Texas Capital Bancshares Inc
NASDAQ:TCBI
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Texas Capital Bancshares Inc
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Good afternoon. And welcome to the TCBI Third Quarter 2018 Earnings Conference Call. All participants will be in listen-only mode during the presentation. Please note this event is being recorded. [Operator Instructions]
I would now like to turn the call over to Heather Worley, Director of Investor Relations. Please go ahead.
Thank you for joining us for the TCBI second quarter 2018 earnings conference call. I am Heather Worley, Director of Investor Relations.
Before we begin our call, please be aware it will include forward-looking statements that are based on our current expectations and 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, Bill, will facilitate a Q&A session.
And now I will turn the call over to Keith, who will begin on slide three of the webcast. Keith?
Thank you, Heather. After I open, Julie will share here assessment of Q3. Then, I will close and open the call for Q&A.
Let’s begin with slide three as Heather mentioned. Traditional LHI growth was up 3% linked quarter on average balances and flat linked quarter on period end. Following the outsized growth in Q1 and Q2, third quarter totals were modest, but expected. Year-over-year, average LHI was up 13% on average and 12% at period end.
The loan pipeline appears healthy for the fourth quarter, winning the highest quality loan opportunities remains our primary focus. Job number one is strengthening our loan portfolio quality for superior credit performance through the cycle.
Mortgage finance average balances were up 11% linked quarter and 12% year-over-year. Period end balances were down 8% linked quarter as we move into the usual softer fourth quarter seasonality. Year-over-year period end was down 3%, far better than the national mortgage market contraction this year of approximately 8%, indicating that we continue to take market share.
Average deposits were up 6% linked quarter and 9% year-over-year. The deposit increases were in interest-bearing deposits, as the demand deposit trend continues to convert to more interest-bearing deposits.
We expect the continued rollout and maturation of new treasury deposit verticals will help us improve our deposit costs, deposit betas, and further diversify our funding. We now have two new treasury deposit verticals operational, with up to six more to be introduced in 2019.
Net revenue grew 3% linked quarter and 15% year-over-year. Our operating leverage improved year-to-date. ROE increased to 14.68% for Q3, largely due to a more normalized loan loss provision. We experienced a modest $2 million in net charge-offs in Q3. Overall, asset quality remains good. Total credit costs in Q3 were $11 million as compared to $27 million in Q2.
Before Julie shares her comments on the quarter, I want to address two topics in particular. First, as we emphasized in the first quarter and again in the second quarter, we experienced extraordinary growth in loans. In fact, the first quarter loan growth was two times the dollar growth we have ever experienced in Q1 in our 20-year history.
We follow this record-breaking growth with the second quarter well above the expectations we shared on the earnings call in April, with the softer pipeline we thought we were going to have to execute on. But despite the softer pipeline, we had very strong growth in the second quarter. It came toward the end of the quarter, they well could have spilled into the third, but it came at the end of the second.
These loan growth numbers through Q2 were all the more outsized since our primary objective in 2018 was and remains a focus on upgrading our loan portfolio for optimum performance through the next credit cycle.
We provided traditional LHI loan growth guidance for 2018 at low-to-mid teens and have not deviated from our initial annual guidance. Further, we guided growth in our mortgage finance loans of mid-single-digit percent growth, with an industry volume contraction forecast to be 8%. Today, we are increasing guidance for mortgage finance growth to low-to-mid teens. We are solidly on track for our 2018 overall loan growth.
Second, we provided annual guidance in January for net interest margin of 3.35% to 3.45%. We increased the guidance to 3.60% to 3.70% in July, and today again we are increasing NIM guidance to 3.70% to 3.75%.
Our loan growth this quarter was slow as compared to Q1 and Q2. We are at or above our guidance and believe to grow faster than low-to-mid teens in 2018 would be imprudent due to the aggressive credit market we see so late in this economic expansion.
Also, while NIM declined sharply in the third quarter, we have anticipated for the past year and expressed our expectation that we could see a quarter in which LIBOR did not lead the Fed funds rate increase and deposit costs could continue to increase. We believe the occurrence of both LIBOR lagging and a stronger than normal move in deposit costs will not be a systemic change, but likely an occasional possibility.
Finally, NIM in the third quarter was meaningfully impacted by squeeze in loan pricing in the mortgage finance category that we see moderating this quarter, and the increased mix of mortgage finance average balances versus more modest traditional LHI growth further pressured NIM. I hope this context for our annual guidance and this overview on loan growth and the quarterly NIM contraction was helpful. Julie?
Thanks, Keith. My comments will cover slide four through 10. Our reported NIM decreased 23 basis points from the second quarter. The change in earning asset mix accounted for a portion of the decrease, an increase of $237 million in average liquidity assets since the second quarter, as well as the larger percentage of total loans coming from seasonally strong mortgage finance, which has a lower yield than traditional LHI, so net 6 basis points of negative impact to the NIM from earning asset shift.
Traditional LHI yields were up only 1 basis point from Q2 and there are several factors to keep in mind. The first is the lagging movement in LIBOR prior to the September Fed rate move as compared to the way it led prior to Fed rate move in the first quarter and the second quarter.
Traditional LHI betas continue to be as expected and are reflected in September 30th ending LHI yield on our floating portfolio, which are up 15 basis points compared to yields at the end of June, and some of the LIBOR based loans didn’t reprice until early October, so we do expect impact of the September move to be reflected in the fourth quarter.
Additionally, Q3 was a weaker loan fee quarter compared to the very strong fee quarter in second quarter. There was a 9 basis point swing and was really a combination of Q2 being much higher and Q3 back to a slightly lower than normal level. We experienced compression in mortgage finance yields as those decreased 23 basis points linked quarter.
