Prosperity Bancshares Inc Q2 FY2024 Earnings Call

Good day, and welcome to the Prosperity Bancshares Second Quarter 2024 Earnings Conference 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 hand the call to Charlotte Rasche. Please go ahead, ma'am.

Thank you. Good morning, ladies and gentlemen, and welcome to Prosperity Bancshares second quarter 2024 earnings conference call. This call is being broadcast live on our website and will be available for replay for the next few weeks. I'm Charlotte Rasche, Executive Vice President and General Counsel of Prosperity Bancshares, and here with me today is David Zalman, Senior Chairman and Chief Executive Officer; H. E. Tim Timanus, Jr., Chairman; Asylbek Osmonov, Chief Financial Officer; Eddie Safady, Vice Chairman; Kevin Hanigan, President and Chief Operating Officer; Randy Hester, Chief Lending Officer; Mays Davenport, Director of Corporate Strategy; and Bob Dowdell, Executive Vice President. David Zalman will lead off with a review of the highlights for the recent quarter. He will be followed by Asylbek Osmonov, who will review some of our recent financial statistics and Tim Timanus, who will discuss our lending activities, including asset quality. Finally, we will open the call for questions. Before we begin, let me make the usual disclaimers. Certain of the matters discussed in this presentation may constitute forward-looking statements for the purposes of the federal securities laws and as such may involve known and unknown risks, uncertainties, and other factors that may cause the actual results or performance of Prosperity Bancshares to be materially different from future results or performance expressed or implied by such forward-looking statements. Additional information concerning factors that could cause actual results to be materially different than those in the forward-looking statements can be found in Prosperity Bancshares filings with the Securities and Exchange Commission including Forms 10-Q and 10-K and other reports and statements we have filed with the SEC. All forward-looking statements are expressly qualified in their entirety by these cautionary statements. Now let me turn the call over to David Zalman.

Thank you, Charlotte. I would like to welcome and thank everyone listening to our second quarter 2024 conference call. We want to welcome the customers and associates from Lone Star State Bank of West Texas and are excited about our partnership. As previously announced on April 1, 2024, Prosperity completed the merger of Lone Star State Bancshares Inc. and its wholly owned subsidiary Lone Star Bank headquartered in Lubbock, Texas. Lone Star Bank operated five banking offices in the West Texas area. For the three months ended June 30, 2024, net income was $111 million or $1.17 per diluted common share compared with $110 million or $1.18 per diluted common share for the three months ended March 31, 2024. Net income and net income per diluted common share for the second quarter of 2024 were impacted by an increase in net interest income and a gain on the Visa Class B-1 stock exchange net of investment security sales of $10.7 million and partially offset by a merger-related provision for credit losses of $9.1 million and merger-related expenses of $4.4 million, an FDIC special assessment at $3.6 million and an increase in non-interest expenses related to three months of Lone Star State operations. Excluding the merger-related provision and expenses, the gain on the Visa Class B-1 stock exchange net of investment security sales and the FDIC special assessment each net of tax, net income was $116 million or $1.22 per diluted common share for the three months ending June 30, 2024. And our annualized returns on average assets were 1.17% and our annualized return on average tangible common equity was 12.34% based on those numbers. We are also pleased that our net interest income before provision for credit losses was $258 million for the three months ended June 30, 2024 compared with $238 million for the three months ended March 31, 2024, an increase of $20.5 million or 8.6%. In addition, our net interest margin on a tax equivalent basis was 2.94% for the three months ended June 30, 2024 compared with 2.79% for the three months ended March 31, 2024 and 2.73% for the same period in 2023. As mentioned on prior calls, these are the results that we expected and we anticipate these tailwinds should continue to be positive for the near future. Our loans were $22.3 billion at June 30, 2024, an increase of $666 million or 3.1% compared with $21.6 billion at June 30, 2023. Our linked core loans increased $1,056 million or 5% from the $21.2 billion at March 31, 2024. Loans increased primarily due to the Lone Star merger. Excluding loans acquired in the Lone Star and First Capital acquisitions and new production at the acquired banking centers since the respective acquisition dates, loans at June 30, 2024 decreased $37 million or 2 basis points when compared to last year, June 30, 2023, and increased $63 million or 3 basis points compared with March 31, 2024. Excluding these acquisition-related loans and warehouse purchase program loans at June 30, 2024, loans decreased $152 million or 8 basis points compared with March 31, 2024. Our deposits were $27.9 billion at June 30, 2024, an increase of $552 million or 2% compared with $27.3 billion at June 30, 2023. Our linked core deposits increased $757 million or 2.8% from the $27.1 billion at March 31, 2024. The increases were primarily due to the Lone Star merger excluding deposits assumed in the Lone Star and First Capital acquisitions and new deposits generated at the acquired banking centers since the respective acquisition days, deposits at June 30, 2024 decreased by $470 million or 1.8% when compared to last year June 30, 2023 and decreased by $298 million or 1.2% compared with March 31, 2024. Historically, our deposits are seasonally lower in the second and third quarters and increase again in the fourth quarter. We have not purchased any broker deposits to offset the deposit loss and we do not currently intend to do so. Our bankers focus on building core deposits. Our net interest bearing deposits represented 34.7% of our total deposits at June 30, 2024. Our non-performing assets totaled $89 million or 25 basis points of quarterly average interest earning assets at June 30, 2024 compared with $83 million or 24 basis points of quarterly average interest earning assets at March 31, 2024 and $62 million or 18 basis points of quarterly average interest earning assets at June 30, 2023, with a significant portion of the balance for each period attributable to the acquired loans. At June 30, 2024, the allowance for credit losses on loans was $359 million and allowance for credit losses on loans and off-balance-sheet credit exposure was $397 million. The allowance for credit losses on loans was 4.02 times the amount of non-performing assets. With regard to acquisitions, we continue to have conversations with other bankers considering opportunities. We believe that higher technology and staffing costs, funding costs, loan competition, succession planning concerns, and increased regulatory burden all point to continued consolidation. We remain ready to move forward in the event a transaction materializes and will be beneficial to our company's long-term future and increased shareholder value. We are optimistic about the future and confident in our ability to create meaningful long-term value for our shareholders. Over the last 12 months, we have returned $284 million to shareholders, $74 million through share repurchases and $209 million through cash dividends. With regard to the economy, CNBC recently announced that Texas was voted the third best state for business in 2024. However, we believe we should have been number one. Sorry, that's Texas humor. It's just the right trying to correct the wrong. Texas continues to shine as more people and companies move to the state because of the business-friendly political structure and no state income tax. Prosperity continues to focus on building core customer relationships, maintaining sound asset quality, and operating the bank in an efficient manner, while investing in ever-changing technology and product distribution channels. We intend to grow the company both organically and through mergers and acquisitions. I want to thank everyone involved in our company for helping to make it the success it has become. Thanks again for your support of our company. Let me turn over the discussion to Asylbek Osmonov, our Chief Financial Officer to discuss some of the specific financial results we achieved. Asylbek?

