Park Sterling's (PSTB) CEO Jim Cherry on Q2 2016 Results - Earnings Call Transcript

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Park Sterling Corporation (NASDAQ:PSTB)

Q2 2016 Earnings Conference Call

July 28, 2016 08:30 PM ET

Executives

Susan Sabo - Park Sterling Bank

Jim Cherry - CEO

Don Truslow - CFO

Nancy Foster - Chief Risk Officer

Bryan Kennedy - President

Analysts

Stephen Scouten - Sandler O'Neill

Tyler Stafford - Stephens

William Wallace - Raymond James

Nancy Bush - NAB Research

Operator

Good morning, and welcome to the Park Sterling Corporation Second Quarter 2016 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Susan Sabo of Park Sterling Bank. Please go ahead.

Susan Sabo

Thank you, Operator. During this call, forward-looking statements will be made regarding Park Sterling's future operational and financial performance. The forward-looking statements should be considered within the meaning of the applicable securities laws and regulations regarding the use of such statements. Many factors could cause results to differ materially from those in the forward-looking statements. We encourage participants to carefully read the section on forward-looking statements incorporated in our press release issued this morning and in all documents Park Sterling has filed with the SEC.

I would now like to turn the meeting over to Jim Cherry, Park Sterling's Chief Executive Officer.

Jim Cherry

Thank you, Susan, and good morning to our listeners. As always, we appreciate your being with us. We're pleased to have this opportunity to discuss Park Sterling's second quarter 2016 results, which we announced earlier this morning. In addition to our earnings release, you can also find an investor presentation on our website, which gives detailed information about these results and which we will be following during the call this morning.

Joining me are Don Truslow, our Chief Financial Officer; Nancy Foster, our Chief Risk Officer; and Bryan Kennedy, our President. I'm going to begin with some highlights of the quarter, and then I'll turn it over to Don to go into a little more depth on the financial results. And afterwards, all four of us will be available to respond to your questions.

I'm going to start on Slide 3. During the quarter we experienced very solid operating results and are pleased to report that our net income for the quarter of $5.6 million or $0.11 a share was up from 2.7 million in the first quarter and $0.05 a share. Looking at maybe a more normalized core earnings on adjusted net income which excludes merger-related expenses and loss on sale of securities was actually $6.4 million or $0.12 per share, which is an increase of 4.5% over the first quarter of 2016 and a 20% increase over the second quarter of 2015. So very good results for us and certainly help give us momentum toward achieving the return expectations that we've been setting with our investors. Period end loans grew a very healthy pace of 9.1% annualized for the quarter, and we continue to exhibit extremely strong, exceptional credit quality with only 0.33% of loans categorized as non-performing.

Non-interest income exhibited strong growth of 14% over the first quarter, and Don will give you a little more color around that, but if you exclude some capital gains and losses out of that, it actually is closer to 15% for the quarter. And as you recall from earlier conversations, we are really focused on offsetting the 20-year decline in net interest margin with other income as part of our strategy of offering diversified revenue stream and building non-interest income is a key component of that. And we're very pleased to see that growing at such a healthy pace, especially when it is complemented by an actual decrease in non-interest expense on both a reported and adjusted basis having declined from the first quarter of 2016.

That's operating leverage, and you've heard us speak about the importance of creating operating leverage in the Company and to be able to grow our non-interest income while actually decreasing or holding down the non-interest expense is exactly the operating leverage we want to create. Adjusted return on assets increased to 83 basis points. That's up from 79 in the first quarter and up 10 basis points from the second quarter of 2015. So, again, very good progress toward our commitment to achieving 1% or better ROA, and we feel like we are on path to continue that progress.

Our financial condition remains very strong, both with Tier 1 common equity of 11.14% and Tier 1 leverage ratio of just over 10%. As a consequence of our continued confidence in our earnings momentum as well as in our capital strength, the Board yesterday approved a 33% increase in our dividend from $0.03 to $0.04 a share, so we feel like this is one of the profitable ways to reward our shareholders. That actually, based on yesterday's closing price for our stock, would give you just over a 2% dividend yield on our stock. So feel like that's a good place for us to be. Finally before turning to Don, just a comment that we've continued to selectively add highly experienced talent to the bank and yet we've been doing this by offsetting those additions and obviously you can see that in the non-interest expense by either not filling positions or in some cases making reductions to make sure that we have the best talent on the field that we can.

We've added a senior credit real estate specialist to our team who'll be devoted exclusively to the real estate portfolio. We've added a number of very strong bankers to the Charlotte market. We announced that a few weeks ago, so I think most of you have seen that, as well as new leadership. We also have added a number of new, during the first half of the year a number of new mortgage banking specialists. And we've recently added a trust officer, as well. So, we feel very good about positioning ourselves for continued growth from experienced people while at the same time maintaining very solid and strong control of expenses. So with that, Don, give us some highlights and detail.

