Earnings Call Transcript - WAL Q4 2021

Operator, Operator

Good day, everyone. Welcome to Western Alliance Bancorp's Fourth Quarter 2021 Earnings Call. All lines have been placed on mute to prevent any background noise. You may also view the presentation today via webcast through the company's website at www.westernalliancebancorporation.com. I would now like to turn the call over to Miles Pondelik, Director of Investor Relations and Corporate Development. Please go ahead.

Miles Pondelik, Director of Investor Relations and Corporate Development

Thank you. And welcome to Western Alliance Bank's Fourth Quarter 2021 Conference Call. Our speakers today are Ken Vecchione, President and Chief Executive Officer; and Dale Gibbons, Chief Financial Officer. 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.

Ken Vecchione, President and Chief Executive Officer

Okay. Good afternoon, everyone. 2021 was a watershed year for Western Alliance as we drove many of our own records for balance sheet growth, total net revenue, and earnings while thoughtfully expanding into new business lines and geographies that will make us an even stronger, more diversified bank. For the year, total assets ended just shy of $56 billion, with loans growing 44% over year to $39.1 billion and deposits rising 49% to $47.6 billion. This strong balance sheet momentum propelled record net revenues of $2 billion, net income of $899 million and EPS of $8.67, which is our 12th consecutive year of rising earnings. Turning to the fourth quarter results. WAL earned total net revenues of $561 million, net income of $246 million, and EPS of $2.32. The strong balance sheet expansion continued with quarterly loan growth of $4.3 billion or 49% on a linked quarter annualized basis. And deposits rose by $2.3 billion or 20% annualized. Loan demand continued to grow across our business lines with C&I loans increasing by $1.8 billion, inclusive of $200 million of CCC runoff along with a $1.8 billion growth in our residential portfolio and $584 million in CRE. One hallmark of our national commercial business strategy is the ability to develop niche specialty banking business and to attract qualified talent to thoughtfully scale new business lines with superior risk-adjusted returns. As an example, since joining in June, our restaurant franchise finance team had $151 million in outstanding and is a positive contributor to earnings. Similarly, our Texas-based single-family home construction CRE team has $235 million in improved commitments. Our loan pipeline and channel checks continue to show a burning of loan growth in our traditional commercial loan businesses. Attracting seasoned senior teams to WAL provides the opportunity to establish new business lines that ramp up quickly due to their existing client relationships. A $6.2 billion increase in average earning assets drove net interest income growth of $40 million or 39% annualized to $450 million as excess liquidity deployment for loans and loans held for sale contributed significantly to earnings. Fee income was $110 million, representing 20% of total net revenue, a decline of $28 million over the prior quarter, as mortgage banking-related income was impacted by seasonal fourth quarter weakness and the mortgage sectors transitioned to a rising rate environment, which comprise gain-on-sale margins. I would like to reiterate that AmeriHome is fully integrated into the strategic fabric of Western Alliance and is thoughtfully managed to maximize value for the entire bank through loans, deposits, and net interest income growth, not just gain-on-sale launch. The B2B correspondent business inside of Western Alliance has several business levers, which can be repositioned to sustain earnings throughout rate and economic cycles. Given the flexibility of AmeriHome’s business model, ongoing mortgage operations can provide multiple revenue opportunities, which serve to offset lower gain-on-sale recognition. Western Alliance's branch-like flexible business model provides us a competitive advantage to leverage operating efficiencies to enhance financial results while investing in business initiatives to drive future growth. Quarterly adjusted non-interest expenses grew $4 million to $235 million, producing an efficiency ratio of 41.3%. To put this in perspective, over the last 5 years, total loans and deposits have grown 2.5 times the rate of operating, excluding AmeriHome. Productivity improvements provide us with the capability to absorb higher labor costs while continuing to fund products and technology investments. Total adversely graded assets were flat, and quarterly net loan charge-offs were just 2 basis points. Western Alliance is one of the most profitable banks in the industry with a return on average assets and return on average tangible common equity of 1.65% and 25.8%, respectively, which will continue to support capital accumulation and strong capital levels. Finally, what excites me most are the differentiated technology and banking services that Western Alliance is increasingly delivering to our clients to solve unique pain points and facilitate transactions. We recently announced a partnership with Tassat Group to deliver blockchain-based payments to our clients using their TassatPay platform. The launch of this program scheduled for early second quarter will allow Western Alliance Bank clients to transfer funds continuously to one another 24/7. Additionally, yesterday, we announced the acquisition of Digital Disbursements, a leading digital payment platform for the class action legal industry that integrates legal settlement claim processes with a multi-product payment portal. This differentiated technology solution enhances the capabilities of Western Alliance's settlement services team and solidifies the bank as an initial leader in the $15 billion legal class action model. Our national settlement services business developed in 2019 and launched in 2020, has been described on previous earnings calls as deposit initiative 1. This business has successfully generated $2.3 billion in deposits as of year-end. And we are thrilled to welcome the new team from Digital Disbursements to help the bank continue to produce unique value-added solutions to the legal service sector. Dale will now take you through our financial performance.

