KeyCorp (KEY) 2020 Q3 法說會逐字稿

Good morning, and welcome to Keycorp's Third Quarter 2020 Earnings Conference Call. As a reminder, this conference is being recorded.

I'd now like to turn the conference over to the Chairman and CEO, Chris Gorman. Please go ahead.

Well, thank you, operator, and good morning, and welcome to Keycorp's Third Quarter 2020 Earnings Conference Call. Joining me for the call today are Don Kimble, our Chief Financial Officer; and Mark Midkiff, our Chief Risk Officer.

Slide 2 is our statement on forward-looking disclosure and non-GAAP financial measures. It covers our presentation materials and comments as well as the question-and-answer segment of our call.

I'm now turning to Slide 3. As you saw in our press release this morning, we reported third quarter earnings per common share of $0.41. Our EPS was more than double that which we reported in the prior quarter and up from the year ago period, which was impacted by notable items. Despite the challenging environment, we generated pre-provision net revenue of $1.9 billion and added $1 billion to our reserve for credit losses through the first 9 months of this year. Revenue in the third quarter was up 3% from the year ago period. Our net interest income continues to reflect the low rate environment, elevated liquidity and changes in balance sheet mix. Average loans reflect strong performance from consumer mortgage and Laurel Road, offset by pay downs of consumer line draws that were made earlier in the year.

Our consumer mortgage business generated funded volume of more than $2.3 billion this quarter, which was up more than 75% from the year ago period and 5% from last quarter. Over 1/2 of our originations were purchase mortgages. Our pipelines remain strong, and we expect to show sustainable growth in continued market share gains. Laurel Road continues to originate high-quality loans that provide us with an opportunity to build broader digital relationships with these targeted clients. In the third quarter, Laurel Road originated over $400 million. We believe that both Laurel Road and consumer mortgage will continue to be relationship-based growth engines for our consumer business. With our strong consumer platform, we have decided to discontinue originating indirect auto loans. The current portfolio of approximately $4.6 billion will run off over time.

Now let me turn to fee income. We had another good quarter. Noninterest income was up from the year ago period, reflecting stronger-than-expected performance. Investment banking and consumer mortgage had another solid quarter. Cards and payments and service charges on deposit accounts, both posted strong linked quarter increases. Don will discuss our revenue outlook in his remarks, we believe we are well positioned to continue to grow both our commercial and consumer businesses.

Our expenses this quarter reflect higher variable costs related to cards and payments activity and production-related incentives as well as elevated pandemic-related costs associated with keeping our teammates and our clients safe. Through our continuous improvement efforts, we are maintaining our focus on expenses, improving our efficiency while continuing to invest for growth, particularly our digital capabilities across the franchise. Credit quality remained solid this quarter as we have remained true to our moderate risk profile throughout the cycle.

Net charge-offs for the quarter were 49 basis points. In the deck, we have updated our disclosure on commercial portfolio focus areas. Don will cover these focus areas in his comments, but I will just say that these portfolios have generally performed consistent with or better than our expectations. The quality of our loan book is also reflected in the level of loan deferrals. Last quarter, our deferrals were the lowest in our peer group, based upon public disclosures.

As of September 30, loans subject to forbearance terms were less than 2% of total loans. That's down from 4.3% at June 30. This equates to less than 1% of clients in both our commercial and consumer businesses.

In the third quarter, our provision expense exceeded charge-offs by $32 million. Our allowance for credit losses as a percentage of period-end loans now stands at 1.88% or 2.04%, excluding PPP loans.

Finally, we have maintained our strong capital position while continuing to return capital to our shareholders. In the third quarter, our common equity Tier 1 ratio increased to 9.5%, which is at the upper end of our targeted range of 9% to 9.5%. In September, we paid a common stock dividend of $0.185 per share, the same amount we paid in the second quarter. I will close by restating that this was another good quarter for Key, which demonstrates our underlying strengths. It starts with our dedicated team and their unwavering commitment to first and foremost, our clients. Being very targeted about where we can compete and where we can win.

Next, costs, maintaining a strong focus on expenses while investing for the future, a big part of this investment going forward will continue to be digital. Credit, continuing our strong risk management practices. And lastly, capital, focusing both on the return on and the return of capital.

I am confident in our ability to manage through the current environment and over time, achieve our long-term financial targets and importantly, deliver value for all of our stakeholders.

Now let me turn the call over to Don to go through the results of the quarter. Don?

Thanks, Chris. I'm now on Slide 5. As Chris said, we reported third quarter net income from continuing operations of $0.41 per common share. Results also reflected momentum across our businesses, including growth in our balance sheet and fee income as well as continued strong risk discipline and capital management. I will cover many of the remaining items on this slide in the rest of my presentation.