Thank you, Mr. Zalman. Good morning, everyone. Net interest income before provision for credit losses for the three-month end of June 30, 2024 was $258.8 million, an increase of $20.5 million compared to $238.2 million for the quarter-ended March 31, 2024, and an increase of $22.3 million compared to $236.5 million for the same period in 2023. The increase was partially due to operation of Lone Star Bank acquired on April 1, 2024. During the second quarter of 2024, we recognized purchase accounting provision expense of $9.1 million related to the Lone Star acquisition. In addition, fair value loan income was $7.2 million for the second quarter, compared to $1.9 million for the first quarter of 2024. The net interest margin on a tax equivalent basis was 2.94% for the three-month end of June 30, 2024, compared to 2.79% for the quarter-ended March 31, 2024 and 2.73% for the same period in 2023. Excluding purchase accounting adjustments, the net interest margin for the three-month end of June 30, 2024 was 2.86%, compared to 2.76% for the quarter-ended March 31, 2024 and 2.7% for the same period in 2023. Non-interest income was $46 million for the three-month ended June 30, 2024, compared to $38.9 million for the quarter-ended March 31, 2024 and $39.7 million for the same period in 2023. Higher non-interest income during the second quarter of 2024 includes a net gain of $10.7 million, resulting from Visa stock conversion, partially offset by the loss on sale of investment securities. Non-interest expense for the three-month ended June 30, 2024 was $152.8 million, compared to $135.8 million for the quarter-ended March 31, 2024, and $145.9 million for the same period in 2023. The lean quarter increase was primarily due to merger-related expenses of $4.4 million, three months of Lone Star Bank operation, and FDIC special assessment of $3.6 million. For the third quarter of 2024, we expect non-interest expense to be in the range of $141 million to $143 million. The efficiency ratio was 51.8% for the three-month ended June 30, 2024, compared to 49.1% for the quarter-ended March 31, 2024 and 53.2% for the same period in 2023. Excluding merger-related expenses, FDIC special assessment and net gain on sale of securities, the efficiency ratio was 49.1% for the three-month ended June 30, 2024. The bond portfolio metrics at June 30, 2024 have a modified duration of 4.1 and projected annual cash flows of approximately $1.9 billion. And with that, let me turn over the presentation to Tim Timanus for some details on loan and asset quality. Timanus?

