Citizens Financial Group Inc (CFG) 2020 Q1 法說會逐字稿

Good morning, everyone, and welcome to the Citizens Financial Group First Quarter 2020 Earnings Conference Call. My name is Alan, 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 Ellen Taylor, Head of Investor Relations. Ellen, you may begin.

Thank you so much.

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Thank you so much, Alan. Good morning to all. Thanks for joining us at the end of a very long week. First this morning, our Chairman and CEO, Bruce Van Saun; and CFO, John Woods, will provide an overview of our results and our outlook and will reference our presentation, which you can find at investor.citizensbank.com. And then of course, we'll be happy to take questions. Brendan Coughlin, Head of Consumer Banking; and Don McCree, Head of Commercial Banking, are here also to provide additional color.

And now for some quick housekeeping, our comments today will include forward-looking statements, which are subject to risks and uncertainties, and you should review the factors that may cause our results to differ materially from the expectations on Page 2 of the presentation and in our 2019 Form 10-K.

We also utilize non-GAAP financial measures, so it's important to review our GAAP results on Page 3 of the presentation and to utilize the information about these measures and the reconciliation to GAAP in the Appendix. (Operator Instructions)

And with that, I'll hand it over to Bruce.

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

We are in the midst of unprecedented times with the coronavirus representing an unseen enemy that's wreaking havoc with people's lives and with our economy. As a large regional bank, we have an important role to play in supporting our customers through these challenges and in providing essential services to ensure smooth functioning of the economy. I am pleased with our performance to date.

Citizens is rising to the occasion. We are working with borrowers on loan modifications and on access to government programs to ensure they have the best possible chance to make it through the crisis. We have used our strong balance sheet to meet over $7 billion in commercial line draws. We have kept our branches open to serve individuals and small businesses. We have 2/3 of our staff working remotely, and we have taken precautions to protect those colleagues who must report to work and have provided them with additional compensation. And we have made $5 million in grants to small businesses and nonprofit partners to help our communities through these difficult times. In short, we are doing what a responsible corporate citizen should be doing.

Our financial performance in Q1 was heading towards an excellent quarter prior to the disruption caused by COVID-19 in March. Nonetheless, we had a very good revenue and PPNR results faced by record mortgage revenue, strong loan growth and expanding NIM. If you plug in charge-offs as our credit costs in Q1, we would have had a $0.94 quarter. But of course, the new CECL accounting standard requires a recalibration of lifetime losses on the loan portfolio given the significantly changed macro environment. This led to a $600 million provision, representing about $463 million, or $0.85, reserve build over charge-offs. As such, our underlying EPS was $0.09 in the quarter. We had $0.06 of notable items tied to our TOP program and Franklin integration costs, so reported EPS was $0.03.

Now this is more front-loaded than many analysts have modeled. We've assumed a deep recession in Q2, followed by a V-shaped recovery in our forecast, which is true, would take us back to more normal provision levels over the balance of 2020. If the recovery is more U-shaped, provisions will be higher. Safe to say, there's a great deal of uncertainty over the economic outlook. We feel good that we have a strong balance sheet position, with CET1 at 9.4%, our LDR at 95% and a strong LCR with enormous contingent liquidity. Our tangible book value per share held steady at $32, and we are confident we'll sustain a strong level of PPNR over the balance of 2020. Our decision to suspend share repurchases for the balance of 2020 should maintain a strong CET1 ratio through varying economic scenarios, including a U-shaped recovery.

We have provided significant granular information on our credit portfolios in our investor deck. We believe, we have maintained a highly prudent credit risk discipline. And as a reminder, our DFAST credit losses have consistently been better than the peer average. We have continued to make progress on all the strategic initiatives that we had teed up for 2020. Our colleagues have done a fantastic job of dealing with the COVID-19-related crisis, while also making sure we are hitting our key BAU deliverables. Current environment presents new risks and opportunities. We are looking for ways to incorporate these into our strategy with an eye towards coming out of the crisis stronger than our peers. We are not cutting back on investments designed to drive future customer acquisition and revenue growth. All in all, a challenging time. We are handling things well. I hope you and your families are healthy and safe.

With that, let me offer a welcome to Brendan, as our new Head of Consumer. And now I'll turn it over to John.

Thanks, Bruce, and good morning, everyone.

On Page 4, let's start with a brief overview of our headlines, as we navigate this unprecedented environment. We entered this crisis from a position of balance sheet strength. For example, after the stress experienced in March, we ended the quarter with a CET1 ratio of 9.4%, even after increasing our allowance for credit loss of $2.2 billion and funding approximately $7 billion of line draws. Our ACL to loans ratio of 1.73% compares well to stress loss scenarios as well as to peers. And our tangible book value per share at quarter end was nearly $32 per share, which is stable versus fourth quarter. Our liquidity ratios were stable with an LDR of approximately 96%, and we remain in compliance with the LCR. Earnings at the PPNR level proved to be resilient as we generated record revenues in fee income, while observing significant negative COVID-19 impacts in multiple fee categories. As a result, we remain committed to investing in our strategic initiatives, including the TOP 6 transformation program and our portfolio of strategic revenue initiatives.

Moving to Page 5. I'll cover some of the ways we are supporting our customers. Many of our customers have been directly impacted by the pandemic, and we have been swiftly moving to assist them during this difficult time, while still taking appropriate steps to mitigate risk. So far, we've delayed payments on loans for about 70,000 retail customers and about 2,400 small businesses. A number of our commercial clients have taken a defensive position as they prepare to weather the storm. Through April 15, we funded about $7 billion of commercial line draws. After the initial loss to draw down on loans in March, we've seen the pace of line draws slow considerably. Finally, we have been literally working day and night to facilitate the SBA payroll protection program for smaller companies with less than 500 employees. As of April 15, we have received applications from over 35,000 companies and have approximately $4 billion in loans registered with the SBA.

Let's move to Page 6 and cover CECL. We increased our allowance for credit losses by approximately $900 million to $2.2 billion at March 31 from approximately $1.3 billion at year-end. This was created in 2 steps: the first was the previously communicated day 1 impact of $451 million effective January 1; the second was a reserve build of $436 million recorded as part of the first quarter provision of $600 million, which also included $137 million of charge-offs. At quarter end, the ACL to loans ratio was 1.73%. Retail portfolio had an allowance to loans ratio of 2.31%, faced by longer duration or unsecured loans; while commercial portfolios had an allowance to loans ratio of 1.2%.

