First Horizon Corp
NYSE:FHN
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First Horizon Corp
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Good morning and welcome to First Horizon National Corporation First Quarter 2020 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Ms. Aarti Bowman, Investor Relations. Please go ahead.
Thank you, Nick. Please note that the earnings release, financial supplement and slide presentation we will use in this call are posted in the Investor Relations section of our website at www.firsthorizon.com.
In this call, we will mention forward-looking and non-GAAP information. Actual results may differ from the forward-looking information for a number of reasons outlined in our earnings materials and our most recent annual and quarterly reports. Our forward-looking statements reflect our views today and we are not obligated to update them. The non-GAAP information is identified as such in our earnings materials and in the slide presentation for this call and is reconciled to GAAP information in those materials.
Also, please remember that this webcast on our website is the only authorized record of this call. This morning’s speakers include our CEO, Bryan Jordan, our CFO, BJ Losch and our Chief Credit Officer, Susan Springfield.
I will now turn it over to Bryan.
Thank You Aarti, good morning everyone and thank you for joining our call. I hope that everyone is staying healthy and safe in this environment. The COVID-19 health crisis is certainly unprecedented and causing significant economic uncertainty across the world not to mention here in the United States.
While early in the game I'm encouraged by the efforts of the Federal Reserve to provide liquidity and orderly markets and the stimulus passed by the Congress and signed by President Trump.
Before we go into the quarterly trends, I'll talk about how we're responding to the COVID-19 crisis. We are focused on supporting the well-being of our employees, our customers and our communities. For our employees, we provided resources and flexibility to work remotely and offered extra sick time and financial assistance for childcare. We understand how critical the role of banks is now and our employees are working incredibly hard to support customers and our communities. Our bankers are proactively reaching out to customers to discuss challenges and solutions. We're participating in the PPP program so far we've approved approximately 5,500 applications and processed $1.6 billion of loans. We're also working with our customers to provide payment deferrals, liquidity lines and fee waivers.
On slide 5, our business diversification combined with our strong capital and liquidity gives us a position of strength from which to successfully manage through the current economic challenges. First quarter results demonstrated our solid foundation, PPNR was up 19% year year-over-year and reasonably steady linked quarter, driven by profitable balance sheet growth, strong countercyclical business performance and excellent expense management. Earnings, however, were impacted by $145 million loan loss provision building reserves to incorporate the steep decline in the economic outlook in March.
We also adopted CECL accounting rule on January 1. Net charge offs remain modest were $7 million in the quarter. We will continue to closely monitor and evaluate COVID-19's potential impact on the economy, our customer base and our loan portfolio.
Our current loan loss allowance represents 74% of 2019 stress test losses over a nine quarter period. As the full impact of the economic shutdown becomes clear, we will make appropriate adjustments if necessary.
Balance sheet trends were strong with period-end loan and deposit growth of $2.3 billion and $2 billion respectively linked quarter. Loan growth was driven by increases in loans to mortgage companies and higher line draw ups. Low rates drove an uptick in volume in loans to mortgage companies. Withdrawals increased from customers preparing for economic uncertainty. Period in deposits reflected significant customer inflow.
So far in April, we've seen deposit growth continue, while line draw ups have moderated. We've also seen some decline in loans to mortgage companies which increased sharply in the last week of March. Our capital and overall liquidity position remains strong with excess funding capacity that will allow us to continue to utilize our balance sheet to support our customers’ needs. Our period-end capital ratios were impacted by an increase in risk weighted assets primarily due to loan growth combined with an incremental provision build.
I'll give a quick update on our merger and branch acquisition before turning the call over to BJ to provide more financial details. Our merger of Equals with IBERIABANK is on track. We've made good progress and integration planning and processes and we've completed initial regulatory and shareholder filings.
Our shareholder votes are set for April, 24 and the two major proxy advisory firms have recommended votes for the merger. We anticipate closing the merger by the end of the second quarter 2020 after final regulatory approval.
Regarding the branch acquisition we've agreed with Truist to postpone finalizing the transaction until the third quarter due to ongoing pandemic situation. The postponement will alleviate customer disruption in this uncertain time and allow us to comply with social distancing guidelines. We believe both of these transactions will enhance our long-term value, with improved funding, additional earnings accretion and capital generation.
I'll now turn the call over to BJ to go through the financial highlights. BJ?
Great. Good morning. Thanks everybody and I will start with financial results on slide 8. Year-over-year highlights included strong PPNR, NII growth on strong balance sheet growth and pricing discipline despite Fed tightening higher fixed income revenue and excellent expense management. The NII was up year-over-year due to strong commercial loan growth coupled with solid deposit pricing discipline with the linked quarter decline driven by lower accretion and fewer days in the quarter.
Fee income was up from continued strong performance from our fixed income business. Average daily revenues were $1.3 million in the first quarter, an increase of 73% year-over-year and up $200,000 per day 19% linked quarter.
Fixed income’s extensive distribution platform remains well positioned to capitalize on its favorable market conditions in today's environment. The implementation of the new CECL loan loss methodology this quarter which as you know is supposed to be an estimate of lifetime losses in the credit portfolio contributed to a much higher provision from $8 million in the fourth quarter to $145 million in the first. Net charge-offs were again very low at only $7 million in the quarter with the additional provision increased driven by future economic factors in the models related to the COVID-19 pandemic. I'll get into more details on the reserve increase in a few minutes.
Balance sheet trends were again strong on both the loan and deposit side particularly in the last five weeks of the quarter. As you can see on slide 9, we saw significant increases in our period-end loans with the vast majority of the growth occurring in the last week of the quarter. Linked quarter total period-end loans were up $2.3 billion, about $1.3 billion of the growth was related to loans to mortgage companies. About $750 million of the loan growth associated with line draws and about $300 million was related to organic loan growth across the other commercial and consumer portfolios.
