Western Alliance Bancorp

NYSE:WAL

Earnings Call Transcript 2020-Q3

[Operator]

Good day, everyone and welcome to the earnings call for Western Alliance Bancorporation for the Third Quarter 2020.

Our speakers today are Ken Vecchione, President and Chief Executive Officer; and Dale Gibbons, Chief Financial Officer.

You may also view the presentation today via webcast through the Company’s website at www.westernalliancebancorporation.com. The call will be recorded and made available for replay after 2:00 p.m. Eastern time, October 23, 2020, through November 23, 2020, at 9 a.m. Eastern time by dialing 1-877-344-7529 using and entering passcode 10148637.

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

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

[Ken Vecchione, President and CEO]

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

I'd like to focus on three trends that define our third quarter results and will continue into the future; robust balance sheet growth, provision reflecting asset quality and consensus outlook and strong net interest income and PPNR that continue to build capital. The combination of these variables generated record net income of $135.8 million and EPS of $1.36, each of more than 45% versus the prior quarter and exceeding our pre-pandemic performance in 2019.

The flexibility of Western Alliance's diversified business model was again demonstrated this quarter as our deep segment and product expertise enable us to actively adapt our business in response to the changing environment and continue to achieve industry-leading profitability and growth, while maintaining prudent credit risk management.

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

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

We believe approximately 21 basis point of this compression is transitory in nature and NIM is expected to rise as excess liquidity is put to work through balance sheet growth, deposit seasonality and warehouse lending driving balances lower and PPP loan forgiveness assumptions normalized. Given these margin trends and balance sheet growth, we believe Q4's net interest income performance returns to Q2 levels and PPNR rises above Q3.

Provision for credit losses was $14.7 million in the third quarter considerably less than $92 million in the second quarter, which was primarily attributable to stable to modest improvements in macroeconomic forecast assumptions, loan growth in low-risk asset classes and limited net charge-offs of $8.2 million or 30 basis points of average assets. Dale will go into more detail and the specific drivers of our provision on our total loan ACL to funded loans ratio now stands at 1.37% or $355 million and 1.46% excluding PPP loans, which are guaranteed by the Cares Act.

If macroeconomic trends remain stable or begin to improve, future provision expense will likely mirror net charge-offs and reserve levels could decline. Loan deferrals trended lower for the quarter as many of our clients have returned to paying as agreed following their deferral period. As of Q3, $1.3 billion of loans are on a deferral or 5% of the total portfolio, which represents a 55% decline from Q2.

We expect $1.1 billion of loan deferrals will expire next quarter, which will continue to drive down our outstanding modification. Our quarterly efficiency ratio improved to 39.7% compared to 43.2% from a year ago period, becoming more efficient during the economic uncertainty provides the incremental flexibility to maintain PPNR.

Finally, Western Alliance continues to generate significant excess capital, which grew tangible book value per share to $29.03 or 4.3% over the previous quarter and 13.4% year-over-year supported by our robot PPNR generation. Capital rose $121.6 million with a CET1 ratio of 10% supporting 15.6% annualized loan growth.

Dale will now take you through our financial.

[Dale Gibbons, CFO]

Thanks Ken. Over the last three months, Western Alliance generated record net income of $135.8 million or $1.36 per share, which is up 46% on a linked quarter basis. As Ken mentioned, net income benefitted reduction in provision expense for credit losses to $14.7 million primarily driven by stability in economic outlook during the quarter and release of specific reserves associated with the wholly resolved credit.

Net interest income grew $18.3 million year-over-year to $284.7 million but declined $13.7 million during the quarter, primarily a result of changes in prepayment assumptions on PPP loans that impacted the increase in recognition. The SBA's interim final rule published in August more than doubled the amount of time that people have to receive forgiveness on their loans and coupled with the system's delay in forgiving forgiveness request processing we now expect that forgiveness processes to be elongated and the average time the loans will be outstanding is projected to up as well.

As a result using the effective interest method,, we reversed out $6.4 million of the fees recognized in Q2 and overall PPP fee recognition has been extended. This is purely a change in timing impacting [ph] with no change to cumulative fee revenue ultimately recognized from this program. The $43 million we are to receive will simply be booked to income more slowly than our original expectations. Net interest income was impacted in Q3 as a result of this timing change by $10.6 million.

