Webster Financial's (WBS) CEO, James Smith on Q2 2014 Results - Earnings Call Transcript

Jul.17.14 | About: Webster Financial (WBS)

Webster Financial Corporation (NYSE:WBS)

Q2 2014 Earnings Conference Call

July 17, 2014 9:00 am ET

Executives

James Smith – Chairman, Chief Executive Officer

Joseph Savage - President

Glenn MacInnes – Executive Vice President, Chief Financial Officer

Analysts

Dave Rochester – Deutsche Bank

Collyn Gilbert – KBW

John Pancari – Evercore Partners

David Darst – Guggenheim Securities

Matthew Kelley –Sterne Agee

Jake Civiello – RBC Capital Markets

Operator

Good morning and welcome to Webster Financial Corporation’s Second Quarter 2014 Results conference call. 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 second quarter of 2014.

I will now introduce your host, Mr. Jim Smith, Chairman and CEO of Webster. Please go ahead, sir.

James Smith

Thank you, Manny. Good morning everyone. Welcome to Webster’s second quarter earnings call and webcast. I’m joined by CFO, Glenn MacInnes for about 20 minutes of prepared remarks focused on business and financial performance within the quarter, after which President Joe Savage, Glenn and I will take questions.

Results for the second quarter reflect continuing solid performance, particularly given a tougher interest rate environment than we envisioned heading into the quarter. By continuing to live up to our customers’ expectations in a market-leading way, we’re generating continuing loan growth, strong growth in transaction account balances, and deepening customer relationships. Results reflect rigorous expense discipline and strengthening credit quality reflective of an improving economy and our effective risk management. We’re making progress along the path to high performance and toward achievement of economic profits.

Beginning on Slide 2, net income increased 3% year-over-year to $48 million. After preferred dividends, net income available to common shareholders was $0.50 a share compared to $0.48 a year ago. Return on average assets was 90 basis points, on average common equity was 8.54, and on average tangible common was 11.52. All my further comments will be based on core operating earnings.

Looking at Slides 3 and 4, results were driven by loan growth in all categories, both linked quarter and year-over-year, especially in commercial banking. Continuing improvement in asset quality and relentless expense management helped produce the 13th consecutive quarter of year-over-year positive operating leverage. Strong growth in commercial loans boosted loan interest income even as lower rates and competitive pricing pressures drove yields lower on loan originations across the board. Lower rates also reduced yields and net interest income in the flat securities portfolio as premium amortizations increased and reinvestment yields declined. As a result, the net interest margin declined a more than anticipated 7 basis points linked quarter to 3.19% while net interest income was flat to Q1 and 5.5% higher than a year ago. Overall loan balances grew 2% linked quarter and 8% year-over-year.

Total loan originations were up 22% from Q1, though down 19% from a year ago, with the decrease primarily reflecting the changed refi environment as residential mortgage originations were 53% lower year-over-year. The overall pipeline totaled $865 million at June 30, up just over 20% from Q1. Notably, after another strong quarter of originations, the commercial banking pipeline is up about 8% linked quarter and the total personal lending pipeline is up 34%.

Core non-interest income was $4.2 million lower than a year ago due to a $5.4 million decline in mortgage banking revenue. Excluding mortgage banking revenue produces an increase of 2.5% driven by a 7% increase in deposit service fees. On a linked quarter basis, core non-interest income was up about 5%, again driven by higher deposit service fees, in this case because consumer volumes were higher than in weather-impacted Q1, and also by higher loan fees.

Fee income was not at the level we had anticipated as mortgage banking revenue was weaker than expected and wealth and investment services revenue and loan fees did not rebound quite as expected from Q1. Glenn will provide more detail in his remarks.

Total core revenue exceeded $200 million for the third straight quarter and grew 2% from a year ago as loan growth drove net interest income higher. We’ve now reported 19 consecutive quarters of year-over-year revenue growth dating back to 2009, which stands out among our peers.

The pressure on revenue from the challenging interest rate environment and the reduction in year-over-year mortgage banking revenue was met with ongoing expense discipline. Expenses were flat from a year ago and 1.4% lower than in Q1, driving the efficiency ratio down to 59.3% and helping deliver positive operating leverage of 2% year-over-year and 2.3% linked quarter. We achieved 5% year-over-year growth in core pre-tax pre-provision earnings to over $80 million, only our second-ever quarter above that mark.

Favorable asset quality was marked by modest linked quarter declines in non-performing loans and assets. As a result, the ratio of NPAs to loans plus other real estate owned improved slightly and is at its lowest level since the end of 2007. The loan loss provision increased modestly to $9.25 million as loan growth was offset by continuing improvement in asset quality. Since net charge-offs were unchanged at about $8 million in the quarter or 0.24% of average loans annualized, there was a small reserve build – about the same as in Q1 – versus a $4.4 million net release a year ago.

In April, the board increased the quarterly cash common dividend to $0.20 from $0.015 previously. As a result, the dividend payout is now about 40%. Our strong capital position and solid earnings support asset growth, provide for future increases in the dividend and selected buybacks, and enable us to confidently pass the annual regulatory severely adverse stress scenario.

The Federal Reserve board’s July Beige Book for the Boston district, which includes the bulk of our four-state footprint, reports that most contacts are at least cautiously optimistic about their near-term growth prospects. Respondents in the tourism, biotech and healthcare industries all describe the outlook as highly favorable.

I’ll now turn to line of business performance beginning on Slide 5. Growth remains strong in commercial banking as we continue to deepen relationships and take market share. Evidencing our success, Webster has received Greenwich Associates Excellence Awards in middle market banking for the past two years in national overall client satisfaction. Commercial and commercial real estate loans combined now total over $6 billion and grew 3.6% linked quarter and 16.5% year-over-year. CRE originations were particularly strong this quarter, pushing the portfolio 5.7% higher linked quarter.

