Western Alliance Bancorporation Q3 FY2023 Earnings Call

Good day, everyone. Welcome to Western Alliance Bancorporation's Third Quarter 2023 Earnings Call. You may also view the presentation today via webcast through the company's website at www.westernalliancebancorp.com. I'd now like to turn the call over to Miles Pondelik, Director of Investor Relations and Corporate Development. Please go ahead.

Thank you. Welcome to Western Alliance Bank's third quarter 2023 conference call. Our speakers today are Ken Vecchione, President and Chief Executive Officer; Dale Gibbons, Chief Financial Officer; and Tim Bruckner, our Chief Credit Officer, will join for Q&A. Before I hand the call over to Ken, please note that today's presentation contains forward-looking statements, which are subject to risks, uncertainties and assumptions. Except as required by law, the company does not undertake any obligation to update any forward-looking statements. For a more complete discussion of the risks and uncertainties that could cause actual results to differ materially from any forward-looking statements, please refer to the company's SEC filings, including the Form 8-K filed yesterday, which are available on the company's website. Now for opening remarks, I'd like to turn the call over to Ken Vecchione.

Thank you, Miles. Good morning, everyone. I'll make some brief comments about our third quarter 2023 results, and then I'll turn the call over to Dale. One year ago, on our Q3 2022 call, we discussed our plans to temper balance sheet growth to bolster capital and liquidity in order to reinforce our financial foundation and position the bank to navigate through a volatile rate environment. The events of the spring caused by duration mismatch at several regional banks validated the importance of our strategy and accelerated its implementation through surgical balance sheet repositioning. The recalibration of our business model to enhance overall liquidity and deposit granularity is designed to make the balance sheet unassailable in the event of another significant market disruption. As a result, our CET1 capital has grown from 8.7% a year ago to 10.6% today. Our HFI loan-to-deposit ratio has improved from 94% to 91%. To provide enhanced protection to depositors and cement the stability of our deposit base, insured and collateralized deposits have risen from 47% at year-end to 82%. In order to fortify our liquidity position, we have materially increased our cash and investment securities and now have $3.2 billion of high-quality liquid asset treasures. Having established strong capital, liquidity and deposit granularity, a sturdy foundation has been laid to deliver earnings improvement going forward. Over the last several quarters, we have prioritized stabilizing and growing deposits as well as optimizing the liability structure by paying down borrowings. This has led to net interest margin growing from our second quarter trough as we have sustained improvement in our funding structure, lowered our adjusted efficiency and produced above-peer return on average assets and return on average tangible common equity. Over the next one to two quarters, we will complete the optimization of our funding structure and be well positioned to deploy excess core deposits into loan growth. In the third quarter, Western Alliance profitability, strong liquidity generation and stable asset quality are proof points to the dexterity of our diversified business model. Before handing the call over to Dale, I want to highlight the drivers of our strong deposit growth in Q3. Core commercial clients, both new and existing, were the primary sources contributing to $3.1 billion of growth. Mortgage warehouse and HOA pushed growth upward and the regional network posted a second consecutive quarter of vigorous deposit contributions. Overall, deposit cost increased 27 basis points. The overall cost of interest-bearing liabilities compressed 5 basis points to 2.8% in Q3 as we utilized deposits to pay down higher-cost borrowings, which Dale will comment on later. Liquidity came in ratably over the quarter to push down our average borrowings. Core commercial deposits cost a marginal 4.04%, including cost of earnings credit rates. Cultivating multiproduct customer relationships remains critical for solidifying and growing client relationships, which is held in the mid-80% range in recent quarters. Our digital consumer channel, a source of liquidity uncorrelated with our core commercial business lines, generated approximately $800 million this quarter at attractive rates relative to the model cost of repaying borrowings. In short, I feel confident in the vitality of our deposit franchise and how it sets up for future success. Now, Dale will take you through our financial performance.

