SouthState Corporation (SSB) Q2 2020 Earnings Report, Transcript and Summary

Good morning, and welcome to the South State Corporation Quarterly Earnings Conference Call. Today’s call is being recorded. [Operator Instructions] I will now turn the call over to Will Matthews, South State Corporation Chief Financial Officer. Please go ahead.

Good morning, and welcome to South State’s second quarter earnings call. This is Will Matthews, and joining me on this call are Robert Hill, John Corbett, Steve Young and Dan Bockhorst. The format for this call will be that we will provide prepared remarks, and then we’ll open it up for questions. Given our inability to travel due to coronavirus, we’re each calling in from different locations. We thank you in advance for your patience with the difficulties presented by holding a teleconference with multiple speakers from multiple locations and phone lines. Yesterday evening, we issued a press release to announce earnings for Q2 2020. We’ve also posted presentation slides that we will refer to on today’s call on our Investor Relations website. Before we begin our remarks, I want to remind you that comments we make may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Any such forward-looking statements we may make are subject to the safe harbor rules. Please review the forward-looking disclaimer and safe harbor language in today’s press release and presentation for more information about risks and uncertainties which may affect us. Now I will turn the call over to Robert Hill, Executive Chairman.

Good morning, and thanks for being with us today. Only 53 days into our merger and much has changed in the world. What has not changed is the speed at which we are moving to integrate two strong companies, the commitment of our team and our Board to success and the opportunities that lay in front of us. While the economic environment has its challenges, the prospects for South State are significant. South State was built on the principles of soundness, profitability and growth. I believe our balance sheet, the revenue and efficiency improvements that can be made and our solid market share in great markets have us well positioned for the long term. While any quarter with a merger involved is more complex, our revenues remain strong, our expense plan on track, and we’re able to take a lot of risk off the table as we combine the two loan portfolios. While there are certainly industry headwinds that will persist in the near term, I believe these challenges also present opportunities for stronger banks to prosper. While 53 days is a very short period of time, in many ways, it feels like these teams have been together for years. Our team continues to rise to the occasion. We are open and honest with each other, building trust and excited to be together as one team and focused on the same set of goals. I will now turn the call over to John for more insight into our quarter.

Thank you, Robert. Good morning to all of you, and thanks for joining us this morning. I hope you and your family is remaining healthy and safe. 2020 has been a transformative year for the banking industry as a whole, and it’s been particularly transformative for South State. We announced a strategic merger of equals with CenterState on January 27. At the time, we saw an opportunity to build an executive team that could lead our company through the digital transformation over the next decade. We also saw an opportunity to combine two of the Southeast premier deposit franchises in the best growth markets in the country. Two months after the merger announcement, while we were actively pursuing regulatory and shareholder approval, the economy shut down. Like others, we shifted to a work-from-home environment and immediately focused on how we could assist our clients in a time of beat. The two most powerful levers we could pull was first to be as generous as possible in providing loan payment deferrals for our borrowers. And then second, to inject as much cash flow stimulus as possible through the PPP loan program. The $2.4 billion of PPP stimulus that South State provided represents about 10% of our $24 billion loan portfolio. And the deferrals we offer represents about 17% of our loan portfolio. In retrospect, I’m confident that we chose the right strategy to be as generous as possible with short-term cash flow relief. By working nights, weekends and the Easter holiday, our bankers delivered for our clients when they needed us the most and that loyalty will pay dividends for years to come. While only about half of the 90-day loan payment deferrals have matured through July, it’s encouraging that the request for a second deferral is significantly lower than the first round and less than we originally expected. Despite the distractions from COVID, we were able to obtain regulatory and shareholder approval for the merger ahead of schedule, and we made a decision to close the transaction on June 7, which was earlier than planned. Now a mid-quarter close is messier from a financial perspective, but we wanted to put the closing in the rearview mirror so that we could move forward with the integration and so we could focus on our clients. I would be remiss if I did not pause to recognize and thank our South State leadership team and bankers. Closing a merger of equals in a stable environment is a very tall order. Doing it during a pandemic is heroic. From the finance and legal team that closed the books in the middle of the quarter right after they completed a $200 million sub debt offering to our relationship managers and support teams that processed nearly 20,000 PPP loans, the work ethic and professionalism of the South State bankers gives me tremendous confidence in the power of this team, and I’m proud to be on the journey with them. Will is going to walk you through our combined second quarter results, but I want to offer my own high level observations. Most importantly, the underlying earnings power of the company is steady and strong. To demonstrate the steadiness of the combined company, we produced a slide on Page 7 of the earnings deck, which illustrates the PPNR trend, assuming that CenterState and South State were combined over the last year. You can see that the PPNR for the second quarter would have been $157 million, which is consistent with prior quarters and actually is slightly better than the same quarter last year. With the merger closing in the second quarter, however, there were two highly unusual accounting issues, even for those of us that are familiar with merger accounting. The first is that with the closing on June 7, the first 68 days of CenterState’s earnings in the second quarter are not included in the second quarter of South State earnings. The missing CenterState earnings for the first 68 days of the quarter would have added $75 million of pre-provision net revenue to South State, if the merger had occurred on April 1. The second highly unusual item is the $119 million CECL reserve applied to the CenterState acquired loan portfolio. This is a result of the new CECL accounting standard that is affectionally known as the double count, whereby an acquired loan portfolio not only receives a traditional mark, but also simultaneously receives a loan loss provision that runs through the income statement in the quarter that the merger closes. And look, I’m not an accountant, but it seems to me, personally, like a belt and suspenders approach to loan loss reserves. The silver lining is that this new accounting approach gives the company a very strong loss absorption capacity. And I know this is a GAAP accounting. But if you add the acquired loan portfolio marks, together with the allowance, it’s as if you have a combined loan loss reserve of 2.66%, which is substantially higher than our peers. With these two unusual accounting items in the quarter, plus the normal merger-related expenses, the company recorded a net loss of $1.96 per share on a GAAP basis. Now, let me take you back to the normalized view of the quarter as if South State and CenterState had always been combined. The combined company produced record revenue, driven by mortgage, correspondent banking and capital market fees. These fee-based businesses really shine in this type of economic environment, and we’ve been very intentional over the years to build a balanced business model. For the last five years, we’ve built successful fee income businesses that performed well when net interest margins decline, in addition to the normal balance sheet businesses that perform well when net interest margins rise. This balanced business model is performing exactly as planned. Both mortgage and correspondent banking enjoyed record revenues and record profitability this quarter even as the NIM came under pressure. Loan growth was down slightly if you exclude the $2.3 billion of PPP loans. And asset quality metrics improved across the board with lower past dues, non-accruals and virtually no net charge-offs. Deposit growth boomed during the quarter and the combined balance sheet expanded by more than $4 billion. Clearly, most of that growth was related to the PPP proceeds and short-term government stimulus. So we anticipate that the balance sheet will shrink over time as the stimulus wears off. And finally, capital. By combining the elevated CECL reserves with the purchase accounting marks, plus the $200 million of sub-debt that we raised in the second quarter, plus a strong and steady PPNR that will get even stronger after we complete the merger cost saves, we feel that South State is well positioned to move forward despite the headwinds that the industry will experience over the next year. Will, I’ll turn it over to you.

