Good morning. My name is Kelly, and I will be facilitating the audio portion of today's interactive broadcast. At this time, I would like to welcome everyone to the Cullen/Frost Bankers 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. For those of you on the web stream, please take note of the options available in your event console. Thank you. I would now like to turn today's call over to Mr. Greg Parker, Executive Vice President and Director of Investor Relations. Mr. Parker, you may begin.
Thank you, Kelly. 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 such statements to 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 the 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 at our website or by calling the investor relations department at 210-220-5632.
At this time, I'll turn the call over to Phil.
Thanks, Greg. Good morning and thanks for joining us. Today, I'll review third quarter 2016 results for Cullen/Frost. Our Chief Financial Officer, Jerry Salinas, will also provide additional comments before we open it up to your questions. In the third quarter, Cullen/Frost earned $1.24 per diluted common share, which is up from $1.17 in the same quarter last year and is up from $1.11 reported in the second quarter this year. Overall, our third quarter results show general improvements compared with the previous quarter and with the third quarter of 2015. Credit quality was stable and continued to show signs of improvement over the first half of this year. Net charge-offs in the third quarter of 2016 fell to $5 million, which was down from $21.4 million in the previous quarter. Energy related charge-offs in the third quarter totaled less than $1 million.
Our provision for loan losses was $5 million, that was the lowest level since the second quarter of 2015. Non-performing assets totaled $101 million, an increase from $89.5 million in the second quarter, this was mostly due to a credit in a Shared National Credit examination that had been classified as a potential problem loan for about a year. I'll talk about growth in more detail a little later, I wanted to point out that this has been the best year ever for new loan opportunities with our total in the third quarter up 10% compared with this time last year. First, let me offer some details on the third quarter credit quality. Regarding the non-performing assets I mentioned earlier, one energy related credit accounted for the majority of the increase from the second quarter to the third.
Total remained at about half the total reported at the end of the first quarter. At their current level, non-performing assets represent only 34 basis points of total assets and only 87 basis points of total loans. Despite continued regulatory sensitivity, conditions are moving in the right direction as commodity prices have stabilized. Loans placed on non-accrual during the third quarter totaled $24.1 million, compared to $16.5 million in the second quarter. That increase also largely is related to one energy sector borrower that I mentioned earlier. Annualized charge-offs represent 33 basis points year to date and 17 basis points for the third quarter. Earlier this year, we said net charge-offs for 2016 can reach 50 basis points of total loans. Currently, we believe third quarter levels to be more representative of what we'll see in the near term.
On problem loans, defined as risk grade 10 and higher, non-energy related were $461 million for the third quarter, representing only 4.5% of total non-energy loans. We've seen only a very modest contagion from the energy sector, given the recent rebound in energy prices, as well as Texas' economic advantages, we continue to believe that significant contagion is unlikely. As I mentioned, despite some lingering effects, rebounding energy prices are removing headwinds. Here's some additional detail about our energy portfolio. Outstanding energy loans at the end of the third quarter totaled $1.38 billion, or 12% of total loans. That compares with a peak at over 16% in early 2015. Since year-end, the energy portfolio has decreased by nearly $400 million or almost 22%. No material change from prior quarters has occurred in the proportions of energy segments in our portfolio.
Energy related problem loans decreased to $556 million in the third quarter from $566 million in the second quarter. Production-based borrowers made up about 75% of the third quarter total, service manufacturing made up the remainder. Energy-related borrowers that are on non-accrual total $51.4 million at the end of the third quarter, that was compared to $42.8 million at the end of the second quarter. The specific loan loss allocation for these credits total $2.5 million for the third quarter, which is flat compared to the second. Now, I'd like to turn briefly to growth in the third quarter. Our total loan commitments have grown at an annualized rate of about 3%. Compared with the third quarter of 2015, total average non-energy loans grew by 5.6%.
71% of the growth in non-energy loans was commercial real estate, 11% was in C&I, and the remaining 18% was in consumer and other. Regarding commercial real estate, the vast majority of the new extension of credit has been to strong existing customers. A significant portion of this is financing for retail centers in Houston, where retail development has lagged behind population growth, for some time now. We also are working with customers on projects supporting major corporate relocations in the North DFW sector. Runoff rates in the energy sector continue to offset some of the gains, but our non-energy C&I commitments have grown at an annualized rate of 5%, and our CRE commitments and consumer lines of credit have both grown at an annualized rate of about 13%. Year-to-date, new relationships are up by 9% compared with this time last year.
