Western Alliance Bancorp
NYSE:WAL
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Western Alliance Bancorp
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Good day, everyone. Welcome to the Earnings Call for Western Alliance Bancorporation for the Second Quarter 2019. Our speakers are Ken Vecchione, Chief Executive Officer; Dale Gibbons, Chief Financial Officer; and Robert Sarver, Executive Chairman. You may also view the presentation today via webcast through the Company's website at www.westernalliancebancorporation.com. The call will be recorded and made available for replay after 2 O'clock P.M. Eastern, July 19, 2019, through August 19, 2019, at 9 A.M. Eastern Time, by dialing 1-877-344-7529, with the passcode 10132284.
The discussion during this call may contain forward-looking statements that relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. The forward-looking statements contained herein reflect our current views about future events and financial performances, and are subject to risks, uncertainties, assumptions and changes in circumstances that may cause our actual results to differ significantly from historical results and those expressed in forward-looking statement. Some factors that could cause actual results to differ materially from historical or expected results include those listed in the filings with the Securities and Exchange Commission. Except as required by law, the Company does not undertake any obligation to update any forward-looking statements.
Now, for the opening remarks, I would now like to turn the call over to Ken Vecchione. Please go ahead.
Thank you. Good afternoon and welcome to Western Alliance's second quarter earnings call. Joining me on the call today are Dale Gibbons and Robert Sarver. I will provide an overview of the quarterly results, and then, Dale will walk you through the Bank's financial performance in greater detail. Afterwards, we'll open the line and Robert, Dale, and I will take your questions.
Western Alliance delivered another exceptional quarter with strong deposit growth, primarily in non-interest bearing accounts which funded high-quality balanced loan growth. We maintain top tier financial performance while positioning our balance sheet to be resilient in front of potential slower economic growth and lower rates.
As you'll see throughout our remarks, our results advanced our key strategic objectives, which include leveraging our branch light business model to drive both disciplined and thoughtful loan and deposit growth, carefully managing our balance sheet with regards to asset sensitivity, accretive capital allocation policies, and de-risking our loan composition, all while maintaining strong efficiency and profitability across all interest rate environments.
The strategy delivered outstanding results. Net income during the second quarter rose to a record $122.9 million or $1.19 per share compared to $120.8 million and $1.16 per share for Q1. Balance sheet growth was exceptional with the Company reaching a new milestone of $25 billion in total assets. The year-over-year net income rose 17.4% and EPS grew 20.2%. Total loans were $19.3 billion, an increase of 25% on a linked-quarter annualized basis compared to $18.1 billion during Q1 2019.
On a year-over-year basis, loans rose by 19.3% assisted by $1 billion of residential growth, a part of our strategic de-risking plan as we view residential loans as a thoughtful responsible alternative to managed loan growth.
During the quarter, we also reduced our construction and land and development loans by $73 million, reducing their representation in our portfolio to 11.5% compared to 12.6% in Q1. Deposits remained a bright spot for us during the second quarter as we grew over $1.2 billion from quarter-end supported by $998 million rise in non-interest bearing deposits.
Total deposits grew on a linked-quarter annualized basis by 24.4%. This bears repeating, 83% of our deposit growth was DDA and non-interest bearing deposits now comprise over 40% of all deposits. This is the second consecutive quarter during which we grew deposits by over $1 billion.
Over the last two quarters, loan growth of $1.5 billion has been fully funded by deposit growth of $2.3 billion. The loan-to-deposit ratio increased to 89.8% from 89.6% in Q1. Continued balance sheet growth more than offset NIM reduction to 4.59%, as we increased net interest income for the quarter by $7.3 million. Total operating revenues grew $7.4 million for the quarter compared to an expense increase of only $2 million and drove a 40 basis point improvement in our efficiency ratio to 42% from Q1.
We are confident in our ability to remain one of the industry's most profitable banks, while also prudently investing in growth initiatives, even in a declining rate environment. Return on assets was 2.05%, return on average tangible common equity was 19.7%, as we continue to post industry-leading performance.
Our financial results were accompanied by strong asset quality. Charge-offs for the quarter were $1.6 million, representing only three basis points of average loans. Non-performing assets were $70 million, up $8 million from the prior quarter, but will remain at near historical low levels. Non-accrual loans and OREO to total assets was 27 basis points in line with the past four quarters.
Turning now to capital management, last month we announced the initiation of a $1 annual cash dividend. We also continue to opportunistically repurchase shares. During the quarter, we purchased 793,000 shares at $42.82, which when combined with last quarter's share repurchase of 1.7 million shares, combined for a total cost of $41.45 year-to-date. Overall, the share count has been reduced by 2.5% through repurchases since the initiation of the stock buyback program in mid-Q4 2018.
On display this quarter was our ability to thoughtfully manage capital allocation between share repurchases and loan growth. Tangible common equity ratio absorbed significant balance sheet growth and opportunistic share repurchases and was 10.2% at quarter end, down 10 basis points from prior quarter, but up 30 basis points from prior year.
