Citizens Financial Group Inc (CFG) 2020 Q3 法說會逐字稿

Good morning, everyone, and welcome to the Citizens Financial Group Third Quarter 2020 Earnings Conference Call.

My name is Greg, and I'll be your operator today.

(Operator Instructions) As a reminder, this event is being recorded.

Now I'll turn the call over to Kristin Silberberg, Executive Vice President, Investor Relations.

Kristin, you may now begin.

Thank you, Greg.

Good morning, everyone, and thank you for joining us.

So this morning, our Chairman and CEO, Bruce Van Saun; and CFO, John Woods, will provide an overview of third quarter results referencing our presentation, which you can find on our Investor Relations website.

After the presentation, we'll be happy to take questions.

Brendan Coughlin, Head of Consumer Banking; and Don McCree, Head of Commercial Banking, are also here to provide additional color.

Our comments today will include forward-looking statements, which are subject to risks and uncertainties that may cause our results to differ materially from expectations.

These are outlined for your review on Page 2 of the presentation.

We also reference non-GAAP financial measures, so it's important to review our GAAP results on Page 3 of the presentation and the reconciliation in the appendix.

With that, I will hand over to Bruce.

Thank you, Kristin, and a good debut for you.

Good to have you on the team.

Thank you.

Okay.

Good morning, everyone, and thanks for joining our call.

We feel really positive about how Citizens continues to rise to the occasion and meet the unprecedented challenges of 2020.

We're taking great care of customers, colleagues and communities, while posting strong results that demonstrate the diversification and resilience of our business model.

We are delivering record levels of pre-provision profit, and we're managing risks on our balance sheet well in the near term, while also preserving and making the strategic investments to position us for growth and success in the long term.

Financial performance in Q3 featured record revenue, fee income and mortgage results.

The low rate and flat yield curve environment puts pressure on NIM, but our well-positioned mortgage business has performed exceptionally well, capturing the refi opportunity, gaining market share and providing a natural offset to low rates.

We included a page on this business in our investor deck.

In short, we believe the mortgage business has room to run given a positive market environment, plus our own strong positioning and capabilities.

In addition to mortgage, we saw a solid quarter in Capital Markets revenue given strong advisory and underwriting performance and a nice rebound in wealth fees.

Consumer fees also continue to move higher off of the COVID and related lockdown lows, which should continue as the economy further reopens and consumer behavior normalizes.

These factors drove noninterest income growth of 11% sequential quarter and 33% year-on-year.

Combined with a modest decline in NII and broadly stable expenses, we delivered underlying positive operating leverage of 2.6% sequential quarter and 9% year-on-year.

Our pre-provision net revenue grew by 22% year-on-year, and it's up 14% on a year-to-date basis.

Now this capital generation ranks near the top of peers and has allowed us to grow loans to support customers, build a prudent level of credit reserves given the uncertainty of the environment, maintain an attractive dividend payout, while delivering a 9.8% CET1 ratio, which is within our targeted range of 9.75% to 10%.

This capital and reserve strength gives us tremendous financial flexibility going forward from a strategic and an operational perspective.

Our view on the economy continues to be cautiously optimistic.

Our consumer credit book is tracking favorable to expectations given past stimulus, economic reopening and forbearance.

On the commercial side, we are seeing some selective credit stress in industry segments that are most impacted by COVID-19 and the lockdowns.

We took sizable charge-offs on 2 credits during the quarter, as loss recognition can be a little lumpy.

That said, we feel we are near peak charge-offs in commercial, assuming the macro environment stays on the current trajectory.

Our work on TOP and BSO continues to make solid progress.

We are adding material work streams to TOP 6 largely centered on digitization, and we will provide a full expense guide on our year-end call.

On BSO, we completed a student loan sale as we developed an originate-to-distribute model, and we've executed an attractive sub-debt exchange that delivered both financial and regulatory capital benefits.

It's been quite a remarkable year, and we feel we've handled the challenge as well, and we're poised for success as the economy recovers.

With that, let me turn it over to John for a thorough review of our financials.

John?

Thanks, Bruce, and good morning, everyone.

Let's start with a brief overview of our headlines for the quarter, starting on Page 5. This was an outstanding quarter for Citizens, despite the ongoing challenges in the operating environment.

We have generated record revenue in PPNR in the last 2 quarters, with an excellent balance sheet position at September 30.

For the third quarter, we've reported underlying net income of $338 million, EPS of $0.73 and record revenue of $1.8 billion.

Our underlying ROTCE was 9%.

PPNR increased 6% linked quarter to another record level and was up 22% year-over-year.

We posted record fee income for the quarter faced by record mortgage fees and strong results in Capital Markets and Wealth.

Also we delivered positive operating leverage of 2.6% linked quarter and 9% year-over-year, as we continued our strong expense discipline.

Net interest income was down 2% linked quarter due to a 3% decline in loans given line draw paydowns and a 5 basis point reduction in NIM due to rates and elevated cash.

This was mitigated by excellent results in interest-bearing deposit costs, which fell 13 basis points linked quarter to 35 basis points.

I should note that on a normalized basis, which adjusts for PPP loans, commercial line repayments and the education loan sale completed in the quarter, average loans were up slightly linked quarter.

We increased our allowance for credit losses to $2.7 billion, which translates to a prudent ACL coverage ratio of 2.29%, excluding PPP loans, up from 2.09% last quarter.

Note that the reserve build during the quarter of $209 million impacted EPS by $0.40 and ROTCE by 5 percentage points.

We believe charge-offs should be stable in Q4.

And barring a deterioration in economic outlook, we should start to see reserve releases beginning in the fourth quarter.

Even with a significant reserve build, we demonstrated excellent balance sheet strength, ending the quarter with a CET1 ratio of 9.8%, up 20 basis points linked quarter and back within our pre-COVID operating level of approximately 9.75% to 10%.

