Western Alliance Bancorp
NYSE:WAL
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Western Alliance Bancorp
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Good day, everyone. Welcome to Western Alliance Bancorporation's Fourth Quarter 2020 Earnings Call. You may also view the presentation today via webcast through the company's website at www.westernalliancebancorporation.com.
I would now like to turn the call over to Miles Pondelik, Director of Investor Relations and Corporate Development. Go ahead.
Welcome to Western Alliance Bancorporation's Fourth Quarter 2020 Conference Call. Our speakers today are Ken Vecchione, President and Chief Executive Officer; and Dale Gibbons, Chief Financial Officer.
Before I hand the call over to Ken, please note that today's presentation contains forward-looking statements, which are subject to risks, uncertainties and assumptions, except as required by law. The company does not undertake any obligation to update any forward-looking statements.
For more complete discussion of the risks and uncertainties that could cause actual results to differ materially from any forward-looking statements, please refer to the company's SEC filings, including the Form 8-K filed yesterday, which are available on the company's website.
Now for opening remarks, I'd like to turn the call over to Ken Vecchione.
Thanks, Miles. Good morning, everyone. I'd like to provide an overview of our 2022 performance and then preface our approach to 2023 before Dale reviews the bank's financial performance. I should also mention that Tim Bruckner, our Chief Credit Officer, is also in the room with us today.
Western Alliance had a strong year in 2022. Our diversified national commercial bank grew loans 28%, deposits by nearly 13% and posted record net revenue and net income growth of 30% and 17.6%, respectively. We accomplished all this while maintaining strong and stable asset quality as net charge-offs to average loans were approximately 0% for the year, while non-performing assets to total assets improved to 14 basis points.
Balance sheet is well positioned to weather an evolving environment as 27% of the loan portfolio is credit-protected and 53% of the loans can be classified as insured or economically resistant. Our goal is to emerge on this slowing or recessionary environment as the top-performing asset quality bank in our peer group, a position we currently occupy.
For 2023, the higher interest rate environment and slowing economy will generate headwinds for the banking industry. As I mentioned on our Q3 earnings call, WAL is focused on bolstering CET1 levels, restraining loan originations with deposit growth, outpacing loan growth while maintaining leading asset quality and growing year-over-year earnings.
We are pleased with the substantial progress made towards this goal. Our CET1 ratio ended the year at 9.32%, which was over 60 basis points higher than the previous quarter.
The rise in capital was driven by a purposeful facility, reducing approximately $1.8 billion in certain low-margin, low deposit categories such as capital call and subscription lines and corporate finance indications. Without these actions, quarterly held for investment loans would have grown $1.5 billion and generated incremental interest income.
Our ongoing investments in diversified deposit businesses should provide liquidity in excess of loan growth. Q4 ending deposits declined $1.9 billion from last quarter, while average deposits declined by only $295 million quarter-over-quarter. This decline was primarily driven by short-term seasonal tax and insurance escrow deposit outflows in the mortgage warehouse group, which has since recovered, with Q1 quarter-to-date average deposit balances up more than $2.4 billion from year-end.
Previous investments in our settlement services, business escrow and HOA deposit businesses as well as the soon-to-be launched corporate trust platform, combined with several other initiatives we look to roll out, provide meaningful opportunities to gather incremental deposits this year. We look for predictable balance sheet growth to improve NIM and grow net interest income in 2023.
After Dale's comments, I will discuss our 2023 outlook in more detail.
Thanks, Ken. For the year, Western Alliance produced record net revenues of $2.5 billion, net income over $1 billion and EPS of $9.70, the 14th consecutive year of rising earnings. We maintained interest leading performance with return on average assets and return on average tangible common equity of 162% and 25%, respectively. Grew tangible book value per share to $40.25, 6.4% higher year-over-year.
As Ken mentioned, we previously identified a near-term priority of bolstering our key capital ratios. We're pleased with the substantial progress made towards this call with our CET1 ratio increasing over 60 basis points to 9.3% in Q4. This strategy led us to proactively restrain balance sheet growth without inhibiting record net interest income and earnings.
The year, net interest income increased 43% to $2.2 billion. Our diversified deposit franchises are focused on generating attractive core funding that drives net interest income and EPS higher rather than purely minimizing deposit betas to maximize the interest margin.
Non-interest income declined $80 million to $325 million as a result of ongoing softness in the mortgage industry. However, improved mortgage-related revenue in Q4 and the pending withdrawal of a large money center bank from the correspondent mortgage business as gain on sale margins and core servicing income could be in the very early stages of stabilizing.
Finally, asset quality remains stable and strong as classified and non-performing assets as a percentage of total assets are still lower than pre-pandemic levels. WAL has dramatically transformed its business over the last decade to become a national commercial bank focused on deep segment expertise, underwriting specialization and greater business diversification. For the year, Western Alliance reported net charge-offs of just $1.5 million or less than 1 basis point of average loans.
During the fourth quarter trends and business drivers, Western Alliance generated net income of $293 million, EPS of $2.67 and pre-provision net revenue of $368 million. Operating EPS was $2.74 or $9.95 for all of 2022. Total net revenue was $701 million, an increase of $37 million during the quarter or 25% year-over-year. Net interest income increased 6% from Q3 to $640 million was primarily driven by NIM expansion, but also benefited from higher average earning asset balances.
During the quarter, the company completed a credit-linked note transaction, bringing 2022 issuances to total $579 million. As of year-end, the company is protected from adverse credit losses on reference pools of loans totaling $12 billion. Overall, non-interest income remained essentially flat from the prior quarter at $61.5 million as mortgage banking-related revenue increased $9 million to approximately $47 million. This increase was partially offset by a $9.2 million mark-to-market charge included in other income.
