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First Niagara Financial Group, Inc. (NASDAQ:FNFG)

Q2 2014 Earnings Conference Call

July 25, 2014 10:00 AM ET

Executives

Ram Shankar - IR

Gary Crosby - President and CEO

Greg Norwood - SVP and CFO

Analysts

Dave Rochester - Deutsche Bank

Bob Ramsey - FBR Capital Markets

Casey Haire - Jefferies

David Darse - Googeenheim

Matthew Kelly - Sterne Agee

Collyn Gilbert - Keefe, Bruyette & Woods

John Pancari - Evercore

David Polson - Axa

Operator

Good morning and welcome to the First Niagara Financial Group’s Second Quarter Earnings Call. Your lines have been placed in listen-only until the question-and-answer session of today’s call. (Operator Instructions) This conference is being recorded and if you have any objections please disconnect at this point.

I would now like to turn the call over to Mr. Ram Shankar, Director of Investor Relations. You may begin.

Ram Shankar

Thank you, Wendy and good morning everyone. Thank you for joining us this morning. With me today are Gary Crosby, President and CEO; and Greg Norwood, our Chief Financial Officer. Before we begin, this presentation contains forward-looking information for First Niagara Financial Group. Such information constitutes forward-looking statements, which involves significant risks and uncertainties. Actual results may differ materially from the results discussed under the forward-looking statements. A copy of the earnings release and an earnings review deck are available under the Investor Relations section at firstniagara.com.

With that, let me turn the call over to Gary. Gary?

Gary Crosby

Good morning, everyone. Thanks for joining us. Greg will walk you through our results in a moment. Before he does that, I’d like to give you my thoughts on the second quarter and an update on our strategic investment plan. First, our second quarter results.

We reported earnings per share of $0.19 which was driven by 7% annualized average loan growth, increased fee income from the seasonal lows in the first quarter and stable credit metrics. Overall, results were in line with the guidance we provided for the quarter. Our balance sheet growth came from both our commercial and consumer loan categories and across each geography. While fee income rebounded after industry wide softness last quarter consistent with what has been heard so far from others the bounce back was not as strong as expected in mortgage banking and deposit fees.

Our expenses are in line with the guidance we gave 90 days ago and credit metrics remained favorable. Our team continues to focus on keeping our customers at the center of all we do further leveraging our footprint and translating that in the strong business fundamentals. We are very focused on day-to-day execution and meeting quarterly performance expectations. At the same time, we’re also moving forward to implement our strategic investment plan in order to further strengthen our competitive position, improve our operating efficiency and deliver value to our shareholders over the long-term.

We have a strong talented team implementing our strategic investment plan. And we continue to enhance our Board’s oversight to hold us accountable for meeting or exceeding the financial performance outcomes expected from the investments. To that end, we’re very happy to welcome Austin Adams as a member of our Board and our Board technology and risk committees. Austin is no doubt already well known to many of you having led technology and operations for three of the largest banks over the past 35 years. Austin was one of the first bankers to recognize that infrastructure, technology and data can be leveraged to improve the customer experience and differentiate a financial institution from its competition. I had an opportunity to tap into Austin’s deep knowledge and experience a couple of years ago and I am really pleased that First Niagara will continue to benefit from his counsel as a member of our Board.

Now let me provide some additional thoughts and a status update in our strategic investment plan. We remain within our time and budget estimates as we continue to move forward on initial projects and complete planning through others. As I’ve said to you before no amount of execution can make up for poor planning. So while time is of the essence we are being very thoughtful in the planning phase of our investments and teaming up with industry experts to ensure that we successfully execute on time and on budget.

And as I’ve said before this is not a technology plan, it’s a plan to deliver superior financial performance and long-term shareholder value and it starts with the customer. Technology is the enabler. And as Steve Jobs said you have to start with the customer experience and work back towards technology, not the other way around. Our investments will deliver the products and services that customers desire most on a channel and device that they’re choosing and on a platform that increases speed to market and reduces cost to serve and cost to integrate new products and services. Our investments are designed to generate additional revenue through greater customer acquisition, higher volumes and more effective cross-selling by giving us a true 360 degree view of the customer.