Our liquidity ratios also improved as we ended the quarter with an LDR of 87%, and we remain in compliance with the LCR.

Our tangible book value per share is $32.24 at quarter end, up 2% compared with a year ago.

On Page 6, I'll cover net interest income.

Net interest income was down 2% linked quarter given the impact of lower rates and a 3% decrease in loans as line draws were repaid, partly offset by lower interest-bearing deposit costs and improved deposit mix.

Despite the challenging rate environment, net interest margin held up well, down 5 basis points this quarter.

Rates drove a 7 basis point decrease through lower asset yields, and higher cash balances were a 2 basis point impact.

These were partially offset by lower interest-bearing deposit costs and outsized growth in DDA.

Moving to Page 7. We delivered record results again this quarter in fees, reflecting our ongoing efforts to invest in and diversify our revenue streams.

Underlying noninterest income was up 11% linked quarter and 33% year-over-year as our fee income ratio improved to 37%.

Mortgage banking delivered record results again this quarter on continued strength in originations, more than offsetting the modest decline in margins compared to last quarter's all-time high.

The mortgage business continues to provide an excellent natural hedge as intended against low-rate pressure on NII.

The Wealth business rebounded nicely in the quarter with revenues rebounding to record levels.

This was driven by a strong increase in transaction volume and a solid increase in AUM.

Service charges and card fees continue to trend back to pre-COVID levels.

Key consumer drivers were increases in credit card purchase volume and debit card transaction volume, each of which is nearing pre-COVID activity levels.

Capital Markets fees were down linked quarter driven primarily by a recovery in trading values in the prior quarter.

Excluding this, Capital Market fees were up 11% driven by accelerating activity in loan syndications and M&A advisory.

Turning to Page 8, let's take a closer look at the mortgage business.

The strong performance of the mortgage business again this quarter has really boosted our overall performance, providing diversification in this low-rate environment.

The business continues to demonstrate the benefits of the scale and diversity of our origination channels off the back of our 2018 acquisition of Franklin American.

We have made significant investments in the business over the last few years, upgrading our customer-facing technology with our focus on innovating the customer experience.

Over 60% of retail applications are now completed through our digital app.

The strength of our multichannel distribution capabilities has enabled us to meet the extraordinary increase in demand in the market, with 2020 the largest year for mortgage originations in U.S. history.

We expect volumes to remain elevated through 2021 at today's rates, and we expect to make market share gains even as rates rise as we transition to a more purchase-driven market given our strength and execution consistency and leveraging our scale and channel diversification across our retail, correspondent and wholesale channels.

Turning to Page 9 on expenses.

Underlying noninterest expense was down slightly linked quarter, reflecting continued strong expense discipline that generated robust positive operating leverage in the quarter.

This continued expense discipline has contributed to the year-over-year and linked-quarter improvement in the efficiency ratio, now at 53%.

Salaries and employee benefits were relatively stable linked quarter and up 3% year-over-year due to expenses connected to strong mortgage banking production volumes.

Next, on Page 10, average core loans were down 3% linked quarter and up slightly after normalizing for the impact of PPP loans, commercial line repayments and loan sales.

We saw growth in consumer lending in both mortgage and student.

Moving to Page 11.

Average deposits were broadly stable linked quarter and up 14% year-over-year, as consumers and small businesses benefited from government stimulus and clients built liquidity.

We were especially pleased with our progress on deposit costs, which declined 29% or 10 basis points to 25 basis points during the quarter.

Interest-bearing deposit costs were down 13 basis points to 35 basis points.

We executed our deposit playbook to manage down deposit costs across all channels, while improving our overall funding mix.

We brought interest-bearing deposit costs down significantly by leveraging data and analytics to personalize offers and optimize pricing for our Affluent and Mass Affluent customers.

We continue to see a shift towards lower-cost categories, with average DDA growth of 8% on a linked-quarter basis and 40% year-over-year.

This continues the peer-leading momentum we have demonstrated in growing low-cost deposits over the last 3 years.

Turning to Page 12 to discuss our CECL methodology and reserves.

We have summarized the key aspects of our macroeconomic scenario, which is a foundational element of the CECL reserve estimate.

This scenario has improved slightly on that use in Q2.

Nonetheless, we used management overlays and qualitative factors to build reserves, focusing on expected performance trends in specific commercial sector portfolios most impacted by COVID-related lockdowns, namely retail- and hospitality-related CRE and casual dining as well as in selected retail products.

We feel we are well reserved at this point for extended pandemic and lockdown impacts from these sectors.

Notwithstanding this sizable reserve build, our CET1 ratio improved 20 basis points to 9.8% given our robust PPNR growth and lower RWAs.

On Page 13, we provide detail on our customer forbearance programs.

In commercial, loans with payment deferrals declined to 1.4% of our commercial loan book, down from 5.2% at June 30, and this has further decreased to 1.2% as of October 13.

For retail, loans in forbearance have declined to 3.8% compared to 6% at June 30 and have further declined to 3.4% as of October 13.

This would be approximately 2% if we reported forbearance ending immediately after the last deferred payment.

The performance of customers that have exited forbearance is trending well, with approximately 95% in current status.

Also for customers that have not taken any forbearance, the delinquency status is trending favorably.

Deferrals in business banking are 8.1% and are expected to decrease to approximately 1% by the end of October, with about 40% of our customers having received PPP funds and reopenings alleviating some of the stress.

Turning to Page 14 on credit.

Nonaccrual loans increased 29% linked quarter given a $254 million increase in commercial, which was driven by 2 credits to mall REITs impacted by COVID-related lockdowns and as well as a $33 million increase in retail.

Note that our total mall rate exposure is approximately $400 million, with 2 credits now in NPA status and the other performing okay.