Thanks, Ken. For the quarter, Western Alliance generated net income of $217 million, earning $1.97 per share and $290 million in pre-provision net revenue. Net interest income rose by $37 million to $587 million, benefitting from the favorable repricing of earning assets and a decrease in higher-cost borrowings. Non-interest income grew by $10 million to $129 million, which included around $6.5 million in non-recurring pretax items like fair value adjustments. AmeriHome faced some challenges due to rising mortgage rates and treasury yields, with mortgage banking revenue decreasing by $7 million to $79 million, as lot volume fell by 5% from the previous quarter, and production margins slightly compressed to 38 basis points. Growth in non-interest expenses was mainly driven by increased deposit costs, as well as software licensing and depreciation expenses. The deposit cost of $128 million reflected our gains in deposit share from new customers and former clients returning funds to the bank. Provision expense was $12 million, attributed to stable asset quality and loan growth centered in low-loss categories. Our provision modeling remains conservative due to the weighting of the Moody's consensus forecast, suggesting an 80% probability of a recession. Additionally, our tax rate increased because of specific non-deductible items during the quarter, but we expect it to decrease to between 20% and 21% moving forward. Overall, we made significant strides in boosting on-balance sheet liquidity, with cash investments increasing by 19% quarter-over-quarter, primarily through the acquisition of more high-quality liquid assets. Gains in deposit share and balance sheet adjustments also contributed to a reduction in wholesale borrowings. Cash and cash equivalents amounted to $3.5 billion, up from $2.2 billion last quarter. Given our strong deposit growth and capital levels, we decided to reclassify $1.3 billion of non-AmeriHome held-for-sale loans back to held for investment, as organic loan growth has decelerated. These reclassified loans consist of short-duration, low credit risk assets, which we believe will generate interest income for the bank moving forward. The remaining loans held for sale are entirely AmeriHome residential inventory tailored for sale to the GSEs, with an average duration of about two weeks. In total, loans held for investment rose by $1.6 billion to $49.4 billion. Deposits surged by $3.2 billion to reach $54 billion at the end of the quarter. Mortgage servicing rights increased partly due to the higher rate environment, amounting to $1.2 billion as of September 30. Total borrowings decreased by $820 million to $9.6 billion at quarter-end, and average borrowings fell nearly $6 billion quarter-over-quarter mainly due to the repayment of Federal Home Loan Bank borrowings and private equity lines obtained earlier in the year. Organic held-for-investment loans grew by $240 million, primarily in C&I, centered around mortgage warehouse, MSR financing, and corporate finance, with smaller contributions from our regional banking operations. HFI construction and land loan growth of $241 million came mainly from lot banking loans reclassified from held-for-sale status. With the national undersupply of homes, we still view the macro backdrop for this product favorably despite the elevated rate environment. The total deposit growth of $3.2 billion was primarily driven by an increase in core deposits and a reduction in wholesale broker deposits exceeding $400 million. Core deposit growth was bolstered by $1.3 billion in non-interest-bearing DDA growth, largely from the Mortgage Warehouse, and $1.6 billion in savings and money market growth. Non-interest-bearing DDA represented one-third of our total deposits, with about 40% having no cash payment or earnings credits. Thus far in the quarter, deposit growth has exceeded $3 billion, although the semi-annual seasonality affecting mortgage warehouse deposits and tax and insurance escrow funds will decrease this figure as payments are made. In terms of debt interest drivers, favorable repricing in a high-rate environment increased the yield on earning assets, while optimization of our liability structure by increasing deposits to reduce short-term borrowings led to a lower funding cost. The securities portfolio grew by $1 billion to $11.4 billion as we focused on adding high-quality liquid assets to the balance sheet. The yield on total investments rose by 15 basis points to 4.91%. About $1.8 billion in securities yielding 4.77% are set to mature by year-end, along with another $2 billion yielding 4.98%, maturing in 2024. Similarly, HFI loans saw a 25 basis point increase to 6.73%, with a quarter-end spot rate of 6.99%. In a prolonged high-rate environment, we anticipate benefits from favorable asset pricing trends. Total fixed convertible loan maturities are projected to average $2.4 billion per quarter over the first three quarters of 2024. Our strategy to refine the liability funding structure through increased savings and money market accounts resulted in a 41 basis point increase in the cost of interest-bearing deposits. This has enabled a $5.9 billion reduction in average short-term borrowings to 14% of interest-bearing liabilities, which contributed to a 5 basis point decrease in the overall cost of interest-bearing liabilities to 2.8% in the third quarter. As previously mentioned, we believe net interest income and net interest margin hit a cycle low in the second quarter. Net interest income increased by nearly 7% despite a slight contraction in average earning assets, and the margin expanded by 25 basis points quarter-over-quarter to 3.67%. Assessing the impact of future rate changes, our rate risk profile is modestly asset-sensitive. Our plus 100 basis point rate shock analysis on a static balance sheet suggests that net interest income could rise by approximately 4%, similarly, it would increase under a minus 100 basis point shock. However, a more thorough review of interest rate risk indicates a 2.2% increase in earnings at risk from a 100 basis point negative shock, factoring in projected declines in ECR-related deposit costs. In a lower rate environment, mortgage banking can act as a buffer for our asset-sensitive balance sheet, benefiting from increased refinancing activity and improvements in sale margins. Our efficiency ratio of 58.8% was 170 basis points higher than in Q2, though our adjusted efficiency ratio, excluding the impact of ECRs, dropped by 50 basis points to 50%, as average balances in mortgage warehouse with ECRs increased by $2.4 billion to $11 billion in Q3. Lower compensation expenses due to normal seasonal factors helped offset the rise in software licensing and data processing costs. We believe a mid to upper 40% efficiency ratio is indicative of the appropriate medium-term investment level to support new business initiatives and the continued evolution of our risk management framework. Pre-provision net revenue for the quarter was $290 million. We maintained solid profitability in Q3 with a stable return on average assets of 1.24% on a larger balance sheet. The return on average tangible common equity was 17.3%, slightly lower than our Q2 level as our capital levels changed. Our proactive credit mitigation strategy has proven effective in normalizing the credit environment thus far. Asset quality remained stable in Q3, with only a $9 million aggregate net increase in special mention loans and classified assets. Notably, nonperforming assets fell by $22 million to $245 million, representing 35 basis points of total assets. Quarterly net loan charge-offs were $8 million or 7 basis points of average loans, compared to $7.4 million or 6 basis points in the second quarter. The growth in low to no loss categories, along with stable asset quality, led to a smaller provision expense even in a normalizing credit environment. Our total funded ACL increased by $6 million from the previous quarter to $327 million, mostly driven by HFI growth in low loss categories, particularly in mortgage warehouse. Even after repaying two credit-linked notes, 22% of our loan portfolio remained protected, with any losses covered by third-party support. The total loan ACL to funded loans decreased by 2 basis points to 74 basis points, but increased by 13 basis points to 154% of nonperforming loans. We believe our allowance is appropriate, particularly considering the significant portion of loans secured by first loss credit protection and low loss categories. A sizable part of our loan growth has been focused on low to no loss products. Our loan portfolio is diverse across risk segments, with nearly a quarter being credit protected, government guaranteed, or cash secured, and over half of the portfolio being insured or resilient to economic fluctuations. If adjusted for these factors, our ACL rates rise to 1.34% of loans. Our strong organic capital growth increased the CET1 ratio from 10.6% to 6.8% when adjusted for AOCI and tax-affected unrealized held-to-maturity securities marks. Our tangible common equity to total assets decreased by approximately 20 basis points from Q2 to 6.8% as the balance sheet expanded slightly, while capital growth was limited by our higher AOCI mark. Following a 45 basis point increase in the five-year treasury during the quarter, AOCI reduced our tangible common equity by $732 million. Including our quarterly cash dividend payment of $0.36 per share, our tangible book value per share increased by $0.57 in the quarter to $43.66. This quarter-over-quarter increase stemmed from our earnings surpassing industry-wide AOCI challenges associated with rising rates. I'll now turn the call back to Ken.

