Earnings Call Transcript - WAL Q1 2023

Operator, Operator

Good day everyone. Welcome to Western Alliance Bancorporation's First Quarter 2023 Earnings Call. 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 Bancorporation's first quarter 2023 conference call. Our speakers today are Ken Vecchione, President and Chief Executive Officer; and Dale Gibbons, Chief Financial Officer; and Tim Bruckner, Chief Credit 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

Thank you Miles. I would like to start by thanking our clients for the trust they placed in Western Alliance and to the people of Western Alliance for their extraordinary efforts over the last month. Since the collapse of three competitor banks in mid-March, our team has worked relentlessly to meet our clients' banking needs. The flexibility of our diversified national commercial banking strategy with a broad range of value-added deposits and deep commercial customer relationships in a wide variety of sectors and geographies all contributed to our firm's resilience in the face of recent turbulence in the banking industry. We believe our focus on sound financial fundamentals, stable asset quality, and rebuilding capital and liquidity levels over the past several quarters have all helped us navigate through this challenging time. As we move forward with a renewed perspective, we are well-positioned to expand our client relationships and continue to achieve a strong returns profile. Balance sheet repositioning included surgical sales of assets and loan reclassifications resulting in after-tax net non-operating charges of $110 million will have an immediate accretive impact on regulatory capital and allow us to prioritize core client relationships with holistic lending, deposit, and treasury management needs. The company earned through these charges and achieved net income of $142 million and earnings per share of $1.28 for the quarter, increasing tangible book value per share by 3.3% to $41.56 from year end to the CET ratio of 9.4%. Immediately after the exogenous events of mid-March, WAL experienced elevated net deposit outflows that soon returned to normalized levels. Outflows were concentrated in a few key client groups that will inform our funding strategy going forward. Suffering from the taint of SVB's failure, approximately $3.3 billion or 42% of our technology and innovation deposits were withdrawn, less than anticipated given that 50% also have lending relationships. Our mortgage warehouse business remained fairly stable on a net basis, with only the loss of a single customer that we expect to return to Western Alliance with more stable deposits. While settlement services experienced some initial volatility from very recently acquired clients, lows normalized quickly. Balances were stable quarter over quarter. Our regional divisions, the strong local brands and small, mid-sized metro business relationships acted as a core source of strength and saw only modest deposit attrition. Non-core regions, which included title companies and other fiduciaries, reacted more reflexively to stock market volatility, withdrawing approximately $2.6 billion. These are non-deposit that we are prioritizing going forward. Since March 20th, our deposit flow stabilized and returned to a healthy growth trajectory with deposits of $2.9 billion to $49.6 billion as of April 14th. Some business lines were never impacted, including HOA with deposits higher by $900 million since the beginning of the year to April 14th. Our flexible diversified business model proved its worth in Q1, while monoline banking models depended on single industries or concentrated customer types failed. 85% of our customers already have more than one product or service with us and we will continue to prioritize client segments with extensive banking service needs that include credit and treasury management, while deemphasizing credit-only relationships. Overall, we'll successfully retain deep-rooted relationships and those for which we offer proprietary integrated treasury management technology solutions like HOA and we'll continue to do more of these. It is also worth mentioning that not a single deposit channel of ours represented greater than 16% of total deposits at the onset of the deposit crisis. We responded to our client's desire for and the market scrutiny surrounding enhanced deposit protection. Since year end, we have taken concrete steps to dramatically grow our insured deposits from approximately 45% of total deposits to 73% as of April 14th. This places us well in the top decile among the 50 largest