Thanks, John. This is clearly an important quarter for the company with the closing of the merger of equals. Additionally, the size of this merger and the impact of CECL merger accounting created a lot of moving parts. When we announced the MOE in late January, we had not expected to be the first MOE of size to receive regulatory approvals and close in 2020, but we are. And we’re also the first one post-CECL and post pandemic outbreak. So we’re going to attempt to give you information you’ll find meaningful amidst all the accounting noise associated with the merger closing. I want to start by recognizing and thanking our excellent finance team at South State as well as the credit and CECL teams. A mid-month closing in the third month of a quarter adds a lot of complexity and time pressure, and I couldn’t be prouder of the work, dedication and collegiality exhibited by our team. Everyone from the reconcilements area to the leaders of the department performed in an exemplary manner. Not only did we close the merger three weeks before quarter end, shortly after completing a $200 million sub debt offering, but we also completed a conversion of the general ledger system and a merger of the two companies’ departments and job selection process for all finance and accounting personnel. The competency and work ethic of this team gave us confidence to push forward with a June 7 closing, and their performance is, I think, a testament to one of the strengths of this merger that has two great teams of high performers coming together to form one high-performing team. I’m pleased and proud to be associated with these folks. I’m going to cover the following items this morning. The significant moving parts associated with the merger closing that impacted our earnings and our balance sheet this quarter; the more significant purchase accounting entries and the resultant loss absorption capacity; our results, both GAAP as reported and operating combined business basis; our capital position; and an update on our merger efficiency realization. Items associated with the merger closing. First, under CECL, we placed a credit and rate mark on the CenterState loan portfolio, including both PCD loans and non-PCD loans. The credit mark on PCD loans resides in the allowance for credit losses, but is not includable as Tier 2 capital. The entire mark on non-PCD loans, credit and rate is a contra asset reducing the carrying balance of these loans, and it is also not includable as Tier 2 capital. Second, CECL also requires us to record a provision for credit losses on the non-PCD loans, and this provision expense runs through the income statement in the quarter of closing. This is the double count effect as these loans have both a credit mark and an allowance for credit losses. Because our merger closed June 7 and due to the impact of COVID on various economic factors that drive CECL loss estimates, we had a relatively high provision expense for acquired CenterState non-PCD loans of $120 million caused by the merger and only three weeks of CenterState operations to help cover that expense. Third, as is true with any merger, we recorded a number of merger-related costs and expenses, including legal counsel, investment banking and employee and contract termination amounts that occur in a merger. Credit marks and loss absorption capacity. Note that when I speak of ratios of allowance and credit mark coverage, I’m excluding the PPP loans from the denominator due to their likely temporary existence and their 100% SBA guarantee. To determine our PCE loans, we had several screening criteria, including past due status, credit grades, credit scores, et cetera, and we also categorize any loan on deferral status and the entire lodging portfolio as PCD given COVID. The total PCD portfolio is approximately $3 billion or roughly 25% of the CenterState loans acquired. I’ll remind you that the definition of PCD is not a problem loan. Also note that the marks are preliminary and will be finalized in the coming quarters. The credit mark allowance on this $3 billion in PCD loans at quarter end was $150 million or approximately 5% of that portfolio. The remaining $9 billion approximately in non-PCD loans, again, excluding PPP loans, received a credit mark of $109 million, which is approximately 122 basis points. Given the screening process for identifying loans to categorize as PCD, we believe the non-PCD portfolio to be clean. Slide 9 shows the total loss absorption capacity on the balance sheet at June 30. $435 million in the allowance, which is 188 basis points of loans, $173 million of which was at legacy South State; another $21 million in the reserve for unfunded commitments, which is another 9 basis points of loans; and another $161 million in unrecognized discounts on loans, equating to 69 basis points of loans, which brings the total to $616 million or approximately 2.66% of loans, as John mentioned. While we all see storm clouds on the economic horizon, we had another quarter of very low net charge-offs, almost zero for the quarter, and past dues continued to be low. Ending NPAs were 38 basis points of assets. Dan is available to answer further questions on credit during the Q&A section of the call. Provision expense on the legacy South State portfolio was $31 million, bringing the quarter end allowance level to approximately 153 basis points of that portfolio plus another 10 basis points for the reserve for unfunded commitments at legacy South State. Given the minimal charge-offs and lack of growth in the quarter, the increase in the allowance was attributable to changes in the economic