So far in April, line draws have abated, loans to mortgage companies balances are down from period end levels and expected to come down about $1.5 billion to $2 billion from period-end levels as purchase and refi volumes decline due to COVID-19 impacts.
In this uncertain environment, our job is threefold in terms of lending. Number one, utilize the government programs particularly PPP to get funds into the hands of those who need it. Two, to keep credit flowing to strong creditworthy borrowers and three, protect our balance sheet and capital levels and in this context where we are seeing the majority of our lending are in areas that tick these boxes.
Over the next quarter, we expect the majority of new loan growth to be driven by PPP loans which carries 0% risk weightings. We expect loans mortgage companies given the industry dynamics related to COVID-19 impacts to come down meaningfully in the range of $1.5 to $2 billion from March 31 levels and we expect line draws to occur but at lesser rates while new fundings decline and offset those incremental line draws.
Turning the deposit trends on slide 10. You see we saw strong deposit inflows toward the end of the quarter with balances up $2 billion linked quarter on a period end basis. The growth was driven by [$1.8 billion] increase in market index deposits. In March, we saw a significant inflow of these balances as customers exited the equity markets and put their cash into FDIC insured accounts. Additionally, we've executed on an additional $1.4 billion of insured network deposit contracts at attractive rates currently between 5 and 30 basis points.
We've seen similar trends in April quarter to-date deposits which are out up by about $2 billion or 5% over March 31 levels. The drivers of deposit growth in April are related to organic customer activity, consumers receiving stimulus checks, seasonal public funds and increases in non-interest bearing commercial deposits as customers hold more cash in addition to continued inflows of market index deposits.
Moving on to capital on slide 12. As I noted earlier we had strong PPNR in the quarter that led to capital generation that supported the dividends and the increase to the provision. As you can see on this slide the decline in CET1 ratio was due to the increase in risk weighted assets at the end of the month. About 54 basis points was related to commercial loan growth from the period end uptick in loans to mortgage companies in addition to the increased line draws. About 16 basis points of the impact was related to higher market risk assets in our fixed income business. The increase was largely driven by a March large spike in value at risk due to the extreme volatility.
Therefore as you all know, capital ratios are calculated on period-end assets not average assets. So even though average assets were roughly $2.8 billion lower than period-end, the capital ratio calculation is sensitive to the spot balance at the end of the quarter. To put the impact of the period-end run-up in assets in perspective, the rule of thumb for us is instead of about a $450 million increase in RWA is equal to about at 10 basis point capital ratio impact. Therefore, that increase in $2.8 billion in period-end assets over the last five weeks of the quarter versus the average assets in the quarter is about a 65 basis point impact to the CET1 ratio.
Said a different way, if CET1 was calculated on average risk weighted assets versus period end, our CET1 ratio would have been about 9.2%. As I said earlier when talking about loan growth we expect risk weighted assets to go down in the second quarter as loans to mortgage company balances decline and new loan growth is driven primarily by 0% risk-weighted PPP loans. With the expected reduction in RWA combined with continued strong PPNR, we would expect our stand-alone CET1 ratio to move back more toward the 9% range in the second quarter.
Slide 13 shows the drivers of change under CECL adoption. As you know CECL replaces the incurred loss methodology with a life of loan estimate concept. While net charge-offs were only $7 million in the quarter, the initial day one impact and so-called economic factors related to the future economic outlook drove the aggregate increase in our reserves.
To put numbers to it, as you can see in the walk forward the ending reserve as of December 31, 2019 was $200 million. We then booked a day 1 impact as of January 1, 2020 of a $106 million and subsequently by quarter end even though we had very little change in portfolio characteristics from things such as charge-offs, grading changes or loan growth in the quarter only $12 million, the economic factors, the associated changes in the future economic outlook lead to an additional $126 million of reserves resulting in an ending loan loss reserve balance at [$444] million as of March 31.
We believe this represents a healthy reserve, particularly when compared to both peers and our own severely adverse stress test, which you can see on slide 14.
Turning to slide 14, there are several key points that I'd like to highlight here. First, as noted in the top bullet, our total loan portfolio is predominantly commercially oriented at 75% of total loans with a meaningful portion of them about 42% considered investment grade equivalent and within that 20% of those commercial loans at quarter end were loans to mortgage companies, which as we've discussed many times carry minimal credit risk.
90% of loan to mortgage company balances are collateralized with government guarantees loans. While these loans are commercial loans and therefore carry 100% risk weighting it held individually on our balance sheet they would be 50% risk weighting. It is a very high quality portfolio.
Second, the consumer loans that we have are of high quality as well as evidenced by the high average refreshed FICO scores and the lack of a meaningful higher loss content credit card exposure. Third, about 12% of our total loan portfolio still has $65 million of unamortized loan mark, in addition to $42 million of reserves which provides additional loss absorption capacity.
And finally, as you can see on the right-hand side of this slide, our reserve coverage to total loans and to Q1 annualized net charge-offs are very healthy relative to peers and we have prudently built reserves that equate to 74% of our severely adverse modeled losses well above the peer averages. And if you add in the additional $65 million of unamortized loan mark, we are at approximately 85% of our severely adverse modeled losses, a very healthy number.
Turning to slide 15, since this is both the first quarter using the new CECL methodology and the factors related to the future economic outlook are such large drivers of both the size of the aggregate loan loss reserve and the first quarter provision, we thought it might be helpful to give you some details on our economic assumptions.
