SB Financial Group, Inc. (SBFG) Q1 2020 Earnings Report, Transcript and Summary

Good morning and welcome to the SB Financial Group First Quarter 2020 Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Carol Robbins. Please go ahead.

Thank you, Elisa. Good morning everyone. I'd like to remind you that this conference call is being broadcast live over the Internet and will be archived and available on our website at ir.yourstatebank.com. Joining me today are Mark Klein, Chairman, President and CEO; Tony Cosentino, Chief Financial Officer; Ernesto Gaytan, Chief Technology Innovation and Operations Officer, and Jon Gathman, Senior Lending Officer. This call may contain forward-looking statements regarding SB Financial's performance, anticipated plans, operational results and objectives. Forward-looking statements are based on management's expectations and are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied on our call today. We have identified a number of different factors within the forward-looking statements at the end of our earnings release, which you are encouraged to review. SB Financial undertakes no obligation to update any forward-looking statements except as required by law after the date of this call. In addition to the financial results presented in accordance with GAAP, this call will also contain certain non-GAAP financial measures. I will now turn the call over to Mark Klein.

Thank you, Carol, and good morning everyone. Thank you for joining us. Welcome to our first quarter 2020 conference call and webcast. As with prior quarters, comments today are supplement to the earnings release we filed yesterday. Literally, these are uncertain times and we have spent considerable time and effort in the quarter protecting our clients, employees and our communities, while preparing for our participation in the government stimulus program, and client forbearances that I'll discuss shortly. Reflective of the tangible capital we raised and have earned over the last five years coupled with our historically strong credit quality metrics and liquidity, we feel we are well positioned to navigate this current crisis. We are confident that strong capital coupled with a reputation for superior customer service and relationship banking will serve us well in these unprecedented times. All that said, highlights for the quarter excluding the effects of the $2.2 million pretax mortgage servicing rights impairment include net income of $2.4 million, down $350,000, or approximately 13% decrease over the prior year quarter. Pre-tax pre-provision earnings resulted in a 3% improvement in our net income over the prior year. Adjusted return on averages assets was 92 basis points, down from the prior year quarter of 95 basis points. Interest income expanded to $10.6 million, up $150,000. As a result, net interest income improved to $8.5 million, an increase of $210,000. Loan balances for the quarter grew $5.3 million improving our year-over-year growth to over $48 million or 6.2%. Likewise, deposits grew and increased $24 million or 4.4% year-over-year. Expenses were up $800,000 due to higher mortgage commissions and a full quarter of our title insurance agency. Mortgage origination volume increased this quarter to a robust $101 million, up over $51 million or 97% year-over-year. Asset quality metrics were elevated a bit in the quarter due to the decline of an asset-based commercial loan, although our level of 61 basis points of non-performing assets remained strong. Finally, significant progress was made and is being made in processing customer forbearances and Paycheck Protection Program loans that we'll discuss shortly. We firmly remain committed to our five key strategic initiatives; growing and diversifying revenue, more scale to organic growth, as well as M&A that we have planned the second quarter of 2020, more products and services with our 30,000 households, excellence in operation and more intimacy with client communications, particularly in these difficult times, and lastly, asset quality. First, revenue diversity. This quarter, mortgage volume and loan sale gains were up from the prior year, 97% on volume, 63% on loan sale gains. However, non-interest income declined to $2.2 million from the prior year quarter of $3 million due to the mortgage servicing portfolio impairment. Adjusting for that, non-interest income was up from the prior year over $650,000. Non-interest income, the total revenue declined to 20% but would have improved at 34% when accounting for the impairment. The mortgage pipeline continues to be near capacity with over 500 loans in process or approximately $117 million. Our numbers are spread across our four regions of Northwest Ohio and Northeast Indiana, $21 million; West Central Ohio Findlay at $16 million; Central Ohio Columbus was $69 million; and Central Indiana Indianapolis market for another $9 million. This quarter marked the one year anniversary of Peak Title joining our company and the results have exceeded our expectations. Abby Waters and her team have integrated with our lending staff while they've maintained all of their prior banking client relationships. We continue to introduce Peak to our statement and commercial clients as appropriate. With a significant increase we're experiencing in mortgage volume, we certainly anticipate a record setting second quarter for this newer division of SB Financial. Our SBA production came in at $1 million with loan sales of $436,000, a rather slow start to the year when compared to both the linked quarter and the year ago quarter with loan sale gains of just $79,000. For the last two months, this space was dominated by our participation in the Treasury PPP lending program. To date, under the first phase of the stimulus, we have approved over $74 million in loans to 414 businesses, or over 99% of our clients that applied. All will be funded in a total of 10 days, and it might add no backlog. Interestingly, as planned, over 95% of our commitments were to existing clients; average loan amount $178,000, median level just $71,000. We intend to take advantage of our preferred lending status to prospect for more new clients in the next phase of PPP funding, as we have plans underway to potentially deploy another $25 million. We currently have 133 additional applications or $6 million with 48 prospects and 85 clients already in the queue and