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FirstMerit Corporation (NASDAQ:FMER)

Q2 2014 Earnings Conference Call

July 22, 2014 11:00 AM ET

Executives

Thomas O'Malley – Director-Investor Relations & Communications

Paul Greig – Chairman, President & Chief Executive Officer

William Richgels – Chief Credit Officer & Executive Vice President

Terrence Bichsel – Chief Financial Officer & Executive Vice President

Mark DuHamel – Treasurer and Director, Corporate Development

Analysts

Terry McEvoy – Sterne Agee & Leach Inc.

Scott Siefers – Sandler O'Neill & Partners LP

Preeti Dixit – JPMorgan

Christopher McGratty – Keefe Bruyette & Woods Inc.

Stephen Geyen – D.A. Davidson & Co.

Operator

Good morning. My name is Jennifer, and I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter 2014 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions)

Thank you. Mr. O'Malley, you may begin your conference.

Thomas O'Malley

Thanks, Jennifer. Good morning. Welcome, and thanks for joining us on our second quarter 2014 earnings call. On the call today, we have Paul Greig, the Chief Executive Officer of FirstMerit; Terry Bichsel, our Chief Financial Officer; Bill Richgels, our Chief Credit Officer; and Mark DuHamel, our Treasurer and Director of Corporate Development. We are going to happy to take your questions following our prepared remarks.

Please note that the press release issued this morning regarding our financial results, along with supplemental slides, are available on our website at firstmerit.com under the Investor Relations section. I would like to remind you that our comments today may contain forward-looking statements that are subject to certain risks and uncertainties that could cause the company's actual future results to materially differ from those discussed.

Please refer to the forward-looking statement disclosure contained in the earnings release materials and our SEC filings for a full discussion of the company's risk factors. Also, please note that our comments and supplemental slide deck reference non-GAAP financial measures. A reconciliation of all non-GAAP reference measures can be found in the supplemental deck.

I will now turn the call over to Paul Greig.

Paul Greig

Thank you, Tom, and good morning, everybody. In the second quarter, we continued to deliver strong performance across all business lines. Our financial results, which I will address in a few minutes demonstrate the progress we are making on our overall business strategy.

Our strategy focuses on capitalizing on multiple opportunities throughout our markets. Organic growth is the foundation of our strategy and the highest priority. To that end, we are delivering results on discrete action plans within each line of business. Our prompt and excellent service differentiates FirstMerit throughout our footprint. We focus on delivering this market leading service through local leaders with strong ties to their communities.

We empower our local bankers as true decision makers in their customer relationships. This develops customer loyalty and encourages customers to expand their business with the bank. We are confident that this local, market focused approach sets us apart and drives organic growth.

We entered the Chicago market targeting the commercial middle market segment, which is the core competency of our company. Since our 2010 entry, we have originated a loan portfolio of $1.8 billion, which represents compound annual growth of nearly 50%. As with all of our markets, the competition is robust. However, we continue to win market share with our unique value proposition.

We are profitably growing the balance sheet with an unwavering eye on credit discipline and appropriate pricing. We expanded into Michigan and Wisconsin with the Citizens acquisition to strategically enter a recovering and growing market rich in middle market lending opportunities. We've developed core deposit relationships and realized efficiencies through revenue synergies and cost savings.

In our first full year, we added $925 million of loans to our balance sheet. We have grown core deposits by $115 million and remixed a solid 78% core deposit up to 83% core deposits. We continue to focus on revenue opportunities related to mortgage banking, bank card, and our indirect businesses. Our organic growth strategy has also been effective in our legacy Ohio markets.

Since our first acquisition in Chicago in 2010, our loan portfolio in Ohio increased $1.6 billion, or over 5% annually, while we've added $2.6 billion in deposits, which is over 7% annualized growth.

The second component of our strategy is to maintain strict underwriting standards and appropriate credit risk management practices. By adhering to appropriate credit structures and pricing discipline, we intend to continue to produce industry leading asset quality, while profitably growing our balance sheet. This process is managed by seasoned bankers and credit professionals averaging over 25 years of experience.

