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 Third Quarter of 2019. Our speakers today 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 2:00 PM Eastern Time, October 18, 2019 through November 18, 2019 at 9:00 AM Eastern Time by dialing 1877-344-7529, passcode 10134684.
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 the current events and financial performance, 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 any forward-looking statements.
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, operator. Good afternoon, and welcome to Western Alliance's third quarter earnings call. Joining me on the call today are Dale and Robert, I will provide an overview of the quarterly results and Dale will walk you through the bank's financial performance in greater detail, and then afterwards, we'll open up the line and Robert, Dale and I will take your questions.
During the third quarter, we continued advancing our key strategic objectives which include leveraging our branch-wide business model to drive disciplined and thoughtful loan and deposit growth, carefully managing our balance sheet with regards to asset sensitivity, pursuing accretive capital allocation policies and de-risking our loan composition, all while being unique in our ability to drive industry-leading growth and efficiency across changing market environments.
Western Alliance produced another record quarter with robust loan and deposit growth, which generated continued increases in net interest income and earnings per share. Our combination of regional banking and national business line lending drove loan growth of 19% on a linked-quarter annualized basis, as we saw a wide-ranging broad participation across our businesses.
We achieved annualized net interest income growth of 18%, with total revenue growth of 22%-plus as we produced positive operating leverage, all while de-risking our balance sheet and improving asset sensitivity. This was achieved against the headwind of a challenging yield curve.
As discussed on our prior earnings call, we expect ongoing loan origination volume to offset net interest margin compression and produce continued increases in net interest income. So let me go through a few of the key highlights.
Net income during the quarter rose 3.6% to a record $127.4 million or 14.6% year-over-year. Our earnings per share grew 4.2% to $1.24 per share and 18.1% from the prior year. Balance sheet growth continues to be exceptional and exceeded our guidance of $600 million per quarter for both loans and deposits.
Total loans were $20.2 billion, an increase of $903 million or 18.8% on a linked-quarter annualized basis and have risen by $2.4 billion over the last three quarters. On a year-over-year basis, loans rose by 20.4% with $1 billion of growth coming from the residential program.
As part of our strategic de-risking plan, we view residential loans as a thoughtful responsible alternative to managing our loan growth, while deepening our warehouse lender relationships. Residential loans now comprise 9.3% of our portfolio.
During the quarter, we also reduced our construction and land and development loans by $55 million, lowering their proportion in our overall portfolio to 10.7% compared to the 12.6% in quarter one. This puts us within striking distance of our 10% target for year-end 2020 with opportunities to balance future reductions. We had another stellar quarter in deposit growth, which really highlights the continued strength of our diversified funding channels and overall deposit franchise.
This quarter, total deposits grew over $1 billion or 18.7% on a linked-quarter annualized basis to $22.4 billion, which is the third consecutive quarter of more than $1 billion in organic deposit growth. This growth was attributable to an increase in savings and money market accounts of $1.2 billion, primarily driven by our Tech & Innovation business due to a healthy capital fundraising environment.
Non-interest bearing demand deposits rose another $78 million to $8.8 billion and over $1.3 billion of our year-to-date deposit growth has been in DDAs. DDA as a percentage of total deposits declined slightly to 39% from 40% in Q2. Overall, the loan to deposit ratio remained consistent at 89.8% compared to the prior quarter.
Continued balance sheet growth drove healthy net interest income expansion of $11.7 million in Q3 or 18.4% annualized, while confronting yield curve headwinds, which resulted in an 18 basis point reduction in NIM to 4.41%.
NIM compression was driven by recent pressure on yield curve, increased deposit liquidity and continued de-risking of our loan portfolio, partially offset by proactive steps taken to reduce our deposit rates, all of which Dale will speak to in greater detail later in the call.
Total operating revenues grew $15.2 million for the quarter compared to an expense increase of $7.7 million, producing a two times revenue to expense growth ratio and an efficiency ratio of 42.4%. We remain one of the most profitable banks in our industry and produce return on assets of 1.94% and return on tangible common equity of 19.4%. We believe our ability to simultaneously drive industry-leading growth and efficiency is the key differentiator.
Our financial results were accompanied by continued stable asset quality, as the markets we operate in are experiencing some of the strongest economic growth in the country. Non-performing assets were $66 million, down $4 million from the prior quarter and remain at near historical low levels. During the quarter, we had net recoveries of $600,000 and loan growth in low loss categories, such as residential, which resulted in a provision expense of $4 million.
Turning to capital management. On display this quarter was our ability to thoughtfully manage capital allocation between loan growth and share repurchases. Last quarter, we paid our initial quarterly dividend of $0.25 per share, we also continue to opportunistically repurchase shares. During the quarter, we purchased 1 million shares at $43.63 bringing total program repurchases to 3.6 million shares at an average price of $41.59.
Overall, the share count has been reduced by 3.4% through repurchases since the initiation of the stock buyback program in Q4 of 2018. We anticipate using the remaining $99 million available under the current plan as opportunities present themselves.
Given all these actions, tangible common equity ratio absorbed the significant balance sheet growth and share repurchases and was 10.1% at quarter end, down only 10 basis points from prior quarter, but up 10 basis points from the prior year period. Tangible book value per share grew 3.9% or $0.95 from the prior quarter to $25.60 and now has grown by 225% over the past five years, as we continue to scale our business.
