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Edited Transcript of WBS earnings conference call or presentation 22-Oct-19 1:00pm GMT

Q3 2019 Webster Financial Corp Earnings Call

WATERBURY Nov 7, 2019 (Thomson StreetEvents) -- Edited Transcript of Webster Financial Corp earnings conference call or presentation Tuesday, October 22, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Charles L. Wilkins

Webster Financial Corporation - EVP

* Glenn I. MacInnes

Webster Financial Corporation - Executive VP & CFO

* John R. Ciulla

Webster Financial Corporation - President, CEO & Director

* Terrence K. Mangan

Webster Financial Corporation - SVP of IR

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Conference Call Participants

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* Collyn Bement Gilbert

Keefe, Bruyette, & Woods, Inc., Research Division - MD and Analyst

* David John Chiaverini

Wedbush Securities Inc., Research Division - Senior Analyst

* Laurie Katherine Havener Hunsicker

Compass Point Research & Trading, LLC, Research Division - MD & Research Analyst

* Steven A. Alexopoulos

JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap & Small-Cap Banks

* Timur Felixovich Braziler

Wells Fargo Securities, LLC, Research Division - Associate Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to Webster Financial Corporation's Third Quarter 2019 Earnings Call. (Operator Instructions) Please note this conference is being recorded.

I will now introduce Webster's Director of Investor Relations, Terry Mangan. Please go ahead, sir.

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Terrence K. Mangan, Webster Financial Corporation - SVP of IR [2]

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Thank you, Sherry. Welcome to Webster. This conference is being recorded. Also, this presentation includes forward-looking statements within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to Webster's financial condition, results of operations and business and financial performance.

Webster has based these forward-looking statements on current expectations and projections about future events. Actual results might differ materially from those projected in the forward-looking statements. Additional information concerning risks, uncertainties, assumptions and other factors that could cause actual results to materially differ from those in the forward-looking statements is contained in Webster Financial's public filings with the Securities and Exchange Commission, including our Form 8-K containing our earnings release for the third quarter of 2019.

I'll now introduce Webster's President and CEO, John Ciulla.

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [3]

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Thanks, Terry. Good morning, everyone. Thank you for joining Webster's Third Quarter 2019 Earnings Call. CFO, Glenn MacInnes, and I will review business and financial performance for the quarter; HSA Bank President, Chad Wilkins, is here with us in Waterbury and will be available during Q&A. I'll begin my comments on Slide 2.

We are pleased with our financial performance for the quarter. Despite the challenging interest rate environment and a less certain economic outlook, our financial metrics continue to be strong. Webster posted its 40th consecutive quarter of year-over-year revenue growth. That is 10 years of sustained top line growth. We continue to execute on our fundamental banking activities, organically adding new customers and deepening existing relationships across all business lines and geographies. Year-over-year average loan balances grew 8% led by commercial loan growth of 11%. Despite NIM compression, the strong loan growth enabled us to maintain our quarterly net interest income relatively flat to last quarter.

Loan growth was funded primarily by deposit growth. Total average deposits increased almost 6% year-over-year, with HSA deposits growing 12.5%. Earnings per share totaled $1 in Q3 or $1.01 adjusted for onetime expense items. This compares to $1.05 in Q2 and $0.98 in Q3 of 2018 when that period is adjusted for discrete items. The adjusted EPS growth is 3% from prior year's third quarter. Tangible book value per share continues to grow and is 16% higher than last year. Tangible common equity also grew by 16% and is $340 million higher than a year ago. Total revenue in Q3 was 2.6% higher than a year ago, while adjusted expenses increased only 1.3%, resulting in a 10th consecutive quarter of positive operating leverage. Our efficiency ratio remained below 57%, even if we continue to invest in our businesses. We've now posted 7 consecutive quarters with return on common equity above 12% and return on tangible common equity above 15%.

Our performance continues to be driven by the purposeful execution of long-term strategic priorities to aggressively grow HSA Bank, expand Commercial Banking and optimize Community Banking. Credit quality remains solid, with key asset quality metrics continuing to be near cycle lows. As a percentage of portfolio, nonaccruals, delinquency and classified commercial loans were all flat to better than a year ago. Despite being relatively late in the economic cycle, at present we are not seeing any material negative trends or correlated behaviors across any geography, product or industry sector.

Turning to Slide 3. I'll comment briefly on our lines of business. Commercial Banking's loan portfolio has increased $832 million over the past year for year-end of period growth of 8%. We continue to adhere to our underwriting discipline, while developing strong relationships by outperforming our clients' expectations. This segment also grew deposits by $277 million or 6.5% over the past year, and our Commercial Banking pipeline was strong heading into Q4. HSA Bank continues to be a market leader and differentiator for Webster, growing its pretax net revenue by 26% so far this year. HSA Bank has added 737,000 new accounts over the past 12 months as we deepen relationships and further penetrate the direct-to-employer market. We anticipate a strong enrollment period with respect to new account growth in Q1 2020 as our opportunities, proposals and new account pipeline are all up year-over-year particularly in the large employer segment.

