Fifth Third Bancorp (FITB) Q4 2020 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. And welcome to the Fifth Third Bancorp Fourth Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker’s presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker today, Chris Doll, Director of Investor Relations. Please go ahead.

Thank you, Melissa. Good morning and thank you for joining us. Today, we'll be discussing our financial results for the fourth quarter of 2020. Please review the cautionary statements and our materials, which can be found in our earnings release and presentation. These materials contain reconciliations to non-GAAP measures, along with information pertaining to the use of non-GAAP measures, as well as forward-looking statements about Fifth Third's performance. We undertake no obligation to and would not expect to update any such forward-looking guidance or statements after the date of this call. This morning, I'm joined by our CEO, Greg Carmichael; CFO, Jamie Leonard; President, Tim Spence; and Chief Credit Officer, Richard Stein. Following prepared remarks by Greg and Jamie, we will open the call-up for questions. Let me turn the call over now for Greg to his – for his comments.

Thanks, Chris, and thank all of you for joining us this morning. I hope you're all well and staying healthy. Earlier today, we reported full year 2020 net income of $1.4 billion or $1.83 per share. We delivered strong financial results in 2020, despite the challenging operating environment brought on by the pandemic. We had several highlights for the year. We generated a record adjusted pre-provision net revenue. We maintained our expense discipline, producing an adjusted efficiency ratio below 59%, which was stable compared to the prior year and remains near decade lows. We generated a record adjusted fee revenue, including records in both our commercial and wealth and asset management businesses. We also continue to generate peer-leading consumer household growth of 3% with outsized success in Chicago and our key Southeast markets. While nearly doubling our reserves, we generated 11.7% adjusted return on tangible common equity, excluding AOCI for the full year and generated an ROTCE of 18.4% in the fourth quarter. Just as importantly, we have successfully navigated the COVID-19 pandemic, keeping 99% of our branches open for business, while working closely with our customers to support them during these challenging times through the PPP program, hardship relief programs, and other outreach efforts that we have previously discussed. Our efforts have been those externally. We were recognized by an independent third-party as a top-performing bank among the 12 largest U.S. retail banks based on our pandemic response for our customers, communities and employees. Also, we had the honor winning the Greenwich middle market CX Award reflecting our commitment to delivering a superior customer experience and for enduring the COVID-19 crisis. Additionally, during the year, we published our inaugural ESG Report highlighting our efforts to generate sustainable value for all stakeholders. And just this week, we announced that we became the first regional bank to achieve carbon neutrality in our operations. Turning to the fourth quarter. We reported net income of $604 million. Our reported EPS include a negative $0.10 impact from the items shown on page 2 of our release. Excluding these items, adjusted fourth quarter earnings were $0.88 per share. Jamie will walk you through the quarterly financial results in more detail in just a minute. Focused execution on our key strategic priorities and our disciplined approach to credit risk management, continue to drive strong financial performance. As we recently announced, we have taken decisive action to drive efficiencies and improve the long-term profitability of the bank by streamlining our operations, including divesting less profitable businesses, such as property and casualty insurance, while still investing in areas of growth and profitability. For example, we recently finalized the acquisition of H2C, which strengthens our health care investment banking and strategic advisory capabilities. We continue to assess, select strategic investments in non-bank acquisitions to improve fee growth. All reported and adjusted return metrics were solid and improved sequentially in the fourth quarter, reflecting our strong operating results, including the provision for credit loss performance. We expect a positive momentum in our operating results to continue in 2021. Net interest income increased 1% sequentially despite loan portfolio headwinds. Underlying NIM, which excludes excess cash and PPP impacts, increased 8 basis points sequentially. We expect to generate differentiated NIM performance relative to peers in 2021 and beyond, reflecting the hedge and investment portfolio actions we have taken over the past several years. Our credit quality remains solid, with net charge-offs of 43 basis points stable compared to the recent quarters. Also, our criticized assets and allowance for credit losses both declined sequentially reflecting our credit discipline and improved credit results and economic outlook. We continue to benefit from diversification and resilience of our fee-based businesses in retail, commercial, and wealth and asset management. Many of our fee-based businesses are generating strong results that are helping to cushion the impact of lower rates. Our robust capital and liquidity levels further improved this quarter, indicative of our balance sheet strength. Our regulatory capital levels have increased for three consecutive quarters, as a result of our strong earnings power, balance sheet dynamics, and the Fed's temporary suspension of buybacks. With the partial relief announced by the Fed in December, we intend to execute up to $180 million in share repurchases in the first quarter. Through proactive management, we have built a strong and stable balance sheet and significantly improved the diversification of our fee revenue. We have done this all while maintaining our culture of expense discipline and demonstrating our commitment to consistent and solid through the cycle performance. Our financial performance continues to give us confidence that we can safely and soundly operate the company at significantly lower capital levels. Though our CET1 target remains at 9.5%, we will continue to evaluate the appropriate target -- capital target as the economy improves. We are also seeing continued strength in our commercial loan production levels in our pipelines. The fourth quarter loan production was the highest in 2020 and was down around 20% from the year ago quarter, but was up over 50% from the third quarter. We are encouraged by the recent trends, the sequential improvement in almost all regions and all verticals. Strong production was more than offset by elevated payoffs and another 1% decline in line utilization. Our middle market pipeline improvement was well diversified throughout our footprint including sigma [ph] strength in our Southeast markets. In corporate banking, the pipeline strengthened again this quarter with improvement in industrials, retail, healthcare, solar and financial institutions, partially offset by continued sluggishness in hospitality and energy. Based on a strong pipeline and stable utilization trends for the first three weeks of January, we currently expect C&I loan balances to improve on a period-end basis during the first quarter excluding the impact of PPP loans. Commercial real estate pipelines continue to be well-below pre-COVID levels. Before I turn it over to Jamie to further discuss results and our outlook, I want to reiterate our strategic priorities, which will enable us to continue to generate long-term shareholder value. Our four key strategic priorities have not changed over the past several years and include leveraging technology to accelerate digital transformation, driving organic growth and profitability, expanding market share in key geographies, and maintaining a disciplined approach on expenses and client selection. We will put the appropriate level of prioritization and focus on areas where we see the highest probability for driving strong financial returns and generate long-term value for our shareholders. Our balance sheet strength, diversified revenues and continued focus on disciplined expense management will serve us well as we navigate this environment in 2021 and beyond. I'd like to once again thank our employees. I'm very proud of the way you have continually risen to the occasion to support our customers and each other doing these challenging times. Fifth Third continues to be a source of strength for our customers and our communities, while remaining committed to equality, equity and inclusion for all. Through the end, we made a three-year $2.8 billion pledge to this commitment through lending, investing and donating, including a $25 million contribution to the Fifth Third Foundation. Our financial results continue to reflect our focused execution, discipline and through the cycle principles. We remain committed to generate sustainable long-term value for our shareholders and anticipate that we will continue improving our relative performance as a top-performing regional bank. With that, I'll turn it over to Jamie to discuss our fourth quarter results and our current outlook.

