RBC Chat with Darren King, Senior Executive Vice President and Chief Financial Officer of M&T Bank. As many of you know, M&T is headquartered in Buffalo, New York, with just over $200 billion in assets, has a market cap of about $26 billion, trades at a price to book at about 1.1 times, and a price to tangible book of about 1.8 times, and on a forward earnings basis, a very low P/E of 8.5 times. Darren, as you know, will be moving out of the CFO position in June and taking on more line responsibilities, so we're very happy that we have him for our conference here. He joined the bank back in 2000, and he was with the consulting firms before that, but Darren, thank you so much for joining us.
Great to be here.
Maybe we could start off by reading René's annual report letter, which is always one of the more enjoyable letters to read. He pointed out that 2022 was pretty good for you guys. You had an ROTCE of almost 17%, 6% operating leverage, and most importantly, you had a very big deal close in People's. So maybe you can share with us, can you update us what's going on with the People's acquisition? How is it going? What have been some of the surprises, both good and maybe a few bumps in the road if there are any?
Yeah. So People's is, I guess the way I would describe it, the system conversion is complete. And so if you think about when you go through a merger, there's the different phases, the due diligence phase, the prep phase, the system conversion, and then as I talk about my next job, the real work begins, which is integrating and integrating culture. And so the system conversion was done in September. There were some documented challenges that some customers had with access, online access. If you look at the People's merger, it was the first merger we did where online and mobile were a big part of everyday life. So if you go back to the merger before that, it was Hudson City, which was really a thrift, and there wasn't a lot of mobile access that Hudson City had, and then before that, it was Wilmington Trust.
And so what we endeavored to do with all the online access, whether it was consumer or commercial, was try and make it so it was completely seamless for the customer. And when you think about the big things that are pain points for customers during switching a bank or a conversion, it's usernames and passwords. And so you want to bring over usernames and passwords and bill pays so that it's most convenient for the customer. When you're doing that and you're bringing those over, particularly usernames and passwords, you're also worried about security. And so when you put in the security protocols, you're looking at how people behave, and you're bumping that up against your history. Unfortunately, you don't convert over the client's previous history.
And so they'll hit some triggers earlier than other customers would while you're learning their behaviors, and your systems are learning their behaviors, and some folks got locked out. And as they got locked out, there was a little bit of higher incidence of lockouts early on in the days of the merger, and that led them to make calls to the call center to get their passwords reset and to get back in. And when that volume comes up, call centers are very sensitive to volume. It caused some delays in people getting answered. And so that cleared itself out through the month of September. By the time we were at the end of October, online access wasn't an issue.
Call wait times were back to normal, and so the normal day-to-day started to take over, which is what you would expect, and now we're spending our time doing what we do, which is helping the People's employees understand the M&T systems, understand the products, and start to deploy our sales practices, whether it's for consumers, small business, or commercial. On the commercial side, it was a similar issue with treasury management. Once folks understood the system, things have settled down. And from a credit perspective, when we talk to the commercial teams in the Northeast, their view of our credit appetite is actually a little bit wider than what the People's credit appetite was, which is interesting.
When we looked at and were going through the due diligence discussions, we found an organization that actually had lower charge-offs through their history than us, which is a pretty tough thing to find. And so it kind of makes sense that that's what we're finding from a credit perspective. So we have the systems things behind us. We've got a bunch of ideas of things that we can do to improve how access works. And the nice part is the benefit of that won't just be for the legacy Pub customers, but it'll affect the whole franchise, and we'll make the franchise better. So that's where we'll spend our time now.
Coming back to the acquisition, the actual doing the deal, can you share with us, because of CECL accounting, the double count on reserves and how that is like an added layer of protection, even though People's never had credit issues?
Yeah. So when you go through the joys of CECL, which I'm not an accountant, so bear with me, but when you bring over the allowance from the acquired organization, you cut the loans into two buckets, right? purchase credit deteriorated, a.k.a. the bad loans, and non-purchase credit deteriorated. And it's that second bucket where you take that double count and you add that to the reserve on day two. And so to your point, you've got, for us, about $240 million of extra protection that's there. And the way it works is over time, as long as those loans do in fact continue to perform, you accrete that back into earnings. But to the extent there's issues, you've got it there.
Yeah. Good. Maybe we could go with just a macro question for you. Obviously, you're here in the Northeast predominantly, and we've seen a number of different economic cross currents. We were just chatting before we started the headline in the Wall Street Journal today, "More women are coming into the workforce, lifting the economy." So even though we got inverted yield curves and the leading economic indicators are negative, there are other positives. What are you guys seeing here in the Northeast with your customers?