We also expect attrition from our third party administrator bucket of accounts, which in aggregate, represented less than 9% of our total footings as of third quarter end. As you may recall from our Investor Day in 2017, this wholesale channel contains our least profitable accounts, where HSA Bank acts only as custodian for the assets. We don't receive interchange revenue, account fees are nominal, and balances are approximately 65% of that of the rest of the book. As a result of one of our custodial clients being acquired in Q3 and another becoming a nonbank custodian itself, we anticipate that the accounts and assets related to these clients will attrite over the next 2 years.

Importantly, HSA Bank's PTNR should not be materially impacted over the next 6 quarters, given the profitability dynamics of the accounts and the fact that transition and account closing fees helped mitigate the lost interest margin. Community Banking continues on its transformational roadmap to optimize distribution channels, invest in digital capabilities and focus on high-value consumers and small businesses. This line of business continues to grow loans, core deposits and full relationships across our Boston to New York retail footprint. We were again recognized as the leading SBA lender in Connecticut and in all of New England with respect to 7(a) loans. Community Banking provides $4 billion of net funding to Webster.

On Slide 4, we highlight the solid loan and deposit growth dynamics that I mentioned earlier. Despite increased uncertainty in the global economic outlook brought on by trade tensions, slowing growth in Europe and other markets and a host of geopolitical event risks here and abroad, Webster's customers remain healthy and optimistic. We continue to see solid activity across our geographic footprint and across our lines of business throughout our retail, wealth, small business and commercial client base.

I'll now turn it over to Glenn for the financial review.

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [4]

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Thanks, John. Slide 5 provides detail on our average balance sheet. The securities portfolio increased $457 million linked quarter and $825 million year-over-year, largely due to balance sheet repositioning. Growth has been primarily in fixed-rate agency residential and agency commercial mortgage-backed securities. Loan growth continued to be led by Commercial Banking, which grew over $300 million linked quarter and $1.1 billion versus prior year.

Business Banking grew $26 million linked quarter and $96 million versus prior year. Linked quarter consumer loan growth of $103 million reflects an increase of $140 million in residential mortgages. Compared to a year ago, residential mortgages increased $368 million. Partially offsetting this and in line with industry trends, we continue to see pay downs in home equity balances. Deposit growth was $407 million linked quarter, led by an increase of $234 million in money market deposit accounts as a result of seasonal strength in public funds. Deposits grew $1.3 billion from a year ago, with 56% of the growth coming from health savings accounts.

Deposit growth funded loan growth, both linked quarter and year-over-year. Borrowings increased $491 million linked quarter and $814 million from prior year funding growth in securities as part of repositioning. The increase in borrowings from a year ago includes $300 million in 10-year senior notes issued in March, which we swapped to floating. The growth in borrowings was all short term or floating, which helped reduce the bank's asset sensitivity. Our loan deposit ratio remains favorable at 84%, and our capital levels remain strong.

Slide 6 summarizes our Q3 income statement and drivers of quarterly earnings. Net interest income totaled $240.5 million, stable to Q2. Our solid linked-quarter earning asset growth of 3.4% was offset by a 14 basis point reduction in net interest margin to 3.49%. The balance sheet repositioning represented 5 basis points of compression but had almost no effect on net interest income. The remaining 9 basis points of NIM compression was in line with our expectations.

The balance sheet repositioning consisted of increased fixed rate securities, funded by short-term or floating rate borrowings, and the purchase of $1 billion of 1-month LIBOR floors, hedging floating rate commercial real estate loans. As a result, asset sensitivity was reduced and future net interest income is protected if rates fall. Versus prior year, net interest income grew by $10 million or 4.4%. Noninterest income decreased $5.9 million linked quarter and $2.4 million from prior year. The linked-quarter decline reflects a higher level of commercial activity as well as BOLI proceeds in Q2. The decline from a year ago reflects a lower level of loan syndication fees.

Reported noninterest expense of $180 million was flat linked quarter and year-over-year. While the preprovision net revenue of $131 million declined from Q2's level, it increased 5% from prior year. Loan loss provision for the quarter was $11.3 million, resulting in coverage ratio of 107 basis points. And our efficiency ratio was 56.6%, up modestly from Q2 and improved from a year ago, and the effective tax rate was 21.3%.

Slide 7 provides additional detail on year-over-year preprovision net revenue growth. Net interest income grew by $10 million. Strong loan growth drove an increase of $14 million from volume, which was partially offset by a decrease of $4 million driven by a lower rate environment. Noninterest expense increased $1.1 million from prior year. This includes $1.7 million of business optimization expense, resulting from a review of technology assets in retail lending.

Beginning with Slide 8, I'll highlight the line of business results. Commercial Banking loan growth was led by Commercial Real Estate, which grew 5% linked quarter and 14% versus prior year. C&I balances were flat linked quarter as a result of higher prepay activity but grew 6% from prior year. Net interest income grew $5.6 million from last year primarily reflecting average loan growth of $1.1 billion or 11%. Noninterest income declined $4.3 million as the prior year's quarter benefited from higher syndication fees, and operating expenses increased $1 million from continued investments in the business. Combined, ongoing loan growth was partially offset by lower fee income, which resulted in a modest increase in PPNR.