Thank you, Greg, and thanks all of you for joining us today. One quick housekeeping item before discussing our financial results for the quarter. As you'll see in our earnings materials, we are no longer adjusting certain metrics for purchase accounting accretion or intangible amortization given that they largely offset and have an immaterial impact on pre-tax income. We hope this will help simplify our disclosures going forward to more easily assess our financial ratio. Now turning to our fourth quarter performance. We ended 2020 with positive momentum and delivered strong financial results. Reported results were impacted by several notable items including a $23 million after-tax negative mark related to the Visa total return swap, a $21 million after-tax charge related to our acquisition and disposition actions as Greg mentioned; the sale of our HSA business remains in process and should close by the end of this quarter. We also recognized a $16 million after-tax charge related to our branch and non-branch real estate efficiency strategies. This includes impairments associated with seven branches we will be closing in April as part of our normal rigor on reviewing our network for efficiencies. These closures are in addition to the 37 branches we announced last quarter. Furthermore as Greg discussed, we recorded a $19 million after-tax charitable contribution expense to promote racial equality. And we also recorded $4 million after-tax from COVID-related expenses. Lastly, we had a onetime favorable item related to state taxes of $13 million. In terms of the financial highlights for the quarter. Despite the nearly 160 basis point decline in one-month LIBOR over the last 12 months, we were able to generate an adjusted PPNR above the fourth quarter of 2019 level. We generated an efficiency ratio of 58%. Our operating performance reflected a 1% increase in NII, a 16% increase in adjusted fees and a 4% increase in adjusted expenses. Given the strong PPNR results combined with continued credit related improvements, we produced strong reported and adjusted return metrics including an adjusted ROA of 1.31% and an adjusted return on tangible common equity of 18.4% excluding AOCI despite growing our regulatory capital 20 basis points during the quarter. Drilling into the income statement performance. The sequential increase in NII of 1% reflected the strength of our balance sheet and deposit franchise. We saw a 4 basis point improvement in our total loan yields, which was supported by both the continued benefits from our long-duration deep-in-the-money cash flow hedges as well as $10 million in additional PPP income. Our NII results included $11 million of incremental favorable prepayment penalties in the securities portfolio reflecting one of the benefits from our strategy to invest in bullet and locked-out cash flows. Approximately 59% of the investment portfolio still invested in bullet and locked-out cash flows at quarter end. And our investment portfolio yield increased 9 basis points sequentially to 3.1%. Net premium and amortization in our securities portfolio was only $1 million in the fourth quarter. On the liability side, we reduced our interest-bearing core deposit costs by another 5 basis points. For the fourth quarter, the average cost of our core deposits was only 5 basis points. CD and debt maturities also provided a 2 basis point improvement to NIM versus the third quarter. Reported NIM was stable compared to the third quarter reflecting the favorable securities portfolio and PPP income I mentioned, offset by the impact of higher cash levels. Underlying NIM, excluding PPP and excess cash improved 8 basis points to 3.14%. Once again, we had another strong quarter generating non-interest income to cushion the rate-driven NII pressure. The resilience in our fee income levels continues to highlight the revenue diversification that we have achieved. Total non-interest income increased 9% relative to the third quarter. Excluding the notable items, non-interest income increased 16%. We generated record commercial banking revenue, which increased double-digits sequentially and year-over-year driven by strength across most of the business. We also recorded TRA income of $74 million as well as gains from several of our direct fintech investments in venture capital funds. These investments generated $75 million of fee income in 2020 and we expect continued gains in 2021. Top line mortgage banking revenue declined $46 million sequentially driven by a $26 million headwind reflecting a decline in rate lock volumes; a $12 million impact from our decision to retain $250 million of our retail production during the quarter; and $8 million due to margin compression. MSR decay in servicing fees were unchanged sequentially and will remain challenged in this environment. While we did not deliver the mortgage results we expected due to capacity pressures, we have seen meaningful improvement in December and January. Non-interest expenses also increased relative to the third quarter albeit to a much lesser extent than fees. Adjusted expenses were up 3% excluding the mark-to-market impacts associated with non-qualified deferred compensation, but is offset in security gains within non-interest income. The largest contributor of the expense growth was performance-based compensation driven by the strong performance in fees related to business growth and other revenue-linked expenses. Moving to the balance sheet. Total average loans declined 3% sequentially with both commercial and consumer balances in line with our previous guidance ranges. Commercial loan balances continued to reflect lower revolver utilization rates, which decreased another 1% in the quarter to 32%. Line utilization rates so far in January are stable relative to the fourth quarter. We currently expect utilization to remain unchanged for the first half of 2021 and are forecasting only a modest increase of approximately 1% in the second half of the year as the economy improves. Average CRE loans were flat sequentially with end-of-period balances declining 1%. As we have discussed before, we believe that the commercial real estate sector is particularly vulnerable to the current economic environment and supports our strategy of lower exposure and our focus on high-quality borrowers. We have provided more information related to our CRE exposures in our presentation this quarter. Average total consumer loans increased 1% sequentially driven by continued growth in the auto portfolio partially offset by declines in home equity and credit card. We took additional action in the consumer portfolio at the end of December to improve our NII trajectory for 2021, deploying approximately $2 billion of our excess liquidity by purchasing government-guaranteed residential mortgages currently in forbearance under the CARES Act provision. These loans are in our held-for-sale portfolio as they are not expected to be held for more than one to two years. These loans provide a more attractive risk-adjusted return than other current investment alternatives. Our securities portfolio of roughly $35 billion decreased 1% compared to the prior quarter reflecting the impact of pay downs combined with the lack of compelling reinvestment opportunities. Our investment portfolio positioning continues to support NII in the current environment allowing for patience in investing at the current unattractive long-term rates. Given the potential for strong economic growth in the second half of 2021, we do not believe long-duration securities are providing an appropriate risk return trade-off. As a result, we do not expect to grow our investment portfolio in the near term. Our unrealized securities and cash flow hedge gains at the end of the quarter remained at $3.5 billion. Also our deliberate actions within the securities portfolio over the past several years focused on structuring the portfolio in anticipation of a lower rate environment and should continue to give us a strong advantage as a very effective hedging tool to help mitigate the rate headwinds. Average other short-term investments which includes