Axos Financial, Inc. (AX) Q1 2023 Earnings Call Transcript

Greetings. Welcome to the Axos Financial, Inc. Q1 2023 Earnings Call. Please note, this conference is being recorded. I will now turn the conference over to Johnny Lai. You may begin.

Thank you and good afternoon, everyone. Thanks for your interest in Axos. Joining us today for Axos Financial, Inc.'s first quarter 2023 financial results conference call are the company's President and Chief Executive Officer, Greg Garrabrants; Executive Vice President, Chief Financial Officer, Derek Walsh; and Executive Vice President of Finance, Andy Nicoletti. Greg and Derek will review and comment on the financial and operational results for the three months ended September 30, 2022, and we will be available to answer questions after the prepared remarks. Before I begin, I would like to remind listeners that prepared remarks made on this call may contain forward-looking statements that are subject to risks and uncertainties, and that management may make additional forward-looking statements in response to your questions. These forward-looking statements are made on the basis of current views and assumptions of management regarding future events and performance. Actual results could differ materially from those expressed or implied in such forward-looking statements as a result of risks and uncertainties. Therefore, the company claims the safe harbor protection pertaining to forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. This call is being webcast, and there will be an audio replay available in the Investor Relations section of the company's website located at axosfinancial.com for 30 days. Details for this call were provided on the conference call announcement and in today's earnings press release. Before handing over the call to Greg, I'd like to remind our listeners that in addition to the earnings press release, we also issued an earnings supplement for this call. All of these documents can be found on the Axos Financial website. With that, I'd like to turn the call over to Greg.

