Flagstar Financial Inc (NYCB) 2020 Q2 法說會逐字稿

Good morning. This is Sal DiMartino, Director of Investor Relations, and thank you all for joining the management team of New York Community Bancorp for today's conference call.

Today's discussion of the company's second quarter 2020 performance will be led by President and Chief Executive Officer, Joseph Ficalora; and Chief Financial Officer, Thomas Cangemi; together with our Chief Operating Officer, Robert Wann; and Chief Accounting Officer, John Pinto.

Today's release includes a reconciliation of certain GAAP and non-GAAP financial measures that may be discussed during this conference call. These non-GAAP financial measures should be viewed in addition to and not as a substitute for results prepared in accordance with GAAP.

Also, certain comments made on today's conference call will contain forward-looking statements that are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to risk, uncertainties and assumptions that could cause actual results to differ materially from expectations. We undertake no obligation to and would not expect to update any such forward-looking statements after today's call. You will find more information about the risk factors that may impact the company's forward-looking statements and financial performance in today's earnings release and in our SEC filings, including our 2019 annual report on Form 10-K and our first quarter 2020 quarterly report on Form 10-Q.

Now to start the discussion, I would like to turn the call over to Mr. Ficalora, who will provide an overview of the company's second quarter performance before opening up the line for Q&A. Mr. Ficalora, please go ahead.

Thank you, Sal. Good morning to everyone on the phone and on the webcast, and thank you for joining us today. I hope that everyone is doing well, and hopefully, some sense of normalcy is returning to your daily lives.

Earlier this morning, we reported diluted earnings per common share of $0.21 for the 3 months ended June 30, 2020, up 11% compared to the year ago quarter and up 5% compared to the previous quarter. Diluted earnings per share were $0.02 ahead of analysts' consensus estimates. We are very pleased with our results this quarter. Despite significant pandemic-related challenges, economic uncertainty and social unrest during the quarter, the company performed well as we continued to execute on our time-tested strategy.

Before I discuss our second quarter results in more detail, I would like to provide some color on our deferral program. After an expected initial surge in payment deferrals in April, the pace of new deferral requests slowed dramatically during the second quarter. Our deferral program is somewhat unique in that it is for an initial 6-month period as opposed to a 3-month period. Therefore, any positive changes will not be evident until the fourth quarter of the year. As noted in today's presentation, at June 30, multi-family and CRE full payment deferrals totaled $5.9 billion or 15.5% of outstanding balances and weighted average LTV was 56%. Specifically, multi-family deferrals were $3.7 billion or 11.7% of the portfolio and had an LTV of 57%, while CRE deferrals were $2.2 billion or 32.5% of portfolio and had an LTV of 52%.

The company has gone through many economic cycles. And while this one is indeed different, our stringent underwriting guidelines and our longevity in the market, which have served us well during previous cycles, are serving us well now. To date, the New York City real estate market, especially our nonluxury rent-regulated multi-family niche, has held up extremely well. Rent collections continue to be above levels we experienced in the second quarter. In fact, we have seen month-over-month improvements throughout the second quarter and into the third quarter. Moreover, New York City has recently entered Phase 4 of its reopening, and many people are returning to work and many businesses are also starting to reopen. This, along with state rent subsidies to landlords, is having a positive impact on our borrowers' cash flow. We remain optimistic that as we get deeper into Phase 4 and business and economic activity in our market begins to increase, the number of borrowers and deferral will decline dramatically. We look forward to sharing our results during our third quarter earnings call as approximately 96% of our borrowers on deferral programs come off their deferrals in October and November.

Moving now to our second quarter results. Our second quarter performance was very strong and reflects significant expansion in our net interest margin, solid top line revenue growth and lower operating expenses. This led to double-digit pre-provision net revenue growth, which is a good indicator of how well positioned we are in the current environment. At the same time, our provision for credit losses declined compared to the first quarter, while our asset quality metrics remain strong and multi-family loan growth continued.

We also announced that the Board of Directors declared a $0.17 cash dividend per common share. The dividend will be payable on August 18 to common shareholders of record as of August 8. Based on yesterday's closing price, this translates into an annualized dividend yield of 6.6%. The major highlight of our second quarter performance is the substantial double-digit improvement in our net interest margin. The net interest margin, excluding the impact from prepayment income, was 2.09%, up 17 basis points sequentially and up 20 basis points on a year-over-year basis.

We were especially pleased with the progress made on our funding costs. Our cost of deposits declined to 1.46% during the second quarter, down 36 basis points on a linked quarter basis and down 60 basis points year-over-year. This was driven by a decline in our average cost of deposits, mostly due to the downward repricing of our CDs. Net interest income, also excluding the impact from prepayment income, rose $21 million or 9% compared to the previous quarter and $29 million or 13% compared to the year ago quarter. We continue to be well positioned for further improvements in both the margin and net interest income, given the repricing opportunities embedded within our funding mix.

On the expense front, our operating expenses continue to trend lower. Total noninterest expenses were $124 million, down 2% compared to the prior quarter and relatively unchanged compared to a year ago quarter. The efficiency ratio was 44% and continues to reflect positive operating leverage. I would like to point your attention to our pre-provision net revenue number, where we showed strong double-digit improvements compared to the first quarter of this year and compared to the year ago second quarter. PPNR for the second quarter was $158 million, up 16% and 19%, respectively. We view this number as an important metric to focus on as it shows the earnings power of the company and our ability to absorb credit costs, generate capital, and supports our commitment to the dividend.