Here is a quick recap of what we’ve achieved so far. In late April, we launched a new loan application processing system for our indirect auto loan business. While it has been only three months our 1,200 dealers have now been migrated on to our new platform and we are already seeing positive results with a 26% increase in the number of loans closed. This is because the efficiency gain from this new system has enabled us to increase the number of applications reviewed for credit analysts as well as the number of loans funded per loan processor. Faster turnaround for our dealers and signage of the business and it’s important for me to note through the First Niagara’s strong credit culture we have not changed our risk appetite or loosened our underwriting standards.

We also recently completed the upgrade of our commercial loan servicing system that automates and standardizes our processes and better supports customer acquisitions in the middle market segment. We have successfully converted over 10,000 commercial accounts to this new platform, with both of these investments having in common is that they each improved the customer experience and increased our level of efficiency and provide us with real sustainable operating leverage. We’re pleased with the outcomes thus far and we’ll continue to provide progress reports each quarter.

As we move forward, my team and I remain committed to delivering the best possible financial performance in the near-term while also making sure we’re keeping our focus and implementing our strategic investment plan in order to produce strong sustainable long-term financial performance. We continue to attract top talent from larger commercial banks and these individuals together with the strong team already in place are making a real difference in our day-to-day execution as well as in our transformational strategic investment plan.

That concludes my prepared remarks, and now I will turn it over Greg for a recap of the quarter.

Greg Norwood

Thanks Gary and good morning. As Gary noted we reported earnings of $0.19 per share up $0.02 from the first quarter. Strong loan growth offset by margin compression, fee income increased from seasonal lows in the first quarter, lower provision expense driven by lower net charge offs and a better tax rate all drove the quarter-over-quarter increase in earnings.

Similar to the first quarter, our fee income was reduced by 7.5 million by the amortization charge pertaining to our historic tax credit investments. This was offset by an equal tax credit that reduced income tax expense. The fee amortization and tax credits will continue into the third and fourth quarters of this year, more on our effective tax rate in a minute.

Revenues excluding the historic tax credit amortization charge increased 5 million or 1.5% quarter-over-quarter driven a large part by a higher non-interest income. Average earning assets increased 6% annualized to 34 billion driven primarily by commercial and indirect auto loan growth. At 3.26% net interest margin was in line with the guidance that we provided. The compression from the previous quarter reflects the ongoing roll on, roll off effect of new loan pricing and prepayments given the competitive landscape.

Operating expenses increased 244 million and was inconsistent with our guidance. The quarter-over-quarter increase reflects primarily volume-related growth, increased marketing and legal expenses as well as depreciation personnel and consulting expenses related to our strategic investment plan. Another good quarter for credit with 30 basis points of originated charge offs down from Q1 of 36 basis points. Our provision for loan growth was up about 2.5 million given stronger than expected loan growth, so net-net a decrease of about 2 million, so overall another good quarter for credit.

Moving to the balance sheet discussion on Page 4, average loans increased 7% annualized in line with our guidance while period end loans increased 11%. Average commercial loans increased 8% annualized. We had a very strong quarter overall and a particularly strong June. The growth was led by our double-digit growth in the Tri-State and Western Pennsylvania markets, and was diversified across industries. Our hires from larger banks over the last 18 months within Tri-State market are driving growth in middle market, business banking and commercial real estate.

C&I loan growth which increased 11% annualized sequentially contributed about 60% of the commercial loan growth and was driven by middle market and equipment leasing segments. Commercial mortgages increased 5% annualized quarter-over-quarter driven by increases in multifamily construction loans and owner occupied mortgage primarily healthcare, partially offset by modest declines in investors real estate. Overall the commercial loan portfolio originations remained granular. Importantly, overall commercial pipeline remains stable.

Average consumer loans increased 5% showing growth in all categories except residential mortgage. Home equity balances have grown for five straight quarters, indirect auto loans increased about 140 million to 1.75 billion. During the quarter we originated about 370 million at a yield to us net of dealer reserve was about 2.90%, as we moved up FICO credit spectrum to 763.

Moving to deposits, average transactional deposit balances which include non-interest bearing and interest bearing checking balances increased 12% annualized quarter-over-quarter. Non-interest bearing deposits increased 18% annualized from the last quarter driven primarily by seasonal increases in average customer balances held. Interest bearing checking balances increased 7% annualized driven both by balance increases as well as net new checking account growth. Average CDs increased over 300 million from the prior quarter reflecting brokerage CD balances partially offset by retail CD run offs. The churns of these broker deposits run from three months to 18 months with interest yields ranging between 30 to 55 basis points.