Thank you, Johnny. Good afternoon, everyone, and thank you for joining us. I'd like to welcome everyone to Axos Financial's conference call for the first fiscal quarter ended September 30, 2022. I thank you for your interest in Axos Financial and Axos Bank. We had another excellent quarter with double-digit growth year-over-year in book value per share and ending loan and deposit balances. Our strong results were broad-based with net interest margins exceeding the high end of our target and double-digit net interest income growth year-over-year. We grew deposits by approximately 29% year-over-year led by strong growth in consumer deposits and deposits from Axos Securities. Excluding a one-time weekly reserve, which I'll discuss later, we reported adjusted net income of $69.6 million for the three months ended September 30, 2022, representing year-over-year growth of 15.6%. Our book value per share was $28.35 at September 30, 2022, and also up 15.6% from September 30, 2021. Highlights for this quarter include the following. Deposits increased 8.8% linked quarter and 29.2% year-over-year to $15.2 billion. We continue to make steady improvements in our funding mix with noninterest-bearing deposits increasing by approximately $1 billion from September 30, 2021. Noninterest-bearing deposits represented approximately 30% of our total deposits at September 2022. The diversity of our funding mix compared to the last rate cycle positions us well to maintain our best-in-class net interest margin. Ending net loans for investment balances were $15.2 billion, up 8% linked quarter or 28.1% annualized. Despite rate increases rapidly since the start of the year, we continue to see good demand for well-secured C&I and commercial real estate loans. Net interest margin was 4.26% for the fourth quarter, up 7 basis points from 4.19% in the quarter ended June 30, 2022, and up 4 basis points from 4.22% in the quarter ended September 30, 2021. Net interest margin for the banking business unit was 4.5% compared to 4.45% in the quarter ended June 30, 2022, and 4.48% in the quarter ended September 30, 2021. Higher loan yields more than offset the increase in funding costs. Axos Securities, comprised primarily of our custody and clearing businesses, made positive contributions to our fee income, deposits, and net income. Total deposits from Axos Securities were approximately $3.3 billion as adviser and broker-dealer clients continue to hold higher cash balances in light of elevated market volatility. Quarterly pretax income improved by $9 million year-over-year to $8.9 million due primarily to higher interest rates. Adjusted diluted earnings per share was $1.18, up 15% from $1.03 in the year-ago quarter. Capital levels remained strong with a Tier 1 leverage ratio of 10.3% at the bank and 8.98% at the holding company, well above our regulatory requirements. Our credit quality remains strong with annualized net charge-off to average loans of 5 basis points versus 1 basis point in the first quarter of fiscal 2022. The slight uptick in our net charge-offs was from very low levels, solely due to losses in our personal unsecured and auto loan portfolios, some of which are later offset on the auto side by collection of credit insurance we have purchased on certain auto FICO bands. We added $8.75 million to our loan loss provision this quarter to support our strong loan growth. The total allowance for credit losses was $155.5 million at September 30, 2022, representing 21 times our annualized net charge-offs and 1% of our ending loan total loans. Loan originations for the quarter ended September 30, 2022, were $2.5 billion, up approximately 19% from $2.1 billion in the comparable quarter one year ago. The first quarter 2023 fiscal year originations were as follows: $312 million of single-family jumbo production, $129 million of multifamily production, $59 million of commercial real estate production, $125 million of auto and unsecured consumer loan production, and $1.9 billion of C&I loan production, resulting in a net increase in ending C&I loan balances of $960 million. Ending loan balances in our jumbo single-family business increased by $124 million to $3.8 billion, marking the second consecutive quarter of over $100 million of net growth in our jumbo single-family mortgage portfolio. We generated $313 million of loan production in the first quarter of 2023, benefiting from dislocation in the jumbo single-family mortgage securitization market. Prepayments in our jumbo single-family mortgage business were $184.3 million in the three months ended September 30, 2022, down from $390 million of prepayments in the prior quarter. While rising interest rates have resulted in reduced overall market demand for jumbo refinances and purchase transactions, we are better positioned than most of our competitors to capture a greater share of the available market given our efficient operations and established track record of execution. Our jumbo single-family mortgage pipeline was approximately $311 million as of October 24, 2022. C&I lending had another tremendous quarter. Demand remained strong across loan types and geographies with a backlog of approximately $790 million at October 24, 2022. We have positive momentum across multiple C&I lending verticals, and we remain confident that we'll be able to sustain strong growth in our net balances while maintaining our credit quality and loan yields. Our loan pipeline remains solid with approximately $1.4 billion of consolidated loans in our pipeline at October 24, 2022, consisting of approximately $20 million of single-family agency gain on sale mortgages, $11 million of jumbo single-family mortgages, $155 million of multifamily and small balance commercial real estate term loans, and $170 million of auto and unsecured loans. We are off to a strong start to our fiscal year with over $1 million of net loan growth in the first quarter of fiscal 2023. While the near-term outlook remains good, we expect loan growth to moderate from the elevated pace we've seen in the past two quarters as the impact of higher interest rates begins to have a more pronounced effect on loan demand in the first half of calendar 2023. Nevertheless, we remain confident that we will achieve the mid-teens loan growth target for our fiscal 2023. Deposits increased 8.8% linked quarter and 29.2% year-over-year. Growth in small business and consumer deposits were offset by declines in certain commercial banking and clearing and custody deposits from elevated levels at the end of the prior quarter. Competition for deposits has increased across most of our deposit categories. We have been successfully retaining and growing consumer checking, savings, and money market deposits through cross-sell and relationship pricing initiatives. In Commercial Banking, our low-cost nationwide deposit gathering and specialized servicing approach has allowed us to be more competitive in maintaining and growing deposits from existing clients. Our investments in cash and treasury management capabilities and teams have increased the pipeline of prospective new treasury management clients. In Axos Fiduciary Services, our bankruptcy trustee business, total deposits were approximately $1.1 billion at the end of the first quarter. We expect a gradual pickup in Chapter 7 and non-Chapter 7 cases and deposits over the next 12 months as the economy decelerates and bankruptcy filings rebound from multi-decade lows. Axos Clearing continues to generate a significant source of low-cost deposits. We had approximately $3.3 billion of clearing and custody deposits at September 30, 2022, including $2.4 billion that was on our balance sheet and $0.9 billion that was placed at partner banks. While the level of cash sorting by advisers and brokerage clients has increased, the cash held at Axos Clearing remains elevated at approximately 11% of total assets under custody and administration. The weighted average cost of our clearing and custody deposits remains very low, even with a rapid rise in the fed fund rates. We have a healthy pipeline of new custody and clearing clients that will help offset the eventual normalization in cash holdings if and when advisers and broker-dealers become less risk-averse. We maintained a net interest margin well above our long-term annual target of 3.8% to 4% once again this quarter, with consolidated and bank-only NIM of 4.26% and 4.5%, respectively. New loan yields during the quarter were as follows: single-family jumbo mortgages, 6.03%; multifamily mortgages, 5.92%; auto, 6.5%; C&I 7.33%. We remain slightly asset-sensitive with 38% of our loans comprised of 5/1 hybrid arms in the jumbo single-family and multifamily portfolio and 53% of our loans comprised primarily of floating rate C&I loans. With the exception of a small portfolio of prime jumbo mortgages, we have no other 30-year fixed-rate jumbo single-family loans or multifamily loans on our balance sheet. The overwhelming majority of our C&I loans are variable rate, excluding the $138 million equipment leasing portfolio. 