So far, we're seeing continued strength, is the way I would describe it. Employment is strong, right? That's the number one thing. When we look at customers, and you'll notice in René's letter, we talked a little bit about what's going on with some of the customers. When you look at the lower balance customers, which also tends to correlate with folks that are maybe more hourly in how they get paid, what we saw over the course of 2022 was we could see the impact of inflation in their accounts, but we could also see the impact of wage inflation. And the wage inflation didn't quite offset expense inflation, but it was close. And so when you look at their balances, they're still ahead of where they were pre-pandemic, but down a little bit from the peak, right?
So when those stimulus and unemployment went into those accounts, we could see it. We talked about it actually a year ago. And when you look at this year, bring it forward, a lot of those balances are still there. And so when you're at that end of the balance spectrum, you kind of keep liquid because that's in case something happens. A furnace breaks, an air conditioner breaks, a transmission breaks, you need to replace a crown, whatever it might be. You keep those dollars there. What we started to see, and we also talked a little bit about this, was for customers who had very high balances, and many of those balances, again, were grown over the pandemic, not because of stimulus for that customer base, mainly because of change in spending habits.
And what we saw last year was as rates started to move, they started to show an interest in looking for yield on those balances. And so, folks, for us, what we saw was people with, disproportionately, folks with over $250,000 in savings accounts started to move money into higher yielding products. Sometimes it was with us. Sometimes we talked about people going to Treasury Direct, right? And so there were lots of different places where balances moved. But the long story short, they were going from low yielding accounts to higher yielding accounts, either with us or with others.
And when you talk to your commercial customers in the footprint, are there any areas that are stronger than others? I know you're very involved with automobile floor planning and stuff. So share with us some of the different lines that you're seeing in terms of what your customers are saying.
Yeah. It varies by segment. The auto dealers are happy. They've been happy for three years. With inventories down, they're paying less to carry inventory, and demand is still reasonably strong. We have seen balances on floor lines tick up a little bit last year. And so you can see that sales have slowed a little bit, but still are very strong. When you look at the multifamily players, rents are strong and vacancy rates are low, and so they're feeling really good about things. Healthcare can just be a challenge. Reimbursement rates are a struggle for many. And in the assisted living, senior housing space, labor shortages are a problem, right? And so when you look at where those industries are, you see them improving from where they were during the pandemic, where occupancy rates really dropped. They're up from those levels, but they're not back to pre-pandemic.
And the issue isn't demand. The issue is supply of labor. And so they're constrained in what occupancy they can get to. And then you see retail. Retail's done really well. The death of retail was predicted early on in the pandemic, and I think the last stats I saw was that in-person retail percentage of sales was basically where it was pre-pandemic. And you see that coming back. And then obviously, office is a place where there remains lots of debate about what's going to happen there. And it's a combination of your point about the workforce and how many people are participating in the workforce, as well as new ways of working from home. And I think that's still playing itself out.
Do you get a lot of questions on the office or commercial real estate, your portfolio, because of physically where you guys are?
We get lots of questions on it all the time, partly because it's a place where we've got an expertise, and we've grown that. Actually, if you look at real estate at M&T, it's been a large part of our book for probably the last 30 years.
Correct.
It's a space that we're comfortable with. We've got a bunch of clients who are multi-generational clients. And so we try to take care of them. But through the pandemic, with all the things that have happened, whether it's with hotels, whether it's with office, whether it's with multifamily, there's always a question about what's going on in real estate. And as we said early on, it was hotels and retail. Those don't seem to be the story right now. Now what's on everyone's mind is office. And New York City is always the place that everyone looks to because there's lots of people here. There's lots of the investment community based here. And so everyone's looking around at what's happening in New York City as a way to think about real estate.
When we look at, like I said, hotels have come back and not really any issue. Office is the place where the concern is now. It's how many people are coming into the office. Will leases be extended? What will happen with loans to office developers or office owners when those loans come due? When we look at what we have here, New York City is maybe about $1 billion out of our portfolio. You said we're a $200 billion bank, so 0.5% of total earning assets, slightly less than 1% of our total loans sit in office in New York City. When we look at the portfolio, the LTVs are strong, at least LTVs at origination.