As to other regional banks, we utilize various Moody's scenarios and wait them to arrive at our quantitative model outputs. We then use more severe scenarios on specific portfolios as warranted to come up with additional qualitative overlays to the model results. So as you can see on this slide 15 in the upper left, our most heavily weighted baseline scenario had the following characteristics. It considers the COVID-19 pandemic impacts including the CARES Act; the Fed stimulus including the open-ended quantitative easing as well as the various announced liquidity and credit facility programs. It assumes a fourth stimulus in 4Q ’20, the recession starting already in the first half of this year with only a partial bounce-back in the third quarter then slow growth with acceleration of GDP growth not occurring until later in 2021 and no return to full employment until 2023.
For certain select portfolios, we felt might have more stress such as the aspects of the restaurant franchise finance or hospitality portfolios, we used more severe Moody's scenarios with characteristics such as in the upper right. At the bottom we also laid out for you the epidemiological assumptions that corresponded with our various weighted scenarios.
Then on slide 16, we thought it might be helpful to graph out some of the key economic assumptions driving the loss estimates and compare them to our stress test assumptions. On each of these graphs you have five lines. The lighter dotted lines are the individual upside baseline and downside scenarios utilized. The heavy blue line is the weighted average of the scenarios we utilize across our portfolios and the heavy gray line is the 2019 stress test assumptions. Few observations that I’d make here.
First on rates assumptions such as for the three-month treasury yield and Fed funds they're very similar. On both GDP and unemployment, the current weighted scenario shows the deeper GDP drop and steeper spike in unemployment initially, but over the following 18 months severely adverse assumptions are worse for longer.
And for key price indexes such as CRE or home prices or the Dow index for equity markets, the stress test assumptions are worse both near and longer-term. While the outlook obviously remains uncertain, a key difference between the stress test assumptions in the current environment to be determined is the ultimate effectiveness of the massive Federal reserve liquidity programs and the unprecedented financial stimulus programs via the CARES Act regardless with our reserves at the March 31 at 74% of our severely adverse modeled stress test losses, we believe we have been proactive in building healthy loan loss reserves for an uncertain environment.
Wrapping up this section on slide 17, wanted to remind you of our stress test results to show the resiliency of our business. First our PPNR earnings power remains strong due to our accounting countercyclical business and fixed income and we are seeing that counteryclicality play out currently and second the lower loss content mix of our credit portfolio with the meaningful portion of C&I and very low risk loans to mortgage companies and underweight CRE portfolio and a de minims credit card portfolio should serve us well in the stress environment.
With that I will turn it over to Susan to give you a little bit more color on our credit portfolio.
Thanks BJ. Good morning everyone. I will start with slide 19, which gives an overview of how our loan portfolio has evolved over the past 10 years since the last financial crisis.
Since 2009, we have meaningfully reduced our real estate exposure and exited certain riskier portfolios. As BJ said our loan portfolio is now commercially oriented with more than 40% of our loans with map to an investment grade rating. And the portfolio is diversified by products, categories and geography. Note, also on this slide our low CRE to total capital ratios versus peers. During this time, we’ve built experienced teams across line and credit leadership with significant experience in underwriting. Within our commercial loan portfolio specialty areas comprise about half of that. This specific industry knowledge by these teams allows us to have strong client selection and strong underwriting discipline and will provide expertise in navigating through this unprecedented economic crisis.
Now I'll turn to slide 20. This slide shows the detail of our commercial loan portfolio based on NAICs industry codes. Our loan balances are across several sectors in C&I.
We've also broken out certain commercial real estate balances as well. The overall free portfolio is diversified across property type and geography.
We remain disciplined in requiring significant equity across property types and have sized new loan amounts in our CRE book using a minimum underwriting rate that was typically 200 basis points or more higher than the prevailing rates at the time of underwriting. This type of underwriting builds some conservatism into the portfolio at the initial origination.
Across all our portfolios, we believe we've taken the right approach to risk and have been prudent in our credit discipline. I'll go over some of the specifics portfolios in the next few slides.
On slide 21, first let's take a look at the healthcare portfolio. It's diversified among physicians offices, medical centers, hospitals and residential facilities. This $1.6 billion of average balances includes the healthcare specialty area as well as other healthcare related loans on our balance sheet. The energy portfolio is $735 million or about 2% of our total loan portfolios. About half the energy portfolio is comprised of reserve-based loans with approximately 70% of reserve-based borrower revenues hedged through 2020 and with approximately 50% hedged through 2021. The remainder of energy portfolio is diversified between midstream compression, refineries terminals storage and other oil field services. Obviously with the price volatility in the energy markets, these are portfolios that we discuss on a very regular basis.
On slide 22, I’ll go over the hospitality and restaurant portfolios. The hospitality portfolio is about $600 million with roughly 3 quarters of it related to hotel. In this hotel portfolio more than 90% of flagged hotels and are predominantly business traveler oriented with very few properties in resort destination categories. The average loan size for our hotel loans is about $14 million.
The restaurant portfolio is $1.3 billion of average balances and include the $1 billion franchise-financed specialty area. These borrowers are experienced business owners and have typically had access to multiple sources of capital and we're about 70% of our borrowers have more than 20 locations.
As we've talked about previously about 2/3 of this portfolio is limited service, meaning fast-food representing well-known concepts. The food service restaurants are mostly family-style restaurants and have limited exposure to fine dining.
I should note that the franchisors are working closely with their franchisees during this time in a number of ways deferring, discounting or waiving marketing fees and royalty fees, lowering prices on supplies that are provided by the franchisors. So in addition to the government programs we are seeing work across different segments trying to help businesses during this difficult time.