The common equity Tier 1 ratio was 10.6%, relatively flat to the prior quarter. Tangible book value per share grew 6.3% or $1.45 from the prior quarter to $24.65. Over the past five years, we have grown tangible book value per share by 213% compared to average peer growth of 67% over the same period, which includes adding back peer dividends.
Lastly, I want to reflect on Western Alliance surpassing $25 billion in assets. We've come a long way since our public company in - since becoming a public company in 2005, having increased our assets by 10.5 times over the $2 billion that we started with.
Back then, we outlined the core principles of our strategy, strength of our management team, our conservative credit culture, the attractive growth characteristics of the markets where we operate and the ability to attract the seasoned bankers with long-standing relationships in their communities.
I'm proud that we stayed true to those ideologies and cultural values as we've grown and these precise qualities that continue to set Western Alliance apart. The people of Western Alliance drive our bank success, and I would like to take a moment to recognize all of the people who have helped us achieve this exciting milestone.
Dale will now take you through our financial performance.
Thanks Ken.
Overall, our strong ongoing balance sheet growth resulted in record earnings despite headwinds from the flattening yield curve proceeding an anticipated Fed rate cut. Net interest income rose $7.3 million or 12% annualized from the first quarter of $255 million, driven by $968 million increase in average earning assets, which outweighed reduced loan yields and higher rates on deposits.
From the corresponding period last year, net interest income was up 13.6%. The provision for credit losses was $7 million for the quarter, an increase of $3.5 million from the prior quarter, due to strong loan growth of $1.1 billion.
Non-interest income was down slightly, up $1.2 million from the first quarter to 14.2%, as warrant income of fair value gains on securities decreased $1.1 million and $1.3 million respectively.
Non-interest expense was up a modest $1.3 million, as professional fees and deposit costs increased by $3.6 million and $1.9 million, partially offset by $2.8 million decrease in compensation costs. The increase in professional fees relates to consulting projects aimed at the implementation of CECL, as well as other technology initiatives that will allow us to continue to grow in future periods.
Share repurchases to date, pulled down the diluted share count to $103.5 million, resulting in diluted EPS of $1.19. Of the approved $250 million authorization, we've now used $107.5 million with $142.5 million remaining.
Turning now to our net interest drivers. During the quarter, despite a flattening yield curve, net interest income grew 12% annualized to $254 million. Investment yield decreased 13 basis points from the prior quarter to $334 million, due to a flattening yield curve and lower reinvestment rates. But overall yield remains up 10 basis points over the past year.
Loan yields rose 15 basis points over the past year to 5.98% in the most recent period. On a linked quarter basis loan yields decreased four basis points due to lower yields on C&I and construction loans. Supporting the decline in yields was our intentional shift towards residential loans, the de-risking of our construction portfolio, as well as the decline in LIBOR. We expect this mix shift to continue.
Interest-bearing deposit costs increased by 12 basis points in the second quarter as a result of acquiring relatively more expensive term deposits prior to the downward shift in short-term rates. This increased funding cost by four basis points, when all of the Company's funding sources are considered, including non-interest bearing deposits and borrowings. We think this will be temporary, since during Q3 we anticipate approximately $980 million of higher cost short duration CDs will roll off or reprice at current lower market rates improving deposit funding.
As stated, net interest income rose $7.3 million during the quarter, or 12% annualized, as our strategic shift in our loan mix away from construction in the reduction in market rates up weighed on the margin. But it was more than offset with improved revenue from our strong balance sheet growth. Given no change in the economic outlook, this will be the theme of our ongoing performance, the volume growth was outweighed decline in net interest margin for the remainder of the year.
41% of our loan book is tied to LIBOR, 20% is tied to prime, and another 12% are fixed rate term loans that mature and therefore will reprice within the next 12 months. As market sentiment shifted from a rising to a falling rate environment, one month LIBOR declined 11 basis points and three months LIBOR fell 29 during the quarter, reducing our margin by six basis points.
As you saw in the second quarter, our net interest income increased at a 12% annualized rate, despite a reduced net interest margin. Based on our earning asset growth at quarter end, that was not reflected in the second quarter average balances, we already have a 4% linked quarter unannualized balance sheet growth baked into the third quarter.
With market driven rates anticipating in July Fed rate reduction, deposit pricing has lagged the loan repricing, which began in earnest mid quarter as LIBOR fell and the yield curve inverted. Net interest margin decreased 12 basis points to 4.59 during the quarter, as the earning asset yields decreased nine basis points, coupled with the four basis point increase in funding costs.
We anticipate reductions in deposit costs to be rapid in a declining rate environment as we expect to promptly adjust rates in response to Fed actions and that deposit betas will accelerate in the near term assuming the Fed cuts rates in July, September, December, and next June, as we have modeled. We have over $4 billion in Money Market and NOW Accounts that have received exception pricing that could see rate reductions.
Regarding loan acquisitions, accretion on acquired loans increased from $2.8 million in the first quarter to $4.6 million in the second. Our remaining acquired loans were $869 million and the remaining marks at quarter end are 15.7. Going forward, accretion will fall to $1.3 million each quarter for remainder of 2019, if all discounted acquired loans paid just their contractual principal commitments, as the acquired loan portfolio is replaced with organic growth.
