Bank of N.T. Butterfield & Son Ltd Q3 FY2020 Earnings Call

Good morning. My name is Carey, and I will be your conference operator today. At this time, I would like to welcome everyone to the Third Quarter 2020 Earnings Call for The Bank of N.T. Butterfield & Son Limited. Please note, this event is being recorded. I would now like to turn the call over to Noah Fields, Butterfield's Head of Investor Relations.

Thank you. Good morning, everyone, and thank you for joining us. Today, we will be reviewing Butterfield's third quarter 2020 financial results. On the call, I'm joined by Butterfield's Chairman and Chief Executive Officer, Michael Collins; and Chief Financial Officer, Michael Schrum. Following their prepared remarks, we will open the call up for a question-and-answer session. Yesterday afternoon, we issued a press release announcing our third quarter results. The press release, along with a slide presentation that we will refer to during our remarks on this call, are available on the Investor Relations section of our website at www.butterfieldgroup.com. Before I turn the call over to Michael Collins, I would like to remind everyone that today's discussions will refer to certain non-GAAP measures, which we believe are important in evaluating the company's performance. For a reconciliation of these measures to U.S. GAAP, please refer to the earnings press release and slide presentation. Today's call on associated materials may also contain certain forward-looking statements, which are subject to risks, uncertainties and other factors that may cause actual results to differ materially from those contemplated by these statements. On Slide 25 of the presentation, we have also included a list of potential factors relevant to the implications of COVID-19 for the bank. Additional information regarding these risks can be found in our SEC filings. I will now turn the call over to Michael Collins.

Thank you, Noah, and thanks to everyone joining the call today. During the third quarter of 2020, we continued to strengthen our position as a leading offshore provider of banking and wealth management with franchise-level market shares in our core operating jurisdictions. Our ability to support clients with world-class financial services helps us generate capital efficiencies, which complements our solid revenues from a conservatively managed balance sheet. As you will see on Slide 4, Butterfield has continued to report strong results with net income of $30.5 million and core net income of $36.5 million or $0.73 per share and a core return on tangible common equity of 16.2%. The core results in the third quarter exclude $6.7 million in staff exit costs resulting from the voluntary retirement and redundancy programs that are being implemented and resulting in the reduction of around 100 full-time roles across the organization. This corresponds to 7.4% of the workforce. In light of the continued ultra-low interest rate environment and business challenges of the COVID-19 epidemic, we have made a significant adjustment to the ongoing cost base to help offset the financial impact to the bank. During the third quarter of 2020, we are pleased to complete the full Channel Islands banking integration, which was one quarter later than planned due to COVID. Overall, I'm delighted with the results of the acquisition and the transition of the business and people onto Butterfield's platform. This now positions Butterfield to grow with a more meaningful market share in the Channel Islands. We also added two new nonexecutive directors and enhanced risk and compliance management with new executive-level hires. In addition to the new directors, I would also like to acknowledge the onboarding of new group executive committee members: Sabeth Siddique, Group Chief Risk Officer; Bri Hidalgo, Group Head of Compliance and Operational Risk; and Kevin Dallas, Group Head of Marketing and Communications. They are all strong additions to our executive management team and have already started making meaningful contributions towards the success of Butterfield. Turning now to Slide 5. In general, the island jurisdictions where our businesses are located have handled the health-related aspects of the pandemic well. Bermuda, Cayman, and Channel Islands are experiencing relatively low infection levels and sporadic cases, which has allowed the local economies to open up and allowed for fairly normal domestic commerce to resume. Visitor numbers for Bermuda and Cayman are down this year with no cruise ship business and significantly lower airlift and stay-over visitors on those flights than in prior years. For context, pre-pandemic, tourism represented 17% and 25% of GDP for Bermuda and Cayman, respectively. While difficult for tourism-related businesses, the islands are doing well and are seeing visitor numbers slowly return with stringent health-related arrival protocols, contact tracing, and testing to control imported and local transmission of COVID cases. At this point, the testing and tracing have been effective at maintaining low rates of transition. On the top right of Slide 5, we have provided a summary of the deferral program we offered to mortgage clients in good standing, which covered a total of 6 months principal and interest deferrals. By the end of the second three-month period in September, the participation rate was 34% of total qualifying borrowers. In order to better understand current customer needs and repayment capacity, we started an ongoing calling program in Bermuda, which has contacted around 500 borrowers or 20% of Bermuda mortgage holders. Of those borrowers, 92% have so far indicated that they plan to resume normal payments, while 6% have indicated that they may require potential further relief. Only 2% have stated that they do not anticipate being able to resume normal payments. As stated in the past, we will continue to work closely with customers to determine how best to help those who experience difficulty. We closely monitor all credit assets and the general credit environment and view these initial results as a positive indicator that the majority of clients should be in a position to resume payments and meet their obligations. I will now turn the call over to Michael Schrum to provide more details on the third quarter.