Year-to-date, customer calls are up by 9%, and prospect calls are up by 13%. We've booked 13% more new non-energy C&I commitments year-to-date than last year. This total represents 41% of the total new commitments. Since year-end, we've increased our personal lines of credit and home equity lines by $163 million, or an annualized rate of 13%. The balances under those lines have increased at an annualized rate of 11%. Consumer loan growth is supported by expanded penetration in the Texas home equity market, which is underdeveloped compared to the rest of the country. With a strong product mix and exceptional asset quality, Frost is positioned well in Texas. We're maintaining our credit disciplines, and that served us well. We're also pleased to see good growth in our current weighted pipeline, and that growth is split between C&I, commercial real estate, and public finance.
You've heard us say many times that through our 148-year history, Frost has grown and expanded through good times and bad, and has endured wars, depressions, recessions, and financial crises. It's worth noting that despite the headwinds from recent low energy prices, Frost has posted solid earnings, increased its dividend, and kept earning accolades for its customer experience. During the third quarter, Frost opened five new financial centers in growing attractive markets. None of that could be achieved without a strong team and a strong corporate culture. In closing, I'd like to thank our people for all their hard work and dedication through the headwinds of the previous quarters.
They are the ones interacting with our customers on a daily basis and nurturing the long-term relationships that have been part of the Frost customer experience, and which give us such optimism as we move through the end of 2016 and into the new year. I'll turn the call over to our Chief Financial Officer, Jerry Salinas, for some additional details.
Thank you, Phil. I'm going to make some comments about the economy, then I'll give some additional color on our financial performance before giving an update on 2016 guidance. I'll then turn the call back over to Phil for questions. The Texas economy continues to improve and expand, a testament to its diversity and resiliency. The Dallas Fed reports that Texas employment grew 2.1% in September and is expected to expand at a similar pace in the fourth quarter. The Dallas Fed now projects 1.2% employment growth for the entire year in Texas, with more than 142,000 new jobs. That's a significant improvement from the first quarter, when Texas jobs declined 1.3%. In September alone, Texas gained more than 38,000 jobs, which was the biggest monthly jump in almost two years. According to the U.S. Bureau of Labor Statistics, Texas led the nation in September job growth.
Stabilization in the energy sector and continued strength in the service sectors suggest ongoing moderate growth in Texas in the months ahead. The state unemployment rate is 4.8%, compared to the 5% national average. Looking at individual markets, Dallas has the highest job growth in Texas this year. In recent months, jobs in the metroplex increased at a 4.1% annual rate. Growth is broad-based across sectors. Employment is particularly strong in construction, due in part to the new corporate relocations in the metroplex. The unemployment rate in Dallas-Fort Worth is 4.1%. Annualized job growth in Austin is 3%, which is a bit slower than earlier this year. The unemployment rate is the lowest in the state at 3.5%. Construction in Austin grew 16.5% in August, while tech-related industries expanded at double-digit rates.
San Antonio employment slowed a bit during the past three months, with declines in manufacturing, retail jobs, and a sharp drop in outpatient healthcare services. Construction, however, remains strong. San Antonio unemployment rate ticked up to 4%, due largely to a recent surge in the labor force. Houston's economic outlook is showing improvement with several months of employment growth and stabilization in the energy sector. That said, there's still some caution about the potential for more layoffs. Jobs in Houston grew an annualized 1.9% over the past three months, with notable gains in leisure, hospitality, and transportation and utilities. Thanks to recent gains, overall employment in Houston is nearly level for the year. Houston's unemployment rate increased to 5.1%, due to an increase in the labor force. For Texas overall, the Dallas Fed once again expects 2.1% growth in the fourth quarter of this year.
Looking at our financial performance, our net interest margin for the quarter was 3.53%, down four basis points from the 3.57% reported last quarter. The decrease in the net interest margin was impacted by a proportionately higher level of balances at the Fed, earning only 50 basis points compared to the previous quarter. The taxable equivalent loan yield for the quarter was 4.02%, up two basis points from the second quarter. The taxable equivalent yield on the investment portfolio was 3.97%, down three basis points from 4% for the previous quarter, and was impacted by a lower taxable equivalent yield on our municipal portfolio, which was down 11 basis points from the previous quarter to 5.53%. The duration of the investment portfolio at the end of the third quarter was 4.8 years, the same as last quarter.