With regards to our asset sensitivity, while the convention is to immediately shock interest rates, we believe in realistic scenario include either a 12-month ramp down scenario with four quarterly 25 basis point reductions, which would reduce net interest income by 2.4% or steepening scenario were short end rates declined 100 basis points and the long end remains flat, reducing net interest income by 2%.
Additionally, these sensitivities assume our static second quarter position as of June 30th. However, as Ken mentioned, management has already begun advancing strategic actions to diversify our mix shift to residential loans and further mitigate margin volatility.
Turning now to operating efficiency. On a linked quarter basis, the ratio was down improved 40 basis points to 42% as revenue growth outpaced expense growth. From the second quarter of 2018 the ratio decreased 10 basis points.
On a taxable equivalent basis, operating revenue increased $29.4 million to 273 in the second quarter of '19 compared to a year ago. Over the same term, operating expense increased $12.4 million to $115 million and generated positive operating leverage of 2.4 times.
Our provision - our pre-provision net revenue ROA of 2.54% and return on assets of 2.05%, these metrics continue to be in the top decile compared to the peer group. Our strong balance sheet momentum continued during the quarter as loans increased $1.1 billion to $19.3 billion and deposit growth of $1.2 billion brought our deposit balance to $21.4 billion at quarter end. Our loan to deposit ratio increased in the current quarter to 89.8% from 89.2% a year ago.
Our strong liquidity position continues to provide us the balance sheet flexibility to pursue attractive risk-adjusted lending opportunities. Notably, our ending balance at June 30 was $36 million greater than the average balance for the second quarter and ending deposits were $1.1 billion greater than the average balance for the second quarter, which when taken together is equivalent to an incremental quarter of loan and deposit growth over what we had on average balance at - for the second quarter.
Tangible book value per share increased $1.45 over the prior quarter and 4.7 or 24.6% over the prior year, despite having repurchased 2.5% of our outstanding shares over the past three quarters. Our industry-leading financial performance is a direct result of the powerful combination of commercial banking relationships within our regional footprint and our national business lines across the country.
Our loan growth of $1.1 billion was driven by increases in C&I loans of $730 million, non-owner occupied commercial real estate of $382 million and residential loans of $119 million. Construction loans declined by $73 million and made up 11.5% of our total loans in the second quarter versus 12.6% when compared to the first quarter.
The intentional decrease advances our strategy of reducing construction loans to 10% of the total loans by the end of next year. $500 million of the $1.1 billion of quarterly growth was in sectors that had a cumulative losses of only $400,000 since 2010, including public finance, mortgage warehouse, non-profit, resort lending, equity fund resources, and homeowners' associations.
Turning to deposit growth and further demonstrating the strength of our deposit franchise, deposits grew $1.2 billion, mainly driven by an increase in non-interest bearing DDA of nearly $1 billion. Over the past year, deposits grew across all types with the largest increase in savings and Money Market of $1.4 billion and non-interest bearing DDA of $729 million.
Over the past two quarters loans were up $1.5 billion and deposits were up $2.3 billion. Over the past year loan growth of $3.1 billion was fully funded by deposit growth of $3.4 billion. We believe our ability to profitably grow deposits is both a key differentiator and a core value driver to our platforms long-term growth.
Total adversely graded assets increased $41 million during the quarter to $$399 million, as special mention credits increased $64 million. The increase in special mention credits for the quarter was primarily driven by three credits that have had modest changes in the credit profile, but are well secured with no elevated risk of loss. We do not see these increases indicative of a trend or area of concern. From the prior year, total adversely graded assets have increased just $31 million versus a $3 billion increase in loans.
Adversely graded assets increased as the result of an increase in special mention credits, partially offset by a decrease in classified accruing loans, non-performing loans and other real estate. Non-performing assets comprised of loans on non-accrual and repossessed real estate increased to $70 million or 0.27% of total assets compared to 0.26% in the prior quarter and have decreased from 0.29% in the prior year. Total adversely graded assets declined to 1.64% of total assets from 1.83% a year ago.
Gross credit losses of $2.6 million during the quarter were partially offset by $1 million in recoveries, resulting in net credit losses of $1.6 million or three basis points of total loans annualized. The credit-loss provision of $7 million doubled from the prior quarter supporting our strong loan growth.
Provisioning related to our loan growth was also increased the allowance for loan and lease losses to $160.4 million, up $13 million from a year ago. This reserve was 87 basis points of non-acquired loans at June 30th, as acquired loans are booked at a discount to the unpaid principal balance and hence have no reserve at acquisition.
For acquired loans credit discounts totaled $10.6 million at quarter end, which were 1.22% of the $869 million purchase loan portfolio, which is primarily from the Bridge Bank and Hotel Franchise Finance transactions.
Relative to our peer group, our special mention loans, classified loans, non-performing assets, and net charge-offs are all lowered - are all lower for us and our allowance is higher than that of the peers, confirming the conservative nature of our reserve methodology.