So turning to Slide 6. Total average loans were $105 billion, up 14% from the third quarter of last year, driven by growth in both commercial and consumer loans. Commercial loans reflect an increase of over $8 billion from PPP loans. Consumer loans benefited from continued growth from Laurel Road. And as Chris mentioned, strong performance from our residential mortgage business. Laurel Road originated over $400 million of student consolidation loans this quarter, and we generated $2.3 billion of consumer mortgage loans. The investments we have made in these areas continue to drive results and importantly add high-quality loans to our portfolio. Linked quarter average loan balances were down 3%, reflecting pay downs from the heightened commercial line draws earlier this year. The pay downs on the lines were greater than expected, and now the utilization rate is below the start of the year. Importantly, we have remained disciplined with our credit underwriting and have walked away from business that does not meet our moderate risk profile. We remain committed to performing well through the business cycle, and we manage our credit quality with this longer-term perspective.

Continuing on to Slide 7. Average deposits totaled $135 billion for the third quarter of 2020, up $25 billion or 22% compared to the year ago period and up 5% from the prior quarter. The linked quarter increase reflects broad-based commercial loan growth -- commercial deposit growth as well as growth from consumer stimulus payments and lower consumer spending. This growth was offset by a decline in time deposits, primarily related to lower interest rates. Growth from the prior year was driven by both consumer and commercial clients. Total interest-bearing deposit costs came down 20 basis points from the prior quarter, reflecting the impact of lower interest rates and the associated lag in pricing. We would expect deposit costs to continue to decline about 6 to 9 basis points in the fourth quarter. We continue to have a strong, stable core deposit base with consumer deposits accounting for over 60% of our total deposit mix.

Turning to Slide 8. Taxable equivalent net interest income was $1 billion for the third quarter of 2020 compared to $980 million a year ago and $1.025 billion for the prior quarter. Our net interest margin was 2.62% for the third quarter of 2020 compared to 3% for the same period last year and 2.76% for the prior quarter. Both net interest income and net interest margin were meaningfully impacted by the significant growth in our balance sheet in the third quarter of 2020. The larger balance sheet benefited from -- benefited net interest income that reduced our net interest margin due to the significant increase in liquidity driven by strong deposit inflows. Compared to the prior quarter, net interest income decreased $19 million driven by lower commercial loan balances. The net interest margin was primarily impacted by continued elevated levels of liquidity. Elevated liquidity levels negatively impacted the margin by 13 basis points, with all other drivers netting to an additional 1 basis point of pressure on the margin. The lower-than-expected commercial loan balances contributed an additional 5 basis points of margin compression.

Recently, we have received several questions about the future impact of our interest rate swap maturities on our net interest margin. On Slide 20, in the appendix, we provide a schedule that details maturities of our swaps. Also, it is important to understand that this portfolio is only one of the fixed rate asset classes as all banks are impacted by maturities of fixed rate loans and investment securities. We also show on this slide that our level of these assets combined as a percentage of total earning assets is in line with peers.

Moving on to Slide 9. Our fee-based businesses had another strong quarter. Noninterest income was $681 million for the third quarter of 2020 compared to $650 million for the year ago period and $692 million in the second quarter. Compared to the year ago period, noninterest income increased $31 million. The primary driver was an increase of $35 million in consumer mortgage business as we continue to grow the business and see record levels of originations. Cards and payments income also increased $45 million related to the prepaid card activity from the state government support programs. Compared to the second quarter of 2020, noninterest income decreased by $11 million. The largest driver of the quarterly decrease was $22 million of lower operating lease income as we had gains on leveraged leases in the prior quarter which impacted the quarter-over-quarter comparison.

Consumer mortgage income was down $11 million, following a record quarter for related fees in the second quarter. These were primarily -- partially offset by an increase in cards and payments related income and higher service charges on deposit accounts. Though down quarter-over-quarter, investment banking and debt placement fees had another solid quarter given the volatile environment, coming in at $146 million for the quarter.

I'm now turning to Slide 10. Total noninterest expense for the quarter was $1.037 billion compared to $939 million last year and $1.013 billion in the prior quarter. The increase from the prior year is primarily related to $52 million of payments related cost reported in other expense as well as COVID-19-related expenses to ensure the health and safety of our teammates. Higher personnel costs from the year ago quarter reflects lower deferred loan origination costs, merit increases and higher employee benefit costs. Compared to the prior quarter, noninterest expense increased $24 million. The increase was largely due to higher payments related costs as well as personnel costs related to elevated employee benefits, primarily health care, which was up $15 million from last quarter.

Moving on to Slide 11. Overall credit quality remains solid. For the quarter, net charge-offs were $128 million or 49 basis points of average loans. Our provision for credit losses exceeded net charge-offs by $32 million or $0.03 per share. Nonperforming loans were $834 million this quarter or 81 basis points of period-end loans compared to $585 million or 63 basis points from the year ago quarter. Additionally, delinquencies actually improved quarter-over-quarter with a 6 basis point decrease in our 30- to 89-day past dues in the 90-day plus category also declining quarter-over-quarter. We've continued to monitor the level of assistance requests we receive from our customers. Over the past quarter, the number of requests for loan forbearances have decreased dramatically. As of September 30, loans subject to forbearance were less than 1% based on the number of accounts for both commercial and consumer loans and less than 2% when using outstanding balances.