forecasts. The other key purchase accounting entry was the core deposit intangible, which received a mark of 114 basis points. Our $2.6 billion CD book was marked the other direction, as these yields were above market at closing date. So our cost on these will decline accordingly from approximately 134 basis points to approximately 29 basis points. Let me now discuss results for the quarter. For the quarter, we reported a loss of $85 million. Excluding the $120 million in the provision for credit losses on the acquired non-PCD loans and excluding the $40 million in merger-related expenses in the quarter, adjusted earnings would have been $38.6 million or $0.89 per share. The timing of the closing was a primary factor in the loss with only 23 days of income production from legacy CenterState and the impact of the full provision expense on the acquired non-PCD loans as well as the merger-related costs. Our net interest margin, with the reduction in rates, the buildup in liquidity and the sale of about half of the CenterState bond portfolio pre-close, we saw a margin compression in percentage terms, although the production of net interest income in dollars showed less compression. Loan yields were 4.25% for the quarter, down 42 basis points from Q1. Total cost of deposits was 29 basis points, down 19 basis points from Q1, and we saw a nice growth in DDA balances. We saw a compression on securities due to the purchase accounting marks applied on the CenterState bonds, and the shrinking of the total portfolio on a combined basis also led to compression. Our reported net interest margin was 3.24% tax equivalent, down 44 basis points from Q1. Let me talk for a minute about the underlying financial performance, which was strong, as John said. Given the mid-quarter close and associated merger accounting entries, we thought this information on a combined business basis would be useful to you, so we have included several slides beginning on Page 17 of the presentation. These comments are on that basis, which are the GAAP historical numbers of each company without regard to purchase accounting entries or any efficiencies that may be realized. As John noted, our PPNR of $157 million was very consistent with the prior four quarters and the PPNR ROA of 168 basis points was strong in light of the expanded balance sheet due to PPP and liquidity. We had a record combined revenue in Q2, up $22 million from the 2019 second quarter. Slide 18 shows how the makeup of the revenue has changed over the last five quarters, with noninterest income moving from 21% of total revenue in the year ago quarter to 28% in this quarter, providing the countercyclical benefit we expect. Slide 20 shows the growth in combined noninterest income from $74 million in the year ago quarter to $108 million in this quarter. In a quarter with work from home and MOE and emerging of two mortgage management groups, our combined mortgage teams did $1.5 billion in production, which is impressive in a period with this many distractions. Our net interest margin on a combined business basis was 3.38%, down approximately 55 basis points from Q1, with net interest income on that basis down approximately $7 million. Combined loan growth was $1.97 billion, but loans declined approximately $300 million, excluding the PPP loans. Year-to-date combined loan growth, excluding PPP loans, is basically flat. Combined deposit growth was $3.5 billion or $3.7 billion, excluding brokered CDs. Noninterest expenses were $175 million for the quarter or $135 million, excluding the merger-related expenses. On a combined business basis for the full quarter, it would have been $225 million. Combined noninterest expenses grew by approximately half of the growth in noninterest income from Q1 and approximately 60% of the noninterest income growth from Q4, reflecting the strength of the commission-based businesses. During the second quarter, we also had increased expenses associated with the pandemic. On a combined business basis, our efficiency ratio in Q2 was 58%, up slightly from 57% combined in Q1. On capital, our ending TCE ratio was 7.6%. Expansion of the balance sheet through PPP reduced the ratio by approximately 50 basis points. Our CET1 was 10.7%, and our total risk-based capital ratio was 12.9%. The ending tangible book value per share was $38.33, up $0.32 from Q1. As I noted, we also have solid loss absorption capacity on the balance sheet. Let me finish by updating you on merger-related expenses and cost saves. Our cost save process is well underway and on target with numerous successful vendor negotiations, operating model and staffing templates being constructed by business leads and cost targets for each. Our core conversion is scheduled for the middle of the second quarter of 2021, giving us ample time to prepare to ensure good execution, and we should begin to realize the bulk of the remaining cost saves at that point. We will recognize some cost saves in the latter part of this year, but most will occur after the conversion. Through June 30, we recognized $81 million in merger-related expenses. We continue to expect to be within our originally announced $205 million total with an estimate of approximately 20% of the remaining amount in the last half of 2020 and the remainder occurring in 2021. We expect the largest quarter for merger-related expenses to be the second quarter of next year when we complete our system conversion. So a quarter with a lot of moving parts, with strong underlying performance, healthy loss absorption capacity and solid credit results thus far. I’ll turn it back to you, John.