Additionally, our asset sensitivity profile has improved as variable rate loan floors are increasing, deposit costs are quickly being adjusted and our loan portfolio continues to shift into longer fixed rate residential loans. We expect asset sensitivity will continue to improve with additional rate cuts, as more loan floors are triggered.
Finally, lastly, I like to thank the 1,800 people at Western Alliance that did a fantastic job to produce these financial results this quarter. And now Dale will take you through the financial performance.
Our managed balance sheet growth resulted in record earnings, despite headwinds from a flattening yield curve preceding the anticipated Fed rate cuts. Net interest income rose $11.7 million or 18.4% annualized in the second quarter to $266.4 million, driven by a $1.8 billion increase in average earning assets, which outweighed reduced loan yields.
From the corresponding period last year, net interest income was up 13.8%. The provision for credit losses was $4 million for the quarter, a decrease of $3 million from the second quarter due to net loan recoveries during the period and the mix shift to high quality residential loans.
Non-interest income increased $5.2 million for the quarter to $19.4 million as equity investment income from our Tech & Innovation segment and gain on sales of investment securities increased $2.9 million and $3.2 million, respectively. Non-interest expense was up $11.7 million, as compensation costs and deposit costs increased by $5.2 million and $3.9 million, partially offset by a $2.9 million decrease in professional fees.
Compensation costs were affected by increased accruals for annual performance incentive plan. Deposit costs were elevated by $2.5 million, due to a single client who maintained higher-than-anticipated balances throughout the quarter, but whose ending balances were zero. We do not expect to repeat of this activity in Q4. We also experienced a $3.4 million loss on sales in OREO property, which was essentially offset by the securities gains. Share repurchases to-date reduced the diluted share count to 102.5 million shares, resulting in diluted EPS of $1.24. As Ken mentioned, of the $250 million authorization, we repurchased a total of $151 million, with $99 million remaining.
Turning now to our deposit drivers, net interest income rose $11.7 million during the quarter to a record $266.4 million. Investment securities yield decreased 26 basis points from the prior quarter to 3.08% due to a flattening yield curve and lower reinvestment rates. Lower long-term rates increased mortgage prepayment speeds and the resulting accelerated amortization of premium was responsible for lowering the overall quarterly portfolio yield by 16 basis points.
On a linked-quarter basis, loan yields decreased 19 basis points due to reduction in interest rates and spreads. Further impacting the decline in yields was our intentional mix shift toward residential loans and the decline in LIBOR, which preceded cuts in the Fed funds rate and prime. Interest-bearing deposit costs decreased by five basis points in Q3 to 1.3%, as a result of proactive steps taken to reduce our deposit rate, immediately after the Fed rate cut.
During the quarter, we lowered our rates on approximately $6.2 billion of exception price deposits with the weighted average reduction of 23 basis points. Additionally, after the Fed announcements, we reduced our stated rates on a $5.2 billion of interest-bearing non-maturity deposits by an average of 29 basis points. This decreased funding costs by six basis points, when all of the company's funding sources are considered including non-interest bearing deposits and borrowings.
However, due to our decision to time rate reductions, coincident with Fed rate announcement, the full effect of these actions are not reflected in the third quarter results. We expect that the effective cost of reliability funding was down to 80 basis points at the end of Q3 compared to the 87 basis point average. The strategic shift in our loan mix away from construction and the reduction in market rates weighed on the margin, but was more than offset with improved revenue from our consistent balance sheet expansion, driving a net interest income increase of $11.7 million for the quarter.
Given no change in the economic outlook, this will be the theme for ongoing performance that we can continue to earn through NIM compression. The net interest margin decreased 18 basis points to 4.41% during the quarter, as our earning asset yield fell 24 basis points, partially offset by six basis points of funding cost decrease. The largest component of the margin decline was from the sharp change in the relationship between LIBOR and Fed funds during the quarter, as the outlook shifted from a rising through declining rates.
With nearly half of the bank's loans tied to LIBOR, loan yields begin declining in the second quarter, however, deposit costs could not be reduced until after the FOMC cut the target Fed funds rate at the end of July. Compression between these two rate indexes reduced the margin by nine of the 18 basis point total decline.
The increase in our on-balance sheet liquidity drove another seven basis points of the margin contraction, as our strong balance sheet deposit growth resulted in $550 million increase in average cash balances during the quarter. Finally, two basis points of the reduction was due to de-risking our portfolio from the ongoing shift into residential loans and lower construction loans. Looking ahead, margin volatility in the fourth quarter should be much lower, as the basis risk issued from the change in direction of rates is behind us and excess liquidity deployment should continue even with additional cuts to the federal funds target, as expected.
With regard to our asset sensitivity, our rate risk profile has declined notably, as our mix shifts primarily to fixed rate residential loans has reduced our net interest income variability due to the changes in the rate environment. Meanwhile, $2 billion of our variable-rate loans are now behaving as fixed since the rate floors are now active after the first two rate cuts we've already have.
This has reduced our interest rate risk and 100 basis point parallel shock lower to 4.8% at September 30, from 6.6% at June 30. As we stated last quarter, we believe a ramp-down is a much more probable rate reduction scenario, which would further reduce our rate risk profile by another 60%. We believe 1.8% reduction in net interest income in this situation is something we can quite reasonably manage through with continued balance sheet growth, earning through margin compression like we did in the second and third quarters of this year.
