

… is 55%. So, there's some fairly good equity coverage there in that portfolio. And these are for the most part, good developers with good flags. Yeah. So, I don't lose any sleep over where we were going to be. We're -- where we're going to end up in our lodging portfolio.

[Alex Twerdahl, Piper Sandler]

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

[Joseph Sutaris]

Sure. Well, we think the dividend is important. We think it’s important to be balanced in that dividend. We don't want our -- the 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 certainly we're biased towards growing the dividend, but also mindful of that balance between capital retention and return to shareholders.

[Alex Twerdahl, Piper Sandler]

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 you are -- bigger cut your capital position is today. Is that a fair way to think about it?

[Joseph Sutaris]

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 -- I -- we don't want to get into a position where we are -- our -- we're willing to kind of, let say, tolerate a near term payout 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 the 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's a lot of factors in play. I think our bias is towards continuing to raise the dividend. But I think if we saw severe storm clouds on the horizon for some reason, the pandemic gets worse, the economic out comes 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 in -- I think we would probably do that on the short term -- on the short term basis. But -- so I would say payout ratio of 40% to 60% give or take, is where we want to be with a bias towards raising it if we can, and we believe that it's sensible.

[Alex Twerdahl, Piper Sandler]

Thank you for taking my questions.

[Joseph Sutaris]

Thank you, Alex.

[Mark Tryniski, President and Chief Executive Officer]

Thanks, Alex.

[Operator]

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

[Erik Zwick, Boenning & Scattergood]

Good morning, guys.

[Mark Tryniski, President and Chief Executive Officer]

Good morning, Erik.

[Joseph Sutaris]

Good morning, Erik.

[Erik Zwick, Boenning & Scattergood]

First, I wanted to start with a couple follow-ups on the lodging portfolio, and I appreciate the detail you gave there, and it seems like you're not too concerned about 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 Serbun]

Yeah. So, Erik, the occupancy rates are taking off, but still not where they need to be. So, I would tell you they're in the 35% to 40% occupancy by and large. And whether it's business or vacation traveling, I don't have a feel for what might be driving the -- driving the occupancy, but I'll be -- anecdotally, in speaking to some of our clients, particularly in destination type marketplace is, they're seeing a pickup 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's in the extent that the hoteliers are going to keep their properties clean, sanitized. So, there's -- certainly those locations that are destination like they're seeing a much larger pickup in occupancy than you would in a more business environment.

And remember most businesses have locked down, have locked down employees. They're not a lot to travel or hasn't been allowed to travel. Hopefully that'll change here shortly and we'll see some business pick up as well.

[Erik Zwick, Boenning & Scattergood]

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

[Joseph Serbun]

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

[Erik Zwick, Boenning & Scattergood]

Then switching gears to the net interest margin. In the third quarter, it seems like there's a couple of variables that could impact it. One, you'll get a full quarter impact of the student coming in, which had a higher net interest margin. And then I guess there's the question 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 Sutaris]

Okay, Erik. This is Joe Sutaris. So, I could take that question. I mean, 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 2020, 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 six or seven basis points, which is the high three fifties 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 of net deferred PPP income, if we recognize some of that, I think you'll see the posted margin or the printed margin 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 is about a par with the second quarter. Obviously, the continued flat and a very low yield curve will present challenges as we move ahead, into the fourth quarter and into the first quarter of next year.

We'd like a little slope, 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 we'll generally -- it'll be difficult to really roll the margin because of the low interest rate environment.

[Erik Zwick, Boenning & Scattergood]

That's helpful. Thanks, Joe. And then one last one, as I think about the last year or so, you've closed the Kinderhook and 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 agitated 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 and the economic outlook?

[Mark Tryniski, President and 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. It's 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 stopped 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's 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 in to the future. And so, I think, you're going to see -- they've gotten beaten down on price in multiple, and so I think there's going to be -- 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 aren't starting from a position of strength, looking out into the future going forward a year or two, and concluding that they are going to have a very difficult time to create incremental value to shareholders.

So, I think that we -- there'll 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 though. 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 something -- 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 Zwick, Boenning & Scattergood]

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

[Mark Tryniski, President and Chief Executive Officer]

Thanks, Erik.

[Operator]

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

[Russell Gunther, D.A. Davidson]

Hey, good morning guys.

[Mark Tryniski, President and Chief Executive Officer]

Good morning, Russell.

[Joseph Sutaris]

Good morning, Russell.

[Russell Gunther, D.A. Davidson]

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 Serbun]

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 $13 million or $15 million [ph]. 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, $130 million in business and the difference is in the consumer portfolio.

[Russell Gunther, D.A. Davidson]

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 Serbun]

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

[Russell Gunther, D.A. Davidson]

Got it. Got it. 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 Sutaris]

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 towards 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 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 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 be.

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 encouraging.

[Russell Gunther, D.A. Davidson]

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 Sutaris]

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 Gunther, D.A. Davidson]

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

[Mark Tryniski, President and Chief Executive Officer]

Thanks, Russell.

[Operator]

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

[Matthew Breese, Stephens, Inc.]

Good morning.

[Mark Tryniski, President and Chief Executive Officer]

Good morning Matt.

[Matthew Breese, Stephens, Inc.]

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 Serbun]

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

[Matthew Breese, Stephens, Inc.]

Understood. Okay. And then, Joe, you mentioned on -- in regards to the 3Q NIM that you -- 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 Sutaris]

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 Breese, Stephens, Inc.]

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 Sutaris]

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 runoff 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 Breese, Stephens, Inc.]

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 then, is the $24 million to $25 million quarterly run rate, is that something we can use going forward?

[Mark Tryniski, President and 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 over time 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.

So -- and the business is doing okay. 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 okay regardless of equity market conditions.

[Matthew Breese, Stephens, Inc.]

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

[Mark Tryniski, President and Chief Executive Officer]

Sure. Thanks, Matt.

[Joseph Sutaris]

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 Tryniski, President and 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]

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect your lines.