Slide 9 highlights HSA Bank, which delivered a solid quarter led by the production of 141,000 new accounts. Our 3 million accounts have $8.2 billion in total footings. Footings were $964 million or 13% higher than prior year, while accounts were 11% higher. Net interest income was 15% higher from a year ago, reflecting growth of 12% in average deposits and a higher net credit rate. The cost of deposits was 20 basis points as it remained flat for 11 quarters. Noninterest income increased 6% from prior year driven by a 12% increase in interchange revenue and a modest increase in account fees. Total revenue for the quarter grew 12% from a year ago while expenses increased 7%, resulting in positive operating leverage and pretax net revenue growth of 17%.

Slide 10 highlights Community Banking. Total loans grew 5% year-over-year, with strong contributions from Business Banking and residential mortgages. Business and consumer deposits grew 9% and 5%, resulting in overall deposit growth of 6% from prior year. Net interest income was adversely impacted by a declining interest rate environment compared to last year. Noninterest income, however, increased 5% led by higher mortgage banking revenue. As a result, total revenue was relatively flat. Excluding $1.7 million of onetime business optimization costs, expenses grew 2% from continued investments in technology.

Slide 11 highlights our key asset quality metrics. Nonperforming loans, in the upper left, had a linked-quarter increase of $14 million. NPLs now represent 83 basis points of total loans, flat to a year ago. $9 million of the increase relates to an asset-based loan where we are confident that we are fully secured. Net charge-offs, in the upper right, were $13.8 million in the quarter. The linked quarter increase was driven by 2 loans in our regional portfolio with no correlated risk. We saw partial offset from a decrease on the consumer side. Commercial classifieds, in the lower left, increased modestly and now represent 274 basis points of total commercial loans. This compares to a 20-quarter average of 320 basis points. Our allowance for loan loss was $209 million, with a provision of $11.3 million and a coverage ratio of 107 basis points. Our allowance for loan loss continues to reflect stable commercial and consumer asset quality.

As you know, the industry is approaching the adoption of a new accounting standard for credit losses, which will go into effect January 1, 2020. We have made significant progress on our CECL implementation plan in 2019 and continue to increase -- and expect an increase of approximately 25% to 35% above our current ALLL allowance. The initial adoption will be recorded as a capital charge and will have minimal impact on capital ratios, which will remain above well-capitalized levels. This estimate is based on our expectation of forecasted economic conditions and portfolio balances as of September 30, 2019.

Slide 12 provides our outlook for Q4 compared to Q3. We expect average loans to increase around 2% driven primarily by commercial and residential loans. We expect average interest-earning assets to grow around 2.5%. With regard to net interest margin, assuming 1 additional rate cut in October, we anticipate 12 to 15 basis points of NIM compression. This includes approximately 3 basis points as a result of balance sheet repositioning executed in Q3. As a result, we expect net interest income to decline $3 million to $5 million.

While the rate environment remains choppy, we would anticipate net interest income to bottom out in Q4 and improve from that point forward. This assumes 2 Fed cuts: one in October and one in March as well as a 10-year swap rate of around 1.6% along with continued loan and deposit growth. For additional perspective, if rates remained where they are today, we would expect NIM to decline 8 to 10 basis points and net interest income to be stable to Q3. Our goal continues to be to maximize net interest income without taking undue risk.

Reported noninterest income is likely to be $1 million to $3 million higher, and we expect our efficiency ratio to be below 57% and our provision will be driven by loan growth, asset quality and mix. We expect a tax rate on a non-FTE basis to be approximately 21%. And lastly, excluding any share buybacks, we would expect our average diluted share count to be similar to Q3's level.

With that, I'll turn things back over to John.

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [5]

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Thanks, Glenn. Webster's third quarter results demonstrate our unwavering focus on building long-term franchise value and maximizing economic profits through strong execution on everything we control. We are growing loans and deposits to maximize net interest income and fee income, staying laser focused on maintaining our credit discipline, deepening customer relationships, diligently controlling expenses, and at the same time, investing confidently in our future. This is how Webster continues, and will continue, to deliver for its customers, communities, shareholders and employees.

I’ve said often that our people make the difference. I am pleased to highlight on this call that Webster's Head of Community Affairs and Philanthropy, Kathy Luria, was recently named the ABA Foundation's 2019 George Bailey Distinguished Service Award winner. In the words of American Bankers Association's President and CEO, Rob Nichols, Kathy Luria's work at Webster serves as an example for the entire industry for how bankers can and should engage with their communities. Thanks to her efforts, it's clear that Webster is making a tangible difference in the community it serves. Congratulations to Kathy and to all our Webster bankers.

With that, Sherry, I'm happy to open up for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is from Steven Alexopoulos with JPMorgan.

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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap & Small-Cap Banks [2]

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Starting on the deposit side, non-HSA deposit costs trended a bit higher again in the quarter and really being pushed by savings deposits. When do you guys expect to see total deposit cost start to trend lower and maybe help offset some of the NIM pressure?

