Associated Banc-Corp

Good afternoon, everyone, and welcome to Associated Bank Corps' second quarter 2020 earnings conference call. My name is Devin, and I will be your operator today. At this time, all participants are in a listen-only mode. We will be conducting a question-and-answer session at the end of today's conference. Copies of the slides that will be referenced during the call are available on the company's website at investor.associatedbank.com. As a reminder, this conference call is being recorded. As outlined on slide one, during the course of discussion today, management may make statements that constitute projections, expectations, beliefs, or similar forward-looking statements. Associated actual results could differ materially from the results anticipated or projected in any such forward-looking statements. Additional detailed information concerning the important factors that could cause associated actual results to differ materially from the information discussed today is readily available on the SEC website in the Risk Factor section of Associated's most recent Form 10-K and subsequent SEC filings. These factors are incorporated herein by reference. For a reconciliation of the non-GAAP financial measures to the GAAP financial measures mentioned in the conference call, please refer to page 23 on the slide presentation and to page 10 on the press release financial tables. Following today's presentation, instructions will be given for a question and answer session. At this time, I would like to turn the conference over to Philip Flynn, President and CEO, for opening remarks. Please go ahead, sir.

Thanks, and welcome to our second quarter 2020 earnings call. Joining me today are Chris Niles, our Chief Financial Officer, and Pat Ahern, our Chief Credit Officer. Associated had an unusual but successful second quarter. I'm proud of how my thousands of colleagues have responded to the challenges. We focused on protecting the health of our customers and colleagues while meeting the needs of our customers. We met those needs with PPP loans, payment deferrals, fee waivers, and the distribution of stimulus funds. We ensured our ability to meet the future needs of our communities and customers with a significant increase in our capital through the sale of associated benefits and risk consulting and a preferred stock issuance. We've seen record inflows of deposits and have abundant liquidity. With the revenue challenge brought on by near-zero interest rates, we managed our expenses down. While no one could predict the ultimate impact of the COVID pandemic on credit, we saw some encouraging early signs from our borrowers. So let's look at our financial results. Turning to slide two, our second quarter GAAP earnings were $0.94 per share, including the $163 million gain on sale of associated benefits and risk consulting. Average loans grew considerably during the quarter, largely driven by PPP loans and commercial line draws. Loan funding, along with government stimulus programs and overall increased savings rates, led to higher deposit balances as well. Our loan-to-deposit ratio was 94% at the end of the quarter, 90% without PPP, and 61% of our total deposits were made up of low-cost deposits. While we haven't seen significant changes in credit metrics yet, our reserve for loan losses increased $35 million during the second quarter, and as of June 30th, our allowance to loan ratio was 1.73% or 1.8%, excluding PPP loans. The sale of ABRC and the issuance of $100 million of preferred stock lifted our capital ratios, CET1 increased 89 basis points from the first quarter to 10.25. Our tangible book value per share also increased, moving up 11% from last quarter to $16.21. Average loan balance trends are shown on slide 3. Commercial and business lending grew nearly $1.7 billion, driven predominantly by PPP loans, an active mortgage warehouse market, and increased draws on general commercial lines of credit. While we saw unusually high commercial line draws at the end of the first quarter, as the second quarter progressed, these lines paid down. Growth in CRE was primarily driven by new loans plus continued funding of construction loans. On average, residential mortgages declined during the second quarter as we continued to sell new production and some portfolio loans to the agencies. Turning to slide four, we show end-of-period loan trends, which will highlight second quarter activity. We ended the second quarter with $24.8 billion of loans, a net increase of $467 million from the first quarter. Included in these balances was over $1 billion of outstanding PPP loans. This was partially offset by $559 million of paydowns on general commercial lines during the quarter. We view the repayment of these lines as a sign our customers have a more optimistic outlook regarding their liquidity than they did at the end of the first quarter. As previously mentioned, our commercial real estate portfolios continued to grow during the quarter. At quarter end, we still had nearly $2 billion of unfunded commitments which we expect will continue to fund up over the balance of 2020 and into 2021. We expect to continue to grow our commercial real estate balances over the course of the year. Turning to slide five, let's look at our portfolio composition at the end of the second quarter. In the second column, we identified our key COVID loan exposures, which I'll highlight on the next page. We've also broken out our deferred loans and our non-accrual loans, which remain minimal. As