ready for funding. We intend to expand these new client loans into full banking relationships, since capacity at some competitors to fund these loans has been constrained. We are now roughly one year into the entering into the Indianapolis market with a mortgage LPO. As we have discussed in prior quarters, we've targeted the Indie market due to it's similar market characteristics to our Dublin, Ohio operation, which as we've reported has been very successful. After clearly some early growing pains, we now have three lenders originating saleable mortgages. Back this quarter we closed $7 million on our prospects to deliver on our short-term goal of generating $50 million annually have improved. Wealth Management assets under our care of -- now $427 million represent a pullback from the all-time high we achieved and reported December 2019 of over $500 million. By the headwinds of these market forces, we feel that this important business line which is clearly unique to a bank our size provides a full service that a relationship based client we seek desires. Our second key initiative, more scale, came into 2020 with a very strong loan pipeline that has been impacted by the current pandemic situation, although we did grow loans in every month of the quarter. Back we were able to add $5 million to our loan balance to this quarter, but certainly well below our expectations and historical growth levels. Loan growth from the prior year was up by $48 million or 6%. Our Lima and Columbus regions lead the way growing 37% and 16% respectively. Net interest income increased to $8.5 million or 2.5% above the prior year but flat to the linked-quarter. Total assets now stand at $1.1 billion and reflect year-over-year growth of $67 million or nearly 7%. Our deposit base expanded to $864 million, up $24 million or 3%, a year-over-year of deposit growth of $36 million or 4.4% increase. The need for us to provide more options by which our clients can access our services and their financial assets has been made much more evident in this past quarter. We have become more flexible and innovative in how we engage with our clients and the electronic aspect of client servicing engagement and delivery will continue to accelerate. Third, deeper relationships, more services per household. This quarter outside client calling efforts were re-channeled to phone calls and digital communications. When our economy literally shutdown, we made a commitment to proactively contact 100% of our commercial clients to ensure them that we were prepared to provide for their liquidity requirements when called upon. We believe that this proactive calling effort was directly responsible for our successful participation in the PPP lending program I just mentioned. The requirements of the program in terms of documentation, quick funding, and tight approval window, certainly put our commercial teams to the test, but clearly they delivered. Our dynamic referral process continues to be a differentiator for our company and we've reported in prior quarters. This quarter we added over $22 million in new business from 222 closed referrals; that's nearly double of what we achieved in the first quarter of 2019, and over the last two plus years, one of our better referring quarters. Operational excellence, our fourth thing. We had a notable shift in our mortgage business mix in the quarter. For all of 2019, the split between internal refinance and new clients of State Bank was 19% internal, 81% new clients. In the first quarter of 2020, the percentage of internal refinance expanded 24% with the month of March coming in at nearly 30%. Given the size of our current pipeline, we expect that higher internal refinance volume will continue well into the second quarter. After the optimization at both our processing locations has been a key focus as we were incredibly pleased to have been able to originate nearly $500 million in residential real estate loans over the last four quarters, quite a testament to the hard work done by our originators but clearly, it would not have been possible without support from our backroom and our operation staff. We have increased our servicing portfolio to over 8,200 loans, with principal balance now of $1.2 billion, household is up 7%, balances up 11% from the prior year quarter. Expense levels for the quarter were up from the prior year but when adjusted for the additional $50 million in mortgage volume expense, growth drops from 9% to 4%. We have implemented a cost reduction plan that includes a number of expense containment initiatives in response to not only the pandemic, but the rapid decline in short-term rates reflective of our asset sensitive balance sheet. We understand how critical expense control will be in 2020 given the business headwinds we're facing. Our fifth and final key initiative, asset quality. We have spent considerable time and effort in the quarter and thus far in April responding to our clients' needs for assistance and relief from the current business situation we find ourselves. We have approved forbearances for our clients in nearly all business lines. Total of 588 loans representing balances of approximately $171 million; 231 in sold residential mortgages representing over $40 million in balances, 177 commercial loans representing over $107 million in balances, and the remainder of 67 loans for $14 million in consumer loan balances. This quarter we had a spike in charge-offs due to one asset based inventory loan that we placed on non-accrual for $2.3 million. We were clearly disappointed about the sizable impact this client had on our historically strong asset quality metrics. As a result, our reserve to non-performing coverage declined to 136% but still above the median of our peer group. Finally, we have taken an expanded look at new credit terms for businesses and clients as we anticipate the longer term effects of a slower growth or no growth economy going forward. Specifically, we have reduced LTVs on CRE deals, increased requirements for borrower liquidity to ensure ample debt service coverage capacity while assessing and reassessing internal approval requirements. I continue to have great comfort with our historically strong credit approval process, including our dynamic loan review schedule. And now, I'd like to ask Tony Cosentino to provide some more details and color on our quarterly performance. Tony?

