Good day, everyone, and welcome to the First Merchants' Second Quarter 2020 Earnings Conference Call. [Operator Instructions]. This presentation contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act. Such forward-looking statements can often be identified by the use of words like believes, expects or may, and include statements relating to First Merchants' goals, business plan, growth strategies, loan and investment portfolio, asset quality, risks and future costs and benefits. These statements are subject to significant uncertainties that may cause results to differ materially from those set forth in such statements, including changes in economic and business conditions; the ability of First Merchants to integrate recent acquisitions and attract new customers; changes in laws, regulations and requirements of the company's regulators; the cost and other effects of legal and administrative cases; changes in the creditworthiness of customers and the impairment of collectability of loans; fluctuations in market rates of interest; and other risks and factors identified in First Merchants' filings with the Securities and Exchange Commission. First Merchants undertakes no obligation to update any forward-looking statement, whether written or oral, relating to the matters discussed in this presentation or press release. In addition, the company's past results of operations do not necessarily indicate its anticipated future results. After today's presentation there will be an opportunity to ask questions. [Operator Instructions]. And at this time, I'd like to turn the conference call over to Mr. Mike Rechin, President and CEO. Sir, please go ahead.

Thank you, Jamie. And good afternoon, everyone. Welcome to our earnings conference call and webcast for the second quarter ending June 30, 2020. Joining me today for presentation are Mark Hardwick, our Chief Financial Officer and Chief Operating Officer; John Martin, our Chief Credit Officer; and Michele Kawiecki, our Senior Vice President and Director of Finance. We released our earnings in a press release this morning at approximately 8:00 a.m. Eastern Time, and our presentation speaks the material from that release. The directions that point to the webcast are also contained at the back of the release, and my comments begin on page four, a slide titled Second Quarter 2020 Highlights. So on that page up top, First Merchants reported net income of $33 million for the quarter or earnings per share of $0.62. The earnings compare to $41.1 million during the same period in 2019, whereas the $0.62 in the second quarter earnings compare to $0.83 earned in the second quarter of 2019, produced a return on assets of 97 basis points. Considered in a related context, the earnings provide pre-tax provision ROA of 1.73% or pre-tax provision return on equity of 13.18%. Balance sheet grew, total assets grew 13 -- grew to $13.8 billion, $3.1 billion or 28.7% over the second quarter of 2019. And as Mark will highlight later, it was a combination of our September 1, 2019, closing of Monroe Bank & Trust, organic growth through the period. And then as the sub bullet point says, total loans were helped by approximately $900 million of PPP volume in a program that's set up very well for our client base. John will be on, obviously, to talk about asset quality. But in consideration of our second quarter provision, our allowance in fair value marks totaled 1.62% of…

Thanks, Mike. Yes, I have a real sense of pride around that communities -- those community support comments you just made, and I'm excited about our ability to just enhance the financial wellness of the diverse communities we serve. So those initiatives are exciting and important. If you turn to slide nine, total assets on line seven increased by $1.4 billion or 21.9% annualized since year-end 2019. Our investments on line one increased by $193 million or an annualized 15%, following up a strong 2019 where investments increased by 59% over 2018, providing really strong liquidity for the company. Loans on line two have increased by $831 million since year-end. Of that increase, the PPP loans accounted for $883 million, net of deferred fees and cost. Additionally, on line three, the allowance for loan losses increased by $41 million or 51% year-to-date, primarily due to COVID-related economic challenges. The composition of our $9.3 billion loan portfolio, shown on the upper right side of slide 10, produced a second quarter 2020 yield of 4.10%, down from the first quarter of 2020 yield of 4.85%. An 83 basis point decline in LIBOR during the quarter was the primary driver of the decrease in loan yields, and PPP loans accounted for about six basis points of the decline. On slide 11, our investment portfolio has a longer duration than our peer group, which is a nice offset to the variable rate loan portfolio that we have. And as of June 30, 2020, our unrealized gain totaled $139.1 million, a $66.6 million increase since year-end. Our yields are stable, totaling 3.02%, with remaining maturities in 2020 totaling $253 million with an average yield of 2.56%; and 2021 maturities totaling $429 million with a yield of 2.25%. On slide 12, total deposits increased by $1.1…