Thanks, Dale. Our guidance for the rest of 2023 continues to be informed by the strategies and priorities laid out in our prior earnings call. So as we look forward to Q4, you can expect loans and core deposits are expected to be fairly flat to several hundred million dollars higher in Q4. Net deposit growth will be impacted by normal Q4 seasonal reductions in mortgage warehouse deposits, offset by growth in the regional divisions and the digital consumer channel. Deposits should still outpace loan growth. Going into 2024, we expect loan and deposit growth to return to our prior guidance. Regarding capital, having closed the 40 basis points of our medium-term CET1 target of 11%, we forecast continued although more gradual progress towards this goal, which we remain on track to achieve in 2024. Net interest margin should remain in line with our Q3 level in a range of 3.60% to 3.70%, supported by asset pricing tailwinds and additional if more tempered borrowing repayment opportunities. Our adjusted efficiency ratio, which excludes the impact of deposit costs, should remain consistent with Q3 levels. Regarding operating PPNR, we expect Q4 to be generally consistent with Q3, excluding the one-time items noted and acknowledging that mortgage banking revenue will be influenced by the impact of the rate environment on mortgage gain on sale. Asset quality remains manageable; projects continue to be supported by sponsors based on our conservative underwriting and low advance rates. Credit losses are still expected to be 5 basis points to 15 basis points through this economic cycle. At this time, Dale, Tim and I are happy to take your calls – questions, sorry.

Thank you. Our first question comes from Casey Haire of Jefferies. Casey, your line is open. Please go ahead.

Yes. Thank you. Good morning, everyone. For the first question on the net interest margin, could you explain what the guidance assumes regarding borrowings? Your deposit growth has been very strong so far this quarter. Ken, you mentioned that you expect this to decrease. So, I am curious about where the borrowings, which were significantly higher at the end of the period compared to the average in the third quarter, are likely to land in the fourth quarter.

Yes. So we have some seasonality within deposit categories that affect this number. But the direction of borrowings is going to continue to be down. So we paid off several of our more expensive funding sources that we achieved or acquired late in the first quarter. And there's a little bit left; I expect we're to pay down that amount as well. So we should continue to see some kind of modest improvement in ending balances as well. And I think the average balances should improve somewhat as well, but not to the degree they did in the third quarter, I would expect.

Yes, Casey, as you've seen, we took down our short-term borrowings by $870 million. But anytime we have any excess liquidity floating around, we use it to pay down borrowings. So average borrowings declined $6 billion in the quarter, and that helped bring down our lower funding rate.

Okay. Great. Dale, I wanted to follow up on your comments regarding the fixed-rate asset repricing benefit in the first three quarters of 2024. I believe you mentioned $2.4 billion per quarter. Can you provide some insight into the blended yield on that and what it could reprice to? I'm trying to quantify the potential repricing benefit.

So, in terms of what the repricing could be, these are coming off at something in the kind of around the higher seven and rates today have spreads of really not less than 300 basis points, 350 from there. And so maybe you don't have another rate increase in there, so I would take that on top of SOFR today. So something in the lower eight.

Okay. So over $7 billion of loans in the first three quarters with 100 bps left.

Approximately.

Okay. Just one last question regarding the expenses. The increase in deposit costs was unexpectedly high this quarter, despite the DDA with ECR rising by 15%. The deposit costs, however, jumped by 40%. I'm trying to understand why there is such a discrepancy. Is the pricing dynamic different now compared to what it has been in the past?

We experienced higher balances and elevated rates, with the average balance increasing by 28% during the quarter. To put it another way, the spreads that our clients receive have remained virtually unchanged.

We don't have the average balances available, but at the period end, they were up 15%. The averages were even higher.

28%, almost double that. Yes.

Okay. Great. Thank you.

Our next question comes from Steven Alexopoulos of JPMorgan. Steven, your line is open. Please go ahead.

