Good morning. My name is Heidi. I will be your conference operator today. At this time, I would like to welcome everyone to the Cullen/Frost third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. A.B. Mendez, Senior Vice President and Director of Investor Relations, you may begin your conference.
Thank you, Heidi. This morning's conference call will be led by Phil Green, Chairman and CEO, and Jerry Salinas, Group Executive Vice President and CFO. Before I turn the call over to Phil and Jerry, I need to take a moment to address the safe harbor provisions. Some of the remarks made today will constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 as amended. We intend that such statements should be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 as amended. Please see the last page of text in this morning's earnings release for additional information about the risk factors associated with these forward-looking statements. If needed, a copy of the release is available on our website or by calling the investor relations department at 210-220-5234.
At this time, I'll turn the call over to Phil.
Thanks, A.B. Good morning, everyone. Thanks for joining us. Today, I'll review the third quarter results for Cullen/Frost. Our Chief Financial Officer, Jerry Salinas, will also provide additional comments before we open it up to your questions. Before we begin, I'd like to take a minute and acknowledge that in August, we lost Tom Frost, our chairman emeritus. Those of you who've followed us over the years understand the impact Tom had on our company. Most of us can recite the mission statement, that we'll grow and prosper building long-term relationships based on top quality service, high ethical standards, and safe sound assets. The reason we have those words to guide us today is because of Tom Frost. Our adherence to those principles is the basis for our success, both in the quarter that we'll discuss and over the long term.
In the third quarter, Cullen/Frost earned $115.8 million, or $1.78 per diluted common share, which represents a 27% increase compared with $1.41 per diluted common share reported in the same quarter last year. Our solid third quarter earnings results from Frost bankers executing the strategy that we've discussed over the past several quarters, focusing on sustained above average organic growth. Our return on assets reached 1.49% in the third quarter, the highest quarterly total in nine years. I'd like to offer some details about the elements that go into this growth. We have continued to grow our loan portfolio while maintaining our quality standards. During the third quarter, average loans were $13.7 billion. This represents an increase of more than $1.1 billion or almost 9% versus the third quarter last year. Growth was broad-based across all categories.
Our provision for loan losses was $2.7 million for the quarter, compared with $8.3 million in the second quarter and $11 million in the third quarter of 2017. Non-performing assets totaled $86.4 million in the third quarter. This was down 30% from the $122.8 million in the second quarter. Potential problem loans totaled $59.1 million, which matches levels before the energy downturn. Net charge-offs in the third quarter of 2018 were $15.3 million, compared with $7.9 million in the second quarter and $6.2 million in the third quarter of last year. Of the third quarter net charge-off total, approximately 75% was related to four credits, all of which had been noted as problems and had allowance dollars allocated to them in previous quarters. Third quarter annualized net charge-offs were 44 basis points of average loans.
Overall delinquencies for accruing loans at the end of the third quarter were $81.8 million, or 59 basis points for the period in loans. That's a number well within our standards and comparable to what we've experienced in the last three years. Total problem loans, which we define as risk grade 10 and higher, decreased $122 million or 19.5% compared to the second quarter and were down about 28% from a year ago. Problem energy loans were down about 46% from a year ago. Outstanding energy loans at the end of the second quarter represented 11% of total loans. Energy industry activity has been a source of growth in markets where we do business, the percentage of energy loans in our portfolio remains well below our peak of more than 16% in 2015.
When we visit our customers across Texas, they tell us they're optimistic about opportunities ahead of them. Because we're well positioned to serve them with a competitive product mix and strong value proposition, we're looking forward to our own opportunities. Average total deposits in the third quarter were $26.2 billion, compared with $25.8 billion in the third quarter last year, and growth was primarily in interest-bearing accounts. In consumer banking, our value proposition and award-winning service continue to attract customers. Net new customer growth is up by 60% compared with a year ago. I'm going to say that again because I like the way it sounds. Net new customer growth is up by 60% compared with a year ago. About 22% of our account openings came from our online channel, which includes Frost Bank app. That's nearly 26% higher than last year.
The consumer loan portfolio averaged $1.66 billion in the third quarter, increasing by 8.2%, or $125 million compared to the third quarter of 2017. On the commercial side, new loan opportunities are up by 8% year to date compared with last year. Core loan opportunities are up by 12%, and large loan opportunities are up by 5%. Our strategy of building our core loan portfolio, which we define as loan relationships under $10 million in size, continues to help provide steady, sustainable organic growth. For the third quarter, new commitments under $10 million accounted for 48% of commitments booked, up from 47% last year. Looking at new loan commitments booked in the third quarter. Overall, they declined from a year ago by 8% due to lower CRE commitments and energy commitments. However, the volume of non-energy C&I was up by 17% compared to the third quarter of last year.