Of our $14 billion of variable-rate loans $9.3 billion or 66% have floors with $2 billion in the money. With each additional 25 basis point rate cut, another $1 billion of loans with floors will be triggered, which reduces sensitivity in the shock scenario by another 50 basis points, further mitigating our recent margin compression.
Turning now to operating efficiency in Q3, we produced another strong quarter of operating leverage while continuing to invest in new products and business initiatives to drive ongoing growth. On a linked-quarter basis, our efficiency ratio increased 40 basis points to 42.4%, as I mentioned earlier, a significant portion of the deposit cost and ORE expense are one-time in nature and not likely to be repeated in the fourth quarter.
On a taxable equivalent basis, operating revenue increased $15.4 million to $288.9 million in the third quarter of 2019, compared to an operating expense increase of $7.7 million to $122.6 million, generating operating leverage of two times. As a core component of our strategy and irrespective of the rate environments, we continue – we will continue disciplined expense management in credit underwriting to maintain industry-leading operating leverage and profitability.
Our pre-provision net revenue return on assets was 2.44% and our ROA was 1.94%. These metrics continue to be in the top decile compared to peers. Our balance sheet momentum continued during the quarter, as loans increased $903 million to $20.2 billion and deposit growth of $1 billion brought our deposit balance to $22.4 billion at quarter end. Our loan-to-deposit ratio remained essentially flat at just under 90%. Our ample liquidity position continues to provide us with balance sheet flexibility to pursue attractive risk-adjusted lending opportunities.
Tangible book value per share increased $0.95 over the prior quarter and $4.90 or 23.7% over the prior year. 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.
Total loans were $20.2 billion, an increase of $903 million, driven by increases in non-owner occupied commercial real estate of $346 million, residential loans of $282 million and C&I loans of $275 million. Residential loans now comprise 9.3% of our loan portfolio, while construction loans have decreased by another $55 million and make up 10.7% of total loans versus 11.5% at the end of the second quarter.
Regarding deposit growth and further demonstrating the strength of our franchise, deposits grew $1 billion in the third quarter, driven by an increase in savings and money market accounts to $1.2 billion. This growth was partially offset by a net decline in mainly higher cost CDs of $221 million. This is the third consecutive quarter of more than $1 billion in organic deposit growth.
Over the past year, deposits grew across all categories with the largest increase in savings and money market of $2 billion and non-interest bearing DDA of $741 million. Year-to-date deposit growth has been $3.3 billion of which nearly 40% has been in DDA. Over the past year, loan growth of $3.4 billion was fully funded by deposit growth of $3.5 billion. We believe our ability to profitably grow deposits is both the key differentiator and a core value driver to our platform’s long-term success.
Overall asset quality continues to remain stable. Total adversely graded assets increased $40 million during the quarter to $439 million and special mention credits increased $36 million to 88 basis points of total assets.
From the prior year total adversely graded assets have increased just $81 million or 2 basis points to 1.72% of total assets versus a $3.4 billion rise in loans. Nonperforming assets comprised of loans on non-accrual and repossessed real estate increased marginally to $66 million or 25 basis points of total assets and continues to hold steady as a proportion of the balance sheet.
Regarding the increase in special mention credits, looking back over five year period, loans that have migrated to special mention have less than a 1% risk of loss as it is an early potential stress indicator that had little correlation to loans becoming nonperforming. Overall, we see nothing in our portfolio that raises concerns or indicates a change in credit outlook as we expect asset quality ratios to remain at historically low levels relative to the overall size of the balance sheet.
Gross credit losses of $2.1 million during the quarter were more than offset by $2.7 million in recoveries resulting in net recovery of $600,000 or 1 basis point of total loans annualized. The credit loss provision of $4 million decreased from the prior quarter due to this net recovery position and the change in the loan origination mix. Provisioning related to our loan growth, increase the allowance for loan and lease losses to $165 million, up $15 million from a year ago, resulting in a reserve of 85 basis points of non-acquired loans at September 30th. For acquired loans, credit discounts totaled $7.5 million at quarter end, which was 95 basis points of the remaining $788 million of purchase loans, primarily from the Bridge Bank and Hotel Franchise Finance transactions.
Finally, we continue to generate significant capital and maintain strong regulatory capital ratios with tangible common equity to total assets of 10.1% and a CET ratio of 10.3%. Despite the payment of our first quarterly dividend of $0.25 per share and the buyback of 1 million shares, our tangible book value per share rose $0.95 in the quarter and it’s up 23% in the past year.
Notably our production rate of tangible book value has been more than 3 times that of the peer group over the past five years. Given capital requirements that banks operate under, we believe that consistent capital creation is fundamental to value creation.
I’ll turn it back to Ken.
Thanks, Dale. On display this quarter was the advantages of our diversified business model that provide us the flexibility to actively adapt our business and capital allocation strategy and response to the changing external environment without sacrificing credit quality. The combination of our regional banking and national business line lending provided powerful growth to net interest income, loans and deposits. Our business model generates positive operating leverage, growth in high-quality loans, industry-leading ROA, ROE and meaningful tangible book value per share growth.
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 on average to continue at the same level as our prior guidance of $600 million in loan growth per quarter fully funded by core deposit growth. Despite a challenging interest rate environment, we expect net interest income to continue to rise as volume increases from residential purchases, higher earning assets and our growing loan pipeline will overcome potential net interest margin compression. The repositioning – I’m sorry, I should say net interest margin compression and the repositioning of our assets sensitivity and projected rate actions.
