Texas Capital Bancshares Inc
NASDAQ:TCBI
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Texas Capital Bancshares Inc
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Good afternoon, and welcome to the Texas Capital Bancshares' Second Quarter 2019 Earnings Conference Call. All participants will be in listen-only mode during the presentation. Please note, this event is being recorded. [Operator Instructions]
At this time, I will turn the call over to Heather Worley, Director of Investor Relations. Please go ahead.
Good afternoon, and thank you for joining us for the TCBI second quarter 2019 earnings conference call. I'm Heather Worley, Director of Investor Relations.
Before we begin, please be aware that this call will include forward-looking statements that are based on our current expectations of the future results or events. Forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from these statements. Our forward-looking statements are as of the date of this call, and we do not assume any obligation to update or revise them. Statements made on this call should be considered together with the cautionary statements and other information contained in today's earnings release, our most recent annual report on Form 10-K and in subsequent filings with the SEC.
Our speakers for the call today are Keith Cargill, President and CEO; and Julie Anderson, CFO. At the conclusion of our prepared remarks, our operator, Andrea, will facilitate a question-and-answer session.
And, now, I will turn the call over to Keith to begin on Slide 3 of the webcast. Keith?
Thank you, Heather. Let's begin with Slide 3. The extraordinary volume we drove in the mortgage warehouse produced strong net income for Q2, despite the effect on NIM. Average mortgage warehouse loans increased 43% from Q1 to Q2. Average mortgage finance loans, including MCA, increased 35% from Q1 2019 and we're up 49% from Q2 2018.
Due to a continued imbalance in risk versus reward, which our bankers are facing in the core LHI market, we are gratified to have such a strong market leading position in mortgage finance, allowing us to generate solid net income with excellent credit supported by strong controls. The exceptional mortgage finance results also served to offset the continued intentional reduction in leveraged lending loans as we focus on strengthening our overall loan portfolio.
Net revenue increased 1% from Q1 2019 and was up 8% from Q2 2018. Non-interest expense, similarly, increased 1% from Q1 and 7% from Q2 2018. Net charge-offs to average total LHI of 0.34% from Q2, increase from 0.09% in Q1 2019 and decreased from 0.73% for Q2 2018. Non-accrual loans to total LHI of 0.47% was down from 0.57% in Q1 2019, an increase from 0.37% in Q2 2018.
On Slide 4, we summarized the breakdown of the energy loan portfolio and C&I leveraged loan portfolio. Energy loans make up approximately 6% of total loans or $1.6 billion as compared to 7% and $1.7 billion, respectively, at the end of Q1 2019. Year-over-year energy loans did not grow. Non-accrual energy loans were $61.1 million in Q2 2019 versus $76.7 million in Q1 2019. Allocated reserves for energy totaled $49.4 million or 3% of outstanding energy loans.
Moving to C&I leveraged loans, we saw a decline of $164.2 million or 13% from the end of 2018. We are on track for an expected 30% reduction for the full year. Non-accruals for leveraged loans were $25 million at Q2 2019 as compared to $30.6 million in Q1 2019. Allocated reserves of $67.5 million amount to approximately 6% of outstanding C&I leveraged loans. We have no significant industry concentration in the portfolio. Also, one of the two leveraged loans of greatest concern last quarter has markedly improved and we are encouraged that the other loan has improved prospects as the sponsor continues to provide support.
On Slide 5, we present a profile of our mortgage finance, LHI business. As you can see on the lower left quadrant of the slide, the efficiency of this business is outstanding, and even more significant in seasonally strong quarters like Q2. The bottom right quadrant shows the combined yield when including fees. The returns are higher still when associated deposits are included.
This business is especially valuable for us at times like the present, when we find ourselves late in the economic cycle with overly aggressive credit and pricing terms being offered for most other LHI loan categories. The scalability and low credit risk for mortgage finance enables us to deliver strong earnings with limited late cycle credit risk. Julie?
Thanks, Keith. My comments will cover Slide 6 through 13. Our reported NIM decreased 32 basis points from the first quarter with 21 basis points related to the earning assets shift, specifically mortgage finance and liquidity. Traditional LHI yields were down nine basis points from the first quarter, resulting from the decline in LIBOR in anticipation of a fed rate cut.
These were slightly lower in the second quarter as compared to the first quarter, but only accounted for one basis point of the declines. Our anticipated mix and pace of loan growth for the remainder of the year will likely result in lower fee levels than we've experienced in the past.
Mortgage warehouse yields were down 19 basis points on a linked-quarter basis. The decline is not related to any shift in competitive pressures, but rather resulted from volume pricing that was already in place. The increased volumes are very positive to net revenue, which includes interest spread as well as a non-interest income component.
MCA yields were down 40 basis points, which was expected with actual mortgage rates down in excess of 60 basis points since the first of the year. There is some lag as we generally hold loans 60 to 120 days, which means we will see further decline in the yield with more recent reduction. We're very pleased with the linked-quarter increase in average total deposit with growth and interest-bearing as well as non-Interest-bearing.
Our overall deposit costs decreased by four basis points from 133 basis points in the first quarter to 129 basis points in the second quarter. The decrease resulted from good growth in DDAs. As previously discussed, with no rate increases, our index deposits remained flat and with a fed decrease they will move down just as they moved up with the [indiscernible] there were continued solid deposit pipeline with some of the verticals getting traction. We expect to be able to discuss more details later in the year.
During the second quarter, we did increase traditional brokered CDs by approximately $500 million as part of the expected surge in mortgage finance. We have a total of approximately $2.1 billion at June 30th. As we previously communicated, while verticals ramp up, we're comfortable using brokered CDs as needed when pricing is more favorable than some of our higher cost funding.
We would expect to see a small movement in NIM for the remainder of the year, if the fed moves down 25 basis points in July. As you know, over 20% of our deposits are linked to fed rates, so that would offset the decreases we're already experiencing on the loan side as those have been repricing those LIBOR moves ahead of the fed. Obviously, how LIBOR reacts after a July cut would have a direct effect on NIM as well, as loan yields will move as LIBOR move. I'll discuss rate impacts in more detail later in my comments.
