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Edited Transcript of HFWA earnings conference call or presentation 30-Apr-20 6:00pm GMT

Q1 2020 Heritage Financial Corp Earnings Call

Olympia May 18, 2020 (Thomson StreetEvents) -- Edited Transcript of Heritage Financial Corp earnings conference call or presentation Thursday, April 30, 2020 at 6:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bryan D. McDonald

Heritage Financial Corporation - Executive VP & COO

* David A. Spurling

Heritage Financial Corporation - Executive VP & Chief Credit Officer

* Donald J. Hinson

Heritage Financial Corporation - Executive VP & CFO

* Jeffrey J. Deuel

Heritage Financial Corporation - President, CEO & Director

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Conference Call Participants

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* Gordon Reilly McGuire

Stephens Inc., Research Division - Research Analyst

* Jacquelynne Chimera Bohlen

Keefe, Bruyette, & Woods, Inc., Research Division - MD, Equity Research

* Jeffrey Allen Rulis

D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst

* Matthew Timothy Clark

Piper Sandler & Co., Research Division - MD & Senior Research Analyst

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Presentation

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Operator [1]

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Okay. So the host speakers, you are in the main conference. (Operator Instructions)

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Jeffrey J. Deuel, Heritage Financial Corporation - President, CEO & Director [2]

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Okay. Perfect. Thank you, Daniel. Welcome, everybody, who called in. This is Jeff Deuel, CEO of Heritage Financial. We're very sorry for the mix up on the phone call. Apparently, we asked for a hosted call and got a general call. Fortunately, in today's environment, we're a lot more flexible than we used to be. So hopefully, you had some time to work on your e-mails while we got straightened out on our end. I'm going to jump into our presentation, and then we will open up for questions at the end. With me in the room are Don Hinson, our Chief Financial Officer; Dave Spurling, our Chief Credit Officer; and Bryan McDonald is our Chief Operating Officer, he is on by extension. He's at one of our remote locations this morning.

Our earnings release went out this morning premarket, and hopefully, you have had the opportunity to review it prior to the call. Please refer to the forward-looking statements in the press release. While it goes without saying this has been a heck of a quarter for our country, our communities and the banking industry. We started out the first 2 months of the quarter, seeing some nice growth in our pipeline, some positive progress with credit quality as a result of our active portfolio management. We also successfully launched our new Heritage Direct treasury management platform. Obviously, things quickly changed as the C-19 pandemic accelerated. Our pipeline began to decrease, and the management team dusted off our pandemic plan.

In Washington and Oregon, we have been operating in stay-at-home status since the third week in March. Our robust regional economy is in a self-induced coma. And although we have managed to flatten the curve, we expect the revival of our economy to take some time. Fortunately, the Governors of Washington and Oregon are talking about a staged approach to a restart. As an essential service, we continue to operate the bank with very little interruption to our customers. Early in March, we opted to close our branch lobbies to most customer traffic and operate through our drive-through facilities. All but 9 of our 62 locations have drive-through capabilities which made the transition that much easier. This move served to keep both employees and customers safe. We continue to operate in this manner, and we are now just beginning to plan for a phased approach to reopening some lobbies in the next couple of months. We are also able to quickly implement a remote work environment for many employees. Approximately 60% of our employees now have remote capabilities, and we have about 325 who are fully remote at this time.

It is important to note that even with the lobbies closed and people working remotely, we continue to add deposit relationships and make select new loans. In parallel with securing our lobbies and our people, we launched a loan modification program for all loan types to provide relief to our customers, and we also began a review of our underwriting parameters in light of the new conditions. After that, we became completely absorbed in the SBA PPP program and getting the stimulus money to customers who needed it. Fortunately, we have seen good success with our PPP program. And at this point, we believe we have served the need of our customer base. Even though we expect the banking industry will experience credit quality deterioration, as a result of the C-19 impact, we believe Heritage will outperform the industry median, similar to our experience in the last downturn. Our long-standing culture is focused on conservative underwriting, active portfolio management and avoidance of loan concentrations, which will pay off for us by keeping credit losses at manageable levels.

We will cover all of this in more detail as we move to Don Hinson, who will take a few minutes to cover our financial results, including color on our corporate operating metrics -- our core operating metrics with some specific comments about credit quality and CECL.

