Q3 2022 KeyCorp Earnings Call
Good morning, and welcome to Keycorp's third quarter 2022 earnings Conference call.
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As a reminder, this conference is being recorded I would now like to turn the conference over to the Chairman and CEO , Chris Gorman. Please go ahead.
Well. Thank you for joining us for Keycorp's third quarter 2022 earnings Conference call. Joining me on the call today are Don Kimble, Our Chief Financial Officer, Clark Khayat, Our Chief strategy Officer, and Mark Midkiff, Our Chief risk Officer on Slide two you will find our statement on forward looking disclosure and non-GAAP financial measures.
It covers our presentation materials and comments as well as the question and answer segment of our call I am now moving to slide three this morning, we reported earnings of $513 million or <unk> 55.
Per common share our results included <unk> <unk> per share of additional loan loss provision in excess of net charge offs.
Revenue was up 5% relative to the second quarter driven by higher net interest income.
With a 13 basis point increase in our net interest margin.
One thing that sets <unk> apart is our approach to managing interest rate risk, we have been very deliberate and intentional and managing with a long term perspective.
While our net interest income is expected to be up double digits. This year, our balance sheet positioning presents a unique and significant upside for key over the next two years.
Even in the event that rates remain at current levels, we will experience a meaningful benefit as our securities and swaps reprice.
If we were to re price our existing short term treasuries and swaps at today's interest rates. We would have an annualized net interest income benefit of over $1 $2 billion, our balance sheet benefits from our strong stable deposit base approximately 60.
<unk> of our deposits are in stable low cost retail and escrow balances in our commercial business is approximately 85% of our deposits are core operating accounts. We grew our loans again this quarter as we continued to add and expand relationships with our targeted clients our growth.
Came from both our commercial and our consumer businesses.
We remain diligent in our underwriting practices and have walked away from business that does not meet our moderate risk profile.
Our fee based businesses continue to reflect current market conditions investment banking and debt placement fees were up $5 million from the prior quarter, but down meaningfully from the year ago period, reflecting the slowdown in the capital markets.
The new issue equity market is virtually nonexistent in the M&A market is currently engaged in price discovery, our pipelines remain solid, particularly in M&A. However, the pull through rate continues to be adversely impacted by market uncertainty, we continue to see more activity moving onto our balance sheet.
In the third quarter, we raised a record $39 billion for our clients of which 23% was retained on our balance sheet well above our long term average of 18%.
We will continue to do what is best for our clients, including offering on and off balance sheet solutions.
Importantly, we continue to make progress with respect to our targeted scale sectors, which are not only high growth opportunities for key but areas that matter to both our country and our economy.
We have made a conscious decision to invest and focus our resources in certain vital growing sectors, including healthcare renewable energy and affordable housing that impact both our clients and our communities.
Both renewable energy and affordable housing or areas of investment and recently passed federal legislation.
Bind the inflation reduction act and the bipartisan infrastructure Bill have allocated over 300 billion.
For energy transition.
In healthcare, we are growing relationships with significant health care providers, and expanding our lower growth business, including our recent market extension to include nurses.
We are also very pleased with the early results from our May 2022 acquisition of Grad fit since the grant Fenn team joined key they have held over 14000 individual consultations for refinance and public service loan forgiveness. These consultations are with prequalified crudes.
<unk> prospects all new to key.
Our expenses continue to reflect our investments in our teammates digital and analytics, we continue to balance expense discipline with investments for the future.
Quality remained strong this quarter with net charge offs as a percentage of average loans of 15 basis points.
Nonperforming loans declined from the prior quarter.
We remain committed to delivering sound profitable growth by maintaining our discipline with respect to risk.
We will continue to support our clients, while maintaining our moderate risk profile, which positions the company to perform well through all business cycles.
Our capital remains a strength, providing us with sufficient capacity to support our clients and return capital to our shareholders.
Our fourth quarter guidance keeps us on a path to deliver positive operating leverage again in 2022 and concurrently make progress against each of our long term goals. We also continue to make tangible progress against the three commitments, we announced earlier this year at our Investor day.
These goals for 2025 are as follows growing relationship households, and our consumer business by 20%.
Growing our senior bankers by 25% and growing our Laurel Road member households to 250.
From 50000.
We're on pace to achieve all three measures, we have grown consumer households, and Laurel road members as well as the number of our senior bankers, although our senior banker hires have been slower in the back half of this year, reflecting current market conditions.
Overall key delivered another solid quarter I remain confident in our future and our ability to create value for all of our stakeholders with that I will turn it over to Don to provide more details on the results of the quarter and our outlook Dan.
Thanks, Chris I am now on slide five for the third quarter net income from continuing operations was <unk> 55 per common share up one from the prior quarter and down 10 from last year our.
Our results in the current quarter reflects strong core operating performance and the resiliency of our business model as we continue to navigate through the current market conditions pre.
Pre provision net revenues was up 9% from the second quarter with a 5% increase in revenue driven by loan growth and by the way that we positioned our balance sheet to benefit from higher interest rates are.
Our results also reflect our ongoing focus on expense management and our strong risk profile.
Turning to slide six average loans for the quarter were $114 billion up 14% from the year ago period, and up 5% from the prior quarter.
We continue to add and deepen client relationships across our franchise, which drove loan growth in both our commercial and consumer businesses.
Commercial loans increased 5% from last quarter, reflecting broad based growth across our industry verticals.