Finally, we continue to generate significant capital and maintain strong regulatory capital ratios with tangible common equity to total assets of 10.2%, which is 130 basis points higher than the peers, and common equity Tier 1 of 10.6%. Tangible book value per share growth rose $1.45 in the quarter to $24.65 and is up 24.6% in the past year.
Notably, our production of tangible book value has been more than three times that of the peer group over the past five years, given capital requirements for banks operate under vis-à-vis consistent capital accretion is fundamental for value creation.
This concludes my review, and I'll turn the call back to Ken.
Thanks Dale.
As you are aware, in June we announced that the Board of Directors authorized the initiation of regular quarterly dividends beginning in the third quarter of 2019 of $0.25 per share. Given the continued success of our strategic approach to our business, the Company consistently creates more capital than needed to support our strong growth and is building a sound financial capital base, which allows us to remain flexible and nimble.
Coupled with our opportunistic share repurchase program, we endeavor to provide superior total shareholder return compared to peers without per tailing growth capital and will reward investors with recurring cash flow for stock ownership.
Just want to add a few words on the outlook. The strength of our product lines and geographic diversity, combined with an experience in credit oriented management team, generates above trend loan volume in a prudent predictable manner. Our diversified model, which is the centerpiece of our ability to prudently manage credit risk and allocate capital while maintaining a growth trajectory is found at other - is not found at other similarly-sized institutions.
This business approach delivers a level of sophistication that offers unique value-enhancing business expansion opportunities. Our record of growth has capitalized on our competitive advantages to drive industry-leading growth. We believe our business model helps diversify risk and protect against and undue risk taking.
Within our market today, we have observed little change in business activity, as our loan and deposit pipelines remain strong. We expect loan and deposit growth to continue a pace at the same level as our prior guidance of $600 million and loan growth per quarter, fully funded by core deposit growth. We do not expect any give back from our strong performance year-to-date, as none of our growth was pulled forward from future periods.
We'll continue to execute our plan of improving our risk profile by decreasing our allocation to construction loans, which we expect will comprise 10% of the portfolio by end of next year. This de-risking process will be complemented by continuing to shift our loan mix into relatively low LTV residential real estate first mortgages, as we will strive to more than double the proportion of our loans in this sector from 8% to 16%. As we enter a low rate environment, we expect our deposit funding mix to remain fairly stable.
We expect net interest income to continue to rise throughout the year, as volume increases from residential purchases, higher earning assets, and our strong loan pipeline will outpace de-risking activities, repositioning of our asset sensitivity and projected Fed rate actions. In quarters where target Fed fund rates are stable, our margin should be fairly stable and lead to net interest income growth tracking our growth in earning assets.
Further, we expect our efficiency ratio to increase modestly as we continue to invest in new business initiatives and value enhancing technology solutions. Our commitment to top level efficiency is advanced by our strategy of providing select business lines that have few - excuse me - advanced by our strategy of providing select business lines that have fewer competitors, lower losses, and high operating leverage delivered through a branch light business model.
Despite economic uncertainty, particularly related to trade in the slope of the yield curve, we have not seen this effect, the behavior of our borrowers in terms of loan demand or potential credit stress.
Given the mature stage of the economic cycle, we continue to emphasize underwriting discipline, and the majority of our loan growth we had this quarter was in areas with little or no historical credit losses.
So to summarize, we grew loans, while reducing our risk, had exceptional deposit growth while improving our mix, grew net interest income 12% annualized despite a 3% or 12 basis points decline in net interest margin, maintained stable asset quality at historically low levels, continue to opportunistically repurchase shares and announced an initiation of quarterly dividends grew year-over-year net income by 17%, EPS by 20%, and positioned the Company to carry forward momentum through the second half of the year. This should enable us to have ongoing EPS growth even in a declining great scenario and we remain comfortable with Street consensus estimates for the remainder of this year and next.
At this time, Robert, Dale, and I would be happy to answer your questions.
[Operator Instructions] Our first question today comes from Casey Haire with Jefferies. Please go ahead.
Wanted to touch, I guess on the loan growth mix going forward and sort of the NIM outlook. Obviously, commercial was a very big contributor this quarter and resi was not, but it sounds like that will change going forward. How - so and I'm assuming that some a lower yield product versus your 590 book. So how does NIM stay stable if that's going to be driving the bus on loan growth going forward?
Yes. So we're really focused on net interest income. And as we talked about, as I mentioned just a minute ago, we've got 4% growth in the third quarter already in terms of average balances, just holding the June 30 balances relative to what our average was in the second quarter, plus we expect to grow again $600 million per quarter in loans and deposits in the third quarter.
When we were talking about when rates were rising, our NIM would rise approximately 5 basis points per 25 basis points to the Federal Reserve action. Although, we have been moving into residential, we put on $1 billion in the past year that relationship still holds. So I would expect about a 5 basis point margin decline when the Fed cuts rates 25 basis points.
I expect the margin to far more than that though, because, if you look at our ending balance because of the strong deposit growth we had particularly at quarter end, which is still with us by the way. Those dollars are really sitting in the federal reserve accounts.
