Fifth Third Bancorp

Ladies and gentlemen, thank you for standing by and welcome to the fifth, third, fourth quarter 2020 earnings conference call. At this time, all participants are in a listening only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star one on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star zero. Thank you. I would now like to hand the conference over to your speaker today, Chris Law, Director of Investor Relations. Please go ahead.

Thank you, Melissa. Good morning. Thank you for joining us. Today, we'll be discussing our financial results for the fourth quarter of 2020. Please review the cautionary statements and our materials, which can be found in our earnings release and presentation. These materials contain reconciliations and non-GAAP measures, along with information pertaining to the use of non-GAAP measures, as well as forward-looking statements about Fifth Thirds performance. We undertake no obligation to and do not expect to update any such forward-looking guidance or statements after the date of this call.

This morning, I'm joined by our CDO, Greg Carmichael, CFO, Jamie Leonard, President, Tim Spence, and Chief Credit Officer, Richard Stein. Following prepared remarks by Greg and Jamie, we will open the call for questions.

Let me turn the call over now for Greg for his comments. Thanks, Chris, and thank all of you for joining us this morning. Hope you're all well and staying healthy. Earlier today, we reported a full year 2020 net income of $1.4 billion, or $1.83 per share. We delivered strong financial results in 2020 despite the challenging operating environment brought on by the pandemic. We had several highlights for the year. We generated a record adjusted pre-provision net revenue. We maintained our expense discipline, producing an adjusted efficiency ratio below 59%, which was stable compared to the prior year and remains near a decade low. We generate a record adjusted fee revenue, including records in both our commercial and wealth and asset management businesses. We also continue to generate peer lending consumer household growth of 3%, with outside success in Chicago and our key southeast markets. While nearly doubling our reserves, we generated 11.7%, adjusted return on tangible common equity, excluding AOCI, for the full year and generated an ROTCE of 18.4% in the fourth quarter. Just as importantly, we have successfully navigated the COVID-19 pandemic, keeping 99% of our branches open for business while working closely with our customers to support them during these challenging times through the PPP program, hardship relief programs, and other outreach efforts that we have previously discussed. Our efforts have been noticed externally. We are recognized by an independent third party as the top performing bank among the 12 largest U.S. retail banks based on our pandemic response for our customers, communities, and employees. Also, we had the honor of winning the Greenwich Middle Market CX Award, reflecting our commitment to delivering a superior customer experience before and during the COVID-19 crisis. Additionally, during the year we published our inaugural ESG report, highlighting our efforts to generate sustainable value for all stakeholders. And just this week, we announced that we became the first regional bank to achieve carbon neutrality in our operations. Turn to the fourth quarter. We reported net income of $604 million. Our reported EPS included a negative 10 cent impact from the items shown on page two of our release. Excluding these items, adjusted fourth quarter earnings were 88 cents per share, Jamie will walk you through the quarterly financial results in more detail in just a minute. Focused execution on our key strategic priorities and our disciplined approach to credit risk management continue to drive strong financial performance. As we recently announced, we have taken decisive action to drive efficiencies and improve the long-term profitability of the bank by streamlining our operations, including divesting less profitable businesses such as property and casualty insurance, while still investing in areas of growth and profitability. For example, we recently finalized the acquisition of H2C, which strengthens our healthcare investment banking and strategic advisory capabilities. We continue to assess select strategic investments and non-bank acquisitions to improve fee growth. All reported and adjusted return metrics were solid and improved sequentially in the fourth quarter, reflecting our strong operating results, including the provision for credit loss performance. We expect a positive momentum in our operating results to continue in 2021. Net interest income increased 1% sequentially despite loan portfolio headwinds. Underlying NIM, which excludes excess cash and PPP impacts, increased eight basis points sequentially. We expect to generate differentiating NIM performance relative to peers in 2021 and beyond, reflecting the hedge and investment portfolio actions we have taken over the past several years. Our credit fall remains solid, with net charge-offs at 43 basis points stable compared to the recent quarters. Also, our criticized assets and allowance for credit losses both declined sequentially, reflecting our credit discipline and improved credit results and economic outlook. We continue to benefit from the diversification and resilience of our fee-based businesses in retail, commercial, and wealth and asset management. Many of our fee-based businesses are generating strong results that are helping to cushion the impact of lower rates. Our robust capital equity levels further improve this quarter indicative of our balance sheet strength. Our regulatory capital levels have increased for three consecutive quarters as a result of our strong earnings power, balance sheet dynamics, and the Fed's temporary suspension of buybacks. With the partial relief announced by the Fed in December, we intend to execute up to $180 million in share repurchases in the first quarter. Through proactive management, we have built a strong and stable balance sheet and significantly improved the diversification of our fee revenue. We have done this all while maintaining our culture of expense discipline and demonstrating our commitment to consistent and solid through-the-cycle performance. Our financial performance continues to give us confidence that we can safely and soundly operate the company at significant lower capital levels. Our CT1 target remains at 9.5%. We will continue to dilute the appropriate capital target as the economy improves. We will also see a continued strength in our commercial loan production levels and our pipe loans. Fourth quarter loan production was the highest in 2020 and was down around 20% from the year-ago quarter, but was up over 50% from the third quarter. We are encouraged by the recent trends with sequential improvement in almost all regions and all verticals. Strong production was more than offset by elevated payoffs and another 1% decline in line utilization. Our middle market pipeline improvement is well diversified throughout our footprint, including significant strength in our southeast markets. In corporate banking, pipeline strength began this quarter with improvement in industrials, retail, healthcare, solar, and financial institutions, partially offset by continuous sluggishness and hospitality to energy. Based on the strong pipeline and stabilization trends through the first three weeks of January, we currently expect C&I loan balances to improve on a period-end basis during the first quarter, excluding the impact of PPP loans. Commercial real estate pipelines continue to be well below pre-COVID levels. Before I turn it over to Jamie to further discuss results in our outlook, I want to reiterate our strategic priorities, which will enable us to continue to generate long-term shareholder value. Our four key strategic priorities have not changed over the past several years and include leveraging technology to accelerate digital transformation, driving organic growth and profitability, expanding market share and key geographies, and maintaining a disciplined approach on expenses and client selection. We'll put the appropriate level of prioritization and focus on areas where we see the highest probability of drawing strong financial returns and generating long-term value for our shareholders. Our balancing strength, diversified revenues, and continued focus on discipline and expense management will serve us well as we navigate this environment in 2021 and beyond. I'd like to once again thank our employees. I'm very proud of the way you have continually risen to the occasion to support our customers in each other during these challenging times. Fifth Third continues to be a source of strength for our customers and our communities, and we remain committed to equality, equity, and inclusion for all. To that end, we made a three-year $2.8 billion pledge to this commitment through lending, investing, and donating, including a $25 million contribution to the Fifth Third Foundation. financial results continue to reflect our focused execution discipline through the cycle principles we remain committed to generating sustainable long-term value for our shareholders anticipate that we will continue improving our relative performance as a top performing regional bank with that alternative discuss our results for current outlook thank you greg and thank all of you for joining us today one quick housekeeping item