58% of our variable rate C&I loans are tied to LIBOR and the other 42% are tied to SOFR, Ameribor, or other indexes. At September 30, 2022, approximately 93% of our C&I loans were above their floors, with another 75 basis point increase in fed funds expected in November. All the C&I loans will be above their floor rates. Demand for our commercial specialty real estate and other C&I loans remains strong, as reflected in the $790 million C&I loan pipeline as of October 24, 2022. Axos Securities, which includes our securities clearing, custody, self-directed trading, and managed portfolio businesses, generated $10 million of pretax income, excluding noncash amortization expense in the first quarter of fiscal 2023, an improvement from adjusted pretax income of $0.8 million in the linked quarter. Our securities business is benefiting from rising interest rates, partially offset by declines in asset-based revenue as a result of market depreciation. Axos Advisor Services held its first in-person adviser conference since 2019 last month. Over 100 existing and prospective advisers attended, reflecting strong interest from independent RIAs seeking an alternative non-competitive tech-forward custodian that can help them grow their practice. Axos Advisor Services is seeing good momentum, adding approximately $200 million of net new assets in the quarter ended September 30, 2022, and a pipeline of 10 new advisers with over $500 million of new client assets that is committed to transfer to Axos over the next 12 months. The pipeline for Axos Advisor Services remains robust, with active discussions with several multibillion-dollar firms looking to move portions of their assets from their existing custody. We are making good progress with various operational and infrastructure initiatives in our clearing and custody businesses. We continue to make progress on the build-out of our proprietary securities core that will reduce operational costs in our securities business by reducing third-party vendor costs, allowing greater levels of straight-through processing, and enabling us to pursue more cost-competitive business opportunities. Higher fee income from Axos Securities was instrumental in helping offset expected declines in mortgage banking gains on sale. As rates continue to rise, we expect this dynamic to continue with higher fee income from off-balance-sheet deposits offsetting lower mortgage banking income. We expect higher margin businesses such as stock borrowing, margin lending to rebound from current levels when market conditions improve. Additionally, we have several initiatives at Axos Advisor Services and Axos Clearing that will optimize and grow fee income from new and existing sources such as mutual funds, ETFs, our model management marketplace, and alternative assets. Our efficiency ratio was 55.9% for the three months ended September 30, 2022, up from 54.4% in the prior quarter. Excluding a $16 million one-time legal reserve, our efficiency ratio was 48.2% in the first fiscal quarter of 2023. Yesterday, we received an unfavorable outcome in the litigation initiated by Union Bank related to our purchase of our Axos Fiduciary Services business. This litigation pertained to issues related to the sale of the business to Axos by Epic Systems and the termination of a prior contract between Union Bank and Axos. Axos' relationship with Union Bank ended a number of years ago, and this matter has no impact on any aspect of the Axos Fiduciary Services business going forward. The jury awarded Union Bank damages totaling $18.3 million, which is offset by a prior amount received by Union Bank of approximately $8 million for a net amount of $10.3 million plus estimates of prejudgment interest. While the company strongly disagrees with the verdict and plans to appeal the decision in the damages awarded, Axos took a $16 million pretax reserve in the quarter ended September 30, 2022. Our diverse lending and deposit businesses and modest securities portfolio position us well for a rising interest rate environment. Our securities book with approximately $258 million in ending balances is less than 2% of the total assets as of September 30, 2022. About half of our securities are floating rate, and the average duration of our securities portfolio was 2.1 years. Unlike other banks, we are not and do not anticipate having material unrealized losses for our securities portfolio. Our single-family jumbo mortgages and multifamily loan portfolios, with $4 billion and $3 billion of loan principal outstanding as of September 30, 2022, represent approximately 26% and 19% of our total loans outstanding, much lower than they were in prior rate cycles. While we expect deposit betas to rise to the end of the Fed tightening cycle, we have more tools from a loan and deposit perspective to help alleviate some of the expected funding pressure. Looking forward, our outlook is that our net interest margin for the fiscal year ending June 30, 2023, will remain above our long-term target of 3.8% to 4%. The biggest factors impacting our net interest margin will be how fast our loan portfolio grows and where our Axos Advisory Services deposit balances are relative to their levels on September 30, 2022. As we stated previously, our expectation is that net loan growth will moderate from the high levels seen in the prior two quarters and will grow by mid-teens in fiscal 2023. If loan growth exceeds our mid-teens based target, then the incremental cost to fund our loan growth will be on the higher end of expectations. With respect to our Axos Advisory Services deposits, the biggest source of incremental low-cost deposits will come from our existing RIA clients. The amount of cash held by RIAs and their client accounts fluctuates based on adviser risk appetite, which can change quickly. Another factor impacting Axos Advisory Services clearing cash balances is the relative rates paid by money market funds and other liquid cash alternatives. Historically, advisers and broker-dealers have not viewed cash sweeps as an asset class and have not actively looked to maximize the return on that cash. However, given the Fed's aggressive tightening, some advisers are starting to evaluate higher-yielding cash alternatives. We have started to engage in productive discussions with custody and clearing clients to come up with solutions that are mutually beneficial for the RIAs and their clients' needs. We are also actively exploring relationship-based pricing that could accelerate the transfer of new custody assets to Axos. Our baseline assumption is that the percent of cash held by Axos Advisory Services clients will normalize to 7% of our assets under custody in fiscal 2023 from 11% at September 30, 2022. If clients become more risk-averse and continue holding a higher cash balance, then our full-year net interest margin will be higher than our baseline target. However, if clients reduce their cash percentages and we have to replace those low-cost deposits with relatively higher-cost deposits, then our full-year net interest margin will come in at the lower end of our target of 4% or higher. Our credit quality remains healthy, and we're not seeing any signs that our borrowers are struggling to finance their debt obligations with us. Net charge-offs to total loans remain low, and our asset-backed lending makes us extremely comfortable about our credit outlook even in adverse economic scenarios. Nonperforming assets as a percentage of total assets was 68 basis points for the quarter ended September 30, 2022, unchanged from 68 basis points for the quarter ended June 30, 2022. Of our nonperforming loans, approximately 55% are single-family mortgages, where we've had historically very low realized losses. Of our nonperforming single-family mortgage loans at September 30, approximately 95% had an estimated current loan-to-value at or below 70%, and approximately 97% were below 80% of our best estimates of current loan-to-value. Given the low loan-to-value of our asset-backed loans, we remain confident that our incurred credit losses will remain manageable even if asset values decline. We had an excellent start to our fiscal 2023 with loan growth and net interest margin well above our full-year guidance. While the uncertain environment presents short-term challenges, we will continue to manage the aspects of our business that we have direct control over: credit, operational efficiencies, capital liquidity, and strategic investments. Our strong profitability, excess capital, and ability to be nimble positions us well to take advantage of market dislocations similar to what we've done in prior cycles. I'm excited to execute on the various strategic initiatives we have in place across each of our businesses. Now, I'll turn the call over to Derrick, who will provide additional detail on our financial results.