As we mentioned during the second quarter call and in meetings during the third quarter, we are addressing competitive pressures in that space. Because of the multiple offerings that we provide, we have more flexibility in evaluating overall relationship pricing and making adjustments as needed to retain and grow market share.
We had a linked quarter increase in average deposits. Our overall deposit cost increased by 18 basis points from 81 basis points in Q2 to 93 basis points in Q3. The increase was expected as Q2 numbers only included a few days of the June Fed rate move on index deposits. Similarly, Q3 only includes a few days of the September move. Overall, increase of 18 basis points is compared to 15 basis points increase from Q1 to Q2, so not outsized and is consistent with our expectations.
With the continued solid deposit pipeline, but as we said before difficult to forecast exact timing and it can be lumpy and how it comes on and all is interest bearing. Our RMs are being incented to focus on deposits, as well as loans.
During the third quarter we chose to layer in an additional 500 million of traditional brokered CDs as we were able to lock in six months and 12 month maturities at a cost slightly less than our index deposit.
As we have noted in the past, the use of brokered CDs makes sense from a balance sheet management perspective but we don’t plan to use an outsized amount of brokered CDs. Important to note, as of the end of month -- at the end of September 75% of our floating rate loans are tied to LIBOR and over 80% of that tied to 30-day LIBOR.
We had good growth in average traditional LHI during the quarter. Second quarter growth as actually higher than expected which impacted the growth from the end of Q2 to the end of Q3, year-to-date it remains consistent with our annual guidance.
Traditional LHI average balances grew 3% from the second quarter and up 13% from Q3 2017. The level of payoff continues to be high primarily in CRE and no sign that that will slow. Our fourth quarter pipeline was positive but we would expect a slower growth quarter than we experienced earlier in the year, which is consistent with our full year guidance.
During the quarter we purchased a senior interest in a securitization trust that is collateralized by the cash flows of four municipal revenue bonds totaling $95 million, while we view the transaction to be similar to any collateralized expansion of credit, the structure of the transaction triggered GAAP rule that require the extension of credit to be characterized as the security on the balance sheet. So basically the $95 million increase in securities is more similar to C&I growth and the yield reflects that.
We continue to see strong average total mortgage finance balances benefited from seasonality and are up from Q3 2017 by 12%. Obviously, we expect fourth quarter volumes to be significantly lower and started to see that trend at the end of the third quarter.
As I mentioned we did see some pickup in linked-quarter average total deposits with all of the growth in interest-bearing. As I noted earlier, we added some additional traditional brokered CDs during this quarter because the pricing was still very favorable as compared to our index deposits. This is proving to be an attractive bridge funding alternatives as we work on our new deposit verticals and other initiatives we have underway.
Primarily interest-bearing deposits in the pipeline but we are also working hard on maintaining and growing existing relationships. Our ends are being incented to focus on deposit growth, as well as loan growth.
Again, asset betas especially as it relates to our traditional LHI portfolio are an important part of the story for us and while we feel good about our balance sheet positioning going forward. We have seen those asset betas perform as expected. We continue to react to specific customer situations, which are evaluated on a total relationship basis. Our index deposit categories total about $5.5 million at the end of the third quarter.
Moving on to non-interest expense and looking at changes in linked quarter non-interest expense were effectively slowing our core expenses, which is primarily salary expense. We are doing a good job of managing this with a lower level of FTE additions year-to-date.
You will note that we had $2.8 million in severance cost, which is related to some organizational changes that we made during the quarter. These are consistent with the messaging we have been doing about focused efforts on better aligning the organization to improve efficiency and client experience, the $2.8 million equates to $0.04 per share.
There is an increase in non-LTI and annual incentive pool from the Q2 levels and that’s driven by annual incentive accrual, which generally continues to ramp throughout the year based on overall financial performance.
Some fluctuation in FAS 123R expense in the third quarter as compared to Q2, primarily related to fluctuations in the stock price. Our third quarter FAS 123R expense of $4.4 million is compared to Q2 expense of $5.6 million.
We had an increase in occupancy, which included $1 million related to a relocation of one of our main offices and the related expenses that were required to be expensed as a one-time charge and does not signal a new run rate.
As we noted in July, legal and other professional was abnormally high in Q2 with some non-recurring expenses. There was about $2.5 million in Q2 that was not normal run rate. Our Q3 levels were down by that amount, but offset by the new variable component added during the first quarter that is directly related to deposit services and was expected to ramp by $1 million to $1.5 million in each sequential quarter.
Net impact was Q3 expense down $900,000, but we would expect to the normal ramp of $1 million to $1.5 million in Q4. A portion of our marketing category is variable in nature and is tied to growth in deposit balances, as well as increases in rates.
The trend in marketing over the last year or so is representative of the increase in run rate expected throughout the rest of the year. While we didn’t see any growth from Q2 to Q3, we would expect to continue to see some increases as we continue to grow deposits, but not more outsized than we would experienced in the past and not every quarter.
We continue to be targeted about expense growth and heading into 2019 planning season that is even more evident. We are focused on targeted growth for staff adds and holding most areas flat as we are improving returns in lines of business.
Our efficiency ratio for the third quarter was 53.6% excluding the impact of OREO, which was slightly higher than our Q2 efficiency ratio at 53.1%, but it was negatively impacted by the $2.8 million severance and the $1 million discussed earlier.
We continue to feel good about overall asset quality, criticized and classified to capital continue to trend down. Criticized loans to Tier 1 capital plus the allowance decreased from 16.4% at Q3 2017 to a current end of Q3, 13.8%. Non-accrual levels are still at a very acceptable level of 0.49% of total LHI. This late in the cycle, we believe that being aggressive with grading is the right thing to do.
As we expected, Q3 provision level is more normalized and it’s driven by provisioning for three relationships moved to non-accrual this quarter and some additional reserves for one of the healthcare loans we discussed in the second quarter. We expect fourth quarter provision levels to continue to be normalized and within our annual guidance.
