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Edited Transcript of INBK earnings conference call or presentation 25-Oct-18 4:00pm GMT

Q3 2018 First Internet Bancorp Earnings Call

INDIANAPOLIS Nov 1, 2018 (Thomson StreetEvents) -- Edited Transcript of First Internet Bancorp earnings conference call or presentation Thursday, October 25, 2018 at 4:00:00pm 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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* Andrew Brian Liesch

Sandler O'Neill + Partners, L.P., Research Division - MD

* 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

* Joseph Anthony Fenech

Hovde Group, LLC, Research Division - MD & Head of Research

* Matthew W. Dhane

Tieton Capital Management, LLC - Senior Research Analyst and Principal

* Michael Anthony Perito

Keefe, Bruyette, & Woods, Inc., Research Division - 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 welcome to the First Internet Bancorp's Third Quarter 2018 Financial Results Conference Call. (Operator Instructions) Please note, this event is being recorded. I would now like to turn the conference over to Allyson Pooley of Financial Profiles. Please go ahead.

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

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Thank you, Kate, and good afternoon, everyone. Thank you for joining us to discuss First Internet Bancorp's financial results for the third quarter ended September 30, 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 third quarter results and then we'll open the call to your questions.

Before we begin, I'd like to remind you that this call -- 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 quantitative information to be discussed today as well as the reconciliation of the GAAP to non-GAAP measures.

I'd now 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. Since this is our first earnings conference call, I'd like to begin with a brief overview of our company and our strategy, and then I will discuss our fourth quarter performance, Ken will then provide some additional details on our financial results.

First Internet Bank opened for business in 1999 as an industry pioneer in the branchless delivery of banking services. Our mission from the start has been to service customers in the digital economy, providing them with customer-centric digital banking solutions, including real-time capabilities for both payments and lending, while maintaining the personal touch of relationship banking.

Over nearly 20 years in business, we have come to understand our customers' preferences for anywhere, anytime access. Our ability to meet their needs has created a tremendous amount of customer loyalty. Today, an increasing number of consumers and businesses prefer digital banking over traditional branch banking. Our national, online and mobile deposit gathering and asset generation platforms capitalize on advancing technology and are highly scalable. Our business model uniquely positions us to build relationships with our customers by using technology to modernize delivery channel of an industry deeply rooted in tradition and by offering the combination of products, services and value that they find compelling. We believe that we are well positioned to flourish within this digital banking ecosystem, which is still in the early stages of a powerful secular trend.

We have built a $2.4 billion nationwide branchless deposit franchise that provides consumers, small businesses, commercial clients and municipalities with the innovative technology, convenient access, high-touch customer service and competitive deposit rates. Our national footprint also enables us to focus our marketing efforts on geographies that are more tech savvy, increasing our overall deposit capture. The success of our deposit gathering activities is borne out by the fact that we have grown our deposits by an average of 31% per year over the last 5 years.

Turning to the asset generation side of our

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franchises, both nationwide and on a regional basis, many of which are appealing market voids with either the larger banks aren't dedicating their resources or whether regional community banks don't have the scale to compete.

On the commercial side, we have developed expertise in the areas of single tenant lease financing, public finance and most recently healthcare finance. And on the consumer side, we have built a franchise on recreational vehicles and horse trailer lending. And of course, we have offered nationwide direct-to-consumer residential mortgages for over 10 years.

We have entered each of these specialty lending areas by bringing in experienced bankers with existing relationships, institutionalizing our origination and underwriting process and scaling the business geographically. These specialty lines are rooted in sustainable industries and have included lower risk asset classes enhancing our overall asset quality and helping reduce our risk-based capital requirements. We are at various stages of nationwide penetration with each of these business lines and we'll continue to grow our market share over time, particularly in some of our newer lending areas. We believe this provides tremendous growth potential for the company.

In addition, we are continually evaluating opportunities to expand into new areas of lending to further diversify our revenue mix and drive incremental earnings growth. We also have built some more traditional commercial lending businesses in carefully selected markets that are regional in nature and are more complex requiring experienced personnel on the ground. Most of this business is in Central Indiana, but we also have a C&I lending group based in the Phoenix, Arizona market. As a result of this strategy, we currently have a $2.5 billion loan portfolio that is both geographically and industry diverse.

Over the last 5 years, we have grown our portfolio at a 41% annual rate. We have funded our growth into the new loan verticals with a series of capital raises since our IPO in 2013. We are committed to raising capital, only if that can be deployed both strategically and profitably and only if it helped us move toward achieving greater scale and operating leverage. We believe that we have met these objectives, as our trailing 12-month net income has grown at a 41% compounded annual growth rate and our diluted earnings per share in an over 12% compounded annual growth rate.

Our return on average assets has increased from 67 basis points to 83 basis points. Our return on tangible equity from 7.7% to nearly 10%. However, we have more work to do to drive ROA north of 100 basis points and ROE into the mid-teens.

We have a number of near-term objectives that should enable us to move forward on our path to higher profitability and further shareholder value creation. These include further extending the scope and market penetration in our specialty lending lines, while also diversifying our revenue stream with additional sources of noninterest income.

We're exploring initiatives to expand deposit channels, and importantly, increase the mix of low-cost deposits. To achieve this, we are working towards deepening our existing business relationships to attract more deposits, such as going after more operating accounts from some of our municipal and commercial customers. We are also developing a nationwide small business deposit strategy to further leverage our digital infrastructure and complement our consumer deposit base.