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [3]

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Steve, that's a great question. I think we do have room as we've talked about often. We think we've got some latitude given the strong HSA deposit growth. But we're also very much focused on continuing to grow our relationships in the Community Bank, and Boston's been continued to be a very competitive market. We do think in Q4 we will see a material reduction in our overall core deposit rates, given what's going on in the market and given some of the opportunity we have across our footprint.

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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap & Small-Cap Banks [4]

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Okay. That's helpful. And then maybe for Glenn, in the past, you've called out NIM declining, I think it was 5 to 7 basis points without premium amortization for every rate cut. Given all the additional hedging now, where is that new level?

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [5]

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So I think as you look into Q4, the guidance I gave was 12 to 15. About 3 of that, as I indicated, is the hedging side of it. If you took out the premium amortization, it's probably worth another 1 basis point to 1.5 basis points going into Q4. The rest is primarily the impact of lower loan rates. And our outlook for Q4 is that with 1 Fed cut in October that you'll likely see in average Fed funds rate go from 2.30% in the third quarter down to 1.83% in the fourth quarter, so that's a 47 basis point drop. And as you know, Steve, about 54% of our loan book is tied in one way to either 1-month or 3-month LIBOR, which would typically follow Fed funds.

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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap & Small-Cap Banks [6]

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Okay. But Glenn, relative to the 5 to 7 range, are we still in that range even with the hedging? Maybe the lower end, but are we still in that range or are we now below it? Just I'm looking even beyond into 2020 at this point.

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [7]

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So on the 5 to 7 in NIM compression?

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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap & Small-Cap Banks [8]

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Yes.

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [9]

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I'm not sure I understand, maybe just repeat that question then.

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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap & Small-Cap Banks [10]

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So in the past, you talked about NIM going down 5 to 7 basis points for every cut. My question is are we still post the additional hedging in that range or are we now below that range essentially?

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [11]

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So the hedging -- let me back up for a minute. So as I get into next year and I look at the NIM compression, and again, assuming a 10-year at 1.60% assuming one more Fed cut in October, one in the end of March on the 18th, I would expect to see 2 to 3 basis points of NIM compression a quarter. That being said, I -- as I indicated, we bottom out in net interest income in the fourth quarter and then we begin growing net interest income.

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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap & Small-Cap Banks [12]

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Got you. Okay. That's helpful. And then on HSA Bank, I wanted to follow-up on John's prepared comments calling out for a healthy 1Q enrollment season. Now that employees are going through their annual health plan selection, are you seeing higher adoption of high deductible plans at this point?

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Charles L. Wilkins, Webster Financial Corporation - EVP [13]

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Yes. Yes, we're seeing -- it depends on what our employers are doing in order to influence the enrollments. If they're using decision-support tools and things like that and education during enrollment, we're seeing a definite increase in enrollments. That said, we're having a great -- our pipeline is very strong as we go into the end of the year. And we expect to be at or well above what we saw last year in our enrollments. Again, 80% of our accounts comes from existing employers so a lot depends on your point how enrollments go through one-one.

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [14]

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And Steve, as you know we've been spending a lot of time trying to educate the employees of our employer customers on all of the pros of funding their account and maximizing contributions and opening accounts. So hopefully, we'll see some influence there. As Chad said, of that 80% of our new accounts that come from our existing customers, hopefully we can influence the enrollment levels.

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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap & Small-Cap Banks [15]

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And then just a final one for Chad on HSA. If I look at fee income growth, it slowed over the past year. Is this just continued downward pressure on monthly account fees and do you expect it to remain under pressure?

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Charles L. Wilkins, Webster Financial Corporation - EVP [16]

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Yes, thanks, Steve. We had -- one thing that impacted fees in the third quarter was about a $400,000 reduction in paper statement fees. We've had an initiative going on to eliminate paper statements. That's being offset by about a $500,000 reduction in the actual cost of delivering paper statements. So that's more of a onetime item, but the savings and the cost will continue. We also are seeing a little bit of pressure on large employer account fees but that's really isolated more towards existing programs that have larger balances. So we're happy to trade fees for existing balances as we go out and compete in the market on large accounts.

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Operator [17]

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Our next question is from Collyn Gilbert with KBW.

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Collyn Bement Gilbert, Keefe, Bruyette, & Woods, Inc., Research Division - MD and Analyst [18]

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Was hoping to get to the end of the queue and let you flush out probably 10x what you're doing on the leverage side and the hedging side before I had to ask my question. But Glenn, could you just walk through this again? I just want to make sure I understand what you're doing here and trying to understand why -- what's going to drive the NII to bottom in 4Q. I guess -- and just, sorry, if you could just walk through exactly what you did this quarter, what you added, the yields of the securities that you added. I know you said fixed duration, but just kind of walk through some of that math again if you would please.