US banks. Also, as of April 14th, uninsured deposit coverage now stands at 158%. This results from the shift towards insured deposits to accommodate depositors' desires to have their funds safe and protected. We will continue to provide client deposit alternatives that accentuate safety in these uneasy times. I think it's important to offer some thoughts on the volatility experienced in our industry since mid-March. WAL navigated through these developments through strategies initiated in 2022 and initially described in our Q3 and Q4 earnings calls, such as deemphasizing loan growth in advance of an economic slowdown, growing deposits on liquidity faster than loan growth, and achieving a greater than 10% CET1 ratio. Formed by lessons learned in the recent stress of the banking system, we have moved up our medium-term CET1 goal to 11% and we are targeting a mid-80s loan to deposit ratio. At the onset of this turmoil, we acted decisively to tap various sources to enhance our liquidity position, engaged with stakeholders through measured, but impactful financial updates, and maintained normal business operations. Looking forward, we will remain focused on building additional liquidity and capital while reaffirming our deposit-led growth strategy. Increased diversification and additional deposit streams are also our top strategic goals. To ensure adequate liquidity over the medium term, we will aim to drive our loan to deposit ratio to the mid-80s by cultivating deeper client relationships. We look to organically, but expeditiously rebuild capital to greater than 10% before the end of the second quarter. Our medium-term CET1 target is 11%. Emulating larger banks that typically have larger capital efficiency will be an important step to drive sustained core deposit growth in the regulatory environment that will likely become stricter in response to recent industry turmoil. Higher capital, higher liquidity, and lower dependence on moderate-rate funding should attract more core deposits and hopefully lead to higher investment-grade ratings. Accelerating HQLA growth in the securities book is also something that we planned. WAL total liquidity and capital, we chose to reposition our balance sheet through targeted reclassification of certain loans and assets from held for investment to held for sale and specific non-core asset sales. We reclassified approximately $6 billion of HFI loans, recognizing an approximately 2% fair value adjustment of $92.2 million after-tax that includes expected future P&L and capital impacts. The after-tax charge will be immediately accretive to regulatory capital as the loans are liquidated and allows us to fulfill client relationships with lending, deposit, and treasury management needs. We already made significant progress in executing this strategy with actions that added 51 basis points to CET1. In Q1, $920 million of loan sales were executed before quarter-end, with another $3 billion already under contract but not closed by 3/31. MSR sales of $360 million, select security sales of $460 million, and the unwind of high-cost mortgage warehouse equity fund resource CLMs all contributed to help offset the HFI reclassification on time charge. In addition, we are moving expeditiously to execute the remaining $3 billion of HFS loan sales. Such sales realized smaller losses than we expected. The remaining HFS loans are incorporated into our Q1 numbers. These actions reaffirmed our plans to surpass a 10% CET1 capital by June 30th. Even with the mark-to-market adjustments from balance sheet repositioning, we still advanced our CET1 ratio by 6 basis points to 9.38%. When considering the contracted loan sales for this month and the unwind of our EFR, CLM, and subscription lines, we've already locked in CET1 ratio above 9.71% before considering our organic capital generation or completing sales of the remainder of the HFS loans, which should ultimately push CET1 above 10%. Finally, Western Alliance has significant access to more than $21 billion in contingent sources of liquidity, to meet customer and operating needs. Access to loan balancing cash and unused borrowing capacity increased to greater than $26 billion with the near-term completion of HFS asset sales, $3 billion of which are contractually agreed to and will be used to pay down higher-cost BTFP and FHLB short-term borrowings and return to more normal sources of financing. We continue to evaluate additional opportunities to establish secured borrowing facilities from other sources. At this time, I'll let Dale take you through the financial results.