interest-bearing cash increased to $35 billion, growing $5 billion from the prior quarter and $33 billion compared to the year ago quarter. In addition to the loan growth headwinds outside of PPP the significant increase in excess cash reflects record deposit growth over the past nine months. Core deposits increased 3% compared to the third quarter, despite a 12% reduction in consumer CD balances which helped drive down interest-bearing core deposit costs by five basis points. Moving on to credit. Overall credit quality continues to be solid reflecting our disciplined approach to client selection and underwriting balance sheet optimization and the improved macroeconomic environment. Charge-offs remained well-behaved at 43 basis points. Nonperforming assets declined $67 million or 7% with the resulting NPA ratio of 79 basis points declining 5 basis points sequentially. Also our criticized assets declined 12% with appreciable improvements in energy, industrial and middle market. Given the solid credit results lower end-of-period loan balances and improvements in the macroeconomic outlook, our reserve coverage declined eight basis points to 2.41% of portfolio loans and leases with improvement in both consumer and commercial. The low level of net charge-offs combined with the $131 million decline in the allowance resulted in a net $13 million benefit to the provision loan. Our ACL decline of $131 million was attributable to several factors. Approximately 1/3 of the decline was the result of lower period-end loan balances with the remainder of the release due to both the improved economic outlook and the improved commercial credit risk profile which is reflected in our lower NPA and criticized asset levels. As is required under CECL, our reserve reflects all known macroeconomic and credit quality information as of December 31. While we are not predicting or forecasting reserve releases at this point, given both the significant uncertainty in the economy and our loan growth expectations to the extent there would be meaningful and sustained improvement in the broader economy, it's not unreasonable that reserves could come down from here even if credit losses tick up. Our base case macroeconomic scenario assumes GDP remains below 2019 levels until the end of 2021; an unemployment rate higher than the current 6.7% ending 2021 at 7.2% and declining to 5.6% by the end of 2022. Importantly, our base estimate incorporates favorable impacts from fiscal stimulus generally consistent with the $900 billion package passed at the end of December, but does not incorporate additional relief as currently proposed by the new administration. We did not change our scenario rates of 16% to the base and 20% to the upside and downside scenarios. Applying a 100% probability weighting to the base scenario would result in a $200 million release to our fourth quarter reserve. Conversely applying a 100% to the downside scenario would result in a $900 million build. Inclusive of the impact of approximately $136 million in remaining discount associated with the MB loan portfolio, our ACL ratio is 2.53%. Additionally excluding the $5 billion in PPP loans with virtually no associated credit reserve, the ACL would be approximately 2.65%. Moving to capital. Our capital remained strong during the quarter. Our CET1 ratio ended the quarter at 10.3%, above our stated target of 9.5% which amounts to approximately $1.2 billion of excess capital. As a reminder we have remaining capacity to purchase 76 million shares from our 100 million share program, authorized by our Board of Directors in 2019 representing $2.4 billion or 11% of our current shares outstanding. As Greg mentioned, we plan to execute approximately $180 million in share repurchases during the first quarter. And should the Federal Reserve permit banks to continue to repurchase shares in 2021 under the current net income test framework, we would have around $1 billion of buyback capacity in total for 2021 assuming no change to our reserve coverage. Moving to our current outlook. We have provided detailed guidance for both the full year and the first quarter consistent with previous fourth quarter earnings calls. We expect full year 2021 total loans to be stable with 2020 on both an average and end-of-period basis, reflecting the full year headwinds of commercial line utilization declines from the second half of 2020 and PPP forgiveness offset by the benefit of the consumer loans added at the end of 2020 and our forecast of $2 billion of new PPP loan originations in 2021. Average commercial balances are expected to decline in the low to mid single-digits range compared to 2020, while consumer balances should increase in the mid to high single-digits range. For the first quarter, we expect average total loan balances to increase approximately 2% to 3% sequentially, reflecting relative stability in the C&I portfolio, continued strength in the auto portfolio and growth in residential mortgage and other consumer loans, partially offset by a 1% decline in CRE. Given the loan outlook, combined with our expectations for the underlying margin to be around 3% reflective of the structural rate protection from our securities and hedge portfolios, we expect NII to decline approximately 3% next year and also decline around 3% in the first quarter relative to the fourth quarter, assuming no deployment of our excess liquidity. We expect non-interest income to increase 2% to 3% in 2021, which includes a 1% headwind from lower TRA income in 2021. If not for the TRA impact, our fee expectations would be for 3% to 4% growth, which includes the impact of approximately $40 million in foregone annual revenue, associated with our business exits as part of our expense savings program. For the first quarter, we expect fees to increase mid single-digits year-over-year, which is not which is a 9% to 10% decline sequentially reflecting seasonal impacts, such as the lack of TRA revenue and lighter other non-interest income, partially offset by the seasonal uptick in wealth revenue from tax preparation fees in the first quarter and significantly stronger mortgage revenue. We expect top line mortgage revenue to improve $30 million to $35 million in the first quarter relative to the fourth quarter and also anticipate stronger results in our loan and lease syndication businesses. We expect full year 2021 non-interest expense to decline approximately 1% relative to the adjusted 2020 expenses, driven by the impacts of our expense reduction program, but partially offset by expenses associated with strong fee growth, servicing expenses associated with the consumer loan portfolio purchased in the fourth quarter and continued investments to accelerate both our digital transformation and our sales force and branch expansion in our growth markets. As is always the case for us, our first quarter expenses are impacted by seasonal items associated with the timing of compensation awards and payroll taxes. Compared to the first quarter of 2020 reported expenses, we expect total expenses to be flat. On a sequential basis excluding seasonal items, our total first quarter expenses are expected to be down approximately 3% to 4% from the fourth quarter. We currently expect to generate year-over-year adjusted positive operating leverage in the second half of 2021, reflecting our expense actions, our continued success growing our fee-based businesses and our proactive balance sheet management. We expect total net charge-offs in 2021 to be in the 45 basis points to 55 basis point range. If the proposed stimulus passes we would expect to be at the lower end of that range. In summary, our fourth quarter and full year 2020 results were strong and continue to demonstrate the progress we have made over the past few years towards achieving our goal of outperformance through the cycle. We will continue to rely on the same principles; disciplined client selection, conservative underwriting, and a focus on a long-term performance horizon, which gives us confidence as we navigate this environment. With that, let me turn it over to Chris to open the call up for Q&A.