Noninterest income fell $700,000 to $20.6 million from the prior quarter. We benefited from a recovery of an additional $5 million in mark-to-market loss on preferred stocks that we recognized in the first quarter. Over the last two quarters, we recovered 80% of that $11 million original loss. Finally, noninterest expense increased $9.3 million as the deferral of loan origination cost fell as PPP loan originations dropped as well as an increase in incentive accruals as our third quarter pandemic -- as the third quarter performance exceeded our original third quarter budget, which was established before the pandemic.

Strong ongoing balance sheet momentum coupled with diligent expense management drove the fee provision net revenue to $181.3 million up 13.5% year-over-year and consistent with our overall growth trend from the first quarter as the second quarter benefited from one time PPP recognition of BOLI restructuring in the Fas 91 loan cost deferrals.

Turning now to net interest drivers, investment yields decreased 23 basis points from the prior quarter to 2.79% and is up 29 basis points from the prior year due to the lower rate environment. Loan yields decreased 35 basis points following declines across most loan types, mainly driven by changing loan mix and in the reduction of PPP loan fees resulted in lower PPP loan yield during the quarter.

Notably, for both investments and loans, spot rates as of September 30 are higher than the third quarter average yields. Cost of interest-bearing deposits was reduced by 9 basis points in Q3 to 31 basis points with an end of quarter spot rate of 27 as we continue to lower posted deposit rates and push out higher cost construction price loans.

The spot rate for total deposits, which includes non-interest-bearing deposits was 15 basis points. When all the company's funding sources are considered, total funding cost declined by two basis point with an of quarter spot rate of 25. Unlike last quarter, where spot rates indicated a likely margin compression in the third quarter, these rates appear to demonstrate that the margin will improve as both earning asset yields will rise and funding cost will fall in the fourth quarter.

Additionally, in October, we called $75 million of subordinated debt that has diminishing capital treatment with the current rate of 3.4%. In spite the transition to a substantially lower rate environment during 2020, net interest income increased 6.9% year-over-year to $284.7 million. As mentioned earlier, during Q3 are extraordinary build in liquidity and adjustments to PPP loan fee recognition, compressed our net interest margin of 3.71% as net interest income declined $13.7 million. However, the majority of these reduction drivers are transitory.

PPP loans reduced our NIM during the quarter by 13 basis point as changes to prepayment assumption reduced SBA fees recognized resulting in PPP loan yield of 1.76%. Excluding, the timing difference, net interest income declined only $4 million quarter-over-quarter, primarily due to interest expense on the new subordinated debt that we issued last May, resulting in a net interest margin of 3.84%.

Referring to the bar chart on the lower left section of the page, of the $43 million in total PPP loan fees, net origination cost that we received, only $3.3 million was recognized in the third quarter. We recognized reversal of PPP of $6.4 million in Q3 and expect fee recognition to be approximately $6.9 million in the fourth quarter and taper off this prepayments and forgiveness are realized. In reality these assumptions are dependent on actual forgiveness from the SBA.

Additionally, average excess liquidity relative to loans increased $1.3 million in the quarter, the majority of which are held at the Reserve Bank earning minimal returns, which impacted NIM by approximately 21 basis point bases in aggregate. Given our healthy loan pipeline and ability to deploy these funds to higher-yielding earning assets, we expect this margin drag to dissipate in the coming quarters.

Regarding efficiency, on a linked quarter basis, our efficiency ratio increased to 39.7% as we continue to invest in our business to support future growth opportunities. As described earlier, the interest expense increase is largely related to a net increase in compensation costs as we now have greater confidence in our ability to execute on our pre-pandemic budget and are no longer benefiting from differed cost for PPP loan originations. Excluding PPP, net loan fees and interest, the efficiency ratio for the quarter would've been 40.7%, which as we indicated last quarter, should be moving closer to our historical levels in the low 40s.

Return on assets increased 44 basis points from the prior quarter to 1.66% while provision feel. PPNR ROA increased 47 basis points to 2.22% as attractive decline in margin from the prior quarter. Discontinued strong performance and capital generation provides a significant flexibility to fund ongoing balance sheet growth, capital management actions or meet our credit demands.