Thanks, Greg. To begin, I'd like to highlight that in addition to our press release, an 8-K with supplemental schedules was filed with the SEC today and is available online through EDGAR or through our website at axosfinancial.com. I will provide some brief comments on a few topics. Please refer to our press release, our SEC filings, and our website for additional details. I'll lead off with an overview of our deposits at September 30 compared to June 30. Our noninterest-bearing deposits declined $407 million from $5 billion at June 30 to $4.6 billion at September 30. Our total interest-bearing demand and savings deposits increased $1.4 billion from $7.9 billion at June 30 to $9.3 billion at September 30. Our time deposits increased $187 million from $1.1 billion at June 30 to $1.2 billion at September 30. Our weighted average interest rate at the end of the period for our total deposits increased 60 basis points from 0.54% at June 30 to 1.14% at September 30. Next, I'll turn to our noninterest expense, which for the quarter ended September 2022 was $116 million, up $11 million in the linked quarter ended June 2022 and up $32 million from the quarter ended September 2021. As Greg discussed, the primary reason for the increase was a $16 million accrual for an adverse legal judgment that has not been finalized. I'll provide some additional information on a few specific expense areas. Salaries and related expenses for the quarter were $47 million, up $3.5 million from the linked quarter and $6.3 million from the year-ago quarter. The $3.5 million linked quarter increase is primarily attributable to our annual salary compensation increases, taxes for semiannual bonuses, and increased headcount. Professional services for the quarter ended September 30, 2022, were $8.1 million, an increase of $0.5 million from the $7.6 million for the three months ended June 30 and a $3.5 million increase from the $4.5 million for the quarter ended September 30, 2021. The primary drivers of the increases were legal expenses and fiscal year-end audit expenses. Advertising and promotional expenses increased to $6.4 million from $3.4 million in both the June and prior year September quarters to support growth in our deposit businesses. Given the competitive landscape for deposits, we expect to maintain a higher level of spending on marketing to grow our consumer and commercial deposits. Lastly, despite strong asset growth, our capital ratios remain in a strong position with our total risk-weighted capital ratio at Axos Financial ending the period at 12.9%. Net capital at Axos Clearing increased 26% on a linked quarter due primarily to higher profitability in our securities business. We continue to maintain additional cash reserves at the holding company available to contribute to our subsidiaries. And with an expected moderation of asset growth, we expect to organically grow our capital throughout the enterprise. With that, I'll turn the call back over to Johnny.