Dale Gibbons, Chief Financial Officer

Thanks Ken. Turning to the first quarter results, Western Alliance earned total adjusted net revenue of $712 million excluding non-operating charges. Net income was $142 million, while adjusted net income was $252 million. Earnings per share was $1.28 with an adjusted EPS of $2.3. Quarterly loans decreased $5.4 million as $6 billion was transferred to HFS matching the deposit decline of $6 billion. Total adversely graded assets increased $35 million and quarterly net loan charge-offs were $6 million or five basis points annualized. Operating return on average assets and return on average tangible common equity were 1.43% and 21.9%, respectively, providing sustainable go-forward earnings. In the quarter, Western Alliance generated pre-provision net revenue of $352 million. Total adjusted group net revenue was $712 million, which was an increase of 28% year-over-year and an increase of $1.9 million for the quarter. Net interest income decreased during the quarter to $610 million. Average earning assets increased by $1.5 billion, while lower yielding cash grew 5% from 2.1% of interest-earning assets, creating a drag on the new. GAAP non-interest income decreased $120 million to negative $58 million, while adjusted non-interest income grew $31.7 million from the prior quarter. Mortgage banking revenue increased $26 million quarterly to $73.3 million as AmeriHome continues to see green shoots in its operating environment. Production margins have widened to more historically normalized levels of 26 basis points and the industry capacity has been rationalized. The retreat of a large money center bank from the corresponding lending market has paved the way for higher margins and win rates. The servicing rights assets continue to produce attractive returns, given the lower prepayment speeds, strong underlying asset quality, and continue to attract interest from investors. In Q1, the sale of $360 million of MSRs at par provides flexibility and a long life path before we come to the market again. Held for Investment decreased $5.4 million to $46.4 million and deposits decreased $6 billion with our total to $47.6 million at quarter end. MSR balances decreased $238 million in the quarter to $910 million. Total borrowings increased $9.6 billion over the prior quarter to $16.7 billion due to an increase in short-term borrowings of $9.8 billion, partially offset by redemptions of credit lien notes of $265 million. Finally, tangible book value per share increased $1.31 or 3.3% over the prior quarter to $41.56 and up nearly 12% over the prior year. We announced the decomposition of our quarterly go-forward and go-forward debt interest drivers; our investment securities portfolio grew approximately $600 million to $9.1 billion as we sold $460 million of securities predominantly credit CLOs. Other investments increased approximately $900 million, which primarily consists of high-quality liquid assets such as treasury bills, part of our strategy to further enhance our liquidity position. Investment yields increased 24 basis points from the third quarter to 4.69% with an end of quarter spot rate of 4.60%. Given the uncertain economic environment, we curtailed loan growth early in the first quarter. This slowdown in credit accelerated in March as we right-sized existing loan balances through reclassification to held for sale and targeted loan sales of approximately at least $7 billion, primarily from limited credit relationship credits or with limited credit spreads. These actions lowered our period-end balance to $46.4 billion. Loan yields continue to benefit from repricing into the higher rate environment and wider overall spread with an end of quarter spot rate of 6.45% compared to an average rate of 6.28%. Our residential loan portfolio of $15 billion is match-funded with non-interest bearing deposits of 16.5%. Turning to a decomposition of our held for investment loan reclassification, loans transferred to HFS nearly half were syndicated credits and capital call and subscription lines. Areas we have previously mentioned we would be deemphasizing. $5.9 billion loan held for sale portfolio had a quarter-end spot yield of 7.34%, which are now funded by FHLB borrowings with the current spot cost of 5.05%, resulting in a modest 2.3% margin. Leading the sales transaction lends support and buoyancy to our net interest margin guide. Total cost of deposit spot rates increased 45 basis points to 1.85% at quarter end compared to an average of 1.72%. This was primarily driven by a $1.5 billion increase in CDs that now comprise 14% of deposits, while non-interest bearing DDAs comprised 35% of our total deposit mix of which 52% have no cash payment to earnings credits. Notably, the spot rate for interest-bearing DDA was lower than the average for the quarter as migration from non-interest bearing checking was accomplished at lower rates than the average interest checking rate. Savings and money market rates were also lower as balance attrition tended to be from larger and higher cost accounts. The interest-bearing deposits increased 78 basis points for the quarter to 2.75% compared to the ending spot rate of 2.82%. The $6 billion decline in deposits during the quarter was roughly evenly split between money market accounts and demand deposits. Overall, net interest income decreased $30 million or 4.7% over the prior quarter, nearly half due to two fewer days in the quarter and the remainder due to balance sheet repositioning actions in light of the deposit loss. Held for sale loans contributed $31 million, which will decline as we liquidate these assets. Net interest margin compressed by 19 basis points to 3.79% due to increased borrowings, short-term excess cash on the balance sheet we had to ensure liquidity, and an incremental drag of 11 basis points. Going forward, we estimate that our balance sheet is fairly interest rate neutral with rate shock sensitivities either up or down only changing net interest income by less than 1%. Our adjusted efficiency ratio increased to 43% from 39% in the quarter and was flat year-over-year. Higher deposit costs of $5 million related to higher earnings credit rates and normal Q1 seasonality were the primary drivers of the increase from the fourth quarter. Pre-provision net revenue was $352 million during the quarter, a 15% increase in the same period last year, and a decrease of $25 million or 7% from the prior quarter. This resulted in PPNR return on assets of 2% for the quarter, a decrease of 15 basis points from Q4. The aggregate of adversely graded credits increased $35 million this quarter. We see nothing significant in this modest migration to indicate widespread deterioration is looming. Total non-performing assets increased $22 million, or 17 basis points of total assets. Net loan charge-offs were $6 million, or five basis points of average loans, compared to net loan charge-offs of $1.8 million, or one basis point in the fourth quarter. Our total loan ACL decreased $7 million from the prior quarter to $350 million as loans were marked down in the ACL release if these credits were transferred to held for sale. Loan ACL to funded loans increased to 75 basis points compared to 69 in Q4 as some of the loans transferred had low loss rate assumptions, leaving capital call and subscription lines and mortgage warehouse credits. Additionally, the reserve associated with commercial real estate was increased as the economic outlook softened. Tangible common equity to total assets of 6.5% and common equity Tier 1 ratio of 9.4% were both bolstered by net income. Like the increase we expect for CET1 in the second quarter, the tangible common equity ratio should rise in tandem. Inclusive of our quarterly cash dividend payment of $0.36 per share, our tangible book value per share increased $1.31 in the quarter to $41.56. Tangible book value per share continued its long ascent as the earnings power of the company surpassed charges associated with the bank's balance of repositioning. TBV also benefited from a reduced AOCI impact after crimping book value last year as bond prices fell when rates rose. I will return the call back to Ken.