And finally, we continue to build upon our entrepreneurial culture to attract, retain top talent because our people are our greatest asset and one of the keys to our ongoing success. We've been recognized for our innovation and are consistently ranked amongst the best banks to work for and we plan to keep it that way.

In summary, our culture, products and platform will enable us to continue to support our growth plans and further expand in both existing and new lending verticals all with a focus on driving improved profitability.

Now turning to our financial results. We are pleased with our results in the third quarter, driven by solid loan growth, excellent credit quality and well-managed expenses. We continue to take a disciplined approach to capital deployment and execute on our lending strategies, including our specialized area of focus in public finance, healthcare and single tenant lease financing.

Net income for the quarter was $6.3 million, which represents a year-over-year increase of 28%, and an increase of 5% from the second quarter of 2018. Earnings per diluted share was $0.61 as compared to $0.71 in the third quarter of 2017 and $0.67 in the second quarter, based on a higher average share count in the quarter -- current quarter, due to our strategic capital raises that have incurred over the last 12 months.

We continue to do a good job reaching our target customers and demand for our suite of loan products continues to be strong, particularly our specialty, commercial and consumer loan.

Our total loans outstanding increased by $120 million from the second quarter, which equated to a 20% annualized growth rate, and were up 33% year-over-year from the third quarter of 2017. Our loan growth in the quarter, while strong by industry standards, has moderated from its historical pace. This is part of our disciplined capital deployment strategy, where we seek to grow our balance sheet in a measured and profitable way and not just grow for growth sake.

On a fully taxable equivalent basis, our net interest income for the quarter was $17.3 million, up 4.2% from the second quarter and up 12% year-over-year. The higher level of net interest income and our well-managed expenses produced an annualized return on our average asset of 79 basis point and a return on average tangible common equity of 8.9% in the third quarter, which was lower than the second quarter, primarily due to our June 2018 equity offering. Going forward, as we continue to deploy capital in a disciplined and profitable manner, we anticipate that our profitability metrics will improve.

In summary, based on our third quarter performance and the positive opportunities that we're seeing, we believe we will finish 2018 strong with another year of profitable growth. We remain committed to executing on our strategy to expand our specialty lending franchise and build upon our expertise in branchless banking, utilizing our nationwide deposit gathering platform to fund our expected growth. Combined with our strong credit culture and highly efficient and scalable back-office operations, this should continue to drive exceptional returns for the shareholders.

With that as an overview, let me turn the call over to Ken to provide additional details on our financial performance for the third 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 on our first earnings conference call. I'm going to highlight and expand on a few areas and try not to duplicate what is already in the press release.

Our total loans were $2.5 billion at September 30, an increase of $120 million from the end of the prior quarter or 20% on an annualized basis. Loan growth this quarter was solid, though lower than recent quarters. As David mentioned, we are sticking to our focused areas and are very disciplined about deploying capital. Our commercial portfolio grew by $84 million in the quarter on a $138 million of funded originations, primarily driven by increased production in public finance, healthcare lending and single tenant lease financing.

Healthcare finance loans grew at the highest rate posting a 36% increase from the second quarter, albeit off a lower base. We are still at the early stages of market penetration with this loan product, which we launched a little over a year ago via our strategic partnership with Lendeavor, a San Francisco-based technology enabled lender focused primarily on dental practices. We also believe that we have a long runway in front of us with our public finance lending. As we have the ability to expand geographically and further diversify our network for deal flow and we are putting resources into this growing business line. We particularly like this asset class due to its high credit quality and lower regulatory capital requirements. And as discussed in the earnings release, these loans are very easy to hedge with interest rate swaps to create LIBOR-based floating rate assets.

On the consumer side, residential mortgages grew by $25 million, more than half of the increase was due to funding construction loans that were originated in prior quarters with the other half being either jumbo or on-portfolio production. Our focused areas of trailers and recreational vehicles continue to do well, increasing 7% or over $14 million on a combined basis during the quarter. We have strong brand recognition in this space and look forward to continued growth.

With respect to our expectations for the fourth quarter, the current pipeline is solid and reasonably consistent with where it was at the end of the second quarter. We anticipate overall loan growth to be between 5% and 8% on a linked-quarter basis, with the range being dependent on the ultimate timing of funded originations and seasonal factors.

Moving to deposits and funding, a portion of the loan growth during the quarter was funded with cash balances driven by deposits sourced late in the second quarter. 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 on a limited basis, about a $100 million in average balances to supplement organic deposit funding. These money market balances are converted to long-term fixed rate funding with interest rate swaps. We had a decline in money market deposits due primarily to the loss of one large customer. This was a situation where another bank was extremely aggressive in going after the customer, and at a certain level, it did not make good business sense to match the extremely high rate the customer was offered.

We continue to focus on opportunities to generate lower cost deposits through the expansion of our small business, municipal and commercial relationships. Success will not come overnight, however, we are happy to report that early in the fourth quarter, we won the operating account business from an important local municipality. When fully funded in December, we expect that it will have an average daily balance of approximately $30 million. Our commercial deposit team put forth a tremendous effort landing this account, and we are optimistic we can leverage this win into additional opportunities.

Turning to net interest margin, as expected, the continued flat yield curve combined with the current deposit pricing environment put pressure on our net interest margin. Our reported net interest margin decreased 11 basis points to 2.06% from 2.17% in the second quarter. And on a fully tax equivalent basis, net interest margin declined 10 basis points to 2.23% from 2.33% in the prior quarter.