Dale Gibbons, Chief Financial Officer

Thank you, Ken. For the quarter, Western Alliance generated adjusted net income to common shareholders of $242.5 million and earnings per share of $2.32. Pre-provision net revenue was $326 million. Total revenue grew $12 million during the quarter to $561 million, and net interest income grew $40 million during the quarter to $450 million, an increase of 10% primarily as a result of significant balance sheet growth and deployment of liquidity into higher-yielding assets. Average interest-earning assets increased $6.2 billion while the lower yielding cash position held for sale fell to 2.3% and 3.9% of interest-earning assets. Although not annotated on this page, I want to address the characterization of 2 items in non-interest income. Regarding the $8 million of securities gains we reported in the second quarter of 2020, we purchased over $100 million of term municipal bonds that were in sectors hard hit by the pandemic, most notably airports. In the fourth quarter, we sold those bonds as they had a recovery in value, and the velocity of rate expectations changed. I know securities gains are often excluded from core analysis, but this seems more like a trading gain to us. Regarding the $7 million credit guarantee revenue. During the quarter, we sold a credit-linked note in which the buyer of the note assumes a first loss position of the $4.5 billion residential portfolio. This $7 million in revenue is the currently expected credit losses avoided by selling these bonds. I had CECL antipathy since before it was born. I don't think it's remotely helpful to investors in understanding bank financials, and it certainly doesn't improve comparability. But I don't know anyone who is taking CECL-based credit provisions and excluding them from core, which is the same principle here. It doesn't make sense to us that if we increase residential loans in both a day one cumulative loss expectation charge and the next day, we sell a credit linked note to put that exact same loss expectation to another party that we should be stuck with a debit in core income we forfeit the insurance credit for determining earning power. Overall, non-interest income decreased $28 million to $110 million from the prior quarter driven primarily by industry-wide gain-on-sale margin compression. As Ken noted, in anticipation of margin compression, we are implementing several initiatives to bridge the gain-on-sale earnings slowdown with predictable and stable net interest income revenue streams. Non-interest expense, excluding merger and restructuring recoveries and loss on extinguishment of debt, increased to modest 1.6% or $4 million, resulting in an efficiency ratio of 41.3. For the year, Western Alliance recorded net income of $899 million or $8.67 per share, a 72% increase over EPS for 2020. Net interest income grew $382 million during the year to $1.5 billion, an increase of 33% year-over-year mainly attributable to increased loan balances and PPP loan fees. Non-interest income increased $333 million to $404 million in the prior year as the AmeriHome transaction closed early in the second quarter and contributed significantly to fee revenue. Finally, non-interest expense increased $360 million or 73% year-over-year as 950 AmeriHome employees joined WAL in the second quarter. Turning now to our net interest drivers. Investment yields increased 5 basis points from the prior quarter to 2.51%. While on a linked quarter basis, loan yields declined 25 basis points following continued strong growth in loans and no loss assets such as residential loans and capital call loans and modest yield compression across other loan categories. We continue to optimize the deployment of excess liquidity into higher-yielding assets and allocated cash yielding 10 basis points as the Fed loans held for sale yielding 3.04%. Funding costs were slightly lower from the prior quarter due to the redemption of $175 million subordinated debt with increased interest-bearing deposit costs of 20 basis points and total cost of funds at 29. The spot rate for total deposits, which includes non-interest-bearing, was 11 basis points. We expect funding costs to bottom at these levels as rate hikes are forthcoming. Overall, net interest income grew $40 million to $450 million during the quarter or 43% year-over-year as average interest-earning assets increased $6.2 billion or 13% during the quarter. The prudent deployment continues, and cash balances were optimized with cash as a portion of average earning assets of 2.3%, a decline from 3.9% in the prior quarter, resulting in a loan-to-deposit ratio of 82%, an improvement from 77% prior. The net interest margin increased 10 basis points to 3.33% mainly driven by lower yields on our commercial real estate portfolio and strong growth in low loss but lower yielding residential loans and capital call lines. With regards to our asset sensitivity, our rate risk profile has been reduced over the last 2 years as we've added fixed-rate residential mortgages, and the yield on the majority of our available rate commercial loans have bottomed out at their contractual floors. We are poised to recognize significant increases in net interest income in a rising rate environment once these floors are no longer inhibiting loan yield escalation and with ongoing balance sheet growth. Consequently, this asset sensitivity is more muted initially but accelerates as interest rates normalize. Currently, $16 billion or 94% of our variable rate loans with floors are after contractual forwards. With a 25 basis point rise in rates, 25% of these loans will rise off the floors. And with a 100 basis point rise in rates, 75% cumulatively will return to variable rate. In a rate shock scenario of plus 100 basis points on a static balance sheet, net interest income will rise $73 million or 4.6%. Using a ramp scenario on a dynamic balance sheet, we expect net interest income to increase $62 million in the next 12 months after quarterly rate increases are initiated. And given the pandemic, the dynamics of our loan floors, $257 million increase over a 2-year time frame if only 4 rate hikes are accomplished through 2023. In a rising rate environment, other areas of Western Alliance income statement may also be influenced. Mortgage sector volumes and profitability are expected to be reduced with lower refinance volumes, partially offset by increased servicing revenue at the life of the mortgage servicing rights are extended. These factors may be partially mitigated as we expect deposit betas and earnings credits on $10.8 billion of deposits to be lower than in the previous rising rate periods and to have longer lag times, but could give back collectively about half of the potential net interest income improvement for our interest rate sensitivity. AmeriHome is now fully integrated into WAL. And gain-on-sale volume and margin contraction can be minimized by accelerating loan, deposit, EPO, and product channel diversification. None of which are available to stand-alone mortgage operators but are available within a bank-owned company. We expect net interest income sourced through AmeriHome relationships to rise throughout the year, countering reductions in traditional mortgage banking income and growing total revenue and NAV. Our efficiency ratio improved modestly to 41.3% from 41.5% in Q3 as our net revenue growth exceeded that of our expense growth. One of the key characteristics of our national business line approaches is high operating leverage. As mentioned in our prior calls, we expect the efficiency ratio to remain in the lower-40s for the year, inclusive of planned technology investments, new product development expenses, and the absorption of higher compensation costs supporting rising rates and deposit account relationships. Pre-provision net revenue increased $9 million or 2.8% from the prior quarter and 58% from the same period last year. This resulted in PPNR ROA of 2.24 for the quarter, a decrease of 21 basis points compared to 2.45 primarily driven by balance sheet growth outpacing PPNR increases. This continued strong performance in leading capital generation provides us with significant flexibility to fund ongoing balance sheet growth, manage capital actions, and meet credit demand. Robust balance sheet momentum continued during the quarter as loans held for investment increased $4.3 billion or 12% to $39 billion, deposit growth of $2.3 billion, and our balance is $47.6 billion at year-end. On a quarterly average basis, loans held for investment grew 16% in deposits. In all, total assets grew 53% year-over-year. Total borrowings increased $330 million over the prior quarter to $2.4 billion primarily due to an increase in overnight borrowings of $275 million and the issuance of $228 million in credit-linked notes, partially offset by the redemption of $175 million in subordinated debt. Finally, TBV per share increased $3.17 over the prior quarter to $37.84. That is up 22% year-over-year. We continue to generate consistent organic loan growth from our flexible national business banking strategy, and are seeing broad-based demand. Loans held for investment grew $4.3 billion in the quarter. Quarterly loan growth was split almost evenly by an increase in residential real estate loans of $1.8 billion, which now comprise 24% of loans, and $1.8 billion also in C&I loans as demand for capital call lines and mortgage warehouse lines remained strong. And we saw an acceleration of demand for broader business managing nationwide, including early success in our new restaurant franchise finance team, CRE loans grew $534 million predominantly as a result of demand in our hotel franchise finance that bounced back as we expand relationships with proven clients and sponsors, while also obtaining tighter underwriting. Additionally, construction and land loans added $79 million. Turning to deposits. We continue to see broad-based core deposit growth across our business channels. Deposits grew $2.3 billion or 20% annualized in the fourth quarter driven by increases in interest-bearing DDA of $2 billion, non-interest-bearing DDA of $295 million and CDs of $226 million, partially offset by a reduction in savings and money market funds of $162 million. Robust fundraising activity and tech innovation, coupled with market share expansion of HOA banking relationships contributed significantly to quarterly deposit growth. We also saw strong performance in regional commercial products. To highlight one of our growing national deposit businesses, business escrow services previously called deposit initiative 2 provides escrow payments and administrative services for M&A transactions. This initiative launched in 2021 with a new senior leader and has recruited a highly effective team and has established offices in New York City and Minneapolis. The team has formed strong relationships with serial acquirers and successfully facilitated over 100 acquisitions, which quadrupled our deposit balances in the fourth quarter in this business line to $600 million. We now have established ourselves as a formidable market competitor in the space. Our asset quality remained stable after the significant improvement seen in the prior quarter. Total classified assets rose $36 million in Q4, reaching $301 million or 54 basis points of total assets. Special mention loans declined $33 million during the quarter to 0.85% of funded loans, greater than a 30% reduction from the prior level seen in September 2020. Total classified assets and special mention loans as a percentage of total assets and funded loans are now lower than in 2019. Quarterly net credit losses were $1.4 million or 2 basis points of average loans compared to $3 million in Q3. Our total loan ACL increased $11 million from the prior quarter to $290 million due to significant loan growth in low loss segments. In all, total loan ACL and funded loans declined 6 basis points to 74 basis points. Adjusting for the $1.8 billion of mortgage warehouse lines and $4.6 billion of residential loans covered by the credit-linked notes, we are ample with first loss coverage as assumed by a third party. The ACL ratio is 89 basis points. Finally, given our industry-leading return on equity and assets, we continue to generate significant capital to fund organic growth and maintain healthy regulatory capital ratios. Our tangible common equity to total assets of 7.3% and common equity Tier 1 of 9.1% were both bolstered by net income and the common stock offering under the ATM but were impacted this quarter by higher asset growth. Inclusive of our quarterly cash dividend payment of $0.35, our TBV per share increased to $3.17 to $37.84. I'll now hand the call back over to Ken to conclude with closing comments.