before discussing our financial results for the quarter. As you will see in our earnings materials, we are no longer adjusting certain metrics for purchase accounting accretion or intangible amortization, given that they largely offset and have an immaterial impact on pre-tax income. We hope this will help simplify our disclosures going forward to more easily assess our financial ratios. Now, turning to our fourth quarter performance. We ended 2020 with positive momentum and delivered strong financial results. Reported results were impacted by several notable items, including a $23 million after-tax negative mark related to the Visa total return swap, a $21 million after-tax charge related to our acquisition and disposition actions, as Greg mentioned. The sale of our HSA business remains in process and should close by the end of this quarter. We also recognized a $16 million after-tax charge related to our branch and non-branch real estate efficiency strategies. This includes impairments associated with seven branches we will be closing in April as part of our normal rigor on reviewing our network for efficiencies. These closures are in addition to the 37 branches we announced last quarter. Furthermore, as Greg discussed, we recorded a $19 million after-tax charitable contribution expense to promote racial equality, and we also recorded $4 million after-tax from COVID-related expenses. Lastly, we had a one-time favorable item related to state taxes of $13 million. In terms of the financial highlights for the quarter, despite the nearly 160-point decline in one-month LIBOR over the last 12 months, we were able to generate an adjusted PPNR above the fourth quarter of 2019 level. We generated an efficiency ratio of 58%. Our operating performance reflected a 1% increase in NII, a 16% increase in adjusted fees, and a 4% increase in adjusted expenses. Given the strong PPNR results, combined with continued credit-related improvements, We produced strong reported and adjusted return metrics, including an adjusted ROA of 1.31% and an adjusted return on tangible common equity of 18.4%, excluding AOCI, despite growing our regulatory capital 20 basis points during the quarter. Drilling into the income statement performance, the sequential increase in NII of 1% reflected the strength of our balance sheet and deposit franchise. We saw a four-basis point improvement in our total loan yields, which was supported by both the continued benefits from our long-duration deep-in-the-money cash flow hedges, as well as $10 million in additional PPP income. Our NII results included $11 million of incremental favorable prepayment penalties in the securities portfolio, reflecting one of the benefits from our strategy to invest in bullet and locked-out cash flows. Approximately 59% of the investment portfolio is still invested in bullet and locked-out cash flows at quarter end. And our investment portfolio yield increased nine basis points sequentially to 3.1%. Net premium amortization in our securities portfolio was only $1 million in the fourth quarter. On the liability side, we reduced our interest-bearing core deposit costs by another five basis points. For the fourth quarter, the average cost of our core deposits was only five basis points. CD and debt maturities also provided a two basis point improvement to NIM versus the third quarter. Reported NIM was stable compared to the third quarter, reflecting the favorable securities portfolio and PPP income I mentioned, offset by the impact of higher cash levels. Underlying NIM excluding PPP and excess cash improved eight basis points to 3.14%. Once again, we had another strong quarter generating non-interest income to cushion the rate-driven NII pressure. The resilience in our fee income levels continues to highlight the revenue diversification that we have achieved. Total non-interest income increased 9% relative to the third quarter. Excluding the notable items, non-interest income increased 16%. We generated record commercial banking revenue, which increased double digits sequentially and year over year, driven by strength across most of the business. We also recorded TRA income of $74 million, as well as gains from several of our direct and tech investments in venture capital funds. These investments generated $75 million of fee income in 2020, and we expect continued gains in 2021. Topline mortgage banking revenue declined $46 million sequentially, driven by a $26 million headwind reflecting a decline in rate lock volumes, a $12 million impact from our decision to retain $250 million of our retail production during the quarter, and $8 million due to margin compression. MSR decay and servicing fees were unchanged sequentially and will remain challenged in this environment. While we did not deliver the mortgage results we expected due to capacity pressures, we have seen meaningful improvement in December and January. Non-interest expenses also increased relative to the third quarter, albeit to a much lesser extent than fees. Adjusted expenses were up 3%, excluding the mark-to-market impacts associated with non-qualified deferred compensation that is offset in security gains within non-interest income. The largest contributor of the expense growth was performance-based compensation, driven by the strong performance in fees related to business growth and other revenue-length expenses. Moving to the balance sheet, total average loans declined 3% sequentially, with both commercial and consumer balances in line with our previous guidance ranges. Commercial loan balances continue to reflect lower revolver utilization rates, which decreased another 1% in the quarter to 32%. Line utilization rates so far in January are stable relative to the fourth quarter. We currently expect utilization to remain unchanged for the first half of 2021 and are forecasting only a modest increase of approximately 1% in the second half of the year as the economy improves. Average CRE loans were flat sequentially with end of period balances declining 1%. As we have discussed before, we believe that the commercial real estate sector is particularly vulnerable to the current economic environment and supports our strategy of lower exposure and our focus on high-quality borrowers. We have provided more information related to our CRE exposures in our presentation this quarter. Average total consumer loans increased 1% sequentially, driven by continued growth in the auto portfolio, partially offset by declines in home equity and credit cards. We took additional action in the consumer portfolio at the end of December to improve our NII trajectory for 2021, deploying approximately $2 billion of our excess liquidity by purchasing government-guaranteed residential mortgages currently in forbearance under the CARES Act provisions. These loans are in our held-for-sale portfolio as they are not expected to be held for more than one to two years. These loans provide a more attractive risk-adjusted return than other current investment alternatives. Our securities portfolio of roughly $35 billion decreased 1% compared to the prior quarter, reflecting the impact of paydowns combined with the lack of compelling reinvestment opportunities. Our investment portfolio positioning continues to support NII in the current environment, allowing for patience in investing at the current unattractive long-term rates. Given the potential for strong economic growth in the second half of 2021, we do not believe long-duration securities are providing an appropriate risk-return tradeoff. As a result, we do not expect to grow our investment portfolio in the near term. Our unrealized securities and cash flow hedge gains at the end of the quarter remained at $3.5 billion. Also, our deliberate actions within the securities portfolio over the past several years focused on structuring the portfolio in anticipation of a lower rate environment and should continue to give us a strong advantage as a very effective hedging tool to help mitigate the rate headwinds. Average other short-term investments, which includes interest-bearing cash, increased to $35 billion, growing $5 billion from the prior quarter and $33 billion compared to the year-ago quarter. In addition to the loan growth headwinds outside of PPP, the significant increase in excess cash reflects record deposit growth over the past nine months. Core deposits increased 3% compared to the third quarter, despite a 12% reduction in consumer CD balances, which helped drive down interest-bearing core deposit costs by five basis points. Moving on to credit. Overall, credit quality continues to be solid, reflecting our disciplined approach to client selection and underwriting, balance sheet optimization, and the improved macroeconomic environment. Charge-offs remained well-behaved at 43 basis points. Non-performing assets declined $67 million, or 7%, with the resulting NPA ratio of 79 basis points declining 5 basis points sequentially. Also, our criticized assets declined 12% with appreciable improvements in energy, industrial, and middle markets. Given the solid credit results, lower end-of-period loan balances, and improvements in the macroeconomic outlook, our reserve coverage declined eight basis points to 2.41% of portfolio loans and leases, with improvement in both consumer and commercial. The low level of net charge-offs combined with the $131 million decline in the allowance resulted in a net $13 million benefit to the provision line. Our ACL decline of $131 million was attributable to several factors. Approximately one-third of the decline was the result of lower period and loan balances with the remainder of the release due to both the improved economic outlook and the improved commercial credit risk profile, which is reflected in our lower MPA and criticized asset levels. As is required under CECL, Our reserve reflects all known macroeconomic and credit quality information as of December 31st. While we are not predicting or forecasting reserve releases at this point, given both the significant uncertainty in the economy and our loan growth expectations, to the extent there will be meaningful and sustained improvement in the broader economy, it's not unreasonable that reserves could come down from here even if credit losses tick up. Our base case macroeconomic scenario assumes GDP remains below 2019 levels until the end of 2021, an unemployment rate higher than the current 6.7%, ending 2021 at 7.2% and declining to 5.6% by the end of 2022. Importantly, our base estimate incorporates favorable impacts from fiscal stimulus generally consistent with the $900 billion package passed at the end of December, but does not incorporate additional relief as currently proposed by the new administration. We did not change our scenario weights of 60% to the base and 20% to the upside and downside scenarios. Applying a 100% probability rating to the base scenario would result in a $200 million release to our fourth quarter reserve. Conversely, applying a 100% to the downside scenario would result in a $900 million build. Inclusive of the impact of approximately $136 million in the main discount associated with the MV loan portfolio, our ACL ratio is 2.53%. Additionally, excluding the $5 billion in PPP loans with virtually no associated credit reserve, the ACL would be approximately 2.65%. Moving to capital, our capital will remain strong during the quarter. Our CET1 ratio ended the quarter at 10.3%, above our stated target of 9.5%, which amounts to approximately $1.2 billion of excess capital. As a reminder, We have remaining capacity to purchase 76 million shares from our 100 million share program authorized by our Board of Directors in 2019, representing $2.4 billion, or 11% of our current shares outstanding. As Greg mentioned, we plan to execute approximately $180 million in share repurchases during the first quarter, And should the Federal Reserve permit banks to continue to repurchase shares in 2021 under the current net income test framework, we would have around $1 billion of buyback capacity in total for 2021, assuming no change to our reserve coverage. Moving to our current outlook, we have provided detailed guidance for both the full year and the first quarter, consistent with previous fourth quarter earnings calls. We expect full-year 2021 total loans to be stable with 2020 on both an average and end-of-period basis, reflecting the full-year headwinds of commercial line utilization declines in the second half of 2020 and PPP forgiveness, offset by the benefit of the consumer loans added at the end of 2020 and our forecast of $2 billion of new PPP loan originations in 2021. Average commercial balances are expected to decline in the low to mid single digits range compared to 2020, while consumer balances should increase in the mid to high single digits range. For the first quarter, we expect average total loan balances to increase approximately 2% to 3% sequentially. reflecting relative stability in the CNI portfolio, continued strength in the auto portfolio, and growth in residential mortgage and other consumer loans, partially offset by a 1% decline in CRE. Given the loan outlook combined with our expectations for the underlying margin to be around 3%, reflective of the structural rate protection from our securities and hedge portfolios, We expect NII to decline approximately 3% next year and also decline around 3% in the first quarter relative to the fourth quarter, assuming no deployment of our excess liquidity. We expect non-interest income to increase 2% to 3% in 2021, which includes the 1% headwind from lower TRA income in 2021. If not for the CRA impact, our fee expectations would be for 3% to 4% growth, which includes the impact of approximately $40 million in foregone annual revenue associated with our business exits as part of our expense savings program. For the first quarter, we expect fees to increase mid-single digits year over year, which is a 9% to 10% decline sequentially, reflecting seasonal impacts such as the lack of TRA revenue and lighter other non-interest income, partially offset by the seasonal uptick in wealth revenue from tax preparation fees in the first quarter and significantly stronger mortgage revenue. We expect top-line mortgage revenue to improve $30 to $35 million in the first quarter relative to the fourth quarter and also anticipate stronger results in our loan and lease syndication businesses. We expect full-year 2021 non-interest expense to decline approximately 1% relative to the adjusted 2020 expenses, driven by the impacts of our expense reduction program, but partially offset by expenses associated with strong fee growth, servicing expenses associated with the consumer loan portfolio purchased in the fourth quarter, and continued investments to accelerate both our digital transformation and and our sales force and branch expansion in our growth markets. As is always the case for us, our first quarter expenses are impacted by seasonal items associated with the timing of compensation awards and payroll taxes. Compared to the first quarter of 2020, reported expenses, we expect total expenses to be flat. On a sequential basis, excluding seasonal items, our total first quarter expenses are expected to be down approximately 3% to 4% from the fourth quarter. We currently expect to generate year-over-year adjusted positive operating leverage in the second half of 2021, reflecting our expense actions, our continued success growing our fee-based businesses, and our proactive balance sheet management. We expect total net charge-offs in 2021 to be in the 45 to 55 basis point range. If the proposed stimulus passes, we would expect to be at the lower end of that range. In summary, our fourth quarter and full year 2020 results were strong and continue to demonstrate the progress we have made over the past few years toward achieving our goal of outperformance through the cycle. we will continue to rely on the same principles, discipline client selection, conservative underwriting, and a focus on a long-term performance horizon, which gives us confidence as we navigate this environment. With that, let me turn it over to Chris to open the call up for Q&A. Thanks, Jamie.