Our strong balance sheet momentum continued during the quarter as loans increased to $985 million to $26 billion and deposit growth of $1.3 billion brought our deposit balance to $22.8 billion at quarter end. Inclusive of PPP, both loans and deposits grew approximately 29% year-over-year with our focus on loan loss segments and DDA. The loan to deposit ratio decreased to 98.2% from 90.9% in Q2 as our strong liquidity position continues to provide us with balance sheet capacity to meet funding needs.

Our cash position remains elevated at $1.4 billion at quarter end compared to $2.1 billion quarterly average, as deposit growth continues to outpace loan originations. While this doesn't pay our margin near-term, we believe it provides us inventory for selecting credit growth as demand resumes. Finally, tangible book value per share increased $1.19 over the prior quarter to $29.03 an increase of $3.43 or 13.4% over the past 12 months.

The vast majority of the $985 million of loan growth was driven by increases in C&I loans of $892 million supplemented by construction loan increases of $103 million. Residential and consumer loans now comprise 9.3% of our portfolio, while construction loan concentration remains flat at 8.8% of total loans. Within the C&I growth for the quarter and highlighting our focus on low risk assets that Ken mentioned, capital call lines grew $267 million, mortgage warehouse loans over $1 billion and corporate finance loans decreased $141 million this quarter.

Loan originations were offset by higher prepayment activity leaving the balance fairly flat. We continue to believe our ability to profitably grow deposits is both the key differentiator and a core value driver to our firm's long-term value creation. Notably, year-over-year deposit growth of $6.4 million is higher than the annual deposit growth in any previous calendar year. Deposits grew $1.3 billion or 4.7% in the third quarter, driven by increases in non-interest-bearing DDA of $777 million which now comprise over 45% of our deposit base plus growth in savings and money market accounts of $752 million.

Market share gains in mortgage warehouse and robust activity in tech and innovation continue to be significant drivers of deposit growth. As we initially described on our Q1 earnings call, while unique credit risk management strategy is focused on establishing individual borrower level strategies and direct customer dialogue to develop long-term financial plans. Our approach to payment deferral request is to look for resourceful ways to partner with our clients along with assessing their willingness and capacity to support their business interests.

We ask our clients to work with us hand-in-hand where buyer clients contribute liquidity, capital or equity as an integral component to modify payment plans. Our approach collectively uses the resources of the borrower, government and the bank's balance sheet to develop solutions that extend beyond their six-month window provided for in the Cares Act.

By quarter end, deferrals had declined by $1.6 billion or 55% reducing total loan deferrals from 11.5% at Q2 to 5%. Excluding, the hotel franchise finance segment in which we executed in unique sector specific deferral strategy, the bank-wide deferral rate is approximately 1.6%. We've received minimal additional request for further deferrals and 98% of clients with expired deferrals are now current in payments. We expect $1.1 billion of loan deferrals will expire in the current quarter, which will substantially drive down outstanding modifications.

Consistent with this trend, as of yesterday, deferrals are down $420 million in October bringing the current total to $880 million. Regarding asset quality, our nonperforming assets to OREO loan ratio remain flat at 47 basis points to total assets while total classified assets increased $28 million or 4 basis points to 98 basis points of total assets. Classified accruing loans rose by $21 million explainable by a few loans of 90 days past due as of September 30. All of these loans are now current.

Special mentioned loans increased $81 million during the quarter to 1.83% of funded loans, which is a result of our credit mitigation strategy to early identify, elevate and apply heightened monitoring to loans and segments impacted by the current COVID environment. Over 60% of the increase in special mentioned loans are from previously identified segments, uniquely impacted by the pandemic, such as the hotel portfolio and the component of our corporate finance division credits determined to have some level of repayment dependency on travel, leisure or entertainment.

As we expect in the past, special mentioned loans are not predictive of future migration to classified or lost, essential to past five years less than 1% has moved through charge-offs. If borrowers do not have through cycle liquidity and cash and capital plans, we downgrade to substandard immediately to remediate. Our total allowance for credit losses rose a modest $7 million from the prior quarter due to improvement in macroeconomic forecast and loan portfolio segments with low expected loss rates. Additionally, recovered $8.2 million of net charge-offs. The ending allowance related to loan losses was $355 million.

For CECL we are using a consensus economic forecast outlook of blue chip forecasters as it tracks management's view to recession and recovery. The economic forecast improved during the quarter which would have implied a reserve relief; however given the still unknown time horizon of COVID impacts, political uncertainty and the unknown status of further stimulus, we adjusted our certain area of waitings to a less optimistic capital.

