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Edited Transcript of INBK earnings conference call or presentation 24-Jan-19 5:00pm GMT

Q4 2018 First Internet Bancorp Earnings Call

INDIANAPOLIS Jan 28, 2019 (Thomson StreetEvents) -- Edited Transcript of First Internet Bancorp earnings conference call or presentation Thursday, January 24, 2019 at 5:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* David B. Becker

First Internet Bancorp - Chairman, President & CEO

* Kenneth J. Lovik

First Internet Bancorp - Executive VP & CFO

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Conference Call Participants

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* Adela Dashian

Keefe, Bruyette, & Woods, Inc., Research Division - Assistant Analyst

* Bradley Allen Berning

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* John Lawrence Rodis

FIG Partners, LLC, Research Division - Senior VP & Research Analyst

* William J. Dezellem

Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer

* Allyson Pooley

Financial Profiles, Inc. - SVP

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Presentation

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Operator [1]

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Good afternoon, and good morning. And welcome to the First Internet Bancorp Fourth Quarter 2018 Financial Results Conference Call. (Operator Instructions) Please also note that today's event is being recorded.

At this time, I'd like to turn the conference call over to Ms. Allyson Pooley from Financial Profiles. Please, go ahead.

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Allyson Pooley, Financial Profiles, Inc. - SVP [2]

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Thank you, Jamie. Good afternoon, everyone, and thank you for joining us to discuss First Internet Bancorp's First Financial Results for the Fourth Quarter and Full Year Ended December 31, 2018. Joining us today, from the management team, are Chairman, President and CEO, David Becker; and Executive Vice President and CFO, Ken Lovik. David and Ken will discuss the fourth quarter and full year results, and then we'll open the call to your questions.

Before we begin, I'd like to remind you that this conference call contains forward-looking statements with respect to the future performance and financial condition of First Internet Bancorp that involve risks and uncertainties. Various factors could cause actual results to be materially different from any future results expressed or implied by such forward-looking statements. These factors are discussed in the company's SEC filings, which are available on the company's website. The company disclaims any obligation to update any forward-looking statements made during the call.

Additionally, management may refer to non-GAAP measures, which are intended to supplement, but not substitute the most directly comparable GAAP measures. The press release available on the website contains the financial and other qualitative information to be discussed today as well as the reconciliation of the GAAP to non-GAAP measures.

At this time, I'd like to turn the call over to David.

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [3]

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Thank you, Allyson. Good afternoon, everyone, and thank you for joining us today. As we enter into our 20th year of operations, we have a lot to be proud of. We had another successful year in 2018 as we reported record net income, driven by 30% loan growth, excellent credit quality and well-managed expenses. We furthered our mission of serving customers in the digital economy, providing them with customer-centric digital banking solutions, while maintaining the personal touch of relationship banking.

Earlier in the year, we surpassed the $3 billion market in total assets and ended the year at $3.5 billion, which represents a 35% compounded annual growth rate for the last 5 years. It took us 15 years of operations to reach $1 billion in total assets and less than 5 additional years to surpass to $3 billion.

Our quest towards achieving greater scale and operating leverage is working. We continue to strengthen, grow and diversify our asset-generation channels with our collection of specialty lending franchises, both nationwide and on a regional basis.

In 2018, we strategically grew our loan balances by $625 million, or 30%, primarily driven by expansion in our specialty lending lines in the areas of public finance, single-tenant lease financing and healthcare finance, which are on the commercial side of our business, and then horse trailer and RV financing on the consumer side.

We also grew our residential mortgage portfolio through the combined efforts of our nationwide direct-to-consumer mortgage business and our Indianapolis-based construction team. We funded this loan growth primarily through new deposits, which grew by $586 million or 28% for the year.

We have built a $2.7 billion nationwide branchless-deposit franchise that provides consumers, small businesses, commercial clients and municipalities with innovative technology, convenient access, high touch customer service and competitive deposit rates.

That being said, our cost of funds continued to increase during 2018 as the competition for deposits remained high and the Federal Reserve continued on its path towards monetary policy normalization, implementing 4 interest rate increases over the course of the year. The increased cost of funds put pressure on our margins and adversely impacted our profitability, somewhat muting the benefit of our loan portfolio growth.

