Earnings Call Transcript - TD Q2 2022

Operator, Operator

Good afternoon, everyone, and welcome to the TD Bank Group Q2 2022 Earnings Conference Call. I would now like to turn the meeting over to Ms. Brooke Hales. Please go ahead, Ms. Hales.

Brooke Hales, Investor Relations

Thank you, operator. Good afternoon, and welcome to TD Bank Group's Second Quarter 2022 Investor Presentation. We will begin today's presentation with remarks from Bharat Masrani, the bank's CEO, and after which Kelvin Tran, the bank's CFO, will present our second quarter operating results. Ajai Bambawale, Chief Risk Officer, will then offer comments on credit quality, after which we will invite questions from prequalified analysts and investors on the phone. Also present today to answer your questions are Michael Rhodes, Group Head, Canadian Personal Banking; Paul Douglas, Group Head, Canadian Business Banking; Raymond Chun, Group Head, Wealth Management and Insurance; Leo Salom, President and CEO, TD Bank America's Most Convenient Bank; and Riaz Ahmed, Group Head, Hotel Banking. Please turn to Slide 2. At this time, I would like to caution our listeners that this presentation contains forward-looking statements. Now there are risks that actual results could differ materially from what is discussed and that certain material factors or assumptions were applied in making these forward-looking statements. Any forward-looking statements contained in this presentation represent the views of management and are presented for the purpose of assisting the bank's shareholders and analysts in understanding the bank's financial position, objectives and priorities, and anticipated financial performance. Forward-looking statements may not be appropriate for other purposes. I would also like to remind listeners that the bank uses non-GAAP financial measures such as adjusted results to assess each of its businesses and to measure overall bank performance. The bank believes that adjusted results provide readers with a better understanding of how management views the bank's performance. Bharat will be referring to adjusted results in his remarks. Additional information on items of note, the bank's use of non-GAAP and other financial measures, the bank's reported results and factors and assumptions related to forward-looking information are all available in our Q2 2022 report to shareholders. With that, let me turn the presentation over to Bharat.

Bharat Masrani, CEO

Thank you, Brooke, and thank you, everyone, for joining us today. Q2 was a good quarter for TD. Earnings were $3.7 billion and EPS was $2.02. We had strong revenue performance, up 8% year-over-year, reflecting increased customer activity and the benefits of our deposit-rich franchise. We delivered approximately 200 basis points of operating leverage across the enterprise, as we continue to see strong returns from our investments. The bank's CET1 ratio ended the quarter at 14.7%, reflecting TD's consistent ability to generate capital organically. This quarter, we are activating the DRIP discount as a prudent response to changes in the operating environment. Our proven business model enables us to continue to deliver for our shareholders while building a better bank for our customers, colleagues, and communities in the digital age. Let me now turn to each of our businesses and review some highlights from Q2. Our Canadian Retail segment earned $2.2 billion. Revenue increased 9%, driven by volume and fee income growth as customer activity continued to accelerate. The Personal Bank had a strong quarter. The power of our deposit franchise in this rising rate environment was amplified by significant growth this quarter, with deposits up 7% year-over-year. Moreover, we are seeing strength in critical segments, such as new to Canada account acquisition, which is up more than 100% year-over-year. In our real estate secured lending business, we are benefiting from a journey-based approach, seeing progress in adviser productivity, pipeline management, and account retention. Our branch network also saw increased effectiveness in pull-through and conversion rates. Our cards business continued to perform well, with card retail sales up 22% year-over-year, driven by a notable rebound in travel-related spending. To deepen engagement and loyalty, we launched My TD rewards, a new hub where customers can easily access and redeem rewards online or on the go, integrating partnerships with major brands like Starbucks Canada, Air Canada, Amazon, Expedia, and Canada Post. The business bank also had a very strong quarter, with double-digit growth in loans. TD Auto Finance ranked highest for dealer satisfaction among non-captive lenders for the fifth consecutive year. In our wealth business, net asset growth and higher fee-based revenue helped offset a moderation in direct investing trading volumes from last year's peak. We have gained market share in both direct investing, measured by new accounts, trades, and revenue, and private wealth management, showing the strength of our offerings across investor segments. TD Asset Management led the banking industry in mutual fund sales for the second consecutive quarter. Our insurance business demonstrated strong performance, reinforcing our number one position in direct-to-consumer and affinity sectors. We also launched cloud-based contact center capabilities, leveraging AI for better call routing to enhance customer experience and response times. In the U.S. Retail bank, we earned US$769 million in Q2. Excluding PPP runoff, commercial loan volumes maintained momentum with strong originations and increasing utilization rates. Credit card sales and auto loan originations rose 15% and 36% year-over-year, respectively, and we experienced good retail deposit volume growth while benefiting from higher deposit margins. We launched a pilot with a leading fintech to automate cash management for commercial customers, integrating TD products directly into their systems. A new general purpose Mastercard was added to our offerings in Target's channels, expanding our strategic partnerships. TD Auto Finance became the first indirect auto lender in the U.S. to offer real-time payments to dealers throughout the day. We also introduced TD Home Access Mortgage, aimed at increasing homeownership opportunities in Black and Hispanic communities. With our investment in Schwab contributing US$177 million, segment earnings reached US$946 million this quarter. We are making progress on our transaction with First Horizon, having engaged with over 100 community groups since the announcement in February. Our commitment to local markets and investment in communities has been positively received, with broad support evident. Our Wholesale Banking business exhibited solid performance despite a challenging environment, achieving earnings of $359 million, primarily driven by higher trading revenues. TD Securities was recognized as the overall Canadian fixed income service quality leader for the fourth consecutive year, and for its expertise in sustainable finance, particularly in the recent green bond issuance. Overall, I am pleased with how we navigated the evolving environment. Credit performance remained strong, and we saw growth, though we also recognize the elevated uncertainty, higher inflation, and potential economic slowdown ahead. With our disciplined risk management and sustainable business model, TD is positioned to face challenges and seize opportunities. To adapt to changing customer expectations, we've launched the Next Evolution of Work initiative. Historically, our operating model supported a few large-scale initiatives, but it needs modernization to handle the volume of change we are driving today. NEW focuses on customer journeys for continuous improvement, adapting functions for cross-functional effectiveness, and adopting agile processes. We have already seen positive results, including faster market response times and greater efficiencies in technology deployment. TD continues to lead in AI innovation, receiving recognition for our AI-powered insights and customer engagement initiatives. We also announced our investment in Signal 1 to enhance healthcare delivery using AI. Furthermore, TD achieved the Well Health Safety rating certification across our entire North American portfolio. TD Bank was recognized for diversity, receiving accolades from DiversityInc and Forbes. These acknowledgments inspire us to pursue a more diverse and inclusive future. This quarter, I announced a 3% pay raise or one-time cash award for the majority of our workforce below the Vice President level, which is a fair recognition of their efforts. I am grateful to work alongside over 90,000 TD bankers globally and thank them for their daily contributions. Now, I’ll turn things over to Kelvin.