In all, total loan allowance from credit losses to funded loans declined to modes 2 basis points to 1.37% or 1.46% when excluding PPP loans. On a more granular level, our loan loss segments account for approximately one third of our portfolio and includes mortgage warehouse, residential [indiscernible] lending, capital call lines and resort lending. When we exclude these segments, the ACL to funded loans on the remainder of the portfolio is 2%.

Provision expense decreased to $14.7 million for Q3 driven by loan growth of lower loss segments and improved macroeconomic factors, while fully covering charge-offs. Net credit losses of $8.2 million or 13 basis points of average loans were recognized during the quarter compared to $5.5 million in Q2. Relative to other banking companies, our lower consumer exposure continues to result in much lower total loan losses.

We continue to generate significant capital and maintain strong regulatory capital ratios with tangible common equity, total assets of 8.9% and a common equity tier 1 ratio of 10%, a decrease of 20 basis points during the quarter due to our strong loan growth. Excluding PPP loans, TCE to intangible assets is 9.3% a modest decline of 10 basis point from the first quarter.

Inclusive of our quarterly cash dividend payment of $0.25 per share, our tangible book value per share rose $1.19 in the quarter to $29.03 up 13.4% in the past year. We continue to grow our tangible book per share rapidly if it is increased three times that of the peers over the last 5.5 years.

I'll now turn the call back to Ken to conclude with comments on a few of our specific portfolios.

[Ken Vecchione, President and CEO]

I would now like to briefly update you on our credit risk mitigation efforts and the current status of a few exposures to industries generally considered to be the most impacted by COVID-19 pandemic. Throughout the quarter, Tim Bruckner and the credit administration team led ongoing focus portfolio reviews by risk segments to monitor credit exposures and performance against cash budget operating plans to the liquidity trough.

We are not waiting for deferrals to run out to make great changes or affect remediation strategies. If borrowers are not performing against defined operating plans or determined to not have a sufficient through cycle liquidity, we downgrades them now to substandard and an enact remediation strategies to ensure the best outcomes. We do not hold loans in essence, a special mention for the time to eventually downgrade and as a result, special mentioned graded loans slowly migrate to classified or substandard.

These facts and daily conversations with our people and our clients help me feel confident that our credit mitigation strategy and early approach to proactively manage our risk segments is bearing fruit and puts Western Alliance in a strong position to come out on the other side of the pandemic in better shape than our peers. In our $500 million gaming book focused on off strip, middle market gaming linked companies, total deferrals were reduced from 37% of the portfolio to only 4% and as of today it's 0% as our clients are now open for business and are performing at or above their reopening plans.

$1.3 billion investor dependent portion of our technology innovation segment has continued to benefit from significant sponsor support for technology firms best positioned to succeed in the scope environment and an active fundraising environment as well. Since March 2020, 55 of our clients have raised over $1.7 billion in capital resulting in 87% of borrowers with greater than six months remaining liquidity up from 77% in Q1.

Our CRE retail book of $674 million focused on local personal services based retail centers with no destination malls, continues to modestly exceed national trends that shows rent collections rising from 50% in May in August. Similarly this portfolio's deferrals have fallen from $176 million to $31 million.

Lastly, our $2.1 billion hotel franchise finance business focused on select service hotels with greater financial flexibility and LTVs had origination of approximately 60% continues to trend towards stabilization. Occupancy rates are tracking national averages currently around 50%, which have tripled from April lows. At approximately 55% occupancy, select service hotels are estimated to cover amortizing debt service. So a typical hotel is operating at breakeven.

Furthermore we are seeing deferrals decline from 83% of the portfolio to 44% of the portfolio and currently we do not anticipate granting any additional deferrals in the hotel portfolio. We are proactively engaging with hotel sponsors to validate ongoing support and hotel performance against operating plans. As mentioned earlier, we are not waiting for deferrals to end for migrating to ensure remediation options.

With strong sponsor support, the worst a great hotel typically receives is special mention. We just finished up with our management outlook. We believe that our third quarter performance is the baseline for future balance sheet and earnings growth. With this record quarter, we beat our quarterly budget that was established pre-pandemic. Our pipelines are strong. We expect loan growth to return to previous anticipated levels of $600 million to $800 million for the next several quarters and low-risk asset classes. However, there will be some offsets as PPP loans pay off or are forgiven.

