Earnings Call Transcript - OFG Q3 2022

Operator, Operator

Higher yield contributed to 43% of the increase in net interest income. The rise in higher-yielding investment securities accounted for another 43%. Additionally, the higher yield on a lower volume of cash contributed 23%. This was slightly offset by a minor increase in the cost of interest-bearing liabilities. Turning to Page 6, we can review our credit quality and capital strength. In the third quarter, net charge-offs totaled $11.3 million, with about half originating from two commercial loans we provisioned in the second quarter. The remainder came from auto and consumer loans, partly due to higher loan volumes and late payments associated with Fiona. The total provision for credit losses was $7.1 million, influenced by two main factors in the non-PCD portfolio: higher auto and consumer loan balances, which added $8 million, and an increase in the qualitative component of the allowance to account for potential Fiona-related losses, adding $1.3 million. The PCD portfolio saw benefits from reduced balances and improved performance of residential mortgage loans, resulting in a recapture of $2.8 million. The third quarter allowance coverage, excluding PPP, was 2.33%, down 5 basis points from the second quarter. The total NPL rate was 1.55%, a decrease of 6 basis points from the second quarter and 53 basis points from a year ago. Overall, credit remained stable, with a minor glitch at the end of the quarter due to the effects of Fiona. Capital remained robust, with the CET1 ratio at 13.34%, an increase from 12.8% in the second quarter. Total stockholders' equity fell slightly below $1 billion, reflecting reduced other comprehensive income, partially offset by an increase in retained earnings. The TCE ratio remained steady at 8.83% compared to the second quarter. Now, here’s José.

José Fernandez, CEO

Thank you, Maritza. Let's turn to Page 7 for our outlook. We're finishing the year with good momentum. We plan to continue to expand our digital-first solutions to provide customers with easy-to-use 24/7 self-service capabilities. We also plan to continue our focus on growing retail and commercial loans and customer relationships as well as our investments in people, technology, and network infrastructure. Ultimately, we're focused on exceeding our performance metrics, specifically efficiency ratio, return on average assets, and return on average tangible common equity. As for the Puerto Rico overall picture, consumers and businesses continue to have high levels of liquidity with excess deposits in their accounts. However, we remain vigilant for any economic repercussions from the worldwide inflation trends and the higher rate environment we operate in. Having said that, we continue to believe that on a relative basis, Puerto Rico will perform better economically than the U.S. given the flow of reconstruction and rebuilding funds coming to the island. Thanks again to our resilient team members for always being more than ready to help our customers achieve their financial goals. This ends our formal presentation. Operator, please start the question-and-answer session.

Operator, Operator

We will take our first question from Alex Twerdahl with Piper Sandler.

Alex Twerdahl, Analyst

First off, I was hoping you could expand a little bit on some of the comments you made about Hurricane Fiona. I think you mentioned credit stability with the exception of some impact from the hurricane. And I was hoping maybe you can sort of expand on that a little bit. And is that what attributed to a slightly higher level of early-stage delinquencies that you saw at the end of the quarter?

José Fernandez, CEO

Sure. So we continue to see credit trends relatively stable. Unfortunately, we had at the end of the quarter, Hurricane Fiona strike the southern west part of Puerto Rico. So it somewhat clouds the picture. But I can share with you a little bit of what has happened after the quarter end in terms of the delinquency levels or at least the delinquent auto loans. So just to share a little bit of color here, the additional delinquencies that we had at the end of the quarter, so far, 30% of that have already put themselves back to current. So that's kind of an indication of an end-of-the-quarter disruption due to Fiona. Also, just as part of the deferrals that the customers have requested, Alex, on the consumer side, we're talking around 600 to 700 of them, a total of $13 million to $14 million. So we're really not seeing that significant effect. So we feel that things should normalize after that end-of-the-quarter event. You can also say that on the commercial side, there was no effect whatsoever and we didn't see any effects from Fiona. So that's from the credit side. So at this point, we continue to see credit stable and are encouraged by what we're seeing on the ground in terms of the economy.

Alex Twerdahl, Analyst

Great. That's helpful color. And then maybe the same point on loan growth and, obviously, a hurricane hitting with two weeks of the quarter remaining, and I imagine there was probably some disruption on everything down there. Did you see loans that maybe would have closed at the end of September get pushed into October? Or maybe just sort of comment on that piece and then also kind of what you're seeing from the pipelines overall. And then just the third part of the question, just the seasonality that you alluded to on the C&I book, is that going to reverse anytime soon?