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [19]

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So yes, and I'll break it into 2 pieces: one is the repositioning activity that we did primarily during the third quarter, and we bought about $1 billion in floors, what that does is protects us on a downside if rates continue to drop, and we think that's prudent; the other activity we did was we purchased securities, and we purchased about 600 -- on an actual basis, about $640 million of securities. And what that does is it removes some of the asset sensitivity. The combination of those 2 is neutral to net interest income. We have a spread that we're earning on the securities. We're still funded primarily by 1 month FHLB of about 50 basis points and the cost of the floors is similar. So those actions are neutral and what they do is they protect us on the downside. So if rates were to drop, the securities that we purchased would have a higher yield. Likewise, if rates were to drop, we have a floor on primarily our commercial real estate loans, which we're hedging. So that's one activity.

When I talk about bottoming out in the fourth quarter, I think you've got to think about the dynamics of the rate environment. And so in the second to third quarter, you saw a 20 basis point reduction in average Fed funds. And then from the third to the fourth quarter, more severe 47 basis point reduction in Fed funds. If you assume that the Fed does not cut again till March 18, that would imply that Fed funds quarter-over-quarter, fourth quarter into first quarter, would be down an average of 13 basis points. So the rate of decline is significantly less. And then if you take that and you assume a 10-year swap rate of around 1.60%, that's how you get your number. So if I'm thinking of Q3's level at $240.5 million of net interest income, I'm guiding to a reduction of $3 million to $5 million, that gets you in the range of $235 million to $237 million in the fourth quarter. What you have, beginning in the first quarter, is you have less pressure from Fed, you have an inflow of HSA deposits, which help reduce some of your borrowing cost. And then you have, as John indicated, further reductions in advance of the Fed reduction on your core deposit cost. So we think 4 to 5 basis points a quarter, we could potentially get on our core retail deposits in a reduction. So those -- that's -- I said a lot. So that's really the dynamics of how we're looking at it.

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [20]

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And Collyn, just to put a finer point on our strategy. We're -- obviously, NIM compression is the big question in the industry. We're not apologetic for being asset-sensitive. Obviously, we've got a very great high-growth source of low-cost funds and we've been growing loans above market rates and the kind of loans we grow generally are floating rate, and we've been able to, if you look back, I looked last night, 3 years ago, we trailed our proxy peer group by 10 basis points in NIM, and we were around 3.10% and now even with the compression, we're still about 20 basis points above our proxy peer group and we're significantly higher on an absolute value. So we feel good about where we are. And our repositioning strategies really are to try and make sure that in the downside scenario where rates start to move more aggressively towards 0, we're protected and we're protecting our income level. But we don't want to leverage and mortgage all of the upside of what we do best in terms of deploying our organic deposits against loan growth over time. So that just gives you kind of the high-level strategy that Glenn talked about in terms of the specific execution.

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [21]

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And Collyn, the only thing I would add to that is that if you go back to our deck on Page 19, you can see how our sensitivity to both a rising rate environment and a declining rate environment. And obviously, as John pointed out, we -- our goal is to maximize net interest income without taking undue risk. So prudent to take some actions just in the event rates did continue to drop.

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Collyn Bement Gilbert, Keefe, Bruyette, & Woods, Inc., Research Division - MD and Analyst [22]

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Got you. Okay. And then, Glenn, if rates go the other way, if we've seen -- if the 10-year has bottomed here and then they go up, I mean, how much risk now is to the NIM if, let's say, 10-year goes back up to 2 or just, I don't know?

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [23]

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Yes. So again, you can see that on Page 19 as far as our disclosure. We have both a rising rate scenario and a declining rate scenario. If short end up or long end up 50 basis points you still -- you've actually increased your upside, you've taken a little away on the downside because we're hedging floating rate loans for the most part, but your upside has actually improved.

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Collyn Bement Gilbert, Keefe, Bruyette, & Woods, Inc., Research Division - MD and Analyst [24]

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Okay. Great, that's helpful. And then I guess, and I haven't done the math yet, so maybe perhaps this answers my second question, but with your fourth quarter guide of an efficiency under 57%, which is kind of consistent, I know you don't give guidance for 2020 but let's assume you guys are always focused on operating leverage and, et cetera, et cetera, if that 57% efficiency holds in 2020, does that imply any material change in the expense structure or how should we think about kind of the expense optimization potentials?

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [25]

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Yes. No, I think we have opportunity, and we've mentioned it on the calls. I think our goal is to drive that 57% efficiency ratio down over time. Obviously, the interest rate environment in the short term impacts that, and we've always said too that we're not going to let an artificial boundary impact our ability to invest in the Commercial Bank, invest in technology for long-term efficiencies or invest in HSA. So I do think there are opportunities, I mean I think we had really nice year-over-year expense discipline this year. And with some of the stuff we're doing in the middle and the back office, we have an opportunity, I think, to actually reduce expenses over time, Collyn. But that's really -- looking right now at LRP, that's really all I'd like to say.

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Operator [26]

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Our next question is from David Chiaverini with Wedbush Securities.