the pandemic's impact on the economy expanded during the second quarter, we responded to our customers' needs by underwriting PPP loans and by deferring and modifying certain loans as shown on slide five. Approximately 35% of key COVID commercial loan exposures have received a modification or deferral, 19% received a PPP loan, and 4% received both. Now let's look at our key COVID commercial loan exposures on slide six. This is an update of the slide we introduced in the first quarter. We continue to monitor risks in the loan portfolio. The table on slide six details our exposures to several categories of commercial loans potentially impacted by COVID-19 and lower hydrocarbon prices. The $2.2 billion represents less than 9% of outstanding loans at the end of the second quarter. Making up 5% of our loan book, retailers and retail commercial real estate remain our largest area of exposure. $664 million of these loans are to retail real estate, of which the majority is collateralized by malls, shopping centers, and non-grocery store anchored strip centers. These loans had an average loan-to-value ratio of approximately 57% at origination, providing a significant cushion for potential deterioration. We would highlight amongst our retail-oriented REITs, which are predominantly investment-grade credits, balances paid down about 54 million from last quarter to about 400 million. Oil and gas loans also declined 35 million from last quarter and account for 1.7% of our loan balances. In the second quarter, we grew reserves further on this portfolio. Despite the price of oil creeping back up from the first quarter, we still remain concerned about the outlook for this industry. Outside retail and oil and gas, our remaining exposure is limited. Hotels and restaurants are our next largest portfolios, and each of these categories represent less than 1% of total loans. Overall, we believe our exposure to COVID-affected industries remains manageable. We're seeing positive dynamics, and our exposures remain relatively unchanged quarter over quarter. Now let me comment on our COVID relief efforts for our commercial customers highlighted on slide 7. At June 30, we had just over $820 million of completed commercial loan deferrals. The loan deferrals included $638 million of commercial real estate, primarily comprising the hotel and retailer borrowers, representing about 11% of the commercial real estate loan book. Commercial and business lending had $184 million of deferrals, or about 2% of that book. New commercial loan deferral requests slowed as the quarter progressed, and many customers with deferrals ending in June have not asked for additional assistance. Our consumer-related COVID relief efforts are highlighted on slide 8. We finished the second quarter with $725 million of consumer loan deferrals, or 8% of the total residential and consumer loan book. New deferral requests have slowed substantially since the peak in May and have essentially ceased since the latter half of June. We also supported many of our customers with waived or refunded fees during the pandemic. Since implementing our COVID-19 relief program, we've refunded or waived nearly $2 million in fees for consumers and small businesses through June 30. Turning to slide nine, early signs are positive. as many customers who receive payment deferrals are returning to normal payment structures. Despite having been granted payment waivers, about 27% of consumers with completed loan deferrals have made at least one subsequent payment. In corporate banking and small business, $46 million of loan deferrals ended during June, and of those, over 90% of customers are expected to resume making payments. Based on early discussions, we expect nearly all of the remaining customers with deferrals in corporate banking and small business to return to making payments. Commercial real estate had $116 million in loan deferrals expire during June. About half of those customers are expected to start making payments again. The other half, consisting either of hotels or retail properties, have requested further extensions. Of the additional loans on deferral, we expect about one-third of these customers to require some form of assistance, with the majority being in the hotel sector. Turning to slide 10, you can see we have built reserves by about $35 million during the second quarter. This brings our total allowance to $429 million at the end of June. Our reserve covers 1.7% of total loans or 1.8%, excluding PPP loans. We've modeled our reserves against the June Moody's baseline with our own qualitative overlays. Additional reserves were set aside for certain industries affected by the COVID-19 pandemic. Reserves on COVID-affected loans covered 6.2% of loan balances compared to about 1.4% for non-COVID-affected loans. As you can see, the bulk of our reserve build is attributed to commercial real estate and oil and gas. During the quarter, we built up our CRE reserves by $27 million reflecting the increased risk profile we see in our retail and hotel portfolios. Additional reserves were also built up on oil and gas loans, which increased by $6 million and now cover 19.4% of the portfolio. Turning to slide 11, you can see our credit metrics have drifted up slightly but remain fairly stable. Potential problem loans increased $73 million, driven by General C&I, and commercial real estate within the key COVID commercial loan exposures portfolio. Non-accrual loans increased 35 million, but are only slightly elevated over the second quarter of 2019. 