Good morning. Thank you for joining OFG Bancorp's conference call. My name is Maria, and I will be your Conference Operator today. Our speakers are José Rafael Fernández, President, Chief Executive Officer, and Vice Chairman, and Maritza Arizmendi, Executive Vice President and Chief Financial Officer. A presentation accompanies today's remarks. It can be found on the investor relations website on the homepage in the What's New box, or on the Webcast Presentations and Other Files page. This call may feature certain forward-looking statements about management's goals, plans, and expectations. These statements are subject to risks and uncertainties outlined in the Risk Factors section of OFG's SEC filings. Actual results may differ materially from those currently anticipated. We disclaim any obligation to update information disclosed in this call as a result of developments that occur afterwards.
We also direct you to the explanation of non-GAAP measurements that are included in our presentation and news release. All lines have been placed on mute to prevent background noise. After the speaker's remarks, there will be a question and answer session. I would now like to turn the call over to Mr. Fernández.
Good morning. Thank you for joining us. Please turn to slide three. Before the market opened today, we reported third quarter results which reflected the impact of several non-core strategic transactions. We generated a 14% increase in adjusted earnings per share. Adjusted return on average assets and return on average tangible common equity also improved, and reported net interest margin continued at a level similar to top-performing peer banks in the mainland. We are extremely pleased with our core performance. Our levels of small business, auto, and consumer loan production, core deposit growth, credit quality, and capital, and the number of net new customers all confirm the effectiveness of our differentiation strategies. Since we made our Scotiabank announcement, we have been engaged in extensive integration planning.
We're extremely excited about how the acquisition will significantly enhance our position as the premier retail bank on the island and establish a strong foothold in another Caribbean market. As always, thanks to our OFG team and the new members who will be joining us from Scotiabank for their commitment and dedication, and to all our retail and commercial customers for their loyalty and support. Please turn to slide four. During the third quarter, we took advantage of positive market conditions both in the U.S. fixed-income markets and here in Puerto Rico and decided to sell a good portion of our remaining NPLs to sell some fully charged-off loans at a profit and to sell almost 40% of our investment securities. Here's how these and other items affected our results. First, provision was increased by a net $32 million.
This reflected a $39 million increase primarily from deciding to sell $95 million of unpaid principal balance NPLs. This was partially offset by $2.4 million in proceeds from the sale of $26 million of fully charged-off auto and consumer loans. It was also partially offset by a $4.5 million decrease in the allowance for loan and lease losses due to improving asset quality trends in Puerto Rico. Second, we had a $3.5 million gain from selling $322 million in low-yielding mortgage-backed securities. I'd like to point out the tactical as well as the strategic benefits of all these transactions. First, they further strengthen our already strong liquidity and balance sheet as we continue to deploy our growth strategy. Originated non-performing loans are now 40% lower year-over-year. Selling them enables us to free up resources, reduce related expenses, and increase operating flexibility.
Combined with our MBS sales, we have close to $1 billion in cash to fund our growth plans, including pre-funding our $560 million acquisition of Scotiabank's Puerto Rico and U.S. Virgin Islands operations. Second, our MBS sale also resulted in another major reduction in higher-cost brokered CDs and wholesale borrowings, which are now down a total of 42% year-over-year. From a management point of view, all of this gets rid of potential distractions so we can focus all our attention on our integration plans with Scotiabank and our growth strategies. Please turn to slide five to review our financial performance. Net revenues totaled more than $99 million. While down slightly year-over-year, they remain up 3% year to date.
A key factor in the third quarter was an 8.7% increase in originated loan income, which offset declines in income from the runoff of acquired loans and of investment securities due to the mortgage-backed security sales. Core non-interest income continued at very steady levels. As a result, on an adjusted basis, earnings per share came in at $0.48. Return on average asset was 1.65%. Return on average tangible common equity was 11.18%. The efficiency ratio was 52.10%, and reported tangible book value per common share was $17.11, up 5.4%. Please turn to slide six to review our operational highlights. Total net loans increased 1.2% to $4.4 billion. Growth of originated loans at 4.8%, more than offset the continued pay down of acquired loans and the sale of non-performing loans that we announced earlier. Loan production totaled $291 million compared to $347 million in the year-ago quarter.