Our consumer business continued to be strong with continued with its strong performance as we saw residential real estate originations of $1 9 billion.
Consistent with our focus of health on healthcare segment, 30% of our consumer mortgage originations were to healthcare professionals.
Lower road originated approximately $200 million of loans this quarter, reflecting the ongoing federal student loan payment holiday as well as the impact of interest rates.
Continuing on to slide seven <unk>.
Average deposits totaled 144 billion for the third quarter of 2022 down $3 billion or 2% compared to both the prior quarter and the year ago period.
Year over year, we saw a decline in nonoperating commercial deposit balances, partially offset by an increase in retail deposits.
Declined from the prior quarter reflected lower commercial and consumer balances.
Both areas were impacted by a reduction in stimulus related funds.
Interest bearing deposit cost increased 17 basis points from the prior quarter. This resulted in a cumulative deposit beta of 9%.
We continue to have a strong stable core deposit base with consumer deposits accounting for approximately 60% of our total deposit mix.
In addition, 85% of our commercial deposits are from core operating accounts.
Turning to slide eight.
<unk> equivalent net interest income was $1 2 billion for the third quarter compared to $1 <unk> billion in the year ago quarter, and $1 1 billion in the prior quarter.
Our net interest margin was 274% for the third quarter compared to 247% for the same period last year and $2, 61% for the prior quarter year.
Year over year net interest income benefited from higher earning asset balances and a favorable balance sheet mix as well as the benefit of higher interest rates.
Quarter over quarter net interest income and margin benefited from higher interest rates and loan growth, partially offset by higher interest bearing deposit costs.
Both net interest income and net interest margin reflects lower loan fees related to a two PPP loan forgiveness as well as the impact of the sale of our indirect auto portfolio in the third quarter of 2021.
Included in the appendix with additional detail on our investment portfolio and asset liability positioning.
As Chris mentioned, we have intentionally positioned key to continue to benefit from higher interest rates over the next few years.
For example, if we were to reprice, our existing 9 billion and short term treasuries and 26 billion of swaps to today's interest rates. We would have an annualized net interest income benefit of over $1 2 billion.
This positions us to continue to grow net interest income and the net interest margin over each of the next few years, even if rates do not increase.
Moving to slide nine noninterest income was 683 million for the third quarter of 2022 compared to $797 million for the year ago period, and $688 million in the second quarter.
Our fee businesses continued to be impacted by the slowdown in capital markets and.
Investment banking and debt placement fees were $154 million for the quarter up $5 million from last quarter, but down $81 million year over year.
Compared to last year. In addition to lower investment banking fees cards and payments income was $20 million lower driven by lower prepaid card revenue, which was partially offset by core growth.
Sumer mortgage income was also lower reflecting lower gain on sale margins.
Strength in our corporate services income from higher derivatives income, partially offset these declines.
Quarter over quarter fees were down $5 million Trust.
Trust and investment services income decline, reflecting lower commercial brokerage commissions operating lease income was lower due to lease terminations in the quarter.
Increases in cards and payments income in the $5 million increase in investment banking fees, partially offset these declines despite.
Despite the increase in other income. This line also reflects a $9 million reduction related to the visa litigation settlement.
This quarter, we also reclassified certain customer related derivative income items from our other income line to corporate services income. This change was reflected in the current period as well as reclassified in prior periods for comparability.
I'm now on slide 10.
Total noninterest expense for the quarter was $1 1 billion relatively stable with last year and up $28 million from last quarter our expenses.
Reflect our ongoing investments in digital analytics and our teammates.
Compared to the year ago quarter, our expenses were down $6 million.
We saw declines across most non personnel line items, including business services and professional fees.
Higher personnel costs, partially offset these declines related to an increase in salaries expense.
This increase included $8 million of lower deferred costs from slower loan originations and $10 million of higher contract labor related to technology initiatives.
Compared to the prior quarter noninterest expense was up $28 million.
Higher personnel costs drove this increase.
This increase was caused by higher salaries related to seasonal staffing and $10 million of lower deferred costs from slower loan originations.
In addition, higher incentive and stock based compensation was driven by a $12 million increase related to the relative stock price change on incentive compensation.
Partially offsetting these increases were declines across most non personnel line items, including occupancy and business services and professional fees.
Now moving on to slide 11, overall credit quality remained strong for the third quarter net charge offs were $43 million or 15 basis points of average loans.
Nonperforming loans were $390 million this quarter or 34 basis points of period end loans, a decline of $39 million from the prior quarter.
We did see a very slight increase in our 30 to 89 day delinquencies and criticized loans this quarter, although both remain near historic lows.
Our provision for credit losses was $109 million per quarter up from $45 million in the second quarter and exceeding net charge offs by $66 million.
The increase in the provision was driven by the change in the economic outlook.
Now on to Slide 12, we ended the third quarter with a common equity tier one ratio of nine 1% within our targeted range of 9% to nine 5%.
This provides us with sufficient capacity continued to support our customers and their borrowing needs and returning capital to our shareholders. We will continue to manage our capital consistent with our capital priorities.
First supporting organic growth of our businesses.
Second paying dividend and as we've mentioned before our board of directors will evaluate a dividend increase in the fourth quarter and third repurchasing shares.
During the quarter, our board of directors approved an extension of our share repurchase authorization of $790 million.
Which is now in place through the third quarter of 2023.