We have also summarized the key aspects of our macroeconomic scenario, which is our foundational element for the CECL reserve estimate. At quarter end, we elected to use the March 27 Moody's baseline, which integrates COVID-19 effects as our base scenario. Due to the uncertainty of the continued economic outlook, we also included an alternate Moody's pandemic scenario and an internally generated scenario. Further, we incorporated the loss adjustment factor to fully account for the benefit of our expected customer assistance efforts and the impact of the various government support programs on our portfolio. In general, our economic scenario assumes a steep drop in GDP in 2Q, followed by a V-shaped recovery in the second half of the year. If this scenario plays out, provision requirements over the balance of 2020 move back to being tied to loan growth. If the pandemic impacts are deeper or it takes longer for the economy to recover, and we are looking at a U- or L-shaped recovery or government programs are less effective, we could require meaningful additions to provisions.

Now let me move to the highlights of our underlying results covered on Slide 7 and 8. Despite the backdrop of COVID-19 pandemic and CECL-related reserve build, our results highlight our operational discipline and the benefit of our diversified business model. We had record revenues and fee income and improved net interest margin and strong liquidity and funding metrics. For the quarter, we reported EPS of $0.09, which was down $0.84 year-over-year and down $0.90 linked quarter, driven by the $0.85 impact of COVID-19 reserve build of $463 million. PPNR of $678 million was up 3% year-over-year and down only slightly linked quarter despite COVID-19 headwinds and the impact of seasonality. We saw strong balance sheet growth, including a 2% average loan growth with spot growth of 7%, which benefited NII and helped offset the impacts of the more challenging rate environment. And record fees were driven by record results from mortgage banking and wealth. We also saw strong underlying performance in Capital Markets and FX and IRP before COVID-19 impacts.

On Page 9. Net interest income increased 1% linked quarter as the benefit of 1% interest-earning asset growth and improved mix was partially offset by the impact of the more challenging rate environment and day count. Net interest margin increased 4 basis points linked quarter as loan yields benefited from widening LIBOR/OIS spreads as well as mix. Our proactive pricing actions produced an 11 basis points decline in deposit costs, which helped mitigate yield curve headwinds, as 1-month LIBOR dropped 38 basis points.

Moving to fees on Slide 10. Noninterest income was up 16% year-over-year, with relatively stable levels on a linked quarter basis. Record results in mortgage banking and trust and investment services fees were partially offset by the impact of COVID-19, but included a total of $36 million of fair value markdowns on loan trading and customer-derivative assets in the linked quarter as well as the impact of the shutdown in other categories. On a sequential basis, mortgage banking fees achieved another record. By doubling to $159 million, this reflected strong refi and HELOC volumes and improved gain on sale margins.

Wealth management posted another solid performance with trust and investment services fees up 2% sequentially, as strong managed money sales offset the impact of market declines. Capital Market fees of $43 million decreased $23 million from record fourth quarter levels driven by $21 million in March on loan trading assets. Foreign exchange and interest rate product revenues decreased $25 million from record fourth quarter levels, including a $15 million reduction from a net CVA adjustment given the fall in rates and lower activity caused by reduced variable term lending volume.

Turning to Page 11. Noninterest expense increased $30 million or 3% linked quarter, largely reflecting seasonality and higher revenue-based compensation. Salaries and employee benefits were up 9% given the FICA tax and 401(k) match seasonal impacts, along with higher compensation tied to strong mortgage originations in the quarter. Year-over-year, our noninterest expense was up 5%, largely reflecting the impact of growth-oriented investments, annual merit and revenue-based compensations, which were partially offset by efficiencies generated from our TOP programs.

Let's now discuss loan trends on Page 12. Average core loans were up 2% linked quarter and up 3% before the impact of loan sales activity tied to our balance sheet optimization initiatives. During the quarter, we sold an additional $500 million in nonrelationship mortgages, which, coupled with fourth quarter activity, reduced average loans by almost $1 billion. On a linked quarter basis, core commercial loans were up 3%, driven by the impact of higher line draws and strength in CRE. Core retail loans were up 1% linked quarter and up 2% before the impact of the loan sales activity, given growth in education and merchant financing partnerships. On a linked quarter basis, period end loan growth was 7%, driven by 15% increase in commercial given higher lines of credit utilization and relatively stable retail loans.

Moving to Page 13. We saw a nice average deposit growth of 1% linked quarter and 5% year-over-year as we benefited from investments we've made over the past several years to expand and enhance our capabilities. On a period end basis, deposits were up 7%, keeping pace with loan growth. We continue to manage down our deposit costs across all channels, reducing CD rates, retail money market promo rates and taking down the savings rate in our digital bank and managing commercial deposits aggressively. As a result, our interest-bearing deposit costs were down 15 basis points.

Next, let's move to Page 14 and cover credit. We continue to assess the impact of the COVID-19 pandemic and instituted a variety of measures to identify and monitor areas of potential risk. Nonperforming loans increased 11% linked quarter, driven by a $69 million increase in commercial, largely tied to a few noncorrelated loans and modestly higher retail. The NPL ratio of 61 basis points increased 2 basis points linked quarter and improved 2 basis points year-over-year. Net charge-offs came in at 46 basis points in the quarter, up modestly linked quarter, reflecting an increase in commercial, partially offset by a decrease in retail. The allowance for credit losses to nonaccrual loans ratio ended the quarter at 283% compared with 179% in the first quarter of 2019, up from 184% in the fourth quarter of 2019.

Turning to Page 15. We have been highly disciplined on credit with prudent risk appetite. In consumer, we remain focused on super prime and prime borrowers. The weighted average FICO score across our portfolios of 760 had approximately 90% of the retail portfolio has a refreshed FICO of 680 or better. Overall, our commercial portfolio is highly granular and diversified in terms of geography, industry and asset class. Roughly 60% of the portfolio is investment grade on a bond equivalent ratings basis, and the risk ratings improved year-over-year. And we remain underweight with peers in commercial real estate. We have been very disciplined around client selection and are focused on sponsors and developers that we have seen perform well and responsibly in prior cycles.

And on Slide 16, it's also important to note that our company run DFAST severely adverse scenario results performed in line or better than the peer average, which, we believe, indicates that we are relatively well positioned to manage with the current crisis.

