Bank of N.T. Butterfield & Son Ltd Q3 FY2021 Earnings Call

Good morning. My name is Tom, and I will be your conference operator today. At this time, I would like to welcome everyone to the Third Quarter 2021 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 conference over to Noah Fields, Butterfield's Head of Investor Relations. Please go ahead.

Thank you. Good morning, everyone, and thank you for joining us. Today, we will be reviewing Butterfield's third quarter 2021 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 and financial statements, 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 and 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. 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. Butterfield's results in the third quarter of 2021 continued to demonstrate the Bank's earnings power and resilience in an ultra-low interest rate environment and health and credit uncertainty in most of our markets. So far in 2021, Butterfield has performed well through a difficult period in our small and wealthy island market. During the recent fourth COVID wave, people and businesses were better prepared and have learned to live with it. We anticipate this to continue and sense our local economies taking on more of a business-as-usual approach without the need for further economy-wide lockdowns. I will turn now to slide four, where we provide a summary of third quarter highlights. Butterfield reported net income for the third quarter of $39.8 million or $0.80 per diluted common share and core net income of $40 million or $0.80 per diluted common share. This represented a core return on average tangible common equity of 17.9%. The Board of Directors maintained a $0.44 per share dividend rate, which reflects the stability of our earnings and targets a through-cycle dividend payout ratio of approximately 50%. In addition to the quarterly cash dividend, we continue to evaluate share repurchases and utilize our share buyback authorization as part of our broader capital management program. Opportunities for organic growth such as the Channel Islands mortgage product and M&A pipeline also remain important factors. During the third quarter, the Bank reached a resolution with the United States Department of Justice concerning the inquiry into Butterfield's legacy business with U.S. clients that was first reported in November 2013. The resolution is in the form of a non-prosecution agreement with a three-year term. The Bank paid $5.6 million in respect of forfeiture and tax restitution amounts, which were in line with the provision that was included in the Bank's financial statements as recorded in 2015 and 2016. While we are required to comply with obligations under the non-prosecution agreement, we are pleased to have this investigation resolved. I will now turn the call over to Michael Schrum to provide more details on the third quarter.

Thank you, Michael. I'll begin with slide six, which provides a summary of net interest income and margin. In the third quarter, we reported net interest income of $75.7 million, an increase of $1 million as we were able to increase the volume of interest-earning assets in the investment portfolio, which saw average balances increase by $342.3 million or 2.3% compared to the prior quarter. Net interest margin of 1.97% was four basis points lower than the 2.01% in the prior quarter due to lower-yielding interest-earning assets. Loan yields were down six basis points in the third quarter due to lower yields on new loan originations due in part to lower yielding production volumes in the Channel Islands. During the third quarter, the blended rate for loan originations was 3.42% for $278 million of new loans, down from 3.57% for $234 million of originations in the second quarter of 2021. During the quarter, the net average balance in the investment portfolio increased by $271 million as we continue to put new money to work in U.S. treasuries and agency securities. New money yields averaged 1.13% in the third quarter of 2021 or 53 basis points lower than the 1.66% in the prior quarter as we added around $400 million of two and three-year treasuries. As we expect longer-term rates to rise over the medium term, we made a decision to invest in shorter-term treasuries to retain some flexibility and add some protection from unrealized marks in the available-for-sale portfolio. Turning to slide seven, non-interest income continued to show stability with a modest increase to $49 million compared to $48.8 million in the prior quarter. Banking fees and foreign exchange revenues grew during the quarter as we continue to see improved economic activity. The Bank's higher non-interest income resulted in a fee income ratio of 39.3% in the third quarter of 2021, which continues to represent a stable and capital-efficient revenue stream for the Bank. Slide eight provides a summary of core non-interest expense, which increased to $84.2 million in the third quarter of 2021 compared to $83.4 million in the prior quarter. The slight increase in core expenses was made up of relatively small value items. In particular, there was an increase in technology and communications cost as we upgraded our desktop access platform during the quarter. In addition, we saw increased professional and outside services fees, supporting some longer-term strategic initiatives, including some spending on our broader ESG strategy. Finally, there continue to be some additional costs associated with the three-year non-prosecution agreement with the U.S. Department of Justice, as we continue to meet the ongoing terms of the agreement. We do expect core non-interest expense to settle back in the $82 million to $83 million range per quarter over the next few quarters, which is already evident from the exit run rate this quarter. Pipeline summarizes regulatory and leverage capital levels. Butterfield maintains conservative regulatory capital levels that continue to be well above statutory requirements. The Bank's elevated deposit levels kept our TCE to TA ratio at 5.8%, slightly below our target range of 6% to 6.5%. We continue to expect this to build back over the coming few quarters. Turning now to slide 10. Butterfield's balance sheet continues to be strong and conservatively managed with a high degree of liquidity. Deposit levels have stabilized with a slight reduction to $13.9 billion this quarter from $14.2 billion in the second quarter. We were able to continue to deploy excess liquidity during the third quarter into the investment portfolio. On slide 11, we show that Butterfield's asset quality remains exceptionally high with low credit risk in the investment portfolio, which continues to be 99% comprised of AAA rated U.S. government guaranteed agency securities. Consistent underwriting continues to result in two-thirds of the loan assets in full recourse residential mortgages in Bermuda, Cayman, and the U.K. We've also made a great start in our first year of our residential mortgage offering in the Channel Islands and expect that book to continue to build to around $500 million over the next four to five years. Non-accrual loans have improved further and are now down to 1.2% of gross loans. We remain vigilant and continue with outbound calling programs and are actively working with any borrowers who may experience difficulties. On slide 12, we discuss 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 5.3 years from 5.0 years last quarter due to moderately slower prepayment speed. Consistent with prior quarters, Butterfield continues to expect a potential increase to net interest income in both up and down grade scenarios. I will now turn the call back to Michael Collins.