We did not complete any share repurchases in the current period.
As we have in prior years, we have updated slide 13 to show our fourth quarter outlook relative to our third quarter results.
Using the midpoint of our guidance ranges would support Chris's comments about delivering another year of positive operating leverage in 2022.
We expect average loans will be up between 2% and 4% and average deposits up 1% to 3% net.
Net interest income is expected to be up between 4% and 6% reflecting growth in average loan balances and higher interest rates.
Our guidance is based on the forward curve, assuming a fed funds rate of four 5% by the end of 2022.
Noninterest income is expected to be up between one and 3%. This reflects an expected seasonal pickup in investment banking and debt placement fees.
We would expect the fourth quarter of 'twenty two to be well below the fourth quarter 'twenty one results.
This also accounts for the implementation of our new NSF ODP structure.
Which will decrease service charges on deposit accounts by approximately $25 million this quarter.
The higher interest rate environment will also impact the earnings credit in our commercial businesses and is expected to further pressure this line item.
We expect noninterest expense to be up between one and 3% for the fourth quarter, reflecting higher incentive compensation related relative to fee production as well as $20 million of one time charges in the fourth quarter, including a pension settlement charge, which will flow through other expense.
For the quarter, we expect credit quality remained strong and net charge offs to be at the lower end of our 15% to 25 basis point range.
Our guidance for the GAAP tax rate remains the same at approximately 19%.
Finally, as shown at the bottom of slide our long term targets, which remain unchanged. We expect to continue to make progress on these targets by maintaining our moderate risk profile and improving our productivity and efficiency, which will drive returns.
Overall, it was a solid quarter and we remain confident in our ability to grow and deliver on our commitments.
With that I'll now turn the call back over to the operator for instructions on the Q&A portion of our call.
Sure.
Ladies and gentlemen, if you would like to ask a question. Please press one then zero on your telephone keypad.
We'll hear acknowledgment that your line has been placed into Q.
If you wish to remove yourself from the queue you may repeat the one zero command one moment. Please for the first question.
Our first question is from Alex Alexopoulos with Jpmorgan. Please go ahead.
Good morning, everybody.
You changed your name.
Yes.
Yeah.
So I wanted to start on the deposit side. So if we look at the $4 billion decline in the noninterest bearing right you're appropriately calling out the decline in non operating deposits. If you look at the $47 billion, where you ended the quarter how much of that is still non operational and at risk to see outflows.
I would say that at the end of the quarter. When we look at our commercial balances, it's still in that 85% range and.
We do believe that.
Part of that decline to be honest. This is that we were a little stingy on some of our deposit rates and it's part of our outlook for the fourth quarter of showing deposits increase we really have two factors. One is seasonal changes and then also to use some of that deposit beta and maybe.
Retain or attract additional customer relationships or nonoperating.
Okay. That's helpful commentary done.
Follow up so if we look at the interest bearing deposit costs and only 25 basis points in the three month T bills now at 4%.
Arent deposit costs going to materially ramp in the quarters ahead for you guys or really for everybody I know that historically retail with sleep, you're right the money that move, but it's a different era today. What gives you confidence that you could continue to see NIM expansion, which you clearly are signaling was the commentary on treasuries and swaps can you really.
Flush that out for us thanks, so much.
Steve It's Chris a couple of things one when we were awash in liquidity, we were pretty disciplined about how what deposits, we kept and what deposits. We pushed out so our starting point is a bit differentiated from where it's been in other cycles. The other thing to keep in mind is that 65%.
60% of our deposits are both consumer deposits in our escrow business, which has significant deposits and we've been really focused on our pillars have been focused on four things one of which has been primacy for some time. So I think we're in a little bit different position than we've ever been in as the cycle changes what we are.
Seeing is that our cumulative beta is 9%.
Through the first three quarters, we think our cumulative beta will be 15% for the year, we're projecting an endpoint on a spot basis of just above 30. So we are anticipating a fairly significant ramp but not the kind of experience that we've had before based on all the work we did prior to that.
Interest the rise in interest rates.
Okay. So is it safe to say most banks are guiding that nims are going to peak in the first half than probably of next year and then trend down in the second half are you guys confident youll see NIM expansion through 2023.
Thanks.
We will provide more in the 2023 outlook in January but youre right as we look at how we're positioned with the benefit that Chris and I, both referred to as far as just the short term swaps in the short term treasuries and those rollovers that.
But we do believe that we're going to grow net interest income and margin even beyond that first half of 2023, and so even with the <unk>.
Increased deposit beta and so that was intentional on our part to have more of a long term focus as far as how we manage interest rate risk and we think that while it's costing us a little bit on a relative basis. Now we think that will be recouping that throughout the later periods of 'twenty three and 'twenty four.
Okay.
Thanks for all the color.
Thank you.
Next we'll go to the line of Erika Najarian with UBS. Please go ahead hi.
Hey, good morning, good morning Erika.
You mentioned.
Chris the $1 2 billion dollar benefit over time.
Early on in your prepared remarks.
Don you mentioned it again.
So I guess, let me let me ask the question.
Number one.
Your C&I loan beta was 53% this quarter.
Is that essentially the impact from the swaps and should we expect a similar loan data.
As the fed continues to raise rates and as we think about that $1 2 billion benefit coming back.
How much of that is coming from the swap book versus the Securities book and over what period of time do you realize that one 2 billion back into your net interest income.