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [3]

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Thank you, Jeff. Our reported diluted earnings per share for Q1 was $0.33, which is down from $0.47 in Q4 2019. The decrease in earnings was due mostly to an increased provision for credit losses. The unfavorable impact to earnings was partially offset by a much lower effective tax rate in Q1. This was due to a combination of factors, including lower pretax income while increasing tax-exempt income instruments, and a $1 million discrete item due to the CARES Act allowing us to carry back an acquired bank net operating loss to 2017. Our stable net interest margin also helped earnings this quarter. The net interest margin expanded to 4.06% compared to 4.02% in the fourth quarter of 2019.

Moving on to the balance sheet. Net loan balances increased $73 million in Q1. Of that amount, $30 million was due to increases in utilization rates for operating lines of credits on C&I loans. Deposits increased $35 million in Q1, while maintaining the same percentage of nonmaturity to total deposits of 88.6%. We continue to maintain very strong balance sheet liquidity. At quarter end, we maintained combined credit facilities at the Federal Home Loan Bank and Federal Reserve Bank of $972 million, and fed fund lines at other banks totaling $140 million. In addition, we have unpledged investment securities totaling $728 million and brokered deposits currently making up only 5 basis points of total deposits.

Our loan-to-deposit ratio was 83.4%. We continue our long-standing strategy of operating with a balance sheet with a low leverage, which we believe will serve us well during our current economic situation. We have also been approved to use the fed's PPP liquidity facility in conjunction with our PPP lending. Regarding credit quality, we had a significant decrease of $10.4 million or 23% in nonaccrual loan balances in Q1. This improvement was due mostly from an agricultural borrowing line of $6.8 million, which exited the bank. This was part of the $20 million relationship discussed at length in the Q3 and Q4 earnings calls which we partially charged off in Q4. We still have $12.4 million in real estate loans related to that ag relationship, which we believe are well secured. These loans will stay on nonaccrual status until we see a history of payments on those loans.

Additionally, we received payment in full on a commercial business relationship of $2.3 million, which was also a nonaccrual status. Our net charge-offs for Q1 were only $417,000. This is a decrease from $1.9 million in Q4 due to the recovery in Q1 of $963,000 from that same ag relationship that was charged off in Q4. This recovery was offset by other commercial charge-offs of $1.2 million in Q1. Potential problem loans increased $14 million in Q1 due mostly to 4 loans downgraded to special mention as a result of C-19 and 8 loans downgraded to provide additional oversight. Potential problem loans would have decreased quarter-over-quarter without the C-19 additions. We are carefully monitoring our exposure to high-risk industries during this pandemic. Our commercial exposure to high-risk categories is relative to loan includes the following: restaurants, $85 million or 2.2% of the total portfolio; hotels, $124 million or 3.2% of the total portfolio; and recreation and entertainment, which includes bowling, fitness centers and other amusement-related businesses of $37 million or about 1% of the total portfolio. In addition, we are monitoring all remaining loan types carefully.

Let me turn now to COVID-19-related loan modifications. At the end of Q1, we have modified 136 commercial loans for a total of approximately $80 million, including a combination of interest-only deferrals on advertising term loans and full payment deferrals. Almost all modifications were for 90 days. Subsequent to quarter end through April 27, we have modified 615 commercial loans for a total of approximately $350 million, with approximately 60% interest-only and 40% full payment deferrals. While consumer loan modifications in number are higher than on the commercial loan portfolio, the dollar amount of consumer loan modifications is less than 10% of commercial loan modifications. We are taking a conservative approach to risk rating and only leaving modified loans at their pre-pandemic risk rating, if it is clear that the operating entity will quickly return to its pre-pandemic performance. As of March 31, we have downgraded 39 loans totaling $36 million in response to pandemic-related issues. Most of our C-19 modifications are being downgraded to watch and are not included in potential problem loan numbers.