Thanks, Derek. Operator, we're ready to take questions.

And at this time, we'll be conducting a question-and-answer session. And our first question comes from the line of Gary Tenner with D.A. Davidson.

A couple of questions. On the segment reporting section of the supplement, just looking at the fee income at the securities business and the corporate eliminations, it strikes me as they took a really large delta there, certainly much more than the year ago period. So I'm just wondering, Derrick, if you could kind of walk us through the moving parts there and how to think about it on a segment basis.

Yes, certainly. That's the cash sorting deposits. So we did try to add some language above the table that covers that the vast majority of those deposits from the Axos Clearing and Axos Advisor Services cash sorting deposits that are held at the bank. So obviously, we have a portion of those held off balance sheet as a portion that is held on the bank's balance sheet. And so the elimination is that the bank pays the securities business for those transactions for those deposits at a roughly market interest rate, and that's what's getting eliminated in that noninterest income line item and in the noninterest expense line item.

Okay. In rose, I went through the fee side. Okay, that helps. And then just in terms of the loan deposit ratio increased this quarter. Obviously, a lot of banks are running a little bit higher than typical on that metric right now. I was just wondering how you're kind of monitoring that and thinking about that going forward.

Yes, certainly. We typically operate just above 1. With the variety of deposit sourcing options available to us, we are comfortable around a range of 1.05, with some fluctuation. Historically, this range is consistent with our usual operations. We are confident in our ability to maintain this performance. There's strong demand in our consumer deposit business lines, and we are also making progress in building customer relationships related to the Axos Advisor Services' new clients. Overall, we are optimistic about the potential of our deposit franchise. We aim to maximize our efficiency because we know we have various strategies and levers to attract deposits, allowing us to operate slightly at or above that level.