Over the last 5 years our net income has grown at a compounded annual rate of 37%. And in 2018, despite the headwinds and the deposit cost, we once again, delivered record net income, which grew by 44% for the year, as we benefited from the growth in our balance sheet, increased operating leverage and ongoing excellent asset quality. Our asset quality is being driven by a combination of factors, including our strong credit culture, and disciplined approach to underwriting. But it is also the results of our focus on certain specialty lending lines that target lower-risk asset classes, such as our public finance and our single-tenant lease financing businesses, which, when combined, make up nearly 60% of our total loan portfolio. We are proud of our track record in credit and believe that is one of our competitive advantages.

Overall, we delivered another strong year of performance despite some of the headwinds we faced. We enter 2019 with a renewed focus on our strategic initiatives and our commitment to building shareholder value.

One of our near-term objectives includes further expanding the scope and market penetration in our specialty lending lines, while also diversifying our asset generation and revenue channels.

During the third quarter, we hired an experienced SBA banker to begin building a platform. And we began originating loans in the fourth quarter. We have been actively evaluating opportunities to expand in this area of lending, which would diversify our sources of noninterest income, while adding prime-rate-based loans to the balance sheet. We look forward to updating you on our efforts in this area in the near future.

I would also like to mention the share repurchase authorization that we recently announced, while our primary goal is to use our capital to reinvest in the business, we believe that our shares are trading at a significant discount to fair value and repurchases then express our confidence in the long-term opportunities for the company and demonstrates our commitment to enhancing shareholder value, while maintaining strong capital levels.

And finally, we remain committed to our entrepreneurial culture. Attracting and retaining top talent has always been a high priority for us as our people are our greatest asset and one of the keys to our long-term success. We continue to be recognized for our innovation and are consistently ranked amongst the best banks to work for. And we're very proud of that fact.

Now turning to some operating highlights for the fourth quarter. Our performance was highlighted by solid loan growth, excellent credit quality and well-managed expenses. However, earnings were adversely impacted by a write-down of a legacy commercial OREO property and continued that interest margin compression, as short-term interest rates accelerated there in the quarter and the yield curve continued to flatten.

Net income for the quarter was $3.6 million or $0.35 of diluted earnings per share, which included the $2.4 million pretax write-off of the OREO properties. Excluding this charge, net income was $5.5 million or $0.53 diluted earnings per share. This compares to a $6.3 million or $0.61 diluted earnings per share for the third quarter of 2018.

We continue to do a great job reaching our target customers. Our total loans outstanding increased by $223 million from the third quarter, which equated to a 36% annualized growth rate, as demand for our speciality suite of commercial and consumer loan products remains strong.

Public finance wrapped up the year with a strong December, which accounted for over half of the team's fourth quarter originations. We also experienced the surge in year-end demand in single-tenant lease financing as certain borrowers pulled forward planned activities from first quarter of 2019 fundings.

From a deposit perspective, we've continued focus on opportunities to generate lower-cost funding for the expansion of our small business, municipal and commercial relationships as well as from traditional consumers.

As we reported on our last call, we did win the operating account business from an important local municipality, which funded in late December, so we'll see the full benefit from this in the first quarter, our commercial deposits team is working hard to leverage this win into additional opportunities.

We have a number of products initiatives in place as we continue to invest in services and technology to improve our customers' ability to manage their finances. Among those, we will be rolling out in 2019, our enhanced digital banking capabilities for small business and commercial clients and relaunching our small business checking product.

On the process side, we have significantly improved our account-servicing capabilities to provide a better customer experience, improve efficiency and reduce risk. For example, we replaced our point-of-sale engine for consumer and small business deposit accounts with a process designed for mobile users that significantly reduces the time to submit an application and improves pull-through rates.

And from a marketing perspective, our goal is to deliver the compelling value proposition we offer in a cost-effective rate to highly targeted prospects. Marketing programs targeted towards consumers and small businesses are scheduled to launch in 2019.

We are also exploring affinity relationships. And we'll be partnering with an organization to drive increased affinity with small business relationships.

And finally, we are working on a strategy to capture deposit business form the credit relationships and the healthcare finance through our partnership with Lendeavor.

In summary, we finished 2018 strong, we've remained committed to executing on our strategy to expand our specialty-lending franchise and further build upon our expertise in branchless banking. Utilizing our nationwide deposit-gathering platform to fund our expected growth. We are also committed to continuing to deploy capital in a very disciplined and profitable manner, and when, combined with our strong credit culture and highly efficient, scalable back-office operations, should drive attractive long-term return for our shareholders.