Net charge-offs were 70 basis points this quarter driven by 2 large credits in commercial: one to a mall REIT; and one in metals and mining.

The increase in commercial was partially offset by an improvement in retail, reflecting the impact of forbearance and the improving economic backdrop in Q3.

We took a prudent $209 million reserve build this quarter, which increased our coverage ratio from 2.09% in 2Q to 2.29% in 3Q, excluding PPP loans.

Despite the somewhat lumpy increase in NPAs and charge-offs during the quarter, we are seeing broad signs of progress in commercial credit quality as the economy recovers.

In the appendix on Page 23, we provide you with an update on our view of the commercial portfolio.

In the commercial portfolio, as businesses have reopened and liquidity has improved from capital raising and federal stimulus, we have seen sectors begin to stabilize.

These include a combination in foodservices credits, including quick-service food concepts that have performed well during the pandemic; the retail trade sector, getting our portfolio of lower-risk gas stations and essential services; the less price-sensitive credits in the energy and related sector; and finally, the arts, entertainment and recreation sector as sports teams and stadiums that have further benefited from professional sports resuming.

Given these positive trends, the areas we consider to be of elevated concern have dropped from 10% in 2Q to approximately 5% of total loans.

The remaining areas of concern have been particularly hit by COVID-related closures mainly across retail-related CRE and hospitality, casual dining, retail trade, educational services and price-sensitive energy.

On Page 15, as I mentioned earlier, we feel well positioned to manage through the current environment with strong capital and liquidity positions.

Our CET1 ratio improved to 9.8%, up 20 basis points linked quarter given our strong PPNR generation and reduction in risk-weighted assets.

We are now back in our target range of 9.75% to 10%.

PPNR as a percentage of average assets was 3.9% year-to-date on a 9-quarter DFAST calculation basis and has increased steadily over the last 5 years, reflecting the benefits of investments and increasingly diversified revenue base.

Strong deposit growth outpaced loan growth, which improved our liquidity metrics and drove the spot LDR down to 87%.

During third quarter 2020, the company completed a subordinated debt exchange that will benefit total capital going forward by increasing the percentage of qualifying Tier 2 debt.

Turning to Page 16, I'll update you on TOP 6. We continue to execute on the transformational and traditional TOP programs, and they've clearly been instrumental in our ability to deliver positive operating leverage and drive ROTCE improvement.

The initiative we launched are expected to achieve the original 2020 pretax run rate target of $225 million, and we are still on track to hit the $300 million to $325 million by year-end 2021.

We are also adding significant work streams to TOP 6 largely focused on accelerating our digital capabilities to create increased efficiencies and frictionless customer experiences.

These should deliver at least $100 million run rate by the end of 2021, and we are working to increase this, though we are also working through the cost impact of how much we'll invest or reinvest in strategic initiatives to drive future growth.

We will be updating our expense outlook, including the benefit of the expanded initiatives to upscale these programs as part of our 4Q earnings call in January.

On Pages 17 and 18, I want to highlight some exciting things that are happening across the company.

As we continue to strategically invest through the crisis to position us well for the medium term, we are focused not only on digitization, but also initiatives that position the franchise well for the long term.

On the consumer side, we are focused on national expansion, with Citizens Access integrating some of our lending businesses to further develop our national value proposition.

In merchant finance, we are continuing to add new merchants to our point-of-sale platform, launching 5 important new merchant finance partners, with more in the pipeline, and we are piloting a new customer-led point-of-sale value proposition.

In commercial, we continue to expand our capital and global markets capabilities, including completing our first lead-left high-yield fixed income issuance, and we are also seeing increased client adoption of our digital treasury solutions.

Now let's move to Page 19 for high-level commentary on the outlook for the fourth quarter.

We expect NII to be broadly stable, with no expectation of PPP forgiveness benefit until next year.

NIM is expected to be down low to mid-single digits.

Loans should be stable, securities up modestly.

Fee income is expected to be down mid-teens off the record third quarter level, reflecting lower mortgage banking fees.

While we expect to see mortgage results come down from 3Q record levels, we do see a significant fee opportunity that should continue into 4Q and well into 2021 at attractive margins, albeit lower than recent historic highs.

Noninterest expense is expected to be up modestly, reflecting seasonal factors, and we're on track for full year operating leverage of around 4%.

We expect relatively stable net charge-offs in the range of 60 to 80 basis points of average loans.

We also expect a reserve release in Q4 given reserve builds taken year-to-date, and we should see a decline in NPAs.

On Slide 20, to sum up, we continue to navigate successfully through the COVID-19 crisis.

The resilience of the franchise is again on display with record PPNR, record fee income and positive operating leverage.

We remain well positioned to continue to strategically invest and deliver on key initiatives.

Our ability to execute well drives our strong profitability, capital and liquidity positions.

With that, I'll hand it over to Bruce.

Okay.

Thank you, John.

Operator, let's open it up for the Q&A.

(Operator Instructions) Your first question comes from the line of Peter Winter from Wedbush Securities.

I was just curious, what gives you the confidence that nonperforming assets are going to decline?

And at this point in the cycle, there still seems a lot of uncertainty that you'd be willing to release reserves next quarter.

Yes.

Why don't I start, John, and then you could pitch in.

So if you look at what drove up the NPAs this quarter, it really was isolated to just 2 exposures we had to mall REITs, which, frankly, had been really stellar-performing companies, best in class, which we've had long relationships with.

But obviously, the COVID and lockdowns and changed behavior caused some stress there, and so we've recognized that.

We do a pretty careful job of forecasting the migration through criticized assets and what could go NPA.

And so we think beyond that, we don't really -- as I think John said in his prepared remarks, we're seeing some broad signs of optimism and some improvement in the overall commercial book.

So we really don't think we're going to be taking a lot new in, and then we'll have some charge-off -- some degree of charge-offs, which will reduce the NPA.