The decline in net interest margin was driven by higher deposit pricing, as our cost of interest-bearing deposits increased by 22 basis points during the quarter to 1.95%. The increase was due primarily to the cost of funds associated with the brokered money market deposits as well as higher CD cost, as maturing balances were replaced with new production in the current higher rate environment. The impact of higher deposit cost was partially offset by higher yields on interest-earning assets, which increased 5 basis points during the quarter to 3.90%. Due primarily to new production, we saw yields increase in the healthcare finance, consumer, commercial real estate and public finance portfolios.

Looking ahead to the fourth quarter and beyond, we expect to benefit from increased yields on new originations, repricing of variable rate assets and the impact of the asset hedging strategy as swaps hit their effective date. However, given the continued escalation in deposit pricing we are seeing in the market combined with our current deposit mix, we would expect to see some moderate compression in our net interest margin for the fourth quarter, probably in the range of 2 to 4 basis points. During the first and second quarters of 2019, we should expect to see net interest margin rebound in the range of 4 to 5 basis points per quarter.

Turning to noninterest income. Compared with the prior quarter, our noninterest income declined $200,000, due primarily to lower revenue from mortgage banking activities, as mandatory pipeline volumes were lower. In terms of product mix for the quarter, 68% of VOT volume was purchase business and 32% was refinanced.

On a year-to-date basis, mortgage revenue was off over 27%, a sudden price appreciation and higher interest rates have impacted application volumes across the industry. With industry-wide origination volumes forecasted to decline, we completed a thorough review of our business model to ensure that our mortgage business is efficient and profitable in the current lower volume environment.

Some changes resulting from this review include the following. First, we reduced mortgage staffing levels by 12%, which is expected to produce annual savings in excess of $600,000. Second, we reviewed our technology and our processes. Through the deployment of upgraded technology over the next several months, we expect to improve the customer experience, streamline document collection and more effectively manage our lead generation sources. As a result, we expect to lower the cost per closed loan and increased closed loan volume per loan officer. And third, we are increasing our focus on government programs, mainly FHA and VA. Year-to-date in 2018, 20% of our origination volumes came from these programs as opposed to 10% in 2017, and we expect that percentage to increase further.

Moving to expenses. We continue to have disciplined expense control. And overall, our noninterest expense decreased to $137,000 from the second quarter, mostly due to lower incentive compensation and medical claims experienced in salaries and benefits line item, and lower cost related to commercial other real estate owned.

From a forward-looking perspective, we do expect that the cost savings produced by the workforce reduction in the mortgage group will be offset by staffing in other areas, as we added bench strength in CRE, C&I and public finance as well as began adding experienced SBA personnel to begin building that platform.

Now turning to asset quality. Credit quality was again very solid with delinquencies 30 days or more past due representing 2 basis points of total loans or approximately $545,000. And our nonperforming loans totaling $256,000 were flat at 1 basis point of total loans at the end of the third quarter. We continue to have minimal net charge-offs, which were $237,000 during the quarter or 4 basis points of average loans on an annualized basis. In general, delinquencies and net charge-offs were combined to the residential mortgage and consumer loan portfolios.

Provision expense for the third quarter increased to $888,000, generally driven by the growth in the loan portfolio. Our allowance for loan losses to total loans was relatively stable at 67 basis points as of September 30, down 1 basis point from the prior quarter. Portfolio metrics continue to remain strong as the portfolio LTV in the single tenant lease financing book was 50% at quarter-end, and new originations came on with an average LTV of 49%. In the public finance portfolio, almost 80% of the loans were made to borrowers with underlying credit ratings of BBB+ or better and over 52% to borrowers with a rating of A+ or better.

Finally, I'd like to spend a few minutes discussing our capital position. While loan balances increased to $120 million during the quarter, the overall balance sheet only grew $87 million or less than 3%, as we deployed excess cash to fund a portion of the loan growth. As a result, tangible common equity to tangible assets experienced only 7 basis points of compression, ending the quarter at 8.85%. We are focused on deploying and managing capital strategically and profitably. We also believe that due to the low-risk nature of our balance sheet, we have the ability to stretch capital further than other comparably sized institutions.

Since the launch of our public finance business in early 2017, we have seen our percentage of risk-weighted assets to total assets decline. At quarter-end, we estimate this percentage to be approximately 70%. As a point of comparison, the average percentage of risk-weighted assets to total assets for publicly traded banks with total assets between $2.5 billion and $5 billion is 78% based on data as of June 30, 2018.

With regard to asset quality, as I discussed earlier, our current ratio of nonperforming loans to total loans is 1 basis point. When you add current troubled debt restructurings to nonperforming loans, that ratio bumps up to 3 basis points. The comparable average for similarly sized public banks is 85 basis points, again based on data as of June 30. Our current ratio of nonperforming loans adjusted to include accruing TDRs is 18 basis points as compared to 72 basis points for the peer group.

With a combination of lower risk assets and top-quartile asset quality performance, we feel comfortable taking tangible common equity to tangible assets down to 6.5%, meaning our last equity offering in June provides capacity to handle a substantial amount of balance sheet growth.