Consistent with our strategy, commercial and business loans now represent over 55% of total loans compared to 52% a year ago and 46% three years ago. Yields are lower, as noted earlier, due to lower rates generally and competitive pricing compression, but also due to a shift in originated asset mix, namely an increase in high quality CRE originations in the quarter. As competition for high quality loans intensifies, we remain disciplined in our pricing execution. The economics of every credit transaction are measured through our internal RAROC model and every quarter we subject the commercial portfolio to external review that validates our pricing relative to peers.

Deposits declined modestly linked quarter and year-over-year as a result of seasonality in commercial and government deposits and the disciplined targeted deposit pricing strategy with respect to non-transaction accounts, particularly in government banking. DDA and other transaction accounts grew 16.5% linked quarter and 23.5% year-over-year. These core accounts now represent 60% of total commercial deposits, up from 47% a year ago.

Non-interest income increased 14.6% year-over-year, though declined 1.5% from a strong Q1. While acknowledging a challenging environment for fee generation driven by intense competition, we believe there are immediate opportunities for accelerated growth in multiple fee categories, notably in cash management, swaps, and loan syndication fees.

In summary, commercial banking posted revenue growth of 8% against expense growth of 4% year-over-year for positive operating leverage of 4%, and this unit continues to earn well in excess of its cost of capital. Momentum continues to build, evidenced by pipeline growth from March 31.

Slide 6 reviews our business banking unit. Business banking is a case in point regarding our focus on providing value-added products to our customers. About 15% of new originations had swaps attached, helping us deliver fee income gains of 14% linked quarter and 11% year-over-year. Business banking continued its steady growth, recording loan growth of 3% linked quarter and 9% year-over-year as higher volume offset lower spreads. Deposits grew about 7% linked quarter and year-over-year driven primarily by higher average account balances. Transaction account balances comprise about three-quarters of total deposits.

Slide 7 presents personal banking results. Overall consumer loan balances were up a bit both linked quarter and year-over-year despite the significant year-over-year slowdown in mortgage originations. Residential mortgage originations were up 43% linked quarter and down 53% year-over-year, with purchase mortgages accounting for 75% of Q2 volume. Given the high concentration of jumbo mortgages consistent with our mass affluent strategy, only $56 million was sold in the secondary market versus $217 million last year and $65 million last quarter, resulting in lower than expected gain on sale income. The pipeline grew 45% from Q1 to $325 million, which should boost mortgage banking revenue in Q3. All other consumer loan originations were up 49% linked quarter and 7% year-over-year as all three categories – home equity loans and lines, and unsecured consumer lending – rebounded from the sluggish first quarter.

Credit card revenue grew 18% linked quarter and 20% year-over-year due to higher sales volumes and growth in transactions. We’ve penetrated 16% of the checking account base with credit cards, up from 10% a year ago, and there is great opportunity for further gains.

Personal banking deposits were up marginally from Q1 and down about 1% from a year ago driven by heavy CD maturities in Q3 of 2013. The average consumer DDA account balance continued to rise by 4% year-over-year to $6,300. Total checking relationships increased once again and the cross-sell product per household ratio improved 7% year-over-year.

Deposit fee income rose 7% linked quarter as debit card transactions rebounded 11% from weather-impaired Q1. Fees were down 1.4% year-over-year, though debit card usage grew 4%.

Investment assets under administration in Webster Investment Services continued their strong growth at about 11% year-over-year to $2.7 billion driven by increased market valuation and customers’ consolidation of their financial assets with Webster. The 33,000 households with Webster Investment Service relationships are among the most valuable at Webster. They average total footings significantly higher than the rest of the community bank, have a cross-sell ratio about 30% higher, and exhibit extraordinary longevity.

Distribution strategy continues to drive and accommodate customer migration from banking centers to self-service channels. Banking center transactions declined by 8.3% year-over-year while overall self-service deposits, including mobile, accounted for about a third of overall consumer deposits, up 20% over last year.

We continued to optimize our physical network during the quarter, reducing banking center square footage by approximately 18,000 square feet or 2.5% year-to-date. Banking center staff declined 7% year-over-year while sales productivity per FTE was up 7%. The bottom line is that we’re generating higher revenue off a lower expense base as we transform the community banking model. Despite the mortgage banking revenue hit, community banking eked out positive operating leverage in the quarter and more than 3% year-over-year.

Slide 8 presents the results of Webster private bank, serving high net worth individuals, families, and charitable organizations. We’ve now completed the transformation to the new model under the strategic plan we announced early last year. We’ve assembled a skilled leadership team, meaningfully expanded our suite of investment choices, implemented a competitive increase in our fee schedule, and upgraded our fiduciary and planning capabilities. We’re seeing the benefits of uniting investment management, trust and estate planning, deposits and lending in a holistic way.

While we’ve attracted $170 million in new inflows over the past 12 months, that progress is masked by two events, one being the sale in Q3 last year of a non-strategic portfolio and the other being the recent departure of two former private bank execs who had been repurposed to producer roles and two portfolio managers who didn’t buy into the new and, I’m certain, improved model. The departures triggered voluntary liquidations of about 15% of AUM, worth about $1.7 million in annual fee revenue. A point worth noting is that the liquidating AUM yields significantly less revenue than our core book and 37% less than AUM booked in the first half of 2014 under the new fee schedule. We have filled the four positions and look forward to resuming net AUM growth as well as expanding into Providence, Boston and New York.

Meanwhile, private banking added more new relationships and with higher average revenues in Q2 than in Q1, and internal referrals also increased linked quarter. The pipeline for AUM is up and the pipelines for residential mortgages and tailored credits each doubled in the quarter. We expect this momentum to pick up significantly now that the transformation of the private banking model is substantially complete.

Slide 9 presents the results of HSA Bank, which now has over $2.4 billion in footings, including over $1.75 billion in deposits. Deposits grew 2% in the second quarter and 19% from a year ago. HSA Bank opened about 35,000 new accounts in the quarter, up 18% year-over-year. The cost of deposits declined 2 basis points linked quarter and is down 10 basis points year-over-year to 31 basis points. Growth in investment assets were split about evenly between market gains and account holder contributions. These fast-growing, low-cost, long duration, tax-advantaged and nationally diverse transaction account deposits will become an even more valuable funding source when interest rates eventually rise.

