Ladies and gentlemen, thank you for standing by, and welcome to the Q3 2021 Midland States Bancorp Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions]. I would now like to turn the call over to your host, Tony Rossi of Financial Profiles. You may begin.

Thank you, Kevin. Good morning everyone and thank you for joining us today for the Midland States Bancorp third quarter 2021 earnings call. Joining us from Midland’s management team are Jeff Ludwig, President and Chief Executive Officer; and Eric Lemke, Chief Financial Officer. We will be using a slide presentation as part of our discussion this morning. If you have not done so already, please visit the Webcast and Presentations page at Midland’s Investor Relations website to download a copy of the presentation. Before we begin, I'd like to remind you that this conference call contains forward-looking statements with respect to the future performance and financial condition of Midland States Bancorp, that involve risks and uncertainties, including those related to the impact of the COVID-19 pandemic. Various factors could cause actual results to be materially different from any future results expressed or implied by such forward-looking statements. These factors are discussed in the company’s SEC filings, which are available on the company’s website. The company disclaims any obligation to update any forward-looking statements made during the call. Additionally, management may refer to non-GAAP measures which are intended to supplement but not substitute for the most directly comparable GAAP measures. The press release available on the website contains the financial and other quantitative information to be discussed today, as well as the reconciliation of the GAAP to non-GAAP measures. And with that, I’d like to turn the call over to Jeff. Jeff?

Good morning, everyone. Welcome to the Midland States earnings call. Before we begin today, I have some sad news to share. Last week, we lost a beloved member of the Midland family when Leon Holschbach, our former President and CEO passed away after a long battle with ALS. Besides being the driving force of an unprecedented period of growth that turned Midland into one of the largest community banks in Illinois, Leon was a great friend and mentor to so many of us at the company. His energy, enthusiasm and hard help build the Midland culture that serves as our foundation today. We were fortunate to have him as a friend and a colleague, and he will be deeply missed. Now, moving to our usually prepared remarks. I'm going to start on Slide 3, with the highlights of the third quarter. We executed well and delivered a strong quarter, driven by positive trends across most areas of our operation. Everything that we have been working on over the past couple of years from adding more banking talent to streamlining our cost structure, to optimizing our funding sources is generating the desired results. We are seeing stronger, more diversified loan growth, a decline in our cost of funds and an increase in our net interest margin, higher levels of reoccurring fee income and improving efficiencies. All of this combined to produce another strong quarter of earnings. We generated net income of $19.5 million or $0.86 per diluted share. And our core earnings power continued to improve as our adjusted pretax pre-provision income was $28.4 million in the third quarter, an increase of 5.2% from the prior quarter. Throughout this year, we have talked about our progress in adding new commercial banking talent, particularly in higher growth markets in Northern Illinois and…

Thanks, Jeff. I'm starting on Slide 6, and we'll take a look at our loan portfolio. Our total loans increased approximately $80 million from the end of the prior quarter. This was due to the higher level of commercial loan production that Jeff previously discussed, as well as a $51 million increase in period end balances on commercial FHA warehouse lines, growth in the equipment finance portfolio, and an increase in consumer loans. The growth in these areas offset the continued forgiveness of PPP loans, as well as continued runoff in the residential real estate portfolio due to refinancing activity. While period end balances were higher on commercial FHA warehouse credit lines, average balances were lower than in the prior quarter. At September 30, our balances of PPP loans were down to $82 million. Excluding PPP loans, commercial warehouse credit lines, and consumer loans added through the GreenSky partnership, our total loans increased at an annualized rate of 6%, which reflects our improved ability to generate growth in commercial and commercial real estate loans. On Slide 7, we've provided an update on our equipment finance portfolio. As of September 30th, we had just $9 million of deferrals, which represents a decline of 74% since the end of the last quarter, we continue to see a steady recovery of our borrowers in the transit and ground transportation industry as the trends in business and recreational travel continue to improve. We've also seen more borrowers return to schedule payments, as well as others that remain on deferral, making some form of partial payment. 88% of the borrowers on deferral in this portfolio are now making a partial payment. On Slide 8, we've provided an overview of our hotel/motel portfolio. As September 30, we had just $7 million of loan deferrals in this…