The provision of $13 million for Q3 compares to $27 million in Q2 and $20 million in Q3 of last year. Our total credit cost for the quarter were really less than the $13 million, as we sold the only meaningful OREO property we had and that resulted in a $2 million recapture of the valuation allowance we took in the first quarter, as well as a $2 million of additional gain that’s included in non-interest income.
While accounting rules require us to account for it as a gain, it’s really a recovery as we had previously taken some charge-offs related to the deal. So the $13 million in provision, less the $4 million related to the OREO sale resulting in net credit related charges of $9 million for the quarter. Charge-offs for the quarter was minimal at $2 million.
Looking at quarterly highlights, we continue to have growth in our linked-quarter net revenue. We have experienced strong traditional LHI growth year-to-date and the portfolio is benefiting from improved margins as a result of a continued move in LIBOR.
While there was an earlier impact from LIBOR moves in the first quarter and the second quarter, the later LIBOR move in Q3 will show up in improved traditional LHI yields in Q4. We continue to improve run rates on core operating expense items specifically salaries and a continued focus on improving efficiency, while enhancing client experience.
ROE and ROA levels improved in the third quarter as a result of the more normalized level of provisioning. The expectation of the ROE trajectory is positive and we expect Q4 to be stable. We continue to benefit from interest rate moves despite the fact that the timing of the improvements can be impacted by how LIBOR moves in comparison to the Fed move.
Current lower liquidity levels have been beneficial for ROA, but we are comfortable holding higher liquidity levels and we expect balance increases during the fourth quarter as mortgage finance moves into the seasonally weaker part of the year.
Lastly, I will cover the guidance slide. No change in our outlook for average traditional LHI growth of low to mid-teens percent growth. We had a slight improvement in our outlook for average mortgage finance growth of low to mid-teens percent growth, which reflects the strong balances year-to-date.
A slight improvement in MCA guidance to $1.4 billion for average outstandings for the year and a slight change in our outlook for average total deposits as we think growth will be in the high single-digit growth and all interest-bearing.
We are improving our outlook for NIM to 3.7% to 3.75% to include impact from the September rate move. Our guidance is still assuming no additional rate increases for the remainder of the year.
We are also taking into consideration that our deposit growth is coming in interest-bearing, and it also assumes we have higher liquidity levels in the fourth quarter with the shift from mortgage finance.
No change in net revenue of mid to high-teens percent growth, no change in provision expense guidance at low to mid $60 million level, and no change in non-interest expense at low-teens percent growth, and finally, no change in guidance for efficiency ratio at the low 50s. Keith?
Thank you, Julie. Please move to slide 11. We are very pleased with our strong earnings and increased ROE this quarter. Traditional LHI growth remains on target for 2018, while mortgage finance growth resulted in an increase in guidance.
Our deposit levels increased, the continued rollout and then maturing of our new treasury management deposit verticals are expected to reduce deposit betas and overall funding costs, while also further diversifying our funding mix. We benefited from a more normalized loan loss provision in Q3 and remain in line with full year guidance.
While we have been focused for some time on upgrading our loan portfolio and addressing credit issues early before the next credit down cycle, it remains job one, so we can perform well above peer through the next recession.
Again, we are not predicting an imminent economic decline, but we know that upgrading a loan portfolio requires a disciplined focus well ahead of the next recession. The time to upgrade is when capital is still active, and there are aggressive lenders.
I am excited about the work my colleagues are undertaking to streamline our organization, improve efficiency and further build on our premier client experience differentiation. We continue to invest in rebuilding our technology infrastructure and delivering better technology tools for my colleagues, so we might create even better service for our clients and increase value for our investors.
Managing NIE growth includes investing wisely in both young and experienced talent, and developing these outstanding new colleagues in our collaborative energizing culture. This keeps us on course to remain a winning business of the future, not just an outperformer over the past 20 years.
The focus on improving ROE the past two years is producing positive results, building the strongest loan portfolio through credit cycle is a key to increasing ROE for years to come. We continue to leverage our treasury management capabilities to improve our funding mix and lower deposit betas with the new deposit verticals. All-in-all, we are fully engaged in building the premiere business for the next decade that we hope you find attractive today and tomorrow.
At this point, we can open it up for Q&A.
Okay. [Operator Instructions] The first question comes from Peter Winter with Wedbush Securities. Please go ahead.
Okay. Thank you. I have two questions. The first one, you talked about you are targeted for better expense growth or managing expenses better for 2019. I am just wondering if you can give a little bit more color around that?
And then secondly, if you maybe have some type of expense growth number for next year?
Yeah. We are early to give guidance on that, Peter, as far as expense growth next year, but the investments we have been making for now, two and a half years and continue to make in some of our -- rebuilding some of our infrastructure -- our technology infrastructure, they finally begin to converge and become integrated -- fully integrated midyear next year, and we think that will be a little tailwind.
But in the meantime, we have an initiative under way here at the bank that we launched about six weeks ago to just look at how we optimize the work structure and deliver even better client experience while picking up efficiencies.
So, the combination of using technology more than we have in the past and being more mindful about where we are focused on driving more core loan growth and core deposit growth in key businesses I think is really going to give us again a running start, which should pick up some tailwind by midyear as we integrate our new systems integration.
Hey, Peter. It’s Julie. It’s really -- and like I said in my commentary, we have been very focused on managing headcount increases. We have always -- we have traditionally added a lot of head count and we are just being more focused on where we add the headcount and we are certainly looking at that closely in ‘19.
But you would expect the efficiency ratio to drop next year, will that be fair?
Yes.