Thank you very much.

Our next question comes from the line of Andrew Liesch with Piper Sandler.

Derrick, I was taking some notes. Did you give what a good run rate would be for expenses here? It sounds like it could be a little higher, but did you give like a total number of where we should build off going forward?

Yes. I believe it's similar to what we shared last quarter. There is some variability due to the legal charge. When considering the 42% figure, which reflects the bank's efficiency ratio along with a minor percentage adjustment, it seems to be the most effective way to estimate expenses. Typically, this aligns with a consolidated ratio that ranges between 48% and 50%.

Got it. That's really helpful. Is that just on the margin guide in the range of $3.80 to $4? It sounds like to get below that high end, you would need the natural level of cash at Axos Securities to decrease to a normal level. If the Fed stops raising rates, then funding costs might balance out, but even so, it would likely still be at the high end of that range at worst. Is it time to update your range considering all the different dynamics in the deposit base over the last several years?

Yes, that's a fair question considering our current position. There are several factors at play. The loan side has become more unpredictable, but there remains a group of loans, specifically the 5/1 arms, which were originated at different times and tend to reflect more recent vintages due to the level of prepayments we encountered before. People are generally not moving away from those loans. Additionally, prepayments are lower now, which is extending the average life beyond the typical 2.9 years. While new assets are being introduced at higher rates, even if they come in on the jumbo side in the low to mid-7s, an increase in the Fed fund rate above 5 could pressure net interest margins for some portfolios. This could lead to an increase in cash sorting or rising deposit betas. However, I don't believe it's realistic to anticipate a drastic drop in NIM to 4% in the fiscal year, as that doesn’t seem logical. While the long-term targets may appear slightly low at 3.8% to 4%, we do gain significant advantages from the securities side, which does vary with cash balances based on market risk tolerances. Thus, we should not expect much upside from the currently high NIMs. We have outlined our thoughts about potential cash percentage changes and the corresponding ranges. Ultimately, our control over this is limited and heavily influenced by market conditions and individual advisers' decisions regarding their balances.

Got it. All right. That's really helpful. I will step back. Thanks, Greg.

Our next question comes from the line of David Feaster with Raymond James.

I wanted to discuss Axos Advisor Services briefly. Could you share your thoughts on the competitive landscape? You mentioned having a strong pipeline, so I'm curious if a volatile or uncertain environment helps you gain market share and expand. Additionally, can you update us on the growth roadmap and the plans for enhancing your capabilities?

Certainly. Those are all great questions. Regarding the competitive landscape, the main factor is Schwab's acquisition of TD Ameritrade, which is set to occur towards the end of 2023. This situation has led many to seek alternative custodians, resulting in significant opportunities for us. Our discussions with potential clients have been very positive, and the demand for our capabilities is strong. While there are some challenges related to market volatility and client communications during transitions, these concerns do not overshadow the overall favorable conditions stemming from the acquisition. As for our growth roadmap, we have a solid technology strategy. We have developed our own securities core, which has required significant effort but promises major cost savings, transitioning from over $10 million in expenses to essentially zero within three years. This transition is expected to reduce our volumes and eliminate incremental transaction costs, allowing more competitive pricing for our services. On the client-facing side, we recently shared a tech vision at our conference that integrates banking services directly into client accounts, streamlining the process for advisers and eliminating manual check processing. Feedback from advisers has been overwhelmingly positive, and we expect to roll out this feature by June 2023. This initiative will enhance the client experience and strengthen our banking operations. Overall, our technology improvements will enhance operational efficiency across our securities firm, even as the industry continues to evolve. The demand for alternative custodians has never been stronger, with clients increasingly seeking responsive service as larger firms may not meet their specific needs. Our commitment to maintaining strong client relationships will ensure we remain a valuable partner for all our clients, regardless of their size.

That's great color. And I was hoping maybe you could touch on the specialty CRE market. You talked about higher rates impacting demand a bit. I'm just curious where you're still seeing demand both by product and geography and just your outlook and how to appetite for growth in the specialty CRE segment.

