Earnings Call Transcript - EFSC Q1 2023

Operator, Operator

Good morning. My name is David, and I will be your conference operator today. I would like to welcome everyone to the Enterprise Financial Services Corp. Q1 2023 Earnings Conference Call. Today's conference is being recorded. Thank you. Jim Lally, President and CEO, you may begin your conference.

Jim Lally, President and CEO

Well, thank you, David, and thank you all very much for joining us this morning, and welcome to our 2023 first quarter earnings call. Joining me this morning is Keene Turner, EFSC's Chief Financial and Chief Operating Officer; and Scott Goodman, President of Enterprise Bank & Trust. Before we begin, I would like to remind everybody on the call that a copy of the release and accompanying presentation can be found on our website. The presentation and earnings release were furnished on SEC Form 8-K yesterday. Please refer to Slide 2 of the presentation titled Forward-Looking Statements and our most recent 10-K and 10-Q for reasons why actual results may vary from any forward-looking statements that we make today. Our company entered 2023 with a great deal of momentum. Loan pipelines were good. Our newer markets and businesses were contributing as expected. Credit was in great shape, and clients are doing very well. Along the way, the industry disruption experienced in early March tested our relationship model, and the results from our first quarter, in particular, how we ended the quarter with respect to deposit growth, liquidity, cost of deposits, borrowing capacity, and capital ratios show that we passed this test with flying colors. During our fourth quarter call, I spoke about the relationship aspect of our depository businesses. We knew that 2023 would be a year that would require us to find the appropriate balance between retaining and growing the space while being mindful of competition and rising rates. What we did not know is that this would be put to the test in a matter of days and weeks in early March. I was impressed, but certainly not surprised by two things: first, our team's commitment and ability to reach out to our clients to explain what was happening and to reinforce our strength and differentiation versus those who are experiencing issues; and secondly, the incredible confidence that our client base had in our company. Since then, we have been working with these clients to remix their deposits, seeking the appropriate balance between yield and safety, using all products and resources available to them. Scott and Keene will provide much more details on this in their comments. The financial highlights for the first quarter can be found on Slide 3. While we can't entirely control how events impact us, I do like our position. We start from a position of strength, both from an earnings and balance sheet perspective. First, net income was $56 million or $1.46 per diluted share for the quarter, and we produced a return on assets of 1.72% and return on tangible common equity of 20%. Our profitability is supported and aided by our short-duration asset-sensitive balance sheet that is a result of the execution of our business model. Despite intense deposit competition and pressure in the first quarter, we were able to expand our net interest margin by 5 basis points to 4.71%. And with two fewer days in the first quarter, net interest income grew to $139 million. While deposit remixing and repricing in the quarter was intense, our total cost of deposits for the month of March was just over 1%. This again reflects the strength and position of our balance sheet and my confidence in our ability to continue to generate superior asset yields and growth to mitigate pricing pressure on funding and deposits. Earnings, combined with our strong asset position in addition to a well-managed investment portfolio resulted in the tangible common equity to tangible assets ratio expanding during the quarter to 8.81%. Additionally, our earnings helped to contribute to just under $2.00 per share to our tangible book value during the first quarter, which closed at $30.55. Turning to Slide 4, you can see that our loan growth remained strong during the quarter as it increased $275 million. This represented an annualized growth rate of 11%, and like in previous quarters, this growth emanated from just about all of our businesses and regions with a focus on quality and a full relationship. We were able to fund this growth with our deposit growth as this grew by $325 million during the quarter and included the use of brokered CDs. At quarter-end, our loan-to-deposit ratio stood at 90% and, due to the aforementioned remixing of our deposits, DDA percentage of deposits to total reduced to 38%. We recognize that the ability to fund our expected loan growth with core deposits will be our greatest challenge for the remainder of the year. We are seeing all the great work we have done over the past several years, diversifying our deposit base and geographies, paying off. We are prepared to defend our deposit base and know that deposit costs will continue to rise. However, our C&I-focused variable rate weighted loan portfolio should provide a good buffer to defend our NIM. Credit quality remained pristine with continued low charge-off activity and low level of nonperforming assets and a healthy allowance level. Slide 5 shows where we will be focused for the remainder of the year. I would expect that the momentum with which we entered the year will continue for the foreseeable future. Those of you who know us well, know that we typically perform extremely well when there is a bit of uncertainty. We grew well coming out of the great recession. We acquired two companies during the COVID pandemic. And I'm confident that we will do what it takes to defend well what we have while having an eye towards taking advantage of what our markets will give us to acquire new clients, new teams and possibly new businesses. With that, I would like to turn the call over to Scott Goodman, who will provide much more details about our markets and our businesses. Scott?