Thanks, Mark. And again, good morning, everyone. For the quarter, we had GAAP net income of $681,000 or $0.9 per share. As Mark noted, our earnings were impacted by the $2.2 million impairment on our mortgage servicing rights and absent that impairment, that income would have been $2.4 million, down $0.4 million which is a 12.8% decrease. Highlights in the quarter included operating revenue, down 5.6% from the prior year, but up 7.3% when we adjust for the OMSR impairment. Loan sales delivered gains of $2.1 million for mortgage, small business and agriculture, and margin revenue was higher by 2.5%. As we break down further, the income statement beginning with our margin; net interest income as indicated was up from the prior year by 2.5%, and flat to the linked-quarter. Our average loan yield for the quarter of 4.74% decreased by 16 basis points from the prior year, overall earning asset yield was down 46 basis points. We had anticipated higher loan growth in the quarter and had been overweighed in cash in anticipation of these fundings, as well as preparing for any client liquidity needs. These higher liquidity levels had a downward impact on earning asset yield, and we expect our mix to improve in the second quarter as we will reduce cash levels and mortgage volume would be a positive to our margin while the PPP program will increase the dollars of NIM slightly. On the funding side, as expected, the quarterly increase in the cost of interest-bearing liabilities we experienced throughout 2019 discontinued this quarter. For the quarter, the rate on our interest bearing liabilities was 1.12%, down from the prior year by 8 basis points, and importantly down from the linked-quarter by 30 basis points. Net interest margin at 3.48% was down 33 basis points from the prior year. Now as I said, we expect our margin to improve in the coming quarters with higher mortgage fees and continued declines in funding costs. Total interest expense costs are down by 3% from the prior year, but down 20% from the linked-quarter. And our margin income growth was also driven by loan interest income of $9.9 million, which is up $0.4 million or 4% from the prior year. Total non-interest income of $2.2 million was down from the prior year reflecting the impairment of our mortgage servicing rights and was offset by higher mortgage origination volume. Adjusting for the impairment, non-interest income would have been up $0.7 million or 18%. In the SBA arena, our originations were down from the prior year with volume of $1 million compared to $3 million in the prior year quarter. Our results did include a full quarter revenue from our title agency, and compared to the first quarter of 2019 increased revenue by $0.3 million. Second quarter mortgage production should eclipse all records for our company. We also expect to improve upon our gain yields as hedge performance will trend higher, with reduced rate volatility expected. This quarter's real estate volume from new clients was down from historical levels but still was 76% of total volume. Total gains on sale came in at $1.9 million which was 2.3% on our sold volume of $84.4 million. Our servicing portfolio of $1.22 billion provided revenue for the quarter of $756,000, and is on pace to deliver $3.1 million in total revenue in 2020. The market value of our mortgage servicing rights declined significantly this past quarter. Calculated fair value of 74 basis points was down 32 basis points and 25 basis points from the prior year and linked-quarters and did result in a $2.2 million impairment. At March 31, 2020, our mortgage servicing rights were $9 million which is down 17% from the first quarter of 2019, and down 19% from the linked quarter; total impairment currently remaining is $3.5 million. Total operating expense in the quarter of $9.4 million was up $0.8 million or 9% from the prior year, but compared to the linked-quarter expenses were down $0.8 million or 7.6%. The higher level of mortgage volume drove compensation higher versus the prior year in addition to higher medical costs. Other expense growth from the prior year was driven by higher digital banking costs as we had more users and some higher legal expenses. We also incurred higher costs related to our mortgage hedging activities as we discussed, due to not only the higher volume but also the higher volatility in the secondary markets. And a full quarter for Peak Title compared to the prior year increased operating expense by $0.2 million. Now let's return to the balance sheet; loan outstanding to March 31 stood at $830.8 million, which was 76.3% of the total assets of the company. We had growth of $48.2 million and asset growth of $67 million from the prior year, and we're up $5 million and $50 million respectively from the linked-quarter. Compared to the prior year loan growth driven by two categories mainly, commercial real estate at $34.3 million, followed by commercial loans at $15.3 million. Deposit levels are up 4.4% from the prior year as we lessened our aggressiveness on deposit gathering in response to our lower loan originations. Also, with our eye on the Edon acquisition scheduled for the second quarter, we will have significant funding surplus of lower cost core deposits when the transaction closes. As Mark indicated, we are participating fully in the PPP funding facility and we have structured the borrowings to fund the bulk but not all the $74 million in PPP loans. We are prepared to expand that borrowing capacity as needed to fund the second phase of this small business lending facility. Looking at our capital position, we finished the quarter at $135.9 million, which is up $4.4 million or 3.4% from March 31 of 2019; and our equity to asset ratio stands at 12.5%. In addition to our reported loan balances, our clients could draw an additional $200 million on approved lines and commitments. In the unlikely event that that would occur, our capital ratios would still be above our internal targets. For this successful conversion of our preferred shares in late 2019, tangible equity is up from the prior year by $18.4 million or 18.4%. On a per share basis tangible book is up $1 per share from the first quarter of 2019. We have been able to buyback a number of shares below book value this year, and we still have shares left under our current authorization. Regarding asset quality, total non-performing assets of $6.7 million are up $2.4 million from the prior year, but flat to linked-quarter. Included in our numbers are $0.8 million in accruing restructured credits. These restructured loans elevate our non-performing level by 8 basis points. In absence of those restructured credits, total non-performing ratio would reduce to 53 basis points. We understand that certain segments of the economy will have an oversized negative impact from the buyers. For our portfolio, we have $73 million in these at risk segments, half of which is in the hotel category. However, only 15% of that $73 million is related to restaurants, bars and sports facilities. Taking into account these levels, our overall diverse portfolio concentration levels, and appropriate allowance levels by category, we are cautiously positive regarding credit deterioration. Provision expense for the quarter was $0.6 million, up from both the prior year and a linked-quarter. As Mark indicated, we charged-off on an asset-based loan in the quarter of $400,000. Our absolute level of loan loss allowance at $9 million is up from the prior year by 10.3%, and our allowance to loan loss percentage has increased from 1.04% a year ago to 1.08% currently. Absent the impairment, our results were largely in line with expectations in the quarter. Looking forward, we will see delays in the loan pipeline, as our clients have hit pause a bit, and potential credit metric weakness will be offset somewhat by the impact of not only the PPP program but our forbearance activity. And as we have also indicated, we were trending toward a record mortgage origination and mortgage revenue quarter in Q2. I'll now turn the call back over to Mark.