Payoff activity was high during the quarter. In fact, the level of payoffs was 62% above the quarterly average for the last year. With regard to our current active loan pipeline, the third quarter was up 25% from the previous year. Finally, as we move through the last quarter of the year, we can look back on an eventful 2018. All year long, we celebrated our 150th anniversary with a series of good deeds and charitable efforts across the state. We launched an Opt for Optimism initiative, which will continue into 2019. We raised the Frost logo on the new headquarters building in downtown San Antonio, which will be completed next year. We expanded our strategic marketing partnership with the San Antonio Spurs and signed one with the Houston Rockets of the NBA to increase our name recognition in key markets.
As you saw in the press release this morning, we plan to significantly expand our presence in the Houston region by building 25 new financial centers in growing market areas over the next 25 months. We've operated in Houston since 1977, and we have slightly more financial centers there than any of our other regions. The area is so big and growth has been so substantial that we've really underinvested there. Our expansion plans will help us increase our deposit market share, which is currently just slightly below 2%, and extend our value proposition to a greater number of customers. Let me say that I'm extremely pleased with what our people at Frost were able to achieve this quarter and so far this year. It's not often you're able to report a 27% increase in earnings.
We can do this because Frost bankers take care of our customers by offering them top quality service and excellence at a fair price. They provide a safe, sound place to do business, and most of all, they provide great customer service experiences that make people's lives better. We've been doing that for 150 years, and that experience has shown us the value of having a positive, optimistic attitude toward opportunities. The long-term relationships that our Frost bankers have built with customers endure through all kinds of up and downs, and I'd like to thank them for that. Now I'll turn the call over to our Chief Financial Officer, Jerry Salinas, for additional comment.
Thank you, Phil. I'll make a few general comments about the Texas economy before I provide some additional information about our financial performance for the quarter and close with our guidance for full year 2018. Regarding the economy, the Texas economy remained strong in the third quarter, and unemployment continued to decrease to record lows. According to the Federal Reserve Bank of Dallas, Texas employment has expanded 2.9% year to date, and September marks the 27th month of consecutive growth. The Texas unemployment rate fell to 3.8% in September, hitting a historical low over the past four decades. The Dallas Fed revised its 2018 Texas job growth estimates to 2.7%. Based on the forecast, Texas should add more than 336,000 new jobs in 2018. Looking at individual markets, since the last quarter, the Dallas-Fort Worth economy has seen a consistent uptick in growth.
According to the Dallas Fed, Metroplex year-to-date employment growth of 2.6% is on par with last year's pace. August unemployment hit near historical lows at 3.4%, below both the state and U.S. rates. Houston's economy expanded 6.4% in August, the fastest among the major metro areas, despite a slowdown in its core energy-related sectors. Year-to-date, Houston employment is up 3.6%, and all of the major sectors have increased year-over-year. Houston's unemployment rate fell slightly to 4.2% in August, the lowest seasonally adjusted unemployment rate since February 2008. The Austin economy grew at an accelerated pace in September. Austin's economy expanded 7.5% in September, above the long-run average of 6%. Third quarter growth was mixed across industries, with a surge in construction and mining activity, professional and business services, while the financial and manufacturing sectors showed declines.
Year-to-date, Austin's unemployment growth is at 3.2%, and the unemployment rate held steady at 2.9% in September. The San Antonio economy expanded at a steady but subdued pace in September. San Antonio's economy expanded at 2.2% annualized rate in September, below its long-term average of 2.9%. San Antonio's unemployment rate was stable in September at 3.3%, below the state and U.S. averages. The Permian Basin economy remains robust. Employment growth has moderated in recent months, but the unemployment rate remains at historical lows. The unemployment rate in the Permian Basin stayed flat at 2.4%, which is the lowest in the state. Month-over-month growth in oil production has slowed, but production is still 34% higher year-over-year. Now moving to our financial performance. Looking at our net interest margin, our net interest margin percentage for the third quarter was 3.66%, up two basis points from the 3.64% reported last quarter.
These favorable variances were mostly offset by higher funding costs on both deposits and customer repos during the third quarter. The taxable equivalent loan yield for the third quarter was 5.04%, up 14 basis points from the 4.90% reported in the second quarter. Looking at our investment portfolio, the total investment portfolio averaged $12.1 billion during the third quarter, up about $125 million from the second quarter average of $11.9 billion. The taxable equivalent yield on the investment portfolio was 3.41% in the third quarter, up five basis points from the second quarter. Our municipal portfolio averaged about $7.9 billion during the third quarter, up about $160 million from the second quarter.
The municipal portfolio had a taxable equivalent yield for the third quarter of 4.15%, up five basis points from the previous quarter. At the end of the third quarter, about two-thirds of the municipal portfolio was pre-refunded or PSF insured. The duration of the investment portfolio at the end of the quarter was 4.7 years, flat with the previous quarter. Looking at our funding sources, the cost of total deposits for the third quarter was 34 basis points, up seven basis points from the second quarter. The cost of combined Fed funds purchased and repurchase agreements, which consist primarily of customer repos, increased to 90 basis points for the third quarter from 25 basis points in the previous quarter. We instituted a tiered rate for our customer repos during the third quarter, but we are also seeing quite a bit of exception pricing in this product.