However, to manage capital efficiently, we'll explore opportunities to pursue loan sales when market conditions are favorable. We are currently in the process of working on a potential sale of single tenant lease financing loans totaling $21 million in the aggregate; that if it gets done, it should close in the fourth quarter. While pricing will be lower than prior sales, the weighted average coupon of the approval is 4.4% as it consist of seasoned loans. As we are putting new single tenant loans on in the range of 5.25% to 5.4%, we feel that this is a good trade that will positively impact earnings and net interest margin, in addition to managing balance sheet growth.

And the last point, I want to make on capital is that we continue to grow tangible book value per share. At quarter-end, tangible book value per share was $27.80, an increase of over $2 or over 8% year-over-year.

With that, I'm going to turn it back over to Kate, 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) The first question comes from Andrew Liesch of Sandler O'Neill.

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Andrew Brian Liesch, Sandler O'Neill + Partners, L.P., Research Division - MD [2]

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Can you just talk a little bit about your loan growth going forward? 5% is certainly solid. I'm just kind of curious, how are you managing loan growth versus internally generated capital? And you certainly had positive comments on the release. But I just kind of curious for what your thoughts are with this 5% rate or could it be a little bit better?

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

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I think, as we look out to the forecast over the next quarter and beyond, I mean, I think, we feel good about what public finance has been doing, what single tenant has been doing. As you identified, the growth itself is down a bit compared to prior periods. As we've talked earlier about there's been some dynamics this year that have impacted the growth rate of the portfolio. Tax reform earlier in the year certainly impacted public finance and to a certain extent the single tenant portfolio. Some of that tax reform continues to kind of work its way through the public finance and the municipal market, although I -- we may be at a -- with rates rising up here recently, we may have gotten to an inflection point on that. I think we feel pretty good about loan growth going forward. I think it's probably in terms of percentage growth, I guess, the law of large numbers is catching up with us a bit. But I think, we feel $120 million of growth during the quarter, we took what the market gave us, that's kind of what we've done in the past. We've -- as we've talked about with investors and analysts in the past, we only -- whether it's single tenant or public finance, we're only funding a small portion, 10% to 20% of the deals we see. We maintain rate, we maintain structure. There's been favorable dynamics in those areas over the past couple of years, but it's slowed down a bit. I think, we feel good. I think the number I threw out earlier in my prepared comments about 5% to 8% for next quarter is, the range itself is going to be dependent on again, the timing of fundings, there is some seasonal factors that may impact the fourth quarter. Single tenant, sometimes when the life companies have hit their quotas for the year, there may be an opportunity to grow balances in that space. As competitions diminished in the public finance space, there's -- you have municipalities and government entities trying to get financing in place by the end of the year. So there could be some opportunities there to be on the higher end of that range. But I think, in terms of like the dollar growth that we've seen over the past year or 2 is probably consistent with what we expect. We have strong -- we have high hopes for the healthcare finance business as well as Lendeavor gains traction in that space and gets -- gains brand recognition. And their pipelines are looking better every day. So even if single tenant and public finance are maybe not what they were last year, the consumer book has done well and healthcare and Lendeavor are doing well. So I think in terms of dollar amounts, we're probably close to where we've been in the past couple of years, if we were to forecast for next year.

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

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And Andrew, the only -- let me add a quick comment that the only area that I would add to in the C&I space, our team is just absolutely knocking it out of the park, having some of the best quarters, the last couple of quarters, they've had since putting the team together 7, 8 years ago, but we're running a little bit in place. We've had some major payoff, not by competitive forces or somebody updating those or anything of that nature, we've had some very large C&I clients that in the kind of economic situation, we had up until yesterday, sold their business and left. So C&I has actually hit all the sales targets we had forecasted for them at the beginning of the year, but the net effect has been minimal because we've lost some large clients due into people selling the business. So that seems to be stabilizing. We don't anticipate any really big ones here into the fourth quarter, so maybe we'll see a little bit of uptick in C&I as well.

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Andrew Brian Liesch, Sandler O'Neill + Partners, L.P., Research Division - MD [5]

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Okay, that, that's really helpful. And then just shifting gears to gain on sale revenue, presumably that was just light with less mortgage activity. I was kind of curious, what your thoughts are on selling portfolio mortgages or single tenant leases advantage growth or concentrations and then also generate some current income?

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

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Well, I mean, as we mentioned, we do have a sale in single tenant that we're working on, that should get -- if it comes together, it will get done in the fourth quarter. And we continue -- in the single tenant space, we continue to talk to the loan sale desks and stay on top of market color. As you guys know, interest rates have risen over the past year. So it's, I guess, the way that we look at it from a balance sheet management perspective, new production could be sold fairly easily at probably a pretty healthy premium, but that's also going to be some of the highest coupon loans in the book. This sale that we're looking at here is really a great opportunity for us because it's a chance for us to get some of our lower yielding stuff that was originated 2, 3, 4 years ago in a lower interest rate environment and replace that with new production in the low- to mid-5 range. On the mortgage side, resi mortgage, portfolio mortgage, we are always in discussions with certain parties to explore sales. We did a couple of sales last year and we continue to explore that. So we look at that, and it's hard to -- that's going to be based on market conditions and timing. And obviously, investor or other buyer appetite out there. But we're always looking, it's just kind of hard to predict the timing of it.

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Operator [7]

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The next question is from Michael Perito of KBW.

