FB Financial Corp (FBK) 2020 Q2 法說會逐字稿

Good morning, everyone, and welcome to FB Financial Corporation's Second Quarter 2020 Earnings Conference Call. Hosting the call today from FB Financial is Chris Holmes, President and Chief Executive Officer. He is joined by Michael Mettee, Interim Chief Financial Officer; Greg Bowers, Chief Credit Officer; and Wib Evans, President of FB Ventures, who will be available during the question-and-answer session.

Please note, FB Financial's earnings release, supplemental financial information and this morning's presentation are available on the Investor Relations page of the company's website at www.firstbankonline.com and on the Securities and Exchange Commission's website at www.sec.gov.

Today's call is being recorded and will be available for replay on FB Financial's website approximately an hour after the conclusion of the call. (Operator Instructions)

The presentation. With that, I would like to turn the conference call over to Robert Hoehn, Director of Corporate Finance.

Thanks, Jamie. During this presentation, FB Financial may make comments, which constitute forward-looking statements under the federal securities laws. All forward-looking statements are subject to risks and uncertainties and other facts that may cause actual results and performance or achievements of FB Financial to differ materially from any results expressed or implied by such forward-looking statements. Many of such factors are beyond FB Financial's ability to control or predict, and listeners are cautioned not to put undue reliance on such forward-looking statements.

A more detailed description of these and other risks is contained in FB Financial's periodic and current reports filed with the SEC, including FB Financial's most recent Form 10-K. Except as required by law, FB Financial disclaims any obligation to update or revise any forward-looking statements contained in this presentation, whether as a result of new information, future events or otherwise.

In addition, these remarks may include certain non-GAAP financial measures as defined by SEC Regulation G. A presentation of the most directly comparable GAAP financial measures and a reconciliation of the GAAP -- non-GAAP measures to comparable GAAP measures is available in FB Financial's earnings release, supplemental financial information in this morning's presentation, which are available on the Investor Relations page of the company's website at www.firstbankonline.com and on the SEC's website at www.sec.gov.

I would now like to turn the presentation over to Chris Holmes, FB Financial's President and CEO.

Thank you, Robert, and good morning. Thank you all for joining us this morning, and we do appreciate your interest in FB Financial.

On last quarter's call, I highlighted the company's priorities and how they have changed in the face of these uncertain times. Those priorities were and still are: first, the health and safety of our associates and customers; second, liquidity; third, our capital; fourth, profitability; and then fifth, growth. I'll touch on each of these priorities in some more depth, but I want to start by saying how proud I am of our team for the level of execution that we achieved on those goals this quarter. A number of our associates listen to this call, and I want to congratulate them on a job that's been remarkably well done.

Our financial performance this quarter was outstanding, including record revenue and pretax pre-provision earnings. We produced an incredible 3.29% adjusted pretax pre-provision return on average assets for the quarter. Our profitability was largely driven by our mortgage team, producing a record $33.6 million pretax contribution. After a $26 million provision that moved our allowance for credit losses to 2.51% of loans held for investment, that's excluding our PPP loans, we had an actual ROAA of 1.30%. The company's earnings power had allowed us to reinforce our balance sheet with fantastic liquidity, a conservative allowance for credit losses and an additional $23 million in tangible book value, all while operating in the middle of the pandemic.

This demonstrates our business model's complementary Bank and Mortgage segments. We frequently described the company as a great community bank with a great mortgage division and this quarter exemplifies that description. I'll dive deeper now under our priorities. Our focus remains the health and safety of our associates and customers. I believe we've entered a new normal for the foreseeable future. Approximately 700 of our associates continue to work remotely, and we have continued to see strong productivity under this environment. While our drive-throughs and our branches never closed, in March and April, we have suspended lobby access for all of our branches in line with guidance from our state and local governments.

As stay-at-home orders began expiring in late April and early May, we moved to reopen our lobbies. We reopened our first branch lobby on May 7 with sneeze guards, hand sanitizer, mask and social-distancing markers in place. By the end of June, almost all of our branch lobbies have been reopened. As case counts have risen and many of our customers have shown a preference in recent weeks for drive-throughs, we have moved to make lobby access appointment-only in some select branches. We continue to monitor case counts, and we'll continue to take necessary safety precautions.

As discussed on our last call, we've been very proactive in reaching out to our customers, and we provided first deferrals to everyone that requested one. This outreach resulted in $918 million in loans being granted at first deferral. Roughly 60% of our initially deferred loans are still in their first deferral period, which makes it a little difficult to get clarity on how those credits ultimately will turn out. Of those loans that have hit the end of their first deferral, roughly $138 million or about 38% of the balances that have requested -- or roughly 38% of balances have requested and received a second deferral. The 38% of balances that have received second deferrals make up about 10% of the notes that have come out, out of deferral.