Thank you, Michael. I will begin on Slide 7 with a summary of net interest income and NIM. In the third quarter, NIM of 2.30% was 18 basis points lower than the prior quarter due to the lower sterling and dollar interest rates, as well as the full quarter interest expense on the new $100 million subordinated debt issued in June. The added expense mainly represents the timing difference between the issuance in June 2020 and the planned redemption of existing issues in the second half of this year. The lower dollar rate environment and buyout options for MBS assets have increased the prepayment speeds in our investment portfolio, which results in an accelerated reinvestment in U.S. agency securities at lower rates. New money yields averaged 1.48% in the third quarter. Floating rate loans also trended lower with an average yield of 4.43%, down 10 basis points versus the prior quarter. During the third quarter, the blended rate for loan originations was 3.78% for $143 million of new loans, up slightly from 3.54% for $152 million of originations in the prior quarter. Turning to Slide 8. Noninterest income was up 12.5% compared to the last quarter due to the recovery in domestic economic activity in the current quarter after the prior quarter's COVID impacts. Banking fees in the third quarter also benefited from a $1.5 million onetime loan structure change fee. The bank's contribution from fees continues to represent stable and capital-efficient earnings. For the third quarter, fees were 38.8% of total revenue. Slide 9 provides a summary of core noninterest expense, which was up 3.3% in the third quarter compared to the prior quarter. Expenses increased due to the return of more normalized activity levels in the third quarter. The bank's recent cost restructure program has resulted in $6.7 million of noncore staff exit costs this quarter. The lower staff complement will reduce future expense run rates with payback from exit costs expected within one year. We continue to target a through-cycle cost/income ratio of 60%, but we do expect to remain in the mid-60s during this ultra-low part of the rate cycle. Slide 10 summarizes regulatory and leverage capital levels. The bank remains very well capitalized with capital levels significantly in excess of Basel III regulatory requirements. Tangible book value per share increased 1.2% in the third quarter and is up 10.8% over the past 12 months. We continue to view growth of tangible book value per share as a very important factor in creating long-term value for shareholders. In addition to the regular quarterly dividend of $0.44 per share, we have continued to repurchase shares during this quarter. As at the end of the third quarter, we had approximately 200,000 shares remaining in our 3.5 million share repurchase authorization from December 2019. We continue to view share buybacks as an important component of our capital management strategy and we'll provide further updates on future authorizations once the 2021 operating plans have been finalized. Turning now to Slide 11. Butterfield's balance sheet continues to be strong and conservatively managed with a very liquid profile. At the end of the third quarter, the loan portfolio represented only 37.4% of total assets and liquid assets were 59.6% of total assets. The bank's balance sheet has now stabilized following a few quarters of declines due to the planned deposit pricing alignment following the acquisition of ABN AMRO Channel Islands in July 2019. The bank has maintained a low-risk density with risk-weighted assets to total assets of 36.7%, down slightly from 37.1% last quarter. On Slide 12, you can see that Butterfield's asset quality remains exceptionally high with low credit risk in its investment portfolio, that is, 99% comprised of AAA-rated U.S. government-guaranteed agency securities. Nonaccrual loans were relatively stable in the third quarter at $74.8 million or 1.5% of gross loans. On Slide 13, we discuss the average cash and securities balance sheet with a summary interest rate sensitivity analysis. Butterfield's weighted average life in the AFS investment portfolio increased to 4.2 years from 3.6 years last quarter. Due to a planned deployment of excess dollar deposits from the Channel Islands acquisition and a repositioning of $350 million of floating-rate Ginnie securities to fixed-rate agency securities. Similar to last quarter, Butterfield continues to expect a potential increase in net interest income in both up and down rate scenarios. I will now turn the call back to Michael Collins.