Scott Goodman, President of Enterprise Bank & Trust

Thank you, Jim, and good morning, everybody. Q1 was a quarter defined by follow-through on a steady and well-balanced loan pipeline and active outreach to our client base for consultation, defense, and exploration of new opportunities around deposit relationships. While the events of March certainly ramped up the volume of client touches, in many ways, this activity was not a departure from the advisory-based approach and consultative sale processes that we have traditionally driven our business model through the years. In that regard, our ability to deploy specific event-driven talking points, content, and product sets into our existing marketing, CRM, and sales management systems resulted in rapid, transparent, and productive client engagement. I'm very proud of how our client-facing and operational teams across the company responded to these circumstances, put our clients at ease, and have created many new opportunities as a result. Turning to loans, summarized on Slides 6 through 8, growth in the quarter was $275 million or 11.4% annualized and 12.2% year-over-year net of PPP. Over the past year, we've experienced growth across all major categories of the business as we continue to prioritize the diversification of our production and the resulting loan portfolios. For Q1, broken out on Slide 8, seasonally typical levels of origination were complemented by slightly lower payoff activity and a modest increase in revolving line usage to produce these results. Growth in C&I reflects success in onboarding new regional commercial banking relationships, as well as the aforementioned uptick in revolving line usage. Growth in commercial real estate and construction development reflective of new asset acquisition and investment opportunities with larger existing relationships, as well as draws on fixed lines representing progress on construction loans closed in prior quarters. In our specialty loan categories, sponsor finance posted solid growth of $43 million in Q1, as we saw a number of closings get pushed from a typically strong fiscal Q4 into the first quarter. Sponsors continue to deploy a strong base of capital in their existing funds, albeit with some patience and discipline around purchase multiples. Life insurance premium finance also experienced growth of $43 million in the quarter with steady new originations and a typical seasonal uptick in advances for premiums paid on existing deals. Following strong growth in Q4, SBA was essentially flat for the quarter. Origination activity was consistent with typical Q1 levels. However, elevated payoff activity muted net growth. Competitive pressures from traditional banks and lower fixed rates have been a headwind to retention of existing loans. We are defending solid credit profile loans in this book with alternative rate structures, and we continue to execute well on the production side of the business. We also expect this channel to be well positioned to take advantage of any potential credit tightening or liquidity restraints that may affect the loan appetite from traditional bank lenders. Tax credits posted a modest reduction in outstandings, reflecting paydown activity from the sale of tax credit inventory, which is typical of the first quarter in this business. There has also been some delay in closings of new projects due to higher interest and construction costs as developers source additional funding. Overall, though, we expect originations to ramp back up and also anticipate activity from newer state affordable housing programs to add some additional new opportunities going forward. Regionally, we posted growth across our footprint, as reflected on Slide 9. The Southwest posted strong results, totaling $85 million of increased loans in the quarter. The region benefited from continued traction from our newest team in Texas as they onboarded new business, including several significant new relationships with food distribution, industrial storage, and medical service companies. Arizona also closed larger loans for new asset acquisitions with existing clients in the storage and hospitality industries. In the Midwest region, the Kansas City and St. Louis teams produced solid origination activity, including funding of a new industrial development with a large existing engineering client and acquisition of equipment with a new transportation company relationship. This region also benefited most from the elevated revolving line activity, given the heavier C&I makeup of those portfolios. And in our West region of Southern California, the portfolio edged up modestly in the quarter, adding to annual growth year-over-year of $75 million or 4.7%. We began to gain traction in the second half of 2022 as we cultivate an expansion of strategy in this market, having added new C&I talent to the acquired base of commercial real estate originators in our L.A. and Orange County markets. Payoff and paydown activity has moderated from the levels experienced earlier last year, and the C&I pipeline activity has been building. We also successfully expanded some key legacy relationships in this portfolio during Q1, including new closings for hospitality, investor retail, and industrial clients. Turning to deposits, which are broken out for the last 12 months and the quarter on Slides 10 and 11. I'll provide some high-level commentary and color around what we're seeing from clients, and then Keene will provide more detail on funding costs and category movements in his comments. Year-over-year, deposits are down $540 million or 4.7%. The largest area of decline is noninterest-bearing accounts, with nearly two-thirds of that occurring during Q1 of 2023. Offsetting a material portion of this decline has been strong growth from our specialty deposit businesses, including $307 million of growth in Q1, as shown on Slide 11. During the first quarter, we grew deposits overall by $326 million. Historically, Q1 has been a seasonally soft quarter for deposit growth in our company with outflows from tax, dividend, and bonus payments. This year, net of brokered CDs, we grew overall customer deposits by $75 million. We did see significant remixing of balances, particularly during the month of March, spurred early on by the publicity of bank failures driving depositors towards perceived risk-free alternatives and more lately due to elevated focus on deposit rates. Consequently, declines in noninterest-bearing accounts have been shifted mostly to the categories of money market interest-bearing demand and time deposits. Slide 12 shows the regional breakout of deposit portfolios. Net of broker deposits, which are reflected within the Midwest balances, core client balances in the geographic markets declined modestly during Q1. Aside from typical seasonal declines related to bonus and tax payments, we did see some consumer clients moving concentrated balances to larger banks, as well as larger commercial clients investing some excess balances in higher-yielding accounts and U.S. treasuries. In general, though, we are not losing core relationships, and we have been successful in using FDIC insured options such as ICS and CDARS to hold on to larger-balanced commercial accounts. We have also selectively structured a variety of pricing options to retain high-value relationships. Our specialized deposit channels, which are broken out on Slide 13, continue to perform well and are contributing strong growth in a turbulent market for deposits. These business lines comprised of community associations, property management, and third-party escrow accounts provide a steady source of new accounts with somewhat limited competition. Other specialty balances are inclusive of sponsor finance and declined in the quarter. A majority of the lost balances in this category totaling roughly $30 million were associated with companies that had been sold by our fund sponsor clients, but which had retained their accounts in enterprise. Generally, these tend to leave over time as the new ownership groups consolidate with their existing banking relationships. However, we saw this behavior accelerate in March due mainly to the fallout from the bank failures. Finally, we provided additional detail on our core funding mix and account activity for the quarter on Slide 14. This data further supports both the diversity and a relationship anchored orientation of our funding base. Balances are spread across four main channels with 38% of total funding in noninterest-bearing accounts. During Q1, our sales process continued to generate positive results, with net increases in new account balances versus closed accounts across all major channels. The net reduction in the number of commercial and business banking accounts is primarily due to consolidation and account closures associated with the remixing of account types and the movement of some balances to treasuries and non-bank alternatives. There is also granularity to these portfolios, as you can see from the average account sizes. Our practice is to require the operating accounts for all C&I loan clients and 80% of all commercial balances are tied to treasury management or online banking products, which adds traction to these relationship deposits. We've also seen a significant improvement in our insured deposits. We spent time confirming account titling and other similar attributes with clients during the latter part of March. This is most prolific in our specialized deposit areas, as we view account titling as a competitive advantage in both HOA and property management. We ended the first quarter with approximately 70% of the deposit portfolio insured or collateralized. With that, now I'd like to turn the call over to Keene Turner for his comments.