We've been in constant communication with our customers as our relationship managers check in and gather information. Anecdotally, we're hearing positive news from the field on our population of deferred loans. We provided a new slide in the Investor Day that gives some feedback that we're receiving from our regional presidents. The summary is that after a trough in April and May, many of our markets have been bouncing back reasonably well. A caution, we continue to monitor market activity in our customer base as the case counts have begun to rise in some parts of our footprint.

Moving on to liquidity. We're thrilled with our $581 million of customer deposit growth. It's a little difficult to tell at this point how much of that will be sticky. The fact of the matter is that we're a trusted partner to our clients, but we don't grow $581 million in deposits in one quarter without some help from broader market conditions. We're going to do our best to hold on to as much of those deposits as we can, but it's difficult to predict at this point how much of that will stay with us past a couple of quarters. We believe we're well positioned to take on Franklin Synergy's balance sheet, which has historically been more reliant on noncore funding, and are communicating with Franklin over the past 6 months. We've identified approximately $415 million in FHLB brokered and other non-core deposit relationships with a cost of around 1.65% that we could exit by year-end. We'll balance that elimination, that core funding, with our current priority of on-balance sheet liquidity, but we believe that we have the opportunity to pay off some wholesale funding more quickly than we had anticipated.

On our third priority, capital preservation, we increased our total risk-based capital ratio to 13.2% this quarter, up from 12.5% in the first quarter, through strong provisioning and profitability. We believe that we have plenty of capital to manage through the downturn. We also maintain maximum flexibility as we currently have only common equity and trust preferred in our regulatory capital stack, and we have an investment-grade rating from Kroll, should we choose to access the debt capital markets for some additional cap or cushion. We believe that our strong profitability and existing capital levels continue to support our dividend.

Moving on to credit. So far, we've not seen significant signs of deterioration in our portfolio. Given the economic environment, we expect some uptick in substandard loans over the coming quarters. And ultimately, we expect some increase in our net charge-off to follow. We still feel very good about our underwriting standards in our portfolio. And we continue to closely monitor our asset quality. Our message to our relationship managers has been that this is not the time to sit over a problem. If you have a loan that needs some attention, then we won't know about any potential issues sooner versus later. And I'm sure we'll face some challenges over the next 6 to 8 quarters, but we won't suffer from a lack of focus.

On profitability, as I mentioned earlier, our pretax pre-provision earnings were $57.8 million or 3.29% as a percentage of average assets, which is a record quarter for us. As expected, the margin has got -- is facing some headwinds of the lower interest rate environment. Our headline margin -- net interest margin number would normally not be one that's acceptable to us. However, this has been partially the result of our on-balance sheet positioning. We've pruned some credits and had prudent loan growth over the past couple of quarters, while at the same time building our liquidity. We'll continue to keep an eye on how this recent influx of deposits behaves and how quickly PPP loans are forgiven. In essence of record synergy, which will have, let's say, a 10 to 15 basis point impact on our core margin, the second and third quarters should be a trough for us. I expect our margin again to bounce back in the second half of the year.

However, the same rate environment that's created the headwinds for our Banking segment allowed our mortgage area to deliver $33.6 million in direct contribution. This was a herculean effort from our team as they capitalize on strong volumes and above-average margins, while benefiting from the record low but steady interest rate environment from March through the end of the second quarter. We expect our mortgage team to capitalize on this environment for as long as it continues.

I have a few other updates before turning things over to Greg and Michael. We've consistently been updating our technology over the past couple of years and consumer online and mobile banking was the last remaining significant platform that was due for enhancements. When we converted Farmers National Bank last quarter, we placed their customers onto our new system, and we've had great feedback from those user experiences and from those capabilities. Later this week, we're converting the rest of our customer base onto that same platform, and we're excited to provide an improved experience for our customers.

On the Franklin Synergy merger, we anticipate closing in August and conversion before the end of the year. Dialogue between those 2 management teams has been consistent and positive since the announcement. We're hearing that their core credit portfolio continues to perform as expected, and they continue to make progress on moving out of that noncore portfolio as well. We are eager to be able to officially join forces with those associates and begin taking advantage of the combined strengths of the team.

With that, I'm going to let Greg go in to a bit more detail on the credit portfolio.

Thanks, Chris. I'll give my high-level thoughts on the portfolio, and then will be available on the question-and-answer section as well.