Ken Vecchione, President and Chief Executive Officer

Okay. Thanks Dale. Our guidance for the rest of 2023 continues to be driven by the strategies and priorities laid out in our Q3 and Q4 2022 earnings calls and informed by the recent banking disruptions. In order to best serve our sophisticated commercial clients, we will continue to aim to be more aligned with the country's largest banks by rebuilding our capital levels, enhancing insured deposits and liquidity, lowering our loan to deposit ratio, and deepening our client relationships. We want to be seen as equals to these peer banks from our depositors' perspective. Eliminating these differences allows us to compete more on service, performance, and what I call, management intimacy, where C Suite relationships can drive deeper banking relationships. Organic earnings balance sheet repositioning, we'll continue to grow capital as we reposition the company for slower growth ahead of a potential economic slowdown. So, let me tell you what this means going forward. Regarding capital, we discussed our imminent lift in CET1 to 9.7% and that we expect to exceed 10% by the end of Q2 through planned loan HFS sales and organic capital growth. Over the medium term, we will target an 11% CET1 ratio, which will be driven by our continued strong return on average tangible common equity and capital generation. As we complete our planned HFS loan sales, we will pay off short-term borrowings and return to more traditional bank funding. Deposits are expected to grow at approximately $2 billion a quarter and exceed more muted loan growth. This will lower our loan to deposit ratio over time towards a mid-80% target. Net interest margin is expected to slightly compress in 2023 to 3.65% to 3.75% given the anticipated flat rate environment, slower loan growth and increasing price competition for deposits. As our liquidity grows, we will look to accelerate HQLA growth in our securities book to further enhance liquidity flexibility. Our efficiency ratio, excluding the impact of deposit costs, should increase slightly to the mid to high 40s given our smaller loan book, partially offset by the inherent operating leverage of our business. Asset quality remains well-positioned and steady as she goes. And then on future economic environment, net charge offs could begin to normalize and we expect net charge offs to range between the first quarter's five basis points maybe up to 15 basis. Overall, we expect PPNR for the full year of 2023 to be down 5% to 10% from 2022 levels due to smaller interest earning assets and higher borrowing costs. However, as we execute our balance sheet repositioning efforts and continue to reestablish our core deposit growth trajectory, we see Western Alliance as an even better institution and better well-positioned for the future. At this time, Dale, Tim, and I are happy to take your questions.

Operator, Operator

Thank you. The first question today comes from Steven Alexopoulos with JPMorgan. Please go ahead.

Steven Alexopoulos, Analyst

Hi, everyone. I wanted to start with the big picture question first. So, just following-up on the balance sheet repositioning in the quarter, a fair portion of your growth over the past few years has come from these non-core segments, right, which you're now exiting. With you shrinking the company down to focus more on core relationships, one, when do you get there, right? When is the bank primarily done in terms of shrinking down to get to these more fuller relationships? And then even more important, what does Western Alliance look like after that? Do you focus on ROE, profitability? Are you still a growth bank? What is Western Alliance 2.0?

Ken Vecchione, President and Chief Executive Officer

Okay. A couple of things there. Let me unpack them all. One, the EFR loans that we have exited in some syndication lines that we exited were all non-core and they reflected our excess liquidity that we had in the company. Going back to the days of 2020 when we had $6 billion to $7 billion of cash sitting at the Fed earning 10 basis points, it was a good alternative to increase net interest income and there was excellent asset quality and that's what we did there. As we continue to reemerge from this. First things first, I want to say our focus near-term is on moving that deposit ratio down and also moving the capital levels up and we're going to do that with a heavy focus and concentration on deposit growth and again muted growth in loans of about $500 plus million. As we emerge from Q4 and position ourselves for 2024, we should be just about ready as we enter into 2024 to hit our CET1 ratios and hit our liquidity into the multi deposit ratios. Now, we've got plenty of opportunity here to grow. I think you'll see us go to some of our core strengths that have always been with us, that have always helped us grow in the past. C&I loans out of warehouse lending is still active. Now, Florida is going to be economically driven as well. Note financing is going to be there. We've been strong in CRE, especially in lot banking. We've always had good performance out of our hotel book. Again, I want to say very clearly it's all dependent upon where the economy is at the end of 2023 moving into 2024. But we will go back to some of the things that we've done well. Also during the course of the remainder of this year, we have a number of different business lines that we are working on to develop. Some of those are on the deposit side and some of them are on the loan side. And as we've done every year, every year and a half, we've rolled out new business lines and opportunities to make sure we propel growth. But I will say, Steve, in the past, if you look from 2022 backwards to 2014, you've seen we've grown loans and deposits on average both about 23% to 26% per year. We never got paid for that. I think what we're going to do is we're going to be a little more cautious on that loan growth, but again accelerating on the deposit side. So, one, we never have to experience a disruption with some information that was put in the marketplace, which I think was inappropriate, but we can get to that point another time. But I think we're going to be a very steady grower. I think we should be able to grow above peer trend like we've always had. I just don't think we're going to grow at the very top end of peer trend. I don't think that's necessary for us.

Dale Gibbons, Chief Financial Officer

I might add that we're really taking a surgical strike here on these types of things. So, capital call, for example, I mean we got into that as Ken said when we had a lot of liquidity. Those are thinly priced fields and we did syndications where we received no deposits. We're not exiting that space entirely, we're still going to do bilateral deals where it's a complete relationship. And that's a way that we can continue to be here, but really step away from the stuff where the marginal cost and marginal benefit from that is fairly muted.

Steven Alexopoulos, Analyst

Got it. That's helpful. Thank you. And maybe just one follow-up. If I look at the deposit decline in the quarter, the $3.3 billion you're calling out through March, the Tech & Innovation segment. We heard from many of the regional banks at this point that they were beneficiaries of the flight out of Silicon Valley Bank. What did you hear from your customers through this period, which drove them to take deposits out of your bank? I would have thought you could have been a beneficiary also. Were they just watching your stock price and panicking? What was it? And did they close accounts or did they just bring balances down to the insured level? Thanks.