Thanks Jamie. Before we start Q&A, as a courtesy to others, we ask that you limit yourself to one question and the follow-up, and then returning the queue if you have additional questions. We'll do our best to answer as many questions as possible in the time we have allotted this morning. Melissa, please open the call for questions.

Thank you. [Operator Instructions] Your first question comes from the line of Scott Siefers from Piper Sandler. Your line is open.

Good morning guys. Thanks for taking my question.

Hi, Scott.

I just wanted to ask about sort of the C&I outlook. Near term, I guess, I would characterize the commentary as constructive, but you had the outlook for just, I think a 1% increase in line utilization in the second half. It seems to me it stands in a bit of contrast from some of your peers who seem to require a more robust acceleration in C&I later in the year. I guess, I'm just curious for maybe more color on how you're thinking about the potential rebound in C&I as the economy normalizes around say midyear or so?

Hey, Scott. This is Greg. First of all, I'd say, we were encouraged by the fourth quarter pipeline growth that we've seen up significantly over the third quarter albeit slightly down from where we were at the end of 2019. So we're seeing progress out there. It's really -- it's pretty broad-based across all of our regions and across our verticals. So we're encouraged by the strength we're seeing there. Obviously, there's a lot of unknowns going in as we go into 2021, digital stimulus, the vaccines and so forth, the recovery. And so it's a hard thing for us to gauge what the expectations are, but there's a lot of liquidity out there right now. So we're optimistic that if the vaccines get distributed appropriately and we get the economy back in full swing second half of the year that those numbers might look stronger. But right now we're just being at the end of the day conservative, but encouraged by the pipelines that we've seen already. I don't know, Tim if you have anything to add?

No, I think, that's absolutely right. As you said, I think, we're particularly pleased with the pickup in middle market production that we saw in the fourth quarter and the continued strength in the industry verticals like renewable energy, technology and healthcare where the bank has made fairly significant strategic investments over the course of the past several years.

Okay. Perfect. Thank you. And then just within your guidance for the full year, I know that you guys conservatively don't include the PPP impacts. Just curious however to the extent that they do come through how are you expecting those to ebb and flow? While most of the forgiveness is from the first half as that expected to be, sort of, a first half event, or how do you see that flowing through?

Yes. Scott, it's Jamie. For PPP in total NII, we expect about $150 million in 2021 which includes about $60 million in accelerated forgiveness fees, which compares to about $100 million of total NII in 2020, which included only $10 million in accelerated forgiveness fees. And right now in our outlook, we expect first quarter forgiveness fees to be in line with the fourth quarter. Perhaps that's we -- we'll be better than that from a forgiveness perspective. We've got about $400 million or a little bit less than 10% of the 2020 originations forgiven. And so as we model it out, we expect the majority of the fees from the 2020 originations to be forgiven in the third quarter as borrowers approach that 16-month time horizon of needing to make payments or have it forgiven. So right now we expect the back half of the year to have a little bit more accelerated fees. And then as we mentioned in the prepared remarks, we expect the 2021 round of PPP to be about $2 billion in originations and then that will accrue at a lower rate just given the five year term on those loans. So we expect about a 1.8% yield prior to any of the forgiveness fees.

Perfect. All right. Thank you all very much.

Your next question comes from the line of Ken Usdin from Jefferies. Your line is open.

Hey. Thanks. Good morning, guys. Jamie, on the fee side I could just hear you reiterate that up 3% to 4% core growth excluding TRA. I heard your core -- your comments about mortgage for the first quarter, but can you just give some more color in terms of what you expect to drive that growth this year and how mortgage fits into that equation?

Sure. I think some of the momentum coming off of 2020 will lead to a very successful 2021 in the fee businesses. We did grow households 3% on the consumer side. And then the investments we made in the capital market offerings over the past several years should bear fruit in 2021. So when you line up the fee categories for 2021, I expect high single-digit growth in treasury management and commercial banking, which does include the capital markets business; mid-single digits growth in consumer deposit fees, wealth and asset management and card and processing; and then low single-digit growth in mortgage.

Got it. So even with the strong year given some of that -- I guess it was a capacity point you made earlier about mortgage. You still think mortgage can grow this year. Is that just because you see production pulling through, or do you see less of the MSR drag over time? Just maybe a little more color on the mortgage side? Thanks.

Yes. On mortgage in the fourth quarter there were capacity constraints and there was the headwind from our decision to portfolio $250 million of our retail production. Those loans will close in the first quarter, and then you'll see that show up in the residential mortgage balances in held for investment. And from there, we do expect the capacity constraints to be behind us. And from an MSR perspective this environment for servicing is certainly challenging. We expect that to abate in the second half of 2021. And all-in the low single-digit growth for 2021, I think is a very achievable number for us.

Okay. Understood. Thanks a lot, Jamie.

Your next question comes from the line of Peter Winter from Wedbush Securities. Your line is open.

Good morning.

Hi, Peter.