Kelvin Tran, CFO

Thank you, Bharat. Good afternoon, everyone. Please turn to Slide 11. This quarter, the bank reported earnings of $3.8 billion and earnings per share of $2.07, up 3% and 4%, respectively. Reported earnings included litigation settlement recovery. Adjusted earnings were $3.7 billion and adjusted EPS was $2.02, down 2% and 1%, respectively. Reported and adjusted revenue increased 10% and 8% year-over-year, respectively, reflecting volume and margin growth in our banking businesses, higher fee-based revenue in our banking and wealth businesses, and prior year premium rebates for our insurance customers, partially offset by lower transaction revenue in our wealth business. Reported revenue also includes an insurance recovery related to litigation. Provision for credit loss was $27 million. Expenses increased 5% year-over-year, reflecting higher spend supporting business growth and higher employee-related expenses, partially offset by prior year store optimization costs. Adjusted expenses also increased 5%. Absent the retailer's partners' net share of the profits from the U.S. strategic card portfolio, adjusted expense growth was 6.5% year-over-year or 6.6% ex-FX. Consistent with prior quarters, Slide 25 shows how we calculate total bank PTPP and operating leverage removing the impact of the U.S. strategic card portfolio, along with the impact of foreign currency translation and the insurance fair value change. Reported total bank PTPP was up 16% year-over-year before these modifications and adjusted PTPP was up 11% after these modifications, mainly reflecting higher revenues in our personal and commercial banking businesses. Please turn to Slide 12. Canadian Retail net income for the quarter was $2.2 billion, up 2% year-over-year. Revenue increased 9%, reflecting volume growth, prior year premium rebates for insurance customers, and higher fee-based revenue in our banking and wealth businesses, partially offset by lower transaction revenue in our wealth business. Average loan volumes rose 9%, reflecting 8% growth in the personal volumes and 16% growth in business volume. Average deposits rose 8%, including 7% growth in personal volumes, 10% growth in business volumes, and 10% growth in wealth deposits. Wealth assets increased 4%. Net interest margin was 2.62%, up 9 basis points compared to the prior quarter, primarily due to higher margin on deposits, reflecting the rising interest rate environment. Total PCL of $16 million increased $27 million sequentially. Total PCL as an annualized percentage of credit volume was 0.05%, up 2 basis points sequentially. Insurance claims increased 34% year-over-year, reflecting the normalization of claims, partially offset by the favorable impact of a higher discount rate, which resulted in a similar decrease in fair value of investments supporting claims liability reported in noninterest income. Noninterest expenses increased 9% year-over-year, reflecting higher spend supporting business growth, including technology and marketing costs, higher employee-related expenses, and variable compensation. Please turn to Slide 13. U.S. Retail segment reported net income for the quarter was US$1.1 billion, up 3% year-over-year. Adjusted net income was US$946 million, down 10% year-over-year. U.S. Retail Bank reported net income was US$902 million, up 6%, primarily reflecting higher revenue, partially offset by a lower recovery of PCL. U.S. Retail Bank's adjusted net income was US$769 million, down 10%, primarily due to a lower recovery of PCL, partially offset by higher revenue. Reported and adjusted revenue increased 12% and 3% year-over-year respectively, as the business overcame lower income from PPP loan forgiveness and lower gains on the sale of mortgage loans, with higher deposit volumes and margins and fee income growth from increased customer activity. Reported revenue includes an insurance recovery related to litigation of US$177 million. Average loan volumes decreased 4% year-over-year, reflecting a 4% increase in personal loans and an 11% decline in business loans or 3%, excluding PPP loans, primarily due to continued pay downs of commercial loans. Average deposit volumes, excluding sweep deposits, were up 10% year-over-year. Personal deposits were up 12% and business