Ken Vecchione, President and Chief Executive Officer

Okay. One, they didn't close accounts, they moved deposits out. So, let's break down the deposit outflow. $3 billion of the deposit outflow, 50% came out of our Tech Innovation and Life Science area. Bridge Bank, which is our technology and innovation arm of the company, was always set up as a challenger to SVB. So, during the panic of Monday morning the 13th, I think people looked and said, what most looks like SVB? Well, here is Western Alliance. Now, what was interesting, only 14% of our deposits and about 11% of our total loans were in the tech and innovation sector. But still, there was a lot of pressure put on our stock price. What you saw was a modern-day bank run, heavy social media and commentary, which got shareholders nervous, which drove the stock price down, we can talk about this later, too, which then forced some of the larger corporates that we had to move their funds through treasury management systems. Then we received a phone call that said, I'm sorry, I'm moving my money, but I see the stock price going down and better to be safe than sorry. 68% of our dollars that went out went out to larger banks, the money center banks. Everyone all said the same thing. When the crisis is over, we're going to come back. And we'll wait and see if that happens. I doubt it, but they should come back because we haven't lost touch with these folks. On the second part of your question as it relates to Tech and Innovation, we were still fighting to pull in deposits during the 13th and 14th of March. Now, that has begun to change a little bit and we are more optimistic that deposit growth will begin to happen in our Tech and Innovation, and that informs us to say why we feel comfortable with growing $2 billion per quarter.

Steven Alexopoulos, Analyst

Okay. I appreciate it. Go ahead Dale.

Dale Gibbons, Chief Financial Officer

In terms of the stock situation – so really, I think the question starts with how did we get caught up in this? And we think the original tie is because of Bridge and the relationship that we have as the prime competitor to Silicon Valley Bank. But for us, it was only 16% of our total versus for Silicon Valley Bank, it was basically their entire business. But so what happened is that when the run started on SVB, I think they looked around who else is in the space, but that perception quickly metastasized into a short narrative. If you look at our options activity, a lot of days, we wouldn't trade options at all. But on that Friday, March 10th, we traded about 1,000 times our normal volume. The most common issue was somebody bought $30 put options, while our stock was trading at $50. On that Monday morning, before the market opened, the New York Times had a pre-market session selling. Nobody trades premarket us, so it's pretty easy to move the stock price around and push it down. We opened at $12 on Monday morning, which was the print. After the entire week, we've been on this kind of uptrend again.

Ebrahim Poonawala, Analyst

Thank you. I guess maybe forward-looking, thinking about just your deposit growth outlook, given sort of the new perspective, talk to us around where you expect deposit growth to come from in terms of business segments? And how are you thinking about just the incremental cost of the deposits coming into the bank?

Ken Vecchione, President and Chief Executive Officer

I'll handle the first part and then Dale will take over for the second part. Regarding deposit growth, we anticipate it will primarily come from our HOA segment, which has remained stable. One key takeaway from our experience is that by utilizing our technology and APIs to connect with management companies, which in turn connect to the HOAs' back-end systems, we create accounts that are not easily transferable. This process typically takes nine months to a year. We are now exploring additional channels where we can establish deep connections within our clients' back offices. The HOA sector is one area where we expect to see growth. Reflecting on 2018 and early 2019, our new business lines, which include settlement services and escrow services, along with our recent launch of corporate trust, will all add to our growth this year. Additionally, our warehouse lending group is naturally expanding, and our regional brands have garnered strong recognition, even more than anticipated. During the recent outflow, there was only a 3% to 5% decline in our regional bank brands. We plan to strengthen our commitment to urban banking as these deposits tend to be very stable, resembling consumer deposits for us. Although we do not primarily operate as a consumer bank, these deposits have proven to be quite sticky. Furthermore, we have learned that providing more detailed information during challenging times is beneficial. The 8-K we released was significant for the market and also served to enable our business development officers to engage with clients more effectively by providing specific data. The more detailed and concrete the information was, the more reassurance it provided. Instead of just stating our long-standing commitment to customer service, clients wanted to know specifics, such as the ratio of insured to uninsured loans and the extent of our coverage. Sharing such data in the marketplace allowed our business development officers to have more meaningful conversations with clients, which proved to be very helpful.

Dale Gibbons, Chief Financial Officer

Yes. Regarding the costs, as we talked last year, we were not playing the beta game. We said we were doing better than others perhaps because our beta is lower in terms of how fast we're raising our funding cost. We were where the market was and that's where the price was all along. So, today, that's where we are. I don't think many banks can really pull in much in deposits as something meaningfully different than effective funds. So, that's what we've dialed in. We do have these varieties of initiatives as well as our current array of deposit gathering divisions, whereby we can continue to execute on that, and I think that's demonstrated by what we've done for the past three weeks.

Ebrahim Poonawala, Analyst

And maybe, Dale, I guess, a different way, when you look at the NIM outlook, 3.65%, 3.75%, how do you think about if the Fed is done with the rate hikes next quarter and rates remain flat from there? Where do you expect the margin to exit 2023?

