Cullen/Frost Bankers, Inc. Q1 FY2020 Earnings Call

Good morning and welcome to the Cullen/Frost Q1 Earnings Results Call. My name is James, and I'll be facilitating the audio portion of today's interactive broadcast. All lines have been placed on mute to prevent any background noise. Operator provided instructions. At this time, I would like to turn the call over to Mr. Avi Mendes. Sir, the floor is yours.

Thanks, James. This morning's conference call will be led by Phil Green, Chairman and CEO; and Jerry Salinas, Group Executive Vice President and CFO. Before I turn the call over to Phil and Jerry, I would like to take a moment to address the safe harbor provisions. Some of the remarks made today will constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 as amended. We intend such statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 as amended. Please see the last page of text in this morning's earnings release for additional information about the risk factors associated with these forward-looking statements. If needed, a copy of the release is available on our website or by calling the Investor Relations department at (210) 220-5234. At this time, I'll turn the call over to Phil.

Thanks Avi. Good morning everyone and thanks for joining us today. Today I'll review the first quarter results for Cullen/Frost; and our Chief Financial Officer, Jerry Salinas, will also provide additional comments before we open it up to your questions. In the first quarter, Cullen/Frost earned $47.2 million or $0.75 per share compared with earnings of $114.5 million, or $1.79 a share reported in the same quarter last year. In a very challenging environment, while our bank lobbies are closed, more than two thirds of our employees are working remotely. Our team continues to serve our customers at a very high level that Frost is known for and execute our strategy of pursuing consistent above-average organic growth. In the first quarter, our return on average assets was 0.57% compared to 1.48% in the first quarter of last year. Average deposits in the first quarter were $27.4 billion, up from $26.1 billion in the first quarter of last year. And average loans in the first quarter were up to $15 billion from $14.2 billion in the first quarter of last year. Our credit loss expense was $175.2 million for the first quarter and that compared to $8.4 million in the fourth quarter of 2019 and $11 million in the first quarter of 2019. In addition to changes related to CECL, our credit loss expense was elevated in the first quarter as a result of COVID-19 related business closures and also challenges faced by our energy industry customers due to recent commodity price declines. Net charge-offs for the first quarter were $38.6 million compared with $12.7 million in the fourth quarter of 2019 and $6.8 million in the first quarter of last year. Annualized net charge-offs for the first quarter were 1.04% of average loans. Non-performing assets were $67.5 million at the end of the first quarter, down 38% from $109.5 million at year end; most of this decline came from charge-offs related to two energy credits we've been dealing with for some time as they moved through the process towards resolution. Overall delinquencies for accruing loans at the end of the first quarter were $122.3 million, or 80 basis points of period loans and those numbers remain within our standards and comparable to what we've experienced in the past several years. Total problem loans, which we define as risk grade 10 and higher, were $582 million at the end of the first quarter compared to $511 million in the previous quarter. Energy-related problem loans were $141.7 million at the end of the first quarter compared to $132.4 million for the previous quarter and $119.3 million in the first quarter of last year. Energy loans, in general, represented 10.2% of our portfolio at the end of the first quarter, well below our peak of more than 16% in 2015 and down from 11.2% in the fourth quarter of 2019. Clearly, we entered the current downturn from a position of strength, but we're not confused. The deterioration of the economy brought on by COVID-19’s pandemic will have a negative, but manageable effect on our portfolio. We're in the early stages of this downturn, which is unprecedented in our lifetime. We don't know the length. We don't know the ultimate resolution. We don't know the impact of massive fiscal and monetary stimulus brought to bear on the problem, but we do know that we'll address these issues consistent with our culture and core values that have guided us through multiple crises over our 152 year history. And while we don't have all the answers and outcomes, I’d like to share a few data points we hope will be helpful. We've identified seven portfolio segments, eight including energy, that we feel have higher than the usual risks due to the current economic dislocations brought on by the pandemic. They include restaurants, hotels, aviation, entertainment and sports, retail, religious organizations and associations and organizations. The total of these portfolio segments represents $1.36 billion at the end of the first quarter. There were $227 million in deferrals related to this portfolio at quarter end. The reserve for loan losses against these segments at the end of the quarter was 2.25%. Looking at energy, this portfolio totaled $1.57 billion at quarter end and carried loan loss reserve of 6.58%. Reserve-based borrowers represented 82% of the quarter end total. Significantly influencing our energy reserve number was an oil price scenario of $9 per barrel for the remainder of 2020. This assumption was combined with borrowers’ plans to manage through the current cycle: hedge positions, cost structures, debt levels, other secondary sources of repayment and other factors. A similar analysis was performed on non-reserve based borrowers. 