Thank you, Michael. We remain optimistic about the financial health and earnings prospects for Butterfield. We are encouraged by the favorable indications that are coming through the retail mortgage book calling program. We expect to have more detail and clarity in the fourth quarter. However, initial indications suggest that the bank's conservative underwriting, payment deferral programs, continued work with borrowers and a well-seasoned low LTV profile should help us manage through this period of potential credit stress. As we have discussed in the past, expense management is an aspect of our earnings that we have some control over. This quarter, we have taken decisive actions to lower the expense base of the organization. We carefully evaluated the operational, cyber, credit, and compliance risk profiles across the platforms and implemented a three-stage program, starting with simplification of business units and senior executive retirements, followed by voluntary exit programs in Bermuda and Cayman, and finally, a redundancy program across the organization. This was, obviously, difficult for the whole organization and particularly for those affected and their teams. But I am confident the program enacted during this quarter will help rightsize the expense base to reflect the current business environment with continued low interest rates and some credit uncertainty. Finally, capital management remains a key focus for us, with emphasis on the sustainable dividend, share buybacks, organic growth, and retaining capacity for potential M&A. It remains our goal that Butterfield continues to deliver top quartile returns and grow long-term value across the credit and rate cycle. Thank you. And with that, we'd be happy to take your questions. Operator?

The first question will be from Will Nance of Goldman Sachs.

Maybe I'll start with the expense base. Clearly, you have implemented several measures to streamline costs, including a significant reduction in headcount. Can you provide insight into what these measures could mean for the expense base as we move into next year? Additionally, how much further work is needed to continue reducing costs?

Sure. Thanks, Will. In Q3, we went through three main stages. First, we experienced some senior departures. Then, 49 employees took voluntary separation, which is akin to early retirement, allowing individuals the choice to leave. Finally, we implemented 51 redundancies across the organization. Overall, this totals about 100 positions, representing roughly 7.5% of our total workforce. I want to emphasize that we're focused on backfilling roles in Halifax, Bermuda, and Cayman where operational risks may have increased. Therefore, we will need to refill some of those 100 positions. Additionally, we've noted in the past that the all-in cost of a full-time equivalent employee in Bermuda and Cayman is around $100,000 each. I estimate that the annual normalized run rate from these actions will be approximately $7 million to $8 million a year after accounting for backfills.

Got it. Okay. That's very helpful. And then maybe just separately, Michael Schrum, I think you've talked about the opportunities to deploy liquidity from the ABN deal. You mentioned the balance sheet basically is now stabilized. Could you just talk about kind of where we are on the liquidity deployment, and how much there is and how much you kind of feel comfortable deploying?

Yes, we've conducted extensive back-testing on the ABN book. You'll remember some of that was in euros, some in sterling, and around $1 billion was in U.S. dollars. This quarter, we also made some adjustments in the investment portfolio, converting some floating-rate Ginnies to fixed, resulting in about $350 million of net new from the existing AFS portfolio, which should slightly improve the net interest margin moving forward. On the ABN side, we plan to gradually release about $150 million each quarter over the next four to six quarters, after which we'll reassess the stability of deposits as we move into next year.

Got it. And then just lastly, on the strategic front, wondering if you can comment on the amount of strategic dialogue that's happening as we've kind of shifted from the freeze situation in the pandemic to more of a manage through type of operating environment?