With that as an overview, let me turn the call over to Ken to provide additional details on our financial performance for the quarter. Ken?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [4]

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Thanks, David. And thank you, everyone, for joining us today.

Total loans increased by $223 million or 8.9% from the end of the third quarter and exceeded the high end of the guidance we provided on last quarter's call.

As David mentioned, we saw a significant origination activity in December, including $27 million of single-tenant lease financing deals that were pulled forward from planned first quarter 2019 activity.

Our commercial portfolio grew by $164 million in the quarter, driven by $217 million of funded originations, primarily due to increased production in public finance, single-tenant lease financing and healthcare lending. Healthcare finance loans, again, grew at the highest rate posting a 31% increase from the third quarter, albeit off a lower base as compared to single-tenant leasing and public finance.

We launched this product just over a year ago via our strategic partnership with Lendeavor, a San Francisco-based technology enabled lender, focused primarily on dental practices. And we are excited about the success that we're seeing within this business line.

Public finance also continues to contribute to loan growth as it increased by $95 million or nearly 16% from the third quarter. We continue to put resources into this business and plan to continue our geographic expansion with lending relationships now in 17 states.

As we have discussed in the past, we particularly like this asset class due to its high credit quality and lower regulatory capital requirements. And these loans are very easy to hedge with interest rates swaps to create LIBOR-based floating-rate assets.

Single-tenant lease financing balances increased $36 million or 4.1% from the prior quarter due to the increase in activity at year-end. This growth does include the impact of a loan sale we conducted during the quarter. We sold a pool of single-tenant lease financing loans with an unpaid principal balance of $15.4 million and a gross weighted average coupon rate of 4.4% for a modest premium during the quarter resulting in a gain of approximately $90,000.

On the consumer side, residential mortgages grew by $37 million or 10%, driven by construction activity as well as jumbo and on-production, originated by our Internet team.

Additionally, our specialty lending areas of trailers and recreational vehicles continued to grow, increasing 6% on a combined basis during the quarter.

Moving to deposits and funding, the largest increase in our funding base was in broker deposits, which was primarily driven by our long-term funding strategy. As discussed in the earnings release, we used brokered variable-rate, money-market deposits to supplement organic deposit funding and then convert a portion of those balances into fixed-rate funding with interest-rate swaps to better match the duration of the loan portfolio.

We also accessed the traditional brokered CD market to lengthen the duration of our liabilities and complement our organic CD production, which was on the shorter end of the curve. While the longer duration brokered CDs carry a higher relative cost, during the fourth quarter we found that we could save 5 to 10 basis points in the brokered market compared to paying up in the traditional institutional CD channels.

In addition, we used Federal Home Loan Bank advances to supplement the deposit funding. To manage interest-rate risk we structured these as long-term funding using interest-rate swaps, saving in excess of 30 basis points compared to standard FHLB bullet rates.

Turning to net interest margin, the ongoing flattening of the yield curve and the continued rise in short-term interest rates combined with the competitive deposit pricing environment, put more pressure on our net interest margin than anticipated. Our reported net interest margin decreased 17 basis points to 1.89% from 2.06% in the third quarter, and on an FTE basis, net interest margin declined to 16 basis points to 2.07% from 2.23% in the prior quarter, exceeding the guidance we provided last quarter.

The cost of funds related to interest-bearing deposits increased 19 basis points to 2.14%, and our overall cost of funds increased 18 basis points to 2.19%. While we expected deposit costs to rise during the quarter, due to a full quarter's impact of long-term hedging strategies related to brokered money market balances and the planned replacement cost of maturing CDs, the pace of the increase in short-term interest rates exceeded our forecast. When combined with the heightened competition in the online deposit space, deposit pricing related to money-market balances and CDs grows faster than anticipated and negatively impacted net interest margin by approximately 6 basis points beyond our original forecast.

However, I do want to point out that since the end of the quarter, we have seen CD rates pull back a bit and as a result, we have reduced rates in our institutional and public funds channels by an average of 6 -- 17 basis points and in our consumer and small business channels by 7 basis points across all maturities.