Before we start Q&A, as a courtesy to others, we ask that you limit yourself to one question in the follow-up and then return to the queue if you have additional questions. We will do our best to answer as many questions as possible in the time we have allotted this morning.

Melissa, please open the call for questions.

Thank you. And as a reminder, to ask a question, you will need to press star 1 on your telephone. To withdraw your question, press the pound or hash key. Your first question comes from the line of Scott Seifert from Piper Sandler. Your line is open.

Morning, guys. Thanks for taking the question. Sure. Yes, sir. I wanted to ask about sort of the CNI outlook. You know, near term, I guess I would characterize the commentary as constructive, but you had the outlook for just, I think, a 1% increase in line utilization in the second half. It seems to me it stands in a bit of contrast from some of your peers who seem to require a more robust outlook. acceleration in CNI later in the year? I guess I'm just curious for maybe more color on how you're thinking about the potential rebound in CNI as the economy normalizes around, say, mid-year or so.

Hey, Scott. This is Greg. First off, I tell you, we were encouraged by the fourth quarter pipeline growth that we've seen up significantly over the third quarter, albeit slightly down from where we were in 2019. So we're seeing progress out there. It's really a pretty broad based across all of our regions and across our verticals. So we're encouraged by the strength we're seeing there. Obviously, there's a lot of unknowns going in as we go into 2021, additional stimulus, the vaccines and so forth, the recovery. So it's a hard thing for us to gauge what the expectations are, but there's a lot of liquidity out there right now. So we're optimistic that the vaccines get distributed appropriately and we get a commie back in full swing second half of the year, that those numbers might look stronger. But right now we're just being, at the end of the day, conservative but encouraged by the pipelines that we've seen already. Tim, if you have anything to add.

No, I think that's absolutely right. As you said, I think we're particularly pleased with the pickup in middle market production that we saw in the fourth quarter and the continued strength in the industry verticals like renewable energy, technology, and health care where the bank has made fairly significant strategic investments over the course of the past several years.

Okay, perfect. Thank you. And then just within your guidance for the full year, I know that you guys conservatively don't include the PPP impacts. I'm just curious, however, to the extent that they do come through, how are you expecting those to ebb and flow? You know, will most of the forgiveness from the first month be expected to be sort of the first half event, or how do you see that flowing through?

Yes, Scott, it's Jamie. For PPP in total, NII, we expect about $150 million in 2021, which includes about $60 million in accelerated forgiveness fees, which compares to about $100 million of total NII in 2020, which has included only $10 million in accelerated forgiveness fees. And right now in our outlook, We expect first quarter forgiveness fees to be in line with the fourth quarter. Perhaps we'll do better than that from a forgiveness perspective. We've got about $400 million or a little bit less than 10% of the 2020 originations forgiven. And so as we model it out, we expect the majority of the fees from the 2020 originations to be forgiven in the third quarter as borrowers approach that 16-month period. time horizon of needing to make payments or have it forgiven. So right now, we expect the back half of the year to have a little bit more accelerated fees. And then, as we mentioned in the prepared March, we expect the 2021 round of PPP to be about $2 billion in originations, and then that will accrue at a lower rate just given the five-year term on those loans. So, we expect about a 1.8% yield prior to any of the forgiveness fees.

Perfect. All right. Thank you all very much.

Your next question comes from the line of Ken Edson from Jefferies. Your line is open.

Hey, thanks. Good morning, guys. Jamie, on the fee side, it's good to hear you reiterate that up three to four core growth, excluding TRA. I heard your comments about mortgage for the first quarter, but can you just give some more color in terms of what you expect to drive that growth this year and how mortgage fits into that equation?

Sure. I think some of the momentum coming off of 2020 is will lead to a very successful 2021 in the feed businesses. We did grow households 3% on the consumer side, and then the investments we made in the capital markets offerings over the past several years should bear fruit in 2021. So when you line up the fee categories for 2021, I expect high single-digit growth in treasury management and commercial banking, which does include the capital markets business, mid-single-digits growth in consumer deposit fees, wealth and asset management, and card and processing, and then low single-digit growth in mortgage.

Got it. So even with the strong year, given some of that, I guess it was a capacity point you made earlier about mortgage, you still think mortgage can grow this year. Is that just because you see production pulling through or do you see less of the MSR drag over time? It's maybe a little more color on the mortgage side. Thanks.

Yeah, on mortgage in the fourth quarter, there were capacity constraints, and there was the headwind from our decision to portfolio $250 million of our retail production. Those loans will close in the first quarter, and then you'll see that show up in the residential mortgage balances and held for investment. And from there, we do expect the capacity constraints to be behind us. And from an MSR perspective, this environment for servicing is certainly challenging. We expect that to abate in the second half of 2021 and all in the low single-digit growth for 2021, I think, is a very achievable number for us.

Okay, understood. Thanks a lot, Jamie.

Your next question comes from the line of Peter Winter from Red Bush Securities. Your line is open.