And I think the thing that we'll be watching, like most people will be watching, is what's happening with lease levels, occupancy rates, price per square foot, and what does that imply for cap rates. And so that'll be the determinant of what happens over time and with the office portfolio. And the other piece of it will be some offices and buildings lend themselves to being repurposed easier than others, right? It's a function of what the floor plan looks like. You'll probably see some will get converted into condos and apartments, and other ones will be more of a struggle for that to happen. But I think there's still lots to play itself out in the office space, not just here, but across the country.
Sure. Maybe if we just follow up on one question there. Historically, M&T has had a very low net charge-off ratio supporting the way you underwrite loans. Can you share with us how important it is to have a lower loan-to-value at origination and why that helps you should things get a little more challenging?
Yeah. One of the most important parts for us, it might seem like it's credit protection. What it is is it means we're co-investing with the borrower, right? When you've got an LTV that's 90%, you're the investor. They're renting your balance sheet, and in some cases, if you're not careful, their risk is asymmetric, right? Which is if things go down, they hand the keys back, and you're holding 90% of the bag, and they walk away from their 10%, but if things go positively and the value of the real estate goes up, they're hugely levered, right? Which means their return is massive, and so when we look to underwrite, we like low LTVs because it means we're co-invested in the property and that the developer or the owner is committed. And obviously, we've got more protection because of the lower LTV.
And then when we underwrite, we try to underwrite to kind of through the cycle, vacancy rates, through the cycle, lease rates per sq ft, and through the cycle, interest rates, right? Because it's easy to find yourself at some point where you think, "Oh my, this is really worth a lot because lease rates are up or interest rates are low." And you convince yourself that the value of the property might not be what it would be through the cycle. So you try to protect yourself with all of those underwriting thought processes at the time of origination. And you hope you get it right. I think history has said we've generally gotten it more right than wrong, but we do have charge-offs, and this time will be no different. There'll be things where that'll happen.
Very good. And one of the interesting topics for this conference has been deposits and deposit betas. You touched on it a moment ago, but maybe we could go back to that. What are you seeing in deposit trends and deposit betas for this quarter and for the year?
Each quarter since last summer, incremental betas have been progressively higher. By the time we were at the end of last year, we were around 20-21% through the cycle cumulative betas. As we go through this quarter, we're probably going to be up towards 30%, right? And we've been talking about high 30s-low 40s through the cycle by the time the Fed stops. That was before this last week and yesterday and everything that happened. But in general, when you look at where Fed funds is today, we haven't seen Fed funds like that since the early 2000s. And I think there's a lot of anchoring in people's minds to bank balance sheets around the great financial crisis and since the great financial crisis. And when rates first went to zero in that crisis, what you saw was everyone go liquid, right?
And so there was no rate to have either in a money market account or in a time account. And so when there's no place to go, people stay liquid and they stay short. 2018, 2019, we got to about two and a quarter Fed funds. And so you've heard me talk about this before. Our experience has been generally for the consumer, they don't tend to pay attention to rates until it's got a three handle on it. And so we went through that this time. And you've seen, I think for us and for the industry, a real shift into time deposits. And if you look back, I think I'll get my math off a little bit, but I think if you look at bank balance sheets pre-2005, you're probably seeing 25%-30% of deposits sitting in time accounts.
And the industry is way down from that through the pandemic, probably in the range of 10%. And so when you think about funding costs and balance movements and shifts, that's what you're starting to see. And that's why you're seeing those betas go like that. You also see it in the commercial world, right? Where commercial excess balances, you've got treasurers, you've got CFOs, and your job is to put that money to work. And so there's been much more activity moving things into sweep. We can now pay interest on commercial checking balances, which we couldn't before the pandemic or sorry, before the great financial crisis. And so it's a little bit different, but it's that absolute level of Fed funds is now starting to get people interested in rate. And that's what you're seeing.
It really accelerated end of September, early October last year when we had the 275-point hikes within 30 days. And it was after that second 75 that we crossed 3%. And then the interest really went and you started to see the flow accelerate.
Got it. Maybe you can distinguish for us when you look at the consumer side of the deposits, a large depositor versus a small depositor and how those behaviors, I'm assuming are different.
Well, I guess let's not put labels on it because everybody's money is important to them. And someone with $5,000 feels really powerful and passionate about that, as does someone with $500,000. I think when you look at deposit levels, we talked a little bit about it in René's letter. What tends to happen is the larger balances are the most price elastic in the short term, right? And it's for those folks where 5 basis points, 50 basis points, when you convert it into dollars, makes a big difference. So a fun story is my daughter is 23 and she's got $3,000 that she saved up for a couple of months of rent. It's a rainy day fund.