Don Truslow

Thanks, Jim, and good morning, everyone. As Jim mentioned, great quarter. We're very pleased with it, and Jim touched on the increases over first quarter and the second quarter of 2015. If you back up and look at the first half of 2016 versus the first half of, sorry, first half of 2016 compared to the first half of 2015, we're up a little over 26% per share when adjusted for merger expenses. So, in a very challenging environment we feel very good about the path that we're on for a good year in 2016.

And really the results follow the earnings equation that we think about, which is growing the loan account in kind of the high single digit range focusing very much on relationship lending, controlling credit costs and having high quality portfolio, growing non-interest income in the low double digits, and being very disciplined in managing expenses. We feel it gives us the right equation, so this quarter follows that right down the line.

I'll skip over slide 4 because Jim touched on many of the points there and maybe move to slide 5, which covers our net interest income, and it's worth spending a few minutes here. As usual, it can be a little bit challenging to untangle what's happening in the net margin yield, but you'll see that net interest income was down $547,000 for the quarter when compared to the first quarter. If you take that amount apart, there's about $325,000 that is due to lower accretion related to acquired loans. We saw $110,000 less in loan fees in the second quarter versus the first, and we had a really strong first quarter. So, a good second quarter on loan fees, but not quite as strong as the first quarter.

And then the remaining $113,000 is really a reduction due to just modest margin compression as well as mix changes in our earning assets and our funding. If you translate all that to basis points, the net margin yield fell about nine basis points in the quarter from the 3.78% that you saw in the first quarter down to 3.69%. And taking that apart, there's about five basis points of the decline tied to the lower accretion, one basis point attributed to -- attributable to the lower fees and the remaining three basis points reflecting the sort of natural compression that's happening due to rates and mix.

Most of the change in accretion is related to the fair market value discounts for the performing acquired loans from First Capital. And during the first quarter call, we noted that this discount amount booked at closing in January was $5.2 million. And we also noted that we expected more than half of that amount to accrete through income in 2016 and that accretion would be somewhat weighted toward the first half of 2016. And, we provided more detail in the appendix on slide 12 but through the first two quarters of 2016, about $1.8 million of the original $5.2 million or say 35% of the original $5.2 million that was originally booked has, in fact, accreted through income. And while difficult to predict precisely because of prepays and refinances, we expect the pace of decline and accretion from the First Capital acquired performing loans to slow down in the second half of 2016 and stretch out through next year and somewhat beyond.

As for the roughly three basis points of compression during the second quarter in core earning assets and liabilities, about half, or 1.5 basis points, were attributable to the yields and mix on earning assets with the other 1.5 basis points roughly attributable to funding rates and mix. And as we also noted in the first quarter, given the very unfavorable interest rate environment, we've been expecting around two basis points to four basis points per quarter throughout 2016 of compression in our net margin yield excluding accretion. So we fell kind of right in line with that during the quarter.

Very briefly, Jim mentioned that loans rose a healthy 9% on an annualized basis from the end of the first quarter to the end of the second quarter. You'll note, though, that the average loan growth was lower than that, coming in at 4%. We had good pipeline coming into the second quarter. There were several transactions that were just slow to close, so a good portion of the loan growth actually was more weighted toward the last half of the quarter. And given that, we feel like we've got a pretty nice running start to average loan growth as we come into the third quarter.

It's worth noting average deposits were up 4%, but when you back out broker deposits and time deposits, which tend to be a little more discretionary and a little more price driven, the remaining categories of demand, money market, and savings were also up a healthy 9% on an annualized basis on average. And importantly, non-interest bearing demand was up $27 million or 24% annualized.

Turning to slide 6, in non-interest income we had a very strong quarter, as Jim noted, in our fee-related activities. On a linked quarter basis excluding the securities loss that we elected to take in the second quarter, we were up 15% in total. If you go back, though, and adjust the first quarter for the BOLI death benefit of $402,000, actually fee income was up about 26% on a linked quarter basis.

Touching on some key components here, service charge income showed steady growth. Very pleased there. Mortgage banking had another strong quarter. Our footprint markets are continuing to exhibit good growth and the addition of experienced bankers that have joined the Company in the last six months or so have really helped drive the increase in this business. Capital markets group had a very strong quarter following a first quarter that saw a limited number of transactions close. We had a strong pipeline coming into the quarter and we've got a very strong pipeline headed into, thus far in the third quarter. So, great performance in this business.