Okay. And then, can I just ask about credit, if you could just give a little bit more color about the three relationships that you have moved to NPA and then also 90-day loans past due also increased, and I am just wondering how you get comfortable. You mentioned also that you are upgrading the loan portfolio to prepare for the next recession, but this will be -- you had the big increase in charge-offs in the second quarter, and then we are seeing an increase in NPAs this quarter. And I am just wondering if you could just talk about what’s going on on the credit side?
Well, you are accurate in saying NPAs increase but very, very modestly, and if you look at our overall NPAs, they are really quite good relative to industry. Back on your earlier question, yes, we have had three new credits that got moved to NPA. Again, it’s not consistent with what we saw industry-wise in the second quarter.
One thing we have noticed and we are taking a closer look at is, there is some commonality in some of the credits being more levered and so we are taking a harder look at just what we are doing in that portfolio.
We have less than 5% in our leveraged lending portfolio or sponsored finance portfolio. But the only thing we see, it’s not a -- it’s not really an industry issue at this point, that could be a bit of an issue is the more highly leveraged companies, and I don’t think that’s unique to us.
What we tend to do, and I think, you know this having followed us for years is get more critical and more challenging and looking at our credit early enough before the downturn, Peter, so that we do have ways to move some of that credit.
Now when they move to non-performing, you are late. So that’s not optimum. But you are going to see some of that activity occur with us, and you should earlier than some banks just as you did with the energy book.
Yeah. On the -- Peter on the over 90, that’s predominantly our premium finance loans and those are basically cash secured, but they will have a fair amount that’s always in over 90 days and so sometimes that spikes up. So there’s nothing that we think is a problem in the over 90, because it’s primarily the premium finance loans.
Sounds great. Thank you.
Welcome.
Okay. The next question comes from Brady Gailey with KBW. Please go ahead.
Hey. Good afternoon, guys.
Hi, Brady.
Good morning, Brady.
So we have the net interest margin for the first three quarters of the year. I mean, you have given us the full year guidance, so we can kind of back in to what you think the 4Q NIM will be and if you back into that, it’s a range of 3.45% to 3.65% roughly. So the midpoint is 3.55%, that’s another 15 basis points lower than this quarter. It just seems to me, LIBOR will catch up this quarter. You will have the mix shift with a lower mortgage warehouse, which will be beneficial. It just seems like the margin should be stable if not higher in 4Q.
The one thing that’s really important factor and you got most of that right for sure is the mortgage warehouse softening, it goes to liquidity.
Yeah.
Now we will have some pickup in traditional LHI, Brady, from that slowdown and seasonality in warehouse, but more of it will go to liquidity than goes to LHI.
Right.
And so that’s the dynamic. We think we will be on the higher end of that range but it’s too early to say.
But that is the big -- that’s the bigger shift, Brady, it’s going from warehouse to liquidity assets.
Got it. Okay. And then, so you bought another $500 million of brokered CDs, that’s on top of it. I think last quarter in 2Q it was about $1 billion.
Yeah.
So now you are at $1 -- you are at $1.5 billion now.
Right.
Sorry, go ahead, Julie. What’s that?
It’s about $1.5 billion at the end of the quarter.
It’s actually very competitive, slightly better than some of our higher priced indexed cost of funds and we are really using that, Brady, to bridge us a bit while we get these new deposit verticals ramped up.
And while we have two out there operational now, they are young and we have got six more coming online next year. But when you look at overall optimum cost of funds, for now this brokered CD money is actually more attractive slightly less costly than some of our most highly priced money.
Okay. So it’s $1.5 billion now, that’s about 7% of your deposits. Do you think that that will continue to increase in the near-term before the new deposit verticals start getting speed and then we will see it go back down?
It’s hard to say. I mean it could. It’s not going to increase significantly. But if we see that as a better cost of funds near-term, it makes sense to us to actually deploy some of it. But I don’t see it increasing significantly. Julie, do you?
No. Probably what’s more likely to happen is some of that -- those are shorter-term fixed, I think, the remaining maturities are two to none. So as some of that rolls off, we might choose to replace it, but I don’t, yeah, I don’t think you are going to see us add too much more, if any.
Okay. And then, lastly for me, I mean, you are talking about slow in the pace of expense growth, you are talking about managing the headcount increase and we saw some severance charges this quarter. Are you thinking about doing a headcount reduction at this point as a way to slow expense growth?
No. That’s really not in the cards. We have made some adjustments to get a more efficient org structure set up, Brady. That was the key reason for that primary severance charge, the primary reason.
And then as we go forward, again, we think we have a much better feel or a handle on how we use existing headcount to redeploy some of that headcount maybe in the same division, but not incrementally keep adding at the pace we have over the years.
And really we add 150 plus FTEs a year, if we can tip that down to 100 or even 80 or 90, that’s a meaningful pickup in efficiency, and I think, we are really getting a lot better at this the last couple of months.
Got it. Thanks, guys.
Welcome.
Thanks, Brady.
Okay. The next question comes from Ebrahim Poonawala with Bank of America Merrill Lynch. Please go ahead.
Good afternoon, guys.
Hi, Ebrahim.
So, the first question, just trying to better understand loan betas as we think about fourth quarter given the noise we have had, both on the mortgage warehouse and the traditional LHI. So if you can help me, Julie, if we think about, one, the LHI for the mortgage warehouse growth that 3.62% means, it’s been all over the place in terms of the loan beta earlier, like given that we have already had the Fed funds and the LIBOR, if you can talk about your best guesstimate for traditional and the warehouse yield going into 4Q, what level of pass-through you expect. I think that will be extremely helpful?
Yeah. So on the traditional LHI, I mentioned that that the ending rate on the floating part of the book is up 15 basis points at 930, compared to 630 and then part of that book doesn’t re-price until Oct -- early -- re-priced in early October. So you will see all of that comes through.
The other -- and we are assuming in our -- in our estimate, we are assuming no further that LIBOR doesn’t lead, assuming there is a December increase. So we would see the full impact of the December LIBOR moves come through in the fourth quarter.