Keene Turner, CFO and COO

Thanks, Scott, and good morning, everyone. I'm going to start with my typical comments on the quarterly financial results, and then I'll address the supplemental information that we provided. Turning to Slide 15. We reported earnings per share of $1.46 in the first quarter on net income of $56 million. Our net interest margin expanded from the linked quarter, which combined with growth in earning assets, helped to modestly expand net interest income. Additionally, fee income was comparable to a seasonally strong fourth quarter, leading to modest expansion of operating revenue in the first quarter. The provision for credit losses was more significant for the first quarter, but not driven by adverse loan trends, and noninterest expense was seasonally higher in the current quarter. All things considered, we're pleased with the performance of net interest margin, loan growth, and funding. Our return profile thus far reflects a strong base on which to build the remainder of 2023. Turning to Slide 16. Net interest income for the quarter was $139.5 million compared to $138.8 million in the linked quarter, an increase of $0.7 million despite two fewer days. Net interest margin expanded 5 basis points in the first quarter to 4.71% on a tax-equivalent basis. The margin performance reflects the expected results from fourth and first quarter increases to the Fed funds rate, combined with continued growth, albeit at a more modest rate than we had forecasted. More details follow on Slide 17. Earning assets grew $194 million on average in the first quarter, and yields increased 44 basis points compared to the linked quarter. Investment balances were higher by $84 million on average, reflecting purchase activity in the prior quarter combined with an increase in the fair value of the available-for-sale portion of our portfolio. The yield improved 12 basis points over the fourth quarter due to the full quarter impact of the securities we purchased last quarter. We already elected to pause additional portfolio investment in the first quarter, and we subsequently halted reinvestment of the majority of cash flows during the recent market upheaval. Portfolio loans grew $275 million in the first quarter, and when combined with strong growth in December of 2022, were higher by $371 million on average compared to the prior period. The total loan yield improved by 46 basis points in the first quarter, which includes a 5 basis point negative impact from purchase accounting amortization and an additional 1 basis point reduction for received fixed swaps. New loans were booked at a yield of 6.53% in the first quarter. Interest-bearing liabilities increased $355 million on average, and the cost increased 65 basis points from the prior quarter. Average deposit balances declined $89 million in the quarter, including a $282 million decrease in average noninterest-bearing balances. The decrease in noninterest-bearing accounts was driven by two distinct factors. First, a combination of customer deployment and rate focus early in the quarter resulted in modest net declines and remixing of balances into higher-rate money market and CD accounts. And second, and most materially, a flight to safety late in the quarter resulted in balances moving into reciprocal accounts or to other institutions for diversification of risk. Of the $450 million decline in noninterest-bearing balances during the quarter, approximately $350 million of that occurred in the last three weeks of March. Interest-bearing checking and money market balances grew $90 million on average, but increased $445 million within the quarter. As noted, this was primarily a result of funds moving from noninterest-bearing accounts to higher-yielding products or in the FDIC insured reciprocal products. We also made the intentional decision to bring in additional balances often at higher interest rates to support balance sheet liquidity during the last few weeks of the quarter. These actions helped to defend against net reduction in balances that occurred as a result of industry stress late in the first quarter. Time deposits increased $145 million on average, including $71 million of brokered funds. Total brokered time deposits grew $251 million within the quarter as we elected to add term funding and avoid reliance on our borrowing lines. Brokered funding adds an element of stability to the overall funding base while we work through a combination of industry challenges and typical seasonality. FHLB advances were higher by $102 million on average, as we utilized short-term debt as a bridge funding alternative during the quarter until brokered CDs and other deposit strategies could be completed. In total, the ending FHLB balance was unchanged from the end of the fourth quarter to the end of the first. Maybe noteworthy here is that we do expect to see FHLB as a part of the funding stack moving forward as it provides flexibility for certain of our specialized deposit categories. These categories collect balances early in the month and then deploy them after the first couple of weeks. Our cost of deposits increased during the quarter as we continue to experience some of the pricing lag we expected from last year. Additionally, a combination of competitive, economic, and industry-based factors push rates higher, and the change in our deposit mix caused additional increases in our deposit costs beyond what we had anticipated. Our average cost of interest-bearing deposits increased 62 basis points from the prior period, which equates to a 72% beta compared to the Fed funds effective rate. With that said, our cumulative interest-bearing deposit beta for this rate cycle stands at 32%, which is in line with our historical level and is only 18% for total deposits. With that said, we are pleased that the cost of deposits in the quarter was less than 1% given where the Fed funds target is, and we are sitting here today with a total cost of deposits at an estimated 1.25%. With all that said, we see a path from first to second quarter to maintain a stable to slightly increasing level of net interest income, albeit that comes with some level of net interest margin compression. We believe that we will continue to see remixing and increased competition, however, the asset side of our balance sheet allows us to mostly absorb those costs. Assuming we can weather the repricing and remixing war in the second quarter, there is an opportunity for us to expand net interest income dollars thereafter. Slide 18 shows our credit trends. We experienced modest net recoveries in the first quarter and the overall asset quality remained stable. Nonperforming assets remain less than 10 basis points of total assets. We recorded a $4.2 million provision for credit losses during the first quarter that was primarily related to an investment in Signature Bank subordinated debt. Our total investment was $5 million and was equivalent to the largest individual portion of