So we have - it's a good problem to have, but we have - we're sitting on a lot of cash, yielding only 2.35%, yet - while that's dilutive to the margin, it's accretive to net interest income and earnings per share. So, yes, we're going to be having a decline in margin. But our margin decline very similar to the second quarter, we expect to be able to earn through to have growing EPS.
And the operating leverage dynamics, the language has changed a little bit there, is that - I mean it sounds like you guys are baking in a bunch of cuts, Dale, I think you said four cuts. So is that - I mean, so the top decile of the peer group, you guys are way above that at 2.5 times revenue to expenses. Are you coming off of that 2.5 times revenue expenses just because of the Fed cuts or just trying to get understanding of what seems to be a change in that language.
Yes, the Fed cuts definitely have an impact, but what the - we're going to be continue to be focused. Operating leverage is the way we make our money here, it's one of the ways. And we feel that we can continue to invest in technologies to bring on new customers and also continue to have a very strong positive operating leverage. But that 2.5 times, which is what we used to do with the rate scenario four cuts is going to be more difficult.
Yes, we're not going to be able to sustain the 2.5 to 1. But with that and with strong expense control, we can still move our operating leverage, it will still be in the top decile, it may increase from the 42% that's at today, but we're comfortable with that, that we can sustain again this pre-tax income growth, efficiency and ongoing EPS growth.
Our next question comes from Michael Young with SunTrust. Please go ahead.
Appreciate all the color that you provided in the guidance and the outlook. But I was wanting to just dig into the loan growth a little more this quarter, obviously with a strong C&I growth. Can you give a little more color on, what's the level of pickup in utilization from clients or any sentiment change that you're seeing. And also if you could just tell us how much was mortgage warehouse related?
Yes. Our loan growth was spread through our regions and through our product lines. So to answer your specific question, warehouse grew $224 million. But we also saw a lot of growth for example in our Equity Fund Resources Group, that would be capital; subscription lines, that went up nearly $70 million.
Tech and finance, which previous to this quarter had a lot of commitments signed, but no loans outstanding; grew this quarter by $144 million. Our muni & non-profit book grew about $60-ish million. So it was spread throughout the product lines and also through the regions.
Okay. Were there any loan purchases during the quarter?
Yes. There were, and that totaled $140 million.
And then maybe just switching to capital as you move forward, you've got the dividend coming in place in the third quarter, obviously, very strong loan growth this quarter and it looks like that's going to continue for some time. Are you kind of looking at back off of the share repurchase authorization for a time or do you still feel like you can move forward with that?
That's, Robert. No, I don't think not necessarily will continue to be opportunistic in terms of - in terms of share buybacks. We evaluated every month and we still have some excess capital that we're growing and even given the dividend.
So it's more a function of stock price than growth at this point?
Correct.
The next question today comes from Timur Braziler with Wells Fargo. Please go ahead.
Maybe looking at - looking at the Arizona deposit growth this quarter, quite impressive. Anything specific that drove that and I guess what's the outlook if there is any kind of promotions or anything else going on that help fuel that growth?
Yes, I mean a lot of the growth came from title companies. We're not doing strong promotions. I would say the entire company since the beginning of the year has been very focused on the deposit growth and particularly focused on non-interest bearing deposit growth, so nothing different there.
What you can see from time to time in the regions contrast to each other is, depending on which customer - which new customer comes in, what customer has on big project they need to pull cash out of, it's kind of hard to kind of predict what's going to happen by region. But all the regions are focused on growing their deposits.
And then maybe switching to margin. Given the strong DDA and flow in Q2 coupled with nearly $1 billion of CDs either rolling off or repricing. Can we see funding costs actually get lower in the third quarter on a quarter-to-quarter basis, and if that's the case, is the margin compression kind of ex any Fed cuts solely going to be driven by the asset side or is there some other dynamic that I am missing that could see some lag and additional funding costs as well?
So, yes. No, I think we can see the funding costs come down a bit. I mean with regard to the margin, as I mentioned, today - so we had $1.1 billion in cash at June 30 in large measure related to the significant increase we had in deposits in the second quarter. That - those funds are predominantly still with us today.
So we had cash of more than doubled, really what we need. And while we want to deploy that into loans, that is basically sitting at the Federal Reserve yielding 2.35%. So that decreases our net interest margin even though it helps us with net interest income.
So I do think there is pressure on the margin without regard to necessarily just kind of what our funding costs are. Although I do think our funding costs are going to be declining in the third quarter.
And then just on the time deposits that are either re-pricing or rolling off. Do you have a gauge as to what's actually going off balance sheet and what you expect to keep on at lower rates?
I don't - we don't have a gauge of that at this time. But we are negotiating with these depositors, frankly from a position of strength. We've had such strong funding growth that we've already told, hundreds of millions of these depositors are saying, look, hey the Fed's going to move on July 31, and just so you know, we're going to move - what we're paying you in lockstep was whatever the Fed does, it's going to be 100% beta on a lot of those deposits.
And they say, yes, we get that. And so far, I think we've got about 100% that we expect to retain on those. But we're going to lose some and we've got the strength in the funding resources and network and levers we can pull that we can deal with that.