Hi, everybody. I want to start, regarding getting back to the $500 million per quarter loan growth target at $2 billion deposit growth in 2024. Once you guys get to the mid-80% loan-to-deposit ratio target, what's more likely that you guys dial up the loan growth expectation at that point or that you dial down the deposit growth?

You'll see on the asset side, you'll see that, that will be the lever that will be used.

Okay. So you're thinking keep the $2 billion deposit target intact and then dial up expectations for asset growth?

Yes. This is Ken. I think so. I think some of the investments that we've made in a number of our deposit-centric business lines will continue to propel deposits forward along the guide that we gave. And as we recalibrate to a mid-80s loan-to-deposit ratio, we'll then turn off the loan growth machine. We've proven here over time that we can generate sound, thoughtful, reasonable loan growth with very little asset quality problems.

Got it. Okay. And then going back to Casey's question on expenses. Excluding the ECR-related deposit costs, which flow through at those sites, how are you guys thinking about expense growth over the next year?

So running from Q3 to Q4, expenses absent the deposit cost will be relatively flat. And as we enter into 2024, there will be marginal expense growth and that marginal expense growth will be predicated on continuing to invest in new products, new services, new business lines, continuing to build out our risk management framework. The hallmark of Western Alliance has been this continuous investment through all cycles to kind of grow the business for future quarters and years. And so as long as the risk return and the investment returns are there, we'll continue to do that.

Got it. So from an efficiency ratio perspective, are you thinking that we'll have improvement through 2024 or that will keep about where you end in the fourth quarter?

Yes, I'd say about where we landed in the fourth quarter. Back to your first question, as we probably exit the second quarter and we achieve our loan-to-deposit ratio, we'll be able to step on the accelerator of loan growth, and that will generate higher interest income, which should provide the denominator of that equation to grow at a faster pace. But right now, if you're modeling, I would say, keep it consistent with Q4.

Right. But it sounds like revenue is set to accelerate here with the margin being more stable, like you said, more loan growth coming in next year, but we should think you're going to spend more of that, at least at this juncture, right? Because it seems like the setup is efficiency ratio improvement next year, where you're saying at least at this point, don't expect that.

Look, I think it is set up that way, but it's a little bit deferred in terms of when that takes place because of the reasons Ken is talking about that we're going to be sluggish on having the loan growth really kind of match 85% of the deposit growth as we continue to pull that number to the LDR number down for a couple of more quarters.

Got it. Okay. Thanks for taking my questions.

Thanks, Steve.

Our next question comes from Chris McGratty of KBW. Chris, your line is open. Please go ahead.

Great. Thanks. Dale and Ken, I'd like to approach this a bit differently. You're on track to meet your 11% target in a couple of quarters, possibly even one to two. Have you considered a share buyback at some point next year given the capital accumulation and the rise in your stock price?

Yes, I think that's a fair question to ask. I think there are a couple of things that will inform our decision. One, as we continue to grow and we continue to get closer and closer to the $100 billion threshold, we have to take into account the AOCI charge that will be applied against it. And so we want to continue to grow our CET1 ratio. Really, 11% is the target; it's not the goal. And we expect to grow through that, all right? That's one. And number two, you'll see the CET1 ratio moderate in the back half of the year in terms of growth because we'll probably step on the accelerator for loan growth once we achieve our loan-to-deposit ratio.

One of the reasons our ratio has improved so quickly is that we have significantly reduced our risk-weighted asset increases, which will rise again as loan growth picks up. We've enhanced our CET1 ratio by 190 basis points since we focused on managing risk-weighted assets and slowed our loan growth. With our organic earnings, we've managed to increase that figure rapidly from 8.7% a year ago to our current 10.6%.

Okay. That makes sense. It feels like there's a combination of maybe both that could be considered in the back half of the year as the AOCI mark narrows and you get through your targets. It feels like a little bit of both.

Yes.

That's fair. Please continue.

I was going to say, even if we're higher for longer on rates, we will see that AOCI mark decline simply because the duration of the portfolio under five years is going to continue to come down.

Chris, just on that, I'd say to you and the rest of the folks on the line, we're looking to build a very strong foundational balance sheet here, right, and not be sucked into any of the problems that you saw in the first quarter with the number of banks having their duration mismatched. And we just want to never go through that again. Or if we have to, have a minimal effect on us. And that's where our intent is, to continue to raise capital levels and also to build our liquidity.

Great. And maybe just one follow-up. I think you've talked about a mid-teens ROE through the cycle. I guess, updated thoughts on that given the higher for longer?

I believe that as our loan-to-deposit ratio continues to indicate our direction, we will accumulate more high-quality liquid assets. Over time, I expect our expense ratio to decrease into the 40s on an adjusted basis. Therefore, I think achieving high teens is feasible for us in the intermediate to long term.

Okay. Thanks.

Our next question comes from Bernard von-Gizycki of Deutsche Bank. Bernard, your line is open. Please go ahead.

So just on deposit costs, maybe I can ask it a little differently. But when you think of how your ECR-related deposit grow based on your guidance, expectations could go for 2024. If rates are steady from here throughout 2024 versus if we do see rate cuts in the second half of 2024, how would you think the deposit costs could migrate under those two different pathways?