Good morning. I wanted to ask about capital. And if you could just go over the capacity, what's left in the existing share buyback, how much you have left. And then secondarily, if the Fed were to lift the restrictions on share buybacks? Just how you're thinking about capital returns?

Yeah, thanks for the question, Peter. In 2019, we approved $100 million share repurchase program. We have 76 million shares left under that program, so call it $2.4 billion. Right now, for 2021, you assume the Fed continues their trailing 12-month net income test, and you look at our guide on earnings, you should generate about $1 billion of capacity. assuming no additional reserve releases. And if you look at our capital from a spot basis at the end of 12-31-2020, we have about $1.2 billion of excess, even with the loan performance that we've had. So I think for 2021, should the Fed open the window, $1 billion or so. I think everything triangulates to that level.

Okay. That's helpful. And then you guys lowered the net charge off guidance from December, where December, I think it was 55 to 65. What gives you the confidence that there's nothing looming, especially with some of these means coming off deferral, assuming we don't get an additional stimulus package?

Yeah. Hey, it's Richard. Thanks for the question. I think it really comes down to the activity we have from a risk management perspective, the confidence we have in the underwriting and our portfolio management. We continue to see consumer loss rates lower than normal. We saw them lower than normal in 2020. We expect that to continue in 2021 as the impact of stimulus rolls through the portfolio. Remember, our portfolio is concentrated in prime and super prime. We have a weighted average FICO close to 760. So confidence in what's happening there from an activity standpoint. We do expect commercial losses to take up a little bit from the end of the high 40s, low 50s. And that's just going to be a function of the normal migration we see in commercial. We highlighted some potential at-risk industries today. in the deck. But we've seen criticized assets come down, as Jamie mentioned. We've seen positive resolutions in our workout group. And so just given what we see in the portfolio, where we see performance restabilization across a number of sectors, we have a lot more confidence in that range.

That's great. Thanks very much.

Your next question comes from Terry McEvoy from Stevens. Your line is open.

Hi. Good morning. Maybe start with a question for Jamie, who I guess by now we'll call the chief cook and bottle washer at Fifth Third. So a question for Jamie. You're pretty clear on kind of the securities purchases and your thoughts there on holding cash. I guess my question, are there opportunities to purchase loans like the government-guaranteed loans that you had in the fourth quarter, as well as the decision to just hold more mortgages on the balance sheet as you think about the next 12 months?

Yeah, and that's essentially what we did in the back half of 2020. In the third quarter, we repurchased our own Ginnie Mae forbearance pool for And that was about $750 million that came on our balance sheet. In the fourth quarter, we purchased a servicers pool to the tune of $2.1 billion, as well as taking the $250 million of retail production and putting it on the sheet. I think, for now, we've done a lot of work on the residential mortgage portfolio to We think the returns are incredibly attractive. I think going forward, I'd like to see, you know, the loan growth be in other categories just given the convexity risk you have in residential mortgage and that we've done enough. So that's why we expect in the first quarter to get back to selling all of our production. But, again, I think the trade that we were able to execute was a nice deployment of excess cash and certainly a far better return than just buying mortgage-backed securities. You know, I think the ROA, you know, is 2% or so on that transaction versus, you know, security purchases are, you know, probably one to sub-one right now.

Thank you. And then just as a follow-up, just looking at the CECL allowance, I'm curious, what was behind the increase in commercial mortgage and commercial construction? Other categories drifted lower. Those two were up higher quarter over quarter. I was hoping to get some insight there. Thank you.

Yeah, it's Richard again. Look, in commercial real estate, we've seen continued negative migration. That's just a portfolio in an asset class that has a longer tail in terms of when problems arise and a longer tail when they're going to be resolved. So we saw criticized assets go up in that sector. And so that plus some qualitative adjustments, because we don't believe that the models fully reflect the variables that are impacting some of these subsectors, like hospitality and retail, in terms of the time of recovery. And so just given the asset migration trends and qualitative adjustments, that drove the ACL for commercial real estate higher in the quarter. Great. Thanks again.

Your next question comes from the line of Ken Zerbe from Morgan Stanley. Your line is open.

All right. Great. Thanks. First question, just in terms of the NII guidance, I just want to make sure that the question, whether the down 3% in 2021, does that include your expectation of accelerated PPP fee income?

Yeah, thanks for the question. So we do include the $2 billion of additional 2021 PPP in our guide. I think the NII guide of down three, that trajectory could improve, I guess, to the point of the first question on the call today, you know, through higher commercial line utilization because we do assume just a small uptick in the back half of the year. And, you know, frankly, there's not much we can do about that. It's a borrower customer demand situation. A steepening yield curve benefit would also help. We anchor our guidance on the January 4th implied forward curve, so perhaps we'll do a little bit better there. And should the curve steepen significantly, then we would have opportunity to deploy excess cash. Third, with regard to the PPP, we're assuming $2 billion of originations, and perhaps that's a conservative number because, as we sit here today, we've submitted over $1 billion in apps in just the first two days. And then, finally, as Greg mentioned, perhaps there will be better commercial loan production through higher borrower demand and CapEx and inventory buildups. And from a production expectation perspective, We're expecting 2021 commercial loan production to be up about 20% or so from 2020, but still, you know, down 7% or so from 2019 levels. So our outlook assumes, you know, improvement, but not returning to a 2019 type of economy.

Got it. Okay. All right. And just my second question, Adam. I think Greg mentioned the 9.5% is your CE Tier 1 target currently, which I totally understand. But you did make a comment that you would kind of reconsider that as the economy gets better. Can you just help us dimension, like, let's assume that the economy is fully better. Like, where is a good level for the third to run on CE Tier 1?

So, prior to... some of the challenges that were cropping up in the environment, we had a 9% target. So should the economy, you know, improve as we hope it does in the back half of 2021, 9% I think is a logical next step for us. When we stress test our balance sheet, we believe our balance sheet has a risk profile that could be run in the 8.5% to 9% range. Our stress capital buffer is currently 7%, so I guess the Fed's perspective is much lower than that. But I think for us, you know, for this year, we're targeting 9.5%, and we'll evaluate that target as we see how the economy unfolds.

All right. Thank you.