Turning to Slide 12. As Chris mentioned, we updated our disclosure that highlights certain portfolios that are receiving greater focus in the environment. These areas represent a small percentage of our total loan balances. Each relationship in these focus areas continues to be subject to active reviews and enhanced monitoring. Importantly, as a group, they continue to perform consistent with our expectations.

Turning to Slide 13. We had shared a summary of our deferrals compared to peers at a recent investor conference. As shown here, our deferral level was peer-leading in the second quarter. As noted earlier, we have seen a dramatic reduction in the deferral levels during the third quarter.

Now on to Slide 14. We have continued to maintain a strong level of capital. We ended the third quarter with our common equity Tier 1 ratio of 9.5%, up 40 basis points from 9.1% in the second quarter. This places us at the upper end of our targeted range of 9% to 9.5%. We believe that this provides us with sufficient capacity to continue to support our customers and their borrowing needs and return capital to our shareholders. In the third quarter, we paid a common dividend of $0.185 per share, which was consistent with our second quarter level. Importantly, over the last 4 quarters, beginning with the fourth quarter 2019, we have earned $1.14 per share, well above our current dividend run rate of $0.74 per share.

On Slide 15, we have provided our outlook for the fourth quarter. We expect average loans to be down low single digits, reflecting lower period end balances coming into the fourth quarter. Consumer loans should continue to grow. We expect deposits to remain relatively stable. Core net interest income should increase low single digits with a relatively stable net interest margin, reflecting the expected benefit of the repayment of PPP loans. The benefit of repayment is estimated to be $20 million to $25 million. Noninterest income in the fourth quarter will remain relatively stable, reflecting an expected decline in consumer mortgage, offset by growth in investment banking and debt placement fees. Noninterest expense are expected to be down low single digits but are highly dependent on the level of variable cost, including production-related incentives. Net charge-offs are expected to be in the 55 to 65 basis point range next quarter. And finally, as shown on the bottom of the slide are our long-term targets. On a reported basis, we will not achieve all the targets this year as we emerge from the pandemic and the economy strengthens, we expect to be back on the path that would lead us to operate within all of our targeted ranges.

With that, I'll now turn the call back over to the operator for instructions on the Q&A portion of our call. John?

(Operator Instructions) And first from the line of Scott Siefers with Piper Sandler.

Don, maybe I wanted to ask first just on the decision to stop originating indirect auto. So the $4.6 billion that will run off, how long is it going to take for those to run off? I'm imagining 3 years or less. But I guess more importantly, do you guys feel like you can outrun that runoff and still generate net growth, for example, via mortgage and Laurel Road where you've got strong origination outlooks?

Sure, Scott. The average life of that portfolio is about 2.5 years. So it will take probably in total about 5 years before it fully runs off. So we will see declines each year in those balances. And Chris can highlight a little bit more as far as the rationale and thoughts as far as the exit of those originations and also why we're excited about the consumer loan origination capacity we can generate now. So...

Sure. So Scott, we've talked a lot about relationships. We've talked a lot about targeted scale. And frankly, the indirect book was -- from a quality perspective, it's just fine. From a return perspective, obviously, you can't generate the kind of relationship returns that we would expect because it's a single product.

Conversely, as you look at our consumer business, as you well know, 2 years ago, we really didn't have a mortgage business. This year, we'll originate more than $8 billion. 2 years ago, we didn't have a Laurel Road business. This year we'll generate more than $2 billion, and we have big plans, obviously, to continue to grow both of those. So the premise of your question, do we think we can outrun it in our consumer business? We do, and we think we can do it on a relationship basis and really use our capital to support our clients or for other things, whether it's stock buybacks or whatever that we think are better use of capital.

All right. Perfect. I appreciate that. And then separately, just sort of a top level question. Now that sort of coming out of the worst of the pandemic, a lot of banks are going to be kind of applying lessons learned from ability to operate without the same sort of infrastructure. Just curious how you guys are thinking about the branch footprint, if you might see any opportunities for something broader to do on the cost side here as we sort of stare down a challenging revenue environment for the next couple of years?

Sure, Scott. We think the pandemic certainly accelerated some trends that were already there. Just to give you some texture. When we bought First Niagara, we had 1,600 branches. Today, we have 1,077. We've invested heavily in digital. Our digital take up, more than 60% of our customers are now digitally active. And so we actually think there is a significant opportunity to take a look at the fleet. And we're in the final throes of planning that, and we'll have more to say on that in January. But in addition to some other things that are fundamental changes, we do think there'll be a change in kind of how we look at the density of our branches. And as you know, we're in some fast-growing areas where we have relatively thin branch footprints, and we think we can replicate that and get the mix right of digital and physical in other parts of our franchise.

Our next question is from Ken Zerbe with Morgan Stanley.

Great. Don, you mentioned that you expect the $20 million to $25 million of PPP accelerated amortization in fourth quarter. I think you're actually one of the only banks that I've heard of so far at least, that's building that in. I think most are looking at first quarter. Has the SBA actually opened up the portal or the forgiveness portal? And are they approving loans? Or is this sort of a question mark in terms of whether or not it actually goes into fourth quarter or not -- based on the SBA?