Those balances averaged about $1 billion during the third quarter, flat with the previous quarter. Regarding income taxes, our effective tax rate for the quarter was 11.4%, up slightly from the 11.1% reported last quarter, impacted by higher net income and a lower benefit from stock option settlements during the third quarter as compared to the second. On a year-to-date basis, our effective tax rate was 10.7%. Regarding the Houston expansion, Phil mentioned in his comments our plan for expansion of our Houston presence by adding 25 new financial centers over the next 25 months. We are currently projecting that the program will reduce next year's earnings per share by approximately $0.19. Regarding estimates for full-year 2018 earnings, we currently believe that based on our third quarter results, the mean of analyst estimates for the year of $6.77 is a little low.
With that, I'll now turn the call back over to Phil for questions.
Thank you, Jerry. We'll now open up the call for questions.
As a reminder, if you would like to ask a question, just press star then one on your telephone keypad. Your first question comes from the line of Ebrahim Poonawala with Bank of America. Please go ahead. I'm sorry, it looks like he dropped off. One moment. Your next question comes from the line of Brett Rabatin with Piper Jaffray. Please go ahead.
Hey, guys. Good morning.
Good morning.
I wanted to, I guess, first ask on the Houston expansion. I'm just trying to understand, you're going to have some more locations. What's the trend of those going to look like in terms of, are you trying to build out more of a commercial platform in Houston, or is this going to be a broad base we're trying to penetrate further with consumer as well? If you could just give us a little more color on what you want to achieve in terms of the growth in Houston, I'd appreciate that.
Okay, great. We want to continue to do what we have been doing in Houston, really all our markets, which is growing relationships, both consumer and commercial. If you look at our overall deposit base today and our book of business, our deposit base runs around 55% commercial, 45% consumer. Historically, it's been closer to 50/50, but that's what it is these days. If you look at the asset base on the loan side, we run about 85% commercial and 15% consumer. Those are the kind of metrics we're going to continue to expect. If you look at the markets that we're going into in the 25 different locations that we've slotted for the next 25 months, they have deposits in those sub-markets equal to the size, roughly, of a San Antonio.
Here you've got a market that basically gives us the opportunity to penetrate something the size of San Antonio, where we're not there today, but we do have name and brand recognition in that market. It's really just opportunity that we've left on the table, and we just haven't made the investment to grow that, and we know how to do it. I'm excited about the opportunity to do it, and I'm really confident of our ability to be successful with it.
Okay, that's a great color. The deposit trends were a little better this quarter, and I know that we've talked kind of about what does non-interest-bearing do, and can that be stable, or can you grow that? Was there anything that changed in Q3? As you're thinking about your deposit betas, are you expecting anything to change in terms of the pace of betas?
I think what we said last quarter was that historically for us, we have seen an uptick in the second part of the year. Really not really too surprised by what we saw. We continue to see that our demand deposits, compared to the third quarter last year, they were actually down 0.6%, but our interest-bearing were up 3.1%, giving us this 1.6 blended. We are seeing good growth on the interest bearing. We're still happy with that and continue to just see pressure on the commercial side. Regarding our deposit betas, what I'm going to say is that we feel like we've done a lot of the heavy lifting. We'll continue to look at what's going on with the competition and want to be fair to the customers, obviously.
I think in a lot of ways, we feel like we're ahead of the game and feel comfortable with where we're at.
Okay, great. Just housekeeping, would you guys happen to have average interest-bearing funds for the quarter, and then interest expense?
Sure, I can get that. Hold on a second. You're looking for the quarter?
Right.
Total interest-bearing liabilities for the quarter were $16.7 billion.
Okay. What was the actual interest expense?
The interest expense was $27,051.
Great.
Sure.
Great. Thanks for all the color.
Thank you.
Your next question comes from the line of David Rochester with Deutsche Bank. Please go ahead.
Hey, good morning, guys.
Morning, Dave.
On the $0.19 impact to earnings next year and the Houston expansion, was just wondering, what are the expected revenue and expense components of that? I would imagine you have some estimate for loan and deposit growth that you're expecting to get in the first year. Was just trying to back into that for 2019, and then the expected impact on expense dollars for next year would be great. Thanks.
Well, I don't think Jerry wants to-
Yeah, our current plan is right now not to give that sort of color at this point. Go ahead.
I think what we can do is we can talk generally about what we've been accomplishing. We're going to let you guys build your model. The estimates that Jerry gave are based upon looking at what we've done on new locations for, say, 40 new locations since early 2000s, say 2006. On average, those locations have grown to about $80 million after a five-year period of time. After five years, they run somewhere between a 1.75% and 2% ROA on using marginal cost associated and direct costs associated with the units. They're off about, in round numbers, about a million and a half once they've reached that five-year period of time, and there's significant growth that happens after that. The numbers that we've used are based on what we've done, and that's sort of the overview for it.
One thing we don't do, and Jerry would tell you this, is we don't give guidance on 2019 until the first quarter of 2019. We're not going to give you specific expenses and revenues related to 2019, we've given you the answer to the pop test, and you just have to do your own writing on that.