Depending on the timing of the realized PPP forgiveness, organic loan growth should more than offset tripled route. In Q4, we expect to see the seasonal declines associated with our mortgage warehouse clients. Therefore, deposit growth will be at the lower end of the target range reducing our excess liquidity. To supplement our residential lending initiative, we acquired Galton Funding, a residential mortgage platform that specializes in the acquisition of prime non-agency residential home loans. The acquisition is a low risk, low cost entry point to building meaningful residential mortgage business line at an accelerated timeframe with over 100 additional mortgage originator relationships. We anticipate that the Galton team will be fully integrated by the end of October and be contributing to loan growth by the year of the year.

As Dale mentioned, our current spot rates indicate that the net interest margin pressure experienced this quarter will subside and net interest margin will trend upwards towards 3.9% in Q4. We expect net interest income to rise in Q4 aided by both an increase NIM and higher end of quarter loan balances compared to the quarterly average. Additionally, it is expected that PPP fee income will pick up next quarter as forgiveness is granted. This will however abate during 2021.

PPNR is expected to increase if net interest income growth will more offset any increase in noninterest expense. Looking ahead, we will continue to invest in new product offerings and infrastructure to maintain operational efficiency, but Q2 and Q3 efficiency ratio at September and will eventually return to sustainable level in the low 40s. Our long-term asset quality and loan loss reserves are informed by economic consensus forecast, which if consistent going forward could imply reserve releases in the coming quarters.

We believe that the provisions in excess of charge-offs year-to-date are more than sufficient to cover charge-offs through the cycle as we do not see any indicators that imply material losses are on the horizon. Finally, Western Alliance is one of the most prolific capital generators in the industry. Our strong capital base and access to ample liquidity will allow us to take advantage of any market dislocations to maintain leading risk-adjusted returns to address any future credit demands or while maintaining flexibility to improve shareholder returns.

At this time, Dale, I and Tim, will take your questions. Operator, if you want to open up the line.

[Operator]

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

[Brad Milsaps, Piper Sandler]

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

You also mentioned that you also did expect deposits from that from the route to go down until you'll get some liquidity I believe there as well. Just want to understand what the moving parts will be within average earning assets as you go into 4Q with everything you talked about?

[Ken Vecchione, President and CEO]

Yeah so mortgage warehouse had a great quarter as you can see by the results. They are increasing market share simultaneously as our warehouse lending clients increase their activity or see increased activity. So we're getting a two form [ph] and that's why you saw the increase, the lodge increase in loan balances this quarter.

Q4 is traditionally a little lighter and so we're just sticking to our Q4 analysis or historical viewpoint that loan growth there will be less and yes, our model is designed such that we can replace loan growth there with other loan growth around the company and that's why we're giving you the $600 million to $800 million range for Q4 loan growth and also the same for deposits. They lose some of their deposits in Q4 as taxes are paid.

[Dale Gibbons, CFO]

Bret, I'd also say that we have a senior loan committee that meets weekly that approves the largest credits in the company and the activity level of loans coming in from the line to that committee, which is loans above $15 million has really stepped up significantly over the past couple of months compared to where we were say in the second quarter and so we think we're seeing broader strength within other classes of loan credit.

And at the same time on the deposit side, despite what we think may happen on in terms of the warehouse lending fees, we're seeing some increase in some of these other channels as well that I think are going to bear fruition in the early near-term.

[Ken Vecchione, President and CEO]

Yeah just add to Dale, we're seeing strength in capital call business. We're seeing strength in the CRE business certainly around the industrial side. We're doing a lot of deals in distribution centers and then tech and innovation is seeing a lot of new opportunities as well.

[Brad Milsaps, Piper Sandler]

And maybe just to follow-up on the loan growth, where are kind of new loan yields coming on the books and you mentioned a spot rate of 450, but kind of curious where new production is coming on? And then can you talk a little bit more about the impact of the acquisition that you made, how much you paid, kind of what's the incremental benefit you see over the next year 6 to 12 months?