Our expectation for the next round of modifications is that we'll see deterioration of borrower sustainability and some downgrades to substandard. Moving on to CECL. The total day 1 impact on allowance for credit losses was $5.5 million, $1.8 million for the allowance on loan balances and $3.7 million for the allowance on unfunded commitments. This day 1 increase in the allowance for credit losses on loans was partially mitigated by approximately $1.9 million of previously allowance related to December 31 PCI loans that were reclassified to loan discounts to be accreted as part of the CECL implementation process. The provision for credit losses on loans in Q1 was $10 million, or a 26% increase from the post day 1 allowance for credit losses on loans. This provision was partially offset by a $2 million reversal of allowance on unfunded commitments due to lower unfunded balances at the end of Q1.

At the end of Q1, the allowance for credit losses on loans increased to 1.23% of total loans from 0.96% as of the end of Q4. As a result of this increase in the allowance and decrease in nonaccrual loans, the allowance to nonaccrual loans increased to 1 point -- sorry, 139% at the end of Q1 from 81% at the end of Q4.

I'll quickly go over some seasonal model assumptions we used. We used a late March Oxford Economic Models for the forecast. Due to the rapidly changing environment, we added additional expected losses to the allowance for certain at-risk industries such as restaurants, hotels and recreation. We also reviewed the impact of the Federal Reserve Bank's 2020 severely stressed scenario, which calls for increased U.S. unemployment rates and severe global recession and elevated stress on corporate debt markets and CRE. Although we did not use this scenario in our final CECL calculation, our allowance as of March 31 was the equivalent of using a 60% likelihood of the fed's severely stressed scenario and a 40% likelihood of the late March Oxford Economics forecast. We will continue to monitor the forecast and economic conditions based on what has occurred post quarter end, we are likely to have elevated provisions for the remainder of 2020.

Moving on to net interest margin. We had an increase of 4 bps in the NIM Q1. This occurred primarily due to a change in the mix on earning assets, higher percentage of loans and lower percentage and overall interest-earning deposits. Loan yields did not decrease as much as might have been expected due to some recapture of previously reversed interest on nonaccrual loans and the funding of higher-earning commercial construction loans during the quarter. As previously expected, the cost of total deposits began to decrease in Q1, dropping 2 basis points to 37 basis points in Q1. Although we didn't experience NIM compression in Q1 due to 150 basis points rate cuts in March, I expect significant downward pressure in NIM starting in Q2. This pressure is expected to be partially mitigated this year by the yields on the PPP loans.

Noninterest expense increased $1.3 million from Q4 levels due mostly to increases in comp and benefits and marketing expenses. Both of these expense categories tend to jump in Q1 from the prior Q4. Comparing year-over-year, our overhead ratio improved to 2.70% in Q1 from 2.79% in Q1 2019. We do expect overall expense levels to increase in Q2 and Q3 due mostly to increased costs associated with the implementation of our new treasury management system and the completion of our usage of the credit for our quarterly FDIC premiums.

And finally, moving on to capital. We remain well capitalized for all regulatory capital ratios. Further, our TCE ratio remained strong at 10.2% at the end of Q1. During Q1, we repurchased 796,000 shares completing one repurchase plan and starting another one on March 12. On March 18, we suspended our buyback program until we better understand the impact of the current economic situation in our long-term capital levels. Yesterday, the Board declared a $0.20 dividend, which is unchanged from the prior quarter. Although we have no plans to cut or cease our dividends at this time, we will be monitoring on a quarterly basis, our capital position and ability to pay future dividends.

Bryan McDonald will now have an update on loan production and PPP status.

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Bryan D. McDonald, Heritage Financial Corporation - Executive VP & COO [4]

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Thanks, Don. As Jeff mentioned in his opening remarks, we saw good momentum in the commercial loan pipeline and production levels in January and February before being heavily impacted in early March by C-19, which then caused us and our customers to shift our focus.

For the quarter, our commercial teams closed $167 million in new loan commitments, very similar to the volume closed in the first quarter of 2019. The commercial loan pipeline ended the first quarter at $506 million, up 30% compared to the fourth quarter and up 13% compared to the first quarter of 2019. Subsequent to quarter end, we have seen many customers put capital projects, expansion plans and bank transitions on hold. And we are now anticipating the actual loan volume closed from this pipeline will be much lower. Gross loans increased $84 million during the first quarter, a 9% annual rate due to lower levels of prepayment and payoff activity and a higher utilization rate on operating lines of credit. The utilization rate on our commercial loans increased by 6% during the quarter, contributing $30 million to the growth and loan prepayments and payoffs were $68 million lower than what we experienced in the fourth quarter. Subsequent to quarter end, the utilization rate has trended down to levels more in line with utilization rates we have been experiencing over the last few years. Consumer production during the first quarter was $47 million, the same as the fourth quarter of 2019 and up from $40 million closed in the first quarter of 2019.