Non-interest expense included -- increased 9% or $27 million, resulting in an efficiency ratio of approximately 47%, primarily due to higher deposit costs related to earnings credits. The efficiency ratio was adjusted to classify deposit cost as interest expense and 40% as remaining operating expenses were essentially flat.
Turning now to net interest drivers. Our asset-sensitive balance sheet benefited from the rising rate environment. Risk investment yields increased 79 basis points from the prior quarter to 4.45% as variable rate securities reprice higher. On a linked-quarter basis, loan yields increased 86 basis points to 570 with an end-of-quarter spot rate of 6.26.
Loans held for sale benefited from rising mortgage rates had increased 76 basis points to 5.63%. Irrespective of the Federal Reserve's rate trajectory, our net interest income will continue to benefit from an average of $2.5 billion of loans maturing or repricing higher each quarter in 2023.
During fixed rate loans are being replaced by these loans to yield over 2% higher while variable rate loans are repricing on the spreads 50 basis points wider on average. Total funding costs, including borrowings and deposits increased 69 basis points to 1.57% as the use of CDs and short-term borrowings increased since the proportion of average interest-bearing liabilities.
Net interest income growth of $38 million or 6% on a linked-quarter basis was powered by a 20 basis point NIM expansion and a modest increase in average interest-earning assets. Increase in total interest income continues to be greater than the change in total funding costs, including ECR expenses, demonstrating our continued asset sensitivity.
The rate shock analysis shows that with the plus 100 basis point shock on a static balance sheet, net interest income is expected to lift over 3%. Using the same scenario on a growth balance sheet, we would expect net interest income to grow over 20%. Fed rates declined, as some are projecting that might happen later this year. Growth balance sheet, net interest income still rises to incident with our decreasing asset sensitivity profile.
Our efficiency ratio increased 140 basis points to approximately 47% after reclassifying deposit costs interest expense. Adjusted efficiency was essentially flat at 40%, again demonstrating the high operating leverage of the company. Deposit costs increased $26 million from the prior quarter due to higher earnings credit rates on deposits, but at a slower rate than Q3 as earnings credit rate paying demand deposits declined.
Pre-provision net revenue climbed 3% to a record $368 million or 14% increase year-over-year, resulted in return on average tangible common equity, excluding all other comprehensive income, 23% for the quarter or 80 basis points higher than last quarter. Western Alliance's leading organic capital generation and continued strong performance provides significant flexibility to fund balance sheet growth, bill capital ratios and meet credit demands.
Loans held for investment decreased $339 million to $51.2 billion, and deposits declined $1.9 million to $53.6 million at year-end, primarily driven by short-term seasonal mortgage warehouse factors. Total borrowings fell $16 million over the prior quarter, primarily from a decline in short-term borrowings, offset by issuance of $95 million in credit linked notes on a reference pool of residential loans.
Finally, tangible book value per share increased $3.09 or 8% over the prior quarter and 6% year-over-year to $40.25 due to strong organic earnings, along with reduced drag from available-for-sale securities marks recorded in AOCI.
This quarter, net loan growth was impacted by our purposeful decision to temper certain C&I loan categories, such as equity fund resources and, to a lesser extent, corporate finance by approximately $1.8 billion in total. These reductions, C&I loans would have grown $220 million with total loans held for investment growth of $1.5 billion on a linked quarter basis.
On C&I growth was driven by $651 million from sponsor-backed commercial real estate, $390 million from construction and $250 million from residential. Additionally, the breadth of our business lines generated healthy loan demand in regional banking, which was $696 million higher than Q3. Hotel Franchise Finance rose $315 million, and tech and innovation was up $140 million.
We are well positioned to maintain prudent growth through a more uncertain economic environment given our diversified loan mix between national business lines, residential real estate and regional banking. Over the last three years, 68% of our robust loan growth has come from low to no loss categories, which now account for 53% of our entire portfolio. Furthermore, we have structured additional loss prevention as 27% of loans are credit protected, which should fortify our industry-leading asset quality.
The range in deposits, competition for funding picked up during the quarter and larger-than-expected seasonal factors combined to temporarily reduced deposit balances. Early deposits declined $1.9 billion, primarily driven by short-term seasonal escrow deposit outflows in our mortgage warehouse group, which are included in non-interest-bearing deposits, but subject to earnings credit rates.
As Ken mentioned, these seasonal factors have reversed since year-end, with mortgage warehouse Q1 quarter-to-date average balances already up more than $2 billion from year-end or 15% higher from the same period year-over-year. Additionally, quarter-to-date average balances for total deposits are up more than $2.4 billion from 12/31 and approximately $660 million greater than 4Q's average balance. Western Alliance's warehouse comprised 65% of the reduction in noninterest-bearing DDA.
End of year seasonality is evident in the linked quarter decline in average deposits of only $295 million versus the more pronounced decline on a period-end basis. Increased competition for liquidity in a higher rate environment drove an 11% increase in total interest-bearing deposits, including a $1.9 billion growth in CDs Interest-bearing demand deposits grew $1.2 billion from last quarter, in part from migration from noninterest-bearing DDA.
Diversified deposit franchise continues to provide meaningful opportunities to attract -- to generate attractive funding to support loan growth. Among our scalable national business lines, we are pleased with the continuing momentum in settlement services and homeowners’ associations. We produced linked quarter growth of $680 million and nearly $300 million, respectively.