HSA Bank expanded its product suite in the second quarter to include health reimbursement accounts and flexible spending accounts, along with new capabilities including mobile access, stacked card payments and claims integration that support our strategy to move deeper into the large employer and insurance carrier markets.

Now I’ll turn it over to Glenn for his comments.

Glenn MacInnes

Thanks Jim. I’ll begin on Slide 10, which summarizes our core earnings drivers. Our average interest-earning assets grew $278 million compared to Q1, attributable entirely to growth in our loan portfolio. Net interest margin of 319 basis points decreased from 326 basis points in the prior quarter. Combined, this resulted in net interest income of $155.1 million, flat to prior quarter but over 5% from prior year.

Core non-interest income increased by $2.1 million or 5% on a linked quarter basis. The increase was driven primarily by a rebound in consumer activity resulting in higher deposit service fees. Core expenses were $1.7 million below Q1 primarily as a result of seasonal reductions in compensation and occupancy expense and a benefit from professional services. Taken together, our core pre-tax pre-provision earnings of $80.3 million were up about 5% from prior year and just below our record level of $80.5 million.

Pre-tax GAAP reported income totaled $70.9 million for the quarter and reported net income of $47.8 million includes an effective tax rate of 32.5% in the quarter. You’ll recall in Q1 we recognized a $2 million non-recurring tax benefit.

Slides 11 and 12 highlight the components of net interest margin. On Slide 11, you see net interest margin for Q2 versus Q1, and as you see, we’ve posted quarterly growth in average interest earning assets of $278 million, virtually all of which was in our loan portfolio. The yield on securities decreased by 14 basis points while the yield on loans decreased by 5 basis points. As a result, our yield on average interest earning assets declined 8 basis points from the first quarter.

Interest income on securities dropped by $2.3 million versus prior quarter. $1.3 million of the decline was due to an increase in securities premium amortization associated with a 1.3% increase in annual cash flows on the MBS portfolio to 17.1%. The accelerated cash flow was driven by a surprising 16 basis point decline in the average 10-year swap rate during the quarter from 286 to 270. The remaining $1 million decline was due to runoff of higher yielding securities, including $45 million of municipal bonds yielding 7.16% which were replaced with lower yielding securities, as well as a slightly smaller portfolio. We expect a significant reduction in municipal call activity going forward but portfolio churn will continue to put pressure on the portfolio’s yield. Higher interest rates would slow down premium amortization and help support the yield.

Our loan growth of $277 million offset portfolio spread compression of 5 basis points, resulting in a net increase in interest on loans of $1.8 million. Taken together, interest on earning assets was about $500,000 lower than Q1.

With regard to liabilities, average deposits decreased $60 million largely reflecting a managed decline in public deposits. The rate paid on deposits increased 1 basis point to 29 basis points due to a slight mix change and rounding. Our CD portfolio cost increased 3 basis points to 113 basis points. We have about $650 million of retail CDs maturing over the remainder of 2014 at a rate of approximately 52 basis points, which approximately equals our rate paid on new and renewing CDs. After adding an average of about $50 million of five-year brokered CDs in Q2, we expect to add about another $100 million in Q3 which will result in the CD portfolio cost increasing about 4 basis points in the third quarter. In doing so, we continue to gradually position our balance sheet for an eventual rise in short-term rates, which I will discuss on a subsequent slide.

Further down, you see average borrowings increased by $316 million. The average cost of borrowings decreased by 16 basis points due to the elimination of double carry costs from issuing $150 million of senior notes on February 11 to replace a maturity on April 15, and a maturity of $100 million borrowing at 316 basis points as well as an increased amount of lower cost FHLB short-term advances. Incremental short-term secured borrowings currently cost about 25 basis points. Combined, the 1 basis point increase in the cost of deposits and the 16 basis point decrease in the cost of borrowings resulted in a 2 basis point decrease in the average cost of interest-bearing liabilities. The net result is a roughly $400,000 or 0.3% decrease in net interest income versus prior quarter and the 7 basis point decline in net interest margin to 319 basis points. After the tax-equivalent adjustment, GAAP net interest income was about $200,000 lower than our record level in Q1.

Slide 12 shows the components of net interest margin versus prior year. The year-over-year view of the balance sheet illustrates the strength in commercial loan growth. In total, average loans grew $1.1 billion compared to second quarter of 2013 with the commercial category representing almost 97% of the growth. Average interest-earning assets grew $1.2 billion or almost 6% compared to a year ago, with loans representing over 92% of the growth. The loan growth drove the increase of $6.9 million in interest on earning assets, while interest paid on interest-bearing liabilities declined by about $600,000. As a result, net interest income on a FTE basis was $7.5 million or 5% higher than a year ago.

Slide 13 provides detail on core non-interest income. Our GAAP reported non-interest income reflects a decrease of $2.2 million from the first quarter; however, Q1 included a gain of $4.3 million from the sale of four collateralized debt obligations. Excluding this and nominal amounts of OTTI in both Q2 and Q1, core non-interest income increased $2.1 million or 5% versus prior quarter. As Jim discussed, we had expected the linked quarter increase to be higher, and I will now discuss some of the key categories.

Deposit service fees performed as expected, increasing $1.6 million, reflecting growth in cash management fees, debit card interchange revenue, and ATM fees. Mortgage banking revenue declined $262,000 from Q1 and totaled $513,000 in Q2. While we had not expected this category to improve until the second half of the year, the decline from Q1 reflects a 14% linked quarter decline on settlement volumes from a lower level of originations for sale in Q1. The quarter also excludes approximately $300,000 in unrealized gains we expect to record in Q3.