We were hearing earlier that several other banks were using the same type of assumptions, if not even more aggressive as far as their prepayment. But the SBA has opened. We've actually started to see some of the requests from customers go through and actually get funded here recently, too. So it still is more of a trickle, but we're starting to see volumes and activity levels pick up, and that's what gives us the basis for our outlook.

Okay. No, that's great. And then the other question I had, I guess, what are you guys planning to do with the excess liquidity on the balance sheet? Like how quickly can you deploy? Do you want to deploy it? Where is it going into?

Yes. We've been looking at all different kinds of uses of that and whether or not we can put it to better use than just sitting in cash. Our challenge right now is that we tend to keep a fairly conservative investment portfolio and really don't want to venture into credit risk in that area. And so the returns on similar type of agency securities that we would invest in are right around 100 basis points. And so we'll continue to assess that to see if we lean into that a little bit more. I would say that we, on a trial basis, started to do -- buy some longer-dated assets and put some forward starting swaps against that, that we'll convert that asset to a variable rate, say, 5 years down the road, which is better aligned with our overall strategy and risk profile. And so we'll consider doing things like that. But that near term, I think we will continue to see elevated levels of liquidity, including cash and treasury bills just because we feel that that's more prudent for us to do in this environment.

And next we'll go to Erika Najarian with Bank of America Merrill Lynch.

My first question is for you, Don. I think that investor conversations have turned from simply credit to thinking about banks on a normalized return basis. And so as I think about the progression of net interest income from that $1.06 billion. So if we exclude PPP, any PPP impact, I'm wondering if you could help us in terms of the walk to what the quarterly run rate could look like in 2021 ex PPP? Because obviously, the runoff of the indirect portfolio is new news versus your high cash levels that Ken just mentioned that you could possibly redeploy versus I think there's a $40 million swing in hedge income contribution from this quarter to perhaps fourth quarter of '21. So any help you can give in terms of how we think about where your net interest income could bottom. And of course, not assuming any loan growth or any changes in the rate environment.

Yes. We'll provide more specifics on 2021 in January. I would say that as far as some of the moving parts that you're right that our swap portfolio will continue to mature over time. I would say that as we highlight on Slide 20 that there a number of fixed rate type of asset classes, including the swaps, the loan portfolio and also the investment portfolio. And I would say that as we look at how we're positioned compared to others, we think that we're right in line with peers as far as that relative mix as far as fixed rate assets. As we look at going forward, we think that our margin will probably bottom out something fairly close to where we're at today with over time having a redeployment of some of that liquidity into other loan categories, whether it's consumer or at some point in time, seeing some commercial loan growth back up again. And so the pressure from these rates and the impact on the maturity and the rollover of those fixed rate asset classes would be offset by the utilization of some of those liquidity sources. And so that would include in that outlook, some reinvestment of -- or prepayment of those PPP loans.

Got it. And just a follow-up question, and maybe this one -- this is for Chris. Clearly, 2020 was an exceptional year. As we think about 2021 and you sort of teased out a potential announcement and how you're thinking about infrastructure and branches for January. You think -- as you weigh the revenue headwinds with efficiency opportunities, do you think KeyCorp can get back on positive operating leverage track next year?

I do. I do. And continuous improvement, Erika, is part of our culture. Each year, we've taken out sort of 3% to 5% and use that as raw material to invest. And we will continue to do that. I think there's some fundamental changes in the way banking is done. And I am confident in both the trajectory of our earnings streams and also our ability to manage our expenses. We do have kind of a unique situation this quarter in that half of the year-over-year increase is attributable to prepaid cards. I'm not saying that that's completely nonrecurring, but I will say that we've invested a bunch of time, energy, people and technology to tamp that down. So the answer to your question is yes.

And next, we go to the line of Matt O'Connor with Deutsche Bank.

I just want to follow up on the exit of the indirect auto. I mean it's not that big of a deal, but it's also a portfolio that you've been growing, I think, pretty nicely. Just in the past year here, I think, that was kind of one of the strategic additions you got from First Niagara. So I'm just wondering like has something changed in the marketplace in the last, I don't know, 3 or 6 months or maybe just elaborate on kind of the timing now, especially at a time when there's just not a lot of loan growth for the industry overall.

So Matt, the real timing as we've now successfully from a standing start built the Laurel Road platform and our mortgage platform. When we acquired First Niagara in 2016, we really didn't have an engine for consumer loans. And it was a good bridge. It being -- indirect auto was a good bridge. But we've always stayed pretty true to the notion that we're a relationship bank, and we're focused on targeted scale where we can be relevant. And as we look at that portfolio in conjunction with the returns, it just didn't achieve what we wanted it to do vis-à-vis investing our capital elsewhere.

Now in terms of anything changing in the market, this isn't what drove the decision. But as you know, the automobile market right now is very hot. Our analysts think sales at retail next year will be up like 9.5%. The value of used vehicles right now because of shutdowns due to COVID-19 are up 15% or 20%. That's not what drove the decision, but that is a fundamental macro driver that's out there.

