M&T Bank (MTB) Q2 2016 Results - Earnings Call Transcript

| About: M&T Bank (MTB)

M&T Bank Corp. (NYSE:MTB)

Q2 2016 Earnings Call

July 20, 2016 11:00 am ET

Executives

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Darren J. King - Chief Financial Officer & Executive Vice President

Analysts

Matthew Derek O'Connor - Deutsche Bank Securities, Inc.

Geoffrey Elliott - Autonomous Research LLP

David Eads - UBS Securities LLC

Ken Usdin - Jefferies LLC

John Pancari - Evercore Group LLC

Bob H. Ramsey - FBR Capital Markets & Co.

Matthew Hart Burnell - Wells Fargo Securities LLC

Brian Klock - Keefe, Bruyette & Woods, Inc.

Gerard Cassidy - RBC Capital Markets LLC

Jill Shea - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Erika P. Najarian - Bank of America Merrill Lynch

Ken Zerbe - Morgan Stanley & Co. LLC

Frank Joseph Schiraldi - Sandler O'Neill & Partners LP

Operator

Ladies and gentlemen, thank you for standing by. And welcome to the M&T Bank Second Quarter 2016 Earnings 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. Thank you.

I would now like to turn the conference over to Mr. Don McLeod, Director of Investor Relations. Please go ahead, sir.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Thank you, Paula, and good morning. I'd like to thank everyone for participating in M&T's second quarter 2016 earnings conference call both by telephone and through the webcast. If you have not read the earnings release we issued this morning, you may access it along with the financial tables and schedules from our website, www.mtb.com and by clicking on the Investor Relations link. Also before we start, I'd like to mention that comments made during this call might contain forward-looking statements relating to the banking industry and to M&T Bank Corporation. M&T encourages participants to refer to our SEC filings, including those found on Forms 8-K, 10-K and 10-Q for a complete discussion of forward-looking statements.

Now, I'd like to introduce our Chief Financial Officer, Darren King.

Darren J. King - Chief Financial Officer & Executive Vice President

Thank you, Don, and good morning, everyone. Since this is my first conference call as Chief Financial Officer, I'll ask you to bear with me. René Jones most recently and Mike Pinto before him, set a high bar for CFOs in general and for M&T Bank in particular. I certainly have big shoes to fill. Before I start, I'd like to take a moment and thank René for the advice and guidance that he's provided to the company and to me personally over the time that we worked together, particularly during the last 90 days. I'm looking forward to working with many of you as well over the coming months and years.

Let's get started. In the second quarter, we generated $1.3 billion of revenue, net income of $336 million, and diluted earnings per share of $1.98. Return on assets were 1.09% and return on common equity was 8.38%. Looking at the second quarter results on a net operating basis, which excludes the after-tax effect of merger-related expenses and amortization of intangible assets, earnings per share equaled $2.07. Return on tangible assets was 1.18% and return on tangible common equity was 12.68%.

Every measure noted above both on a GAAP and net operating basis improved from the first quarter. The efficiency ratio also improved to 55.1% in the second quarter, down from 57% in the first quarter, and 58.2% in the year ago quarter. We were able to deliver these results against the headwinds that we and our clients faced, including an uneven economic recovery in growth, persistent low interest rates and volatile financial markets.

There are many highlights from the second quarter that characterize the state of the bank and before we review the details, I'd like to take a minute to review a few of the more noteworthy developments. Probably the biggest highlight of the quarter was receiving a non-objection from the Federal Reserve to our 2016 CCAR capital plan. While we learned our results in the second quarter, the non-objection was the favorable result for months of hard work by many of our colleagues around the bank, as well as the payback on the investments we've made over the past several years in our risk management governance, processes and technology. We know however that the CCAR bar keeps rising and so this quarter we'll begin the preparations for CCAR 2017.

Another highlight of the second quarter is the continued growth of our loan portfolio. While on the surface 3% annualized loan growth isn't particularly exciting, a look at the details reveals that lending to commercial customers increased an annualized rate of 11% against the decline in the residential mortgage book of an annualized 16%, largely the result of expected runoff in the Hudson City mortgage portfolio. This is a pretty typical pattern when you're converting a thrift to a commercial bank. Against this backdrop, credit quality on M&T hallmark remains strong.

In the second quarter, as noted on prior calls, we've been reinvesting a portion of the savings from the merger and the BSA/AML savings to position the bank for the future. We launched a brand campaign in New Jersey to introduce ourselves to the new market. We reminded our legacy markets who we are in the face of changing competition and we continued to invest in our technological infrastructure along several dimensions. For instance, in foundational elements like data, in employee tools like teller cash recyclers, and in customer convenience and security that will be seen in the form of our upcoming new and improved mtb.com website and enhanced security at our ATMs through the upcoming deployment of (5:06) protocols.

So while unique unto itself, this quarter reflects the continuous cycle of invest and harvest that has characterized M&T Bank for many years. Overall, we would describe it as a solid quarter.

Let's take a look at the details. Diluted GAAP earnings per common share were $1.98 for the second quarter of 2016, improved from $1.73 in the first quarter and equal to last year's second quarter. Net income for the quarter was $336 million, up 13% from $299 million in the linked quarter and up 17% from $287 million in the year ago quarter. After-tax expense from the amortization of intangible assets was $7 million or $0.04 per common share in the recent quarter compared to $7 million and $0.05 per common share in the first quarter.