Moving on the balance sheet. Total loans were $42.3 billion, relatively unchanged compared to the previous quarter as good growth in multi-family portfolio was offset by decline in the CRE and specialty finance portfolios. On a year-to-date basis, total loans are up $412 million or 2% annualized. After seeing some modest growth in multi-family portfolio in the first quarter, total multi-family loan growth was stronger this quarter, increasing $325 million on a sequential basis to $31.6 billion or up 4% annualized. However, this was tempered by a $114 million sequential decline in the specialty finance portfolio and a $105 million decline in the CRE portfolio. The linked quarter decrease in the specialty finance portfolio was primarily due to commercial borrowers reducing inventory and some larger borrowers accessing the public markets to raise capital and using the proceeds to pay down debt. Despite this, we see the specialty finance business reverting to form next quarter.

Origination activity continued to be very strong as total loan originations, excluding PPP loans, increased 21% on a linked quarter basis to $3.3 billion, led by multi-family originations, which increased 70% to $2.4 billion. Second quarter originations exceeded last quarter's pipeline by $1.2 billion or 60%. Speaking of the pipeline, we continue to see strong demand from our borrowers as our current pipeline is $2.2 billion, 5% greater than the first quarter pipeline. Importantly, included in the pipeline is approximately $1.3 billion or 60% of new money.

On the funding side, total deposits declined $243 million or 3% on an annualized basis compared to the prior quarter. Continuing the trend from the prior quarter, CDs declined $2.1 billion, primarily due to the drop in market interest rates at the end of the first quarter and the company's strategy to significantly reduce the rates it offers on CDs. Most of this decline was offset by solid growth in other lower cost deposit categories. Our wholesale borrowings increased modestly compared to the previous quarter as advances from the Federal Home Loan Bank of New York increased $75 million.

On the asset quality side, our overall asset quality metrics continue to be very strong. We reported a provision for credit losses under CECL of $18 million, down from the $21 million we reported in the first quarter of the year. This exceeded net charge-offs by $14 million and led to an increase in the allowance for loan losses. We had no charge-offs in either quarter in our core portfolios. Net charge-offs totaled $4 million or 0.01% of average loans compared to $10 million or 0.02% of average loans in the prior quarter. The majority of the charge-offs in both periods were taxi medallion related. Nonperforming assets were relatively stable, increasing $4 million or 7% compared to the first quarter level. This translates into 12 basis points of total assets compared to 11 basis points last quarter. Excluding nonperforming taxi medallion-related assets, NPAs would have been $30 million or 5 basis points of total assets compared to $28 million last quarter, also 5 basis points of total assets.

Lastly, I'd like to end my formal comments by once again thanking all those who continue to serve on the front line of this crisis, the doctors, the nurses and all other first responders and to our employees, management and Board here at New York Community, who have shown extraordinary dedication during this most difficult time.

On that note, I would now ask the operator to open the line for your questions. We will do our best to get to all of your questions within the time remaining. But if we don't, please feel free to call us later in the week. Operator?

(Operator Instructions) Our first question is from Ebrahim Poonawala with Bank of America.

I guess, just first, if you could just touch base on the net interest margin, very strong this quarter, but CD cost still at 2%. Tom, just talk to us in terms of your previous guidance of double-digit margin expansion every quarter this year. Do you still expect that? And what are we seeing on the multi-family loan yields and the CD costs as we look into the back half of the year?

Ebrahim, so that's right. We had an improved margin in the Q2. Obviously, the margin was a beat. We expected the margin to be up 10 basis points. It was up 17. Going into Q3 and Q4, we still anticipate double-digit margin expansion for each quarter throughout the remainder of 2020. So we're very bullish about the margin improving further from here given that we still have a substantial amount of CDs repricing as well as borrowings repricing. And overall spreads in the multi-family side is still very strong. If you think about in the next 3 months, we have about $5.4 billion of CDs repricing at 1.99%. And going out for the next 12 months, it's $12.7 billion that's going to reprice at 1.69%.

Our current offering rate right now in the market, our highest rate is 65 basis points, that's a 7-month CD. And many customers are just going into the short-term CD, which is 3 months at 50 basis points. And in many circumstances, many customers are just ending up in post maturity as given the pandemic, and that's a 2 basis points cost of funds on that type of post maturity numbers. So we've been clearly getting significant improvements there. As far as overall yields on the multi-family side, we were fortunate to have that very nice spread throughout the pandemic. So we're still around that 300 basis point spread, albeit there's been some competition as of late from the agencies. So we're mindful of that, but the economic spread clearly is a much better spread than it was in the previous year.

Got it. And I guess just moving to the multi-family space. Talk to us in terms of -- do you expect like if activity -- you gave pipeline numbers, but just what's the health of the market as you think about coming out of this COVID. Clearly, a lot of concerns around the New York City economy. Like do you really expect a lot of activity and buyers coming in? Is there enough price discovery happening? Give us some color around that and your expectation for growth.

So Ebrahim, I think what's encouraging is that we've improved our retention rate as expected this year above the 50 percentile. So the goal here to get to our 5% net loan growth story for 2020 was to get our people focused on what's coming due. As you're aware of, there's significant amount of money coming due in the next few years. So we're targeting those types of customers and anticipating a very high retention rate as compared to the previous year. Although 50% -- I think the number was 52% for the quarter, we anticipate that to continue throughout the year. That is key for our expectation to continue our net loan growth story for 2020.

As far as purchase and sales transactions, as you can imagine, during the COVID pandemic, there wasn't any. We're hearing there's some deals that are coming through in Q3 and Q4 and we'll be mindful of that. So we believe that the second half will be the opportunity to see some activity in the marketplace. But it's been pretty much at a 0 level throughout the second quarter because of the COVID pandemic. That being said, we have a very strong pipeline, $2.2 billion, of which 60% of that is new money, and the yield is still very strong. I believe the overall pipeline yield coming out into the third quarter is a 3.24% yield. So that's an impressive yield. It's still hovering around that 300 basis point spread.