We had a slight reduction in average traditional LHI during the quarter and that was consistent with the runoff in our leveraged loan portfolio as well as some decline in energy. Traditional LHI average balances down -- were down 1% from the first quarter and up 6% from this time last year. The level of payoffs continues to be high, primarily in CRE, where we're continuing to replace runoff with fundings on existing commitments and new originations. In contrast, the C&I leverage runoff is not being backfilled. We would expect payoffs and C&I leverage to pick up during the remainder of the year.
We had a very strong average total mortgage finance balances driven by the seasonally strong quarter, which was even stronger with lower mortgage rate. Average balances were up from the second quarter of last year, about 49%. We would expect Q3 volumes to be quite strong with the continued seasonality and low rate. We're very pleased with the good growth in linked-quarter average total deposits with the mix of interest-bearing as well as non-interest-bearing.
Our slower core loan growth is and will continue to be beneficial to our marginal cost of funding. We started to see improvements in deposit mix in the second quarter with some contribution from vertical as well as from existing clients, including mortgage finance escrow account. We would expect that to continue with meaningful improvement more evident in 2020 as verticals get more traction and we continue to deepen existing relationship.
Moving to non-interest expense. We continue to show positive trends in core operating expenses, specifically looking at the changes in salaries expense. The second quarter salaries and employee benefits were up about 6% from Q2 in 2018. We're managing at a much lower level of FTE additions, but ensuring that we're still being very opportunistic in targeted areas.
As a reminder, a portion of the marketing category continues to be variable in nature and is tied to growth in certain deposit balances. We expect the Q3 and Q4 expense levels to be fairly flat with Q2. Q2 level was consistent with the high-end of our previously discussed range from $1 million to $2.5 million increase, depending on volume. Those volumes are expected to be flat for the remainder of the year.
The second quarter includes an MSR impairment of $2.8 million and the first quarter had an MSR impairment of $2.9 million, so a total of almost $6 million of non-run rate expenses negatively affecting total non-interest expense for the year. Our efficiency ratio for Q2 was 52.8%, which is consistent with Q1 levels. We expect similar levels for the remainder of the year.
Turning now to asset quality. We continue to be positive about overall credit quality, despite the higher level of charge-offs and provisioning in Q2. Non-accrual levels are still at a relatively below level of 0.47% of total LHI. Charge-offs, primarily related to two energy deals and both were part of the increase in non-accruals discussed in the first quarter.
While each of these credits discussed last quarter had unique characteristics, poor development results were common along with other challenges unique to each and not necessarily indicative of the rest of the energy book. We believed each were adequately reserved at the end of the first quarter, but additional information on realizable asset values driven by market liquidity worsened our position, which resulted in additional reserve needed.
Additionally, we experienced an uptick in total criticized levels in the second quarter, which was not expected but was related to only one energy deal downgraded to special mention, not classified or substandard. Important to note that the significant increase in total criticized since the end of the year has been primarily in the special mentioned category. Our total criticized, as a percentage of total LHI, remains low at 2.6% and we have rigorous action plans for problem loans. For all criticized loan relationships, we have ongoing dialogue with borrowers to understand client performance.
In general, no new information was revealed from the receipt of third-party audits throughout the quarter that would point to further deterioration or issues that were not otherwise known. As, you know from our history, we're always focused on being proactive with grading and especially late cycle, which can drive higher provisioning and classifications early. The $27 million in second quarter provision is driven primarily by additional reserves needed for the two energy loans and some limited migration. $14 million of the $27 million were related to those two energy deals.
As we've mentioned, we expected a larger portion of provision in the first half of the year, so Q2 provision level is consistent with the overall guidance but was related to a different loan category than originally expected. Generally, we remain positive that provision for the second half of the year will be in line with guidance. $20 million or 34 basis points of charge-offs in the second quarter with $15 million of that related to the two energy deals.
We continue to see strength in linked-quarter net revenue, strong volumes in the mortgage finance contributed to that increase. The second quarter non-interest income also includes $6.5 million related to a legal settlement, which is obviously non-recurring but is consistent with the $8.5 million in the first quarter. No future amounts are expected.
We had a loss on sale of loans in non-interest income resulted from holding some MCA loans longer, which increases the hedging cost and is offset in additional spread income. Our non-interest expenses are continuing to improve the run rate on core; year-over-year 7% increase in non-interest expense compared to prior-year Q2 and compared to 8% net revenue growth.
Our ROE and ROA levels were lower in the second quarter as a result of the higher provision level and ROA levels were negatively impacted by the higher mortgage finance and liquidity levels. We could see some lift in ROE levels later in the year as provision levels coming lower than guidance. We are constantly evaluating opportunities to improve returns for the long-term.
Looking now to our 2019 outlook. We're decreasing our guidance for average traditional LHI growth slightly [indiscernible] mid-single-digit growth from the previous mid- to high-single-digit. We're being very diligent about growth as we're very open to growing if the opportunities are right. We're listening to our people about what they're seeing in the market related to risk versus reward, and are focused on maintaining strong franchise value as we head into what could be a challenging point in the cycle.
On average mortgage finance, we're increasing our guidance to low- to mid-20% from high-teens percent. That takes into consideration the additional growth so far this year and an expected strong Q3. Obviously, this is the lowest risk asset category for us, so we're happy to exploit the opportunities available with lower mortgage rates, even if it means temporary dilution to some of our performance metrics.
No changes to our MCA guidance of $2.5 billion for average outstandings for '19. The MCA will continue to benefit from additional volumes from the lower rate. We're increasing our guidance for average total deposits to low-double-digit from high-single-digit percent growth. That's reflective of the DDA growth that we experienced in the second quarter. We still believe that most of the growth from the year will be from interest-bearing, but DDA should be flat to slightly up compared to 2018.
We're decreasing our guidance for NIM to 3.35% to 3.45% from 3.60% to 3.70%. The decrease was driven primarily by the earning assets shift we've experienced and we continue to have from total mortgage finance, which is relatively a lower yielding asset. While slightly punitive to NIM, the added growth is very positive to net revenue.
As always, our guidance assumes no fed changes in rates for 2019. However, it's important to understand how we believe rate cuts will impact us and we're focused on it in terms of income. With a 25 basis point move in July, we estimate the impact to income over the next 12 months would be less than 1.5% with little impact for the remainder of 2019. Assuming 50 basis points with 25 in July and 25 in September, that 12 months impact moves to 3% to 5%.