On Page 17, we highlight the granular and diversified nature of our commercial portfolio, along with the areas in commercial that have been most immediately impacted by the COVID-19 shutdown and low energy prices. We have done a deep dive across the majority of the commercial portfolio to identify cash flow and liquidity vulnerabilities, with an eye towards helping our customers through these challenging times, while taking additional steps to more tightly manage risk. Together, these sectors account for approximately 11% of total CFG loans. Overall, we think that the percentage of our portfolio concentrations to these areas of perceived risk are largely at or below peer median. We've highlighted on the slide some of the factors that we consider to be risk mitigants to these portfolios, and we have individual tear sheets in the Appendix on each industry that provides more detail on the factors we are monitoring.

Moving to Slide 18 on retail credit. Our refreshed FICO scores on the consumer side of the house are around 760, and 70% of the portfolio is collateralized. So for some of the areas of potential concern, I would just highlight briefly, in education, we got, again, very high FICOs and the InSchool book is 95% co-signs. In the education refinance portfolio, borrowers have been in the workforce for 6 years on average and 55% of them have advanced degrees and about 1/3 of the portfolio has been co-signs. The consumer unsecured book includes $2.5 billion of short-duration merchant partnership loans largely driven by the Apple platform as well as loans through Vivint, ADT and Microsoft and a firm called Peloton. It's important to note that the vast majority of this portfolio is subject to loss-sharing arrangement. And the remaining $1.5 billion is our unsecured installment portfolio, which has very high FICO scores of 760 on average. As with commercial, we've included more details on these consumer portfolios in the Appendix.

On Page 19. As previously mentioned, we feel well positioned to manage through the current environment with strong capital and liquidity positions. The strong deposit growth kept pace with elevated loan growth, leaving our liquidity metrics steady. We have a diversified funding profile with a very strong base of core deposits and substantial capacity to do more for our clients as they manage through the crisis. In March, we announced that we would cease share repurchases, and with the extent of a pandemic disruption becoming clearer, we have decided to extend that through the end of the year to ensure that capital levels are strong to meet loan demand. We expect to remain well capitalized and intend to maintain the dividend at the current level.

On Page 20, I want to turn into a few exciting things that are happening across the company. While we are, first and foremost, focusing on helping our clients, we have not stopped working to help build a better company. We are driving forward on our strategic initiatives so that we emerge well positioned for the future. We are continuing to execute on the transformational TOP programs, and we are also moving forward with our major strategic revenue initiatives, while considering new opportunities arising from the current environment in an effort to drive higher revenue growth coming out of the crisis.

Moving to Page 21. Given the impact of the pandemic, it's challenging to predict an outlook for the future, and we no longer affirm our full year 2020 guidance. Nonetheless, we do, however, want to offer some higher level commentary on key categories for full year 2020 with a reminder that we currently expect to see more of a V-shaped recovery start to play out in the back half of the year. We believe we can deliver modest growth in net interest income, which includes the benefit of the PPP program. We expect that strong loan growth will more than offset a meaningful decrease in NIM due to rates. And noninterest income is now expected to be broadly stable as strength of mortgage is offset by COVID-19-driven weaknesses in other categories. The outlook for fees will depend upon the pace and magnitude of recovery in the second half of 2020.

Noninterest expense is expected to be up modestly given higher compensation tied to stronger mortgage production and impacts from COVID-19, which includes government lending programs and customer relief efforts. Provision expense has the greatest potential for variability in 2020 and will depend on the depth of the recession and the pace of recovery. We expect to see strong loan growth driven by higher line draws in commercial, the impact of government programs like PPP as well as the increased demand in education and merchant financing. At the same time, we anticipate a strong increase in commercial and retail deposits, reflecting heightened liquidity, given Fed actions and the low rate environment. Our regulatory capital ratios are expected to strengthen from current levels under the V recovery scenario, as net income, coupled with the suspension of buybacks through year-end, more than offset the impact of higher RWAs. Even in more severe economic scenarios, we expect our capital ratios to remain strong and above required minimums.

Now let's move to Page 22 for some high-level commentary on the second quarter. We expect NII to be up low to mid-single digits as strong loan growth more than offsets a sizable decrease in NIM. Fee income is expected to be down in the low to mid-single-digit range, reflecting COVID-19 impacts on service charges, card and other fees. Noninterest expense is expected to be up slightly given the COVID-19 impacts mentioned earlier. But net-net, we would expect positive operating leverage in the quarter. Provision expense will depend on the depth of recession and pace of recovery. Finally, we expect significant loan growth reflecting line draws in commercial, the impact of government programs and increased demand in education. Our capital, liquidity and funding positions are expected to remain strong.

To sum up, on Page 23, we are focused on delivering well for our stakeholders in these challenging times. We have a strong balance sheet and leadership team and colleagues base that give us confidence that we'll rise to the occasion. Now let me turn it back to Bruce.

Okay. Thank you, John. And operator, let's open it up for Q&A, please.

(Operator Instructions) Our first question will come from the line of Erika Najarian.

I'm wondering, as we think about a potential U- or W-shaped recovery, how does the economic parameters that are playing out during this pandemic compared to the DFAST scenarios that imply a cumulative loss rate of 4.1% over 9 quarters?

Yes. So I'll go ahead and start off on that, Erika. I mean, I think, the way that we look at this, just big picture, is how -- when you look at our reserve to loans ratio, the $2.2 billion that we have and that 1.73%, that really positions us well when you go back and look at the 2018 cycle, which was the last time we went through the Fed process. And it also positions us well for the 2020 cycle for -- based upon our internal estimates of how much coverage we're creating. So just to cover a few numbers on that front. If you go back to the Fed scenarios and look at the adverse scenario, and there's been a fair amount of analysis that illustrates that the rate environments and other aspects of the adverse are pretty similar to what we're going through today. And our $2.2 billion would represent $86 billion -- I'm sorry, 86% of coverage on those losses in the adverse scenario in terms of our internal estimates. The Fed numbers would be around 55%. If you -- we think we'll do better than the Fed. We've had remapping issues that have gone in our favor, and we've consistently estimated losses that would be lower than the Fed models would indicate. But even if we were to look at the Fed models, we have 55% coverage of the adverse scenario from back then. You fast forward to even if there was a severely adverse scenario, similar to what the Fed scenario would indicate in 2020, our coverage would be around 45%, we believe is maybe better than -- maybe some peers given the comments made earlier about where we think our loss ratios are going to come out. So we think that positions us very well. And maybe I'll stop there and see if that's responsive.