Sure maybe I can take a crack that Erika and I don't have that broken out where C&I, but for total commercial the swap impact for commercial yields cost was 43 basis points on a linked quarter basis and so.
Instead of the increase that Youre seeing for commercial yields that she is the actual loan itself would have translated to 116 basis point increase and so I think that can be much more consistent with what you might be seeing for some others that don't have that hedge impact.
And so this quarter, we did see that kind of relative change on that category as far as the impact from swaps.
As far as that $1 2 billion.
It really relates to the.
The swap book and the maturities and also the short term treasuries those treasuries.
Which total about $9 billion really mature throughout late 2003 and throughout 2000 and for the swap book between now and the end of 'twenty three we got seven $3 billion of swap maturities and another $7 5 billion in 2004, and so if we just look at that time period for the next two years.
And using that same math as far as the repricing, we'll have $900 million of that $2 billion annualized net income pickup occur in that two year time period 1.2 of the $1 2 billion I'm, sorry, 900 million out of the $1 2 billion.
Occur in that two year time period.
Got it and my follow up question is on expenses I think that.
Key has always been very good at managing expenses, particularly relative to fees and I think that.
It probably surprised the street in terms of the.
On the personnel costs relative to.
What happened on the fee side, especially and I'm wondering given that you called out some of the $12 million.
And the $10 million in your slides.
How should we think about the 655 going forward.
And.
Okay.
I guess.
Mike.
Other question and I'm, sorry, I'm not getting this out quickly.
Is this just.
Something that even though the capital markets remain dislocated inflation and the.
Competition for talent will continue to push this pressure this up alright.
A couple of things one our expenses were higher than what we had guided to for this quarter and for the second half of the year. If you look at the components of what drove that change and I'll get to your.
Question as part of this.
There are three items that really caused our outlook for all of 2022 to be higher than what we previously.
Expected one is more one time items, we've got a pension settlement loss projected in the fourth quarter and also some branch consolidation that brands are building consolidation type of costs associated with that and those two combined to $20 million.
Outside of personnel, but within our operating losses.
During the second quarter, we are seeing our operating losses from the prepaid card product come down through the second quarter and we expected that to continue through the third and fourth quarter than what we actually saw was those costs actually go up and so it wasn't a huge increase that compared to what our relative positioning wasn't expecting.
<unk> was for for that category, it's about a $30 million increase in the second half of the year our expense structure for us.
And the good thing about that is that we have taken action to address that and we will start to see that over time, but.
But the other good thing is it has a limited life to it. These are related to funds that were distributed as part of the.
Stimulus programs and they are winding down and so we don't think that will have an ongoing impact with the.
The third component, Eric really as deferred loan origination cost and and that cost us about $20 million and most of that is with our reset of our consumer loan originations and the cost that gets deferred associated with that and so we will see it.
Increases from from that continue for some time period, because we're not seeing.
<unk>.
Return of the previous origination levels.
That will be there.
For the fourth quarter, we expect to see our capital markets revenues pick up and as we've said before the incentive compensation expense tends to be correlated to the tune of about 30 cents on the dollar. So for every dollar of investment banking and debt placement fee increase we will see that come through incentives.
As far as where we see for other salary and personnel costs.
I would say just looking at the year over year.
Adjusting for some of these items I talked about for the deferred loan origination costs and things.
Our total salary dollars were up about.
10% and head count is up about 5% now some of that includes some of the smaller acquisitions, we've done throughout the year.
And so that does imply a 4% to 5% inflationary impact for some of the salaries. Some of that is because of the lower end of the Batesville continue to have increases some of its market pressure and we will be working through that as we set our expectations for merit increases for for 2003 and <unk>.
Beyond and.
I think that the important thing here Erika also is that we're very focused on driving positive operating leverage we expect to do that this year and we haven't given guidance for 23 or beyond yet, but we expect to continue that through the next several years as well.
Thank you.
Q.
Next we'll go to John <unk> with Evercore. Please go ahead.
Good morning.
Good morning.
Related to your last comment there on on the operating leverage I mean, your cash efficiency ratio is running at about 60% year to date.
Jeff.
Wondering how you can help us think how you're thinking about that for 2023.
And if not maybe if you can help us with the magnitude of pause op leverage that we could see in 'twenty three and then separately. Your long term target you maintained that at 54% to 56, how should we think about what you would need to see to be able to achieve that level. Thanks.
John It's Chris Good morning, So I think I think our efficiency ratio for the quarter. We just printed was right around 58%.
It's not.
We do aspire to get to 54% to 56, but as Don mentioned, what we're really focused on is positive operating leverage and if you think about our capital markets business coming back. If you think about some of the many investments that we continue to make coming to fruition and you think about the trajectory.
That Don described from an NII perspective, obviously that continues to move us toward that long term target that you referenced.
<unk> 54 to 56.
Okay.
Alright, Thanks, Chris and then.
Alright.
In terms of.
Deposit growth expectations.
I appreciate the color you gave near term wanted to get a little bit of color on how you think about the.
<unk> growth as you look into.
2023.
If you can talk about the mix shift of noninterest bearing towards interest bearing and then overall growth levels do you think incremental declines are possible as we look into.
Into the early part of 'twenty three.
Well I mean.
We're really kind of going into a bit of uncharted territory I will tell you. This though we have been pretty consistent and that our non interest bearing have been right around 32% and that Hasnt moved and I don't anticipate.