Thank you, Asylbek. Our non-performing assets at quarter end June 30, 2024, totaled $89,570,000 which is 40 basis points of loans and other real estate, compared to $83,811,000 or 39 basis points at March 31, 2024. This represents a 6.87% increase. Since June 30, 2024, $2,517,000 of non-performing assets have been removed or put under contract for sale. The June 30, 2024 non-performing asset total was comprised of $84,497,000 in loans, $113,000 in repossessed assets, and $4,960,000 in other real estate. Net charge-offs for the three months ended June 30, 2024 were $4,368,000 compared to net charge-offs of $2,143,000 for the quarter ended March 31, 2024. This is a $2,225,000 increase on a linked-quarter basis. There was a $9,066,000 addition to the allowance for credit losses during the quarter ended June 30, 2024, resulting from the Lone Star State Bank of West Texas acquisition. No dollars were taken into income from the allowance during the quarter ended June 30, 2024. The average monthly new loan production for the quarter ended June 30, 2024, was $278 million compared to $308 million for the quarter ended March 31, 2024. Loans outstanding at June 30, 2024, were approximately $22.321 billion compared to $21.265 billion at March 31, 2024. The June 30, 2024 loan total is made up of 41% fixed rate loans, 30% floating rate loans, and 29% variable rate loans. I'll now turn it over to Charlotte Rasche.

Thank you, Tim. At this time, we are prepared to answer your questions. Our call operator will assist us with questions.

And the first question will come from Peter Winter with D. A. Davidson.

Really nice margin expansion this quarter, even if I exclude the purchase accounting accretion. Can you just give an update on that NIM outlook by fourth quarter? It seems like you can do better than the 3% and how you're thinking about the NIM into next year.

I think we have to look at our NIM, what happened in the second quarter. So we had two things happening, right? It was our organic growth on NIM that we expected, plus we had a Lone Star acquisition that helped. So those two combinations gave us pretty good lift in the margin. So if we look at our model, I think it's still showing improvement on the margin, continuous improvement on the margin going forward. And for the fourth quarter, I think we expect being a little bit better, but right now we say that our exit margin will be around 3% as we guided, so it has not changed since then, but we expect for better as we hopefully continue to grow loans and manage our deposits.

I believe I can provide you with some reassurance. The net interest margin, according to our models, indicates that we will achieve what we projected. The situation is improving, and I anticipate that we will meet our targets by the year's end, potentially even surpassing them. Our projections for the next six, twelve, and twenty-four months suggest that we should see a consistent increase, within a range of 200 basis points in our model. I believe we are on the right track, with an expected net interest margin of around 3.2% in twelve months, based on our static model where loans and deposits remain constant. In twenty-four months, we may return to a more typical net interest margin, historically around 3.4%. That's our current goal. Regarding net interest income, while we prefer to see it rise, there are potential challenges if interest rates decline, which could pressure net interest income. It will take time to understand the changing interest expenses and the impact of repricing. Therefore, there could be some short-term fluctuations, but I believe our long-term outlook remains valid. We've seen our figures improve significantly over the past year, and I expect this trend to continue.

And then just one more question, just loan, can you just talk about loan demand, maybe provide an update on the competitive landscape for lending? We did see some pressure on period-end loans from legacy prosperity and then also just continued runoff from First Capital. Are we getting closer to the bottom there?

Yes. This is Kevin. I think we are, Peter. I think it's going to be aided by the prospect of rate cuts, which I think is going to both stabilize deposits. In fact, we were talking earlier in the week that, with the prospect of rate cuts, a lot of money that moved off the banking industry's balance sheet into treasuries will work its way back into the bank. I think we were talking about that on Monday and then, lo and behold, yesterday, we had a client move back in the process of moving back in about $20 million out of treasuries back into a money market account here at the bank. But it'll also aid in the way people are thinking about growing their business. So I think going back through our guidance so far for the year, we started off the year with 3% to 5% growth in core loans. Q2, we backed that off a little bit saying that it probably towards the lower end of back end loaded, and that's where we sit today. It's still very, very competitive out there for almost everything we look at. And so it's still a knife fight when it comes down to rates and things of that nature, but I'd say in the last couple of weeks, we've seen particularly in our middle-market customers who in the short run are more likely to be borrowing more as construction projects we approve may not fund for six or nine months from now. Some renewed optimism in where the economy is going and some inventory builds and some folks in fact expanding plant and equipment. So I think the second half is going to have the prospect of being much better aided by the general belief that rates are going to moderate.