deposits were up 7%. Strip deposits declined 7%. Net interest margin was 2.21%, flat sequentially, as higher deposit margins reflecting the rising interest rate environment were offset by lower PPP loan forgiveness, lower loan margins, and higher prepayment income in the prior quarter. On Slide 29, we've continued our disclosure on the impact of the PPP program. This quarter, PPP revenue contributed approximately $28 million to NII and 4 basis points to NIM. Most of the benefit of PPP revenue has now been realized. Total PCL was a recovery of US$15 million, a decline of $32 million sequentially. The U.S. Retail net PCL ratio, including only the bank's share of PCL for the U.S. strategic cards portfolio, as an annualized percentage of credit volume, was minus 0.04%, lower by 8 basis points sequentially. Expenses increased 2% year-over-year, reflecting higher employee-related expenses and business investments, partially offset by prior year store optimization costs, lower COVID-19 expenses, and productivity savings in the current year. The contribution from TD's investment in Schwab was US$177 million, down 9% from a year ago. Please turn to Slide 14. Wholesale net income for the quarter was $359 million, a decrease of 6% year-over-year, reflecting higher noninterest expenses and a lower PCL recovery, partially offset by higher revenues. Revenue was $1.3 billion, up 8% year-over-year, primarily reflecting higher trading-related revenue, partially offset by lower underwriting fees. PCL for the quarter was a recovery of $9 million compared with a recovery of $5 million in the prior quarter. Expenses increased 10% year-over-year, primarily reflecting the continued investments in Wholesale Banking's U.S. dollar strategy, including the hiring of banking, sales and trading, and technology professionals and the acquisition of TD Securities' automated trading, previously Headlands Tech Global Markets LLC. Please turn to Slide 15. The Corporate segment reported a net loss of $151 million in the quarter compared with a reported net loss of $186 million in the second quarter last year. The year-over-year decrease reflects lower net corporate expenses and lower amortization of intangibles. Net corporate expenses decreased $25 million compared to the same quarter last year. Adjusted net loss for the quarter was $79 million compared with an adjusted net loss of $106 million in the second quarter last year. Please turn to Slide 16. The common equity Tier 1 ratio ended the quarter at 14.7%, down 49 basis points sequentially. We had strong organic capital generation this quarter, which added 45 basis points to CET1 capital. This was more than offset by an increase in RWA, the impact of the repurchase of common shares prior to the First Horizon acquisition announcement and the impact of our US$494 million investment in First Horizon convertible preferred stock, which accounted for 8 basis points of CET1 capital. We are activating the DRIP discount for our upcoming dividend as a prudent response to a number of developments and uncertainties in the operating environment. Inflationary pressures have led to greater volatility in interest rate markets, and there is an increased possibility of an economic slowdown. Conversely, should interest rates continue to rise, we would expect expanding margins for TD's Canadian and U.S. retail segments and higher fair value accounting adjustments upon closing of the First Horizon transaction, which would result in a higher initial capital requirement and higher accretion of the fair value adjustments into earnings over time. We also expect the Canada recovery dividend to have an adverse impact on CET1. In all of these developments and uncertainties into account, we believe it is appropriate to take steps to build our capital buffer to support continued business growth. RWA increased 4% quarter-over-quarter, mainly reflecting higher credit risk and market risk RWA. Credit risk RWA increased $13.9 billion or 4%, mainly reflecting higher volumes in Canadian retail and wholesale. Market risk RWA increased $3.6 billion or 18%, reflecting market volatility. The leverage ratio was 4.3% this quarter, and the LCR ratio was 119%, both well above regulatory minimums. I will now turn the call over to Ajay.