Your next question comes from Bill Clarkash from Wolf Research. Your line is open.

Thank you. Good morning. We saw MacBook repricing headwinds to loan yields persist throughout the last CERB cycle, not just for Fifth Third, but across the banking system. I believe about half of your loan portfolio is variable rate and the next to the short end of the curve, but there's still some repricing you have to come through. Would you expect a similar dynamic with further pressure on loan yields to come in this CERB cycle as well? Maybe if you could just speak to that, maybe compare and contrast what's different about this cycle.

Well, I think that's a good observation, and we are experiencing that phenomenon. And we saw it in the fourth quarter, and it's a factor in our first quarter guide. Right now, from C&I production levels, just given the floating nature of the portfolio, Yields are roughly in line, maybe five bps below the current portfolio. But on the consumer side, which is more fixed-rate in nature instruments, we are seeing new production yields 25 to 35 basis points below portfolio yields. And so that is certainly a headwind in our NII outlook.

Understood. Separately, sorry if I missed this, but I wanted to ask about if you could give some color on new money rates in light of the curve steepening that we've seen. On the security side, it seems like some of the dynamics around QE have led agency MBS spreads over treasuries to turn negative, which would seem to temper some of the benefits of the steeper curve. But I was hoping that you guys could discuss some of the opportunities that you see there.

Yeah, I think it's a great question, and we're seeing a divergence in practice across the banks. Our view in terms of what the rate environment would need to progress to in order to put our excess liquidity to work is we would like to see 50 basis points or more improvement in the entry points, either through the spread widening or curve steepening process. A lot of banks, to your point, buying in on the 25 basis points of steepening or even before that, the credit spreads have tightened 10 basis points or more over that time so that the net entry point improvement to us is not that compelling. In fact, by our math, if you bought in the third quarter or even in the first couple months of the fourth quarter, you lost $2 in value for every $1 in carry you picked up over that period of time. So you still have more risk should the curve steepen further, and we don't want to be stuck in a bad trade chasing balances at what are still historically low levels of rates. So the good news for us is we are very well positioned in the investment portfolio. We have the luxury of time. Portfolio cash flows are about a billion dollars a quarter is how we're modeling it. So we just think being patient, we can afford to be patient, and we'll move when we think we are getting the appropriate risk return in the environment.

That's very helpful. Thank you for taking my questions.

Your next question comes from the line of Erica Najarian from Bank of America. Your line is open. Hi.

Good morning. My first question is a clarification question. You know, Jamie, you mentioned a billion dollars in buyback capacity for the year, but that would imply that the Fed extends its income test beyond the first quarter, correct?

Yes. Okay. $180 in the first quarter, and then any additional repurchases are certainly subject to the Fed allowing us to do so.

So if they lift the income restriction, I guess number one, what are your plans for DFAS participation this summer? And number two, where could that capacity grow to if you were not subject to that income restriction after first quarter?

So the... I'll take the second part of the question first because that's the easier one. Right now, against our target of 9.5, we have $1.2 billion of excess capital. So until the economy shows significant improvement, $1.2 billion would take us down to our target. So I think that's a fair number to use. The income test will deliver a little bit less than that. In terms of the CCAR opt-in, you know, it's funny because, again, We discussed this as a team, and we officially have until April 5th to decide. But right now, given that our binding capital constraint is our own internal target of 9.5% versus the Fed's prior stress capital buffer for us at 7% or even 7.2% in their COVID tests, should they adopt those December results in the SCB, we're And frankly, we feel like our team deserves a respite following the six stress tests we did during the pandemic. And there's essentially nothing to be gained by participating. So I think for now, if I had to decide today, I would decide not to opt in.

Got it. And just my second question is on the net charge-off outlook for this cycle. You know, should we think of that 45 to 55 basis points as your quantification of the peak, or are you accepting, you know, the spike to be delayed in 2022? I'm just trying to square that with a 2.6.5% reserve ex-PPP.

Yeah, so it's interesting. When you look at the guide for us, the 45 to 55 basis points, for the first quarter, we actually expect charge-offs to be in the 40 to 45 basis point range and grow during the year. And to your point, losses get pushed out, but we certainly expect the 45 to 55 range to be the peak, even though some of the additional stimulus are, you know, elongating the cycle. I think ultimately the peak of the cycle keeps coming down, which is why we continue to guide to a better and better number. So right now I think 45 to 55 will be the peak for us.

Got it. Thank you. Your next question comes from the line of John Pinkerry from Evercore ISI. Your line is open.

Morning. On the back to the capital topic, given your thoughts on capital and where you stand in terms of excess, can you just give us your updated thoughts on M&A potential in terms of both bank opportunities and what your thoughts are there as well as on the non-bank side?

John, that's great. Good question. as often as you might imagine. First off, we haven't changed our position. We're really focused on non-bank M&A opportunities, as evidenced by our recent acquisition of H2C that really supports our not-for-profit health care, part of our vertical. So it's really about making sure we are additive to both our products and our service capabilities for our fee-based business, whether it be wealth and asset management, our payments capability, our capital markets capability. That's what we're spending our energies right now. And then really getting out of businesses that are more hobbies, such as we talked about our property and casualty business that wasn't really providing the returns we were looking for and we couldn't get the scale. So our focus is going to continue to be on those opportunities to enhance our business value proposition and grow those feed businesses. And that's the move we've been focused on the last five years mainly. From a bank M&A perspective, it's not on our agenda right now. As always, we would assess an attractive situation, but today that's not our focus. Our focus is on non-bank M&A as to the businesses we just discussed.

Thanks, Greg. And then on that front, on the non-bank front, I know you mentioned wealth and asset management. Just to confirm, is it both areas that you'd be interested in? I know you've expressed an interest in wealth. but you would also be interested in the institutional asset management side as well?

No, not the institutional side. We're pretty much focused on, like I said, the wealth and asset management side, where we've made acquisitions like the Franklin Street Partners in North Carolina. That's pretty much our focus right now on the wealth side of business. Okay. Got it.

That's helpful. If I can ask just one more question. In terms of the securities portfolio, I just wanted to get an update on – on how the underlying credit within the securities book is holding up. I know you have a CRE concentration there in terms of CMBS. I just wanted to get an update there on what you're seeing in terms of the performance of the underlying securities, if there's any stress there evolving. Thank you.