Thanks, Mark. My comments will begin on slide 22. Looking at the top right of this slide, you will see the allowance for loan loss roll forward for the quarter. We had a beginning allowance balance at the end of Q1 of $99.5 million, plus net charge-offs of just $230,000, plus the Q2 provision expense of $21.9 million. That brings the June 30 allowance for loan loss balance to $121.1 million. I would remind you that we elected to defer the adoption of CECL. So we calculated the provision using the incurred loss method, but continue to run our CECL models parallel. We believe the provision expense this quarter materially approximates the -- what provision expense would have been under the CECL method. Moving down to line nine. The remaining fair value marks on purchased loans totaled $29.3 million. Adding those marks to the allowance balance totals $150.4 million, which is a healthy 1.62% of total loans, which Mike mentioned earlier in his remarks. Next on slide 23. This slide is intended to show you that when considering our robust capital and allowance for loan loss levels that we have nearly $500 million in reserves to cushion us through the economic downturn. So let me start by walking you through the allowance at the top of the page. The table at the top shows a roll forward of our allowance for loan loss since December 31, 2019. The first highlighted line shows our current allowance balance of $121 million with an allowance to loans total ratio of 1.30%. When excluding the PPP loans from total loans, the allowance to loans is 1.44%. As I said earlier, we did not adopt CECL, but in our 12/31/19 Form 10-K, we disclosed that the estimated CECL day one adoption impact, if we had…

All right. Thanks, Michele, and good afternoon. I'll begin my comments on slide 25 with a detailed look at changes in the portfolio, provide an update on modifications, discuss the PPP loan program further, discuss some of the specific COVID-sensitive loan portfolios, cover some mortgage lending highlights and then review first quarter asset quality. So turning to slide 25. C&I loans grew on line one by $718 million during the quarter, resulting from the origination of roughly $908 million in PPP loans, offset somewhat by decline in line of credit utilization. Dropping down to line 10, mortgage loans grew by $19 million, while home equity loans on line 11 declined by $38 million. The active refinance market helped to maintain and grow the mortgage portfolio, while second mortgages were likely included in refinances, which caused our second mortgage balances to decline. Slide 26. This shows a diversified loan portfolio, grouped by bank call reporting, which is tied to collateral. And yet, as one would expect, concentrated in the states we are located. There have been 2,548 cumulative payment deferral modifications granted to roughly $1.124 billion with roughly 1,869 commercial modifications. At quarter end, there were no commercial second deferrals or modifications granted. And I checked yesterday, and we had less than $5 million of second commercial deferrals to date. It is difficult, if not impossible, to determine the number or the amount of second payment deferral modifications that will be requested, but I've been pleasantly surprised by the low number of requests and grants thus far. We have established processes for a second modification request to analyze and work with borrowers depending on individual circumstances. These include reviewing need and expected repayment in a COVID environment with financial analysis and financial information determining the borrower's ability to repay. Drilling into…

Thank you, John. I'm going to move to page 40, we have some -- offer a couple of comments, and then we'll take questions. So we aspire to demonstrate many of the needed ingredients to be a true high-performance banking company and often do. I would submit there's some of that in our second quarter, and they're highlighted specific bullet points on 40, whether it's a earnings stream, pre-tax provision of nearly $60 million, it will help to continue to build capital and cushion. TCE that already stands just under 10%, absent the effects of the PPP loans. Liquidity for all purposes. The diversified loan portfolio that John just covered in the slides I thought were insightful. But maybe most of all, experience and talent in working through a recession. And so -- and John Martin; and Mike Stewart, our Chief Banking Officer; and then dozens and dozens of other bankers charged with monitoring their portfolio and the health of their borrowers. I feel like that as what comes, whether it's next quarter's modifications or the entirety of the portfolio to include new requests in less certain times, I'm very confident that our commercial backbone will be up to the test. This corporate social responsibility, which is two-thirds of the way down the bullet points, really gives us a chance to invest in the staying power of our marketplace and it will do so. We got nearly 2,000 teammates on board with that set of opportunities under Scott McKee's leadership. Going to take a deep look at our channel of deliveries. We've always been looking toward platform work in the consumer bank. I think we're going to widen that out and see if customer experience has had them change the way they'd like to use our company. And there's a lot of technology that we've been evaluating for quarters now and look to make an investment on when the time is right, sooner rather than later. So we're excited about that. I'm going to finish by referring to a page that we looked at not that long ago, page seven, the unemployment rate decline and how it feels. While our loan demand might be less than it was historically prior to the COVID period, it's very much out there, and it's a function of our dialogue with our clients. So while overall loan demand might be beneath where we'd like it to have that 8%, 9% organic growth. There's industry pockets that are really running hard, and there are pockets that we participate in. So we know we'll get our share there. I'm encouraged by the sticktuitiveness of our entrepreneurial middle-market client base and look forward to watching their recovery as I watch the strength of our company. So at this point, Jamie, if there's folks that have questions, we're ready to address them.

