Good morning, and thank you for joining Bank of Marin Bancorp's earnings call for the third quarter ended September 30, 2022. I'm Andrea Henderson, Director of Marketing for Bank of Marin. During the presentation, all participants will be in a listen-only mode. After the call, we will conduct a question and answer session. At that time, if you have questions, please press one followed by four on your telephone. If at any time during the conference call you need to reach an operator, please press star zero. This conference call is being recorded on October 24th, 2022. Joining us on the call today are Tim Myers, President and CEO, and Tani Girton, Executive Vice President and Chief Financial Officer. Our earnings press release, which we issued this morning, can be found on our website at bankofmarin.com, where this call is also being webcast.
Before we get started, I want to note that we will be discussing some non-GAAP financial measures on the call. Please refer to the reconciliation table on page 3 of our earnings press release for both GAAP and non-GAAP measures. Additionally, the discussion on this call is based on information we know as of Friday, October 21, 2022, and may contain forward-looking statements that involve risks and uncertainties. Actual results may differ materially from those set forth in such statements. For a discussion of these risks and uncertainties, please review the forward-looking statements disclosure in our earnings press release, as well as our SEC filings. Following our prepared remarks, Tim and Tani will be available to answer your questions. Now I'd like to turn the call over to Tim Myers.
Thank you, Andrea. Good morning, everyone, and welcome to our call. Our record third quarter results highlighted our unwavering commitment to disciplined fundamentals. Our balanced and measured approach supported solid loan originations, excellent credit quality, and improved efficiency. We also continued to benefit from ongoing earnings accretion from our 2021 acquisition of American River Bank. We remain focused on building long-term customer relationships based on great service and local market expertise. As such, with rates rising, our funding costs have remained low as our customers continue to value our high touch approach. We have an exceptionally strong base of core non-interest-bearing deposits that allows us to grow methodically and efficiently while delivering consistent performance in all rate environments. More than half of total deposits were non-interest-bearing at September 30.
While our cost of deposits was flat, rising rates positively impacted our earning asset portfolio, increasing our net interest margin by 11 basis points in the third quarter. Positive loan origination trends persisted in the quarter on a year-over-year basis. We grew our core loan portfolio, boosted net interest income, and expanded our margins. Excluding PPP, our loans were up $5.1 million in the quarter, offset primarily by payoffs related to construction project completions. We generated $52 million in originations in the quarter, up 60% from the year earlier quarter. Our year-to-date originations of $204 million doubled what we produced during the first nine months of 2021. That noted, we are seeing some easing in demand in certain segments of our business as rising rates impact borrowing costs and borrower sentiment.
We are mindful of recessionary concerns, but from where we sit today, we are cautiously optimistic about the economic health of our markets through the remainder of the year. Additionally, our excellent asset quality and strong credit culture position us well to weather any slowdown. In fact, our credit quality continues to improve, with classified loans down almost 10% and nonaccrual loans representing just 0.5% of total loans. Subsequent to quarter end, $7.1 million in long-standing substandard loans paid off, and this will lead to further improvement in our credit metrics. As a result, there are no longer any pandemic-related payment relief loans on our books. Now I'll turn to some final highlights from the third quarter. We delivered record net income of $12.2 million compared to $11.1 million in the second quarter.
Diluted earnings per share of $0.76 compared to $0.69 in the second quarter. We are realizing the expected earnings accretion from the American River Bank acquisition and remain on track to meet the targets announced when the merger became public. With 53% of total deposits being non-interest-bearing, the average cost of deposits was just 6 basis points, unchanged from the prior quarter and better by 1 basis point on a year-to-date basis. With rates rising, we anticipate that deposit costs will increase in the coming quarters, but we expect a gradual shift, and we will carefully manage this on a customer-specific basis. Given the enduring strength of our financial performance, our board of directors declared a quarterly cash dividend of $0.25 per share payable on November 14, 2022. This represents the 70th consecutive quarterly dividend paid by Bank of Marin Bancorp.
Now, I'll turn the call over to Tani to discuss our financial results in greater detail.
Thank you, Tim. Good morning. Our third quarter earnings translated into a return on assets of 1.11% and return on equity of 11.65%, up from 1.03% and 10.74% in the second quarter. Net interest income totaled $33 million in the third quarter compared to $31.2 million in the second quarter.