Finally, assuming 50 basis points in July and 25 in September, the impact could be closer to 6% to 8%. With none of these scenarios take into consideration is the additional volumes in mortgage finance other than those we've already assumed for the remainder of 2019, we also don't take into consideration any stimulus to the economy this might dry up, which could change core growth assumptions going forward.
Lastly, this doesn't have the full impact of initiatives already underway that better position our funding mix during 2020. Our guidance for net revenue remains a constant at high-single-digit percent growth. The same for guidance for provision expense, which remains at high -- mid-to high-$80 million level.
We're increasing our guidance slightly for non-interest expense to mid-single-digit to high-single-digit percent growth from the previous mid-single-digit percent growth. We continue to feel very good about the slowing of our core operating expenses, but the impact of MSR impairment charges as well as more of the variable marketing cost in the first half of the year has driven some upward pressure on that range. Our guidance for efficiency ratio remains at the low-50s.
Finally, turning to our longer-term outlook, we are committed to these long-term goals and we'll be validating them as part of our three-year planning process, which is kicking off in the third quarter. As you know, the initiatives we have in place are focused on repositioning our balance sheet to be more stable through a rate cycle.
Certainly there can be variability at different points in the cycle, but these are the right targets and we're committed to achieving them. We're confident we have the right initiatives underway and, historically, we have been very successful at repositioning as needed and expect the same success this time. Keith?
Thank you, Julie. I'll close with a few comments and then open the call for questions. Our business model has always been and will continue to be winning and developing exceptionally talented business partners. While technically we are employees of Texas Capital, we've never recruited colleagues, who thought of themselves as merely an employee.
We place the highest priority in selection of a new colleague on whether or not they have a passion for building a premier, industry-leading business, then we focus on skills and experience. The same holds true in our renewed strategic focus on selecting clients, who see the value in the premier strategic banking relationships we offer.
Today, we offer many new products and services through collaborative specialists, who deliver multifaceted client solutions alongside our relationship managers. We can and do punch above our weight and at $30 billion in assets we are a force in the Texas market as well as in the national markets, and we are never satisfied but always pushing to be one of the very few elite banks in the US able to successfully compete in our targeted niches with any bank for decades to come.
The substantial strategic investments we have made in recent years and will continue to make in the future will position us to be the premier financial services company of the next two decades, not merely a bank who moves too slowly to win tomorrow, only focused on next quarter's profit or growth. We understand the importance of growing profits, but also wisely investing a portion of today's profits for sustainably higher profits in the future. Those banks who set themselves apart as transformational leaders in the industry will win the premier clients who similarly are bold and investing in their company's future also.
Texas Capital Bank will continue to be a transformational leader and my colleagues will continue to engage our business on their clients in a business builder to business builder relationship. This is a powerful advantage we intend to further accentuate as we continue to invest in the finest talent, technology and strategic initiatives to ensure a bright future for our clients, colleagues, investors and communities.
The strategic initiatives implied are building a stronger deposit base, loan portfolio and more efficient premier client experience. The results will elevate our profit and ROE for years to come. We are very optimistic that the smart, collaborative, hard work we are accomplishing will deliver superior financial performance over the years ahead.
We are preparing to exploit overly aggressive short-term competitors as we focus on quality-first and building a premier business of the future in every decision we make. We are fortunate, indeed, to be Texas-based and benefit from the prosperous economy all around us. We have never had such outstanding talent join our bank as we have experienced this past year. It is a powerful combination to add such strong new talent to the extraordinary veteran talent developing into franchise players, as we all build the Texas Capital Bank of the future.
It's time. Let's open the lines for Q&A.
[Operator Instructions] And our first question will come from Brady Gailey of KBW. Please go ahead.
Hey, good afternoon, guys.
Hello, Brady.
Hey, Brady.
I wanted to start with energy. We saw the couple of credits move into the non-performing bucket last quarter, you took some losses on this quarter, now we have another loan that has been classified special mention. I think as we headed into this year, we were all concerned about levered lending, but now most of the noise you're seeing is really on the energy side.
I mean, I've heard you say these are kind of one-off deals and not TCBI's typical energy loan. But -- can you just give us some color on what's happened with these three credits? Why did -- why are they problematic? And maybe some color specifically on the new special mention energy loan?
Well, the new special mention energy loan, we're very encouraged, has a low probability at this point, certainly of a further downward migration. So it is one we've identified, we're working closely with the client, but feel good about the prospects on that holding up on its quality as is. The other two loans were instances where borrowers entered into very aggressive drilling programs.
And in a couple of cases they were trying to prove up some large prospects and rather than only drill in the heart of the prospect properties, they stepped out a little bit. And, as a result, it created some cash flow challenges. And while we don't typically run into this kind of situation, we're very alert that with all the activity in this industry over the last 2.5 years, a lot of it being, Brady, private equity investors, we're going to be just more intense than ever at taking a careful look at the operating of the properties and not simply be convinced that we have a really great borrowing base scenario, because the decline curves are so steep on the shale properties.
Even though the good news is you get your capital back very quickly on these quick decline curves, you have to be confident that the operator has a sound strategy on how to use that money on existing production we're loaning against to backfill and create that ongoing cash flow on future production. And in these cases, that was not the case. So, we feel like these are one-off deals.
But, again, as we did a year ago, I think we have been early to identify an energy situation. I think there are couple of other banks beginning to experience some of this quarter. And I think we're ahead of the curve, taking a careful look at our clients who are executing on their plans and that their sound plans.
All right. And I know when you saw some credit noise in your levered lending portfolio, you decided to shrink that portfolio like you're doing. When you look at energy in this noise, maybe just talk about longer-term, your commitment to the energy lending space and if you would feel more comfortable having less energy exposure at TCBI longer-term?
Well, it's premature to say longer-term, Brady, but in the near-term, we're taking a much more deliberate approach on what we're managing today as opposed to having our bankers and our teams actively looking for that next brand new client. We'll pick up new clients here and there, but they're going to be outstanding top quartile accounts of opportunities, which is definitely the case in leveraged lending.
In fact, we just picked up one of the best leveraged loans we've had in 20 years that we closed here in just the last week or so, but it's a very different high-quality, top-tier opportunity. And the same will be the case in this energy category, we'll only look for very, very high-tier opportunities and we'll let some of the other credit to runoff or plateau.