Our next question is from Mark Fitzgibbon with Piper Sandler.

I wondered if, first, you could give us a sense for what rent collections look like today on your rent regulated, non-rent-regulated multi-family buildings?

Yes. So Mark, I would tell you that -- go ahead, Joe.

No, I was just going to say that our rent collections have been quite strong. Despite the expectations or the headlines that are occurring with regard to other lenders, in our circumstance, we're in a very good place. And it's not atypical for us to have tenants that have every expectation and capacity to stay in their apartments. So we are getting a very good flow of payments from our tenants.

So Mark, I would say, specifically, when you look at quarter-over-quarter, we're above that 85 to 90 percentile on rent collected from, obviously, the multi-family. So that is very strong. Each month, as we evaluate that, it's been coming stronger as we go through the summer months here. So as far as the third quarter is concerned, obviously, it's the beginning of -- the end of July, and we see some very strong numbers coming through as far as collections. As far as the overall portfolio, when you think about the deferrals and you look -- think about what's going on with the multi-family side, I believe approximately 42% of those loans that are in deferral have 100% rent regulated on the multi-family side. In the total multi-family side, I believe 62% has some form of rent regulation.

So we're mindful of that, given the magnitude of the rent-stabilized portfolio and the level of the payments that's coming in, we feel very confident that those customers will revert back to full payment status as we get back to the second half of the year because our payment deferral program starts to kick in into October and November. So we're mindful of that time frame change. However, the good news here is that the collections that we see because we have the operating accounts, we're seeing the money coming in on a monthly basis. So we're very pleased with the overall cash flows.

Okay. And then I know asset quality has really been amazing there over time, but does it make sense to continue to build reserves given the uncertainties today in the world?

Well, Mark, you know the history -- the company's history has a pristine asset quality metric. So if you think about -- we adopted CECL in Q1 quantitative versus qualitative, I would allocate 2/3 of our reserves as, at this point in time, qualitative and 1/3 is quantitative because we don't have a history of any significant losses. So when you think about the magnitude of the rent-stabilized portfolio, we -- these numbers are high for us. So obviously, we were very public about our guidance that Q1, we felt that was going to be the largest reserves [after] adoption of CECL. As we monitor the macroeconomic backdrop, that will change over time. But it appears that given where the current portfolio is leaning towards, we anticipate to have a very manageable transition as we go towards the end of the year. And hopefully, as the city comes back to full Phase 4, we'll start to see better performance metrics. But it's -- obviously, it's too soon to tell, but the overall macroeconomic backdrop when we run it through our CECL calculations, it's mostly qualitative.

Okay. And then lastly, I think you said in the release, you have $103 million of PPP loans held for sale. What are the economics of holding those loans versus selling them today look like? And is that the plan to sell those in 3Q?

It's immaterial. It's $100 million on 1% type of return. It's not going to be -- it's an immaterial number. That plus the fees are insignificant for the company. We will -- as you can imagine, most of our customers were not eligible. Property owners given their structure were not eligible to tap the PPP funds. So we were there for our customers that had eligibility and also for customers that were not getting -- noncustomers that we're not getting access to PPP through the money center bank. So we stepped in locally as a community player. However, we did not do a whole lot of PPP. We had the program in place, but most of our customers were not eligible.

Our next question is from Steve Moss with B. Riley FBR.

I just want to start just on the loan growth front. You mentioned in terms of the quarter, you're expecting -- the upcoming quarter expecting a rebound in the specialty advanced portfolio. Kind of wondering what drives comfort there. And then just for the back half of the year, pipeline looking pretty good, it's kind of like -- do you still think close to mid-single digits for 2020 is good or maybe just a little bit below?

Yes. So Steve, I would say, we still feel very confident the second half will be stronger than the first half. Obviously, we're coming out of the depths of the pandemic. And we expect the specialty finance, that's -- it's obvious. Many companies were buckling down their cash position. They were harboring -- managing inventory differently given the lack of economic activity. That will pick up. Capital markets were very strong for that business. So many of these A-rated companies have access to very attractive alternative financing through the capital markets. And they paid -- they accumulated lots of cash and paid down some of their shorter-term liabilities. We anticipate them to draw down some cash as they build up more inventory for anticipated better economic activity as the country comes out of the pandemic. So we believe that we should be on track.

I mean the growth has been phenomenal in specialty finance over the years. I believe we'll still be on track for that 25% to 28% type net growth on specialty finance. I think if you look at where we are today, we're 23% annualized. So we should see some growth for specialty finance for the second half of the year. As far as multi-family, it's driven predominantly right now from -- within our own portfolio as well as getting other transactions within the marketplace refinancing. It's not purchase and sales. We believe eventually, there will be the opportunity where buys and sells come together, and we will participate in the financing of that. So it's been very slow in Q2 as expected. We've been doing a bunch of non-deal road shows, Joe and I. And we've been very public that didn't expect to see a whole lot of growth. We're very pleased that we did have net multi-family growth through the quarter, and we anticipate that to pick up in the second half. That means for us, based on a retention of north of 50% of our own portfolio, we should be in line to get that low, call it, mid-single-digit net loan growth.

Okay. That's helpful. And then just in terms of the provision this quarter, kind of curious as to what the economic assumptions and the drivers were there?

I mean pretty much, obviously, we're more inclined to deal with the issues from CoStar's economic forecast. So we have the most recent CoStar's baseline forecast that was released as of April 28 as of March 31. And we have the Moody's economic scenario, which is the baseline forecast released on June 9 as of May 31. So those are the current forecasts that we run with. I'd say for us, it's more driven off a property price decline since we are real estate base. We're not a C&I lender. So you think about unemployment and bankruptcies and the like, that really drives some of the C&I players. So when you look at the overall backdrop economic landscape that we're using, we still have a substantial amount of this CECL calculation. It's qualitative, just because of the history of the bank that has no losses as we look at the portfolio. But clearly, property price declines will then drive our CECL more so than unemployment factor.