Ken Vecchione, President and Chief Executive Officer

Thanks, Dale. 2021 really was an exceptional year from an earnings and loan growth perspective as our distinctive national business strategy model continues to hit on all cylinders, and our new initiatives are already paying for themselves. We are very excited about the diverse set of growth opportunities in front of us as we enter 2022. Looking forward for the full year 2022, we expect loans held for investments to grow in excess of $2 billion per quarter from prior guidance of $1.5 billion to $2 billion, or low to mid-20% growth rate for the year, with a flexible origination mix designed to maximize net interest income. Residential loan purchases will remain strong, but the relative contribution to growth will be driven by liquidity so as not to crowd out core commercial lending opportunities. Deposits will grow in line with loans as we continue normalizing the loan-to-deposit ratio, which today stands at 82%. The efficiency ratio for the year will remain in the lower 40% range as we continue to invest in risk management and technology as well as build out our teams to respond to growth opportunities we see in front of us. We believe that net interest margin declines have abated and expect net interest margin to rise in concert with the FOMC actions. Stable and rising NIM, coupled with strong balance sheet growth, will drive net interest income higher. Regarding capital, our strong organic capital generation continues to support balance sheet growth. However, quarter-to-quarter variability around this growth may require incremental capital actions to maintain a baseline CET1 ratio of 9%, including sales of credit-linked notes and common stock issuances from time to time. To facilitate this, we expect to add 2 million shares to our ATM capacity. In conclusion, we continue to see a strong pipeline and have the operating flexibility to both execute on near-term opportunities while investing for long-term growth. We believe the current full year consensus guide is the floor for 2022 but should tilt more to quarters 3 to 4 to reflect the seasonal and cyclical nature of our business lines and AmeriHome's reposition. Finally, one last note regarding Robert Sarver, our Executive Chairman. Our independent directors are actively engaged in monitoring the allegations being investigated by the NBA. The independent directors have hired an independent outside law firm to advise the independent directors on this matter and assist them in conducting an investigation to evaluate Robert's continued leadership role at the company. The investigation is being directed and overseen by the independent directors and to be clear, is not the result of any allegations related to the company discovered by the Board or the NBA. In addition, Western Alliance has and will continue to assist the NBA in an ongoing investigation as requested. At this time, Dale and Tim Bruckner, who is in the room, our Chief Credit Officer, and I are happy to take your questions.

Operator, Operator

Thank you. Our first question comes from the line of Casey Haire with Jefferies.