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David John Chiaverini, Wedbush Securities Inc., Research Division - Senior Analyst [27]

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So starting out with the commentary you said about some custodial relationships that were acquired in the quarter and how it represented 9% of total -- I think I heard you say, 9% of total HSA accounts. I was curious what percent of deposits that represents.

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [28]

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Less than that, slightly less than that, about 7.5% to 8% in deposits. So can I -- and I'll restate because I don't want there to be confusion on the phone. So those 2 custodial relationships, where the accounts are less profitable, 65% of the average balance, no interchange fees and nominal account fees, they were across 2 custodial customers, one of which was acquired, although I'm not going to mention names, you probably know, one of them was acquired in the third quarter and the other one has a nonbank custodial license now to take on the deposits. So we expect, based on contractual relationships, that over the course of the next 8 quarters or so that a large majority or all of those accounts and deposits will attrite. We're working with both of those customers to make sure our customers, to make sure that all the underlying customers, are not impacted and it's smooth. And the key point I wanted to make is that between the economics of those accounts and the transition and account closing fees that we will receive over the course of these next 8 quarters, the impact to us financially is offset by the net interest margin we lose on those assets going away from us is offset by those transaction and closing account fees.

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David John Chiaverini, Wedbush Securities Inc., Research Division - Senior Analyst [29]

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Great, that's helpful. And then shifting gears back to the balance sheet repositioning, was this a onetime action in the third quarter or can we expect additional balance sheet repositioning going forward?

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [30]

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So Dave, it's Glenn. It's -- those are the actions that we took during the third quarter. It's evolving. It depends on our view and where we think we're positioned. But let me just say, we want to continue to be very conscious of protecting the bank in a down rate environment, but we also don't want to hold back on a rising rate environment. So that's our strategy. We're operating within a band of that. So I'll just say, I mean it depends on your view of the rates.

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David John Chiaverini, Wedbush Securities Inc., Research Division - Senior Analyst [31]

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Yes, yes. Well ideally, I'd like to see them go up but it doesn't always work out that way. So shifting gears to credit quality. You mentioned that the increase in NPLs was an asset-based loan and that you believe you are fully secured. I was curious as to what industry that was in?

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [32]

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I believe it was a distribution company. And again, fully followed cash dominion, so we think that we're -- there's not a risk of loss there as we look at in present time. And I did note, it's -- we talk about the episodic nature of some of these categories and asset quality, if you look year-over-year, NPLs are flat as a percentage of total portfolio too, so while we're always concerned when something flows in there, David, it doesn't give us significant cause for concern.

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David John Chiaverini, Wedbush Securities Inc., Research Division - Senior Analyst [33]

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Okay. And then last one for me is on CECL. You mentioned about how that reserve could go up 25% to 35%. Can you comment on what the ongoing impact to EPS could be given that home equity lending is penalized under CECL? And you guys have been running that off, so that could actually be a tailwind for you, but wanted to hear your thoughts there.

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [34]

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Yes. So it's too hard to say right now. It's going to be driven by volume. You're correct in that our longer-dated assets obviously have a bigger CECL impact. That being said, when we look at it, we like things like mortgage banking, our mortgage customers have higher checking accounts. They also purchase more banking products and services. So it's too soon to say if it -- the implications to any particular product.

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [35]

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I think that's right, David. We thought about it. I'm one of those that shares the concern that if we get into a significant downturn in credit crisis that there'll be a procyclical issue with respect to CECL, meaning there may be a disincentive for banks to continue to aggressively make mortgage loans and extend longer-dated credit to consumers. But I think if we look through our general models right now, we don't anticipate shifting our current mix, which as you know, is about 2/3 commercial and 1/3 consumer. We don't think that in the short term, either our EPS will be impacted or kind of our business rationale and strategy will be impacted by the results of CECL.

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Operator [36]

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Our next question is from Laurie Hunsicker with Compass Point.

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Laurie Katherine Havener Hunsicker, Compass Point Research & Trading, LLC, Research Division - MD & Research Analyst [37]

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Just staying with credit, I was hoping that you could give us some update in terms of just where you are with respect to your leverage loan book? And then also specifically within consumer where you are with lending club both in terms of balances and what you're seeing there in terms of nonperformers and charge-offs?

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [38]

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I'm happy to answer those questions, and you know I like answering credit questions. So on leverage, if you go back to the January call when we sort of laid out and were transparent about where we were on leverage, the amount of leverage loans both from a funded perspective and from a total exposure perspective that our leveraged debt origination has not moved as a percentage of portfolio, so it's roughly 10% of the commercial portfolio and 6.5% of the overall bank loan portfolio. And the interesting dynamic there, Laurie, was besides the fact that, and I'm going to knock on wood here, we've had -- none of the charges we had in year-to-date 2019 were in that bucket. And as you know, we've had really good success over the last 10 years and even before in that category. We also don't have an increase in classified or watch or worse loans in that category. So really, it's status quo.