Got it. And my follow-up question is, I'm wondering if you could help quantify the magnitude of net interest margin decline in the second quarter. And of that magnitude, how much would be attributed to the Payment Protection Program? And if we assume that those loans pay off by third quarter, does that mean that NIM could be at a higher starting point in third quarter versus 2Q?

Yes. It's a good question. So the way I would look through it is, you start off with the rate environment itself. And given the LIBOR/OIS spread widening out in the first quarter, we really haven't felt all of the impact of the rate cuts from 1Q, and there's an expectation that that will narrow in in the second quarter. And so LIBOR and rates, in general, we have expectations will be down, call it, 70 basis points or so across the curve, both in the short and in the long end. In the past, we've indicated that for every 25 basis points, you would see about $15 million of NII impact with respect to NIM. And so that will help you triangulate and for -- that $15 million is typically in the neighborhood of 3.5 basis points. So if you triangulate all of that, that will give you a sense for maybe low teens impact to the rates.

The other aspects we have to look at in 2Q is mix, as you mentioned, how large will the PPP program be, that isn't in dilutive. What is our mix in the rest of the loan portfolio? We're seeing a reasonable loan demand underlying the PPP and other line draws. So that's still happening in our education portfolio and merchant finance that we indicated earlier. That actually provides a benefit. So -- but when you look at all of those things, we still think that there will be a meaningful and significant decline in net interest margin given rates in the second quarter.

The third -- your question about third quarter, based on how we're planning to account for PPP, which at the moment looks like we'll all flow through the NII line. And if you think about the forgiveness cycle, if we're going to amortize the fees that we expect to earn on the PPP program over the contractual life of the loans up through the forgiveness date, so if you expect maybe 8 to 10 weeks after funding that there could be some forgiveness, and majority of loans being forgiven, given that this is intended to be a grant program. You would see all that come into NII in the third quarter, all driving net interest margin, then that would reset net interest margin higher in the third quarter.

And I would just add, Erika, also you commented on NIM, but don't lose sight of the fact that we're calling NII to be up in Q2 because of volume. The volume effect should offset the NIM contraction.

Your next question will come from the line of Ken Zerbe.

I really appreciate the guidance that you gave on Slide 6 about CECL. I think it helps out tremendously. The question I have, just your first bullet there, you talked about you're using Moody's baseline, but you're also saying you're using your own internal assumptions. Can you just talk a little bit more about your own internal assumptions? Are they more severe or less severe than Moody's? And how much weight did you put on your own assumptions versus the Moody's assumptions?

Yes. A couple of thoughts on that. So I think our baseline scenario that has this overweight is the Moody's 3/27. The internal scenario, I would say, is maybe equal to slightly more punitive than that scenario. We have another Moody's scenario. At the time that we were closing our books, I think, the 3/27 was -- baseline was really one of the most punitive Moody's scenarios that was out there. So we had another one that was slightly less punitive than that coming -- but still pandemic-driven. So we used 3 in general, but the majority was really focused on this Moody's baseline. The other scenarios had a variety of other lenders associated with it. I mean we have this 18% down with GDP and the 9% on unemployment. But as an example, our internal scenario would have gotten unemployment up to 11%. So just to give you a sense for how we mix and match here. There's a significant amount of uncertainty, which is why we're using multiple scenarios, and we think that helps inform the ultimate outcome.

I would add, Ken, too, that we were trying to be as conservative as we could. I think by taking that very late forecast into account, we've certainly been watching where has the Moody's scenario model moves, and I'd say it's moved a little more conservatively. It's hard to say what exactly -- how that translates into impact on our reserving at this point. I think we just have to see more data play out before we could look at that. So if the recession is either deeper, which currently looks like that could be the case and then the recovery ends out extending a little bit, which I'm not sure necessarily is the case. We just have to see. I mean there's certainly a big groundswell for starting to reopen the economy given the pain that everybody is suffering. So we'll just have to watch those 2 factors and then go back and update things as we get to the end of the second quarter.

Okay. Great. And then just one other question. On the same slide, you mentioned that if there is a U-shape recovery, for example, you could have meaningfully higher provisions. Like, I understand the concept, but I guess my question really is, like, it seems that you're -- the assumptions you've made went from, let's say, a good period, right, to the -- before the pandemic, to something really bad, including the deep recession. Can you just help us understand if there is a U-shape recovery and it takes another quarter for things to get better, why does provision -- why would provision be meaningfully higher the next step? I mean maybe not higher than first quarter, but why would it be fairly large given the vast majority of your assumptions that you've already made sort of the vast majority of the negative revision, so to speak? Does that makes sense to your economic models?

Yes. Maybe I'll answer it this way, Ken. I mean I think one thing we've -- as Bruce mentioned, we did look and notice that since March 27, that Moody's has updated, I think, it was on April -- it was earlier this week, April 13, earlier this week. And we're seeing some eye-popping GDP numbers that's come out, instead of 18%, it's 30%, et cetera. I think the depth is one thing, but the length of the downturn in terms of whether it's a U is another. At a very big picture, I think one way to think about this is if something like that was to occur, I would basically -- I think we're positioned in a way that our capital ratios, which are around 9.4% at the end of the quarter, would remain broadly stable to up slightly, even if we were to directionally consume another scenario that would have certain -- the aspects of Moody's update that would have taken GDP down to 30%. And I think that that's what this is about, is articulating capital strength. And our allowance to loan coverage would, of course, increase. It would get to something with a 2 handle on it as opposed to 1.73%. And -- but nevertheless, our capital ratios would be broadly stable to up, potentially even up slightly under one of those scenarios.

Yes. And I would just add to your specific question as to why, Ken, I'd say, if it takes longer to get back to an operating economy, clearly, there's more stress on companies that can't open and start collecting revenues and serving customers. And then clearly, individuals don't get back to work as quickly, so there's more stress on individuals. So you would just have to do the recalibration on that and see where that puts you. So I think it's possible. I think we've put a good number on the board here in the first quarter, and we'll have to wait and see how much adjustment we'd have to make based on further input. But in any case, I think, John did underscore the big point, which is our capital ratio is strong and can absorb that. And so we feel good that we can both meet the loan demand coming in from our customers, put away what we need to if we need more reserves and still maintain a very strong capital position.