So to summarize, we continue to generate robust loan growth, while reducing risk, had exceptional deposit growth of over $1 billion for the third consecutive quarter, grew net interest income 18% annualized, continue to maintain stable asset quality at historical low levels, grew year-over-year net income by nearly 15% and EPS by 18%, position the company to carry-forward its momentum through the fourth quarter and into next year, and we reduced asset sensitivity and further insulated ourselves in a down rate environment.
So operator, at this time, if you would open the line and Robert, Dale and I would be happy to take your questions.
Thank you. [Operator Instructions] The first question today comes from Michael Young with SunTrust. Please go ahead.
Hey, good morning.
Good afternoon to you.
Thank you. We ended the last call with unsolicited comment on M&A, so maybe we’ll start this call with a solicited comment on M&A. Where do you feel the appetite is for acquisitions at this point? Or should we take the activity on the share buyback, just seeing a better value in buying your own stock at this point?
Yes, it’s Robert. I would say probably more the latter. I mean, we’re continually evaluating the best use of our capital on a daily basis looking at a lot of deals. But as of now, we’ve chosen to invest in our own brand and our organic growth and to repurchase our own shares. So I would say probably more the latter.
Okay. And then just on the one to four family purchase strategy. I’m curious if you could just talk about, it sounds like you have a pretty strong appetite to continue that as a de-risking measure, but has anything changed relative to the drop in tenure rates and the yields you’re able to get on that paper and the seasonal impact, capital allocation to that or anything like that. Any changes in the strategy there?
Nothing in strategy, we still think it’s a very effective method which will extend the duration of our assets, and do so with something that should perform quite well, should an economic downturn present itself at some time in the future. So rates are lower than what we were getting initially going into the program, but we’re still getting into the lower 4’s in terms of yields. These are really good quality underwriting at 67%, 68% loan to value, 760 FICO, mid 30s on debt to income.
And we’re able to do this because we’re buying things that maybe don’t quite fit in the box from our mortgage warehouse originators, that would be qualified. So some of these are loans that have an IO period in the beginning, some of these are loans that are not necessarily primary residences, but by well-heeled borrowers. So we’re continuing to execute on that, and we think it’s really helping in terms of our interest rate risk management.
And there’s one other thing to add to that, which is it puts us closer to our warehouse lender. So we now have another product to offer them in addition to warehouse lines, MSR lines, note financing, getting in deeper with the deposits and now picking up some of their volume on a forward flow basis. It gives us an opportunity to remain close to them.
The next question today comes from Timur Braziler with Wells Fargo Securities.
Hi, good morning. First one from me, Dale, you had mentioned couple of times that there was a large deposit on the books for the quarter that has now exited. I’m just wondering what’s the size of that deposit?
That was a little over $500 million average balance for the quarter. We still have a relationship with the client. But those deposit dollars were zero by quarter end.
Okay. And then maybe sticking with deposits, certainly, quite encouraging to see the drop in funding costs this quarter, and I know from prior conversations, you guys had been proactive in addressing the deposit rates kind of right after the Fed has cut. I know the full impact of what’s been done already will be reflected in the fourth quarter results. But going forward, that proactive approach, does that reduce ability to lower deposit costs further on additional rate cuts? Or are you expected to see similar magnitudes for each incremental rate cut we see?
Well, I don’t know, how rate – low rates are going to go. I mean, if we got to this zero band, I mean eventually you’re going to get some compression in terms of ability to cut. But this is where the floor has become so effective, because as rates get lower, a greater proportion of our loan portfolio becomes effectively fixed rate. So it’s an asymmetric kind of a return in that – if and when rates ever go up again, we should actually have increased the sensitivity on the other side. So yes, I mean, if rates continue to drop substantially in other number cuts from here, you are going to see some compression. But the floors will be stronger.
Hey, we’ve moved pretty quickly, immediately after the two rate cuts and what we’ve noticed as many of our competitors did not. So I think as they catch up to us next quarter on the next cut, then there’ll be less opportunities for our clients to go elsewhere and they’ll see the same action among many more banks.
Okay. That’s good color. And then just if I could one more, looking longer term in this rate drop environment, are you guys still thinking that 1.5 to 1 kind of revenue to expense level is still achievable in 2020? Or is that fully dependent on how many additional rate cuts are going to be?
Look, going forward. We expect to continue industry-leading and peer group operating leverage as part of our strategic growth management programs. We have a core discipline of expense management within the company. I do not expect that to change and we’ll bounce that against the delivery on platform expenses and services and also new product expenses that we may spend. So we’ll do what’s right for the company as we go forward.
Understood. Thank you.
The next question today comes from Brad Milsaps with Sandler O’Neill. Please go ahead.
Hey, good morning guys.
Good morning. Afternoon
Hey, maybe kind of a three part question around credit. You guys have excellent asset quality numbers, but just kind of curious kind of bigger picture kind of what you’re seeing in the credit environment in terms of pricing underwriting. And then just any additional color on what drove the increase in the adversely rated credits. Understood that’s coming off a low base, but just kind of any color there. And then Dale, just any color around CECL might also be helpful.