Casey Haire, Analyst

Yeah, thanks. Good morning, guys. Question on the balance sheet growth guide, specifically the deposits. I mean, I think we all appreciate that the loan generation is pretty strong. And you guys are capable of doing more than that $2 billion. And to the extent that you guys do, it sounds like you want to keep the loan-to-deposit ratio in the low-80s. Can you match that loan growth on the deposit side, which will obviously be a little bit harder in a rising rate environment?

Ken Vecchione, President and Chief Executive Officer

The answer is yes, okay? That's why we made the loan and deposits just dollars growing the same amount. But our pipelines look very strong. And I just want to reinforce that the $2 billion loan guidance floor and the $2 billion of deposit guidance floor are really at the low-end as before. Our pipelines are very strong, and our deposit pipelines are looking at the moment for the first quarter closer to double the floor map. So we think we're off to a very good start, and we think deposits will be strong throughout the year. And we're very excited about what we're seeing in the marketplace.

Dale Gibbons, Chief Financial Officer

Casey, regarding your comment about keeping our loan-to-deposit ratio in the low-80s. So we look at held-for-sale loans as not really an alternative to the loan growth. That's an alternative cash for us. It's just a much better yielding one. And for the most part, they already have a great risk-adjusted capital ratio on them because you're putting those loans to a GSE. And so instead of keeping money at the Fed or some other bank, putting it into these short term basically puts that we have to the GSEs on these mortgages is a much better deal. But that's where the substitution is. So I would look for our loan-to-deposit ratio to continue to climb through the 80s, getting back into more like the lower 90s.

Ken Vecchione, President and Chief Executive Officer

I want to emphasize that our held-for-sale assets are generating a 3% yield, which is comparable to a short-term money market asset backed by the government. We are pleased with that approach.

Casey Haire, Analyst

Okay. Very good. Understood. Regarding the deposit growth pipeline, how much do you anticipate will come from the recently announced Tassat partnership? I'm trying to understand how much this could serve as a significant deposit generator, similar to what we've seen at other banks. What kind of forecast are you anticipating for 2022?

Ken Vecchione, President and Chief Executive Officer

Fair question. Right now, we haven't baked in anything. So when we discussed or said that the floor is $2 billion, but I think we'll be more likely to double that for Q1. Much of that incremental growth is coming from our efforts at AmeriHome to drive a higher deposit growth into the company. So both the Digital Disbursements announcement today and the blockchain announcement connected to Tassat, we have not put any numbers, any deposit numbers into our forecast this year. We are very hopeful and we expect for those programs to generate greater deposits. But at this time, our first goal is let's get that blockchain program with Tassat launched in early second quarter. And once we see the reception, we can then determine how to give you some guidance on future deposit growth. I should say both of those programs, the national business line strategy settlement services and also business escrow services, they both report to Dale. So do you want to add anything to that, Dale?

Dale Gibbons, Chief Financial Officer

No. That's absolutely correct. I mean, I would tell you, we have high hopes for what can be executed here. And we've already started conversations with the authorities. But nothing is baked in to what we're talking about.

Casey Haire, Analyst

Okay. Very good. And my last question is about the gain-on-sale line. Can you provide us with updated insights on the gain-on-sale margin trend from the 28 basis points we saw in the fourth quarter? Additionally, with increased production volumes, can you experience gain-on-sale pressure? Ken.

Ken Vecchione, President and Chief Executive Officer

So one of the things that we're doing what we call either repositioning or pivoting AmeriHome is to buy and sell non-QM and jumbo loans. We started this immediately when we bought the company; we set up the program. We have 850 clients at AmeriHome. We had to go out, educate, train and then approve them to make non-QM and jumbo loans. Today, 250 clients are approved. And they're generating about $200 million a month in mortgage loans. I tell you all this because as we go through the year, we're going to be leaving the conventional market, which is seeing more compression in spread. And to the extent that Western Alliance or the commercial side of our balance sheet doesn't want any of those mortgages or it doesn't hit our risk-adjusted returns, we will then sell them off in the marketplace. And we think those margin spreads there are much higher, somewhere at 35 to 40 basis points today. So that was a long-winded answer to say as we reshift the focus inside of AmeriHome, the lower margin spreads today will grow throughout the year. And that's why I just want to bring something back to my comments at the end. That's why I said, hey, when you think about our earnings for 2022, I said, let's tilt them a little bit more to the back end as we roll out all those non-QM and jumbo programs to our 850-member client base.

Casey Haire, Analyst

Okay. So the $200 million is what you did in the fourth quarter. How big can that number grow to?

Ken Vecchione, President and Chief Executive Officer

Yeah. That's a very sizable number. And I'll just say it could be very sizable. And let us get through another quarter and start building on it. And then the numbers we give you will have a lot more confidence in, and it will give us more credibility. But we see that number building all throughout the year, especially into 2023. We're very optimistic about this. Thanks.

Operator, Operator

Your next question comes from the line of Brock Vandervliet with UBS.

Brock Vandervliet, Analyst

Thanks. Good morning. I think we should revisit the rate sensitivity. The most complex aspect was Slide 8 and its last point. Dale, could you go over that again? I believe everyone understands the basic rate sensitivity, but it's the offsets related to the mortgage businesses that seem to be confusing investors.

Dale Gibbons, Chief Financial Officer

Thank you, Brock. You're right. We experienced cyclical and seasonal challenges in the mortgage market during Q4, especially with the anticipation of rate increases. If this trend continues, we forecast that the baseline guidance Ken mentioned related to our current business mix will face further pressure as rates rise by 100 or 200 basis points, which will negatively impact non-interest revenue from that operation. It's also important to point out that while we have some deposits with earnings credit rates, their impact will likely be less significant than the potential effects from the mortgage sector. However, this does not take into account what Ken indicated regarding the shift towards non-qualified mortgages or jumbo mortgage origination and other initiatives aimed at mitigating these pressures. Additionally, we have not included expected growth in this analysis. Last year, we listed 860 mortgage warehouse clients from whom we have not yet tapped into for MSR lines, warehouse lines, or deposits. In comparison, we have just over 100 clients at the bank. We have now expanded our team to engage this group, which should enhance performance. While we expect improvements on the net interest income side, there will still be pressure on fee revenue from mortgage operations.