The total investment portfolio averaged $12.38 billion during the third quarter, up about $582 million from the second quarter average of $11.79 billion. Our municipal portfolio at the end of the third quarter was $7.2 billion, up $120 million from the $7.1 billion at the end of June. At the end of the third quarter, about 68% of the municipal portfolio was pre-refunded or PSF insured. Regarding income taxes, during the third quarter, we chose to early adopt an accounting standard, which becomes effective next year, related to the recognition of income tax effects associated with the settlement of share-based payments, like when a stock option gets exercised. Previously, those tax-related effects were recorded as increases or decreases in paid-in capital. Under the new standard, the tax effects of settlement go through income tax expense.
The early adoption of that statement had a favorable impact on income tax expense for the quarter of $1.5 million. Without that discrete tax item, our effective tax rate for the quarter would've been 13.6%. Our capital levels remain strong with our common equity Tier 1 ratio at 12.4% at the end of September. Regarding full year 2016 earnings, we currently believe, given year-to-date reported earnings through the third quarter of $3.42, that the current full year mean of analyst estimates of $4.50 is low. Estimates a little higher than the current mean of $4.50 would be more reasonable. Now I'll turn the call back over to Phil for questions.
Thank you, Jerry. Now we'll open up the call for questions.
At this time, I would like to remind everyone, if you would like to ask a question, please press star, then the number one from your telephone keypad. Your first question comes from the line of Steve Alexopoulos of JPMorgan. Your line is open.
Hi, this is Scott Murphy on for Steve Alexopoulos. Could you give a little more color around where you expect the runoff from the energy portfolio to stabilize? Is there any idea of where that portfolio might be headed?
The portfolio actually, I don't believe will decline a lot more. That's going to depend on some specific deals, and what happens with specific customers. We're seeing good opportunities today. The thing is, we're just being really selective. Deals that are coming in are mainly higher equity deals, some acquisition loans. There's lots of opportunity, and we could grow it probably as much as we wanted, but we're just being careful. We've talked before, we want to prune the hedge in the downtime, make sure that the customers that you're adding are the cream of the crop and sort of cut off the stuff on the bottom that doesn't make sense for you to be in. I don't think we'll have a lot of drop in the energy portfolio unless we get some one-off customer that loses a deal or cashes out.
Great. Thank you. That's helpful. Could you give a little more color regarding that larger energy credit that moved into non-performing this quarter?
Yeah. It's a deal that is a offshore deal. It's a gas deal. It's a shallow offshore. It's natural gas. It's got more leverage than it needs, and it needs a higher gas price to really be effective in its business model. It's that kind of thing. Like I say, it'd been a potential problem loan for us and one that's not a new credit for us. We've been watching and working with them for, well, I'd say a year to a year and a half. It'll work its way out, or not, depending upon the environment. I'm not too worried about it.
Okay. Well, great. Thank you very much.
Your next question comes from the line of Brady Gailey of KBW. Your line is open.
Hey, good morning, guys.
Hey, Brady.
Morning.
It looks like your loan growth was kind of flat linked quarter, and now we know why. The energy book was down a decent amount. Was there anything else going on besides energy pay downs that impacted the flat loan growth into 3Q?
I think payoffs in general have been higher, and we've been experiencing that all year long. You're just seeing people finance deals long term. You're seeing people sell businesses. I think our amortization and payoffs have been about double what we expected going into the year. I think that's the main thing.
Do you see that changing as we move into 2017?
I hope so. It's hard to call. I think one thing that happens when rates are this low is you get multiples really high on a business, and a person takes a look at the prices that those things generate, and they go ahead and hit the bid. You'll see people getting liquidity in that regard. You'll see people financing deals out and maybe selling real estate deals because of low cap rates. I think if we get a little bit of increase in rates, you might see a bit of a slowdown in that. I think it's hard to tell if it'll be the same level as this year, but I hope it will be.
Okay.
I hope it'll be better. Excuse me.
Okay. The energy loan loss reserve, I think last quarter was a little over $66 million. Did that change much in 3Q?
Could you repeat your question, Brady?
Yes. The energy loan loss reserve, last quarter, it was a little over $66 million. I was just wondering if that changed much in the third quarter.
Brady, that's down to $62 million.
$62 million. Okay. Then Jerry.
That's a reserve coverage of 4.5%.