Sure. No, I appreciate that. I guess, bigger picture, your loan growth goal this year was high singles up to 10%. As you're thinking about it next year, you're expecting that you could possibly exceed that, just given the openings of the branches you're talking about?
I don't think we're giving comments on next year until January next year.
Okay. No, that's fair. I guess, as it pertains to next quarter perhaps, how are you guys thinking about NIM expansion with future rate hikes? We got a little bit of expansion this quarter. Is this sort of what we should expect going forward with the September hike?
I guess what I'd say is this quarter, of course, was impacted by LIBOR. LIBOR didn't move the way everybody expected. I think in the case of the three-month, it was pretty flat.
Yep.
I think some of that would be dependent on that. What I said last quarter about the NIM % was that we kind of expected slight upward trends, and I guess I'd continue to say that as I sit here in the third quarter looking forward.
Okay. Just switching to fee income, noticed you had a little bit of a bump up in the trust fee income line this quarter. Was just wondering what drove that, and then how you're expecting that to trend from here.
What we did see was about $2 million of the increase was in investment fees, and obviously, we had some help from the markets, but we've also had some account growth there, so that's been good.
Okay.
We saw our oil and gas fees were up $1 million, and obviously, we're helped by the increase in the oil prices. Also, we've gained some new customers, and we've got an enhanced product offering that's helping those revenues there.
Is this a good level to grow from here, or do you think that some of those fees were a little elevated this quarter?
I'm not aware of anything that was unusual this quarter.
Okay
In that line item.
Just one last one, just in other income, it looked like that was maybe a couple of million above the core line from last quarter. Anything in that, or is that a good run rate going forward?
No, I think that's pretty choppy. Looking at the detail, there's really not a whole lot there. I think we had an insurance settlement probably was the biggest piece of it, which was maybe $700,000, something like that. Everything else, there's just a lot of choppiness in there, but nothing else popped out.
Okay, great. Thanks for all the detail, guys. Appreciate it.
You're welcome.
Your next question comes from the line of Ebrahim Poonawala with Bank of America. Please go ahead.
Good morning, guys.
Good morning.
Morning.
I guess just first question, Phil, you mentioned the new customer growth, and I think you mentioned 60% year-over-year of customer growth. What does that mean? If you can help us sort of think through around, obviously, you're investing in the franchise, but what does that mean in terms of fee income growth, deposit growth as we think about Frost 12 months from now or the next few years? If you could help put a framework around that would be helpful.
Okay. First of all, Ebrahim, let me give you the raw numbers. First of all, let me get to customers. Customer growth in this quarter was up 60% higher than the customer growth of the third quarter last year. In raw numbers, what that was, we grew new customers in consumer side a little over 2,000 customers in the third quarter of last year. We grew 3,300 customers in the third quarter of this year, and we did that by increasing new customers and expanding that number by 6% from where it was, and we reduced the number on attrition by 6%. We are doing well on both sides. We're increasing the growth on a gross basis, and we're reducing the amount of attrition that we're having.
What it tells me is how healthy is your value proposition, and are you getting your name out in the marketplace, and are you becoming a viable alternative for people who are deciding to switch banks? I really believe that we're getting some traction there. Just some examples of things we're doing to help develop that. We've got a number of things going on. For the first few quarters ago, we were really developing our marketing message, and we were reducing the amount. We really hadn't had that much a marketing spend. We've increased that. We've built that around something we call Opt for Optimism. Whether or not you like our stock or company, I encourage all of you to go to the Opt for Optimism website with Frost. That's optforoptimism .
Just look at what the content there and what it is we're trying to do. We're trying to build community. We're trying to inspire generosity. Take the 30-day optimism challenge. It'll make you a better person. Those kinds of things have actually began getting some, I'll call it, a little bit of a viral movement with it as we enlist partners on the web. I think our awareness is better. You might have noticed, as I mentioned, we're the jersey partner for the San Antonio Spurs. Ultimately on that deal, we'll get hundreds of millions of brand impressions that we wouldn't have gotten before. It's a really unique opportunity there. A more limited but still significant arrangement with the Houston Rockets.
There are things we're doing there to get our brand impression out there. I think we're doing a better job digitally of just improving our spending and messaging and targeting on people that we represent a good fit for and letting them know of our capabilities and other things. It's also interesting, I think, that we've done all that and really just opened up one location this year, and it was a small one in Fort Worth, and two last year. It's not like we've been expanding our footprint and developing those numbers. We know that expanded locations help with that, but we've been doing this, I think, just by doing a better job.
I think, to your question, it will result, you can't tie it to the one quarter, but directionally it's going to result in more fee income, more deposits, just through more relationships. One thing I'll say with regard to the digital side, we do a really nice job on the digital side. You can open an account. You can download our app on your phone and open up an account. We've done that development ourselves. We do that work and do that development at Frost. When you look at the digital accounts we've opened in Houston, 60% of the digital accounts that we've opened in Houston are within a 5-mile driving distance of a Frost Bank branch. I think even though digital's important, physical locations are as well, and what we're doing is we're giving both alternatives to the customer.