Thank you, Michael. This September marked the fifth anniversary of Butterfield's IPO and listing on the New York Stock Exchange. Since our listing, we have been clear about our strategy to be a leading independent onshore bank and trust company, with limited credit exposure, consistent non-interest income generation, prudent expense management and high risk-adjusted returns. We have achieved growth organically and through acquisitions, including the 2016 purchase of HSBC's Trust and Asset Management operations in Bermuda. In 2018, we successfully acquired Deutsche Bank's Global Trust Solutions business, which helped us establish a licensed trust operation in Singapore as well as a mid-market corporate banking business in Jersey. In 2019, we completed the acquisition of ABN AMRO Channel Islands, which expanded scale to banking operations in Guernsey and Jersey. We have grown significantly since the IPO in September of 2016, with a compounded annual growth rate of 7% for deposits and 6% for customer loans. During this time, we have managed through varied economic and interest rate conditions while maintaining quarterly core returns on tangible common equity in the range of 15% to 25%. We have also improved tangible book value per share by a compounded annual growth rate of 6% and created significant shareholder value, paying out over $400 million in cash dividends and repurchasing a total of 7.3 million shares, representing approximately a 14% concentration in share count. Butterfield is well-positioned to continue to grow and remain on this path. Our success is anchored in the strong balance sheet, capital-efficient fee businesses, prudent expense control, balanced capital management, low credit risk, relevant products, and excellent customer service, which yield consistent return and long-term growth. We greatly appreciate the support of our shareholders, the Board of Directors, customers, colleagues, and all the stakeholders who have helped contribute to the bank's journey thus far. Thank you. And with that, we'd be happy to take your questions.

Thank you. We will now begin the question-and-answer session. And the first question comes from Tim Switzer with KBW. Please go ahead.

Hey, good morning. I'm on for Mike Perito. Thanks for taking my question. You guys had a little bit of NIM pressure on both the asset and liability side this quarter, it looks like. And you talked about kind of the new money yields in the securities portfolio being a little bit lower due to a shorter duration, that makes sense. Could you talk about what you're seeing on maybe the loan yield side if that is resulting in more pressure? And then also, what's kind of driving the higher deposit costs as well?

Thanks, Tim. This is Michael Schrum. Starting with the loan yields, we experienced modest growth in period-end balances. However, most of the new originations shifted from Bermuda, where we saw more paydowns, to the Channel Islands. The Channel Islands provide lower yielding deposits, generally in the 3.25 to 3.50 range, mainly from the new mortgage products we've introduced this year there. This shift among currencies and jurisdictions contributed to a slight compression in net interest margin on the loan side. Regarding investment yields, they have continued to decline, with elevated prepayment speeds. We did see some moderation in those speeds during the quarter, with repayments decreasing to around $300 million. Considering current rates, we decided to opt for shorter-duration investments to maintain flexibility while we await clearer signals about the trajectory of longer-term rates. This strategy will allow us the flexibility to redeploy or reallocate our investments over the next year or so. Finally, as for deposit costs, they have remained stable at 12 basis points, while interest-bearing demand deposits saw a slight decline of three basis points. We have reviewed our longer-term fixed deposit offerings. Overall, we align closely with the market, noting slightly higher deposit costs in the Channel Islands, Bermuda, and Cayman. As we continue to grow in the Channel Islands, we aim to remain competitive, so it's likely that our deposit costs won't rise much beyond the current 12 basis points, which we still see as an inexpensive source of funding.