Dale Gibbons, Chief Financial Officer

Yes, I think it's important to revert that 3.79% has a couple of things in it that are depressing that number. One is that it has a very large cash position that we had for three weeks of March, basically, whereby we took down large dollars from the FHLB or the FRB and we had it in cash. Our balance sheet was close to $90 billion on some of those days, and we ended the quarter at $71 billion. That was at an upside-down spread. That caused our margin to drop by 11 basis points. In addition, we talk about the HFS loans that are coming out of here that have a spread of 2.3%. You take that out of our margin at 4.79%, and our margin rises about 20 basis points. So, the 4.79% is already depressed. Holding that level or declining slightly, I think that helps with the modeling.

Casey Haire, Analyst

Yes, thanks. Good morning guys. I wanted to touch on the borrowing paydown. If you guys continue to grow loans, deposits at $500 million, $2 billion, respectively, can we expect the borrowing to be the use of the excess liquidity as you get there ratably and to what level?

Dale Gibbons, Chief Financial Officer

Yes, I mean, I think your bottoms are going to come down, obviously, to a level. I don't have a dollar figure for you, Casey. But yes, we'll take them down. I mean, we operated last year with the borrowing position in kind of the mid-single digits, could be lower than that. But we expect to be using the FHLB and also are a good accordion for day-to-day liquidity as people withdraw, deposits come in and things like this. And so that's a pretty stable source to do something like that. What we don't want to do is we don't want to rely on the FHLB for just standard operating liquidity.

Ken Vecchione, President and Chief Executive Officer

I think your numbers are about right. We could maybe get to that loan to deposit ratio a little bit sooner. That will be informed by our deposit activity, right? So, if we do a better job, it will come down quicker. But I think your numbers and direction are about right.

Casey Haire, Analyst

Regarding the efficiency ratio guidance, I understand that there's a lot happening in the short term or recently. Can you provide an expense run rate for the second quarter as a starting point?

Ken Vecchione, President and Chief Executive Officer

I'd rather mention that the guidance is in the mid to high 40s. The expense run rate or efficiency ratio is something I've discussed on many calls; it reflects the residual impact of our business. We have a clear target for EPS, and there are certain elements we won't compromise on. We are committed to the development of our risk management programs and technology. We've invested significantly in our technology, and our payment systems are functioning exceptionally well without any failures, which we are very pleased about. Our confidence in achieving deposit growth is bolstered by new business developments we've made since 2018 and 2019, particularly in the deposit area. These initiatives will continue. If we don't invest in the company to foster growth, we won't achieve sustainable deposits or loan growth. While I can't provide a precise answer for Q2, I can affirm that mid to high 40s is our target within the broader outlook I've shared.

Casey Haire, Analyst

Got you. And just last one for me. If I take the spot rates that you guys provided in the slide deck and then give you credit for all of the HFS sales and layer in that high 40s efficiency ratio, I get about 1.4% ROA and an 18% tangible ROE. Does that sound about right?

Dale Gibbons, Chief Financial Officer

1.4% ROA, are you suggesting that for the year, it's more or less accurate?

Casey Haire, Analyst

Yes. Well, yes, like a run rate of 3.31% with all the spot rates that you guys give and then giving credit to the balance sheet restructuring, the $6 billion fully offloaded.

Dale Gibbons, Chief Financial Officer

Yes, so maybe you're a little bit off and I think it's because you're jumping to the efficiency ratio instantly. And you said high, I don't know what a high means.

Brad Milsaps, Analyst

Thank you for taking my questions. Dale, I wanted to follow up on the spot rate discussion. I was encouraged to see the lower deposit rates at the end of the quarter. Do you think this is a one-time event? Would you expect those rates to increase again? I believe you mentioned that your deposit growth would mainly come from higher-cost sources, but I wanted to understand how the spot rates align with your deposit growth objectives in the current environment.

Dale Gibbons, Chief Financial Officer

Well, I do think that we have two sources of deposit growth here. One of them is at a more marginal cost, and that's going to be kind of new money, I believe. The other is recovery of funds from clients that pulled funds out in the last three weeks of March. I think that we're going to have success on both of those categories in terms of where the lower-cost money came from. It really was predominantly in the tech space. We've talked to these enterprises. A lot of them say they're going to come back. They just want to see a little bit of calmness and stability kind of reenter the space. So, I think we're on track to that.

Brad Milsaps, Analyst

Okay. And do you have a sense for maybe ECR deposit growth? I mean those were basically flat linked-quarter. What percentage would that be of how you're thinking about growth throughout the year?

Dale Gibbons, Chief Financial Officer

Yes, I think ECR deposit growth is going to climb as well. A lot of that comes from different elements of our HOA division as well as our mortgage warehouse operation and escrow funds related to principal and interest in title and taxes and insurance, those heavy CRs with them. I think we're optimistic about how that can go this year too.