We're not focused on growing categories that we're not 100% comfortable with and, right now, we're just taking a little bit of a more cautious look at energy as we did leveraged lending, that's paid off for us on leveraged lending and we think it will on energy as well. But long-term, we've always been in the energy lending business and we have no plans to not be.
Okay. Great. Thanks for the color.
You're welcome.
Our next question comes from Brett Rabatin of Piper Jaffray. Please go ahead.
Hi. Good afternoon, everyone.
Hi, Brett.
Wanted to talk about the margin for a second and just I want to make sure I understood the guidance relative to -- there was commentary about a further decline in yield on the warehouse and just wanted to make sure I understood, Julie, what the guidance is relative to both the further decline in the mortgage book and then just how you're sort of responding to LIBOR and as you plan on taking additional action on you talked about stemming some of the asset sensitivity?
Sure. So the guidance that we gave, lowering the NIM, that's just assuming nothing else changes. That's assuming that there aren't -- that the fed doesn't move. And so -- so that's taking into consideration the shift that we've seen and that we'll continue to see in Q3 with the outsized falling from mortgage finance.
But then what I tried to do is give you a little bit of color on if the fed moves in July, if they do a 25 basis points move in July, we'd expect that to affect us for the next 12 months about 1.5% decrease in incomes. So -- but, again, that doesn't factor in other things, that's just looking at the math as it is right now. That doesn't factor in if that could change some of our growth aspirations. None of that factored in. It also doesn't factor in what we expect to happen later in 2020 related to some of the deposit initiatives.
Okay.
So as far as doing other things right now, I think at this point it's the economics of doing any kind of hedging doesn't make sense. Certainly there are things like that that we will continue to actively look at, but we don't think at this point that makes any sense.
Okay. And then I wanted to make sure I understood -- so the DDA growth in the quarter, you had a really nice bounce back there. It didn't sound like you are expecting that to continue. Can you, one, talk about the growth in the quarter? Was that a function of mortgage or other businesses? And then I want to make sure I understood, sort of, how you're thinking about DDA growth from premier and how it relates to the margin guidance? Thanks.
Yeah. Sure. The growth in the second quarter, it was mainly from existing clients and that did include some mortgage. Q3, we think there we could see a little more growth in Q3. I said for the year, what's changed is now for the year, year-over-year. We think that DDAs could be flat to actually up a little bit and that's definitely a change in what we were seeing in January.
Okay, great.
As Julie mentioned earlier, Brett, some contribution too from some of our new verticals and then also just core treasury. Where there have been these opportunities, we really didn't mind, because deeply -- because we grew the company so rapidly. In some cases, we had loans to clients that we had not really gone back and worked as hard on the treasury. So we're picking up steam in all those categories with some of the recent seasonality also was partly due to the mortgage business.
Okay. And then maybe just on the businesses I've asked in the past and I think, Keith, you gave me a number one time on the new businesses and how much they contributed. Any update on that? And then just any update on how you're thinking about what they could contribute over the next year?
I think we're poised to have a very significant pickup in their contribution over the next 12 months. We have our three biggest initiatives teed up to launch in the fourth and very early first quarter. And the ones that we've launched today are making good progress, but they're just so young that in some cases we're testing the pricing breath and not interested in just driving volume.
We're trying to find a sweet spot and be sure we're not only creating diversified funding, but also lower cost funding. And, early on, it's an experiment, because you want to go get your name known, these are national verticals, so you tend to pay a little more and now we're trying to get that just right and we're pleased with the progress. Not all of them are going to be home runs, we knew that and said that from the beginning, but we were highly confident that we're on the right track and these three coming up will be our three biggest.
Okay. Thanks. I appreciate all the color.
You're welcome.
Our next question comes from Ebrahim Poonawala of Bank of America Merrill Lynch. Please go ahead.
Good afternoon, guys.
Hello, Ebrahim.
So, Keith, just wanted to go back to credit, right. So I hear everything you were saying in terms of being early. But, at the same time, when you talk to investors, right, there is very little confidence around credit outlook. From every quarter after quarter, the stocks are -- where it is with just five years ago from a valuation standpoint, 1.1 tangible book, so it is expressing a lack of confidence. And then I hear you talking about making high-quality loans going forward.
As someone who followed the company for a long time, I think part of the appeal of owning the stock has been if you guys have been known to be conservative underwriters. So I'm having a hard time to reconcile the book that we have today, the surprise on the energy front that we're seeing and just your level of confidence that we're getting towards the end of addressing some of these credit issues. Would love to sort of get your thoughts around this?
Well, I think the improvement we're seeing in leveraged lending, and that's the case in our numbers this quarter, should be encouraging to you, Ebrahim. But, I hear, the energy is -- we identified a couple of them, now we had these larger charge-offs and it really contributed to our provision coming in as we guided. We just didn't expect it to come from this. We expected it to come from leveraged lending, but we're making so much headway on being all over -- managing that leveraged lending portfolio.
And, again, the same is true just a couple of quarters later when we identified a couple of these energy deals that I don't believe it's going to turn into something that's prolonged. But, honestly, until we post just as clean as a whistle quarter and I hope that's the third quarter, I hear you, and I think we're on the right track and it's going to be solid on the balance of the back half of the year.
But you and I will be even more confident when we're talking a quarter from now. But I can tell you all the indications from my team, and I've got the best team around, is that we're all over this energy portfolio and I don't expect us to find some systemic, very significant issue. We could surface another deal, if it's possible, but I don't see that at this point in time today.
And just you mentioned that you didn't expect charge-offs to come from here, does that imply that this potential for some upward drift on that provisioning guidance as we look into the back half, or do you feel extremely confident in terms of the mid-to-high $80 million?
I'm as confident as I can be. I'm encouraged that we're not seeing the kind of continued follow through on leveraged lending. I'd have a lot more concern if I was still seeing the leveraged lending not performing much better, Ebrahim. And that I saw some systemic issue in the energy portfolio. I really believe we'd be risking the balance sheet early compared to some banks, but we've done it because we've had a couple of bad deals and these categories get our attention early.