Also included in the second quarter results were $13 million of pre-tax merger-related charges incurred in connection with the Hudson City acquisition. This equates to $8 million after-tax effect or $0.05 per common share. Merger-related expenses in the second quarter – or sorry, excuse me, merger-related expenses in the first quarter totaled $23 million pre-tax. That amounted to $14 million after-tax effect or $0.09 per common share. Consistent with our long-term practice, M&T provides supplemental reporting of its results on a net operating or tangible basis from which we exclude the after-tax effect of amortization of intangible assets as well as any expenses associated with mergers and acquisitions.

M&T's net operating income for the second quarter, which excludes intangible amortization and merger-related expenses, was $351 million, compared with $290 million in last year's second quarter and $320 million in the linked quarter. Diluted net operating earnings per common share were $2.07 for the recent quarter, improved from $2.01 in the year ago quarter and that figure was $1.87 in this year's first quarter. Net operating income yielded annualized rates of return on average tangible assets and average tangible common shareholders' equity of 1.18% and 12.68% for the recent quarter. The comparable returns were 1.09% and 11.62% in the first quarter of 2016. In accordance with the SEC's guidelines, this morning's press release contains a tabular reconciliation of GAAP and non-GAAP results, including tangible assets and equity.

If we turn our attention to the balance sheet and income statement, taxable equivalent net interest income was $870 million in the second quarter of 2016, down $8 million from the linked quarter. The decline reflected a combination of a narrowing of the net interest margin and a change in the mix of interest earning assets.

Let's look at the specifics. Net interest margin declined to 3.13%, down five basis points from 3.18% in the linked quarter. What we consider to be core margin pressure accounted for about three basis points of the decline. That includes the impact of a slightly more costly mix of deposits, including the impact of the Hudson City time deposits as well as growth in savings deposits associated with our mortgage servicing operations.

On the non-core side, interest bearing deposits with banks, which primarily reflect cash on deposit at the New York Fed, averaged $8.7 billion during the second quarter, up by over $500 million from the prior quarter. That increase, the result of higher balances of trust deposits, decreased the margin by approximately one basis point.

Average investment securities declined, reflecting normal principal amortization as well as a step-up in prepayments. Those prepayments of higher yielding securities and a limited amount of reinvestment into lower yielding LCR compliance securities reduced the yield on the portfolio. We estimate these factors diminished the margin by an additional basis point.

The cost of deposits reflects, in part, our decision, which we previously discussed, to maintain pricing for customers in the Greater New York area whose accounts were formerly held at Hudson City Savings Bank. We'll offer more thoughts with respect to that pricing in a few moments.

Average loans increased by about 3% annualized or $572 million compared to the linked quarter. Looking at the loans by category, on an average basis compared with the linked quarter, commercial and industrial loans increased an annualized 14%. Commercial real estate loans increased by about 10% annualized. As noted earlier, those two categories combined grew an annualized 11%. Also, as noted, residential mortgage loans declined at an annualized 15% rate. Consumer loans grew an annualized 5% with growth in indirect loans, including auto loans, partly offset by a decline in home equity lines of credit. Loan growth was consistent across most of our footprint, including Upstate New York, Pennsylvania, Greater New York City and New Jersey. Growth in the Mid-Atlantic region was slightly softer.

Average core customer deposits, which exclude deposits received at M&T's Cayman Islands office and CDs over $250,000, increased at an annualized 8% from the first quarter, reflecting the higher level of trust and savings deposits that I mentioned earlier.

Turning to non-interest income, non-interest income totaled $448 million in the second quarter compared to $421 million in the prior quarter. Mortgage banking revenues were $89 million in the recent quarter compared with $82 million in the linked quarter. Residential mortgage loans originated for sale were $858 million in the quarter, up some 30% compared with the first quarter, while the gain on sale margin was relatively stable.

Our commercial mortgage banking operation had a strong quarter as well, with a slight increase in multi-family commercial mortgages originated for sale combined with a favorable mix of higher margin loans than that prior quarter. Trust fees improved to $120 million in the recent quarter, up from $111 million in the previous quarter. That increase reflects about $3 million of seasonal tax preparation fees that usually occur in the second quarter as well as fees from net new business, particularly on the institutional side. Service charges on deposit accounts and commercial loan fees also improved from the first quarter.

Turning to expenses, operating expenses for the second quarter, which exclude merger-related expenses and the amortization of intangible assets, were $726 million, improved from $741 million in the prior quarter. On that same operating basis, salary and benefits declined by $28 million from the seasonally high level in the first quarter. Partially offsetting that decline was a $16 million increase in other costs of operations, including higher professional services expenses. The operating efficiency ratio improved to 55.1% in the quarter, down from 57% in the first quarter and 58.2% in last year's second quarter.

Next, let's turn to credit. Our credit quality remains in line with our expectations, which is to say strong, with continuing low levels of non-accrual loans and net charge-offs. Non-accrual loans declined to $849 million and the ratio of non-accrual loans to total loans was 0.96%, improved from 1% at the end of the first quarter. Net charge-offs for the second quarter were $24 million compared with $42 million in the first quarter. Recall that the first quarter's results included $14 million of charge-offs associated with consumer loan customers who were either deceased or filed bankruptcy, compared with just $5 million in the recent quarter.

In addition, the results for the second quarter included a $7 million recovery on a previously charged-off commercial loan. Reflecting that recovery, annualized net charge-offs as a percentage of total loans were 11 basis points for the second quarter, while the comparable figure was 19 basis points in the previous quarter.

The provision for credit losses was $32 million in the recent quarter, exceeding net charge-offs by $8 million, reflecting overall loan growth as well as the ongoing shift to a higher proportion of commercial loans as the Hudson City mortgage portfolio pays down. The allowance for credit losses was $970 million at the end of June. The ratio of the allowance to total loans was 1.10%, unchanged from the end of the first quarter.