All right. As a reminder, we are conducting this call remotely, and I ask that you please direct your question to the appropriate individual you’d like to respond. This concludes our prepared remarks. And I would like to ask the operator to open the call for questions.

[Operator Instructions] And our first question will come from Stephen Scouten of Piper Sandler. Please go ahead.

Hey, good morning, everyone.

Hi, Stephen.

So, let me start. I guess this is a Will question primarily. I’m wondering if you could give us an idea just on the impact and, excuse me if I missed this, on the PPP, specifically on the NIM and maybe some sort of basis point estimate of what the excess liquidity impact is in NIM? And kind of, I guess, relative to the 3.38% that you put in the presentation, where you think the NIM could kind of normalize longer term whenever that occurs.

I’m going to let Steve start with that question, Stephen.

Stephen, it’s Steve. Yes, just a couple of points on the NIM, as we combine the companies. Let me just kind of, first of all, remind us that this is a very core deposit funded bank. We have 1.1 million customers, 800,000 checking accounts. If you see on Page 23 in the deck, as Will mentioned, there was a lot of deposit growth over this past quarter on a combined business basis, about $4.5 billion. Our checking accounts make up 54% of the deposits and our DDA make up 33%. So very, very core funded. Of the $4.5 billion we grew in deposits, we have about $4 billion sitting on the balance sheet and just excess liquidity, not invested in short-term funds. Normally, we would probably have somewhere in the $1 billion to $1.5 billion range. So we have about $2.5 billion to $3 billion more excess than normal, and that creates about 30 basis points of pressure on the margin. And that’s why you see in the deck, where Will referenced, the actual margin dollars didn’t decline all that much, but the margin percentage did. So hopefully, that’s helpful. Just to build the bridge, on a combined basis, we were 3.38%. And a couple of things that you need to keep in mind. Number one, we did accept that offering at the – toward the middle of the end of the quarter. That creates a couple of basis points pressure. That’s not in that 3.38%. Also, on the fair value accounting that Will mentioned around particularly the securities book, that portfolio was around 2.60% for half of the securities book. We sold half of it and marked the other half. So that creates another 10 basis points of pressure. And then ultimately, we did the fair value marks on the loan book. Of course, we already have some discounts on the loan book and just really we loaded that. And then, of course, prepays will kind of move that. And then the last piece is just on the PPP program. We have a slide in the deck toward the end of the presentation, Slide 34, that talks about the amount of PPP unearned fees that we have at the end quarter, it’s about $67 million. And of course, depending on when that forgiveness time happens, we expect most of that toward the end of the year, in the first of next year based on what we know today. That will impact margin going forward. So I know a lot of moving parts, but hopefully you’ll see that the 3.38% will be adjusted down from a percentage unless – when we move back the balance sheet, the investments towards another $1 billion. So hopefully, that’s helpful for you.