Okay. So I’ll take parts A and B and will give Dale part C. So general quality – a general statement, asset quality remained stable. Our portfolio looks fine. We see no economic stress from the economy. As I always say, we see more self-inflicted wounds, whether it’d be partner disputes or companies expanding too quickly or ill time or poorly executed acquisitions or poor cost controls, those drive some of the stresses in the companies that we’re dealing with.
As a general statement, though, I’ll say that we believe we’re at the top end of the expansion. So therefore, we’re lending as if the expansion is coming to an end even though this is not our opinion. So we’re trying to grow safely, thoughtfully and a very conservative managed way. As it relates to some of the activity this quarter, I think what’s important to know is, our credit process and philosophy. So our credit process is based on early identification and resolution. So we like to identify early, elevate early and that creates more resolution options and it also creates them sooner for us. It also garners early executive level attention, so many people are on any loans that either fall into the special mention category or fall into substandard.
And so in reality, we cycle loans in, we cycle the amount – I’m really talking about special mention here that do drive a little bit more special mentions in terms of dollars. But to reiterate what Dale said only 1% of all special mention loans are charged-off as we look at that over the last five years. So I’d end by saying, there really is no trend in our special mention composition, it’s all back to self-inflicted wounds or companies that are beginning to show some weakness that we want to make sure we intend to right away.
Regarding CECL, Brad. As you know, this is something that’s going to be done on the first of next year and depending upon economic conditions at that time. But we expect a charge of about 20 basis points of our capital position at adoption based upon current situation, and that would cover both the reserve build as well as reflecting what we need to do for unfunded commitments.
That’s helpful, Dale. Thanks. And I know it’s early, but would you expect kind of provisioning to sort of track to keep the reserve at that resultant level?
Yes, it could be. So if that’s a 20%, 30% increase in the reserve that provisioning given the same economic outlook, we’ll probably have a comparable rate of increase.
Great. Thank you, guys. Really appreciate it.
The next question today comes from Casey Haire with Jefferies. Please go ahead.
Great, thanks. Good morning. So question on the loan deposit growth guidance, it just feels a little bit conservative, given the performance year-to-date especially on the deposit side which is averaging about $1 billion a quarter. And Ken, your point, it sounds like business activity is still pretty good, so just trying to get a feel for why the conservatism in the guidance?
So we say the average is $600 million certainly on the deposit side. Q4 is seasonally a slow quarter for us in deposits, all right. So I keep that in mind, and sometimes whether it’d be on the loans or deposits, it’s hard to control when deals get completed. So for example, in Q1, our loan growth was only $400 million. So these things have an ebb and flow to it and so what we like people to think is, on average, it should be $600 million, some quarters it’ll be far more and occasionally, it’ll be less.
Okay. Fair enough. And then just on the liquidity side, what is the – how optimistic are you that you can work down the excess liquidity? And is there just given the deposit momentum, is there any thought to getting a little bit more aggressive with the securities book, especially with, I mean, the deposit initiatives that you have on the comp could potentially build this – your deposit momentum could accelerate? So I’m just trying to get a sense, liquidity drag could be here to stay for a decent while if these trends continue.
Yes, I mean it could continue the liquidity drag, I don’t expect it to increase from where we are. As you know, kind of how we got here for the third quarter is we had a substantial run-up in deposits going into the end of the second quarter. And that was elevated throughout the third quarter and then came down a bit as of the last day. So I would expect and we did purchase some securities, I’m sure you saw that too, we’re up fully – it was up a bit in Q3.
Given the seasonal outlook that Ken just mentioned in terms of the fourth quarter, I think we’re going to burn off some of that liquidity drag and we’ll look at this on an ongoing basis rather than loading up in securities and buying residential mortgage back, which is mostly what people purchase. I rather deploy it into our residential purchase program. It’s certainly a better return for us. And so we’ll see how that plays out, but I think liquidity drag is likely to have a little bit at least.
Got you. And just last one from me. The Hotel Franchise Finance that has been growing the last year or so. Is it – I thought the plan was just sort of to maintain that? Or is – just wondering what’s behind the increased appetite to grow that portfolio?
Well, we like that product and we’re growing it in what we think is a prudent way. So with low loan-to-value, loan-to-cost numbers, with sponsors that are well capitalized, and only working with operators as well that have maybe a dozen or more hotels with top brands in top MSA areas and primary/secondary locations in those top MSAs. So when we have some opportunities and we have deals that meet that entire criteria, we put our money into the Hotel Group.
We don’t expect it to increase proportionately to the loan portfolio from here though. I mean, we had an increase in the third quarter, some of that’s going to be sold down. That’s some of the things going on. So I think this is a proportionately kind of a high watermark.
Great. Thank you.
The next question today comes from Arren Cyganovich with Citi. Please go ahead.
Thanks. I think the thing that stands out for me is, you have the strong organic growth and we agree in terms of our model that you can outgrow the NIM. The skeptic in me though is little bit worried about the level of growth in potential credit quality associated with that. Now you have a good history in the past several years of delivering on credit. Can you give any kind of examples of maybe some of that conservatism that you’re taking in terms of this growth? So that we give folks a little bit more comfort in terms of that credit outlook.
Yes. Let me start with that. I think our business model is a little bit unique and that we have a lot of different products in a lot of different markets that we lend money to. And because we have so many different channels and types of businesses we’re lending to, we can look for better risk-adjusted returns as opposed to the typical bank our size that may be does commercial lending, commercial real estate and consumer. So we’re in so many different niches that we’re able to reallocate capital on a current basis to niches that provide us protection in a down economy, and that’s what we’ve been doing for probably the last three or four years.