Loans 90 days past due, on which we continue to accrue interest, excluding acquired loans that had been marked to fair value discount at acquisition, were $298 million at the end of the recent quarter. Of these loans, $270 million, or 91%, are guaranteed by government-related entities.

Turning to capital, M&T's common equity Tier 1 ratio under the current transitional Basel III capital rules was an estimated 11.01% compared with 11.06% at the end of the first quarter, which reflects earnings retention less $154 million of share repurchases during the second quarter as well as net loan growth. I'll offer our thoughts on our 2016 capital plan, which received no objection from the Federal Reserve, in a few moments.

Next, I'd like to give you an update on several of the projects we've been working on. As previously announced, we completed the conversion of Hudson City during the first quarter, in which we converted them to our systems and operations, including loan and deposit accounting, mortgage servicing and other core applications. All the Hudson City facilities were rebranded to M&T at that time. Speaking of branding, those of you who work and live in the Greater New York, New Jersey market have undoubtedly seen a step-up in our advertising as part of this process.

More recently, we've been working on the longer-term initiative of converting Hudson City from a thrift culture to M&T's commercial bank culture. We're continuing to hire in the New Jersey market, including commercial lenders, business bankers, and wealth advisors. We've hired some 49 customer-facing employees since the beginning of 2016. To complement our commercial hiring, we've begun an accelerated business banking training initiative for some 30 Hudson City branch managers, who are on a fast track to learn M&T's branch sales practices. Training also continues for our other branch-based colleagues, increasing their familiarity with our entire suite of commercial bank products and services.

Our investments in technology include continuing to enhance our ability to capture and organize data for risk management and capital planning requirements as well as for improving customer service. These investments paid a dividend in the form of our 2016 CCAR results but, as noted earlier, the bar rises every year requiring continuous improvement in our risk management practices.

Beyond our data initiative, you should see some tangible results from our technology investments shortly, including a major update to our website within the next several weeks, and an updated mobile app that we anticipate rolling out later this year. We're also working on enhancing the tools we give to our employees to improve our interactions with customers by simplifying the processes that employees must follow to complete their work. These projects are still in the early stages.

Lastly, we've discussed in a general way, the opportunities presented to us by the changing competitive environment occurring, or about to occur in our footprint. We know from firsthand experience that change brings uncertainty. Whether it's with their personal banking or business banking, customers seek stability when considering their banking options. We are here to help customers in our communities as we have been for over 160 years. To offer one example, using checking account acquisition as a proxy for new customer acquisition, year-over-year growth in Greater Buffalo is nearly 19%, almost twice as large as the average across the remainder of the footprint.

Now, let's turn to the outlook. As is our usual practice, without giving specific earnings guidance, we'd like to offer our thoughts as to how we are tracking against the outlook for the full year that we gave you on the January call. While our outlook is mostly unchanged from the previous calls, one factor that has changed is the outlook for increases in the Fed funds rate. At the time of our January call, the forward rate curve was implying two actions by the Fed in calendar year 2016. There now appears to be a little prospect for even one increase this year, perhaps not even until mid-next year to late next year. But even without any Fed action, the curve has flattened with the yield on 10-year Treasuries touching an all-time low recently.

Our ability to maintain a stable year-over-year margin will be impacted by that changed interest rate outlook, but that could be somewhat offset by our ability to reposition the balance sheet, particularly with respect to trust deposits and the pricing on Hudson City time deposits. Loan growth this past quarter was largely in line with or slightly better than our expectations, with solid growth in commercial loans, both commercial and industrial and commercial real estate. Partially offset by slower growth in consumer loans and the expected decline in residential real estate. Absent rises in interest rates, we don't expect the pace of repayments to slow. Fee revenues remain in line with our expectations given the normal seasonal effects.

On expenses, our outlook for the second half of 2016 is to be somewhat consistent with the first half. This includes the FDIC surcharge imposed on banks over $50 billion in size, which will add about $5 million per quarter to our FDIC assessment as well as our ongoing investment program. We remain focused on producing modest positive operating leverage on a year-over-year basis. We don't expect any additional merger-related expenses in connection with Hudson City. Our outlook for credit is little changed over the short-term. We're still not seeing pressures on credit, either non-accrual loans or charge-offs.

Regarding our capital plan, we were delighted to receive no objection from our regulators to the plan we submitted in connection with the 2016 CCAR process. As you know, we plan to repurchase $1.15 billion of M&T common stock over the four-quarter period beginning July 1. In addition, the plan contemplates our board considering an increase in the common stock dividend to $0.75 per quarter in January of 2017. While there is no reason to expect we won't execute on this plan as proposed, I would remind you that all of these capital actions are subject to our normal capital governance policies and unexpected adverse macroeconomic events could impact our actions. Of course, as you're aware, our projections are subject to a number of uncertainties and various assumptions regarding national and regional economic growth, changes in interest rates, political events, and other macroeconomic factors, which may differ materially from what actually unfolds in the future.

Now, let's open up the call to questions before which Paula will briefly review the instructions.

Question-and-Answer Session

Operator

Your first question comes from Matt O'Connor of Deutsche Bank.

Matthew Derek O'Connor - Deutsche Bank Securities, Inc.

Good morning.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Good morning, Matt.

Matthew Derek O'Connor - Deutsche Bank Securities, Inc.

To follow up on the expense outlook of back half of the year similar to the first half, I guess first, just to clarify, is that on a reported basis or ex merger charges?