I think it's worth noting because we have our capital markets capability and it is an emphasis for us, particularly in providing interest rate swaps for our customers, that we've tended to steer customers who are looking to fix rates on larger loans toward swaps given the favorable terms that we can provide to them and to minimize the interest rate risk that we're taking on our balance sheet. And the economic tradeoff here, of course, is that we are basically recognizing some of the income related to those loans in capital markets fee income rather than putting fixed rate loans on our books, which might help our net interest margin look better in the short run but require us to shoulder the interest rate risk in the long run. So, we're very pleased with all the other non-interest income activities as well. Really across the board good performance, and we are especially pleased to see the focus that we've had in diversifying our revenue sources reflected in our results during the quarter.

Turning to slide 7 looking at non-interest expenses, adjusting for merger expenses we were down $282,000 for the quarter. The reduction is in part the result of continuing to recognize the cost saves tied to the merger with First Capital and continued good results in resolving OREO properties. As of the second quarter, we think about 85% of the $6 million in run rate cost saves that we anticipated at the time of the First Capital merger have been realized, and we expect the remainder to be realized this quarter, the third quarter.

Couple of quick notes here. Salaries and benefits include about $150,000 in non-merger severance costs related to seven former employees. The loan and collection expense you can see is up about $236,000. That's driven mainly by a campaign that we ran for new equity lines of credit, and as a part of that campaign we absorbed the closing costs that are normally paid by the borrower. So that was a spike up related to that campaign and would expect that that will come back down in the third quarter. And as Jim noted, we continue to improve our efficiency, and our adjusted efficiency ratio fell to 64% from 65% in the first quarter and down from 71% in the second quarter of 2015.

Turning to Slide 8, asset quality remained very strong. Non-performing loans were down $1.8 million, and that was mostly due to the resolution of a loan that was designated as non-performing last quarter and that we actually noted in the call. Non-performing loans were 33 basis points at quarter end, down from 42 basis points at the end of the quarter, so at very low levels. As we experienced in the first quarter, we also had net recoveries during the second quarter. Provision expense for the quarter was $882,000, and that's up from $556,000 in the first quarter.

In combination with the net recovery, the provision resulted in about $1 million increase in the allowance for loan losses. And I just want to point out that while the credit quality of the loans on our books is very solid, as you can see in the numbers, we felt that as we came into the end of the quarter that it was prudent to increase the qualitative portion of our allowance. And this was really driven by the general rise in general economic uncertainty that we were observing, the market volatility, and all the things that were going on as the second quarter came to a close.

And you might remember that the disappointing jobs report had just come out, and that seemed to have caused the Fed to put an expected rate increase on hold. The Fed also shifted their signaling to a possible economic slowdown and a significantly longer timeframe for increasing the Fed funds rate. We also considered the significant market disruption and uncertainty caused by the Brexit vote. And of course, since then, the equity markets have hit all-time highs. The Fed is now signaling that the economy is on stable on footing, and the rate increase may very well happen by the end of the year, if not by September. So, it's amazing how quickly things can change, but again, even though we haven't seen or observed any stress in our loans, given the volatility in the markets at quarter end we felt that it was prudent to increase the qualitative portion of our allowance.

So to wrap up my thoughts before we go to Q&A, again, we are very pleased with the results in the second quarter and for the first half of this year. There are certainly environmental headwinds impacting all banks, especially the shape of the yield curve and sort of the uncertainty around what will happen in terms of the Fed raising rates, but we think that we are relatively well positioned in very good markets with very strong talent and very strong business mix and are very pleased with how 2016 is unfolding.

So, Jim, with that I'll turn it back over to you.

Jim Cherry

Thank you, Don. Just before we go to Q&A, on Slide 9 I'll give you just some highlights of our focus for 2016 and really beyond. We feel very good about our current size and scale and our ability to perform on a very high level given the investments that we've made over the last number of years in the lines of businesses and in people. So our focus at this point is really on achieving operating leverage as this business model continues to mature. That operating leverage is going to be achieved by increasing the banker revenue contribution as newer bankers build their portfolios and get a revenue carry in addition to the productivity that we're seeing.

We're going to continue to focus on cross-selling opportunities and deepening and broadening the relationships that we have with our existing customers. Now that we have multiple lines of businesses and solutions that we can provide to our customers, we want to make sure that if they have a need that we're the ones that are meeting those needs and are able to satisfy them.

We're focused on continuing to build our presence in some very highly attractive markets. As you know, we have over 88% of our deposits are in markets that are growing faster than the national average. We believe that gives us a strength in the franchise that's very attractive.