Auto and consumer lending remained strong at $142 million and $48 million respectively. Commercial lending at $66 million reflected continued growth of small business customers. Core deposit average balances increased 3.4% to $4.6 billion approximately. This reflects growth in commercial loans, net new customers, and our larger core retail funding base. Loan yield declined seven basis points, reflecting higher returns on originated loans and lower yields on acquired loans. Originated loan yield increased 11 basis points from the net effect of Federal Reserve rate hikes last year, and a larger proportion of higher yielding originated commercial and auto loans in the portfolio. Core deposit costs continue to remain relatively low, up only 18 basis points year-over-year. The end result was a net interest margin of 5.35%. Please turn to slide seven to review credit and capital.
The net charge of rates and provision obviously increased as a result of our non-performing loan sales. The sales, however, reduced the NPL rate 145 basis points year-over-year, as well as the total delinquency rate. Excluding items, provision of $11.7 million, decline $2.8 million, reflecting better asset quality and improving economic conditions. Capital continued to build. Once again, our ratios increased across the board to new multi-year highs. Total stockholders' equity increased 8.2% to $1.05 billion. Our tangible common equity ratio climbed to 14.07%. In our news release, we provided a formal indication of how CECL implementation will affect us. We're estimating an increase in the current allowance in the range of 16%-23% for the originated book, and no effect on the acquired book. Please turn to slide eight for our outlook.
To sum up, we're building excellent momentum as we prepare to close on our acquisition of Scotiabank's Puerto Rico and U.S.V.I. operations. We expect to receive regulatory approval by the end of the year. We're excited for what our future holds as we will become the premier retail bank in Puerto Rico. With this, we end our formal presentation. Thanks to everyone for listening. Operator, let's start the question and answer session.
Thank you. In order to ask a question, simply press star then the number 1 on your telephone keypad. Again, that is star one. If at any point you wish to withdraw your question, press the pound key. Our first question comes from the line of Brett Rabatin of Piper Jaffray.
Hey, good morning, everyone.
Good morning, Brett.
Wanted to first ask, José Rafael, can you just talk about for a second, when you look at the macro picture in Puerto Rico, the stats tend to be flattish. The GA index has been bumping along at 120. Cruise ship visitors have been down a little bit. Auto sales are okay. There was a report last week on Bloomberg that referenced a few of the things, talking about the potential for Puerto Rico to only get $39 billion of the $69 billion of funds from FEMA and HUD. I was just curious if you could give us some color on what you're seeing economically in Puerto Rico and then what you've heard about the potential decline of funds coming to Puerto Rico.
Sure. What I think we're living right now here in the island is transitioning, an economy transitioning, from not only the aftermath of Maria reconstruction, but also for the last 12, 13 years of economic contraction. Federal funds are coming in. They're coming in slower than anticipated. There's still a little bit there of uncertainty regarding the magnitude of how many funds are going to come and slow down to the island. The truth is that there's very little knowledge on the ground in terms of the specifics, Brett, in terms of the dollars and on when are those funds coming in. They are certainly trickling in primarily for the roads. There's a lot of rebuilding on the roads and the bridges. There's still work in progress in terms of the electric power authority and its restructure.
There's still a lot of expectations on the housing funds coming in for rebuilding and actually building new homes. We are seeing some of our larger construction services clients being awarded projects to build and rebuild homes. Those funds have already been allocated. They've been awarded, and they have yet to be disbursed because there's still some hoops to go through. My expectation would be that we will continue the end of the year as we have seen so far this year, with lots of noise on when the monies will come in and how much will come in, and how the fiscal board portrays in Washington, how much is the fiscal plan including in terms of federal funds.