Going forward, we expect continued growth from our deposit business lines, including business escrow services to continue to generate attractive deposits, fund ongoing balance sheet growth and soften the impact of elevated rates on overall funding costs.
Our asset quality remains strong and stable. Classified assets and non-performing assets as a percentage of the total are still lower than pre-pandemic levels. Total assets increased -- total classified assets increased $8 million in Q4 to 58 basis points of total assets, only 2 basis points higher than Q3. Total non-performing assets to total assets were down 1 basis point from last quarter to 14.
The prospects for greater economic volatility continues to evolve. We believe our underwriting discipline borne out through our national business line strategies has prepared us well for additional credit stress that may accompany greater macro headwinds.
However, we have not observed any preliminary signs of material uptick and credit migration trends, and we also expect to instead of to reduce our exposure to the more sensitive loan categories this year. Sound asset quality decisions will dictate our thoughtful loan growth trajectory and enable us to maintain profitability despite heightened economic uncertainty.
Quarterly net charge-offs of $1.8 million in the quarter or 1 basis point of average loans of the full year 2022 net charge-offs to $1.5 million. Those quarterly charge-offs have been stable at approximately $2 million per quarter for the past year, while net charge-off variances result from volatility and recoveries.
Provision expense for credit losses was $3.1 million, primarily due to uncertainty surrounding a percentage recession, offset by risk-weighted asset optimization efforts, sale of corporate finance indications and reducing capital call and subscription line exposure. Base cases for a mild recession listed allowance for credit loss assumptions weighted towards Neo's consensus forecast, which has shifted toward increasing the recessionary and more conservative scenario.
Total loan ACL to funded loans was 69 basis points, while our ACL to non-accrual loans was 420% at year-end. Testing for the $12 million of loans covered by credit linked notes, where ample first loss coverage is assumed by a third party, the ACL coverage rises to 89 basis points. We believe these superior asset quality trends are sustainable throughout economic cycles due to Western Alliance's deliberate post-GFC business transformation strategy.
Coming back to that time period, nearly 70% of losses Western Alliance incurred during rate financial prices came from loan categories comprising 44% of the loan portfolio. Those categories make up less than 6% of total loans. Contrast, 87% of the current portfolio is insured and resilient categories.
The insured category consists of credit protected, government guarantees and cash secured loans. Resistant loans are categories which have historically no or low losses. The Categories have experienced de minimis losses since 2014.
[Indiscernible] loans are supported by strong collateral and counterparties as well as our underwriting expertise. This category might experience some grade migration, realized losses are minimal due to limited recovery -- uncovered collateral risk with average loss of only 2 basis points and a maximum quarterly annualized loss of just 16 basis points.
13% of the portfolio we blew is more sensitive to economic growth. Lending in this category has been focused on unique sub-segments that offer the highest risk-adjusted returns and where we leverage our sector knowledge and underwriting capabilities to maintain superior relative asset quality. In 2014, these loans have experienced a maximum quarterly annualized loss rate of only 71 basis points with average losses of five.
Exceptional post GFC asset quality has been highlighted by minimal net charge-offs of only $29 million since the beginning of 2014. Comparing the ARP performance to the 32 publicly held banks with assets between $25 billion and $150 billion based in the United States, we realized the lowest average net charge-offs and the lowest quarterly annualized maximum charge-offs as a percentage of total loans over the same time period.
While the past decade has been a period of relatively low credit stress, our leading performance in low average losses and, more importantly, the lowest loss volatility among peers bodes well as to how Western Alliance will outperform peers if and when credit stress becomes more acute.
On our last earnings call, we discussed our renewed focus to rebuild capital and have made strong progress so far. Our tangible common equity to total assets ratio of 6.5% and common equity Tier 1 of 9.3% were both materially higher quarter-over-quarter.
In our industry-leading return on equity and assets, we continue to generate significant capital to fund organic growth and to lift well-capitalized regulatory ratios. This strong capital generation during this quarter is the equivalent of issuing approximately 5.5 million shares.
As previously mentioned, TBV per share increased $3 to $40.25 and since 2013 has grown 4.3 times faster than the peer group. We believe our business diversification, excellent asset quality and ability to generate solid operating leverage will continue in a softer economy and validate our franchise as a high-performing all-weather growth bank.
Back to Ken.
Thanks, Dale. I was pleased with the management team's ability to adapt to the changing interest rate economic environment to produce record operating results in 2022, a thoughtful balance sheet growth in conjunction with executional focus, position the bank to capitalize on matters income sensitivity while simultaneously growing both sides of the balance sheet with industry-leading performance as the quality remains solid and stable with those signs of elevated stress.
Looking forward for the full year 2023, we expect continued careful balance sheet growth driven by our diversified business model with a flexible origination mix designed to maximize net interest income. We expect loans held for investment to grow between 10% and 15% and deposits to grow between 13% and 17%.
Our specialized deposit franchises generate funds for more economically agnostic and secularly strong sectors, which offer significant deposit growth opportunities in excess of loan growth.
We also expect improved interest expense on the marginal deposits raised as we had fewer term deposits and favorable interest-bearing deposits. Net interest margin is expected to expand between 4% and 4.10% as it moves in concert with Fed fund actions. Favorable earning asset repricing dynamics per quarter will support NIM even if the Fed pauses hikes this year. Net interest income is expected to grow between 20% and 25% for the year in a rising rate environment and to exceed growth in ECR-related deposit costs.
Growth and efficiency ratio for the year should remain in the low 40s as we will continue to invest in risk management, technology and new business lines to take advantage of the attractive growth opportunities we see in front of us. In aggregate, we expect pre-provision net revenue growth of 11% to 15%. Excellent asset quality should remain intact, but we could return to more normalized losses if the economy enters into a recession.