What I will say interestingly is that in the second to third quarter, our leverage loans didn't grow at all. And an interesting stat is year-over-year, the origination level in our Sponsor & Specialty group, where most of our leveraged loans are, was actually down 52% from prior year, whereas in ABL and Commercial Real Estate, we were up mid-teens in both of those categories. And again, we're -- we take a disciplined approach but that's not a result of the strategic shift. It's a result of, I think, we're living up to our promise to stretch on price, not on structure. So if you look at the net result, our originations year-over-year across the commercial bank are actually 14 basis points better from a weighted average risk rating, and our spread is down significantly, almost 70 basis points, our credit spread. So I'm not going to say that will last, if we have great opportunities in Sponsor & Specialty, and we have great opportunities in leverage loans, we're going to continue to underwrite them because we have confidence in it. But I think those credit trends and those credit metrics underscore the fact that we've been disciplined in the way we view the marketplace.

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Laurie Katherine Havener Hunsicker, Compass Point Research & Trading, LLC, Research Division - MD & Research Analyst [39]

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Okay. Great. And then what is your charge-off running -- charge-off rate running right now in the Sponsor & Specialty book?

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [40]

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It's well below our commercial. I don't have that number out, but it's -- I -- well below our 21 basis point, 20-quarter rolling average. And we were 28 basis points this quarter and none of the Sponsor & Specialty loans contributed to loans.

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Laurie Katherine Havener Hunsicker, Compass Point Research & Trading, LLC, Research Division - MD & Research Analyst [41]

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Okay. Perfect. And then last question around that. What percentage of your book do you consider covenant lite at this point?

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [42]

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I think back in January, I gave you something like less than 3% of the leveraged loans were covenant lite. I think it's probably low single digit, 1% or 2%. And Laurie, to be quite honest with you and to be transparent, I think that's some of the reason why our Sponsor & Special originations have been down because we haven't been chasing the market as aggressively because so many of the transactions, even BB transactions are covenant lite, and we've been very disciplined, I think, in that process.

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Laurie Katherine Havener Hunsicker, Compass Point Research & Trading, LLC, Research Division - MD & Research Analyst [43]

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Okay. Thanks, Glenn. And then on lending club, can you just give us an update on how big that balance is and what the charge-offs are running?

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [44]

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Sure. And it's John, I wanted to...

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Laurie Katherine Havener Hunsicker, Compass Point Research & Trading, LLC, Research Division - MD & Research Analyst [45]

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Oh, I'm sorry, John. I'm so sorry.

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [46]

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That's okay. Yes, Glenn doesn't answer the credit questions, but -- I'm only kidding. Lending club is $177 million in its funded exposure at the end of the third quarter versus a $230 million exposure in 2Q of 2016. We've been running that book down slowly. And I will tell you, it's economically profitable, it is less than 1% of our overall loan portfolio, and it is not a critical element of our strategy. But even with higher interest coupons and higher charges, it's actually economically profitable for us. So we're not emphasizing it, and we're not anxious to exit, but it's a very, very small portion of the whole.

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Laurie Katherine Havener Hunsicker, Compass Point Research & Trading, LLC, Research Division - MD & Research Analyst [47]

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Okay. And then just looking at your charge-offs, again, the $2 million or so in consumer charge-offs, are most of those coming from that lending club book?

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [48]

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A portion. It's a mix.

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Laurie Katherine Havener Hunsicker, Compass Point Research & Trading, LLC, Research Division - MD & Research Analyst [49]

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Okay. Great. I can follow up with you off-line. I just wanted to go back to where David and Steven were on HSA, as I just want to make sure that I understand this. So as we look at your current balances, so you finished September with total footings of $8.163 billion. Of the 2 custodial relationships that are gone, was any of it reflected in that number? And then maybe, can you also help us specifically think about what fourth quarter is going to look like, both in terms of deposits and in terms of HSA investments? I realize obviously that 1Q is your seasonally strongest but in other words, if we're just thinking about how those phase in, and also the 1 HSA custodial relationship that was acquired, did that close in third quarter or when is that expected to close?

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [50]

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It closed in the third quarter. So the third quarter numbers don't reflect any of this attrition. We have obviously, begun the process of working with our customers to come up with a schedule and the process under the existing contracts to move those. That's why we know the process is going to take up to 8 -- the next 8 quarters. We don't have the final details in terms of quarter by quarter by quarter, but what we wanted to do is be very transparent about the fact that we know that more than likely, the vast majority or all of these accounts and balances will attrite over 2 years. We wanted to be careful to let you and the market know that the economic impact to HSA and to the bank is mitigated over the next 6 quarters. Obviously, we'll have to then replace those deposits in those accounts. Chad may be able to give you some insights as to whether the fourth quarter will be impacted. But again, we don't have the exact schedule run off. And one of the reasons we wanted to talk about it is when we do get to 1Q and start to look at our organic growth rate and all the wonderful work we're doing in the direct-to-employer channel, we want to be able to say absent these less profitable accounts attriting, this would be our performance versus market. So Chad, I don't know if you want to give some insight as to what you think the fourth quarter impact will be.

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Charles L. Wilkins, Webster Financial Corporation - EVP [51]

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Now there's a chance that a small percentage of the overall deposits could move off before the end of year, in the fourth quarter, but we're still working that out. And again, it would be a very small and immaterial percentage of that entire book.