So we didn't just assume they were one-off deals, we look more deeply at how we're running the business. We've got our bankers really focused on being very thorough in how they're looking at go-forward business plans with our clients in these areas and I believe these are two of the higher risk categories that banks are going to face over the next few quarters and I think we're ahead. But we'll have to prove it to you and I think we will in the very near term.
Understood. Okay. Because I think that obviously the view around speedtrack [ph] the expectation is we're on sort of a slippery slope on credit. So, as you said , I guess we'll have to wait for a quarter to see better results before that can be proven or disproven. And just separately in terms of the strategic targets, I think I heard Julie talk about you're going into sort of offsite to discuss these targets now.
Do we -- is there any realistic possibility that you can get below 15% efficiency ratio in a 12-to-18 month time frame or -- because I feel like we're on the other side of the rate cycle. So you have that headwind to deal with going forward. If you can just talk about how you see the bank getting to sustainably a sub-50% efficiency ratio? And in your sense, what's the timeframe we can get there?
Well, it'll be two things. You mentioned the headwind of the rate scenario. Again, we were talking about a whole different rate scenario seven months ago, I think all of us. So these things can ebb and flow, and we'll have to see how that plays out. But if it in fact turns into a downward two or three, two or three ticks that'll be challenging to get there as soon as you're projecting or asking.
Secondly, it's the pace of investment. And we have a number of initiatives that are going to deliver extraordinarily improved and sustainably higher profits and better ROEs, but in the near-term they are added expense, and that's one of the things that they were choosing to do is invest and setting up the company with better, more granular and lower cost funding and deposit base, while the economy is, we think, in the later innings. But I hope it lasts a long time. We don't see any clouds that are on the horizon.
They give us great heartburn, there are a lot of positives about our economy, particularly in Texas, but even nationally. However, we're just more conservative about how we're preparing, so that we can exploit whenever opportunities pop up in a down cycle or otherwise.
And this funding, getting it right is super important. But also the opportunities we see, Ebrahim, in some niches in the C&I world that we're exploring, I think, have a great opportunity for us. And we think we can, over time, over the next few quarters, begin to generate some very strong, diversified growth with clients that are going to be full relationship clients. And, again, that's been part of our shift this last year is not focusing on a transactional loan-only client. And that's part of our strategy to, again, build a stronger long-term earning power in the company.
So I think it's going to be a while -- it's the bottom line. Unless we see this rate scenario stabilized sooner than some are concerned, it won't. There's not an immediate change we can create there, but I will tell you we have a -- this added advantage in the rate scenario where we typically get outsized volume in our mortgage finance and it's just great credit quality when we get it.
And when we get it in such large volumes, it does put pressure on them, but it creates an enormous amount of earnings and they're very high quality, low credit risk earnings. So that is a positive and it certainly is, as you can tell from one of our exhibits, a very efficient business. So that'll help us as we invest and get set up for the next strong growth run we're going to have over the next several years.
And just on that last, if I may squeeze in a follow up, do you anticipate the mortgage rate, how it spreads to widen if the fed cuts and we see one or two cuts. We saw this is quite tightening on the way up. Just wanted to see what your view was around that?
Well, it seems to be stable and we think probably that'll be the scenario. But there isn't a lot of room to go anywhere but up. But I'm not going to predict that we'll get necessarily wider margins until we can report that to you, but we are confident that it's going to stay at least stable if not improve a little.
Got it. Thanks for taking my questions.
You're welcome.
Our next question comes from Jon Arfstrom of RBC Capital Markets. Please go ahead.
Thanks. Good afternoon.
Hello, Jon.
One simple one, Julie, for you. When you talk about your fed funds scenarios, do you mean net income or net interest income?
Net interest income.
Net interest income? Okay. I just wanted to make sure I heard that correctly. And then on the NIM guidance, just very big picture with the 3.35% to 3.45% range and everything we know today. I think you're saying low 3.30%s in that range for the rest of the year, but a lot of the pressure is really already occurred on the margin, is that a fair way to look at it?
All right. What we saw -- yeah -- what we saw with just the mix shift in the second quarter, we expect that to continue in the third quarter. Fourth quarter. we would assume that when kind of seasonality end, then it becomes seasonally a little bit weaker, but, yes, we would expect to see something similar for the next -- for the rest of the year.
Okay, All right. Good, that helps. And then, Keith, for you, just I know there's a lot of focus on leveraged lending and energy. And you talk about this risk/reward balance in the core LHI, but I see some rundown and leverage in energy as well. So it seems like, maybe, there's some decent activity in core LHI, can you maybe talk about that balancing act and what kind of activity you're seeing there?
There is definitely decent activity. It's just -- Jon, a couple of years ago, when we would go-to-market in our core C&I, the deals we wanted, we would win a very high number of those, 50% plus even with a lot of competition. Today, we're taking ourselves out of the process fairly early, because the terms just simply don't make sense. And so our hit rate is just lower. It's not that we couldn't grow those loans quite a lot faster, it just wouldn't be a very wise move to book such incredibly underpriced risk/reward.
And, again, we're seeing credit terms that just don't make sense to us in advance rates that are much too rich and weak collateral basis, if any, and it used to be covenant-light, now it's covenant gone in so many cases. And, of course, everyone's after high-quality credit as it should be. But still, high-quality credit, you've got to be sure you're going to win if you win the deal and I think you're losing in a lot of cases, because the return, it is so poor and you have very little, if any, protection. So that's the scenario.
So our guys are just having to work a lot harder to win deals and they're growing modestly, they're backfilling a lot of the pay downs. But, normally, with the effort we're putting forward and the best talent we've ever had on the line, we just keep attracting phenomenal new talent, we should be growing much faster if we had the right risk/reward terms.
Okay. That's helpful. Thanks.
You're welcome.
Our next question comes from Peter Winter of Wedbush Securities. Please go ahead.
Good afternoon.
Hello, Peter.
Keith, I was wondering -- it's my understanding that there is an internal concentration limit where you don't want to see mortgage-related loans -- kind of, I guess, you wanted to be more in the low-30 percentage and this quarter it's at 40% If I include the MCA loans. I'm just wondering if that's what your thought is on how big you want this portfolio or how big you're willing to let this portfolio get?