I think it's also I could say that where deposits have been and now the competition has been, we have had opportunities to increase our position and some shared credits that we've had. But again, I think our terms and conditions we kind of toughened up a little bit to holding that we really want to keep. We still want to build customers that have true relationships with us. And I think that's held us back a little bit too. But that's by design we kind of pulled back ourselves, hoping and waiting till we see the turnaround in deposits and all that stabilize and come back to the bank. Tim, did you say?

Yes, I believe everything you mentioned is absolutely right. What has been encouraging for me is that when we speak with existing customers and potential new clients about possible future loans, they all have projects they want to initiate. There is considerable enthusiasm about getting things underway. Essentially, they are all waiting for a rate cut. I believe that any rate reduction will boost their confidence. If we were to see a 100 basis points rate cut, which may not happen immediately, but could, I think we would start to see some projects move forward. Therefore, I feel reasonably optimistic that conditions will improve as we progress through the year and certainly into the next.

The next question will come from Manan Gosalia with Morgan Stanley.

On either loan yields or NIM, are you able to separate out how much of the expansion came from the core Prosperity portfolio and how much came from the Lone Star acquisition?

Yes. If you look at our margin expansion, our core NIM improved from 276 to 286. Our organic was very similar, maybe a basis point better than what we did from Q4 of last year to Q1 and the rest of them came from Lone Star acquisitions. So I think if we looked at it like a 50-50 increase was between Lone Star and organic.

And that organic expansion is coming from the fixed rate asset repricing?

Yes. The repricing story continues and we expect it to continue from here.

And then maybe if you can just speak to some trends on the deposit side, what do you think on NIB excluding what you got from Lone Star? And just as you're thinking about downside deposit betas and rate cuts from here, how should we expect the deposit portfolio to behave?

I don't know about the best answer on this, but I'll give it a shot and you guys can tag in. I think as we look at the month of July, I'd say it's still fierce out there. I mean, we still get some requests for modifications off of the rate sheet, but stabilization would be the word I would use. I mean, through Tuesday anyhow, last time, having looked at the balance sheet for today, core deposits outside of public funds are actually up, not very much, but they're up. There wasn't brackets around it and that was encouraging for us to see. So I think stabilization and to the extent we do have rate cuts, I think that will improve even more so.

I think that's exactly right. I mean, that's what I'm seeing is stabilization. I think that we also will see deposits as we compete against the government and the treasuries and interest rates come down. I think you'll see more people coming back into the bank. So I think we see that. Just I always keep in mind though, this is a quarter for us where we, you can go back historically and we've always lost deposits this quarter and next quarter seasonally just because of our public fund. So keep that in mind. I think overall, our overall feeling is that deposits are we never really went out and bought broker deposits. We really weren't to stay where we're at. And so I think we all feel about the same.

We didn't pursue deposits through higher rates like many banks with higher loan-to-deposit ratios. We have kept our money market rate at 3% at the highest, with a few exceptions above that. You might argue that this decision led to some deposit losses over the past couple of years, but not significantly; we lost a few quarters. However, I prefer to see it differently. We've discovered how resilient our core deposit franchise is, as our customers have remained loyal. If you examine our overall cost of funds, you'll see that it is considerably better than that of most other banks.

And I think you hit a high point there when you mentioned people staying with us, sticking with us. When I talk to customers and potential customers, they're into treasuries for the obvious reason to yield. But their preference is to have the money with us. And they'll say that. They really prefer not to have all their money with the federal government for whatever reason. That's their own decision. But it's good to hear that dialogue and how many of them say, we really want to start moving money back to you guys. Now proof is in the pudding whether they do or they don't. But I think there is a desire to do so. And if the treasuries weaken some more, I think you'll see more money coming our way.

The next question will come from Dave Rochester with Compass Point.

Maybe just to round us out on the loan discussion, it looked like the First Bank loans were down maybe almost 25% since the deal closed. But it sounds like that's stabilizing here. How are you thinking about the potential runoff at Lone Star? Is there anything in that book that you want to get rid of? And then outside the core loans on the warehouse side of things, how are you thinking about that trend from here? It looks like you guys saw some good seasonality this quarter, so we get to hear what you're thinking on that front going forward. And are you still adding clients to that business or is it steady state right now?