So you put that all together, and I think we're feeling pretty confident on the commercial side.

And then if you look at consumer as well, we've had really, really healthy trends, even surprising -- to the point of being surprising, but very solid in terms of delinquencies, so feel really good there as well.

John?

Yes, may I -- I'd just add, just higher level.

We have pretty good line of sight when you think about over the next 60 to 90 days about what's going to migrate on the commercial side.

I mean, we've got paydowns and charge-offs that are coming through.

And things -- as we mentioned in our overall areas of market concern, we were at 10% last quarter.

That number has fallen to 5%.

We delineated where the puts and takes are with respect to that in our slide deck.

And so we've done a bottoms-up cash burn analysis, which Don can comment on.

So we feel reasonably comfortable with that guide on a nonaccruals basis.

And yes, just on the reserve levels with releasing reserves, just, I feel like there's still enough uncertainty in the economy.

Just what gives you a decision to release -- properly release reserves next quarter?

Yes.

I mean I'll go ahead and take that one.

I mean, I think this comes back to the methodology of CECL in the first place.

I mean, we've been -- over time, there's been significant uncertainty with respect to the scenario, and you saw how that trajectory played out over the first and second quarter where we built in both quarters.

This quarter, the scenario actually got a little better.

And I think, at least from what we can see, the level of uncertainty has started to shape into something that we feel comfortable with our outlook.

I think the difference this quarter in terms of our build is we've been spending a lot of time with individual sector reviews, and that really was those management overlays and the qualitative factors and what drove our build this quarter.

After we've gotten through all of that, when we -- if the scenario -- barring a deterioration in the environment, we feel like after analyzing what we expect the loss content to be in these categories, that the reserving requirements have been satisfied.

And so therefore, the loss content has been provided for.

And therefore, on a go-forward basis, the way CECL works is that you would charge off against the reserves that you've already built, and the provisions would be driven by your origination and go-forward activity.

So from our standpoint, that would mean reserve releases, which -- with provisions less than charge-offs.

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

So as we take a step back, obviously, unfortunately, given the timing of where we are in the year, I'm sure you'll get a lot of questions on '21, and I know you'll defer us to January for details.

But as we take a step back and we think about all the work that you've done, either through the TOP programs and building your fee income-generating capabilities and weigh that against, obviously, the interest rate challenges and the swap income roll-off, as we think about normalized return sort of post the spike in credit that we all expect for '21, as you think about normalized ROTCE for Citizens sort of in a post-COVID recovery world with no help with rates, do you think that you have enough in the till with TOP or fee generation to achieve like a 10% or low double-digit ROTCE on the other side?

Yes.

I'll start and then, John, you can add your perspective.

But yes, I think that's certainly the case, Erika.

So if you look at what we've delivered just this quarter was 9% with a huge reserve build, which the build basically cost us 5% of ROTCE.

So you can do the math on that.

But we'll, I think, going forward, have lower credit costs.

We'll have some NIM headwinds.

But again, we consider hedges as part of the strategy in managing a low-rate environment, but our mortgage business was also part of the strategy as well.

And so there seems to be a great fixation on hedging, and some folks have put hedges on.

I think we've done a nice job there, but some folks may have some longer duration or more hedges, but they don't have the size mortgage business that we have.

And so I think, if you look at our PPNR generation through this year, we're really top of the class in terms of how we've been performing.

So we expect there to be linked to run in the mortgage business through next year.

60% of the households in the country would benefit, I'd say, by more than 50 basis points in terms of the math if they refinance their mortgage.

So there's going to be continued demand on the refi side.

As the market goes back to a purchase market, we also are very well positioned.

We probably have the most diversified origination channels of any bank-owned mortgage company with exposure to retail, to correspondent and wholesale.

We've worked really hard to digitize that business and gain market share and be able to handle volumes efficiently.

So I feel really good about that.

So I'd say we're kind of on the doorstep of crashing through double-digit ROTCE.

I think we can get there and certainly sustain it.

But it's going to take all the levers of the fee investments that we've made, doing more TOP and continuing to focus on driving efficiencies, looking for volume in terms of loan growth, and we see -- we think there's going to be some opportunities.

We think we uniquely have some niches on the consumer side that some of our peers don't have.

And I think also, in commercial, we've been able to achieve nice growth through the build out of some of our regional geographies.

So we know what we have to do, we know what the objective is and we're going to keep driving towards that original medium-term targets.

I think you probably need a little help from rates to get all the way there.

But certainly, double-digit seems like a bar we can hurdle.

John?

Yes.

I think -- not too much to add other than I think it's -- I think that we have been a self-help story in the past, and I think we absolutely remain so going forward.

In the NII space, our BSO actions and with interest-bearing deposit costs at around 35 basis points, there's a lot of opportunity there for us.

And we are a completely different bank than we -- this is first is last.

And so you can expect that our interest-bearing deposit costs are going to find new lows for the bank compared to where we were at the end of the last ZIRP.

On fees, like night -- it's night and day with respect to our diversification.

A combination of the organic investments that we've made and the inorganic acquisitions that we've made have been extremely powerful in the fee generation space as you're seeing in mortgage.

But we shouldn't forget about wealth, which is hovering around record levels on its own.

But sometimes, it gets overshadowed by the eye-popping numbers in mortgage, but the diversification there is great.

And the Capital Markets business has never been more diversified.

And then in -- and finally, expenses, we've had a history of our TOP 6 programs.

That will continue, that will be a hallmark of what we do, and we have a lot more opportunity there as well.

So those are the final points I'd make.

Your next question comes from the line of Scott Siefers from Piper Sandler.

I just wanted to ask on credit broadly.

What is your sense for when loss content will really begin to materialize?

I think it kind of feels like it keeps getting pushed back, and the consensus view now seems to be sort of mid- to even late 2021.