Looking at our objectives, they are to achieve a 1% ROA and also to continue to drive down our efficiency ratio in order to create operating leverage and stronger return for our investors. At the same time, we are continuing to selectively pursue opportunities to expand and enhance our business strategies in ways that would provide attractive values to our shareholders.

Overall, we feel really good, obviously, about the fact that we're firing on all cylinders. All parts of our Company have contributed to our results this quarter, and we feel very good about the momentum we have going into the next half of the year. And I think Don highlighted a number of those areas where I think we are ahead of the curve, whether that's in the fact that a good part of our loan growth during this quarter actually occurred at the end, the fact that we've got most of our cost saves have been now realized and so many of those expenses, we closed the First Capital, we completed our conversion of First Capital in May, and so those expenses now would be out for the next quarter. So we've got a lot of good tailwinds that should be pushing us forward during the second half of the year. So with that we'll stop and be glad to entertain your questions. Operator, Chad?

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question and answer session. [Operator Instructions]

Our first question comes from Stephen Scouten, from Sandler O'Neill. Please go ahead.

Stephen Scouten

Guys, really good quarter on the loan growth front here it looked like, and I was curious if you could tell me what you're seeing there on a C&I front and especially with so many banks kind of backing away from CRE based on exposures, if you're seeing any more competition on those C&I loans or if you see any overall market changes there.

Jim Cherry

Well, the C&I lending environment has always been very competitive, especially in the markets that we are in. I might let Bryan comment in a moment on that, but I would make just a comment or two about the commercial real estate concentrations and all. We're very mindful of the guidelines, and I think they -- we think they are appropriate. Heard one regulator make the comment that if you have a lot of eggs in one basket then you need to make sure the basket's very strong. If you look at our credit culture here, I think you can see by performance that we have an extremely strong and talented credit culture in the bank.

Don Truslow has a very strong background, obviously, in risk as well as finance. Nancy Foster brings an extraordinary background of risk management, and of course, our Chief Credit Officer, Nina Cloaninger, was Chief Credit Officer of BofA for the East Coast. Have a lot of that, but we've added, I think as I mentioned earlier, we've added an additional senior credit officer on the real estate side who will be exclusively devoted to monitoring and managing our real estate exposure.

So with all of those things, we feel very good about our position and continue to remain competitive in the market with real estate. Have heard anecdotally, and I'll let Bryan comment maybe more on this, but anecdotally we have heard a number of institutions that have said that there should be some firming, if you will, of rates around the -- especially the construction side. I think there are more and more that are beginning to withdraw from that, and as they do, hopefully that'll allow us to -- while being selective will allow us to maybe improve the margins on some of that business.

Bryan?

Bryan Kennedy

Yes, a couple quick things. One is to follow up on Jim's comment about the CRE. I think we are seeing both increased demand and decreased availability of CRE credit out there a little bit. A number of you have seen articles about CMBS deals that were done in 2006 and '07 that have hit their 10-year mark, and we've actually seen some requests from folks to refinance out of their CMBS into a bank loan. And the nice thing is when you get to that point you should be able to get better pricing and you really want to do those for full service customer relationship opportunities. To touch on the C&I, the C&I is exceptionally competitive -- it is something everyone's focused on. It's exceptionally competitive. We have seen pricing probably tighten up a little bit more than we've seen our last couple years.

Structures seem to be holding reasonably well. What I say is I think there's also, one of the things we've done over the past year is really tried to build up the capabilities that go along with that other than the credit fees. As you've heard us talk about, we've spent a lot of 2015 installing and converting our commercial online banking platform to something that is much more robust than the off the shelf product that we had, and some of our competitors are using that still, that we are out going against. So that's the kind of thing that we've done along with the capital markets capabilities. We've got foreign exchange in there. So things like that -- in the markets we're in those middle market companies need those kinds of capabilities.

Most of that business is with the larger banks, and what makes it difficult to move business is if people thought they're taking a step backward in capabilities. And so we believe for the target market that we are going after that we -- they don't have to take a step backward. I think that's one of the reasons we've been able to attract some of the C&I bankers we've attracted over the last several years is they've looked at what their options are. And they've got plenty of options, and they wanted to go to a place where they felt like they had a better chance of winning business, not just because we have the credit team and the things like asset-based lending, but they have the other products that really are what drive this commercial relationship on a day-to-day basis.

We're very optimistic about the new -- three new C&I bankers we have in Charlotte and their ability to win some business in this market and continue to move our business mix more toward the C&I business which has both good credit opportunities but also annuity income from treasury services, fee income opportunities from capital markets and foreign exchange, so it's, we think we are exceptionally well positioned to be successful in that arena.