sub-debt or loan we would hold. Slide 19 presents the allowance for credit losses. The allowance for credit losses increased by $1.4 million in the quarter to cover loan growth. The allowance for credit losses represents 1.38% of total loans compared to 1.41% at the end of the year. When adjusting for government guarantees, the allowance to total loans was 1.53%. On Slide 20, first quarter fee income of $17 million was stable with the fourth quarter, although the composition of fee income did change slightly between certain categories. Overall, fee income remained at a consistent percentage of operating revenue in the first quarter. Turning to Slide 21. First quarter noninterest expense was $81 million, an increase of $4 million compared to $77 million for the fourth quarter. Compensation and benefits was the main driver of this increase, primarily from seasonally higher payroll taxes and 401(k) match. Also, the run rate is a reflection of continued resource investment in the associate base, both in the form of net hiring activity, as well as a partial period of impact of merit increases. Deposit service expenses declined from the linked quarter. We did expect this line item to expand sequentially, and we are pleased that it did not, however, requires some further explanation. First, as a reminder, that the fourth quarter included the cumulative impact of the competitive decisions we made in that quarter of roughly $1 million to maintain certain client relationships. And second, we were accruing the line item to reflect that clients would be able to largely have expenses to offset against the earned credits. However, this ended up not being the case, and some of that expiration occurred in the first quarter. Thus, the run rate for the first quarter, we estimate was around $14 million, and we expect that to expand from the first to the second quarter by $1 million to $2 million, reflecting both continued growth in balances and rates. Overall, we expect noninterest expense to increase to $83 million to $85 million in the second quarter, reflecting both an increase in deposit service expense and anticipated higher commissions. The first quarter's core efficiency ratio was 50.5%, an increase of 240 basis points compared to the fourth quarter, driven primarily by a rise in both interest and noninterest expenses in the quarter. With some moderation of our net interest margin and net interest income expectations, we do expect core efficiency to move up slightly in the coming quarters, to be roughly 52% to 53%, barring better fees or that we are too conservative on net interest income. Our capital metrics are shown on Slide 22. Strong first quarter earnings and a $24 million improvement in accumulated other comprehensive income resulted in a nearly 7% expansion of tangible book value per share to $30.55. Right now, our earnings profile and high capital retention rate are supporting our flexibility in being defensive from a capital accretion perspective, while we are also comfortable building the franchise with existing and new client growth. We have always been thoughtful about our capital actions and how we manage the balance sheet, not doing too much of any one thing. This is reflected in our tangible common equity ratio nearing 9% and our common equity Tier 1 ratio over 11%. While we look at the investment portfolio on Slide 23, you can see that we apply the same principles and philosophy managing here. So, while we use held to maturity to help manage volatility in tangible common equity and accumulated other comprehensive income, we did so at a measured level. Thus, after-tax unrealized losses on held to maturity are approximately 40 basis points of tangible common equity, and total available for sale and held to maturity losses are approximately 150 basis points on common equity Tier 1 to roughly 9.7% common equity Tier 1 capital, including all unrealized securities losses. Separately, we use the investment portfolio for two purposes. We have a shorter-term component, which is roughly 60% of the portfolio for liquidity, cash flow, and municipal deposit pledging purposes. This would represent agency mortgage-backed and CMOs, T-bills, and other government-sponsored securities. The remaining 40%, we invest in 10- to 15-year new issue municipal securities. We utilize this portion of the portfolio to stabilize our extreme asset sensitivity because our loan portfolio is short duration with a 2.5-year weighted average life, and we have a portfolio of mostly saleable variable rate SBA loans. In the first quarter, we sold $8.8 million of SBA loans and recognized a $0.5 million gain on the sale. The SBA sale was a practice for contingency planning, as we had not executed any sales since acquiring Seacoast in 2020. Also in January, we sold roughly $30 million of lower-yielding securities at a gain and reinvested the proceeds at a higher yield. It's worth reiterating here that the loan portfolio was almost 65% variable rate, so while our 6-year investment portfolio duration may seem long on the surface, we use it purposely and we kept it proportionate in size to our long-term balance sheet targets, despite having billions in excess cash in 2020 and 2021. We slow-played investing that cash to be cautious of its resiliency, and that strategy, along with investing methodically over numerous quarters, supports our current capital position, profitability, and flexibility moving forward. And finally, on Slide 24, we provided some additional context on liquidity. I'll first start by saying that roughly 70% of our deposits are insured or otherwise collateralized, reflecting collateral pledged to municipalities, use of CDARS, account titling for trustees and custodians, and, in some cases, surety bonds for our specialized deposit businesses. That means that the remaining 30% is above insurance limits and is within the available $4 billion of liquidity that we now have. You might expect, we spent a good portion of March, pledging additional collateral in case we needed to be defensive given the turmoil that occurred in banking. Finally, and worth noting, many of the balances that are greater than the insurance limits are with long-time clients who have full banking relationships here and have grown with us over decades. With that, we feel our prospects are sound to fund the balance sheet with deposit growth in 2023, and our position in the profile, particularly in specialty deposits, lends itself well to support that growth even in the face of an environment focused on deposit insurance. Additionally, while the cost of deposits has increased, we believe our lending businesses are adequately positioned to continue to deflect and absorb some of those costs. While returns may decline modestly, they are doing so from a high starting point, and our earnings profile remains differentiated and robust. With that, I appreciate your attention today, and we're now going to open the line for analyst questions.

Operator, Operator

Thank you. We'll take our first question from Jeff Rulis with D.A. Davidson. Your line is open.

Jeff Rulis, Analyst

Thanks. Good morning.

Jim Lally, President and CEO

Good morning, Jeff.

Jeff Rulis, Analyst

I’m not sure if I heard it from Scott or Keene, but the outlook on loan growth and pipelines seemed optimistic, along with some potential seasonal items. I would like to understand your expectations for net growth for the rest of the year.

Scott Goodman, President of Enterprise Bank & Trust

Sure, Jeff. I can give you some color. I think maybe on the specialty side of the business, those continue to be very steady performers. I think maybe the only outlier was tax, which we've seen, as I mentioned, seasonal decline related to tax payments and some of the construction projects, just kind of waiting to re-bid. I think we're seeing that, and we fully expect that niche to perform as expected for the remainder of the year. The rest of those businesses continue to plug along. I think we've seen that in prior quarters, very steady businesses. I think within the regions, we're seeing good opportunities, solid pipelines. Overall, we're seeing maybe some stress competitors back away from the market slightly. And I think we're going to get opportunities to look at higher quality loans, number one, and I think also prioritizing strong pricing there as well. So, I think we feel very good about the opportunities that we're leaning into, and I think it bodes well for the pipeline for the rest of the year.

Jeff Rulis, Analyst

To put a number to that, Scott, I mean, it had low double-digit growth this quarter. It sounds positive, but high single digits...

Jim Lally, President and CEO

Yes, Jeff, this is Jim. I'll take that one. We remain confident in achieving mid- to high single-digit growth for the year. By being more careful with pricing and other factors, as Scott mentioned in his remarks, we're not experiencing as much payoff activity. However, if we have the chance to acquire strong families and businesses that enhance our relationships, we will do so, as it adds long-term value to the company.

Jeff Rulis, Analyst

Great. Thanks, Jim. I wanted to discuss capital as it increases. I know you've been cautious during the pandemic, and with more opportunities arising, as capital grows, what are your thoughts? You've been proactive with buybacks, but do you have any plans for preserving capital or considering acquisition opportunities? I'd like to hear your thoughts on the capital side.

Jim Lally, President and CEO

Jeff, I think our posture is that, first and foremost, the capital we can use for our growth objectives, we've got a sound credit quality right now. I think there's a bit of slight recessionary times that we'll all have to combat through all this. So, we're going to basically stay put relative to buybacks at this time. On acquisitions, that's a long-term view. We're always interested. We have to figure out when the dust settles, what can we use acquisitions for to enhance the value of the company. But that's something that's a little bit longer term for us at this point.

Jeff Rulis, Analyst

I’d like to hear from Scott about the specialty loan breakout. As you consider the current stressed environment, what do you see as the areas of highest and lowest credit risk within the specialty loan book, including SBA, sponsored loans, life insurance, and tax credits? Which areas do you perceive as having a higher or lower risk profile?

Scott Goodman, President of Enterprise Bank & Trust

Yes. If we consider the two ends of the spectrum, life insurance premium finance, due to the liquid collateral backing those loans, represents the lower risk side where we need to monitor the portfolio's yield. Our expectations in that area have been fairly stable, and we've achieved the desired growth. We can also adjust that aspect with relative ease. On the other end, in sponsor finance, which is understandably riskier due to its cash flow-based nature and slightly higher leverage, we conduct thorough reviews of that portfolio, examining every loan in detail on a quarterly basis. Currently, we are very satisfied with its performance, with leverage typically around three times or less and strong coverage. However, we will continue to monitor this closely given the current economic conditions.

Jeff Rulis, Analyst

Okay. You put SBA and maybe with the government backing and tax credit, you put those kind of in the middle in terms of risk profile of those four categories?

Scott Goodman, President of Enterprise Bank & Trust

Yes. I would say it's closer to life insurance, right, than sponsor. As I mentioned, we're continuing to be bullish on origination activity there. What we've had to do in terms of holding some of the book though is shift a little bit to a fixed structure, which holds some of those loans on the books, but does affect the ability to sell those loans in the market, and we'll just continue to evaluate that risk versus reward as we move forward. But I think that sector, certainly as we see banks pull back from traditional lending, maybe as the yield curve normalizes and if the economy does soften, that's a countercyclical niche that we should do well for us over time.

Jeff Rulis, Analyst

Great. Thanks, Scott.

Operator, Operator

Next, we'll go to Andrew Liesch with Piper Sandler. Your line is open.

Andrew Liesch, Analyst

Hey, good morning, guys. Thanks for taking my question. Just on the funding of the loan growth, recognizing that reinvesting in the securities portfolio, it doesn't sound like that's going to be a priority anymore. So, I'm just curious, what are the cash flows coming off that? And then is that going to be sufficient to fund loan growth? It sounds like you're going to be bringing out some FHLB in keeping some of those in the funding mix. Just kind of curious the outlook of funding the loan growth.

Keene Turner, CFO and COO

Yes, Andrew, I appreciate your question as it highlights a point that may have been unclear. We do not foresee a long-term shift from our investment portfolio to loans. Currently, we haven't made any changes; we simply have an investment subsidiary, and the cash we haven't reinvested is currently idle. We wanted to navigate the next couple of months effectively before resuming regular balance sheet management. Our balance sheet is appropriately sized, and our investment portfolio target as we reached the year's end reflects that. When we project net interest income and margin, we plan to maintain the investment portfolio at a relatively stable size. Fair value fluctuations have affected it slightly, but we intend to reinvest approximately $250 million in cash flows expected this year, which we believe is a sound strategy for managing interest rate risk. Based on my earlier remarks, while the timing may be uncertain, I believe we can fund the growth we anticipate for this year through customer deposits. Historically, our enterprise has faced challenges in growing deposits during the first half of the year due to commercial factors, including tax payments and after-year-end bonuses, compounded by pressures from March that may have impacted our strategies. However, moving forward, especially as we enhance our efforts in the coming weeks and into the second quarter and the remainder of the year, we aim to increase customer funding while stabilizing competition and remixing in the industry. Although we will utilize FHLB to navigate the fluctuations from our specialized businesses, we expect to achieve overall growth and establish a viable approach to core funding the balance sheet in the latter half of the year. This shapes our expectations moving forward, allowing us to defend our earnings per share and operating revenue levels without needing to remix, even if it may seem slightly more profitable in the short term. This could pose longer-term challenges by concentrating interest rate risk in a setting where we might be overexposed to declining rates. As Jim mentioned, our focus remains on building the franchise and acquiring relationships while seeking out funding opportunities.

Andrew Liesch, Analyst

Got it. You've covered all the other questions I had. I will step back.

Operator, Operator

Next, we'll go to Damon DelMonte with KBW. Your line is open.

Damon DelMonte, Analyst

Hey, good morning, guys. Hope everybody is doing well, and thanks for taking my question. I joined kind of late, so I apologize if this was covered. But when you look at the deposit mix, the noninterest-bearing are down to 38% of total deposits from 43% last quarter. Keene, can you just give a little perspective as to kind of where you see the ultimate remixing kind of landing for the noninterest-bearing deposits?

Keene Turner, CFO and COO

We don't have a specific percentage in mind at the moment. Since March 31, we've experienced a decrease primarily due to business flows and tax payments, much of which is coming from DDA. There’s still some remixing occurring in the CDs and CDARS. On the other hand, we observed positive activity in the specialized space that offset some of that decline in early March. While we acknowledge the reduction and anticipate more remixing, it's difficult to predict whether it'll stabilize at 35%, 31%, or another figure. We have intensified our monitoring of deposit flows more than ever before. If any funds leave, we're ready to engage in discussions to recover them structurally. Overall, we expect deposit costs to rise significantly from the first to the second quarter, although perhaps not drastically from the 125 basis points we recorded in March, assuming some level of remixing. Additionally, in reviewing the overall cost of the deposit base in relation to the Fed funds rate and comparing it historically to 2019, we find ourselves at a similar cost level for deposits today even with nearly double the Fed funds rate. We are optimistic about this and believe we have some flexibility with the DDA percentage while still preserving net interest income and profitability. I can't provide a precise number, but that's our perspective on the situation.

Damon DelMonte, Analyst

That's okay. That's good color. Thank you. And then, did you say that the loss on the sub debt security was $5 million?

Keene Turner, CFO and COO

Yes, during the pandemic, there was no loan growth, and while many banks were issuing subordinated debt, we participated moderately in both the investment loan portfolio and Signature, which was one of the few at $5 million positions, while most were in the range of $1 million to $3 million. At that time, Signature had a better credit rating and was offering an attractive coupon, so we acquired a small portion. Although it wasn't ideal, we approached it as we do with everything, exercising caution and avoiding excessive risk. We're pleased that we maintained that limit of $5 million.

Damon DelMonte, Analyst

Okay. So, if you back out that $5 million from the loan loss provision this quarter, it kind of leaves you with not much of a provision for this quarter. So, how do we kind of think about the provision in the coming quarters?

Keene Turner, CFO and COO

Yes, what's interesting is that the underlying economic data, such as unemployment and GDP in our model, has actually improved from the fourth quarter. Looking back over the past six to eight quarters, we aimed to be conservative as we anticipated a more negative economic sentiment, which we incorporated into our qualitative factors. The good news is that both credit quality and asset quality remain excellent. Over time, the key factors we have become increasingly integrated into the forecast, so we need to be aware of that and adjust accordingly, being honest about the current situation. This is what is influencing the overall composition. Moreover, there are certain areas where growth formulates during the quarter and where we see origination activity. Therefore, it is really a combination of these three factors, along with a sequential decrease in the level of reserves for unfunded commitments from the fourth quarter to the first quarter, that drove this. I believe we have a modest provision for new loan growth, but underneath that, there are some favorable changes in the composition between the allowance for loan losses and unfunded commitments that are reflected in that provision number.

Damon DelMonte, Analyst

Got it. Okay. That's all I had for now. Thank you.

Keene Turner, CFO and COO

You’re welcome. Thanks, Damon.

Operator, Operator

Okay. Next, we'll go to Brian Martin with Janney. Your line is open.

Brian Martin, Analyst

Hey, good morning, guys.

Jim Lally, President and CEO

Hey, Brian.

Brian Martin, Analyst

Hey, Keene, just going back, maybe I missed it as I joined us late a little bit as well. Just on your kind of your margin commentary. Just can you talk about just where the March margin was? I think you gave the spot rate for the funding, but just where the March margin was? And just kind of how you're thinking about NII or margin perspective? And I apologize if you already covered that.

Keene Turner, CFO and COO

No, I didn't give an actual number. So, obviously, first quarter margin was 4.71%, March was 4.64%, and then our spot margin right now is just under 4.6%. Loan yield is roughly 6.4%. And then, as I indicated, we've got about 1.25% rate that we're assuming on deposits, and we triple check that this morning through the first 24 days of March, and that data is still holding up. So, all else equal, as long as that, we've got some level of degradation of funding costs in there for the remainder of April and then May and June. But when we look at that, combined with the growth that Scott and Jim talked about, that's what gets us to the second quarter net interest income dollars potentially being level here to the first quarter.

Brian Martin, Analyst

Okay. Regarding the balance of the year, it seems your hope is to see the net interest income dollars increasing sequentially in the second half of the year? Is that correct?

Keene Turner, CFO and COO

Yes, I believe that while the level of competition and shifting in the market is still present, it is diminishing. The significant transitions from DDA to CDARS or certificates of deposit are playing out, and the bank needs to replace those with additional funding. It seems that these changes are slowing down, and we expect to see some of this continue into the second quarter. If we can move past much of the remixing, we will benefit from the day count in the future. We are being very strategic and disciplined about asset origination, especially considering Scott's comments about others possibly cutting back. There is a potential path forward, but it heavily relies on the second quarter being the final period of significant changes, allowing us to return to some stability in the business, even with increased deposit costs across the industry and for us. I must admit that predicting two quarters ahead is quite difficult because we do not control the external factors. However, that’s how we are viewing the rest of the year. Even if the situation turns out worse than expected, we generally expect to maintain our net interest income, which could still position us strongly for the coming years.

Brian Martin, Analyst

Got it. That's great. You mentioned reducing some of the asset sensitivity. How are you considering potential rate cuts and managing the balance sheet if that happens?

Keene Turner, CFO and COO

We have engaged in some interest rate swaps primarily on variable rate loans, but we've only completed a small portion of our intended execution. If we aim for $500 million to $1 billion, we've accomplished between 25% to 50% of that target. We're monitoring the interest rate environment and plan to increase our activity in swaps to mitigate potential downsides. We've noticed a slight impact of 1 basis point on margins this quarter, which shows some effect. Our investment portfolio also supports this strategy. We're taking a cautious approach to manage cash pressures and funding shrinkage, which could heighten asset sensitivity. Our goal is to resume normal operations while using swaps to adjust downside risk strategically, aiming for minor adjustments if opportunities arise. That's our current approach.

Brian Martin, Analyst

Thank you for that. Jim, you mentioned that your position on the buyback is similar to last quarter. I'm curious about the circumstances under which you would consider resuming the buyback once capital is built and business returns to normal. Is this something that might remain off the table for the rest of the year until things stabilize?

Jim Lally, President and CEO

I think that what you said is correct, Brian. Your lips to God's ears is about getting back to normal, and when it does, we'll certainly reassess that.

Brian Martin, Analyst

Okay. And maybe just one for Scott. I guess, on the trends, credit quality is very strong. Regarding the trends in criticized assets this quarter, was there anything positive or negative that you're observing and monitoring?

Scott Goodman, President of Enterprise Bank & Trust

No major trends. It's pretty flat, Brian. As I said, we're looking hard. So, we feel really good about the quality of the portfolio right now.

Brian Martin, Analyst

Okay. Perfect. And just maybe the last one for me, Keene, regarding some of the fluctuations in fee income. Any thoughts on the tax business bouncing back this quarter compared to last? How should we view that? Or just the overall perspective on fee income aside from the variations in private equity and the CDE?

Keene Turner, CFO and COO

Yes, I would say there's really no revelations on the change in the pause around fee income. I think as the environment pressures margin, I think that the tax credit business from a fair value perspective does hedge that slightly, and we saw that last year with some of the negatives last year with margins rapidly expanding. So, this quarter was really a reflection of just a modest fair value change. And just even every quarter, even if rates don't change as we move forward, just present value of cash flows. You pick up a couple of hundred thousand dollars, just a fair value. And the longer term, 10-year SOFR rate moves down slightly, obviously, your discount rate declines and then you're going to pick some of that back up. So, it's a little bit challenging to predict. The sensitivity hasn't changed about $800,000 for 10 basis points. And I think our expectation moving forward is that second and third quarter will be fairly light on the nonrecurring items, and then we'll have a seasonally strong fourth quarter on tax credit and maybe we'll have some private equity or CDE hit along the way. But generally, our expectation is there are a couple of million dollars for each in total.

Brian Martin, Analyst

Got you. Okay. That's all I have. Thanks for taking the questions.

Keene Turner, CFO and COO

Thank you, Brian.

Operator, Operator

And we do have a follow-up question from Jeff Rulis with D.A. Davidson. Go ahead.

Jeff Rulis, Analyst

Keene, I wanted to quickly follow up on the expense expectation that $83 million to $85 million. A little surprised that we're legging up again, I guess, with the seasonal kind of payroll, 401(k) step-up in the first quarter. I know you mentioned you're fortunate on the deposit costs and expect a step up in commissions. But I'm just trying to figure some of those comp costs in Q1 figured they might roll over a bit, trying to get to where you were in Q1 to continue to increase in the second quarter.

Keene Turner, CFO and COO

The transition from the first quarter to the second quarter generally shows that compensation tends to remain level. While investments in the business and various other expenses may lag slightly, the comments regarding commissions reflect ongoing growth and progress. A significant factor in this situation is the improvement in deposit costs, as we saw a decrease in the first quarter, which turned out better than expected. We are returning to a level that aligns with expectations for the second quarter, indicating that it hasn’t decreased significantly. This is influenced by two main factors: the competitive nature of the market and the fact that larger banks, facing funding challenges, are strong competitors. Additionally, we continue to see substantial growth in that underlying business, which contributes to those expenses. While I acknowledge your concerns about compensation and benefits, we might be slightly conservative by expecting a run rate of $2.5 million. However, we are still adding positions and selectively strengthening the organization, so I want to manage expectations appropriately. Ultimately, the main influence here is the deposit business.

Jeff Rulis, Analyst

I appreciate it. And I just wanted to confirm. Is that $83 million to $85 million, is that good for the remainder of the year or just 2Q alone, and then you'll revisit?

Keene Turner, CFO and COO

I believe that deposit service charges are likely to increase throughout the year. We anticipate continued growth and expansion in that area. Additionally, if interest rates rise, a 25 basis point increase could result in approximately $0.5 million additional revenue per quarter just from that rate change. This should help clarify how to factor that into your models concerning Fed funds.

Operator, Operator

Got it. Thank you.

Keene Turner, CFO and COO

You’re welcome. Thanks, Jeff.

Operator, Operator

Okay. And I show that there are no further questions at this time. I'll now turn the call back over to Jim Lally, President and CEO, for any additional or closing remarks.

Jim Lally, President and CEO

Thanks, David. And thank you again for joining us this morning and your continued interest in our company. Everyone, have a great day, and we will talk again at the end of the second quarter. Thank you.

Operator, Operator

This does conclude today's conference call. You may now disconnect.