[Ken Vecchione, President and CEO]

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

[Dale Gibbons, CFO]

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

So standard agency paper could be like 2.25% and these yields will be 3.25% to 3.5%. The acquisition came with 12 people, four sales people and eight operations people and it provide us with a dedicated sales force and servicing operations and so this will allow us to ramp up our residential purchase volume while improving customer service with knowledgeable experts. It provides cross-selling opportunities to the Galton customer base. Galton has 100 warehouse lenders that they work with, 30% of which is an overlap with us, but the other 70% will allow us to offer our warehouse lending lines and then to remove mortgages off of the warehouse lending line on to our balance sheet if they fit our credit box.

We've seen Galton in operation for a couple years. We've probably seen over 1,000 mortgages that they've underwritten. So we have a real sense that their approach to credit mirrors ours and we think the big impact here will be seen middle of next year as this thing continues to ramp up and we bring them into the fold here. So where we were doing residential mortgages, either bulk purchases or forward flow agreements off the side of our debt, meaning other people had other responsibilities, we now have a dedicated team to do this and knowledgeable people and that's what excites us about this opportunity.

[Operator]

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

[Chris McGratty, KBW]

Dale I just wanted to make sure I got the fourth quarter guide back to pretty quickly, the 3.90% I believe Ken you said 3.90% margin, is that a fully loaded margin with the impact of the fees of the PPP?

[Dale Gibbons, CFO]

Correct, yeah the $6.9 million level that we show on that one page, so rebounding from the second quarter, but much lower than what we had -- we break from the third quarter but more than we have.

[Chris McGratty, KBW]

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

[Dale Gibbons, CFO]

Yes.

[Chris McGratty, KBW]

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

[Dale Gibbons, CFO]

Yeah so the warehouse book is $3.9 billion and capital call is $737 million. We see that we have stability here, we have an opportunity to continue sustaining earning asset growth. So we believe we can even if there were margin pressure in 2021, that we have -- we've got the growth trajectory that we can sustain increases in net interest income.

[Chris McGratty, KBW]

And if we look more on just the mix of the earning asset, as we look at the mix between cash and securities, it's call it roughly 20% of earning assets, is that the same -- is that the proportional mix you would expect of the balance sheet going forward may be toggling between cash and securities of 20%?

[Dale Gibbons, CFO]

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

[Chris McGratty, KBW]

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

[Dale Gibbons, CFO]

I think the bond book had actually, I know there is kind of a lot of room. I think we're comfortable with our loan to deposit ratio in the 90s. So that's going to drive some of the investment securities portfolio, but we've got a couple billion dollars, $2.5 billion of mortgage-backed securities in there that are yielding $100 million, $150 million less than if we buy we think similar risk credit with low LTV first mortgages.

So there's the possibility that after we shop up our current liquidity through residential and other channels, that may be we don't need to grow the MSR book anymore and that could become a smaller proportion of the balance sheet in aggregate.

[Chris McGratty, KBW]

And then last one if I could, just with the topic on taxes, anything meaningfully different in your tax structuring tragic today if we got tax increase that the same math opposite direction would work next year?

[Dale Gibbons, CFO]

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

[Operator]

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

[Michael Young, SunTrust]

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

[Ken Vecchione, President and CEO]

I would argue that we do have relationships and what we're doing is with each warehouse lending customer, we have a warehouse lending relationship, we could have an MSR relationship, we can have node financing relationships, they provide deposits to us and they also provide us with a go-forward flow on residential mortgages. So don’t think about the relationship as the end customer in their home. Think of it as a mortgage servicer, which controls a lot of business and we see an opportunity now there is dislocation in the market with a number of mergers and also I'd just say poor performance that we're coming in with higher high touch customer service that we're getting business that's coming to us and we're not having to struggle to bring that business in.

So that job is very important and that's what's driving the balance sheet growth. We're not trying to buy mortgages for mortgages sake. It's really the warehouse lenders and those relationships that we have with them.

[Dale Gibbons, CFO]

In terms of the repurchases, we can sustain a balance sheet growth and while we don’t have an idea of being opportunistic in terms of share price, we think the long-term value creation is from expanding the franchise.

[Michael Young, SunTrust]

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

[Dale Gibbons, CFO]

There's been no liquidation, no foreclosures. The hotel book is given it's circumstances performing okay. 45% of the book has a debt service coverage ratio above 1%, 45% is below it and then we've got a few construction loans. So we don’t have a debt service coverage ratio on that. You can see hotel occupancy coming back to 50% that's about where our hotels are tracking to the national averages.