You mean the third quarter.
Third quarter, well, that happened in the third quarter, but it’s going to come through in our fourth quarter LHI yields.
The other thing is the fluctuation in the loan fees. It was up from Q1 to Q2. It was up about 7 basis points. Q2 to Q3, it was down about 9 basis points. Generally, we don’t see anything more than maybe a 3 basis points to 5 basis points fluctuation from quarter-to-quarter. So, I would say, had we had a more normalized fee quarter, we would have added another 4 basis points or 5 basis points to the LHI yield in the third quarter, so…
It’s very seasonal.
Yeah.
And a lot of the biggest deals as you will appreciate, those get syndicated and launched in the second quarter, Ebrahim.
But, I guess, the important thing to remember is that, in looking at our ending 930 yields and what our -- and what’s kind of -- what’s re-priced in early October, we are still seeing the same kind of betas that we have seen on the core book to-date.
Got it.
On warehouse?
Yeah.
On warehouse we started talking on the second quarter call and then in Q3 on different meetings that we had that we were starting to see competitive pressures. So that was kind of an outsized catch up from Q2 to Q3. We could see a little more pressure. But I think that’s going to flatten as we go forward and if LIBOR continues to move up in the future, we could see a portion of that come through in the warehouse yield.
There is a real struggle in that space, Ebrahim, to hold market share. Now we are still taking market share, but those that are just trying to stay in the business at a reasonable run rate, it’s put pressure on that yield. But we really think we are close to bottoming out on fourth quarter or early next year on that pressure.
It’s important to remember that all you can see for that line of business is just the loan yields. What’s also tied in there is a whole relationship with deposits or an MSR facility and all you can see is this. So we don’t cut yields across the board. We look at each relationship.
Understood. And I guess just moving in terms of, I guess, deposit growth should be the driver of balance sheet growth given where we are and your comments around being conservative on credit, and if that’s going down to high single-digit percentage growth, is that kind of what you expect with all these verticals coming through next year, is high single-digit type balance sheet growth environment that we are in today? And it’s one thing for a growth coming in interest-bearing deposits, do you still expect demand deposits to continue to decline at the rate we have seen year-over-year this year?
It’s early to give you guidance on next year, but generally, yeah, I wouldn’t be surprised once we get into January to be talking with all of you about our single digits on loan growth and deposit growth, because we are not interested, even as the verticals get traction and just absolutely growing, we want to optimize our cost of funds, which means some of our highest cost of funds, we would envision replacing with some of these better beta, lower beta, new vertical deposits too. So, again, could we grow double digits next year in loans and deposits? We could, I don’t think that necessarily optimizes our earnings and ROE, Ebrahim.
And Ebrahim, on the DDAs, I think, you will see, I mean, we are still working hard at increasing DDAs to offset some of the migration that’s happening there to interest-bearing and I think if you look from Q2 to Q3, we didn’t have much net run off.
So that’s -- I don’t -- the year-over-year decrease, like if you look at averages from third quarter and fourth quarter of last year, down to where it is this third quarter, I don’t expect to see anything that pronounced. I think it’s going to be much smaller -- similar to what you saw from Q2 to Q3.
Got it. Thanks for taking my questions.
You’re welcome.
Thank you.
Okay. The next question comes from Michael Rose with Raymond James. Please go ahead.
Hey. Good afternoon.
Hi, Michael.
Hi, Michael.
I followed you guys for a long time and it seems like pulling off of the hiring is kind of a little bit different from where your DNA has been historically. I mean, is this a kind of a secular shift for you guys as you have gotten bigger. And I understand the commentary about the environment where we are and all the external pressures out there from non-bank lenders. But it seems like this would be the type of environment where you guys would continue to hire well-seasoned lenders, well-positioned lenders looking for a new home?
Yeah. One of the things we have really accomplished just in the last three years, Michael, is building a team of young talented people, hiring undergraduate out of school and MBA students, and bringing them through a training program. And we are having really good success with those folks and they are really contributing and beginning to sprinkle them across our businesses in all areas.
So, yes, we are continuing to hire experienced bankers, but we also importantly are shifting our overall age to be more accompany that has another 20-year run as we shift over the next 10 years to 15 years, some of our business owner, clients or CFOs to be millennials. We want to have our young people be ready to take those handoffs and they are doing a great job.
The other thing we are doing is org structure wise. We are looking at being a flatter more horizontal company than adding more vertical layers and we just think that’s the way companies have to organize to be more responsive and efficient, and that would be able to react fast enough to market demand and client experience.
So those are some fundamental things we are doing. I am excited, because we have leaders across our company and then teams under our leaders. They have really taken this initiative and run with it. So it’s not something just coming from Julie and me, or our NEO team, it’s something everyone buys into -- is a way that improve client experience but also efficiency.
And this should enable us to hire fewer new people, but actually increase the value of our existing people as we leverage them with technology and get them in the optimum seat to contribute value.
All right. That’s great. Thanks for the color. And maybe just one follow-up question, just wanted to get your longer-term thoughts on the warehouse business. It’s clearly going through some changes 12 times at some point are going to go down, electronic mortgage, how should we think about the future of that business. I know it’s 30% of loans, I mean, what’s the longer-term play here?
We think it has a great future for us. I don’t think it necessarily has a great future for everyone. We have set ourselves up to be able to scale and we have proven we can over the years. But we are positioned to scale significantly as the market overturn against the shift to more electronic payments.
And again, if you are not investing heavily in technology, and again, we were the leader in the industry to offer you notes, so we have been at this for several years, it just hasn’t had lot of adoption yet, but it’s coming. You better be set up the scale or you are not going to be able to generate the kind of returns on this very credit safe asset that you need to generate.