Turning to Slide 5 for a discussion of net interest income and the NIM, net interest income was 272 million, an increase of 1.2 million over the prior quarter. There was a $2.5 million benefit to NII from accretion on early payments of some CLOs compared to 1.5 million last quarter. There was no retrospective adjustment on our CMO portfolio for prepayments fees in 2Q compared to the 1.1 million we recorded in the first quarter. CRE repayment penalties were lower than expected as well. Net-net normalized NIM was about 2 basis points lower at 3.24%.

Loan yields declined 9 basis points quarter-over-quarter driven by the continuation of replacing higher yielding or fixed rate loans with lower yielding variable loans as well as a shift in the mix towards lower yielding indirect auto and C&I portfolios from commercial real-estate. Our new commercial loan pricing remained relatively stable compared to last quarter. Competition remains tough and we continue to walk deals that don’t meet our spread hurdles allowing us to maintain our spreads quarter-over-quarter. So again the impact this quarter is more the roll on roll off effect.

Turning to credit. Our provision expense was 22.8 million a bit better than our guidance due to lower than expected commercial charge-offs during the quarter, partially offset by higher provision for loan growth. Provision expense continues to exceed net charge-offs as we provide for loan growth. We continue to evaluate our originated allowance levels given changing portfolio mix, particularly the continued seasoning of our growing indirect portfolio. Our allowance to originated loans remained at 1.21% which as you know excludes the acquired portfolio because it has its own credit mark.

The originated loan balances at June 30 increased 808 million to 18.2 billion from prior quarter end. This was partially offset by $220 million reduction in acquired balances. Non-performing originated loans increased about 15 million from the prior due to two unrelated commercial credits one in Western PA and the other in our New England market. Our commercial and consumer delinquencies remained stable quarter-over-quarter. Finally, our acquired book continues to perform in line with our expectations. We still have over 100 million in credit marks against the $4.3 billion portfolio with a flat 2.5% coverage ratio quarter-over-quarter.

Turning to fee income as presented on Slide 8, fees increased 4 million from seasonal lows in the prior quarter. However at a macro level if you look at fee income on a year-over-year basis you can clearly see the impact of the changing environment whether it is customer driven NSF fees or the interest rate impact related to capital markets and mortgage banking revenues. On a quarter-over-quarter basis mortgage banking income increased 54% or 1.8 million driven by greater locked volumes reversal of repurchased reserves partially offset by modest declines in gain on sale margins. Closed volumes increased 40% quarter-over-quarter to 274 million, 70% of which were purchase volumes.

Insurance commissions increased 11% quarter-over-quarter consistent with seasonal patterns. While deposit service charge increased 2% quarter-over-quarter the increase was lower than what seasonal trends would suggest. The industry wide decline in NSF incident rate as well as a favorable shift in our checking mix for its higher tiered products diminished the increase. On the flip side the benefit of higher balances held by our deposit customers was reflected through higher debit interchange fees which increased approximately 700,000 or 11% quarter-over-quarter. As a result, merchant and card fees which includes both debit and credit card interchange fee increased 1.3 million sequentially.

Credit card purchase volumes increased 13% quarter-over-quarter. The decline in capital markets fee income reflects lower syndication income from elevated first quarter levels partially offset by an increase in derivative fees. As we’ve noted previously the appetite for swapping variable rate loans to fixed rate has diminished because there are more competitive long-term fixed rate pricing options in the marketplace given the competitive landscape.

Moving on to expenses on Slide 9. Operating expenses totaled 244 million in line with the guidance we provided and up 5.7 million from the prior quarter excluding restructuring charges in the first quarter. Higher business volumes impacted most expense categories. Salary and benefits was essentially flat as volume related increases in incentive comp and higher headcount were offset by lower medical benefits. Increase in occupancy and equipment was driven by an accelerated write off of certain leasehold improvements of $1.4 million. The increase in technology and communication expense reflects higher depreciation associated with the implementation of the new loan systems that Gary mentioned offset impart by lower technology vendor cost.