It's a little above the guidance. And, again, we use guidance terms and we feel like, because it's just such a great piece of paper still today that we're able to finance and the liquidity is so excellent in this product to turning over every two or three weeks that it's just the right place to deploy our loan growth, right now. But, no, we do not want to see this. We're not looking at raising that guidance range that we have of roughly 25% to 35%.
We actually pushed it up, I think, to 38% here about a year ago and we're just right at a little above that. But it is not our plan to expand that over the long run. We like the 25% to 35% range, but it's just the place we think is the safest and best to generate earnings at the moment.
Okay. And then if I could just ask one more question on credit with energy. So we had a Regional Bank Report this morning that took some charges on energy. They said it was getting tougher to liquidate some of these troubled energy loans, just less demand from the capital markets, so I'm just wondering are you guys seeing that as well? And could it result in some charges, maybe, over the next two quarters?
I don't see that as anything about to happen to one of our clients, but they are accurate in their description of the capital markets not being very fluid for energy. There was just an avalanche of money pouring into this category over the last two and a half years after the long down trough we experienced, huge amounts of private equity and even foreign sovereign fund money coming in to invest in this asset play. And we don't see that kind of dry powder out there coming after buying the assets today.
So we feel good about, overall, the staying power and the ability of our clients to operate, but they're not going to be able to, if they want to just sell their assets, get the kind of price that they might have gotten a year or two ago. And so, they need to be able to operate, maintain their cash flow and manage their expenses, run their business well. And, over time, this will become attractive again.
There's just so much concern, apparently, on the -- with the overall world economy that private equity is becoming anxious. They're also more concerned, Peter, about looking at their true cash flow out of these shale plays. The money is very, very significant when you go drill these horizontals and in the shale plays, particularly the Permian, you can have 4 to 10 or 12 layers of pay zones and when you start stacking six or eight horizontal wells and there's a 1,250 acre kinds of templates, I mean, you quickly get to $60 million or $80 million for one layer and you get $0.25 billion almost for four.
And so it's significant money and it's going to continue to, I think, attract bigger and bigger players and I think that's what we're going to see over the next few years as some of the very biggest worldwide oil companies are going to become the bigger players over time in the Permian.
All right. Thank you.
You're welcome.
And so you're comfortable then where your energy loans are marked if...
We are. And we think again, at some point, some of the bigger players are going to want to buy our clients' properties and they'll make up a nice profit. But if you have to go-to-market today and find buyers, it's a pretty shallow capital market.
Okay. Thanks, Keith.
You're welcome.
Our next question comes from Jennifer Demba of SunTrust. Please go ahead.
Thank you. Good afternoon. Keith, can you just give a little more color on why you chose not to raise the provision guidance for this year? And what gives you real confidence that you guys have a handle on that? And then my second question is on your interest in buybacks, your stock still remains much cheaper than your peers? Thanks.
Let's start with your first question. We don't take lightly reaffirming that guidance, because it is a very significant number relative to how our earnings will come in for the year. We do believe we have a handle on our energy portfolio and that we don't have significant other problems there and we're very, very comfortable as we can be at this point, Jennifer. Things could change on a deal or two, but then we're ahead of the curve on a leveraged lending. That's performing quite a bit better than we expected. And so that, I would say, is kind of the counterpoint that causes us to feel like we're still good on provision.
But if we do find something new that's a significant deal in either leveraged lending or energy, it could change the game. We just don't see it today. And we have a really thorough loan review process, but more importantly we've got the entire line, each of the RMs and their Portfolio Managers, I mean that's across the company, we're all over our loan portfolio and in particular leveraged lending and energy. We've been concerned about a slowing economy for longer than probably I want to admit. So I think we have a pretty good grip on it and we -- to put any more out there, it would just be a guess to give you a higher number than what we're giving you.
Okay. And your interest in share repurchases?
Well, again, it is still a tool that we think about. We also believe we have other opportunities that we should examine on how we use our capital that could be much better for our shareholder and we're looking at different opportunities, both organic growth opportunities but also a possible fee businesses that may have opportunities for us to take a look at and those are the reasons why we have not yet used that tool.
What kind of fee business opportunities would you be examining?
We mentioned before, and that would still be the case today, but something related to private, wealth, advisory business, that's doing extremely well for us. But to simply grow it organically, it's going to be hard to make it big enough to make as big an impact if we don't look at the possibility of some M&A. But we've got to be very thoughtful about how we go about that, because we're, as everyone knows, we're very bought into organic growth is really the most sound way to go, but it's one of those opportunities our team is doing so well that we think we probably can integrate the right-sized opportunity and still have the outstanding culture to pick up some other great talent and make that work.
Another one that we've kicked around is something in the capital markets area. Our clients -- we're getting to a point where our clients have more needs than they did when we were smaller, just a few years ago. It'd be very rare we'd have a client that would have a need other than senior debt or their treasury management and maybe swaps and things of this sort, but there are other things that we think we may be able to do there and so we've added some talent there and we might even look beyond simply talent, but it's too early to make that call.
Thanks so much.
We know we need to continue to move the needle on our mix of income to have more fee income and not be as reliant over the next four or five years on just net interest income spread.
Thank you.
You're welcome.
Our next question comes from Steven Alexopoulos of JPMorgan. Please go ahead.
Hi, everybody.
Hi, Steve.
Wanted to start out for Julie. Regarding the impacts you're providing from rate cuts, which is very helpful, what the deposit beta you're assuming in those scenarios?
Yeah. We don't usually talk too much about betas. I'll give you some color on it, though. The index deposits that we have, which is about 20% of our book, we would assume that -- that's something close to 100% going down just like it was going up. Some of the other areas -- I mean, we've made some assumptions, but I don't want to talk too much about those and, obviously, as rates moved up, we were evaluating client relationship and we would do the same thing going down, but it could vary. So that's probably all that I'll say on that at this point.
Okay. When I look first at those scenarios, they seem to be not as dramatic of a negative impact as what you disclose in the 10-Q, what's the difference?
Yeah. We get that question and the 10-Q, that's a pretty scripted, that's a pretty, I don't know -- it's a lot more regimented, what we report as a shock. And so, we don't -- we -- pretty much that's at a given point in time and we just run the math. With this that I've given guidance.