[Operator Instructions] And our first question today comes from Scott Siefers from Piper Sandler. Please go ahead with your question.

Good afternoon, guys. Thanks for taking the question.

Sure, Scott.

I was hoping, John, that you might be able to provide a little more detail on those three credits that you mentioned that drove the increase in nonperformers, the two senior living ones and the logo company. I'm guessing given that there were virtually no net charge-offs, you probably haven't necessarily charged those down. But just -- I'm curious for what kind of loss potential you might see, if you have charged them down, kind of where they're charged down to, etc?

Yeah. Hey, Scott. We haven't charged those names down. A little bit of background, essentially, what we had were two specific nursing homes that were in the process of lease-up, and both of them were hit with the coronavirus. They were a little slow to lease-up initially anyway. With the coronavirus, they experienced issues, and as a result, really fell backwards in terms of their occupancy. There hasn't been any charge at this point. We're in the process of getting updated appraisals, and we have laid -- or put in place a specific reserve.

Okay. Perfect. And did any of those -- had they received any forbearance? Or just given that they were experiencing some trouble or slowdown before COVID, were they just sort of not eligible?

Well, they probably could have been eligible for COVID. But given the issues that they were experience -- experiencing, we thought it best to recognize the nonaccrual status rather than try to mask it, if you will, for someone who is potentially not going to be able to pay even without the deferral. So it was transparency more than anything, Scott.

Okay. Perfect. All right. Thank you. And then, Mark, maybe one for you, just on the cost base. A really good cost control quarter. It sounded like things might elevate a little in the 3Q. I was hoping you could maybe just provide a little color on what would cause the upward pressure on costs in the third quarter.

Yeah, Scott. The -- there are a couple of items that I highlighted. Just -- the $2.3 million of deferred salary expense, that was all related to the -- to our PPP origination. So we won't have that deferral into the future. So that is where 2.1 -- $2.3 million of the increase comes from. The reversal of an accrual that we had from the termination of a rewards program that was in place was $1.6 million. And then the contribution level and kind of the bonus accruals kind of offset one another. And that's how I kind of moved from $60 million up to $64 million for the third quarter.

Okay. Got it. Thank you very much. Appreciate you guys taking the question.

Sure. You're welcome.

And our next question comes from Terry McEvoy from Stephens. Please go ahead with you questions.

Hi. Good afternoon.

Hi, Terry.

I'm just curious on the accounting for the salary expenses that were deferred, will that flow through expenses, future expenses? Or is that netted against the yield or the fee that will come through net interest income?

Terry, this is Michele. That actually will come through the salaries line. And so we deferred a total of $2.5 million, that will be amortized over 24 months. So you could expect to see an impact of about $300,000, $320,000 each quarter coming through salaries expense.

Thank you for that. And then a question for Mark. Thanks for pointing out that there was 6 basis points impact to the margin from PPP and running through some of the repricing opportunities on the CD side. What are your thoughts on the core margin, call it, in the third quarter? Will there continue to be some incremental asset yield pressure? And do you see that coming down?

We think we'll have some incremental asset yield pressure, so I would expect to see a modest reduction in loan yields. But we do feel like the ability to reprice the CD book and continuing to tighten our pricing on the deposit side can offset whatever reduction we might see in the third or fourth quarter. So we kind of -- we feel like we've hit a level that we can maintain going forward. But the way this quarter played out, there was a lot of volatility, and we're monitoring it, watching it closely and managing it as well as we can.

Thank. And then may be a question...

This is Mike. A tactic that should offer some help relative to asset yields, particularly with the LIBOR decline that Mark covered earlier in his comments, is the implementation of a LIBOR floor that we've put in place probably 90 days ago, but we didn't have the ability nor the appetite to just unilaterally deploy it against all of our LIBOR-based loans, but are deploying it in every new loan situation or rewrite situation to include the majority of the modifications that John's team evaluates. So with the floor that we have in place over the book of business that's LIBOR-based, I think it's going to provide a nice net, if you will, beneath erosion on loan yield.

And maybe to -- that's a good explanation. I think the key is that those floors weren't in place as rates declined. Now that we're at a lower rate environment, every chance we have to renew a loan, we're putting new floors on the books.

Thanks for that. And then just a quick last one for John. Any of the four nonperforming loans or nonaccrual loans and then the 90 days past due, any of them connected to the sponsor finance portfolio?

The fashion -- the logo where name was connected to the sponsor book, yes.

Okay. Thanks everyone.

Thanks, Terry.

And our next question comes from Damon DelMonte from KBW. Please go ahead with your question.