We are still witnessing strong demand for multifamily construction projects, which matches our investment strategy. We operate within a loan-to-cost range of under 50% for these products with our partners and funds, and that remains solid. Currently, the demand is healthy, but the focus shifts to our projections concerning new projects, especially since financing for projects that have been delayed is now happening. It's essential to consider how recent interest rate and cap rate changes will influence decisions for future projects. Notably, the uncertain state of the securitization markets is advantageous for banks and firms with stable funding sources. For instance, we experienced significant growth in our real estate lender finance business. Loans in this sector, traditionally securitized, are now appearing on our balance sheet because they come with higher advance rates and better pricing. We appreciate this trend since it allows us to assess each loan individually, which will support our loan growth. Additionally, we are observing some types of loans, like asset-backed lines, becoming more appealing due to widening spreads, which we might consider participating in. From our viewpoint, we don't aim to aggressively raise capital, having grown somewhat faster recently than our sustainable pace, given our return on equity must align with asset growth over a reasonable timeframe. Overall, we're confident in our diverse asset portfolio and do not anticipate being without asset growth. Despite declines in some markets, competition has also diminished, particularly in the single-family sector, where previous operations impacting credit and pricing have significantly reduced.

That makes a lot of land. And then just last one for me. You've done a great job proving out your rate sensitivity and driving margin expansion. And you talked about the more floating rate loans than you've ever had. I'm just curious how you think about managing rate sensitivity going forward. Obviously, we're about to get another 75 probably next week, another 75 next month. But just curious whether you're considering locking in some rate sensitivity and how you'd approach that, whether it's through for more fixed-rate lending or even potential synthetic opportunities?

Yes, those are interesting questions, and we are exploring some of those aspects. I don't want to make any definite statements at this moment. One point I would emphasize is that we are not using deposits to engage in lending from a CD standpoint. Therefore, as we examine these different elements, we must ensure they align, and we don't want to be committing to long-term funding without having long-term assets associated with it. There are numerous opportunities available, and we are actively considering them. However, I don't have any specific updates on that right now.

All right. That's fair. All right. Thanks, everybody.

Thank you.

Our next question comes from the line of Michael Perito with KBW.

We've covered a lot already, but I have a few credit-related questions, mainly regarding our loan book. To start on a broader scale, the allowance for credit losses is just over 1% today. The composition of our loan book has shifted significantly over the past few years; for example, jumbo loans now represent about 26% compared to nearly 53% three years ago, especially following the pandemic. I'm interested in your thoughts on the current reserve level relative to our business mix. Additionally, we've noticed other banks adjusting their qualitative assumptions about the economy and their allowances for credit losses this quarter. Could you provide an overview of your current assumptions in that regard?

Yes, certainly. I’ll also point you to the supplement filed with the SEC earlier. Slides 3 and 4 provide a good summary of the additions we’ve made to the allowance, which is 8.8% for this current quarter. As you've mentioned, we are just over 1% of total loans. However, when we break that down among categories like single-family warehouse, single-family mortgage, multifamily, and commercial mortgage, where the loan-to-values are 57% and 52% on a weighted average across those portfolios, you will see a lower percentage of the allowance for credit losses at 45 basis points and 49 basis points, respectively. In the commercial real estate sector, which includes some construction loans and non-real estate commercial and industrial loans, you will find that we are well above 1%. For auto and consumer loans, we are well above 2%. Each segment of the loan portfolio exhibits its own dynamics. A consistent theme throughout the entire portfolio is our low loan-to-value approach, particularly with structured products, resulting in many commercial products having loan-to-value and loan-to-cost ratios well below 50. This is a factor in our allowance analysis and when we stress the portfolio, it plays a significant role. It would take considerable stress to result in losses given the low collateral values.