José Fernandez, CEO

Yes. So we are still seeing loan growth in the mid-single digits for this year. At the end of the quarter, we might have had some closings that were postponed, but I don't want to make too much of a deal out of that. I actually think that the biggest impact on loan growth in the quarter were a couple of commercial account lines of credit that were fully paid because of the excess liquidity that our customers have, and that accounts for in the vicinity of $50 million to $60 million. So, I'm just giving you a little bit of the detail of what's happening within our commercial book. We do have a very good pipeline coming into the end of the year, and we continue to feel optimistic about, again, our target here of mid-single digits for the end of this year. When we look at loan growth, we're seeing positive origination trends. We're seeing a strong positive pipeline. But certainly, pay-downs and line utilizations are down. So that's kind of what's having that effect. I'm hopeful that next year, we'll have more line utilization. And frankly, I also need to point out that higher interest rates are also putting a little bit of a dent on loan originations because rates are significantly higher. And as everybody knows on this call, they've gone up faster than they have in the last 100 years. So it's having an effect on our commercial clients thinking about financing projects for the longer term. So I'm not saying that we're slowing down, but it's certainly going to have an effect.

Alex Twerdahl, Analyst

Got it. And then next question for me, just on the overall size of the balance sheet with some of the deposit outflows. The balance sheet is now sitting just over $10 billion. Last year, you guys were able to defer Durbin by a year. And I'm just curious how you're thinking about sort of balance sheet management going into the end of the year, especially considering that obviously pushing Durbin out another year would be a substantial savings.

José Fernandez, CEO

Yes. So we are a lot better positioned this year than last year to achieve it. So let's see how the fourth quarter plays out. Deposit trends have stabilized after the end of the quarter given what I mentioned earlier about some commercial clients using their excess cash to pay down lines and stuff. So we'll update on what the outcome is about the $10 billion mark by the end of the year. But certainly, we're closer than we were last year in terms of total assets. I can say though that at the bank level, we closed below $10 billion. So the CFPB gets postponed because it requires four consecutive quarters of compliance above $10 billion. So in that end, we are kind of pushing it for four more quarters.

Alex Twerdahl, Analyst

That's great. And roughly how much does that save, the CFPB component?

José Fernandez, CEO

I'm sorry?

Alex Twerdahl, Analyst

Does that CFPB component result in any savings that you can point to?

José Fernandez, CEO

Not really because we already are planning on being above the $10 billion at some point in the near future. So we are preparing ourselves to be fully compliant. It just gives us more time. So it doesn't have an effect on that.

Alex Twerdahl, Analyst

Great. And then just one final question for me. I was hoping you could just remind us what the tax treatment for the purchases of U.S. treasuries are down in Puerto Rico. My understanding is that there are some differences to how a U.S. bank might report taxes on those purchases. I’m just wondering if you could remind us if that’s the case.

José Fernandez, CEO

Yes, I'll let Maritza answer that one.

Maritza Arizmendi, CFO

Yes, we do have benefits on the income from the treasuries that we invest in. So there is a tax effectiveness that we would benefit from that investment.

Alex Twerdahl, Analyst

On a tax-affected basis, those could potentially be higher than what you would observe in a U.S. bank. Will this have a significant effect on your tax rate in the upcoming quarters?

Maritza Arizmendi, CFO

Yes, that's correct.

Operator, Operator

We will take our next question from Kelly Motta with KBW.

Kelly Motta, Analyst

Great quarter here. I thought I might start on efficiency. Last quarter, you lowered your efficiency outlook to the mid-50s range, and you’re currently there given the strong NII growth you’ve had. Just wondering if you could maybe update us on your outlook for efficiency and kind of how you’re managing expenses to that, whether stronger NII should maybe allow efficiency to move lower than the mid-50s or if you’re going to continue to invest and have expense pressures that will kind of keep you there. Just any color on that would be very helpful.

José Fernandez, CEO

Thank you, Kelly, for your question. We will continue to invest in our infrastructure and network as it's essential for differentiating ourselves in this market, focusing on a 24/7 self-service digital-first approach. To achieve this, we need to maintain our efficiency targets in the mid-50s. We are currently benefiting from operating leverage, as Maritza mentioned, and we aim to exceed the goals we set for ourselves both quarterly and annually. We are committed to our mid-50s efficiency ratio since we also want the flexibility to enhance our technology investments as needed. That's the perspective we hold on our business strategy.