Our goal remains to prudently bolster key capital ratios in line with macro environment with a CET1 ratio of between 9.75% and 10%. Our bank's industry-leading return on average tangible common equity produces significant organic capital of approximately 45 basis points of CET1 net of dividends per quarter, which provides us with significant flexibility to achieve our strategic objectives, grow capital ratios, on balance sheet growth or to take other capital actions.
At this time, Dale, Tim and I are happy to take your questions.
[Operator Instructions] The first question comes from the line of Casey Haire with Jefferies. Please proceed.
Thanks. Good morning, guys. No way I cut all that guide, Ken. But I just -- I did hear the NIM guide. I think you said 4% to 4.1%. I'm assuming that's for the year. Can you just give us sort of the progression, how you see it trending throughout the year and exiting the year? And what Fed forecast are you guys assuming? Thank you.
So, on the Fed forecast, we actually have only one rate increase at the beginning of the year. That's about a week from now for 25 basis points on the upside. We also have 2 rate decreases, both 25 basis points placed into our Q4 forecast. We're probably less confident about those rate declines, but we think it's a good, prudent thing to do in order to manage our efficiency ratio and not have expenses run ahead of potential revenue increases. So that's the rate forecast.
On NIM, we expect it to grow slowly through the year between 4% and 4.10% is pretty tight for us. So probably crosses over 4%, a little more towards the end of Q1 into Q2 and then just grows generally from there.
Okay. And within that deposit growth guide, which I think you said 13% to 17%, any sense -- I'm assuming there's a lot of negative mix shift baked into that. But any sense of where DDA as a percentage of total deposits can settle versus that, I think, we're low 40s today?
I'll start, and I'll let Dale answer that second half of the question, but deposit is between 13% and 17%. That's $7 billion to $9 billion, right? And just to be clear, what we're trying to do is grow deposits at a rate faster than loan growth, and that's what we mentioned on Q3.
In terms of growth areas for us, in terms of businesses, that may give you some confidence around the deposits, our HOA business in 2022 grew $1.3 billion, and we kind of see that still being the same. We also see growth coming from our settlement services and our business escrow services lines of business. And those, we invested in, in 2018 and '19 with a stronger rollout as we got into 2020. And those businesses did rather well. Certainly, settlement services did rather well in 2022, and then the rest is -- in terms of deposit growth will come from the regions.
Okay. It's pretty difficult in today's environment to garner new non-interest bearing deposit relationships. But as we indicated, we have seen a recovery of approximately half of the DDA that declined in the fourth quarter, were primarily related to mortgage banking operations and the seasonal trough is 4Q. So I'm going to stick with that, that we think we can hold about half of what came down in the fourth quarter.
But again, what we're focused on from here is how do we sustaining our deposit growth trajectory and then putting on loans that have plus 300 more -- or more spread between them, and that can drive net interest income kind of regardless of what the Fed does.
Okay. Great. And just kind of tying this all together. You guys talked about the 9.80% number this year, you got there. The Street had you at 10.75% for '23. Do you feel like -- I can input all the components and work it through? But I'm just wondering, do you feel like that 10.75% is doable with this guide?
So Casey, what I'd say is our PPNR guide is between 11% and 15%. And from there, you have to take a viewpoint on what you think is going to happen in the economy in terms of determining the provision. So the provision will naturally grow because of balance sheet growth. We're not seeing any cracks in asset quality. We -- it looks pretty good.
But listening to a number of the talking heads, many people think towards the back half of 2023, we'll see some weakening in asset quality. Again, we haven't seen any of that, so you're going to need to make your own assumptions regarding charge-offs on top of provisioning. But the PPNR guide is between 11% and 15% for next year.
Understood. And last one for me, just the loan deposit growth, is that average or period end?
So we talked about kind of both of those numbers. But from here, I expect this to recover about half of the DDA decline in the fourth quarter by period end.
Okay. Thank you.
The next question comes from the line of Brad Milsaps with Piper Sandler. Please proceed.
Good afternoon. Thanks for taking my questions. I appreciate all the color around guidance. Maybe -- I wanted to maybe delve into credit a little bit more. Dale, you gave a lot of color, but just kind of curious with everything that's going on, all the uncertainty. Just can you talk a little bit more about what were the drivers of the $3 million provision this quarter? I understand that a lot of movement within the risk-weighted assets, you didn't have a lot of loan growth, but it would just seem that most outlooks have worsened in the $3 million provision. Might seem a little light, maybe relative to the environment. But just wanted to get some more color there, particularly maybe as it relates to 2023?
Well, let's start with -- if you work backwards from the $3 million and add on to that the sale of the corporate finance applications, which we sold, plus the fact that this is a quarter where we didn't grow and we took down our EFR balances, when you kind of reverse engineer it, we would have been closer to what we've posted in previous quarters. So the $3 million really represents net of those actions.
Dale, you want to talk about the CECL stuff?
Yes. So we have -- we subscribe to kind of the Moody's kind of performance. And that has, as we indicated, kind of gradually deteriorated. Like I said, we're not seeing that. For us, the most significant variable is really what happens on the commercial real estate metric. I think for most banks it probably has to do with unemployment.
And when you look at where they are on a decline on the consensus and then we also consider S-4, those levels are still kind of well above what our advance rates are on -- towards the real estate transactions. And so while they pick up a little bit in terms of loss, it's not as dramatic as maybe some other institutions might realize.