Yeah, we're invested in about $3.5 billion of non-agency CMBS securities. And it's holding up well. The delinquency rates are mid to high single digits, but the credit enhancement right now is approaching 40%. And we only invest in the super senior AAA rated tranches so that we're at the top of the repayment stack. So we're not concerned about the credit exposure in the non-agency book. Got it.

Okay, great. Thank you.

Your next question comes from the line of Mike Mayo from Wells Fargo Securities. Your line is open.

Hi. I think I heard you correctly. So you're kind of guiding for negative operating leverage in the first half of the year and positive operating leverage in the second half of the year and kind of flattish for the year as a whole. Is that kind of a fair summary of what you guys said? Yeah. Yeah. Okay, so the question really is, on the spending, and I'm sure there's a lot of opportunities to spend money, but from the strategic landscape, you know, you have a lot of large banks that are opening up branches in some of your markets, others that are saying, you know, branch flight digital first, some are trying to use their credit cards in the markets to cross sell, others are moving kind of middle market businesses into your area. So as it relates to the kind of the competitive banking wars in your markets, how do you think about that? I mean, are you seeing any impact yet? Are you worried about that over the next five years? Is it much ado about nothing, or is this a major strategic threat? And you say, hey, we need to spend more money on X, Y, and Z.

And, Mike, let me start. This is Greg, and I'm going to throw it to Jim. This is a great question for him also. You think about the investments we're making. We still expect to run on expense basis down next year as we continue to make the strategic investments. Our strategies, and you've heard this over and over, have not changed in the last five years as far as how we're focused on our business, which is digital transformation. getting our business organic opportunities to grow our businesses, such as our fee-based businesses I just discussed a moment ago, and being added to the acquisitions. Our fintech plays that add to our products and capabilities to deliver to our customers our services. So we're going to continue to focus on that. You know, we're very competitive. You know, the household growth that we've seen at 3%, strong growth in our southeast markets. You know, we're a leader in the Chicago market. So we like those investments. So we're very comfortable in our ability to compete. We think our investment structure we have in place today allows us to continue to grow our franchise and be extremely competitive. So we're not going to change that. We're going to continue to feed the opportunity that we think creates the greatest value for our shareholders. Let me let Tim add a few.

Yeah. I mean, I think competition is always something that we watch closely. And I think I wouldn't isolate it just to the folks who are traditional financial institutions that are building into our markets. We pay a lot of attention to the fintech companies, particularly given that in some cases they are arbitraging the regulatory apparatus at the moment. in a way that creates imbalanced competition. I think the point that Greg made that to me is the most important one is we have on a sustained basis continued to gain share, even in our highest density markets, over the course of the past three or four years on primary banking relationships, which we view as being the best measure of market share because the decisions you make on pricing a deposit product or where you dominate headquarter deposits or otherwise have a big impact on the FDIC numbers that you sometimes see people use on a period-to-period basis. So the strong household growth we have seen across the franchise, in particular in focused markets like Chicago and the Southeast, as Greg mentioned, on the consumer side of the business, and the strong core relationship growth that we continue to see out of our middle market franchises are things that give us confidence in our ability to continue to compete.

So you say 3% household growth over what time frame? And that's an interesting way to think about it because what you're making for a household is depressed from a below-rate environment. the 3% household growth over the past year or what timeframe?

Yeah, it's 3% household growth over the past year. But if you were to look at our growth in prior years, it would have been in the 2% to 3% range quite steadily. So we've actually seen some acceleration driven both by the build-out in the southeast and the growth rates for our Chicago market post-MV have been among the strongest in the franchise and definitely far stronger than we had seen in Chicago when we were fifth third on the standalone basis. All right, thank you.

Your next question comes in line of Saul Martinez from UBS. Your line is open.

Hey, good morning. Thanks for taking my question. I wanted to follow up on Erica's comments and questions. It seems to me like your reserve ratios are just completely inconsistent with your charge-off guidance. Your NCO of 50 basis points at the midpoint you know, at the peak of the cycle does seem to be suggesting that, you know, the government has effectively played the role of superhero and prevented a credit cycle from really even emerging. And your reserves are about five times that. And I would guess your weighted average remaining life is about five years. And that, you know, that doesn't even consider that your NCO rates are going to fall from here. So can you just help me, you know, bridge the gap on, you know, your reserve levels relative to to your charge-offs because the conclusion would be, you know, would seem to me to be that you're making, you know, an ample level of qualitative adjustments or your probability weighting downside scenarios pretty conservatively and that we should be thinking that it's pretty likely you're going to see pretty significant reserve releases, you know, coming in the coming quarters.

Yeah, it's a very good question, and the answer really comes down to the fact that the modeling of the ACL is based on the Moody's hypothetical scenario, and that's frankly why we included that in the prepared remarks so everybody would have that information. It is certainly a scenario that is – One, the base scenario is more conservative than our own outlook. And two, does include a 20% allocation to a downside scenario that obviously we don't expect to happen. So by its very nature, delivers an ACL reserve that would be higher than our expectations for losses in this environment.

So is your model factoring in net charge-offs that are higher than what you're guiding to in 2021?

Well, the reserve calculation is a three-year for us, a three-year reasonable and supportable period, and then it reverts back over the remaining years to your historical loss rates, whereas our guide is our internal modeling over the next 12 months. So you can have differences in that given the different scenarios that are used.

Yeah. I don't want to belabor this, but, like, if you're saying that this is the peak and your reserve is five times that, it just seems hard to disconnect the two to that degree. It just seems like there is a hard time to square away there.

Yeah, I think to your question, it's if the outlook – continues to improve, all other things being equal, the reserve will come down and should come down. Our point is we remain conservatively positioned and prudently positioned given the uncertainty in the environment, and we'd like to get through another three to six months and see how this unfolds with vaccine efficacy and the economy turnaround. I think that's really important.

It's a good problem to have. Go ahead.