Our next question is from Collyn Gilbert with KBW.

Just on the deferrals, do you -- so providing the vacancy rates in the multi-family book was super helpful. Thank you for that on the slide deck. But just curious how those vacancy rates might look on the deferred loans, do you have that by any chance?

So what -- yes, we're going to be 1 quarter behind everybody else given the nature of our program, Collyn. So as Mr. Ficalora indicated in his prepared remarks, we have a 6-month program. I will tell you with certainty where we stand today, the conversations we're having with our customers is getting out of the program because they're ready to pay. So we haven't had any adverse discussions about people looking for extension, but it's too early to tell. That being said, we did a relatively deep dive into the portfolio that we have, it's on deferral. We looked at our CRE book on retail. We looked at the CRE book on office. And what we've determined when we pulled the files and we went back to the customers and tried to evaluate the cash flows, it appears that when we look at the retail portfolio, we have reviewed approximately 90% of our CRE retail deferrals and 74% of those loans reviewed have rents coming from essential businesses. 54% of those loans reviewed have 50% or more of the rents coming from the essential businesses.

So that gives us some encouragement that despite the pandemic, they were still collecting -- they're booking sales, so obviously, they have the capacity to pay some form back to the bank as far as debt service coverage. In respect to office, a little bit different. We reviewed the -- we're still in the process. We reviewed approximately 70% of the CRE office deferrals and know that 88% of those loans reviewed have rents coming from essential businesses, of which 31% of the loans reviewed have more than 50% coming from essential businesses. So they're still open. I mean not everyone is open. But as we're getting into Phase 4 and we feel that, overall, we should have a good showing at the end of the year with a lot of these particular credits coming off deferral. Just another note there, on the specialty finance side, 100% of our specialty finance loans coming off deferral in July made their payments. So we had approximately $200 million in total, I believe $90 million has -- we have $90 million that paid in July. We believe the rest will be procured in August. So we're very confident that there's very low -- no loss content in the specialty finance business.

Okay. That's very helpful. And just kind of along those lines, right, if we play this out, everything that's happening in New York City and understanding, obviously, things are starting to open up, but it's so -- the city is just obviously so different than what it was before. If we play this through, I mean, where do you -- when you -- some of your borrowers -- where would vacancy rates need to go to really start to stress some of your borrowers?

So it's interesting point. Obviously, our debt coverage ratios upon origination are very strong. Obviously, that's changed as there's no income coming in. So you think about the weighted average debt service coverage ratio in respect to our CRE portfolio, I believe that number is like [1 70]. So think about the coverage there. We typically underwrite at a more conservative level, as Mr. Ficalora indicated, the average LTV is low, 51.92%. And when you look at the areas that we want to say may have more difficulty, let's say, for example, commercial mixed-use, where you have more of a concentration of businesses struggling to reopen and you have less residential above that, that LTV is at 48%. So you really have real deep equity embedded in these credits and a lot to walk away from. So no one's knocking on the door and saying, here, take my keys. We don't have a 48% LTV. So we're in a very good spot. We believe that it's going to take a little time for some of those other types of credits.

However, when you look at the majority of the portfolio, which is multi-family, rent collections are high. They are within 90 percentile, which is pretty impressive. And now bear in mind, we have lots of stimulus within the government intervention today and probably more to come, which will continue to help people pay their rents. And then -- and we have high unemployment pockets within the city, different aspects of the city, in particular, The Bronx. And I would say, on an LTV perspective, we were very cautious in Manhattan, so our overall LTVs in Manhattan are always lower. The numbers are just more attractive as far as how we lend in Manhattan than we do in The Bronx because of -- we're very cautious about cap rates and the value expansion over the past 20 years. So we think that we have a very low leverage portfolio that's backed by a substantial amount of wealthy property owners that have real long-term equity built into the game here.

Yes. The rent rolls are very stable in our buildings because the people themselves, the tenants have rent control, rent stabilization. They can't move to a new building and get that same benefit. So they want to maintain that apartment. They want to maintain rent control. So we have a very high concentration of people, tenants that are inclined to stay in the buildings they're in because they have huge economic advantage. That really plays extremely well, even in an environment such as this.

Okay. And then just one follow-up. Just another kind of broad question. In terms of your pipeline, right, you said 60% is new money. What's kind of the -- what's the sort of the background or the dynamic of that -- of those borrowers coming in?

Just getting business from other banks, right? We're in this space. This is our core business model. Other banks that are going through their own issues and struggling, we focus in this multi-family CRE niche in this particular marketplace. So clearly getting loans from some other banks that are coming up for renewal, you can imagine how much is out there that has to be renewed. We have a substantial amount of our own loans that have to be renewed in the next 1.5 years. So that's going to be the focus until the property transactions start to occur. We believe that will eventually pick up. The good news day, you're starting from 0. So we're growing with no property transactions. When the market does pick up, we believe we'll be a participant there and do solid credits.

Our next question is from Ken Zerbe with Morgan Stanley.

Tom, in terms of the -- your expectation for the low to mid-single-digit loan growth this year, is that going to be driven by a rebound especially finance or more on the multi-family side?