57% of the production portfolio is hedged in 2020 and 32% in 2021, both at prices in the mid-fifties. The average breakeven for the portfolio is $18.66 per barrel. Our focus on commercial loans continues to be on consistent balanced growth, including both the core component, which we define as lending relationships under $10 million in size as well as larger relationships while maintaining our quality standards. Regarding new loan commitments booked, the balance between these relationships went from 53% larger and 47% core at the end of 2019 to 57% larger and 43% core so far in 2020. The movement towards larger loans year-to-date was mostly due to two large public finance transactions. New relationships were off to a strong start in the first part of the quarter, but were negatively affected in February and March by the COVID-19 pandemic, resulting in a decline of 16% compared with the first quarter of last year. The dollar amount of new loan commitments booked during the first quarter rose by 6% compared to the prior year. We continue to look at many deals and in the first quarter we booked 13% more loan commitments from opportunities compared with the same quarter last year. In CRE, we saw the market become more liberal in terms of structure. Our percentage of deals lost to structure increased from 76% this time last year to 91% in the first quarter of this year. Our weighted current active loan pipeline in the first quarter was down about 30% compared with the end of the fourth quarter due to the effects of the pandemic. On the consumer banking side, we continue to see solid growth in deposits and loans. Overall, net new consumer customer growth for the first quarter was 3.3%, up from 2.9% a year ago. Same-store sales as measured by account openings were down by 1.1% through the end of the first quarter. In the first quarter, 33% of our account openings came from the online channel, which includes our Frost Bank mobile app; online account openings were 31% higher compared to the first quarter of 2019. The consumer loan portfolio averaged $1.7 billion in the first quarter, increasing by 2.6% compared to the first quarter of last year. Overall, Frost bankers have risen to the unique challenges presented by the pandemic and its resulting shutdowns with a mix of keeping our standards and sticking to our strategies along with a truly remarkable amount of flexibility and adaptability. We opened the 11th of our 25 planned new financial centers in the Houston region in the first quarter and we have two more openings scheduled for May. Even if lobbies remained closed during the new branches' scheduled openings, one of the new locations is a motor bank and will begin serving customers on day one. We continue to hire talented, experienced bankers as part of our Houston expansion and we've already filled more than 170 of the approximately 200 positions expected. I'll talk more in a minute about our efforts around the Paycheck Protection Program, but I wanted to note that during the first round of funding for this important small business program, Frost was number one in the Houston market in terms of the number of PPP loans approved. In Harris County, we helped nearly 2,000 businesses get loans for $616 million and that shows our strong commitment to the Houston market and reinforces our strategy of bringing our value proposition to more customers there. Later in the first quarter, we began offering programs to assist our customers similar to the disaster loans and other relief efforts that we implemented after Hurricane Harvey. Frost announced that it would donate $2 million to non-profit agencies assisting with pandemic relief in the areas where we have operations. Just before the quarter ended, Congress passed the CARES Act, which included provisions for $349 billion in small business loans through the Paycheck Protection Program, or PPP. We knew that Frost small business customers would benefit greatly from PPP loans, so even as we closed our lobbies and set up our employees to work remotely to protect them and our customers, we mobilized for the PPP application process. Even though the SBA finalized its application with only hours to spare, we were ready to begin processing on day one and the demand was tremendous. We received more than 9,000 applications in just the first four days. By comparison, we processed about 9,000 commercial loans in a typical year, but we dug in and our Frost bankers adapted with technologies and they developed systems on the go and through lots of hard work and many long hours, we wrestled PPP to the ground. The initial funding was set up to last two months, but it was exhausted in less than two weeks. Before that happened, Frost received 14,000 PPP applications for a total of $3.3 billion and because of the dedication and commitment and effort of thousands of Frost bankers, more than 10,500 of our small business customers, or more than three quarters of those applying, received SBA funding in the first round for $3 billion, or 90% of the amount requested. Based on our size, we projected we'd be fortunate to receive approval on about $900 million. Instead, we were able to secure more than three times that amount. That $3 billion represents continued paychecks for workers whose employers have been affected by the pandemic. Through this process, our small business customers experienced the true value of having a relationship with Frost. Every quarter, when we share our financial information, I’ll talk about the great work that Frost bankers do in executing our strategies while taking care of customers. This time I can say that I've never been prouder of the work our people do on behalf of our customers. I hope our shareholders have the same sense of pride, knowing that their company is truly a source of strength for our customers and our communities and also a force for good in their lives. That's what makes me optimistic that we'll get past the many challenges that remain. Our credit teams have reached out to borrowers and our industries that are most affected by the pandemic. We continue to work very closely with both commercial and consumer customers. We're keeping a close eye on the recent anomalies in oil prices and the impact that that's having on the economy. We'll follow our best practices and public health guidelines as we formulate plans to return to our offices and re-open our lobbies. Our commitment to customer service was confirmed this month when Frost received the highest ranking in customer satisfaction in Texas in J.D. Power's U.S. retail banking satisfaction study for the 11th consecutive year. We sometimes take these achievements for granted or consider them routine. The events over the past few months should stand as a reminder that there's nothing routine about Frost and its culture. Now I'll turn the call over to our Chief Financial Officer, Jerry Salinas for some additional comments.