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Michael Anthony Perito, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [8]

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I wanted to start with Ken maybe on the hedging strategy. I was wondering if you can maybe walk through the mechanics a little bit of what the specific drivers of the 4 to 5 basis point increase in margin error in the first and second quarter. And then, also, more broadly, where do we kind of go from there? I mean, I guess the hope of all this hedging activity to kind of remove the margin as a volatile variable in your income model and hold it steady? Or how do you see yourself positioned after that initial rebound you expect in the early part of next year?

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

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Yes. I mean, the hedging strategy, kind of from a big picture perspective if we think about our asset classes, single-tenant is a longer term fixed-rate product, although we obviously get a lot of equity upfront and it's amortizing. Some of the consumer portfolios are longer term. Obviously, mortgages. And in the public finance loans, by their nature, are longer term as well. Really, the only real variable rate asset generator we have today that's producing new assets is in C&I. So the ability to take advantage of the changes in hedge accounting and convert some of the public finance production into LIBOR-based variable rate assets was an attractive opportunity for us. I think -- look at it a couple of different ways. One, it just -- it adds asset sensitivity to a balance sheet, where as I said earlier, a lot of our organic engines we have in-house today are longer term fixed-rate. It's certainly defensive against rising deposit costs. So it's -- and obviously, from a long-term interest rate risk management perspective as well, it provides protection there. So I don't know if I'd characterize it as a better sale on rising interest rates per se, but it's just to add asset sensitivity and make sure that our balance sheet is well positioned in an up rate environment.

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Michael Anthony Perito, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [10]

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Okay. Helpful. So I guess, to summarize. I mean, if short-term rates continue to move, you feel, at a minimum, this will at least help you hold margin steady? And then, if...

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [11]

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Yes.

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Michael Anthony Perito, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [12]

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If short-term rates kind of stall out here, is there any negative impact from that? Or do you think, at that point, your margin would likely stabilize as well? Just...

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [13]

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No. I mean, I think if short-term rates were to maybe continue to climb, but stall out a bit, we might have some hedges that we've put on this year. I mean, these are simple 3-month LIBOR swaps, where you -- the receive side is 3-month LIBOR and the pay side is what the swap rate is for that particular duration. If short-term rates were to not move here today. We probably have a number of swaps that the LIBOR hasn't reached that fixed-rate. The forward curve has LIBOR continuing to move up. But even if we got 25, 35 basis points or so, we'd probably be fairly neutral, on the hedging strategy. But I guess, the way that I'd look at it is, if short-term rates didn't move anymore, just went up modestly, but we got more slope back to the yield curve, that's as beneficial to us and NIM, as rising short rates and having variable-rate assets. So there's a few different scenarios there, where NIM can expand in forward periods.

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Michael Anthony Perito, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [14]

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Got it. Helpful. And then maybe switching over, the comment in the release, David, about still focused on opportunities to diversify revenues. I guess, one, where are you guys kind of at in that regard? I mean, it has -- you guys raised the capital. Curious if there's anything getting closer in the pipeline that maybe you guys can announce per se, but guide us towards the opportunities in your pipeline there? And then -- but secondly, I mean, how broad has this deposit conversation gone? I mean, we've seen some of your peers in this branchless bank vertical start to white-label partner with other larger firms and provide their kind of technology and digital platform as a service to those firms' clients. I mean, is that something you guys are exploring? And then, I'm just curious, generally speaking, how broad the kind of the deposit searches has gone at this point?

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [15]

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Michael, from that standpoint, we're in the same type of conversations with entities all across the country, existing deposit source, using our platform to work on adding more feature functionality to their world. Just traditional pipelines of deposits that we haven't experienced in the past. And also, again, from the capital side, and other, the small business game that we talked about, as Ken mentioned in his comments, we have already started building out some SBA internal capabilities here that we have not had in the past in anticipation of more SBA opportunity coming our way, and that process, hopefully, get this quarter, early first quarter. So yes, we're working both sides of the balance sheet. It's probably -- we are putting more effort on the deposit side than we have in the 19-year history of the organization. And we're kicking a lot of rocks over. We're seeing a lot of opportunities, and it's constant, we're working both sides of the balance sheet very heavily.

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Michael Anthony Perito, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [16]

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And then, just one last one. Ken, you talked quite a bit about capital in your prepared remarks. And I'm sorry if I missed it, but I heard you say, that generally speaking, that you view, on a relative basis, your capital ratios is able to lever down a bit further than peer, even the lower risk balance sheet. But did you actually provide or if not, can you provide kind of ranges of capital, where you feel your operating at kind of a efficient capital structure? Maybe not. I understand there is moving targets, and it depends what growth looks like. But just in an ideal world, like, where do you kind of see that sweet spot of where you want to operate?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [17]

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Well, I think if we were -- if we can grow and continue to execute on some of the strategic initiatives that we're working on, and obviously, we can't go into detail on a lot of that stuff, and David mentioned some of that. And get some things on board, and get that profitability up into the north of 100 basis points and into 115, 120 ROA, and we're self-sustaining with the risk profile we have, I mean, I think, we'd be comfortable running, on a constant basis, a TCE in the 7.5 to 7 range. On a -- again, on a continual basis, getting to the point of being self-sustaining on the capital side.

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Operator [18]

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The next question is from Brad Berning of Craig-Hallum.

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Bradley Allen Berning, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [19]

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On the deposit franchise building effort, congrats on the big Muni win there. Can you be a little bit more specific about the deposit franchise opportunities that you're seeing and the visibility on those to execute? Whether it be in expanding the Muni or whether there is other target markets and niches that you're looking at? I was just wondering if you could help us understand how visible is that effort.