Darren J. King - Chief Financial Officer & Executive Vice President

Ex merger charges because we think we're finished with those one times as of the second quarter. So if you take those out and look at what our total expenses were in the first half, probably close to where we'll be in the second half of the year.

Matthew Derek O'Connor - Deutsche Bank Securities, Inc.

Okay. That helps. But I guess still like if I think about the back half, normally you have seasonality working in your favor since 1Q's high and you should still have cost saves coming in, I think, from Hudson City. So, I guess why flat versus down?

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Sure. I think there's a few factors going on there, Matt, which affect things. So, first of all, we've got the FDIC assessment going up $5 million a quarter right there. What you'll see is that when we look at our other cost of operations, which is really where we're focused, legal expenses are up in the second quarter and will likely continue at that pace in the third quarter and fourth quarter and possibly increase slightly as we go through our defense with some of the Wilmington Trust indictments that are out there. And we will be continuing to make the investments that we've been talking about in the franchise, especially continuing on path with technology.

So, those are probably the big things that you'll see in there. Oh, and the other thing, of course, which I should mention, is we'll be right in the throes of some of the changes that will be happening in our marketplace in the third quarter and we'll probably spend a little more on advertising as we try to take advantage of the changes that are happening. So some of those things are kind of more permanent in nature, some of those – more permanent is probably a bad description. Some of those things will run their course over the rest of this year and some of them will probably take a little longer.

Matthew Derek O'Connor - Deutsche Bank Securities, Inc.

Okay. And how much was the litigation this quarter?

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

I think it was roughly an increase of $4 million from what it was in the first quarter of the year.

Matthew Derek O'Connor - Deutsche Bank Securities, Inc.

Okay. Sorry, do you have that number handy or is it in the 10-Q that I can look it up? The first quarter level?

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes, I think it was about $14 million. That's what it was for the quarter.

Matthew Derek O'Connor - Deutsche Bank Securities, Inc.

Okay. So, that will probably stay elevated for maybe the near-term, medium-term, but obviously longer-term would hopefully come down then?

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

That's how we're thinking about it.

Matthew Derek O'Connor - Deutsche Bank Securities, Inc.

Yes, okay. Thank you very much.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes.

Operator

Your next question comes from Geoffrey Elliott of Autonomous Research.

Geoffrey Elliott - Autonomous Research LLP

Oh, hello, there. Thank you for taking the question. On the increase in deposit costs in the quarter coming, I think you said after Hudson City, could you remind us first of all the mechanics of why that's coming through now in 2Q when the deposits have been on the balance sheet for a couple of quarters?

Darren J. King - Chief Financial Officer & Executive Vice President

Yes, sure. I think really what you're seeing there is kind of what I would describe as a timing mismatch, that the rate of decrease in the Hudson City mortgage portfolio is about $900 million a quarter, and the rate of decrease in the time deposits, it has been closer to $100 million in the quarter. And that's been a conscious decision on our part to maintain that pricing while we get the branch staff ready to have a different conversation with those customers than they've had in the past. So because the mortgages are running off a little faster or a lot faster in this case than the time deposits are, the impact of those deposits on the margin is exaggerated.

Geoffrey Elliott - Autonomous Research LLP

And when do you think you start having some of those discussions and figuring out whether the relationships with those deposit customers make sense and if they don't make sense, get to rid yourselves of some of the interest expense that comes through from them?

Darren J. King - Chief Financial Officer & Executive Vice President

So that process is going to begin this quarter, and will play itself out over the course of the third quarter and fourth quarter of this year. If you look at the book, it's relatively short. I think 75% of it is 12 months or less. So that's kind of the timeframe over which these discussions will happen and it's something that we'll be focused on obviously over the course of the coming quarters.

Geoffrey Elliott - Autonomous Research LLP

Thank you.

Operator

Your next question comes from David Eads of UBS.

David Eads - UBS Securities LLC

Hi, good morning.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Good morning.

David Eads - UBS Securities LLC

So, you guys had really good growth on the CRE side this quarter. That's sort of been a hot topic recently with the concentration limits of smaller banks and OCC's outlook on risk in the markets. I'm just kind of curious, your view on the competitive environment there. Whether you're seeing other banks pull back? Whether you're seeing kind of irrational pricing or irrational terms in some market and just kind of where do you think we are there?

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Sure. I guess I'll offer a couple of thoughts as it relates to CRE. First, when we look at where our growth has come from, it's been fairly broad-based across our geographies and across property types, so we're not seeing any concentrations or things that we would point to that we would get worried about. When we look at pricing, I wouldn't say that it's going up, but it seems to have stabilized somewhat. So we feel better about that and when we look at the amount of equity that's in the deals, it's still at or above where things were back in 2006/2007. So I think the market's learned its lesson as far as that goes. When we look in our markets and where we're winning business, it doesn't seem to be at the moment, coming from any particular competitor that might have reached concentration limits but I know that's an issue that's out there. I think when we do see things that look a little crazy to us, either in terms of pricing or structure, it tends to be the non-bank lenders that are in that space, and we would tend to shy away from that and keep our powder dry.

David Eads - UBS Securities LLC

Great, that's helpful, and can you give any color on where the commercial pipelines are this quarter compared to last quarter? Or how things are shaping up for the rest of the year?

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes, sure. When we look at the commercial pipeline and where it stands right now, it's pretty similar to where it was at the end of the first quarter. So when we look forward, I guess I don't have a reason to believe right now that we'll see a meaningful decrease in the production levels, but we're also not anticipating any crazy upticks either.

David Eads - UBS Securities LLC

Great, thanks so much.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

No problem, thank you.

Operator

Your next question comes from Ken Usdin of Jefferies.