I believe ECRs will exhibit a very high beta. They have increased significantly, and we anticipate they will decrease sharply as well. If there are rate cuts, I expect we will be able to lower those rates almost in sync. Additionally, some of these ECRs are linked to effective Fed funds plus a certain number of basis points. One of the main reasons the industry faced pressure on deposits is due to competition from the bond market. As market participants become more confident that the FOMC has completed its rate hike cycle, I believe this will alleviate some of the pressure on deposit costs for the entire industry. This situation may also present us with an opportunity to adjust some of the figures related to those ECRs.

Dale gave you the rate side, and I'd also add. For us, we expect another 25 basis points in Q4 with several cuts towards the back end of next year. So deposit costs will rise and fall along with those rate cuts. But if you're talking about total dollars, also keep in mind, if we exceed our guide, which we have in the last two quarters, you'll see the volume aspect take hold, and you'll see dollar-wise the ECRs rise. So it's going to be a little bit of a rate volume mix as we go forward. In addition, what Dale was alluding to earlier in terms of the deposit initiatives we have. We think that we have some of these will grow more quickly than what our warehouse deposits, which is kind of heavy ECR dependent have done, and that would give us a broader distribution and more diversification on our funding structure.

Great. And I appreciate that color. Maybe just on office CRE. I know your credit has been really good, but if I look at the 3Q exposure, I believe it increased from $2.3 billion in 2Q to $2.6 billion. Just wondering any color you can provide on the increase and if there's any loan sales.

Tim Bruckner here. I can take that. Any increase would have been in-flight balance increases, fund up of tenant improvements; it would be good news money with signed leases. We didn't increase new exposure in office.

Yes. I'll just say as long as you brought that up, remember, 89% of our office portfolio sits in suburban locations. Only 3% sits in central business districts; about 7% sits in Midtown. And our office book represents new construction or new vintage Class A in core submarkets. So again, we go with experienced sponsors, proven track records in adding value and repositioning. Our LTV there is about 60%.

Great. Thanks for taking my questions.

Our next question comes from Brandon King of Truist Securities. Brandon, your line is open. Please go ahead.

Hi. Good morning. So I wanted to follow up on the topic of ECR deposits. And just to confirm, are you expecting that composition of the DDA-based ECR deposits, are you expecting that to march higher over the course of next year?

I believe that acquiring DDA funds in the current high-rate environment is quite difficult. The increase in DDA during the third quarter was primarily due to mortgage warehouse activities. We did see some success with straight, flat DDA in the regions during the quarter as well. However, I anticipate that most of our deposits will be in interest-bearing checking or money market accounts.

Okay. Got it. Makes sense. And then I wanted to talk about the shift from the held-for-sale loans to held for investment, and particularly the lot banking loans. Could you walk us through the original thought process of designating those held for sale and then elaborate more on the decision of bringing those back as held for investment?

Yes. Let me take that. So this was a liquidity decision, right? So in Q2, we grew our total deposits by about $3.5 billion here. This quarter, we grew a little over $3.2 billion. I also want to emphasize, we paid down broker deposits by $441 million. So otherwise, we would have grown by $3.7 billion. And back from Q1, we put some loans into HFS in order to be ready to create additional pools of liquidity, which aren't needed. And so we moved these loans from HFS back into HFI. And regarding your lot banking question that you alluded to there. Generally, our lot banking programs are all on schedule with the builders. And really, the builders cannot afford to lose any of this inventory and lose control of their for-sale demand. So again, this is a segment of loans category that we like a great deal and has a very good risk/reward attribute to it. And we've never, since we've been doing it here at the bank, suffered a loss on that.

Got it. That's all I had. Thanks for taking my questions.

Thank you. Our next question is from Ebrahim Poonawala of Bank of America. Ebrahim, your line is open. Please go ahead.

Hi, good morning. Just maybe, Dale, when you think about the $2 billion per quarter deposit outlook for next year per quarter, just talk to us about the source of that deposit growth, where that's coming at and what is your assumption around the rate at which these deposits are coming on? Is it meaningfully below so far? Just some color around how we should think about that and just how that's probably going to impact your NII, NIM outlook until rates get cut. Thanks.

I'll take the first half of that and pass it over to Dale for the second half. Concerning the sources of deposit strength, next year we expect to see contributions from some of our traditional lines. The HOA is projected to perform well, and warehouse lending and note financing typically show strong results year after year. A key factor will be developments in the mortgage industry, which could lead to either an acceleration or a significant pullback, resulting in more deposit growth. Additionally, we anticipate that several of our newer business lines will contribute more significantly than they have in the past, including our settlement service business, business escrow services, and Corporate Trust business. These areas should grow at a rate above historical averages. Furthermore, it's worth noting that the regions have shown solid growth for two consecutive quarters. We appreciate this growth being more granular rather than large and sporadic, as seen in other parts of our business. Finally, we have achieved remarkable success with our consumer digital platform, exceeding our initial forecasts, and we expect this trend to continue throughout 2024.

The majority of the pricing we are seeing for new business falls between the low threes and the low fives, which includes areas like mortgage warehouse and other channels we discussed. I believe we will find ourselves in the middle range. We calculated a weighted average for the quarters, and I think that will serve as a good target for 2024.

Got it. That's helpful. And maybe, Dale, sorry if I missed it, just in terms of your outlook given the mortgage rates are 8%, how are you thinking about what origination gain on sale fees could look like in the absence of any rate release?