Wealth and investment service revenue was unexpectedly flat at $8.8 million to prior quarter, while we anticipated being higher. While loan fees increased $408,000 linked quarter, this was not at the level we anticipated and we expect this category to be stronger in Q3 as a result of higher anticipated closings on Webster’s agent transactions.

Slide 14 highlights our core non-interest expense, which declined $1.7 million from Q1 and is essentially flat to a year ago. During the quarter, we continued to invest in business growth as evidenced by increases in marketing and technology. We also opened a commercial lending office in Washington, DC. Expansion into the Washington market has been a part of our strategic plan and we see this as an area of great potential for Webster.

We managed the impact of additional investments through continued expense discipline across all areas of the organization. This quarter, a combined increase of $1.8 million in marketing and technology expense was offset by a reduction in professional services. We also recognized on a linked quarter basis reductions in occupancy, compensation and benefits as a result of expense seasonality.

Management discipline is reflected in our efficiency ratio, as you see on Slide 15. Despite revenue challenges in the quarter, we achieved positive operating leverage on a linked quarter and prior year basis, resulting in an efficiency ratio of 59.3%. Our efficiency ratio was 108 basis points lower than linked quarter and 72 basis points lower than a year ago.

Slide 16 provides detail on our interest rate risk profile. Our risk profile to a steepening of the yield curve is asset sensitive, and the results presented here are modestly improved since last quarter. Our Q2 results have highlighted the investment portfolio’s sensitivity to changes in prepayment speeds. This continues to be one of the driving forces behind the benefit from rising long-term rates. Our view on timing on the eventual rise in short-term rates has not changed from the mid to late 2015, and is consistent with the market. The timing, of course, is uncertain and could change based on economic data in the coming quarters.

As noted earlier, we continue to take gradual steps to protect ourselves and prepare for the eventuality of higher short-term rates. We are limiting duration risk in the investment portfolio through asset selection and have kept new purchases at durations between 2.9 and 4.0 years over the last five quarters. With 54% of the portfolio in HTM and an AFS duration of only 2.8 years, our tangible common equity ratio is well protected from increasing rates.

On the liability side, we have been lengthening duration by opportunistically buying LIBOR caps, entering into forward-starting swaps, and issuing five-year retail and brokerage CDs without adding significant cost. The asset sensitivity of our core bank is growing with over three-quarters of our loan bookings in the last three quarters are floating or periodic rather than fixed rate, and our deposit funding composition also continues to improve with 85% now in core accounts. HSA Bank provides us with a unique funding advantage in the form of deposits with long average lives, low price elasticity, and rapid rate of growth. With HSA now comprising over 11% of total deposits, we feel we are less susceptible to an outflow of (indiscernible) deposits than many of our peers.

Turning now to Slide 17, which highlights our asset quality metrics. The benefits of improving asset quality are increasing. The annualized net charge-off rate was at or below 25 basis points for the second quarter in a row as net charge-offs were just under $8 million in both Q2 and Q1. Non-performing loans declined to $144.5 million and were 1.09% of total loans, our lowest level since Q4 2007. A reduction of a little over $1 million in OREO also led to an improvement in the ratio of NPA plus OREO to loans, which totaled 1.14% at June 30. New non-accruals were significantly lower at $23.7 million in the quarter compared to $33.9 million at Q1. $23.7 million in new non-accruals also compares to an average of just under $36 million for the four prior quarters. Past due loans also saw a decrease of a little over $1 million in the quarter and now represent 0.35% of total loans.

Commercial classified loans now total $269 million or 3.66% of commercial loans, compared to 3.35% at March 31 and 4.54% a year ago. The $30 million increase from March is due to a few downgrades, and the ratio to classified to loans remains at historically low levels of less than 4%. Assuming recent economic trends remain intact, continued improvement in key asset quality metrics can be expected in Q3 and beyond.

Slide 18 highlights our capital position. Tangible equity ratios improved from prior quarter and prior year while supporting almost $349 million and $1.2 billion in balance sheet growth respectively, once again highlighting the strength of our core earnings. Tier 1 common to risk-weighted assets declined slightly as most of our asset growth was in loan categories with higher risk weightings, but also higher yields and better economic (indiscernible). We continue with approximately $40 million of approved but unused share buyback capacity.

Before turning to back to Jim, I’ll provide a few comments on our expectation for the third quarter. Overall, average interest-earning assets will grow in a range of 1 to 2%. We expect average total loan growth to be in the 2% range with growth expected to be led by C&I and commercial real estate once again. We expect to see continued pressure on net interest margin, and assuming the 10-year swap rate stays close to its current level, we would expect to see 3 to 4 basis points compression in Q3 driven by lower securities and commercial loan yields. Of course, NIM will vary with loan and security prepayment activity, and that is also dependent on the future course of interest rates. That being said, we expect net interest income to increase about $1 million over Q2, driven by loan volume with some offset in NIM compression.

Our leading indicators of credit continue to be encouraging and signal further improvement in asset quality. With the outlook for loan growth in Q3, we see a modest increase in the Q3 provision.

Regarding non-interest income, we expect mortgage banking revenue to improve from the less than $1 million level seen in Q2 and Q1. In addition, we anticipate seeing stronger Q3 growth in wealth management loan fees and client swap activity. As a result, we anticipate core non-interest income to increase about 6% linked quarter.

We continue to demonstrate a disciplined approach to investing in the business, and as a result we expect our core operating expenses to be at or below our targeted level to achieve a 60% efficiency ratio, and we expect the effective tax rate on a non-FTE basis to be around 32.25%. Based on our current market price and no additional buybacks in the quarter, we expect to see the average diluted share count to be in the range of 90.5 million shares.

With that, I’ll turn things back over to Jim for concluding remarks.

James Smith

Thanks Glenn. Our results demonstrate our sustained success in growing our businesses and generating positive operating leverage in pursuit of our economic profits. We’re making good progress in our quest to be a high performing regional bank.

We’re now happy to take your comments and questions.