I wanted to ask about capital. And if you can, if you could just go over the capacity what's left in the existing share buyback? How much do you have left? And then secondarily, if the Fed were to lift the restrictions on share buybacks, just how you're thinking about capital returns?

Yes. Thanks for the question, Peter. In 2019, we approved $100 million share repurchase program. We have 76 million shares left under that program. So call it $2.4 billion. Right now for 2021 you assume the Fed continue their trailing 12-month net income test and you look at our guide on earnings you should generate about $1 billion of capacity assuming no additional reserve releases. And if you look at our capital from a spot basis at the end of 12/31/2020, we have about $1.2 billion of excess even with the loan performance that we've had. So I think for 2021 should the Fed open the window $1 billion or so is -- I think, everything triangulates to that level.

Okay. That's helpful. And then, you guys lowered the net charge-off guidance from December -- towards December, I think it was 55 to 65. What gives you the confidence that, like, there is nothing looming, especially with some of these loans coming off deferral, assuming we don't get an additional stimulus package?

Yes. Hey, it's Richard. Thanks for the question. I think it really comes down to the activity we have from a risk management perspective, the confidence we have in the underwriting and our portfolio management. We continue to see consumer loss rates lower than normal. We saw them lower than normal in 2020. We expect that to continue in 2021, as the impact of stimulus rolls through the portfolio. Remember, our portfolio is concentrated in prime and super prime. We have a weighted average FICO of close to 760. So confidence in what's happening there from an activity standpoint. We do expect commercial losses to tick up a little bit from the -- into the high 40s, low 50s. And that's just going to be a function of the normal migration we see in commercial. We highlighted some potential at-risk industries in the deck. But we've seen criticized assets come down, as Jamie mentioned. We've seen positive resolutions in our workout group. And so, just, given what we see in the portfolio, where we see performance restabilization across a number of sectors, we have a lot more confidence in that range.

That’s great. Thanks very much.

Your next question comes from the line of Terry McEvoy from Stephens. Your line is open.

Hi. Good morning. Maybe start with a question for Jamie who, I guess, by now we'll call the chief cook and bottle washer at Fifth Third. So a question for Jamie. Pretty clear on kind of the securities purchases and your thoughts there on holding cash. I guess my question, are there opportunities to purchase loans like the government-guaranteed loans that you had in the fourth quarter, as well as the decision to just hold more mortgages on the balance sheet as you think about the next 12 months?

Yes. And that's essentially what we did in the back half of 2020. In the third quarter, we repurchased our own Ginnie Mae forbearance pool and that was about $750 that came on to our balance sheet. In the fourth quarter, we purchased a servicers' pool to the tune of $2.1 billion, as well as taking the $250 million of retail production and putting it on the sheet. I think, for now we've done a lot of work on the residential mortgage portfolio to improve it. And we think the returns are incredibly attractive. I think going forward, I'd like to see the loan growth be in other categories, just given the convexity risk you have in residential mortgage and that we've done enough. So that's why we expect in the first quarter to get back to selling all of our production. But, again, I think, the trade that we were able to execute was a nice deployment of excess cash and certainly a far better return than just buying mortgage-backed securities. We think the ROA, it was 2% or so on that transaction, versus security purchases are probably 1% to sub-1% right now.

Thank you. And then just as a follow-up, just looking at the CECL allowance; I'm curious, what was behind the increase in commercial mortgage and commercial construction? Other categories drifted lower, those two were up higher quarter-over-quarter and I was hoping to get some insight there. Thank you.

Yes. It's Richard, again. Look, in commercial real estate, we've seen continued negative migration. That's just a portfolio and an asset class that has a longer tail in terms of when problems arise and a longer tail when they're going to be resolved. So we saw criticized assets go up in that sector. And so, we -- that, plus some qualitative adjustments, because we don't believe that the models fully reflect the variables that are impacting some of these subsectors, like hospitality and retail, in terms of the time of recovery. And so, just given the asset migration trends and some qualitative adjustments that drove the ACL for commercial real estate higher in the quarter.

Great. Thanks again.

Your next question comes from the line of Ken Zerbe from Morgan Stanley. Your line is open.

Hi. Great. Thanks. First question, just in terms of the NII guidance, I just want to make sure that the -- or question, whether the down 3% in 2021, does that include your expectation of accelerated PPP fee income?

Yes. Thanks for the question. So we do include the $2 billion of additional 2021 PPP in our guide. I think the NII guide of down 3%, that trajectory could improve, I guess, to the point of the first question on the call today, through higher commercial line utilization, because we do assume just a small uptick in the back half of the year. And frankly, there's not much we can do about that. It's a borrower-customer demand situation. A steepening yield curve benefit would also help. We anchor our guidance on the January 4th implied forward curve. So, perhaps we'll do a little bit better there. And should the curve steepen significantly then we would have opportunity to deploy excess cash. Third, with regard to the PPP, we're assuming $2 billion of originations but as we -- and perhaps that's a conservative number because as we sit here today we've submitted over $1 billion in apps in just the first two days. And then finally, as Greg mentioned, perhaps there'll be better commercial loan production through higher borrower demand and CapEx and inventory buildups. And from a production expectation perspective, we're expecting 2021 commercial loan production to be up about 20% or so from 2020 but still down 7% or so from 2019 levels. So, our outlook assumes improvement, but not returning to a 2019 type of economy.

Got it. Okay. And just my second question I think Greg mentioned the 9.5% your CET-1 target currently which I totally understand and you make a comment that you would kind of reconsider that as the economy gets better. Can you just help us dimension like let's assume that the economy is fully better like where is a good level for Fifth Third to run on CE Tier 1?

So, prior to some of the challenges that were cropping up in the environment we had a 9% target. So, should the economy improve as we hope it does in the back half of 2021 9% I think is a logical next step for us. When we stress test our balance sheet we believe our balance sheet has a risk profile that could be run in the 8.5% to 9% range. Our stress capital buffer is currently 7%. So I guess the Fed's perspective is much lower than that. But I think for us for this year we're targeting 9.5% and we'll evaluate that target as we see how the economy unfolds.

All right. Thank you.

Your next question comes from the line of Bill Carcache from Wolfe Research. Your line is open.