Ajai Bambawale, Chief Risk Officer

Thank you, Kelvin, and good afternoon, everyone. Please turn to Slide 17. Gross impaired loan formations decreased 4 basis points quarter-over-quarter to 12 basis points, reflecting higher prior quarter formations in U.S. commercial, largely related to government-guaranteed Paycheck Protection Program loans. Please turn to Slide 18. Gross impaired loans decreased 3 basis points quarter-over-quarter to a new cyclical low of 30 basis points, largely reflecting further resolution of Paycheck Protection Program loans in the U.S. commercial portfolio. Please turn to Slide 19. Recall that our presentation reports PCL ratios, both gross and net of the partner share of the U.S. strategic card PCLs. We remind you that PCLs recorded in the Corporate segment are fully absorbed by our partners and do not impact the bank's net income. The bank recorded provisions of $27 million or 1 basis point this quarter, decreasing by $45 million quarter-over-quarter, reflecting lower impaired PCLs and a larger performing allowance release. Please turn to Slide 20. The bank's impaired PCL was $314 million, decreasing by $15 million quarter-over-quarter and remaining at cyclically low levels. Performing PCL was a recovery of $287 million compared to a recovery of $257 million last quarter. The current quarter recovery reflects additional allowance releases across all segments. Please turn to Slide 21. The allowance for credit losses decreased $231 million quarter-over-quarter to $6.9 billion or 87 basis points, reflecting improved credit conditions. However, the release was tempered due to the increased economic uncertainty largely related to geopolitical risks and inflation. The bank's allowance coverage remains elevated to account for this ongoing uncertainty that could affect the economic trajectory and credit performance. In summary, the bank continued to exhibit strong credit performance this quarter as evidenced by lower gross impaired loan formations, gross impaired loans, and PCLs. While these key credit metrics remain at or near cyclical low levels, economic uncertainty continues to be elevated. TD, however, remains well positioned, given we are adequately provisioned, we have a strong capital position, and we have a business that is broadly diversified across products and geographies. With that operator, we are now ready to begin the Q&A session.

Operator, Operator

The first question is from Ebrahim Poonawala from Bank of America. Please go ahead.

Ebrahim Poonawala, Analyst

I guess, I just wanted to follow up on capital and better understand, one, maybe for Kelvin. Give us a sense of what the hit to CET1 would be if rates stay where they are and you were to close the deal today? If you could help us quantify that. I'm just trying to understand the DRIP and whether the initiation of the DRIP is just out of abundance of caution or is there a meaningful hit? So I would appreciate if you could quantify what the impact would be from the movement in interest rates, and then now a follow-up tied to capital and just how you're managing the results?

Bharat Masrani, CEO

Before Kelvin speaks, Ebrahim, this is Bharat. It's great to hear from you. I understand there have been many questions about this. Kelvin mentioned it in earlier calls as well. To give you some context, historically, our bank doesn't go out and hedge this particular issue because when we look at the underlying offsets within the bank and our net interest sensitivities, we assess how our earnings are affected when interest rates increase. This also applies to First Horizon's earnings in similar circumstances. Furthermore, as Kelvin mentioned, any additional fair value adjustments related to this transaction will be counterbalanced by the accretion we will earn after the transaction closes. I wanted to share this perspective on how we approach these situations, which has been our practice for many years in all our acquisitions. Perhaps Kelvin can provide some of the specific numbers you were inquiring about.

Kelvin Tran, CFO

Thanks, Bharat. I think, in other words, we do have a natural hedge when interest rates rise because we see margin expansion in both our Canadian and U.S. businesses, including underlying earnings of First Horizon. But maybe I can just give you more of a sensitivity measure because this number would move around. It's about 50 basis points. For every 50 basis point increase, there's about $350 million on an after-tax basis.

Ebrahim Poonawala, Analyst

That's extremely helpful. And I totally get it, Bharat, in terms of it's just a timing issue where if it comes through earnings over a period of time. And just on First Horizon and one more question, I mean, I think the U.S. regulatory process has become a little more prolonged over the last year. One of the concerns that I heard is that TD is uniquely the G-SIB relative to the other bank M&A that's been announced, I would love to hear your thoughts around one conviction level in terms of getting the deal through the regulatory sort of finish line? And is TD different than the other five transactions that are out there because of being a G-SIB?

Bharat Masrani, CEO

Well, I don't want to comment on what the other transactions might be, but we feel very comfortable. Our process continues. And we did this transaction on the basis that it meets all the requirements of all the regulators. So, we continue to be comfortable and are working hard to get it to closing. And so, I don't think it would be appropriate for me to comment on how this compares to other deals out there because each one has its own unique feature.

Ebrahim Poonawala, Analyst

That's fair. And just one last for Ajay, on reserves, like you still have a loan loss allowance, which is about $1.3 billion more than pre-COVID levels or $1.4 billion. We've seen some of your peers take reserves down to pre-COVID or below. Is this entire excess as of just because of the uncertain macro backdrop? And could this flow into earnings? Or is there something else going on with regards to mix or how you perceive the portfolio?