The yield on the loan portfolio declined 2 basis points to 4.17% as higher yields earned on the C&I, residential mortgage and consumer portfolios were offset by significantly lower prepayment fees in the single-tenant lease financing and healthcare finance portfolios. Overall, the decline in prepayment fees accounted for about 6 basis points of the decline in net interest margin quarter-over-quarter.

Turning to noninterest income, compared with the prior quarter, our noninterest income was essentially flat as lower revenue from mortgage banking activities was offset by the gain on sale of single-tenant lease financing loans and other noninterest income.

During the quarter, revenue from mortgage banking was down over 18% as mandatory pipeline volumes declined compared to the third quarter. And for the year, mortgage revenue was down 27% as home-price appreciation and higher interest rates impacted application volumes across the industry.

As a reminder, last quarter, we reduced staffing in this area, and we are in the process of upgrading our technology, which is expected to lower the cost for a closed loan and increased closed loan volume per loan officer. The implementation of this technology is on track to go live during the first quarter, and we are expecting a lift in revenue this year.

Moving to expenses, noninterest expense of $12.7 million increased by $2.7 million or 27%, as compared to the third quarter, due primarily to the $2.4 million write-off of commercial OREO properties that David mentioned earlier. These are 2 student housing properties located in Illinois that were originally underwritten in 2010 and transferred to OREO in 2012 when it was determined that the borrower committed fraud. The revaluation of these properties was driven by deteriorating conditions in the local market and the initiation of a marketing strategy to move the properties off our books. I think this is important to note that given the circumstances surrounding these properties and the nature of the lending we do today, we believe, these are isolated incidents and are in no way an indication of any systemic credit issues within our portfolio. Aside from these properties, the only item in OREO is a residential mortgage property with a carrying value of $554,000.

Excluding the write-down of the OREO properties, operating expenses remained well contained and rose less than 3% compared to balance sheet growth of almost 11%.

Now turning to asset quality. Credit quality was, again, very solid as nonperforming loans to total loans remained low at 3 basis points. We did see an uptick in the dollar amount of nonperforming loans as 2 credits: one, C&I; and the other, owner-occupied, CRE, moved to nonaccrual status. We are in the process of exiting those relationships and believe we are well collateralized.

As additional color related to our credit administration activities, during the fourth quarter, we exited almost $18 million in C&I and owner-occupied CRE relationships, rated either monitor or special mention. While these credits were currently performing and the borrowers demonstrated strength at the time of underwriting, there were subsequent indications that weaknesses could develop should economic conditions deteriorate. Delinquencies 30 days or more past due did increase to 15 basis points of total loans, or approximately $3.5 million. While still a low number compared to the rest of the industry, it was a large increase for us and was due primarily to one seasoned residential mortgage loan with an unpaid principal balance of $3.1 million. So property is located in a desirable area and a recent appraisal valued the home at $5.3 million. We are working with the servicer to bring the borrower current.

We continue to have minimal net charge-offs, which were $295,000 during the quarter or 5 basis points of average loans on an annualized basis. In general, net charge-offs were confined to the consumer-loan portfolios with no individual loan comprising material portion of the total amount charged off.

Provision expense, for the fourth quarter, increased to $1.5 million, driven primarily by the growth in the loan portfolio. Our allowance for loan losses to total loans was, again, relatively stable at 66 basis points as of December 31, down 1 basis point from the prior quarter. Portfolio metrics continued to remain strong as the portfolio LTV in the single-tenant lease financing book was 50% at quarter-end when new originations came on with an average LTV of 51%. And the public finance portfolio, almost 70% of the loans were made to borrowers with underlying credit ratings of BBB+ or better and over 47% to borrowers with a rating of A+ or better.

Related to capital, despite the strong balance sheet growth during the quarter, capital levels remained solid and can support continued growth. Tangible common equity to tangible assets declined to 8.03%, but given the lower-risk nature of our balance sheet and top-quartile asset quality, we believe, we have plenty of runway to support balance sheet growth.

As David touched on earlier in the discussion, we did repurchase shares under the announced stock repurchase program. In December, we repurchased 10,897 shares at an average price of $19.83 per share or $260,000 in total. So far in the first quarter, we have purchased another 17,101 shares at an average price of $23.07 per share. In total, we have repurchased over $610,000 of our stock at prices significantly below tangible book value.