Moving on to interest rates. Our first quarter interest rate for new commercial loans was 4.24%, a decrease of 19 basis points from 4.43% last quarter. In addition, the average first quarter rate for all new loans was 4.46%, up 1 basis point from 4.45% last quarter. The mortgage department closed $26 million of new loans in the first quarter of 2020 compared to $52 million last quarter and $22 million in the first quarter of 2019. The mortgage pipeline ended the quarter at $54 million versus $15 million last quarter and $27 million in the first quarter of 2019. The growth in the pipeline is due to a spike in refinance activity caused by the drop in long-term rates.

Refinances made up 70% of the pipeline at quarter end. Finally, I'd like to cover the bank's participation in offering loans under the SBA Paycheck Protection Program. At the end of the first quarter, we started preparing to launch our fulfillment of PPP loans after the President signed the CARES Act into law on March 27. Our application package was made available to customers on Friday, April 3, and we went live processing applications on Monday, April 6. We are very fortunate to have a very experienced SBA team here at Heritage, having been a preferred SBA 7(a) lender for many years. This proved critical in designing the requirements and workflow for the PPP. In addition, we benefited from having internal IT capabilities to stand up a fulfillment and reporting system for SBA PPP lending during the weekend of April 4 and 5. The system allowed us to organize ourselves, see in real-time our volumes at each process step and shift work between several hundred staff members, many of whom were working remotely and working extended hours. This allowed us to fulfill over 2,800 applications in the first phase of funding, with an average loan amount of $244,000.

Most important to us, we were able to process the full backlog of customer PPP applications received during the first round of funding. Being left only with a small number of unprocessed applications when SBA funding was exhausted on the morning of April 16. These applications were fully processed when the second round of funding went live on Monday, April 27, and we continue to process new applications. We process PPP applications exclusively for our customers until we are current on our backlog and processing new applications within a few hours of receipt. After achieving this level of process efficiency, we opened up the process to known prospective customers. We anticipate many new relationships will result from our ability to help them with their SBA PPP application.

I'll now turn the call back to Jeff.

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Jeffrey J. Deuel, Heritage Financial Corporation - President, CEO & Director [5]

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Thank you, Bryan. We feel very good about our performance in light of the overlay of C-19. We have successfully and safely addressed the needs of our employees, customers and the communities we serve. It was particularly important for us to be able to perform at a high level in support of PPP. As a result of adding IT development capability to the team 2 years ago, we were able to stand up an automated platform in a matter of days. We believe this capability provided us with a competitive advantage in our markets. While we have not seen notable deterioration in the loan portfolio, we expect to see stay-at-home actions continue to take its toll on the at-risk industries. We will need to get beyond the PPP funding and the modification deferral period to fully begin to see the damage. We agree with others that businesses will suffer 2 shocks back to back, an immediate and in most cases, total revenue shutdown that transitions to a recession with very slow revenue growth. This is a different set of parameters than we have ever seen before, and we are not sure how it will play out as the economic resuscitation gets underway in our footprint. We are pleased with our performance and progress in the first quarter.

Despite the challenges from C-19 and a rapid decrease in interest rates, we believe Heritage is well positioned to navigate these challenges, and we will continue to benefit from our core deposit franchise and conservative credit culture while maintaining our focus on net interest margin and expense management. Furthermore, the robust liquidity and capital position on our balance sheet provides us with a solid foundation to adjust to challenges and take advantage of opportunities. As I said earlier, we're pleased with our performance to date and immensely proud of our team for their performance during this difficult time. That is the conclusion of our prepared comments.

So Daniel, maybe we can open up the line to answer questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And we do have a question from the line of Jeff Rulis.

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Jeffrey Allen Rulis, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [2]

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To the margin, Don, the -- how much was that -- how much did the interest recovery add to the 4.06% reported and kind of what was core, I guess, if you -- quarter-to-quarter?