And then I understand how mortgage is a relationship product. But just remind us on Laurel Road, how you've transformed that into more of a relationship product versus kind of a one-off?

Sure. So this is something that we're, frankly, very excited about. We're building a national digital bank, and it's going to be focused on health care professionals. And so we've already obviously built the loan consolidation business. That's all digital. Then in many cases, within 6 months something like 50% of those customers that refinance their doctor or dentist loans -- dental school loans, buy a home. We've now built a complete digital mortgage application. And where we can take it from there is, on a national basis, to be really focused, Matt, around doctors and dentists in terms of opening accounts, et cetera. And that will open up then the opportunity for us, in the case of dentists most because they're mostly independent business people as opposed to doctors who are part of large groups. That will give us an avenue to do a lot with them. So we see Laurel Road as a platform that we've grown a lot. It's been -- it's achieved everything we hoped it would, and we think there's a lot to do on top of it. And then one other area where we could potentially focus is expand beyond doctors and dentists but within health care. Health care, as you know, is -- 18% of the GDP going to '20, what -- kind of $4 trillion -- $6 trillion going to $8 trillion. So that's how we're thinking about it.

(Operator Instructions) And next, we'll go to Gerard Cassidy with RBC.

Can you kind of share with us -- I think you mentioned on the call that you're at the top end of your capital guidelines of 9.5%. We know the share repurchase programs have been temporarily suspended by the Federal Reserve, at least till the end of the year. Can you share with us your thinking of share repurchases for 2021 and where you'd like to bring that capital ratio down to? And because the change in the stress test, where the Fed does not approve any longer a bank's plan to buy back stock or pay a dividend as long as you surpass the required minimal capital ratio, you've got the latitude or the optionality to kind of do the buyback the way you see fit. So could you give us some thoughts on could you ever consider a Dutch auction if this suspension goes into the second half of next year in your capital ratios in the high 9s to do 1 big buyback at one time to bring down the capital ratio?

Gerard, this is Don. And as far as the share repurchases, we feel very good about where our capital position is today. I would say, to your point, that we would expect that the capital ratio is to continue to increase as long as we're not buying back shares. And so we highlighted that we are up 40 basis points. As far as the consideration for when we would be back in to buy shares that we'd want to have a little bit better clarity as far as the clear direction on the economy and where that's heading and making sure that we continue to have the capital to support our customers, support our organic growth and continue to support that -- the dividend. And so those will be priorities for us above just the share buyback.

One other potential consideration is that with the impact of the CECL accounting change and how it impacts our capital ratios. There's about a 30 basis point or so impact that we'll see over time there as well. But we do feel very good about where we're at from a capital perspective. We do believe that it will increase. And if available and things allow and permit, we could consider adjustments that would allow us to probably more proactively manage that overall share count with either a large share repurchase program or market purchases like we've done in the past.

Very good. And then circling back to credit. Obviously, Key in the past has had issues with credit during a recession. And I know it's been a goal of management to prove to investors that's not going to be the case in this cycle. If we exclude for a moment, the change in mix of your portfolio today versus what it was like in '07 and you take a look at, obviously, the government fiscal programs that have been implemented to help people through this downturn. What are you guys seeing today that really strikes you as different than what you've seen in the past on the behaviors of your borrowers?

Yes. Maybe I'll go ahead and start, Gerard, and Chris and Mark might have some thoughts to add to that. But I would say that the biggest difference that I would see, and this is just coming in midstream in this, but Key really has pivoted to a relationship strategy. And if you take a look at where the portfolio was before the last crisis, that it was more transaction-oriented as opposed to relationship. And so we had outsized exposure and some commercial real estate developers, and it was more on the project as opposed to an ongoing steady stream of cash flow for us. And so I'd say that the migration to that relationship strategy is having a huge payback for us.

On the consumer side, we're following similar trends. It's a very high quality, very consistent portfolio. And as we talked earlier, we really want to continue to have that more on a relationship type of approach as opposed to transactions. I don't know. Chris, what we add to that?

No. What I would add is it's been a 10-year journey. We after the financial crisis, we sat down and evaluated where were lost money, how we lost money? And it -- we basically -- it was principally in real estate. It was project-level real estate. It was where we didn't have a deep relationship. In some cases, that -- it was a business that was indirect business, third-party business. And we went about the business of derisking our portfolio. And we have been disciplined enough that we have foregone revenues such that we could position ourselves. So we have the capital and the ability to support our clients and targeted prospects in an environment like this. The other thing I would just remind everyone of is of the capital we raised for our customers, Gerard, only 18% of it goes on to our balance sheet. And so that, too, is something that I think is unique for us in that we can serve our clients without necessarily putting it on our balance sheet. But it's -- you're exactly right. It's been a long journey.

Our next question is from the line of Bill Carcache with Wolfe Research.