Ken Usdin - Jefferies LLC

Thanks, good morning. One more follow-up on the net interest income side. To your point earlier about not potentially having the rate hikes, the loan growth and the remixing into securities seems to be a support, but underlying it you mentioned the three basis points of the core pressure and is that on an ex-rates basis how we should expect things to go from here which is that you're able to fight off the NIM pressure with the balance sheet growth?

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

I think when we look at the NIM pressure and the ways that we fight it off, it's primarily with the deposit pricing and primarily with that CD book. Obviously, we'll use some of the proceeds, if you will, from the mortgage paydown to fund loan growth, but we'll need to supplement that on the deposit side. We think we've got ample funding between money that we have at the Fed as well as money that we have in savings account that we don't need to rely on that CD funding for growth. And as we can change that mix and bring the percentage of CDs on the balance sheet down somewhat, and/or bring down the average rate that we're paying, that's the biggest lever that we have to fight off that margin compression.

Ken Usdin - Jefferies LLC

Right. So we might not see a lot of earning asset growth but you might be able to offset the core pressure with the remixing.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

I think that's probably a true statement. I think the challenge will be at least in the near-term over the next couple of quarters just making sure we can outrun the net interest income impact of the runoff or the payoffs in the residential mortgage book from Hudson City.

Ken Usdin - Jefferies LLC

Okay. And on the fee side, just one quick question, the wealth business had a good quarter. I know some of that is seasonal. Are we seeing a bit more stability in that business now and was there any help from fee waiver recovery in that line as well?

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

I guess the way I tend to think about that business is you got the seasonality part right. When you take that out, we still had a nice quarter. We had some good growth in the institutional part of the wealth business. We saw some customer balance acquisition. The financial markets, it looked like they were going to hurt us a little bit with Brexit but in the end have been okay. And then on the waiver recovery, there's always waiver recovery, but there's always offsets too, right, that there's some new business that you might do some pricing actions to get a customer to join the business. So, I think net, you could say that there was some waiver recovery but it would be modest. It wouldn't be a big driver of the increase.

Ken Usdin - Jefferies LLC

Okay. Understood. Thank you.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes.

Operator

Your next question comes from John Pancari of Evercore.

John Pancari - Evercore Group LLC

Good morning.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Good morning.

John Pancari - Evercore Group LLC

Wanted to see if you could talk a little bit about your plans for reinvestment of liquidity on the balance sheet and how you look at the securities book now, particularly given what we're looking at here on the longer end of the curve. Thanks.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes, sure. I guess we're at an interesting point. Given where rates are and where the book sits today. I guess when we look at what some of the options are of where and how we can invest, the current yields on some of the investment options don't look particularly compelling. And I guess as the book pays down, we'll probably look to reinvest the paydowns back into the market, either in Ginnie Maes or Fannie Mae securities, but I don't think we're looking to really grow that book right now just given where interest rates are. We'd rather put the cash to work in loan business rather than in the securities book and try and keep that relatively flat unless we see a move in rates.

John Pancari - Evercore Group LLC

Okay. All right. No, that's helpful. Thanks. And then separately on the capital front, just wanted to get your updated thoughts in terms of where you stand on the regulatory obligations still tied to the Hudson City merger and then also how soon you could be out there with some potential interest in bank M&A again? Thanks.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Sure. I guess as it relates to bank M&A, we've obviously – we continue to do our work to build our risk infrastructure, particular note was AML/BSA, but we continue to make great progress on the aspects of the written agreement that we were obligated to and we're nearing completion of those activities. But we have to finish our work so that the Fed can come in and do their work and hopefully remove the written agreement from us. We don't have a timeline on when that might happen but we're always hopeful that it will be soon, but you can't really control that.

Could you repeat the question on Hudson City?

John Pancari - Evercore Group LLC

Well, no, it was just the regulatory obligations around that. You kind of just answered that with that answer. But I guess my second question was really just once you clear those hurdles, could you be back out there looking at potential bank M&A, particularly given some of the headwinds some of the smaller banks in your markets could be facing?

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes, if you've watched us through the years, you know that we've always been a bank that grows through acquisition, but we do complement it with organic growth. I think for all the reasons that we talked about when we did the Hudson City merger, we think that New Jersey is an attractive footprint for us in terms of customers that are there, both business customers as well as consumers. And it's a natural fit with our franchise.

That said – and obviously with our capital levels, we're in a good capital position to do deals. All that said, we're not interested in doing a deal for a deal's sake. We're interested in doing things that are positive for our shareholders. And to us, that means accretive to earnings and capital and we'll be patient.

John Pancari - Evercore Group LLC

Great, thank you.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes, no problem.

Operator

Your next question comes from Bob Ramsey of FBR.

Bob H. Ramsey - FBR Capital Markets & Co.

Hey, good morning.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Good morning.

Bob H. Ramsey - FBR Capital Markets & Co.

Just wondering if you could talk about, with the CCAR authorization, I understand it's all sort of dependent on economic outlook, but is the idea that you sort of start off doing a quarter of the total authorization a quarter and then adjust as necessary as you go through the next 12 months? Or do you start off a little more cautious? Are the buybacks a little more front end loaded? How should we think about the pace of activity?

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Probably the best way to think about it is split evenly over the course of the four quarters.

Bob H. Ramsey - FBR Capital Markets & Co.

Great. Okay. And then I wonder now that Hudson City is done and closed and you've had a little bit of time with it under your belt, just curious if there have been any surprises, what kind of the biggest takeaways are and where you see the greatest opportunity from here?