Thank you, Tony. No doubt this quarter presented some opportunities quarterly as well as challenges and including the servicing portfolio impairment that Tony discussed. We anticipate that the economy and our markets will trend in much the same direction as the rest of the country, albeit with, again slower growth or no growth in the next six months. That said, we remain quite optimistic that our commercial mortgage and SBA business lines will continue to provide the inertia for more earnings momentum well into the second quarter. Also, we just announced an 11% increase in our common dividend. As we sit today, we expect the dividend level would continue our measured pace upward throughout 2020. I want to thank all of our more than 250 employees for helping our clients and communities with their everyday financial needs over the past few months. Clearly, our senior leaders have demonstrated exceptional flexibility and leadership under some pretty difficult times. Now, I'll turn the call back over to you Carol for additional questions.

Thank you, Mark. I'd like to remind everyone on the call today that this webcast will be available on our website at ir.yourstatebank.com. Elisa, we are now ready for our first question.

Thank you. We will now begin the question-and-answer session. [Operator Instructions] The first question today comes from Brian Martin of Janney Montgomery, please go ahead.

Hey, good morning guys.

Good morning Brian.

Hey, I appreciate Tony your comments there just about the industries and kind of some potential risk or hot topics as far as the hospitality and the restaurants. Can you just give a little color on how those are trending today? And just -- maybe just kind of give some comfort on, maybe loan to values for those -- if those properties -- just to kind of get a sense for, how you think those are going to play out as you go through this potential downturn?

Hey Brian, just a couple of comments. Jon Gathman is with us and rather than speculate a bit, if you don't mind, I'd like to ask John to give us some few comments with regard to those particular sectors.

Sure.

Sure. So, the short answer to your question is, and remind me the specific industries or maybe you didn't cite the specific industries; but we have entered into forbearance agreements with -- like most banks, most all commercial loans that have requested one. And as you might imagine, we are at 79% of those industries that are considered at-risk by our definition, by [indiscernible] definition, that's about 7.5% of our portfolio. And of those it's a bidding total at the moment but there's been no to increase in delinquency and those as they've all been under forbearance. I fully expect that we'll begin to see some pressure there. The average loan to values; to answer one another part of your question; the average is 66% but that average is misleading. Of those that are at-risk, we have not taken any high-risk loan-to-value business, never above 80%. Certainly, most of those are going to be in that 60% to 70% range, and we forecast marginal additional losses from those at-risk industries, which again is 7.5% of our total portfolio.