So just curious to hear your thoughts.

And then just at a very top level, what kind of cycle, like, do you really think you're sort of setting yourselves up for?

It seems like with current info, most of the economy will sort of slog through, and it's just these isolated areas that will see the real pain.

So is this something where we could really resolve most of the credit cycle next year?

Or do we see this sort of bleeding on for a couple of years from here?

Sure.

So what I'd say on that is you have to look at commercial and you have to look at consumer.

Consumer has been extremely well behaved, and we've had folks on forbearance.

The people rolling off forbearance have actually been current, and we haven't seen any uptick in charge-offs.

But I think the residual folks who are on forbearance, there will be some charge-off content there, and I think that probably doesn't peak until sometime in the middle of next year.

So whether that's Q2 or Q3, we'll see.

I think on the commercial side, we've got hit with 2 one-offs this quarter.

And there's -- the pig is going through the python.

I don't think there's significant jumps on the commercial side.

I think we're probably nearing the peak charge-offs, but they'll stay elevated for a while before they move back down, I think, in the second half of the year.

So I'd say our outlook is that most of this should resolve over the course of next year, setting us up for, I think, more normalized charge-off rates as we head towards 2022.

Any comments there, Brendan?

Do you want to comment on the consumer side at all?

Yes, let me just add a little specificity.

So John quoted a few numbers in forbearance.

We're increasingly confident that, that portfolio is of high quality, particularly with some portfolios that were of high interest that hadn't gone through a cycle before.

Our student portfolio is holding up incredibly well so far, and the merchant finance portfolio is equally holding up incredibly well.

And in fact, that portfolio has almost no customers in forbearance at all.

And delinquency is still flat for pre-COVID.

So we're feeling really, really strong about consumers.

As John mentioned, the customers that are firmly still in forbearance has moved from a peak of ever forbearance at 8% to now 2%.

And our delinquency rates have been flat to down at the same time.

So we're seeing a lot of gearing out of the forbearance portfolio with very minimal impact to distressed consumer behavior so far.

So -- and we're out of the woods, but surprising on the green shoots that we're seeing are quite positive.

Yes.

And Don, maybe you want to talk about…

Yes, I'd echo that.

And I do think it's kind of elevated for next year, but we're kind of peaking out where we are right now.

I think -- remember, I'll just emphasize what Bruce said.

Our view is based on a client-by-client liquidity analysis, where we project out current rates of cash generation versus current rates of cash burn, and we're seeing really positive trends.

We've taken 25% of the companies that were in the high-risk category out of that category based on our last analysis.

We're also seeing record level of customer deposits, so they have heavy levels of liquidity sitting with us.

And we're seeing -- on a customer-by-customer basis, we're seeing the bigger customers, as everybody knows, are going to the public markets and grabbing any amount of liquidity that they get in the high yield in the equity markets.

And the smaller customers, while they're having a little bit of a more difficult time, they're managing their businesses in a really conservative way for cash.

So they've kind of cut expense levels, and they're positioning their businesses to survive a extended slowdown, if there is an extended slowdown.

So we feel good about what the customers are doing on an individual basis.

Great.

That's perfect color.

And I guess, if I could sneak one in here.

Just Bruce, you noted the kind of emerging emphasis on things like hedging programs, which you guys have benefited from.

I've noticed the same thing.

I guess, maybe, John, as you sort of think about things into next year, when and how do we see some of those hedges that you guys have put in place roll off?

And sort of what is the sense?

Should we just sort of recast our focus onto the fee drivers such as mortgage and wealth that you alluded to earlier?

Or how do we kind of replace those benefits as they do roll off?

Yes.

I mean, basically, the hedges that are in place roll off throughout 2021.

By the end of 2021, most of that benefit is starting to wane.

But what I do is take a step back on NIM overall.

The levers that we're pulling and have very large opportunity to get after is what I mentioned earlier.

With respect to interest-bearing deposit costs sitting at 35 basis points, we expect those to decline significantly in 2021.

We -- that's on the sort of funding side of things.

We also are focusing on the asset side, so we have broader BSO efforts, rotating our capital and allocating it into better risk/return categories and profiles.

And then I'd -- you heard from Bruce earlier, the mortgage business has room to run.

There are trillions of dollars of mortgages that are -- that have a refinance incentive.

And I think that -- I would say, that we're -- we have -- that business is rate-sensitive and has been part of our hedging story and has done incredibly well and a lot of the NIM headwinds.

Frankly, I guess I could say most of the headwinds, all of it in 2020, and probably on a cumulative basis through 2021, most of those rate headwinds will be offset by expected mortgage fee -- elevated mortgage fee revenues.

So -- and then, of course, you heard -- when you have rates falling, that's a big impact, and we'll have to look at all the levers across the self-help that we feel like is alive and well here, and that would include expenses, and TOP 6 is part of that.

Yes.

And the last thing I would say, Scott, and I know hope is not a strategy.

But if you consider that we could see real progress on the health front, and you could get -- these treatments are progressing nicely, vaccines are progressing, you could see another stimulus bill.

It seems like the folks in Washington are getting closer on that.

You could actually see a fairly decent rebound next year, which could result in a steepener in the curve, which could create a lot of benefits and also opportunities to lay on some more hedges.

So anyway, we're keeping our eye on that but…

Yes.

We may be on some hedge…

Yes.

When you run your scenarios, you have to consider that as a possible scenario.

Yes.

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

Also on the credit front, I know you mentioned the -- that you're closely tracking loss migration, and that has influenced your commentary around nonperforming asset levels likely to decline.

Can you just give us -- do you have what your total criticized assets trends were for the third quarter and how that may break down in terms of the special mention versus classified?

Yes.

I -- we published that in the Q. I would say, directionally, it's up, and it's mostly special mention.

So you'll stay tuned for the details on that.