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

I guess, there haven't really been a lot of surprises that we would note, at least anything that stands out. I think we feel that the spot we're at with Hudson City is about where we expected to be at this point, kind of 120 days post a system conversion. There's work to be done to get the branch teams up to speed, especially from a thrift, up to speed on the breadth of products that we offer as well as learning the systems and then getting used to a sales environment. So that's kind of proceeding as we would expect. And as we mentioned, that's why we feel comfortable that now we're kind of ready to start taking the step that we're ready to take on the deposit pricing.

And then for the commercial and business parts of the bank, we've been there actually with M&T bankers pretty much since shortly after the announcement date, so really our focus there has been to keep that group of people engaged. And since we got the deal done, they've been excited and have the ability now to work with the branches and offer more confidently the deposit side of the relationship. And then we've been out recruiting and we're trying to grow that business through people additions. I think the thing that we pay a lot of attention to is just like we pay a lot of attention to credit and we want to grow in that footprint. We're going to grow under the kind of terms and structure that we know is good business, so we're not going to rush it. And the same thing kind of applies to people, that we know that finding and adding to our teams, people that fit our culture and understand how we do business and think about relationship and think about good structure, it's more important to us that we get the right people on the teams rather than fill the spots quickly.

So, I feel really good about where we are. I think we're tracking to where we would expect to be. And we just got to manage the pace that we talked about a little bit earlier on, which is the pace at which those mortgages run off and the pace at which we grow the commercial balances to offset that. But overall we're very pleased with where things are.

Bob H. Ramsey - FBR Capital Markets & Co.

Great, thank you.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

No problem.

Operator

Your next question comes from Matt Burnell of Wells Fargo Securities.

Matthew Hart Burnell - Wells Fargo Securities LLC

Good morning. Thanks for taking my question. Just a question in terms of the commercial pipelines. You were saying that they were Iargely unchanged quarter-over-quarter. I guess I'm curious how much of the commercial growth, if you break it out this way, has come from legacy Hudson City markets and how much of that is coming from legacy M&T markets? Because it would seem to me that with the recent conversion you – one would have thought that you might have had a somewhat stronger pipeline in the second quarter. And we've also heard from a couple of other banks that commercial demand has slowed a little bit from the start of the year. So, maybe just a little more color on the commercial demand.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Sure. Well, as you would expect, when you look at the New Jersey markets, the growth rates there on commercial loans are actually slightly higher than what you would see in the rest of the footprint. We kind of averaged, just get the number here, 38% growth in C&I this quarter, annualized. That's an annualized number. And 18% in commercial real estate in the quarter, which those are higher than what you would see in the footprint, but it's off a small base, right? So I think when you look at the total loan growth, we're pleased with how things are going in New Jersey. We are building the pipeline there and we are getting growth rates that are faster than what you would see across the rest of the footprint. But it takes time for the dollars to build, right? So the percentage of dollars of growth that New Jersey represents is still small and growing compared to the size of the legacy balances and footprint.

Matthew Hart Burnell - Wells Fargo Securities LLC

Okay. Thanks very much.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

No problem.

Operator

Your next question comes from Doug Doucette of KBW.

Brian Klock - Keefe, Bruyette & Woods, Inc.

Hey, Darren. Hey, this is Brian Klock. I had some technical difficulty there. So, can you hear me okay?

Darren J. King - Chief Financial Officer & Executive Vice President

Oh, they changed your name?

Brian Klock - Keefe, Bruyette & Woods, Inc.

No, it's me. Thanks for taking my call. I just wanted to follow up on the margin side. It looks like the C&I loan yields after the fourth quarter, the December hike, you've seen a positive carry through into the first quarter, and then you had another eight basis points expansion in the second quarter. So is there still repricing going on or was there any sort of recovery that impacted the second quarter or what do you expect to see from the C&I loan yields going forward then?

Darren J. King - Chief Financial Officer & Executive Vice President

There was a couple of big recoveries early in the second quarter, but I think when we look at pricing and loan yields, I guess I'd go back to what I mentioned before, that it feels like things are stabilizing and when we look at the yields of business – new business that have been originated, the yields bounce around a little bit but really have been pretty stable for about the last four months to six months. And obviously a lot of that's tied to LIBOR. So you've got to watch what's happening with LIBOR, which moves around a little bit, but overall pricing is pretty stable and I wouldn't expect to see big movements over the course of the coming quarters, either direction.

Brian Klock - Keefe, Bruyette & Woods, Inc.

So is there a sort of core margin, or the core C&I loan yield? Is it closer to the 3.39% from the first quarter, if you adjust for those recoveries? Or is it still something that's...

Darren J. King - Chief Financial Officer & Executive Vice President

It's probably in – yes, yes.

Brian Klock - Keefe, Bruyette & Woods, Inc.

Okay. Okay. All right. Thanks. I'll get back in the queue. Thanks.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes. No problem.

Operator

Your next question comes from Gerard Cassidy of RBC.

Gerard Cassidy - RBC Capital Markets LLC

Thank you. Good morning.

Darren J. King - Chief Financial Officer & Executive Vice President

Good morning.

Gerard Cassidy - RBC Capital Markets LLC

Can you guys share with us, you pointed out in your quarterly numbers that your return on average common shareholders' equity was 8.38%, which generally is believed to be below most banks' cost of capital of around 9% to 10%. This company, pre-financial crisis, used to deliver ROEs of around 15%. Can you share with us how you expect – I know we're not expecting it to go back to 15% because of the increased capital levels, but can you share with us what you think you can do to get that above your cost of capital?