Question and Answer Session

Operator

[Operator instructions]

Our first question is from Dave Rochester of Deutsche Bank. Please go ahead.

Dave Rochester – Deutsche Bank

Hey, good morning guys.

James Smith

Morning, Dave.

Dave Rochester – Deutsche Bank

Jim, you were saying the personal banking pipeline was – did I catch this right? – 34% quarter-over-quarter?

James Smith

I was talking about the mortgage banking pipeline at $325 million was up about 40%.

Dave Rochester – Deutsche Bank

Okay, and then the commercial pipeline, that’s up 8%?

James Smith

That’s correct.

Dave Rochester – Deutsche Bank

So would you say you guys are more positive, perhaps, on loan growth in 3Q versus 2Q?

James Smith

Certainly on the personal bank side, yes. I would say the commercial bank has continually demonstrated that momentum.

Joseph Savage

Yes. Hey Dave, this is Joe Savage. It’s pretty interesting if you take a look at the originations that we did in the first half of the year, it was really stunning because we had that strong first quarter and we actually, as you recall, drained that pipeline. We’ve been racing to rebuild it, and I would say that—and we’ve had great close activity. We’ve done some meetings with our folks. We feel reasonably good that we’re going to have a solid third quarter. How that pipeline ends up – you know, it may be a situation where our close activity is moving at a rate almost greater than we can replace it, but we feel pretty good.

Long answer to your short question, but we’re not in any way intimidated by that number. We think that number might actually climb a little bit as we head into Q4.

Dave Rochester – Deutsche Bank

Great, I appreciate that extra color there. Switching to expenses and the guidance, it sounded like you’re still thinking that you can come below that 60% efficiency level. I was just wondering in terms of the actual dollar amount trend in 3Q versus 2Q, do you expect to see that flat to down, or should that actually grow a little bit as we go into the back half of the year?

Glenn MacInnes

Dave, it’s Glenn. I think that you might see a little growth – modest, I would call it – as we continue to invest in the business, but we have, as we indicated, every intent to be 60 or below.

Dave Rochester – Deutsche Bank

Perfect. Just one last one on the loan growth side – can you talk about what drove the stronger growth in CRE this quarter, as in where you guys are seeing the opportunities and if you expect to see—it sounds like you expect to see that momentum continue in 3Q.

Joseph Savage

Yeah, sure – again, this is Joe. It was a great quarter. We put on 13 loans and I think what this group wants to hear, we really stayed true to our debt service coverage ratio and LTV is sitting at about 160 and 57% LTV, so we’re putting on good quality stuff. Probably the one thing I’d want to say for everybody to hear is that in our CRE book, we’ve got a seasoned group of folk. It’s been fairly broad-based where that activity has been occurring, but interestingly we were a tad worried about general overall pricing and structural deterioration, and when talking to our Bill Wrang, who heads our CRE book, he basically said he’s putting out more term sheets but he’s not winning them because he’s not getting the hit rate he wants, but fortunately we’re able to still get the momentum. So I would say in the markets that you would expect us to be good in, the Pennsy Philly area, Jersey, Boston, New York, it’s going to be pretty good.

One additional bit of color that I would want to add, though – we’ve got the multi-family representing about 50% of that activity, although we’re right within our ranges on that activity. So we think it’s going to be pretty good. We think it’s going to be broad-based. We’ve got a highly engaged group, so no reason not to think it won’t go well.

Dave Rochester – Deutsche Bank

Great. All right, thanks guys.

Operator

Thank you. The next question is from Collyn Gilbert from Keefe, Bruyette & Woods. Please go ahead.

Collyn Gilbert – KBW

Thanks, good morning gentlemen. Just to follow up a little bit on that question, can you guys talk a little bit more about the DC initiative and what you intend to do down there, and how you intend to do it?

Joseph Savage

Yes Collyn, this is Joe, and I’ll take a shot at that again. As you know, we were tickled several years back with what we did in the Boston area – that went well, and we gradually started expanding that group. As you recall, really the pioneers, if you will, going into territories would be areas like commercial real estate and asset-based lending, we replicated that model and we’re replicating that model in the New York area and in the Philly area, with the frontrunners generally having been in that group, and then we filled back in with the middle market group. So precisely to Glenn’s comment, the leaders that will take charge in seeing what it is that we think we can accomplish in Washington with start with the CRE lender that we brought on board, and we also have presence with ABL; and then ultimately I think John Ciulla and team are going to have to make the determination of whether or not it’s robust enough to consider bringing in middle market banking and filling out that franchise.

It has been a wonderful growth story for us, but out of the gate, precisely to Glenn’s point, we brought a seasoned in-market commercial real estate lender in, and our Bill Wrang is down there fairly regularly with him looking at what opportunities may be available.

Collyn Gilbert – KBW

Okay, so you still would sort of characterize it in the early stages, and you’re not—

Joseph Savage

Precisely.

Collyn Gilbert – KBW

Okay, all right. Just to talk on the lending side, is there anything in particular that would be driving—just the commercial classified credits now look like they’ve up-ticked for two quarters in a row. Is it one-off there, or are there any trends? Obviously, Joe, you’re talking about competitive pressures, the environment is intensifying, and I’m just trying to gauge what’s the timing before this trickles into credit cracks?

Joseph Savage

That’s a great point, and you’re right – they did tick up, and maybe the way I’d characterize it, I was looking at these numbers in the commercial bank, that classified number sits about as low as I’ve ever seen it at 2.5% of the total book, so Dan Bley and the credit team—we feel pretty good about that number. And of course, Collyn, there’s another side to that – what do we see with respect to NPLs and the charge-offs and those kinds of things, and those continue to be pretty good.

I don’t want to paint a rosy picture here – we do do big tickets, and we’re now at that point where the numerator, if you will, is so small that you can add a $50 million transaction and really move the needle, so not a lot of names came in. I think one or two were—in fact, I got a flash of four came in, so it’s not big that’s going on there.