Despite the write-down of OREO and interest rate moves that impact shareholders' equity through AOCI, we continued to grow tangible book value per share. At year-end, tangible book value per share was $27.93, an increase of nearly $2 or 7% year-over-year and [add] a premium to where our shares currently trade.

Before I wrap up my comments, I want to provide some color on our outlook for 2019. Related to loan growth and balance sheet management, we feel very good about our ability to continue generating assets. Our CRE team has built a finely tuned machine in single-tenant lease financing and current pipelines look pretty good.

Our C&I teams in Indianapolis and Arizona are picking up traction and have the potential to have a very solid year. Public finance has been an enormous success since we launched it in early 2017, and we expect continued success, although the recent decline in long-term rates may have an impact on production as potential borrowers look to the public markets.

However, we are also cognizant of where our stock price is trading and the need to manage capital efficiently, and to deploy it in a manner that enhances profitability. To that end, we will actively manage the balance sheet so that we can capitalize on the opportunities in front of us, while preserving capital in a difficult environment. To reposition the balance sheet and improve the mix of earning assets and, therefore, improve net interest margin and EPS as well, we may pursue loan sales that allow us to move lower yielding assets off the books and free up liquidity and capital to fund new originations at higher rates.

With regard to our outlook on net interest margin, the yield curve has flattened even more with the recent decline in long-term interest rates. Current interest rate forecasts are predicting some volatility on the front end of the curve, with short rates beginning to decline over the last half of 2019, while longer rates stay relatively static. If the implied forward-rate expectations hold, 2019 will continue to be a difficult interest-rate environment. The upside to this is that we eventually see a ceiling on deposit costs early in the second quarter. The downside is that net interest margin compression will likely continue into the first quarter, probably in the range of 6 to 9 basis points on an FTE basis as we deploy existing balance sheet liquidity before starting to come back up in the second quarter.

Related to loan-growth expectations, given the changing interest-rate environment and our objective to drive profitable growth, we are targeting annual portfolio growth in the range of 18% to 20%. This expectation is somewhat lower than our historical track record, but with the existing market conditions being what they are, we believe a strong focus on enhancing the mix of earning assets will create greater shareholder value in the long run.

With that, I will turn it back over to the operator so we can take your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question today comes from Adela Dashian from KBW.

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Adela Dashian, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant Analyst [2]

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This is Adela on for Mike Perito. I was just wondering about that profitability outlook for your mortgage business, given recent volumes? And do you think there is some need to tweak expenses in this business at all going forward?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [3]

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I mean, in terms of profitability in the mortgage business, we do expect to generate -- we do expect some revenue growth over the course of 2019, while keeping the expenses, relatively, in check. I mean, we're not projecting a tremendous increase in overall expenses for next year, and certainly not in the mortgage space as we have repositioned it. We don't expect a lot of increase, overall, in the expense space in mortgage, but are forecasting an increase in revenue for the year, given the technology enhancements that we've invested in.

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [4]

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With the cut we did in the fall, that actually returned the group to profitability even with the lower originations there in the fourth quarter So that the -- as Ken just stated, the investments we were making in the technology side pan out as we anticipate they will, the -- their numbers are actually going to come up quite significantly next year for the bottom line. Again, market is in front of us. For us, as a general rule, when tenure goes down it's not a good position but that helps the mortgage side of the operations, so we're looking for a good solid year out in 2019.

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Adela Dashian, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant Analyst [5]

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Okay. Great. And then, if I could also ask, I know you've been active in the share repurchase space lately, what's your top priorities in terms of capital deployment at this point?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [6]

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I mean, I think our primary objective is to continue deploying the capital we have into earning assets that enhance profitability and drive increased earnings. I mean, we recognized where the stock price is. And, to be honest with you, being able to buy back our stock at a significant discount to tangible book value per share is attractive. But I think, I mean, in terms of deployments, the #1 priority is to continue funding profitable growth, but do that in a disciplined manner, understanding that capital is not unlimited and then taking a some -- taking a little bit there and continuing to repurchase shares in the market.

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Operator [7]

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Our next question comes from Andrew Liesch from Sandler O'Neill.