Brock Vandervliet, Analyst

Okay. I understand that. I just keep coming back to that last bullet point. But does the last bullet point where interest rate sensitivity says it could be dampened by half. Do we, therefore, prorate the NII impact you show on the left side or is it totally different?

Dale Gibbons, Chief Financial Officer

No, no. Maybe we should clarify here. The rate sensitivity isn't going to be reduced by half. Instead, it's about the increase in PPNR from a higher interest rate environment. For example, we're projecting $377 million over two years in an eight-quarter rising rate scenario. We're suggesting that this figure could actually be closer to $180 million or $190 million contributing to PPNR. While $377 million represents what you'll see in net interest income, there will be lower growth or slower increases in fee revenue. Therefore, this reflects a change in PPNR rather than just net interest income when considering the potential 50% reduction.

Brock Vandervliet, Analyst

Okay. And just in the resi loan yields detail here. The loan yields continue to compress 309 to 289. I would have expected those went in the other direction and lifted this quarter. And maybe that's a mix issue in terms of what you're selling versus retaining. Can you just cover that?

Dale Gibbons, Chief Financial Officer

Yeah. You're right. Our current on-the-run acquisitions now. We're in the lower 3s. And so I would think that has bottomed out.

Ebrahim Poonawala, Analyst

Hey. Good morning.

Ken Vecchione, President and Chief Executive Officer

Good morning.

Ebrahim Poonawala, Analyst

I guess just first, I wanted to follow up on the legal investigation that you flagged, Ken. One, is the expense related to the initiation of the investigation this quarter? And should we expect the legal expense line going back to where it has been just from a number standpoint? And then what management to the Board to initiate this because it feels like at least about 60 days ago, you didn't see a need for having a standalone investigation versus what the ESPN was doing. So would love to hear some color around that, how quickly can this get wrapped up so that this no longer remains an overhang on the stock?

Ken Vecchione, President and Chief Executive Officer

Let me address the expense question first. There has not been any significant impact on the legal expenses, and I do not expect it to increase in any significant way. We respond to inquiries from the NBA, but I don't foresee this investigation affecting the legal expense line substantially. Regarding your second point, I would like to clarify your assumption. The independent board members have been actively involved from the outset of the ESPN report and the NBA investigation. This is just a further step in the process, and they are fulfilling their due diligence and fiduciary duties to the company. This is simply the next phase in the overall process.

Ebrahim Poonawala, Analyst

And is there a time line by when we probably conclude all of this?

Ken Vecchione, President and Chief Executive Officer

So really, this is being handled by the independent directors and their counsel. And I'm really not in a position to comment on the scope or duration of the investigation. Sorry.

Ebrahim Poonawala, Analyst

Got it. And I guess a separate question just around rate sensitivity. I think you expect the margin to have bottomed out and move higher as the Fed moves. Dale, if you can give us a sense of understanding the rate floors. What should be the lift to the margin from the Fed hikes, if any? If you could quantify that, that will be helpful.

Dale Gibbons, Chief Financial Officer

So, out of the gate, it’s going to be fairly muted. I mentioned that we have 94% of our variable rate loans are at the floor. We’re not going to see much there. Conversely, I think there is a lot of liquidity in the industry. And I don't see where pricing pressure would come from other institutions or on a competitive basis to increase funding costs. And so it does start out fairly modestly and then climbs. So I mean it's going to be kind of single-digit millions for the first increase. And then the next number will be a multiple of that. And then it will probably double again, as we get, say, 75 to 100 basis points off of the floor. And then it's going to be more ratable based upon the overall mix of our loans that are variable rate, which is substantial.

Ebrahim Poonawala, Analyst

Got it. If I could ask one last question, Ken, you mentioned that the $9.80 EPS from consensus should be a minimum, and you expect to exceed that. What assumptions are you making regarding gain on sale income based on the forward curve's indication of rates? How significant of a decline do you anticipate in gain on sale compared to the fourth quarter levels?

Ken Vecchione, President and Chief Executive Officer

The first quarter is typically challenging, similar to the fourth quarter, so I wouldn't expect any improvement in gain on sale during Q1. However, I believe that sector will start to pick up around early spring or late winter, around March. We anticipate improvement in Q2 and Q3 moving forward. By the second half of the year, our loan mix will shift, becoming less reliant on GSE paper and more focused on non-QM loans, which contribute positively to our margins. Therefore, we expect to see improvements starting in the second quarter and continuing throughout 2022.

Ebrahim Poonawala, Analyst

Got it. Thanks for taking my questions.

Operator, Operator

Your next question comes from the line of Timur Braziler with Wells Fargo.

Timur Braziler, Analyst

Hi, good morning.

Ken Vecchione, President and Chief Executive Officer

Good morning.

Timur Braziler, Analyst

Just to circle back on the last comment on residential production. I guess is there a good way to think about it kind of the next two quarters about down AmeriHome is still primarily conforming you're going to use that time to continue building the resi both on balance sheet and then as that product switches to non-conforming in the backend of the year all that production will be sold off. And I guess when that switch occurs, will that trigger a change in your appetite for production out of AmeriHome? Or will that level still be the same, just going through the gain on sale line?

Dale Gibbons, Chief Financial Officer

I want to clarify one assumption. What we are purchasing from AmeriHome, and what AmeriHome is selling to our commercial division, consists of non-QM and jumbo loans. We are not holding the conventional loans on our balance sheet, which they acquire as part of their correspondent lending operations before selling them to the GSEs. Currently, we have an inflow from AmeriHome for non-QM and jumbo loans, and we initiated this program before acquiring AmeriHome. From our group of around 100 clients, some continue to provide us with forward flows. As AmeriHome's volume increases, we may reduce the forward flows from our existing customer base while always assessing the best return we can achieve, whether from AmeriHome or our current clients. I hope that clarifies things.