Ajai Bambawale, Chief Risk Officer

Yes. No, thanks for the question, and let me respond. So what I would say is expect prudence from us. There is uncertainty out there. And the sources, as I said, even on the last call, are changing. Our allowance really accounts for this uncertainty that's out there. Having said that, if the macro conditions improved and the uncertainty reduces, then yes, we would be looking to release more reserves. But as you're aware, the situation is quite fluid right now. And what the future holds, who knows. But to the extent we are in a recessionary scenario or even in a stagflation kind of scenario, it is possible we may have to build reserves. I think, at this point, because we are seeing all this uncertainty, we're just being very prudent, very careful, thoughtful, and deliberate in how we are releasing our reserves. So hopefully, that helps.

Operator, Operator

Thank you. Next question is from Scott Chan from Canaccord Genuity. Please go ahead.

Scott Chan, Analyst

So just on personalized banking, you talked about a lot of town halls with senior executives. And Bharat, maybe at a high level, have you learned anything in these hard meetings after the announcement that you could possibly share, maybe in terms of people or culture or anything like that?

Bharat Masrani, CEO

I'll pass it on to Leo in a second. I attended some meetings with the various groups and it was terrific to engage. TD Bank America's Most Convenient Bank and TD generally have always been well received in the communities. And our purpose is to enrich the lives, not only of our customers and our colleagues, but of our communities as well. And that has played well in all these meetings we've had. But maybe Leo can give you more color because Leo was in various meetings himself and his old team as well, and can give you a bit of color on the meetings we've had.

Leo Salom, President and CEO, TD Bank America's Most Convenient Bank

Sure, Scott. Thank you very much for the question. We've had the opportunity to essentially do 15 town halls across 13 cities over the course of the last four weeks. And it's been a terrific opportunity to get to know the entire organization. We met with over 6,000 employees. I'd say a couple of things that stood out, and I think more falls into the category of reaffirming our beliefs going in. One, there's no question First Horizon is a very strong commercial bank with very strong and deep ties in the local communities. And that came across, and the talent in that space we view is going to be very additive as we continue to build our commercial bank and as we try to grow the middle market space. I think the distribution that they've built across the Southeast is very compelling. They've got 412 branches. We got a chance to actually visit many of those cities that are experiencing above-average population growth and above-average banking formation. And I think we're quite excited about how we can bring our retail model to bear, a model that has served us very well on the East Coast, to be able to grow the retail franchise. And so, I think that was quite encouraging. But I would say probably the thing that I would harp on the most is just the culture. I think it's an organization that's humble at its core but very ambitious in terms of what they want to achieve and very committed to serving their clients and their local communities. And I think that certainly resonates with us. It's how we built our franchise in the U.S., and we look forward to bringing these two organizations together. And really, the time that's been spent most recently is working very closely in our workstreams to start to stitch together what the combined organization is going to look like. And I look forward to sharing some of our progress on that end on future calls.

Operator, Operator

Thank you. Next question is from Meny Grauman from Scotiabank. Please go ahead.

Meny Grauman, Analyst

Regarding First Horizon, I wanted to ask about the upcoming community meeting in August. Are any concessions expected during that process?

Bharat Masrani, CEO

Sorry, Meny, just to make sure we understand. What do you mean by concession?

Meny Grauman, Analyst

Specifically, I'm wondering about overdraft. Could there be a scenario where you have to do something more on overdraft fees overall for your U.S. business? Is there a risk there for that?

Bharat Masrani, CEO

I'll let Leo answer that. But I think all these community arrangements are pretty consistent with how they work, and we would expect to follow a similar line. Leo, do you have any further color on that?

Leo Salom, President and CEO, TD Bank America's Most Convenient Bank

Meny, I can refer back to what I mentioned last quarter. We are implementing the overdraft strategy we previously discussed. On April 8, we raised the minimum threshold for overdraft fees to $50, which was a significant part of our proposed changes. We have additional changes planned for the fourth quarter, and their impact aligns with the guidance we provided last quarter. The only other update we've made, which is not directly related to First Horizon, is the decision to eliminate our NSF fees. This change is a minor addition to last quarter's overall impact, totaling less than $40 million a year, which is not substantial by itself. However, we believe that combined with the other changes we announced last quarter and the NSF elimination, we are now in a very competitive position, offering our clients both choice and value. We feel confident about the overdraft adjustments we've made. We've been actively engaging in community discussions, meeting with over 100 community leaders through five listening tours organized by the NCRC. These meetings have been valuable, and the feedback will help shape the community benefit agreement we plan to establish over time, which is separate from the public hearing.

Meny Grauman, Analyst

Got it. And then just as a follow-up. In the U.S. business, you highlight the lower fee income from overdraft and the lower gains on the sale of mortgage loans. I'm wondering if you could break out the impact of both of those and how we should think about that going forward as well?

Leo Salom, President and CEO, TD Bank America's Most Convenient Bank

Well, I would say from an overdraft standpoint, we implemented April 8. So it was a relatively small time series. The overall impact, which I shared with you last quarter, was that the aggregate impact of all the changes was $250 million. And to that, you should add the $40 million number. And that will give you a sense of what the impact is going to be related to overdraft. With regards to some of the other changes, prepayment and some of the gain on sale mortgages, it really depends on market conditions. So I wouldn't necessarily read too much into it. To the extent that market conditions change, we would certainly look to see those numbers flow over time. I do want to just comment that as we continue to grow our wealth franchise, as we continue to lean into growing our core checking account base and continue to accelerate the growth in our cards business, we would expect us to be able to generate fee income from those activities to be able to help compensate for some of the declines in the overdraft space.