I do believe that there are lots of moving parts, and there's lots of listeners out there that have a vested interest, particularly bondholders, on how these things come out. I think we'll continue to have quite a bit of noise and create somewhat the uncertainty that is keeping the economy relatively flat. My expectation would be that next year, funds will start flowing in a more consistent basis. The impact on the economy as most of the local non-political economists in the island are projecting, and we'll see the results. I am encouraged. I am encouraged with what we're seeing. Our customers, commercial and consumer, are certainly in a much better financial position than they were a couple of years ago, and their balance sheets show it.
Appreciate all the color there. I was also curious, with all the changes in the balance sheet here, can you give us an idea of how interest income might play out with the four pieces, originated loans, acquired cash and securities, which is obviously lower this quarter, how that affects the 4Q run rate for that interest income?
Yeah. First, let me just say a couple of things here. We were very opportunistic this quarter. Interest rates in fixed income securities are at, again, I would say record lows again or multi-decade lows. Given the acquisition that we're pending to get approvals from on Scotia, and the fact that the value of that transaction is $3.8 billion of core low-yielding, low-cost deposits, it make a heck of a lot of sense for us to just not have to rely on brokered CDs and wholesale funding that are a lot more expensive. We don't need to have that extensive funding. That's the first thing. We took advantage of that, and we know it's going to have a little bit of a short-term impact, but the transaction expected to close in the fourth quarter.
We're really managing the bank for the longer term, Brett, and not necessarily for the fourth quarter. If it has a little bit of a reduction in interest income into the fourth quarter because of the sale of the securities, we take it, and we move forward because the added value comes in with the acquisition. Secondly, on the NPL sales, look, we are getting rid of capital that was not well used. What we're seeing is interest from the U.S., capital coming into the island interested in buying this. We're seeing a better bid. Again, we were pretty good in the quarter at getting these transactions firmed up, and we're excited to get rid of those assets.
We'll be able to reduce operating expenses on that sale alone at the tune of $1.5 to $2 million, simply because we won't have to work out quite a few residential and small commercial loans. Again, they didn't impact interest income because they were basically not generating any interest income for us. It clearly cleans up a lot of unnecessary work and dedicate our resources to what we're here for. What we're here for is to grow. The acquisition of Scotiabank, Puerto Rico and USVI gives us tremendous potential and tremendous momentum for us to grow and take advantage of how the economy is transitioning to a new phase here in Puerto Rico.
Okay. If I could sneak in one last one just on Scotia, how that review process is going. I know you're looking for regulatory approval. Can you give us any update on the timing of the transaction?
There's not much I can add. Regulators are engaged with us, and we're engaged with them. They'll have to go through their process. We're conscious that the level of information sharing is active and real time. We're confident that by the end of the year, we should have a positive response on the approvals.
Okay. Appreciate all the color.
Thank you, Brett. Have a good day.
Our next question comes from the line of Alex Twerdahl of Sandler O'Neill.
Hey, good morning.
Good morning.
Good morning, Alex.
Just to clarify on the last question there, you said that you're reasonably confident that you'll get regulatory approval by the end of the year. Are you also confident the deal will close by the end of the year?
Both, yes.
Okay. Just clarifying there. Just wanted to ask a little bit more on the loan growth numbers that we saw this quarter. We saw loans go down a little bit, but I think they're probably impacted by the loan sales. Maybe you can just give us sort of some color and help us discern a little bit more on sort of what the organic core loan growth looked like during the quarter, and then also kind of how your pipelines are looking into the end of the year and into 2020.