Alright, thanks Eric. We'll wrap up on Slide 18 with a few comments on our outlook. I want to begin by providing some information about how we expect to be impacted by Goldman Sachs’ pending acquisition of GreenSky. We've had ongoing discussions with GreenSky. And at this point, we expect that new loan originations through the GreenSky partnership will continue through the second or third quarter of 2022, which will enable us to keep outstanding balances in this portfolio relatively stable over that period. After the new loan originations, and we expect the portfolio to decline by $400 million to $450 million during the following 12 months. Based on traditional repayment trends, we would expect the remainder of the portfolio to run off over the next few years after that. Although, we weren't anticipating an end to the GreenSky relationship, the work we have done in other areas over the past couple of years to improve our business development capabilities has put us in a better position to be able to offset the runoff of this portfolio. This includes the additions we have made and will continue to make to our commercial banking team, further expansion of our equipment finance group, the build out of our SBA lending business and the upcoming launch of a consumer loan origination portal on our digital banking platform. And we'll evaluate other fintech partnership opportunities as well, although nothing that would represent the same type of volume as the GreenSky program. Through the contributions that we think we can get from all of these other areas, we believe we'll be able to offset the impact of the GreenSky runoff. And when that process is complete, we'll have a more diversified loan portfolio, comprised of more full banking relationships that generate both loans and core…

[Operator Instructions]. Our first question comes from Terry McEvoy from Stephens.

A question on the reserve. The GreenSky portfolio, given the strong credit profile, there was a 25 basis point reserve. And as you think about, Jeff, all the areas that you mentioned in terms of future growth, how is that going to impact the reserve ratio? And should we build in maybe some incrementally higher provisions in the latter part of next year, as part of the balance sheet transformation you ran through?

Yes. I think that's right as we sort of -- as GreenSky rolls out and we put more commercial real estate loans on the books, we are going to increase from 25 basis points, so 1% or more than 1%. So, yes, we would expect that we'll be recording some provision as we get into next year.

Okay. And then, the servicing deposits, the $400 million that came in the fourth quarter. As we think about next year, how much volatility would you expect to see within those deposits, given the elevated levels that you have today?

As it relates to servicing deposits, for the most part, they're fairly stable. There is a little volatility in it as loans are being rate modified. And so, there is some movement in deposits. But usually it’s, we take on more deposits in a short period of time, and then they'll come back. So, that sort of $400 million is sort of -- it's probably a baseline number. And at times it might be quite a bit higher than that. And sometimes it'd be at the end of the quarter and sometimes it'd be during the middle of the quarter. But I think that that's sort of a baseline that we think is going to stay. And then from there it will incrementally grow as their business grows and there'll be a little up and down, as they’re processing business.

Thanks. And then maybe one last question, if I could, for Eric. The FHLB pre-prepayment, could you just run through that data again in terms of the size of the FHLB advance, maybe what the interest rate was, and then the prepayment penalty and what you'd expect to save in terms of just interest expense going forward.

Yes. Terry, I'd be happy to. So we unwound $130 million of FHLB advances, $80 million of those were longer term advances that carried rates just to tick over a 2.5%. The other $50 million was a shorter term advance that was matched with the interest rate swap that we unwound as well and took a gain on. So when you look at the total $130 million, the interest expense going forward to save will be approximately $2.2 million annually. And then the prepayment penalty was $4.9 million, which was offset by the gain on the swap of $1.8 million.

Our next question comes from Michael Perito with KBW.

Hey, good morning. Sorry to hear about Leon, Jeff. I have a lot of good memories from the IPO and coming out of Effingham and I'm sure you do as well. So sorry to hear the loss. I wanted to spend a minute on the GreenSky partnership. So it sounds like you guys will have more time to replace the loans than I originally expected, which is great. Gives you guys some more flexibility there, but I apologize if I missed it. Can you maybe just walk through the yield impact, where the GreenSky loan yields generally were and where you expect releasing your term, most of the CRE that's going to replace it to kind of come on?

Yes. So the GreenSky portfolio is sort of between 350 and 375-ish, something like that. And it depends on the mix of the portfolio at any period of time, but sort of in that range. And I would say commercial real estate is coming in probably a little -- on average a little bit less than that. I don’t see a big difference in top-line yields.

And you mentioned kind of potentially pursuing other partner -- fintech partnerships to generate some volume, obviously nothing to the magnitude that GreenSky was. But just curious if you could give us some more parameters around what types of products interest you have? Is this largely going to be something more in the consumer arena, again, to kind of diversify the portfolio or is there other areas that you are looking at? Just would love any more thoughts or color you have that you’re willing to share?

Yes, so you know, more on the consumer side. As I sort of reflect back on the last 18 months and look at how that GreenSky portfolio performed, in some tough times it's performed very well. And I think having some diversification in consumer in a good way where we have some credit enhancements. So these programs that we're looking at also have some level of credit enhancements to help. Sort of not have one sort of large partnership with one company, but maybe a couple, do a few partnerships with some companies that we'll do business with, that isn't going to -- that'd be a sort of a quarter to 1/3 of where were at with GreenSky.

And then the -- just the margin impact of all this. I mean, I think the -- correct me if I'm wrong, Eric. The core NIM is like 317, I think in the third quarter. You're bringing on almost 0.5 billion of deposits from Dwight. That sound like they're going to go into securities at least initially, or most of it, and then over 18 months period, you have call it $0.5 billion or 350 to 375 loans that sound like you could actually replace fairly close, but certainly, maybe slightly below with the CRE production. So, I mean, is it fair to think of your NIM on a core basis likely being -- I don't want to say depressed, but I guess for lack of a better word, somewhat depressed for the next five quarters here until that captive Dwight fund has been a little bit more efficiently deployed and you guys have had a year or so to replace some of the lost GreenSky loans?