I guess I would characterize it as continuing discussions across our jurisdictions, obviously. If we saw overlap acquisition opportunities in Bermuda, pretty unlikely, but Cayman or the Channel Islands, we continue to be very interested. Obviously, we're also interested in the trust world and, specifically, we would be very interested in an acquisition in Singapore potentially to build our scale. We've got a great operation there now, but we need to run more fee income through it. So that's a focus. I would say that it's still a strange time. I mean, I think, talking to various parties, there clearly going to be opportunities, and there's going to be a point in time where I think more transactions will happen. But looking at the banking side, it obviously is very difficult to value credit assets. I mean we're looking at our own credit, and we think we're in reasonable shape. But it's not like normal days. So I think banking acquisition would be more difficult than a trust acquisition today, but we are continuing to have discussions across the board.

The next question is from Alex Twerdahl of Piper Sandler.

First off, just wanted to go back to some of what you were talking about earlier, on the laddering out of securities, and sort of appreciate that you're set up pretty well from an NII standpoint, no matter what happens with rate changes. But just given the current outlook for rates and kind of big interest environment for a while, do you think that you have enough levers to reverse NII kind of pushing margin aside? Obviously, there's a lot of moving parts there. But if you look at NII, it's been declining in the last couple of quarters. Obviously, a lot of pressures, but based on some of the things you're talking about in laddering out the securities book, etc., do you feel like we've kind of reached a bottom on NII? Or is there still some room for that to move lower?

That's a great question. Currently, our loan yields are below the book yields for existing loans mainly due to where we are originating loans. We've seen more mortgage origination in Cayman at lower rates and in sterling, which is beneficial for net interest income but creates pressure on loan yields. We noticed a seasonal peak in prepayment rates in July and August, and we expect that to moderate as we move into winter, which should slow down prepayment speeds in the investment portfolio. About 60% of the net interest margin impact from the investment yield this quarter was due to accelerated prepayment speeds, while 40% was related to rate and volume. Future performance will depend on how much prepayment speeds decrease, particularly with buyout options. Deposits rolled into fixed-term deposits at lower rates, as anticipated, but this was slightly offset by the euro demand deposits maturing in ABN and the growth in retail deposits. Inflows from optional redemptions from pensions, due to fiscal stimulus, increased bank deposits, though mostly in noninterest-bearing accounts. The subordinated debt added about three basis points, mainly as a timing difference for the upcoming quarters. On the cost side, we expect to see deposit costs decline in the next couple of quarters, which should help. With the laddering out of the investment book, we are somewhat addressing the reinvestment challenges. We believe things will stabilize in the near term, and in the longer run, it will be influenced by the 10-year rate. Recently, the 10-year rate has shown some movement, and our new money rate this quarter is at 1.48%. It will depend on the longer durations in the yield curve, but it seems like the short end has bottomed out.

Okay. Yes. Thanks for the additional color there. And then when I think about loan growth, I know you have the initiative in the Channel Islands that might take a couple of years to kind of result in some material loan growth. And then I also believe, and correct me if I'm wrong, that you guys have participated in some lending to the various jurisdictions in which you operate in order to help with their stimulus programs. Based on those facilities and what's drawn and what's expected to be drawn in the near term, can we expect some loan growth in the next couple of quarters? Or is it going to be kind of more of the same, sort of relatively flattish?

Yes. I think flattish. So I think we're very excited about being able to participate in those government programs. In total, that's about $300 million of committed across Guernsey, Jersey, and Cayman Islands. Very little of that is drawn this quarter. And I think the latest news from Cayman is, they don't really expect that to draw, by public statement from the Minister of Finance there, until Q3. So they actually believe that they have enough in their checking accounts to make it through to Q3 of next year and then we would expect a gradual draw on that facility. Jersey and Guernsey, again, they've had very little need to draw on those facilities, but we are getting a little bit of commitment fees with those facilities. And so I would say, flattish overall.

Okay. And then just final question for me. Obviously, we have a big event in the United States next week with the presidential election and potential change in administration could have some tax implications, which you guys are pretty much immune from. But I'm just wondering, as you kind of think about the geographies and there might not be direct implications from a tax change, but there's often knock-on implications, is there anything in the tax language that you've heard that either excites you or concerns you at this point?