Okay.

All right.

And then also on the credit side, the -- wanted to see if you could just give us a little bit of update on what you're seeing in your commercial real estate portfolio.

Are you beginning to see stress there?

I know you mentioned the mall REITs, but just curious about other properties, how that portfolio is trajecting.

It looks like you added a fair amount to the reserve this quarter there.

Yes.

I think it's really what we mentioned.

It's retail and hospitality where we're focused.

If you click through the different asset classes, office looks like it's holding up pretty, well with rents being paid.

Well, multifamily, looks like it's holding up pretty well.

We've got our eye on trends there.

We don't have the big exposure to some of the cities suffering, bigger tips like New York and San Francisco, fortunately.

Right.

And then you get into industrial and health care, and those are also holding up quite well.

So the place we're focused is on the retail and hospitality.

On the hospitality side, we've got an exposure to business travel, which has obviously slowed.

But we've got very diversified sponsors, and we've got some support provided by those sponsors in terms of flag chains, which have overlay guarantees on some of that.

So it's really around the other areas of retail, and we feel like we're in pretty good shape with the reserves we put up at this point.

Yes.

I think what we tried to do here was really look at if we're in an extended period of either lockdowns or consumer behavioral shifts that goes well into 2021.

And if that puts more stress on these narrow sectors, let's make sure we've taken credit off the table and put up a sizable reserve there.

And the other thing I mentioned is we are working with all of the sponsors.

We really bank the best sponsors out there, and they're working with us, and they're restructuring the properties that are having temporary dislocation.

So -- and we've given some forbearance, but they're also putting some money in to pay interest and keep the properties operate.

Okay.

That's helpful.

If I could just ask one more on the efficiency, that $100 million, just to confirm, we do not yet know how much will fall to the bottom line of that $100 million.

Yes.

That's good, John.

So we conveyed -- we communicated appropriately.

So we are going to -- we're working on launching a number of work streams.

Some of those are in Brendan's area in consumer, the big digitization push.

And so far, the tally is up to at least $100 million.

So that's good news, and we're going to keep trying to drive that higher.

We also have a couple of pages in there on some of our strategic initiatives.

And so one of our objectives here is to really keep investing for our future, so that we come out of this challenging period in even better position with a stronger franchise that's positioned to grow and to continue to do well.

And so we're working through the pacing of some of those investments and which ones to prioritize.

So we're kind of reluctant at this point to give you a full update on expense guidance until we complete that work.

But I'm sure, we knew there was going to be a clamoring for what have you got so far, so we put the number out there.

Stay tuned to January, and we'll give you all of that in the context of our full year guidance that we do every January earnings call.

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

If I could just follow up on the last question a little bit.

So TOP 6, you're on track, and you still have another $75 million to $100 million by year-end.

And then the new $100 million on top of that, not looking for expense guidance, but just can you help us understand, of that $175 million to $200 million that you -- at minimum, you expect to get next year, the approximate mix of like what comes through expenses of that and what comes through revenues of that because you're talking about like these new revenue opportunities, as you had just alluded to, Bruce?

Yes.

Yes.

I'll go ahead and take that.

I mean, I think in -- the majority of this is an expense-driven program.

There are some revenue opportunities that are there in the traditional TOP program, as we have done historically.

But for example, the transformation piece of this is 100% expenses for the most part.

And I would say that, that's really the main driver of the program.

But we also do use the program to fund revenue opportunities as well and to drive the upside on that front.

I would hasten to add, though, that when you start doing the numbers, you're looking at the run rate target of around $225 million by the end of this year.

That rises to as high as $325 million, so there's $100 million there.

And then we also mentioned the additional $100 million at least that Bruce mentioned as well.

So we wanted to make sure that we weren't losing track of those different hundreds.

Yes.

Yes.

Exactly.

Yes.

Okay.

Very good.

And then second question, just, John, on the PPP in general.

Many banks have thought through that forgiveness might start in the fourth quarter.

It seems like you guys are conservative in terms of not at least putting it in your core, your NII guide.

But can you just help us understand, and I know it's more of a timing question, but just what you expect and how do you expect us to all go with regards to forgiveness timing.

And also just how much was PPP in the 3Q NII as well?

Yes.

Sure.

I'll start off and maybe Brendan will comment on it.

But in terms of process, I mean, the forgiveness process can take up to 5 months.

There's many steps that have to be made.

Maybe Brendan can talk about the invitation approach that we're taking in the fourth quarter.

But I think that our view is, given the complexity there, that it would be appropriate to -- in the outlook to not include any acceleration with respect to forgiveness as a benefit.

That said, we do -- as you know, the way the accounting works is that we are incorporating the expected fees on a level yield basis over the life of the 24 months of these loans.

And so every quarter that goes by, we are recognizing P&L that is attributable to the PPP program.

In the third quarter, the yield on the program is nearing -- somewhere between -- nearing 3% in terms of yield.

And from a pretax standpoint, if you -- it's maybe in the $25 million range for the third quarter.

So that gives you a sense.

And all of that, when I call it pretax flow, that's really after the expenses.

That's a tiny bit higher on the NII line.

So -- and that number will be -- with no forgiveness, we'll see that again in a similar number in the fourth quarter given the way that the accounting works and if forgiveness really -- is really a 1H 2021 event as we are forecasting.

Yes.

And I would say one thing on that.

It's Bruce, and then I'll let Brendan go.

But Ken, initially, you -- we take it out over roughly 8 quarters, and I think we had $140 million, $150 million roughly to amortize on a straight-line basis.

But we thought that forgiveness would occur much sooner.

We had thought some of that would trickle into Q3 and Q4.

But now, it looks like that will largely be a '20 -- first half '21 event.

But the spike is going to be lower since the longer this goes towards the end of the period, then you won't get the same spike as if you had a massive acceleration into, say, Q3.