Again, when we underwrote these hotels, we underwrote good liquid sponsors that had the ability to pull on capital from their LPs and they did that to enter into many of the three plus three or six plus six deferral relationships. Ken, do you want to say anything else.

[Ken Vecchione, President and CEO]

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

[Operator]

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

[Gary Tenner, D.A. Davidson]

Just wanted to ask on the mortgage acquisition that you talked about earlier, Dale, are there any other -- is the revenue coming up of that purely the mortgages that you put on balance sheet or are there any -- is there any another associate of revenue or fees, anything that would be related to that?

[Dale Gibbons, CFO]

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

[Gary Tenner, D.A. Davidson]

Okay. And Dale you made mention of this when you talked about balancing the investment portfolio against the resi book. You’ve been paying around in the kind of 9.5% or plus or minus in terms of residential loans. Where would you take that now you’ve got this other stream of product coming out?

[Dale Gibbons, CFO]

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

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

[Operator]

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

[Brock Vandervliet, UBS]

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

[Dale Gibbons, CFO]

Well I think it's good but there is two areas that I want to keep my eye on. One of them is I'll call it PPP deposits. So we $1.8 billion of loans that we made and we deposited into these accounts and we track how much money is still there and that number is still over $1 billion and it's like what well that's going to get burned somehow at some point in time, maybe that's a little bit lazy because we're in this no rate environment. So we want to keep our eye on that piece of the thing.

And then the second piece is kind of the mortgage warehouse area. Obviously it's been a torrid pace of refinancing that's going to increase volumes generally and so I think is there space for kind of take a breather of that scenario. Now my read of what's transpiring is while maybe the refi business is going to temper to some degree, there is still a lot of people that are eligible for refi in terms of putting themselves in a lower area.

So is there some area that could come out of that, I think there is. What we have, well we've talked about our two business lines that are deposit generating. Those both did run into a little bit of a sidetrack because of the pandemic. Each of them benefits from in-person contact for development of personal relationships with these enterprises that they service. We think that's coming out of it now. We think those pipelines look strong also.

Ken mentioned the tech and innovation space and one of our competitors was fairly bullish in terms of what that outlook is like and we would second that assessment. So while we may see softness in a couple of these categories that have been really powerful in 2020, we think we've got handouts that we can make to sustain the relay performance in 2021 to some of these new areas.

[Brock Vandervliet, UBS]

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

[Ken Vecchione, President and CEO]

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

[Operator]

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

[Timur Braziler, Wells Fargo]

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

[Ken Vecchione, President and CEO]

I think we can see where we are in terms of the operating expense level. So we think the margin is fairly stable even if rates stay at this level for maybe in perpetuity for certainly an extended period of time. And then our expenses running at around $0.40 relative to the revenue we bring in, we think that's pretty sustainable as well. So we had volatility in the second quarter for a variety of reasons we talked about.

Really the underscores that we're looking at the third quarter of 2020 is really being a pretty good base line. I know some of you have commented or looked at that we had these gain from security recovery about $5 million in the third quarter which of course we did, but in my view, I don’t back that out in terms of what a run rate is because I'm offsetting that with the reversal we had in PPP going forward.

So we think the revenue is a good base to come from. We think the expense base is a good base from which to grow, but again holding it in kind of the low 40s on efficiency.

[Timur Braziler, Wells Fargo]

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

[Ken Vecchione, President and CEO]

So they prepay it, so before they got six months of deferral, they've prepay another six months and this is what we recommend that they do because it takes them out until the second quarter of next year, which you can differ assumptions in terms of when we get out of this with therapeutics and I think vaccines are just pretty close around the corner. I think by that point in time what we're -- these entities, these hotels are going to be able to benefit from relaxed social distancing.

And so they prepaid it all. So yes, they are paying as agreed because they're dipping into basically a control account that is making the principal interest debt service as they come off of deferral.

[Timur Braziler, Wells Fargo]

Okay. And is that around 50% that's six plus fixed of that or is it going to be a smaller amount that's about $1.1 billion?

[Ken Vecchione, President and CEO]

Of those that are coming up in the fourth quarter, it's predominantly the six plus six because they were done -- we did some that were three plus three, those typically came off mostly in the third quarter right. So the fourth quarter for those the six plus six is that we’re done in the second quarter of this year

[Timur Braziler, Wells Fargo]

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

[Dale Gibbons, CFO]

That was part of it that drove the decline in balances. There is a reserve release on an asset that we were able to get off our books and we were happy to get off our books.