Okay. And the biggest -- I guess, where they sit today, no one's -- they have the forbearance. So the -- and I guess the greatest chunks of within that portfolio is it really just -- the hotels as you said were half of the portfolio, and then you said -- was it restaurants are 15%? Was that -- maybe I missed that, that was Tony's comment, I guess.

No, that's correct. And I would just tell you -- yes, of the 7.5% exactly, almost exactly half as hotels. Of those hotels we are at an average loan to value of 56%, again, averages are misleading, there is couple of very good ones in there. Two of those of the total hotels, which is the bulk of $16 million of the $35 million; $16 million have not requested forbearance and are -- if there is such thing cash rich at the moment, and absent a prolonged effect of the virus, they're in the situation to weather the storm for the next three to six months. So we have seen zero increase in our delinquency as we sit here today understanding that the remaining $20-some million of hotels are under some level of forbearance, mostly not necessarily because they could but because they could. We have entered into specific negotiations on two I'm aware of, the total $12 million which call it 8% of the 7.5%; so, you're talking not quite one-tenth of the $7.5 million at risk. Those hotels, one is an Indie near an airport, and one is in Columbus, are both well situated, depending on travel restrictions being lifted to pick their business back up.

Got you, okay. And maybe just -- there was a little bit larger provision this quarter. I guess, just as you guys assess the situation, I mean do you anticipate some reserve building as you go forward? Just -- how should we think about as this thing plays out and you guys get more calls from your customers? And kind of monitor the situation then we're seeing a lot of banks get pretty proactive this quarter with reserve building. And just kind of wondering how we should think about that for you guys in the coming quarters?

Brian, just a couple of high level comments. Obviously, the PPP program, as well as forbearances, both generally bittersweet but given the fact that it's bringing substantial relief to our clients and putting them in a position to constrain there needed liquidity; we're pretty bullish on the loans we've put on our books the last 10 years, albeit in the bull market that we've had. But clearly, I know John and I -- and our office of Strategic Management have talked immensely about the potential opportunities that will be presented to us in the PPP program relative to our clients and potential fees that there could be a certainly a potential conversation of how do we may build for future potential stress in our portfolio. And John, you can clean it up a little better from what I have just said.

Well, I would just add, certainly your comments are well founded. As we look to triple-off for the first quarter which as, you know, a triple is largely looking backwards model. Our credit quality has been so good for such a long time that we were somewhat limited but we did make significant adjustments in environmental factors, as you might have imagined, reflective of the current environment. And I think the increase in provision was as much about those changes environmental factors and was that specific credit where there was room in the reserve to handle a specific credit. But we are certainly keeping our eye on the future and adjusting those environmental factors mentor [ph] with that.

Okay. You know, maybe just one on the PPP for a minute. Can you just talk about; if you said it was $75 million or so, I think that's what it was -- kind of what the rate is on that as you anticipate? And just -- I guess I'm trying to think if it's -- if it's a 3% rate, I'll let you give the number but if it's a 3% rate that would look like it's a couple of million dollars, $2 million plus on the fee side. Just wondering, do you anticipate kind of bulk -- I guess receiving the bulk of that benefit, if you will, in kind of 2Q and 3Q? And maybe there is some stragglers or just how that comes in, but just -- A) the percentage, and then B) just how you're thinking about it coming into the income statement?

Brian, this is Mark. Just one comment; from my seat, I'm really optimistic about the applications we've taken, with the average of $170,000 and a median of $71,000. We've clearly held the line on 414 applications that go to where the government had intended, which is to small businesses. That said, John, I know there is some weighted numbers out there as to what it is potential that we might realize on fees on those 414 loans.

Yes, that is correct. We anticipate some additional guidance, I know some came out yesterday on the fees and how we apply for those. But as Mark said, I too am very pleased; and in fact, we took the additional step here at State Bank of giving the customers what we knew, which unfortunately, the SBA hasn't been -- it's been as you know, a hurried program, but educating them on what we knew and making sure that our borrowers and our lenders are communicating about the expectations of the program. And maybe where your question was going is, we expect by and large this to be completely forgiven and when we're done with this to have a very small percentage of additional credit that may not be forgiven by the federal government.

Yes. And Brian, I would just add; in terms of as Mark and John both have said, in terms of the forgiveness of the client, relative to the fee side indications and guidance today are that we will get that within 10 days of funding. So, our expectation is all of our first tranche will be funded within by end of day today. So we would anticipate by no later than mid-May the worst, that all those fees would endure to us. Again, I would suspect as most banks are going to look at that relative to their provisions and everything else going forward. You know, and based upon our median, our levels probably going to be 3% to 3.5% depending on where we are.