Thank you. Good morning. We saw back book re-pricing headwinds to loan yields persist throughout the last strip cycle not just for Fifth Third, but across the banking system. I believe about half of your loan portfolio is variable rate and the mix was to the short end of the curve, but there's still some re-pricing yet to come through. Would you expect a similar dynamic with further pressure on loan yields to come in this strip cycle as well? Maybe if you could just speak to that and maybe compare and contrast what's different about this cycle?

No, I think that's a good observation and we are experiencing that phenomenon. And we saw it in the fourth quarter NIM and it's a factor in our first quarter guide. Right now from C&I production levels just given the floating nature of the portfolio yields are roughly in line maybe five bps below the current portfolio. But on the consumer side which is more fixed rate in nature instruments, we are seeing new production yields 25 to 35 basis points below portfolio yields. And so that is certainly a headwind in our NII outlook.

Understood. And separately sorry if I missed this, but I wanted to ask about if you could give some color on new money rates in light of the curve steepening that we've seen? On the security side, it seems like some of the dynamics around QE have led agency MBS spreads over treasuries to turn negative which would seem to temper some of the benefits of the steeper curve. But I was hoping that you guys could discuss some of the opportunities that you see there.

Yes, I think it's a great question and we're seeing a divergence in practice across the banks. Our view in terms of what the rate environment would need to progress to in order to put our excess liquidity to work is we would like to see 50 basis points or more improvement in the entry points either through the spread widening or curve steepening. A lot of banks to your point is defined in on the 25 basis points of steepening or even before that. But credit spreads have tightened 10 basis points or more over that time so that the net entry point improvement to us is not that compelling. In fact by our math if you bought in the third quarter or even in the first couple of months of the fourth quarter you lost $2 in value for every $1 in carry you picked up over that period of time. So, you still have more risk should the curve steepen further. And we don't want to be stuck in a bad trade chasing balances at what are still historically low levels of rates. So, the good news for us is we are very well-positioned in the investment portfolio. We have the luxury of time. Portfolio cash flows are about $1 billion a quarter is how we're modeling it. So, we just think being patient -- we can afford to be patient and we'll move when we think we are getting the appropriate risk return in the environment.

That's very helpful. Thank you for taking the questions.

Your next question comes from the line of Erika Najarian from Bank of America. Your line is open.

Hi, good morning. My first question is a clarification question. Jamie, you mentioned $1 billion in buyback capacity for the year. But that would imply that the Fed extends its income test beyond the first quarter, correct?

Yes. $180 million in the first quarter and then any additional repurchases are certainly subject to the Fed allowing us to do so.

So, if they lift the income restriction, I guess number one, what are your plans for DFAST participation this summer? And number two, where could that capacity grow to, if you were not subject to that income restriction after first quarter?

So the -- I'll take the second part of the question first because, that's the easier one. Right now, against our target of 9.5%, we have $1.2 billion of excess capital. So, until the economy shows significant improvement, $1.2 billion would take us down to our target. So I think that's a fair number to use. The income test would deliver a little bit less than that. In terms of the CCAR opt in, it's funny because, we've discussed this as a team and we officially have until April 5th to decide. But right now, given that our binding capital constraint is our own internal target of 9.5% versus the Fed's prior Stress Capital Buffer for us at 7% or even 7.2% in their COVID tests, should they adopt those December results in the SCB, frankly, we feel like our team deserves arrest at following the six stress tests we did during the pandemic. And there's essentially nothing to be gained by participating. So, I think for now, if I had to decide today, I would decide not to opt in.

Got it. And just my second question is on the net charge-off outlook for this cycle. Should we think, of that 45 to 55 basis points as your quantification of the peak, or are you expecting the spike to be delayed in 2022? I'm just trying to square that with a 2.65% reserve ex PPP.

Yes. So, it's interesting when you look at the guide for us, the 45 to 55 basis points for the first quarter, we actually expect charge-offs to be in the 40 to 45 basis point range and grow during the year. And to your point those losses get pushed out. But we certainly expect the 45 to 55 range to be the peak, even though some of the additional stimulus are elongating this cycle. I think ultimately the peak of the cycle keeps coming down, which is why we continue to guide to a better and better number. So right now, I think 45 to 55 will be the peak for us.

Got it. Thank you.

Your next question comes from the line of John Pancari from Evercore ISI. Your line is open.

Good morning. On the -- back to the capital topic, given your thoughts on capital and where you stand in terms of excess, can you just give us your updated thoughts on M&A potential in terms of both bank opportunities and what your thoughts are there as well as on the non-bank side? Thanks.

John, this is Greg. Good question. I get it often as you might imagine. I think first off, we haven't changed our position. We're really focused on non-bank M&A opportunities as evidenced by our recent acquisition of H2C that really supports our not-for-profit health care part of our vertical. So it's really about making sure that we are additive to both our products and our service capabilities for our fee-based business whether it be wealth and asset management, our payments capability, our capital markets capability. That's where we're spending our energies right now and then really getting out of businesses that are more in hobby such as we talked about our property and casualty business. That wasn't really providing the returns we're looking for and we couldn't get the scale. So our focus is going to continue to be on those opportunities to enhance our business value proposition and grow those fee businesses. And that's the move we've been focused on the last five years mainly. From a bank M&A perspective, it's not on our agenda right now. And as always, we would assess in an attractive situation. But today, that's not our focus. Our focus is on non-bank M&A, that adds to the business we just discussed.

Thanks, Greg. And then, on that front, on the non-bank front, I know you mentioned wealth and asset management. Just to confirm, is that -- is it both areas that you'd be interested in? I know you've expressed an interest in wealth, but you would also be interested in the institutional asset management side as well?

No, that's pretty -- no not the institutional side. We're pretty much focused on like I said the wealth and asset management side, where we made acquisitions like the Franklin Street Partners in North Carolina. That's pretty much our focus right now on the wealth side of the business.

Okay. Got it. That's helpful. And if I can ask just one more question. In terms of the securities portfolio, just wanted to get an update on how the underlying credit within the securities book is holding up. I know you have a CRE concentration there in terms of CMBS. I just wanted get an updated -- an update there on what you're seeing in terms of the performance of the underlying securities if there's any stress there evolving? Thank you.