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Unidentified Analyst, [8]

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This is actually [Thomas] on for Andrew, today. So actually you guys answered quite a few of my questions in your commentary, but I was just wondering, do you guys have a preliminary estimate on the basis-point benefit from the swaps that are becoming effective?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [9]

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It's a bit tricky to tell. I mean, what's happened with the hedging -- and keep in mind there's a couple of reasons why we have to hedge these assets. The majority of our internal asset-generation capabilities today are longer term in nature, whether it's single-tenant lease financing, public financed, healthcare finance is longer term, albeit fully amortizing loans, same in consumer space. So we have to balance short-term interest-rate risk, which is -- what probably most of the folks on this call are interested in the immediate impact on net interest income, along with balancing long-term interest-rate risk and economic value of equity, which is what our regulators are most focused on these days.

In terms of the impact of the hedges in this quarter, we had a slight negative to that as kind of the first round of hedges began to become effective. And some of that had to do with timing of when the swaps went effective. For example, 3-month LIBOR ran up over 40 basis points during the quarters, so we had a couple of our earlier hedges go effective with rates of in the kind of the $250-, $255-range and LIBOR ended the quarter in kind of the $278- to $280-range. So we did -- we saw a slight negative there due to timing, plus we had some other hedges that, went effective, that didn't have deferred starts -- that didn't have full 1-year deferred starts on them but had partial -- partially deferred starts and had a higher fixed rate.

Kind of all in all, the weighted average pay rate on our public financed hedges is in the range of, call it, $280 to $285. And 3-month LIBOR right now, is at, again, call it, $278, $279. So on a weighted average basis, the floating rate is right in line with the pay rate on those, I guess, the impact of how those will benefit current period NII depends on the view and where LIBOR rates go.

If we go back in time, 2 to 3 months ago, put forward the implied rate curve, all had LIBOR rates continuing to escalate higher throughout 2019 as the Fed had 3 planned rate hikes on the horizon and the Fed funds future's market followed that. Fast forward to today, and while the Fed may have -- may say they have a couple of planned rates hikes, the market is doing something else with LIBOR curves coming down over the course of 2019. Fed funds rates are predicted to decline as well.

So all in all, I think, about regards to our outlook for net interest margin, we're not bumping up short rates in our models. So right now, the impact is really net neutral on the swaps over the course of the year, with certain timing differences may impact quarter-to-quarter. I know that was long-winded answer, but hopefully it answered the question.

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Unidentified Analyst, [10]

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Yes, definitely. Thank you for the color for that -- on that.

And then, just looking up the OREO properties, I might -- I may have missed this, but did you guys discuss what drove the revaluation right now? And then, had you tried to market the properties in prior years?

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [11]

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Yes, actually in 2018, we had a health services company that was looking to buying one of the properties from us. They were actually subleasing it for period of time. We did engineering studies. They -- we're looking to make a -- more than $1 million investment in the property to get it up to the standard that they needed. It was a publicly traded health services company. All of the year they opted not to buy the building from us. In fact, they closed down their facilities in Carbondale in total, and moved to another location. So that prompted us to put the properties back out in the market. The -- obviously, the problems that they've had in the state of Illinois over the last few years and not having a budget created problems for universities throughout the state. They've, finally, passed the budget here in '18, things seem to stabilize, but the market is down significantly. And without finding an alternative purpose to the education market, that's why we opted for the write-off and went ahead and listed. We were in the position, over the last couple of years, where we really couldn't market the properties because there was a lot of question whether the university would even remain in Carbondale, that's stabilized, so it's now and the commercial opportunity we had went away. So it's time to put it out on the market and let them build student housing and put it to use.

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Operator [12]

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Our next question comes from Brad Berning from Craig-Hallum.

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Bradley Allen Berning, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [13]

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Can you spend a little bit more time on the deposit franchise, kind of, efforts. You talked about some of the efforts there. But just help us think about when do you think we'll see, potentially, more material shifts in the funding mix, given the little bit slower targeted loan growth rate, obviously, still strong loan growth but can you talk about whether that will be helpful for you in moving the needle for -- from a deposit-mix standpoint?