Your next question will come from the line of Terry McEvoy with Stephens.

Maybe starting with fee income. I was hoping you could expand a bit on your second quarter outlook. I know you mentioned service charges and cards. But any insight and thoughts into, say, mortgage and Capital Markets?

Yes. I'll go and start off. I mean I think that we've seen another record quarter in mortgage and record in wealth. On the Capital Markets front, frankly, before the loan trading mark that we took, which had an impact of $21 million in the quarter, we were having an exceptional quarter on top of exceptional quarter in 4Q. So mortgage outlook is still quite strong. We had an excellent quarter in 1Q. I think our early expectations are that we'll have a similar performance in 2Q. I mean it's early days and things can move quickly. But from what we've seen in April, although maybe lot volumes may not be quite as strong as they were in the first quarter, margins have really, frankly, increased to levels that we've never seen before, given all of the operational capacity issues across the industry. And we've been a source of financial strength and execution certainty, and that has driven our margins up in mortgage...

And allowed us to gain market share as well.

Absolutely. And we're taking share across all our channels, which is really excellent to see. It's positioned us extremely well. And in the wealth space, we've been able to have -- frankly, manage money sales, really nice uptake there that's been offsetting our market declines. And so we've had good momentum on that front. And then in Capital Markets, it's really market dependent. So those are some...

Why don't we let Brendan offer any further perspective on consumer? And then, Don, you could offer a comment on commercial.

Yes, well said. I think, John, on mortgage, the nonbanks are having some challenges as well. So we're swooping in to make some share and supporting your comments around margins widening out, we expect that to broadly continue. Our pipeline is extremely full. We're growing our LOs mildly through Q1 and into Q2. So we expect mortgage to continue to be extremely strong through the quarter. On the service charge line, our debit transactional volume was down at the end of March 35% to 40%. That's driving the pullback in Q2, both on debit fees but also less transactions leads to less overdraft occurrences. So we do expect that to recover towards the back half of Q2, broadly aligned with our guidance and a V-shape recovery in -- through Q3 and Q4, but that's putting some strain on Q2 for service charges. And I think John covered the wealth story really well, so I won't add anything to that.

Yes, on Capital Markets, I think, in general, deal activity will be low because of the uncertainty in the environment. But there are a couple of encouraging signs we're beginning to see. I mean there's huge inflows into the high-yield funds over the last couple of days. We're actually seeing more high-yield issuance as companies try to garner more liquidity and buffer their liquidity position. So we're benefiting a little bit from that now. And you'll remember that we also bought another boutique M&A firm this quarter, and they happen to be very focused on restaurant restructuring businesses. So we're beginning to see some opportunistic flow there. And I'll just -- I'll also mention that we're actually seeing some quite strong activity in our IRP businesses right now as those companies actually are garnering liquidity by restructuring existing swaps and putting some swaps on the books to take advantage of their current positioning. And on the market, John talked about, we've actually seen about 30% of that reversal already as we're seeing rallies in both the leverage loan market and the high-yield market. So some of that's come back to us already. So we're cautious, but we're seeing a few signs of life out there.

We'll go next to the line of Matt O'Connor with Deutsche Bank.

So there's been some ongoing concerns in the market that you take more credit risk, and I think some of the details that you provide today should alleviate those concerns. But here we are entering a credit cycle, and I think this is a chance to show that your credit is not worse than others. Obviously, your estimates internally are better than peers. But as we think out over the next several quarters, couple of years, what are the metrics that we should be looking at to evaluate your credit performance versus others? And it sounds like an obvious question, but obviously, there's all these payment deferrals going on. So it may not be as straightforward as kind of look at the traditional trends, but wondering how you would think about and frame that.

Yes. Let me start, and then John, you could pick up. But it's almost -- I remember when we did have that perception out there that we had grown fast and it won't end well and so we had people inside the shop say, "Gee, just wait until we get a recession and then we can prove it." I really almost wished for a recession. I said be careful what you wish for because I'd be happy to just stick on many, many quarters and years without experiencing a recession. But here we are. So I think we feel really, really good, first off, on the consumer side of the house that each of those portfolios that we have, we've stayed with a very conservative risk appetite, super prime, high prime. We've moved into spaces where we think we can get good risk-adjusted returns even with that conservative risk profile. And so you saw us grow, explore and pioneer the growth of the education refinance market, which we think is one such place. And then also in our merchant financing unsecured business where we have loss-sharing arrangements with very strong credit counterparties, that also, I think, gives us a very good risk-adjusted rate of return in those portfolios. And so some of the Fed modeling doesn't pick that up, and we obviously have the ability to understand that and pick that up. So I do think we'll end up performing well on the consumer side, better than expectations, and I think, better than peers. And so that would be kind of the bedrock that you should be watching that, and I think, hopefully, you'll see us deliver on that.

And then similarly, on commercial, we have -- as we've grown the book, we've actually grown faster with bigger companies, bigger customers in the mid-corporate space, and those customers tend to be more highly rated than the middle-market companies. And so there, again, that should benefit us when we go through this period. And I think we've also been very disciplined in terms of the industries that we're banking, trying to be -- stay well diversified, trying to make sure our hold positions are granular. And so I think that should also provide a benefit. In the areas of commercial real estate or sponsors, we've also kept the list of counterparties that we want to deal with quite tight, folks that we know with -- we know and have done business with for a long time. We think they're good operators. We think they treat their banks well. So I think that should also work in our favor. And then I guess, you'd look at the same things, you'd be looking at the charge-off rate in those portfolios over time. So anyway, I think we will -- now is the proving time. So we feel good about how we've maintained our discipline and how we've done BSO and repositioned ourselves to make higher net interest margin and better returns while keeping an incredible discipline on the risk part of the equation.

Yes. Maybe just to add to that, Bruce, I mean, I think, you asked about metrics. I mean -- I guess I'd break it down, charge-offs have always been lagging. They may be even more lagging in this cycle than in the past given all the forbearance activities that we're going to be engaging in. But nevertheless, we will be monitoring them. As you think about the current positioning, I think, we keep an eye on reserves to total loans, which we indicated was 1.73% today. I would also maybe just highlight the diversification across the balance sheet and keep an eye on that. We are right around 50-50 in terms of commercial retail. And when you dig into each one of those books, whether it's on the commercial side, the areas of interest or concern are all in the low -- very low percentages of the overall book and geographically diversified as well.