The third part of our strategy is efficiency improvement through expense reduction and increased productivity. Evidence of our progress is displayed this quarter in our efficiency ratio of 59.5% adjusting for costs related to our branch closings.

A fourth pillar of our strategy is disciplined capital management. The objective is to support shareholder dividends and organic growth. We manage our capital levels to ensure that we have the balance sheet flexibility necessary to withstand industry and/or economic pressures. While we evaluate M&A transactions to determine whether they meet our stringent criteria, these types of opportunities are secondary to our organic growth strategy.

Finally, we're striving to become best-in-class in regulatory management. To that end, we believe investments we are making now will limit the impact on our future earnings stream of increased regulatory requirements affecting the financial sector.

Now, let's review the second quarter financial performance. We reported $59.5 million in net income for the second quarter of 2014 or $0.35 per share. Total revenue for the quarter was $272 million, up 7 million or 11% annualized compared with the prior quarter. Higher net interest income supported by strong loan growth and the rebound in fee income contributed to the revenue increase this quarter.

Second quarter 2014 results also include branch closure costs, which reduced fee income by $4 million or the equivalent of $0.01 per share. Adjusting for those costs, return on average assets is 1.03% and our return on average equity is 9% for the quarter.

Second quarter 2014 average deposits increased $1.2 billion or 6.3% to 19.5 billion over the year ago quarter. This increase was driven by core deposit growth of $1.5 billion or 10%. At the end of the second quarter 2014, core deposits represented 88% of total deposits. Our success remixing the deposit base allows us to maintain deposit costs at the low end of the industry.

For the quarter, total deposit costs were 19 basis points. Average deposits declined off the prior quarter due to the seasonal decline in public fund balances, our continued practice of deemphasizing non-relationship certificates of deposits, and our decision to reduce a wholesale deposit relationship.

Period end loans increased $361 million or an annualized 10% over the prior quarter. We generated solid net loan growth despite run off in the covered loan portfolio. Factoring out the $67 million in covered loan attrition this quarter, end of period total loans were up $428 million, or 12% annualized.

The originated loan portfolio increased $640 million or 24% annualized. Of that growth, approximately 593 million, or 22% annualized came from new production and $47 million was transferred over from the acquired portfolio. Our credit metrics remain solid with net charge-offs at 22 basis points for the quarter, down from 31 basis points last quarter.

Nonperforming assets remained at very low levels in the second quarter at 53 basis points, down from 58 basis points last quarter and 72 basis points a year ago. Noninterest income increased $5.3 million, or 8% from the first quarter and increased $3.1 million, or 4% over the prior year. As expected, this increase reflects the more historic levels of underlying customer activity following the impact of the severe weather experienced across the Midwest in the first quarter.

As I noted, other income was reduced this quarter by $4 million due to the changes – charges from the recent branch closures. Noninterest expense was $167.4 million, down $1.9 million or an annualized 4.6% off last quarter's level. While expenses were a bit higher than we wanted this quarter, we remain on pace to achieve the additional $18 million in annualized cost savings in the second half of this year.

The company is in a strong position to grow profitably and organically. We have a proven strategy and empowered employees focused on successfully executing our plan in obtaining our objectives.

I'll now turn our call over to Bill Richgels for discussion on credit. Bill?

William Richgels

Thank you, Paul, and good morning, everyone. This morning I will discuss the credit performance of each of FirstMerit's three distinctive loan portfolios, namely: organic, covered and acquired.

First the organic portfolio, credit quality continues to be strong with our provision for organic credit losses remaining at lower levels consistent with the last several quarters and where we set in the credit cycle. Total net charge-offs for the organic portfolio were $6.2 million, down from $8 million recorded in the prior quarter.

In that charge, our net loss rate for the retail organic book was 37 basis points compared to 42 basis points in prior quarter evidencing solid performance. The commercial organic book net loss rate for second quarter was 15 basis points compared to 26 basis points in the first quarter. Our commercial delinquency numbers are positive with organic delinquency improving to 23 basis points compared to 32 basis points in the prior quarter.