On slide 23, I'll talk about loans to mortgage companies, one of our specialty areas that we talk about every quarter. Period-end balances were $5.7 billion. As BJ noted earlier over a billion dollars of the growth came in the last five days of the quarter. The growth reflected elevated levels of typical month end increases driven by -- largely by increased refinance activity.
Loans and the mortgage companies are counter-cyclical business since low rates tend to drive mortgage activity. The loans to mortgage companies include collateral that are 90% government guaranteed mitigating most of the credit risk.
As BJ noted earlier, if these loans were directly on our balance sheet they would require only a 50% risk weighting. We have over 25 years of experience in this business and our balance sheet capacity knowledge, stringent focus on operational controls and expertise have led to increase market share.
With our commercially oriented diverse loan portfolio and our consistent balanced approach to risk, in addition to our reserve build associated with CECL adoption and the increase associated with the unknown economic impact of COVID, we believe we are well positioned to weather the current crisis.
I'll turn it back to Bryan for the wrap-up.
Thank You Susan. On slide 25, we're excited about our merger of equals with IBERIABANK. We see it as truly transformative. We've made a great deal of progress planning the integration, the merger strengthens our presence in key markets, diversifies our loan portfolio both geographically and in industry concentrations and it gives us an unique opportunity to drive greater efficiency.
From the day we announced the merger we have each been comfortable with the combined loan portfolios and while the economy has changed due to the Corona virus pandemic, I believe together we are a stronger and better institution positioned to drive attractive shareholder returns and strong earnings accretion.
While these are clearly unusual times, I believe we are well prepared to deal with the fallout of COVID-19. We have a strong capital and liquidity base. We've maintained consistently strong underwriting standards and have built a diversified portfolio that is focused on profitability and our loan loss allowance is strong. We have good expense controls in place and very importantly we have solid underlying earnings power. We're facing an economic environment that differs from many in the past but we're also seeing unprecedented government programs aimed at mitigating COVID-19's economic effects and hopefully leading to a quicker recovery.
Our company stands ready to continue to assist our employees, our customers and community in an effort to overcome COVID-19's impact and revitalize the economy. The health and safety of our employees remains of utmost importance. It's almost unimaginable the amount of work that our folks did over the last several weeks to help the treasury and the SBA roll out the PPP and really serve our customers and communities. Teams of people working around the clock; grateful for all of the dedication and commitment that my colleagues have shown in dealing with these unprecedented times; many of them working remotely. So thank you for all that you were doing.
And with that Nick, we will now turn it over to you and ask for questions.
We will now begin the question-and-answer session. [Operator Instructions] First question comes from Steven Alexopoulos, JPMorgan. Please go ahead.
Good morning everybody.
Hi Steve.
I wanted to start on reserves. If we look at the 2Q reserve build, it seems fairly aggressive in terms of the reserve covering 74% of DFAST losses, which is well above peers. Now we look at most banks, their risk for another sizable reserve increase in 2Q just given the outlook and the economy seems to have worsened since March 31. How do you guys think about this for First Horizon? Do you think you're at risk also or do you feel like with the assumptions you’ve made, which seemed more harsh than others that you've gotten ahead of the curve?
Hey Steve. It's BJ, good morning. So we obviously as I talked about used the Moody's economic scenarios which were done very late in the quarter and then even through April we continue to monitor the economic assumptions and so while we ran our models using ratings from the Moody's scenarios as I talked about earlier we also overlaid qualitative reserves on top of those specifically stress sectors to make sure that we were trying to take into account as much as we knew at the end of the quarter to be able to build as healthy reserve and try to follow what is supposed to be the rule around CECL which is truly estimating your lifetime losses as of a period ending.
And so with all those factors, we tried to be as we tried to be over the last 10 plus years very prudently conservative in terms of transparency and how we built those reserves and so as you talked about we built it much more towards a severely adverse environment.
Clearly the unknown going forward is what does the economy ultimately do, how do borrowers actually behave, how do the stimulus programs and the unprecedented Fed programs ultimately soften the impact but those are hopeful and what we wanted to do is make sure that we were building as healthy a reserve as we possibly could right now.
So next quarter as we would in any given quarter we'll reevaluate our existing portfolio and the portfolio changes as well as any new economic factors over the next 90 days and reevaluate but the bottom line is we feel very good about the healthy reserves that we built this quarter.
Hey Steve, this is Bryan. To add on to the BJ's comments, this is an environment that we sit around and we like the rest of the world clearly have a lot of things we don't know what we don't know and maybe more than any other environment in my career there are more known-unknowns than we've seen that at any point in time.
And our view, really if you go back through the 2007, 2008, 2009 timeframe was to make sure that we provide as much transparency about what's in our portfolios and we try to be realistic, not overly conservative but realistic and conservative about what we think the lifetime losses are in the portfolio and lay that out for our investor base and our regulators as well.
At the end of the day our risk profile is very-very different today than it was in 2008, 2009 and 2010 but we've taken the same approach which is to be realistic to take what we do think the economic environment looks like and as BJ said use a Moody's baseline and then those portfolios we think will be adversely impacted, use more severe scenarios around them but again provide transparency and be realistic about how we think it plays out.
As BJ said facts on the ground are going to change. We're all going to know a lot more in 90 days and we know today we're going to know a lot more in 180 days and we'll make adjustments as necessary.
That's helpful. Maybe for Susan, can you give us a sense as to the loans which you provided deferrals, modifications in the quarter? Maybe the overall balance and maybe some color on which segments?
Certainly. So if I look at the deferrals that we provided, business purpose deferrals would be on about $3.3 billion worth of underlying loan balances. Of that about $600 million would be what I consider small business. The two biggest portfolios you would imagine, we had about $850 million in CRE or about 20% of the CRE book and about -- not quite 40% of the franchise finance. And then the remainder was in just what I would call core C&I.