Timur Braziler, Analyst

Okay. That’s helpful. Yeah, that’s helpful. Thank you. And then maybe looking at the average levels of loans held-for-sale versus the period end balance. Is that the typical trend that those balances kind of pickup throughout the quarter and then there is more selling towards quarter end? And I guess as we head into next year, are those average balances kind of what should be as easy for our assumptions for loans held-for-sale or is there going to be a stepdown at the end of this quarter?

Dale Gibbons, Chief Financial Officer

You may have noticed that we have an AmeriHome team. Our loans tend to peak at or near month-end and particularly at quarter-end. As a result, our average balance tends to lag behind the balance at the end of the period. I refer to it as a phenomenon similar to a telephone wire, where it picks up and then drops again. To address this, we need to plan for the held-for-sale book at AmeriHome more carefully, given the limited time we have to manage it. Therefore, we've intentionally reduced our average balances compared to the ending balances. When combined, they create a more stable average. Moving forward, I believe we've reached a suitable place. We've adjusted the held-for-sale portfolios to where we want them. I don't anticipate further growth in that area, whether in ending or average bases. Now that we've increased our liquidity from the AmeriHome acquisition, we have $6 billion in cash. Our focus is now on what to add to the held-for-investment book, which is what Ken was referring to when discussing the growth of high-quality non-qualified mortgages. These mortgages have low loan-to-value ratios, typically in the mid to high 60s, with FICO scores around 760 and debt-to-income ratios in the mid-30s. We believe these will remain resilient to fluctuations in the business and residential valuation cycles.

Timur Braziler, Analyst

Okay, great. Thank you.

Operator, Operator

Your next question comes from the line of Brad Milsaps with Piper Sandler.

Brad Milsaps, Analyst

Hey. Good morning, guys.

Dale Gibbons, Chief Financial Officer

Good morning, Brad.

Brad Milsaps, Analyst

Dale, you think kind of the NBA data as the proxy. Your mortgage market share has kind of been plus or minus 2% for the past couple of quarters. I was curious if you had an idea of kind of where you might see that increasing to over the next, I don't know, 12-18 months as you guys kind of continue to take share if that's one way to think about it.

Dale Gibbons, Chief Financial Officer

Well, we have a pretty flexible model whereby we can step up on the share space to continue to take volume. So I think that's going to really depend upon what else we see kind of going on. We are sensitive to how the elastic demand and pricing is in that space. We don't want to come in so strong that we start pushing down pricing overall. But within that parameter, I think we could be taking up share to again, address the expectations that we have from AmeriHome away from what they're doing on our balance sheet.

Brad Milsaps, Analyst

And just curious, you addressed kind of the level of held for sale that's going to remain pretty stable from here. But just kind of curious, if you do hold those for longer and generate more interest income, does that impact your gain on loan sale at all? Just kind of curious if there's a bit of a trade-off there. Maybe we're not seeing it as much in fee income, but you're picking up more NII. Just kind of curious kind of how the two pieces might work together.

Dale Gibbons, Chief Financial Officer

Yeah. Let me say bingo. That's exactly what the conversation is. And we work with AmeriHome very closely to make sure that the net economics are better for the bank, whether it be just taking the loans in holding them for 3 weeks and then putting them to the GSEs, we're getting a full gain on sale that way or by having them reside and nest on our balance sheet for a longer period. So we look at it both ways. And wherever the best economics are, that drives what we do.

Brad Milsaps, Analyst

So if those loans have sort of reached nodal level and you guys continue to take share, you could actually see all else being equal to maybe the gain-on-loan sale fee income line improve a bit first quarter kind of notwithstanding due to seasonality?

Dale Gibbons, Chief Financial Officer

Correct. Yes. That's a fair comment.

Ken Vecchione, President and Chief Executive Officer

On the C&I side of things, some really nice growth this quarter. I was curious if you could just maybe offer a little more color. Is that line utilization coming back? Was some of that purchased again? Do you feel like there's some real momentum out there on the C&I side as things get back to normal and businesses rebuild inventories and things like that? Or is that kind of still to come in terms of the growth you're seeing? I would say the growth we're experiencing aligns with what we've been mentioning throughout the year. Warehouse funding has generally been strong this year, although it was a bit quieter in the fourth quarter. Subscription lines and capital call lines have continued to perform well this quarter, increasing by about $600 million. Additionally, we saw good growth in the hotel sector, which grew by approximately $380 million. Our regional lines or businesses collectively grew by over $1 billion this quarter as well. Overall, I would characterize it as a solid quarter. Regarding warehouse lending, there are three components to consider. Traditional warehouse lending remained relatively flat, but the MSR line, which is included in that total, grew by nearly $200 million. Our note financing business, also categorized under warehouse lending, grew by another $250 million. This is where we observed growth for the fourth quarter.

Brad Milsaps, Analyst

Great. Thank you.

Operator, Operator

Your next question comes from the line of Chris McGratty with KBW.

Chris McGratty, Analyst

Great. Thanks for the question. Dale, I know you mentioned the low-40s on the efficiency ratio. I'm interested kind of near term as this mortgage business gets reset a bit, maybe you can speak to some of the flexible expenses that would come out.

Dale Gibbons, Chief Financial Officer

In the first quarter, expenses tend to be tighter due to payroll taxes and certain professional fees, alongside a decrease in revenue caused by a reduction in the number of days from 92 to 90. This will affect the efficiency ratio, likely bringing it to around 43 to 44 for Q1. However, AmeriHome can adjust its processes and structure based on their specific needs and opportunities. Overall, we believe our efficiency and expense management are quite strong.

Chris McGratty, Analyst

Great. Thanks. Could you clarify what you mentioned about being comfortable with the consensus for 2022 guidance? I missed that.

Dale Gibbons, Chief Financial Officer

Yeah. So it's a floor.

Operator, Operator

Your next question comes from the line of Brandon King with Truist Securities.