That moving a lot as we go forward and as I mentioned earlier. This deposit book has been pretty well scrubbed over a period of time.
Having said all that as interest rates continue to rise.
Some deposits that previously were deemed to be not interest rate sensitive will in fact be interest rate sensitive and we saw some of that movement in the third quarter, where some of our public sector customers that are more interest rate sensitive moved.
We're obviously watching it very closely and it's.
It's certainly an interesting dynamic, particularly as the fed unwind their balance sheet concurrently.
Okay. Thanks for taking my question.
Next we go to the line of Gerard Cassidy with RBC. Please go ahead.
Good morning, Chris <unk> done.
Morning Gerard.
Chris you talked about the strength in the commercial and industrial loan growth and you have taken on more of your originations than you have in the past as more of your customers are coming onto your balance sheet, rather than going to the capital markets.
Questions. One can you share with us what percentage of that portfolio is considered leveraged loans and then also in that same kind of vein. How big is your syndicated loan portfolio did that impact the growth this quarter.
So a couple of things.
Our leverage book Gerard it's been pretty consistent at about two 5%.
Total loans and what's interesting about that is its been two 5% even when we were a much smaller company. So that portfolio has a lot of velocity. It's in our it's in the segments in which we focus.
Theres been some talk about some of deals that are hung lately. We've just had just a de minimis bark.
Over the last six months in that book, So we feel really really good about that most of the growth that youre seeing Conversely is really an investment grade credit and the market was dislocated enough and our clients were trying to do things in an expeditious manner and we have really grown the percentage of our C&I book that.
Investment grade as we brought more onto the balance sheet right now our C&I book is about 50% investment grade, which is a bit of an outlier.
For for a bank of our size.
And when you underwrite the new originations do you guys I assume you always do this but are you stressing and for two.
200 to 300 basis points higher rates, just so that you're protected if rates are to go quite a bit higher from here.
For sure.
Our first stress that we always run is actually 300 basis points and we run a lot of stress other stresses and when you get into anything Thats leveraged we stress EBIT die and we stress interest rates because.
That's the danger of anything Thats leverage as you have the concurrent decline of EBITDA and the increase in borrowing costs.
Do a lot of stressing with respect to those credits.
Very good and then as a follow up question.
Your credit quality, obviously superb like many of your peers and I know thats going to be a defining moment for you folks through the cycle. So the question I have is on the consumer loan portfolio.
The FICO scores I think you've shown it averages out to $7 72.
Have you guys. There's been some chatter that FICO scores like I think college screens have been inflated.
Seeing anything where the FICO scores, if you compare them to five years ago. They are inflated or is that really not the case.
I haven't personally done the analysis, but just because we look at this stuff all the time.
I think theres, probably I think theres, probably a lot of like like they teach the SAP I think theres some instruction on how to get your FICO score up having said that if you think about the super Prime customers that we're focused on doctors dentists, which for example, where 30% of our.
Mortgage origination.
Our originations last quarter, we feel really really good about our consumer book as we look kind of across all the metrics and Gerard Youre right. There actually was some technical change in some of the FICO scores.
And I don't know if it was by law are what they had to exclude certain I think it was medical related costs or loans or expenses and so if you would adjust for that I think that today's FICO score is probably 10% to 15 basis points higher than the same would be.
Several years ago, and so instead of our 772 it might be a 760, which is still a super prime even historic standards.
Very good thank you Dan Thank you Chris.
Thanks Jordan.
Next we go to the line of Ebrahim <unk> with Bank of America. Please go ahead.
Hey, good morning, good morning, Werent DRAM.
Tom just wanted to follow up on the swap and Treasury securities portfolio. So.
Get in terms of how this should help NII.
NII.
That's obviously assuming that Canadian stay high for the next 12 to 18 months.
Is that anything that you plan to do ahead of time to lock in that upside or just give us a sense of.
And if we get through the next three to six months.
Let me start losing some of that benefit that you would have otherwise had and is that a way that you expect to logged in ahead of time.
We're continuing to review that on a regular basis I would say that our Alco committee as we get together, we tend to think that we're going to see rates higher for longer just given what we've experienced in the current marketplace, but even with that you've seen a little bit of a tick up again as far as our forward starting swaps and thats exactly the purpose of that Ebrahim.
Is that where we're looking to put on swaps that actually kick in some of these will mature and start to lock in some of that forward benefit for us as well and we're not ready to do a wholesale type of repositioning to achieve that but we do expect to continue to use that tool over the next several quarters to help.
Lock in some of that benefit.
That's that's fair and I guess, just a separate question following up on credit left to do with your portfolio, which you have a lens into sort of the middle market commercial CRT.
How soon do you expect that customer base are you seeing areas, where you you've kind of pulled back given the rapid rise in interest rates and what youre seeing in the market in terms of spread widening I think what are the areas, where you're seeing theme that you pulled back as a bank and where do you like do you actually start seeing a fall of four 5%.
Funds.
Most certainly creating pressure for a subset of that segment.
Sure I'll take that one.
Clearly I mean last year.
Our view for some time has been that these work that inflation would be persistent and that rates would have to be higher for longer and if you go back to a year ago in September when we exited indirect auto.
$3 $3 billion portfolio that was an area that we thought and I still believe we'll be under intense stress in the market.