Yes. We're invested in about $3.5 billion of non-agency CMBS and it's holding up well. The delinquency rates are mid to high single digits, but the credit enhancement right now is approaching 40%. And we only invest in the super senior AAA-rated tranches, so that we're at the top of the repayment stack. So we're not concerned about the credit exposure in the non-agency book.

Got it. Okay, great. Thank you.

Thank you.

Your next question comes from the line of Mike Mayo from Wells Fargo Securities. Your line is open.

Hi.

Hi Mike.

I think I heard you correctly so you're kind of guiding for negative operating leverage in the first half of the year, and positive operating leverage in the second half of the year, and kind of flattish for the year as a whole. Is that, kind of a fair summary of what you guys said?

Yeah.

Okay. So the question really is, on the spending. And I'm sure, there's a lot of opportunities to spend money, but from the strategic landscape, you have a lot of large banks that are opening up branches in some of your markets, others that are saying branch like digital first, some are trying to use their credit cards in the markets to cross-sell, others are moving kind of middle market businesses into your area. So as it relates to the kind of the competitive banking wars in your markets. How do you think about that? I mean, are you seeing any impact yet? Are you worried about that over the next five years? Is it much to do about nothing, or is this a major strategic threat and you say "Hey, we need to spend more money on, X, Y and Z?"

Mike, let me start. This is Greg. And I'm going to defer it to Tim, because this is a great question for him also. If you think about, the investments we're making, we still expect to run on an expense basis down next year, as we continue to make the strategic investments. Our strategies and you've heard this over-and-over have not changed in the last five years as far as how we're focused on our business which is digital transformation, feeding our business organic opportunities to grow our businesses such as our fee-based business that I just discussed a moment ago. And that being added to the acquisitions our fintech plays to add to our products and capabilities to deliver to our customers, our services. So we're going to continue to focus on that. We're very competitive. The household growth that we've seen at 3%, strong growth in our Southeast markets, we're a leader in the Chicago market. So we like those investments. So we're very comfortable on our ability to compete. We think our investment structure we have in place today allows us to continue to grow our franchise. And be extremely competitive. So we're not going to change that. We're going to continue to feed the opportunities that we think creates the greatest value for our shareholders. Let me let Tim add, from his side.

Yeah. No. I mean, Mike new competition is always something that we watch closely. And I think I wouldn't isolate it just to the folks, who are traditional, financial institutions that are building into our markets. We pay a lot of attention to the fintech companies. In particular given that in some cases they are arbitraging, the regulatory apparatus at the moment in a way that creates imbalanced competition. I think the point that Greg made to me is the most important one, is we have on a sustained basis continued to gain share, even in our highest density markets over the course of the past three or four years on primary banking relationships, which we view as being the best measure of market share. Because the decisions you make on pricing a deposit product or you domicile headquarter deposits or otherwise, have a big impact on the FDIC numbers that you sometimes see people use on a period-to-period basis. So the strong household growth we have seen across the franchise in particular in focused markets like Chicago and the Southeast as Greg mentioned, on the consumer side of the business and the strong core relationship growth that we continue to see out of our middle market franchise are the things that give us confidence in our ability to continue to compete.

I think -- so you say 3% household growth over what timeframe? And that's an interesting way to think about it, because what you're making for household is depressed from a -- the low rate environment, so the 3% household growth over the past year or, what timeframe?

Yeah. It's 3% household growth over the past year. But if you were to look at our growth in prior years, it would have been in the 2% to 3% range, quite steadily. So we've actually seen some acceleration, driven both by the build-out in the Southeast. And the growth rates for our Chicago market post-MB have been among the strongest in the franchise and definitely far stronger than you've ever seen in Chicago, when we were Fifth Third on a stand-alone basis.

All right. Thank you.

Your next question comes from the line of Saul Martinez from UBS. Your line is open.

Hey. Good morning. Thanks for taking my question. I wanted to follow-up on Erika's comments and questions. It seems to me, like your reserve ratios are just completely inconsistent with your charge-off guidance. Your NCO of 50 basis points at the midpoint you're -- at the peak of the cycle it does seem to be suggesting that the government has effectively played the role of superhero and prevented credit cycle from really even emerging. And your reserves are about five times that and I would guess your weighted average remaining life is not five years. And that doesn't even consider that your NCO rates are going to fall from here. So can you just help me bridge the gap on, your reserve levels relative to your charge-offs, because the conclusion would be you've -- would seem to me to be that, you're making an ample level of qualitative adjustments or your probability weighting downside scenarios pretty conservatively. And that we should be thinking that it's pretty likely you're going to see pretty significant reserve releases in -- coming in the coming quarters?

Yeah. It's a very good question, and the answer really comes down to the fact that the modeling of the ACL was based on the Moody's hypothetical scenario, and that's frankly why we included that in the prepared remarks, so everybody would have that information. It is certainly a scenario that is one, the base scenario is more conservative than our own outlook; and two does include a 20% allocation to a downside scenario that obviously we don't expect to happen. So, by its very nature delivers an ACL reserve that would be higher than our expectations for losses in this environment.

So, is your model factoring in net charge-offs that are higher than what you're guiding to in 2021?

Well, the reserve calculation is a three-year -- for us a three-year reasonable and supportable period, and then it reverts back over the remaining years to your historical loss rates whereas our guide is our internal modeling over the next 12 months. So, you can have differences in that given the different scenarios that are used.

Right, yes. I don't want to belabor this, but like if you're saying that this is the peak and your reserve is five times that, it just seems hard to disconnect the two to that degree. It just seems like there is a part that's more weighter.

Yes. I think to your question, if the outlook continues to improve all other things being equal, the reserve will come down and should come down. Our point is, we remain conservatively positioned and prudently positioned given the uncertainty in the environment and we'd like to get through another three to six months and see how this unfolds with vaccine efficacy and the economy turnaround.

I think that's definitely important.

Yes, right.

That's really important, Jamie, just to...

Yes. It's a good problem to have. Yes. So, go ahead, sorry.

Yes.