For a refresher, we are, at our core, a community bank that makes loans to support the economic activities of our markets. This strategy means dealing with and putting our faith in local people we trust and know to be good operators. Our strategy has always been to focus on end market lending while avoiding shared national credits and purchasing participations for the sake of growing loan balances. Our portfolio reflects that bias.

Since we last spoke, we had raised $315 million in PPP funding for customers that needed some help at the outset of this downturn. And you can see the industries where those PPP funds went on Page 11 of the presentation. We are also working through our deferral program. (inaudible) Chris, our relationship managers in the field are having positive conversations with our borrowers, but it's still too early in this process for us to really know what will happen with many of those credits. Of the roughly $920 million in loans that received a first deferral, we still have around $550 million that have not come out of that first forbearance period. At this point, $138 million have received approval for a second deferral. That number will increase as we continue to work through the remaining deferrals.

Feedback from clients that received initial deferrals is across the board. With our open door policy, many of our clients accepted the first deferral based more upon uncertainty rather than actual business level. As such, that group won't be needing or requesting second deferrals. For those that are seeking second deferrals, some clients still have limited revenues, such as restaurants and hotels. Others don't have an urgent need for a second deferral but still aren't back to 100%, and building some cushion right now is prudent.

In general, uncertainty reigns. But anecdotally, the reopenings have provided a level of relief that has generated a modest increase in confidence for our clients. With that, we continue to monitor those loans, and we feel positive about them, but we cannot tell you how many will deteriorate and how many will ultimately participate in a second deferral period at this point. We will look to continue to update our investors as we participate in investor conferences this quarter and on next quarter's earnings call.

On overall asset quality, we did experience an uptick in substandard loans from $74 million to $88 million from the first to second quarter. The majority of this increase was related to poor relationships, with approximately $13 million in aggregate outstanding balances as of June 30. Each of these loans have been marginal credits prior to the pandemic and have deteriorated with the economy. So this was not an unexpected increase.

Moving on, on Slide 12. We've laid out some of our industry -- specific industry exposures again. Before I give updates on those, each of those percentages use our total loans held for investment as our denominator. If we were to exclude PPP loans, then those would read retail, 8.3%; health care, 5.7%; hotel, 4.3%; other leisure, 2.5%; transportation, 2.2%; and restaurant, 1.4%. These percentages are generally in line with where they were last quarter.

Slide 13 reflects the largest segment within these industry groups, our retail portfolio. As reflected here, it is pretty much a portfolio split evenly between C&I, including owner-occupied real estate and our nonowner-occupied CRE properties. This is a segment that has received a lot of attention nationally as the retailers have been forced to deal with closures and landlords have been impacted by tenants not being able to make their payments. For us, so far, and we've reached out to our relationship managers on a property-by-property basis, our portfolio has fared okay. As we've discussed before, this portfolio is fairly well distributed across our footprint and across a wide variety of underlying sources of repayment. In other words, the retailers ultimately making the payments.

For our CRE property, this is a portfolio that looks like $2 million to $4 million local strip centers, not large power centers or malls. Our largest single loan is less than $8 million and is fully leased with a conservative loan-to-value and strong investor group. The C&I portfolio reflects the comments from our market leaders that you saw on one of the earlier slides. Overall, generally positive.

Slide 14 shows our health care book. As we've discussed in previous calls, this portfolio has an emphasis on the assisted living and skilled nursing side of the business. This too is a segment that has received a significant focus associated with the virus. But thankfully, reports from our clients have been satisfactory with no known outbreaks in their facilities. Physicians too have continued to manage through the process and incorporated new protocols within their practices.

On Slide 15, we continue to monitor our hotels. The portfolio as a whole has about a 57% loan-to-value. And heading into this, we felt good about the underwriting of our portfolio and still do today. Hotels have become a waiting game as we know that people will start traveling again, but we just don't know when yet. As a result, we are inclined to work with our clients in this space, and provide additional deferrals as requested or needed. Reports on occupancy coming back have been mixed across our footprint. For the week ending July 4, total Nashville MSA occupancy, not just our clients in the area, was at 38%. Our largest client has seen similar levels on their Nashville properties at around 32% versus 70% occupancy back in February.

However, we have a larger client who reports their property north of Atlanta being in the 80% range in June and July. So that's great to hear. As a reminder, we have not been responsible for all of the construction cranes building downtown Nashville hotels and only have one property there, which is to an operator we trust with a high-quality national flag. 2 of the 4 loans that I mentioned moving to substandard this quarter were hotels. Those are properties acquired in previous acquisitions, which did not benefit from our standard underwriting event toward higher equity, national flags and strong operators. Frankly, the properties weren't performing too well before the pandemic, it just exacerbated their issues. Our teams are addressing appropriate exit strategies at this time.