Whenever I see numbers like that, and that was customers, if you looked at account growth, new accounts are actually up 120% during that same period of time. I am really energized about that, and I think all these positives, along with the operating leverage that we've been developing, I think earnings were up about 20% last year, been up 27%, 28% this year. We are deciding to invest that increased operating leverage in expanding in these great markets at a time whenever our recognition and our capabilities and really our performance on customer development is improving.
Got it. That was very thorough and helpful. Thank you very much. Just going back to the Houston expansion, so a lot of what you said applies in terms of, I guess, how you think about growing in Houston. Would love to get your thoughts around why Houston versus Dallas-Fort Worth, because obviously you have presence in both markets. Just wondering, were there any specific attributes to Houston that causes you to want to expand there versus Dallas, or?
Well, we are going to expand in both. The 25 we are talking about over the next two years really is in addition to normal expansion we do in the market anyway, and our plan is to continue to grow. Our loan growth, as we've said many times, has been high single digits. Let's assume if it continued to do that, you might want to consider growing your branches something similarly. We will continue to expand in other markets, and we've got a number of locations on the board right now for Dallas, and I think that we will want to do that. The thing is that our base in Houston is just bigger than Dallas right now. Dallas-Fort Worth, I know they don't like to be lumped together, but the government does it when they do the MSA.
If you add all our locations there together, we are very well represented in Fort Worth. We are underrepresented in Dallas. The absolute size of the market in Houston is geographically about the size of Dallas-Fort Worth when you look at going from Katy to the eastern markets that we are going in. We've just got more opportunity, I believe, to leverage what we are in Houston, where we've been for, gosh, 40 years or so, 40-plus years. Dallas is a good opportunity for us. We are going to grow in Dallas, and we are going to grow significantly there. Right now, we felt like the best place for us to allocate our energy and capital and resources, and to make the biggest impact was in the Houston market.
Got it. Just one last one. I appreciate that you don't want to give a lot of moving pieces around your expansion, but just from an efficiency and ROA, ROE perspective, we are about a mid around 55% efficiency ratio this year. Do you see that improving over the next few years, given all the things that you talked about?
The thing that I guess we continue to say is we really don't give guidance going forward. I think that, if I was modeling it, the way you need to think through this is, Phil mentioned that we're talking about targeting one a month for opening, you've got to certainly basically grow the business from there, if you will. That's kind of the thought process I would use if you're talking about the mix between revenue and expenses as you do your modeling.
I'll just also comment there, just conceptually, a couple of things. One is that, remember, we're doing this in a period of time when we've been expanding and increasing operating leverage. We've seen our profitability increased significantly is really because of two things, is one is higher interest rates, second thing is, what I call a bit more efficient balance sheet by more consistent loan growth. We've been able to do that. We still got runway on interest rates. We've got runway on the loan growth as well. Those two things will sort of, notwithstanding Houston, I think will continue to help with regard to our operating leverage on the company. The second thing I'll say, is that our efficiency ratio runs in the, I think, you said like mid-50s or so.
58, yeah.
Say 58 or so. If you look at the various segments of our business, really the traditional intermediation part of the business is a lower efficiency ratio than our total company because we've got a number of businesses like wealth management and others, which are great return on equities, but fairly high efficiency ratios by the nature of those businesses. While we'll have some of that growth with the Houston expansion, it's going to be primarily a traditional intermediation business with loans and deposits. I think the nature of that over the long term is going to be a lower efficiency ratio for that part of the business. I think that, let's just say, I don't expect it to hurt our efficiency ratio as this investment matures.
Understood. Thanks for taking my questions.
You're welcome.
Your next question comes from the line of Jennifer Demba with SunTrust. Please go ahead.
Thank you. Good morning.
Good morning, Jennifer.
Any thoughts or interest on share repurchases with the bank stocks now significantly lower over the last several weeks?
Jennifer, I think you know we've got $150 million in buyback program authorized, and we've said we're going to be opportunistic, and we have not utilized any of that, so I'll just leave it at that. How about that?
Thank you very much.
Yes.
Your next question comes from the line of John Pancari with Evercore ISI. Please go ahead.
Thanks for taking my question. Could you discuss your thoughts on funding loan growth using cash flow in the securities book and accordingly allowing the low loan-to-deposit ratio, which is around 52%, to kind of drift higher going forward? I understand that you look at it in terms of loans and munis together as a percentage of the total base, but just curious about how you're thinking about funding loan growth going forward.
I think that the main thing we want to do, as you talk about going forward, we've got a long-term view, is we'd like to fund it with deposit growth. We also will use the securities portfolio and liquidity as well. The thing I think you'd see us use, I mean, let's sort of rank order how you'd use it. I'd like to use deposit growth to fund loans, which is going to continue to give us runway and a loan-to-deposit ratio below peer, but growing. Secondly, we've got, Jerry, how much do we have at the Fed now?
Just about $2.8 billion.