I’m sorry, Stephen. With respect to the PPP question impact on the margin, it really didn’t have a very significant impact because we had some fee recognition in the quarter, as you see there on Slide 34. So the net impact of lower yield on that portfolio in terms of the base rate, combined with the fees, it really wasn’t very impactful to the margin.

Okay. Great. And then I don’t know if you had talked about this plan beforehand, but the large – the sale on half of the securities portfolio, and it looked like maybe there was about a $40 million gain on securities there prior to the deal close. What was the logic there, I guess, the thought process, especially given all of the excess liquidity in the system, I’m just kind of surprised you would sell an earning asset there.

Sure, Stephen. This is Steve. Under fair value accounting rules, we have to mark these securities to market. So effectively, you get those yields going forward. And when we completed the merger, those security yields were in the 1.25% range. And we just decided to put some on the shelf and let’s see how we progress through the PPP and other things, just to be conservative, so that we can invest all of our securities – or half the security book in at 1.25%, and we’ll just have to layer that back in over time.

And if you think about it, Stephen, there are some great bonds that we sold, but they were great bonds closer to par. We don’t like them as much with the kind of premium handle that we’re going to have on them because, as Steve said, you’re effectively buying them at acquisition date. So that played into our thinking as well.

Perfect. Really helpful. And then just one last thing for me, I guess. And maybe this is a Steve question as well. But it looks like if I try to run rate the legacy CenterState correspondent business, it looks like maybe the $33 million for a full quarter based off that $8.3 million number given. I’m wondering how you think about that business moving forward, the trends there? And then kind of, I guess, with Slide 20, you gave the combined noninterest income of $108 million for this past quarter, which obviously is kind of a big jump from the back half of last year on a combined basis, if that is, indeed, apples-to-apples. So just kind of frame up fee trends, if you could, and especially that correspondent banking?

Sure, Stephen. I’ll take that question. As it relates to what John had talked about in his prepared remarks, we’ve tried to build the business so that when rates go up, of course, our core funding will just – the margin will increase. But when rates decrease, we have some countercyclical businesses that hopefully offset some of that pressure. It won’t offset all of it, but it will offset some of it. And you’ve seen that as our PPNR has been pretty flat year-over-year. So that’s a high level comment. As it relates to the $108 million on Slide 20, I’ll give you the breakout on a combined business basis for the quarter. The mortgage banking income would have been about $43 million. $30 million would have been – rough numbers, would have been the correspondent banking and then about $7.5 million to $8 million would have been the wealth management business. So those three add up to about $81 million of the $108 million. The other $27 million would just be the ordinary service charges, card fees, kind of reoccurring fees. As far as our outlook on those businesses, as I mentioned, mortgage had a blowout quarter. And as John mentioned – or Will mentioned, a $1.5 billion worth of production, which was just superb, given that we’ve had less – we had fewer than 10 employees in the office. And to be able to do that just really speaks highly of the team and Tom and Steven and Brent. That business continues. The pipelines continue to be strong. And so as best we can tell, that business continues to do well. As it relates to the correspondent business, fixed income has picked up in that business. The interest rate swap business has been very good. I would expect, over time, that the interest rate swap business, in an environment like this, would not be as good over the next few quarters, still be strong, but just be less strong just given the credit environment generally around that. So hopefully, that’s helpful. We think that the business itself, the noninterest income fee businesses and the business owners who own that have just done a great job, and it’s really helped out in the middle of a lot of margin pressure.

Great. That is very helpful. Congrats on getting the deal closed. And thank you guys so much for all the combined data given in the presentation. That’s very useful. So, thank you.

Thank you.

our next question is from Jennifer Demba of SunTrust. Please go ahead.

Thank you. Good morning.

Good morning.

Good morning.

Question on your lending pipeline. What kind of near-term loan growth are you expecting? And what are you seeing in terms of interest from your borrowers right now?

Jennifer, this is John. I’ll take that. You’re watching this play out on the evening news every night as states open and then they close again. And I’ve had a chance to travel around this quarter to five of our six states, trying to get a pulse of what’s going on. I’ve had calls with all of our presidents. For the quarter, the last quarter, we did see the loan portfolios decline slightly in five of our six states. We actually saw some growth in the state of North Carolina. Generally, the pipelines are down now about 25% to 30%. And I think our approach is, we really want to lean in and take care of our existing clients through this process. But as far as new business is concerned, we want to be prudent and conservative in our underwriting until there’s more clarity past the virus. So I do think that new loan growth will be somewhat muted in the next couple of quarters as we navigate through this.

And my second question is on cost savings. Will, you said you have some cost savings in the second half of this year. Can you give us a sense of how much of that $80 million might be realized this year?