So we’re watching it carefully, and that’s kind of why I made my comments when I tried to add some additional color for what Bill Wrang was bringing on the CRE book, because those guys are doing a real good job with the LTVs and DSE disciplines and not winning deals, winning the deals, I guess, that meet their standards.

Collyn Gilbert – KBW

Okay, that’s very helpful, and then just one final question, Glenn, for you on the NIM. I think we were all sort of hoping that maybe the NIM was bottoming and we were—anyway, the NIM was bottoming, and obviously it didn’t this quarter. What was the surprise or what occurred that you didn’t anticipate that caused the NIM to fall more than what you were projecting?

Glenn MacInnes

Yes, I think it was on the investment security side, was the impact from the 10-year and how that affected CPRs, particularly in, say, the last month, the last month and a half where they accelerated. Now, CPRs are relative to particular bonds, and we saw higher premium bonds paying off more than typical. So usually when we see a CPR increase of, say, one, we would expect to see a $600,000 hit on net interest income, and in fact we saw almost a 1.2, so almost double the impact. That’s a function of what bonds chose to pay off, so that, I think, is the bigger surprise as far as with respect to NIM. So when I look at the decline in basis points, the 7 basis points, about 5 is attributable to the securities portfolio.

Collyn Gilbert – KBW

Yes, okay.

James Smith

Also just to add to that, and then the reinvestment rate—

Glenn MacInnes

Yes. I mean, there’s two things in there, and there’s the investment portfolio. So the reinvestment rate, and that we had $250 million come off at, say, 3.80 and was reinvested at, say, 2.64, so there was 116 basis points that you could characterize as churn, right?

Collyn Gilbert – KBW

Okay, yeah. Got it, okay.

James Smith

So that 20 or 30 basis points in the 10-year really does make a difference.

Glenn MacInnes

It does.

Collyn Gilbert – KBW

Got it. Okay, that’s all I had. Thanks guys.

Operator

Thank you. The next question is from John Pancari of Evercore Partners. Please go ahead.

John Pancari – Evercore Partners

Good morning guys. Along the lines of the margin question, it looks like your new money yields on loans, looking at 5/31 there, pulled back notably in the second quarter, so can you give us a little bit of color there? I know you referenced competitive pressure you’re seeing on pricing and structure on CRE. Can you talk a little bit about the competition you’re seeing, and do you expect that the new money yields can continue to trend lower?

Joseph Savage

This is Joe speaking again. I would say I would expect—I guess the one bit of good news is it’s about 100% floating is what we’re putting on in the book. The other side of that is that yes, we are seeing the new money yields going in. Interestingly, some of the payoffs have been about that same number, so that’s good news for us. We typically ask our team as we prep for this call to give us the dynamics on how the markets are changing, and one of the comments that they’ve been fairly consistent that pricing is settling out a little bit right now. There is still competition out there, but it’s settling out.

So I would say it’s there, and it’s going to push us; but when you have the return on capital discipline that put forward, basically what it means is we’re going to have work harder to get transactions to meet our pricing hurdles.

James Smith

But to the question about more intensity, it’s really intense out there right now, and if the 10-year stays in the level of 2.50 or higher or swap rates up around 2.60, 2.70, we don’t think there’s going to be significant additional compression on new money.

John Pancari – Evercore Partners

Okay, all right. Then secondly on the—real quick just on the wealth management revenue again, the main reason for the flat rev is the departures, correct, for that total wealth management line?

James Smith

That had a meaningful impact, yes.

John Pancari – Evercore Partners

Okay, and is there—I know you replaced the people, and it sounds like you’re a little bit more positive now, but any potential for incremental departures? I mean, could this cause anything, because I know with wealth management businesses, once you get a string of departures and AUM declines, it can really get moving.

James Smith

Yes, I think most of that action happened in a concentrated period and that we’re solid and strong and the team is committed. You know, what happens is you want everything to go smoothly and everybody to be happy with very significant fundamental change that you’re making, but it doesn’t always play out that way, so I think that’s what happened here. I know that the team led by Dan Fitzpatrick is very solicitous of the people in the group. They seem to be quite cohesive, they are quite optimistic. We’ve got a really good model. I mentioned that the pipelines have doubled in the deposit and the lending side, AUMs are up, referrals are up. Everything is a go there, so we’re not expecting to have any serious additional fallout.

John Pancari – Evercore Partners

Okay, and if I could just hop back to the margin real quick, I appreciate the color you gave us for the third quarter margin. Can you give us a little bit of color about the margin beyond the third quarter, particularly given the securities yield pressure, the loan yield pressure, and CD costs moving higher?

Glenn MacInnes

Sure. So I think the fourth quarter, we expect the investment portfolio to bottom out, and then you heard the comments with respect to the commercial portfolio where we think that we’re sort of at the bottom there, too. So I think flattish to you should start—begin to see an increase.

Now of course, this all depends on rates, and we’re thinking that the 10-year is going to continue to go up. I think our average for the third quarter, or what we’re thinking based on the forward curve, is that the fourth quarter will have a 10-year about 288 basis points, all right? So we’re sitting here today at 2.65, we’re thinking the third quarter we go up 9 basis points on average to 2.75, and then another 15 to 2.88, and that’s in line with the forward curve. But all our assumptions are obviously driven by that.

John Pancari – Evercore Partners

Okay, and if I could just ask one last question around rate sensitivity, have you guys talked about the amount of deposits that could potentially move off your balance sheet at all once short rates move higher?

Glenn MacInnes

Sure, yeah. We do (indiscernible). It’s probably about 5% of total deposits. I think that—

John Pancari – Evercore Partners

That could decline?

Glenn MacInnes

I’m sorry?

John Pancari – Evercore Partners

That could move off your balance sheet, correct?

Glenn MacInnes

That could move off, and I think—

(audio lost)

And then on the funding side, I’ve highlighted sort of three things – the brokered CDs, the purchase of LIBOR caps, and the forward-starting swaps, and those two combined, I think, well position the bank for the eventual rise in rates.