21 million of the increase came from oil and gas, with most of the rest coming from commercial real estate. Our net charge-offs continue to be almost exclusively in the oil and gas space. Our oil and gas reserve increased 273 basis points from last quarter, The loans in this portfolio are all shared with other banks, and our high level of reserves reflects a conservative view of the ultimate outcome for some of these credits as we wind down the business. Turning to slide 12, average deposits were up nearly 1.9 billion or 8% over the first quarter. Most of this growth came from low-cost, non-interest-bearing checking accounts and savings accounts. Deposits remained elevated due to PPP loans staying in accounts, government stimulus money, and generally higher savings rates amongst consumers. Our low-cost deposit mix continues to improve as these balances made up 61% of overall deposits at the end of the second quarter. Turning to slide 13, second quarter net interest income was $190 million, and year-to-date margin came in at 2.66%. Pressure on the margin is being driven by asset yield compression relative to our ability to reduce liability costs as a result of the Fed cutting rates to near zero. Total cost of interest-bearing deposits dropped to 25 basis points in June as we reduced pricing across the board. While second quarter NIM declined 35 basis points from the first quarter, we expect NIM to stabilize in Q3 and recover somewhat in Q4. Total interest-bearing liabilities fell to 57 basis points in June, driven by the remix of our deposit base and interest rate reductions. Turning to slide 14, second quarter non-interest income came in at $254 million. The mortgage business remains active, resulting in an increase of $6 million from the first quarter. Gross mortgage banking income was $20 million, offset by $8 million of MSR impairment, resulting in $12 million of net mortgage banking income. We saw a decline in service charges and deposit account fees during the second quarter of about 4 million, driven by less customer and economic activity during Q2. We expect activity to recover as we go through the year. The gain on sale of assets was 157 million during the quarter. We've further broken that down on the next slide. We closed the sale of ABRC on June 30th. The sale resulted in 266 million of proceeds and a gap gain of $163 million after personnel and transaction costs were accounted for. The net after-tax gain was $104 million, and second quarter earnings per share, excluding the gain, was $0.26. Separately, we recognized about $6 million in losses on non-AVRC-related write-downs. The bulk of this was driven by the write-down of an equity interest in a company related to a restructured oil and gas loan. Turning to slide 16, we look at our customer activity. Branch activity has slowly started to come back since April. However, customers have moved away from using the lobby and continue to use the drive-thrus. Prior to COVID, about 65% of transactions took place in the lobby, but this has shifted to only 30% as of late. Customers are also resuming normal spending levels as debit and credit card spend increased 23% from April to June. During the COVID outbreak, we've seen a strong shift to mobile banking. Even with branch lobbies reopening, active mobile application users have increased 15% from January to June. This is a positive trend, which we feel will provide efficiency opportunities in the long run. On slide 17, you can see our continuing downward trend of expenses. Total non-interest expense was 183 million, down 9 million from the first quarter. The decrease in expense was spread across several categories. Personnel expense was down 3 million due to lower benefits. Fringe and equity plan expenses partially offset by higher commissions. Occupancy was down 2 million since we weren't plowing snow. Business development and advertising were down 2 million as we had less business travel and marketing activity during the quarter. As shown on slide 18, our regulatory capital levels remain strong. The sale of ABRC added 41 basis points to our CET1 ratio and 27 basis points to our TCE ratio. Overall, CET1 increased to 10.25 from 9.36 in the first quarter. Our tangible common equity ratio also increased to 7.25, up from 6.9 in Q1. As I mentioned, tangible book value per share is now $16.21, up 11% from the first quarter. We expect capital to continue to build through the remainder of 2020. Finally, on slide 19, we discuss our outlook, which includes several updated items. We expect our margin to stabilize in Q3 and to improve in Q4 as we see PPP loans pay down. For the full year, we expect our margin to come in between 255 and 2.6%. This assumes the pay down of our PPP loans in Q4 and early 21. Mortgage banking will continue to be elevated in Q3, and service charges will start to return to normal levels as COVID-related fee waivers have expired and consumer activity continues to pick up. Our quarterly expense run rate is expected to be about $175 million due to $15 million in quarterly expense reductions from the sale of ABRC. With an outlook for low rates stretching through next year, We're currently taking a look at our expense base beyond our current guidance, and we'll have more to discuss later this quarter. Based on our expected view of economic activity within our footprint, we anticipate loan loss provisions over the second half of the year to be less than they were in the first half. And with that, we'd be happy to answer your questions.