Okay. And if Tony if those -- say you start collecting the fees like you're saying, it may first early -- or let me guess, this quarter do -- if those are only out there for 90 days. So, you know, if you think about the split of how much revenue you could get, if they all go away after 90 days, which I understand isn't -- it's the optimistic outlook, but if they were to all go away in 90 days, would the bulk of the revenue then be realized in third quarter? I guess as you kind of think about, you collect some fees, for the two months you have them in 2Q, and then the bulk of that would just have a big spike in third quarter. Is that how we would think about it?

I would be the opposite. We would ignore all of the fee side in Q2, and then whatever else on the margin side at that 60 to 65 basis point spread between the one and the 35 ongoing; our expectation is 80% of our $75 million will fully get provided and forgiven in the eight week period. So we'll have an increase in balances on an average basis that will flow back down by 3Q and 4Q.

And Brian, one comment; as I've said in my remarks, we were quite pleased with 95% of our numbers going to known clients that we have. So we've not taken a flyer on anything yet where we've just allowed anybody to come in the front door and do a PPP, I mean this is clearly for small businesses and our clients predominantly. That said, this next round, we're looking at taking just a little bit of a bigger bite on the prospect side because we literally think there are a number of competitors out there who never want and not prepared to handle the backlog, and we think we can marginally move to a little higher level with this new $310 billion that was just approved.

Got you, okay. Yes, there is still a lot of uncertainty, a couple of banks have said, they would bring that fee in over a 24-month period; so they would start taking in the fee, 124 [ph] of it, and when they did pay off, it would -- they'd get the bulk of it. It doesn't sound like maybe that's the way you're thinking about it, so until there is more clarity, it's just going to be a moving target for a lot of people, but thank you for the color on that. So, how about just one -- Tony just as it relates to the margin, and there is a lot of moving parts in there. I guess when you think about the rate -- the emergency rate cuts we had, you guys -- as you kind of mentioned, the mortgage fees that are coming in the next two quarters are typically common and your ability to reduce and be proactive on the funding side. Just, if you kind of boil it down, I guess, how are you thinking about the margin, at least in the second quarter today? And then, just directionally, kind of thereafter given no real change in the rate environment from where we are.

Yes, I'm sure Mark will have some commentary. As I've indicated in the comments, we were maybe a little overly cautious on liquidity. We weren't really sure what was going to happen with some of our clients, and where expectations were going to go. We had -- as we talked about $200 billion of potential utilization; our clients have stayed relatively stable and secure, and we felt good about that but we didn't want to be caught unawares. So we were a little heavy on cash, the mix impacted us certainly in one queue; that's going to go away here in the second quarter. I mean, we're going to fund the PPP program, a portion of that was internal funding; and we started to lower deposit rates kind of that March 1 timeframe, and we've continued to move rates down kind of -- on a very good trend. So, the bulk of that's going to show up in 2Q and then I think the big mortgage pop that we're going to have in 2Q is going to drive. And as we look at it, the increase in earning asset balance was kind of offset by price, and we kind of got to the same place we were. I think price will get a little better in 2Q, and our earning asset balance will come down $15 million to $20 million or so because we're not seeing the loan pipeline outstanding as we expected.

And the other the other part to that comment Tony, it does not generally include the $48 million that we anticipate coming from the Edon acquisition, albeit at most likely was 36 basis points, probably going to go down dramatically, not any better than the 35 basis points we have with the Fed but clearly a lot less than our current marginal cost of funding at 1.12 [ph] or so. So that'll help us on a little bit upfront, give us a little bit margin left.

Yes, okay. So that's so direction, Tony, it should be up in 2Q and then it probably gets -- it's up even further in third quarter, I've seen something going on with the acquisition of Edon. I mean, I'm not and I'm kind of leaving out the PPP for the moment, just looking at kind of the other components; so liquidity, the funding side you're making changes to but direct to say, up in 2Q and then maybe even up a little bit more in 3Q as you sit today?

I would concur with that. Yes, that's my -- our expectation.

Okay, perfect. That is helpful. How about just your update, I guess, if you can on or just your outlook, if you would on a mortgage; just -- kind of where you see kind of production for the year? And then, you know, the gain on sale margin just as you're kind of thinking about things today, how -- that's changed a little bit this quarter but the refinance activity I'm sure played a part. So, just try and understand that dynamic as we go forward.