We've taken a harder look at some of the things that I just talked about, looking at some of the client relationships, the different categories of our deposits, what we think some repricing that might happen because of things that were negotiated as the rates went up and things that might happen on them. So we just do a little bit more -- there's a little more profit to it and more finessing than what's reported in the 10-Q. What's reported in the 10-Q is just kind of the quick math of if it happened tomorrow and everything followed the rules.
Hello, Steve. This is Keith. You're going to fully appreciate this. I'm sure you do. But we just don't have the category moves that a more retail bank would add on the deposit pricing and that's what gives it a little more complexity, the relationship price, and so we might -- if someone wants a better deposit price to find we need more business.
And how do we get more profitable business? That might be fee business, that might be loan business, and then we look at the overall ROE and are we getting a deeper share of wallet? And so that does add complexity except for that 20% Julie mentioned that moves in sync, a 100%, pretty much I think that with fed funds.
Thank you. And then on the loan side, you had a nice reduction in C&I leveraged loans, including non-accrual and criticized. Did you guys sell loans in the quarter or were these just normal payoffs?
No, these were normal payoffs with a little help in some cases. But most of it was just normal portfolio turnover and that's how we really built -- primarily how we built our forecast back in January for the year of about 30% runoff is the typical velocity of turn that we have been seeing of late on these private equity portfolio companies, plus about 5% as we work a little harder on not being as open to modifying deals and things of this sort. So that we get others to refinance, while there's still a refi market and that continues to be the case.
Okay. Then one final one. So if I look at loans at some mortgage, the decline seem to be much more pronounced or just a headwind from running off leveraged loans. Can you give more color of why you saw that decline this quarter? Thanks.
That was mainly the rundown of energy and leveraged lending, that was about -- I'm trying to remember, about $270 million combined. So that was 80% plus of it, I would say. Is that right, Julie?
Yeah. I mean, if you look at -- and certainly if you look at the ending balance. Yeah, that was almost exactly what it was.
So year-over-year the energy loans were flat, but from the first quarter they actually came down $100 million.
Yeah.
Okay. Got you. Okay. Thanks for the color.
Okay.
Thanks.
Our next question comes from Casey Haire of Jefferies. Please go ahead.
Yeah. Thanks. Good evening. Julie, just one more follow up on the NIM. The loan yields, I was wondering if you could provide the spot rates where they were at June 30th for LHI, mortgage finance and MCA?
No, I didn't get that and I don't have that. I mean, the commentary I may to kind of gave you the general direction. Obviously, it will start with MCA. MCA, the newer production that has come on in the last 30 days have obviously going to be -- that's going to be related to what the -- what overall mortgage rates look like. Warehouse, that's pretty stable, as we said. And then on the core LHI, I mean that's going to move a lot more.
So most of the pricing -- like we saw when it was going up, there will be some lags, there are few ones, they don't all reprice on the same day. It takes about 30 days. It can take up to 30 days to move. So there should still be some repricing in the core LHI, but again it's going to be that -- there's going to be that significant of a difference.
Okay. I mean, so on the MCA, specially like what is new -- what is the new money yield on that production in the current environment?
I mean, it's similar to what are the 30-year mortgage rates are.
Okay. All right.
And then just on a quarter range.
Yes.
Somewhere in there, Casey.
Okay. And then the -- just appreciate the expense guide, but what -- if -- what's the slowest you could grow expenses and still support your initiatives if we do get a tougher -- if we do get a more dovish, if we get a lot more fed cuts, what sort of the slowest you could grow expenses going forward?
I think that we're -- I guess, I would say, what we've talked about is what we feel comfortable with. We are being very deliberate about what we're not going to sacrifice opportunity to save a few dollars here and there. So certainly we are managing the overall hires a lot better, but we're still going to be opportunistic. But I guess I would say that what you've seen -- what we feel that we've seen so far this year compared to last year and compared to years in the past, it's dramatically different. And so, we can't continue to evaluate that.
Again, we're -- I think I said we're about to go into our planning process, so we'll certainly look at those again and certainly take all of that into account of what we expect are going to happen with rates, kind of where our initiatives are, but I would say that that what we've given guidance is what we feel comfortable with for now.
Great. Thank you.
You're welcome.
My next question comes from Michael Rose of Raymond James. Please go ahead.
Hey. Good afternoon. Just a couple of clarification. Hi. Good afternoon. Just a couple of clarification questions. So the non-interest expense guidance, does that include the MSR impairments that you've seen in the past two quarters?
It does. That is that and then the variable deposit. That was really the reason that we've expanded the range, nothing else. On the core, we feel good about that. But, yes, it does include that.
Okay. And then...
[indiscernible].
Yup. Perfect. And then just wanted to get a sense for if there was anything in other fee income. This quarter it looks like a jump up about $6 million and I've been running at a rate much lower than that.
That was -- I mean, I called that out in the commentary, that was $6.5 million related to a legal settlement. We had $8.5 million in the first quarter, $6.5 million in the second quarter, but there'll be no more of that. That's finished.
Okay. So that comes out of the run rate. And then just the -- I know it's variable from quarter-to-quarter, but the gain or loss on sale, loans up for sale was up pretty dramatically this quarter. Again, I know it bounces around, but is there a way to think about that or how we should project that on a go-forward basis?
So, as I tell people, we have all of the information every day -- all the information, and we have trouble of forecasting it exactly like it is. I guess, all I can tell you is, we're constantly evaluating the economics of the individual tranches. Does it -- does the spread -- does the additional carry outweigh the additional cost to extend the hedge? And so it just can vary from quarter-to-quarter based on the volumes that we're seeing, based on what the market is doing.
Okay. And then maybe just one final one for me just going back to the mortgage warehouse. Just to understand the question earlier about the percentage it stands as a percentage of loans, but as we think about next year rates, if we do get a couple of fed rate cuts and mortgage rates continue to tick lower, I mean would you be comfortable operating above your range, so to speak, in the near-term, because historically you guys have had much stronger LHI growth.
Obviously, it's a lot of large numbers. This is a good opportunity set; as you mentioned earlier, it's a good risk/return at this point in the cycle. Why wouldn't you continue to see average balances grow beyond 2019?
Well, we want to be sure we're optimizing our return too. And so as much as we wanted deploy our loan assets and capital well, we also just have to be really thoughtful about return on capital too, Michael. And so we'll certainly take care of our clients. We're not going to be out there trying to win a lot of market share in this environment and I don't think we'll want to operate above the guidance over the next year or so.