I'd say both. I mean, obviously, we were slightly down in Q2 on specialty finance. We've been historically growing it very nicely. We've turned down a lot of deals. It was more pricing this quarter. But we had, as I indicated, significant access to the capital markets. And given the pandemic, many businesses were slow to react and they were harboring cash. As the economy opens up, these businesses will draw down. We have some other businesses that were drawing down because they were very busy, like, for example, in Albertsons, for example, they're taking down financing because they have a tremendous amount of selling of grocery. So there's an example of one taking down credit where others are harboring credit. We think we'll see some good momentum on the [cars] in inventory as there's a tremendous demand. There's just no inventory out there to sell cars .

But I think for the most part, I think all of our core businesses in the specialty financial will start at least accessing credit on their lines. We have a very significant line. If you look at the roll forward of our reserve, we had a large commitment contingency built on CECL because of the substantial line because we had so many payoffs. But we think that will improve. And as far as multi-family, we think that we'll continue to grow throughout the year, hopefully at a stronger pace in the second half. And CRE is on the table. CRE is one up here in the [ebb], and I don't envision a lot of CRE growth, but -- pure CRE. But multi-family and specialty finance should be the contributed factors towards the plug for that potentially mid-single-digit net loan growth that we plan to achieve for the end of the year.

Got it. Okay. And then it sounds like your borrowers are in fairly good financial health. But just out of curiosity, if they did come to October or November, do you have the ability to put them on another 6-month deferral? Or does it have to come off?

Sure. Sure. Look, there's a lot of flexibility right now because we're still in a black swan event, a pandemic that's being supported by the government as well as the regulators. We believe there'll be some further, I guess, guidance as we move along throughout the year. But we're just 1 quarter behind Ken. And that's -- if someone's put us in a competitive disadvantage when you talk about the book because I'd love to give you more information, but our customers are just midway through their deferral program. We believe that on the multi-family side, given the magnitude of cash flows coming in that we see every day because we have the bank accounts, we see the operating accounts and the cash flow coming in, and we talk to the largest customers, the collections are high. And as I indicated, there's a lot of government stimulus that's assisting that.

As far as office and CRE and commercial mixed-use, that is going to be a matter of the reopening phase and the strength of the borrowers. And given that we're very frugal on our lending, and we are very focused on being conservative stringent underwriters, we have a lot of deep value of equity. So we believe that if they do need help, we can give them help, it's going to be a case-by-case basis. I know a lot of our overall customers that are, let's say, we'll call them the smaller mom-and-pop neighborhood type businesses will be supported by the tenants as they come back into the city. But the city is still going through this Phase 4 reopening, and it's going to take a little time. So we do have flexibility...

By the way, we also -- yes, just so I could add. We also have a higher rate of interest on every dollar we defer. So when you take massive amounts of money that are being deferred at rates that we could not get in the marketplace, it's very attractive to the bottom line.

Yes. And Ken, the other comment, I'm going to repeat it again, it's important that the conversations we're having right now is that they don't want to accrue any more interest. They want to pay their bills because they have the cash flow. So as you give them 6 months of balance sheet time to bring collections in and they have an abundance of cash, they're still accruing interest. So they want to stop the accrual of interest and pay it and get back to normal payment status. Because if you're collecting most of your rents every month, you have the capacity to pay. That's the conversations were happening. So we're excited as we go into Q3 and in the beginning of Q4, we should be in a position to see a substantial rollback of these deferrals. And whatever has to be dealt with, we'll deal with it as it comes along, in particular, under the CARES Act, there's lots of flexibility.

Got it. Okay. And just really quick last question. In terms of the expense outlook, obviously, expenses came in lower than your guidance for this quarter. How are you thinking about it for the rest of the year?

Yes. So it's interesting. We're -- obviously, given the pandemic, we're spending less money for the most part. But we are definitely focused on efficiency. The good news is that we anticipate by the end of the year, we can hit that 42% efficiency ratio at -- not on a full year average, but hopefully by the quarterly average. And that was the original plan. So we probably beat our plan by $10 million to $15 million. If you recall back to last year's guidance, we assumed 2020 will be between $510 million and $520 million. We could probably hit $500 million. So I'd say it's reasonable to bring that down for the year to $500 million, which will be flat year-over-year. So we're very happy about where we are. For the quarter, Q3 will probably be around $125 million. We were $124 million last quarter, which should be around the same. So we're very pleased with the containment efforts that we were showing here as a business. But it's well contained.

And hopefully, as we have growth, we'll have operating leverage with significant margin expansion as we go throughout 2020. Margins holding up very nicely, and we still feel highly confident that we'll have that double-digit margin expansion every quarter this year. Now we brought a lot of margin in, in Q2, more than I expected, 70% better than guidance, but that had a lot to do with the dynamic of the marketplace and the accelerant Fed adjustments that were taking place. And as we can all realize, we are liability-sensitive, double-digit liability-sensitive institution, so we should benefit from low-for-longer scenario by the Fed.

Our next question is from Steven Duong with RBC Capital Markets.

On the risk weighting for your multi-family portfolio, can you remind us again, I believe for loans that adjust, the LTV threshold is 75%. And is it correct, the debt service coverage is [1 15]?

No, I believe it's 80%, I believe it, yes. Right. Yes, fixed rate is 80%. 120% is the coverage ratio.

Okay. And that's for adjustable rate loans, is that right? Or fixed?

Fixed rate.

80% and 125% is fixed rate.

Fixed rate, yes, 125%.

And then just like how do you guys...

So Steve -- let me just expand upon that, Steve, just to be clear. We are -- under the CARES Act, we believe we have flexibility right now because if you have a building that has no cash flow, you're not going to be penalized from the previous year's financial statements if no one's -- if the business is closed. So we think there'll be flexibility there. We've actually had considerable dialogue regarding that throughout the industry. When we reopen fully and we look at the new cash flows, we believe that there's some good coverage. In the most part, our coverage is very high. I indicated that we're [1 70] on our CRE book. I believe our multi-family book, that was in deferrals at [1 53]. So there's a lot of room there as we get to that stage.