Jim Cherry

Stephen, I'd just add to that that I think a lot of banks think of C&I as simply commercial real estate that's owner occupied. And when we think about it, we think of that on a much broader basis related to equipment financing, inventory, and receivables financing and really banking the entire company as Bryan illustrated. And in that part of it, I would say that we are highly competitive and frankly most of our community bank competitors do not play well in that area because they don't have the products and capabilities that Bryan mentioned while they may still be very competitive on the owner occupied real estate side. So good question. Thank you.

Stephen Scouten

Yes. No, that's a really helpful answer. Thanks so much. And then maybe on the M&A front, obviously there was a big deal kind of in your overall markets there, and I'm curious if there's any specific opportunities you might think you could take advantage of as a result, whether it be teams that might be available or any dislocation opportunities and specific areas of focus if you think those are out there.

Jim Cherry

Don't know yet. I mean, I think it's early. There have been some recent announcements. We continue to be looking for and sensitive to opportunities to bring in really good talent. We feel like we've done that a number of times, including in the last quarter, and so, but don't, just don't know when those things may surface or arise, but we're certainly mindful of them.

Stephen Scouten

Okay. That's fair. And then lastly, Jim, I think you mentioned obviously, I forget the exact words you used here at the end of your commentary, but kind of evaluating attractive options to your shareholders to move towards that one ROA. Are there any specific initiatives that you guys are evaluating or anything different than we might expect to see from you guys in the near future or just kind of small changes here or there potentially?

Jim Cherry

Yes. No, I think what you saw this quarter is indicative of the approach, and Don, I thought, said it very well. It's continued to have very good, solid expense management while letting the bankers that we've hired build portfolios. I think some don't realize if you, I think our bankers have, what is it, around 30some million average portfolio carry. We think they can carry 50 million, so depending on the type of banker, and we've got some that'll be 80 million or 100 million. And so as they build up their portfolios and get a carry on that in addition to their new production, then we think we've already got that built in, so what we need to do is to let those investments that we've already made and some new ones, we've made some new ones, to position ourselves well for 2017 and beyond.

We expect those new investments to be essentially expense-neutral this year, as I said, by making other cuts, we're not filling positions that allow us to do that, and then we expect them to be revenue-enhancing during 2017 and beyond. And then the final one, of course, is building those other income sources, which, 14% to 15% growth over the last quarter I think is indicative of those capabilities.

Stephen Scouten

Great. Well, thanks so much, guys, for taking my questions. I appreciate it.

Operator

Our next question is from Tyler Stafford with Stephens, Inc. Please go ahead.

Tyler Stafford

Hey, Don, just a question for you on the NII growth. Obviously, that declined slightly this quarter. With the high single-digits growth you're expecting and maybe -- or more probably likely pressure from -- on the core loan yield side with rates remaining low and some modest headwinds on the accretion, can you just talk about the expectations to grow NII this year and next?

Don Truslow

Good question, Tyler. Obviously, it's a little hard to predict very accurately because of the impact of the accretion, but as I mentioned, as we think about the earnings formula given the mix that we have and the expectations around margin, even with that kind of two basis point to four basis point compression across the various quarters, we think that the high single digit loan growth will get us to where we need to be. It is -- I mean, obviously net interest margin is just a challenge. I mean, there are headwinds to growing that.

Some of the reduction and slug of the reduction this quarter really came from the drop off in accretion that I mentioned and that we talked about in the first quarter, so to the extent that that accretion is not dropping off as fast going forward as I tried to point out, that may assist a little bit in holding net interest income steady and letting some of that loan growth actually flow into growing net interest income.

Tyler Stafford

And then on the capital markets piece, obviously nice progression in 2Q. How sustainable or how should we think about the growth from 2Q levels out of capital markets?

Don Truslow

Yes, it was an exceptional quarter in capital markets, and that's on top of a quarter that was where we did not see many transactions close in the first quarter, and so that was an unusually low quarter. That income item tends to be a little more episodic, so the level you saw this quarter is maybe a little higher than what we would expect kind of from a trend line standpoint, sort of more the 450 to 500 or so thousand range has been our trend line. So, if we hit second quarter levels again in the third quarter, that'd be terrific, but we would be very pleased and moving back to trend line. But, that's a line item that is just going to be a little bit choppy from quarter to quarter just given the nature of those transactions.

Tyler Stafford

And then, Jim, I know it's early on, but can you talk about the early success you're seeing in the Richmond market, both on the loan and core deposit side?