Retail consumer delinquency for the organic portfolio remains stable at a low level of 126 basis points, compared to a 123 basis points prior quarter. Directing your attention to the covered loan portfolio, the provision for covered loans was $3.4 million, consistent with the $3.1 million in the prior quarter and down from $4.2 million in the prior year quarter.

Looking ahead to the termination of the FDIC coverage on the commercial portfolio in the second quarter 2015 we are able to describe our remaining forecast for this much reduced loan portfolio. Out of a remaining commercial book of $304 million, roughly $171 million are performing re-underwritten, de-risked and will be held to maturity. Of the $133 million balance we will monetize roughly $93 million during the next three quarters, and we will have a residual balance of $20 million by December of 2015 at appropriate carrying values.

The indemnification asset is expected to be fully amortized by the end of the expiration of the FDIC loss, commercial coverage period in the second quarter of 2015. All-in-all this portfolio is performing within our expectation and the realized values are well beyond our original underwriting of the same.

And lastly, I will discuss the Citizens' acquired portfolio. In this acquired CRBC portfolio, acquired non-impaired net losses totaled $3.8 million compared to a $5.6 million in the prior quarter. Recoveries are up and this book should continue to improve over time. An additional provision for acquired impaired loans $2 million was recorded in second quarter for a total provision in the acquired portfolio of $5.8 million.

The annualized totaled acquired net loss rate was 45 basis points, compared to 82 basis points the prior quarter after giving effect to recoveries reflected in non-interest income. This portfolio is tracking in line with our expectations and better than originally estimated. Over the course of the last year, the acquired portfolio, criticized and classified component was significantly reduced.

In 2013, $353 million of CRBC criticized and classified loans were added to our portfolio. This acquired C&C portfolio has been reduced $201 million, or 44% reduction over that period.

With that I'll turn it over to Terry Bichsel. Terry?

Terrence Bichsel

Thanks, Bill, and good morning, everyone. I'm going to cover some additional detail on the second quarter financial statements and then update our guidance for the remainder of 2014.

Slide 4 of the earnings release supplement shows you the income statement highlights. Net interest income at a $199.7 million is up $1.8 million. The provisions for loan losses totaled $15.3 million, $700,000 higher than last quarter. Non-interest income at $72.6 million was better than the first quarter by $5.3 million and non-interest expense was $167.4 million, lower than last quarter by $1.9 million. This is places second quarter pre-tax income $6.1 million higher than the first quarter.

Slide 5, shows recorded non-interest income of $72.6 million, which represents 26.6% of revenue, up from 25.4% last quarter. All categories show to rebound from the first quarter. The expected recovery in fees this quarter is evidence that the consumer behavior is restored after being suppressed by severe weather last quarter. Service charges up $1.9 million and card fees up $1.3 million were the largest increases in customer driven transaction fees this quarter.

Other operating income includes $4.1 million of costs associated with branch closures, covered loan recoveries also within this category were up $2.4 million from last quarter.

Slide 6, shows non-interest expense declined $1.9 million from last quarter. The first quarter did include $1 million in one-time merger related expenses and the second quarter net occupancy costs improved by $2.7 million due to the elevated weather-related costs that impacted the prior quarter. Loan related transactional costs were up $1 million from the prior quarter. While expenses were higher than we wanted in the quarter and adjusted efficiency ratio excluding branch closure costs at 59.5% is indicative of managing costs in the right direction.

Slide 7 through 9 provide detail on the drivers of our net interest margin. Please note that slide 8 has been added this quarter as additional disclosure to show the impact of the credit mark accretion on the net interest margin. The net interest margin was down 9 basis points from last quarter to 3.75%. The yield on originated and acquired loans was stable from last quarter, each down 1 basis point.

The yield on covered loan – on the covered loan portfolio improved 88 basis points reflecting improvement in the re-estimated portfolio of cash flows. Originated loans, average balances were up $644 million while covered and acquired loans were down $354 million. While the effect of this mix shift affects the net interest margin ratio, loan growth stabilized and provided net interest income growth.

We expanded the size of the investment portfolio by a $170 million on average in the second quarter. We purchased $200 million of mortgage backed securities and supported the duration with Federal Home Loan advances and brokered CDs. This action was taken to offset the effect of the mandatory redemption of a portion of the Federal Home Loan Bank stock that we own.