Professional service expenses increased almost equally by higher legal fees as well as consulting engagements in IT and enterprise project management office tied to our strategic investment plans. Promotional deposit campaigns in our retail segment drove the $1 million quarter-over-quarter increase in market and advertising expenses. The increase in the FDIC expense reflects higher assessment on construction loan balances. Our expenses increased by -- other expenses increased by approximately 2.1 million half of this increase was driven by several small one-time items. Our effective tax rate was 14% was lower than our guidance reflecting state tax refunds received in the prior year returns. The impact of these credits together with the tax deductibility of the historic tax credit amortization benefited second quarter EPS by approximately a penny. Overall our low tax rate reflects the benefits accrued from taxable reorganization of the subsidiary as well as the tax credits from our investments in historic tax investments, both of which will only benefit the third and fourth quarter of 2014.

Slide 10 has the outlook for the third quarter relative to current consensus models. Overall the current $0.18 EPS street consensus estimate for the third quarter is in line with our expectations. Our net interest margin we see some modest downward bias to the current street average of 3.24%. Based on where we ended June 30th our outlook for earning asset growth is modestly above the street expectations of 34.2 billion. We expect GAAP NII to approximate to 271 million that the street expects.

Moving to fees there will be a similar historic tax credit adjustment to fee income offset by associated tax benefit in each of the quarters in 2014. Excluding a similar 7.5 million charge in the third quarter we expect fee income to increase low single-digits from adjusted second quarter fees of 88 million. Deposit fees, mortgage banking and insurance commissions will be the primary drivers of this increase. Expense estimates of 246 million for the third quarter are in line with our expectations. The street’s loan loss provision estimated at 26 million-27 million is generally consistent with ours. We expect third quarter net charge offs to average plus or minus 40 basis points of originated loans up from the low second quarter charge off rate of 30 basis points. Our tax rate in the third quarter should be between 15% and 16% inclusive of the $7.5 million tax credit benefit to our historic tax credit investments as well as the continued benefit of our taxable reorganization of our subsidiary.

With that Wendy, let’s open it up for the Q&A portion of our call.

Question-And-Answer Session

Operator

Thank you. (Operator Instructions) The first question today is from Dave Rochester with Deutsche Bank.

Dave Rochester - Deutsche Bank

Hey. Good morning guys.

Gary Crosby

Good morning Dave.

Dave Rochester - Deutsche Bank

I was just wondering, have you guys received your stress test results at this point?

Greg Norwood

Sure Dave, let me take that, it’s Greg -- our information and we don’t receive a Federal Reserve and OCC set of calculations. As we mentioned in the past we have submitted our information in the first quarter, we continue to feel good about what we submitted and we feel good about the dialog that we’re having with the regulators on an ongoing basis and are actually starting the process for next year. So net-net feel good about the ongoing dialog and where we’re positioned.

Dave Rochester - Deutsche Bank

So you’ve got feedback from them on this year’s process at this point it sounds like?

Greg Norwood

Yes I would tell you, we’ve had dialogue with the regulators on this probably moving into our third year now net dialogue continues to be very positive.

Dave Rochester - Deutsche Bank

Perfect. And you guys are still comfortable with your capital position of stress scenario?

Greg Norwood

Yes as we mentioned before the results that we have we feel good about the outcomes.

Dave Rochester - Deutsche Bank

Perfect. And then just moving on to the investment plan of it, the 200 to 250 that you had mapped out for that, how much of you spend cumulatively at this point and what is the amount in the run rate in 2Q?

Greg Norwood

Yes, Dave so as we have mentioned the past the 200 to 250 we think about it as being about 65 million per year, through the first six months we’re a little bit less than the 50% amount on that but feel good about the 65 million plus or minus as we look through the end of the year.

Dave Rochester - Deutsche Bank

Got you, so we should see a little bit of ramp-up in that spend I guess going through the fourth quarter.

Greg Norwood

From a cash basis, yes.

Dave Rochester - Deutsche Bank

Great. Just switching to the margin I was just wondering what assumptions for the curve and premium amortization expense, do you include in your margin guidance for 3Q at this point?

Greg Norwood

So if you think about when I said to, we did not have a retro adjustment in the second quarter, we did have the 1.1 million in the first quarter. So we do not see any retro benefits to the margin have not included that in our forecast. When we look it when you think about it in the spot rate environment and expect the amortization to be about 5 million which is what it has been both the first and the second quarter absent in the quarter adjustments. So 5 million is what we expect.

Dave Rochester - Deutsche Bank

Perfect. And just about bouncing back to the margin, I was surprised to see the C&I yields remain stable at that 356 level, can you just talk about the trend have C&I pretty much bottomed out of this point do you think?