Thank you, Phil. Today I’m going to avoid our usual commentary about the Texas economy, given the level of economic uncertainty in the short term; there wouldn’t be value in macro comments at this time. I will point out that it has been reported that businesses in Texas received more PPP loans than businesses in any other state, and we are proud to have been a leading participant in that program, as Phil mentioned, making approximately $3 billion in loans over a remarkably short period of time. We are now involved with the second tranche of that program, and we continue to assist our customers during this challenging time. Now I will turn to our financial performance in the first quarter. Looking at our net interest margin, our net interest margin percentage for the first quarter was 3.56%, down six basis points from the 3.62% reported last quarter. The decrease primarily results from lower loan yields and balances at the Fed as well as an increase in the proportion of balances at the Fed as a percentage of earning assets, partially offset by lower funding costs. The taxable equivalent loan yield for the first quarter was 4.65%, down 23 basis points from the fourth quarter, impacted by the lower rate environment with the March Fed rate cuts and decreases in LIBOR during the quarter. Looking at our investment portfolio, the total investment portfolio averaged $13 billion during the first quarter, down about $678 million from the fourth quarter average of $13.6 billion. The taxable equivalent yield on the investment portfolio was 3.46% in the first quarter, up nine basis points from the fourth quarter. Our municipal portfolio averaged about $8.5 billion during the first quarter, up about $109 million from the fourth quarter. The municipal portfolio had a taxable equivalent yield for the first quarter of 4.07%, down one basis point from the previous quarter. And at the end of the first quarter about two thirds of that municipal portfolio was PSF insured. As we mentioned last quarter, during the fourth quarter, we purchased $500 million in 30-year treasury securities yielding 2.27% as a hedge against falling interest rates. During the first quarter, given the volatility in the yield curve, we decided to monetize the gain associated with those treasuries and sold them, resulting in a pretax gain of approximately $107 million. The duration of the investment portfolio at the end of the first quarter was 4.6 years, down from 5.4 years last quarter and was impacted by the sale of those 30-year treasuries. Our current plan does not include any material investment security purchases for the remainder of the year. Looking at our funding sources, the cost of total deposits for the first quarter was 24 basis points, down five basis points from the fourth quarter. The cost of combined Fed funds purchased and repurchase agreements, which consists primarily of customer repos, decreased 26 basis points to 0.95% for the first quarter from 1.21% in the previous quarter. Those balances averaged about $1.26 billion during the first quarter, down about $158 million from the previous quarter. During the first quarter, we did redeem our $150 million in preferred stock, resulting in the recognition of $5.5 million in debt issuance costs, which reduced net income available to common shareholders for the first quarter and resulted in the elimination of that $2 million quarterly dividend going forward. Looking at our credit loss expense, the components of our total credit loss expense consisted primarily of $110 million for the energy portfolio, $34.8 million for the commercial real estate portfolio and $22 million for the C&I portfolio. Our energy reserve coverage at the end of the first quarter was 6.58%. Moving on to non-interest expense, total non-interest expense for the quarter increased approximately $22.4 million or 11.1%, compared to the first quarter last year. Excluding the impact of the Houston expansion and the operating costs associated with our headquarters move in downtown San Antonio, non-interest expense growth would have been approximately 7.6%. We are withdrawing our previous earnings guidance and will not be providing any EPS guidance for full year 2020 at this time given the uncertainty surrounding the economic impact of the pandemic, including the potential impact of future expected credit loss expense. I will say that given the Fed rate cuts in March and a continuing decline in LIBOR rates, we do expect our net interest income and net interest margin percentage to decrease from their first quarter level. We will see a positive from the impact of the PPP loan. But given the short-term nature of those loans, we expect that benefit to be relatively short term as the fees associated with those loans will be earned into interest income over the life of those loans. During our call last quarter we did provide guidance around projected expense growth for 2020 over 2019. During these uncertain times, we continue to focus on managing expenses including looking for ways to operate more efficiently. As a result, we currently expect that noninterest expense in 2020 will grow at about 8.5% over 2019; that's about 2% lower than our previous guidance. With that, I will now turn the call back over to Phil for questions.