That makes sense. If I could follow up on the investment portfolio strategy, I understand you're waiting for higher yields to come. How patient are you willing to be considering your elevated cash levels? Would you continue to invest in short-term securities, or is there any kind of macro environment that might change your approach, even without a significant increase in yields?

Yeah. Thanks for that. Maybe I should have been a little bit more clear. We did redeploy most of the runoff actually back into agency MBS. So, you can see a duration extension there. But net new money we put into two and three years. So, about $400 million went into two to three-year and about $250 million went back into agency MBS at an average rate of around $125 million.

Okay. I got you.

In terms of the broader question about whether anything would change our thinking, there has been significant volatility in the rates market right now. We remain very sensitive to these changes, so we're being patient, generating some yield from our running book while also keeping flexibility as we observe how tapering and long-term rates develop.

Yeah. That certainly it seems like the right approach right now. Okay. Thank you.

The next question comes from Timur Braziler with Wells Fargo. Please go ahead.

Hi, good morning. Maybe circling back to the Channel Islands, what's the loan balances at quarter end?

I believe we have the end of period balances in Note 12 of the financial segment reporting. Regarding the net new product balances, Channel Islands refers to both the U.K. and the Channel Islands, including the ex-ABN book. The net new mortgages this year are around GBP50 million at the end of Q3. We expect this to increase to approximately $0.5 billion in four to five years. While it's a cautious outlook, it may not significantly impact our overall performance, but it's surely beneficial from our viewpoint.

Yeah. As you remember this was our plan to turn the Channel Islands into more of a full-service retail bank. And actually, we were able to jump-start the mortgage volume pretty quickly because we used a lot of our people in our London office, the Butterfield Mortgages Limited. So, we have a good team there. It focused on central London mortgages, but they were able to really help with the Channel Islands mortgage book. And probably the first new residential lender there in sort of a generation, and it's been a really good start. So, we're pretty excited about it.

Okay. So, I guess, looking at the disclosure for U.K. loans, is that implying that the central London book has been growing in 2021 as well, or has that still been relatively flat after last year?

Yeah. It's been relatively flat. As you remember, these are IOS, so three to five-year duration, so kind of running fast to keep the balance flat. Obviously, London has just started opening up, so people actually are able to show properties again. It's a broker-introduced market there. So, it's been relatively flat up until now. But the market overall is fairly vibrant with a pretty good pipeline.

Okay. Thank you. And then maybe switching over to the deposit side. The third quarter decline, I guess, how much of that was planned transitory exit? And then, as you look ahead, what type of visibility do you have for the deposit balances in the coming quarters?

We spent considerable time reviewing deposits on a client-by-client basis, focusing on those over $10 million and the movement of these funds on and off our balance sheet. I would attribute the outflow to the search deposits that began in December of last year. The outflows mainly come from intermediaries such as law firms and an accumulation of cash balances from hedge funds in Cayman. As we approach the fourth quarter, we typically see seasonal increases in Cayman as the year-end approaches. We are actively communicating with our customers regarding the duration of these deposits and their interest in term deposits or off-balance sheet options. Overall, the outflow is primarily driven by search deposits, and we can expect this trend to continue, which should help ease the pressure on the TCE ratio.

Yeah. We're also doing a better job on directing some of the bigger clients with transitory money into our money fund. So, the sweep was more effective this quarter than in previous quarters. So, I think it's starting to come off a bit, but I also think we're just managing the flows better.

Okay. Regarding the deposit question and the pressure on the TCE ratio, we've observed a lower level of buyback activity since TCE is still below 6%. Does this TCE level affect your capacity for mergers and acquisitions, or are these two aspects not connected?

Yeah. Great question. So, if we're buying a fee business, which is some of the opportunities that we've been looking at more closely, obviously, that doesn't impact the TCE ratio. If you're buying a bank or balance sheet, it could be either accretive depending on what you’re buying to the TCE ratio. But I think, certainly, the quality of the regulatory capital stack is very high with a very high component of CET 1. So, there's other opportunities for funding or capital funding if we found a larger transaction, particularly in the fee business we've talked about before. So, I wouldn't really say it's a major constraint.

Okay. I have one final question. Regarding the fee businesses, particularly the trust business, it appears that fees within trust have remained quite stable over the past few years. What is the organic outlook for the current trust business? You've been exploring a trust for some time now. Is pursuing M&A really the next step to achieve higher trust fees, or are there ways to increase fee utilization from the existing platform?

Yes. To actually see an increase in trust fees, it really requires mergers and acquisitions. The trust business provides stable fee income but doesn't grow on its own. Typically, you might see about a 1% or 2% increase in fee income from new trusts each year, as setting up these complex family trusts takes a long time. At the same time, you tend to lose about 1% or 2% as sellers move on and funds are distributed to beneficiaries. Thus, the business remains flat without acquisitions. We are still engaging in productive discussions, but as we've mentioned before, this process takes time. A key factor in moving forward is our own risk appetite from an Anti-Money Laundering perspective. We are very careful about what we accept, which often means we need to structure trust acquisitions in complex and time-consuming ways. While we continue to have constructive discussions, it does have a long lead time.