Thanks for the disclosures on Slide 20. I wanted to ask about the hedging program run off on the bottom right-hand side of the slide. Is the right way to read this chart that if we multiply the weighted average yield by the notional value of the on and off-balance sheet hedges, we get the quarterly contribution from the hedging program? And if so, it looks like the declining hedging benefit would translate into a $160 million headwind in '21 and $114 million headwind in '22. Is that the right thought process?

I would say that this assumes that we have no replacement of the swaps going forward. So this is just a runoff of the existing book. And so depending upon where the yield curve moves and how that would reposition, we could see some differences there. And then also would assume that we're taking no other actions on balance sheet to minimize or mitigate some of that impact.

Understood. And if I may, just as a follow-up. So beyond the hedging portfolio runoff, can you discuss a little bit, maybe just some color on the front book, back book dynamics if the low rate environment persists. Maybe just give us a sense of how much you're receiving and pay downs of back book loans and securities that would have to get redeployed? And what the yield differential is between new money rates now and what's coming off?

Sure, can. Generally, our loan portfolio has an average life of about 3 years. And so just to use that as a proxy for the kind of roll off that we would have on the portfolio and repricing. If you take a look at our C&I and most of our commercial portfolios, they tend to be LIBOR-based. I'd say that the spreads on new originations are fairly consistent overall with what the back book would have and not seeing a lot of change in that overall repricing for that portfolio. We have seen a little bit more acceptance of some floors that are being placed on the products. And so that will be helpful for us going forward. But that book as a general rule, doesn't have a lot of repricing or risk from that perspective. If you look at some of the fixed rate portfolios, residential mortgage, it's a fairly new portfolio for us. We are seeing growth there that I think that the current yield on that portfolio on balance sheet is around 3.50% or so as far as residential mortgage. Current production is closer to a 3% kind of overall yield for that portfolio. So a little bit below current average rates, but not significantly different.

As far as some of the other consumer categories, whether it's home equity or Laurel Road student loans or some of the other categories, we're looking at probably about 80 basis points or so gap between what the existing portfolio is compared to what the legacy book is on that side.

For the investment portfolio that for the core portfolio, excluding the treasury bills that we've been adding as far as some of the excess liquidity position, we're seeing a roll-off of those yields around the 2 40 and a replacement yield of around 1%. So about 140 basis points of shift there. Keep in mind, too, that, as we highlighted on the deposit side, we're expecting to see our average interest-bearing cost of deposits decrease by 6 to 9 basis points in the fourth quarter. And we should see some additional opportunities for benefit there going forward as well. And so probably at a slower pace, but still helping to offset or minimize some of the exposure there.

And next, we'll go to Kenneth Usdin with Jefferies.

Guys, I was wondering if you can dig in a little bit more on the outlook for loans. So obviously, not surprising to see the declines this quarter from the pay downs. And you mentioned that loans will continue to detract going forward a little bit. But what do you see in terms of just any change in improvement in activity on the manufacturing side, on inventory, et cetera, that we might look forward and start to see a point of stabilization, some others are even pointing to growth. So just your broader outlook on the potential inflection in loans.

Sure. Ken, it's Chris. So there's no question that as we look at our C&I book, the utilization is below where we would have thought it would be right now. It's frankly below the beginning of the COVID-19 crisis. I think there's a few things that can serve as a driver to loan growth on the C&I side. One is an inventory rebuild and as the economy ramps up -- I mean, state the obvious, as the economy ramps down, these companies throw off a lot of cash as it ramps up, they consume cash. I think that could give us an opportunity as well. The other thing that is going on, M&A discussions in the beginning of the second quarter were nonexistent. As we look at what the discussions we're having with our customers day in and day out. I think people are really starting -- you won't see it in the fourth quarter, but people are really starting to think strategically. Just this week, I met with 3 clients, and they're in areas that you would think they might still be hunkered down, and they are really starting to think strategically. So I think the levers on the C&I book will be transactional. But even before transactional, I'd like to see, obviously, some greater utilization. I think those are a couple of opportunities.

Okay. And then on the follow up to that, on the corporate activity side, just wondering if you could talk a little bit more about the pipeline for investment banking, and what the mix of investment banking has been in terms of like the public versus private and CRE markets. Like is any of that kind of back to a normal or still have good pipelines ahead? If you could fill that in, too.

Sure. So as we look forward, I would describe the pipelines as solid. The real variable was our M&A business, which is a strong business, which basically was nonexistent, as I mentioned, kind of in the second quarter. Our backlogs now, Ken, and M&A are equal to what they were going into the crisis. And obviously, a lot of deals went away. So I find that to be encouraging. As I look at our fees, this quarter, we were about at $146 million. We, I believe, will be up in the fourth quarter. I don't think it will be at the record kind of we've been -- we've had $200 million quarters before. I don't think we'll be at $200 million, but we'll certainly be somewhere between $146 million and $200 million. The pipelines are solid. The real estate commercial mortgage business is, obviously, in this rate environment continues to be pretty strong.

And next, we'll go to John Pancari with Evercore ISI.