Great. And as you think about areas that you want to grow in, in 2023 in terms of the loan portfolio, would those be areas in your mind? I mean you mentioned wanting to grow in less risky areas, maybe areas that more risk would have, maybe more variable rate loans. Just kind of curious how to think about the areas that you want to grow in vis-a-vis kind of how that might impact provisioning.
So I'll say our loan pipeline still remains active. I would see us growing a little more in note financing, build-to-rent. Multifamily looks strong as long -- as well as industrial. You'll see some pickup from construction loans that we did in previous quarters that are beginning to fund up, and hotel financing will be active as we look going forward.
Specific residential could be interesting. What we don't want to do is get in front of Fed action and kind of decrease asset sensitivity until there's more clarity in terms of where rates are headed, but I do believe that mortgage rates that begin with the 7 is probably going to be something that's going to work out over time.
Great. Thanks guys. I’ll hop back in queue.
Thank you. The next question comes from the line of Steven Alexopoulos with JPMorgan. Please proceed.
Hi, everybody. I wanted to start on the deposit side. In terms of the deposit growth, the 13% to 17%, could you talk more about how you see the mix evolving through the year? And particularly, I'm curious how much of the growth do you plan on getting from ECR deposits, time deposits. It's obviously a fairly aggressive deposit growth guide?
Yes. So like we said, I mean in terms of actual kind of core non-interest-bearing DDA, if we could hold that flat, I think that would be a win. So -- and I think the larger ponderance is going to be in interest-bearing money market accounts, and those come in different varieties in terms of spreads that we offer depending on the relationship and whether there's a credit tied to it as well.
I do think that the CV side is probably going to increase a bit more than it has, but probably to a lesser -- at a lower rate than what we've grown recently, and then interest-bearing checking is where I think it's also going to be kind of a strong growth area. Much of our HOA deposits kind of flows into that category at this point in time.
So at the end, the DDA, I think you're going to see it's still going to probably diminish as a proportion of total. The growth there is going to be in ECR related, big chunk in money market accounts and a little bit more in CDs.
Got it. So Dale, if we follow that through of interest-bearing deposit costs were $197 this quarter, where do you see that moving to by 4Q '23 in terms of what you need to get in terms of this NIM being stable to up a bit? What are you assuming deposit costs rise to interest-bearing?
No. I mean it really depends a bit on your rate forecast. But what we see is that interest-bearing deposit costs right now and I throw -- if I throw deposit costs in there from ECR, we grew during the fourth quarter, our net interest income was up about $39 million. If I add the interest expense, plus the ECR charges, gave up about 3.25 of that, I think that, that range is probably going to more or less be intact. So I think we're going to incrementally improve net interest income, including ECR debits against it, but at a diminished rate than what we saw the past couple of quarters.
Okay. When I look at where some of your peer regional banks have come out this quarter in terms of what they're paying on deposits, they -- many of them have barely budged on some of these categories. Curious what's the conversation you have with prospects? And is this just a massive opportunity for you to bring over new household’s businesses? And do you see as more of a consumer or a business opportunity? Thanks.
Well, we're a commercial bank, so we don't have much in the way of consumer deposits, and so our deposits are going to be floating at the marginal higher end of interest expense. But we focus on net interest income, and we have the ability take those deposits and put them in 100% beta loans, and hence, make the spread on it. And so that's been the conversation.
We're seeing larger clients move some of their money to us and having conversations about moving money to us. We like that. And what's really a little bit different for us in terms of how we approach business, thought it to change somewhere in the middle of Q3 of last year is we used to lead with loans, and now we leave with the deposit conversation. And we're very clear that there will be no credit extended unless there's a very strong deposit relationship, and that conversation has been well received by our client base.
Thanks for taking my questions.
The next question is from the line of Ebrahim Poonawala with Bank of America. Please proceed.
Good morning. Yes, a few follow-up questions. Maybe one, I'm not sure if you already mentioned this, apologies. Just around the expense outlook as we think about core expenses. Just remind us in terms of the growth rate you are thinking about as part of your PPNR guidance. And also the one key seasonality that we should be thinking about.
So I think about last point. What is the one thing we should be thinking about? Do you hear that point?
The first quarter seasonality, like I'm assuming like first quarter historically is marked the high watermark for the efficiency. I'm just wondering if there should be a seasonal lift in expenses that we should be baking in.
Yes, I'll take the second part of that first. The answer is yes. Our expenses tend to pop up a little bit more in Q1. But overall, our efficiency ratio we're targeting is in the low 40s, which we've always targeted, and we have one of the leading efficiency ratios in the industry.
We kind of feel that that's the right place to be. It allows us to continue to make the appropriate investments in the bank on both risk management and technology as we continue to get bigger and bigger, but it also allows us to invest in new products and new businesses. And many -- for the last several years, we've been investing, as I said, in settlement services, in business escrow services.
We've got a new initiative. We just recently launched in deposits that we're not ready yet to talk about, but we built last year that's off to a good strong start. So keeping the efficiency ratio in the low 40s allows us to generate the operating leverage we want, also invest money today for future performance.
Got it. And what does that imply just in terms of how you're thinking about just the expense growth for the year? Is it high single digits?
So it's going to be high single digits, might be low double. If you look at the kind of the PPNR element, of 11% to 15%, holding the efficiency ratio, basically flat at as to where we are. Could provide for a little more room. But what we're going to do is we're watching this closely. I mean -- and so as things -- we authorize FTE, as we continue to demonstrate performance on growth of the balance sheet, we're going to have revenue feed our expense expansion.
I want to make sure we're not talking across each other. So my commentary was on the adjusted efficiency ratio without deposit costs because Dale just talked about that, putting it towards net interest income. So on the adjusted efficiency ratio without the rise in deposit costs, that's what we think we'll be in the low 40s. Okay?