At this time, we will be conducting a question-and-answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation zone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up the handset before pressing the star keys. One moment, please, as we poll for questions. Our first question comes to the line of John Ashbrook with RBC. Please, speak with your question.

Hey, thanks. Good afternoon. Big picture question first, Phil. You talked about encouraging early trends, and then I think another comment, you said positive dynamics. Are you just referring to some of the branch count and consumer type activity that you highlighted, or are you talking about something else, some more activity and optimism with your commercial book and commercial real estate book?

Well, it's several things, John. So certainly the fact that debit and credit card usage has trended up pretty dramatically here over the last month or so is encouraging. But in particular, as we look at the 90-day deferrals that we gave at the start of all this, which were starting to expire in June and will continue to expire this month and next month, Most of those borrowers who got deferrals are going back to making payments, which is very encouraging. Now, we're still waiting on the consumers who we gave six-month deferrals to, but more than a quarter of them, even though they had deferrals, have been making payments. So as we launched into this unusual situation of granting deferrals and waivers, we're We didn't really know what to expect as we got to the back end of that, and we're certainly gratified that these customers are able to resume their normal payments.

And on oil and gas, I hate to bring it up because we don't have time to talk about it. Go ahead. Fine. It feels like with your reserve levels, some of the charges you've taken, gotta be close to the end of the pain on this in terms of at least impacting the quarterly provision and the quarterly run rate. What would need to change to make it worse in your mind?

Yeah, it's a good question. If you look at the level of reserves we have, in addition to the charge-offs we've taken against the book that remains, we've got this portfolio marked at about 66 cents on the dollar, roughly. It's been interesting this last week, as other banks have reported, there's a real divergence of views on what's going to happen here. We had one peer bank make the decision to sell the large bulk of their energy portfolio and their reserve secured loans at a very significant discount, but not outside of where we have our bookmarked. And we had another peer bank which has much, much lower reserves against a much larger book, expressing a lot of optimism as we go through the summer end of the fall redetermination period. So there's really a wide spectrum of views on how all of this is going to turn out amongst banks, and we think it's been prudent as we've been marking this book down, taking charges, reserving substantially against it. We should be very well positioned to your point, to get through this without a hell of a lot more pain. It's been bad enough as it has been, but I think we're in a pretty decent spot with the mark that we have today.

And then just one last one. I'll take a shot at it, but Q3 provision, I know it's hard to project it, but what would be kind of the key drivers to your model, assuming... you know, the economy is relatively stable in terms of, you know, driving the need for more, you know, call it economic factor reserve building.

Yeah, so you heard us express that, you know, based on our assumptions, we think that back half of the year provisioning will be less than the first half, and that's based upon economic activity continuing as it is today. and not having to experience, you know, a widespread shutdown of economies in our footprint. So absent that, we feel pretty comfortable with the guidance that we provided.

I know it's tough, but all right. Thanks, guys. I appreciate it.

Yep. Our next question comes from the line of Scott Cypress with Piper Sandler. Please do with your question.

Good afternoon, guys. Thanks for taking the question. I wanted to ask one on the margin. You noted stability, which is definitely good, and then the expectation for some recovery in the fourth quarter. I'm gathering that that's based on the expectation for forgiveness of people the PPP loans, or at least a portion of them, and the accelerated fee that you get there. How much of the notion of recovery in the margin of the fourth quarter is indeed based on that, and what would happen to the margin X, any acceleration of PPP fees?