And then you go on the retail consumer side of things, mostly collateralized in areas that we understand and have been in businesses for a very long time. And where we are not collateralized, it's distributed across several different asset classes, not all cards. We're in student. We're in cards. We have merchant finance and there's a personal and secured product. So we think that is the name of the game there. So those are the current metrics. Forward-looking metrics really comes down to stress results, which we fared better than median in the past; and our internal modeling, which we have been increasing levels of sophistication over time and we've been backtesting and trying to keep current. So I think those are the 3 areas you'd want to monitor when you're thinking about things through the cycle.

And can you just -- that's all helpful color. Can you just remind us, this Slide 16 where you talk about your internal stress tests showing loss rates going down 50 bps versus last year? Can you remind us what drove that? Was that some derisking or model changes? Or just remind us what drove that big drop.

Yes. I mean, I think, there was a couple of things. I mean, I think, that over time, we've been doing a better job of mapping our risk ratings to we would -- basically had, frankly, underappreciated the strength of the risk ratings across the portfolio. And so that was the driver of the improvement. Secondly, the full effect of loss-sharing arrangements in our merchant finance portfolios were being fully built in. And then third, just over time, the noncore portfolio has been dropping, which had some higher loss content. It's gotten down to a very small level. So those are the things that come to mind for me in terms of what the drivers were.

Yes. And I think also the cumulative benefit of BSO is also being picked up as well.

Our next question will be from Brian Foran with Autonomous. Mr. Foran, we've lost your line. (Operator Instructions)

Yes. Can you hear me?

Yes.

Okay. Sorry about that. Going back to the stress test. I wonder if you could just speak a little more to the impact of Fed support and broader government stimulus. And I'm sure it's hard to put a number on it, but I guess the thing that's striking to me is, if I look at unemployment and GDP, clearly, we're probably going to be worse, at least for a little while. But on the other side, it assumes the stock markets are at 13,000, BBB credit yields are at 6.5%, whereas they're like 3.5%, 4% today. So when you think about the balance between the macro versus asset prices, clearly, the macro is probably the biggest input, but how much of a buffer or shock absorber do those better asset prices give in your minds?

Yes. I'm not sure I fully appreciate it. So you're asking...

Well, I think that the thrust of the question is the Fed has obviously stepped up here, if I understand it, and that's made a big difference in the markets. Certainly, the pricing of assets has come in, which is a signal that credit quality is better or potentially companies who experience less stress, at least from solvency, as long as the Fed is playing the way they're playing. And so how much weight do we place on that when we kind of do our modeling and look at the reserving that we're doing. Is that the question, really, is that the thrust of the question?

That was, yes.

Yes. I'd say there's a couple of things. When you -- it has a meaningful impact. I mean, I think, that's one of the big items that distinguish this current stress environment from possibly the modeled environment you would see coming out of the Fed, ironically. So when you go back to the 2018 cycle and you see the results there, they don't have this massive stimulus that we have given reasonable weight to in our outlooks. And so that is embedded. And it's not just the government actions, which are significant on the fiscal front and the monetary front. It's also our internal actions that are idiosyncratic and all of the things that we're doing to get ahead of this that are very hard to model in...

Like forbearance, forbearance.

Exactly. All the forbearance that we're doing, all the modifications that we're doing and how aggressive we're being there. And our insights and instincts around where to target those efforts, we've built that in in our modeling, along with the overall support from the government. That's a meaningful impact. And the other thing to keep in mind, and I should add this, the other important distinction when you look back at severely adverse scenarios is that all of those scenarios are all U-shaped, as you've heard from Bruce earlier. U shapes are very stressful, V shapes are less so. And so even if GDP and prior severely adverse scenarios don't fall by as much as we're all saying that it could fall today, the fact that it stays low for such a long period of time is what creates all that stress in the prior severely adverse scenarios. So when you fast forward to where we are today, what we're assuming and what we have in our numbers is more of a stronger recovery in 2H is more V-shaped, and we also have the support -- the significant support of the stimulus and our internal actions.

I do think, though, it's safe to say we've never seen -- I mean the Fed has pulled out all their tools from their toolkit from the last go around and then they've added more. And the fiscal stimulus bill was ginormous and very extensive and fast in terms of trying to get the cash out to help companies and to help individuals. And so we really don't have much to go by in terms of modeling all of that. The kind of easing off of TDR treatment on forbearance to encourage that, that's another delta that hasn't been in prior models. So there's just a lot of uncertainty overall with this modeling. And I think all banks are doing the best they can, both with the scenario and then kind of some of the offsets from federal government actions, from the federal reserve actions and then from the internal actions, which is why, I think, we'll just need more time to clarify kind of what is that true picture as we go through the second quarter.

If I could sneak in one more. If I just think about your ability to maintain dollars of CET1 capital over the next year, like total loss absorption capacity, I guess, you've got $650 million a quarter, maybe $700 million of PPNR. I mean it seems like you would have some security gains you could harvest if you needed to, which would pull it into CET1 capital, and then you've got some relief on the CECL accounting. I mean it kind of seems like when you add it all up, the loss absorption, so to speak, over the next 4 quarters, maybe it's like $3.5 billion or something. Is that kind of a fair way to think about it?

Yes. So I'll go ahead and start.

I would probably just say it's ample. That we are very focused on continuing to deliver strong levels of PPNR. I think that's one of the first lines of defense. And we see, I think, notwithstanding all of the change in the environment, our PPNR level was still up versus a year ago in the first quarter and it was close to flat on a sequential quarter basis. And we think there's a good ability to sustain that over the balance of the year. So you'd basically start with that. We have obviously some BSO actions that we could take if we needed to kind of release some RWAs and also create some additional capacity. And then I think on the capital line, we think our dividend is secure, but we've curtailed buybacks for the rest of the year. So if you put that all together, I'd say we're very confident in our outlook that if the situation worsens, we have a very strong capital position and levers to pull and ability to continue to post good CET1 ratios.