Greg Norwood

Well, let me talk to you about it this way when I talk to the business leaders, one of the things we are bring very disciplined in sticking to our spread guidance and our spread goals. So we have locked deals and that help us keep our spreads in line with where we planned beginning the fourth quarter of last year. The other thing I would tell you is the portfolio turnover in C&I is a little bit less than what we had anticipated so the roll on, roll off volume and is a little less in C&I and also the bigger impact is in the CRE book from roll on, roll off because it just has higher rate historic loans.

Dave Rochester - Deutsche Bank

Perfect, alright. Thanks guys.

Greg Norwood

Thanks Dave.

Operator

Thank you. The next question is from Bob Ramsey with FBR Capital Markets.

Bob Ramsey - FBR Capital Markets

Hey. Good morning guys. I know you said that you’d spend less than half of the 65 million you expect to spend on common rails in the first half of the year. Could you just give me a sense of how much less than half I am just trying to get a sense of what ramp in the back half looks like if it’s modest or if it’s more?

Greg Norwood

Again I think about it at a very level because the cash is one element of the approach the other is what the expense is. I think on a macro level is our cash flow estimates for the back half of the year have been reflected in the EPS and our expense estimates. But to you question I guess Bob and I’d say plus or minus 10%.

Bob Ramsey - FBR Capital Markets

Okay, that helps give me some sense. And then I am curious in the indirect auto portfolio when you guys make loans how do you think about affordability in terms of debt to income for the borrower? Do you have an average for sort of originations by that measure or could you tell me what the tails look like?

Greg Norwood

Yes, let me try to help you with that Bob. When you think about the indirect if you know the modeling for that creates 100s of pricing buckets that look at LTV, look at FICO, look at DTI, PTI and it’s really hard to look at the credit decisioning focused just on one metric. What I will tell you as Gary mentioned in his remarks is the advantage of our new system is two-fold one provides much better customer services to the dealers but it allows us to get more granular in our pricing buckets. So we can get more precise and making sure we have the right rate for the right customer. So it does allow us to expand the modeling and we’re continuing to evolve that as we speak.

Bob Ramsey - FBR Capital Markets

Okay. I guess I can appreciate there is a lot of different pieces that go into that underwriting and people do fall in different buckets. But any sense for the overall portfolio what the DTI looks like or if there is a limit that you guys don’t go beyond?

Greg Norwood

No, I wouldn’t get into the details and the limits by definition of the model they are. Some of those are important driven by the LTV and the FICO so a very low LTV for somebody who is putting down a lot of cash. Your DTI might be a little bit different or PTI might be a little bit different.

Bob Ramsey - FBR Capital Markets

Okay, alright thank you.

Operator

Thank you. The next question is from Casey Haire with Jefferies.

Casey Haire - Jefferies

Good morning guys. I want to dig in on the loan pipeline sounds like you guys had a pretty good June want to see how the pipeline was shaking up at the end of the quarter. And then also as a follow up on the indirect auto. The coupon there kind of fell pretty decently here in the quarter. Just wondering do you still have an appetite for that type of lending giving a lower price point?

Greg Norwood

Thanks Casey. On the loan pipeline, you’re right. We did have a very strong June. The overall pipeline levels quarter over quarter remain about the same, probably a little bit of dip in the early stage for July. But we still feel good about the overall pipeline relative to a very strong June. On the indirect, certainly if you think about it first quarter is new origination yield was a little bit higher than trend average we were having in second quarter is a little bit lower. As we look into the third quarter we would expect the new origination yields to increase modest so not the same decline in indirect. But certainly we’re very mindful of the indirect business the cycle pointed the cycle we’re in and we’ll very mindful of balancing volumes and yields as we go forward.

Casey Haire - Jefferies

Okay, thank you. And then on switching to fees, sounds like you guys have, you expect some modest growth again this quarter. Just wondering what are the drivers given that it looks like you might have over earned a little bit on the other income line and some of the capital markets obviously doesn’t sound like it’s hot product right now?

Greg Norwood

Yes, as I said I’ll expand a little bit as we think we’ll see some lift in insurance quarter-over-quarter wealth management also feel good about and banking services. And you’re right if you look at our other non-interest income and bank boldly they’re pretty much net-net flat quarter-over-quarter. And we would see that about the same maybe a little plus or minus. But again I think it comes back to what I mentioned is it’s going to be wealth management, insurance, banking services with mortgage banking also providing some potential benefit.