Yes. Thanks. I'll take that one. As we look forward, Q3 to Q4, mortgage servicing income should be sustained quarter-to-quarter, maybe even a slight growth as our MSR balances grow. In Q4, you generally have a seasonal fall with—that happens. I think it may be a little more acute at the higher rates that we see here presently.

Got it. Thank you.

Thank you. Our next question comes from Matthew Clark of Piper Sandler. Matthew, your line is open. Please go ahead.

Thank you. Just a few questions around credit or maybe one or two here. Just the reduction in special mention nonaccruals, can you speak to how these credits were resolved? Did most of them mature? Or did you push them out of the bank? Just trying to get a sense for the workout process.

Sure. Tim Bruckner again. So I'm going to take the nonaccrual nonperforming first. About half of the improvement in that area is pay out or pay down, okay? The other half of the upgrade to performing categories. With regard to special mention, we base our credit culture on early elevation. And so we use that category very much as a transitional category. So as we signaled on the prior calls, we completed a deep portfolio review; we move assets into that category, and then we press for speedy resolution. So with respect to the movements in and out, those are dictated then by our strategy, which generally involves required re-margin in this environment.

Okay. And then the other one for me around expenses. Can you speak to the investments you may still need to make to become or be considered a $100-plus billion bank, assuming you get treated like one beforehand by the regulators?

Yes. I think the second part of that question is right on, which is most banks in our size category will start to be treated like a $100 billion bank well before you get there, and you've got to build that framework in advance. And that framework is—begins to look and feel a little more sophisticated around capital stress testing, around liquidity stress testing, and the framework that kind of evolves around that. As we get bigger, we'll have to make more investments into reporting that the larger banks over $100 billion will have to do. But we believe that starting it early and kind of building it into the run rate because then there's going to be costs that you're going to have to have to continue with the—not only the development but the reporting and the management and the monitoring. We're trying to build it in now and kind of build out towards that.

Okay. Thanks, Ken.

Our next question comes from Gary Tenner of D.A. Davidson. Gary, your line is open. Please go ahead.

Thanks. Good morning. A couple of questions. In terms of the ECR deposits, can you give us the average for that in the quarter versus the 17.1 quarter-end?

We'll get back to you on that one.

Okay. Thank you. And then in terms of your kind of 2024 expenses and kind of marginal growth, is that inclusive of the FDIC special assessment kicking in the first quarter? Or should we think about it as sitting on top of core growth?

Especially with that, we're considering the special assessment, which it hasn't been defined yet in terms of exactly how it's going to come out. I mean, I think that it could be revised. Yes, we're—that excludes that. We think that's just really kind of below the line, and I think that's how the Street will treat it.

Okay. And then last question. In terms of—Ken, when you're rolling through the fourth-quarter outlook, and you mentioned net charge-offs. If I heard you correctly, you kind of also suggested net charge-offs through the economic cycle in the 5 basis point to 15 basis point range beyond just the fourth quarter. Did I hear that correctly?

Yes. That's correct.

All right. Thank you.

Our next question comes from Andrew Terrell of Stephens. Andrew, your line is open. Please proceed.

Thanks. Good morning. Just one quick one for me. I wanted to ask on Page 11 of the presentation, the earnings at risk disclosure that you provide. In the down 100 scenario, the up 2.2% for earnings there, can you talk about just your comfort level with that level? Is that where you would like the company to holistically be at? Or any changes you'd like to make to that position? And then can you also talk about what the underlying mortgage assumptions are in the down 100 scenario from a gain on sale margin and volume perspective?

They are not significantly different. We believe margins would improve. If you look at what happened as we entered the pandemic, margins essentially tripled during that time. We feel confident about managing the decline, and while we are a bit more constrained on net interest income, we are performing better in terms of expenses related to the ECR and AmeriHome revenue. A 100 basis point drop isn't likely to significantly boost refinancing activity. However, we believe it could positively impact purchase volume. If there were a 200 basis point decline, we anticipate that could create opportunities for a substantial amount of refinancing that took place over the past year, as well as increased refinancing activity on a cash-out basis for those moving from 4% to 6%, instead of reaching the mid to upper 7s.

Okay. Thanks for taking the question.

Thank you. Our next question comes from Timur Braziler of Wells Fargo. Timur, your line is open. Please go ahead.

Hi. Good morning. One more on ECR for me. I guess as you look at fourth quarter specifically, how much of that DDA growth is expected to stick around? And then should we see a commensurate reduction in ECR during the fourth quarter if DDA balances do go down?

Yes, you should see that the volatility in deposits in the fourth quarter relates to the mortgage warehouse business, which accounts for most of the ECR credits. As that volume decreases, you can expect a corresponding decline in the ECRs in the operating expense line.

Okay. And I guess, just given the seasonality in the warehouse business, how likely is it that, that $1.3 billion of DDA growth that's on third quarter, how much of that actually rolls off with that seasonality next quarter?

I think there are two things going on. So the growth that we had in the third quarter was a baseline improvement, which I think that has life, the same power. The decline we're going to see in the fourth quarter is from taxes and insurance, escrow funds explicitly. So while that will come down in the fourth quarter, we expect to retain the higher deposit levels kind of moving forward into 2024. So we should see a more pronounced rebound coming into Q1 than the decline that we see in Q4.