$2.8 billion, just under $3 billion there. There's lots of liquidity there to be used. There's the, not municipals per se, but we get treasury portfolio that we also have available, which is a fairly significant part, and that's a lower yielding piece.
Got it. Could you talk about the drivers of the paydown activity that you saw this quarter in terms of products and markets? Just wondering, with the long-term rates up since at least quarter end, is that paydown activity kind of abated in recent weeks?
The paydowns really were, I think a lot of them in commercial real estate, as people moved projects to permanent. It was pretty widespread. If I had to pick one market where it was probably a little bit heavier, I recall just in talking with our folks at Fort Worth, it was fairly high. I think that sort of abated some. It's just the nature of the business, right? I mean, we've got great core loan activity, and we've worked on that. You all know about that. Half our loans are large loans and you're just going to see things happen and people take advantage of different things. I wouldn't read anything more into it other than just the way the business works.
Okay, just one last question about the Houston expansion. In the press release, I think you highlighted that the deposit market share still is only 2% in that market. How much of your focus is deposit generation with this expansion in Houston? Given that deposit competition is particularly intense in this market, how will that influence deposit costs, at least to what degree going forward?
Well, deposits are a big part of it, right? If you look at, just say, look historically at, take a branch breakeven analysis, okay? Everyone's got their own analysis. I'd say it probably runs around, let's say, $35 million, and you loan out a third of that, all right? Deposits are important for that analysis, you probably reach breakeven in about somewhere between two and three years, probably maybe 27 months on average, I guess. From that point on, as you continue to grow loans and deposits, that's really where you add to that profitability I talked about by year five. They're both important, but our growth in deposits is really checking account driven. You want to talk about the deposit base a little bit, Jerry?
Yeah. I think if you know anything about our deposit franchise, about 60% of it is in checking accounts, I think we perform pretty well there. A big part of who we are is relationship driven, in a lot of cases, we may get the deposit first before we get the loan relationship, even on the commercial side. I think that we've been able to be competitive with deposits. I think that our deposit rates currently are very competitive. I think also, if you look at the J.D. Power Awards that we've won for customer service over the last eight years, we've performed better than most or than all, really, in the state of Texas. I think that really from that standpoint, at this point, we think that our rates are competitive.
We don't think at this point that we'll have to do anything special there. Again, we've got a lot of visibility and exposure, deposits are important to us, we'll continue to focus on doing what we need to do to grow them.
Great. Thank you.
If what you're asking is because of this strategy, do we plan on really increasing deposit betas to bring in high cost money, that's not our plan. Our plan is a very relational plan, which means it's a very, first, a checking account driven plan, and then build from there. It's going to be core type accounts.
We are historically very competitive. I think Phil talked about marketing dollars, so certainly we'll spend some marketing dollars there to make sure that we're competitive on those to the deposit customers there. We'll be doing some new things there in Houston to make sure that we're able to grow the franchise.
Got it. Thank you.
Your next question comes from the line of Jon Arfstrom with RBC Capital Markets. Please go ahead.
Hey, thanks. Good morning.
Morning.
Question for you on the commitment comments that you made. You talked about commitments being down about 8%, but if you exclude CRE and energy, it's actually up quite a bit in C&I. Can you just talk a little bit about CRE and energy and what's going on there? Is that the market or is that your caution that's driving that?
With energy, as we discussed before, we're just being really careful in that segment because we're reducing the concentration down, but we're still growing. I guess we were up a little bit below our average growth rate, but somewhere between 5% and 7% year-over-year for energy, as I recall. I talked to our folks about it. We're probably saying yes for every four noes.
Okay.
We're just being careful. We're building great relationships with some that we haven't had the opportunity to build before. We're curating some others. That's what's going on with energy. I'm not concerned about that at all. By the way, our people are doing a great job and building good business there. I'm really proud of what they're doing. We've got a great brand in that space. With regard to CRE, I think a lot of it was we had a huge year last year in CRE, particularly early on. The nature of that business is it's a little bit choppy. With regard to our view on it, competition we're seeing is price probably first, but that's everywhere. You see it on guarantees and term on projects. We're relational driven, right? We bank customers in that area.
We don't just bank projects. I feel really good about what we're doing, and I think that we've got good opportunity. As I talk to our folks, probably in Dallas, we're being a little bit more careful, because you're seeing supply, which is really strong. You got to see a good 2019 to absorb it. I was asking and I was saying, kind of, what's the view? Because we bank a certain way. We bank people. We've got a great reputation on. I said, "So what's the view?" He says, "Well, they really respect us, but they go to the easy money." Okay? We're losing some deals, but I think we're still seeing opportunities to get the kind of projects that we want.
It was just a little bit lumpy, but the fact that we're down from last year, I think has more to do with last year. I wouldn't read it as we are just totally pulling back on CRE. We've always been careful. As you know, we said for years, we don't swing one way or the other in these things. We are a consistent source and player because we deal with relationships in these markets, and I think that helps us really. It's not a sign that we're afraid of it and we're moving out of things.