Jennifer, it won’t be a significant amount. The bulk of it will come in 2021, and the largest, of course, once we do our system conversion. But there are savings we realize along the way, both through some headcount reduction and some vendor renegotiations. But the vast majority of them will come in 2021. I don’t have a good hard number to give you for the rest of this year, but I didn’t want you to think we hadn’t achieved some already and won’t be achieving some more this year.

And did you have some unusual expenses in the second quarter that might not reoccur in third quarter, for example, related to PPP lending or that kind of thing?

Yes, on our FAS 91, we capitalized costs associated with the origination of loans, and so – on the PPP side, specifically, that’s in there. But we do have, and it’s in the deck in here, about $3 million in expenses where we were paying extra to branch employees who are working in the branches and extra staff expense associated with the virus, about $3 million. It’s in one of the pages of the deck; I just don’t have right in front of me.

Thank you.

Our next question comes from Kevin Fitzsimmons of D.A. Davidson. Please go ahead.

Hey. Good morning, guys.

Hey, Kevin.

Good morning.

Just I appreciate all the comments and all the detail on how you’re looking the loss absorption just between the traditional reserve build and all the complexity – accounting complexity with the deal, but then also the fair value discounts on the acquired loans. So all that being said, how do you all think about reserve building going forward? We’re obviously going to learn new information September 30, get a new update on the duration of what we’re looking at and get new forecasts. But I have to think, given that 2.66%, it’s a fair statement, that if you agree with it, that the bulk of reserve building is behind you. But if that’s true, I’m just trying to get a sense for how you’re going to look at the reserve or provisioning over the back half of the year. And particularly as it relates to the $67 million in PPP fees coming due, will most of that fall to the bottom line? Or will you look to take a chunk of that and throw more to the reserve? Or are there other things?

Thank you, Kevin. I’ll take a stab at that and if Dan wants to elaborate, he can, if needed. Like everyone, our CECL model has a number of loss drivers in it. And the loss drivers are based upon economic forecasts given the forward-looking nature of CECL. So as of June 30, we feel like our process led to the appropriate level of reserves based upon economic forecast at that time. Should they worsen from here, we, and the industry as a whole, will need to build reserves further from this level. So I think if I were to convey to you a great deal of confidence about where I thought provisions were heading for us or anyone else at this point, that would be misleading. There’s just too much – too many unanswered questions and too much unknown about how this pandemic and its impact on the economy goes. But we feel very good about the reserves we have on the balance sheet today, very good about the capital position and that degree of unrecognized capital we have. And like we – I think I referenced in my comments, but also in the deck, a portion of that doesn’t make its way into our capital ratios. The allowance on the PCD loans of about $150 million is not in capital, and, of course, the discounts aren’t either. So about $300 million of that number does not appear in our capital ratios. But anyway, it’s a bit of a non-answer, because frankly, we just don’t have a good crystal ball at this point about future economic forecasts.

Got it. All right. One just additional question. Deferrals I guess, looks like declined to a little under 12% on a combined basis. And I know a lot of banks are seeing a lot of moving parts over the – in coming weeks between more round one deferrals maturing and additional new entrants to round two extensions. I’m just curious, based on what you’re seeing now, where do you think that 11.7% or so of deferrals settles when you get toward the end of August or so.

Yes. Kevin, it’s John. Dan Bockhorst is on the line, is our Chief Credit Officer, and he’s got a pretty good handle on that. Dan?

Thank you, John. If you look at Slide 32 of the deck, so far, approximately 40% of the deferrals have expired, and the percentage of the loans on deferral has declined from approximately 17.5% to that 11.5% number. As another 50% of deferrals expire over the next several weeks, we expect that trend to continue, and we estimate we’ll end up in the mid-single-digit percentage of loans on deferral. The future is still somewhat unknown on what the continued impact of COVID-19 will be, and there is the potential for a W in deferrals long-term, but we like the way the trends are going right now.

And Kevin, this is Will. I’ll just – let me also just remind you one thing that’s not unique, but somewhat unique to us. And that is that with the acquisition, we – as you see in the deck, we articulated the categories of the screening process for determining PCD loans and all of the lodging portfolio from CenterState and all of the loans on deferral from CenterState were classified as PCD. And as you saw, the PCD book has about a 5% mark on it. So we thought – we think we have some appropriate capital set aside, hopefully, for those as well.

And on the second deferral, John, to your comment earlier about you thought it was the right approach to be generous, I’m assuming when folks ask for a second, there’s much more of a rigorous credit-driven process being applied to them?

Yes, that’s exactly right. Dan, you want to comment on the credit process when someone asked for a second renewal?