No. This is the conversation. It's Greg. With the conversation, we are obviously -- that's on the forefront of how we think about our business. But we are taking a conservative approach. We do want to wait and see over the next couple of quarters how this vaccine plays out, how the economy out. You're exactly right. If you look at what we've got modeled versus what our expectations are, I think there's significant upside for reserve releases as we go in to the latter part of this year if things play out as we expect they would.

Okay. Just as a quick follow-up additional question on expenses, just make sure I'm getting the glide path right here. Would see -- based on your full year and your first quarter expenses, it would seem like at the midpoint of the range you're factoring in about $1.1 billion a quarter of expenses from 2Q to 4Q. And I guess you get there in 2Q with -- most of the way there with the seasonal expenses going away. But, I mean is it fair to say like how do we think about that glide path? And should we be thinking that by fourth quarter as some of these expense initiatives filter through you could be even below that $1.1 billion as you run rate as you head into 2022?

Yes. It's a good observation. We do have a higher run rate in the first quarter and due to the seasonal items that we typically haven't that I discussed in the prepared remarks. And yes, when you model it out, $1.1 billion is a fairly good run rate to assume given the revenue projections. If the growth ends up being better than the 3% to 4% then expenses obviously revenue ranges would be higher. But for our outlook, right, you are exactly right. And then the benefit that we might have in the fourth quarter to the extent our lean process automation and other initiatives pay off sooner than the 2022 time horizon then you could see some additional improvement in the fourth quarter. But for now, we're expecting $100 million to $150 million of savings to occur in 2022 and not in 2021.

Got it, okay. Thank you very much.

Your next question comes from the line of Gerard Cassidy from RBC. Your line is open.

Good morning, Greg. Good morning, Jamie.

Good morning.

Hey, Gerard.

Coming back to loan loss reserves, when you take a look at your loan loss reserve on January 1, when the CECL was put into place for you and your peers, I think your loan loss reserve was about 180 basis points. Clearly -- there you go. Clearly it's higher today. Do you think ultimately, I don't know if it's 2022 or 2023, but is that a good end point that we should look at in terms of when this whole COVID issue is behind us? And then, the second part of this whole loan loss reserving, once your guys' view on CECL now that we've had it for a year? I know it was a very tumultuous year. But do you think it's made it more volatile, less volatile?

I'll take these questions. I think Greg can answer the second one.

Okay.

In terms of the 182 and the day one level, we spent a lot of time looking at that as to when should we or if we ever should return back to that day one, 182 basis points. And right now our current thinking is that in order to get there, it will take -- it's going to be measured a lot longer than several quarters, because we're going to exit this this crisis with corporate debt levels leverage levels significantly higher coming out than they were going in. And you would the way the modeling works you would have to have an economic outlook as well as the outlook was essentially in 4Q of 2019 and that might be hard to ever get back to at least in the next couple of years. So I think the bias for all of our reserves across the industry is probably to take a longer period of time. And ultimately if you said if - take a guess as to where that plays out over the next two years. Or at the end of two years from now would you be at your day 1? I'd say we probably are over that number because of the corporate debt levels and because the economic outlook is probably not as favorable as the 4Q 2019 outlook was when we adopted CECL.

Got it.

In terms of it's volatility absolutely yes. I mean obviously given the CECL methodology and going into a stress environment you saw this huge, huge swings that we're dealing with right now then also the adjustments necessary to release of reserves. On the models that have been tuned for this no one modeled in a pandemic. These are new models. So there's a lot of qualitative adjustments to these models that bears burdens to the uncertainty in front of us right now. So and it does definitely makes them more volatile for us.

No doubt. Greg here is a bigger picture question for you. When you go down the elevator in the evening the outlook for the banking industry including Fifth Third is positioned very well. Assuming that the economy recovers as we all think it will as bank stock prices as you know from your own stock price since the Pfizer announcement right after the election has been fantastic. What do you see as the everything is hopefully going to shape out real well this year but what are the risks that you worry about when you go down that elevator at night?

First off good question. I think we're well positioned to be competitive in the markets that we're in. The investments that we've made I think are aligned with our long-term growth expectations and success of our business. So I feel really good about how we're competing today. The challenge always is, is when we look what watch these fintech players come forward not under the same regulatory oversight that we're doing with capital expectations and so forth so there's a threat there that we're kind of watching. If they get access to the banking system payment rails and so forth that could create some stress for us that I'm very concerned about. But as far as our investments in fintech entities themselves, the investments that we're making I'm comfortable with. It's really those fintech players out there that aren't under the same regulatory framework that we are creating some stress for us snooping around the edge of our profit pools and maybe shifting some customer behavior. So that's probably the thing that keeps me up most at night. As far as competing against other banks I think we've done all the right things to do that just making sure we keep our eyes open and we have been on what it looks like against some of these other nontraditional bank players. To that end that's why we've made significant investments in our digital capabilities and really created a digital bank ourselves. All of our lending products are online available - production online service capabilities. And we've made huge investments in our digital capabilities to make sure we're well positioned to deal with those type of threats.

Your last question comes from the line of Christopher Marinac from Janney Montgomery Scott.

Thanks. Greg just leveraging off of your last answer to Gerard. Do you see fintech acquisitions as a necessary item in the future, or do you just want to be a good customer of these companies?

I think once again we've been either a partner or acquirer of fintech opportunities. Once again it gets back into our strategy whether it's buy partner then build. So we always want to focus on the technology and capabilities that are already out there. And it fits into our strategic direction with respect to how we're going to gain a lot with proper offer or how we're going to offer it. And what the opportunity looks like from a growth perspective we'd like to buy that capability if it's already there. It's a quick way to get to the market. If we can't do that you can watch us do numerous fintech partnerships to allow us to get the capabilities through that type of relationship. And if we can't do that you've watched us build and build those capabilities. And that's really been our mindset over the last decade with respect to how we handle fintechs or how we address those long term.

Great. Thanks very much, and thanks for all the information this morning.

Thanks.

We have no further questions at this time. Mr. Doll I turn the call back over to you.

Thank you Melissa and thank you all for your interest in Fifth Third. If you have any follow-up questions please contact the IR department and we will be happy to assist you.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.