Yes, I believe that when you examine the average, we are essentially competing with banks and partners. If we used loan-to-value ratios similar to those banks, our metrics and loan loss models would indicate much higher levels of loan losses as well. For instance, if we accepted 70% or 65% loan-to-value risks on construction lending, we would see substantially higher loss rates. However, we are not provisioning for those loan losses since we're not engaging in those practices. Analyzing the situation, our portfolios are in the 150s and above range, historically experiencing virtually zero losses, with none anticipated in the near future. Although these predictions are inherently forward-looking, we have been in this business for a long time. The effects of COVID faded quickly, and it has been quite a while since we faced a prolonged, deep recession. Our loans maintain a breakeven status at valuation cap rates of 10, 11, or 12, indicating we are still far from any significant risks.

Got it. That's helpful and relates to my second question, which follows up on an earlier inquiry. If we look at the supplemental slide, particularly the loan breakout, most of the growth this quarter came from CRE specialty and lender finance. Could you remind us about how loans in those categories are structured and what typical collateral looks like? Is it developed properties, sites, or a mix? I'd appreciate a refresher as those categories continue to grow at a good pace.

The commercial specialty real estate business comprises various product types. This includes completed buildings that generate cash flow or are undergoing repositioning or sellout. For instance, completed condominiums that are in the process of being sold out. Typically, the debt structure consists of 70% of the total cost, with us holding around 65% to 70% of that debt. There may also be a subordinate fund attached to us that could involve certain recourse levels, requiring them to address any deficiencies, whether in interest or principal, swiftly. If they fail to do so, they would relinquish their loan to us and could transfer that piece to us if necessary. This usually results in roughly a 50% loss on a loan-to-cost basis, capped at the property's estimated stressed value. Each loan is backed by a strong partner who bears the loss risk, and during challenging times like the COVID period, it's been rare for even the partners to face any losses. Occasionally, under stress, they might not achieve full default interest rates and could waive some default interest, but they are required to get back on track. The structure allows for collaborative discussions with partners, who generally possess significant liquidity, enabling them to address project issues, though there have been few. We believe this structure is safer than straightforward multifamily investments, as some multifamily borrowers may have overextended themselves at low cap rates in light of sustained rent increases. Additionally, specialty loans tend to feature strong underlying sponsors with substantial liquidity, who are also prepared to forfeit significant economic interests in the properties. This is why we maintain a virtually no-loss portfolio in this domain.

Thanks. Great, I appreciate you spending some time on that.

Thanks, Mike.

Could you provide more details about the legal judgment? I was a bit taken aback by it and would like to understand it better. Additionally, I know you're facing some limitations now; without raising more capital, you can grow to what you mentioned regarding your return on assets. However, do you have any remaining flexibility in the balance sheet that might allow you to exceed that?

I'll address the last question first. Yes, there is some cushion in our capital. We've raised funds, and we currently have excess capital based on the risk weighting of certain assets at 50% and 100%. While we do have this excess capital, it's not something investors should expect to systematically use to grow beyond our return on equity. There will certainly be quarters when we outperform that return on equity, but it won't be a consistent trend at this time. Overall, I believe we have a good growth rate, and the situation with our excess capital depends on the mix of our 50% and 100% risk-weighted assets. Regarding the first question, we have been dealing with some legal matters for a while now. A few years back, we had a class action lawsuit that was ultimately resolved within our insurance limits, and we don’t have any significant ongoing business disputes. The recent complaint is largely directed at EPIC and involves the seller of the business, which has unintentionally dragged us into the situation due to various complexities. We believe this outcome is inappropriate, but we are making the necessary financial provisions for it. This should resolve the matter concerning our exposure in most significant ways, although I can't guarantee there won't be any surprises from the legal side. Nonetheless, the chances of that are very low. We are exploring potential appeal options for this case, but overall, I think we've navigated through most of the legal issues we've faced in recent years. While we can't predict the future, I'm optimistic that we're moving past these challenges and can focus on running the business going forward.

Okay, that helps.

We have reached the end of the question-and-answer session. I'll now turn the call back over to Johnny Lai for closing remarks.

Great. Thanks, everyone, for joining, and we will talk to you next quarter.

Thank you.

This concludes today's conference. And you may disconnect your lines at this time. Thank you for your participation.