Hey, good afternoon, guys. How was it going today.

Good, well, Damon.

Great. So just to kind of circle back on the margin outlook. Mark, where would you put the core margin at this quarter when you take out the fair value accretion that was recorded?

Yes. So if you go to the slide 15, the reported margin was 3.19%, you back out 12 basis points for fair value, gets you to 3.07%. And then you can add back six related to PPP to get to the core. So you're at 3.13% on a core basis, ex PPP and fair value.

Got it. Okay. And then the fair value the first two quarters of this year were around $3.5 million or so. Do you expect that to start to trail off in the back half of the year?

That feels like a pretty stable number based on how much we still have outstanding. And as -- so as we're building our models through the rest of 2020 and even into 2021, that's a pretty stable number.

Okay. And could you just repeat again how much in the way of CDs you have repricing again throughout the second half of the year?

Yes. We have $900 million that we should pick up about 140 basis points of savings as those reprice through the remainder of the year. They're currently on the books at an average rate of 1.77.

Got it. Okay. And then just the last question. As you guys clearly pointed out, pretty healthy provisioning and reserve building in the first half of the year. How do we kind of think about that as we go through the second half? Do you think you kind of retreat a little bit from that $20 million quarterly level? Or do you think that given what you're seeing across your footprint, it's going to be prudent to keep that level up there?

John, I know, is looking at his materials, getting ready to answer. I know that the quarter's $21.9 million was really an 80-day assessment of where we are under the incurred loss model. That obviously plays into it. And then we do a really deep environmental scan. So it's kind of pulled together, as you might guess, toward the back end of the quarter. And I'm not going to predict anything. We're going to do the exact same thing. We're going to look at our incurred losses through the first 70, 75 days of the quarter and kind of assess where we are and look at John's team for what else we might see. John, do you have any addition to that?

Yes. No. As long as the asset quality holds up and continues, it should be consistent with what we've seen in the past. And on any individual name, that -- those will be added as specific as necessary.

We think that the work that Michele covered earlier, and there's a lot of moving parts with the PPP and such. But when you get to a number, as she called out, that can be pro forma-ed into the future post CECL to a number that starts with a two that -- we think that, that's a healthy level. And yet the economy is not done surprising us. We're going to keep a close eye on it.

Very good color. Thank you very much guys. Have a great rest of the day.

Thanks, Damon.

Our next question comes from Daniel Tamayo from Raymond James. Please go ahead with your question.

Hi, good afternoon. So just at the end of your comments, Mike, you mentioned that some industries are running hard, and you might see some growth there on the balance sheet. Wondering if you could go into a little bit more detail on which industries you're referring to.

Sure. It's a little bit anecdotal and John might have some answers, but it's kind of an inside-outside thing. Anything that participates outside -- as we're watching commercial companies that are serving outside activities, they have more backlog and more need for employees than they can find to meet the demand. So I'm talking about trailers, RVs, camps, campers, tractor suppliers. People are spending money on their home, so pool installers, home contractors, painters, roofers.

Construction.

Construction, maybe not so much new construction, certainly not office construction, but yes, building out heretofore announced construction projects are swamped. You drive to the office in the morning, as we've been doing, I eyeball my way through who's parked on the side of the road. And then in direct contact with our clients, the ones that are really just trying to cajole their workers back into the workforce. So there's some real points of strength, and they've been even kind of growing as the months have turned from May into June into July. So there's reason for optimism. And yet at the same time, we still got, on balance, 12% unemployment. So there's people that haven't seen fit to call everybody back yet. But reasons to be optimistic.

Yeah. That's good color. Thank you. And from a similar side, looking at the -- I guess, breaking out the portfolios, but from a geographic standpoint. You gave some good information on some economic metrics by state. But wondering what you're seeing in your different markets, if you're seeing any kind of divergence between the Indy market and others? Or how you're thinking about that start to play out as we see states kind of operate differently and markets operate differently as we come out of this -- hopefully, come out of this recession?

Yes. I think it's somewhat even. Mike Stewart lives that on a daily basis. But I know that there is a parallel, I think I heard it in your question, with the, you want to call it, aggression that any particular governor chose to deploy relative to their unique reopening. I would say, of the four states we do business in. Michigan has probably been the slowest to approach normalcy, if you want to call it that. And so I think our backlog there might be a little bit light. And in addition to which the Monroe franchise is newest into our company and probably has undertaken the most change, and yet it's got awesome upside. Ohio and Indiana, really kind of throughout doing relatively well. And so that's where I see the majority of the backlog that's beginning to replenish itself.