Thank you, Jerry. Okay, we'll open it up for questions now.

Your first question comes from the line of Brady Gailey of KBW. Your line is open.

Hey thank you. Good morning guys.

Hey Brady.

Good morning.

So if you look at period end loan balances, you had some strong growth in the first quarter. Can you expand on what drove that and how you are looking about loan growth for the rest of the year, excluding the PPP?

Yes, let me give you some clarity now. Are you looking at period end or are you looking at average numbers?

I was talking about period end loans which grew up…

Period loans.

Yes Brady, we did from a linked quarter basis have pretty significant growth. We grew 4% on period end, so about 16% annualized. A big portion of that growth if annualized was related to our C&I portfolio that was up almost 6.7% actual growth and if you annualize that it's almost 27%. We did see some increases in commercial lines that were drawn on during the quarter, especially during that time period leading up to March period end. We have seen some of that begin to subside the pace of those draws. And I'm going to say that was the bulk of the increase there. We actually had a decrease in energy between December and March; they were down $84 million.

We also had some nice gains in the public finance area with some large deals. One related to a port in the state and a very large medical center HVAC transaction. So both of those things were also positive.

All right. And then when you look at the SBA's PPP, you had $3 billion in round one, how much do you expect to do in round two and where is that fee coming? I think most banks are saying it's around 3%. Would that be a fair estimate for Frost?

Our fee is running about that. It ended up maybe being a tad lower in the first round. But I think we’re seeing a little bit smaller balances in the second round. And so I think it will be solidly in the 3% range. As far as volumes, a couple of things are happening. One is we are making sure that we get through as best we can the applications that were not processed in the first round, so our backlog there was somewhere between 3,000 and 4,000 applications. I can't remember the exact number right now. And so we are working on those. As we look at the second round applications, which we may be at the point of processing now, late last night, we may have started that. We're seeing a little bit lower volume; we received about 2,000 applications as of yesterday evening, with loan balances being a little bit on the smaller side. So still good activity, but not the huge rush that was there at the beginning because I think a lot of larger, more sophisticated customers had more visibility of the program. As far as where we're booking that, that's going into interest income.

Okay, that's helpful. And then finally from me, you mentioned 57% of the energy production is hedged in this year, 32% next year. Are you going to say 30% are 100% of the total production, or those are the percentages of your energy customers that just have some level of hedging?

Yes, those are customers that have some level of hedging.

Okay, great. Thanks guys.

Thank you, Brady.

Your next question comes from the line of Ken Zerbe of Morgan Stanley. Your line is open.

Okay, thanks. Good morning. Maybe a multi-part question. Can you just talk a little bit more about the increase in net charge-offs in the quarter? Also layer in how much of that related to energy and whether, how much of the energy reserve build is related to specific reserves versus more general CECL reserves, if that makes sense.