Yes. Mike, I think that's right. So I kind of think about our NIM ex-PPP as like that 324 number. And I think over the next couple of quarters with this influx in liquidity, we're going to see some compression on that number, somewhere between probably 10 basis points and 15 basis points as we -- and then see some upside maybe a year from now as we put some of that cash to work and continue to grow out the loan portfolio. But yes, in the short term from that 324 number ex-PPP, I think we'll see some pressure in that 10 basis point to 15 basis point range.

[Operator Instruction] Our next question comes from Nathan Race with Piper Sandler

A question just on kind of loan growth outlook maybe a little further out. Once the GreenSky loans start running off in the back half of next year, and with the pieces that you've put in place on the commercial bank side of things and within some other segments as well over the last several quarters, how are you guys kind of thinking about just net growth in the back half of next year? And again, I don't mean to get too far front of us, but maybe as you think about into 2023 as well, should we expect some growth or is the GreenSky runoff headwind going to be a challenge in that -- those may be flat it down a couple of years out from today?

Yes. We think we have a lot of good things going. That runoff isn't going to start until back part of next year. So the good thing is we've got almost a year to work, and we've laid a lot of good groundwork to sort of hopefully offset that runoff. So I think in the short term, we're going to be able to see some loan growth, because we've got good commercial pipelines and the GreenSky portfolio is going to be sort of get-hold at about the same level. So, I think we will see loan growth in the next year. And as we get to the back part of the year, as the GreenSky portfolio runs off, I'm not sure we're going to be able to match the runoff. So, I think the loan balances are going to go up, and then they're going to start to migrate down a little bit as we move into early '23, because the GreenSky runoff is going to be -- it's pretty quick, like $400 million in a year, $450 million. There is a lot of money to get to work. So, I do think, there will be some loan balance pressure in that first -- sort of first year, sometime in late '23 to late '24. Then the -- actually the GreenSky portfolio begins to sort of slow their -- the slowdown begins and we will sort of go out for another two, three years before it will all run away. So, that's the period of time that we are going to begin to build today to then hopefully hold that as steady as we can for that period of time. It will be challenging, because it's a pretty big number.

Right. Got it. Really helpful. I appreciate that, Jeff. And perhaps just turning to capital, would love to just get some updated commentary just in terms of the priorities. Obviously, you guys were active on the buyback in the quarter, which makes sense, just given the decline in evaluations during the quarter. But as you kind of sit here today, based on what you're seeing in terms of acquisition opportunities, either on the whole bank side of things or on additional platforms to supplement what you guys have, perhaps on the wealth side of things, would just love to get some updated commentary in terms of how you guys are thinking about excess capital, which I imagine should continue to build over the next few quarters here, at least, and kind of where the priorities shake out today?

Yes. I mean, our priority is to build our capital ratios, with the caveat that, if our stocks trade at evaluation where we can get one or less than a one year earn back, we are going to use some of our current quarter earnings to buy some stock back, sort of what we did in the sort of third quarter, make roughly $20 million, with dividend out 6, we bought 5 back. We retained 10. If our stock starts to trade at a better evaluation, we will not be buying our stock back. We'll retain all. And then we’ll continue to look for, I'll say, smaller sort of easy integration opportunities, such as ATG, right? And maybe it's not in the wealth space, maybe it’s in another business of ours. But really sort of small, sort of add-ons that are nice little add-ons, they don’t create a lot of disruption in the company. I'll say, over the last two years, not having M&A on the table has really helped us focus on running, I think, a better business, building pipelines and building a company that can grow organically, not just through M&A. And so, if we can get that done, which I think we're through, we're through all the building now it's sort of, let's continue building and watch some of the fruits of the labor and a company that has a lot of expertise on the buying side, I think it's a great combination as we get into like '23.

Definitely. And I apologize if you guys touched on this, but in terms of the outlook for having to provide for some growth as the GreenSky book runs off, starting in the middle part of next year, I guess what's kind of the outlook for charge-offs within that context in terms of the reserve trajectory going forward?

I mean, I think we would expect charge-offs to be anywhere from 10 basis points to 20 basis points is sort of where I would project charge-offs in, right? That's hard to do. And we're trending -- that number is trending in the right direction.

I’m showing no further questions at this time. I’d like to turn the call back to management for any closing remarks.

Thanks for joining everyone. We had a really, really solid quarter and look forward to speaking with everybody next quarter. Thanks.

Ladies and gentlemen, this concludes today’s presentation. You may now disconnect and have a wonderful day.