Ladies and gentlemen, thank you for standing by, and welcome to the Quarter 3 2020 Live Oak Bancshares, Inc. Earnings Conference Call. [Operator Instructions]. I would now like to hand the conference over to your speaker today, Greg Seward, General Counsel. Thank you. Please go ahead.

Thank you, and good morning, everyone. Welcome to Live Oak's Third Quarter 2020 Earnings Conference Call. We are webcasting live over the Internet, and this call is being recorded. To access the call over the Internet and review the presentation materials and commentary that we will reference on the call, please visit our website at investor.liveoakbank.com and go to today's call on our event calendar for supporting materials. Our third quarter earnings release is also available on our website. Before we get started, I would like to caution you that we may make forward-looking statements during today's call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from our expectations are detailed in the materials accompanying this call and in our SEC filings. We do not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of today's call. Information about any non-GAAP financial measures referenced, including a reconciliation of those measures to GAAP measures, can also be found in our SEC filings and in the presentation materials and commentary. I will now turn the call over to Chip Mahan, our Chairman and Chief Executive Officer.

Thanks, Greg. Good morning, all. Slide 3. We are extremely excited about talking about the best quarter in our company's history. We acknowledge, as Chris Donat from Sandler Piper noted in his report this morning, that Live Oak is a complicated story. And we're going to attempt to unpack that for you now. Headlines. We're hitting on all cylinders. Margins up, originations all-time high, loan sale prices at or near all-time highs, fintech investments raising money at frothy valuations, even got a break on the servicing asset [indiscernible] and with all this production, Huntley was able to keep expenses in check. What could possibly go wrong? Everyone knows that small business in America, the 28 million small businesses in America, create 66% of the new jobs, and they're struggling. Many of you that hold bank stocks are worried about the small business portfolio. The object of this exercise today is we want to create the most transparent bank in the United States relative to showing you the quality of our loan portfolio and the capital that stands behind it. So let's get going. Next slide. You've seen this one before. Capital at the end of the quarter, $532 million, fair mark and loan loss reserve allowance for credit losses, it is these days of $62 million gets you to about a 26% capital ratio adjusted compared to $2.3 billion of unguaranteed paper. I'm happy to report that our guaranteed loan portfolio grew from about $1.1 billion to about $1.7 billion. And with this frothy secondary market, that is worth about $155 million pretax, to put another arrow in our quiver. I guess the third thing I'd like to show you on this slide is the past dues, like, they're not any. This had to do with the SBA subsidy in…

Sounds good. We have a couple of slides on some of the fintech investments, both in the context of Live Oak Ventures and Canopy. Chip, you've mentioned the right place, right time, right model, I'd probably add right tech to that. We are finally live with the deposits platform after 5 years in the shop. And this is really exciting because it's the new tech stack aperture of the next-gen onboarding system, Finxact, as a next-gen core, all validated, API first. Huntley is going to talk more about this, but a shout out to [indiscernible] as you've been more than patient on this particular topic. Relative to Live Oak Ventures, look, we've been really excited to get some write-ups based upon some of the recent valuations. This should be seen as precious non-dilutive Tier 1 capital to the bank. When Live Oak Bank decides to upstream into the holding company and then downstream into the bank, there are some significant advantages there. The most notable this quarter, obviously, is Greenlight, where we took a $13.7 million mark to the good. If you recall, we invested $3 million in 2018 in the Series A and $2 million in 2019 in the B. And Greenlight continues to perform at record levels. As you know, these are debit cards for kids, but it's a mission-based theme, where it's really helping families with financial literacy. On to Canapi, as you guys know, Canapi is the successor of Live Oak Ventures, and it really allows us to invest at scale. I mean, given it's a $600 million fintech fund powered by banks as limited partners. We've been super busy in quarter 3 as well. And as you all know, it's a highly competitive market and evaluations are frothy. Even still, we won 3 deals against…

Great. Thanks, Neil. We'll turn to Page 19. To say it's been a challenging year for everybody would be a massive understatement, and especially for small business owners. In the face of everything that was going on this year, Live Oaks, roughly 600 people accomplished some pretty amazing things in the third quarter, just like we did in the second quarter when the PPP program was live. Our focus throughout the year has been constant, that of our customers, our employees, the communities that we're in and then supporting small businesses with our personal service, our capital and our technology. While we've all been affected by events of this year, we're exceptionally proud of how the dedication of our people, the commitment to our industries and our brand have resonated across small businesses. Hopefully, we've all gotten a chance to review our earnings release. And Brett, CFO, highlights, and as Chip said, it's a really strong quarter financially across the board. On pages 20 and 21, we'll try to unpack some of the headline numbers and all of these are adjusted for PPP, both the loans and the excess liquidity to give a bit more view into the core. We'll run through these relatively quickly and then get into some more details on subsequent slides. So as Chip said, our loan portfolio grew $600 million in the quarter, driven by our origination as well as slower prepayment speeds across the portfolio. Total assets were relatively flat as we were able to redeploy a substantial amount of the excess liquidity we stockpiled earlier this year. We enjoyed a really strong capital build, driven by our core earnings plus the fintech activities and as the PPP earnings flow into capital as well with our capital ratios, as you can see there, increasing…

[Operator Instructions]. First question comes from the line of Jennifer Demba.