Brad Milsaps, Analyst

Okay. I have a follow-up regarding the loan spot rates mentioned on slide 14. You provided an average of 6.28%. I assume this includes the loans you transferred to held for sale at the end of the quarter. With the spot rate at 6.45%, I assume this does not include those loans held for sale, which would indicate a significant increase over the average. If I were to exclude those loans you moved, is that the correct way to interpret this?

Dale Gibbons, Chief Financial Officer

It is the right way to think about it. Yes. We've kind of, I'll say, reverse engineered it on page 18, where we took the spot yields for the entire quarter and what that was in that spread and hence coming up with $31 million as the revenue piece associated with the HFS disposition.

Ken Vecchione, President and Chief Executive Officer

So, I think it's want to say that we've got 50% of that already cemented and we're just waiting to close towards the end of April. The other $3 billion were in active conversations with. We don't see any reason why we're not going to get it done by the end of Q2. Could something drag into a little bit into Q3, maybe. But right now, we're encouraged with the conversations we're having with the parties across the table from us.

Brad Milsaps, Analyst

Okay, great. And anything else on CLN unwinding? Do you think you're done in that regard?

Ken Vecchione, President and Chief Executive Officer

Well, there will be some more CLNs that unwind as part of the $3 billion that we're looking to sell, and that's all factored into our net CET1 side. Of course, you lose capital efficiency when you unwind them, but you're getting rid of the assets on the other side. Net-net, these transactions are all capital accretive to us.

Dale Gibbons, Chief Financial Officer

Yes. The capital call and subscription in CLN, which is the one we're talking about, is already contracted. It's being unwound daily. They're taking loans out of that every day. And so it's just whittling down. I think it's going to be over by the end of this month, and so that will be gone. In terms of the other CLNs we have, we still have three that are all residential. We don't have plans to unwind or dismantle those.

Timur Braziler, Analyst

Hi good morning. Looking at the HQLA build in the quarter, can you tell us where we are in that process, maybe provide like HQLA to total assets? And as you continue to build that out, is that additive to the current securities balances or is there going to be some additional repositioning that kind of keeps the securities book flat while HQLA grows?

Ken Vecchione, President and Chief Executive Officer

Yes. So, I mean we're going to be taking that up. I don't have a limit for you. There's demand associated with HQLA as you surpass $100 billion. We're going to be on a trajectory to kind of have that rise. But it's not going to jump in any substantial way that's going to disturb margin or things like this.

Dale Gibbons, Chief Financial Officer

Yes, I would say that's going to be informed by our insured to uninsured level. That's number one. Back to lessons learned, if some large corporates bring back their money, then we need to sign a higher level of volatility to those dollars and hold some of those dollars in HQLA. So that will also be part of the mix fabric of the new deposits coming in.

Timur Braziler, Analyst

Okay. And then construction loans continue to grow at a nice clip. Curious if you can provide what the current unfunded balances are in that book and what the funding schedule looks like there for the rest of the year?

Tim Bruckner, Chief Credit Officer

Sure. Tim Bruckner here. The funding schedule for the rest of the year rolls out at about $400 million a quarter. Within our funded loan balances and forward projections, that's accounted in the volume. That represents the trajectory of the unfunded for this year.

Timur Braziler, Analyst

Okay, great. And then one last one for me, maybe going back to Steve's question. On the bigger picture front here, where do you ultimately see Western Alliance falling into the broader technology innovation sector once that recovers? Assuming there's going to be quite a lot of dislocation from Silicon Valley clients. And do you ultimately see Western Alliance playing a larger role in that sector?

Ken Vecchione, President and Chief Executive Officer

I think it's going to be a sector that's going to be positioned against the other growth areas that we have. It's not going to overwhelm the deposit composition or the loan composition; that's something we've seen. We're not going to be the new tech bank. I do feel very strongly that those that are picking up the tech people out of SVB, there have been a number of banks. I think people are going to migrate to us and stay with us because consistent performance is very important here, not only a consistency of the people that you deal with, but also the consistency of the credit granting process and the credit review. We've seen over our time here, banks that have jumped into tech and innovation, they think it's C&I lending. Tim Bruckner can pick up on this in a second, if you like. But it is not. We've seen people jump in and say, hey, I'm here to provide you credit. All of a sudden, they see, wait a minute, you're lending against possible negative cash flows or clearly negative cash flows, you're lending against VC's commitments to put in money over time, and it's a different C&I loan.

Tim Bruckner, Chief Credit Officer

Yes. Thanks, Ken. It is. We recognize and adapt to a changing environment. In the tech space, we've got a change in competitive landscape concerning the lenders involved. We've got a changing landscape regarding the VC. We think that we are well-suited in this space. We have a deep understanding of the space, but we're moving forward fully advised by what we've seen and are seeing and the changes that have presented themselves. I don't expect that this will hold a significantly larger position on our balance sheet as we move forward.

Ben Gerlinger, Analyst

Good afternoon. I was wondering if you could share your thoughts on Western Alliance's approach. Historically, the company has had an entrepreneurial spirit on both sides of the balance sheet. It appears that on the left side, you are pulling back and focusing on your core clients, likely due to the economic volatility and the need to proceed cautiously. As we transition out of a recession or navigate it, has there been a change in how Western Alliance operates? Can we expect you to reenter markets that you've previously left, particularly in terms of long-term growth opportunities?