Jim Cherry

Yes. Both ways feel very good, and I think we mentioned it in the first quarter, which has been unusual for us. But in the first quarter, Richmond actually -- combined teams in Richmond actually led our loan production for the quarter. So that felt very good. In terms of perceptions in the market, I think that's where it's especially rewarding. We are playing well, well above the size of our footprint, even though we now have a very good and concentrated footprint in that market from a branch standpoint. But from a name recognition and knowledge in-market, we really play exceptionally. Bryan, I don't know if you'd add some things because that market really reports to Bryan directly.

Bryan Kennedy

Yes, I think we're getting both good opportunities on the CRE and the C&I front there. It's really, First Capital had a nice mix of both businesses and the team we hired from StellarOne really was one CRE lender and three primarily C&I lenders. Again, we're not competing typically with the smaller community banks for that business, so again, it's a little bit choppy, too, because these are $4 million, $5 million, and $8 million kind of transactions that when they happen they move the needle a little bit. But the Richmond pipeline is very robust and very excited about what we have going on there in both fronts.

Jim Cherry

Just because of the scale of what we have in Richmond and Charlotte, we would expect those two cities to typically lead in our performance, but because of the choppiness of the commercial portfolio or lending, you're probably going to see one or the other at any given time compete for that honor, and we've done our best to strengthen the Charlotte team to compete effectively with what we think is a very strong Richmond team. So, we are enjoying that competition frankly.

Tyler Stafford

Okay. Thanks, guys. I appreciate it.

Jim Cherry

Thank you, Tyler.

Operator

The next question is from William Wallace, with Raymond James. Please go ahead.

William Wallace

First question, if I could, I'd like to go back to CRE concentration just because it's been, there's been so many headlines about it and we've seen some capital raises around it. On the surface, I look at your capital ratios. It seems like you guys would be well within any kind of limits that the regulators would want to talk about, but you did not screen as having any CRE concentration before the First Capital deal and then you did with that deal. So my first question is one, have the regulators, have they come to do a special visit to look at your CRE concentrations?

Jim Cherry

No. I guess the best thing I could give you from a regulatory standpoint to give you at least the signal we would have, and that is that we announced and closed the First Capital transaction in less than 90 days. And to do that we had to have strong regulatory approval for what we were doing. Very clear that we were going to exceed the regulatory guidelines, which are just that, the guidelines that I described when we closed that transaction, so it was not an unknown to us.

And I think that the feedback we continue to hear both directly and indirectly that is all about the attention and management that you give to that. If you got, and we do that across the board. It's not just commercial real estate. Anywhere where you have concentrations in the Company you need to make sure that you've got stronger credit metrics around that and that you're very mindful and attentive to it. Nancy, would you, any comments you would add?

Nancy Foster

Wally, I would add that although we didn't screen above that guideline in the past, we have typically operated in the 250% range of commercial real estate to capital, and in the kind of 85% on the AC&D, so those are relatively high and it's been a core competency. So, we very much have built a risk management practice around having a concentration in commercial real estate. And so just bumping over that threshold isn't a real meaningful difference here. So we are very much prepared for it, and I don't think the regulators will see that as a big shift for us. And to Jim's point, that's why it wasn't real difficult in getting the deal approved.

Bryan Kennedy

And we had more geographic diversity in that book than most of our competitors do. If you think about having -- being in Charleston and Greenville and Raleigh and Charlotte, Wilmington, Richmond, there's -- that book is pretty spread out so that we are not subject to one particular market's -- any kind of disruption locally.

William Wallace

And do you guys already currently -- with the systems you have in place, do you guys have stressed the portfolio from a geographic down to maybe industry classifications and even individual loan --.

Nancy Foster

Yes, absolutely. Yes, so as I'd mentioned, we have always operated as if we had that concentration and expectation around our risk management practices. So that's not to say we won't continue to enhance those with the Senior Credit Officer as being an example of that and going forward taking those stress tests to even a higher level of detail. But very much have been doing things along those lines really for the last five years.

William Wallace

My next question is in regards to margin. Don, I'm referencing slide 12. The data on that slide, you're presenting it a little differently than you did last quarter, and I can't get the numbers to foot from the accretion last quarter versus what you're saying it was this quarter. Last quarter I had that the first quarter was 2.6 million and now I have it rounding to 2.8 million for the first quarter. So, I'm just trying to get a sense as to what the difference is there and looking at maybe how the core margin changed.

Don Truslow

Let's see. It should. I don't have the first quarter with me, but if you're looking at the middle of that page, the first quarter 2016 column, and you see the $1.27 million and the $255,000, that would be the amount of basically the FAS accretion or the acquired performing accretion. And then down at the bottom, the $1.471 million, if I'm reading across here right, would've been the impaired accretion. So the --.

William Wallace

Right. Yes, so last quarter that number down at the bottom was 12 something, 12, 70-ish.