Congratulations on a good quarter and congrats on the deposit platform. You gave a lot of good information in those slides and in your commentary. I want to start with the hotel loan sale, what brought you to do that? And will there be more sales in future periods?

Yes. Steve Smits, our Chief Credit Officer is here, and I think you can describe it best, Steve. Give that a shot.

Yes. So Jennifer, this is Steve Smits. I'll start, and certainly, Chip, you can add some additional thoughts from your perspective. To start with, clearly one of our most impacted industries. Chip talked about the COVID-6. And for us, really, it's the COVID-5. If we look at our portfolio, hotels being at the top. And really, we had to look at it as not necessarily that we were expecting to take an immediate loss. However, the administrative burden to work these loans through to the other side is a consideration that we thought about. There were certainly many of them very highly likely to go to nonaccrual before they got better. That would be an impact. And the need for us to hire additional special assets personnel to focus on this portfolio was a reality, possible dealing with litigations and bankruptcies and other things. So it was a multiyear administrative burden that we had to pair that against just taking some risk off the table so that we could focus on the rest of the portfolio. And that really was a driver in the decision, is really looking at the long-term burden to get them through to the other side and the cost to do that. And we were in a fortunate position where it made sense that we could take that off so we could focus on the rest of the portfolio.

Yes, I think that's right. I think it's offense and defense, Jennifer. I mean, we have so many arrows in our capital quiver that just to sit here and slug it out for three years with those $55 million worth of loan. There's no doubt we would have gotten that money back, but better focus on offense and defense and having we -- just because we could, we had the ability to do so. And we will do that again in the future, if necessary.

I also think that the secondary market was incredibly strong. And I think we were pleasantly surprised with the levels that we were seeing on these properties and that factored into it as well. But I think we're not actively out marketing a bunch of other assets in the portfolio, but we'll be opportunistic to manage risk, as Steve said.

Very helpful. Chip, I know we -- no one here really knows what's going to happen. But do you have any guess as what your net charge-off levels could look like over the next 2 to 4 quarters based on the level of economic activity we see today?

So I'll turn that on you Jennifer. If you can tell me exactly what's going to happen in Washington, D.C. relative to what they're talking about now to help small business then we can probably tell you that. But the answer is we just don't know. I mean, I would say that are we reasonably confident that something is around the corner for Small Business America, particularly those that have been affected, have 0 revenues in some cases. I mean, I think there's probably more help on the way there. But as I said in one slide earlier, we're going to operate this bank as if there's going to be nothing else, and they will make those decisions at the time. But I just don't have a clue.

Okay. One more question, expenses. Huntley, you said probably need more staff. So what kind of expense trends should we see over the next 2 or 3 quarters? Are there full expenses coming up in terms of accruals or whatever?

Yes. And I can turn this over to Brett for some details. But on the people front, it's really -- we're seeing more loan activity than I think we ever could have anticipated at this time. And so you think about loan closures and underwriters, things like that, that's really where we're seeing the need for some additional people. So that will have a modest impact on the total number. But I don't think there's anything major accruals up or down that we're expecting on the expense side. And so I think it will creep up modestly over the next couple of quarters, but we're going to fight hard to keep it pretty flat if we can. Brett, anything you want to add to that?

Maybe the only thing I would add is, I think you've seen us -- and we've communicated or shown in actuals in the past when we take on various initiatives such as SBA general lending and nonuser expenses that have a future payoff. And this quarter, specifically, using that same example, I can see through the loan originations by the FDA generalists, how that initial investment paid off. So maybe to Huntley's point on adding NIE for staffing, et cetera. As we see opportunity, I think one great thing we've done is invested in those, and it does have future returns. So there could be modest increases there, quarterly.

The next question comes from the line of Chris Donat from Piper Sandler.

I had nothing to say, but I really do. Anyway, looking at Slide 10 and the originations, as we think going forward, and I realize it's kind of like the net charge-off question of if we can tell you what's going on in Washington, then maybe you could tell us what's going on with originations. But if I think about scenarios where nothing happens, should we expect originations to be sort of like what they were pre pandemic? Or do you now have with the deposit platform and the liquidity on your balance sheet and the -- assuming the secondary markets where it is, an opportunity to really be meaningfully above where you were with originations pre pandemic?

Yes. As I said a minute earlier, Chris, our pipeline is at an all-time high, right? Trying to be somewhat conservative. Do we have the players on the field today that could originate on an ongoing basis, $2.5 billion plus, maybe as much as $3 billion on an annual basis? I would say the answer to that is probably yes. I'd be loathed to predict anything higher than that.