The next question today comes from Brad Milsaps with Sandler O'Neill. Please go ahead.
Dale, just - you just addressed this to some extent. But it does sound like you have a lot of confidence in being able to pass along Fed rate cuts to depositors. Do you think sort of as you look at your deposit cost today of around - at least the interest bearing of around 135 basis points. Do you think you can get those back to where they were in the first or second quarter of 2018? Assuming we do get the four cuts that you guys are looking for or do you think there's going to be more lagged in that?
You know, I think we have a lot of control and a lot of strength in order to be able to not have a lag. And so, I expect that in general, you're going to see kind of a mirror image of betas as they rose kind of coming in, let's say we get four cuts here and we're going to see those betas be fairly sharp in the beginning and then as we get to lower rates, I think they're going to become a bit more muted. So, but out of the gate, I think our betas are going to be fairly high.
And then just a follow-up for Ken. With the $1 billion of DDA growth this quarter, how much of that would you say it was maybe driven by some of the deposit initiatives you've talked about over the last year versus just and maybe hard to delineate between the two, just from your regular business. Just curious if there is still a lot on the comp from some of the initiatives you've been talking about?
There is a lot on the comp. So what we define is the deposit initiative number one, grew $60 million this quarter. And deposit initiative, two, which is not even up and running yet, grew $26 million.
And I want to say about both of these initiatives, we are pacing ourselves on this, we're not rushing. We need - we want to make sure the customer service aspect and be able to deliver what we say we're going to deliver, it's very important to us.
And so with the other parts of the business really kicking tail here, we are pacing ourselves not to push out and get ahead of our skis. But we are pleased that deposit initiative one brought in $60 million. And by the way, deposit initiative two, really doesn't go live until into Q4. So we're a little ahead of ourselves, but we able to bring in some dollars this quarter.
The next question comes from Chris McGratty with KBW. Please go ahead.
Dale, maybe a question on the balance sheet. The $600 million loan growth, appreciating the remix that's going on between construction and resi. How should we be thinking about the proportion that comes from resi over the next, call it six quarters. Is it 50%, is it more than that, any help would be great.
I think it's going to be - I think it's going to be 40% and it could be even a little bit higher. I mean frankly the second quarter, we thought was going to come in a little stronger than it did. We had about doubled the $130 million we had in that growth in origination behavior. But as others experienced, when rates fell sharply the refi business really picked up and that pulled that in.
I think that refi business while still strong, is in quite as hot as it was then, and so we think that proportion is going to be climbing here.
Let me just add a little something. I've been on the road a little bit visiting our partners, here. We hope on a growth basis that kind of drive about $200 million through what we call the flow side of the business. Now they'll lose some of the existing book because rates are dropping, and then we'll also be opportunistic in terms of buying portfolios. So that's sort of the way to think about it at the moment. And that's against the $600 million overall loan growth target that we have.
The $1 billion, follow-up on the non-interest bearing deposits the $1 billion. Can you speak to the granularity of that deposits setting. I think a couple of quarters ago, you pushed a couple out. So number one, speaking of the granularity and two kind of early trends in the third quarters whether you've retained those or any those were seasonal? Thanks.
All right. Back to the quarter you're referencing, which is Q4. We let one customer go for credit reasons not pushing out for deposits; that's one. Number two, some of the investments that we made in technology really showed up this quarter in our warehouse lending group, where our warehouse lending deposits rose $550 million and almost 100% of that found its way into DDA.
So we did pick up one or two major customers, one in warehouse lending and then one or two in the regions. So I think that's what helped drive some of the growth, and it looks like we're holding on to everything, that's what I would say for Q3.
Okay. So that - so the flat balances that you had talked about in the past, we are probably upside to that number, okay. Maybe last one down on the tax rate, how should we think about it, it was a little late this quarter?
Yes, we had some kind of modest non-recurring gains, I would say, and 18% is what we guided at the end of the first quarter and I would continue that going forward.
The next question comes from Jon Arfstrom with RBC. Please go ahead.
Question on construction and development. I think we all understand that mix change that you're going through, but anything new to report positive or negative in terms of trends that you're seeing in the health of the book.
So we're going through a change here. We just went through a change of Chief Credit Officer. So our outgoing Chief Credit Officer has now become the Chair of our Senior Loan Committee. And he has less day-to-day responsibility, but more responsibility to go out visit customers and ensure that he feels comfortable with the credit that's coming in, especially part of the large credits.
Our new Chief Credit Officer, the first thing I asked him to do, new when I say new to the role, but had been - he has been in the Company for over three years. I asked him to tear apart the construction land and development book and give me his own independent viewpoint on that.
And as late as this morning he still feels very comfortable with the book. And so what you see in us driving down the percentage by taking down the numerator and also growing the denominator is really just to make, I think investors feel more comfortable that we don't have any outsized risk sitting on our balance sheet. But he went through it and he feels very comfortable where we are today.
I would guess you are seeing some terrific opportunities in Phoenix and Vegas and new relationships potentially, and I think we understand the reason the concentration issues but my guess is there has to be a lot of activity that you can pick from?