Darren J. King - Chief Financial Officer & Executive Vice President

I guess I'd offer a couple of thoughts. We spend a lot of time thinking about return on tangible common because that's one of the key binding constraints in CCAR and we focus a lot on that. When you look at the capital levels of where we were pre-crisis and where we are now, they're at least double.

Gerard Cassidy - RBC Capital Markets LLC

Correct.

Darren J. King - Chief Financial Officer & Executive Vice President

So two elements to managing or thinking about returns as we go forward. One obviously starts with the capital we carry to run the bank. So that was part of our CCAR announcement and our CCAR ask, and we'll be continuing to look at the volatility of our earnings and our charge-off levels and continue to work on our capital policies to make sure that we were adequately capitalized but not overly capitalized. And that will help.

The other thing that I guess we think about when we look at our return versus our cost of capital, when you look at the volatility of our charge-offs and you look at the volatility of our earnings, we would kind of think that our cost of capital will be towards the bottom end of the industry because our beta's lower. So when you look at that, we think our cost of capital would be below the average in the industry and we think that over time as we continue to make the changes to the business to improve profitability as well as return capital, that those would be the factors that we would be thinking about as we move the needle on returns up in a positive direction.

Gerard Cassidy - RBC Capital Markets LLC

Great. Following up on your comments on CCAR, I congratulate you for using the mulligan. We wish more banks would do that. I notice that, if I recall correctly, the amount of capital that was reduced because of the CCAR process was considerably higher this year than last year. I think it was over 600 basis points this year and last year it was just under 300 basis points, if I recall. What caused that to be so much greater this time? And second, if it was totally due to the Hudson City deal, should we expect as you integrate that further that that kind of reduction in capital should be reduced on a go-forward basis?

Darren J. King - Chief Financial Officer & Executive Vice President

Yes, so, I guess a couple of thoughts on that. I'll be honest with you. I'm not as familiar with the 300 basis points and 600 basis points that you're mentioning, but I guess a couple of things that I think about. First off, if you think about the mulligan and how people use that, I guess I feel the need to kind of address that, that we didn't go into the process with the intention of using the mulligan. We followed our process and did our analysis of our PP&R and our capital levels under stress and we set our ask based on what we think is the target that we need to run the bank. I think what we saw is that there were some differences between our analysis and the Fed's and they built a process that gave people a chance to make an adjustment because they can see that they're looking at things differently than we are. They get to see the industry and we don't. And they built a process that I think is sound in allowing you to make that change.

So we were fortunate that it was in place and we used it. I think when you think about our returns over the last three years, if you add in this year and the prior two years, we'd still be towards the bottom end of returns in the industry and we were cautious leading into the Hudson City acquisition because there's always uncertainty when you're doing a deal and we didn't want to have any issues. I think if you look on a going forward, we kind of see where our earnings are going, where our PP&R is going. We'll continue to make progress on our models and our loss rates and I think looking at the balance sheet and as the balance sheet changes, we feel like our capital levels, even with this buyback, will be pretty good and depending on what happens over the course of the next year, we'll be looking to continue to bring those levels down closer to, I guess, closer to what our targets are, and/or where we were when we passed CCAR over the prior couple of years.

Gerard Cassidy - RBC Capital Markets LLC

Great, thank you.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes.

Operator

Your next question comes from Jill Shea of Credit Suisse.

Jill Shea - Credit Suisse Securities (USA) LLC (Broker)

Good morning. Thanks. Credit quality continues to be very strong and the provision run rate was down this quarter with the lower net charge-offs. Can you just touch on how you think about the total allowance percentage as you shift towards a more commercial loan mix over time and how we can think about the pace of reserve build as we look out?

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes, sure. And I think if you look at the bank pre Hudson City, where the mix of earning assets was more commercially oriented, as the Hudson City mortgages run off, which tend to have a lower loss rate, and the portfolio shifts to be a little more commercially-oriented, both C&I and CRE, that over time will shift and the allowance for losses will likely shift as the mix shifts.

I think if you look at the quarter, charge-offs were very low for the quarter because we had a big recovery. I think if you look at how we feel about things going forward, the first quarter was probably a little high and the second quarter was probably a little low and we would expect to be somewhere in the middle of that as we go through at least the next couple quarters.

Jill Shea - Credit Suisse Securities (USA) LLC (Broker)

Great, thanks.

Operator

Your next question comes from Erika Najarian of Bank of America.

Erika P. Najarian - Bank of America Merrill Lynch

Hi, good morning. I had a quick follow-up to Ken's line of questioning. Given your comments about modest earning asset growth and what you're doing on the liability side to defend the margin, can we see stability to maybe modest growth from that $863.8 million net interest income number ex any change in the yield curve? And also, maybe some more color on how you can manage the trust deposit volumes which is clearly bloating your cash. I think you alluded to that in your prepared remarks.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes, so I guess starting with the net interest income. Over the next couple quarters, it's probably going to be tough to see any growth there just because of the rate or the expected rate of decrease in the residential mortgage portfolio from Hudson City. So that's a big hill for us to climb to get back to flat or positive. I think when you look at the margin itself, we think we've got some opportunity there that's in our control from the Hudson City time deposit book to bring that down to reduce the cost of funding the assets on the balance sheet and obviously we're seeing and expecting to see some continued growth on the commercial loan side.

As it relates to trust deposits, I guess we could do something to turn those deposits away but when we look at it, it's a good deal for us because it requires no equity and we park the money at the Fed. And I think René had mentioned on prior calls, but I'll just remind you that with some of our business in the trust side, we get paid either in fees or in deposits. And in the current environment, many people are choosing to pay us in deposits. So while it reduces the margin in the short-term, it's positive for net interest income and for earnings. So we don't get too fussed about where the margin prints because of what's going on with trust demand deposits.