Thanks Brian, this is Mark. And I remain very bullish on mortgage lending; as we indicated that we're on a basic run rate of $500 million. We're currently having conversations with Ernesto Gaytan leading those conversations on how do we prepare ourselves, given the markets we're in of Indianapolis, Columbus and all of Northwest Ohio; how do we prepare ourselves to do more with less, with more engaged process, with new software, and potentially working smarter here so that we can do $750 million. Pretty sooner you think that as rates bottom out, the refinancing of our portfolio will begin to subside a bit, again, as we move into -- I think the next two or three quarters. But that said, we continue to see some improvement on the purchase side. Some of our competitors have announced that they're not doing anything on the purchase side unless there is 20% down and 700 credit bureau; we think there is still some opportunity in there, although we continue to be quite prudent on how it is we're doing PCG kind of mortgages, as well as Freddie Fannie. So, we're still bullish on the business line but I think we'll probably see some eventual decline of refinancing our own portfolio once everyone gets down to 3%.

If I might add, Brian; I think Mark is spot on in terms of volume. I think we're going to have as we said, a record setting level in the second quarter based upon what's already closed and what we anticipate in the pipeline. And I would say, candidly, I've been around the mortgage business a long time, it was one of the tougher pricing markets we've ever seen in terms of secondary, in terms of correspondent pricing, in terms of what people were giving you on the backend to buy product and there were a lot of lenders that got kind of caught out with bad pricing, and we hung in there a little bit. But we paid a little bit of price on the hedge and what we backed off on due to volatility. I anticipate rate volatility to significantly subside and we'll start to make a little bit more money on the yield side and on our hedge side; so that's why I anticipate that it's going to be much better here in 2Q.

And Brian just one sidebar, we have begun to do a little bit more strategic thinking about how it is we can potentially differentiate, how we approach pricing in four distinct different markets, which we think will give us a little bit of opportunity to again, determine how do we go from a $500 million run rate to $750 million, albeit with a little bit more of a regional approach to pricing and closing and processing. And Ernesto is leading the charge for us in that arena.

Got you, okay. And I was just going to ask, Tony or Mark, the gain on sale margin, it should -- maybe think about it being a little bit lower than where it's at today as you go into the next couple quarters? I think it was around 2.3% as we as we sit today.

I would expect that to -- that would be the floor that we would look at going forward. I mean, we were kind of a 2.5% range or so for 2019, all in when we look at everything; so I would expect we'll be a little bit better here in 2Q.

Okay, perfect, that's helpful. And maybe just one more, it was just on the cost reduction plan. If you can just give a little bit of color on; I guess the impact or just simply look at the current level of expenses, however, you can talk about that, just your expectations for the expenses as you go forward here outside of the ebbs and flow that come with the incentive for mortgage, just kind of the core rate that we're looking at from an expense standpoint.

Yes, I think as we look at operating expenses for the quarter, obviously relative to the prior year, you have bit of the noise with much higher mortgage volume and the Peak Title impact; but if we look at the linked-quarter, we had some incentive things in Q4 that came off the table here the first quarter of '20. We think this is a relatively solid run rate. I think the -- we don't know today what the expectations will be for reopening locations and how customer interaction is going to happen, we just don't know what that level of cost containment and/or differentiation is going to be. We have a sense of what that's going to be, and we think – we've put some things in place relative to compensation and some other things that we think will help us going forward.

Yes. Brian, from a granular perspective, really looking at very, very limited changes in compensation, if at all; looking at our contribution to the ESOP, looking at incentive plans, looking at travel, looking at marketing, looking at conference expenses, you know, all kinds of things we're looking hard at. We've put a hiring freeze on to make sure there is not just business as usual, just because somebody was in a position doesn't mean we're going to replace them all. And so we're just -- as I mentioned, several years ago we were 100% optimistic and no pessimism and '18 and '19 we went to maybe 80% optimistic, 20% pessimistic, and then coming into '19, maybe a little more pessimistic. And now here in 2020, I think those thoughts and approaches to business have really found us well in terms of where we've landed here now in 2020, albeit in a pandemic that no one expected. So we're just looking at everything on a number of fronts, knowingly that it's probably going to continue to get more difficult, as we move into a no-growth economy. And we will clearly see how good we have been at underwriting credits that we think we've been pretty good at and had a pretty good process for taking credits to officer's loan committee, and having four or five people look at the credits before we got involved. So we're cautiously optimistic on where we go in the midst of less activity and constraining expenses in the process.

Got you. And you guys made some comments about this loan growth being a little bit slower here which makes a lot of sense. And just as you guys look at the two things; I guess just, maybe your outlook as you think today, high level about '21, what level if you were projecting -- whatever level of growth you were thinking in '21, are you backing off that number from what you were thinking? Is it where we sit today given what's going on? And then, B) just if you can -- so that's one. And then the second question is, if you can just comment on the timing of the close of Edon and just how that's proceeding? That's it that I have.