Don Truslow

We did have the re-class. Yes, we did have a re-class. You're right. There was a re-class out of the loan system servicing income. So, this time that's a little bit lower. You're right.

William Wallace

So what is that servicing income as it relates to the mark, to the accretion?

Don Truslow

So, think of the servicing income basically is just the normal interest income that we would get on the note. And the accretion line item, the next one down, that's the accretion of the actual discount.

William Wallace

Okay, so that's the -- so how could there be a change from one quarter to the next?

Don Truslow

Well, it wasn't a change. It was basically -- there was a chart last time, and so there was a portion that was -- of the actual discount that was up in loan servicing, so we re-classed it down into the next line item. It was just the issue of a new chart and getting it lined up. So, the numbers you're seeing in this chart right here really are the consistent ones to use, and I apologize for that for the last quarter.

William Wallace

No, no problem. I just wanted to make sure I could understand the magnitude of the change in core margin.

Don Truslow

Yes, no very good question. Very good question.

William Wallace

Okay, thanks. So, so, and then that sort of foots into this capital markets revenue, the big jump up this quarter. Just so I understand, that's related to interest rate swaps, right?

Don Truslow

That's correct. Those are back to back swaps basically.

William Wallace

So when you have as much volatility as we saw, I'm guessing the volatility around the short end is probably what's going to drive here or no? Is it [indiscernible]?

Don Truslow

Most of those are marked off the 5-year mark.

That's correct. Those are back to back swaps basically.

William Wallace

Okay. So volatility will create more gains on those than a consistent move over the course of a quarter. Is that correct?

Don Truslow

Well, the income that you see, the swap component of the income you see in non-interest income is basically the fee that we get for booking the swap upfront. So most of that is transaction-driven as opposed to marking the swaps.

Now, embedded in that as we, I think, talked about in the first quarter, interest rate levels will cause us to either put up more credit valuation adjustment or release some, and lower interest rates tend to drive a negative against that line item. So we had about 145,000, I think in the first quarter going from memory, basically CVA mark which deducted from the capital markets income line item.

This quarter, because interest rates fell even further, there's about a $55,000, I think, additional mark that is included, a negative mark that is included in that line item. So you will see CVA or credit valuation adjustments flow through that line item as either a discount or an addition. And if rates go back up, particularly in the 5 year range, say next quarter or in subsequent quarters, then I would expect a good portion of that to be a mark to reverse back out and come back into the income.

William Wallace

And so you're netting the mark, so that mark, that 767 is net of the mark? That's not the, it's not in another other item?

Don Truslow

It's net of the CVA mark on the swap to our underlying loan customers, yes.

William Wallace

Okay. Okay. All right. I appreciate that. That's helpful. So, my last question then is on the expense side. You talked, I think you referenced this a little bit earlier. I apologize if you've already answered this directly, but you talked about some areas where you had pressures, like the loan and collection expense specifically, and then you talked about the remaining 15% of the $6 million annual cost saves will be hit in the second quarter. Will that, will those be offset by the cost of the new team that was hired out of Community One?

Don Truslow

No. No, we, the new team basically is expense neutral from basically some personnel shifts. So, for instance, I mentioned in salary line items that we had about $150,000 in severance costs from a handful of employees. So there are other things that we are doing in the expense area, particularly in managing our markets and that we're basically making the additional team expense neutral for 2016.

Jim Cherry

That's a great question, Wally, and I really appreciate your asking it because I want to make sure that our investors know that we are not now eating into the savings that we said we would get to make new investments. We are reallocating resources within the Company that are outside of the savings. So, we expect to fully realize the benefits of this acquisition.

Don Truslow

It's important as we move forward given just the great markets we have and to continue making investments, but we're just trying to be as smart and as wise as we can in figuring out how to pay for those kind of self-pay for those. And on the loan closing costs, I want to be really clear, be sure I was clear, but those are -- that bump up -- related to a marketing campaign, so you can almost think of those as marketing expenses related to a one time campaign. So, we don't expect that level to repeat, but that was a management decision to invest some money to attract some more retail business into the Company.

William Wallace

Okay, so if I kind of net out the loss on the disposal, your fixed assets, and the merger expense, I get to a core number of about 20.6 million. So with the additional cost saves and then the kind of bouncing back off of that marketing cost, it sounds like the run rate on your core level should be closer to maybe 20.2 or so. Is that a fair comment or are there going to be other costs that are layered in where I should be thinking about 20 to 20.5 or so? I'm just trying to think about where you're set up moving forward.