Operator, Operator

Thank you. Next question is from Sohrab Movahedi from BMO Capital Markets. Please go ahead.

Sohrab Movahedi, Analyst

Just two quick questions here. Leo, you obviously have spent a lot of time since announcing the First Horizon. Are you able to also talk about where some of the revenue synergies may be coming?

Leo Salom, President and CEO, TD Bank America's Most Convenient Bank

Thank you for your question, Sohrab. As I mentioned last time we spoke, we didn't include revenue synergies in our model. However, I believe there are significant opportunities as we combine our two organizations that will generate revenue synergies. One key opportunity is merging our commercial banks, which will enhance our presence in the mid-market sector by leveraging their capabilities along with our balance sheet and the TD Securities product line. I'm confident this will provide a strong platform for accelerated growth over time. Additionally, as I mentioned earlier, there are prospects in the retail space that I find promising. If we consider the penetration rates we currently have on certain products and apply that to the First Horizon base, it could yield another substantial source of synergy. We will work through these opportunities and prioritize them in our integration efforts. While we have projected $610 million in expense synergies, we are equally focused on maximizing these revenue synergies because I find them to be very exciting and beneficial for the overall growth of the franchise.

Sohrab Movahedi, Analyst

Okay. Exciting but not quantifiable yet? Is that the right way to think about it?

Leo Salom, President and CEO, TD Bank America's Most Convenient Bank

We're working through those. But suffice to say that we're very optimistic.

Kelvin Tran, CFO

Yes. So when we look at operating leverage, like we don't manage expenses on a quarter-to-quarter basis, it's more on a medium-term basis. And so, we continue to work towards building positive operating leverage over that time frame. And to help you quantify the expense impact of the 3%, it's about $290 million on a run rate annualized basis.

Operator, Operator

Thank you. Next question is from Nigel D'Souza from Veritas Investment. Please go ahead.

Nigel D'Souza, Analyst

I just had a quick question for you first, just to clarify some of your information on Slide 35, with your loan-to-value disclosure. The HELOC LTVs on that slide, just wanted to clarify, that is inclusive of the mortgage balances associated with those properties as well?

Ajai Bambawale, Chief Risk Officer

It should be, yes.

Nigel D'Souza, Analyst

When I examine the loan-to-values, the HELOC loan-to-value is actually lower than the loan-to-value in your mortgage portfolio. Could you elaborate on this? I would expect that borrowers with both mortgages and HELOCs would have higher loan-to-values compared to those with just mortgages.

Ajai Bambawale, Chief Risk Officer

We'll have to take that away. We'll have to look at the data and come back to you on that.

Nigel D'Souza, Analyst

Sure. If I may shift to your allowances, I see how a decline in forward-looking indicators could result in fewer reversals or more provisions. However, observing your Stage 2 loans, approximately 7% of your total loan portfolio is classified as Stage 2, compared to around 3% before the pandemic. This indicates that your Stage 2 levels are now about 2 to 3 times higher than pre-pandemic figures. I'm curious about why these loans haven't shifted back to Stage 1 and what is hindering that migration.

Ajai Bambawale, Chief Risk Officer

Yes. So we saw a lot of migration to Stage 2 through the pandemic. And I'd say over the last few quarters, we've seen a lot of migration back. Not all the loans are migrated back because of the uncertainty out there and because of the macroeconomic scenarios we're using. What you got to keep in mind is these Stage 2 loans don't just reflect delinquency numbers. But to the extent the macroeconomic scenarios drive different probabilities of default, you're at a different stage of your loans. So over time, as I said, the macro conditions improve, we should see more migration and if the uncertainty reduces. However, things could go the other way as well. As I said, it's pretty fluid right now, the whole situation.

Nigel D'Souza, Analyst

Okay. But fair to say that the ones have higher PD than your Stage 1 loans?

Ajai Bambawale, Chief Risk Officer

Right.

Nigel D'Souza, Analyst

Okay. And looking at your forward-looking indicator disclosure this quarter, when I look at the downside scenario, you now have a scenario where rates could move higher in the short term and real GDP could decline. So is that representative of your stagflation scenario? And how does that impact your expected credit loss modeling this quarter?

Ajai Bambawale, Chief Risk Officer

Yes. So our downside case is a formal stagflation, for sure, so higher inflation, lower GDP. What's the second part of your question?

Nigel D'Souza, Analyst

How did it impact your expected kind of loss modeling and provisions for performing loans this quarter by introducing that scenario?