We are seeing opportunities right now that six months ago, we weren't seeing, right, very clearly where competition has pulled back in places. And so we continue to see that. I think how long that lasts is an open question as well. We will run hard as long as we see it and continue to have some of these businesses mature, that will help support that. But feels good right now, and we'll continue. But to chip's point, I think those numbers are good in terms of what we can visibly see.

Okay. And then just with the 6-month P&I program with the SBA, assuming we don't see anything like that again. I mean, I thought I heard a comment from chip that, that was like 1/3 of originations was sort of to take advantage of that deadline? Or did I mishear that one?

Yes. I think that's probably right. I mean, if you didn't have that, I mean, we would not have done $1 billion. But we probably would have done $600 million or $700 million in the quarter [indiscernible].

Yes, I think that's fair. Look, the majority of our origination benefited from that, right, which is great because it will support the borrower. But how many loans would have not happened without that subsidy, I think, is probably closer to 1/3 or less. Most or all of the customers had the opportunity to expand business acquisition, et cetera, and it was a nice to have, not a have to have. So that's the right way to think about it.

Well, and we took some business away from conventional lenders because when the borrower did the math, on an SBA loan at a higher rate, then he came with us because of the P&I payments. And that would be a onetime situation as well.

Okay. And what I just want to ask one more on compensation. I think you've been pretty clear on the creeping up part, but is there any benefit you have from say, the investments you had made in launching the deposit program, do you have some expenses that drop-off in that regard? Or should I think about you is you've got to like you're in the early stages here with the deposit platform. And now you have a lot of other things you want to add to it so there will be continued expenses with that?

No, that's a great question. The benefits that we'll see happen at deposit conversion, let's call that first part of next year. And then ultimately, loan conversion, which will take a little more time. And those will be relatively modest actually, just given we don't have the scale of units, right, that some really big banks do, but it will be meaningful. But really, to your point, is about growth, it's about new product development. So we'll likely reinvest that of savings in continued products. So I don't think you'll see a big move either way as it relates to technology spend over the next 12 to 18 months.

Well, they would be [indiscernible]. In other words, we have a number of people that were doing a lot of things to get us at this point, and that job will be done. Then on the other hand, if you think about 100-and-whatever we have on the lending side, right, we may have not that, but a whole lot of folks on the deposit side, calling on practice management software companies generate new relationships that we have been talking about now for years. And now it's around the corner.

Next question comes from the line of Ammar Samma from Raymond James.

Congrats on a very good quarter. So maybe starting on the all-in reserve coverage. It was down to about 2.66 from the 3.09 last quarter. Can you talk a little bit about the underlying unemployment and GDP forecast in your model and then maybe just your overall comfort with the reserve at these levels moving forward?

So this is Steve Smits, Chief Credit Officer. So I'll start. First of all, my confidence in our strategy, very confident. And talk a little bit about unemployment. You hit on a metric that's very important to our model for our general reserves and a reminder, that we heavily reserved in the early half of this year. We've seen some improvements in the forecast for unemployment. That impacts our model. Also, I'll point out, if you reflect on the slide that chip discussed on our stress measures, that is important because we used that strategy to put a mark on the level of that -- flows right into our model for what we're preserving against. So we are taking a micro loan level. So we're very fortunate in that we have a very robust servicing platform. It bodes very well in environments like today with uncertainties. So we reach out to every single borrower on a loan level. We place the mark based on their level of stress based and some very specific challenges that they may be finding. And that rolls into a qualitative factor that we plug into our provisioning model. And that correlates very closely to what we're seeing in unemployment. So that gives me confidence that it's doing what we expected to do.

Okay. Great. And then maybe a bigger picture, follow-up question. Has the pandemic opened up any opportunities to maybe lend in new verticals? Maybe remind us of the process behind entering a new vertical? And are there any plans in the pipeline right now?

So a great question. Look, in terms of new verticals, we do analysis, we research around the market, the credit characteristics, and then importantly, the market structure. So are there referral sources, influencers, experts, et cetera, how can we have somebody either in-house or that we're very close to with that expertise in that industry to help us drive success? And we really, I think, hit the pause button on that for the last several quarters as we've had a lot of them that were maturing, and we wanted to sort of see that through. I think that the -- what has COVID done and has it opened up anything, we look at our verticals, and I think some of them have more opportunity, either because of less competition or because of the market they're in. So I think we sort of like the breadth of what we have our generalists and our sponsors are seeing some transactions in certain sub industries that may be taking place as a result as well, see a little more technology, a little more services stuff. But overall, I think we really like the footprint that we have and some are growing. The diversification of that allows some to thrive a little more than others in this time.

There are no further questions at this time. Mr. Chip Mahan, please continue.

Yes. We thank everyone for joining us today, and look forward to seeing you 90 days from today.