Casey Haire - Jefferies

Okay. And just lastly on the expense front, just wondering given regulatory spend is becoming a bigger burden for all banks. How much --I know that the common rails is in large part a big upgrade in getting you guys more efficient. But how much of it contemplates BSA AML type requirements?

Greg Norwood

That’s an easy one to answer in. None of it contemplates BSA and AML. One of things we’ve talked about for some time now, back to our conversion from a thrift to a bank as we’ve invested significantly in the AML, BSA space. As you probably know Optimize is one of the systems out there. We’ve had that often running, have increased our headcount over the last several years appreciably.

So with respect to AML, BSA, we feel very good about prior investments. Certainly one of the things that we've mentioned as you highlighted in the strategic investment plan is the more robust -- your 350 view of a customer, the more robust your view is for regulatory purposes as well as the broad business of pricing, of risk management of credit, loss mitigation.

So by design the more effective we are in our infrastructure integration and product, the better we'll be from a regulatory perspective. I would also point out from a DFAS [ph] perspective, we spent couple of years now preparing for that, the systems, the people, the process relative to the 10 to 55 thing and feel good that we did have a robust repeatable process and gotten good feedback on our processes.

Operator

Thank you. Your next question is form David Darse with Googeenheim.

David Darse - Googeenheim

Greg, as you look at the indirect auto seasoning, is that occurring as you'd expect or is there anything else in credit trends. Because I guess a number of other portfolios are also seasoning from the growth. Is there anything different in the seasoning if the seasoning threat [ph] persists?

Greg Norwood

Yes, let me bifurcate that, both from a commercial and indirect. If you think of our commercial journey dating back to ‘07, ‘08 the commercial book continues to perform well. Certainly we had lower charge offs in both the commercial C&I and CREE for this quarter. The indirect side, as I mentioned that book is seasoning and it's seasoning below what we would have had in our business model expectations. So the charge off rates, as we get some vintages more into the complete cycle are better than expected. So the two points would be commercial seasoning has been going on for three to five years now; feel good about that. In indirect the seasoning we’ve seen is actually better than our business model expectations.

David Darse - Googeenheim

Okay. Is there anything different in the increase in commercial real estate NCLs this quarter?

Greg Norwood

No. As we mentioned in the first quarter we had an increase in our construction book but that increase in the second quarter was very modest. So not much different in the overall book.

David Darse - Googeenheim

Okay. And then could you walk over the tax rate I guess for the third quarter, that should also be a good rate for the full year and then do you have any color on 2015's tax rate.

Greg Norwood

So your first question, the third quarter tax rate is about the same for the fourth quarter as well. And if I go back to -- we talked in January that from the 2015 perspective, while we’re not getting guidance we would expect the effective tax rate in 2015 to look more like the back half of 2013, which if you look at that David is about 29%. So that’s a good way to think about it from a 2015 perspective.

David Darse - Googeenheim

Okay. So based on the things you’re working on in the current quarters, nothing's changing that view yet or won't change?

Greg Norwood

For the remainder of the year?

David Darse - Googeenheim

For 2015.

Greg Norwood

Well, again the point I would say is we've had significant reductions this year. If you think a long term number is about 32% effective tax rate, the 29% does consider that there are tax strategies that would lower that about the 3 points.

Operator

Thank you. The next question is from Matthew Kelly with Sterne Agee.

Matthew Kelly - Sterne Agee

Hi. I was wondering if you could talk a little bit about your construction lending, where those balances were growing and what types of rates and terms you’re getting on construction credits.

Greg Norwood

Sure, let me give you kind of the growth perspective and then maybe a little bit on the rates. Generally, it’s across the footprint. I would maybe more a little bit in the up-state New York area. We talked about it in the past as is to linked the historic tax credits and that the combination of the economy and both the federal and state tax credits has really been pushing developers into moving in into more historic sites in up-state New York, in particular have some opportunities there. So that’s probably where the bigger increase is. As far as the yields, if you think about L plus 275 relative to the new construction lending.

Matthew Kelly - Sterne Agee

Okay, got you. And then the health and maturity securities, what have you been buying in that bucket? So AFS is coming down, HTM up. What's going into the book?