Okay. Great. Thank you for taking my question.

Thanks.

We still have time for questions. We have a question from Jeffrey Kitsis with Piper Sandler. Please go ahead.

Good morning.

Good morning.

I was wondering if you could give us an update on the M&A strategy. I know you gave some helpful commentary on sensitivity of M&A to capital levels, but can you give a broader update on what you guys are looking for right now?

It hasn't changed. Our existing banks, especially in Bermuda and Cayman, continue to generate a significant amount of capital, while our markets are growing slowly. This makes it challenging to reinvest in Bermuda and Cayman. Therefore, our strategy has been to utilize that capital generation for two purposes. First, we aim to acquire private trust companies, which we've successfully done in the past to expand that business, typically within our existing regions. Second, we look to opportunistically acquire banks in the Channel Islands, specifically in Guernsey or Jersey. There are limited opportunities for acquisitions in Bermuda and Cayman, so that's our focus for growth. One of our strategies has been to balance our exposures and risk profile across the three regions, and we believe we have made substantial progress in achieving that from a balance sheet perspective. As a result, we feel more diversified. The two main components of our strategy are trust acquisitions and banks in the Channel Islands.

Thanks. And I appreciate the commentary on the Channel Islands mortgage operation progress. Going into the 4Q, are there any other dynamics around loan growth that we should be aware of similar to the repayment of the government facility that we saw in 3Q?

No, I think we are clearly keeping an eye on the situation. As we move beyond COVID, we've had discussions with some of the larger facilities we established for the Cayman government and our commitment to the states of Jersey, which have not been utilized as expected. They're reassessing whether they need the fiscal stimulus capacity we initially agreed to at the start of the pandemic, and it seems some are looking to reduce their exposure. However, I am optimistic that we will see more activity in central London regarding transactions and refinancing, as the pipeline looks promising. The Channel Islands are progressing well, and Bermuda is seeing a lot of cash buyers, which means there isn't much leverage and demand remains somewhat sluggish. Meanwhile, Cayman is growing rapidly, and we are taking the necessary time to align with our risk appetite there. Overall, I believe we are experiencing a slightly improved growth outlook compared to what we observed during the pandemic.

That’s all for me. Thank you for taking my question.

Thank you.

We still have time for questions. We have a follow-up question from Timur Braziler with Wells Fargo. Please go ahead.

Hi. Thank you. Maybe just looking at net interest margin, I guess, looking at the dynamics for both loans and securities with those new money yields coming on below the portfolio yield and some catch-up on the averages relative to period imbalances. Is it safe to assume that there's some incremental NIM compression coming in the following quarters? Or is there anything that I'm missing there that could kind of sum that off?

We are continuing to utilize our cash balances, although we are cautious about the search deposits and their durations. We are currently updating our behavioral analysis on these deposits. Given the current state of our balance sheet, we are focusing more on net interest income rather than net interest margin, aiming to maintain it at the $75 million level, depending on the movements in the rates market. We remain sensitive to these changes, with about two-thirds of that sensitivity concentrated at the front end of the curve and one-third at the back end. Recently, the 10-year yield has been somewhat more encouraging, and we see some staging in the two to three-year range. This situation does lead to NIM compression but helps with our running book yield. Therefore, we find it beneficial to keep net interest income at that $75 million level. The NIM will largely be influenced by any reductions or normalization in deposits, which should allow us to move forward without incurring significant losses in the investment portfolio, providing us with added flexibility.

Okay. And then, as we think about deploying excess cash into securities, I know the number before had been around $150 million a quarter. Are the trends in the third quarter kind of indicative of what your plan is going forward? Or is there a unique opportunity given the runoff there to reinvest some of those yields, I guess, how should we be thinking about putting cash sort in the securities book going forward?

Yes, when we identified opportunities, as we did in the second quarter, we allocated $400 million into mortgage-backed securities. This contributes to the gains we currently see in that securities portfolio. Although there's significant volatility in the 10-year, we now have a structure in place with a two and three-year ladder, which helps mitigate net interest income compression through increased volume in the investment portfolio and shorter durations. While it may appear as a larger net interest margin compression, it offers us flexibility as we await further market guidance.

Got it. Thank you.

Thanks.

This concludes our question-and-answer session. I'll turn the conference back over to management for any closing remarks.

Thank you, Tom, and thanks to everyone for dialing in today. I know it's a busy morning for calls for everyone. We look forward to speaking with you again next quarter. Have a great day.

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