So we are dedicated to working with these great customers who are experiencing this difficulty related to the pandemic and believe that this could be a factor in addition to the government programs that can help get them beyond this point. In addition to that on the consumer side we've had the deferrals on traditional consumers about $256 million of balances and mortgage about $230 million.
Okay. Thank you Susan.
I think it was mentioned earlier about $100,000 in fee waivers.
[About $1,00,000 in fee].
Okay. Thank you. And finally for BJ, I know it's almost impossible to forecast the margin here but in terms of just the ability to absorb losses, can you talk about, do you think you can grow net interest income in the coming quarter with all the pressure on NIM and some offsets on PPP? Thanks.
Yes. So we do have a slide 28, if you want to look at our net interest margin and net interest income trends in the appendix but yes I think in terms of NII, I think there's going to be continued pressure as we expect LIBOR to continue to come down. It remained more elevated than I think any of us would have thought given the rapid decline in Fed funds but we expect that to continue to come down. It hasn't yet come down to where we think it'll be. So that'll continue to be a headwind.
Our teams have done an excellent job both taking care of customers and growing deposits while also remaining very disciplined around pricing whether it’s base rates, earnings credit rates, promo rates, retention rates, etc. And as you can see in the quarter, we brought deposit rates down quite significantly and I would expect that to continue into the second quarter. So that will be helpful as well.
I would expect that those two the net impacts would probably be a net negative because LIBOR and our floating rate loans would come down more than what we could bring down deposit costs but as you said the PPP program particularly around the fees that we will generate from the $1.6 billion of fundings that we are making will flow through the net interest income line and hopefully be able to offset any of the net negative in terms of the rate dynamic. So all of that to say is I do think that we can hold our net interest income relatively steady with the addition of the PPP feeds.
Perfect. I appreciate all the color. Thanks.
Thank you.
Thanks Steve.
Next question from Ebrahim Poonawala, Bank of America. Please go ahead.
Good morning.
Morning Ebrahim.
Hey. I guess Bryan just following up to your comments relative to 2008-2009, I think there's one like you provided a lot of details on the portfolio like at what point at like what's your level of comfort around the portfolio as someone who took the bank and came to the bank in ‘07, ran it through the crisis, through the clean up. When you look at the portfolio, do you see a realistic risk where losses exceed your severe loss estimates because I think the numbers we can all look at, you should be able to earn it even if you have $600 million instead of $440 million that you reserved today but just talk to us in terms of the portfolio around and just your confidence around like that numbers is probably the high-watermark when you think about losses?
Yes. So as I think about the portfolios today versus 2007 and 2008, I don't think there's any comparison at all. The risk profile in the portfolio is completely different. We didn't have, we don't have the national businesses. We don't have all of the residential construction. We don't have all of the non-footprint home equity exposures and we didn't have a lot of that, we don't have the correspondent portfolios that we had in 2007, 2008 and 2009.
Today we have made a very conscious effort over a 10-year period to transform the way we underwrite, the way we document, the collateral and there was a slide, I don't recall which one, there's a slide in there BJ show me, page 19 it shows the risk ratings in the portfolio and sort of the evaluation but I would suggest that I have a very high degree of confidence in our underwriting and our portfolio management. We have transformed it intentionally.
Our mantra has been we want a portfolio that we will be proud of in any cycle and this would qualify at any cycle and we believe that this portfolio will perform well. Clearly, our losses will go up as everybody's will. But we think this portfolio will hold up and perform very, very well and so I think there's very low comparison to 2007-2008 and if the framework that people are applying how do we do in 2007-2008, how we're going to perform today it's night and day. I think the portfolio performance will be vastly different and vastly better in this cycle.
Got it. And I guess Susan, just following up on that what percent like -- do you know what percentage of your restaurant finance customers were or total business customers were qualified for the PPP program?
You asked about franchise finance customers currently are applying?
Yes. How many qualify for PPP? Yes.
Yes. 50% of our franchise finance customers have applied for PPP.
Got it and in terms of the mortgage warehouse like 90% of the collateral government GSE back mortgages, is there any risk in terms of the warehouse where a mortgage company runs into trouble like do you see any meaningful credit risk there or not?
I really don't. We've got that 90% of government back another 5% or 6% is jumbo and really conforms in every other way except for the loan size and a small amount of non-QM.
Our experience Ebrahim with those portfolios even when we've had to manage out of a position, the collateral is liquid. It is -- we liquidate it and we get out of the position and so we see it as more of an operational risk portfolio than a credit risk portfolio as Susan just reiterated as you pointed out it's a highly liquid. Almost essentially a conforming GSE eligible portfolio. So we see it as very little credit risk and it's really most important that we stay focused on what we've always been focused on is that we have good title to good collateral.
The other thing Ebrahim is that even mortgage warehouse customers were highly profitable through 2019 and year to-date 2020 and so their ability should you have a mortgage or two that can't go into the permanent market, their ability to pull it back, amortize it, take it back from us their ability to do that it's been increased because of the profitability that they've had in ‘19 and year to-date 2020.
Got it and if I can sneak in one last for BJ, just when I look at your amended S-4 from March 9, stocks come down, just help us think through around how the pro forma capital ratio tangible book looks coming out of the IBERIA deal, if you could provide some colors that would be helpful.
Yes. So clearly with the significant moves in the stock price there's been some talk around, do you have goodwill or do you have a bargain purchase gain and those types of things and really when it comes down to it, none of that really fundamentally changes the tangible common equity that you'll get from the transaction. So the tangible common equity will be the same. What's going to change as we get closer to close is clearly the fair value marks that we're going to be looking at on the portfolio from a credit perspective or an interest rate or liquidity mark perspective as well as the mix of PCD, Purchase Credit Deteriorated versus non-PCD loans and that mix and how we'll have to account for those.