Well, we remember too now, as we are bringing down the percentage, one of the ways to do that is we are increasing the price. So we're going to be far more selective in who we bring in as we bring down the overall level of representation to total loans.
Okay.
But I will say, Nevada is very busy, Vegas is a very busy, [indiscernible] is busy, Phoenix is very busy in terms of building. Absolutely.
Okay.
But the - the busier it gets, the more you have to focus on your credit underwriting. And so that's how we kind of monitor the flow. As Ken said based on price, but also based on equity and debt coverage ratios. So in a stronger environment, you're going to want to have more cushion in debt coverage and your want to require more equity.
It makes sense. That kind of dovetails in the next question, it's more philosophical. But for rate cuts, it's pretty aggressive relative to what your peers are saying but just curious if that comes true, does it change the way you think about risk or growth potential for your company? Because on one hand you're saying your economy is rock solid, but if we do get four rate cuts it seems like you're going to have quite a bit of growth. And I'm just curious, if you feel blending gets riskier non-bank competitors come back in and all the stuff we dealt with before.
So we actually believe there's going to be just two rate cuts. But we're setting the company up to be prepared for four rate cuts. And that way, as everyone looks forward, they have to think through what their operating expenses are going to be, how we're going to grow; that's one.
Number two, since 18 months to 24 months ago, we've been blending as if we are in the very last innings of this expansion. So, if we have a couple more rate cuts, I don't think we're going to actually change our philosophy in granting credit because we've been tightening up, and we've been concerned - sorry, we've been always worried that we're - that the expansion may stop. So we've been very conservative in how we are pushing dollars out the door.
Third, as it relates to earnings and what we plan to do, if we have four rate cuts, we may just very well have somewhat slower loan growth, but we'll still have EPS rise year-over-year.
So, John, if I'm like you and I'm sitting there, and saying to myself, okay, you guys are defensive and you're concerned about credit quality and focus on risk, but how do you keep growing every quarter, and how do you kind of put those two together and what I would say is, just from a high level perspective, let's talk about credit.
I've had a chance to meet with a lot of other banks out there in the market, our size, a little smaller a little bigger. And at the end of the day on the credit side, we just have a much more robust and sophisticated model than most of the banks our size. It's based on a broader loan product array, more geographic options and a more sophisticated credit allocation model. And so, what all that translates to is that allows us to have stronger growth than our peers and also at the same time be generating better risk adjusted yields than our peers.
We just have a lot more buckets, and those more buckets along with our credit allocation model allows us to be much more forward-thinking and be able to modify and adjust to different markets based on product and geography. And that's how we get better growth without taking on more risk.
The deposit side is a little bit different. The deposit side, the Company also has a lot more deposit products, and I don't mean like a checking account product or loan product, what I mean is a product that specifically fits a niche of customers.
So on the deposit side, while we are able to continually grow faster than peers where quality core deposits is, we are in a lot of different markets that our required products too sophisticated for community banks, but the deposit market isn't big enough for big banks to really focus on. We're able to bring in a lot of business from that standpoint.
And so at the end of the day what I think a lot of people lose sight of is, we're not just a large $25 billion community bank. A lot of banks our size have gotten - where they've gotten by doing the same thing over the last 20, 30, 40 years, they just gotten bigger. We're not so much - we're bigger, but we're actually different. And in the difference in our model is what allows us to keep putting out these growth results that are superior to peers, but at the same time manage our risk.
The next question comes from Gary Tenner with D.A. Davidson. Please go ahead.
Just a couple of follow-ups, in terms of the deposit growth, I noticed there was a big chunk came from tech and innovation space. Is that to be thought of as some money on deposit from capital raise – rounds or is it venture capital related deposits what's the chances of the that?
Actually it's both, Northern California has been seeing a great deal of capital raising and that has generated from the technology and finance side, about $449 million of incremental deposits for us. But also as we move a little bit deeper into equity funding, which is the capital call and subscription lines. For example this quarter our deposits were equaled almost dollar for dollar, what we put out in loans. So we're generating from that perspective, which is to say, those are existing customers that have cash that we're able to bring on to our balance sheet.
So it's about the VC fundraising and having their balances as well as the - probably portfolio or company balances?
Yes, correct.
All right sorry, and then just in terms of just the buyback. The rest of my questions have been answered. I know you kind of talk about being opportunistic. The last couple of quarters, you've been buying anywhere from the high 30s to low 40s, now we're back in the high 40s. So how should we think about your relative appetite at this level versus 42 bucks [ph]?
I think we again look at the market and on debts I think you could see us buy some stock, but I'm not going to tell you exactly at what price we buy around.
Our next question comes from Brock Vandervliet with UBS. Please go ahead.
On this warehouse deposits, how – on the mortgage warehouse deposits. How seasonal are those, are those pretty sticky or do those kind of ebb and flow with the mortgage activity behind it?
So there is a little more seasonal in Q4. They do have an ebb and flow, they actually build up during the course of a quarter, and then they dip as payments are made and then they begin to build up again. So you've got that ebb and flow just naturally inherent in that business.