Lastly, also within this segment is an approximately $5 million property, which we've discussed previously in the Memphis market, and its exit is being addressed by our teams and has significant reserves. As we note, the summary on this page says it all, we continue to remain concerned about the space and our teams are monitoring it heavily.

Other leisure on Slide 16. As a portfolio that includes categories going into this that were highlighted as potential industries of concern, so far, we've seen satisfactory results here, too. And as noted here, some areas such as marinas, have actually seen a pick in business associated with consumers looking for safe recreational activities. Segments such as theaters have not been as fortunate. But as noted, we've been in close communication with that operator and guarantor group, and they've developed a plan and have the resources to carry on.

Moving on to Slide 17, transportation and warehousing. Similar story here. A segment for concern, but overall has performed okay. On the larger end of the business, it looks like the operators are reporting good results. On the smaller side, this seems to vary by company. We had one of these smaller operators with loans with us under $1.5 million filed bankruptcy this quarter and moved it into substandard. This is an industry that has more than its share of undercapitalized operators, and it's not unusual, frankly, with or without a pandemic, to see things like that pop up. We do like to point out that within this segment, we're glad to report that we have no exposure to commercial airlines or cruise lines.

Lastly, on Slide 18. We break out our restaurant exposure. We're hearing mixed results from these customers as the full-service operators are struggling more with the closures along with costs and issues associated with reopening at reduced capacities. But the quick service side seems to be surviving and, in some cases, doing better than prior years as they've adapted their drive through business. As we note here, one of our largest clients reports good results and has benefited from their model, which includes more of a fast casual and sports bar combination, as well as benefiting from being an overall lower-leverage operator. We do highlight here also a larger relationship that's not in the 1.4% of restaurant exposure that is not performing to par. And without further improvement, we could see a future downgrade on this one. Overall, the segment that we will continue to monitor closely.

I'll close by saying that for our entire portfolio, we're working with clients and frankly seeing positive direction with the reopenings in our markets. We're thankful for the diversification of our footprint across both metropolitan and community markets as well as diversification of the size of our transactions. However, it is still -- overall, like most banks in these times, we have some noise in our engines, isolate, not systemic and not any more or less than the rest of the industry at this point. But we're managing for a conservative position and hoping for the best. Our future results will ultimately be affected by the length and depth of the downturn. As governmental assistance programs run out or new ones are developed, our customers will be impacted.

With that, I'll turn things over to Michael to talk more about our profitability.

Thank you, Greg. I know that we've covered a lot so far. So I'll give some brief color on CECL, margin and mortgage, and then be happy to answer any questions after our prepared remarks.

First, on CECL. We used a blend of economic forecast that Moody's put out in late June. With our markets generally opened since early May, the pre-downturn strength of Tennessee as a whole and the pre-downturn strength of Nashville, which is one of the hottest job markets in the country pre-COVID, we did not feel that waiting 100% baseline made sense for us at this point. The resulting economic input to that wind are laid out on Slide 19. The largest drivers of the increase this quarter were the CRE index and the unemployment rate, which you can see both deteriorated from last quarter's forecast. These inputs and adjustments ultimately led to 2.51% allowance for credit loss, which we believe is hopefully higher than any losses that we'll see over the cycle, but we don't mind carrying that given the levels of uncertainty going forward.

Moving on to margin, which, as Chris mentioned, is facing some pressure due to both balance sheet mix as well as lower-yielding assets. On the balance sheet mix, we've been trying to nail down how much of the increase in deposits is related to PPP funding and other government stimulus programs to determine how much liquidity we can expect to retain. However, depositors' cash is fluid and comes from many sources. Deposit balances of customers who received PPP funds from our origination are up $250 million from March to June. If you dig deeper in cap increase by the amount of PPP funding that they received from us, that only accounts for $138 million of deposit growth. We'll continue to stay short and liquid with these funds from excess deposits in the near term as we determine how the recent influx will behave.

For some slight guidance on our yields and costs. Contractual yield on loans, excluding PPP loans, is 4.59% for the month of June as opposed to 4.75% for the quarter. Cost of non-time interest-bearing deposits in June was flat at 0.55% versus 0.56% for the quarter and cost of customer time deposits was 1.7% in June versus 1.78% for the quarter. We have cut rack rates on deposits about as much as we intend to cut them, so to execute on bringing down our liability costs, we'll need to continue to work some of our higher-priced money market accounts down. As a reminder, we have $560 million in CDs with a weighted average cost of 1.75% repricing in the second half of 2020. The weighted average rate for those products would roll into is currently 38 basis points. So we have real opportunity on the time deposit front as well.