Okay. Two more things I want to touch on. I know you don't give the forward guidance on the margin, but I think what you're saying is you don't feel any unusual pressure on deposits, and you still have an upward bias on the earning asset yields. Is that fair? Is that big picture enough?
Yeah, I would be okay with that.
Oh, okay. Good. Then I guess back to Houston, the hiring plan, I know 200 people is not a lot in terms of the grand scheme of things in Houston, but I think culturally you have to get it right with that kind of expansion. Can you talk a little bit about the hiring plan and how you plan to approach it?
Absolutely. First of all, you're dead right, and I'm so proud of you, Jon, for talking about culture as it relates to this because that's who we are, and that's a piece that we've got to get right. We're going to do the hiring plan two ways. One is that it really gives our people there an opportunity. I think people like to be part of a company that's growing and is developing its business. I think we're going to have, and we already have some buzz internally about growing these positions. In a city that's tough to get around, there'll be some opportunity for people to work closer to home, frankly, which I think will be good. I think it'll help employee satisfaction and retention. We're also going to be on onboarding new people and new leaders in the new markets that we're going into.
I think that the early indications of our efforts there have been really positive in my view. I'm really excited about what we're seeing. I think a lot of it is, sure, we're competitive in terms of pay and all those things. Everyone has to be. I think people are excited about joining a company with a reputation like ours that is investing for the future. A specific part of our efforts in hiring these new people is onboarding of new employees and cultural indoctrination, if I can use that word. What we want to do is expand the brand and expand the culture. We don't want to have it diluted, and what we're looking for is people who want to buy into that, which is what we've always done.
We're dead focused on it, and we are not going to let that get away from us. We are just not.
Yep. Okay. All right. Thank you.
You're welcome.
Your next question comes from the line of Michael Rose with Raymond James. Please go ahead.
Hey, guys. Thanks for taking my question. Sorry if I missed this earlier. You guys had a nice drop in non-performers. Just wanted to get some color there. As I look at the reserve ratio, it's about 1%. I know you've been below that before. Credit looks pretty good at this point. Just any sort of commentary on how comfortable you are with just generally credit at this point. Thanks.
I'm extremely comfortable, but you always have to knock on wood with credit, right? I wouldn't be a Frost banker if I wouldn't worry about credit. The trends are just great. The third quarter inflow of problems was only $83 million. It's averaged $112 million for the year. Last year was $166 million per quarter. If you look at 2018 resolutions of problems, we had $469 million of favorable events, which include upgrades, payments, and payoffs. The unfavorable events, which are really charge-offs, $34 million. We're just seeing good movement there. If you look, our level of non-performers, which today is $82 million, it's still heavily weighted towards a couple of energy, and particularly one energy credit that continues to move through the Special Mention Asset, and at some point, we're going to get that resolved. I really look forward to our non-performing levels being lower.
The charge-offs were elevated this quarter. They were really, as I said, four credits. One of them came on in 2016 as a problem, some in 2017. One of them was at the end of last year as a potential problem. About half of those were energy-related. The other two were just general business. That just happens. You had a company that lost a major customer. Another company, we've talked about the other one before, had problems sourcing the inventory and lost some relationships, and it really, really hurt their business, ended up liquidating. That stuff happens. We're not proud of it, but that's banking, and we're going to try to get better from all those, but I feel really good about credit.
Okay. Thanks for the color. Maybe one follow-up question. I think last quarter, you guys talked about savings of $8 million-$9 million pre-tax from the FDIC surcharge roll-off. Just wanted to get a sense if that's still the right estimate, and then if that played into the investment decision in Houston as it relates to the number of centers and the size, if you'll take some of those savings when they eventually do hit and roll it into the expansion.
The number that you quoted, the eight to nine, I think is still where we're at. Really, I think the Houston decision, you're right, there may be some offset there, but really, the Houston decision was really just the right decision to make for us. Even regardless of whether we were aware of that savings or not, this was just something that we needed to do and wanted to do to continue to grow our business.
Understood. Thanks for taking my questions.
Your next question comes from the line of Peter Winter with Wedbush. Please go ahead.
Thanks. Good morning. I was just wondering with the 2018 expense guidance of 4.5%. I guess it's off the base of $747 million. It seems like you could come in below that level unless you are expecting a big step up in 4Q expenses.
We're going to stick with our guidance. I think that there was some concern that maybe the guidance was too high given the low second quarter, and we did mention that we expected that some costs would be higher. We talked about the advertising programs and such. At this point, I think the guidance, yeah, we're going to stick to that.
Okay. Just for sure, one more question on that Houston expansion. As I think about 2020, when you're going to continue to open up another 12 branches and the hiring, should we expect a similar type of earnings impact in 2020, or will you start to see some earnings accretion from what you do in 2019 and it should be less?