We're entering the other thing that I always look for is any place that there is leverage in our casualty had just asked a question about leverage loans. That's an area that we pay a lot of attention to another area that we pay a lot of attention to is just real estate broadly and by strategy, we're focused on apartments multifamily.
In industrial interestingly those values are up significantly from pre pandemic levels.
With respect, 15% and 39% respectively.
The other area, where I think that theres going to be.
A lot of dislocation as an office.
Particularly P&C class office.
Those buildings are leveraged and obviously people have changed the way they work.
That's not a business that we're in in any significant way, although we do have a $600 billion third party commercial loan servicing portfolio, which is that that's off us.
And now the second largest category below retail where you would expect that starting to go into active special servicing are these b and C class offices in central business districts. Those are few of the places that I would bring to your attention.
And just on the also skews Inc.
And then just given the nature of the leases or is it going to be more like what are you seeing that big box retail malls. When it's paid out over the last decade as opposed to in any given quarter or any given year.
Yes, I think I don't think it's a cliff event I think it's a slow burn because if you think about these b and C class office space. They have many many tenants with varying termination dates on their leases I think it will be I think it will be a slow but consistent burn.
Thanks for taking my questions.
Sure.
Next we go to the line of Scott <unk> with Piper Sandler. Please go ahead.
Good morning, guys. Thanks for taking my question.
Chris I was hoping you could sort of walk through the <unk>.
Banking pipelines and pull through I think we can all see what's what's happening in the industry, but some companies are noting that theres still enough activity taking place at sort of the smaller end of the segment middle market and below that it's keeping sort of activity going to prop up numbers. So.
Are you seeing healthy activity versus what's still slow and just given your background.
Do you think there is a point, where we will say get price discovery, and then increased activity, despite higher rates and the weaker economic backdrop.
So I do so.
The activity has remained strong and we had a very good quarter in this area.
Areas like syndicated finance, so that area continues to be strong.
The areas that are really challenged.
<unk> is the public equity market, that's a market. Unlike the debt market, where its binary either you can issue equity or you can't basically and right now you clearly can't do.
The M&A markets.
Im confident we will come back we are involved in a lot of these strategic discussions and whats happening Scott is if youre a buyer you basically have sort of a free option Europe theres no huge impetus to close everyone is looking out over the horizon in predicting a downturn and so if you havent locked up as sort of dragging your feet.
Wait and see.
What the downturn is going to look like our.
Our pipelines remain strong in that business, we continue to selectively hire people it will come back.
I don't think its going to come back I don't see any significant market change in the fourth quarter by the way, but I do think I do.
You think the business will come back.
Having said that I have.
<unk> been doing this for a long time, there is an inverse relationship between the amount of time, you've been working on the deal and the probability that its actually going to close and so I throw that out as a watch point.
Perfect. Okay. That's good color. Thank you and then maybe Don.
This notion of.
OCI marks in the tangible book and TCE hits has gotten a lot more attention a lot of companies have begun to move pretty substantial amounts of their securities portfolio to held to maturity.
In a sense you can sort of make the TCE tangible book issue go away with the wave of a hand, so to speak so maybe just some thoughts on why you guys are keeping most of the available for sale.
To what degree does TCE matter in your eyes is that govern any of your capital management thinking or things like that.
Sure that as we look at our future security purchases were starting to put a portion of those into held maturity, whereas it used to be primarily only into the available for sale.
And so we're just separating some where we might want to have bullet maturities, where we can do some.
End of life type of swaps attached to it that we need to keep those in available for sale as opposed to move them into our held to maturity.
The TCE ratio isn't a high priority for us our main capital ratio that we focus on is the common equity tier one ratio in some of the other.
Our regulatory ratios, whether it's tier one or total and so thats why you saw us take action in the third quarter with the preferred stock issuance and also a sub debt issuance and we feel very good about how we're positioned across the capital spectrum.
Other thing to think about too as far as the TCE ratio. If you would just back out the OCI.
Impact for TCE that would take our ratio up by 330 basis points and so on that adjusted basis.
Which will all come back over time, because we don't have risk of those.
Those investments not being paid off because theyre all agencies are U S treasuries.
We're going to see that realized and so thats more of the area of focus for us as well.
Perfect. Okay, great. Thank you guys for taking the questions.
Next we go to the line of Matt O'connor with Deutsche Bank. Please go ahead.
Good morning, just wondering what youre seeing in loan pricing trends specifically in commercial obviously, the absolute yield is going up because of higher rates, but are you seeing.
Improvement in spread given we see widening in the marketplace and public markets.
That's a great question, Matt and what's ironic about this to date, what we've seen as credit spreads widen out for the investment grade.
<unk> that we serve in and because they are seeing that in the capital markets for the middle market space because of the competition there tends to be more local we havent seen the commercial spreads widened that much yet we would expect that to.
Pick up over time here, but the near term the spreads are holding in but not expanding on the commercial for the lower middle market customers.
Any way to quantify on the investment grade or as you mentioned, you're overweight investment grade versus others. So that's probably a positive for you.
Yes.
It is for us and I would say that on the credit spread widening we've probably seen a good 20 basis points of widening generally on pricing reflective of credit spreads in the market.
Okay. Thank you very much.
Uh huh.
Next we have a question from Mike Mayo with Wells Fargo Securities. Please go ahead.
Hi.
One negative one positive the negative is the personnel expense up so much quarter to quarter and I get one time items, 8%.
Just versus.
It's just.