So we're clearly going through all of that work right now and as Bryan talked about we anticipate closing the transaction towards the end of the second quarter and we'll be doing our calculations on fair value marks as of that date.
Thanks for taking my questions.
Next questions from Brady Gailey of KBW. Please go ahead.
Hey thanks. Good morning guys.
Good morning.
When you look at some of the categories in your loan book that would be deemed higher risk like energy, hotel, restaurant, healthcare. I mean none of these exposures are big for First Horizon which is good but when you look at the other riskier exposures which categories are you most concerned about actually losing money as this current economic status continues?
Brady clearly we stress several portfolios heavily as we previously discussed and the immediate impact to hospitality and restaurants was significant and then within the health care sector since all non-elective procedures and visits and – or could I say, that's where we've seen the most requests for assistance either in deferrals or liquidity line.
What we don't know as we've talked about previously is the stimulus that's out there in the additional stimulus that is planned to be out there with another round of PPP, the Main Street lending program, the specific programs for healthcare, hospital, it could end up being better than it looks right now because we've not seen an economic environment with this much stimulus.
So even while we believe those portfolios are probably more at risk based on what's going on today which is why we did stress some of those portfolios a little bit more heavily.
Really, as Bryan said the next 90 to 180 days, I think all of us will see what is the impact and then the other thing that I've been thinking about as we think about managing these portfolios, not just see what happened during the shutdown is what patterns of behavior change and how does that drive different things. So I think what we will all have to kind of go through this together and see how we emerge from the COVID pandemic.
All right. That's helpful and then First Horizon has been great, operating leverage and lowering its expense base and getting the efficiency ratio down. I mean when you look at the company now, especially with what's going on with higher provision costs and the net interest margin coming in, is there opportunity to go back and look at the expense side even more to harvest some more savings at this point?
Hey Brady this is Bryan. We appreciate the confidence and our ability to manage it. I think our team has done a very good job. And we saw – it gets masked a little bit by FTN Financial and we had in our expense pays a $10 million roughly for increase in our reserved for unfunded commitments. If you take those things out, we showed good credit, good expense leverage in the first quarter from fourth quarter and from a year ago.
We will have a fair amount of work to do and we think that there are opportunities to control some costs in the categories of known, unknowns. It's not clear today of what our work footprint looks like. Today we have about 50% or more of our people who are working remotely, how do we have to space people out and some of those things but we do think that there is operating leverage that we can get in the foreseeable future.
The other thing that I pointed out when I commented about our IBERIABANK. When we do that merger of Equals, we still feel very strong like we can get at least $170 million of cost savings out of that combination and those are calls that neither one of us can get it if we weren't doing that merger.
So in essence we have a cost tailwind by completing that merger that also allows us to restructure our entire combined cost base and that's I think there is opportunity for leverage on the cost structure but there's some things about the operating environment that we'll need another 90 days or so to figure out how it impacts us.
All right. Then lastly for me BJ, when you're talking about the mortgage warehouse coming down $1.5 billion to $2 billion, you're talking about end of period balances, correct?
Correct, yes. So you saw, I think on one of our slides Brady that literally in the last five days of the quarter we saw loans to mortgage companies go up by about a [billion two a billion three]. So it’s huge-huge spike and we actually show you the day-by-day chart from December 31 to March 31 of what loans and mortgage companies did.
So if you go back five weeks before the end of the quarter it was almost $2 billion change over five weeks. So significant run-up. We expect that to come back down in that $1.5 billion to $2 billion range from the period end simply because on the purchase side we've seen a significant back up in reduction in applications as you might expect because of the COVID pandemic and people just being very hesitant on new purchases. And then even with refi, there's still activity out there but a lot of it is just finishing what was already in process and if you think about having to do a refi, there are appraisers that have to go into houses. There are title companies and closing attorneys that actually have to be able to finalize the paperwork and with the stay at home orders and those types of things it's made it much harder to actually get those things done.
So again the combination of those two we believe caused the spike at the end of the quarter but correspondingly we think will cause a reduction of a somewhat equal amount by the end of the second quarter.
Hey Brady this is Bryan. I want to add to BJ. Our estimates vary but it was something like 20% or so of the mortgage universe to benefit from these low rates and a refi environment and as BJ said a lot of that started in the March timeframe and we'll see the pull through. There are some structural issues that BJ mentioned to further refi.
I think purchase volume, which is a little less than half a day continues to decline and like depending on your outlook on the economy unemployment rates are going to have an impact on ability to refi.
So we think that there's natural downward pressure on that. We talked about that portfolio and its impact on the capital ratios and as that portfolio shrink those capital ratios go up one of the reasons that I don't worry in addition to the strength of the credit portfolio about the CET1 ratio at a given point in time is if the economy gets bad and that capital is more of an important factor, that mortgage warehouse business is going to be probably $1 billion or a $2 billion portfolio.
It's going to come down because the economy is bad. Those capital ratios go up, the neighborhood of a 100 basis points if that happens. So that portfolio, it will ebb and flow based on the economic environment and the impact of rates. We like that business. It is a business it has, as Susan said, very strong customer base and it has been very attractive to us from a financial perspective.
So we're not worried about what that portfolio does. BJ's sort of pointing out that it's got a natural tendency down over the next couple of months so as you're modeling don't forecast it. It's almost $6 billion in outstanding.
Got it. Thanks guys.
Next question comes from Michael Rose of Raymond James. Please go ahead.