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [3]

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Jeff, I think it had a couple of beeps to that. So not a lot, but it did help some. But again, I think that, again, we didn't feel the impact of all the rate cuts until we -- because it happened so late in March that we won't feel a lot of that until this quarter. And mostly on the loan side, obviously because our cost of deposits will not be able to drop as fast as our loan balances, our loan rates will be.

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Jeffrey Allen Rulis, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [4]

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Okay. So if it's 4.01%, 4.02%. And you talked about, I think, in the release about deposit lag pricing, that's more of a kind of a balance of the next couple of quarters. So again, maybe an acceleration of some compression given the rate cuts didn't have a lot of time to impact the quarter's margin.

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [5]

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Correct. Correct. Again, about -- almost 1/4 of our loans are fully floating. So if you just think about that, 150 basis points. Now some of them are -- have floors, but even then, when they get rewritten each year on their anniversary, they're liable to get rewritten at lower rates. So even if they're on a floor now that will change as the loan gets renewed.

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Jeffrey Allen Rulis, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [6]

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Got it. To the credit side, the ag and C&I credits brought out of nonaccrual. I think I recall those were somewhat one-off issues, but trying to see if there's any related hope that others here that are similar or are they true singular credit issues?

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Jeffrey J. Deuel, Heritage Financial Corporation - President, CEO & Director [7]

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I don't think that there is an overlay to all of those loans that's specific to the group, I think they're all individual issues. We are -- always work in the portfolio. We talk about that all the time, Jeff, and I think that we're hopeful that we'll see progress much like we've already seen.

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Jeffrey Allen Rulis, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [8]

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And on the -- you mentioned some C&I downgrades. I don't know if you've got a percentage or just in broad terms, the group of those that have deferrals or PPP support? Any idea on that?

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Jeffrey J. Deuel, Heritage Financial Corporation - President, CEO & Director [9]

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Well, there's clearly customers in the PPP program that we're happy to see participating. The deterioration that was related to COVID, which was a series of what I would characterize as larger loans moving into the problem loan category are -- obviously larger got attention sooner. And they're part of that category of at-risk loans, specifically, most of it is hotels. And it was just an exercise on our part to start taking action on some of them sooner than later.

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Jeffrey Allen Rulis, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [10]

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Great. And one last one, if I could. Just what would be the -- maybe for Don, the true-up on that reserve to loans at 1.23% if you were to include credit marks additionally?

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [11]

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Jeff, I'm not quite understanding your question.

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Jeffrey Allen Rulis, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [12]

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The acquired credit discounts that maybe -- so reserve to loans at 1.23%, but did you have an additional balance that would exceed that reserve level?

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [13]

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Well, I think we had $1.9 million that we switched over.

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Jeffrey Allen Rulis, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [14]

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Okay. So that effectively went away? There's not a...

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [15]

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Yes. So it went from allowance basically into discounts that will be -- that's one reason why normally we see as the balances decrease, the accretion percentage goes down overall to the impact on loan yields, it stayed the same this quarter. And that's because we drew in another -- that amount and then the $1.9 million, it's not going to get accreted as opposed to being part of the allowance, which it was before.

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Operator [16]

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And we have a question from the line of Mr. Matthew Clark.

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Matthew Timothy Clark, Piper Sandler & Co., Research Division - MD & Senior Research Analyst [17]

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On the CECL adjustment this quarter, using a late-March forecast with things, obviously deteriorating in April, I know that forecast was pretty dire, but is there -- is it fair to assume that we'll see some additional reserve build here in the second quarter before -- yes, maybe even the third too, but before you start to kind of use that reserve to realize the losses?

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [18]

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Yes. I think that -- this is Don. I think that we will continue to see that. Again, I expect higher reserves throughout this year. And I think that Q2 and probably Q3 will be probably -- I'm guessing the high points. But really depending on what happens, right? It's hard to predict right now what's going to happen long term and how long this is all going to go on for. But right now, I would expect continued high levels of reserves per quarter over the next probably couple of quarters at least.

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Matthew Timothy Clark, Piper Sandler & Co., Research Division - MD & Senior Research Analyst [19]

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Okay. And then on the higher risk exposures, the restaurants, hotels, recreation and entertainment, can you give us a sense for the underlying LTVs and debt service coverage ratios there? And maybe the average loan size and whether or not there's any other industries that you might be concerned about that others have talked about, like health care, senior living facilities, schools, churches, things like that?