Don Truslow

Yes, I -- good question. I would think that you can -- once the cost saves are achieved that the underlying core run rate in expenses ought to be sort of that 2% to 4% annualized range. So, in other words, we're -- as we're growing, we don't have an expense initiative and so just there should be a natural underlying kind of 2% to 4% roughly growth rate in our expenses on an annualized basis.

William Wallace

Oh, so a lower base than you had in the second quarter?

Don Truslow

Right. And there are always going to be sort of unusual things in each quarter, so we're just trying to point them out to help folks get to a core underlying run rate.

Operator

[Operator Instructions] The next question is from Nancy Bush of NAB Research. Please go ahead.

Nancy Bush

Two questions. Back to the capital markets quarter that you had and just a sort of more general question about the build out of the capital markets platform, I mean, do you have the platform built out to the size that you want it right now and/or when you have these great quarters in capital markets, are you able to sort of reinvest into a further build out in product or technology or whatever? Could you just sort of speak to the size of capital markets as they are right now?

Don Truslow

Yes, it's actually -- as people think about capital markets, it's actually a pretty simple business. It's -- we're really focused on interest rate risk management for our customers. So, think interest rate swaps, basically, and then foreign exchange. So, we are not making our own book. These are all back-to-back swaps with very highly rated counterparties and so it's relative to what people think about in capital markets, we're not out trying to build a trading floor. On the other hand, it is business that is growing for us, and we are looking to probably add some talent, just some capacity in this area because it's been successful. But, it would be in the manner of some additional people or person as opposed to having to build out trading platforms.

Nancy Bush

Okay. Great. And secondly, go ahead.

Don Truslow

Does that answer your question? I want to be sure I --

Nancy Bush

Yes, it does. Thank you. Secondly, several companies that have reported this quarter have talked about the benefits of bringing in teams of new producers, etc. I think Pinnacle is sort of in a constant process of finding new producers and bringing them in and realizing business gains as a result and several others have spoken of it as well. I'm curious, I mean, when you bring in these new teams of producers, sort of what happens to the rest of the sales force? Is there a, and I think you may have alluded to this, Don, I mean, is there sort of a reordering of the sales force where maybe low producers go out or is everybody expected to come up to this level of production? I mean, how does that work? How do you do this without sort of constant churn in your sales force?

Jim Cherry

Nancy, that's a really good question, and the answer is I think there is a delicate balance. You're always mindful of the, of trying to reallocate and allocate your resources effectively and appropriately. So we do have bottom performers. We have a very transparent information system on how people are performing, and so frankly, most of its self-selection. There are people that realize they are not hitting the benchmark. Well, typically, those folks also are not carrying the portfolios and don't have the significant relationships.

So, it doesn't have the customer impact that churn might have if you were losing some of your higher performers and more talented bankers. And that is a rarity for us. I won't tell you it doesn't happen because it does to anybody, but in general, that's, fortunately, knock on wood, has been a rarity for us, so most of the turnover we have had had been with folks who have self-selected out and said this really doesn't work well for me and need to move on.

So, the other part of that is we are continuing, and I do think in a growing company if you expect to continue to grow, you've got to continue to find ways to invest in talent, but it can't all just be investment. You've got to find ways to pay for that and that's being very mindful and disciplined about the reallocation of resources.

Nancy Bush

Also, I mean, do you, Jim, set a target, I mean, is bringing in these producers more episodic, is it more opportunistic, or do you sort of set a target saying we want to bring in X per quarter? I mean, how do you do that?

Jim Cherry

It depends. So, if, for example, if you looked in the mortgage banking group, we've absolutely had a target for adding additional mortgage bankers as we believe we had a platform that could accommodate those and allow us to effectively grow that business. The nice thing about that, as you know, that that's a commission based business. There's some upfront cost, generally some carry, and then it goes pretty quickly to commission. So, there, as an example for us this past year has been much more goal oriented around what we wanted to do with that line of business. A little bit the same, perhaps, in the welfare here.

In commercial, been a little bit more opportunistic. As those opportunities have arisen, we have taken advantage of those opportunities and been a little bit more opportunistic I would say than the other. But there are some markets that we would welcome those opportunities. And, especially these key growth markets, so we're continually attentive to those, and we want to make sure that if and when those opportunities come up we're in a position to take advantage of them.

Operator

Ladies and gentlemen, this concludes our question and answer session. I would like to turn the conference back over to Jim Cherry for any closing remarks.

Jim Cherry

Thank you. We had very good Q&A and appreciate all of your interest. If there's any follow-up questions we'd certainly be -- welcome those. But in the meantime, we will do our best to continue to demonstrate the kind of results that we did this quarter going forward in future quarters. Thank you again.

Operator

And thank you, sir. The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.

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