Yes. There are two aspects to your question. Regarding Lone Star, it is a very different bank compared to First Capital, and it has strong credit quality loans that we appreciate and are underwritten as we prefer. I don't anticipate significant runoff from that portfolio; it is quite clean. In fact, it’s rare for Randy Hester to describe a bank as really clean, but he led the due diligence team and confirmed it. Therefore, I don't expect a lot of runoff from that portfolio. It's a solid bank, and we really value the people there. It’s a great deal for us. On the warehouse side, we've actually let go of several customers in the last 15 months. Our peak customer count in that area was around 43 or 44, and now we are down to about 32. This reduction was due to either rates or performance issues, which led us to reduce our exposure or eliminate certain customers entirely. In essence, we didn't lose customers; we decided to let several go. The customers we do have now have been excellent partners. We are entering the seasonal period for this business, which seems overshadowed by the years of refinancing and echo refinancing booms. We are back to normal operations. When I initially projected an average of $900 million for Q2, I was concerned we wouldn't reach that at the end of May, as April and May were rather weak. However, June showed significant strength, which has continued into July. The average for July stands at $1.105 billion, and I expect this trend to carry into August, though it may slightly moderate due to seasonality in September depending on interest rates. If I had to provide a conservative estimate for the quarter’s average, I would say around $975 million, but it's more likely to be in the range of $1 billion to $1.25 billion.

I would add, you look at the comparison between Lone Star and First Capital, for example, in our non-performing assets as of June 30, about $36 million is First Capital, in other words, about 40%. On the Lone Star side, it's about $2 million about 2%. And I think that's indicative of what Kevin mentioned about the difference in the quality of the portfolios. I would be surprised if we had big drops in loans outstanding from either one of them at this point in time. I think we've pretty well identified the problems at First Capital. There's always surprises down the road, but I wouldn't think they would be overly material. So I think we're seeing some stabilization there.

And maybe switching to M&A. Appreciate all the opening comments there on that front. I was wondering what the conversation level was like at this point? Has that picked up at all with stock prices moving in the right direction here to levels possibly closer to where seller expectations would be? And what do you think the chances are? You do get a deal done here over the next year? And then absent the deal, how do you guys think about buybacks going forward with the stock trading where it is, but with capital likely continuing to grow at a fairly decent clip here over the next year?

There's no question, I think. I think if you saw the conventions and all the political stuff that's going on right now, there was a lot of optimism a week or so ago about if there is a change in administration or there is a change that would be more favorable to banks. And I think that's true. I think if you saw a change of administration, you would see more M&A going on. And I think that it even stirred up a lot of people. We do have more costs coming in. I think it's the last week or so and the last few days or so, it's kind of mitigated a little bit, nobody really knows which way it's going. But I think if you do see a change in administration, you definitely will see a big uptick in the M&A market.

On the buybacks?

Yes. I think that you're right. We seem to be making good money, and even it shows that we’ve even continued to make more and more money. But when our stock does go down like it did, it was unfairly. We felt it was an unfair price. We're going to probably always jump in and buy back.

The next question will come from Catherine Mealor with KBW.

I just wanted to follow-up on the margin conversation. You mentioned targeting maybe with some upside of 3% margin by year end '24 and then maybe hitting around 320 by mid-'25, and that's what you've told us before. How should we think about the kind of initial downside to margin once we start to see cuts? I know you mentioned that there might be some volatility. Is there a scenario where the margin declines? Or is there still enough back book asset repricing to where the margin still is going to continue to move up throughout '25? Just maybe not at as high of a pace as we factor in the cuts?

Again, I don’t have the exact figures you’re looking for. However, I would say that there will likely be some fluctuations. I believe the numbers we provided should align with those timeframes, but it may be somewhat uncertain until adjustments can be made. We are confident in this model, and I’ve been part of it long enough to feel assured about it. So, we think we will reach that goal, but it may be erratic in the meantime. We will look more closely at the specifics you’re asking about. There could be short-term variations, such as a drop in the prime rate where we can’t immediately adjust interest rates, or it might take time for assets to reprice. I understand what you’re asking, and it’s a valid inquiry for us as well, and we will continue to explore it further.

Yes. And just to add to that, our balance sheet has been neutrally positioned when we looked at it and we run some models.

Up and down.

Yes, up and down. So when we run some models down 50 basis points, our model still shows that at the end of the quarter or end of the year at exit, net interest margin still holds up around 3%. So even with that, we feel confident where we are.

As a good point, I see that even if we had 50 basis points, we still end up with 3 basis points.

Yes, because of the neutral position and we still have a tailwind of our security repricing from 2%. We have repriced that 5%-plus, that's our tailwind that's helping us. So with that, I don't think that there's much change even with 50 basis points. But personally, I believe we're going to have maybe one cut rather than two cuts.

This is a static balance sheet. If the loans significantly decrease or increase, it will impact this analysis. We're really focused on a static balance sheet analysis.

And can you remind us, do you have the dollar amount of fixed rate repricing maybe in the back half of this year and then into next?

