Good day, ladies and gentlemen, and welcome to the Bank OZK second quarter 2019 earnings conference call. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session and instructions will follow at that time. If you require operator assistance during the program, please press star then zero on your touchtone telephone. As a reminder, today's conference is being recorded. I would now like to introduce this conference call. Mr. Tim Hicks, you may begin, sir.
Good morning. I'm Tim Hicks, Chief Administrative Officer and Executive Director of Investor Relations for Bank OZK. Thank you for joining our call this morning and participating in our question and answer session. In today's Q&A discussion, we may make forward-looking statements about our expectations, estimates, and outlook for the future. Please refer to our earnings release, management comments, and other public filings for more information on the various factors and risks that may cause actual results or outcomes to vary from those projected in or implied by such forward-looking statements. Joining me on the call to take your questions are George Gleason, Chairman and CEO, and Greg McKinney, Chief Financial Officer and Chief Accounting Officer. We will now open up the lines for your questions. Let me ask our operator, Kevin, to remind our listeners how to queue in for questions.
Ladies and gentlemen, if you have a question or a comment at this time, please press the star then the one key on your touchtone telephone. If your question has been answered and you wish to remove yourself from the queue, please press the pound key. Our first question comes from Ken Zerbe of Morgan Stanley.
Great. Thanks. Good morning.
Morning, Ken.
I was hoping we could start off with expenses. It looks like expenses ticked up a little bit, versus what I thought was a seasonally higher quarter back in first quarter. Can you just talk about what drove the higher expenses this quarter, and more specifically or more importantly, what is the outlook for expenses on a go-forward basis?
Hey, Ken, this is Greg. Let me start on that, and then George and Tim can chime in, too. We're continuing to build our infrastructure, as we've been doing now for a number of quarters. We are in the late innings on that. I think we're getting close to having that built out. We are hiring individuals to really come in and take the place of third-party consultants that we've been using to help us get some of these programs up and stood up. There's a little bit of a transition in some of that as you bring individuals in, and then begin to exit consultants out of the bank. That process is ongoing. We expect that to continue over the next quarter or two.
I think you'll probably see a little bit of continued increase in overhead in the next couple of quarters as we continue to make that transition, get the remaining infrastructure in place. We think that if we can get beyond the seasonally challenging Q1 of 2020, I think there's a pretty good opportunity to keep the overhead, I'm going to say, a little more in check. That's not to say it's not going to continue to have some increase, but I think you'll see the rate of increase, as we get to that point in time, much more likely to be muted, at least relative to what you've seen the last two or three quarters.
That's really the biggest driver in overhead as we think about overhead the last four, five, six quarters, and that continues to be probably one of the biggest drivers as we think about overhead for the next two or three quarters.
Okay. That does help. Maybe switching gears, in terms of the North Carolina credit, I understand you're trying to sell the South Carolina credit. With the North Carolina credit, it almost sounds like you're taking on the responsibility of finishing the project or the build. Can you just expand on that a little bit more? What exactly is happening, and what's the timeframe with that? Thanks.
Yeah. Good question, Ken. As you are aware from previous calls, the sponsor there developed a lot of houses, and there was ongoing development of lots. Some of those houses were not fully completed. There's a custom home there that's being built for a custom buyer. We're completing those sort of construction elements and lot development area activities and expect to sell those homes and lots as developed. There is some remaining work to be done on that project. The question will come at some point in time, how you continue development. Do you just sell lots? Do we need to develop some more inventory? We're going to try to operate that in a way to maximize our proceeds and hopefully recover some monies that we've written off.
We're not going to get into a massive development project, there is work to be completed, it is an ongoing operating project with amenities that operate and so forth. We're going to operate it and work our way out of it in an orderly manner.
Go ahead.
The South Carolina property is obviously a much simpler project to sell, because it's ripe for someone to acquire it and reposition it, redevelop it in a major way. I will comment, a couple of the analysts I noted in their write-ups, commented that we had foreclosed on these properties. We actually did not foreclose on either one of them. We acquired title in deed -in -lieu transactions, and that took a little while because we had to do all of our OREO and recheck all of our environmental due diligence and insurance, and get certain permits and operating licenses transferred, and so forth. Both transactions were transferred to us in a cooperative bridge loan transaction with the cooperation of the sponsors.