Okay. Got it. And then lastly, for me, just on the mention of HQLA and tying that back into the $100 billion threshold. I know you've been growing HQLA now for a couple of quarters. But is any of that build in relation to that $100 billion threshold? And I guess, what's the remixing of the bond book look like with additional HQLA purchases and how punitive might that be in this rate environment?

I believe there's a connection here, and we might see a gradual increase in high-quality liquid assets targeting the $100 billion mark over time, which we're not quite at yet. Additionally, as we reduce the loan-to-deposit ratio, those funds will shift towards investments with better liquidity, as we've discussed. I want to clarify that this isn't a major changing factor; it will be a steady progression towards higher levels of high-quality liquid assets in the coming years.

Great. Thank you for the questions.

Our next question comes from David Chiaverini of Wedbush Securities. David, your line is open. Please go ahead.

Hi. Thanks. I had a follow-up on the rate sensitivity. So in an environment where the Fed does pivot and we see 100 basis points of rate cuts, I see NII down 4%. But clearly, on the ECR side, we should see some cuts there as well or declines there. How should we think about the PPNR impact of 100 basis point cut in rates?

Well, if you go to PPNR, that's really going to be your earnings at risk. So you're going to see with lower levels of expenses as you'd identify, but you're also going to see higher levels of revenue from AmeriHome mortgage operation. And so on an EAR basis, this really is worth really talking about a kind of a PPNR kind of framework, and that would pick up.

Got it. Can you discuss the health of your borrowers and their ability to withstand higher rates as the roughly $2.5 billion of quarterly CRE maturities occur next year and the loans reprice?

All right, sure. So first, I think that discussion was in the context of the investment.

Well, it was $2.4 billion, but it was total loans.

Yes, total loans, not just CRE. So our CRE is entirely floating rate, one, I think that's important. And is entirely for the not central business district. So when we underwrite an office, we underwrite suburban office. And so we've already dealt with the role, so to speak, because the interest rates have already come up, and we've already made the grading decisions, and then we've already executed our strategy. And at this point, over 75% of that portfolio, we've either affirmed the structure that exists or we restructured and re-margin in the present environment.

Great. Thanks very much.

Our next question comes from David Smith of Autonomous. David, your line is open. Please proceed.

Thank you. So within the deposit outlook for the fourth quarter, can you give us some more details on what's embedded about the mortgage warehouse decline? If we take the regional deposit growth of $1.5 billion and $0.8 billion digital consumer this past quarter, that would imply something like a $2 billion reduction or so in mortgage warehouse. Does that sound reasonable?

Yes, that sounds very reasonable. So that's what's going to happen in the mortgage warehouse. And then you would have the digital consumer platform, the regions and some of the specialty lines picking up that flat to kind of get us back to even. Just so I'll say this as kind of a point. We made a strategic change with our warehouse lending business over the last year or so, where we used to have more P&I accounts, which saw a lot more volatility month-to-month. We moved more to tax and insurance accounts, right? Same clients, different liquidity deposits. And so you don't see the big swings month-to-month, but you do get them towards the middle of the year and towards the end of the year when they drop down and then have to built up. So as these balances build up, they'll build up starting on December 1 thereabouts this year, and they'll build up for the next six months going out into 2024. So this should have a little more stability. That's just a change that we made here.

And given how much of the ECR balances are in mortgage warehouse, is it possible that we could see deposit costs down quarter-on-quarter in the fourth quarter? Or is that going to happen too late in the quarter?

No. I think you can see it down in Q4. Absolutely.

Considering the NIM guidance of 3.6% to 3.7% compared to 3.67% in the third quarter, there are positive factors such as the repricing of fixed loans and some additional borrowing pay down. It appears there are more positive factors at play. I would like to know if you could identify some of the negative factors that might prevent it from rising above 3.7%.

Yes. So you also saw that we had an increase in our cash position at quarter-end relative to the last quarter and the average balance for the quarter. And so that is going to consume some of that otherwise opportunity to have a higher yield, higher spread.

And lastly, on capital. Are you saying you think CET1 ratio could decline in absolute terms as you step up loan growth in the second half next year? Or it'll just continue to grow more slowly?

We don't expect a decline. The target is 11%, and we will aim to exceed that target. We anticipate growth at a slower pace once we surpass 11%.

Are there any more inorganic levers you can pull here after like the CLN repayments? Or is it basically going to be a function of earnings and asset growth from here?

It's going to be a function of earnings and continuing to watch our risk-weighted assets and making sure we optimize that quarter-to-quarter.

All right. Thank you.

Thank you. Our final question comes from Brody Preston of UBS. Brody, your line is open. Please go ahead.

Hi, everyone. How are you.

Good.

I want to just follow-up to make sure I was following the warehouse commentary correctly and just kind of piece it together from last quarter. So I think you were up $3 billion in July during the last conference call, and it looks like you ended up $1.6 billion for this quarter. And so it came down at the end of the quarter, and then we're expecting another $2 billion of potential runoff from there in the fourth quarter just on a seasonal and a low point. Am I following that math correctly, Dale?