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David A. Spurling, Heritage Financial Corporation - Executive VP & Chief Credit Officer [20]

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Yes. This is Dave Spurling. The high-risk industries we've identified, obviously include restaurants, hotels, as Jeff mentioned, recreation, fitness centers, but we've also got on that list some dental or dental borrowers and also churches, if that answers your question.

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Matthew Timothy Clark, Piper Sandler & Co., Research Division - MD & Senior Research Analyst [21]

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How much in terms of exposure there for those 2 other categories?

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David A. Spurling, Heritage Financial Corporation - Executive VP & Chief Credit Officer [22]

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The exposure on those other categories are fairly low. The largest exposure is in hotels, restaurants behind that. And the hotel exposure was about -- was at $119 million, I believe. And the restaurants is about $84 million. Those are the predominant high-risk categories.

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Matthew Timothy Clark, Piper Sandler & Co., Research Division - MD & Senior Research Analyst [23]

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Okay. And the underlying LTVs and coverage ratios there, if you have them?

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David A. Spurling, Heritage Financial Corporation - Executive VP & Chief Credit Officer [24]

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On the real estate side of things, our LTVs tend to be pretty conservative weighted average in the portfolio is about 55% to 60%.

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Matthew Timothy Clark, Piper Sandler & Co., Research Division - MD & Senior Research Analyst [25]

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Okay. And then now just on the PPP program, can you give us a sense for the average loan size there? How much might still be in the pipeline? I'm not sure if you already mentioned that. And then how you might be modeling it, whether or not you're just assuming that most of it will come and go by the end of the third quarter? Or do you feel like you're going to stick around longer?

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Bryan D. McDonald, Heritage Financial Corporation - Executive VP & COO [26]

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Matt, Don you want to start, and then I'll follow you.

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [27]

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Sure. Again, through the -- through quarter end -- or not through quarter end, for the first tranche that we got funded was $687 million, average was $244,000. And again, a bulk of those were under $350,000 and/or between $350,000 and $400,000. Again, I would say, in fact, if you break it down further, under $100,000 was about 9.4%. $100,000 to $350,000 was 22.5%. Half of the loans and balance were between $350,000 and $2 million. And then about 18.5% were over $2 billion. So those are the funded piece. And then we still have -- we're still getting other items through, our applications through. They haven't necessarily been funded, but they've been approved. And we're up to around -- our applications right now that we think we will get through is about $885 million and then it drops the overall average, though, we're including all of that down to about $220 million. So that the -- the loan size has been going down over time. And -- but that's because we're looking on to putting on probably another 200 in the second tranche as of right now.

Bryan, do you want to add anything to that?

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Bryan D. McDonald, Heritage Financial Corporation - Executive VP & COO [28]

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No, that's right on.

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Matthew Timothy Clark, Piper Sandler & Co., Research Division - MD & Senior Research Analyst [29]

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Okay. But is it fair to assume a 3% origination fee on average, not 5%?

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [30]

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I think it's going to be higher than that, yes. Because again, only -- again, about half of it is -- half of the loans are between the $350,000 and $2 million to get to 3% and only about 19% is over $2 million. So it will be between by 3% and 4%, on average.

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Matthew Timothy Clark, Piper Sandler & Co., Research Division - MD & Senior Research Analyst [31]

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Okay. Got it. Okay. And then maybe just the spot rate on deposit costs at the end of March, if you have it?

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [32]

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It was lower. I think it was closer to 35 basis points at play and towards the end of spot rate. So -- but we keep dropping the rates in this market.

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Matthew Timothy Clark, Piper Sandler & Co., Research Division - MD & Senior Research Analyst [33]

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Okay. And then just a good tax rate to use, given the lower level of income going forward?

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [34]

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Well, depending on our income levels, as far as the effective tax rate, if it's similar, and we didn't have the discrete item, it would be closer to 13%. But again, a lot -- the effective tax rate itself will depend on the pretax income going forward. But -- because, again, we don't -- our tax or perm tax items that are used for that calculation, actually grew a little bit in Q1 so...

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Operator [35]

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And we have a question from the line of Jackie Bohlen.