Yes. For the second renewal, there is a much more rigorous process. We’re updating financials, really determining that there is a need that the deferral request is coming from a company that has been impacted by the current economic environment. And we’re also really pushing strong for those that do get a second deferral, that, that second deferral is interest-only as opposed to a full principal and interest deferral. On round one, about 26 of the deferrals were interest only. And then round two, it’s still a little bit early, but about 37% right now are on interest only. So we like the way that trend is heading, and it’s going in the right direction.

All right. Thank you very much, guys.

[Operator Instructions] Our next question comes from Catherine Mealor of KBW. Please go ahead.

Thanks. Good morning.

Good morning.

Good morning, Catherine.

A lot of great color on the PPNR forecast. I think one follow-up on that is just on the combined expense base. Will, I think you said that combined, you’re at about $225 million. And is it fair to say it doesn’t feel like there’s a lot of onetime kind of in that number? It feels like you probably have a little bit of elevated from mortgage, but – and the fee income. But assuming that, that all stays fairly strong near term, you should probably have expenses stay around that level. And then it feels like the $3 million you mentioned was paying for extra staff, maybe that’s offset by the FAS 91, so you’re kind of a wash there. And so I guess, big picture, is that $225 million kind of a good core number to grow from here, from the back half of the year before we start layering on cost savings?

Yes, Catherine, let me start, and maybe Steve can talk a little bit about the efficiency ratios in those businesses. But it is – given the strength of our noninterest income business lines, that does make the job of forecasting even more difficult because those business lines, compensation structures, as you know, are largely incentive-based or commission-based. And so when we see growth in revenue in those business lines, obviously, we see growth in expenses. And I mentioned in my comments that the relative NIE growth from prior quarters relative to the noninterest income growth in prior quarters, but that does make a little more of a challenge. So the answer to your question is, at current levels of noninterest income production, that the NIE levels would probably be a good estimate of where we’ll be. If those were to fall or rise from here, then it would accordingly react. But Steve, you want to mention something about the efficiency of those businesses a bit?

Sure, will. Yes. Thanks, Catherine. I think there’s a – back to the slides in the deck toward the end of the presentation, it gives a historical perspective of the financial statements, and it looks at the trend rate for noninterest expense and for noninterest income. And one of the things you’ll notice as, for instance, is, in the fourth quarter, our noninterest income was around $87 million. Our adjusted noninterest expense was in the $212 million. So if you kind of run that math forward, you can kind of see that the – we’ve had additional noninterest income of $22 million in the last couple of quarters and about – additional noninterest expense of about $13 million. So that – it’s really running an additional – a 50% efficiency ratio on the additional noninterest income. And of course, that’s blended across all those commission businesses. But I think that’s a general good way to model it, depending.

Yes, that’s really helpful. Yes. Steve, that’s great. And then this is a CECL question since this is a new world for all of us. And so my question is, Will, you mentioned that you put most of the – or all the ones that are in the lodging book and then all of the CenterState loans that were on deferral into PCD. And so as those roll off deferral, does that change anything with your reserve or the way you just think about your forward expected losses? Or because you just kind of categorize that as PCD, you don’t have to make any kind of quarter-to-quarter changes as the quality of those loans perhaps get better or worse?

Catherine, once a loan is PCD, it’s PCD unless we make – unless we have another decision event around re-underwriting, if you will. So they’re PCD forever. As we determine the need for the allowance or if the economy improves and forecast and it dictates a lower reserve needed than we have, then it comes back in via reduced provisioning or, I guess, in some circumstances, negative provisioning. So that’s how it works.

Okay. But just coming off the deferral wouldn’t necessarily generate a large reserve release in that estimate, I guess?

No, no. It’d really be more – I mean that might be a good credit factor about our thoughts about the collectability of that loan, of course, but that in and of itself, no.

Okay. All right. Great. And then just one kind of just big picture question on just your markets. I mean, I feel like last we spoke, some of your coastal markets were doing actually relatively better than many other markets of the country. And of course, now we’re hearing of a lot more COVID cases in Florida and along the coast. And so just can you provide just some kind of broad general color around what you’re hearing from your customers and your local businesses? And any specific markets or kind of types of credits that you’re more worried about now than you may have been last quarter?