She said, "Dad, I think I should put this in a high-yielding account because I'm not being smart with my money." I said, "I think that's a great idea." So we went through and we looked at all the places where you might put that money. Then she said, "Boy, this is going to be great. It's going to be worth a lot in 12 months." I said, "Well, yeah, let's just do that math." When we worked through the difference between getting 3% or 3.5% over 12 months on your $3,000 and then pay tax on it, she was proud of the fact that she was being very conscious and thoughtful about her money, but then a little disappointed in what it translated into real dollars in her pocket.
And so I think one of the things that it's easy to do is it's easy to sit in the profession that we all sit in, which is very analytical and every basis point matters, that when you get into life, sometimes liquidity and the safety of knowing that that money's there and it's accessible trumps the extra 50 basis points. And it's really basically as you move up in balance tier where you start to see people pay more attention because in dollars, it's worth more.
Right. Absolutely. Maybe speaking of interest rates, can you share with us your thinking on interest rate hedging? You've done it in the past, of course. Just where are you today in that strategy?
Yeah. You know what? It's our objective to run the bank so that there's a degree of predictability and consistency in our revenue. And our objective isn't to be an interest rate bet or to take them, but to run the bank as close to neutral as possible. And so what you've seen us do last year was reduce our asset sensitivity, which was really being driven by the level of cash we had on our balance sheet. And our reticence to take the cash and to put it into the securities portfolio, bless you, until we saw some rate, right? And we were very, very concerned about the impact of AOCI on our equity levels and our ability to do repurchases. And so we held tight on putting that money to work. As rates went up last year, obviously, we started to build the securities portfolio.
We did put on some interest rate swaps, and then we looked to add some fixed rate exposure and duration through the mortgage portfolio, right, so if you look at the securities book and you looked at it pre-pandemic and through time, we tried to build our securities portfolio as a little bit of a barbell, and so we would kind of get an average yield and an average duration by having two and three-year treasuries and then one-year pass-throughs in the MBS portfolio, so that would average out to give us kind of the duration that we wanted in the portfolio as well as yield, and so the securities portfolio helps with your asset sensitivity and bringing it down so that your interest income becomes more predictable. We like the derivatives and we like the swaps because they're equity-friendly, right?
And so when you've got the mortgage-backed securities in the portfolio, you've still got that negative convexity that you deal with, whether it's in the book or it's in the securities portfolio. And so as we went through last year, we took some duration in the portfolio. We were portfolioing everything that we originated. We'll go back to originate and sell this year and start to migrate the longer-term asset into the securities portfolio through MBS. And we'll continue to use interest rate derivatives to extend out a couple of years, especially given the shape of the curve.
Absolutely. Changing questioning, maybe you could talk a little bit about credit quality in general. Obviously, your bank, as I mentioned, has had very low charge-off levels over the years. You tend to carry maybe a higher level of criticized or non-accruals, but you certainly don't have the charge-off issue.
Yeah. Criticized, the way I tend to think about it is criticized is like probability of default, right? And charge-offs include loss given default and non-accruals kind of somewhere in between. But what sits in your criticized book or what sits in your non-accrual book is the whole loan. And it's rare that you charge off the whole loan, right? And so there's always this disconnect between what's non-accrual and what charge-offs look like. Criticized is high. It's been higher than we would typically have, higher than we care to have, but it's a function of the economy and the speed at which you're seeing new updated financial statements. When we look at what's underlying in the criticized portfolio, most of the areas, whether it's office, well, office is probably the biggest challenge. Healthcare, retail, hotel, those aren't growing in criticized. They're coming down.
Office is moved up through last year, kind of leveled off. I expect it'll probably come up a little bit again in the criticized portfolio. You'll see some of that likely move into non-accrual. Probably see some charge-offs, whether it'll be full charge-offs, probably partials as loans come due and you look at where loan-to-values are, you probably see some partial charge-offs, but overall, it's what we talked about before, the underwriting and the protection that you have with the LTVs minimizes the losses, and really, with the non-accrual portfolio or the criticized, you're just spending more time with the client, right, and your goal is always to keep them in business, and how do you help them think about restructuring? How do you help them thinking about their business? Do you put people together to help each other out who are in the same industry?
Different ways that you're working with the client to try and keep them in business.