Yep. You're absolutely correct. Even though you see loan balances going down, they're primarily impacted by two areas. One is the runoff of the acquired book, but more importantly, the sale of the NPLs. If you look at it, X the NPL sales, we have loan growth. What we're seeing into the fourth quarter, we're seeing a good pipeline still. We see on the commercial small and middle market commercial business, we see a good pipeline. We continue to be encouraged with what we're seeing on auto lending. We're seeing a slight improvement in mortgage lending also. Consumer lending remains steady. We had a good quarter again, this third quarter with $48 million in originations on the consumer side. What we're seeing is a good momentum into the fourth quarter.
Again, we're working on many work streams right now as we are planning the closing and the integration of Scotiabank. We have our hands full, but having said that, our teams continue to be very focused on generating the business and on executing on our plan on the fourth quarter.
Okay, cool. Just talking about the provision a little bit going into next year. First off, I really appreciate the color you've given on CECL and sort of the day one impact to the reserve. How should we think about the reserve and the provisioning into 2020 with CECL, as well as you had this little adjustment due to some macro factors in Puerto Rico this quarter. How should we kind of think about the, one, a good starting point for the reserve or the provision for starting the beginning of next year and then two, how that is actually going to be impacted by CECL?
Before I pass it to Maritza, I just want to say a little bit big picture. I mentioned it earlier when Brett asked us the question. It's a little hard for us to be able to give you more color on the provisioning next year, simply because we are in the midst of closing an acquisition. That will have its own intricacies. From a macro perspective, our expectation is that credit trends will continue to move in the right direction, and therefore that should have somewhat of an impact throughout the year. I don't know if Maritza has any additional color there.
No, I agree with José's comment. We have been focusing on having the model ready for day one, and we share with you the day one impact. At this moment, it's too early for us to add some color on how day two will impact the levels of provisionings. As José mentioned, we will be working with that, and as soon as we have some information, we will share with you.
Okay. Just a final question. Can you just help me sort of jibe the NPL sales? What was the mark on the loans? I saw that there's $29 million of mortgages and $9 million of commercial NPLs that were sold. How can we get that back to the $95 million in unpaid principal balance?
Good luck with that, Alex.
Yeah. In general, Alex, at this point, we won't share any pricing for competitive reasons. The figures are there, and we thought these levels of pricing that we get are far better than what we saw before pre-Hurricane levels.
Yeah. Again, as Maritza mentions, we're happy with the pricing we've gotten better than what we got pre-Maria and better than we saw in the last 12 months for sure. We really don't want to be sharing too much specifics there in terms of the pricing.
Can you share with us kind of how you determined which NPLs you sold off about a third of them? Is there any common characteristics between them that made them particularly worth selling and whether or not we should expect further loan sales in subsequent quarters?
Yeah. Okay, you asked two questions. I'll give you two answers. The way we looked at it was, let's focus on residential because they are small, $120,000, $115,000 per loan. Let's focus on small commercial because, again, those are more costly to work out than the bigger ones in terms of the operating side. That's how we looked at it. They're all non-performing, non-accrual loans that were in bankruptcy, some of them. We just had to kind of spend a lot of time on them. That's kind of what was the first driving force behind it. Many of them were non-accrual. Many of them were having cash flow challenges in their own businesses. That's kind of where we came from. Number two, should we expect more sales? I don't know if you realize, but the level of NPLs that we have is quite low.
We do not expect to have any additional sales. We do feel that we've cleansed all these legacy NPLs from residential and small commercial particularly, and we're good to go. Again, opportunistic in the quarter and happy to get it done with additional liquidity coming into the market.
Thank you for taking my questions.
Yep. Welcome.
Our next question comes from the line of Joe Gladue of Alden Securities.
Good morning.
Morning, Joe.
Let me start with, I guess you talked a little bit about the balance sheet going forward, but typically you've run with a level of securities that's maybe, I don't know, 17%-20% of total assets. It's well below there now. Do you think you'll be sort of drifting back towards that level after the Scotia acquisition, or do you plan on running with a lower level of securities going forward?