Hey thanks guys. So it looks like if I take those four categories that you outlined is kind of higher risk, it's about 15% of loans ex-warehouse. Do you have a sense for what that looks like with IBERIA included like I know their energy portfolio is about 5.5% and you guys are about 3.5% pro forma. Do you have a sense for A, what that would look like on a complexion based system and B, would you look maybe de-emphasize some of those portfolios or take a bigger mark potentially on those portfolios once you consummate the deal? Thanks.
So I will speak to couple of portfolios as you mentioned, your energy comment was correct on the combined basis. On a commercial real estate, if you are just talking about commercial real estate overall then they do have a larger commercial real estate as a percentage of their portfolio than we do. So that will go up but I do want to reiterate we did significantly diligence on each other during the process before the merger was announced and while the energy portfolio will go up to somewhat, the CRE portfolio will go up a little bit more, we do feel very good about the disciplined underwriting and client selection that both banks have employed instead feel like we'll be able to manage through that.
I do think there probably is an expectation that over the time as we are a bigger bank as an MOE, but we would look for ways to continue to diversify the portfolio and clearly those could be areas where over time we would want to de-emphasize the growth there. It doesn’t -- we want to remain open for good customers once we get beyond this pandemic but at the same time that's another benefit of being a bigger organization is the ability to continue to diversify.
So that's really how we're thinking about that but again pre-pandemic looking at the portfolios, very similar approach, very disciplined approach to initial underwriting, servicing and client selection.
Okay. That's helpful. Maybe just one follow-up for me if I look at the PPP program, just one or two questions there. I think if I combine both you and what IBERIABANK announced last week it's about 3.5 billion. How long would you expect those loans to stick around? And then when you do combine the company do you expect to hold those loans as held for sale or held for investment because the way I understand is if you hold it for investment it'll impact the margin but if you hold it for sale the fees will go through non-interest income? Thanks.
Yes. That last question, I think we've fully decided yet on which one we're going to do. HFI or HFF. So we're still working through that. I think the terms are two years but forgivable portion of that is much shorter. So we would expect them to largely just stay on the balance sheet maybe through the balance of this year running down towards the end of the year.
It's got a zero risk weighting to Michael and I think we'll also step back and look at the liquidity facility that the Fed has provided, it's because that looks like an attractive way to fund. These are zero risk weighting but as you point out they're very low spread with a 1% coupon rate.
So we've been running as I said in my transition the question we've been running really-really hard to get these loans underwritten, booked and funded. So now we catch our breath and we'll figure out how we finance them on the balance sheet but we don't think it's a problem either way on the balance sheet or using the Fed facilities and so we'll work through that over the next 30 days or so.
Yes and forgive me for stating the obvious but what I'm talking about is that what we just funded, if the government does re-up the program and comes on new rule will have it going on further but again, the way I understand it is the fees as well as the spread are included in the margin. So once we figure out exactly how that's going to flow through and when you recognize that fees we will certainly be transparent and disclose all of that.
Okay. Very helpful. Thank you.
Thank you.
Our next question comes from Tyler Stafford, Stephens. Please go ahead.
Hey guys, good morning.
Good morning Tyler.
Hey. I apologize I hopped on really late. So I'm sorry if you've already covered this but I just had a question around the fixed-income business. This quarter it looks like the revenues out of that segment were up around $14.5 million but the expenses were up around $19 million and there's a footnote that said that the fees were impacted by trading losses given the extreme market volatility. So can you just, I guess help parse out for us what is going on but I guess behind the curtain in terms of the negative operating leverage this quarter and why that should move differently next quarter? Thanks.
Yes. Hey Tyler it's BJ. Yes. So what we clearly saw in the quarter was the rapid change in, increase in volatility which led to our higher market risk assets because of higher value at risk. So Mike Kisber and the team and fixed income did an excellent job working through our inventory and managing our exposures and marks over the last five weeks of the quarter but as they were repositioning the inventory and having to take those marks, those trading losses day-to-day were coming through the revenue side but the actual activity of the sales force was fully commissionable if that makes sense.
So though our ADR was net about $1.3 million in the quarter. If you take out the trading losses the gross ADR was more in a million seven range but netting out those trading losses that reduce the ADR. So your revenues looked lower with the higher commissionable variable comp on the other side.
As they've worked through that inventory by the end of the quarter, it's very much better position such that going forward we believe we're going to have much lower net trading losses and the gross ADR and the net ADR will be much more aligned and you'll see the normal pattern start to reemerge between our incremental revenue growth and any incremental variable comp growth.
Okay.
This is Bryan. We refer to them as negative split. You've heard us say in the past we're in the moving business. We're not in the storage business. We moved these portfolios through the balance sheet and the significant dislocation that happened particularly in the municipal bond market place, some of the corporate marketplace and the volatility that sort of erupted in the late March timeframe was largely stabilized by the efforts of the Fed that I mentioned earlier to bring liquidity and stability to the marketplace.
So we think the majority of that sort of worked through the systems and there were days in there with high volatility where we did a day I think it was about $5 million in average daily revenue that made it down to about three with the negative split. So there was a lot of activity and we think that the stability in the marketplaces largely put that behind us and we think it ought to move to more normalized levels depending on how things play out in more normalized levels in the second quarter. The second quarter is off to a decent start.
Okay. Thanks for that Bryan and BJ. So I guess if some of these more extreme market volatility issues and trading losses have been cured at this point, I mean do you expect, I guess going back to Bryan your last comment there, 2Q to be more towards that gross 17 or the net 13 or somewhere in between or what's your kind of near-term expectation what you're seeing?