Yes, this is Mark. And I'd like to have Jon for obviously some comments perspective. But relative to loan demand; as we've disclosed Brian for, I think a number of quarters and several years, we've been elated being at the median level of growth, we've never aspired to be at the 75th like we do on everything else. In terms of performance, we've been really happy at that 5% to 7% medium to high digit -- single-digit growth in the lending arena. So I think that's going to play well to the position we find ourselves now here in 2020; so Jon will have some more comments. With regard to Edon, we're steaming along nicely. The full expectation is that we'll get that done, the second quarter from a financial perspective and integration. And then, literally in the third quarter from an operational perspective, full integration, full name change, and everything in the middle. And so Jon, more comments on that loan demand perspective 2021?

Yes. I agree with what Mark said. You know, we have the right people and we're in the right markets, we expect to be at that median or slightly above median level with some really, really key people in those markets and in the right markets. That said, what that median level of growth is as we look at third and fourth quarter; that'll be the challenge and we have realistic expectations of what that might look like, but we expect to fare as well or better than our peers.

That's a great comment, Jon. What's the new normal; what's the new median. So that'll be the key, Brian; what's the new normal and new median, and what's GDP going to be, and what do we have here and how many more stimulus programs are left or how many can they monetize and going forward?

Yes, a lot of uncertainty. So, well the -- and the Edon deal was going to take some of that excess liquidity and put it to work, so I guess it could just change a little bit of the dynamics or just maybe push it out a little bit depending on the level of growth is -- if high was the way we should think about it?

Yes. I think Brian, at high level and you know all this. Clearly, with forbearances; and Jon and I have talked about this, with forbearances and PPP, we're going to delay principal pay down just by default. And if we do that for three to six months and get some regulatory guidance on how far we can go, and you add PPP in that, and some clients are still taking advantage of the landscape, the people that put themselves in a position with liquidity and have a good business model; we think we've put ourselves in a position to capitalize on whatever small growth is going to be out there. So, we remain cautiously optimistic and we hope we can come through this at the end of 2020 looking like we had a pretty good solid model coming into the beginning of the year.

Yes, okay. Well, that all sounds good. Well, I appreciate all the color. Thanks for taking my questions.

Thanks, Brian.

Take care, Brian.

[Operator Instructions] The next question comes from Toni Molinari of Cutler Capital Management, please go ahead.

Good morning, Toni.

Hi, how are you doing?

Just great.

I was hoping you could shed some color on the credit stress testing that you've done to your commercial portfolio and what the results look like? And if you can include things like unemployment rate and cap rates, that would be helpful.

What I can tell you is, as we have looked at -- I mentioned the number 7.5% of our -- those are first wave at-risk industries. We have completed 100% of reviews on all of those. As Mark said earlier, we would expect our borrowers -- if we're doing proper underwriting to be able to weather a short-term storm, and as we sit here in April, I think that's what we've seen now. We've assessed all those for cash liquidity capital going forward in terms of actual cap rates and stress testing; we have not done that at this moment.

Okay, thanks. And then, if you could provide a little more color on the forbearance program that you're offering, is it 60 days, 90 days, four months?

Yes, I would say with the exception of Freddie Mac that has their own set of rules or SBA, any government agency that has their own set of rules. On our internal portfolio, we've started with the policy, we've done 60-day curtailment waiver on all four plans and three months or 90 days of principle, largely principle forbearance, principle interest for all categories of loans with the knowledge that three months may not be enough, and we'll be assessing that here in probably early May.

Toni, interesting to note, of course, as you're well aware, we have probably a residual portfolio of maybe $20 million, Jon, on SBA, on our books that awaited yield of seven plus. And recently, we did the calculation with a six-month forbearance coming from SBA; we're going to receive about $500,000 to $550,000 per month for six months on behalf of our residual portfolio for the clients that we've done SBA loans on. So that's going to be great relief, as you're well aware to all of our SBA clients, hard to figure out where the government's getting all the money but we kind of sort of know where but that's got to be a positive for the business line that we've been doing for actively five years now or so.

Great, thank you. That's really helpful.

Take care.

This concludes our question-and-answer session. I would like to turn the conference back over to Mark Klein for any closing remarks.

Once again, thanks to everyone for joining with us this morning on our first quarter webcast and conference call. We look forward to certainly connecting with you in July for our second quarter results, which should include the closing of our acquisition of Edon State Bank. Thanks for joining, and goodbye.

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