The increase was primarily driven by higher average balances and yields on investment securities that added $1.4 million in interest income, while our cost of deposits remained flat. Year to date, net interest income of $94 million was more than 25% higher than the first three quarters of 2021. This demonstrates the value added by our acquisition, other deposit growth and higher interest rates, which overwhelmed the $6 million decline in PPP income year over year. Other changes during the third quarter included increases in cash and deposit balances as network deposits were returned to the balance sheet to replenish expected deposit outflows. Stockholders equity decreased due to market value adjustments to the available for sale investment portfolio, partially offset by earnings.
As Tim highlighted, our third quarter tax equivalent net interest margin improved 11 basis points, driven by higher average balances and yields on interest earning assets and a stable cost of funds. We recognized $260,000 in PPP fees during the quarter, down from $573,000 in the second quarter. At the end of the third quarter, our loan portfolio had only $7.6 million remaining in PPP loans, net of $161,000 in unrecognized fees and costs. There was a provision for credit losses on loans of $422,000 in the third quarter compared to no provision in the second quarter. The provision this quarter was primarily due to an increase in qualitative factors to account for the ongoing deterioration in the economic outlook not captured in the quantitative portion of the allowance.
There was no provision for credit losses on unfunded commitments in either the third or second quarter. Third quarter non-interest income was consistent with the second quarter at $2.7 million, with some line items increasing and others showing modest declines. Of note, we took the opportunity to replace some short term, lower yielding securities in the investment portfolio with higher yielding investments, which generated the $63,000 loss on sale of investment securities. That loss will be recovered before year end with the additional yield on the new investments. Non-interest expense of $18.7 million in the third quarter was down $200,000 from the second quarter. Charitable contributions were down as grant funding related to the bank's corporate giving program substantially occurs in the second quarter.
Additionally, there was a $345,000 valuation adjustment to other real estate owned based on a recent appraisal. Finally, a favorable resolution on a vendor contract termination fee in the third quarter resulted in a partial reversal of amounts accrued in the second quarter, reducing expenses by $200,000 quarter-over-quarter. As we continue to integrate and build on our most recent acquisition, the efficiency ratio illustrates the quarter and year to date, respectively, both improved from 55.7% in the prior quarter and 65.7% in the first nine months of 2021.
As there were substantially more acquisition related expenses in the comparable period, the improvements on a non-GAAP basis were 257 basis points quarter-over-quarter and 433 basis points year-over-year. All capital ratios were above well-capitalized regulatory requirements. The total risk-based capital ratio for Bancorp was 15.1% at September 30 compared to 14.7% at June 30, and the bank's total risk-based capital ratio was 14.7% at September 30 compared to 14.2% at June 30.
September 30 tangible common equity of 7.5% for Bancorp and 7.3% for Bank of Marin were down 24 and 53 basis points, respectively, due to a $22 million increase in after-tax unrealized losses on available for sale securities associated with rising interest rates during the third quarter, partially offset by earnings. Overall, Bank of Marin's strong balance sheet liquidity and capital continue to generate profitability across interest rate and economic cycles and enable us to execute on strategic initiatives going forward. With that, I'll turn it back to Tim to share some final comments.
Thank you, Tani. We believe that Bank of Marin is well positioned to build upon our long track record of delivering strong and consistent performance and attractive returns to our shareholders throughout all cycles. We have a well-established franchise built upon a disciplined banking model, one of the lowest cost deposit bases in the sector, a carefully constructed loan portfolio and solid credit quality. We are focused on deepening relationships with long-standing clients and continuing to expand our commercial lending to new clients across Northern California. While we know that excellent in-person service and financial expertise of our bankers will always be vital, we also know that customers increasingly manage their finances online. As a result, we continuously evaluate enhanced digital offerings.
By optimizing our delivery channels, we will continue to identify cost saving opportunities to offset potential investments in technology. In closing, I want to thank everyone on today's call for your interest and support. We will now open the call to your questions.
Thank you. If you would like to register a question, please press the one four on your telephone. You will hear a three-tone prompt to acknowledge your request. If your question has been answered and you'd like to withdraw your registration, please press the one followed by the three. Questions can also be submitted via the webcast page by clicking the Ask Question tab and typing your question into the box that appears below the tab. One moment please for the first question. Our first question comes from Matthew Clark with Piper Sandler. Please press...