Taking you out of sequence in the earnings release supplement, slides 19 through 22 provide additional detail on the acquired and covered portfolios that are a significant component of our balance sheet.

Acquired loan income was $61.5 million in the second quarter compared to $66.5 million in the first quarter. Within this income the accretion of the credit mark on acquired non-impaired loans was $14.4 million compared to $17 million last quarter. And the accelerated component within those amounts due to pay-offs and additional payments at $5.4 million compared to $6.4 million last quarter.

Without the accelerated component the net-interest margin was 3.65% and 3.71% last quarter. The remaining loan mark on the non-impaired loans is $122 million.

Slide 21, shows the detail on the accretable yield on the impaired acquired loans. The re-estimation of impaired loans this quarter resulted in the reclassification of $10.5 million of expected additional cash flow to accretable from non-accretable following $19.5 million of reclass last quarter. At quarter end $137 million of accretable yield remains to be recognized as interest income over the remaining life of the loans.

The earnings benefit from improving cash flow estimates over the past three quarters totaled $76.4 million which will be recognized as future interest income. This offsets $5 million in cumulative credit impairment provisions recognized to-date by a ratio of 15:1.

Slide 22 details the cash flow re-estimation of the covered portfolio which resulted in $5.5 million of additional cash flow being re-classed to accretable from non-accretable compared with $6 million last quarter.

The provisions for originated, acquired and covered loans totaled $15.3 million. The provision for originated loans at $6 million compares to net charge-offs at $6.2 million this quarter reflecting stable and strong asset quality.

The provision for acquired loans at $5.8 million is comprised of $3.8 million provision for acquired non-impaired loans. This provision should also be viewed within the context of the $14.4 million accretion of the credit marks discussed earlier. In other words, we are offsetting part of the credit mark accretion with $3.8 million provision recorded this quarter.

The other component of the acquired provision is for credit impaired loans totaling $2 million. This represents reductions in cash flows that are recognized immediately as a provision and an addition to the reserve.

The re-estimate for credit impaired covered loans resulted in a provision of $3.5 million, in this quarter improved cash flows on loans where we had previously had cash flow reductions and established an allowance resulted in the reversal of the indemnification asset recorded in prior periods for these loans.

Turning now to our guidance for the remainder of 2014, based on our robust pipeline and history of success in the new and legacy markets we expect to continue to experience strong loan growth over the second-half of 2014. We're projecting net loan growth of between 1.5% and 2% for each of the next two quarters or total 2014 net loan growth of 7.5% to 9%.

In a low interest rate environment for the remainder of 2014 we expect the net-interest margin to decline in both quarters in a range of between 10 basis points and 12 basis points. We expect two reinvest $507 million of maturing investment portfolio of cash flows over the rest of 2014 at a similar rate to that which is maturing. Our investment portfolio duration is 3.8 years supporting our overall goal of asset sensitivity.

We are maintaining an asset sensitive balance sheet that will respond to a 100 basis point and 200 basis point yield curve increase with a projected increase in net interest income of 1.85% and 3.63% respectively. There is no change to our core deposit strategy. Certificates of deposits that mature over the remainder of the year totaled $1 billion at a cost of 75 basis points with 70% expected to renew in place at approximately 20 basis points.

The aggregate provision for organic, acquired and covered loans is expected to be in a range of $12 million to $50 million over the next two quarters. Organic loan net charge-offs are expected between 20 basis points and 25 basis points.

With the expected restoration of fee income this past quarter the expected range is between $70 million and $73 million per quarter over the remainder of the year.

Execution on the announced cost savings will reduce the non-interest expense run-rate to a range of $160 million to a $163 million per quarter. We're continuing to work on improving productivity with a financial goal to preserve and grow pre-provision net-revenue. The tax rate should approximate 31% over the remainder of the year.

That concludes my remarks. I will now return the call to Tom O'Malley.

Thomas O'Malley

Thank, Terry. Jennifer, we're now ready to take questions from the participants.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Terry McEvoy with Sterne Agee.