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [20]

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The Muni opportunity is big. Some of that is restricted here in the State of Indiana for example. Municipalities have a requirement for particularly tax dollars to keep those within state-based institutions. Some other states have similar plays. So it's a big opportunity, Brad, right here in our back door, and obviously, the big win that we have, we think we can leverage that to several municipalities here throughout the State of Indiana. We are looking at other states that don't have similar laws to what Indiana has as a play. We continue to work on the HSA program, which we've worked up with a couple of PPOs in different organizations to partner with them in getting HSA accounts out to their ultimate customers and employees. We talked a number of times about trying to crack into the homeowners association market. We're looking at escrow opportunities. I mean, we -- you run the gamut, we're out, as I said earlier, kicking off over every stone we can to come up with opportunities from the deposit side.

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Bradley Allen Berning, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [21]

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And then on the follow up to the SBA comment. So it sounds like you're staffing up from an operational standpoint there. So I take it that you feel pretty good that you're going to be able to put some loans in early '19 or sometime during '19, to start adding fee income from that business model. Is that the right way to think about that?

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [22]

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Yes. Internally with what little effort that we've put to it without going beyond that, we've already turned up a $10 million pipeline within our existing base here today. We hope to add more here, as I said earlier, later in the quarter or early first quarter. We're anticipating that could easily bring us a $100 million plus in SBA originations in 2019.

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Bradley Allen Berning, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [23]

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And given the fee income and given the deposit work that you're doing, help us understand your thoughts on ROE profile for the institution that you think about on a one -- 12-month, 24-month, 36-month kind of time frame. How are you guys thinking about where do you want to get to?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [24]

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Brad, I think, a lot of it just has to do with timing. I mean, I think, in kind of what the normalized capital base is. I mean, I think, there is no reason why we can't strive to have an ROE in the mid- to high-teens. If we have everything on board and made some progress and some deposit initiatives, obviously, some of that, you'd need a full quarter or a full year run rate. But if we can get some of the good SBA on board, some of the other things we're looking at, some traction in the deposit world, and had a full year run rate with that, I mean, you're probably talking an 18- to 24-month time frame to really ramp it up, to get the full benefit of all of that. But we'd certainly want to be seeing incremental benefits on our way there.

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Operator [25]

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The next question is from Joe Fenech of Hovde Group.

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Joseph Anthony Fenech, Hovde Group, LLC, Research Division - MD & Head of Research [26]

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So my question on the hedging strategy was asked, so just maybe one more on that. Maybe, Ken, if you can explain the genesis of the decision with the change in the accounting standard that made the hedging strategy more feasible? And then, also maybe walk through the mechanics of sort of the 1-year delay, and how that works from when you put the swaps on to when the benefits begin to kick in, and sort of how that timing works? Can you maybe layout for us when the bulk of these were put on?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [27]

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Sure. Yes. Just without kind of going into the details of FASB guidance, previously, hedge account, it was very difficult to hedge amortizing or prepayable assets and achieve the level of hedge effectiveness as measured -- as the accountants wanted you to measure it, to maintain kind of that hedge accounting status. In my opinion, the accounting bodies and the FASB corrected a long overdue mistake with that. And kind of in the second, third quarter of last year, finalized the guidance to make hedging, amortizing, and prepayable assets much easier. And quite frankly, what they did is they created a couple of new restructures to hedge under, and they made the hedge effectiveness testing much easier. And in particular, we've utilized 2 forms of the hedging in the accounting guidance. The first is called the last-of-layer approach, and second is called the partial-term hedge. So in the public finance portfolio, what we do with that is we use partial term hedges, basically saying we hedge the asset not for the life of the asset, but just for a part of its life. And in the public finance portfolio, the loans are very easy to hedge, because a typical structure may be -- it may have an 18-year maturity and a 10-year call, meaning that the borrower can't prepay it until the call date. So what we can do, from an accounting perspective and from a economic perspective, is easily attach a simple 3-month LIBOR swap to that loan through the call date. So in this instance, if you had an 8-year -- or excuse me, an 18-year loan with a 10-year call, we would put a swap on it to the call, and then, when the swap matures, you're still left with an 8-year loan, but something that's -- has already been partially amortized and probably has a weighted average life of less than 4 years, and has cash flowing very strongly. So that obviously makes it easier to reinvest cash and manage the interest rate risk there. So that's what we've been doing with the public finance loans. We've also utilized the last-of-layer structure in hedging certain long dated -- longer-dated assets in our securities portfolio. Namely, municipal bonds and longer-term mortgage-backed securities. What you do with that is you -- you take a pool of assets. Say, you've got a pool of $100 million of assets that are amortizing and have prepayable features. What you do is, if you have an average term in that portfolio of those assets of 10 years, and you look at amortization schedules and throw a prepayment assumption on top, maybe you guess, at the end of the 5 years, there might be $45 million left of that. Well, then what you do is, you hedge that $45 million. Hence, the last-of-layer term. So we've done that in our securities portfolio, and that's a form of hedging that would be appropriate if we wanted to go down the path and look at hedging a portion of the single-tenant lease portfolio as well. The mechanics of the hedges are pretty easy. As I mentioned earlier, they're just simple 3-month LIBOR-based swaps, where we receive 3-month LIBOR and we pay the swap rate. So if we did a simple 5-year term today, the 5-year swap rate is, let's just call it 3.15, 3-month LIBOR is now close to 2.50. So if you put a swap in today that was effective today, you would have a carrying cost there of 65 basis points, if I'm doing my math right there. The difference between 3-month LIBOR and a 5-year swap rate. When I talk about the deferred start, what you're able to do with some of these hedges is say -- say, you're going to -- let me go back to my example of the public finance loan with the 18-year maturity and the 10-year call. If you had a wider divergence between, say the 3-month LIBOR and your 10-year swap rate, but you felt that rates were -- short-term rates were increasing, you could put a deferred start in, meaning that 1 year from now or some point from now, because not all of ours are 1-year starts. We may line it up with the first interest payment date or the first principal date. But at some point in the future, that's when the swap really kicks in. So if you think that 3-month LIBOR is going up in the forward curves as it is, what you can do is defer when that swap -- when those swap payments begin, and get a little bit more convergence between 3-month LIBOR and your fixed rate. Does that help, Joe?