Good morning.
Good morning, Matthew.
Good morning. How are you?
Good, thanks.
Maybe just starting on deposit pricing, sounds like you're starting to feel a little bit of pressure. Obviously, costs were unchanged this quarter, but I guess what are you assuming for your, you know, your deposit beta through the cycle at this point, you know, when you budget?
The deposit beta is. We haven't changed our assumption since we last published it. We brought it down to closer to our historical betas, but not quite all the way. The historical betas were running a little over 20%, but the model betas are a little higher than that. We do understand that we're in a different environment. We do see competitors raising their rates, and we are hearing a little bit of noise. We will continue to evaluate rate change requests on a relationship by relationship basis. It's really about the whole relationship, not about, you know, sort of raising rates across the board. Go ahead.
Yeah. I would just say that the runoff that we did show as, you know, net bringing stuff back on the balance sheet was really the result of significant deposit customers and their seasonal or normal course of business. It was not deposit outflow due to our lagging in raising rates. We will raise categories where prudent, but as Tani said, we'll look at all these relationships on a case-by-case basis and be prudent about it. We continue to believe we can manage that with our strong noninterest-bearing base.
That 20% historical, is that interest bearing or is that total deposit cost? I can double-check, but.
Yes, that was total.
Okay. Then just on rates on new loans, I guess how are they trending here in the third quarter and even in the fourth? Trying to get a sense for the weighted average rate on new production.
Yeah, they're trending up. There's some categories that'll trend up faster in the fourth quarter. If you look at, I think the loans count that came on in the quarter were up in every category, but one versus the prior quarter. We just had some high notes. It's a finite pool, so it's affected by individual examples. We had a couple loans that paid off that were a higher rate. The loans that paid off were actually 10 basis points higher on a dollar weighted average than the loans that came on. If you look at it on a category by category basis, we are trending up in every category.
Okay. Tani, do you happen to have the monthly NIM, monthly margin in September?
You want the September net interest margin?
If you had it.
Take a look. Why don't you go ahead and I'll
Okay.
I'll give you that in a sec. I just have to pull it out.
Sure. Maybe, Tim, back on loan growth, loan balances, you know, down a little bit. I guess what are your thoughts on, you know, production basically got cut in half. It sounds like, you know, demand has obviously slowed for obvious reasons. What, I guess, what's your sense for net loan growth going forward? I mean, do you feel like you can kind of hold the line, or do you feel like we might shrink a little bit?
We feel positive. I mean, I look at it a little bit differently. Yeah, the payoffs in PPP loans were up slightly. You know, I'm not trying to overemphasize the slightly up, but the production was up, you know, $20 million over last year's quarter. Yes, it was down on a linked quarter basis, but like a lot of people in the industry, that prior quarter had a lot of pull-through because of rates. You know, our pipeline, we're happy with our pipeline going into the fourth quarter. If you look at the payoffs that we've had, $169 million of commercial loan payoffs year to date, $105 million of that were in categories that really aren't controllable. Asset sales, cash deleveraging or deleveraging with cash, and project completions.
Sometimes it takes some time to bring some of that back on. For example, when the construction loans pay off, those tend to be lumpy. We brought in, you know, $13 million of payoffs last quarter, but we brought in $18 million of new loans, 12 of them not committed or not used yet. We feel good about where we're at in terms of trends. It's just unfortunately, we can't predict the timing of these payoffs, but we don't expect them to continue at that pace. There's no reason to believe, but it did have an unfortunate offset to what's been really, really good loan production this year.
Last one for me. Just on the bump up in nonaccruals, the 5 new credits, I think 3 of them are related. Just can you give us a situation there and any plans for resolution, including any potential loss content?
I'm sorry, Matthew. I was going through my notes. Can you repeat your question again?
Sure. Just wanted to touch on the five new credits on non-accrual. I think three of them are related to one relationship. I just wanted to get a sense of.
Yeah.
What the situation is there and plans for resolution?
Yeah. That is to some extent was a pandemic impact, customer. However, that customer is, you know, exploring selling assets and reducing our debt, so we have a plan for that. But you know, the biggest one in that category was, frankly, the one that happened as a subsequent event because that loan's been in that category for a long, long time. Getting that monkey off our back was great.