Okay. Then you mentioned the kind of one-time impact on the tax rate. If you adjust for that, it's 13.6%. Is that a pretty good forward run rate for taxes?
Brady, what I would do is, that tax effect for the quarter was $1.5 million. On a year-to-date basis, it was $1.6 million. If you pull out that discrete item out of the year-to-date tax rate, you'd come back to about 12%, and I think that's probably more reasonable for the fourth quarter. That's kind of what I'd go with.
Okay, great. Thank you guys.
Thanks, Brady.
Your next question comes from the line of Brett Rabatin of Piper Jaffray. Your line is open.
Hey, good morning, guys.
Morning.
I joined a few minutes late, just was hoping for some color on the margin outlook from here and what you guys are doing in the securities portfolio, maybe even what you did during Q3 as well.
What I said last quarter on the net interest margin that we were looking at flat to down a little bit. We're actually down four basis points this quarter. What I said during my comments was that a lot of it was related to higher balances at the Fed proportionately. What I guess I'd say for the fourth quarter is really kind of consistent. We're still looking at that flat to down. A lot of it'll depend on what happens with deposit balances and what we do at the Fed, keep our balances at the Fed. That's what I'd look at if I were modeling something. As far as what we did during the quarter, we actually had purchases in the quarter of $324 million of the investment portfolio, and it was all in municipal securities. They had an average TE yield of 4.53.
They had about a 19-year average life with 10-year calls.
Okay. That's helpful. Just thinking about the outlook as we go into 2017, obviously energy prices are better, and I know there's probably everyone's got one or two credits that they have to deal with that may not be currently sort of through the snake yet. As we think about 2017, can you guys give any color on how you think about provisioning? The reserve obviously has come down a little bit on the energy book. Can you give us any color on that?
Directionally, the portfolio, particularly regarding energy, is stable and improving. You're exactly right. There's some credits that are still moving through the snake. I like the term that you used. We'll just have to see how those turn out. I'm not particularly worried about that situation, but we've got a lot more credits where the momentum is to improve. Our reserve's always been most sensitive to classified levels. We got some credits that many more credits, if you look at the energy portfolio, are directionally improving than others that are moving through the snake. I think the trend there is for improvement. Once you begin seeing improvements in a cycle, they don't come fast, but they tend to gain momentum over time. I think that's what we're seeing.
Another thing to keep in mind is the improvement that we're seeing in the energy portfolio, you can tend to think it's, well, it's price movements. Prices are going up, that's great. What happens if those prices move around? Most of the improvement recently, I think, has been because of de-leveraging as opposed to just price movements. That de-leveraging is hard work. As I said last time, you see these properties sell, you see these transactions happen, and the tendency is to think, "Okay, well, prices are up now we can do deals." These are things that have been worked on for a long time, and we've been staying close to our customer. When the opportunity happens in the market, you're able to take advantage of it.
I'm really proud of the work our people have done. Given what's happening with acreage sales and prices you're seeing there, I'd like to believe that we'll continue to see improvements and opportunities for people to de-leverage going forward. I would expect that the outlook provision-wise, particularly compared to this year, is better as we see it today.
Okay. Great. Appreciate all the color.
Again, if you would like to ask a question, please press star then the number one from your telephone keypad. Your next question comes from the line of Brendan Stoner from Stoner Equities. Your line is open.
Hey, good morning, guys.
Good morning.
Morning.
I just wanted to ask a couple questions here. I got on the line a little bit late, I apologize if this question was already asked, could you just talk about how you guys think about the low interest rate environment? I know that loan growth was a little tepid, and I applaud you guys for not being in such a hurry to lock up capital at such low rates. Could you just discuss a little bit about how you think about allocating capital moving forward into the next few years, and where you guys see rates going?
First of all, as it relates to low rates, I'm against them. I think that the thing to keep in mind about our company is we continue to be solidly asset sensitive, we want to maintain that position. We're going to have to make some investments in securities as we move along, just because we don't expect to have loan demand to deal with all the funds we're producing. We will have to do some investing. While we do those, we'll continue to maintain ourselves in a position that's going to take advantage of higher rates, because we believe that's what's going to happen in the short term, not by a lot, but by some. It doesn't have to be a lot of rate increase to be really beneficial to us. I'd say that's sort of our view.