Yes, well, first of all, the charge-offs for the quarter were heavily related to energy. There was, I would call, $38 million related to two credits, which were nonperforming. We described those as we've been moving through the process for a couple of years or even longer. They were written down to values which at the time were based upon deals that were on the table in one case and in a bankruptcy in another where there has been an offer related to. Honestly, as we've seen the COVID-19 pandemic impact and the reduction in demand worldwide, I think those values are certainly at risk. So that's really what that relates to. It brought both of those two credits down to, I think, a combined amount and we were close to getting out of the process, but it didn't quite make it through in time for the pandemic.

Just to clarify, our total was $38.6 million for the quarter and $33.8 million of that was energy related, as Phil mentioned.

And then in terms of specific energy reserve build versus more general CECL?

We didn't book any specific energy reserves.

What we did was our team used the Moody's baseline forecast that was adjusted around the middle of March that took West Texas Intermediate down to $35 flat for three years. That was part of an F8-type scenario. Moody's continued to revise their outlook given the global developments between Russia and Saudi Arabia and the pandemic. We decided to use overlays rather than simply switch to a different Moody's model input. So our energy reserves created were primarily related to overlays rather than specific reserves. That is what increased the reserves, not so much specific reserves but macro overlays and Q factors.

If Moody's updates their models to be more reflective of the situation with energy in the pandemic, we might see a reduction of overlays.

Exactly. To give a little more insight, the stress testing that was done on the energy portfolio assumed $9 per barrel during 2020 and then increasing to $36 in 2021, $40 in 2022 and $45 thereafter. That work created the overlay. The overlay in the energy portfolio, including Q factors, was about $88 million. Our expectation is that during the next quarter when the CECL models rerun with more updated inputs, a big portion of that overlay would migrate into model-driven results, but we'll have to see what the models produce.

Makes sense. And then just one follow-up. I think you said you brought energy as a percentage of total loans from 11.2% down to 10.2%. How did you bring it down so much in the quarter, and where do you envision this going over the next few quarters?

I think we had a little anomaly in the previous quarter and returned to a more normalized level based upon activity. We have been working to reduce the exposure of the energy portfolio and we'll continue to do so. We're aiming to get it below the 10% level and over time move it more towards the mid single-digits, but that takes time because of existing credit agreements and the timing involved. We remain in the business and want to be there for the best customers, but we will continue to rationalize exposure down to be more in line with other portfolio segments.

And of course, as Phil mentioned earlier, we did have almost $34 million in charge-offs; that affects the percentage as well.

Understood. All right. Thank you very much.

Your next question comes from the line of Dave Rochester of Compass Point. Your line is open.

Hey, good morning guys.

Good morning.

On the energy book, can you give some background on how far along you are in the redetermination process and what you're seeing in terms of how much lines are declining for customers and what utilization is at this point?

We are about a third of the way through the redetermination process that happens at this time of year. What we've been seeing thus far is about a 13% reduction in valuations.

So the actual lines to customers have only come in 13%?

That's the reduction in valuations. We've been working to reduce exposure over and above the redetermination process. As Jerry mentioned, the energy oversight council we've put in place is reviewing major energy credits; we've been talking with customers about operating plans, expense reductions and cash flow. We've been successful in getting some line reductions even before maturities, so not all reductions are tied to redeterminations.

And then how does that inform the reserve for the quarter? Do you extrapolate results from that one-third onto the two-thirds remaining and set the reserve that way, or will we see incremental reserve flow into 2Q for the additional two-thirds you're working on now?

Remember some of what we did in the first stage of CECL and the overlay was based on a stress test that assumed $9 oil for the year. At that point the reserve used stress assumptions that predated some redetermination actions.

Got it. For the two energy credits you talked about charging off, what was the severity on those?

They were significant. I would say we wrote them down substantially; as a rough rule of thumb, at least three quarters on those credits were impacted.

They had some pretty significant charge-offs as we described.

Okay. Backing up to the total loan book level, could you give that deferral amount again on the higher-risk bucket that you mentioned, the $1.36 billion, and then what was the total deferral percentage for the entire loan book at this point?

The deferrals for the higher-risk bucket, not including energy, as of April 23 were $227 million of the $1.361 billion outstanding. For the entire company, deferrals were about $1.3 billion, which is about 8% of our loans.

And then maybe just one last one on the NIM. 2Q I know is when you'll get that full quarter impact of the rate cuts; can you bracket or estimate the magnitude you're expecting for 2Q?