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Laurie Katherine Havener Hunsicker, Compass Point Research & Trading, LLC, Research Division - MD & Research Analyst [52]

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Okay. And Chad, maybe can you just help us think about if we fast-forward a year, a year from now or the end of 2020, what those balances might look like just incorporating all of the changes that you're making within HSA, your marketing push, et cetera, as we think about footings, both deposits and investments, how should we be thinking at growth for 2020?

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Charles L. Wilkins, Webster Financial Corporation - EVP [53]

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Well, as John was saying, it's hard for us to estimate exactly how much of that book is going to roll off in 2020 as we're working through the transition with our partners right now. The growth rates of that portfolio are consistent with our overall growth rates across the rest of the book. And we continue to focus on increasing those growth rates particularly in the channels that we have the most influence in. I can tell you in our new account production indirect, for instance, is up about 15% year-over-year where we're seeing actually a decline in new account growth rates in the custodial channels. So we expect to be able to -- our game plan is to replace those deposits and accounts over that time frame.

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [54]

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Laurie, I think the guidance I gave was that -- and Chad talked about the fact that our pipeline and so forth shows that we're hoping that one-one in this enrollment cycle whereas you know is the greatest portion of new account acquisition, we hope to exceed. And our pipeline shows that we'll exceed last year's new account openings. And then as these underlying custodial accounts attrite, and we get closer to the January call and the April call, obviously, when after the quarter, we'll be able to sort of reconcile all that for you.

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Operator [55]

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Our next question is from Jared Shaw with Wells Fargo.

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Timur Felixovich Braziler, Wells Fargo Securities, LLC, Research Division - Associate Analyst [56]

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This is actually Timur Braziler filling in for Jared. Not to beat a dead horse but just getting back to the HSA, the 2 custodian accounts, is that the 9% of third-party accounts and 7.5% of total deposits? Or is that still third party?

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [57]

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Those 2 accounts make up the lion's share of that. So if the question is -- there are some other customers in there but it's below $50 million in total footings and deposits and around 20,000 accounts not related. So if the question is, is there more to come? There really isn't a material amount left in that activity. That activity made money for us, it was less profitable and it's not something that we wouldn't do for another client, but it's not been, as you know, where our focus has been and the lion's share of our account growth over time has come from our growth in direct to employer.

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [58]

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And I'd add, John, that there is a chance we may maintain a relationship with one of those custodial partners longer term, but it would be much smaller than what we have right now.

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Timur Felixovich Braziler, Wells Fargo Securities, LLC, Research Division - Associate Analyst [59]

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Okay. That's helpful. And then, John, maybe looking at the commercial pipeline, I think you guys said that it was strong heading into the fourth quarter. What's the composition of that? Is that primarily CRE or are you going to see a rebound in traditional commercial growth?

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [60]

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Timur, it's been across the board, at least in the pipeline, and so far what we can say is commercial real estate continue to be strong, not only from an origination perspective and a pipeline perspective but there's been a slowdown in prepays there. And as we explore that, maybe just an interesting point in time where buyers and sellers -- the buyers want a higher and higher pricing and I mean the buyers want to pay a lower price given where cap rates and everything are, and the sellers are holding out for higher price, but we don't see really any deterioration in the underlying metrics particularly where we are. And if I look at the data points, our debt service coverage ratios were actually higher period-over-period and our LTVs were slightly lower period-over-period. So I just think the dynamics in our CRE with our existing sponsors and some of the great work we're doing throughout the footprint is generating some outperformance there. So it looks like we're getting growth throughout the commercial bank, but commercial real estate in particular seems to be really, really active.

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Timur Felixovich Braziler, Wells Fargo Securities, LLC, Research Division - Associate Analyst [61]

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Okay. Great. And then just one last one for me, looking at the linked-quarter increase in commercial classifieds, anything to note there or any asset class that's primarily driving that or is that pretty granular?

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [62]

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We actually had a couple of asset-based transactions there but it's really nothing. And as I said, I don't want to dismiss it because we look at all risk migration. But we know that the watch and worse levels, which are the criticized assets below are actually down, so we're not seeing a real flow, these were episodic. And as Glenn mentioned, if you look at our rolling average of several quarters in that 3% range, we're still well below our general operating level of commercial classified and still at cycle lows. So I -- after we did our review this quarter, I didn't see anything in there that concerned me.

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Timur Felixovich Braziler, Wells Fargo Securities, LLC, Research Division - Associate Analyst [63]

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Okay. So the ABL that popped up in nonperforming and then the increase in classifieds, there's no, like, geographic concentration?

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Glenn I. MacInnes, Webster Financial Corporation - Executive VP & CFO [64]

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No.

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John R. Ciulla, Webster Financial Corporation - President, CEO & Director [65]

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No.

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Operator [66]

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

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Terrence K. Mangan, Webster Financial Corporation - SVP of IR [67]

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Thank you so much, Sherry. I appreciate everybody getting on the phone and your continued interest in Webster. Have a great day.

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Operator [68]

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