Unknown Analyst

Okay secondly, last quarter you had mentioned, Glenn, on the call that you expected mortgage banking to rebound in the second half of the year and sort of in that range a $1.5 million to $2 million a quarter. Is that still a good estimate?

Glenn MacInnes

Yes, I think that is a good estimate, and you have to keep in mind that there’s about $300,000 lower cost to market of unrealized gains that we’ll recognize in the third quarter that we couldn’t recognize in the second quarter, so that’s part of it. But really, Mark, it was driven—you look at the first quarter activity, which was down to our all-time low on a purchase, at least for the last couple quarters, and the 14%--that translated into a 14% decline in settlement volume. So we expect it to come back over the $1 million level, so I think a $1.2 million, $1.3 million is the appropriate level.

Unknown Analyst

The last question I have sort of follows up on Collyn’s earlier question about the DC expansion. Can you help us think about how large this portfolio is likely to become, and also give us a sense whether this lending initiative expansion is likely to include some opening of branches in that market or acquisition of branches in that market?

Joseph Savage

Sure, I’ll take a shot at that, and Jim may want to add to it with respect to the branch notion. Typically what we’ve been doing, Mark, in these large markets, at least at this juncture, it’s been effectively branchless. We’ve got the one major branch bank in the Boston area, and we have our New York offices really piggybacking on our asset-based lending franchise. So really, the notion is to lead first with the commercial bank and in those units where our—I guess I’d say our competencies are easily exportable, given the people we have. So if you think about—you know, you go down to Washington and you think about that business, that would essentially largely be coming out of the gate as a commercial real estate book.

So if we saw over the next couple of years, I’ll say with respect to commercial real estate $150 million, that would be a good day, assuming it met our RAROC hurdles. So we like to give these things some amount of gestation and then we can accelerate. I think our Philly initiative we started many years ago, that’s in the $500 million-ish category today, so that gives you a feel for how we go at it.

Unknown Analyst

Thank you.

James Smith

And Mark, I’ll just add to that, that the way that we’re managing the program, we don’t need the retail exposure to be successful on the commercial side. We’ve demonstrated in Boston, it’s happening in New York and in Philadelphia, and I’m sure we’ll have the same experience in Washington. If you’re talking 10 years out, though, you’d have to think we probably would have some kind of additional physical presence there, just for the convenience of the people in the market, but not –a full-fledged retail franchise would not be necessary to make this strategy work.

Unknown Analyst

Thank you.

Operator

Thank you. The next question comes from David Darst of Guggenheim Securities. Please go ahead.

David Darst – Guggenheim Securities

Hey, good morning.

James Smith

Hi David.

David Darst – Guggenheim Securities

Jim, you were giving us some statistics on your sales per FTE year-to-date. Is any of that beginning to show the benefit of changes that you made to your incentive compensation system?

James Smith

Oh, very definitely, and in fact we expect that productivity number to increase as a result of what we call the WIN program – the Webster Incentive program. We are seeing those people that have been through that program are producing at an increasingly higher rate; so I mentioned that we’re up 7% year-to-date. In terms of overall sales productivity, we expect that number to go higher. This principal agent arrangement on incentives is working beautifully because the interests of the seller are aligned with that of the client and for the benefit of the company as well.

So we’re 7% year-to-date. Let’s say that the all-in rate should be closer to 12 to 15% productivity improvement, so you can actually sell the same amount or more by identifying and meeting your clients’ needs with a staff that is significantly smaller in size, very, very efficient.

David Darst – Guggenheim Securities

So where would you say you are in rolling it out across the entire franchise? Are you through the pilot and it’s fully launched?

James Smith

It’s through the pilot, it’s fully launched. It’s taking hold, so it takes a quarter or two to really see what it can do, but it is delivering as we had expected.

Glenn MacInnes

I think the only thing I would add is not only is productivity up, but we are selling the right products, meaning that the profitability is aligned with what we’re selling both in the center and in the distribution network, and that’s significant for us.

James Smith

It actually—along those lines, one of the things we’ve talked about over the last couple years is our product and customer profitability model is a significant part of making sure that we have the alignment correct. I mentioned it in a shareholders’ letter a couple years ago that it would help us make better choices over the near term and could become a competitive advantage over the longer term, and we are getting closer to the latter.

David Darst – Guggenheim Securities

Okay, got it. Thank you.

Operator

Thank you. Our final question comes from Matthew Kelley of Sterne Agee. Please go ahead.

Matthew Kelley –Sterne Agee

Yes, hi guys. Getting back to that question on deposit sensitivity, just so I’m clear, you would expect an outflow of 5% of your deposit base under what interest rate scenario does that match up to?

Glenn MacInnes

I think that would be under a short-term increase of, say, 200 basis points.

Matthew Kelley –Sterne Agee

Okay, got you.

James Smith

So we call it the surge, Matt.

Matthew Kelley –Sterne Agee

Yeah. Then on your $304 million of commercial real estate originations, you suggested that the yield on those originations was pretty close to the 3.73 portfolio yield – is that correct?

Joseph Savage

The yield on the – let’s see – on that book came in at—no. I would say that would have been an all float book yields, I’m going to guess would have been somewhere in—this is just going to be a guess. We’d have to give you the right number. I’m looking at the spreads as I’m talking to you at 213, but I want to guess it’s probably in the 270-ish area, but that would be ballpark.

Matthew Kelley –Sterne Agee

For real estate originations?

Glenn MacInnes

--CRE for the quarter.

Matthew Kelley –Sterne Agee

Yeah, I’m looking at Slide 29, just the 304 million of originations.

Joseph Savage

Yeah, you know what? Just to make sure I give that to you correctly, why don’t I get that to you so I confirm that. I don’t want to—

Matthew Kelley –Sterne Agee

Okay, that’s fine.