Terry McEvoy – Sterne Agee & Leach Inc.

Hi, thank you.

Paul Greig

Hi, Terry.

William Richgels

Hi, Terry.

Terry McEvoy – Sterne Agee & Leach Inc.

Hi. I'm just – I just wanted to clear [ph]. Over the last three quarters you've taken a $5 million provision for the impaired acquired loans, but re-classified about $75 million from non-accretable to accretable. I just want to make sure I have that math correct and assuming all that over time will flow into net interest income?

Terrence Bichsel

Terry, it's Terry Bichsel. Yes, that's exactly the point we're trying to convey, that we keep re-estimating and getting improvements to our cash flows on the credit impaired acquired loans and as a result that cash flow gets pushed into the future as interest income and any declinations on loans that are re-estimated, get taken as immediate provisions and an addition to an allowance. So that recognition is a 15:1, the 15 being pushed out into the future and the one being taken currently.

Terry McEvoy – Sterne Agee & Leach Inc.

Thank you, and then while we're sticking with the reserve you talked about the covered commercial loan portfolio and $171 million that's performing and held to maturity. As you look out over the next year, will there be a need to provision a reserve for that portfolio of loans? I just want to make sure I understand that statement correctly.

Terrence Bichsel

Those loans once classified as impaired at the original inception date we refer to those as SOPO3 loans and once in an SOPO3 category they stay there and the re-estimations of the cash flows will be treated exactly the same as we do today, except that the indemnification asset that's associated will be fully amortized off the books post the expiration date of that policy.

Terry McEvoy – Sterne Agee & Leach Inc.

And just one last…

Terrence Bichsel

So therefore there is no additional reserve.

Terry McEvoy – Sterne Agee & Leach Inc.

Yes, sorry about that, and then just one last question for you, Terry. The loan loss provision guidance of 12 to 15, how much of that do you see being impaired acquired loans or is that the kind of the X-factor and why you have that range in your guidance.

Terrence Bichsel

That if I didn't make that clear in the stated remarks, I should have. That guidance on the net charge-off ratio would refer to the organic loan portfolio only. And then the guidance for the provisions in the aggregate are the notional dollars that were given.

Terry McEvoy – Sterne Agee & Leach Inc.

Perfect. Thank you.

Operator

Our next question comes from Scott Siefers with Sandler O'Neill & Partners.

Paul Greig

Hi, Scott.

Scott Siefers – Sandler O'Neill & Partners LP

Hi, guys. Good morning. Hey, Terry, I just wanted to, I guess, also a follow up on one or two of Terry's – Terry McEvoy's questions on the provision. Do you have a sense for when the kind of the noise in the provision will begin to abate because on the one hand, if you look at just sort of the charge-off numbers and they're still very, very low and just on a, call it organic basis, your credit costs will be running much lower than the aggregate provision.

So at what point will that, I guess the combination of the provision for acquired loans and provision for covered loans, will that really start to taper-off? In your view, if you can sort of look ahead a little?

Terrence Bichsel

If we take the three components in sequence, the organic component as you noted are credit metrics support ongoing good performance in charge-offs and provisions with the loan growth that we're experiencing. We would expect that we would be adding provisioning for loan growth, accepting for future improvements in criticized and classified although those levels continued to move to historically low levels as a percentage of a portfolio.

In the acquired portfolio, as that portfolio is maturing down, let's just say, for example, there is a fairly significant piece of that that is consumer and within consumer there is the boat RV portfolio, so that's cash flowing and amortizing off the books. And then we're rewriting new loans in the organic portfolio for that.

So the new loans are being provided for within the new loan growth and the organic or the acquired portfolio's amortizing down. And as it does, the charge-offs associated with that should move down as well. The point that Bill was trying to make earlier or did make earlier, there is a piece of pre-April 12 recoveries that are in our noninterest income that are approximately $2 million a quarter, that you should look to net against the charge-offs that we're taking and the provisions we're taking on the acquired portfolio each quarter to look at it net, but that acquired component charge-off should continue to move down.