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Joseph Anthony Fenech, Hovde Group, LLC, Research Division - MD & Head of Research [28]

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Yes. So that's really helpful color. And I guess -- so the thought process, if you started this roughly a year ago, I mean, the bulk of these benefits should really start kicking in for you here in the fourth quarter, first quarter, second quarter next year?

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [29]

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Year ago with -- we did a 1-year deferred start on the stuff we were doing 1 year ago, Joe, because the marketplace had talked about, for 2 or 3 years, that the Fed was going to do 2, 3, 4 rate increases a year, and then wound up doing one or 2. So we took the gambit that if they followed suite, and one to 2-year -- 1 to 2 months this year, we'd be in good position 1 year out. Obviously, been done 3, still talking about a fourth. So as the market -- the Fed has stepped up the rate increases over the course of 2018, we've shortened down the start term. As Ken said, a lot of the activity that we've had, particularly in municipal markets, we're thinking that the swap will kick in at the first reset or first payment date and stuff. So some of those have been shortened from a 1-year start date, down to 6, 9 months. So yes. Some of it will start to kick in here fourth quarter, first quarter next year, and then, 6, 12 months out here, we'll have 55% of the municipal portfolio as hedged and the swaps will all be in place at that point. So that's what we're talking about earlier, the pickup that we should have through 2019.

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Joseph Anthony Fenech, Hovde Group, LLC, Research Division - MD & Head of Research [30]

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That's really helpful guys. I know the details on this stuff can be a little mind-numbing. So I appreciate the explanation. David, on M&A, assuming that you wouldn't want to use your stock at these levels to do a deal, and also, that you wouldn't want to issue capital to do a deal at this stock price. So assuming I'm right on that, do you still see opportunities out there, if the stock price doesn't rebound here in the near term?

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [31]

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We do. Part of the activity that we're doing is lifting teams. So -- and there'll be some assets that will come with it, but it's not really acquisition of the company itself. So premiums are minimal. We think we've got a couple of opportunities that we have, sufficient capital base today, and sufficient cash that we could do a couple of smaller opportunities that have big potential upside in our world.

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Joseph Anthony Fenech, Hovde Group, LLC, Research Division - MD & Head of Research [32]

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Okay. And I know same -- on the same token, I know you want to preserve the capital for growth, potentially M&A down the line. But in extreme circumstances like this, I think the stock closed at [$18] on the book last night, would you be opportunistic in terms of share repurchase for circumstances like this? Or is that not on your radar at this point?

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [33]

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We look at, obviously, all opportunities in front of us. I wouldn't put that one at necessarily the top of the list. But if it stays down there and nothing else that has a better financial impact and return to shareholders comes about, then it would be a consideration. We're definitely looking at everything.

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Joseph Anthony Fenech, Hovde Group, LLC, Research Division - MD & Head of Research [34]

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Okay. Fair enough. And then, David, you've had great success with the timing of the entries into the new business lines, most recently, with the municipal business. Any other areas that look particularly attractive -- well, actually, you talked about that earlier, but what sort of drives the decision-making process for you? Is it geography? Is it the person or the team you're getting? Or is it the business line itself, and then you go out and find the team to help you do that, and you're sort of agnostic to geography?

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [35]

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That's really a combination of all 3 of those, Joe. Obviously, the right people as we mentioned in my comments, I think, the statement that our success over the last 20 years is finding the right people that can work in our kind of entrepreneurial space and opportunity. Something that we can do in a national footprint. We obviously get economies of scale, gives us a much wider approach as we've done in the municipal markets, and in the SPL assumed in the consumer, we bid on only 20% of the activity we see. So we get a local institution that's going nuts on covenants or pricing. We can walk away from it. So it really is a combination of all 3. The health care. It was built around the team, the technology, their time-to-market, able to execute deals effectively, efficiently. We brought the national footprint to them. We started out kind of West Coast-based. I think we're now in 9 states across the U.S. They're about to sign a couple of large national partnerships that could really kickstart that one. The SBA program, obviously, is a national footprint, unlike traditional C&I lending that's not big in scope and scale. There's ways you can do that on national. A lot easier than you can do traditional C&I lending. So national footprint, great team, great people, and obviously, bottom line opportunity, SBA has not only good, adjustable rate assets, they also have fee income from sales and secondary market, which would take some of the edge off the mortgage side from our end. So it's really all 3 points.