Had the onetime items seem to repeat and therefore, maybe they arent. So one time I mean, I guess, you said fourth quarter might have some more next year do you expect more one time items or when do we get more core expense numbers because that seem to come in a little higher than expected and on the positive side as far as your outlook for NII and the NIM.
I mean, your NIM of two 7% a decade ago. It was close to three 7%.
Conceptually, we've had almost 14 years of zero interest rates.
Now that we're getting out of that could you potentially get all the way back to three 7% or what are some of the ins and outs.
Since the global financial crisis that could help or hurt that.
Sure as far as personnel personnel.
A couple of things that we've talked about as being one time or just <unk>.
Different one is the pension.
Settlement loss that will have in the fourth quarter. The good thing. There is is that with rates being higher the threshold is higher for us to be in a position to have to realize that.
Losses in the future and so we do think this truly is more one time in as long as rates remain where they're at or even go a little higher.
We shouldn't see that come through.
The charge.
The one thing that you will see Mike is that a good portion of our long term incentive compensation is tied to our stock price and and we want our employees to be shareholders and have a consistent objective to what our shareholders have as well and so part of that incentive compensation expense does fluctuate.
<unk> from time to time with our share price and so.
Our expectation and hope is that we'll see our share price increase and so from that you will see the.
The incentive compensation expense increase with that as well.
Beyond that Mike, but I would say for the current quarter versus a year ago as I mentioned before the core salary line item is up about 10% with about 5% of that coming from head count related increases some of that is from acquisitions, we've done and we had about a 4% kind of merit increase.
Impact to that as well throughout.
Throughout the year and that reflects some of the experience we had for right sizing the lower salaries, but also the market pressure. They were seen in so near term I think we'll probably see a little higher than our typical 2% as far as wage inflation going forward, but.
I think we'll see that settle down and and as Chris has said that we will continue to make investments in talent and especially in our frontline bankers and also in the technology space to continue to grow our business but.
With that we'll be holding people accountable there, making sure that we're getting the appropriate returns on those investments in and showing the growth going forward, yes. The only thing I would add to that is on the technology front there has been a transition.
Think about full stack engineers, Rob some contract labor to people that are part of our head count. We just think it's important as we continue to become the digital bank that we are.
That we control that talent and so that's that's a piece of what Youre seeing there Mike.
And then Mike as far as the margin expansion I don't want people to start thinking that we're going to get a three 7% margin because.
Our risk profile is much different than what it was historically and so it is relationship based but we do see significant growth from that and so one just a simple math of that would be taking a look at our full year net interest income and if you just layered on top of that the $1 billion two that we've talked about the repricing of the swaps and the treasuries.
That clearly gets you into the mid threes and maybe not to the three 7% range, but we would see some meaningful lift from here if the rates play out with this kind of environment.
And then just one follow up on that comment about technology. So.
Less consultants to more full time employees, so that you can better control.
Daphne is that the idea of this and what was the tipping point for that change.
The tipping point was.
As we were in the pandemic.
And everybody was was short on talent, we were getting more turnover from some of our contractors than frankly, we wanted to get and we wanted to be able to literally have continuity and we wanted to drive our strategy in a consistent way with leadership and so we made the decision in certain areas.
Dialed back.
Contract labor and to hire in.
When I say, it's full stack engineers and the nice thing is with some of the acquisitions. We've made Mike we have the kind of leaders that can attract the kind of people onto our platform that we want as we go to the next level.
Yes.
Alright. Thank you thank.
Thank you.
And our next question is from Ken Houston with Jefferies. Please go ahead.
Thanks, a lot good morning.
John just one more follow up on the balance sheet mix. So the securities portfolio has been hanging around 50 billion and just wanted to understand with that planned run off in that good slide you have in the back about the maturities do you expect to keep the securities portfolio around this size from here and then.
Just trying to understand how that.
That gets funded incrementally given that youre still expecting decent loan growth.
There's really two pieces of our investment portfolio one of the core book, which is about $40 billion and the other is the U S treasuries, which are about $9 billion.
Think near term in our outlook would suggest that we think that core portfolio will hang in there around the $40 billion level and so we think thats appropriate just from a liquidity perspective, and a balance sheet mix for the U S. Treasury portion of the portfolio will make some assessments is that maturities are those maturities come through and we'll get the benefit.
Whether we use that for future funding or we can just go ahead and rollout into the core portfolio and so yet to be determined how that plays out but but but.
I would say that there's probably less certainty on that 9 billion short term treasury portfolio.
And just following on to that then so the $1 two benefit wood wood does adding contemplate any type of delta and sizing of both the securities book and the overall swaps book as you get to those out years.
The swap book assumes that it would stay the same and then on the Treasury portfolio. It has either.
Assumed impact of rolling that over into more one year treasuries or using that for funding and at the same net bottom line impact at this point in time.
And then just sorry, one more follow up just do you have an understanding or can you help us understand just when the near term swaps.
Detriment just from natural higher rates kind of gets to its bottom and then you start to get that incremental benefit rate of change starts to happen I guess it sounds like Thats in next year, but do you have an understanding of kind of when that pivot happens.
What I would say that a couple of things we'd have to know for that when do when do a short term rates peak, because thats going to be the main driver as to when that negative impact happens for the existing portfolio and then as we have the rollovers of that book will be picking up over 400 basis points.