Thank you.
Matthew, going back to your question, let's go with roughly five basis points higher than the third quarter NIM for September.
Great. Thanks again.
Mm-hmm.
Our next question comes from Jeff Rulis with D.A. Davidson. Please proceed.
Thanks. Good morning.
Morning, Jeff.
Hi. Just a few follow-ups on a couple of those topics. You know, Tim. You know, while the originations may be down linked quarter, you know, certainly the payoff activity difficult to forecast, but that was down meaningfully. Just wanted to get your sense, and that's a tough number to peg, but given where we are with rates, do you think that that's headwind going forward? I mean, you know, the trend linked quarter was down quite a bit. How has that translated into the fourth quarter and your expectations for payoffs in, call it, 2023 on a relative basis to 2022?
Well, that is a tough one to predict, Jeff. I mean, we feel good about our pipeline going into the fourth quarter. We do have some payoffs that we know are gonna happen, but by and large, there's no reason to believe. I think overall, outside some specific cases, the rate environment is going to affect sales, not dissimilar to how it's affecting everyone's pipeline activity, which is people taking a pause because borrowing costs are way up. Certainly we're seeing that in fixed rate commercial real estate lending. You know, rates aren't historically high in the bigger scheme of things, so we think activity will continue. It's just hard to predict how long people sit on the sidelines. Yes, demand is down from where it was in Q2.
We don't, outside those specific payoffs, have any reason to believe they're gonna continue to at the pace that they have, and we're gonna continue originating loans. Like I said, you know, loans have a bit of a seasonal character for us, and we feel good about where we were this quarter relative to the same period last year, and are, I guess, what's the word? Tentatively optimistic about the fourth quarter net growth.
Got it. Just looking at the rates on the funding side, I guess a little surprised that the average rate on money market came in linked quarter. That was down. Is there anything going on with that balance that would be sequentially lower?
We have some customers that have seasonality to their own businesses with high inflows and outflows. One of those customers had significant outflows during the quarter, and they had significant balances in money market.
Okay. Fair enough. Yeah, just the last one on the subsequent payoffs. Again, any detail on the type of loans that were paid off within that $7 million?
That was one loan. It was one of the pandemic payment relief loans, but it also has been substandard for many years, and non-accrual for some time. I'd rather not give specifics on the type of business, but the business was sold and assets was sold, and we were paid off.
Is there any recoveries or, you know, relative to the mark, anything that we can expect in fourth quarter? You know, the balance is coming down, but anything else tied to that?
Not to that one, no.
Okay. All right. I'll step back. Thank you.
Our next question comes from David Feaster with Raymond James. Please proceed.
Hey, good morning, everybody.
Morning, David.
I don't want to beat the loan side to death, but I just want to get your sense on the pulse of the market. Are you seeing any? I mean, you talked about higher rates kind of starting to impact things, but are you seeing much change in demand just given the uncertainty in the economic backdrop? Like you said, you know, maybe some projects that just don't pencil and are falling out of the pipeline.
Then just any commentary on the competitive landscape from your perspective. If you could remind us of the seasonality in your loan portfolio, that'd be helpful.
Yeah. That's a good question. There's a lot in there. There's no question the pipeline is down from what it was in Q1, Q2, when everyone was starting to get settled through, right? At those low rates demand was very strong. We have seen a falloff in demand. We haven't seen a fallout because as you said, deals don't pencil out, meaning credit quality of the things we're working on seems to be generally within our appetite. There's always ones we pass on, but they tend to follow the pipeline pretty quickly. It's more the demand side. Again, we feel good about our prospects for net growth in Q4. We expect payoffs to be down in the quarter. Lending, you know, seasonality. I do tend to compare year-over-year.
It's not always equal in its seasonality, but you tend to have after really strong production quarters, lower production quarters. There were a number of years where Q4 was just a blowout quarter from an origination standpoint. I do tend to look, and it's just positive when I look and say, okay, well, yes, it's down linked quarter, because of the rate movements. We are up significantly over where we were last year. It means we're still doing a lot right. Nikki Sloan and her group are continue to drive really hard to build a strong pipeline. Would I like it to be bigger? Yes. That is where I think the demand at these rate levels is affecting it. There's nothing that leads me to believe we won't be able to be competitive.