Greg Norwood

Yes. So what's going into the HTM is more the agency CMO. The split is more a combination of the CLOs prepaying, which are in the AFS plus an increasing CMO aspect of the health and maturity. So, both numbers are moving in opposite directions and that’s what’s driving the change.

Matthew Kelly - Sterne Agee

And what the yields on the agency CMOs you’re buying versus CLOs running off?

Greg Norwood

The agencies are about 2.70-2.75 and the CLO’s, variable rate are 3 to 3.10.

Matthew Kelly - Sterne Agee

And what was the C&I utilization rate during the quarter and how does that compare to Q1 in the year ago period and what are you seeing there and just in the general health of your business borrowers?

Greg Norwood

Line utilization I would say was pretty much flat quarter over quarter in the mid to low 40%. And if you think back over the last four or five quarters, it’s kind of covered in that. So we haven’t seen an enormous move in the overall line utilization rates.

Operator

Thank you. The next question is from Collyn Gilbert with KBW.

Collyn Gilbert - KBW

Just to hop back to the indirection discussion, given the improvements that you’ve made on your system kind of back office and processes, how large do you think that portfolio could get to or what’s your appetite there for how big you want to build that business?

Greg Norwood

Collyn, I think a couple of ways to think about that is the improvements really are going to allow us to make it a more precise and thus more profitable risk adjusted spread and being able to be more tactical around that. So we see a better yielding return asset because of the investments. The volume is, particularly I would say over the next three to five quarters is going to be based on where the industry for indirect is. We certainly could grow it but we want to make sure we do it at the right yields. We have a balance of about 1.75 now. Certainly that’s going to migrate up but at a lower pace than it did for the last six quarters. So we haven’t locked in on a balance cap but we also look at what are different types of financing that we could possibly do around that in the future as well.

Collyn Gilbert - Keefe, Bruyette & Woods

Okay, that’s helpful. And then just on the C&I side, the growth that you’ve seen in the last two quarters. Is there anything in particular that’s been driving that? Are you guys seeing larger deals come through or just maybe a little bit more color as to what’s driving that good C&I growth the last two quarters?

Greg Norwood

I think it’s a couple of things, as we mentioned last quarter and this quarter the increase is pretty granular. So if you look even our tables, you don’t see a big increase in 10 to 20 or over 20. So, it’s not a real lumpy growth. So we view that as a very positive relative to what the team is doing. The other is we continue to have the same strategy of hiring key big bank experience and Tri-State is just the last example of that. The loan growth there was appreciably north of 50 million this quarter and that’s a big number certainly for the size of the market but overall it was the absolute largest. So is that ability to attract talent and that talent to attract new customers that understand our model and like our model.

Collyn Gilbert - Keefe, Bruyette & Woods

Okay, that’s helpful. And just one final question on the funding side. You guys have talked about kind of the composition of transaction deposits to total deposits migrating up to that 36% in the last year. Do you have a goal for that level in mind?

Greg Norwood

No, it’s a short answer. But I will tell you particularly in the strategic investment plan we will see that move higher. That’s a big effort of various aspects, including our online account opening. And as we move forward through our strategic planning process, you’ll see us focus on that as well.

Collyn Gilbert - Keefe, Bruyette & Woods

Okay. And then I said that was my last question. But one more just tied to funding. Your appetite for broker deposits, I know that was a big driver this quarter. How are you balancing that will borrowings and just how large do you want to get that broker deposit -- those balances to be?

Greg Norwood

I don’t see it increasing appreciably from the absolute levels we’re at now. So plus or minus that. We like the ability to be very tactical and precise on the duration of those deposits. So that with the funding cost makes a good alternative right now. But I don’t see that growing a lot.

Operator

Thank you. (Operator Instructions) The next question is from John Pancari with Evercore.

John Pancari - Evercore

Wanted to get a little bit more color on the securities portfolio, particularly how you think about the size of the book here. I appreciate the color you gave on where you’re investing in the HTM and AFS. Just want to get your thoughts on the overall size of the book and what you think it could trend from here?

Greg Norwood

Sure, from the perspective of 2014, we don’t really see it changing much. It bounces 50 million here 50 million there and you have to kind of look at both the date balances and the average balances. But John I don’t see that growing much in ’14 and certainly as we look to ’15 and ’16, we’ll look at the overall balance sheet and asset allocation.