But it is going through a cycle now with headwinds yet again in that teen on mortgage volumes latest from the NBA as of the last two days, or they think it could be another 10% plus down here next year and we could well see an 8% to 10% this year, it’s running about 8% down versus a year ago. So cumulative down three years in a row is going to cause a lot of consolidation.
To further address your question, Michael, I would expect -- we will even have some peer customers, but most of our customers would be beneficiaries of the consolidation. Therefore, overall, we think we will continue to take market share in a challenged environment. So we like the business, but we have worked hard to position our self to handle what’s coming and we believe we are in a good shape to do it.
Okay. So fair to assume that this is a mid to high teens ROE business and given the investments you have made, the market share you are trying to grab, fair to say that that’s the assumption short to intermediate term.
That’s right. And you are going through this period where there is some winnowing out, that’s going to happen. Most of the non-bank clients and prospects, as well as the banks that are going to serve that group, we think were well-positioned to benefit as the cycle runs its course. But we are definitely in a cycle everybody is scrambling to hold on the market share.
All right. Thanks for taking my questions.
Welcome.
Okay. The next question comes from Brett Rabatin with Piper Jaffray. Please go ahead.
Hi. Good afternoon, everyone.
Hi, Brett.
Hi, Brett.
Wanted to first just ask here, there has been some consternation this quarter through the earning season so far with ending period DDA versus averages. And I was curious, was there anything unusual that affected during our period DDA versus kind of the average for the quarter and how should we think about the difference there?
No. I think average, I think, I always say average is a better indicator of what’s going on. We do have some fluctuations. We got deposits in several different industries that lend themselves to sometimes run-off at the end of the month, but then build back up. So, I think, overall, the averages are just a better indicator of what’s going on.
Okay. And then you briefly addressed the new verticals, maybe could you give us any color on kind of what you are seeing so far with the platforms in terms of balances and what the average cost is or are we again to point where we can maybe get a look at those numbers?
Well, I see my team shaking their head, no, but I am going to give you a little bit color, so I will be in trouble after the call. I am not going to tell you what category they are and of course you will appreciate that. We are still getting a lot.
But with one vertical having been up for a good part of the year and the other just recently getting launched, we are around 600 million in new deposits in those two new verticals. So, I am not saying that’s an awfully strong start. These are not the ones that we think will be even stronger growers. We don’t know if we will sustain this rate of growth, but we are off to a good start.
Okay. And then, I want to make sure I was clear on one last thing, just the closing comments in the PowerPoint, you said selective about growth areas and positioning our portfolio. This quarter, were there things that you specifically exited versus payoffs in the quarter that affected kind of the net growth or how do we think about your comment there, are you actually kind of exiting positions into what you kind of see as peak-ish credit?
No. We are not exiting positions, but we are being very, very deliberate about pipelines in terms of -- do we really want to pursue and close the deal, do we want to win the deal, if we win the deal, is that really an above average credit in that part of our portfolio, and this late in the cycle it needs to be, as opposed to just something that, yeah, we are, okay, with. It’s a 30th percentile kind of quality, but we think it’s going to work out. That’s not a good debt this late in the cycle for new credits.
So, I think, we are just being more selective, and you have to be early. Again, it’s challenging because you want to grow in a healthy way, but the best loans everybody’s after and some of them are just unbelievably cheap relative to even the good quality that it offers.
So we are going to have to be thoughtful about always booking better than average quality as we go forward. We hope we have another couple of years with expansion. We just can’t bet on it. Now is the time, well there is so much capital chasing assets and loans included, especially non-banks chasing loans that are so aggressive. Now is your opportunity to miss some of the late vintage credits that you will really regret you did in a year or two when we get into the down cycle.
So we are certainly open for business, we had a great first half again had that second quarter that came on so late in outstandings. Some of that’s spilled into the third quarter. I think, you probably be happy-as-a-lark because we told you in April we had a soft pipeline going into the second quarter and our team was just so good, they closed a lot of deals in June.
And it kind of pulled some of that volume that matters normally fallen into the third quarter into the second quarter. We are happy with where we are, and we think it’s the right pace of growth at this stage of the cycle.
Hey, Brett, I think it’s really consistent with what we have been saying, what Keith has been saying for a while about certain categories that we were being very cautious about. And then, just a reminder, for kind of our history, our growth has been lumpy in this year, it was just a little more lumpy toward the front end.
We are seeing continued rapid pay-downs of banks are these days on CRE and our CRE numbers relative to capital continue to go down. We are now in the low 80s as a percent of capital at one time we are in the 120 just year and a half, two years ago.
But the things we are doing to replace that run-off are all about quality. Be sure that we get the right, better than average quality in the portfolio and I’d be fine if that goes back to 95 or so percent of capital, but it has to be, because we are finding the best quality that we have seen.
Okay. That’s great. I appreciate all the color.
You’re welcome.
Thanks, Brett.
Okay. The next question comes from Dave Rochester with Deutsche Bank. Please go ahead.
Like, before I answer your question, Dave, my guys are shaking their head. It wasn’t 18 months ago we were at 120 of capital levels. What Randy three years ago?
Yes.
Yes. C&D, that subcategory…
Subcategory, yeah, yeah.
The subcategory C&D…
Yeah. And development.
… construction and development. So we are continuing to bring that down and that we are just reducing our risk overall, for an asset class is still really great in our portfolio, but we know it’s more cyclical in a downturn than other asset classes typically. I am sorry, Dave.
Sure. Sure. No problem. Thanks for taking the questions. Just -- regarding NIM on the guidance, I just wanted to make sure I had this right, it sounds like you are expecting the loan fees to potentially be up a little bit in 4Q, the mortgage warehouse yield maybe down a little bit to flattish at this point with the LHI yields up decently, is that roughly right?
Yes. Correct.
That is right.
That is correct.