I think throughout the quarter you saw, you know, I would've liked to seen our commercial loan rate yields go up more than they did, but especially early in the quarter, there was a lot of competition that was sort of tamping that down from going up at the rate the market rates were. I think going into this quarter, that will be more on even footing.
Okay. That's good color. Then, you know, bringing some of the off balance sheet deposits back on balance sheet, we saw the liquidity position increase. Just curious how you think about that near term. Would you expect to deploy that or invest in, whether into loans or securities or do you think you're, you know, preserving that for potential deposits, deposit flows, which it sounds like was really more a function of seasonality, but just curious how you think about that.
Yeah, exactly. We tend to maintain a higher fairly high level of liquidity on the balance sheet because we do have some, you know, some large customers that have big movements in their cash. You know, the movements of balances tend to be a little bit on the lumpy side. That's what we were doing there. The other thing is that as rates have increased, the earnings on the off balance sheet deposits or with the deposit networks are not as competitive as they were. To the extent that we have a little bit we're leaning a little bit more towards investing in the securities portfolio as opposed to off balance sheet, that's to capture these higher yields.
Okay, that makes sense. You know, staying on the securities book, you took a bit of securities actions in the quarter. You talked about the low earn backs, makes all the sense in the world. Just curious if there's. As you look at the securities book, are there other opportunities on the docket? How do you think about the securities portfolio going forward? I mean, how are cash flows, quarterly cash flows? What are roll- off yields? With those cash flows, are you likely to reinvest into the securities book, or would you rather use that to potentially fund some of the loan growth?
Well, we'll always fund the loan growth first. We've got healthy cash flows off of the investment portfolio. Depending on the you know, the rate scenario, they run from $75 million-$150 million a year. We have, you know, with our loan to deposit ratio down in the mid-50%, we have plenty of room to grow the loan portfolio. Our number one priority on the securities portfolio is to support loan growth. To the extent we can redeploy that money into loans, we will do that. That said, it will take us a while probably to get back up to our desired loan to deposit ratio. In the meantime, we can use, I mean, the securities portfolio.
That's why we were able to transfer a significant portion to held to maturity back in March, because we do still have ample balances in the AFS portfolio.
Okay. That's helpful. Thanks, everybody.
Thank you, David.
Question comes from Andrew Terrell with Stephens. Please proceed.
Morning, Andrew.
Hey, good morning, Tim. Morning, Tani.
Hi.
Hey, if I could, maybe just start going back to the margin. Tani Girton, I think you mentioned the month of September was maybe 5 basis points above the 3Q average. I heard the commentary just around rising kind of deposit costs, but it sounds like the loan production is coming in at a better yield as well. I'm just curious, as you look out over the next kind of few quarters, do you think the margin can move higher from that, call it low 3.20% level from here? Or will deposit costs mainly offset that potential expansion?
I am optimistic that our margin will increase. You know, we continue to be asset sensitive, and we continue to manage the deposit costs very closely. If I had to make a projection, I'd say we're still moving in an upward direction.
Yeah, I agree with that. Again, if you look at the loans that came on versus loans that came off, the yields on those, some of the ones that went off were lumpy, like in construction. Those tend to have a higher rate that was variable and went up with the market. It didn't have the same net impact we'd like. The new loans we've been funding in that group as well as other categories, we think will expand the yield side. We can't predict the timing of when, you know, deposit costs might increase, but as Tani said, we're being very cautious, and we're all optimistic about further NIM expansion.
Great. Very helpful. I appreciate it. All the color. Tani, I think maybe it was last quarter you mentioned there might be some lingering cost savings coming out of the American River deal. Are those completely layered into the 3Q expense run rate at this point? I guess just how should we be thinking about the cadence of expense growth into 2023, just given maybe what seems like a tougher macro backdrop?
Yeah. We are not completely done with all of the ARB synergies, so there's more cost savings coming. Yeah. Again, it could be a little lumpy, you know, to the extent that when we do initiate actions, there might be some upfront costs and then the follow-on savings. Obviously the returns on those are pretty good, which is why we would do them. Tim, did you want to add something to that? Okay. I think I'd say, you know, the run rate absent all of that activity is, you know, the third quarter run rate. It's a good proxy.