Noted. And -- go ahead. Yes. And I guess maybe a separate question. Going back to credit, and I understand the macro uncertainty. But when you look at your PPNR guidance that you've given, even assuming provisions mid-year 2020, would imply earnings at about $10.50. I'm just wondering, is there anything around the loan book that causes that hesitation when you think about EPS outlook for this year relative to your guidance?
And obviously, you expressed comfort with the asset quality of the book. I'm just wondering why you -- what would be the scenario in which that $10.50 EPS plus or minus would not be achievable?
So as you know, CECL works, it really comes down to the end of the year and then the outlook into 2024. So if Moody should turn more bearish as we put on loans, you're increasing your provision for the life of that loan, not for the risk that's in the book. And so that's why we've been a little bit more reticent on quoting where we think EPS numbers are and then stay more on the PPNR side. Those are the things that we can control.
On asset quality, again, we're not seeing any issues at this moment. I would point you to a little bit the last two slides in the presentation, where we think we've been able to grow in loan growth in a very prudent way and keep our charge-offs down. And I would remind you that 54% of the book is either in short or resilient or resistant categories.
Got it. And if I may, one just follow-up. When we think about the loan growth, 10% to 15% for this year, a lot of macro uncertainty. Like should we be worried in terms of the quality of loans that you're putting on the balance sheet right now at this point in the cycle? Like what -- how -- just from a client selection standpoint, is there a risk of adverse selection?
No. So we're not going to grow for growth's sake. So the asset quality is incredibly important. In my opening comments, one of the things I want to get rid of is any connection to the GFC 2007 and '08, '09. I want no connection to that, and we are a completely different company. So we want to grow above trend. Yet at the same time, we want to have above-trend asset quality or best-in-class asset quality. We're working on doing both.
So we're not going to sacrifice the asset quality for higher loan growth. Having said that, after going through our reviews, we think the range that we gave of 10% to 15% allows us to grow the loan book without growing into a recession and also protect or remain with stable and strong asset quality.
We will pivot as necessary as new facts and situations emerge. I mean we did this during the pandemic, one of the few banks that sustain a growth trajectory during that point in time and where we go. We weren't sure, how is it two years or four years to a vaccine. So it went into a capital call and a low LTV residential, and never lost a dime on either of those. And so we're going to be nimble about what about our -- using the flexibility of our business model to sustain -- hearing to sustained earnings performance improvement over time.
Got it. Thank you for taking my questions.
The next question comes from Brandon King with Truist. Please proceed.
I wanted to touch on loan yields. I know, Ken, you mentioned last quarter, seen a loan committee turn down 31 loans initially getting better pricing. So I wanted to get a sense of what the outlook was for loan spreads going into this year and if you're still getting the same reception from clients?
I'll give you another story to that, too. So our loan yields are holding in from that last conversation we had when we did our Q3 earnings. Dale mentioned, spreads are up about, on average, 50 basis points. And we're not getting a lot of pushback on pricing.
I don't have any numbers for you, but I can tell you when we say no to a loan that has good asset quality and good pricing, we usually are saying no because it's not generating the deposits that we want to accompany that loan. And what we're seeing is that when we turn down those loans, those loans have been returning to the senior loan committee now with greater deposits.
So what we're encouraged about is that the pricing is holding and our determination to see more deposits to accompany the loans has been following through from our credit committee.
Okay. That's helpful. And then as far as the risk-weighted asset optimization, is that process complete? Or is there still some work to do going into this year?
Tim, love to take a shot at that one. You've been running the process.
Yes. Thanks, Ken. That is ongoing, and it's definitely a part of our culture. So something that we'll continue to do. There's definitely remaining benefit to be achieved through optimization. Some of that's in, in the targeted growth portfolio mix, and some of it is just structural with our clients. But ongoing improvements are still expected. Thanks.
Got it. Got it. And then just lastly, on the mortgage warehouse deposits, I understand the seasonality in the fourth quarter came back in this quarter to date. But should we expect a similar kind of magnitude as far as seasonality in the fourth quarter of this year and going forward?
It was more pronounced in the fourth quarter of '22 than we've ever seen before, and I think some of the reasons for that are -- so we have some of our accounts related to taxes and insurance and others are principal related. So the access in insurance, we expected a decline largely because of California property taxes are due in 4Q.
The P&I payments tend to have much more intra-month ebb and flow, but not so much kind of seasonal elements, and that changed a bit this time. So from our view, I think there were very few refinancing and almost very few sales of residential real estate that took place in December. And so as a result of that, when somebody pays off and say somebody pays off the loan or REIT has refinanced, I'll say, the 5th of December, what will show up for us is we'll get a deposit, including that principle of that of that loan. And that is remitted to one of the GSEs two weeks later.
Well, that didn't happen, and so I do think that you can make your own projection about what December of '23 is going to look like. But the dearth of activity in the month of December, which I don't see a seasonal trough anyway, but it was more -- it was certainly more significant than usual, and that contributed to this. And that seems to be turning even now, maybe an early turn in terms of kind of the spring buying and selling season, I'm not sure.
Okay. Thanks for taking my question.
The next question comes from the line of Andrew Terrell with Stephens. Please proceed.
Good morning. Looking at the capital call loans down around $1.2 billion this quarter. Is that the pace of runoff we should expect out of the book over the next couple of quarters? And I know there are some associated CLNs against the portfolio. I guess, do those securities remain in place as the capital call portfolio comes down? Or would the CLNs fall commensurate with the reference pool?