Kelly Motta, Analyst

That’s super helpful. And circling back to the Hurricane Fiona impacts. One of the items you called out were fee waivers and the reduction in activity that made fees slightly lower this last quarter. Just wondering if those fee waivers have ended and we should expect a more normalized quarter or if that’s something that’s going to continue into Q4 be a consideration.

José Fernandez, CEO

Yes. When an event like Fiona occurs, our priority is to ensure the safety of our people and our customers. We take both aspects seriously as part of our standard operating procedure. For our customers, we waived the fees until September 30, which means the fourth quarter will not be affected by these waivers. This is essentially a one-quarter issue.

Kelly Motta, Analyst

Got it. And last question for me on the buyback. It doesn't look like you repurchased any shares in the quarter. I believe $36 million remain on the authorization. Just wondering about your appetite for buybacks and thoughts about completion, yes.

José Fernandez, CEO

Yes, got you. Look, Kelly, we remain extremely optimistic about our outlook for the fourth quarter and 2023. We also are vigilant for the clouds that are getting closer in terms of inflation and interest rates going up and all the recessionary talk and reality that we will probably be operating in. So when we look at our balance sheet, the key to our long-term success has been operating with a very strong balance sheet and operating with strong capital levels. And that has allowed us to weather all the storms that we've had to deal with in the last 20 years that I've been almost CEO. So when we are looking at buybacks today, yes, we might be able to go out there and be more aggressive on the buybacks. We will remain opportunistic, but we also want to have the strong balance sheet in the event that there is an economic situation in the world and the repercussions that it might have in Puerto Rico. So that's kind of how we view this. That doesn't mean we're not going to be in the market if there is a good opportunity for us to do so. But we feel at this point in time, we have to operate with a stronger balance sheet than normal and make sure that when the clouds subside, we'll be in a lot better shape and position. So that's kind of how we view this. And that's been our recipe for success and, in some instances, survival in this market, and that isn’t going to change in the near future.

Operator, Operator

We will take our next question from Brett Rabatin with Hovde Group.

Brett Rabatin, Analyst

Wanted to, first, José, just talk about – you mentioned Fiona and talked about that. Can we talk about maybe just the reconstruction, so to speak, of Puerto Rico since the last big hurricane? I saw that the GAO warned the subcommittee for the House of Representatives here recently that the reconstruction wasn’t advancing as fast as maybe it should be. Can you just talk about what you’re seeing besides the hurricane activity in terms of rebuild and what progress has been made in your mind?

José Fernandez, CEO

Sure. Thank you for your question, Brett. So if there's a silver lining to Hurricane Fiona hitting the island, it's the awareness and the fact that Washington and Puerto Rico leaders realize, and makes it patently clear to them that the reconstruction and rebuilding efforts need to have a higher urgency than what they have exhibited in the last several years. So to me, after Hurricane Fiona and the focus on Puerto Rico again and the fragility of the electric grid, I actually think that there is a lot more focus, and it's an opportunity for local and federal officials to collaborate and kind of get things going. Because at the end of the day, we need to have a more reliable, resilient, low-cost, diversified, and well-governed not only electric grid but also infrastructure, public services. So to me, that's the silver lining. I can't quantify it, but I certainly see a lot higher-level federal officials being involved in this reconstruction process and trying to look at ways to facilitate the flow of funds into the island. So the jury is still out there, though. The proof is in the pudding, right? That's what you see. That's what you hear. But the proof is in the pudding. And hopefully, they deliver.

Brett Rabatin, Analyst

Yes. Let’s hope that the LUMA uses this as an opportunity to improve the grid and its resiliency and maybe cost as well.

José Fernandez, CEO

And Brett, if I may add, I also think that it doesn't change the thesis. Actually, it enhances the thesis that Puerto Rico's economy will, on a relative basis, perform better than the states. Because simply, the size of the economy relative to the amount of funds coming in and hopefully accelerating coming in should certainly solidify the thesis. So that's kind of how we see it.

Brett Rabatin, Analyst

Okay. And one of the other questions I had, I think people were concerned about, to some degree, as the Manheim Index has finally turned lower, that as car prices possibly decline, maybe both new and used, that might have an impact on your credit quality. Can you just talk about auto for a second and just how you think about the potential decline in auto values impacting your portfolio?