Yes. And just to add to that. I mean, I think, Bruce mentioned stability in PPNR, that's one of the first lines of defense and our diversified -- increasingly diversified business model across NII and across fees is really helping on that front. Our transformation programs are helping on that front. I would also mention that -- I think you mentioned securities, just based upon where rates are, we exclude -- given we've excluded AOCI from our capital ratios, but if you were to take a look at that, that's in -- it's almost $1 billion of marks that are unrealized. And so that's part of the balance sheet strength that you would want to look at in the event that you're trying to figure out that part of the story as well. I mean all in, RWA is expected to rise during the year. And if our scenarios hold, we expect that our CET1 ratios are going to be stable to rising throughout the year. So you put all that together, and I think that's hopefully responsive to your -- to triangulate what you're trying to get to in terms of where dollars of capital strength will be.

We will next go to the line of Gerard Cassidy with RBC.

I know -- first, the transparency of your slide deck is one of the best, so thank you for doing that. It's very helpful for all of us. And on Slide 5, where you give us some good detail on the forbearance. And I know this is going to be a difficult question to answer, but 2 parts. What percentage of your portfolio do you think will actually ask for forbearance, both the commercial and the retail? And then second, how are you guys going to monitor loans that go into forbearance and actually are going to be charge-offs or they're going to be nonaccruals, but initially, they're going into forbearance because everybody is, I think, permitted to do that? Can you share with us some of the guardrails that you might have to develop to make sure that you're not -- again, not doing it on purpose, but there's an extend and pretend limitation here?

So Gerard, it's Don. On the commercial side, we've actually done an extremely detailed liquidity cash burn analysis across the portfolio and bucketed our clients into 3 buckets. One, a bucket that we need for some kind of restructuring and call -- we don't really call it forbearance in the commercial bank, but some kind of payment relief or restructuring in payments. And that's a very small portion of the portfolio, like, less than 5%. Then there's another, maybe, call it, 20%, 25% where we think 2 or 3 quarters out, they're going to need some covenant restructuring and maybe some relief from covenants depending how the recovery materializes. And then the vast majority of the portfolio, we think, looks just fine from a cash-on-cash standpoint. So we're really looking at everything cash-on-cash at this point, and it will be developing. But we're very comfortable that it's a relatively limited number of people in our portfolio that are going to need really payment relief.

Go ahead, Brendan.

Yes, on the consumer side, we've got about 4% of our portfolios in forbearance status at the moment. The majority of those are 3-month forbearance programs. What's interesting is we're seeing a meaningful amount of our forbearance customers that are actually cash flowing and still making their payments. And so we believe a large percentage of our customer base is doing this as a safety net and not yet under duress yet. So we're working hard on analytics to subsegment our forbearance portfolio to identify further treatments. As they come off the 90 days, if there are some that have significant stress and can't make their payment, we've got another lever for another 90 days prior to having them roll through charge-off. And for those that waded through the quarter successfully, they'll come back into full principal and interest payments. So we've got a variety of collection tactics and support tactics for our customers to help them make the right choices, a variety of other levers in our collection shop should alternative programs make more sense than a full forbearance as well. So we'll see how the next few months goes.

That will come from the line of Ken Usdin with Jefferies.

I just wanted to ask a little bit about -- on the line draws, you guys mentioned in one of the earlier slides, obviously, how they had slowed through April, and that the usage has been in the industries most affected. I wanted to ask about -- you mentioned that about 60% of the draws are converted to deposits. And what do we take away from that? Meaning, is it that the other 40% might be being used? Or is it that those just aren't current customers? And do you expect -- how do you expect -- any sense that whether -- if the line draws are less at this point that you're going to start to see some of these just get paid down if, in fact, we do get the V shape and how quickly?

Yes. I would actually say we are seeing some pay downs already. I think early days, say, the first 2 weeks of the pandemic, we saw a lot of preemptive draws in size, particularly in the kind of BBB segment, which is where they were concentrated. So the bigger companies felt very liquid and strong balance sheets. The weaker companies, frankly, don't have a lot of capacity to draw, so they're really concentrated in the crossover sector. Some of those are starting to come back. And what we've seen over the last, actually, 2 weeks, is more deposit inflow kind of in scale than we've seen line draw. So I think there's a lot of just very defensive behavior early on as companies got their heads around, one, whether their banks were going to be there, and I think a lot of them was testing banks, and those are beginning to come back. And then just where was this thing going and let's garner as much liquidity. So the market seems to have calmed down significantly. People will draw and pay back, but we see it kind of regular way right now. And what we do expect is some of those deposits to be -- beginning to be used as companies go through periods of disruption. So we would expect a regular downdraft of the deposits that are sitting with us, and that's really why we did this cash burn analysis that I talked about on Gerard's question. We can really see it client-by-client and track it to make sure our analytics are right.

I think the important thing, Don, too, is that we did see nice deposit growth away from just the companies who were drawing lines. Ken, I think, there's a good confidence that our LDR is going to continue to stay well behaved, particularly with all the liquidity that's in the system.

Yes. Excellent. And then Bruce, just a follow-up. On the prior slide, you talked about assessing new opportunities arising from the current environment. I'm just wondering, is that a -- is that any change in what you had already been contemplating in terms of continuing to add to the franchise? And what types of things do you think might appear for you strategically in that regard?

Yes. So we had done last year, when we rolled out TOP 6, a fair amount of work on our strategic thinking, where some opportunities where we have strengths that we have a right to win, that we can leverage those strengths to find new revenue streams, the way we did with education refinance or we did with our merchant partnerships. And so growing Citizens Access to digital bank, taking it to the next level was one. Better serving small businesses, SMEs was another. And then going -- taking our merchant business in some new directions. I think all those things still make a lot of sense, and we're continuing to keep up our investments there. But we're also looking at how has the world changed and are there additional offerings. Certainly, the world is becoming more digital as people have to stay home, and we see tremendous upsurge in folks using the online and mobile platform. And so what does that mean for the future? Does it mean that, for example, the wealth offering for Mass Affluent, that they might be more willing to deal with the virtual advisers is how business now are going to take off. So we're just looking at a whole bunch of brainstorming sessions to think through. The world is going to be different, how do we play, how do we make some additional investments and retweak our overall way of doing business and the strategy.

We'll go next to the line of John Pancari with Evercore ISI.