[Operator]

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

[David Chiaverini, Wedbush Securities]

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

[Ken Vecchione, President and CEO]

Yeah so we thought this was again if you look at kind of the business lines with which we can select from which to grow, this was a great time to go into mortgage warehouse. The demand was strong, the quality is excellent and because of the cycle where we are, interest rates have to be after the FOMC actions, it's a robust growing area.

So I don't think that what's gone on there is sustainable long-term. If rates start to rise, I think it's going to come down significantly although the purchase market is pretty active still and that maybe has a more legs to it and less cyclicality, but in any event, it's just a good example of hey, we can go here because this has activity. This is something where we can move in the immediate timeframe that we did that basically earlier this year. That holds back in 2021, which I think is a reasonable probability.

Like I mentioned, we're looking at things that are coming to our credit committee and they're strong and they're diversified and we think that that's where we can kind of pivot to as this one may wane a bit.

[Dale Gibbons, CFO]

Let me just add, first remember that while we have $3.9 billion sitting out there in loans, we have almost an equal amount $3.6 billion sitting out there in deposits. So it's a great strength of deposit growth for us and so I think that's important to remember.

The other thing is when we say warehouse lending, you got to remember that includes MSR lending, that includes node financing and warehouse lending and so it's a combination of all other things that we do have some other levers to pull when we're dealing with some of the -- our clients.

[David Chiaverini, Wedbush Securities]

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

[Dale Gibbons, CFO]

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

If you look back to kind of what a standard normal situation might be, if you take where numbers were as of 12/31/19 before this pandemic started, net add in, the overlay that was done at the beginning of this year for the adoption of CECL, which frontload provisioning as everyone is well aware. That number was about a 1% number for us in terms of reserve level.

I think in a more benign environment and less uncertainty I think you go back to that level with the mix, if the mix is lower, I think that number could even fall further.

[Operator]

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

[Andrew Terrell, Stephens]

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

[Dale Gibbons, CFO]

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

[Andrew Terrell, Stephens]

That's helpful. And maybe just a bigger picture question, these two I guess the overall revenue are consistently just around the mid-single-digit range. If we're a lower for longer interest rate environment, are there any thoughts to essentially growing out any pieces of the offering in the fee income base?

[Ken Vecchione, President and CEO]

So we're always looking at that. As you know we're very low. We lead the industry in many different categories. We do now lead the industry in fee income and so we're working on a few things. I would say they're going to be marginal at this point. There's nothing that's going to move the deal as we as we look towards the 2021. So we're a spread business and for us it's important for that balance sheet growth to occur. Good asset quality of course that will negate some of the raw, some of the lower funding, lower interest rate environment.

But remember we're able to get floors on our loans and 78% of our loans have floors and so the impact to us on a NIM basis will not be as great.

[Operator]

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

[Jon Arfstrom, RBC]

I think everything has been pretty much been covered. Touchy-feely philosophical question for Tim or Kim, Kim look at this and your making more than you were pre-pandemic, the return are tangibly from a tangible on a 20%, the stock is about 30%. So the gap is probably credit concern. Do you feel like we're all overreacting to that or should we expect some kind of spurge in losses over the next few quarters that doesn't seem like you're indicating, but are we missing something here?

[Ken Vecchione, President and CEO]

The short answer is yes. If you piece through everything we said today, we said that the baseline of earnings for Q3 a $136 million this quarter is going to be the baseline going forward for the upcoming quarters into 2021, assuming at this point the same provisioning of about $15 million. Now we don't see large losses on the horizon, we don't see charge-offs rising dramatically. It's hard to find them in our book of business at this point. So even our provision maybe a little high and certainly would be a little high if the consensus of economic forecast is changed to be more favorable for the vaccines and what have you and more states opening up after the election.

So I think that a lot of investors I'll say that way overreacted to what they thought our losses could be right. Almost $10 billion of our book is in really, really low loss categories and as I said we don't see the losses coming our way and we're feeling good about where our net interest income is going to be in Q4 and we're feeling good that the baseline for earnings is what you see this quarter.

[Ken Vecchione, President and CEO]

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

[Operator]

The conference has now concluded. Thank you for attending today's presentation and you may now disconnect.