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Jacquelynne Chimera Bohlen, Keefe, Bruyette, & Woods, Inc., Research Division - MD, Equity Research [36]

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One quick follow-up on the PPP in terms of the new customers. So that -- the additional roughly $200 million that you're processing through the second round, is that all new customers? Or did you have some that carried over from the first round? I just wanted to make sure that I was clear on that.

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Bryan D. McDonald, Heritage Financial Corporation - Executive VP & COO [37]

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Jackie, this is Bryan. We had just the inflow, so stuff that maybe was taken after 8:00 the night before, round 1 ran out, and then we had a certain number of incomplete applications that hadn't been able to be processed. So -- and then, of course, between the time it closed and the time, the second round of funding opened, we had additional customers that came and applied during that period of time. So our daily flow the last few days has been maybe somewhere in the neighborhood of 100 applications. And it's different day to day, but it's more of a mix of prospects and customers versus, of course, all customers when we went into Phase I. So there is still customers in there along with prospective customers that we've been calling on.

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Jacquelynne Chimera Bohlen, Keefe, Bruyette, & Woods, Inc., Research Division - MD, Equity Research [38]

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Okay. And in terms of these new customers, what do you think the likelihood is that you could bring the other pieces of their portfolio in both loans and deposits over to you after things begin to normalize again?

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Bryan D. McDonald, Heritage Financial Corporation - Executive VP & COO [39]

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Yes. We're already seeing that, Jackie. We didn't go into it with the requirement around that, but we're seeing a number of customers be open to talking to us about other banking services as a result of doing the PPP loan form. It's a little early, but we're already seeing customers being open to moving additional business to us.

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Jacquelynne Chimera Bohlen, Keefe, Bruyette, & Woods, Inc., Research Division - MD, Equity Research [40]

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Okay. And were you actively marketing these customers? Meaning, were these prospective customers that you have been reaching out to in hopes of obtaining their business? Or were these just customers coming in looking for a loan?

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Bryan D. McDonald, Heritage Financial Corporation - Executive VP & COO [41]

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They were predominantly prospects that our bankers had been calling on previously. So in many cases, for many years, everybody has their prospect list and actively calling. So as they finished up handling the needs of their existing customers, the applications they had in hand, they then turn their attention to -- through the prospects they had been calling on to see if we could help them with a PPP loan.

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Jacquelynne Chimera Bohlen, Keefe, Bruyette, & Woods, Inc., Research Division - MD, Equity Research [42]

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Okay. Great. Just one last one and then I'll step back. In terms of the treasury management system, I had a light note, I think from last quarter that, that's roughly on $1 million in added expenses in the year. First off, is that still an accurate number? And second, was any of that included in 1Q? Or will that all flow in, in 2Q, realizing that, that $1 million is an annual number?

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [43]

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Yes. And that -- Jackie, that's gone up some. The implementation is going to be more than we initially thought. So I think we probably have another -- I think another $1 million or $1.1 million left, and we did about, I think, about $400,000 in Q1. So -- but that should be done by end of Q3, the remaining $1 million or $1.1 million.

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Jeffrey J. Deuel, Heritage Financial Corporation - President, CEO & Director [44]

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Jackie, one of the issues we faced into was we launched in the first quarter. And the first wave of customers were handled quite well actually, and then C-19 hit. So what we had to do was shift our waves of customers to double up the next wave later in the year so that we could get past what we were dealing with the last 8 weeks. So that just presented additional costs because we had to reset our arrangement with the vendor that's helping us through that process.

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Jacquelynne Chimera Bohlen, Keefe, Bruyette, & Woods, Inc., Research Division - MD, Equity Research [45]

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Okay. Okay. That's helpful. And that $400,000 number, is that an annualized number?

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [46]

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No, that was a number in Q1. And then like I said, we'll have another -- about another $1.1 million, I think, left over the next 2 quarters.

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Jacquelynne Chimera Bohlen, Keefe, Bruyette, & Woods, Inc., Research Division - MD, Equity Research [47]

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Okay. And that one -- so the $400,000 is not annualized, but the $1.1 million is?

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Donald J. Hinson, Heritage Financial Corporation - Executive VP & CFO [48]

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$1.1 million is what's left to be spent over the next 2 quarters.

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Operator [49]

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And we have a question from the line of Mr. Gordon McGuire.