Okay. Very good. If I could, Tim, I saw there were no buybacks this quarter. Just any update you can provide from a capital standpoint. How are you feeling about capital? Are you targeting trying to grow the capital base from here? Any appetite for buyback at this point?
Yeah, I would say right now we continue to be cautious for capital or leaning towards capital preservation. It doesn't mean that you know as this progresses that doesn't change. We continue to look at the impact of AOCI adjustments and potential opportunities out in the market and just continue to weigh all those. But it's you know by and large a concept we're still committed to. It's more a matter of timing. Right now we're still leaning towards the cautious capital preservation side for this quarter.
Yep, understood. Okay. Thanks for taking the questions.
Thank you.
Our next question comes from Woody Lay from KBW. Please proceed.
Hey, good morning, guys.
Morning, Woody.
The nonaccrual take up, but that feels like a pretty one-time in nature event, and they're still at a low level. Just overall, how are you feeling about credit in your local markets?
We feel good. There was three loans I think that moved over that were all tied to one relationship. Like I said, we expect some resolution relatively soon on some of that. We feel very good about the large one that dropped off subsequent. That's been the big one there for a long time. You know, in a lot of our markets, a lot of our customers were not seeing, you know, a lot of signs of recessionary pressure on sales or rents. We continue to see pressure on office rents and occupancy in certain markets, and places like San Francisco remain a concern. We haven't seen material deterioration from prior quarters of some of the, you know, properties or issues we've already talked about.
Got it. You did increase the reserve just based on increasing some qualitative factors. You know, how do you think about the reserve going forward, especially just as the unemployment rate remains low, but there is a considerable amount of macro uncertainty?
Well, there is, and that's a very good question because under the CECL model, an increase to the forecast, Moody's unemployment rate in California and some of the other macro factors, which are frankly somewhat redundant, and the qualitative factors, would drive that number up. We spent a lot of time talking about that this quarter and feel comfortable with the reserve we took here. There's no question when that number moves, that's going to affect all of us using those qualitative factors, in our provisioning.
I would add that to the extent that the underlying forecast starts to reflect that could lead to a reduction in the qualitative factors. Right now, we just feel that the forecast is not quite onerous enough.
Right. All right. That's good color. That's all for me. Thanks, guys.
Thank you, Woody.
Our next question comes from Tim Coffey with Janney Montgomery Scott. Please proceed.
Hey. Morning, everybody.
Morning, Tim.
Morning.
Hey, Tim, I appreciate your commentary on the local economies and what you're seeing in your footprint there. Most of my question has been asked and answered already, but I just wanted to kind of circle the wagons on the deposit outlook.
You have a lot of levers to pull to maintain a low deposit cost. I'm wondering if we look forward and recognizing you had a really good quarter in deposit growth, do you anticipate deposit balances to be static to slightly down? Would that be the right way to think about them?
I think it would, but our balances have been somewhat hard to predict. Like Tani's talked about, we have some large clients with some seasonal and sometimes just non-seasonal large inflows and outflows. The timing of that, I think we alluded to the large outflow we saw from one of those this quarter at the end of last quarter. We don't always know exactly the timing of that, so it is hard to predict. You're right, we have a lot of levers. We have a lot of liquidity. It's a strong balance sheet Tani's managed, and Randy and the retail side of the bank are doing a really good job of managing this on an incremental case-by-case basis, and we'll just continue that approach.
you know, we have to be fair with customers, but and honor relationships, but we are being very cautious to manage the overall impact. If that shows a net runoff to some manageable extent, that might be the case. It's really been hard to predict because we've had some big inflows as well from other, you know, ongoing business activities of existing clients.
Yeah. I would add that what we do is we plan for it, and we've been planning for outflows for quite some time. Even after the financial crisis, we planned for outflows. On a historical trend basis, it's always gone up and that's what we try to do. I think what's really important in this environment is we're really focused on right sizing at the right price. Not bringing deposits in because you know, with pricing. It's really relationship focused.
Great. Okay.
That's right.
Great. That's a very helpful color. Thank you very much.
There are no further questions at this time.
Well, thank you, everybody, for joining us on this call. If you have any questions, you want to discuss further, please give me a ring. Thank you.
That does conclude the conference call for today. We thank you for your participation. As such, please disconnect your line.