I don't know if we have the next year. Historically, we've said we have about $2 billion in bonds that are repricing. And on the loan side, we had, how much for?

So loans or cash flow, we'd say about $5 billion, but out of $5 billion, fixed is about 40%. And so that's going to be repricing on the loan side and $2 billion of securities.

Yes. I think the fixed and variable is closer to 60%.

Okay. Yes. My mistake. 60% on the fixed side of the loan.

So $3 billion a year, $1.5 billion in the back half of the year.

And $1 billion from the securities in six months.

And then maybe just one more margin question. You've talked about excess cash building to $1.5 billion to $2 billion. That's still your plan for the back half of the year or are we kind of coming back on the lower end of that range?

That would be a yes, unless I can convince the Federal Reserve to change their opinion of what's liquidity. Again, I can talk with them. It's really crazy because we have $15 billion of lines of credit between the Federal Home Loan Bank and the Federal Reserve. And we really consider that, a phone call and it can drop this. So we used to run with not a lot of liquidity because we could just draw on our lines. But again, after the Silicon Valley deal and Signature and all that, I mean, everything changed and they came up with this deal. But the truth of the matter is you had $1.5 billion on hand. And there was truly a real run that wouldn't be enough. You have to draw on these lines. And we probably have more liquidity. We have probably more lines available than anybody in our average accounts like $30,000. So I'm hoping we can convince them to change. It probably will over time if this probably won't be right away.

And especially if you're considering M&A, maybe to be on the high end is a safer place to be?

Say that again at the high end?

We've made significant progress in accumulating cash. A key factor in this was the security sale during the quarter that contributed to our efforts.

And the cash flow from our investment portfolio.

The next question will come from Brett Rabatin with the Hovde Group.

Wanted to ask the M&A question in a different way. I feel like the regulators have some idea they'd like to see deals announced that are out of market, low branch closures. And so I wanted to ask if you're thinking about M&A, do you have to get on a plane to have talks or can you still drive a car, i.e., in Texas? Any comments today you would have on whether in state or out state might be more likely for you?

I believe this ties back to our discussion. If there is a change in administration, I don’t think it will have a significant impact whether it’s in Texas or another state. Currently, you are likely correct that they want to see some action. The overall philosophy, which comes from higher up rather than just the heads of agencies like the FDIC or OCC, indicates that the preference is for situations where things are not shut down. However, I sense that the tone is shifting. They appear to be recognizing the necessity for some mergers and acquisitions. My intuition suggests that this will happen unless the administration remains the same, in which case we might revert to our previous situation. While I can't fully assert that, I do believe the regulators' stance is evolving. The recent closures like Silicon Valley Bank and Signature Bank, as well as Republic, have likely unsettled the regulatory agencies. It seems they are taking time to assess the current banking landscape and gain comfort. I think progress is being made. Overall, I anticipate an improved tone. But if the administration changes, a mini boom could be expected.

And Brett, keep in mind, it's a 10-hour car drive from Houston to Far West Texas.

The other question I wanted to ask was this quarter, you had a provision. Last year, you had one quarter with a provision. How should we think about any thoughts on provisioning from here? And I know that obviously depends on if loan growth reaccelerates, what have you?

How should I answer in a minute, but the provision this time was just solely based on our CECL calculation and because of the merger. But I mean, really, we have $350 million, I’m talking from the top of my $359 million in reserve, $397 million if you count what's in our other reserve for unfunded loans, and we have $80 million something loam. So we have over 4x the amount of reserves is what we have is non-performing. So I think we're pretty good right there.

Yes. But the only reserves we've put up in the last couple of years have been acquisition-related to the day one CECL numbers. So the two points in time you're referencing were both acquisition related.

Well, second quarter of last year and second quarter both related first. Last year was our First Capital Bank acquisition. This quarter's Lone Star per CECL rules and GAAP rules, you have to put provision expense on the loans you're bringing over. That's a rule change but there was no provision on ourselves.

Yes. I think it's safe to say unless something changes materially, and we look at this every quarter when we run our models. But in our minds, things would have to change pretty materially for us to be thinking about posting provision this year, outside of the acquisition.

And maybe just lastly on the expense guidance, $141 million to $143 million in the third quarter. Is that net of expense savings? Can you maybe give us a little more color on how you get to that number in 3Q?

Yes. Just this quarter, we had a little bit higher because of the extraordinary items and we had some projects we had. So that's why we came a little bit higher. But $141 million, $143 million is including the Lone Star operation we're going to have, and that's in combination. We're going to still continue to have some savings from the Lone Star acquisition, but we're working on some project that's going to run up the expenses. So the net-net, it's kind of offset each other. That's why our guidance did not change from $141 million to $143 million, and we feel pretty confident about that on the third quarter.