I see. With the North Carolina project, is there any risk of additional write-downs in terms of your exposure if you don't complete the project and you sell just the lots, or basically any other risks to you guys?
Well, there's always a risk of additional write-downs. I think that's extremely low in both transactions, given the conservative nature of the appraisals that we received and the fact that we wrote the assets down when we received those appraisals in the third quarter of last year to 80% of appraised value. Of course, we've previously mentioned on the South Carolina project that in the couple of quarters after we put it on non-accrual, we captured a $500,000 or so of cash flow that went to reduce the balance on that. I think write-downs are unlikely, but our practice is to reappraise OREO properties on an annual basis. As long as they're in foreclosed assets, they're subject to reappraisal, and if those appraisals came in more adverse, then we would have a write-down from that. The reality is, I think that's very unlikely.
Okay, just one more question, if I could. I understand how hard it is to forecast repayments on the loan portfolio, the RESG portfolio. Is there a way of kind of quantifying the lower bound of potential loan growth? I did notice that you did reduce your loan growth guidance for the year due to even more elevated payoffs. I'm just wondering how bad could it be within sort of a reasonable expectation, like if you go through loan by loan of your portfolio to try to examine what could pay off, where is the lower bound of loan growth this year?
Well, we base our projections based on a loan-by-loan analysis. As you know, in our RESG portfolio, we average about 14 loans per asset manager. Our asset managers are very close to those transactions. These tend to be larger, complicated transactions, so sometimes a sponsor says, "We expect to pay this off in May," and for some reason or another, negotiation with their partners, negotiations with the lender on the other side, that moves forward to or moves back to August or October for some reason. As we've experienced quite a bit recently, we've had a few projects that were pretty sizable that have been pulled forward on the spectrum.
We had at least one pretty sizable project in Q2, and we've got a couple more coming in the second half of the year that we've been notified or repaid on that have not even reached a CO status. It's historically been very rare for us to get paid off and refinance mid-construction or before a project at least has a temporary certificate of occupancy. We've got several of those examples that have accelerated repayments this year. We're giving the best guidance we can give on that, but there are things that cause those payoffs, repayments to be sometimes delayed, sometimes accelerated, and you can do your very best to predict that, and you're usually right within a quarter or two, but sometimes you get surprised.
All right. Thank you very much.
Thank you.
Our next question comes from Timur Braziler with Wells Fargo Securities.
Hi, good morning. Maybe looking at the deposit side and some of the commentary around cost of interest-bearing deposits, what's being done that gives you guys optimism that you can lower the potential cost of interest-bearing deposits ex a rate cut in the third quarter?
Timur, hey, this is Tim. Good morning. I think we're actively managing that deposit book. We really started on July 1 with a lot of our institutional public fund customers talking about the rate we pay on those. Obviously, LIBOR went down 10 basis points in Q2, even though Fed hadn't moved, rates have decreased, and we've had those conversations with some of our larger deposit customers. We really started that really early in the quarter. Trying to stay ahead of what the Fed's doing, and even though the Fed hasn't moved yet, some of those rates have already come down. Even our promotional CD rates we brought down in early July as well. You've seen many in the industry also bringing down their deposit rates.
I think between that and the moderated loan growth guidance that we've outlined here allows us some flexibility to help replace some of our higher deposit customers with some lower deposit customers and we're working hard to do that and feel like we've got the ability to be, as we said in our management comments, to be slightly down on cost of interest-bearing deposits, even in a flat rate environment, for this quarter.
Okay. Maybe just looking at broader deposit growth, you guys have historically looked out at loan growth projections and then backfilled that kind of with deposit gathering objectives. Is the linked quarter decline in deposits an indication of kind of the lending outlook? What's the goal for growing deposits in an environment where loan growth is going to be pressured?