Maybe we could get your take on troubled debt restructurings that's changed, as you know. Maybe you can share with us just how you had to account for them and what it means today. And will that influence behavior by the bank working with their customers?
The short answer is it doesn't change the behavior. What TDRs really have done is change the accounting and the capital treatment, right? And so when you go through and someone's in a situation where they do need to restructure, you note that loan as a TDR and they carry a higher capital charge through CCAR and SCB because the belief is that they're more likely to go bad. And so that's really the big thing. But for us, the capital ultimately, if you're restructuring the loan, you're restructuring it again to keep the client in business and to avoid the charge-off. And so while TDRs kind of constrain capital in the short term because you have to hold capital against it, they're actually great for capital in the long run because the worst thing for capital is charge-offs.
Right. You're a bit unique because of the People's Deal that you're going to go through DFAST again this year. This would have been your off-year. What's your view of the economic outlook and markets outlook they gave us in February? How are you approaching it?
I guess when you look at the scenario that the Fed's going to use, it's actually in the rules of what things have to look like, where the unemployment rate has to get to, how they think about GDP, how they think about HPI and CRE, price inflation, or CREPI. It's a tougher test this year, not because the endpoint is tougher, but because the start point is better, right? And so you're in this world where you're starting from a lower unemployment base, which means to get to 10%, it's a bigger distance from 3.5%-10% than from 5%-10%. And so it's that change over time that most models are sensitive to. And so from that perspective, I think you see credit loss is higher for most people. But the offset is you're starting from a better spot from net interest income, right?
So rates are higher. Most people have a higher net interest margin than they had last time we did the test. And so your pre-provision net revenue should be higher as well. So what you're producing in terms of capital under stress should be better. The losses are likely to be higher. For some people, those will equal out. Some of them will be better. Some of them will be worse. But those are the puts and takes, and we'll see how they fall out in the past.
And how about what you read on the commercial real estate angle in the forecast? Much different from last year? Maybe a little better for you this year, or?
There's M&T and then there's the world. I think in the world and how the test is working, the Fed's shifting emphasis from hotel and retail to office and healthcare. And so that will affect us just like office and retail did. But we've been working hard over the last 18 months on our portfolio. And if you look at where we ended 2022, we're not quite 50/50 C&I and CRE, but we're close. And the percentage of construction in our portfolio is down dramatically. We talked about CRE declines last year on the calls. Most of that was talking about construction loans that we're paying off. And so those are the, that's the portfolio that's treated the toughest in the stress test. And so those things should be helpful. And like I said, our PPNR is going to be much better.
Yes. Oh, absolutely. Maybe last night you guys put out an 8-K with some updated guidance. Maybe you could share with us some of your thoughts behind your guidance.
Yeah. I mean, I think the simple story is no change for the year. So that's a good start point. Really, when we look at the Q1 and where we're trending, revenue looks to be pretty in line with what we thought it would be and where the world is, both whether it's net interest income or fees. Expenses, as we've gone through the Q1, when we look at, we have a large uptick every year in the Q1 on seasonal comp. And the issue there is people who are retirement eligible, you have to front-load a bunch of the expenses associated with their compensation. And with People's, we gave credit for years of service. And so when we estimated what those costs would be, we underestimated it a little bit. So we gave an update to that.
But otherwise, when we look at where things are trending, we're comfortable with where we are for the full year. Looks like the Q1 expenses. It won't be equal all year. In addition to the seasonal comp, might run a little bit heavier than average in the Q1, but for the full year, we're comfortable with where we're going.
Then in the last few seconds here, share with us your thoughts on capital. You guys have always managed your capital very effectively. Tell us what you're thinking now in terms of giving back excess capital to shareholders.
Yeah. Well, I mean, the reason we're all here is to protect the shareholders' capital and get a return on it. And so as we're talking about our thoughts on net interest income and hedging and predictability and lack of volatility, that plus strong underwriting and low charge-offs is what allows you to run with a lower tangible ratio than others. We're a little constrained right now because of the SCB, but even with that, we still are holding more capital than we think is necessary to keep the bank safe and sound. And so our first priority is always to put the capital to work, making loans in our communities. And when there's not an opportunity to do that, then we look to give it back to shareholders in the most friendly way. So some combination of dividends and repurchases.
Very good. Well, we've run out of time, and I want to thank you very much and good luck in your new role.
I appreciate it. Thank you.
Please join me in a round of applause thanking Darren.