Sorry. No, this is a conversation, Greg. This is a conversation, obviously, that's on the forefront of how we think about our business. But we are taking a conservative approach. We do want to wait and see over the next couple of quarters how this vaccine plays out, how the commie plays out. I mean, you're exactly right. You know, if you look at what we've got modeled versus what our expectations are, we can simply get upside for reserve releases as we go into a lot of part of this year, if things play out as we expect they would.

Okay. Just as a quick additional question on expenses, just make sure I'm getting the glide path right here. You know, based on your full year and your first quarter expenses, it would seem like at the midpoint of the range, you're factoring in about $1.1 billion a quarter of expenses from 2Q to 4Q. And, you know, I guess you get there in 2Q with most of the way there with the seasonal expenses going away. But, I mean, is it fair to say, like, how do we think about that glide path, and should we be thinking that by fourth quarter as some of these expense initiatives filter through, you could be even below that $1.1 billion run rate as you head into 2022?

Yeah, it's a good observation. We do have a higher run rate in the first quarter, and due to the seasonal items that we typically have and what I've discussed in the prepared remarks. And, yes, when you model it out, 1.1 is a fairly good run rate to assume given the revenue projections. If the growth ends up being better than the 3% to 4% and expenses, obviously revenue would be higher. But for our outlook, you are exactly right. And then the benefit is, that we might have in the fourth quarter is to the extent our lean process automation and other initiatives pay off sooner than the 2022 time horizon, then you could see some additional improvement in the fourth quarter. But for now, we're expecting 100 to 150 million of savings to occur in 2022 and not in 2021. Got it. Okay. Thank you very much.

Your next question comes from the line of Gerard Cassidy from RBC. Your line is open.

Good morning, Greg. Good morning, Jamie. Good morning. Hi, Gerard.

Coming back to loan loss reserves, when you take a look at your loan loss reserve on January 1st, when the CECL was put into place for you and your peers, I think your loan loss reserve was about 180 basis points lower Clearly, obviously, it's higher. There you go. Clearly, it's higher today. Do you think ultimately, I don't know if it's 22 or 23, but is that a good endpoint that we should look at in terms of, you know, when this whole COVID issue is behind us? And as the second part of this whole world loss reserving, what's your guys' view on CECL now that we've had it for a year? I know it was a very tumultuous year, but do you think it's made it more volatile, less volatile? In terms of the 182 and, you know, the day one level, we spend a lot of time looking at that as to, you know, when should we or if, we ever should return back to that day one 182 basis points. And right now, our current thinking is that in order to get there, it's going to be measured a lot longer than several quarters, because we're going to exit this crisis with corporate debt levels, leverage levels significantly higher coming out than they were going in. And the way the modeling works, you would have to have an economic outlook as good as the outlook was, essentially, in 4Q of 19. And that might be hard to ever get back to, at least in the next couple of years. So I think the bias for all of our reserves across the industry is probably to take a longer period of time. And ultimately, if you said, you know, take a guess as to where that plays out over the next two years or at the end of two years from now, would you be at your day one? I'd say we probably are over that number because of the corporate debt levels and because the economic outlook is probably not as favorable as the 4Q19 outlook was when we adopted CECL. Got it.

In terms of volatility, absolutely yes. I mean, given the CECL methodology and and going into a stressed environment, you saw the huge, huge swings that we're dealing with right now, but also the justice necessary to release those reserves. The models haven't been tuned for this. No one modeled in a pandemic. These are new models, so there's a lot of qualitative adjustments to these models that, you know, with their burdens to the uncertainty in front of us right now. So it does definitely make some more balls, of course.

No doubt. Greg, here's a bigger picture question for you.

When you go down the elevator in the evening, the outlook for the banking industry, including Fifth Third, is positioned very well, assuming that the economy recovers as we all think it will. Bank stock prices, as you know from your own stock price since the Pfizer announcement right after the election, has been fantastic. What do you see as the – you know, everything is hopefully going to shape out real well this year, but what are the risks that you worry about when you go down that elevator at night?

You know, first off, good question. I think we're well positioned to be competitive in the markets that we're in. The investments that we've made I think are aligned with our long-term growth expectations and success of our business. So I feel really good about how we're competing today. The challenge always is when we're watching these fintech players come forward, not to same regulatory oversight that we're dealing with, capital expectations and so forth. So there's a threat there that we're kind of watching. If they get access to the banking system, payment rails and so forth, that could create some stress for us that I'm very concerned about. But as far as our investments in fintech entities themselves, the investments that we're making, I'm comfortable with, it's really those fintech players out there that aren't under the same regulatory framework that we are, hurting some stress for us, nipping around the edges of our profit pools, and maybe shifting some customer behavior. So that's probably the thing that keeps me up most of the night. As far as competing against other banks, I think we've done all the right things to do that. and we have been on what it looks like to compete against some of these other nontraditional bank players. To that end, that's why we've made significant investments in our digital capabilities and really created a digital bank ourselves. All of our lending products are online available, lots of our products are online, service capabilities, and we've made huge investments in our digital capabilities to make sure we're well-positioned to deal with this type of threat. Great. Thank you, Greg. Thanks.

Your last question comes from Christopher Maranac from Jay Montgomery. Scott, your line is open.

Thanks, Greg. Just leveraging off of your last answer to Gerard, do you see FinTech acquisitions as a necessary item in the future, or do you just want to be a good customer of these companies?

You know, I think, once again, we've been either a partner or acquirer of FinTech acquisitions. Once again, it gets back into our strategy, whether it's buy, partner, then build. So we always want to focus on the technology and capabilities already out there. It fits into our strategic plan. direction with respect to how we're going to offer, how we're going to offer it, you know, and what the opportunity looks like from a growth perspective, we'd like to buy that capability if it's already there. It's a quick way to get to the market. If we can't do that, you've watched us do numerous fintech partnerships to allow us to get the capabilities through that type of relationship. If we can't do that, you've watched us build and build those capabilities. And that's really been our mindset over the last decade with respect to how we handle fintechs or how we address those opportunities. Great.

Thanks very much, and thanks for all the information this morning. Thank you. Take care.

If there are no further questions at this time, Mr. Dollar, I turn the call back over to you.

Thank you, Melissa, and thank you all for your interest in Fifth Third.

If you have any follow-up questions, please contact the IR department, and we will be happy to assist you.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.