Yeah. We feel like we have the ability to grow deposits to match our loan earning asset growth. We do model that and project that on a monthly basis. We're really comfortable in that mid -90% loan-to-deposit ratio. Sometimes there are timing differences that move that percentage point at the end of the quarter one way or the other. We're very comfortable in mid- 90% loan-to-deposit ratio and feel like we've done that for the last several quarters, been in that range and would expect to continue to be in that range, as we just project out what our deposit growth needs are based on what our earning asset needs are.
Okay, understood. Just one last one for me. Looking at the indirect RV and marine portfolio, the number of dealer relationships has seemed to kind of find a level here between 13 and 1,400. The growth continues to accelerate. I know there's some seasonality in 2Q, I guess just looking at the existing dealer footprint, what's the remaining potential out of that footprint? Meaning, is there opportunity to continue seeing accelerated growth from that existing footprint, or do you need to actually grow the dealer network in order to further accelerate that growth?
Well, that's a good question. If you're following the marine and RV manufacturers stocks and their reports, you'll notice that marine and RV manufacturers are shipping less, selling less to dealers than they were a year ago. There's a bit of a slowdown in the manufacturing side. That it would imply that your average dealer is selling less as well. We've been able to maintain good volume this year, and that's in part due to the fact that we have had some modest growth in our dealer network over the last year. That's not been a ton. The capability to grow that dealer network is there. As we continue to monitor this portfolio and the performance of this portfolio and get more and more history with the data on that, we would expect to expand that dealer network.
That dealer network could probably go to 1,700 or 1,800 dealers in a more mature state for that unit. Over the last several quarters, we've been adding dealers every quarter, and you remove dealers every quarter. Our program is very focused on monitoring the performance of our dealers and the quality of paper we're getting from our dealers and various other dealer performance metrics we're monitoring. We routinely terminate relationships with dealers and routinely add dealers. The capability is there as we get more seasoning on this portfolio to add another significant tranche of growth in the future.
Thanks for the questions.
Thank you.
Our next question comes from Jennifer Demba with SunTrust.
Hey, guys. It's actually Steve on for Jennifer. There's been a lot of talk about condo sales in New York and Miami. How are your projects there filling up, and are you guys becoming more cautious on future projects in these areas?
Steve, I would tell you we're not changing our underwriting standards at all. Our projects are doing very well. Nine quarters ago, we probably had 13 or 14 active condo construction projects in the greater Miami area. That's probably seven or six now. We've had, I think at least six or seven of those projects that CO'd and very quickly paid off. We think that number of projects based on sales that are in place and construction progress, probably by end of the year is two, Tim?
Two to three, yeah.
Two to three.
Yep.
Our Miami condo exposure is paying down a ton through selling of condos, and we've got a lot of sales and a lot of sales activity on the project. We're feeling extremely good about the credit profile of those projects, we're deeply regretting that we've been unable to replace it with new volume. We would love to have 14 more projects of the same credit profile, presale deposit profile of the ones that we had at September 30th last year, that half of them, more or less, have paid off in the interim. Our New York portfolio continues to perform without any issues. We've gotten paid down on several projects there and paid off on several projects there in the last quarter. Our new originations in New York are not as large as they were a year ago. There's less new product being created.
Interestingly, if you look at the Q2 originations for our RESG unit, Washington, D.C. MSA was number one, Boston MSA was number two, Philadelphia was number three, and New York was number four, right in line with Orlando, Florida MSA and San Diego. New York, Orlando, and San Diego were four, five, and six, but just separated by a couple of million dollars. We feel very good about our New York portfolio and the way it's holding up, but you're not seeing as much new product production there. Our New York growth is slowing a bit.
Has that been kind of the limiting factor then on portfolio growth? Just not enough product or projects out there? Is it competition, other things, structure, pricing?