Sure. So as we mentioned on slide 19, we do expect PPP to pay down mostly in Q4 and then into early 2021. And on page four of the press release tables, we show you the remaining unamortized PPP fee balance. So you can track it with us, but we're saying mostly in Q4, so just half or more, and then the balance over the 2021. So you can sort of back into the rough number. I would note our guidance, I think when we had spoken probably back in May, we thought it would stay above 260, but obviously since then, the PPP program has been basically extended out, right? So instead of beginning to realize some of that in the Q3 period and then the rest of it in Q4 and less in 2021, we've had to push that out, which is why our margin has trended a little lower from our guidance perspective.

Yep. Okay, and I guess what I'm getting at is just sort of the steady state margin. Do you think it's – I know we think it's stable in the third quarter, but presumably outside of PPP, would that continue? In other words, have we kind of reached a bottom for the margin?

Well, I would say the bottom is going to be hit in Q3, right? So on a month-to-month basis, June was a little worse than May, and it probably trends a little lower in July. and then it starts to bounce up, right? So, you know, it'll find its absolute floor in Q3, probably not too far below where we are, but pretty close, but it's going to stabilize, and then we expect it to bounce up as we move through the balance of the year. And the two factors there are, you know, in Q4, the PPP pickup, but also we're seeing spreads beginning to widen, right? So we'll find our floor probably here in July, right? and it'll start moving back higher as we move through the rest of the year on spread widening and the PPP.

And we've got our CDs, which will continue to roll off and grind lower, so there'll be some structural reduction of our liability costs just as longer-dated deposits mature and get repriced.

And we note, you know, I think we show you the average... yield for the deposits was 28 basis points, and if you look at the slides, you'll see the number for June was 25, so that the overall interest-bearing deposit cost, CDs, and money market and checking continues to grind lower as well, which is why, again, we'll hit bottom here in July, it feels like, and then start moving higher from there.

So even without PPP, we'd be trending about where we're hitting now, and maybe a little bit up as liabilities repress.

Yeah, perfect. Okay. That's what I was getting at, so I appreciate that color. And then, final one, just on the mortgage expectation, where you note your expectation for elevated mortgage revenues, are you guys thinking about that on the basis of the $12 million reported mortgage line, or are you sort of thinking about it X the MSR, so like up from a base closer to $20 million?

Yeah, so we've got... As we sit here right now, still have a $1.6 billion pipeline of mortgages to work through. So that's the highest it's been in two years as we sit here today. Forecasting MSR impairment is always difficult because you've got to pick a rate on a day. But one would hope we wouldn't see an impairment like we saw today. at the end of the second quarter. So we would be working off more of the $20 million number than the $12 million number, hopefully. We'll see. Now it's just such a figure in the air and lifted.

That's as good a forecast as any in the mortgage business. Perfect. I appreciate your guys' thoughts.

Our next question comes from the line of Ibrahim Kunawala with Bank of America. Please, do your question.

Good afternoon, guys. Good afternoon, Ibrahim. I just want to follow up, Phil, in your response to John around this customer activity. Talk to us in terms of what it looks like in the markets. We've clearly seen an uptick in cases, lockdowns in certain parts of the country. Just when you think about your customers, your footprint, How do things look today relative to April, May? Have you seen kind of a negative move in the last few weeks, or are you seeing steady return to normalcy? Just any color would be helpful.

Yeah, so, you know, rightly or wrongly, Wisconsin continues to have activity, even though our COVID infection rates are as high or higher than they've been. just because of, as you will recall, the Supreme Court threw out the government's ability to control much. So economic activity in Wisconsin continues and is, you know, reasonably robust. And then, you know, Minnesota is somewhere in between here and Illinois because Chicago is still relatively locked down. So we've got kind of a wide spectrum there. But, you know, our forecast is that things will – continue as they are across the footprint and perhaps, you know, a little more activity down in Chicago will lend itself to the assumptions that we made when we said, you know, provisioning is going to be less in the back half. Go ahead, Chris.