That's good color. And so on new loans, how are you guys approaching the appraisals, given, I guess, the lack of transactions and the shutdown? Like I'm just trying to understand like how you guys are doing that.

Well, you can imagine, it's with an abundance of caution, obviously. I will tell you that when customers are pulling down some money to cash out refi, we're very conservative. We're holding back multiple months of proceeds. We're holding back escrow. We're holding back any items that we felt needs to be escrowed as far as we get to the pandemic. We're also taking out a certain percentage of an adjustment based on appraised value just because of an abundance of caution. And if you're not selling your building and you want to be -- you have to refi and you think you have real value, we're willing to do a cash out refi, but at a little much less of an amount. And we may lose deals because of that, and that's fine because we're an abundance of caution type lender. That's the history of the company.

Great. And then just moving on, your loan spreads are still pretty high. If rates are permanently at this level, would you expect the spreads to remain where they are?

Steve, we're going to be in the market. So obviously, we had a good shot in Q2 as the agencies pulled back. The agencies are back today. So let's not fool ourselves. We do compete with the government. The government is probably the largest player in the marketplace, and they've tightened up their spreads, but they also are hovering on yield maintenance. And if you're comfortable with yield maintenance, then you may go with the government. Some of the largest players will go with the government and put that loan on the shelf for an extended period of time. But for the most part, as a portfolio lender, given that we're flexibility, as far as structure, personal guarantees as well as dealing with the cross collateralization, we have the ability to be competitive.

And I'd say the biggest fear today is that you deal with the government and the government rates tend to be tighten when they have a large appetite and their appetite is significant. But we'll compete. And if we have to be a little bit less than 300, we'll be within the market.

Got it. And just one last one for me. Joe, you had mentioned that people are heading back to work with the reopening in the New York market. Roughly, in your opinion, where are we in terms of activity versus a year ago?

Well, it's very hard to say because there's not consistency in how this evolves. But I would say to you that the marketplace today and prospectively represents, depending on the nature of the asset, the kind of assets we're talking about, a period of uncertainty that has the potential for some of the revenue sources to dissipate. Most important, however, for us, is that we have the vast majority of our people are tenants that have extraordinarily attractive rents, and they want to maintain those relationships. They are highly motivated to do that. So despite the fact that there could be a first floor tenant that is not deriving revenue because they are not sufficient numbers of people in the marketplace using their store, the vast majority of the rents we collect are not driven by that. So I'd say that we're in a good place. And we will continue over the course of this evolving cycle to be in a place where the vast majority of our revenue is, in fact, continuing.

We don't have tenants that -- even, for example, if a person is in a rent-controlled department, and they virtually have a loss of their job, they would borrow money to stay in that apartment because that apartment is the most valuable asset they possess. The idea that we will have ongoing revenues from the properties that we lend on is extraordinarily high and different than the vast majority of lenders in the New York market. So that distinction needs to be fully grasped. It has occurred cycle after cycle, that's why our assets continue to perform even in difficult periods. So when massive foreclosures are occurring, our assets are performing. Our owners are actually able to go out and buy the foreclosed properties. So this is not atypical from the standpoint of the consistency of performance in the unique differences in our asset mix, but this is a period which will continue to provide opportunity for the owners of our buildings to take advantage of those buildings that were way overpriced, that did not have a stable good tenancy, that did not have rent control, rent stabilization as a significant component of the revenue stream. That is, for us, a distinguishing characteristic.

So anyway, I'm very pleased that our current situation is demonstrating the uniqueness of our business model. And I think as we go quarter-by-quarter into the future, it will be more and more obvious in the differences between how we perform and how others perform.

Our next question is from Matthew Breese with Stephens.

Just a follow-up on the appraisal process. What are you seeing for new rent-regulated New York City multi-family cap rates? How have they been adjusted? Or are the appraisers adjusting cap rates, not adjusting cap rates and adjusting rents or pro forma rents? Just curious how, on their side, things have changed and what the implied valuation changes of multi-family could be?

So Matt, I'd say the transactions that you reflect was back in the third and fourth quarter of last year, we had some notable large 100% rent-regulated buildings that traded and those cap rates were around 5%. I believe that's still consistent. There hasn't been an adjustment despite lower interest rates, despite the direction of interest rates so, you think that -- actually, on a quarter-over-quarter basis from Q3 to Q4 last year, it was a slight drop. But with an abundance of caution, when you look at the appraisals, you tend to be reappraising internally and you tend to put your stop gaps on certain aspects of the rent roll in order to be more conservative. But I don't think you saw any magnitude adjustment yet in the cap rates. However, it typically correlate to lower interest rates. So that has not changed much. So the fact that rates are lower, cap rates have held constant over the past 6 months.

Got it. Okay. And then just looking at the geographic breakdown of your multi-family exposure, there's $6 billion outside of the state of New York. Just curious how this segment of the portfolio has held up and if there's any major or notable differences in rent collection?

Yes. So we did a deep dive on the portfolio regarding the magnitude of the deferrals. Let's just talk about the deferrals. When you think about the breakdown, I'd say we have $1 billion that's in The Bronx, a little less than $1 billion in Manhattan, all locations, approximately $3.6 billion. Most of the deferrals are coming from the 5 boroughs. As far as outside the city, it's insignificant, the deferrals. That kind of gives you an indication that the city was probably hit the hardest in respect to people that looked for relief as an abundance of caution. I truly believe that many customers that have multiple [assets] with the bank, looked at the marketplace when COVID hit that the relief was there, let's use the relief, see how we make out. And as the cash flow continues to come in every month and their balance sheets start to swell with excess cash, they're accruing interest. So I feel highly confident on the multi-family side that you're going to see a substantial amount of deferrals come off deferral come off on November 1.