José Fernandez, CEO

Yes, I read the same reports. I want to highlight the situation of the auto market in Puerto Rico. First, Puerto Rico lacks a mass transportation system, which positively skews automobile sales; if you don’t have a car, you can’t get to work. Secondly, there has been pent-up demand for years, and after the pandemic, the influx of consumer cash enabled people to change their vehicles. Therefore, I am surprised that new auto sales remain at their current levels. The situation was made worse by low inventory levels for some brands in Puerto Rico. Going forward, I expect to see some normalization in sales and prices. When lending to auto clients, the collateral is an important aspect of credit assessment, but the focus remains on the consumer. For over a decade, we have improved our credit profile through better consumer originations in recent years. This has resulted in our loans being high-yielding assets, currently yielding over 8.5%. Charges are significantly lower than previous cycles on the island, encouragingly allowing us to gain market share against competitors. We foresee stabilization and normalization in this area. While we do not expect to maintain the same origination levels, we are not observing significant deterioration in car prices or the credit profiles of consumers.

Brett Rabatin, Analyst

Okay. I appreciate that color as well. And then maybe just last, on the margin, given you only had 4 basis points of deposit cost increases this quarter, which was really nice versus the mainland, and I do believe that betas will lag the U.S. Can you talk about maybe the margin from here? It seemed like it would continue to move a little bit higher. But then, as you mentioned, as rates continue to move higher, it gets tougher to originate loans maybe at higher rates. What do you think the outlook is for the margin maybe past the fourth quarter?

José Fernandez, CEO

Yes. As you mentioned, our betas are significantly lower than our U.S. peers, which has allowed us to navigate this unique cycle where the banking system has excess core deposits. Additionally, we currently have only three or four banks on the island, whereas we previously had ten to twelve. These factors will likely lead us to perform differently, and positively, compared to mainland U.S. banks regarding deposit betas. Regarding margins, the rapid and substantial interest rate increases by the Fed are benefiting us and will continue to have a positive impact on our margin. However, we don't expect the same rate or magnitude of margin increases as we have experienced this year since we anticipate a slight rise in the cost of funds. The key issue we need to monitor is how higher interest rates on variable commercial loans might affect our commercial clients. So far, we haven't seen any negative effects, and we're closely observing the situation. That's our perspective on margins, betas, and the impact of higher interest rates on our commercial clientele.

Operator, Operator

We'll take our next question from Timur Braziler with Wells Fargo Securities.

Timur Braziler, Analyst

Maybe just a couple of follow-ups first. Going back to Alex’s question on the $10 billion balance sheet size, José, you said you’re better positioned this year to achieve it. Are you meaning you’re better positioned this year to kind of go below $10 billion in the fourth quarter and delay Durbin? Is that the…

José Fernandez, CEO

That's correct, yes.

Timur Braziler, Analyst

Okay. And I know that as the balance sheet had been growing through the year, that was less of an emphasis and you guys are better positioned to absorb Durbin. Does this just kind of fall in your hands somewhat just given the outflow of deposits you saw in the third quarter? And maybe just talk longer term about, as we go into '23, overall balance sheet size and how that factors into the strategy.

José Fernandez, CEO

Yes. Currently, we are observing that balance sheet growth may be somewhat challenging due to interest rates. This presents an opportunity for us to potentially drop below the $10 billion mark this year, but I want to be cautious in predicting that outcome. We are in a more favorable position now. Moving into next year, we still have excess deposits, which we will focus on deploying into loans when the opportunity arises, particularly in the commercial sector as well as the consumer side, but mostly on the commercial side. For 2023, we expect loan growth to be in the low single digits. We will likely be around the $10 billion mark in 2023, subject to how our commercial clients manage their liquidity and how competitors in Puerto Rico respond to rising interest rates. We are already observing some of these dynamics. Ultimately, these are the factors influencing how our balance sheet size will change, and it does not appear that we will significantly exceed the $10 billion mark in the near future, so we will be operating at this level.

Timur Braziler, Analyst

Okay. And for that type of loan growth assumption for '23, just looking at the puts and takes, I'm assuming you're expecting continued strength on the commercial side. I know commercial originations have declined for a couple of quarters in a row now. I'm assuming you're expecting that to kind of turn and then the offset would just be lower production out of consumer and auto. Is that the right way to think about '23 loan growth?