James Smith

Matt, you can see on Slide 32 where we have the commercial banking yields, or yield on the fundings, so it’s 333 for commercial banking in total, and that obviously consists of the commercial real estate component.

Glenn MacInnes

But I’ll come back to you with that, Matt.

Matthew Kelley –Sterne Agee

What’s your view on the Boston real estate market? A lot of development there on the residential condo front. What’s your exposure there, what’s your view of that market in terms of supply-demand absorption, and your activity in the Boston market?

Joseph Savage

The Boston market has been a very strong market for us, and it’s an intensely competitive market. We have seen decent absorption in that market, so we’re not seeing an AQ potential issues. It continues to be strong multi-family. Probably the big story there from our vantage point is that it’s another one of those intensely competitive markets, and when I was talking about earlier the fact that we’re not getting as many hits on the terms sheets we’re putting forward, I think that’s especially true in that market. We’re, quite frankly, surprised at some of the tickets that are being written by the smaller banks specifically there.

But it’s a big market for us – half a billion dollars. It’s probably—I’ll bet you I’m pretty close on that number off the top of my head.

Matthew Kelley –Sterne Agee

Got you. And then what was the commercial line utilization rate? Any change there and any change in kind of the overall health of the small and midsize C&I borrowing customer?

Joseph Savage

Yes, there’s really two—it’s interesting. There are really two areas where utilization is a dynamic process in the commercial bank. Really, the others are more term funding related items, and those areas are asset-based lending. That’s been very solid. Think of that in terms of if you ex out your letters of credit out of that stat, you’re talking about 54% to 56%. It’s been pretty solid over two years.

The other interesting one, second best and second most important would be our middle market regional, and that’s lifted from about 37, 38 up to 42, so pretty good. Whether that means anything – we’ve seen the same articles in the newspapers. We’re not going to get too—we don’t want to get too far out in front of determining whether or not that’s a trend, but it’s not bad.

Matthew Kelley –Sterne Agee

Got you. Last question on your agreement with Jones Lang, give us an update on the branch consolidation, total facilities cost, management – how that’s going, where we are in that progression, and how much cost savings is left on that side of the business.

James Smith

Yes, I’d just say I mentioned in my remarks that we’d taken out 18,000 square feet out of the banking centers in the first half – that’s about 2.5% of the total and is consistent with the program we’ve had in effect for quite a while. We expect there will be additional opportunities to do some three-for-two, two-for-one consolidations. The number of banking centers is about the right size. They may have over time, we’ll have them be a little bit smaller, they may be better located. They’ll all be electronically outfitted. That’s part of—(audio lost), which is value-added beyond the lower cost of delivering the facilities management and other services that they provide to us. The effect of their impact really is probably you’re seeing it in the numbers at this point.

Glenn MacInnes

Yes, I would add that I think the last—you know, you’ll see more of this, but it’s really bigger than JLL. It’s about rationalizing our distribution network, so you’ll see additional closures this year or consolidations – like, three-for-one, I think, is potential for the fourth quarter, at least that’s what we’re working on. But really, the retail banking team keeps rationalizing the network. So it’s JLL helping us rationalize the network, but you’ll see that cost continue to come down.

Matthew Kelley –Sterne Agee

And what is the report card on deposit and customer retention? How does that compare to your expectations? As you close these branches, are you maintaining in line or less or more than what you anticipated as you start to close locations?

Glenn MacInnes

Yes, I think we’re generally in line with what we anticipated on the closures, so there is an attrition factor that’s probably close to 20, maybe a little over 20% when you do this. But that’s generally in line, I think, with the industry and what we anticipated seeing.

James Smith

And we do a pretty thorough analysis office-by-office to make sure we know not just where the customers live and what other offices they could bank in, but how they bank today and where they use the ATMs and how much online banking they do, and whether they use mobile. So the ones that we’ve targeted for consolidation have been the ones that would give us the biggest yield, and our analytics have been very strong.

Matthew Kelley –Sterne Agee

Got you. Thank you.

Operator

Thank you. Our next question is from Jake Civiello of RBC Capital Markets. Please go ahead.

Jake Civiello – RBC Capital Markets

Hey, good morning guys.

James Smith

Hi Jake.

Jake Civiello – RBC Capital Markets

Glenn, you provided us with your expectations for the 10-year for the rest of the year, highlighting that they’re in line with the forward-swap curve, if I heard you correctly. Can you give us any perspective as to what would happen with the NIM if the 10-year actually stays flat for the rest of the year?

Glenn MacInnes

I don’t have those in front of me, but obviously there would be continued pressure. I think we’d probably go down to 3 to 4, and then maybe another 3 to 4 in the fourth quarter.

Jake Civiello – RBC Capital Markets

So 3 to 4 each quarter, you’re saying?

Glenn MacInnes

Yeah, yeah.

Jake Civiello – RBC Capital Markets

Okay.

James Smith

We’re not predicting that.

Glenn MacInnes

But we’re not predicting it. I mean, I’m just—

Jake Civiello – RBC Capital Markets

I know. None of us can predict what’s going to happen with the interest rates, so I’m just trying to get some perspective on if things stay static with what they are today.

Glenn MacInnes

But I think you’ve got to be careful about drawing any conclusion, then, about the securities portfolio, because again it depends on the bond selection and the individual securities selection, that you can’t extrapolate and draw a linear forecast from that. So we’ve been successful up to this quarter in outpacing NIM compression through portfolio increases, particularly on the commercial side. So this is one quarter where we’ve seen an impact from the securities portfolio, and again somewhat unexpected in that the 10-year didn’t go up and we saw CPRs, which typically have a 60 or 90-day lag, sort of hit on the securities portfolio.

Jake Civiello – RBC Capital Markets

Sure, that’s fair. I understand. Thank you.

Operator

Thank you. We have no further questions in queue at this time. I would like to turn the floor back over to management for any closing remarks.

James Smith

Thank you, Manny, and thank you all for being with us today.

Operator

Thank you. Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your lines at this time, and thank you for your participation.

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