John Pancari - Evercore

And then separately on the new loan origination yield, again I appreciate the color you gave on indirect home equity as well as construction, but do you have new production yields for the C&I book and particularly the leasing originations that you cited for the quarter?

Greg Norwood

Couple of things I tell you. I don’t know the leasing off the top my head. We could follow up with you on that. It’s obviously a smaller book, but a growing book for us. C&I and CRE we feel good about the spreads remaining relatively flat, in part because the business is real disciplined about walking deals where the spreads are not supported by the customer relationship and that’s one of the main reasons why our spreads for the first six months have been where we expected and relatively flat.

John Pancari - Evercore

And do you know what those spreads are?

Greg Norwood

Again it is consistent with 250 to 275 range.

John Pancari - Evercore

Okay, all right. And then separately on the deposit service charge amount for the quarter, so are you implying you expect that second quarter level is appropriate for a new run rate going forward?

Greg Norwood

Well couple of things John. I think it’s pretty clear that the incident rates across the sector are declining and we're no different. I think what we would also say from our perspective is our collection rates actually for the first half of the year are better than what we’ve experienced say back in 2013 timeframe. So we’re kind of managing collecting it with a customer centric view and appreciating that the actual incident rates are coming down across the industry. When I look into the third quarter, I would say sales will probably go up from the second quarter but a lot of this is managing the collection rates relative to customer experience appreciating that the incidents will continue to decline.

Gary Crosby

And one point I guess I would add to that John is I mentioned in my remarks, the other side of that equation is the higher account balances we have that typically will correlate to higher debit fees so all the NFS will be going down on one line, your merchant and card fee number is in another line and it’s going up relative to higher debit interchange.

John Pancari - Evercore

Okay, all right. And then lastly in terms of your deposit base, just wanted to get your thoughts the deposit elasticity in a potentially rising rate environment. How are you thinking about the sustainability of your deposit base and are assuming that you could see run offs as rates rise.

Greg Norwood

Sure. So certainly we model the book like most do in QRM kind of alternative scenarios. In an up 200, as far as a runoff, we generally think about it as a 5% for the first year and our asset sensitivity in the second quarter, although preliminary we expect to be about the same as it was in the first quarter overall.

Operator

Thank you. The next question is from David Polson with Axa.

David Polson - Axa

Continuing on the stress test, DFAST I guess, do you expect that you’re going to some disclosure about that? Is that process for the 10 billion to 50 billion banks? Is there some end point -- some kind of -- at some point where they -- there is disclosure on those banks such as yours. And also on the capital front on a related issue, it was flat from last quarter. It's still on a low end of peers. And with the new Moody's downgrade in March, would you try to make that sort of a -- would you try to cushion yourselves at that the near 8% level, you're seeing pretty loan growth, would you decide to curb that loan growth, would you try to sell a preferred, or would you try to sell a business to make sure that it doesn’t -- it's at least cushioned at the current level.

Gary Crosby

So David, let me address your DFAS question first on disclosures. Per regulation disclosures, it would be required after the submission next year. So we and others would disclose relative to those requirements for sure. From a capital perspective I would say our priority continues to be to accumulate capital and we look at both in the near term and the long term. So continue to think that we’re well positioned relative to the low risk nature of our balance sheet, which includes the acquired portfolio $100 million credit mark. Certainly the EPS accumulation is important and our number one strategy is to accumulate capital organically.

David Polson - Axa

Okay. You were just talking about a certain mark and I’m not sure about that. Are you saying that maybe the certain conservatism in the capital numbers themselves vis-à-vis like marks [indiscernible]?

Gary Crosby

No, what I would saying is in our purchase accounting for the acquired loan portfolio from the prior acquisitions, we have about 4.3 billion in outstanding loans that have a credit mark of about $100 million to $105 million and that credit mark really reflects those loans at closer to market value than what GAAP is. So when you really look at the capital levels, you have to consider how much we’ve got embedded relative to the acquired loan portfolio. If you’d like, I could have Ron give you a call to walk through some of that because we’ve given quite an amount of information over the past couple of years on that.

Operator

And I show no further questions.

Ram Shankar

All right then. Thanks again everyone for joining us today. And we look forward to talking to you in about another 90 days.

Operator

Thank you. This does conclude today’s conference. Thank you very much for joining. You may disconnect at this time.

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