Next question will come from Michael Rose with Raymond James.

I wanted to clarify the exit rate for the fourth quarter. Is that based on core figures or does it include the accretion income? Additionally, what do you anticipate the schedule for accretion will be for the next couple of quarters?

Okay. I'll answer the second question first. So our expectation that normalized accretion for the third quarter will be $4.5 million for third quarter. And so when we gave guidance of being a 3% of exit, that's including the normalized say, run rate or fair value income.

That's inclusive of the purchase accounting accretion. That's perfect. I noticed that the trust fees were down this quarter, and I'd like to know if there's any specific reason for that. Most banks have actually seen those fees increase a bit, so any insights would be appreciated.

Yes. I believe our trust income remains stable as we did not lose any customers. In the second quarter, we experienced some one-off ordinary income. In the first quarter, there was some extraordinary income due to a trust-related state fee, which made that quarter unusual. However, the typical run rate is $3.6 million. Comparing the last year to this year over six months, our trust income has increased by over $1 million. It may appear to have decreased, but the unusual event in Q1 skewed the perception.

In fact, our trust assets continue to grow year-over-year. A lot of the deposits that were in the bank are in the trust department.

Yes, that's what I was asking. Also just last for me, just in the other expense or other income that was down about $2.2 million Q-on-Q. And I know bumps around a little bit, but that's the lowest level we've seen in a while. Anything happened this quarter or offsets or anything we should consider?

Yes, there was nothing unusual. Usually, we have one-off income every quarter here and there, and we had a significant one-off income happen in Q1, which we did not see this one. But I think the run rate, what we had of I thought $36 million to $38 million, that will be a normal run rate, and we should be expecting that in the Q3 and Q4.

The next question will come from Brandon King with Truist Securities.

So I wanted to follow-up on expenses. I think you mentioned how there are some investments being made. So just how are you thinking about expense growth beyond the third quarter? And what are you expecting also from an inflationary standpoint in your expense base?

I believe that in the fourth quarter, expenses should remain stable. I don't anticipate any significant increases during that time. Looking further ahead, it's challenging to predict, but we don't expect anything major. We are working on some projects that may lead to increased expenses in 2025, but nothing significant is on the horizon at this time.

And you've been accruing for some of those additional expenses, haven't you? A little bit that we'll be facing later on.

We incurred expenses that we have not paid yet. We recorded them as additional expenses in the second quarter. I think I previously mentioned an expected increase of about 2% to 3% in year two or three. That is likely to happen, but at the moment, I can't think of anything else.

Brandon, it can be challenging to come up with a response. However, we have been effective in reducing our costs and finding ways to lower expenses when our income does not increase. Historically, we have managed to maintain our expenses at their current level.

And then a question on loan growth. I know before you mentioned how you've been holding more resi loans, production on the balance sheet instead of selling it. But any updated thoughts there and how you're thinking about whether keeping more residential production on the balance sheet or maybe being more opportunistic in the secondary markets?

I would say we are being more opportunistic in the secondary markets. We have mostly limited the growth in that portfolio. We do prioritize our core customers and have some one-time close products that continue to fund and complete. However, new originations are down, which is largely due to the size of our balance sheet. The category reached 33% to 34%.

Correct.

Of the balance sheet. We just think that's a comfortable level for us and a high end of the comfortable level. So we've set pricing in that category to get paid for what we are going to produce and what we will produce. We hope, in many cases, it will be available in the secondary market, and we can generate some fee income through loan sales.

That is total, including the Lone Star, FCB and all other acquisitions. So it's in total.

The next question will come from Jared Shaw with Barclays.

Just looking at the discussion around loan growth as well as the cash and securities, where do you think a good exit rate for average earning assets is for the end of 2024?

What was the exit rate?

What will the average earning yield be?

Yes. As we evaluate our model, we continue to observe growth in that area. I can't specify exactly what it will be. Currently, in the second quarter, we had 468. I believe it will continue to increase.

It's hard because, I mean, the Fed does come down rate cuts related. I mean on a static basis, there's no question it would continue to go up. I think that would change if the rates are less. That's just a really hard question.

Just in terms of using cash flow from securities to fund loan growth versus deposits, just trying to see where an exit rate could be, given the loan or with expectation?

Bad to ask on something like that, but again, it's going to be a lot really theoretical, I think. But we can look at it.

Even with the liquidation of the securities, even when placed in cash, we are currently earning overnight rates of 540. So, we are seeing an increase from 2 to 540 in those cash holdings. This represents a significant missed opportunity, as those funds could have been allocated to loans at a higher rate, but we are still gaining 340 basis points.