Brandon King, Analyst

Hey. I wanted to touch on loan growth expectations with the guidance of $2 billion per quarter. Are you expecting a similar composition as last year Q4 for this year? And do you anticipate any changes within that composition, especially with the change in strategy with AmeriHome in the back half of the year?

Dale Gibbons, Chief Financial Officer

I think currently, and moving forward, we are seeing an expansion of credit demand across various areas of our business. This trend began during the pandemic, initially focusing on mortgage warehouse lines, residential real estate, and capital call lines. As Ken pointed out, we're now observing growth in technology, hospitality, and regional markets. I anticipate this trend will persist. On the residential side, if our deposit growth is strong, we won't tighten credit underwriting. Therefore, the increased liquidity will primarily benefit the residential segment, particularly in the non-qualified mortgage area we discussed. I expect the residential component to remain consistent with what you mentioned, likely just over 40% in Q4. A range in the 30s to 40s appears typical. If deposit growth exceeds expectations, we should see the residential segment absorb that increase.

Brandon King, Analyst

Okay. That's helpful. And then you mentioned how hotel franchise finance bounced back in the quarter. You also mentioned tighter underwriting. And I wonder if I can get any more details on the sort of underwriting standards you're applying out compared to where they were before.

Tim Bruckner, Chief Credit Officer

I think it has been beneficial over the last year to underwrite some of the best structures, partly due to a pullback in the market. We are observing very low loan-to-cost and loan-to-value advances, particularly within the flags and asset types that we prefer. This trend is evident in our target market. Additionally, we are generally underwriting with reserves that we wouldn't have considered before the pandemic. Therefore, I would describe our approach as conservative, thoughtful underwriting that is well-priced.

Ken Vecchione, President and Chief Executive Officer

When you mean reserves, you mean both operating reserves for somewhere between 6 and the 12-month period and also payment reserves for principal interest again for 6 to 12-month period.

Brandon King, Analyst

Okay. And then as far as the loan yields on the book, how have they trended since there's been sort of a reopening of the economy? Had loan yields come down some based on what they were last year?

Ken Vecchione, President and Chief Executive Officer

So in the midst of the pandemic, we were doing some underwriting still with hotel properties. And into the first part of 2021, the yields were higher there because there was less competition. And that's what we demanded to do underwriting at that time. In addition to, as Tim said, we had tighter underwriting standards. So as more people come back into the market, a number of our floors have dropped. We're still getting better pricing in that segment than we are elsewhere in our book of business. But yes, it has come down somewhat throughout 2021. Still great, very good risk-adjusted returns here.

Operator, Operator

Okay. And then lastly, I wanted to touch expenses. I just want to get a sense of what your investment priorities are for the year? And also get an understanding as far as how hiring has gone? I know talent acquisition has been tough in this inflationary environment and the quote-unquote Great Resignation. But I just wanted to get an update on the plans for the year.

Ken Vecchione, President and Chief Executive Officer

Yeah. So we had a net growth in hiring this quarter, which is good. I agree that there is a war for talent, and we're out there trying to hire as many people as we can as soon as we can. And we have, appropriately so changed compensation levels inside of the bank to retain people as well as to attract new people. What I said in my opening remarks, our efficiency ratio, our productivity improvements have been so significant that it has been able to capture the increase in the cost of new hires and retaining people. So that's question one. What was the other question?

Brandon King, Analyst

Yeah.

Ken Vecchione, President and Chief Executive Officer

Yeah. On investments, the priority starts with risk management and technology. We need to have that right given the strong growth profile and trajectory that we have. You can do some simple math and say, hey, pretty soon, these guys are going to get to $100 billion, and we need to be ready to be regulated as a $100 billion bank. You don't start that when you get there. We've started that actually last year, we started it. So that investment has been in our numbers and will continue to be in our numbers, both for risk management and technology. For new business lines, it's interesting. The new business teams that we have brought on fortunately because they're such senior seasoned bankers with great relationships. They come on and probably inside of 6 months, though on a run-rate basis those groups are paying for themselves already. So we don't have a large trend in bringing on new teams, at least we haven't yet, all right? And then in terms of stuff that we're doing organically, embedded in our low-40s efficiency ratio guide is the incremental work we're doing, for example, with Tassat to get our blockchain payment system up and running. But also included in there are new business lines that we are beginning to build or examine that we hope will help us towards the back end of 2022 and give us some momentum into 2023. So we always look at our budgets as an 8 rolling quarter process. So we can lay out what we think is the appropriate spend in year one and begin to see what's going to happen in year 2 in terms of a payback.

Brandon King, Analyst

Okay. Thank you very much.

Operator, Operator

Your next question comes from the line of Gary Tenner with D.A. Davidson.

Gary Tenner, Analyst

Thanks. Good morning. A couple of questions. First, Dale, I just want to make sure I understood kind of the mechanics or context around that credit loss note recovery. Is it simply that the additional CLNs issued in the fourth quarter reduces the exposure under the expected loss model, that's why you get that gain?

Dale Gibbons, Chief Financial Officer

We sold the credit-linked note for approximately $230 million, where the buyers of that note take the first loss on a $4.55 billion portfolio of residential mortgages. We won't incur a loss unless the losses on those loans exceed 5%, which seems extremely unlikely since we've never had a loss on these loans. Although the loans remain on our books under CECL, we have a reserve of $7 million for them in our ACL calculation. Since another party is assuming that loss, we remain responsible but can offset it by repaying the buyers of the note, minus the losses assigned to them due to their first loss position. This results in a gain of $7 million. This can all happen within the same quarter as we continue to originate residential mortgages, typically selling them to third parties. This approach reduces the risk weighting from 50% to 20%, making it more cost-effective than issuing common stock to compensate for the 30% reduction in risk-weighted assets.

Ken Vecchione, President and Chief Executive Officer

One other thing that Dale said, I would like everyone on the phone to know that we're going to be coming to market with this on a periodic basis. So you're going to see this happen again during the course of 2022, either another time or maybe at least 2 times. So this income that we're getting from it is going to find its way into the P&L.