And as noted earlier, the provisions on the credit impaired component, the bads get recognized immediately, but we've had substantial goods, where we have that 15:1 ratio that I described in Terry McEvoy's question. And then lastly, on the covered portfolio, we have got approximately $45 million of a reserve sitting there and on those loans. And as they move down, we would be expecting to use that provision and net charge-offs or provisions against the income statement for that portfolio should move down as well.

So all in all, for the acquired and the covered, we would expect those to migrate down. The organic is going to be, we're at absolute lows of charge-off levels plus we have loan growth there.

Scott Siefers – Sandler O'Neill & Partners LP

Yes, okay. That's very good color, and I appreciate it. And is your sense that they will get to a point where in the aggregates, I guess it's kind of embedded in your $12 million to $15 million range for the provision. But do you think there is a point where even in spite of having to provide for new loan growth, we could still see credit costs come down, maybe even below that $12 million level just as the provisions for the acquired and covered pieces abate. In other words, if there is a race where you provide for new loan growth being originated versus the tail off of these other two pieces, is that something you see as possible or how would you think about that dynamic?

Terrence Bichsel

Over the longer haul I think that that maybe possible as those other two tails roll out. But I would stick with our guidance as we've stated it today that in the aggregate, the $12 million to $15 million covers those three components, the organic, the acquired, and the covered And that the basis point guidance that we gave for charge-offs refers to the organic component, which as you can see is at pretty absolute low levels of charge-offs levels for this stage of the recovery.

Scott Siefers – Sandler O'Neill & Partners LP

Okay, perfect. And then just one I want to make sure I understood your margin guidance correctly. The down 10 to 12 basis points that, that's for the full second half, right, not 10 to 12 basis points per quarter in the next two quarters?

Terrence Bichsel

Well, as we had a 9 basis point reduction from first quarter to second, what we're saying is, it could be in that range in each of the next two quarters.

Scott Siefers – Sandler O'Neill & Partners LP

Okay. So in the aggregate potentially, I guess $20 million to $24 million….

Terrence Bichsel

Yes.

Scott Siefers – Sandler O'Neill & Partners LP

For the second half. Okay, all right, perfect.

Terrence Bichsel

Yes.

Scott Siefers – Sandler O'Neill & Partners LP

I appreciate all the color Terry. Thanks.

Terrence Bichsel

You're welcome.

Operator

(Operator Instructions) Your next question comes from Steven Alexopoulos with JPMorgan.

Paul Greig

Good morning, Steve.

Preeti Dixit – JPMorgan

Hi, good morning, everyone. This is actually Preeti Dixit on for Steve. A quick question on the expense guidance of $160 million to $163 million per quarter, I'm guessing that's with the $18 million of cost [ph] is fully saved in. Maybe it would be helpful, Terry, if you could talk about what expense base we should consider heading into 3Q given that quarter was a bit higher than you expected and then just updated timing on the expense savings being phased in?

Terrence Bichsel

There was – there were a number of small expense categories throughout the income statement, the expense piece of the income statement that no one really stood out to be able to deduct out and give you a firm absolute run rate as we launch out of second quarter. What I would say is that, as Paul indicated in his comments with the consolidation of the branches that occurred this quarter, that begins to immediately be recognized into the run rate in the third quarter that gets us into that range.

And then further as we move on into the fourth quarter, the other components begin to fully manifest themselves, that being a continuation of our enterprise sourcing or our vendor contracting initiative and we have some straight through processing actions that we're taking that will enhance our credit adjudication process and that should be fully operational as we get into the fourth quarter.

So I'm sorry I can't give you any better precision on the absolute launch point, but those actions will get us into that range.

Preeti Dixit – JPMorgan

Okay. That's helpful. Is there anything incremental beyond the $18 million that gets you to the lower end that seems to apply a little bit more in terms of the expense cuts? Maybe just how to think of the range of $160 million to $163 million?

Terrence Bichsel

I'm really trying to give ourselves a little bit of a room for variability in those cost savings coming on and increases in other components of our income statement, which we're covering, which would be merit increases and volume related increases associated with the growth in the balance sheet. And then some marketing expenses that we'd also be offsetting. And so those can be a little bit periodic and thus that's the relative range that we're giving.