So what Ken was alluding to earlier, what we have, there's the escrow funds from a mortgage warehouse client are bifurcated into two pieces. One is tax as an insurance; that's the one that we think is more attractive because it's a little more stable profile. And the other was principal and interest. Well, principal and interest is on a monthly cycle. But funds build up and then somewhere around the 20, 24th of the month, they get spun out to the government-sponsored enterprises. The other one is build up for six months, some even longer than that. And then they're paid to the taxing authority. So the preponderance of our portfolio comes from California. And so California taxes, I think, they're due in like November or something like this. And so you're going to see that come down. So what you saw earlier was really just normal cyclical behavior. And so in, say, in the middle of the month, you're going to have a higher number in principal and interest that then comes back out. So even though that number came down from where it was maybe in mid-July to the end of September, the actual balance trend is actually still positive, growing during that particular time. We're just hitting a high point on the monthly sine wave that we get on P&I payments. So that trend looks strong because of the balance from quarter end to quarter end looks good. What we're saying is the balance from quarter end to quarter end for the fourth quarter is going to be down, not because of P&I, which looks good, but because of T&I and not because of client impairment, just simply because that's the cycle in terms of how those funds are distributed.

Got it. Okay. I appreciate the clarification. And then I wanted to just ask on the spot loan yields. I think if I remember in the slide correctly, it was 6.99% on the spot rate for the yield, which I guess I wanted to relate that to the residential portfolio to kind of get towards that spot yield. It implies that you have to get more expansion in that residential yield. And so how should we be thinking about residential loan yields going forward?

I believe residential loans will not see much movement. Currently, the CPRs on these loans are at 5%, which is among the lowest levels ever recorded. This indicates that they are gradually reducing. That said, it's important to note that we have about $2.4 billion in loans that are repricing every quarter, which could change things. A small portion of that will involve residential loans, but the majority will not. For those residential loans coming in, the rates are essentially starting around 8%, and they appear to be aligned with SOFR today at 3 to 3.5%. As these loans run off, they are being replaced with significantly higher rates. Additionally, even variable rate loans are being substituted at higher spreads due to economic uncertainty and tighter conditions. Did you hear Dale's response, Brody?

Yes. It just cut out there for a minute. I guess, that makes sense. It's just that the loan yields jumped up a bit this quarter on the resi book, and that kind of caught me by surprise.

Well, we did some modest dispositions of residential loan.

Our final question today comes from Jon Arfstrom of RBC Capital Markets. Jon, your line is open. Please go ahead.

Thanks. We're going to get out of the weeds here for a second. Are you signaling flat EPS for the fourth quarter? Just when I look at the guidance on Slide 19, is that what you're signaling?

Yes. So we're signaling flat PPNR with some sensitivity to the gain on sale on the mortgage business, depending on the backup on rates that you're seeing here. That's what we're signaling.

Okay. Okay. So that's difficult for us to model, but you're saying PPNR, excluding that, it's going to be relatively stable.

Yes. I think that's a fair answer. Yes.

Yes. Okay. Okay. And then what's your level of confidence in loan growth returning in early 2024? Dale mentioned your organic loan growth has slowed, but what's your level of confidence in getting that greater than $500 million a quarter back in the run rate?

Yes. If you're talking about getting it back, say, starting in Q3 or towards the end of Q2, I'm confident about that, yes. We have enough channels, Jon, to bring in that loan growth. I will say subject to macroeconomic events, right, subject to the economy and what we see. So it's not loan growth for loan growth's sake. It's if we don't like the credit, we're not lending against it. But everything being equal, we have a high degree of confidence in this company to grow loans in excess of $500 million, and loan growth will follow the deposit growth that we've laid out.

Right. Okay. How about as you look to 2024? I mean it seems like you have a couple of quarters left, maybe one or two left, to do what you need to do on funding. I'm assuming that means that the margin starts—especially if the Fed is done, I'm assuming that means the margin starts to lift in early 2024, which means PPNR also starts to lift in early 2024. Is that—am I looking at that the right way?

So for us, we've got a rate increase in December, which will carry into the first two quarters of 2024. At the end of the second quarter, we have three rate decreases modeled in there to the back end of the year. So you've got to keep that in mind. But as we think about 2024, as I said, with deposits following the $2 billion guide and loans growing at a moderate pace, which is that $500 million, we see sort of the dexterity and agility of the national business line framework and the regional growth gives us confidence in that balance sheet construction going forward. So that's sort of what we're seeing along with stable asset quality as we go into 2024.

Yes, I'm just—I'm looking at the $8 consensus number. And it feels to me like it's good. It puts you at 5 times earnings, but your stock is down 8%. And I'm just curious if I'm missing anything when I think through your kind of medium-term to longer-term outlook.

I'm also surprised that the stock was down 8%. We were very pleased with this quarter. And relative to other banks that have reported, I thought we did fairly well. And we're not ready to give full 2024 guidance, but I think you can take what we said directionally correct and model from there.

All right. Eight bucks from me, anyway. All right. Thank you. See you in November.

Okay. Thanks, Jon.

Ladies and gentlemen, this is all the time we have questions for. So I hand back over to Ken Vecchione of the team for any closing remarks.

Thank you all for your questions and your participation. And we look forward to the Q4 earnings call. Thanks again.

Ladies and gentlemen, this concludes today's call. Thanks for joining. You may now disconnect your line.