Tim Bruckner again. I'll take the first part of your question on the portfolio runoff. Answer is no. It's not to be expected. That was driven by a handful of large transactions. We elected to exit for return reasons. As we move into the coming quarters, we won't see similar dollar amounts of runoff at all.
So we do have a CLN on the -- I appreciate you remembering that, on the capital call and subscription lines. That CLN as opposed to the residential ones, which are closed. So it's a specific pool of loans. And as those loans pay off or whatever, that's done and the CLN runs down. This one is a -- has substitution ability, so it lasts for three years.
So we have the ability to -- if something comes out of that, we could put something else in it. That CLN is a fraction of our total capital call and subscription lines, so it doesn't really have much of an effect there. It was really done for, as Tim indicated, for return purposes, not so much for capital management because we've already taken a portion of those down to 20% through that process.
Okay. Got it. And then, Dale, do you have what the MSR valuation change was this quarter? And then any thoughts on just run rate for mortgage servicing and then gain on sale income?
Yes. We had no change in the valuation of the MSR in Q4, and so what that means is that the hedging basically very materially complete asset what was taking place in terms of market rates. So there wasn't any valuation adjustment that was -- that had happened.
Kind of going forward, I think there maybe is going to be some MSR dispositions that take place, and so it's not going to have an effect on the market. But at the same time, I think there's a little more stability in terms of what people expect around refinance behavior, and so that could kind of extend the lives and the confidence in terms of what those servicing rights are worth.
I would add that, as you look quarter-to-quarter, I would think about the total mortgage income being relatively flat to Q4. I think that was your specific question. And while too early to call a trend, I would say that the first 20 or so days into January, we are encouraged by margins rising in the business as that large money center bank as the correspondent lending market. And so we've got our fingers crossed that, that continues to move forward. But at this point, that's a positive. That's an emerging opportunity, we think. But right now, I would keep Q1's mortgage income relatively flat to Q4.
Okay. Got it. And then if I could just sneak one in on the last point, just the competitive dynamics in the correspondent business, perhaps that does create some tailwind to the gallon sale margin. But does the exit of a large competitor give you kind of greater opportunities to grow the balance sheet at all?
We're going to still have the balance sheet relative to our capital CET1 goals of getting towards 9.75% to 10%. As you know, MSRs, if they grow in an outsized way versus our internal capital generation, become punitive. So we will be sellers of MSRs throughout the year. And with that, we also hope if we sell to non-banks that we keep deposits that are accompanied with these MSRs as well as possibly even providing MSR financing to the buyers, and that was always our premise as -- when we bought AmeriHome.
Understood. Okay, thanks for the question.
The next question comes from the line of Chris McGratty with KBW. Please proceed.
Great. Thanks. Dale, the capital build in the quarter, I think the way I'm thinking about it, many thought you would build capital, some thought you build reserves. I'm interested kind of in your dynamic on how you're thinking about building one versus the other. And could you just remind us 10% of the target, I think prior commentary is to get there by midyear. But with recent efforts and maybe some more, like any change in time line there?
Yes. So I mean it really starts with the reserves. So we look at our loans, our exposures and overlay that with what Moody says and our own interpretation of kind of market and economic market sentiment outlook. And we drive GAAP compliance kind of seasonal number, and I realize that ratio is lower than other -- some others in the space. And I think you don't look any further than our asset quality in terms of charge-off behavior and changes in terms of kind of what's transpired there.
I mean we have -- in the slide deck, we have kind of our segmentation in terms of credit protected, resistant, resilient and then the more sensitive piece. And that is just a small fraction. 1/8 of our loan book is something that we think is going to have some, perhaps, volatility.
Another measure that we look at is, I think, your ACL and divide that by annual charge-offs. And if -- I mean are we -- we had zero this year, but even if you took a couple of basis points on it and divide that into 60 basis points, you're going to get 30 years charge-offs. I know this is not -- this is a better than most years, but the average duration of our loan book is only is under 4%.
So all sorts of ways we look at it, and we think our reserve works as is. So now it's about what we talk about in terms of what falls down to the bottom line in terms of tangible common equity. I wouldn't move up our time line at all. I know, I think 60 basis points is a fairly significant move for one quarter. But we're going to do both. We're going to grow capital, and we're going to grow our balance sheet at the same time, sustain an improving trajectory in terms of net interest income and sustain our returns while our capital continues to climb toward the high 9s later this year.
Chris, to be very specific, I think you can look for us to be in that capital range of 9.75% to 10%, towards the back end of the year. We got a real jump on Q4 by opportunistically selling some loans and then being able to move quickly in the EFR space. That's our capital call and subscription line. So quite frankly, we're pretty proud that we were able to move the capital 60 bps in one quarter, but I think you can look towards the back end of the year for those numbers.
And Ken, that's all organically, right, there's no more CLNs assumed in that?
We don't have any CLNs assumed in there and certainly no ATM either.
The next question comes from the line of David Smith with Autonomous. You may proceed.
You share the run rate for the ECR and the deposit costs as of 12/31, what that would be on kind of a full quarter basis?
Yes, I wouldn't say that materially changed from where we were from for the quarterly number. It didn't grow quite as much as maybe something anticipated because the dollars came down in terms of ECR deposits. But I think that we can track from the fourth quarter number, overlay what you think is going to happen in terms of equals actions and what you think is going to happen on the balance sheet in those particular categories. That should work. We have dollars we have in there with consequent those big.
Okay. And in terms of the mortgage warehouse deposit book, can you share the breakdown between non-interest bearing and interest-bearing there? Is it notably different from what the mix was for the bank as a whole as of the fourth quarter?