We have been monitoring the situation closely. The Democratic administration is likely to impose more taxes compared to a Republican administration. However, we have experienced similar cycles before. The reinsurance industry is particularly sensitive, but it has undergone changes that have diminished the tax benefits of being based offshore in Bermuda. Many companies have maintained their strategies and chose to stay in Bermuda rather than relocate to the U.S. or Dublin. This decision is likely due to the broad market presence in Bermuda, which offers significant advantages beyond taxes, including proximity to key industry players such as accountants, brokers, and bankers. While there may be changes affecting offshore earnings for U.S. companies, this could have some impact, particularly on large technology firms that we do not serve as clients. Although they may have offshore incorporations, we don’t rely on their deposits, so any financial shifts may affect us only marginally. It's something to monitor as it evolves, but I don't expect it to significantly impact our business.

The next question is from Michael Perito of KBW.

I have a few clarification points I'd like to discuss. Michael, you mentioned that after some of the backfill, expenses would be around $7 million to $8 million per year. To clarify further, does this mean that our core expenses in the third quarter, which are at $84.5 million, are expected to decline to under $83 million early next year once all these actions are fully implemented? Is there anything else we should consider, or is this an accurate understanding?

No, I think that's totally fair, Mike. As part of the voluntary separation program, we, obviously, were very careful to make sure that we didn't impact operational risk. So some of those are going to be staggered release dates. So I think as you think about the financial impact over the next couple of quarters, it's going to be a step down.

Okay. And then I appreciate the commentary on the kind of the M&A outlook. But as we kind of take that to the next level too, and think about the share repurchases here, I mean, it seems like based on your prepared remarks that there's some appetite for that to continue. I guess, just trying to kind of think of the magnitude of that. I mean is it fair to think that with more asset or bank-oriented M&A looking to be more challenging right now that you guys probably have a little bit more appetite to use capital on share repurchases, as a lot of these trust assumptions that you guys have made in the past haven't really had that big of an impact on your capital position?

Yes, I believe that's a reasonable assessment regarding our appetite. While it's linked to market conditions, our focus on maintaining the sustainability of the dividend remains unchanged. Currently, our payout ratio is in the high-50s, partly due to the cyclical nature of CECL reserve builds, and we feel confident about this. In the absence of any profitable M&A opportunities, we can review our forward planning model and determine that we don't require substantial additional capital from retained earnings, aside from possibly modest amounts for credit migration. Our high return on equity supports an increased allocation towards buybacks. As you may recall, we initiated a buyback program in December 2019 with a $3.5 million authorization, which is nearly fully utilized. We plan to reassess our capital strategies as we finalize next year's plans, and your insights are quite valid.

Okay. Lastly, I want to ensure I understand the deferral trend correctly. At the end of the quarter, approximately 34% of the mortgages were still in deferral at the conclusion of the program, and you reached out to about 20% of the total customers. Most have indicated they can make the payments. So, is it correct to say that the reason they haven't made the payment yet is that it hasn't come due, but you expect them to? By the end of next quarter, should the number of mortgages potentially still on deferral be less than 5%, or am I misunderstanding something?

Yes, that's exactly right. We initially had an opt-out for the first three months followed by an opt-in. We started with 50% of eligible borrowers opting in, but that number declined to 34% as some opted out during the quarter. We've looked into the higher LTV buckets and reached out to those who may have been slightly late previously to check their status and see if they're aware of what's happening. A few indicated they might have difficulty coming off the program, and we're working with those customers on next steps. However, this represents a small percentage of the borrowers we've contacted, which primarily come from the higher-risk group. Additionally, in Q4 and Q1, many deferrals were retained, contributing to an increase in our deposits as people saved more during this time. We’ve spoken with 20% of our higher-risk borrowers, approximately 500 out of 2,500, and the feedback is generally positive. Still, I want to note that Bermuda is entering its down winter season, and we anticipate it won’t bottom out until next year. We remain cautiously optimistic but will continue to monitor the situation closely and keep in touch. It's a small group of 2,500 borrowers, and we’re familiar with their locations and many families, so our support will persist.