Ajai Bambawale, Chief Risk Officer

Yes. So we didn't change the weight on the downside. And if you look overall, like the uncertain macro situation and the downside and the weight on the downside is a factor, led us to actually temper the release, which is what we called out. So overall, macro between the base and the downside actually led to a tempering of our release.

Nigel D'Souza, Analyst

Got it. And last question for me. When I look at the downside scenario, the assumption you have for home prices is about the same as your base case scenario despite rates moving higher in the downside scenario. So should we take that away as your expectation that home prices are going to remain where they are not declining even with rates moving up?

Ajai Bambawale, Chief Risk Officer

That's a great question, and thank you for calling it out. And let me talk about housing just for a minute. So, I think the starting point for housing is really two years ago. And the big increase that we've seen in house prices over the last two years, I believe that number is 45%, is actually a material risk mitigant for our book. When we did our allowance scenarios, and this is partly because of timing, we did view that there would be some price growth, both in the base and the downside case. And the reason for that is there are many supporting factors, including unemployment, income levels, supply constraints and, of course, the population growth. A house view, however, there's been recent data and a house view has adapted. And I'd say now, we are expecting some correction in the housing market. And some of that 45% gain that I talked about is going to recalibrate. So we would see some unwinding of that in the coming quarters. And we did actually take that into consideration in our allowance process and put in an overlay. But what I drive comfort from is a few things. One is our customer base and their risk profile is strong. Second, our underwriting standards haven't really changed, and they've been through the cycle. Third is we are using a qualifying rate, a stress rate to approve these loans. And lastly, and this is an important point, the job market is still very strong. So, we'll relook at it next quarter, but it's not like we completely ignored it. And those numbers that you call out a point in time, yes, and you're right in calling it out.

Operator, Operator

Thank you. Next question is from Lemar Persaud from Cormark Securities. Please go ahead.

Lemar Persaud, Analyst

I have a quick modeling question to start. I believe I heard in the opening remarks about either a 3% pay raise or a one-time cash award. Could you clarify the size of the one-time cash award in noninterest expenses since it would likely be non-recurring?

Kelvin Tran, CFO

Yes, it's Kevin. That's right. The one-time cash award is only $10 million and it is one time.

Lemar Persaud, Analyst

Okay, consequential. Okay. Then to my real question here. I just want to come back to the discussion on capital, particularly as it relates to First Horizon. I understand that you get the benefits of additional accretion from higher rates or that natural hedge you're referring to when the deal closes. But does that often take that into consideration? Or would it assist CET1 ratio, even if temporarily kind of touch the 10.5%?

Bharat Masrani, CEO

It's difficult to comment on precisely how regulators will view this, but we've traditionally managed this in our usual way. We have been responsible capital managers, so I am confident that not only will we complete the transaction as planned, but we will also maintain capital levels that comply with all regulatory requirements.

Kelvin Tran, CFO

Maybe I can clarify that the accretion after day one would add to capital after that period. Additionally, the natural hedge isn't just applicable after day one; it also includes rate increases during this time. First Horizon has generated more revenue, as has the bank in terms of Canadian retail and the U.S. business. All of this functions as a natural hedge as well.

Operator, Operator

Thank you. Next question is from Paul Holden from CIBC. Please go ahead.

Paul Holden, Analyst

Sorry to belabor the point, but I'm going to have to ask a follow-up question on this, First Horizon first fair value adjustment. So one is if there's a plausible scenario where rates increase significantly between now and then, and then a possibility that rates decreased thereafter. Would that therefore suggest you would take a goodwill impairment charge later on down the road and then thereby decrease your capital associated with the transaction? Is that how to think about the natural hedge in that type of scenario?

Kelvin Tran, CFO

It's Kelvin here. The goodwill write-down is a significant event, and it's not just based on rates alone, you have to look at the entire business and the value that it generates. So, I wouldn't draw the conclusion between those two.

Paul Holden, Analyst

Okay. And so how do we think about you earning that back? And in that type of scenario, again, rates move higher significantly in the next six to nine months. But then if there is a recession, they're going to come back down?

Kelvin Tran, CFO

Yes. This pertains to the accounting process for business acquisitions. I'm going to get a bit technical, so please bear with me. In the context of clothing, you adjust the value of assets; for example, if the loans are valued at par, you would write it down to $30. Over time, that $70 difference will gradually return to par, reaching 100. Ultimately, this amount will come back to you as you receive cash, which will contribute to your earnings.

Paul Holden, Analyst

Understand. Okay. Thank you for that. So the other question I wanted to ask was just on your underwriting appetite. Today, very clear in terms of how you're managing your credit allowances and taking a conservative view, you also made some comments about expecting housing prices perhaps to decline here. Does that mean you decrease your underwriting appetite or really, I guess, tighten up your credit parameters today?