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Joseph Anthony Fenech, Hovde Group, LLC, Research Division - MD & Head of Research [36]

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Okay. Great. And last one for me. Ken, with the growth in some of these other areas, and maybe the potential sale with $20 million or so of single tenant like you talked about, where would CRE concentration approximately at quarter end? I know you're targeting a certain level there?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [37]

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Joe, I don't have the number in front of me right now. I'm guessing it's probably going to be in the high-3s.

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [38]

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Just to back that one. I believe that we just completed safety soundness again, and I think we've told you guys in the past, we have regulatory blessing to potentially carry that. Again, based on the product that we're offering and the quality of the product, we could go up to 6x capital if we wanted too. So there's no concern about asset quality or concentration internally or externally from the regulatory books on our CRE products.

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [39]

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Yes. I think -- I mean, we include -- in our internal concentration, we include the owner-occupied in that. And I know that the regulators exclude that. When we include that, we were 390-some-odd-percent at the end of the quarter, end of the second quarter. And I don't think that number would change materially. And then, you back out owner-occupied, and you'll probably close at [6.5 times 3.6] something like that.

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Joseph Anthony Fenech, Hovde Group, LLC, Research Division - MD & Head of Research [40]

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But safe to say, you guys have operated much higher levels in the past, that you don't feel any need, this is -- this level where you're at now is fine. There's no sort of internal or external pressure or impetus to get that concentration level lower?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [41]

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No. None whatsoever.

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Operator [42]

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The next question is from John Rodis of FIG Partners.

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John Lawrence Rodis, FIG Partners, LLC, Research Division - Senior VP & Research Analyst [43]

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Ken, maybe, just a couple of quick ones. The tax rate, what should we -- 10%, 11% going forward? Or...

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [44]

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I think for the foreseeable future, in the quarters, that's probably good. For the benefit of everybody on the call, I mean, the effective tax rate is, for us, obviously, it's driven -- it's heavily impacted by the tax exempt income from the municipal lending business. And the proportion of tax exempt revenue to taxable income. One thing with mortgage underperforming and producing lower revenue there, that's, I believe had an impact on that tax rate. But yes, I think we're modeling internally for the foreseeable future in that 10% to 11% range.

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John Lawrence Rodis, FIG Partners, LLC, Research Division - Senior VP & Research Analyst [45]

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Okay. And then, Ken, on the expense side, you talked about some savings out of mortgage, and then, offset that with new hires. Do you think, sort of looking at 2019, you can keep total operating expense growth sort of low double digits, 10% to 12%?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [46]

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Yes. Yes. That's probably a good range. That's what we're looking at right now. Low single -- low double digits is where we're looking at right now.

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Operator [47]

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The next question is from Matt Dhane of Tieton Capital Management.

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Matthew W. Dhane, Tieton Capital Management, LLC - Senior Research Analyst and Principal [48]

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I was curious, I wanted to delve a little deeper into the health care loans. First of all, can you remind me, are those floating rate loans? And then, secondarily, my other question is, around the current growth that you're seeing with those, you talked about a really robust pipeline. Can we expect to see it even accelerate from these types of quarterly levels that you are seeing here?

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [49]

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It will go -- it will increase over what it's been through the course of this year. They're getting up to speed. We're anticipating, next year, that we're going to do somewhere in the range of, probably, $35 million to $50 million quarter and opportunity. It is mostly fixed rate product. What is coming to that market based on the 10-year term, some of the newer deals will starting to see 5-year reset on it. We also have an opportunity to do some build-out loans that have a much higher short-term yield term, where a dentist is adding a new chair or a new Dentist to the practice and they need to do a build out for them, some equipment leasing opportunity. So the bulk of the business is business acquisition, or commercial real estate, buy in a practice in a building, and that's on a 10-year term in 10-year amortization. But we do see some opportunities over the next 6 to 9 months to get into a little bit of equipment leasing with them/and or build out play that will have a higher yield shorter-term.

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Operator [50]

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The next question comes from Bill Dezellem of Tieton Capital Management.

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William J. Dezellem, Tieton Capital Management, LLC - President, CIO and Chief Compliance Officer [51]

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I'd like to circle back to your asset growth and how you reference the rate of growth will likely slow is simply due to the law of large numbers. As a result of that, are you anticipating that less capital raising activities -- equity capital raising activities, will take place? Or talk to that issue, if you would, please?

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Kenneth J. Lovik, First Internet Bancorp - Executive VP & CFO [52]

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Bill, I think, I'd maybe just go back to my original comments in the script about capital and how we feel about our current position today. I mean, I think, with the current year-over-year growth, and the dollar amounts probably being as good a run rate as any could look at. I think, that gives us a fair amount of time to -- before we be in a position to have to raise capital. So I don't -- we don't have any capital raising plans imminent on the horizon, I think, we feel like we have a lot of runway with the capital we have. Obviously, we have a number of things going on and a number of strategic initiatives. And while we don't think any of those may require capital today, it might accelerate growth in some area. But everything that we're looking at are -- ways -- not only are -- in terms of asset or deposit generation, also additive to profitability. And again, moving that ROA, ROE far north of where they are today. And again, maybe hopefully get into the position of being self-sustaining on capital.

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Operator [53]

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This concludes our question-and-answer session. I would like to turn the conference back over to management for closing remarks.

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David B. Becker, First Internet Bancorp - Chairman, President & CEO [54]

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We'd just like to thank everybody for joining us for our first official earnings call. We look forward to speaking to all of you very soon. We appreciate your time today. Thank you very much.

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Operator [55]

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The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.