We're planning on having a lower level of securities going forward, Joe. Our expectation is to be able to first deploy the cash to close and finalize the transaction and make the payment. Also, our planning forward is for deploying into loans and have the ability to focus on our most important markets, the small commercial and middle market commercial auto. With the acquisition of Scotiabank, we'll have a lot more scale on the residential side, we'll be able to do a little bit more there, too. It won't happen immediately, as you can imagine. In our planning, the intention is not to extend duration on the fixed income securities market and better deploy it on the higher yielding loan buckets.
Okay. All right. Again, you did discuss some of the loan outlook and pipeline and everything. Just wondering if you could give a little more color on the U.S. originations. Looks like this was the lowest quarter since you started that program for originations. Is that because you've kind of reached the level you're comfortable with, or is there anything else going on there?
No. We've mentioned in the past, the U.S. loan program continues to be an important part of our strategies going forward. It has its ebbs and flows. Some quarters we'll do $12 million like this quarter, others will do $40 million or $50 million. It just depends on what we see. Again, we're being very prudent, very conservative. Lots of things can come up our alley, but we're not necessarily going after it. We're being very methodical, and that's why you'll see that ups and downs on a quarter-to-quarter basis.
All right. Fair enough. I guess I'll just ask if you could give some color on the deposit pricing trends in the island and where you're expecting them to go.
Well, with Federal Reserve Bank bringing down Fed funds twice this year, the expectation of one or two more cuts, I think any potential pressure to increase cost of funds in the past, it's certainly subsided. We still have excess liquidity here in the market in Puerto Rico. That has been very helpful throughout the ending to the higher rate cycle. Now that we're back into a lower rate cycle, and of course, with the acquisition of Scotiabank, it gives us tremendous strategic benefits because we really have a solid core, low cost funding base with almost 500,000 clients. Again, we don't foresee significant or any pressure going forward in terms of the cost of funds. There might be some competitive pressures in the local market trying to focus on us, which we are seeing, but we know how to play defense, too.
We don't expect that to affect us going forward, Joe.
All right. Well, thank you. That's it for me.
Yeah. Thank you, Joe. Have a good day.
Our next question comes from the line of Glen Manna of KBW.
Hi. Good morning.
Good morning, Glen.
I just wanted to follow up on Alex's question. I'm trying to kind of get into what was the organic loan growth rate. I know, José, you said that loans were up. When I look at loans held for investment at period end, third quarter versus the second quarter, it looks like they were down $97 million. How much of that $97 million drop was due to moving the loans to held for sale?
Glen, part of the reason why we're not giving that number is because we're being very cautious with pricing in terms of the sales. Again, we're using unpaid principal balance as the metric to disclose the sales, which was $95 million between acquired and originated loans. In the end, when you see we have organic loan growth primarily from the auto originations, which was $140 million. We have around $30 million of repayments every month. You have an idea there. The same with consumer. We had a very good quarter. Residential mortgage has been trending down because of repayments all along. Again, commercial, small business, auto and consumer are the drivers for us to remain growing our core loan book in the numbers for this quarter.
Well, that's the thing. I think what's kind of masked in all of this is when you look at originations and you back out the U.S. loan program, OFG USA, originated loans on the island were actually up like 3.3% quarter-over-quarter, which is pretty good because the third quarter is usually a seasonally soft quarter for you guys.
Yep. Those are good numbers for us, too. We're seeing 2% to 3% annual average growth in the loan portfolio when you look at it. The run rate for this quarter was, when you look at it from an organic perspective, excluding the sales of the NPLs, it remains around 2% to 3%.
Okay. Maybe just a little bit of color on, you sold some lower yielding securities. Right now it's in cash. Maybe you paid off some brokered CDs. What's the NIM trajectory here? Do you hold this level? Do you increase? Kind of the impact of what's going on in the mainland in terms of the rate environment?
Yeah. Go ahead, Maritza.