So if you look at where the growth is coming from and then you look even further within that growth at the underwriting standards, I think you’d be pretty, pretty comfortable. We have a number of things – we’re not doing as much of that we used to do. And so we’re just really able to kind of change where we allocate the funds and we use that to kind of mitigate our risk, and as I said, look for the best risk adjusted returns.
Yes, just to add a few things, Brad, that to what Robert said, this quarter saw over $100 million increase in capital core lines, to Robert’s point, very, very low to no losses in that business product, resort finance went up. Again, we’ve never had a loss there and the team that’s running that has never had a loss in over 30 years. Residential portfolio that Dale mentioned, very strong asset quality as well. So that’s the – some numbers maybe or examples behind the model that Robert mentioned.
Yes, and like as an example, some of the things we don’t do as much of today because we think that the market hasn’t priced the risk properly or maybe the risk levels aren’t there would be restaurant franchise finance, some of the corporate syndicated credits or corporate finance group, these are areas we’ve cut back on because we think the market is maybe a little too aggressive on.
Yes, I’m thrilled some are lending in there too.
Yes. Good point.
Thanks. It’s helpful. I appreciate that. The second question I had was just on kind of the recent weakness in some of the valuations of technology, unicorns etcetera. Are you seeing anything from your – in Northern California or your Technology & Innovation businesses that would be impacted by these lower valuations?
So what we’re seeing is, first, they’re having a very, very strong capital raising activities and a lot of our deposit growth this quarter came from there. We’re seeing loans churn at a little bit faster rate generally the average maturity of our loans is 3.5 years for our entire portfolio, but it’s much, much less than that in the Tech & Innovation. We’re seeing some aggressiveness on pricing and structure from newly established competitors. But we’re not following that because we think there is enough activity for us to pick and choose what it is that we like. And also in that – in Tech & Innovation, we’re putting a little bit more capital allocation to our capital call line strategy.
Okay. But nothing from a valuation standpoint that would cause any kind of negative impact to your balance sheet?
No.
Okay. Thank you.
The next question today comes from Chris McGratty of KBW. Please go ahead.
Great. Thanks. Maybe Dale for you, I think in your prepared remarks you said, given the strategies with the floors and the deposit pricing that the pressure on NIM might be a little bit less severe kind of going forward. Maybe you could make some additional comments in terms of severity, especially with the comments on liquidity coming down a little bit for Q4?
Sure, so these floors, we have two from our – I think two rate cuts, we’ve got $2 billion in the money. The next one, where we’ll put another $1 billion in the money. The one after that goes to about $1.2 billion and then a $1.4 billion. So we’re gradually becoming kind of one dimensionally kind of fixed rate on our loan portfolio, should rates kind of continue to fall. And then meanwhile, we continue to have expectations that we’re going to be able to respond quickly based upon set action, we’ve got another ALCO meetings, set for October 30th right after they meet if they move – we’re going to move. And I think that helps us in the third quarter and now that the shift and kind of the basis is behind us where LIBOR is no longer anticipating fed rate increases. I think that is – will mitigate the risk that we have in terms of kind of further rate cuts from here.
Okay. And with the focus on NII, I mean, if we get our cut in October, we should still – given the balance sheet momentum, you still see commensurate growth of NII that we saw maybe this quarter. Is that a reasonable?
Well, I think the net NII growth will be slower in the fourth quarter, so in the third quarter that was the inflection point for the margin change at 18 basis points. I think the fourth quarter is going to be the inflection point for the change in terms of net interest income. So I’m looking for – while the margin drop should be substantially less, I’m looking for a lower growth in terms of net interest income. We’re going to get the effect of potentially as many four rate cuts that are going to have an influence on fourth quarter net interest income. The one in July, the one in September, the one in October, which we believe is going to happen and maybe it’s a little bit hefty, if we get the fourth one in December versus only two rate cuts affected the third quarter number.
Okay. But even under that scenario, it – sequentially it’ll be higher is what you’re saying?
Yes, we believe we’ll be able to exceed where we were in Q3.
Great. And maybe just one more, the expense line, the deposit costs you talked about this quarter being kind of just one-off. But if we look over the last couple of years obviously that numbers has grown considerably as rates have risen. How do we think about that expense line into 2020 with rate cuts? Is that – is there a correlation that that number should come down or is it kind of steady in that $7 million to $8 million in the quarter?
Yes, I think in the fourth quarter. I think, we're going to look a lot more like we did in the second quarter than the third. If we get additional rate cuts, obviously, that will release pressure on that number and it should otherwise lower except that to the degree we're continuing to move our deposit liabilities that will be a countervailing effect. So, I'm not sure exactly how this necessarily is going to sort out, but I would look for the third quarter number is being essentially a blip that will largely reverse.
Great. Thank you.
The next question today comes from Tyler Stafford with Stephens. Please go ahead.
Hey, good morning. Nice quarter. I want to start on, I guess, first on expenses, the salaries increased due to the estimated corporate bonus payout that you mentioned in the deck. I know for 2018 you achieved 138% incentive payout. So, I was just hoping if you could give us Dale some details about how much you've accrued so far in 2019 and what incentive reduction tailwinds you might see, just given a tougher end share backdrop is, if you do just achieve that, I guess 100% baseline going forward.