I guess the other thing I'd say is, when you look at our company's balance sheet, we've got maybe one of the lowest cost of funds in the country, not because we're not paying fair rates, we pay right in the median in rates, it's because we have a relational deposit base, and this kind of deposit base is costless. We know that we've got the opportunity to compete on price as it relates to asset pricing on loans, and if it's in the interest of growing long-term relationships. We'll be allocating capital that way and feel good about it.
I appreciate the comment. One more question for you guys. I definitely realize that you have a nice balance between your deposit base there. Could you touch on a little bit of the energy loans? Again, apologies if I got on the call late and this was already discussed. I know your last annual report kind of mentioned most of those energy loans maturing within 12 months or so. Is that still the case? Do you have any figures on most of the maturities for those energy loans as they roll off and are prepaid, whatnot?
Just think of it like a traditional commercial portfolio. They're revolving facilities. They're for different things, and they're structured and priced different ways depending on what it is. Just like a commercial portfolio would be, I don't think there's anything, in my view, that's dramatically different about that portfolio that should influence you one way or the other. The main thing they are is relationships. We work with those customers to take care of their needs, depending upon what's going on in their business going forward. That may be a short-term deal, that may be a longer term deal, depending on just what they're doing. That's not on my radar right now.
Okay. I appreciate that. Congratulations on the quarter. Thank you for all your hard work.
Thank you.
Your next question comes from the line of John Moran of Macquarie. Your line is open.
Hey, how's it going?
Hello. Good.
Good. Hey, I've got a couple of housekeeping questions around the securities book. Then one just circling back on credit. I guess I'll hit credit first. The one on the SNC, I think Phil, you said it was leverage driven. Was that the EBITDA look back that's the new bright line test in the OCC guidelines? Is that what drove that?
The increases in classifieds related to the SNC exam are definitely related to that.
Okay.
In fact, I don't remember any of those new classifications having a reserve deficiency. In fact, most of them can pay off the deal in the economic half-life. That's the way we used to underwrite energy loans for generations. What's happened is the regulators are using a bright line test. If it's a 3.5x EBITDA versus cash flow, you're going to get a special mention credit. If it's 4 or more, you're going to get a substandard credit. It doesn't take into account the life or the half-life of the property. It'll include all debt, even the unsecured debt positions, even if you're in a first lien position. It's very different than the industry's been underwritten for years and years, and it's reduced liquidity in the industry.
That's the way the regulators are looking at it, you've got to play by their rules. That's what drove the increases related to the SNC exam.
Understood. I think you said-
Excuse me. That wasn't just in the non-accrual increase. That was in the increases related to classifications as well.
Got you. You said that the one larger one that slipped was gassy, right? Gas has obviously had a nice recovery, and I think some folks are thinking that that's sustainable. I guess the follow-up question would be, if that's the case and the EBITDA improves quickly, that could come back in.
Well, the problem is that they're using the cap or the EBITDA from trailing 12 months.
I got you. Yeah.
They're not looking forward, right? They're using periods, a lot of these were June 30th, you're using that period, that first part of this year, which is horrible, and then the last half of last year, which was not good either. What you're using, you can't use today, which the current prices and current projections of prices. You won't really see that work its way through until you get some calendar behind you. You know what I'm saying?
Understood. Yep. It could take a whole year. Okay. Got you. That's really helpful. The housekeeping items just around the securities book. Yields, I think you guys said were down 3 basis points linked quarter. Do you have handy if, Premium amortization ticked up and caused some of that? The muni yields were down 11 basis points, if I got you right. Just a little bit more color on that.
Yeah. The purchases that we made in the fourth quarter on the muni book were at, I'd say an average TE yield of 4.53, and that for most of year to date, if you look at the purchases, that yield is about 4.55. Obviously, our current yield is 5.53. The current year purchases that we've had have had an impact on the TE yield.
Okay, got you. Then Prem am?
Say that one more time. I'm sorry.
I'm sorry. The premium amortization, if any, if you have that number handy, what it was 3Q versus 2Q.
You're looking for premium amortization on the muni portfolio?
On the whole book.
On the whole book. Give me a second. It should be $13.1 million.
Okay. $13.1 million this quarter. Was that up or reasonably flat from 2Q?
That was Let me see. It was up from the third quarter or the second quarter, excuse me. The second quarter, I guess we were at 11 and a half.
Okay, perfect. Thanks very much.
Sure.
There are no further questions at this time. I pass the call back to Phil for closing remarks.
Well, thank you very much for your interest and support. This will conclude our call. Thank you.
This concludes today's conference call. You may now disconnect.