Well, the arithmetic of it is, if you continue to open up branches and the others haven't reached profitability, I mean, it'll be more, just the math of it, right? You reach a-- just like with any other investment, right? You reach a burn rate, and then it becomes less and becomes accretive to what it was the previous year, and then it becomes accretive to where you were before you started. It's just the nature of it, right? I think we said earlier, historically, these things average about a million and a half burn. When you look at what it throws off after a five-year point and what that does for our company on any reasonable PE, I'm very excited about what it's doing and about what it does for us. The only question about this, because the math is simple, okay?
The only question is, can we do it, right? That's the only, to me, relevant question, and I am confident of our ability to do it because this is what we do. If we can't do this, why are we in banking right now, right? I mean, this is what we do. I feel very confident about our ability to achieve it, and I'm really excited about what it does for our growth trajectory over the next 5-7 years in Houston.
If I could just ask one more question, Phil, how did you come to the decision to do it de novo versus buying something or buying another bank?
The reason is, look, Peter, Jerry and I bought, I don't know how many banks and how many brokerage companies, insurance brokers, we probably bought 40 companies. We've done it a lot. We've normally done it to build out markets. We're in markets now where we have mature, viable platforms. The question that we've been asking is, do we take and spend shareholder money to just increase mass in a market, or do we spend operating leverage, right? Do we spend our balance sheet, or do we spend our income statement in developing these markets? I'm convinced that we build greater shareholder value if we can grow it organically. You have to have the opportunity and ability to do it.
I'm convinced everything we bring to the table, and I hope that the things we've been talking about, and people who know us see that we are a viable candidate to develop these markets. Heck, we got the second-largest free ATM market network in Houston. That means we're bigger than two big fails. We've got the chops, in my view, to get this done. Do I want to pay-- because look, everything I've got is tied up in this company. I always say, if my family's going to have anything, it's because this company's going to do well.
Am I just going to take a 150-year company with the kind of valuation quality we have and just give X percent of it to someone because they put together a few branches and hired a few lenders just so I can get bigger in a market I'm already in? I don't want to do that. I think that we can reward our shareholders better as long as we have the opportunity to grow organically. All that said, I don't want you to think that, well, we'll never do an acquisition ever. We may not in my tenure, but we might.
If we ever did, my view is that the best use of something like that, and we do them rarely, but the best use we've had of those is when it put us in a market where we weren't that gave us the ability then to grow organically. I'll give you an example of that. 20 years ago, we did Overton, and we wouldn't be in the North Texas market today, I don't think, well, we wouldn't be, if we hadn't done that acquisition, okay? Another example would be the Permian Basin that we did four years ago, and that market is, yes, it had its lumps for a couple of years, but I was talking to our regional president out there, and it is hotter than it's ever been, and it's the best report I've ever had for that market.
He made an interesting comment that it stuck with me. He said, "We used to be a niche bank in a niche market, but now we're broadening our base." That's really what we do, is we go into a market, we grow long-term relationships, and we broaden them. I don't want to give the impression that I hold acquisitions in contempt. It's just, to me and to our team, when you've got the ability to grow organically and you're in fantastic markets, and we are in Texas, let's leverage that. That's the way to create value. That's my stream of consciousness thinking on acquisitions right now.
That's really helpful. Thanks, Phil.
Your final question comes from the line of Brady Gailey. Please go ahead.
Yeah. Hey, good morning, guys.
Hey, good morning.
Phil, just to clarify, you talked about the $1.5 million burn per branch. You're saying that each branch, once it's up and running, has an expense base of roughly $1.5 million pre-tax annually. Is that what you're saying?
No, I'm saying that the net income of the branch would be a net loss of a million and a half as it burns its way through profitability. Brady, these are averages. We have some branches that reach profitability slower, some sooner. Some we do great, others we don't do as well, this is the average of what we've done for a long period of time on the locations. It's kind of like a burn for a business. You'll lose money for X period of time, between two to three years, and the burn has been on average about $1.5 million.
Okay. Just so we can sense the magnitude, what's your current branch count at Frost?
133. Hope I got that right, within one or two.
Okay. Lastly for me, it looks like you all charge off some allocated reserves with the four credits. Your loan loss reserve ratio is now right at 1%. I know if you look back, I don't know, three or four years ago before the energy thing popped up, you all were below a 1% reserve. Is there any reason to think you all wouldn't head back below 1% going forward?
Brady, if I would've answered the question just kind of the way you asked it, to be quite honest with you, we have been below 1% before, and of course, it's all formulaic based on our allowance calculation. As long as credit quality is where it is, yeah, I would not necessarily be surprised if we're below one.
Then actually on the reserve, CECL, we're still over a year away, any comments on the impact that CECL could have on your reserve?
Well, I guess I have to say we don't like CECL, obviously. It's too early to tell. Obviously, what ends up happening is that you'll have to look at kind of your loan makeup at 2020 and what your economic forecast is at that time. I think right now we're in good shape. We're at where we need to be from a planning standpoint, no, we wouldn't be anywhere near ready to give any sort of impact at this point.
Got it. Thanks, guys.
Thank you.
There are no further questions in the queue.
All right. Well, thanks everyone for your interest, and we are adjourned.
This concludes today's conference call. You may now disconnect.