That would have really altered the timing in a material way.

But at this point, since we are steadily recognizing and then there's less time remaining to accelerate, the spike shouldn't be as dramatic, just to make that mathematical point.

Yes.

On the timing, the one thing I would just add is, keep in mind, the customer doesn't need to incur interest charges until October of next year, and so there's no huge pressure point for our customers to apply for forgiveness right this second.

And so with -- they don't have to pay, they don't have to pay.

So with the various bills going through Congress that would possibly be quite positive to these customers, there's a bit of a waiting game, and that's what we're hearing from most customers is that they'd rather wait and see what flexibility is afforded to them before they jump in and start the forgiveness process.

So we're getting a handful trickled in.

And then to John's point, once the customer provides all their documentation, the SBA still has a 3-month window to stamp it and say, "Yes.

It's able to be forgiven." And that's the recognition event, is when the SBA stamps it.

So there's a bit of a tail on this as we expected, as Bruce pointed and John pointed out to be…

And a few things.

Some small business owners are being cautious here and just holding on to that cash to see what the forgiveness terms are that they would not have to pay it back, which is one of the reasons we still have elevated cash balances.

So they've dipped into their own pocket to keep the lights going in the business.

And so we'll -- I think there's just a bit of caution generally, as you said.

Yes, yes.

Understood.

One just quick clarification, John.

That $25 million pretax, was that the fee part of it?

Or was that also with the NII just from the loan yield?

Yes.

It's -- that's a fee part of it and the NII, so it's all-in, and that's consumer and commercial.

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

So just in terms of credit, it sounds like the management overlays drove most of the reserve build this quarter.

What did your CECL model, if we look at CECL by itself, actually tell you to do with the reserves?

I think it's hard to parse it, Ken, actually, because, to us, the CECL model is not just a macro forecast.

It's a process that involves many, many, many variables, and management judgment is one of those variables.

So I think it's just hard to parse that.

Got it.

Okay.

And then maybe just on the same topic.

I guess, why apply the management overlays this quarter?

I mean, I'm sure you had some earlier in the year, but it seems like maybe this quarter had more of the qualitive adjustments rather than during the…

Yes.

I think we've had -- overlays are -- and qualitative factors are part of the process every quarter.

I think the reason to call these out was you had a slight divergence.

It looked like the macro forecast was a little better.

The backdrop was a little better.

But what we're seeing is that consumer behavior and the effect of lockdowns is going to be more prolonged, and I think we saw when we were assessing it in the first quarter and second quarter.

We think it could be well into 2021 before we get back to the life as we knew it, into a normal lifestyle, which means these retail and hospitality, entertainment, travel, all of that genre could still be in a difficult situation for longer.

So you wouldn't necessarily pick that up from your macro forecast.

I mean that's a kind of unique aspect of certain businesses are disproportionately impacted from the new normal about how we're living our life, and so that's why we're calling that out.

Your next question comes from the line of Vivek Juneja from JPMorgan.

A couple of -- I'm going to just follow up on some of the themes that have been coming up.

The release in reserves, Bruce and John, that you're expecting in the fourth quarter, which loan categories do you think that you're expecting to see that at this point?

Where is that visibility coming from?

Yes.

I mean, I'll go ahead and take that.

It's -- Vivek, it's kind of like -- the way CECL works, as you know, I mean, we provide for all of the loans that we -- that are outstanding at September 30, both for the loss content that we see after considering our macroeconomic scenario and then our qualitative factors that we review by loan category.

And if we're right, and it's very hard to say that you can be, there's so much uncertainty, that -- a lot of that build, as you know, in the third quarter came through the commercial portfolios and, as we've mentioned earlier, CRE and retail and hospitality, and we also mentioned casual dining as sectors where we've built reserves.

So once that's done, then, theoretically, at least, you're just going to charge off against those reserves going forward, assuming you were right about what the loss content is and what the scenario will be.

The rest of your provisioning then would only be focused on your front book activity and growth.

So where we're going to grow going forward, let's say, for example, in the residential mortgage and student and merchant spaces, we would provide additional reserves for those loans as they come on as well as the C&I loans that we're going to see as you get to the end of the fourth quarter.

So it really is -- you have to sort of look at it in those 2 buckets as we extend…

And just to make an assumption that the environment won't deteriorate in a meaningful way, so that you wouldn't need to add to any further reserves around the back book.

Now there could be some of that, but we don't see it -- a sufficient amount of it to result in a reserve build and a need for reserve build.

Okay.

And what are you thinking about the student loan book?

Because that forbearance rate has stayed pretty high.

It hasn't come down.

It's higher than even resi mortgages.

Could you comment on why that's the case?

They've just not come up for -- how long is the forbearance period?

Have they just not come up yet?

Or have they gone -- or what percentage have gone in for an extension of the deferral?

So we're actually starting to see it gear down a little bit in the recent weeks.

It was lagging a little bit principally because the majority of our student loan book is student loan refi.

And a lot of those customers also have government loans, which had significant forbearance periods that were kind of automatically granted.

And so customers were triggered by the government event, and they called all the private lenders and banks and raised their hand for forbearance.

And there's sort of no reason for them to delink those 2.

So we've been aggressively working with our customers to make sure we try to understand where they're at and if there's a capacity to pay.

But if they are still on the fence, we've been allowing them a little bit of leeway to land on their feet.

But every underlying dynamic we see in that portfolio is quite positive.

We call it a superprime portfolio.

The credit is [7 80] plus in that portfolio.

And particularly in the refi portfolio, they'll make 6-figure income.

That's the sector that's been the least impacted by unemployment.

And so we feel quite strong that this is -- there's no significant underlying dynamic that's different in student than any other portfolio in consumer.

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

So a couple of questions.