You'll have to forgive me on the 21st day of April I'm not going to take the bait on that. Average daily revenue has been good. There's a couple of things that could impact a business that I think we will keep our eye on. One is as financial institutions broadly speaking or funding PPP loans and a number of our customers until they can put loans into the Fed facility that will constrain liquidity.
So that could have some impact on the bond business and I think our total return business continues to look good. We're optimistic about the outlook for the quarter and as we started off, if 21 days or so is a trend we're starting off in the same area we ended the first quarter in. So we feel good about the outlook but it's way too early in the quarter and as I said there's too many unknowns about the economy to know how this is going to play out over a 90-day period.
Sure. That's totally fair. Thanks Bryan. And then just one more for me on the mortgage warehouse business. How much of the mortgage clients or balances are to mortgage originators versus mortgage servicers?
It's almost exclusively mortgage originators. We have very, very little mortgage services.
There's some of our customers that will service but we do, we don't really finance in that space. Our lending is against the originations.
Okay. That's very helpful. That's it from me. Thanks guys.
Thank you.
Thanks Tyler.
The next question comes from Garrett Holland, Baird. Please go ahead.
Good morning. Thanks for taking the question. Appreciate all the detail, but could you help us understand the sensitivity in the reserve level and the potential reserve build. If you weighted the CECL forecast more toward your downside economic assumptions versus the baseline employee for the current reserve level at 1.3
Yes. So let's see, to try to give you a sense of the magnitude. I think the pure downside model would probably be I am doing this off top of my head, about 70% more than what the baseline would be, 60% to 70% more.
So I think we took that into account in terms of: a, our weightings of the baseline upside and downside as well as what we talked about particularly around the sectors where we thought they were most vulnerable to that downside and might not have as much support from the various stimulus programs or the Fed facilities that others might have.
So we took all that into account using quantitative modeling, multiple discussions on qualitative modeling and overlays and feel comfortable about how we've looked at the aggregate reserve to this point.
Thanks BJ. And then just a follow-up on IBERIA. Obviously, a lot has changed on the macro front since you announced the deal and heard the reiteration of the cost savings projections. Do you still feel good about the time frame for realizing those benefits and maybe some of the pro forma profitability metrics?
Yes. This is Bryan. So if I take it in reverse order, can you tell me what the economy is going to be at the end of 2021, and I can tell you better about the pro forma profitability metric. But I think, over time, yes, I feel very good about our ability to get to the pro forma profitability metrics. I think by 2021, we have forecasted about 75% of the cost saves in 2021 and being at the run rate by the end of 2021.
I still feel good about that and our ability to achieve that. It will be interesting to see how the first year plays out. We may be a little shy in year one simply because of all of the needs to support PPP and the market that we're in. But we think, by the time we get to the end of the year, even then, we will be at our 25% cost reduction level in 2020.
So we still feel good about it. We still feel good about our ability to hit the pro forma profitability numbers. We're not sure that 2021 will be or 2022 will be back to 100% economy. But given that, it is, we feel good about our pro forma.
That's helpful. And then just wanted to ask a quick one about the dividend payout here. Obviously, capital levels are solid, but wanted to confirm how you're thinking about that claim on capital?
Yes, sure. So we think that returning capital to our shareholders is important. And BJ pointed out in the several slides in the deck and in the appendix on our stress testing. And our stress testing through the most severe adverse scenarios, we assume that we continue with the dividend at current levels. And that's our working assumption that we continue to manage the dividend at current levels, and we believe that capital adequacy is sufficient and pre-tax, pre-provision earnings, even net of provisions, will be adequate to clearly support the return of capital to our shareholders.
Thanks Bryan. Appreciate it.
You're welcome.
[Operator Instructions] Our next question comes from Jennifer Demba, SunTrust. Please go ahead.
Hi Jennifer.
Thank you. Good morning. Hi, Bryan what do you think the long-term implications of the pandemic shutdown are going to be on First Horizon? Whether it be less need for office space or other implications?
Yes. We've spent a good bit of time talking about that. And we think there are a number of things, operationally, office space, and in the short run, how you clean office spaces and things of that nature, how you protect customers that come in your financial centers. It's interesting. I'm doing this off the top of my head.
All of our financial centers are open. Most of the activity is happening in a drive-thru facility. Our transactions are down, but we're doing all of it through drive through facilities. And in some ways, you almost have to smile because we're using old technology to serve customers, a drive up facility.
Clearly, customers are using call centers, are using online technology. I do think that we'll have to figure out how we cope with social distancing probably for if you believe the epidemiologist for a year or two, maybe longer.
I think people have gotten much more comfortable, and we're much more comfortable in our ability to work remotely. We've done the vast majority of the PPP work on a remote basis. So I think where more people working remotely, we will probably need less office space in centralized facility.
Within those spaces, we will probably spread people out more. I think customers, over time, will do less business in financial centers because they've gotten closer to technology and using the tools that are available to them. So I think it is a opportunity to really rethink how we do business.
And that's one of the things that as we plan for the integration of the merger of equals with IBERIABANK is as we think about how does this change our business long term? And as we make our systems and process decisions, let's think about what this educates us about customers and customer preference and the likelihood of doing business.
So I think more remote banking, spread out more, more social distancing and using more technology to serve customers in unique and different ways.
Thank you.
You are welcome.
This concludes your question-and-answer session. Now I’d like to turn the conference back over to CEO, Mr. Bryan Jordan for any closing remarks. Please go ahead.
Thank you Nick. Thank you all for taking time to join us this morning. Please let us know if you have any further questions or need any additional information. Most importantly in this environment stay safe and stay healthy. Thank you again. Have a great day.
Conference is now concluded. Thank you for attending today's presentation. You may now disconnect.