Sure, Catherine, this is John. As I mentioned, I have traveled to five of the six states, and I’ve had calls with all of the market presidents in the last two weeks and got a lot of feedback from them. So let me kind of describe for you what I’m seeing as the new COVID economy because there’s winners and losers in the new COVID economy. Anything that’s related to home improvement is slammed, they’re just as busy as they’ve ever been. Residential is performing very good. Residential construction is performing very good. There’s not a lot of residential product on the market. So, I’m hearing of cases of multiple offers on homes. I’m hearing of cases where people are purchasing homes through video chat. From a recreation standpoint where people are so cooped up at home, businesses that are connected to the boating business, so the RV business, are doing phenomenally well. I heard a story. You cannot buy a bicycle in the city of Charlotte because those businesses have performed so well. Trucking and logistics, you think about what’s going on with the distribution channels right now. They’re performing very well. I’m hearing that at Lakeland, Florida, hearing that out of Charlotte. Medical, medical has bounced back. Interesting note, somebody said the cosmetic surgery business has performed very well because you can have cosmetic surgery now and recover at home in privacy. So dental businesses, the dental businesses basically shut down in the month of April. They’re all back – and the dental businesses that asked for a deferral, none of them are asking for a second deferral. So those are all very positive elements of the new COVID economy. The negatives are kind of obvious. It’s anything event driven, whether that’s conferences or catering, those businesses are suffering. Hotels, it’s kind of a tale of two stories. There’s leisure hotels and then there’s business hotels. The leisure hotels are really coming back. And that represents about 2/3 of our hotel book, we have more leisure oriented. If you can get these hotels up to about 40% to 50% occupancy, they can start carrying their P&I payments on a breakeven basis, and we’re seeing that with the leisure side. The business side, however, is a different story. That’s going to be a lot longer recovery cycle. And then on the retail side, clearly, longer term, we’ve known that there’s these secular trends in retail. But for our book, it’s very tenant specific. The single-tenant businesses seem to be performing better. Anything with a drive through seems to be performing better. So we don’t see near as much loss content in the retail side as we would in the restaurant space. So I hope that gives you some color of what we’re seeing as far as the new COVID economy.

Yes, really helpful, John. Congrats on a great quarter, guys, and closing the deal.

Thank you.

Thank you, Catherine.

Our next question comes from Christopher Marinac of Janney. Please go ahead.

Hey, thanks. I wanted to follow up from a credit perspective as it pertains to the deferrals. At what point do those get risk rated to either special mention or substandard? Is that coming up in the fall? Or is that already happening for you now?

Dan?

Yes. That is happening now. That is primarily a third quarter event. In the second quarter, we saw a migration into watch. And this quarter, for those businesses that are seeking a second round of deferrals, we’re evaluating those risk ratings. Most of them would probably end up in a criticized type category as we go through this quarter.

So Dan, we’ll probably see some adjustment in the 10-Q coming up in November. Is that fair?

Yes.

Okay. Great. And then just a follow-up on what happens to a loan that has been acquired, it has a fair value mark, and then it pays off, and perhaps it’s renewed as a new loan. How do you reserve for that? Does the reserve before the fair value mark become a guidepost on kind of how you treat that new loan?

Chris, my answer would be that, that’s a separate discrete decision at that point. It’s – and the past mark or allowance required for that loan would be – would not necessarily be a guide for what the future would be. It may very well be correlated, but that wouldn’t be the guide in my view.

Okay. It just gets back to Kevin’s question on reserves and overall kind of how that goes, is kind of why I asked.

Sure. Sure. And I know all of us have a very cloudy economic crystal ball. Hopefully, what we and the industry are doing in terms of building reserves ultimately is setting aside capital that does not get charged off in losses. But at this point, it’s just too hard to know what’s going to happen in the economy. So...

I appreciate it. Thanks for all the background this morning.

Certainly, thank you.

Our next question is a follow-up from Stephen Scouten of Piper Sandler. Please go ahead.

Hey, guys. Thanks for letting me through one more in here. John, I appreciate all your comments about the new COVID economy. That was incredibly helpful. I was wondering, just in particular, you guys noted the exposures around your retail loans being primarily in three of the Florida markets. And I’m just curious, in particular, those markets that you’re seeing, I think it was – I can’t find that slide, I think it was Tampa, maybe Orlando and one other market. I’m just kind of curious, again, maybe piggybacking off Catherine’s question, just what you’re seeing in terms of new shutdowns or fear down there in those markets?

Yes. Good question, Stephen. Florida has been kind of on the forefront of opening the economy, and it does not seem like there’s political will to close the economy. Things have opened up considerably. I would tell you the markets in Miami-Dade county, Broward and Palm Beach, they’re going to be the more restrictive economies, whereas Tampa and Orlando are not as restrictive.

Got it, very helpful. Thanks, John.

You bet.

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

Yes. Thanks a lot. These are great questions, and I hope that we’ve been able to provide some clarity on a quarter with a lot of moving parts. And hats off to Will Matthews for putting this deck together to show you what the combined company looks like. It’s been helpful to me. I hope it’s been helpful to you. I hope you also get a sense for how well our teams are performing together at South State. Our goal is to seek to become one high-performing team that creates a lot of value for our shareholders. Since we’re not traveling to any investor conferences over the next quarter and we can’t see you face to face, just want you to feel free to reach out to Steve or Will, if you need any follow-up to clarify on your models. Thanks for joining us this morning, and I hope you have a great day.

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