First, John, you mentioned that you -- the hedges should mostly roll off, and the headwinds from the hedges rolling off should be pretty -- for the most part, fully realized by the end of '21 and certainly '22.

And I think we've estimated that the headwind is probably in the $200 million, $250 million annualized from the hedges rolling off.

Can you -- is that -- I mean, can you just give us a sense of the magnitude of the incremental headwinds, if our number is more or less right?

How should we see that -- those incremental headwinds sort of materialize in '21 and in '22?

Yes.

It would be a fraction of that.

I -- without really getting into the numbers, it's not nearly that big.

It's not -- it's nowhere near that from what we can see.

How we track through 2020, I mean, you got to think about where -- what the terms are and -- which we publish.

And you can see what the terms are on those swaps, I believe.

But it's much, much lower than that.

And I'd say, if I could just bring it back bigger picture to -- sure, those are running off, but the mortgage business has been part of our hedging strategy all along.

The majority of the NIM headwinds on a cumulative basis are being offset in 2020 and 2021 by the mortgage business.

And we also have a very significant lever with respect to interest-bearing deposit costs this time around in ZIRP given all of the investments we've made in the analytics and product capabilities and orientation of our bank across consumer and commercial with respect to the relationship-driven deposit gathering that we have embarked upon, which takes years to do, but that started many years ago.

So we're starting to see that bear fruit.

Those are the things I think about when you're trying to consider the puts and takes for next year.

Yes.

No, I get that.

But maybe we can go over with the mechanics offline, but there does seem to be a sense from the investment community that the headwinds we're talking about, on a static basis, not factoring in some of the offsets are in the hundreds of millions of dollars.

But just to be clear, you're saying that estimate, just on aesthetic basis, nothing else, just the hedge you're rolling off, that number is way too high.

Is that correct?

Is that right?

That's correct, that's correct.

And we can take you through the math on that offline with some publicly available information, and we'll just make sure that you can -- you're seeing it the way we see it.

Okay.

Just one other question on NII.

What are you assuming for forgiveness in -- ultimately throughout the course of the first half of next year, what percentage of loans?

So the full percentage -- so we're -- there's a 15% tail that we think will be forgiven on the back end.

And so the other 85% will come through mostly in 1H, but there's some that will come through in the third quarter as well.

That question comes from the line of Dave Rochester from Compass Point.

Just on your NIM guidance, was just curious how much deposit growth you're assuming that feeds into that, if any or if you're looking for more of that continued favorable mix shift that you've been having there, favoring the lower cost of deposit?

Yes.

It's primarily a mix shift story.

I mean, we've gotten surge deposits like many other banks.

We think some of that may stick around for quite a while in through -- well into 2021, so there's that benefit.

We've paid down -- everything you can pay down, and we're sitting around with some excess cash.

And so excess cash is a drag on NIM, call it, about a 2 basis point drag or so in -- on a quarter-over-quarter basis in the fourth quarter.

But it's getting up to near, call it, 8 to 10 basis points on an absolute basis in the fourth quarter, all that excess cash.

We'll see -- we'll look to see that pay down over time.

But as it relates to deposits, really, we're seeing great mix shift into DDA.

We've had, I think, 3 years running now, peer-leading DDA growth, and that's part of the next story.

And it's just accelerating that trend that already was happening with us.

That's nice to see on the deposit side.

Yes.

You mentioned the cash that's sitting there.

I mean, are there any lumpy maturities on the borrowing side that maybe you can take advantage of and use some of that cash to pay those down?

Anything over the next year that we can look for will help the [push-in]?

Yes.

I mean not a lot.

So our flow of funds are down to 0. And then our senior debt, we only have very, very modest and maturities coming in early 2021.

We just called one issue, and we did a sub debt exchange.

So we're working that as much as we can, but not a huge amount of opportunity there.

Yes.

All right.

And then if you guys have any color on new loan yields and securities purchase yields that you guys are seeing today.

I'm just trying to get a sense for where we could ultimately be going on the average earning asset yield if we continue to see this flat curve over the next couple of years.

Yes.

And so for securities, I'll take.

And maybe Don or Brendan want to talk about spreads, but -- I mean, on the loan side.

But it's not a great story on the securities side.

There's a 40, 45 basis point, call it, negative front book/back book in terms of runoff, which comes off at around, call it, 190 basis points.

And you've got reinvestment coming on at around 140 or 145 on the front book for securities.

So that's the story there.

I think in commercial, we're seeing strong -- sort of spreads are up, but rates are down, so that's good.

In the consumer side of things, we're seeing some interesting positive trends there in auto, which has been quite good and really strong spreads there.

And maybe I'll just let Don or Brendan add anything else.

Yes.

I think auto has been very strong.

Student loan refi has also been very strong.

We're seeing a significant increase in margin across basically all the products.

So…

Maybe I'll also add merchant.

We just had a nice string of wins.

And Apple just launched their -- is launching their new product.

Our merchant business kind of has the profile of a credit card business.

Apple, we're gearing into the new product release for them right now with the 5G bump, so we're enthusiastic about that.

Microsoft All Access has geared up for this big launch right now seasonally.

And we just launched, as John pointed out earlier, 5 new merchant partners really centered in home improvement, electronics and fitness, similar to our Peloton relationship with the firm.

So we're really bullish about the growth there.

We're actually getting some really decent momentum that should really help offset some of the yield headwinds on some of the other portfolios by bringing in something of that high yield.

Yes.

On commercial, we're generally getting anywhere from 10 to 30 basis points better spreads on new originations, and we're also putting LIBOR floors on a lot of transactions, which are helping the overall yield.

That seems to be holding.

Okay.

All right.

Thanks for the question.

Okay.

I think that's it for the queue.

Thanks again for dialing in today, everyone.

We appreciate your interest and support.

Have a great day.

And everybody, stay well.

Ladies and gentlemen, that does conclude your conference for today.

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