Excuse me over 300 basis points on the swaps as they would rollover and so thats that will help offset that but it probably be sometime in 2023 that we start to see that peak in and move the other direction.
Got it thanks, John Thank you.
And our next question is from Betsy <unk> with Morgan Stanley . Please go ahead.
Hi, good morning, good morning.
A couple of questions. One I just wanted to understand what kind of loan growth you've got baked into your outlook and and what is your expectation for how youre going to fund that loan growth.
So what we've done on the loan growth front, we would not see the same trajectory of loan growth that we've experienced in the last couple of quarters our guidance for <unk>.
Q4 is 2% to 4% Betsy.
And we've had a lot of lift from on the consumer side.
Over the last several quarters.
Don't see the same level of lift.
That I think youre going to see we haven't given guidance yet for 2023, but.
With respect to loan growth, we're targeting 2% to 4% in the fourth quarter and just the fund that our guidance for the fourth quarter is also a 1% to 3% increase in our deposits.
And if you go through the math.
Pretty close match there as far as the mid points of both are around that $3 billion kind of range and so it's.
Sure.
We think we'll be fairly close to funding that through just the core balance sheet growth.
Have used other.
Wholesale funding to help.
Fill that gap in the last couple of quarters is expected to be more core going forward.
The deposits don't come through for whatever reason.
Can you just give us your hierarchy of how you would go about funding. It is it securities roll off or are you first go to the wholesale funding piece.
Near term we have been using.
<unk> advances and locking those.
Debt maturities of our term maturities. So we would probably continue that and then as I mentioned before we're still yet undecided as far as the roll off of the U S. Treasuries when they start coming through next year, and then 24 as to how we use those proceeds.
And then just lastly, I know that forward curve is looking for the fed to be.
The dawn in early 'twenty three but.
If it if they end up extending.
The rate hike cycle going further into 'twenty three how should we expect that impacts the outlook here.
I know you mentioned that <unk> got the benefit of the short term.
The swaps rolling off that should help but I'm just wondering is there any timing.
We should be considering here.
Yes.
Don't think theres any cliff or any events there that we still view the rates going up we will still have a net positive even with deposit beta has been higher than what they had been before and then just the repricing of the swaps and treasuries will be additive for us and so we think that.
We still will be able to grow net interest income and margin throughout the next couple of years, even if rates do go beyond the.
The current outlook.
Got it Okay and then just last question going back to the quarter in mortgage for the quarter very strong results here.
I just wanted to understand.
What's the main driver of that was and the tail of the leg on that type of ink.
Increase thanks.
So for US it was it was driven.
Really by purchase.
87% of our originations were purchase and this is a relationship based business, 30% where medical professionals. So.
<unk>.
Basically refinance business Betsy has completely dried up I would envision from here that purchase mortgage continues to decline in this environment as we believe we're in for a cycle that's higher for longer.
So.
Reflecting.
<unk> loans, it had probably started a quarter or two ago.
So we should expect that should tail off and are these.
30 year fixed you are putting on our 15 year.
Arm floaters can you give us a sense of the construct.
It tends to be more arms and 15 year, we do have some 30 year fixed and some of our Dr. Dennis program that we've had that.
I'd say, it's a mix of those and we would expect to see the fourth quarter origination levels to be lower than what the third quarter was.
It still is a core product for us and something that we had under weighted in the past. So we still think there is room for for some modest growth in the balance sheet there okay.
Okay, great. Thank you thank.
Thank you.
And our final question will come from Bill Kirk <unk> with Wolfe Research. Please go ahead.
Hey, good morning, Chris and Don.
I wanted to follow up on your comments around the modest increase in the reserve rate due to the economic outlook can you give a little bit more detail on what kind of unemployment assumption is implicit in in that reserve than what you would expect the reserve rate to go to if unemployment were to increase to say the 5% to five 5% range.
Sure.
Yes, as far as what we use as our baseline for our seasonal reserves, we tend to start with the consensus assessments from Moody's and so we did see a shift in that from last year to this year I would say that Moody's unemployment levels are using about a 4% unemployment level for for <unk>.
2023.
I don't know that off top my head what the.
That could be a scene that go into 5% because we'd have to have the other components of the economic outlook.
I would say that if we look at where our reserves were back at January one of 2020.
I would say that the unemployment levels and economic outlook was.
A little worse than what we're seeing now today and.
Our reserve levels, there were about 10 or 15 basis points higher than what they are today for us.
So.
A lot of moving parts and pieces, but I think that.
It's not going to be a huge change, but that still would be reflected in our reserve.
That's helpful. Thank you and separately it seems intuitive that the cohort that you're targeting with your Laurel road products would perform relatively well in a downturn, but is there any less credit history for this asset class and if so can you give a little bit of color on the kind of data and analytics that youre using to underwrite potential customers and whats the approve.
<unk> rate of customers seeking alone through Laurel road, and actually those would actually receive one.
I would say that we do have data for doctors and Dennis programs. Both on the residential mortgage side and also for student loans that history is continuing to be build out we are using that insight in order to inform our credit underwriting decision I don't have the.
Exact approval rate for loans, but you would probably assume that it's fairly high given the nature of the.
The Doctor that we're approaching who is going from say 80000, a year and compensation of 300000 plus in.
As a firm commitment and a new assignment with a.
Large hospitals.
I would assume that it could be a fairly high approval rate.
Understood. Thank you for taking my questions. Thank you.
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