Okay.
And the only other thing is, as we go into the fourth quarter where mortgage finance is seasonally weaker that shift is going to go into liquidity assets, which is obviously…
Yeah.
… a lower rate.
And some growth again traditional LHI.
Yeah.
Definitely.
Yeah. Yeah. That sounds right. Thank you. And then on the increasing deposit cost for the quarter, this quarter, is that generally the pace that you are expecting in quarters in which we have rate hikes going forward?
We think it was a little elevated this quarter.
Yes.
But we will just have to see as things move ahead. It was more the other factor as Juile pointed out and just a way outsized move in deposit costs.
Yes.
But we have been talking about this for over a year. We could have a quarter where we have real outsized deposit costs move, we just haven’t seen that in a big way yet, but that still could happen in a quarter.
Yeah. Because I think if you compare the move from Q1 to Q2, and Q2 to Q3, we were -- it was up a couple of basis points.
Yeah.
But, yeah, nothing outsized. So, I think, it’s a fair run rate.
Okay. Okay. So there’s no like partial…
Yeah.
… catch up embedded in this or anything, okay? Got you. And then, I guess, just bigger picture question on asset sensitivity. Going forward or maybe with just the September hike, I mean, I guess, you have kind of given us the components, but just bigger picture. How much do you expect NIM to benefit from rate hikes ex any kind of liquidity build?
I will tell you Dave.
For the next rate hike, what do you think?
Here’s why…
Exactly.
… we hesitate, you know the dynamics…
Right.
… that we deal with that.
Yeah.
And that shift mortgage warehouse seasonally, lumpy growth, traditional LHI. So, let us say it this way, we are continuing to see some expansion particularly in traditional LHI near-term in the third quarter in particular it was tough on yield competition in the warehouse space.
But, again, as we said earlier, we think that’s going to really -- that trajectory of downward push on yield is going to flatten some over the next couple of quarters and bottom out soon, okay?
Yeah.
I am not sure that…
Yeah.
… that answers exactly your question, but I am trying to give you the right context.
The NIM expansion is still going to happen with rate move. But like what we saw in the third quarter, how core -- how traditional LHI yields moved up, that’s going to be lag because of what happened with LIBOR.
Right.
So there can be some timing considerations that you have to take into account to see all of that expansion.
Got you. Okay. Great. Just switching to expenses, I know you are not talking about headcount reductions or anything like that, but it looks like your expense guide for the low double-digit this year points to something maybe lower expense level in 4Q, is that what you are expecting at this point or are you expecting?
No. We had several, yeah, fourth quarter, we are expecting fourth quarter expenses to be lower than Q3, we had those kind of one-time things in Q3. So, yeah…
Yeah.
… that’s exactly what we are planning.
Got you. Great. All right. Thanks guys.
Thanks, Dave.
Okay. The next question comes from Geoffrey Elliott with Autonomous Research. Please go ahead.
Hello. Thanks for taking the questions.
Hi.
Hi, Geoffrey.
When you are seeing those non-interest bearing deposit balances decline, do you have a sense of where they are going, are they going into interest-bearing balances with you, are they going into interest-bearing accounts with other banks, are they going into off balance sheet products, are they getting deployed, from your discussions with clients, where is that money going?
It’s really virtually all staying with us, but it’s converting the interest-bearing. We are watching that carefully. We are not seeing DDA migrate out and go somewhere else. Now some of it I will tell you is being deployed in the businesses those that are growing and some of them are beginning to do some CapEx expense expenditures, Geoffrey, with the tax incentive.
So there is some of that going on and with GDP running as hard as it is, you would a little of that, but it’s not migrating out of the bank, so we expected some of that to convert, it’s going to convert quicker, of course, with our commercial banking focus without the brick-and-mortar retail business and that’s what’s occurring so far.
Thanks. And can you help us think about what portion of the remaining DDA is potentially going to convert into interest-bearing versus what you think is pretty sticky and stays within the DDA category even if rates keep on moving up?
Well, we still believe that the trajectory or pace which is converting is going to begin to tip down and others that have so much of the retail are going to then begin to experience a little steeper trajectory dealing with online bank competitors, I just can’t tell you when.
I don’t think the pace is increasing. I think it is decreasing some. But it will continue for still a while until we can put together two or three quarters and we convinced all of us that that slowed. But we don’t see that becoming a bigger issue near-term than what we have experienced the last few quarters.
Yeah. Geoffrey, it’s important to remember that we are very treasury management focused. So a large percentage of those DDA are tied to some kind of treasury services. So there’s a certain amount that they are going to keep to cover their charges. So that we think that certainly help slow that.
We have over 90% of our clients on our treasury system and that was all in the mid-50s four years, five years ago, we have worked hard to make that stickier because of the future rate increase environment that we are experiencing now.
Great. Thank you very much.
You’re welcome.
Sure.
Okay. The next question comes from Brad Milsaps with Sandler O’Neill. Please go ahead.
Hi. Good evening, guys.
Hello Brad.
Hi, Brad.
Hey, Keith, just to attack maybe the NIM question a different way, if your guidance hold as you expect this year, it looks you will generate about 20 basis points or 25 basis points of year-over-year NIM expansion compared to about 35 basis points in 2017. If the Fed raises rates again in December and then maybe a couple of times next year and LIBOR sort of follows is expected, would you expect to get a similar amount of expansion in ‘19 or do you think the environment is such that it’s super competitive and maybe on the asset size is going to be more difficult to generate the increases in spread that maybe you have been able to in ‘17 and ‘18.
Well, you are teasing me, Brad, you are tossing me to answer this off the top of my head as I did a few quarters ago when I got in trouble with Julie. But I want to curl a little bit. I was pretty close on that estimate.
Yeah.
And this year I am going to do this again which I should learn…
Right.