José Fernandez, CEO

Yes, we are anticipating that the global economy will enter a recession next year, which will impact Puerto Rico and consequently affect loan originations. However, on the island, we have a unique situation due to the rebuilding and reconstruction funds in play. This means we are experiencing single-digit loan growth primarily driven by commercial loans. While mortgage balances are expected to decline, we do anticipate increases in consumer and auto loans, although not at the same rate as this year.

Timur Braziler, Analyst

Okay. And then just putting the funding base in context with that line of commentary, it seemed like some excess liquidity was used to pay down lines this quarter. I guess, what's the incremental capacity? Or I guess, what's the incremental level of kind of excess deposits, as you called it, that they're still on the balance sheet? And with that willingness to kind of let some of that money be used to pay down loan balances, Maritza said that the beta is going to outperform prior cycles. Can you give us a sense of what you're expecting for through-the-cycle beta and kind of how that transitions here in the fourth quarter and then through '23 after the Fed stops hiking?

José Fernandez, CEO

The first part of your question regarding the excess liquidity our clients currently have is difficult to answer. However, rising interest rates on their lines of credit are encouraging them to utilize their cash to reduce those balances. While I cannot provide a specific answer to the first part, I can offer some insights based on past data from a different economic cycle. During the 2016-2019 period, when interest rates increased, we observed a beta of approximately 17%. This was in a competitive landscape that was somewhat different from today. Additionally, the pace and scale of the rate increases at that time were also different, which could offset one another. Currently, our beta stands at around 3%, slightly under that mark. As Maritza noted, we anticipate that in this cycle, beta may remain lower, or if we want to be conservative, similar to the previous cycle which had a beta of around 17%. However, this remains uncertain because interest rates have risen significantly in a very short span. It will be interesting to see how the Federal Reserve navigates the transition from growth to stabilization and the effort to reduce inflation. We will provide further updates over the next couple of quarters.

Timur Braziler, Analyst

Okay, that's great. And then just last for me, going back to Kelly's question on the buyback and kind of your response. Is that implying here that we're kind of through the excess capital position? I mean capital ratios improved in the third quarter versus the second quarter where you guys were active in the buyback. So I'm just wondering, is that just increased caution on your end and then trying to be opportunistic or...

José Fernandez, CEO

Exactly. So it doesn't change our long-term perspective. We recognize that we have a strong capital position. We are observing changes in the global macro environment and want to proceed with caution. We need to understand the implications of the rapid rise in interest rates. Often, such a shift can lead to significant issues, such as in junk bonds or the housing market. Therefore, we must remain vigilant and manage our capital wisely. This approach does not alter our long-term goals. We are aware of the advantages of buybacks and increasing dividends, and we have been achieving that this year. We will stay alert for any opportunities that arise. However, my concerns stem from the current macroeconomic climate, which historically can lead to negative outcomes globally. I want to ensure that we are prepared and not caught off guard.

Timur Braziler, Analyst

Got it. No, that makes sense. And sorry, I know I said that was the last question, but if I can just ask one more on the allowance. So it looks like over the last couple of quarters, we've seen some level of normalization of credit. And in that dynamic, allowances still trended lower. Just looking at the allowance ratio here at 2.3%, is that fairly stable? Is there still some room to take some reserves off the table here just given maybe the more broad improvement off of when you originally put that on? Or should we expect that level to be more or less flat going forward?

José Fernandez, CEO

Maritza will take that one.

Maritza Arizmendi, CFO

Yes. Timur, how we see it at this point, 2.33% and given the scenario with the marine, we feel that the delinquencies are stable. We have some glitches during the quarter due to Fiona, but we will keep an eye on how the payments will continue to come in. But in general, we think that so far, we see that coverage stable at this point. We don’t see any potential releases of reserves. I think it’s adequate at this level, and that’s the scenario we’re managing at this point.

Operator, Operator

At this time, there are no further questions. I would now like to turn the call back over to you, Mr. Fernández, for any additional remarks.

José Fernandez, CEO

Thank you, operator, and thanks again to all our team members for their hard work and dedication. Thanks also to all our stakeholders who have listened in. Until next time. Have a great day.

Operator, Operator

We would like to apologize for anyone who had problems listening to the first part of the webcast. A webcast replay should be available shortly after the call ends. This does conclude today's program. Thank you for your participation. You may disconnect at any time and have a wonderful day.