I might just add, you know, if you look at the June unemployment rates data, if you look at sort of the coasts, you'll find, you know, unfortunately places in the teens But if you look at Wisconsin and Minnesota, you're looking at eight-handle unemployment. So there is a pretty strong difference between the activity levels on the coast versus the upper Midwest.

Well, that's helpful. Go ahead.

No, I was going to say, in Minnesota and Wisconsin are the core of our market and exposure and activity and customer bases, of course.

Understood. Understood. And I guess just moving to slide 16, and maybe this will be a few quarters out, but I think you were very thoughtful in terms of how you brought down expenses coming out of the last crisis. As you now think about just the change in customer behavior, the digital adoption, how are you thinking about what this means for further rationalizing the branch footprint, the efficiency opportunities down the road?

Yeah, so as I mentioned, we are taking a look at the expense base and applying some of the learnings that we've had from this, particularly this work-from-home environment. So we've got a number of initiatives underway internally to figure out what work looks like for us as we go through the rest of the COVID period and thereafter. We're still operating from home. We don't have people in our corporate offices. I mean, Chris and Brian and I are sitting here, and there's probably 20 people when there's normally 500 people in here. And we don't have any big plans to bring a bunch of people back, and the fact of the matter is the company's operating just fine. We're processing a massive mortgage refi boom, and all of that is going into our thinking about how we reduce our expense run rate going forward beyond what what we've just guided. So we'll have more information as we get into the quarter as we continue to work on this. There's also obviously opportunities to think about how we're serving customers. The mobile pickup, the online pickup, the fact that even now that we've opened our branches, people now are much more likely to go through the drive-thru than come into the lobby. presents a lot of different opportunities to think about how the model works going forward, and we're thinking through all that right now, Ibrahim.

Ibrahim Hamdi- Good afternoon. Thanks for taking my questions.

Our next question comes from the line of Terry McAvoy with Stevens. Please state your question.

Terry McAvoy Hi. Good afternoon. Good afternoon, Terry. The CET capital up to 10.25% following the sale, and you said earlier capital should grow in the second half of this year. My question is, do you have a targeted capital level? We used to talk about that in the past, and the reason I ask is that if we look out into 21, is it appropriate to think about buyback activities, kind of think about putting them into our models if we're assuming a return to more normal credit trends?

Yeah, it's a little bit early to forecast that. Right now, more capital is better, given the uncertainties that are out there. We've said that we're not going to buy back shares the balance of the year, and as we get toward year end and we see what credit looks like and we see where our capital ratios sit, we'll obviously take a look at that. But certainly as we sit today, having... You know, significantly more capital, having a larger tangible book value, and being awash in liquidity are good things.

Okay. And then as a follow-up question, in the first quarter, the reserve build was mostly CNI, and then as I look at the second quarter, it was mostly CRE. So when you think about the back half of this year and the prospects of incremental building, do you think it will be heavily weighted towards one or the other, or more of an even split?

My guess is that I don't know exactly how far it's gonna build, to tell you the truth. You know, because I think as we get toward the back half of the year, I would think some of the oil and gas stuff will resolve itself one way or the other, although we're well-reserved against that, so one wouldn't think that we'll have a lot of provisioning to do. But if I had to guess, you know, I don't think outside of oil and gas we have a lot of stress in the commercial space. So if we're going to build, I'm guessing it'll be the retail-oriented commercial real estate, whether it's retailers directly or retail tenants in properties. That's probably where we would see it.

Great. Thanks, Phil. Thanks, Chris.

Yep.

Thanks. Our next question comes from the line of Chris McGrady with KVW. Please do with your question.

Great. Thanks for the question. Chris, maybe going back to the interest income for a second, I want to ask the margin question a little bit different. If we fast forward six months and the PPP is behind us, how do we think about stability and ultimate growth in core and interest income, given the outlook for growth, a little bit more on the deposit replacing and the full effect of loan yields?