Yes, so we're north of $40 million here in terms of estimated accrual for bonuses in 2019. And that number, I mean – that number could be variable, depending on what we're going to be doing in terms of performance against the budget when approved in the beginning of 2020. So, I mean, the big driver for us in terms of the change from where we were estimated, where we were at $630 million versus now, is really in demand deposits. We've got a goal in there and you can see it in the proxy in terms of what that number was for core demand and we now believe that we're going to achieve that and we were somewhat uncertain about that earlier and that kind of moved the needle for us. So, I can't speak to what the specific goals are going to be like for 2020, but we have the expectation as we've stated that we're going to continue to be able to earn through kind of where we are in terms of margin compression and I think something that was fed up with would enable that to be a variable item should we fall short.
Okay. Yes, no doubt the fundamental results you guys have put up this year weren't that higher incentive comp, I totally get that, but can you tell us where that $40 million is, I guess relative just to a baseline number for 2019?
So the baseline number will be about $30 million – about $10 million higher.
Okay, perfect. And then just last from me just on the mortgage warehouse, could you tell us what those average balances were for the third quarter?
The average balance for the…
For the mortgage warehouse balances?
I don't have that number in front of me, I'm going to have to – we have to get with you afterwards, Tyler.
Okay. All right. Thanks, guys.
The next question today comes from Matthew Clark of Piper Jaffray. Please go ahead.
Hey, good morning. You happen to have the spot rate on interest-bearing deposits at the end of September.
Well, so I said 80 basis points, which was a blended number including DDA. So if you back that back out, you're going to be basically divided by about 0.6 or something like that, so…
Got it. I understand. Okay, and then just on the buyback, I guess, any sense for any change in appetite going forward, we're not like to slow that down to some degree or vice versa?
Well, we've said, we got about $100 million left in the authorization. And I think looking at levels of under two times book and under 10 times current earnings starts seem fairly attractive. So, I'm not going to tell you exactly what we'll buy and how much, but the program is going to continue.
Okay. And then Dale, I think last quarter you talked to for every Fed rate cut and five basis point impact to NIM, if you add that to liquidity down seven, I know the timing of the Fed cut was the two cuts were – you wanted to start the quarter either, but with these floors coming into play, I mean how do you think about that – after you had two cuts kind of in the rearview mirror here going forward?
Yes, I think the two cuts and the five bps per cut was basically borne out and what I'm labeling the basis risk that was happened in the third quarter, I don't think that includes liquidity obviously, I think we're basically on track with that. And as such we're looking for a margin compression substantially less in the fourth quarter relative to the third. It was brought up earlier that we do have a kind of – that is if you get a lot lower rates from here, we're going to run into compression on the liability side repricing, which I think offsets what we're doing on the loans and then the floors related to that. So, I would say the relevant range is that still a fairly decent kind of metric, five bps per quarter for up to two or three additional cuts.
Okay. Great. Thank you.
The next question today comes from Jon Arfstrom with RBC Capital Markets. Please go ahead.
Thanks, good morning. Can you give us an update on the deposit initiative progress, I think we ask you that every quarter and it seems to get a little better, but give us the latest?
Yes the stuff moving along the deposit initiatives number one is active, we brought in balances last quarter, we've held those balances this quarter and we continue to move in a slow, but steady pace ensuring that we have the right customer service and technology to satisfy our customers. Product initiatives number two just went live this quarter, we just had our first sales meeting the other day planning out how we're going to grow that. So really not much to add there. Although, they have gotten some balances and which surprised us all.
Okay, good. And then a question on the floors, you made a comment about getting ahead of the competition. I'm just curious, are these floors that were already in place or you went out and ask for them or you're doing it on renewal? Help us understand that process.
Of course, they've been an integral part of our credit underwriting process for years, through this whole way. So it's only lately been a topic of discussion in the broader sense.
Yes, okay. Difficult conversations at all with clients, if you're saying that your peers aren't doing this at all?
Maybe, but that's offset by the reliability and convenience that we give them and we're able to get them.
I think maybe more banks use floors than you think, John.
Yes. It's a brand new topic for us and obviously, Ken, you made a comment that you're acting as if you're coming to the end of the expansion, even though it's not your opinion and the floor conversation leads me to believe we're acting as if – you're acting as if rates are going much, much lower, even though you may not believe that. Is that a fair statement?
Yes, that's right. But it doesn't hurt to have these floors.
Okay. All right. Thank you.
The next question today comes from Brock Vandervliet with UBS. Please go ahead.
Thanks. I've figured you're not going to use the floor here to talk about 2020 guidance. So you already would have done so, but just directionally, as you think about margins and NII assuming two or three more cuts. I would expect at some point your – the asset yields reset more quickly and then you get a catch-up on the funding side causing a longer-term lift, as we kind of peer around the corner in NIM. Is that a fair analysis in terms of your balance sheet?
I think directionally that’s right, I mean, we’re focused on the net interest income. So, as we head into next year, as we said a few times, we expect to overcome any NIM compression. We also expect asset quality to remain flat and for us to manage our expenses are appropriately.
I think it could play out that way, Brock. I mean we’re dialing in three more rate cuts. I think we have some skepticism, whether it’ll be that many particularly if maybe Brexit gets done and a little more better results and confidence coming out of Europe, which I think has been a factor in terms of what’s affected the rate environment here. But I think you made a scenario that has some reasonable probability of playing out.