But we'll have to evaluate that kind of quarter-by-quarter based on returns and just also overall strength of the balance sheet and our capital position. We feel really good about where we are on capital, but it's important that we manage it really well, so we have these other opportunities we're developing that we can exploit also.
Okay. Thanks for taking my questions.
You're welcome.
Our next question comes from Brad Milsaps of Sandler O'Neill. Please go ahead.
Hey, good evening.
Hello, Brad.
Just to follow up on Michael's question, Julie, about the loss on the MCA loans. I think you mentioned on the fourth quarter call that you would typically, maybe, see a bigger [technical difficulty]
Hello, Brad, did we lose you? Guess, we'll move on and he'll call back in. Operator, should we take the next caller, I think we lost Mr. Milsaps.
Sure. Our next question will come from Gary Tenner of D.A. Davidson. Please go ahead.
Hello, Gary. Disconnected?
Gary, the line is open on our end. Perhaps, you are muted on your end.
Move on.
And our next question will come from Chris Gamaitoni of Compass Point. Please go ahead.
It seems we're having technical problems. We're trying to determine the status.
Okay. We will try out the next question from Brock Vandervliet of UBS. Please go ahead.
Can you hear me?
Yes, Brock, we got you.
Yes. We -- finally, we have a winner.
That's great. I just blew away the queue in front of me. That's amazing. Whatever it takes to get in the question. Yeah, it does seem like something wonky happened with the call, but anyway just on the criticized loans, the increase here from $364 million to $629 million, is it -- that they're just kind of stuck in the pipe and you can't sell them? Why are they? Why do they keep building up like this?
You're talking about the total criticized? I mean, we are not trying to sell the criticized. I mean, are you talking about just the overall criticized loans?
Yes. And the criticized level and given other pressure in the portfolio, I would think you might try and work them down or take up your -- yeah, I'm puzzled that the rate of increase and that you can't work those down more quickly?
So, I'll make a couple of comments and then Keith can add some color. But one of the comments that I make in our commentary was that it's important to note that the big increase in criticized from the end of the year to 6/30, the biggest category that's increased is special mentions.
So we're not -- I mean special mention means there's some identified weakness, but that doesn't necessarily mean that that's something that's going to migrate. So when we -- this is typical of what we do when we see a weakness in a particular category is we maybe get a little harder on our grading and downgrade things, because we want them to get that special attention. So...
And we're conservative, Brock, on upgrading credit once we do have a downgrade. And so, to your point, there will be movement in a number of these, but it's just going to take more time. We want to see multiple quarters of improved performance before we say, hey, this is fine now. And so, we'll grant you that we're somewhat conservative on that, but it's served us well over the years.
And I realize these are at the beginning of the process as they're criticized, is there a level at which you would consider taking up your provision guidance, given the increase or you seem to be comfortable where it is at present?
We're comfortable. We just don't see a significant migration from that special mention at this point. So, again, we've identified a number of these credits. We're watching them carefully, but we don't see that those are going to move to the right and become substandard right away. If we really believe there's going to be more migration, our methodology would address that and how we would provide, and it's all built into how we would go about coming up with that provision.
Okay. And just shifting back to the rate sensitivity and there is a couple of different comments earlier in the call about this, but relative to the disclosure that we see every quarter in the Q, is the sensitivity level likely to change much here in the second quarter?
What you see in the Q, that's a kind of a regimented calculation, what we -- what the guidance that I've tried to give you is a more realistic view where we take into consideration more of the characteristics that we see in the different components, both on the asset side and the deposit side.
And that regimented calculation isn't likely to change that much.
Correct. I hope the disclosure is not going to change much, right. That's just kind of a -- that's a -- it's based on SEC guidelines, we kind of -- we do the math and it's a shock and it happens if you just don't put a lot of -- a lot more qualitative thought into that.
One size fits all.
Yes.
And so we're trying to give you the more custom…
Yeah. What we think is more realistic and it's taken a little bit more brainpower to come up with that.
Okay. All right. Thank you.
You're welcome.
Our next question comes from Ebrahim Poonawala of Bank of America Merrill Lynch. Please go ahead.
Hey, guys. Just one quick one, Keith. I think, you brought up M&A from a standpoint of acquiring something. I was just wondering how the Board and how you think about M&A from the standpoint of merging with an in-market or out-of-market player? And do you see that as an avenue to create shareholder value or do you not think that the model like TCBI could work as part of a larger player?
Well, again, it's my job to be sure that I'm always looking at every option that would optimize shareholder return, Ebrahim. But we find it very, very challenging to find other MOE type of potential partners. We find it very challenging that their model would actually give us a tailwind post-merger in terms of higher performance, better performance.
One of the big challenges is, we simply think the traditional brick and mortar distribution model is really going to be a headwind model for years and years to come. While it has a place in most banks template, we prefer our business model and the initiatives we have underway on multiple new treasury verticals, we think we are going to set our model up as to be even more a model for others to emulate rather than us.
Again, considering getting on board with the model that I think that will have a lot of headwind. And also the talent acquisition approach that we take is very unique and by organically growing and having this exceedingly high bar on any talent we bring on and then the talent development once they're here, we just don't see that as a common way to approach talent building and talent acquisition with other companies and we think talent and technology are going to be just vitally important to deliver this very premier strategic connection that's going to keep us an elite competitive company.
In fact, we want to be one of those top five right under the Mega Five that are the best at the markets we cater to these private companies. So it makes it difficult to see our way on a strategy that would be one that would succeed at that elite level and we think our model, it has a path, we have a path to get there.
That was helpful. Thanks a lot.
This concludes our question-and-answer session. I will turn the conference back over to President and CEO, Keith Cargill, for closing remarks.
Well, I'm very grateful to all my colleagues and our clients for another strong quarter and for the progress we're making to create the Texas Capital Bank for the next two decades. Thanks to each of you for your interest in our company, and we hope to talk with you soon. If you have questions, please call us. Thank you.
Thank you for your participation in TCBI's second quarter 2019 earnings conference call. Please direct request for follow-up questions to Heather Worley at heather.worley@texascapitalbank.com. You may now disconnect.