Yeah, so again, I would say on the end, a couple of things, right? So on the loan side, We have a margin on most commercial credits, as you can see from the tables, that is approaching, effectively, the margin floor. So, effectively, when we hit in Q3 here, you know, why was that zero? So basically what we're earning is the quote-unquote quoted spread to the customer is effectively the floor. So that's gonna hit that floor. And the good news is, from our contractual structure, We've got LIBOR zero floors in there, so it's not going to go lower. And so on the loan side, we're kind of hitting the floor in July, and as we roll over, renew, and add new, we're getting a little bit more spread with each of those actions, so we assume our spreads will widen a little bit as we move forward. As Phil pointed out, you've got a back book of CDs that's going to roll and continue to roll down. So as we look at our total deposit book, again, our cost was 28 basis points for the quarter. but the CDE book was at 144. Well, that's generally one year and in. If you look at our maturity detail that we disclose in our call reports, you'll see that. So essentially that's going to roll off and come down towards that 25 basis points. So that's a real dollar savings that will just come in over the next 12 months and a lot of that in the next six months. So you're going to see a roll that's going to be beneficial. And we'll continue to work on other liability levers, and that's sort of on the core just loan and deposit side. And then the PPP, we think, again, will be a positive that pops in Q4 now and then into Q1. So all of that together says we should see core improving as we move through the year plus PPP.

And then to answer your question on NII, Chris, we've got a significant backlog of CRE, which will be funded up through this period of time well into next year. That's going to help. We've got a residential mortgage boom. And we can choose whether we're going to sell some of that onto the agencies or perhaps portfolio some of it. We're thinking through that at the moment. So we could get some growth there on NII. Commercial is a little harder to forecast right now. There's just not a lot of new activity going on. People aren't out looking to change their banks. But, you know, assuming the economy continues along this path and slowly improves and we would expect to start to see some commercial loan growth, too, as we get farther into the year and into next year. So I think with cost of funds continuing to grind down, funding up on CRE, perhaps resi mortgage, and then hopefully on commercial, you know, we should start to see some consistent growth in NII as we get later into the year and then into next year.

That's very helpful. Thank you. If I could just ask one more on the deferral program. Can you speak to what you might do different in round two, if there are round twos, in terms of re-underwriting the borrower that needs a little bit more help?

Thanks. Yeah, so it's going to be very dependent upon the borrower's circumstances. So, for example, in the hotel space, which is very small for us, we've got... you know, a couple of customers who have substantial outside resources and so we're hopeful there that, you know, we'll be able to stretch out some of those loans and get through this period of time until they get their occupancy back up. The retailer stuff is highly dependent upon, you know, how people come back to retail stores. But early indications, again, are pretty good since people are generally getting through their deferral period and starting to pay. And, again, a lot of our loans, bulk of our loans, have substantial guarantors behind them as well. So, you know, the initial... push, you know, what the pandemic was. If someone needs a deferral, we'll give it to them. But as we come up to that initial 90 days rolling off in June and going forward, these are turning into, let's have a serious discussion about what it looks like. And we've been, I don't know if the word is surprise, but we've been pleased with the response that we've been getting. That's why we have a general sense of optimism at this point about it.

Great, thank you. And Chris, could you just repeat the fees? I was looking quickly through the deck. I didn't see it. The remaining PPP fees?

Yep. It's in the press release table. Sorry, Chris, if I wasn't clear. It's on page four, and it's in the middle of the page, and it says payment protection program fees net, and there's $24 million at the end of June that have not yet been amortized in.

All right, awesome. Thank you. Our final question comes from Michael Young with SunTrust. Please do with your question.

Hey, thanks for taking the question. I wanted to maybe just follow up on the commercial construction book. It looks like there's about a 4.5% reserve there. Is that just an abundance of caution or should we read that to mean that, you know, what's in that construction book is maybe more, you know, in a higher risk segment, maybe retail or hotel, et cetera?