What we're seeing, Glen, is something similar what happened to us this third quarter, that the Fed moved rates during July. We have only a reduction of three basis points in the NIM. What we're seeing for this next quarter will be something very similar. We will see probably a slight reduction in the yields on loans, but it will compensate through the reduction in the wholesale funding. That's how we see the NIM going forward, probably stable or going down three, four basis points as we did this quarter.
Okay. Refresh my memory. When you announced the Scotiabank deal, you were going to sell $1 billion of securities post-closing. Are the securities that were sold this quarter, is that inclusive of that amount? Should we expect $700 million in sales post-closing? Is it still $1 billion in sales post-closing?
No. We were opportunistic, Glen, in the quarter when we saw interest rates dropping. We kind of preempted that transaction that we announced when we announced the Scotia deal. We've done the sale. Once we do the closing, the investment securities that are carried from Scotia, we'll take a look at them, but they will carry in into our balance sheets. To answer your question, we announced post-deal, but we did it pre-deal because of market conditions.
Okay. There's a pretty significant difference in the amount, right? $330 billion or million this quarter, and then it was $1 billion, I think, when you announced it, right? When you announced the deal.
Yeah. Remember last quarter, we also sold securities.
Oh, okay.
That adds a little bit more. There's not much of a difference. Maybe $200 million difference, and that we build in cash. If we don't need to sell, we don't need to sell.
Okay. Just I know, in a quarter where you have these kinds of adjustments and things moving around, the tax rate can flip around a lot. I think Maritza, you had said last quarter you expected a second-half tax rate of around 32%. It was 26% this quarter. Where do you expect that to go?
Well, the effective tax rate for the year is estimated at 30.15%. It's basically the changes, the mix of this transaction because we have higher proportion of exempt income versus taxable income. That's why it get reduced from the original expectations.
30% more or less going forward.
Okay. Thank you.
Yep. Thank you, Glen. Have a good day.
Again, ladies and gentlemen, if you wish to ask a question, simply press star then the number one on your telephone keypad. Again, that is star one. Our next question comes from the line of Brett Rabatin of Piper Jaffray.
I just want to follow up on two things. One, just want to make sure I understood the pro forma liquidity or when we close the deal, how much liquidity you're anticipating having on the balance sheet?
Given the transactions that we did this quarter and the past quarter, we expect to have the same level of liquidity that we announced. It's just that we preempted the sale of securities in this quarter and the previous quarter. There are no different expectations there.
No. Okay. I just want to be clear on that. José Rafael, can you just talk about for a second, when I look at the commercial loan production, I mean, that's kind of trended. Obviously, 2Q last year was kind of a different quarter. The numbers have kind of moved down a little bit over the past year, and I'm just curious if you can give any color if that's a function of activity or you're just seeing heightened competition from your peers. I know you want to become the lender of choice to the SME market in Puerto Rico. Can you give us any color on kind of production trends in commercial?
Yeah. Actually, the production trends this year in the small commercial are a lot better than last year. Actually, we're very happy with the small business commercial lending business this year. What's pushing the comparisons in somewhat of a negative way is the larger ticket items. There you have more competition, and that's kind of where we are. Having said that, we do have seen also the postponement of some transactions that are in the pipeline and that we expected to close this quarter. Maybe they close in the fourth quarter. Maybe they're pushed into the first quarter of 2020. They're still live transactions and significant ones.
All in all, I think the way we have transformed the retail channel and the way we have focused on the small commercial client is starting to pay off in a more consistent basis, and we're extremely happy with the performance on that sector. Looking forward to build on it once we do the acquisition and into 2020.
Okay, great. Appreciate the additional color.
Yep. Thank you.
Again, ladies and gentlemen, if you wish to ask a question, simply press star then the number one on your telephone keypad. There are no further questions at this time. I would like to turn the call back over to Mr. Fernández for any additional or closing remarks.
Thank you, operator. Thank you to all for listening in today. I wish you a good Monday and a great week.
Thank you, ladies and gentlemen. This does conclude today's conference call. You may now disconnect.