Just to confirm, so when it comes to your loan loss reserve level now post the build that you put through this quarter, so based on what you know now and your assumption for the direction of the -- of how this plays out, there's nothing you see that happened in April after you close the books that will point to the need for an additional loan loss reserve build in the second quarter for COVID?

I'll start off there. I mean, John, as I mentioned earlier, I mean, clearly, Moody's scenarios have worsened. I think we have to digest what we're hearing and seeing in those updates. As I mentioned, we have -- as one of our base scenarios, we have GDP falling 18% with a V-shaped recovery in 2H. The update from Moody's indicates GDP falling 30%, with nevertheless, still a recovery later on. We have an internal...

Just as it relates to John's specific question about closing your books, I mean, that scenario came out this week, and our books were closed.

Correct. Exactly.

So I think we had the best information at the time we did our close. And I think we've leaned on being at the conservative end in the assumptions that we took. But as we go through the month of April, it may be that people think this will be a bit deeper and it may last a little longer, and we'd have to come back and reassess that.

Okay. All right. Yes, I just wanted to put that in context to what you were assuming in terms of the shape of the recovery and what was dialed in. Okay. And then separately, in terms of -- on Slide 16, your stressed analysis that you ran, resulting in the 4.1%. What was the stressed CET1 output from when you ran that?

Yes. The stressed CET1 would be in the neighborhood -- in a severely adverse scenario, and I guess I'd say it this way, in terms of what we submitted for 2020, in a severely adverse scenario, using our estimates of losses, which we believe are quite prudent and predictive, we would be in the neighborhood of 8% of CET1.

Okay. Got it. All right. And then one...

It's probably a little better.

Probably a little better. I mean look at -- I mean that's probably maybe a moment -- a temporary low point, but you'd be in the -- something in the 8% to 8.5% range if you go quarter-by-quarter. We did a 9-quarter outlook of somewhere ranging between 8% and 8.5%.

Got it. Okay. And did you disclose the amount of loan loss reserve against that $15 billion of higher risk sectors that you flagged?

No, we did not.

We have one last question queued from the line of Saul Martinez with UBS.

So I wanted to follow up on, I think, it was Ken's question, just -- it's a bigger -- just more bigger picture question. Obviously, we're all kind of focused on what's directly in front of us right now. But during times like these that you often will see more meaningful structural change, more meaningful inflections in the competitive backdrop, consumer behavior. I'm wondering if you have any perspective on that. Have you had time to take a step back and kind of think about where the puck could be going and how the situation will influence that? And in addition to that, how you think about your own strategy in that environment? For example, does it make Citizens -- the importance of investing and being successful with the Citizens Access strategy that much more important as a client acquisition tool? So just more of a broader question on the industry. And how you think about -- how you'd sort of recalibrate or you might recalibrate your strategic initiatives on the back of that.

I'll ask Brendan to kick off on that one.

Yes. I mean, on the consumer side, the most obvious trend is an acceleration of one that was already happening, which is the drive to digitization. And so I look at all the things that we have in play, some of which we've got a jump on our peers, like you pointed out, Citizens Access on a national banking, digital franchise like Merchant Finance. Like the future of our brick-and-mortar distribution network, how do we reposition it for consumers that have got used to coming in less frequently, but still being able to manage their money effectively and get advice. And Bruce pointed out, virtual wealth advisers. We've got a lot of these things in motion. We've got a significant investment in our mobile and online banking platform that should start to go live in beta form in Q2. I view it as an acceleration of a lot of those things. So we're spending some time to figure out how do we get out on our front foot even more. How do we capitalize on consumer trends that are changing very rapidly, situationally, and we think they could be very sustaining. And I think the level of confidence I have is high because we're in a position of strength to have all of these things already in motion with teams making progress and taking share in the market. So we're trying to figure out which ones of those to pick and choose to really put some significant acceleration, and that's how I sort of see it on the consumer side.

Great. Thanks, Brendan.

Just one quick follow-up on CECL then. If we do see a longer recovery and not a V-shaped recovery, and you did give some helpful reference points on your allowance by product type. And it seems this quarter, the reserve build was really spread out across consumer and commercial. But what segments would you think are most vulnerable to reserve true-ups? And -- because I do think your loan book is a little different from a lot of other peers, you do have a lot of loan types with longer weighted average remaining maturities, which for any given loss content will have a higher reserve. So I'm just curious like how we should think about sort of the evolution of those reserve rates if you were to have to build greater reserves?

Yes. So on 26 of the materials, I mean, we gave some -- a breakout of what the -- what drove the 173 basis points that we had called out. I mean I think, what drove CECL in the first place being very punitive standard in terms of -- versus incurred loss is, as you mentioned, those categories that have a lot of -- or have some longer maturities associated with them. So as you look at InSchool as a place that would be a driver, other areas where there's higher loss content, but there's also higher returns, such as car and unsecured, that's an area to keep an eye on. And so those are the 2 that jump out to me on Page 26. On the commercial front, some of the areas inside commercial maybe show up with a little bit less loss content, but those are the top 2 that I see on Page 26.

Why is InSchool so much higher than refi? I don't know, maybe it's an obvious answer...

Yes. I mean when you think about that -- what we mentioned a little earlier, is that -- and maybe Brendan can comment on this, but these are really high FICO, basically great credit risk, great relationship opportunity, people that's been in the workforce for, on average, 6 years. I think the average comp is a 6-figure comp type of borrower. It's pretty high quality versus being InSchool with deferring...

Yes. Well, and you've got usually have a parent guarantee on that, but the thing that really kills you in the CECL calculation is the maturity. I mean there are 10-, 12-, 15-year loans in many cases. So that's why that number is high. We don't necessarily think we'll have any immediacy to charge-offs on those portfolios, but that's where CECL doesn't always give you the answer you would expect. And in fact, delinquency on those portfolios hasn't moved much at all yet. And so we're early innings on watching those portfolios, but we're liking what we're seeing so far, it's early duration. Remember, InSchool also has a 4-year deferment period, where -- before they graduate, that extends the duration there, too. That's really what's driving the CECL difference on that.

Okay. I got to close it up. So anyway, thanks, everyone, for dialing in today. We certainly appreciate your interest and support. Have a good day, and please stay well.

And ladies and gentlemen, that will conclude your conference call for today. Thank you for your participation. You may now disconnect.