Mortgage started as a strong counterbalance to the declining yields at the bank pace in the second quarter. The group benefited this quarter from strong origination volumes and capacity constraints in the industry that led to higher margin on loans in our pipeline and ultimately on our gain on sale margins late in the quarter. These capacity constraints have extended the amount of time it takes for mortgages held for sale to be originated and has contributed to higher than typical margins. You probably noticed that in our mortgage banking revenue components, fair value changes were $34.8 million for the quarter as opposed to $3.2 million in the first quarter, which is obviously significant. As you recall, mortgage revenue is recognized at the time of interest rate lock and subsequently, the interest rate-like pipeline has been hedged. The gain on sale line item is a bit of a lagging indicator and our current fair value is more indicative of where our gain on sale margins came in during the month of June and where we would expect gain on sale to be in the first half of Q3.

Timing also played the part in whether the gain on sale and fair value mark, and the large value percentage drop in the first quarter was indicative of market dislocation in the mortgage market. Ultimately, with the help of Fed intervention, mortgage secondary markets returned to pre-COVID levels and led to wide margins and robust demand.

We also have a continued focus on expense control. Our core banking expenses were slightly down from the first quarter. We completed the conversion of Farmers National Bank of Scottsville on May 17, and we have finalized our planned reductions in force for that acquisition and should be at a full run rate of expense savings in the third quarter.

With that, I will turn the call back over to Chris.

All right. Thanks, Michael, and thank you, Greg, for that color.

So we know that challenges are coming as we manage through economic uncertainty, the Franklin merger, and the continued impact of the pandemic. That being said, we executed well on our stated priorities and had a very strong performance this quarter. We're coming off the quarter with exceptionally strong earnings and moving forward with our reinforced balance sheet positions us for success. Our complementary business segments of the strong community bank and the strong mortgage segment also position us for success in the current low interest rate environment. Our credit portfolio is behaving normally today, and would break free headwinds in the coming quarters.

Moving forward, we position ourselves for a good combination with Franklin Synergy, and we're excited about the closing of the transaction. Pandemic notwithstanding, we're ready and excited for the balance of 2020. With that, I'd like to open it up for questions.

(Operator Instructions) Our first question today comes from Stephen Scouten from Piper Sandler.

So I wanted to get one point of clarification, if I could. On the loans that are in deferral currently, I think, if I heard you right, from the $918 million, counted like $550 million were still in deferral and then I think you said $138 million were -- requested a second deferral. So as ballpark, does that mean about $250 million have already fallen out of that $918 million in total initial deferrals? Is that close to correct there?

Yes, that's right. It's in the $240-ish million, $250 million, something like that. Yes.

Okay. Great. Great. And so -- I know you said a lot of your customers felt like they were doing this on a proactive basis and probably wouldn't need a second deferral. But what's your feeling, with the $250 million that came off, maybe do you have any indications on what type of industries? Is there any concentrations there that could glean any -- give us any color as to how the overall market is performing there?

Yes. I'd say it's across the board. There's no industry concentration. Some of it is actually consumer. And so you got a consumer piece of that, and there are not a lot of industry concentration. It'd be representative of the community bank that we are. Greg made reference to the fact we're a community bank and it kind of reflects to the community. I would say -- it's not exactly your question, but I think it may help a little bit. If you notice, 10% of the -- if you noticed, there was a bigger percentage of dollars, the number of loans, and so you do see some where -- hotel would probably be a good example -- where they're probably going to request a second deferral but they're going to have a higher balance. And so you're going to see some smaller ones particularly that just don't ask for a second deferral, keep going.

So we see some with more balance that ask but we have seen no concentration. We know we do have -- I would say this, too, as we look at larger balances, we know we do have some that are still out there. They were already talking to about a second deferral. Again, hotels would be a good example where we may have a $25 million or $30 million credit, really comfortable with the collateral, really comfortable with the owner and really comfortable with the investors. And as Greg -- again, as Greg said, it's just a matter of time, so...

And one thing also, Chris. We have seen some customers go from a deferral that's complete deferral, P&I payments to just interest-only now as well, so -- as they manage through this.

Yes. It's a good point.

Okay. That's very helpful. And it seems like you guys are pretty well ahead of the game from a reserve standpoint, at least to me here, and should be in the top kind of decile, quartile, maybe over your peers relative to reserves-to-loans. So can you talk a little bit more about the -- I know you laid out the CECL math in that one slide, but talk about the quantitative versus qualitative factors there? And then maybe also with that one larger credit that I think it was a $25 million relationship you mentioned, if that has specific reserves? And if so, if you have that number of specific reserves related to that credit?

Yes. So I will take the first part of that, and then I'm going to let Michael comment on CECL and see Greg will comment on the credit. And I would say this, Stephen. And look, CECL is still -- while we've been talking about it for a long time, we're 2 quarters in and I think we're all still learning some things about it. And one of the things that we've -- we have probably -- and this is my impression, and Michael may slap me on the hand here, but I do -- and you may remember this, I did start my career in public accounting with Ernst & Young. So I do actually have an understanding and appreciation for the theory behind some of these things. And so we sat pretty closely and hasn't made as many calls. And my perception is we haven't made as much in terms of qualitative adjustments as many of our peers. We look at the numbers and we look at what comes out on ours, and we stick pretty close to what it says even though -- I would tell you, we don't think we need all that, frankly. I mean -- but bankers are often the last to know. And so we don't actually think we need all that, but that's what the number is saying.

So we stick pretty close to the numbers because it's new. And I think there are a lot of folks out -- a lot of banks, and I'm not being critical here, that are making a lot of qualitative adjustments and probably more than we are, and I think that probably sticks us in the higher tier. So that's just some of mine now, but Michael, feel free to correct me if I'm...

Yes. I think that's well said. I can't slap your hand since we're socially distanced. But -- so, Stephen, from an overall CECL model perspective, Chris is right, we did take the model output, but we adjusted our assumptions. Last quarter, we're 100% baseline. Quite frankly, the economic forecast varied pretty widely this quarter. And from a [slight] Moody's perspective, deteriorated significantly, depending on which scenario you are looking at. So our forecasting committee looked at that, and we saw some green shoots in the economy. You install nonfirm payroll number, improved retail spending during the quarter was set at all-time record, I think, up 17% on 1 print. And so that had us change kind of our forecasted assumptions a bit to a more positive outlook than a baseline or a consensus.

That being said, as you can tell on the slide, the numbers were still worse. GDP was worse. Unemployment for 2020 and 2021 was higher. And as we mentioned, commercial real estate, which is a major driver in our model because of our construction and that nonowner-occupied exposure was worse, the price index. So that all spit out a higher number. And then qualitatively, we look at that -- we looked at a Tennessee-only run and said, "Hey, we feel like we're in a better spot." And we did make some adjustments down. But to Chris' point, it was not materially. I think we have some wiggle room there. We also got some really good feedback from our markets that said things are looking pretty decent. But we don't know.

Greg mentioned government stimulus, a second wave, other factors that kind of go into that. And so we're cautious, but we felt it's appropriate at this time. And like I said, we don't plan on actually realizing $115 million in losses.

Yes. We'd all be excited, sorry. Greg, you want to comment there?

I just -- Stephen, on the -- I think you had 2 other specific questions. That $25 million referenced on this slide, that is on our watch list at this point. And as far as the $5 million property, you're asking about reserves, that -- those reserves, not to be too specific about, are in that 30% range.

Okay. So no, with that watch list credit, no reserves against that yet today?

Just our standard volume.

Yes. Just what's picked out of the standard formula for all of the watch list.

Okay. Perfect. That's always helpful. Maybe if I could squeeze in one last one. I'm curious if you could comment on the Nashville residential real estate market. Obviously, based on your mortgage results, which obviously is not Nashville-only, but it seems like the environment is good, but with FSB's concentration there in construction, I'm just curious how that's holding up.

Yes, sure. I will -- Greg and I will both comment on that. Yes. So residential real estate has been, for me anyway, surprisingly strong nationally, given again the fact that we're in a pandemic, but -- and even stronger locally than nationally, if you take Nashville. Inventories are low, builders are humming and we see that reflected in our portfolio. So it's quite strong. Sales activity is strong. And so it continues to go, especially at certain price points. And I'd say the mid-level price points, it's really, really strong.

Yes, I agree. And I echo those pricing comment. They have continued to do well. And I think the interest rates helped on that. One thing you might be interested in, for our 1-2 family construction, our group that is focused in the Middle Tennessee area, led by Bill Waldkirch, who does a great job with his group, has approximately $225 million plus or minus in commitments, with around $120-plus-or-minus million in outstandings. You've got that -- and that's spread out Davidson, Williamson and Rutherford and some other county. Davidson's 27%, Williamson's 33%, Rutherford 17%. All of those markets are just doing great. When you look at that portfolio, specs are around 23%, presold, just 40% of the total. So it is -- it's just done very well to date.

That's great, guys. Congrats on a phenomenal quarter.

And our next question comes from Catherine Mealor from KBW.

Just a couple of maybe follow-ups, just I want to confirm a couple of things. So you mentioned in your slide deck that you expect for the PPP loan to have $5.5 million of fee income. So are you bringing these revenues through spread income or through fees?

They go through spread income.

Okay. Perfect. Perfect. So I'm not sure, I just wanted to confirm that. And then on -- if we look at your reserve build slide, you see a pretty big jump in your construction. I see the loan category goes from 3.8% to 6.4%. Is the jump there really more of a factor of the CRE price index declining, as you mentioned before? Or is there anything specifically in that portfolio that you're more worried about today?

Yes. Catherine, this is Mike. It's not credit specific, it's more of the price index and CRE outlook.

Yes. It's not credit specific at all. It's actually -- yes, it's totally driven by the outlook.

That's right.

Okay. Great. And then one NIM clarification. You mentioned that you expect Franklin to be 10 to 15 basis points impact on the core NIM. Is that, exclude -- you also talked about the FHLB brokered and noncore funding coming off by year-end. Is that inclusive or exclusive of what you can do with the funding once the deal is closed?

Yes. That's exclusive of that. We've been expecting about a 10 to 15 basis point impact on our margin. And as we're working through here, we're looking at things that we can do to lessen that impact, and this excess liquidity helps.

Okay. Great. And then I know I'm 4 questions. But my first 2, I mean, are your little (inaudible). But one more and I'll be done.

We don't have a limit. I guess we would have to call it at some point, but with Kevin, we usually go about it.

So my last one is just on Franklin. If you could just provide an update on how you're thinking about the loan mark and your ability to exit some of their noncore loans as with the original plan with that deal?

Yes. So loan mark, if we think about -- we sort of -- we thought about it in 2 segments: core portfolio, which is -- core portfolio is performing as expected. It's very similar to our portfolio, perhaps a little more real estate-weighted, but in terms of underwriting, it's similar to our portfolio. And so we'd say it's behaving not unlike ours and not unlike what you expect in this market. So some unknowns there, but we're -- we'd say it wouldn't be much different than the outlook for our own portfolio. And the outlook has changed because the world is different, but not materially there.

On the institutional portfolio, which was when we announced the transaction back in January, it was about $430 million. That portfolio has been a little more volatile as we continue to monitor the valuations on that. And it probably had dipped more earlier. We've seen some of that. So the values on some of that come back. And so it's -- I'd say I don't know what the mark -- the mark would be bigger right today than what it was in January, but it's also a smaller portfolio. And so as we have sort of written the waves up and down on that over the last 3 or 4 months, it's probably substantially higher than where it was in terms of valuation less mark. And when I said we're optimistic, as I mentioned, they continue to work that portfolio, and so there were a couple of loans in there that they had identified that were taking some write-down on. They've already done that. And -- but most of what they're getting out of today, they're getting out of at par, and so we continue there to be optimistic. And I can't give you too much more color on that because we're not sure where it'll be when the transaction closes. Greg?

Tell you what, one thing that we could add, I don't have any specifics, but in my conversations with them, as you mentioned, they have a significant real estate portfolio and they've shared in the robust Middle Tennessee results and sales activity with their builders. I think on the PPP -- on the deferral program, they've had similar numbers as to ours as far as how that has worked through. So I echo your comments.

Yes. They're -- they continue to really work that down. They had that strategy in place to work that down, just we'll work it down more quickly together then they would have been able to work down on their own. Their Chief Credit Officer, Eddie Maynard, and Dave McDaniel are doing a really good job of just working and continuing to work that. So it will be even less when we close the transaction than it is today because they constantly get things that work in there.

Our next question comes from Brock Vandervliet from UBS.

You gave some color in your opening remarks, and I can see the slide on the mortgage results. Just trying to get my head around what happened this quarter with the gain on sale and, as important, what you're thinking kind of going forward, whether it be seasonality and kind of what we should look for in terms of the profitability of the mortgage area in the future?

Yes. Michael has a very deep knowledge in the mortgage part of our business. I'm going to let him comment on that, Brock. I will just reiterate, great quarter, strong -- as you said, strong gain on sale, strong margins, strong production, and so we kind of hit on all cylinders. You want to specifically answer those, Mike?

Yes. Brock, I think part of the variability and one reason we added the fair value basis, it's to kind of demonstrate that. If you remember at the end of the first quarter, we were a little uncertain as to what the world looked like, so we had to reserve. We adjusted some pull-through assumptions. And so that creates some variability between the 2 quarters. But overall, that 3.80-ish number in our fair value market is more indicative of where we've been executing. Some margins are materially higher than where they were in the first quarter and, quite frankly, historically. Do we expect them to remain elevated? Yes. At the same level? Likely not. As capacity comes in, we'll certainly see margins lower, but we expect a strong third quarter. Is it going to be in the second quarter? I'm not going to say it. Our team can execute, but it's not likely September. It's a short business month, and it's just not likely. And Wib, I don't know if you have anything to add there?

I'll say that's grown enough. We haven't looked any commentary, but I'll say the seasonality factor does come in. Brock, you mentioned that it will come in September, which is usually a lower month for us. And so in the quarter, we had 3 really great months all stacked together. And September is a lower month, and so that will be one to impact seasonality. And in the fourth quarter, of course, seasonality will really come into play with...

Yes. There are several things at play. Obviously, a factor in it, capacity is certainly one of them. The industry is at capacity right now. And I guess when you start talking about these elevated margins, as Michael said, we've had an opportunity across the industry to elevate the margins. Is that sustainable? Likely not. But we don't see it changing much in Q3. But as we get into that seasonality part of Q4, which would be traditional, we expect to see some of that come down.

Okay. And I can tell from the disclosure of your channels, retail correspondent wholesale really haven't changed. Is there anything you're doing differently with respect to the products? Is this all vanilla-conforming? Or are you doing any non-QM?

Yes, Brock. So we are in the consumer direct. In retail space, we exited correspondent wholesale reverse early to middle of last year. So -- but we are 100% QM product. We don't operate in kind of that non-QM space, reducing some, generally, but primarily conforming. We aim to fill every loan we originate in the mortgage division. It's prime product.

(Operator Instructions) And our next question comes from Ammar Samma from Raymond James.

I think the kind of big topics have been hit. But just circling back to expenses, you've got the FNB Financial franchise coming on and then the cost savings coming out next quarter. You've got Franklin coming on as well. And so how should we think about kind of the core bank expense run rate maybe in the next couple of quarters and then when all the cost savings are out?

Yes. So the core bank run rate has been -- actually has been flat for the year. And we really like to keep it in that flattish kind of way for the rest of the year. We do have -- we've completed the FNB Scottsville transaction, which is -- and converted it, so we have a little bit come out there. We'll also have a little bit of just natural increase, so I think of that as more flattish. And then, of course, when Franklin comes on, we'll have that increase in expenses. But as I think about just the legacy core bank, it should be flat.

Okay. I appreciate that. And then on margin, you gave the commentary on the 10 to 15 basis points from Franklin. Are you able to strip out your kind of core ex PPP margin right now, and then how we should think about that core moving forward?

Yes. I mean ex PPP, it's probably 5 to 7 bps higher and really carrying excess liquidity is another 10 or so, 10 to 15. So as we deploy some of that liquidity and kind of work through that, you'll see some stabilizing in NIM.

Okay. And then last one for me, bigger picture. Has the pandemic provided any opportunities to maybe rethink the business model? That could be from a branch perspective, a head count perspective, internal processes, et cetera.

Yes. I think the pandemic caused you to rethink everything. And so we -- our branches, we've got some -- if you look at bank branches today, I mean, you see -- I think you could park in front of some meaningful percentage of bank branches and watch it. And if you just put them under surveillance Monday through Friday for the 8 hours that they were open, you'd probably be amazed at the lack of traffic for some reasonable percentage of bank branches in the country today, which tell you that you don't need necessarily the transaction capability of those branches. And so we already were thinking -- had been thinking that way.

I think this makes it even -- that being said, we have some very, very busy branches that have been around for decades and decades and decades and get heavy lobby transaction -- heavy lobby and transaction traffic. And so we got them on both ends of that spectrum and everywhere in between. It does cause -- we have seen transaction activity drop, at least live across the counter transaction activity drop and not return at this point. And I think that probably doesn't ever return at the same level that it did because we've seen folks use remote channels even more than they were before. So yes, it caused you to rethink your branches, it causes you to rethink your nonbranch facilities as well because we've got 700 people working remote. And expenses are completely in check, maybe even going down a little bit. And so it causes you to think about what kind of other office space you need going forward and how you react to that.

And so it also caused you -- everybody is already thinking about their investment in technology, the technology that they deploy and how they make sure that their customers are able to completely transact business in an efficient way. So it does cause you to rethink all of that. It's not that we weren't thinking of that because we were, but it gives you some new perspective and it makes -- and it maybe moves your plans into a faster -- it probably speeds your adaptation of some things that you've been thinking of, so...

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

All right. Well, thank you again, everybody, for joining us today. We really appreciate your support. We're grateful for a great quarter, and we look forward to the next one. Everybody, have a great day. Thanks.

Ladies and gentlemen, with that, we'll conclude today's conference. We do thank you for attending. You may now disconnect your lines.