So most of the mortgage warehouse deposits are in DDA with an ECR, and that is the preponderance of all the ECR dollars that we have.
Got it. Okay. And lastly, in terms of the RWA benefit that you got from the reduction in equity fund resources. Could you expand on that a little bit? I imagine that it must not be zero risk weighting. But given the kind of the risk that those loans tend to have, it must be a pretty low risk weighting, I would have thought.
The general construct of providing a credit linked note is to provide protection, i.e., first loss taken by a third party. So we get funds in. We sell the bond to a third party, and they get that interest on that bond less any losses that are -- that arise from this reference school. So on the EFR loans, these subscription lines, they're normally 100% risk-weighted. But because we've done -- we've sold a note to a third party, and they assume first loss, the first 12.5% of losses in that portfolio, they pay. And actually, we already have their money, so we control how much they get back as we only pay them back, less any losses incurred.
And because of that architecture, whereby you have moved the now kind of the structured product to a AA or better category, it's basically treated as a 20% risk-weighted asset. So no matter what type of asset you come from, you end up at 20. So residential, you started at 50, end to 20. Capital call and warehouse, you started 100 and you still 20.
Okay. Got it. So without the CLN though, the risk weighting is 100. Got it. It's good to know. Thank you.
The next question comes from the line of Timur Braziler with Wells Fargo. Please proceed.
Hi, good afternoon. Just a couple of follow-ups. With deposit growth expecting to exceed loan growth in '23, what's the excess funding going to be used for? Is the primary focus initially to down some of this near-term borrowing? Or is that excess funding going to be layered into the securities book?
Could either or, but our first goal would probably be to lower our borrowings and take down that cost.
Okay. Great. And then, again, following up on the large bank exiting the correspondent space, and thank you for not mentioning the bank by name, but pretty large player in the space. What happens to that market share? Is that market share kind of split amongst the rest of the constituents? And are you expecting AmeriHome's portion to grow? Or are you more or less kind of ring-fencing that and keeping the existing business as is? Was kind of competitors maybe getting more of that market share that's up for grabs?
So I think like some of the other competitors, they balance market share with gain on sale margin, and that's what we do. So if we can hold our existing market share and grow the gain on sale margin, that works for us, and that's sort of where we've been. And I think that's what the industry is trying to do, and there seems to be a little discipline going on here. But without mentioning that bank that left, it's early days, and we'll wait and see, and we'll clearly have more color on it as we get through the end of the first quarter.
During the third quarter, which is when margins dropped, we did a little experiment whereby we pulled back in terms of activity and purchase volume, and we saw margins move up a little bit in that scenario. And I'm not sure that's the reason why, but they basically stayed at a somewhat elevated place from how far they've fallen to in the fourth quarter. So I don't know if we're encouraged by that, and we'll see what happens.
Got it. Thank you.
The next question comes from the line of Jon Arfstrom with RBC. Please proceed.
Thanks to everyone. Ken, a question for you on the chart you have on the Slide 18, the economically resilient portfolio positioning. That's a mouthful, sorry. What do you expect that mix to look like in one to two years from now? I guess another way is, where is the emphasis in terms of your growth drivers from where we're starting today?
Tim Bruckner. You will see us focused growth, particularly through any potential or real recession, any areas that are resistant to recession. At the same time, you'll see us reduce our exposures in some of the more sensitive areas. So we'll do that more with precision than with a broad brush, but specifically getting -- lowering exposure, getting out of industries that are particularly sensitive and then really the resistant areas that's sticking to our net.
When we talk about growth there, we're talking about relationship growth. So these are with sponsors that we know not just at the lender level, but at the top of the house. And we're growing specifically at low loan-to-value, high amount of sponsor investment in the deal. What we're doing differently though, right now, we can do it, we can be more selective as we're being very selective about the submarkets as well that we're in if it's real estate related, and that's where we're growing.
Okay, okay. Got it. Dale, a question for you. The PPNR growth of 11% to 15%, maybe obvious. But what do you see as the key risks, meaning what brings you closer to 11% or below 11%? And what could put you at the higher end?
I mean, first and foremost, we see our task in front of us is sustaining deposit growth. With deposit growth, we've got the balance sheet leverage. We can -- believe we have opportunity in the asset side to deploy this at significant spreads, which will drive NII, obviously driving PPNR, which -- and of course, avoiding much in terms of the provision costs other than the higher balances.
So I think that's the number 1 thing, sustaining our deposit growth. And we've got a number of initiatives, and some of them are coming to fruition, I think, now. And we think we're going to be on track.
Qualitative reserve size, any help you can give us on that? How big is the qualitative piece of your reserve?
Yes, I can. It's -- as far as the -- you're talking about the qualitative adjustments on the AC upgrade, about 5%.
Okay. And then, Ken, just one for you. How are you judged? How are you guys judged? Is it tangible book value growth? Is it EPS? Is it credit? Where are you guys most focused in terms of the financial metrics that we look at for the coming year? Thanks.
So as it relates to performance, it's sort of up and down both the income statement and the balance sheet as determined by our short-term or STI compensation, EPS, loan growth, deposit growth, asset quality, operational quality and the growth in our capital base.
In terms of the LTI, of course, it's the share price, and the share price is motivated by the growth in EPS. And so those are the things that we focus on.
Okay, alright. Thank you.
Thank you. There are no additional questions at this time. I will now hand the call over to Ken Vecchione for closing remarks.
Thank you all for joining us today, and we look forward to talking to you about the Q1 results in the next couple of months. Thanks.
That concludes today's conference call. Thank you. You may now disconnect your lines.