Look, I think our CECL methodology borrowed heavily from our experiences in the last downturn and over time. So construction loans have, during downturns, been where people have taken larger hits in the past, and our CECL methodology necessarily sort of looks at the last couple of recessions and factors that in. So, you know, that's partly the issue. and I think it was high on day one. As you can see, it was one of the larger buckets where we increased our reserves on day one, and it continues high because in both Associated Bank's own experience and in the industry's experience, that's where when things go, you know, if the construction projects stop, there's usually pain for all involved, and if the environment shifts on you as people are completing projects, the amount of time they may sit unutilized or underutilized causes sometimes more challenges than other projects that are already occupied or completed. So that's just good practice to have a little more reserves in that bucket.

And Michael did, to just give you a little color on what's in there, 62% of... Loan production this year, which is mostly funding up this stuff, is in either industrial or multifamily. Very, very little in the retail space, which, of course, would be the riskiest space.

Okay, that's helpful. And maybe just a follow-up on the capital commentary, Chris. You made the comment that you expect capital to continue to build. I guess I'm just trying to level set that against, you know, potential increases in, you know, non-performing assets as we move forward through the crisis. You know, at what point do you think the risk weightings on those will increase and maybe offset some of the capital build that's occurring naturally?

Yeah, so I think there's a couple of things to keep in mind. So we are assuming that a good portion of the PPP balances come off. So that's a billion dollars. And even if only half of it comes off, and we're certainly thinking most of it does by the end of the year, that means our tangible assets are going to come down by more than half a billion off that top. which means the tangible common equity ratio will just naturally drift higher. In addition, as Phil mentioned, we're looking at lending that likely is looking reasonable to add to volumes before the end of the year. So, again, there will probably be a slight positive, but not enough to offset the more than half billion of PPP that will come off. So we'll have a net improvement just because the balance sheet effectively shrinks. That will have less of an impact on the risk-weighted assets because what we'll be adding will be real commercial CRE, 100% risk-weighted stuff, and what's coming off is the zero risk-weighted stuff, but we expect to earn our dividend and more over the course of the back half of the year, and so therefore we'll have capital accretion and net balance sheet shrinkage, which will contribute to higher capital ratios as we move forward.

Okay, perfect. And one last just clarification. Just on the effective tax rate for the year, you know, 26% this quarter, so that gets me to a pretty low tax rate in the back half of the year. I just wanted to make sure I was thinking about that correctly.

Yep, and we've guided that we think that it's going to be less than 18%. It's kind of a quirk of the way you need to account for the sale. So we recognize the sale this quarter, so we have to sort of fully tax it at the full marginal rate. And because some of the ABRC acquisitions in the past were tax-free acquisitions, we didn't have tax basis in them the way we have on other deals. So the tax rate on that deal was a little bit higher than normal. But as we move through the course of the year, you have to average out to a normalized full-year tax rate, and so it will just naturally come down over the subsequent quarters, and you'll see the overall we expect to be something less than 18%.

Thanks. A call for me. We do have one final question coming from the line of Jared Shaw with Wells Fargo. Please do with your question.

Hi, good afternoon. This is actually Timor Braziler filling in for Jared. Two quick questions for me. One on the CRE growth this quarter. I guess where are you seeing the incremental demand for CRE now? And I guess is that Are those industries where you're seeing demand today, is that kind of where you're expecting growth to come in for the rest of the year as well?

Yeah, so the growth you're seeing is generally construction loans funding up and construction loans that have completed, stabilized, and flipped over into the investor bucket. So this is stuff that was mostly originated a year ago. There isn't a lot of new origination going on anywhere, as you would expect. And the bulk of it, as I told Michael just a minute ago, is in the industrial and multifamily space.

Okay, got it. And then just as you look at the second round of deferral requests, will you be asking the borrower for something in exchange for that second round of deferrals, whether it's a guarantee or increased collateral, anything like that?

It completely depends upon the circumstances, but generally, yes. Got it.

Okay, thank you.

Yep.

There are no further questions left in the queue, and I would like to turn the call back over to Mr. Phillip Flynn for the closing remarks.

Okay, great. Well, we appreciate you all joining us today, and we look forward to talking to you again in October. As always, if you have any questions, give us a call, and as always, thank you for your interest in Associated.

This concludes today's teleconference. You may now disconnect your lines at this time. Thank you for your participation, and have a wonderful day.