But there is tax payments are due usually in November and that did contribute to our seasonality that we had in the fourth quarter of last year.
And the rate sensitivity, the shock analysis that you show that down 6.6 or so, that hasn't changed much from the Q1 shock that you showed in the Q. As you look at the prospect of four cuts, do you feel like you're positioned the way you want to be or there are other levers that you would pull beyond just adding more resi mortgages as we go forward?
Well, we've looked at other elements like swaps and whatever else. I think swaps can be fairly efficient, but with the pricing they are at today, we can't get there from here. But we would consider doing something synthetic like that. We have other – categories as well. So we've been extending some securities – some securities durations. We've got some public finance types of things and we're doing that longer term fixed rate. The residential piece just happens to be the largest.
No, I mean - yes we've been doing this and yet over the – not just the last quarter, as you know, over the past year our shock scenarios really haven't moved much. I believe that, that will change and we're going to start making bigger dents there, as we do move or in terms of the residential piece. And as we pull down construction which is a 100% basically tied to either LIBOR or prime. So I think we're going to be pulling down some things that are highly sensitive, moving into things that are less sensitive.
And I think we have seen that number move a bit. But you're right, I mean that's why my guidance was a year ago, it was like, hey, we're going to expand our margin five basis points for 25 and it's still that same ratio, we're going to drop five for 25 on the way down.
Our next question comes from David Chiaverini with Wedbush Securities. Please go ahead.
A couple of questions for you so starting with the efficiency ratio, you mentioned how it could increase modestly from the 42%. Can you provide a sense of magnitude of how much it could increase?
You know it drift off modestly as we go through the year. And that will be somewhat dependent on how many rate cuts come at us. It also helps, again one of the advantages that we have here that helps the efficiency ratio is that, we basically got another quarter of loan growth in this quarter and that gave us such a high average balance. So that should generate more revenues, which should help our efficiency ratio.
And related to that, you mentioned how you're investing in technologies. And you gave the example of the benefit seen in the warehouse lending group. Can you provide other examples of where you're investing in technology?
So those two deposit initiatives are all the generated by technology in the back office to provide the appropriate customer service. So those are two places. I would tell you that there are the things that aren't sexy in this company. CECL, making sure we have the right BSA system. So what I would say the guts of what makes a bank a bank we continue to invest in. Fortunately, we're not a consumer bank so we don't have to go against the big money center banks.
But we do have to continue to invest to make sure our infrastructure can not only support where we are today, but we're trying to build it out for where we're going. With ongoing enhancements required to be – just to be consistent and to be competitive on treasury management services. Those are getting better all the time, more mobile applications, more functionality.
And then shifting gears to credit quality with the increase in special mentioned loans you mentioned how there's no trend developing. But I was curious, if you're able to disclose what areas or loan categories those were in?
So let me just take you through maybe three or four of them real quick and you can get a sense. We have a property that's being built, a spec home in California. The property is completed, the construction ran a little longer, the builder funded all the cost out of pocket, it sits there at a 44% LTV, I've walked the property it's beautiful. And quite frankly we put it in there, because the builder went longer than projected. But no risk of loss and we're in good shape. We have a assisted living memory care facility in Arizona or again the LTV there is 66%, they were lagging behind in terms of their residency, they switched managers.
We don't see there is any problem there and the borrow has put up money to not only cover the next six months of interest, but also any operating deficit. We have a hotel with one of our really good sponsors that saw a little more supply in the area than they expected, their RevPAR was a little below, but we're sitting there with an LTV of 58% and that sponsor has put the hotel up for sale and they have enough cash on their balance sheet to carry it for another 17 months.
And then we had a few smaller deals, which we are all in tech and innovation where we’re just waiting for the infusion of equity capital to come in, but the remaining months of liquidity are now drop below six.
So when something drops below six, it's our standard practice to put that on special mention. So Dale kind of quoted in his prepared remarks, there is nothing that's across the company that's giving us concern, but we watch all of those things and when it goes on special mention it gets more attention, actually gets attention even before it gets there. But these are the things that we've put on special mention this quarter.
The next question comes from Arren Cyganovich with Citi. Please go ahead.
I was just curious if you could talk about the deposit growth, how much came from new customers versus existing?
It was about 40% from new customers. The largest customer just coincidentally as Ken was alluding to, was approximately the same size as the one that we walked away from in the fourth quarter.
This concludes our question-and-answer session. I would now like to…
Operator?
Yes.
Thank you. I was going to say, just turn it over to me. Just before we go, one question that wasn't asked that hugely is that - is what does the M&A landscape look like. So let me throw that out to Robert and have him give a few comments on it.
Yes, sure. I mean we have always preferred organic growth to acquire growth. And as we said before any deal we would do would have to be both financially and strategically accretive. But at this point looking at the landscape and looking at where we're at, we're really more focused internally. We think our organic growth, our operating leverage and share buybacks provide enough levers for really strong EPS growth and tangible book value growth, and that's where our focus is today.
Okay, thank you all for attending the call and we look forward to talking to you about our Q3 results. Have a great day, everyone.
The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.