Thank you very much. Appreciate it. That's all I have.

[Operator Instructions] And our next question comes from Brian Martin from Janney Montgomery. Please go ahead with your question.

Hi, guys. Thanks for taking the question. Just two for me. Mark, I appreciate the color on the expenses next quarter. Just any thoughts on whether you guys have any initiatives in place, expense initiatives, looking out now that we've kind of entered this period of the pandemic as you look at branches and whatnot going forward, anything like that on the horizon you're anticipating?

Yes. I think every department of our company is looking closely at expense levels and trying to identify ways to, in some cases, take advantage of a new operating environment, like in the case of retail, or just looking for ways to be more effective and efficient. So as we are moving our way into planning for 2021, which really starts in earnest here in about another month, we have teams across the company that are already putting together their tactics and their recommendations, some based on how they view they could improve the efficiency and performance of the company and some based on the direction that executive management has given them. So we think we have opportunities to continue to create efficiency from end-to-end, from the customer all the way through the back office, and we're going to have to look really closely at them as we work our way through this 2020 budget season or for the rest of 2020 for our 2021 plan.

Brian, it's Mike Rechin, just going to add to Mark's thoughts. As you've watched, we have looked at our retail and banking center optimization over the years. That will continue. We think it's a tiny bit early to draw transaction counts, which really dove low in the March, April time period. We're going to give a full chance to see how that's getting used, but it's clearly front and center for what we look at. We've also, in 2019, made a technology investment that allows us to see fintech companies that have really strong innovation around the back office of a bank. So while consumer optimization is a tool we've used in the past and we'll continue to, we think there's even more upside for some of the operational areas of the bank.

Got you. No, I appreciate the color. And maybe just one other one, which was just -- as it relates to the fee income, a couple of areas that really took a little bit of a turn for the -- I guess, the worst this quarter, the service charges and the derivatives. Just in general, some of those -- the timing of when you might expect, at least, on the service charges to respond -- to pick back up. Mark, I thought you said that they might start to begin to pick up. I guess maybe I just missed that. If you go back on your comments...

Mark is looking for a note, I think, because we did see a nice lift in June relative to the earlier part of the quarter. But clearly, our consumer banking leadership wanted to make full offering to our consumer customers of the CARES Act features about protecting folks through the time. So all of those numbers, overdrafts and any other fees, were really held back or eliminated for a certain period of time. So that ought to have a natural lift to it. The derivative, the hedge that you talk about, kind of speaks to my comment, Brian, about loan volume being a little bit down because those are origination fees around commercial borrowers locking in rates. And so as you can see the number clearly didn't go to zero. It had been on a really steady ascent based on the interest rate environment. I've already seen a little bit of volume pickup there. So that will be a live item for us. I fully expected it based on the hunker-down approach that many of our customers had trying to get through. If you're using PPP, you're trying to keep employees, not necessarily originate new loans. So yes, down. And Mark made the comment about the other customer-driven fee activity in the wealth business. Wealth business fee generation is one month in arrears. And so the figures shared with you in the wealth business would capture the March, April, May 90-day time period, which really bore the biggest brunt of the market declines. And so I think we were probably 4% or 5% lower in fees out of that business than we other would have been. And so starting with June into July, we'll see where the market goes, but it's had a little bit more life to it.

Yes. Okay. I appreciate that color. And maybe just one -- just a modeling question. I think -- do you have -- or I don't know if Michele or Mark -- wanted to see average balance of PPP in the quarter or just in the dollars of contribution in the quarter?

Yes, I bet you will be able to pick that up quickly here. I see some keyboarding, Brian.

Okay. If not, I can follow-up.

Yes, we'll send you an email with it. The 883 is the period end and -- do you have it, Michele?

Yes, I do. Actually, Brian, it's $703 million -- was the average balance for the quarter.

Okay. Okay. And I guess I'll just back into the yield, you gave the other piece. So, OK, thank you so much.

Thanks, Brian.

And ladies and gentlemen, at this time, I'm showing no additional questions. I'd like to turn the conference call back over to management for any closing remarks.

Thanks, Jamie. I have none. I appreciate the questions. I know it was a longer call than normal. We were trying not only to make sure we convey what we know about the business, but kind of having some intuition for what allows folks to get the best feel for how First Merchants is doing through this period of time. We look forward to your continued interest. If you have any follow-up questions from material we weren't able to get to, I'd ask you to give us a call, and we'll see if we can't provide that. Appreciate your interest. Talk to you soon.

Ladies and gentlemen this does conclude today’s conference call, we thank you for attending, you may now disconnect your lines.