Ajai Bambawale, Chief Risk Officer

Yes, it's Ajai. So the simple answer is no. We're not going to change our credit parameters. I think you've heard from us many times that we're through the cycle underwriters, and we'd like to keep our underwriting standards consistent, and that's the intent. So we would not change our underwriting standards unless we thought there was going to be unexpected loss. So, consistent underwriting standards should be expected from us. The other sort of comment I'd make is that we're actually seeing very good quality on our residential book, whether it's HELOC or residential mortgages. If you look at delinquencies, charge-offs, formations, gross impaired loans, they're at historical lows. And you look at our origination metrics, you look at our customer quality, just the scores, they're in very good shape. And the customers are in very good shape. So, I know things are changing and we need to monitor how things will change and how customer attributes may change. And to the extent they change, we'll certainly factor it into our allowance process. But as of now, we feel pretty good about the quality of our book.

Operator, Operator

Thank you. Next question is from Jooyoung Kim from Credit Suisse. Please go ahead.

Jooyoung Kim, Analyst

Just a quick question on U.S. Retail. I'm wondering what you're seeing in terms of client demand and utilization for commercial loans, as the rate of decline seems to have slowed down. And I think a part of that is the PPP impact diminishing. I'm just wondering where we could start seeing that commercial loan growth pick up ahead?

Kelvin Tran, CFO

Thank you for the question. We indeed observed a significant increase in commercial lending during the quarter. To give you an idea, gross originations rose by 47% compared to the previous year, and more importantly, there was a slowdown in pay down activities. Line utilization also increased by 250 basis points. When you combine these three factors, it resulted in a strong spot growth of around 3% for the quarter, which we are pleased with. Specifically, we are seeing growth in the middle market and our specialty lending areas, such as health care, municipal, and not-for-profit education. However, we are not experiencing as much demand for loans in the small business segment and the lower end of our community banking sector. These areas are still navigating the post-pandemic landscape, and it may take additional time to see the growth we desire from them. Nonetheless, I am satisfied with the results from our established mid-market and specialty businesses. While I'm optimistic, I also acknowledge the current uncertainties in the marketplace, so we remain cautious about the outlook.

Jooyoung Kim, Analyst

I'd like to follow up on capital. Considering the discount on the DRIP and the positive growth outlook, could you provide insights on whether there is any change in your expectations for the ratio after the First Horizon acquisition closes?

Kelvin Tran, CFO

Yes. It's Kevin. No, we don't see any changes.

Operator, Operator

Thank you. And last question is from Darko Mihelic from RBC Capital Markets. Please go ahead.

Darko Mihelic, Analyst

Two questions. One is for Riaz. And I guess the other one is maybe for Kelvin, maybe for Bharat. Just going back to the capital thing for a moment. When you announced the First Horizon deal, you mentioned you terminated the NCIB, which makes sense. But you didn't announce the DRIP then. So what has changed from then until now to sort of make you guys think about employing the DRIP? I mean, I can think of one thing, which is maybe the federal budget, but I would have thought that the environment looked pretty gruesome back then and rate increases were already factored into your thought process. So just want to make sure there isn't anything there that I missed. Like what has actually changed since February to now that says you have to use a DRIP?

Bharat Masrani, CEO

There is a significant amount of uncertainty present, and market volatility is quite intense. We have been cautious in our approach, ensuring that we cover all bases. We prefer to be careful rather than limit our purchases. This strategy seems appropriate given the unpredictable environment we are facing. Since February, circumstances have shifted markedly. The conflict in Europe is ongoing, and energy prices are fluctuating significantly. As is common for us, we aim to be prudent in response to this volatility and uncertainty.

Darko Mihelic, Analyst

Is it too late to hedge now, Bharat?

Bharat Masrani, CEO

It's not been our approach. The natural way we look at it is, it served us well, and I'm sure it will serve us well here as well. So, we are quite comfortable with the approach we've taken. And I think Kelvin has explained to you the accounting. And I know before this deal ends, each one of you are going to become experts in purchase accounting and now exactly what would are the puts and takes on this. But we feel very comfortable. Look at TD's net interest rate sensitivity, if that is what you're worried about, look at First Horizon's net interest sensitivity and then, of course, the accretion that comes after closing. So I think overall, we feel very comfortable, but we want to maintain a particular level of capitalization given the volatility that we, all of us, are experiencing.

Riaz Ahmed, Group Head, Hotel Banking

Thank you for that, Darko. Our total loan portfolio of approximately $4 billion includes corporate lending, prime brokerage securitizations, and similar products. The margin you're interested in is an overall measure of these elements. As our funding costs rise, you may notice that the margin decreases slightly. In some segments, we can adjust the margins fairly rapidly, but the corporate lending segment tends to be the last to respond to these changes. We are committed to managing this portfolio responsibly and pricing it appropriately to support our desired clients while achieving the necessary returns.

Bharat Masrani, CEO

And Darko, you make a good point. While we're very comfortable with our current position, I don’t want to speculate about what could happen in the global markets. So while I won't say it's impossible to change, we're quite confident in the approach we've historically taken and in our current stance in the market cycle based on our observations. We remain very comfortable.

Operator, Operator

Thank you. Your conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.