The main uncertainty is how PPP loans will affect net margin and how quickly they'll be repaid. Internally we've discussed scenarios where perhaps 75% might be repaid within the first 10 weeks, but that's speculative. There were input challenges and credit considerations with PPP; we don't fully understand yet how that will play out. That uncertainty will be a big driver for net interest margin movement in 2Q.

Any way to estimate backing that out, even roughly, to see the underlying NIM pressure because PPP will be noise in 2Q and maybe 3Q depending on forgiveness?

If you back out PPP, we were at 3.56% NIM. Our current projection is that full year we'll still be north of 3%. You'll see a drag especially between Q1 and Q2. After that it levels out a bit, but expect significant reductions in the NIM with LIBOR and short rates down. We're keeping liquidity high and have not borrowed from the Federal Reserve's liquidity programs.

Okay, all right. Thanks guys. Appreciate it.

Thank you.

Your next question comes from the line of Jennifer Demba of SunTrust. Your line is open.

Thank you. Good morning.

Good morning.

Phil, you mentioned your $1.36 billion of loans in more vulnerable categories. Of those categories, what are the larger exposures within that $1.36 billion?

Here's the segmentation. Religion and public finance outstandings at the end of the quarter were approximately $336 million. Restaurants total outstanding was $275 million, hotels $239 million, aviation $196 million. Associations and organizations were $115 million, entertainment and sports was $114 million and retail businesses were about $86 million. That's the breakdown for those categories.

Do you have SBA loans?

We have some traditional SBA, but not a lot; it's in the $150 million range. Were you asking about PPP loans or regular SBA loans?

Regular.

Regular SBA is not a big factor.

Okay. And I assume the hotels are mainly limited service type properties?

Our hotel exposure committed was $314 million across 28 projects, eight of them in construction; those construction projects will be finished sometime this year but opening timing is uncertain. Average loan-to-value is 64%. Our owners are experienced with significant equity and good operators, many Hilton and Marriott flags. These are not gateway-city assets or theme-park related. We feel good about the portfolio; sponsors generally have good liquidity. We may see some risk rating increases, but at this point we don't see significant loss exposure.

What does the restaurant book look like?

Restaurant commitments are about $340 million, and $119 million of that has asked for deferrals at this point. Two thirds of that committed portfolio are multiple-format restaurants, multi-site franchisees. The exposure that concerns us more is the small independent restaurants, where loan sizes are under $100,000; that cohort totals about $6.4 million. That's where we see most vulnerability at this stage. We're relying on our judgment and experience because many financial statements are older and don't reflect the rapid changes from the pandemic.

Thanks so much. Good color.

You are welcome.

Your next question comes from the line of Jon Arfstrom of RBC Capital Markets. Your line is open.

Thanks. Good morning.

Hey, Jon. Good morning.

I had a different topic, but I wanted to follow up on Jennifer's question. It looks like you had some downgrades in problem loans outside of energy. Can you touch on that and the broadness and frequency of your loan grading process?

We did see new problem loans in some larger public finance related areas, including organizations in the arts or education which were downgraded. Energy was the main area for increases in risk grade 10 and higher. As for grading, our officers are responsible for accurate grades and we measure relationship manager performance. We want to avoid 'double-downgrades' and are focused on consistent grading practices. I didn't notice anything in the non-energy downgrades that caused particular concern.

If we can come back to that, just on PPP, curious why you think you were able to secure three times what you expected? Also, can you take a stab at how much of that $3 billion is customers new to Frost?

We prioritized serving existing commercial customers because that was the fastest way to get money into the community without having to onboard new customers under BSA/AML requirements during the initial surge. Beyond that, it was the people and culture at Frost. We had over 500 volunteers from across the company working long hours to get applications processed, many working nights from home. A large proportion of applications required follow-up to be accurate and complete; that work drove very high completion rates and helped us get about 75% of applicants funded in the first round. The success really reflects exceptional effort across the organization, and also the broader banking community's hard work.

Jon, I have the detailed information broken down by risk rating and commercial loan class in our 10-Q. Page 17 offers current year by class and risk rate and Page 18 has the December comparison with the new CECL disclosures. We'll file the 10-Q shortly after this call and it will have the detail.