Preeti Dixit – JPMorgan

Okay. That's helpful. And then just a question on the originated loan yield is down a basis point in the quarter. Were there any prepay fees or unusual items impacting that yield, and maybe you could talk about where new loans are coming on are compared to the portfolio yield of 367 [ph]?

Terrence Bichsel

We would always have income within our total interest income component that would be representative of fees, and that does move a bit from time to time.

Preeti Dixit – JPMorgan

Maybe some color on where new loan yields are coming in at?

Terrence Bichsel

Yes. On our originated loans on the commercial side, we would be approximately 3.05% and on the consumer side about 3.8%.

Preeti Dixit – JPMorgan

Okay. That's helpful. Thank you so much.

Terrence Bichsel

Thank you.

Operator

Your last question comes from Chris McGratty with KBW.

Christopher McGratty – Keefe Bruyette & Woods Inc.

Hi, guys.

Paul Greig

Good morning, Chris.

Christopher McGratty – Keefe Bruyette & Woods Inc.

Hey, Paul and Terry, just on the margin guidance, it seems a little bit more cautious than maybe three months ago. Maybe I want a little bit more clarity. But in terms of the 10 basis points to 12 basis points a quarter, can you provide some color on whether that's – maybe I missed it. Is that's more on the acquired book or are you pushing it to get the growth or is it more pressure on legacy or the current book?

Terrence Bichsel

There are a couple of components to consider. as the acquired book, the non-impaired component, amortizes down the accretion will naturally step down so as you see in the supplementary slides on the non-credit impaired acquired loans there is a full year's worth of accretion quarter-by-quarter. And you can see how that steps down and then as we move toward the expiration date of the FDIC, insurance component, any improvements in portfolio cash flows associated with those loans where we had previously established indemnification asset, we begin to amortize that indem-asset a little faster.

Now the offset to that is, the loans that Bill indicated will survive through the indemnification – or the FDIC insurance expiration. Those loans will continue on into our run rate into the foreseeable future, but we've got to amortize the indem-asset off. And so there can be a little step up in the indemnification asset amortization.

And then as pointed out in the prepared remarks, as we are remixing from the acquired and covered and adding back the organic portfolio, the differences you can see on the slide, differences in the portfolio yields from one to the other, the growth is making up for that. And then in terms of maintenance of the size of the investment portfolio in the CD run-down, there is not a lot of remaining opportunity in the CD remix that we have, but we still have some.

So that’s where we're saying the ratio is going to move down, but the loan growth we'll be working to offset that in the coming quarters.

Christopher McGratty – Keefe Bruyette & Woods Inc.

Okay, that’s helpful. Just a follow-up, I think, next year that – you did guidance for the back-half of this year, but next year it's kind of a year strictly with Citizens and we'll be seeing a lot of your peers that have done larger transactions. That's kind of when the – that's when the margin is really at risk. I was wondering if you could provide any clarity on kind of when you expect kind of an absolute margin given your comments at the bottom, given the run-down of entire higher yielding assets.

Terrence Bichsel

What we see is the accretion on the non-credit impaired portfolio continues to run down as I previously described. But we think we are out about a year to that stabilization point.

Christopher McGratty – Keefe Bruyette & Woods Inc.

Okay. So, basically a year from stabilizing margins, great. The last question is on, you used to provide the duration of the portfolio: the covered, acquired, impaired and non-impaired; do you happen to have what your assumed duration of those portfolios are?

Terrence Bichsel

I believe we gave guidance on that a couple of quarters ago and we'll have to refresh that, so I don’t have it to give you on this call.

Christopher McGratty – Keefe Bruyette & Woods Inc.

Thanks a lot.

Operator

Your next question comes from Scott Siefers with Sandler O'Neill & Partners.

William Richgels

Hi, Scott.

Scott Siefers – Sandler O'Neill & Partners LP

I have a couple of follow-ups. Paul, so even after kind of netting away some of the movement within the loan portfolio, the organic growth still looks very strong, I was just hoping you could chat for a second or so on your thoughts about just the sustainability of the kind of organic trends that you guys have been putting up?