I wanted to see if we can get some incremental color on risk migration this quarter or with the 24% increase in your criticized assets. I just wanted to see if you can give us a little bit of the granularity on what drove that migration and what asset types? And then also, is that increase in criticized reflected at this point in your existing loan loss reserve?

Sure. I'll go ahead and answer the last part of that question first, and then Mark can help provide some of the clarity as far as the migration. But as far as our loan loss reserves that we established at June 30 and now at September 30. Keep in mind under CECL that you're looking for the life of loan type of losses. And so embedded in there is the assumption that you're going to see migration into criticized and classified and increased losses throughout the next several quarters. And so those were all baked into both June 30 and September 30. If we look at where we're at today, whether it's criticized class side, charge-offs and nonperforming, we're actually better at September 30 than what our models would have assumed as of June 30 for this first quarter of that time period. And so we're actually seeing better credit quality migration than what have been expected and contemplated as part of our June 30 reserve. Mark, what about the areas of that migration?

Yes, I'd echo that, Don, better than what we would have forecasted on the migration. And then the drivers really are the same things you're seeing in the focus areas in the disclosure. So the consumer business is, so consumer discretionary, consumer services, the oil and gas business. Some transportation. So it's really those are the drivers that we see.

Okay. All right. And then another question just on credit. If you -- it sounds like you're confident in the adequacy of where the reserve stands now. So if charge-offs continue to rise as they did this quarter. For the fourth quarter and beyond, would you expect that you would underprovide for those charge-offs?

We've talked before about how the CECL works. And really, there's 3 drivers to it. One is what's the economic outlook. And so I would hesitate to try to speculate or guess as to what that will be as of December 31, given the environment that we're in and given how election is right around the corner as well, but that will clearly impact the overall reserve levels.

And if I look at between the second quarter and the third quarter assumption sets, what we saw as far as that economic outlook was probably a better near-term performance was actually realized in the September summary than what we would have assumed in the June summary. But longer term, the recovery rate was a little slower. So unemployment levels remained a little bit higher in our September 30, and GDP level and recovery was a little slower than what we would have assumed. And so generally maybe a little bit slight negative as far as the overall impact there.

And so first is economic outlook. Second would be migration of the portfolio that as we just talked about, that our loss models that are used for CECL will assume that the portfolio goes through a specific migration, based on the economic outlook. And so if you perform better or worse than that migration, you would see a need to either increase or decrease the reserves. And then the third would be is the new loan production. And as we highlighted last quarter on the call, normally for loan production, that would imply a provision expense of $80 million to $100 million a quarter versus the $160 million that we had this quarter. And so that's elevated compared to what we normally would have expected as far as just matching the loan production.

This quarter, what we did do was to actually supplement what our quantitative models would have produced. And so we added about $100 million between model overlays and also our qualitative assessment to the reserve -- to bump up the reserves, just to make sure that we weren't recognizing too quickly the benefit of that migration and given the economic uncertainty that we're still facing right now. And so we think that was a prudent thing for us to do. And we would have seen a lower level of provision if we had not had done that this quarter.

Our next question is from Mike Mayo with Wells Fargo Securities.

Just in simple terms, why did you guys build reserves this quarter when many of your peers didn't? And where do you think charge-offs, 49 basis points in the third quarter peak? And when do you think that happens?

Sure. As far as the built-in the reserve, I'd say it's fairly modest. And what we wanted to do was to make sure that we weren't taking credit too early as far as the better-than-expected migration and also uncertainty on the overall economic outlook. And so we felt that was appropriate to do. Last quarter, we were being challenged, whether or not our reserves were adequate. And we still are a little low compared to peers as far as the reserves. And so that also influenced the -- our assessment as to whether or not we wanted to show reserve declines this quarter. And so we decided to go ahead and layer in on top of that, some additional model overlays and also qualitative reserves. And so if you look at our total allowance for credit losses, Mike, it's at 1.88%. And if our average loan life is roughly 3 years, that would imply charge-offs of around 60 basis points for some time. And I would say that as we take a look at what our projections would have. We'd probably see some continued display increases through the middle of next year, and that would probably be the peak, and then start to trail off again.

So the peak would be like double or 70 or 80 or any -- I mean I know -- not many have given this, but some have.

I would say that it would be elevated a little bit from the 49 basis points, and we're talking about 55 to 65 next quarter. They go up a little bit from there, yes, but probably not a doubling from here.

Okay. And then the tougher question. So 2% of your loans are in forbearance. And you said that's down significantly. I guess that's 1.6% commercial, 2.3% consumer. If the music were to stop today because at some point, you'll stop with the forbearance, what would be the impact on charge-offs and revenues?

As far as it's charge-offs. I mean, one, we've already built in extra reserves for those loans that are in forbearance. And so I think that's an appropriate consideration there. Two, if we look at the forbearance, and especially on the commercial side, we're not just automatically granting forbearance. We've got to work with the customer and make sure that we understand that this truly is a bridge for them on an interim basis, and this isn't just a delay of the inevitable. And so we are taking a look at credit quality without the "benefit of that forbearance." I would say that on the consumer side, even though we have loans in forbearance, we're still very happy with the quality of that underlying customer base. But still have consumers that will eventually have the capacity to continue to repay the collateral values for those products, whether it's home equity or residential mortgage, are still quite strong. And so I wouldn't see that as a significant impact as far as either charge-offs or P&L for us as those would mature. Mark, I don't know if you have anything to say.