Okay. That helps. Thank you.

Your next question comes from the line of Steven Alexopoulos of JPMorgan. Your line is open.

Hey, good morning, everybody.

Hey Steve.

Good morning.

To start, following up on energy. What were the problem loan balances at the end of the first quarter? It was $132 million last quarter. And what specific deferrals did you provide to energy companies in the quarter?

Problem loans at the end of the first quarter were $141.7 million compared to $132.4 million at the end of the previous quarter. We saw some migration with increases in risk grade 11. We had a credit dependent on asset sales that deteriorated given high discount rates and low prices; that contributed to the deterioration. Regarding energy deferrals, we have not seen material deferrals requested by energy customers; de minimis amounts to date.

Thank you. On the expense outlook being taken down for 2020, is that related to the Houston expansion? Is that being slowed at all?

Expense moderation is not because we're slowing Houston. It's more about being careful on hiring generally, assessing whether we need to replace roles, and managing expenses across categories. We continue the Houston expansion and have been investing there for years. Our results in Houston have been strong: new household acquisition is 146% of our goal, loans are 260% of goal, deposits 68% of goal but improving — over the last three months deposits are 108% of goal and consumer deposits 240% of goal. Commercial takes longer to develop. We remain excited about the Houston expansion and expect it to continue to perform over the long term.

How many branches have you opened in Houston at this point and how many are left?

We opened 11 of the planned 25, so 14 remaining.

Thanks so much for the color.

You’re welcome.

Your next question comes from the line of Matt Olney of Stephens. Your line is open.

Hey, good morning and thanks for taking my question. Phil, you mentioned the bank's intention to reduce the energy exposure over time to the mid single-digit level. Can you talk more about the driver of that decision? Was it made at the board level? Does this speak to the risk profile or volatility?

That decision was not a board-mandated edict; it's been an ongoing strategic posture. When I joined conversations earlier we had energy exposures of 16% or more. We decided to stop growth and move it down to a 10%–13% objective and now aim for mid single-digits over time. It's about asset allocation, volatility and shareholder expectations — our stock was highly correlated with oil prices. Our shareholders don't sign up for that level of volatility. We want a more balanced portfolio, continue to serve the industry, but reduce relative exposure and grow the rest of the business, particularly core loans under $10 million. It must be done thoughtfully over time consistent with credit agreements and relationships.

Perfect. Thank you very much.

Your next question comes from the line of Ebrahim Poonawala of Bank of America Securities. Your line is open.

Good morning, guys.

Good morning.

Most of my questions have been asked. Phil, regarding M&A: in a world with market dislocation, would you consider distressed M&A opportunities or remain focused on organic growth?

We're still focused on organic growth for the reasons we've discussed: brand, operational alignment and long-term shareholder value. The pandemic introduces more variables around credit and integration, so organic expansion remains our priority.

Understood. And on the energy numbers, you assumed $9 in 2020 and $36 next year; if prices are higher next year, is the portfolio well reserved based on your stress analysis?

The stress scenarios assumed very low 2020 prices and a recovery in 2021. If production reductions materially constrain supply over 12–24 months, prices could swing higher given sensitivity. Our overlays were built to account for a severely stressed scenario; higher prices next year would be favorable to portfolio prospects.

Okay. Got it. Thank you.

Your next question comes from the line of Michael Rose of Raymond James. Your line is open.

Hey, thanks for taking my questions. Two follow-ups. The total potential problem loans were up $71 million; it looks like about $9–10 million of that was energy related. What made up the other component and how much was in that higher-risk category? Also thoughts on the dividend and buybacks?

The largest increase outside energy was a credit reliant on property sales that ran into higher discount rates and lower prices; that relationship is about $49 million exposure. Regarding capital and dividend, our priority is the dividend. We have $70 million remaining on an authorized buyback program that expires in July and we decided not to do any buybacks under that program. We continued the $0.71 per share dividend this morning and are focused on preserving that dividend given capital strength.

Great. Thanks for taking my questions.

Thank you.

There are no further questions at this time. You may continue.

Okay. Well, we thank everyone for your interest and with that, we’ll be adjourned. Thank you.

Ladies and gentlemen, this concludes today’s conference call. Thank you everyone for participating. You may now disconnect.