Paul Greig

Yes, the organic growth remains very strong. The health of our underlying markets is good and the bankers that we've hired are delivering solid results across all of the footprint. An example would be our commercial pipeline, which was $2.8 billion at the end of last quarter, has grown to $3.4 billion this quarter. So we are very pleased with the progress that we've made in the markets and all of our markets. And we are looking for a very strong growth in the second-half of the year, primarily focused on C&I lending, however, we have made some good progress in selective CRE lending as well as healthcare, nursing home, assisted living project.

So with that good growth across all of our commercial products and we are starting to see some nice traction as well in our indirect synergies that we've talked about, whereby we are offering marine, RV, indirect in our legacy footprints and we are introducing automotive, used auto, indirect in Michigan and Wisconsin. So both the consumers as well as the commercial side are seeing some nice traction and making good progress.

Scott Siefers – Sandler O'Neill & Partners LP

Okay, that’s good color, and I appreciate it. And then Terry just, sorry to hammer on the provision, but just the provision for originated loans just any increases you've had there, those are all just new loans or credit costs for new loans being originated, right. There is no earlier vintage stuff that maybe you're kind of watching, it's all just new stuff and new growth that you are providing for, is that an accurate characterization?

Terrence Bichsel

Yes, I'm going to give you an answer and try to clarify as I go. When we describe organic loans what we are saying is that’s the history of what we had on our balance sheet prior to the Citizens acquisition. That would not be Chicago, would not be covered, but it would be all new loan growth that we had since the Chicago acquisitions and our legacy market. So that’s organic excludes covered and acquired, and it’s the old FirstMerit footprint and then growth in all of the footprint since each of the acquisition dates.

Scott Siefers – Sandler O'Neill & Partners LP

Yes.

Terrence Bichsel

What we would have is then the criticized and classified, the delinquency levels, that will be spawning charge-offs out of that book. And as we grow it on the margin, we would be providing additional provisions for growth for that. Up until now, because we've had significant reductions in our criticized and classifieds, reserves associated with that in fact has been paying for loan growth.

Once you get to a certain absolute level that doesn’t allow anymore freeing up, unless you have to begin to provide for that loan growth, but you are providing at a risk rating that is at a good quality level. So it’s not an exorbitant reserve level associated with those loans. It's less than the average in the portfolio allowance as it exists.

Scott Siefers – Sandler O'Neill & Partners LP

Okay, that's perfect. I appreciate it.

Paul Greig

Thanks, Scott.

Operator

Your last question comes from Stephen Geyen with D.A. Davidson.

Stephen Geyen – D.A. Davidson & Co.

Hey, good morning. Most of my questions have been answered. Just one question on the funding, with the pretty decent loan growth that you guys are generating organically, just curious how your thoughts, I guess, really your thoughts on the funding for that and what that might come in as far as cost?

Mark DuHamel

So, it’s – good morning. It’s Mark DuHamel. Balance sheet remains extraordinarily liquid. We have asset base liquidity or assets that we can pledge to the Federal Home Loan Bank or do repo with the Street of $5.6 billion. We're in a slight borrowing position this morning borrowing about $100 million. What we've seen is our deposit growth has been strong and we're confident that we can fund the loan growth.

Terrence Bichsel

Let me add, not to your question, but before you move to the next question. We had an earlier question on the duration of the acquired components and I believe that’s 0.9 years is the average duration, Mark.

Mark DuHamel

That’s right. And, Chris, we can get you the break-out by the three distinct portfolios, but in aggregate it’s 0.9 years. Steven, did you have any other questions?

Stephen Geyen – D.A. Davidson & Co.

No, that’s it. Thank you.

Mark DuHamel

Thank you. I think that was our last question, so on behalf of the FirstMerit team here, we would like to thank you for your participation and interest. And we look forward to talking with you later this year. Thanks and have a great afternoon.

Operator

This does conclude today's conference. You may now disconnect.

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Source: FirstMerit's (FMER) CEO Paul Greig on Q2 2014 Results - Earnings Call Transcript
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