And then just the last for me, just circling back to something, David, you had said in your comments. If we look at lower rates, I think you had said margins should still be neutral, but that could spur deposits coming on to the balance sheet as well as some loan growth but NII could be under pressure. I guess just trying to square that, how are you still seeing good growth with stable margins? You would think that would be driving better NII?

Yes. I don't have the model in front of me, but it seems that increasing net interest income may be more challenging as interest rates decline. Achieving sustained growth in net interest income could be tougher. Our net interest margin indicates that, regardless of interest rates changing by 200 basis points, we expect it to continue increasing over the next 6, 12, and 24 months. This outlook is influenced by our existing assets and a reduction in deposit expenses. There are many factors at play, and trying to understand this without models can be quite difficult. However, I feel confident in where we stand with these models.

Yes. I think what David was saying is that net interest income is going to continue to grow. However, there will be a period when our floating rate book decreases alongside rates, while deposits won't adjust as quickly.

That's exactly what I'm trying to say, that's the noise that I meant.

That's his version of the noise.

Your next question will come from Jon Arfstrom with RBC Capital Markets.

David, another way to frame the margin questions is to ask what you believe a normalized margin for Prosperity would be. I know it's a challenging question, but you mentioned 3.40 earlier. We're trying to understand the nuances regarding the impact of rising or falling rates. What are your thoughts?

I think historically, we've gone back and looked at our historical net interest margin. I’m looking to cut him because he did this for me, here this stuff. If I'm wrong, jump in. But normally, a normal net interest margin for us historically has been around 3.40. There's been some highs and there have been some lows, but historically, that's where we would end up at.

And do you think we had these liquidity discussions a quarter or two ago? Is the balance sheet any different? Or do you think that we can eventually get there?

Absolutely. I'm very comfortable with these numbers. They are based on a model we've relied on for the last 25 to 30 years, and I genuinely believe in them. The only warning I would give is if there were significant fluctuations in loans or deposits. I view both of those changes positively. After COVID, we saw a surge in money flowing into banks, which we mostly overlooked. However, in the last year and a half to two years, we've faced challenges with rising interest rates and decreasing deposits. Nevertheless, I believe that the current trends are favorable for us. As interest rates decline, I expect money that had been outside the bank will return, particularly from treasuries and improved investor sentiment. This will lead to an increase in loans as people will be more inclined to borrow when rates drop, especially for the loans they have been postponing, as Tim mentioned earlier. Overall, I see this as a positive situation. That said, it's a volatile world, and things could change unexpectedly. Based on common sense, we should anticipate a positive trajectory over the next couple of years.

I don't know if this will make any sense or not. But I'd say, we are always confident in these NIM numbers we’ve been given here and we've hit them consistently throughout the year. No delays, nothing else. We've been right on the mark. If anything, we become increasingly confident.

Yes. I think so for me.

How about return on tangible normalization? I mean you can see it in the charts, right? I mean, obviously, it seems like it's a margin issue and you alluded to it, David. But what do you think is an appropriate return on tangible for your company?

I believe that prior to the decline in earnings due to the net interest margin and the spread, we were targeting a return on tangible capital of about 15% or 16%. I think that is reasonable and aligns with our goals. It's worth noting that we have a higher tangible capital than many banks, which typically range around 7% to 8%. Our leverage ratio exceeds 10%. We might be questioned for maintaining such a substantial capital reserve, but it has been beneficial for us when buying back stock and pursuing acquisitions. While we could increase that number significantly, we've chosen to keep our capital levels high. That’s just how we operate; we’ve always aimed to ensure we are well-prepared, much like my wife says about keeping extra socks and underwear on hand. That’s the reason for our additional capital.

That's a new one for me, David. I have a follow-up story for you, David, off the call. Just one more last one. Not a big deal on credit, obviously, it looks good, but you guys show your non-owner occupied commercial real estate. Can you just talk a little bit about what you're seeing there when things come up for renewal and maybe the overall health of that book?

I would say that our book is highly competitive. We recently reviewed something and noticed that our lender offered us a lower rate than we expected, around 799. He pointed out that other banks are providing special rates for owner-occupied properties that fall between 700 and 750. The market is competitive right now, especially since it typically involves comprehensive services. You get access to the company's credit line and treasury management business, and it's performing very well.

This concludes our question-and-answer session. I would like to turn the conference back over to Ms. Charlotte Rasche for any closing remarks. Please go ahead, ma'am.

Thank you, ladies and gentlemen, for taking the time to participate in our call today. We appreciate your support of our company, and we will continue to work on building shareholder value.

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