… from my mistake. Next year I do believe we will have expansion. It will be modestly less than what we saw this year. It -- I just don’t see things changing quickly enough on the conversion of DDA to interest-bearing.
I don’t see the new verticals coming on fast enough to make a big difference on that other than slowing it some in ‘19. I think that will begin to change in ‘20 as they mature and we have more experience with those new verticals and hopefully lower betas and lower cost there. But in the near-term through ‘19 my best guess is we will still see the expansion, but it will be more modest.
Which is pretty consistent with what we said from the beginning that for each move we would get just a little bit less.
Right. And then just to follow-up on the warehouse, I heard you say in answering with the other question that should flatten out, maybe go down a bit in the fourth quarter, with each move in LIBOR do you think you are going to have enough pricing power there to increase it as you move through ‘19 like you did this year or what does your crystal ball say kind of on that environment?
The next couple of quarters I don’t think we will. I think we will end up passing through most all of that benefit on LIBOR to the clients. It’s just a highly competitive environment. The good news is, I don’t see us having to move our index down much over LIBOR as we have had do to a degree relationship profitability base.
But still the last couple of quarters, we have had to do that more than I think we will going forward. But I think we are still a couple of quarters away, Brad, from us being able to actually benefit on increases in rate on our warehouse yields.
Very helpful, Keith. Thank you.
You’re welcome.
Okay. The next question comes from Brock Vandervliet with UBS. Please go ahead.
Hey. Good afternoon.
Hi, Brock.
Shockingly, I think, virtually all my questions have been answered, but let’s see, something you remarked on in your opening remarks in terms of changing the incentives on deposit growth or looking at them? What have you been considering or been implementing there that could be a needle mover going forward?
We -- since inception we have always tweaked our incentives as we needed to and so that’s what we have done this year, just tweaked it a little bit more to incent more deposit growth, still incenting loan growth, but a portion of it is more is more focused on deposit growth.
And what’s largely driving that, Brock, is not just the importance of getting our funding improved overall on diversifying the funding getting the costs in a better position. But it’s also our focus on growing loans very deliberately well above average quality on any new loans we are doing. So it all made sense for us to make that, that mid-year shift for our RM incentives.
And in terms of that quality focus now regarding the CRE paydowns. Is this kind of a natural progression of construction loan that goes to permanent financing elsewhere or is this credits that have a balloon payment or whatnot and you just don’t want to keep in the bank?
No. We don’t really do much term real estate. We have not been comfortable really, Brock, with the low cap rates and high valuations in the market to loan 75%, 80% against those values. So this is the normal C&D, the projects completed rather than get the more typical three or four years ago additional year or so for lease-up after the project is done.
These are just paying off very early. Like shortly after completion and certificate of occupancy and there continues to be an extremely strong appetite for REITs and other finance years including insurance companies to do those term financings. And so that’s happening at a faster pace than we experienced even three years ago.
Okay. Great. Thank you.
You’re welcome.
Okay. The next question comes from Casey Haire with Jefferies. Please go ahead.
Thanks. Good afternoon, guys. One more on the mortgage warehouse, just help me out with the strategy of continuing, in your words Keith to significantly scale this business because it sounds to me like the incremental margin is 2% on it. I understand it comes from deposits and the credit quality is strong. But I mean with your margin today at 3.70% growing this line is going to be extremely dilutive to margin. So I am just -- I am not understanding why this is a -- this is going to continue to be a point of emphasis for growth going forward.
Well, one of the key is, is we don’t telegraph for competitive reasons what we have in DDAs and other product that we offer these folks. And some of that and the DDAs are very meaningfully meaningful contributors to overall margin, but I am sure you understand, we just can’t telegraph all the details around that because our competitors would jump on it.
We -- from a scale standpoint, just to give you a little context, okay, see six years ago we had 43 people, I am sorry, 64 people handling about a $0.5 billion a month in volume. Today we have in the low ‘40s, handling up to 8 billion to 10 billion a month and this is before e-notes are widely adopted.
So we have capacity to significantly scale even with today how notes are handled and that’s not with as much electronic speed and efficiency, we will have to be able to scale it, all competitors will as we move to more e-notes because they simply won’t be on the line nearly as long.
But the labor cost and the speed at which we can service them will be far quicker and far lower on the labor cost if you have the technology scale potential and we have built that, so we won’t have to add again headcount, lots of new cost and we think that’s going to help us sustain a really nice return for a wonderful credit quality asset.
Hey, Keith, couple more points, there is no provision for loans losses that’s allocated to these loans, so that certainly improves their overall returns. And then, I guess, the other point that we said in the past that we do manage this portfolio to be 25% to 30% of our loans.
So it’s not like we are planning to grow that to an outsized amount. We have always managed that as a concentration and quite honestly we look at it as a better asset to invest in versus fixed rate investment securities, works about better yield shorter duration, but again no credit cost that kind of thing so.
The real cost you have to incur we think and not every one of our competitors necessarily does this. But we think it’s very prudent is fraud risk and we laid that risk off to the Lloyd’s of London and have for years. But those premiums are quite competitive and because of our great history in that regard, it’s not a huge cost. But it’s an important risk to mitigate we think and we do that with Lloyds.
Great. Thanks for the color.
You’re welcome.
Okay. This concludes our question-and-answer session. I will turn the conference back over to President and CEO, Keith Cargill for any closing remarks.
We thank you each for your interest and your time. We are optimistic about what we have underway. We have many strategic initiatives that we kept you appraised over the course of the year and we are locked on the execution and we are very excited about what the results are going to produce for all of us over the next few quarters. So, again, thank you for your interest in our company and good night.
Thank you for your participation in TCBI’s Third Quarter 2018 Earnings Conference Call. Please direct any requests for follow-up questions to Heather Worley at heather.worley@texascapitalbank.com. You may now disconnect.