Ken Vecchione, President and Chief Executive Officer

Yes. First, I want to emphasize that we take pride in our entrepreneurial culture. Many associate this with our business development, such as deposit growth and loan activity. While that's true, our real strength in entrepreneurship emerges during crises and in handling transactions with clients. For example, during COVID, our hotel portfolio faced projections of losses ranging from $100 million to $1 billion. We acted swiftly to implement a unique program—requiring clients to post cash for deferrals, which initially faced skepticism from our sponsors. However, once they understood our intent to have them commit to their projects, we achieved nearly 100% participation in the program, with no late payments. We experienced a rush for liquidity from our bank, but by Tuesday afternoon, we had established the plan to offload non-core assets. Our prompt actions enabled us to secure deals at favorable marks early in our presentation. This reflects our entrepreneurial spirit. While we may appear to be retrenching, we are actually utilizing this spirit to strengthen our capital and enhance our deposit base, as evidenced by our increase in insured deposits from 45% to 73% in five weeks. When we focus, we can achieve things quickly. As we look ahead to Q1 and Q2, we anticipate a stable balance sheet, but as we progress through Q4 and align our capital and liquidity strategies, our core strengths will resurface as we plan for 2024. It’s important to note that we don’t need to pursue rapid growth; past experiences have shown that this approach hasn't been rewarded. Our strategy will continue to adapt based on the economic landscape.

Ben Gerlinger, Analyst

Yes, that's great color. I appreciate it. The confidence is the best capital in this environment. The only other question I had is kind of just where your share price is today. Seeing it wall under tangible book is like seeing a snowman in Phoenix. I'm just curious, your appetite for share repurchases. I know you're trying to build capital, so that would fly in the face of it, but just anything on that end?

Ken Vecchione, President and Chief Executive Officer

Yes, that's not in the conversation at the moment. We'll not be in the conversation until we cross over 11%. The decision then will be dependent upon the economy and other economic events. We'll reassess capital management alternatives at that time, but that's not something that's even contemplated or discussed.

Brandon King, Analyst

Hey. So, I wanted to touch on credit, and I appreciate the guidance, and I wanted to get a better sense of how you think this credit normalization process will play out for Western Alliance, particularly for this year?

Tim Bruckner, Chief Credit Officer

Sure. Hi it's Tim Bruckner. First, I'd say that as we look at our portfolio right now, it's performing and doing exactly what we wanted it to do in this economy. We're at our foundation a relationship bank and we don't enter into transactions complicated with mezzanine and sub-debt. So, we've got direct, frank, straightforward and ongoing dialogue with each of our customers in that sense. So, when we talk about how we're doing, how we relate, that's informed by this active dialogue. I expect that you see stability with any economic downturn, and I also expect that there is a chance for some migration to criticized or special mention, we don't see significant migration based on the direct relationship and the active dialogue that we're having, and that holds true across all segments that we lend in.

Brandon King, Analyst

Okay. And my follow-up that was as far as the uptick in classified assets. Is that kind of the general story there as well?

Tim Bruckner, Chief Credit Officer

Yes, exactly.

Ken Vecchione, President and Chief Executive Officer

In terms of the provision, it looks like it was driven by a charge-off and it feels like you're comfortable with credit and growth is slowing intentionally. But is there anything that prevents that provision from coming way back down next quarter?

Dale Gibbons, Chief Financial Officer

Well, yes. I mean it was driven by a charge-off. We disclosed that we had a debt obligation of Signature Bank and wrote that off.

Jon Arfstrom, Analyst

Okay, good. That's a good message with your valuation. And then I guess last question probably would have been a good first question. Do you feel like you're dealing with any abnormal stresses right now at your company? Or is this kind of over in terms of managing the stressful situations from mid-March?

Ken Vecchione, President and Chief Executive Officer

I want to be cautious and not assume everything is resolved. The situation has calmed down, and it’s crucial that we maintain this calmness for our depositors starting Wednesday. Our cash inflows and outflows are roughly balanced, and we began to see growth around the 20th. There is a sense of stability among our depositors. However, we remain very attentive to ensure that we follow through on what we've communicated during this call. That is extremely important. We aim to be recognized as a transparent company that follows through on its commitments. Additionally, we strive to be innovative in addressing and resolving issues promptly. If you want to know what concerns me, it's making sure we diligently execute on everything we've discussed. As for other potential events that could impact the industry, First Republic's situation remains unresolved, but we have demonstrated that we are distinct and separate from them. There was a time when their issues affected us, but we have moved past that. We're also monitoring Fitch's recent downgrade of our investment grade. We are anticipating another rating agency might act regarding our status, as they've placed us on watch. However, we observed no outflows related to Fitch's actions, and we will see how things unfold. Once we clear this last hurdle, the focus will be on executing our growth plan. Thank you.