That being said, you have a -- we don't have a whole lot of exposure outside of the 5 boroughs and the New York City marketplace. So we do have credits in New Jersey. We have some in Philly and Baltimore area, Mainline Philly. But again, as you think about the magnitude of the portfolio, it is really New York City dependent.

Yes. Got it. Okay. You mentioned commercial mixed-use is a category that's seeing some stress. Could you just talk about why that asset class in particular might be or is more exposed in the current environment? Is it just simply the nature of that bottom floor commercial tenant? And then the amount disclosed, which is super helpful, is that solely CRE mixed-use? And I'm just curious if there's additional mixed-use in the multi-family bucket.

So we've identified and we'll just identify it again, it's in our public filing this morning, that the commercial piece was approximately $334 million of the $706 million. So we have $706 million of commercial mix use, which is where we believe may have some additional difficulties, given the magnitude of the rent roll that's still in the process of reopening. When you think about that as a percentage of the portfolio, that's 47% of that book, it's looking for some help because these businesses were completely shut down for the most part. However, the LTV in that book is 48%. So it's a very low leveraged portfolio with a very high debt service coverage ratio upon pre-COVID. And obviously, 65% of the revenue is coming from the ground floor, and let's say, for example, you have a 5-story walk up, they're going to need maybe additional help down the road. That -- there's no question, that's a possibility. We don't know, it's too soon, but it's just logical to assume that given that's the highest percentage of deferral is where the area of focus is.

And is there additional mixed-use in the multi-family portfolio?

Yes. Remember, the way we categorize is multi-family versus commercial. If it's over a certain percentage, it goes into commercial. So over 60% -- 50% goes into commercial. Less than that, many buildings have some component of ground floor revenue that's come from commercial.

Got it. Okay. And then just lastly, could you just talk about M&A? In this environment, you do have a currency advantage. Are there any discussions taking place? And if so, can you talk about that a little bit? And then remind us of what you're looking for in terms of geography, size, balance sheet profile in a partner.

Joe, you want to...

Yes. I think there's no escaping the fact that we have a long history of being informed as to the kinds of opportunities that the marketplace presents. Our currency is very well suited in many cases, not all, but in many cases, our currency is very well suited to create accretive transactions. So there are partners who have sort dialogue so as to understand whether we do or do not and then under what circumstances, we might be willing to do a transaction. It is part and parcel of how we look at the value creation that we've accomplished over our public life and that we intend to accomplish into the future. There are no banks that we've combined with that didn't wind up having a substantially better performing currency. Their investment in their company paid them far more by investing with us. So as you very well may imagine, there are many people that are very familiar with, and I'm talking about not just CEOs, but also bankers that are very familiar with our track record and our desire to do accretive deals.

So you could assume that we have opportunities that are being analyzed and that there is good reason to believe that the future period will present adequate opportunity for us to execute on an accretive deal. Importantly, we will do deals that are good for our shareholders. The only reason we ever do a deal is because we believe it creates greater value for shareholders. There are no deals that we've ever done that didn't create greater value for our shareholders. So yes, in this period and in the period which may become more difficult into the future, there will be opportunities with the differential between our currency and our target's currency should be sufficient to be an obvious value creation for all of us. There's only one currency in a deal, that's the surviving currency. And every deal we have ever done has created a greater value for those that took our currency.

And Matt, I would just add to Joe's commentary that we're not going to do a transaction that's going to take down tangible book value. So that's one of our limiting factors. So as you can imagine, as the stock improves, then we will be more desirable to do something here. But given where our currency is right now, as Joe indicated, certain transactions just can't happen because of the partner's currency. It has to be tangible book value accretive. That's just something that we feel very strongly about.

Our next question is from Peter Winter with Wedbush Securities.

I was curious, how much exposure do you guys have to the 1031 exchange? And the reason I ask is if Joe Biden were to win, part of his tax plan is to eliminate the 1031 exchange tax incentive.

Right. So Pete, let me handle that one. So obviously, we do not have a 1031 exchange business, but our customers do play in that space. So the value creation that's been created [to] the New York City real estate market has been through the 1031 exchange. As you're fully aware, the deferral of taxation through literally generational holdings is the impetus on many players being -- creating more value time over time over generational holdings as they utilize the tax code. Under the Trump administration, they locked in that 1031 exchange for real estate, where other lines of businesses were excluded from that. So we do not have a business that is a 1031 exchange business. Other banks do that business. We just participate in the purchase and sales which facilitates the transaction. So I will tell you with clarity, if that does happen, it's not good for real estate. I mean, it is obvious. I hope you are wrong by the way.

Our next question is from Christopher Marinac with Janney Montgomery Scott.

I appreciate all the information this morning. I just wanted to ask about the CET1 ratio under the scenario that Joe was just talking about with the merger. Is there a lower band to where you may take that just temporarily on a closing, and then obviously, it would improve as you retain earnings?

No. I would say, look, like we talked about, capital is king for us. We don't -- we have a very strong capital allocation process because we have a little risk bank. But the last thing we want to do is do a transaction and take out our ratios down. So if we were to be successful on announcing a transaction, you'd assume that ratio would improve right at announcement at a closing. That's clearly one of our deciding factors and when looking at combining 2 institutions together, improving capital position.

Okay. Great. That's helpful. And then just a quick one. I know you talked a lot about asset yields, but is there any relation to the history back in 2009 and '10 when rates reset to how the asset yields held up then? It just seems that they're holding up better now, and maybe that's an advantage for you well beyond that...