I'd say the same, and they do continue to come down. And we -- also, what rolls off of -- and exits, we're seeing really high current rates, sort of 96%, 97% or higher. So seeing good performance.

And if I can squeeze in one more. Chris, acquisitions, bank acquisition, the environment. I mean competitors are under pressure, the industry is a little under pressure. What's the appetite?

So as you know, we've been successful in acquiring niche businesses. And I think you can expect us to continue to look at those. I'm really proud of the fact that we've been able to acquire foreign digital companies and successfully integrate those, investment banking boutiques and integrate those. In terms of whole bank acquisitions, that's not really a focus of ours, Mike, we think we have everything we need to be successful. And we think the right strategy is to execute our strategy to create value for the shareholders.

Our final question will be from Steve Alexopoulos with JPMorgan.

This is Janet Lee on for Steve. Of the $23 million quarter-over-quarter increase in card and payment income this quarter, what percentage of that is from the prepaid card activity supporting state government programs that is going to start winding down in 2021? And also, can you comment on the level of organic spending and transaction volumes during the quarter excluding the prepaid card activity?

Sure can. As far as the percentage increase, I would say the majority of the increase in that cards and payments related revenues was related to the prepaid card activity. Keep in mind also that we saw a similar increase in the expenses linked quarter. And so the earnings risk for that is nominal as far as changes on that front.

As far as the activity for other card balances that I would say that in the third quarter, we're seeing levels that are fairly comparable to what we would have seen as far as spend on both the credit card and debit card and maybe transaction counts might be a little lower on debit card, but the average ticket size is a little higher. And so we're seeing -- getting closer to return to normal. I don't know, Chris, if you have any other thoughts there?

No. Obviously, the mix has changed a bit. There's -- people aren't traveling. People aren't going to restaurants. But in the third quarter, it actually the spend eclipsed that of the third quarter of last year.

All right. That's helpful. And my follow-up is on the deferral. On your $1.8 billion loans on deferral, how much of that -- how much of that is on loans and COVID-19-exposed categories? And which industry are you seeing the highest re-deferral rates?

Mark, do you have thoughts on that as far as -- I would say generally that we're seeing a higher percentage in those industries. But I don't know if there's any 1...

That one that kind of stands out. And the re-deferral rates are -- it's been in the kind of 15% range. So it's been very, very low.

And we will take another question from the line of Saul Martinez with UBS.

A couple of follow ups. First, here on the prepaid card income, you just mentioned that the majority of the increase or almost all of the increase came -- comes from that and payments. Is it fair to say that -- it seems like your guidance for fourth quarter still includes pretty elevated level of prepaid income and associated expenses. Is that correct? And can you just help us understand what kind of magnitude is sort of baked into the fourth quarter?

I would say, both the revenues and expenses remain elevated compared to normal levels, but down slightly from what we would have seen in the third quarter. And so there's a number of different things would drive both the revenue and expenses, and we're seeing some of the activity levels for those areas decline slightly in our outlook.

Got it. And secondly, I wanted to go back to the earlier question on hedges. I want to clear if you blessed Bill Carcache's math or not. But based on that, can you just help us understand what is the sort of NII protection that you're currently getting from your swamp of just doing the math on Slide 20. Seems like it's in the neighborhood of about, call it, $500 million -- or, say, $130 million a quarter with a weighted average maturity of 3.4 years. So I guess, it rolls off over 6, 7 years, which would imply sort of $82 million headwind annually from just -- and I know this is assuming no replacements and the other stuff you can do to offset it. But I mean is that math broadly correct that that's kind of the protection you're getting today and the runoff will provide something close to, say, $80 million, $90 million, $100 million headwind annually? Or is that completely off?

Well, keep in mind that as we look at our loan portfolio, 70% plus is variable. That's different than many of our peers. And so if you look at the swap book that we have, it really is to shift the actual net adjusted position to be more in line with peers as far as that overall fixed percentage. I would say, as far as the math, I think we're right around 27 basis points of our margin this quarter relates to the benefit from interest rate swaps. And so the math probably isn't too far off. I'd have to go back and recalculate all the numbers to make sure that we're in sync there. But that is if you just look at that 1 line item would be correct. But keep in mind that we were also seeing a corresponding reduction in our net interest income coming from those commercial loans that are LIBOR-based that we use these to hedge that impact. And so it's difficult to say, just looking at that 1 line item, what's the impact, but you have to look at the overall balance sheet and the moves on not only the asset side, but the liability side to see the true impact is going forward.

And with that, I'll turn the call over to the company for any closing comments.

Well, thank you, operator. Again, we thank all of you for participating in our call today. If you have any follow-up questions, you can direct them to our Investor Relations team, (216) 689-4221. This concludes our remarks. Thank you.

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect.