Earnings Call Transcript - EWBC Q3 2022

Operator, Operator

Good day, and welcome to the East West Bancorp Third Quarter 2022 Earnings Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Julianna Balicka, Director of Investor Relations. Please go ahead.

Julianna Balicka, Director of Investor Relations

Thank you, Betsy. Good morning, and thank you, everyone, for joining East West Bancorp's Third Quarter 2022 Earnings Call with Dominic Ng, our Chairman and Chief Executive Officer; and Irene Oh, our Chief Financial Officer. This call is being recorded and will be available for replay on our Investor Relations website. During their remarks, Dominic and Irene will reference a slide deck that is available on our Investor Relations site. Management may make projections or other forward-looking statements, which may differ materially from the actual results due to a number of risks and uncertainties, and management may discuss non-GAAP financial measures. For a more detailed description of the risk factors and a reconciliation of GAAP to non-GAAP financial measures, please refer to our filings with the Securities and Exchange Commission, including the Form 8-K filed today. I will now turn the call over to Dominic.

Dominic Ng, CEO

Thank you, Julianna. Good morning, and thank you, everyone, for joining us for our earnings call. I will begin the review of our financial results with Slide three of our presentation. This morning, we reported net income of $295 million and earnings per share of $2.08 for the third quarter of 2022. Our earnings per share grew 58% annualized for the second quarter of 2022. Total revenue of $627 million grew 55% linked quarter annualized and included record net interest income of $552 million. Strong revenue growth and improved efficiency drove third quarter 2022, adjusted pretax pre-provision income growth of 66% linked quarter annualized. Asset quality continued to be healthy with very low charge-offs. Our bottom line returns are industry-leading. We returned 1.9% on average assets, 20% on average equity, and 22% on average tangible equity this quarter. Quarter-over-quarter, all our profitability ratios expanded. And importantly, all our capital ratios grew. With our impressive operating margins and strong capital, we are well positioned for continued success and to appropriately navigate a range of possible outcomes in an environment of elevated uncertainty. Slide four presents a summary of the balance sheet as of September 30, 2022. Total loans reached a record $47.5 billion, an increase of $926 million or 2% from June 30. As anticipated, loan growth slowed in the third quarter. Year-to-date, loans are up 15%, excluding the forgiveness of PPP loans, and we continue to expect that full-year loan growth will be in the range of 16% to 18%. Our loan portfolio is well balanced between commercial real estate, commercial and industrial, and residential mortgage. This diversification is a fundamental strength that provides both stability and optionality to generate prudent growth as economic cycles change. Total deposits were $53.9 billion as of September 30, 2022, a decrease of $486 million or 1% from June 30. Third quarter average deposits were $54.1 billion, essentially unchanged from the second quarter. Our deposit book is well diversified by deposit type, and 40% of total deposits were noninterest-bearing demand accounts as of September 30. Turning to Slide five. We have a resilient balance sheet with strong capital and high liquidity. As you can see in the exhibit on this slide, all our capital ratios expanded quarter-over-quarter. As of September 30, 2022, we had a common equity Tier 1 ratio of 12.3%, a total capital ratio of 13.6%, and a tangible common equity ratio of 8.35%. The East West Board of Directors has declared fourth quarter 2022 dividends for the company's common stock. The quarterly common stock dividend of $0.40 is payable on November 15, 2022, to stockholders of record on November 1, 2022. We did not execute any buybacks in the third quarter. Moving on to a discussion of our loan portfolio, beginning with Slide six. As of September 30, 2022, C&I loans outstanding were $15.6 billion, sequentially up 2%, and total C&I commitments were $22.2 billion, sequentially up 1%. Our C&I loan utilization rate was unchanged quarter-over-quarter at 70%. Our C&I portfolio is well diversified by industry and sector. Slides seven and eight show the details of our commercial real estate portfolio, which is well diversified by geography and property type and consists of low loan-to-value loans. Total commercial real estate loans were $18.7 billion as of September 30, 2022, up 1% from June 30. In Slide nine, we provide details regarding our residential mortgage portfolio, which consists of single-family mortgages and home equity lines of credit and is primarily originated through East West Bank branches. I will highlight that 83% of our home equity lines of credit are in a first lien position. Residential mortgage loans totaled $13 billion as of September 30, 2022, growing 4% from June 30. I will now turn the call over to Irene for a more detailed discussion of our asset quality and income statement.

Irene Oh, CFO

Thank you, Dominic. I'll start with our asset quality metrics and components of our allowance for loan losses on Slides 10 and 11. The asset quality of our portfolio continues to be strong. Quarter-over-quarter, criticized loans decreased 11%, and the criticized loan ratio improved by 29 basis points. Special mention loans decreased 20%, largely from upgrades of CRE loans, primarily hotel loans, due to improvements in financial performance and liquidity. Classified loans were essentially unchanged. As of September 30, non-performing assets were $97 million or 16 basis points of assets. During the third quarter, we booked net charge-offs of $7 million or a low 6 basis points of average loans annualized as compared with net recoveries of 6 basis points annualized in the second quarter. Our allowance totaled $583 million as of September 30 or 1.23% of loans compared with 1.21% of loans as of June 30. During the third quarter, we recorded a provision for credit losses of $27 million compared to $13.5 million for the second quarter. The quarter-over-quarter build in reserve and allowance coverage largely reflects the current macroeconomic outlook, which is weaker than a quarter ago, as well as third quarter loan growth. While credit quality remains strong and the current credit environment is benign, we are watchful of various challenges affecting the economy and our customers, taking proactive actions where warranted, including conservatively building our allowance. And now moving to a discussion of our income statement on Slide 12. This slide summarizes the key line items of the income statement, which I'll discuss in more detail on the following slides. Of note, amortization of tax credit and other investments in the third quarter was $20 million compared with $15 million in the second quarter. This is lower than what we had previously anticipated because of timing. Certain tax credit projects are delayed, and the recognition of the associated amortization expense will be in the fourth quarter. Accordingly, we currently expect the amortization of tax credit and other investment expense to be approximately $30 million in the fourth quarter. Third quarter 2022 income tax expense was $89 million compared with income tax expense of $83 million for the second quarter of 2022. Year-to-date, the effective tax rate for the first nine months of 2022 was 23%. We currently expect that the full year effective tax rate will be approximately 22%, including the impact of tax credit investments expected in the fourth quarter. I'll now review the key drivers of our net interest income and net interest margin on Slides 13 through 16, starting with the average balance sheet. Third quarter average loans of $46.9 billion grew $2.2 billion or 20% annualized. The strong growth across all loan categories drove a favorable mix shift in average earning assets quarter-over-quarter. In the third quarter, average loans made up 79% of average earning assets compared with 76% in the prior quarter. Third quarter average deposits of $54.1 billion declined only $78 million quarter-over-quarter, remaining essentially flat. Growth in interest-bearing deposits nearly offset the decrease in demand deposits as some customers shifted excess balances to higher-yielding options, reflecting market dynamics and a rising interest rate environment. Average non-interest bearing deposits held up and made up 41% of total deposits in the third quarter. Turning to Slide 14. Third quarter 2022 net interest income of $552 million was the highest quarterly net interest income in the history of East West Bank, growing 66% linked quarter annualized. The net interest margin of 3.68% expanded by 45 basis points quarter-over-quarter. As you can see from the waterfall chart on this slide, net interest margin expansion in the third quarter reflected the impact of higher loan and earning asset yields, which increased the NIM by 71 basis points plus a favorable earning asset mix shift which expanded by 7 basis points. This was partially offset by 33 basis points of compression from the funding side. Turning to Slide 15. The second quarter average loan yield was 4.75%, an increase of 80 basis points quarter-over-quarter. The average loan yield comprised an average coupon yield of 4.65%, plus yield adjustments, which contributed 10 basis points to the overall loan yield in the third quarter. As of September 30, the spot coupon rate on our loans was 5.10%. In this slide, we also present the coupon spot yields for each major loan portfolio through the last four quarter-end periods. You can see the positive impact of rising interest rates on each loan portfolio as loans are repricing. In total, 62% of our loan portfolio is variable rate, including 30% linked to prime rate and 27% linked to LIBOR or SOFR rates. Most of the loans reprice at least monthly. I would also highlight that 43% of our variable rate CRE loans have customer level interest rate derivative contracts in place. We will help our customers enter into loan level interest rate derivatives helping to protect them against rising debt service costs. At the same time, the loans remain variable rate on our balance sheet, and the big benefits from the asset sensitivity. Additionally, $2 billion of the 86% of variable rate C&I loans also have derivative contracts in place. Turning to Slide 16. Our average cost of deposits for the third quarter was 51 basis points, up 34 basis points from the second quarter. Our spot rate on total deposits was 74 basis points as of September 30, 2022, a year-to-date increase of 65 basis points. This translates to a 22% cumulative beta relative to the 300 basis point increase in the target Fed funds rate over the same period. In comparison, the cumulative beta on our loans has been 55% as our loan coupon spot rates increased 166 basis points year-to-date. We started the rising interest rate cycle from a position of strength, with historically high levels of demand deposits for East West Bank and strong liquidity. This has bolstered the asset sensitivity benefits of our variable rate loan and securities portfolios, supporting strong revenue growth through the cycle as rates continue to rise. We're pleased with the lag in deposit beta cycle-to-date. This has come through careful deposit cost management. As rates continue to rise, we believe our approach will continue to support an expanding net interest margin and robust net interest income growth in the coming new year. With 41% of our average deposits in non-interest bearing accounts and with the growth that we have had in treasury management products and annualized accounts since before the pandemic, we feel comfortable about continuing to navigate the cycle well. Moving on to fee income on Slide 17. Total non-interest income in the third quarter was $76 million, down from $78 million in the second quarter. Customer-driven fee income and net gains on sales of loans were $69 million, up 7% or 26% annualized from the second quarter and up 10% year-over-year. We saw growth across most of the fee income lines of business this quarter. Moving to Slide 18. Third quarter non-interest expense was $216 million. Excluding amortization of tax credits and other investments and core deposit intangible amortization, adjusted non-interest expense was $196 million in the third quarter, up $14 million or 8% sequentially driven by higher compensation and employee benefits expense. In comparison, our sequential total revenue growth was 14%, exceeding expense growth and generating positive operating leverage. Quarter-over-quarter, our efficiency improved. Third quarter adjusted efficiency ratio was 31% compared with 33% in the second quarter. Our adjusted pretax pre-provision income grew 17% sequentially or 66% annualized, and our pretax pre-provision ROA was an attractive 2.7% in the third quarter. And with that, I'll now review our updated outlook for the full year of 2022 on Slide 19. For the full year 2022 compared to our full year 2021 results, we currently expect year-over-year loan growth, excluding PPP, to approximately 16% to 18%, unchanged from our prior outlook; year-over-year net interest income growth, excluding PPP, of approximately 35%. This narrows down to the upper end of our prior outlook, which was for net interest income growth ranging from 30% to 35%. Underpinning our interest income assumptions is the forward interest rate curve as of September 30, 2022, with Fed funds expected to reach 4.50% by year-end. Adjusted non-interest expense growth, excluding tax credit investment amortization, of approximately 11% year-over-year, which is a slight increase from our previous outlook. With our strong revenue growth, we expect positive operating leverage and modestly improving efficiency next quarter. For the full year 2022, we now expect that the provision for credit losses will be approximately $80 million. This is up from our previous outlook and largely reflects the changed macroeconomic backdrop compared with a quarter ago. We currently expect that the full year 2022 effective tax rate will be approximately 22%. This is slightly higher than our previous outlook, which was for an effective tax rate of 21%. The change in our outlook reflects higher pretax income and a lower amount of tax credit investment as compared with our previous forecast. We currently expect that the fourth quarter tax credit investment amortization expense will be approximately $30 million.

Dominic Ng, CEO

Thank you, Irene. In closing, we are looking forward to finishing 2022 on a high note. Our strong operating margins and capital give us the confidence that we will navigate emerging and changing economic cycles well. I wish to thank all of our dedicated bankers for their excellent work, which is reflected in our strong financial performance. I will now open up the call to questions.

Operator, Operator

The first question today comes from Ebrahim Poonawala with Bank of America. Please go ahead.

Ebrahim Poonawala, Analyst

Good morning.

Dominic Ng, CEO

Good morning.

Ebrahim Poonawala, Analyst

Maybe first question, just around deposits. Obviously, a lot of focus in terms of client behavior given the rising rates. The loan-to-deposit ratio has crept up to 88%. One, maybe just talk about how high you think that loan-to-deposit ratio will go before you start being more active in terms of managing deposits. And second, how does this translate into where you think the margin peaks? And for East West, would that also mark a little bit of a peak in NII? Or do you expect NII growth to continue until driven by loan growth?

Irene Oh, CFO

There are many questions there, Ebrahim. I may not remember them all, but I will try to address them. Sorry, it’s early for me here. To start, I want to focus on the latter part of your question, which is likely the most important given the current situation. We do expect margins to continue to grow from here, including in the fourth quarter. Year-over-year, we also anticipate improvements in margin and net interest income for 2023. While I won’t provide specific guidance, I want to emphasize that point. Despite expecting increases in deposit betas, which you saw a little of in the third quarter results, the growth we are experiencing in our loan and securities books is significantly outpacing that. Regarding deposits and the loan-to-deposit ratio, we ended the quarter at just under 88%, with an average around 87%. We feel confident about increasing our ratio from this point and, while we haven't publicly stated this before, that remains our position. Our core funding is very strong, and we believe that moving into the low 90s is something we can comfortably achieve.

Ebrahim Poonawala, Analyst

Got it. And I guess just a separate question. You talked about the hedging that your customers have done. But talk to us if we are heading into a recession, where you see the biggest drivers of credit risk for East West's loan book?

Irene Oh, CFO

Yes. I think at this point in time, the hedging for us has been a balance sheet management strategy in this period of time. Until this year, when rates were so low. But certainly, we wanted to share that it protects our customers in this period because the debt service is easier for CRE, multifamily, and also for C&I loans. On the credit side, at this point in time, credit is still very benign. Certainly, if you look at the results we have in the third quarter, criticized loans are down. Charge-offs are still very benign. As we look through the portfolios, I wouldn't say there's an area that we're really concerned with from a credit perspective, but we continue to monitor and evaluate our portfolio.

Dominic Ng, CEO

I think from a macroeconomic perspective, and that's why we have increased our provision simply because with this kind of spike in interest rates, one would expect that the economy will slow down. So therefore, we are anticipating maybe things are going to slow down. However, we just haven't seen much in terms of a credit quality issue at this point. Everything seems to look pretty good as you see that our criticized assets actually come down and so forth.

Operator, Operator

The next question comes from Chris McGratty with KBW. Please go ahead.

Chris McGratty, Analyst

Good morning. Irene, I want to circle back to the NII question. I think that's part of the reason your stocks weak this morning. The NII guide, the implied guide for Q4, can you just put a little bit more clarity around it? Because the $1.5 billion that you cite as a starting point, your actual number is a little bit lower than that, excluding PPP. I just wanted to get a little bit of a fine-tune on the fourth quarter?

Irene Oh, CFO

Well, I think when we look at the fourth quarter, maybe I'll just share a little bit more specifics. Based on the forward curve at 9.30%, if you kind of break it down, and maybe this will help you, Chris, in the analysis. Now we expect the loan yield to continue to increase, right? Maybe not the same pace of the increase that we saw in the fourth, but close to that. On the security side, based on variable rate and the nature of the portfolio, probably another 20 to 30 basis points. In total, especially if you look at it from a NIM perspective, NII, I think the timing of the increase in the cost of deposits is something where we're modeling that the deposit betas will continue to increase. We've been very fortunate, as we've talked about in our prepared remarks, of the lag. But I think we're just realistic as rates continue to increase, then they will chop. But overall, I think the guidance that we gave in specifics as far as NII growth, at that higher end of that range, 35% is a number that we're comfortable with at this point in time.

Chris McGratty, Analyst

Okay. As a follow-up, I want to clarify whether the 1.5 is the starting point or if it's closer to 1.476. I know this might be getting into details, but there’s a significant difference in the implied trajectory. I'm trying to understand if net interest income in Q1 will increase from the Q4 figure we're discussing.

Julianna Balicka, Director of Investor Relations

This is Julianna. If I can jump in with the precision level of that. You are looking for guidance that has the word approximately in it. If you start with the 1.47% starting point from 2021, a 35% increase on that implies an NII growth of $560 million, but an NII increase of 36% of that implies NII growth of $574.5 million. Now we put in the word approximately because, quite frankly, whether it's going to be 35% or 36% right now, it's impossible for us to tell given the fact that some of the things such as deposit betas, you cannot know two months in advance. But what we are comfortable telling you is that we are hitting on the upper end of our guidance, and we're moving higher as we're talking about because as Irene said, we expect our NII to continue to grow. But in terms of the actual precision, unfortunately, from where we sit, we are unable to provide that level of detail. So just take the word approximately and use your judgment.

Operator, Operator

The next question comes from Gary Tenner with D.A. Davidson. Please go ahead.

Clark Wright, Analyst

Hi there. This is Clark Wright on for Gary Tenner this morning. I just had some thoughts on capital, some questions. In terms of the buyback, the stock is now trading below where you repurchased in Q2. How are you thinking about the buyback here moving forward into kind of economic headwinds and a revised economic outlook?

Dominic Ng, CEO

At this point, we do not anticipate doing any buyback simply because we are looking at the macroeconomic situation with the Fed making this unprecedented rate spike. I think it will be prudent for us to hold on to our very, very healthy capital ratio. One of the great things about where we are today is that when we look at East West, we have incredible earnings power, very high margin, high liquidity, and benign credit quality issues. East West has always done well whenever economic cycles go down. That's when we actually make most of our money. While we're very proud of our financial performance for the first three quarters so far, I believe we will be even prouder if the economic situation gets worse simply because we have a very strong balance sheet that allows us to have all the flexibility we need. That's the reason why we have always been somewhat cautious about doing too much buyback; having all the dry powder in place in a downturn may be much more advantageous for us.

Clark Wright, Analyst

Got it. Thank you. And then if I could just pivot over to loan growth in your outlook. What are your thoughts on the mix heading into 2023? You had strong single-family growth here this quarter. But just in terms of CRE and C&I, where is that going to be going in at? What are your thoughts heading into the next year?

Dominic Ng, CEO

Well, we obviously expect loan growth to slow down compared with 2022 or '21 simply because with that kind of rate environment, naturally, we expect that investors, maybe not all business enterprises are going to go in there and start making aggressive acquisitions of, let’s say, commercial real estate investments or building apartments, buying warehouses. A lot of those activities that were taking place in a much more normal interest rate environment will likely slow down considerably in the early part of 2023. I would expect that those types of activities will slow down. Massively increasing inventory is also something that I would say will most likely be out of the question. So with that, we expect the C&I and CRE growth will most likely be coming down. We will provide guidance when the time we release our fourth-quarter earnings. When it comes to residential mortgages, we are also expecting somewhat of a slowdown, simply that I would expect that there would not be as much refinancing or even home purchases. But as of today, we still see positive numbers in the pipeline for both C&I, CRE, and also in single-family mortgages. While we are seeing encouraging numbers in the pipeline reports, we are also very prudent and looking at the macroeconomic situation and the interest rate environment coming forward, and we are taking a more conservative outlook in terms of what it may be.

Operator, Operator

The next question comes from Jared Shaw with Wells Fargo Securities. Please go ahead.

Jared Shaw, Analyst

Good morning, everybody. I guess, first, just on - back on the deposits. What's your expectation for sort of a through-cycle beta on deposits? And does that assume that DDA stays roughly stable as a percentage of the total?

Irene Oh, CFO

Yes, great question. Earlier in the year, I think we shared that given the expectation for where rates were and where the Fed was moving, we thought our through-cycle betas for deposits would be about 30%. As a reminder, in the last cycle, although a very different cycle, our through-cycle beta was 37%. As we shared on the details of the presentation, cumulatively, our cumulative beta to date has been 22%, quite a bit of lag and then also up from where we were at 6.30%, which was 15%. At this point in time, given the pace of the rate increases from the Fed, we do expect that the through-cycle deposit betas will increase from that 30%. More specifics as far as what's happening next year will be shared next year. As Dominic has mentioned, we believe there will still be significant NII expansion.

Jared Shaw, Analyst

Okay. That's good color. Thanks. And then looking at the allowance for loan loss and the growth this quarter, should we think that the ratio of allowance to loans can continue to march up if we don't see a significant change in the economy? Or will that really be more dependent on either portfolio performance or incremental deterioration from here?

Irene Oh, CFO

Yes, great question. I think when we look at our models, largely, the drivers for the models are GDP growth, unemployment, CPI for CRE, the market dynamics in the areas where we have CRE loans, and also for the single-family HELOC, HPI. As these deteriorate or change, we are appropriately booking the reserve. I think if there are — at this point in time, as we discussed earlier, there are no major weaknesses that we see. But we want to be realistic and prudent, especially with the way the calculations are for allowance, to increase as appropriate if macroeconomic factors decrease. That was one of the reasons for the increase in the allowance of 2 basis points. I'll share that of the $27 million we booked, approximately $10 million was related to the new loan growth we had in the quarter.

Julianna Balicka, Director of Investor Relations

And if I can add, Jared, to your prior question about the deposit betas that Irene was answering, one of your questions was about the deposit mix. Let me just highlight that before the pandemic, we were at 30% DDA at the end of 2019. Today, we're at 40% DDA. We do not think we're going to go back to the pre-pandemic levels. We are confident we're going to be above pre-pandemic because the growth in DDA has come from operating accounts, treasury management products, and services-linked accounts. So we have a much stronger deposit mix than last cycle.

Dominic Ng, CEO

And also, I want to add that those accounts come from a lot of new customers or existing customers that used to use other banks for operating accounts because we did not offer the services. Now, East West Bank has improved GTS product offerings that allow us to transition many of these East West Bank clients to move their operating accounts from other larger banks to us. So in the last two years, net operating account growth has been quite phenomenal. In fact, it reflects on some of the GTS fee income growth as well.

Operator, Operator

The next question comes from Brandon King with Truist Securities. Please go ahead.

Brandon King, Analyst

Thank you. Good morning.

Irene Oh, CFO

Good morning, Brandon.

Brandon King, Analyst

Yes. So I was curious if you can give us an update on kind of the planning strategically regarding potentially locking in your rate sensitivity for the balance sheet and protecting against the downside of rates potentially in the future?

Irene Oh, CFO

Brandon, it came in and out. Would you mind repeating your question? I'm sorry, I didn't quite catch it.

Brandon King, Analyst

Yes, yes. I was curious if you can update us on your plan or thoughts on potentially locking in the asset sensitivity of the balance sheet against kind of falling rates in the future?

Irene Oh, CFO

Okay. Great. We have increased our balance sheet hedging strategy with our asset sensitivity, as you know, to try to lock in, I think those are great words, our asset sensitivity. So I can share that, as of 9.30%, well, we actually entered into trades just after 9.30% as well. So as of today, we have about $2.75 billion of hedges and also collars that we have entered into to help preserve our margin and NII if and when rates fall. That's something that we'll continue to evaluate, looking at with our ALCO committee as far as what's appropriate given the asset sensitivity and the balance sheet of the bank.

Brandon King, Analyst

Got you. And if you don't mind sharing, what is kind of the duration of those hedges and collars?

Irene Oh, CFO

They range, I think, four to five years.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Dominic for any closing remarks.

Dominic Ng, CEO

Well, thank you all for joining us for this call. We are looking forward to speaking with you in January to share our 2022 year-end results. Thank you.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.