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [14]

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Yes, I think there's a couple of things that we are working on. But we -- I think, we talked about it in the last call, we put in a new front-end POS system. We're having tremendous results from that. We're getting it ready to roll that same Fed Product out in the small business community. It took our pull-through on applications from 3% to 4% to closer to 40% and of the folks that actually come in and start the application process, now 80% of them are completing it. So we're starting to see a pickup in the basic [out] process. We're looking at maybe an adjustment on the money-market rates as the market seems to be stabilizing. Obviously, the money market cost is considerably less in some of the CD products out there today. We talked about the municipality that we opened up here in Central Indiana. We hope to leverage that. Our C&I kind of business team is out working with the small business components. We've got a lot of, I guess, products and services to offer that we had not offered in the past. We're also just recognized there'll be press release, a little ahead of the game as one of the top 10 best checking accounts in the country for consumers based on price product features, so we're working the deposits side of the balance sheet as hard as we're working the other -- the lending side of the balance sheet. We have the affinity program that we'll be rolling out. It's not a huge, kind of, brand name, but it's a first for us in the kind of the affinity processes and we've got other opportunities in that space we're looking at. So getting more traditional money market checking accounts, both from consumers and small businesses, is a major driver for our marketing team here in 2019.

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Bradley Allen Berning, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [15]

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Given that, do you think like the mix of more core deposit at lower cost of funding at the end of '19, do you think -- is that something that can be meaningfully moved to mix? Or is it to keep pace with, kind of, the loan growth mix?

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [16]

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Again, we're -- we dare not try to forecast what's going to happen to rate [tenants] . I think the -- it'll be significant, if the Fed stays to one increase over the course of the year. I think that's kind of built into a lot of the deposit base. And by maybe the higher cost CDs, we can see 50, 60 basis point savings. And what the cost of funds -- new cost of funds are coming in at, so potentially if the Fed does what they're kind of forecasting at the current time and we stay with one increase, it can be pretty significant by year-end. We dropped, as Ken reported in his details, some of the rates 10, 15 basis points here in January. We only had, in the fourth quarter, 2 small increases. So -- and we're still seeing good volume coming in and it's not hurting us at the current time. So I think, kind of, the rest of the world is realizing that the race to the top of the deposit race is not smart for anybody, and we're seeing it, kind of, come back to a more neutral position. In fact, I think Ken also mentioned that we think it's going to top out here in this first quarter and start to drop over the course of the year, across the board.

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Bradley Allen Berning, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [17]

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Understood and that's helpful, thank you. Going on last follow-up. SBA, can you touch base with how new teams are going and new team prospects are going to help improve the, kind of, the noninterest margin side of the equation for the fee side of the world?

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [18]

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Yes, we were actually having tremendous success at the end of the fourth quarter. We still have a group that we're looking to acquire, coming on board here in 2019. But internally, our pipelines have exceeded $20 million, and we're looking at adding staff still here on our back door, and the SBA like the rest of the world is, kind of, at a grinding halt. Our PLP application is sitting on an empty desk in Washington DC, right now. The SBA market is -- I think the last headcount we had was 4 individuals showing up for work in that community. So not the start we we're hoping, but we have made some significant hires and head back to have that back-office honed and we're hoping to have our PLP status at this point and once the government gets back to work, we think that could be a fairly significant opportunity for us here in 2019.

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Operator [19]

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And our next question comes from John Rodis from Fig Partners.

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John Lawrence Rodis, FIG Partners, LLC, Research Division - Senior VP & Research Analyst [20]

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Ken, you said you expect the margin to be down, what, 6 to 9 basis points in the first quarter and then, maybe flatten out the second quarter. With that said, do you still think you can grow net interest income dollars for the year in the 10%-or-better range? You grew net interest income 16% to 17% in 2018.

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [21]

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Yes, I think we feel good about being able to grow net-interest income. I mean, I think in the first quarter it's going to be challenging, no doubt, as we see continued compression. But as net interest margin stabilizes and begins to tick upward in the second half of the year, we do forecast growth in that NII line item, and we do have growth -- year-over-year growth in it. So we do feel like we should be able to do that, assuming that interest rates hold to the forward curve. I mean, the thing that really benefits us, too, is -- and we haven't -- these aren't in our models because what we have is a, basically, a very flat yield curve, but assuming that we do see -- we do expect growth in NII, in kind of second quarter and beyond. But the thing that would actually benefit us the most is if we could just get the long rates to go back up. I mean, right now, the 10-year treasury at -- somewhere floating between 2.70% and 2.80% with elevated short-term rates is -- creates a difficult operating environment when several of our asset classes price off that treasury or rate is tied to that. If that 10-year treasury would tend to -- trend back up to that 3-plus to 3.10%, 3.20% range, that would be a net benefit for us. But we're not expecting that. We're not holding out hope for that over the course of the year. But we still -- we do expect net interest income to begin, kind of -- begin growing again. We acknowledge, on a GAAP accounting basis, it's been flattened out for 4 quarters, 4 or 5 quarters on an FTE basis. It continues to trend up with the impact of the public-finance portfolio. But, no, we get some stabilization. The key is the stabilization of the deposit costs. And we can get those to stop rising and run, then we can, kind of, go off once again and get that net interest income number to start growing.