Okay. And as a follow-up, year-to-date, roughly how much of the deposit growth is coming from Tech & Innovation?
Give me a second on that and I’ll give you an answer.
And I guess is there any aspect of those deposits that you would flag in terms of being more volatile and perhaps tying back to what looks like a very conservative guide on deposit growth?
So, I’ll answer your first question. Our Technology group generated over $700 million for this year, you would then look at Life Science added a little bit, but – and Equity Resources added a little bit. But most of that comes out of the Tech – and Technology sector. I’m sorry, what was the second question?
Second question is – just is there a inherent volatility to those deposit flows that you would call out that perhaps ties back to your seemingly pretty conservative guide on deposit growth overall?
Yes, I think that’s a good observation. You can see that happen, they raise money for a reason. You can see some of our companies being taken out and purchased, which then, you’ll see flow through our fee income line through equity and warrant income, and therefore, our loans may soften a little bit and then that’s incoming, and then outgoing, would be our customers using their cash to buy other companies. and hopefully, we tie into loans that they need for that, but they’ll use their equity and cash before they pull down on our loans.
The deposit growth we’ve had in that sector has exceeded that of the bank overall, it’s also very low cost, very attractive to us. But yes, it is a bit lumpier and it does have a greater volatility, and in some respects, a little more difficulty in terms of forecasting than some of the other elements of our funding sources.
But historically, if you look at Bridge Bank over the last, in excess, of 15 years including multiple cycles of money coming in and the money going out, they’ve grown their deposits every year.
Got it, okay. Thanks for the color.
The next question today comes from David Chiaverini of Wedbush Securities. Please go ahead.
Hi, thanks. A couple of questions, first on the mortgage warehouse business, how much of the deposit growth was related to mortgage warehouse in the quarter?
So, it’s kind of the mortgage warehouse probably grew this quarter a little bit less than it normally does. So, under 10% – sorry, they grew about, I’m sorry, about $40 million of the $1 billion in deposits.
Okay, that’s good in respect of seasonality heading into the fourth quarter. And then do you – similarly on mortgage warehouse, do you happen to have the period-end balance of loans outstanding? You mentioned you didn’t have the average balance, but did you happen to have the period-end?
Yes. It is one – just under $1.8 billion.
Great. And then shifting back to the floor conversations. So, the typical average life you mentioned for the overall portfolio is three and a half years. Is that the same for the loans that have floors that the average life is three and a half years?
I mean the floor loans tend to be – probably tend to be a little bit shorter, I mean the commercial real estate tends to be a little more fixed rate. And so it’s going to be on the shorter side of that two and a half to three years, I would say.
But it’s an exception to not have a floor in a floating rate loan.
And each time these loans are renewed, I imagine if the interest rate environment is coming down that the floors would come down as well, when a new floor is put in upon origination. is that correct?
I mean for the most part floors are either at or moderately below 25 basis points to 50 basis points below the current rate using the metric of what the index to off of prime or LIBOR. Lately, that’s not the case, we put on a number of loans in the third quarter and into the fourth quarter, whereby the loan – the fixed rate portion of the loan is active, i.e., that rate is higher than what the index plus the spread would be on a floating rate basis.
The floors hit before we did the loan. That’s simple way of saying it.
Okay, that’s helpful. And then final one from me going back to credit with the increase in special mention loans $36 million. I know how you said there’s less than 1% risk of a loss on those loans, but curious as to either what industry or loan category kind of made up the increase this quarter?
Yes. there was nothing in terms of a concentration. It’s spread out through our entire book, and I’ll just leave it there. I think that’s a simplest answer.
Got it. Thanks very much.
The next question today comes from Gary Tenner of D.A. Davidson. Please go ahead.
Thanks, good morning. I just wanted to ask another kind of question regarding credit; you made the comment that even though you don’t necessarily think the expansion is coming to an end you’re lending is though it is. Could you square that with the 18% year-to-date growth rate, I mean we’ve got a lot of banks that are – loan growth is being pulled back, estimates are coming back on growth. Are they just being not much more conservative or what – how do you square that?
I’d add a couple of things to that or the way I’d square it is one, we have residential loans that are a big forward flow and purchase activity and that was over $300 million this quarter against $900 million of total loan growth, so that helps us. And also, I’d come back to the lines of businesses we’re in. So, capital call had $100 million of growth, a lot of banks were not in that, Resort Financing had about $35 million to $40 million, a lot of banks are not in that. So, Robert said earlier in the conversation here, it’s because of how we’re able to allocate our capital among a variety of different products; a lot of those products are not being carried by competitors. Remember the characteristics of our national business line, very few competitors, we get pricing stability, occasionally pricing power very, very good asset quality and high operating leverage.
Yes. fewer competitors allow the banks that are in the field to have better underwriting, stronger credit. If you’re just out making generic business loans, C&I loans, you’re competing with every community bank, mid-sized bank and large bank, you’re going to have more stress on rates and pricing, and on credits structure. If you’re doing a lot of the niches we’re in, you’re going to be able to get much better credit structure behind the deals you’re doing.
Okay. Thank you.
This concludes our question-and-answer session. So, I would like to turn the conference back over to Ken Vecchione for any closing remarks.
We thank you all for participating, and we look forward to talking to you for our fourth quarter call. Thanks again, everyone.
The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.