Gary Tenner, Analyst

I have one more question. Ken, regarding your comments about the shift in production, a third of the clients approved for non-QM and jumbo are currently producing around $200 million a month. If all your clients get approved and they double that production, it could amount to $3.5 billion to $4 billion quarterly in that type of production. Is the expectation that the overall mix will adjust to around 25% of that production, while the rest remains conventional? Is that the correct way to view it?

Ken Vecchione, President and Chief Executive Officer

I appreciate your enthusiasm regarding the idea that all 850 clients are fully engaged with the program, but I don't believe that's going to be the reality. As a result, I don't expect to see $3 billion a quarter. However, by the end of 2022, I do think we can achieve around $1 billion a quarter, depending significantly on how quickly we can educate, train, and get our client base approved to roll out this product, which we believe they want. We will also analyze the dynamics closely and set internal benchmarks. Our liquidity will always influence how much we keep on our balance sheet. If we find more favorable economics in selling loans, we'll pursue that. Conversely, if it makes more sense to retain them, we'll do that as well. This flexibility highlights what we've consistently stated since acquiring AmeriHome: a mortgage company within a bank can leverage various strategies to generate income streams for the parent company that a standalone entity wouldn't be able to utilize as effectively. That's one of the appealing aspects of AmeriHome, and I hope I have addressed your question.

Gary Tenner, Analyst

Yes. Thanks, guys. Appreciate it.

Ken Vecchione, President and Chief Executive Officer

Thanks.

Operator, Operator

Your next question comes from the line of David Chiaverini with Wedbush Securities.

David Chiaverini, Analyst

Hi, thanks. I have a question about the M&A pipeline, especially regarding nonbank activities in relation to your announcement about Digital Disbursements. Can you discuss your interest in pursuing more transactions like that?

Ken Vecchione, President and Chief Executive Officer

So as a general rule, one of the first lenses of a thought that goes into whether or not we want to do a transaction is what is the return on management's time? We've got a lot of organic growth opportunities. And we are, as you can tell, very excited by them. And as you've seen from our production, either on the loan side or the deposit side, we have been very successful with the ones that we've launched and the ones that we've been cultivating. So the first thing is return on management's time. If there are products or certain niches that are very good for us to bolt on to our existing program, we like those, all right? We're not out there like many of the other banks fishing for a partner to do a sizable deal. I always say that that's not what we're looking for. But of course, we're pretty opportunistic if something falls on our lap we will quickly recalibrate and see if it works for us. But right now, that's not the conversations we're having where it's more about the smaller lines and also really on what can generate transitional or transformational growth like we think the blockchain payment program can do over time once we get comfortable with the mechanics of it and once we bring in incremental clients to the company.

Operator, Operator

Your next question comes from the line of Jon Arfstrom with RBC Capital Markets.

Jon Arfstrom, Analyst

Hey. Thank you for taking the questions. Just two questions. On the guide for EPS in '22, you're talking about a steeper ramp maybe later in the year. How steep of a ramp are you talking about? I have a 2.24 for the first quarter, a 2.62 for the fourth quarter on consensus. And I don't really care about the first quarter. I'm interested more in the fourth quarter. So just help us understand how steep that ramp is throughout the year.

Dale Gibbons, Chief Financial Officer

Yeah. So I would consider here cutting your Q1 a bit and say that number was 10%. Growing 10% to the back half would be appropriate for us.

Jon Arfstrom, Analyst

Okay. And you feel like it's sustainable EPS growth? I know you talked about some of the carve-outs. But again, I'm just trying to think about 2023. I know that's a long way out, but that's sustainable is what I'm thinking about.

Dale Gibbons, Chief Financial Officer

I believe we have momentum with what we've shared so far. We haven't included any new developments or initiatives related to deposits or some of the AmeriHome deals. Overall, we are optimistic about the economy. I'm not sure how many rate increases we will see, but I anticipate at least four. We are factoring in three rate increases this year, in March, June, and September. However, I don't think that will be the end of it, and those increases should also help drive momentum. I understand there are implications to what we are discussing.

Ken Vecchione, President and Chief Executive Officer

Jon, your question.

Jon Arfstrom, Analyst

Let me ask you one more thing, Ken, before we move on. Dale, you just mentioned it, and there are many questions regarding mortgages. I understand these aren't easy to answer, but do you prefer higher short-term rates? Would that be beneficial for earnings? Also, if someone bets on rate hikes increasing, would that be advantageous for you when considering everything together?

Ken Vecchione, President and Chief Executive Officer

Yeah. The answer is yes. I go back to that Slide 8 that Dale was saying, those numbers represent net interest income increases. Take half of that, and that falls to the PPNR line. And so yeah, it's beneficial to the company. And certainly, once you clear the third going on to the fourth rate hike, most of our floors will be in the rearview mirror, and we're going to get a higher beta improvement on those loans that we carry, Jon.

Jon Arfstrom, Analyst

Okay. Okay. And then just last one, longer-term return on tangible thinking as rates rise. I know you got some provision questions in there, but can you hold this level of returns?

Dale Gibbons, Chief Financial Officer

We are currently at 9.1 on CET1, and it could potentially rise to 9.3 or 9.4. There may be some capital implications related to this. As we mentioned, we expect to see margin expansion, especially in a rising rate environment. This should keep us stable at our current position. Even if rates do not increase or plateau sooner than expected, I believe we will remain above 20.

Jon Arfstrom, Analyst

Yeah, okay. All right. Thanks for taking the question.

Dale Gibbons, Chief Financial Officer

Thank you.

Operator, Operator

There are no further questions in the queue. I'll now turn the call back over to Ken.

Ken Vecchione, President and Chief Executive Officer

Okay. I just want to say thanks, thank you to everyone for joining us today. And we look forward to speaking to you again in 3 months. Have a good day.

Operator, Operator

Thank you for participating in today's conference call. You may now disconnect.