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John Lawrence Rodis, FIG Partners, LLC, Research Division - Senior VP & Research Analyst [22]

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Okay. Can the -- what sort of effective tax rate should we use for '19?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [23]

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I mean, I think, right now, I mean, probably somewhere in -- probably 10% is probably as good an estimate as there is. I mean, I know that obviously backing out the OREO write-down, which created a tax benefit for us this quarter, our effective rate was 3%. With that, I would say, you've got to keep in mind that mortgage revenue was seasonal. That was probably even below seasonal low expectations. So with mortgage revenue, again, it's not going to double over the course of 2019, but we do expect to see some modest increases in that and, kind of, get the -- that proportion of tax exempt to taxable revenue, kind of, back in line with, perhaps, what it was throughout -- part of 2018. I think a 10% rate is as good as anything.

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Operator [24]

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(Operator Instructions) Our next question comes from Bill Dezellem from Tieton Capital.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [25]

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I had a couple of questions. First of all, would you please discuss your thoughts relative to prepayments going forward. And how that would compare to what you experienced in Q1, 2 and 3 last year?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [26]

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Generally, on average, we see -- we have -- we see a pretty consistent average amount of prepayments in the CRE space, particularly single-tenant lease financing. Because in that space, consumer activity or customer payment behavior isn't always driven by rate. There is a huge tax component to it as well as people manage their tax position and work with 1031 exchanges and things related to that. So relative to our average -- kind of, what our average balance kind of floats around prepayments in the fourth quarter were significantly lower than that. And then, in the third quarter, significant -- I would say, they were a little bit elevated more than average. So when you think of the delta between third quarter and fourth quarter, it was a fairly significant dollar amount, and again, the level in the fourth quarter was low. It's hard to -- we have a good average of what those numbers are, but it can vary from quarter-to-quarter. And over the course of 2018, we probably experienced the greater degree of -- a higher amount of prepayments on the front end of the year versus the back end of the year. So it's just sometimes very tricky to predict with exact precision the timing of that.

In healthcare finance, which is a newer line of business, not a lot of seasoned loans in there, but you do start -- you do see prepayment behavior there. And it's a little bit too early in our lifecycle there to, kind of, project those with precision, but we have seen those because we build into that -- those loans -- pretty good prepayment protections. And then, in the C&I space, owner-occupied, it's kind of -- it's case specific on the timing of that.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [27]

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I anticipate the number is going closer to the first half of the year versus the second.

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [28]

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Yes, I -- well, in the absence of other information, I'd say that there should be a reversion to the mean.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [29]

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Yes, that's helpful and then, would you talk about the loan yield in the fourth quarter? And how it held reasonably constant relative to the third quarter? I would've thought it may have ticked up with rates directionally up?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [30]

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Yes, the impact -- the decline, the overall decline in the loan yield was driven by the lower-than-average prepayment penalties, because pre -- under GAAP accounting prepayment penalties flow through net interest margin. So across certain portfolios, we saw an increase, and in some cases, nice, healthy increases in the yields on C&I portfolio, consumer, the RVs and the horse trailers, yields of residential mortgage portfolio that we hold on our balance sheet, those continue to go up. And even new production in CRE, single tenant and healthcare finance were higher yielding than they were early in the year. But in those 2 loan categories, in particular, the decline in prepayment penalties resulted in declines overall in those portfolios. And when you blend all the dollars together, it resulted in a 2-basis-point decline in the portfolio yield. Ex that amount we -- ex the change in prepayments are being lower than the mean, the yield in the portfolio would have gone up. Now when this matched the increase in the deposit costs, then it probably would've been up a few basis points.

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Operator [31]

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And ladies and gentlemen, I'm showing no additional questions. We'll end today's conference call. We do thank you for attending. You may now disconnect your lines.

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [32]

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Thanks, everybody.

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [33]

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Thanks.