Erika P. Najarian - Bank of America Merrill Lynch

Got it. Thank you.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

No problem.

Operator

Your next question comes from Ken Zerbe of Morgan Stanley.

Ken Zerbe - Morgan Stanley & Co. LLC

Thank you. Good morning.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Good morning.

Ken Zerbe - Morgan Stanley & Co. LLC

A question on expenses. The guidance that you gave, the second half's going to be roughly equal to the first half ex the merger charges. I'm going to go out on a limb and say it's probably a fair bit higher than what I was building in, maybe consensus was building in for second half. But when we think about 2017, obviously you get some further cost savings related to Hudson City, but are we also looking at more of a parallel shift higher in expenses in 2017, or just trying to think of if there's any offsets to the increase. Thanks.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes, so here's how I think about it. When you look at the expense increases that are going on, I'll bucket them into a couple of categories. So if we start with savings from Hudson City, we've largely achieved that. There's maybe a little bit to come through the back half of the year, but it might take a little longer on some of those pieces as we work through ORE and expenses like that.

When you look at the run rate for the rest of the year, there's change in the deposit charge, the FDIC charge, and that will go up in the third quarter. We think it will start to move a little bit down in time as we change the mix of assets and liabilities on the balance sheet. We've got some increases for events, I would call them, one of them being the change that we see happening in our marketplaces and what we'll spend on some advertising dollars to take advantage of that. And then we've got the other event that is going on and will through the end of the year which is the legal things that are happening.

So, those will elevate expenses for the back half of this year. I wouldn't expect them to carry on all through 2017, right? So the advertising we know pretty certain what will happen with that because there's a time limit to that. With the legal stuff, we know we have a trial date in January but those dates can change, so I don't want to get too crazy on that. But that's part of what's driving some of that expense.

When you look at the other places where we're investing, it continues to be in technology and that will move around a little bit quarter-to-quarter, but that's some of where the increase was in this quarter and some of that will be continuing on through 2016, 2017.

Ken Zerbe - Morgan Stanley & Co. LLC

All right. Thank you. I appreciate it.

Operator

Your final question comes from Frank Schiraldi of Sandler O'Neill.

Frank Joseph Schiraldi - Sandler O'Neill & Partners LP

Hello. Thank you for taking the question. Just one quick one. Just trying to get a sense on the potential for repricing deposits from Hudson City customers. How do we think about – in terms of if it's a customer, you look at it, you want to retain, do you expect you are going to continue to sort of operate this two-tier payment or pricing model or do you think it's going to be a much tougher conversation in terms of if you remain an M&T customer, you accept sort of M&T CD pricing? And I'm wondering just how far over the next 12 months we could see that repricing and how front loaded that would be over the next two quarters versus the next 12 months?

Darren J. King - Chief Financial Officer & Executive Vice President

Sure. So I guess if you think about the conversation with these customers, it probably goes and ends one of three ways. So one way is we say to someone who's a CD only customer, here's the rate we're offering to people that only have CDs with us. That rate will be lower than what they're earning today and would be more in line with what we're likely offering in our existing markets. The customer can choose that or they can choose another alternative, which would be to broaden their relationship, maybe bring a checking account relationship with them where they have their paycheck deposited. And if they bring that to us, then their rate would stay roughly where it is, but we would get the benefit, if we add the low cost deposit from the checking account and that really opens up some fee income opportunities through debit card interchange that goes with checking accounts or other maintenance fees that go with those accounts.

And then the last option is if they don't like the rate that we're offering them standalone and they choose not to broaden their relationship with us, they may choose to leave and go elsewhere looking for a yield that suits their needs. And so what we'll see over time is we'll see probably a combination of two things. We'll see a decrease in the rate that we're paying and we'll also see a decrease in the balances that sit within those time accounts. And the combination of those two things is what will help reduce the interest expense and help manage some of that margin compression that we were talking about.

Frank Joseph Schiraldi - Sandler O'Neill & Partners LP

Okay.

Darren J. King - Chief Financial Officer & Executive Vice President

Like I said before, I don't have the exact numbers in front of me, but when you look at the book, the vast majority of it, I think it's about a $12 billion book and three quarters of it we'll reprice over the course of the next 12 months. So there you're talking about $9 billion that we'll reprice over the course of the next 12 months. And I think there's a little bit of front loaded to the third quarter based on my recollection, but if you think about it, fairly evenly split across those quarters. That would be a good way to think about it.

Frank Joseph Schiraldi - Sandler O'Neill & Partners LP

Okay and is the majority of that money, that $12 million, is that CD only customers right now or is that not the case?

Darren J. King - Chief Financial Officer & Executive Vice President

I guess it's a good chunk of it. When we look at that portfolio, it's probably 75% to 80% single service and would be CD oriented. So that's – I'm just trying to think about it in balances and reflect on some of the numbers I've seen, but I don't have that exact information off the top of my head so I don't want to misquote.

Frank Joseph Schiraldi - Sandler O'Neill & Partners LP

Okay. All right, great. Thank you.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Yes, no problem.

Operator

This concludes today's question-and-answer session. I will now turn the floor back over to Mr. Don MacLeod for any additional or closing remarks.

Donald J. MacLeod - Administrative Vice President, Assistant Secretary and Director of Investor Relations

Again, thank you all for participating today. And as always, if clarification of any of the items on the call or news release is necessary, please contact our Investor Relations department at area code 716-842-5138.

Operator

Thank you. This concludes your program. You may now disconnect.

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