It's interesting you mentioned that. So obviously, let me just go back to 2014. 2014 and the end of '13 is where we had the low-for-longer scenario with the Fed. They had rates close to 0 for extended period of time, which is kind of where we are today, and our cost of deposits was 50 -- as low as 58 basis points. I think right now, we're at 116 on cost of deposits. So we have a lot of room there. On the asset side, we had a much stronger asset yield because those rates were coming down from a much higher plateau. The negative is that you have refi yields coming down to literally slightly less than where they were a year ago. So the 320s and 330s are being refinanced at 3%, 3.10%, 3.15%. So you're not getting the benefit, but the cost of funds drop is significant. It's conceivable that we can go below the cost of deposit scenario where we were in '13 and '14 if the Fed continues to keep their rates close to 0. And that's a very -- that's a reasonable scenario. So you'll make it up on the cost of fund side.

We have -- and during that period, our borrowing costs were dramatically higher. So we have approximately $975 million remaining in 2020 at a 1.78% on the wholesale side. And 2021, we have about $1.1 billion at 2.03%. And if you think where the market is on, let's say, 2-year bullets, 3-year bullets, it's 40, 50 basis points and potentially going lower. So I think the positive here is that we're going to do as much as we can to get reasonable spreads. We can't control the market, but we will be lending. But the cost of liabilities for our model is coming down significantly in a zero-for-longer scenario.

Our next question is from Dave Rochester with Compass Point.

I appreciate all the guidance on the expense side. I was just wondering about the lower comp expense this quarter, if that were from a reduction of the workforce or lower bonus accruals or some combination of that? And then if you think there's more capacity for more steps on that front in the back half of the year or even next year? And then maybe on the branch network, what you guys can do there, if anything, to capture some expense saves there?

So let me address the comment on the [straight out], it was all driven off of payroll taxes. Q1 is always the high quarter for the year and you have to true-up social security and payroll expenses. So that's the high point. Our payroll should be relatively consistent. So what you saw last quarter should be consistent in Q3 and probably Q4. As far as branch opportunities, we're always open to looking at leases that are coming due and coming available. We'd rather not take charges. We took one in the beginning of the year that we felt was appropriate when we looked at some of these opportunities. And as they come along closer to their renewal, we evaluate the profitability and we will consider that down the road. But clearly, we're not looking to take additional charges for that.

Okay. And then just one question on the end of the whole deferral process. If you guys have any multi-family or commercial real estate and deferral that come off at the end of that period, and they aren't cash flowing, and you have to call those TDRs and mark those. I know you guys are really well positioned from an LTV basis. But how do you mark those if there aren't any appropriate real transaction you can use in the market at that point? Or if there are deals going on at much lower prices because assets are coming out of structures and hitting lower bids?

So Dave, we're not marking them down, you just -- if they're TDRs, they're TDRs. I mean obviously, you're correct. I mean if there's no cash or the financial wherewithal from the borrower can't support it, you're going to carry them at the appraised value.

Right. And so if there are really no good transactions going on, and I mean, you're obviously using transactions to figure out where you value those assets is there...

Yes. We reappraise, we'll get updated appraisals, you go through that process. Again, I think I would say you're more inclined to deal with that on the office and retail side and maybe the mixed-use. But on the multi-family side, you still have a lot of customers here that are getting flushed with cash. So you're correct, it's going -- no one's coming out of this unscathed. It's going to be loans that have to be dealt with after the process goes through the multiple opportunities of giving them some relief, but we don't really know exactly when that will come for us. We feel very strongly that we're going to have very strong statistics to discuss at the end of the year. Bear in mind, we're 1 quarter behind the entire banking space because we felt it prudent to give them 6 months relief in the epicenter of the pandemic. We were proved right. I can tell you with certainty as we've gotten into Phase 4, businesses are opening right now. And the conversations like I've discussed we're having is, I don't want to -- I don't want to accrue this interest. I want to pay you, so I don't have an interest accrual. And that's the ongoing conversation.

There will be some that will have a difficult time. And given the low leverage we deal with, we'll work it out. And hopefully, it won't be a material number.

Have you guys set up any kind of a reserve for interest income for some of those loans that are on deferral where you think they might not be able to come off successfully?

Nothing material.

Okay. And then I guess, just lastly, what are the prospects of actually being able to extend deferrals again come October for some of those loans that are having trouble still we've heard from some banks that accounts may not allow that. They might force the TDR classification. But just curious what you guys are hearing.

Dave, I'd say that there is flexibility, and I'm hoping we don't have to go there. But if we do have to go there, there's lots of flexibility. We're in a black swan pandemic event that has to be dealt with but has significant government support here. So in the event a business is forced to shut down for a extended period of time, I'm assuming there's some flexibility under the CARES Act. If they can't reopen because the government says you can't open or they elect not to open, there's going to be some flexibility. We deal with a lot of large borrowers. We have a lot of large buildings that are rent regulated. We also have large credits. And those large credits are -- some are uniquely positioned, but some of the smaller players may have the issue of reopening and the capacity and we have to deal with that. And as that comes to a point where we have to sit down and discuss the next round of deferral, we'll deal with that.

But there's no question that there's flexibility. And it's important to note that what we're hearing from the industry that there'll be more flexibility coming. I will tell you that all our people are sitting on a number of panels of potential clarity on how to deal with this after 6 months. I believe by the time 6 months comes around, you'll probably have more clarity from the industry.

We have reached the end of our question-and-answer session. I would like to turn it back over to management for closing remarks.

Thank you. I want to thank you all for joining us today. And hopefully, we provided some insight into what keeps us unique. However, we will be available for those that have additional questions over the course of the day and the period ahead. Thank you all.

Thank you. This does conclude today's conference. You may disconnect your lines at this time, and thank you for your participation.