Yes, I believe they do. One of the larger properties, Fairmont Southampton, has closed for renovations that were planned before COVID, which removes some hotel beds from the market. However, the smaller and medium-sized hotels we've been involved with have seen a significant staycation market over the last six months. Some hotels experienced occupancy rates of 60% over the summer as travel declined and many people chose to spend their weekends in hotels. This was a somewhat unexpected boost, but as we head into the winter season, things will likely change. Overall, it seems that most of these hotels have sufficient cash reserves to sustain themselves for several months.

Next question comes from Timur Braziler of Wells Fargo.

I just wanted to follow up on some of Mike's questions. Any deferrals out of the U.K. mortgage book?

No. So we didn't do a deferral program in the Channel Islands or the U.K. So you'll recall, there's a 3- to 5-year I-owes. We have worked with some customers, again, those with 60 LTV originations, 65 LTV originations and not really a hint of delinquency or anything in that book. So no deferral programs there.

As you consider the transition of deferrals for the Bermuda and Cayman mortgages in the upcoming quarter, how does that relate to potential losses, even though it appears minimal? More importantly, regarding reserves, they increased a few basis points this quarter. Is this an expected trend as you gain more clarity, or do you anticipate that you have essentially finished reserving at this point?

Yes, you're correct. On the CECL front, there wasn't much activity this quarter, partly due to a slightly improved GDP forecast. Moving forward, it will depend on the actual loss content. We have about a dozen cases that are more challenging, and we need to work with customers towards a more permanent solution, whether that means selling directly or using a TDR program. This will eventually influence the model in terms of probabilities of default for the rest of the portfolio. So far, it doesn’t appear to be significant, but it will depend on the macroeconomic outlook. If conditions worsen significantly, that could negatively impact us. The actual loss content and our approach with customers will affect the probabilities of default moving forward for that segment. I'm cautiously optimistic at this stage. We're in a period where people are starting to resume their payments, which should provide clearer indications, though there's still some uncertainty. Overall, the signs are promising, but having cash on hand is certainly beneficial.

Right. And then lastly, just looking at the growth in demand deposits this quarter, anything transitory in there that you see leaving the fourth quarter? Or was that all pretty much core and is going to stay on?

Yes. It's primarily driven by retail activity and a decrease in noninterest-bearing accounts, especially in Bermuda and Cayman. This situation largely stems from cash inflows coming from deferrals into retail savings, along with pension programs in both regions that allow for voluntary withdrawals. This cash has certainly deposited into the bank. The real question is whether this cash will be allocated into investment portfolios in the long run. It appears that people are being cautious about their expectations. Additionally, there's a significant amount of liquidity entering the balance sheet, all of which is comprised of solid retail deposits.

And Timur, Ascendant's BELCO, the national utility, was just sold to a Canadian utility company and about $200 million of those sales proceeds are coming to Bermudian shareholders. A lot of that might go into real estate as opposed to deposits, but that's something that all the banks here are watching as a potential increase in the deposit base, at least in the short term.

Got it. And sorry, actually, I have one other question, if I could just sneak it in here. On fee income, it's been a nice rebound this quarter versus the depressed level last quarter. Are we back to kind of a normalized level here? Or is the expectation that things could turn relatively worse in the fourth quarter given that it's seasonally weaker in Bermuda?

Yes, I would start with the merchant acquiring. Volumes on our debit cards are actually higher than they were at this time last year, which is a positive trend. Credit card volumes have decreased, particularly due to the lack of tourists in Cayman. This quarter includes a one-time $1.5 million fee that likely won't recur. Typically, Q4 is a strong quarter for the bank, mainly due to the Cayman tourism season. The economy is gradually reopening, but the outcome will heavily depend on hotel occupancy and credit card volumes in the Cayman Islands for the fourth quarter. However, domestic activity seems to have returned to pre-COVID levels in both Bermuda and Cayman.

And this concludes our question-and-answer session. I would now like to turn the conference back over to management for any closing remarks.

Thank you, and thanks to everyone for joining today's call. We look forward to speaking with you again next quarter. Have a great day.

Thank you. The conference has now concluded. Thank you all for attending today's presentation. You may now disconnect your lines. Have a great day.