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Gordon Reilly McGuire, Stephens Inc., Research Division - Research Analyst [50]

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Don, I wanted to clarify a comment you made earlier. You -- for modified loans, you downgraded if you did, you didn't feel like they could return to pre-COVID levels of performance, is that correct?

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David A. Spurling, Heritage Financial Corporation - Executive VP & Chief Credit Officer [51]

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Gordon, this is Dave. We had a bias towards taking credits to watch, but in those instances where the borrower and client was more likely to return quickly to pre-pandemic performance, we left those at their original risk rating.

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Gordon Reilly McGuire, Stephens Inc., Research Division - Research Analyst [52]

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Okay. And do you have the ratio of what watch loans at this point versus, I guess, March 31 versus December?

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David A. Spurling, Heritage Financial Corporation - Executive VP & Chief Credit Officer [53]

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I don't have those numbers handy, but I know there was -- in the first quarter, in March, there was kind of a spike in watch credits due to the downgrades that were a result of modifications.

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Gordon Reilly McGuire, Stephens Inc., Research Division - Research Analyst [54]

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Okay. But those did not flow into potential problem loans. So I guess the $18 million or so COVID-related potential problem loans, are those going to be able to be subject to modifications?

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David A. Spurling, Heritage Financial Corporation - Executive VP & Chief Credit Officer [55]

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Those were kind of outliers. Those were some credits that -- the 2 predominant ones were destination hotels. And they presented more risk than we thought a normal modification would present. So we did take those down to special mention and it became DPLs.

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Gordon Reilly McGuire, Stephens Inc., Research Division - Research Analyst [56]

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Okay. And do you have the mix of modification or how much of the modifications you had were related to the higher risk portfolios that you identified?

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David A. Spurling, Heritage Financial Corporation - Executive VP & Chief Credit Officer [57]

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I don't have that breakout. But as was mentioned earlier, it was kind of an even split between interest-only on amortizing and full payment deferrals, but don't have the breakout by industry.

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Gordon Reilly McGuire, Stephens Inc., Research Division - Research Analyst [58]

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Okay. And then, Bryan, I think I heard all new loan originations were up 1 basis point to 4 46. I guess what drove -- what do you feel like drove that? Was it increased credit spreads? Or did the construction utilization drive that higher? Was that kind of abnormal?

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Bryan D. McDonald, Heritage Financial Corporation - Executive VP & COO [59]

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It just -- most of the quarter's production just predated the big drop-off in rates. So Don mentioned the fed rate is dropping, but of course, the Federal Home Loan Bank Indexes that tend to mirror the treasury rates, of course, higher we saw those fall off. So it was really the mix of loans and then just the fact that the quarter just didn't capture most of the downward rate movement we've seen.

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Gordon Reilly McGuire, Stephens Inc., Research Division - Research Analyst [60]

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Okay. And then last one for me is how you guys are thinking about funding the PPP loans that come on the balance sheet?

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Jeffrey J. Deuel, Heritage Financial Corporation - President, CEO & Director [61]

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Well, as I mentioned, we're all signed up with the fed to use their liquidity facility. For that, we haven't started doing that yet, we haven't needed it. And -- but for one thing is that we've got the loans out there and they go into the person's deposit account, but really nothing or not much has been spent yet because it all happened pretty recently. So -- but as that money gets spent and we need the funds, we'll start to pledge those to that facility and take those funds from that facility. And as a reminder, that facility is 35 basis points. And -- but there are no nonrecourse borrowings.

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Operator [62]

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And there are no further questions at this time.

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Jeffrey J. Deuel, Heritage Financial Corporation - President, CEO & Director [63]

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Thank you, Daniel. I think then we're ready to wrap up this quarter's earnings call. We thank you all for your time and your patience as we got our call underway. We appreciate your support and your interest in our ongoing performance, and we look forward to talking with many of you over the coming weeks. Thank you, and goodbye.

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Operator [64]

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Ladies and gentlemen, this conference will be available for replay after 1:00 p.m. today through May 14 at midnight. You may access the AT&T replay system at any time by dialing 1 (866) 207-1041 and entering the access code 3443789. That does conclude our conference for today. Thank you for your participation and for using AT&T teleconference service. You may now disconnect.