It's a combination of all of that. We've commented for a number of quarters now that we've seen a lot of competition in there . There are lenders that are willing to be more aggressive on credit and leverage than we're willing to be. There are lenders in certain markets on certain product types that are being very aggressive on price. I think we've been just clear without exception that we are not going to sacrifice our credit standards. We've got credit standards that are high. We expect to continue to be very disciplined and only do transactions that meet our credit standards. We're not going to do transactions that get so cheap that we don't generate an appropriate risk-adjusted return. We're negotiable to some extent on price, but not beyond a limit. The result is that growth is the tertiary consideration and the variable that adjusts.
Because we're being disciplined without exception on credit, and we're being reasonably disciplined on our return standards, we've seen less growth. That is a result of two things, as you say. One is competition, and two is the fact that there are just fewer deals that meet our credit standards today than there were a year or two or three years ago, when there was a lot more room to build product in most markets.
Thanks.
Thank you.
Our next question comes from Stephen Scouten with Sandler O'Neill.
Hey, guys. Good morning.
Hey, Stephen.
Thanks again for all the color you guys give in the management comments. Very helpful. I'm kind of curious how you guys are thinking about average earning asset trends through 2019 and into 2020, given the lower loan growth outlook and some of the details that you gave, like in figure eight, around RESG potential repayments over the next couple of years. Wondering if it's possible that average earning assets are relatively flat on a net basis, or if that's too punitive a view in y'all's minds.
Great question, Stephen. What I would tell you in that regard is that the accelerating trend of repayments of loans in our RESG portfolio as well as community banking and portfolio. We're having a lot of repayments and refinances in the community banking portfolio, too. It's a very competitive environment in that world as well. That, coupled with just the ongoing paydowns in our purchase loan portfolio certainly provides a headwind to growth in total loans and, hence, a headwind to growth in average earning asset. We have a strategy that we articulated in the management comments document to address that and the impact of that on net interest income. One is we're working very hard in our real estate specialties group without sacrificing our credit quality or our pricing standards to just work really hard to generate a good volume of new originations.
Through the first half of this year, we generated about $3 billion in round numbers of originations. We're running a little bit ahead of the average pace for last year. We would hope that that origination trend would continue through the back half of the year, and hopefully even accelerate a bit into next year. Secondly, we are getting good volume out of our indirect marine and RV business. We hope to continue to get good volume and growth out of that. As I responded to Timur's question, there, that is a business that perhaps we can scale up even a little more by adding another meaningful addition of dealers to our relationships there. Thirdly, we hope to get some significant increases in volume from our different verticals, specialty lending verticals in our community banking group.
Then we hope to also reduce our cost of funds, Tim sort of addressed that, by more effectively managing our mix and pricing of deposits. It's a battle to grow earning assets when you've got as many repayments as we do. We've got a strategy to attack that. Hopefully, that strategy will be successful. We also hope that we can get some lift to our net interest income from both growing earning assets some and mitigating that cost of deposits. It's a work we've got to do and it's not going to be easy. Our team is very committed. I think if we can be, if market conditions will allow us to be successful, I think we will, because our team's working hard to do that.
Yeah. That's very helpful. Maybe on that funding side, on the deposit side, obviously, I heard Tim's comments earlier, but I'm curious how you think your deposit betas may react on the way down if we get two or three or four rate cuts here. If you think the first couple of cuts would have a minimal kind of beta, and then it would ramp as we saw in the reverse, or kind of how we can think about that potential improvement on funding costs with each theoretical rate cut?
I'm going to turn that back to Tim.
Hey, Stephen. I think it will act fairly similar to how it did on the way up. We had a high deposit beta on the way up. I think we're going to have a high deposit beta on the way down. We are actively managing it. As I said earlier, we started out this quarter trying to actively manage it ahead of any move. Hopefully that'll get us ahead of it. Deposits will lag a little bit from LIBOR specifically. LIBOR moves pretty quickly. I think over a several quarter period, it'll catch up and have a little bit of a lag to it. We're working hard really early on in this quarter to offset any of that and feel good about the efforts we're making.
I think you pointed out in your note as well, our reduced or moderated loan growth, and I said it earlier, should allow us some flexibility in running away some of our higher cost deposit customers.
Perfect. Yeah, that all makes sense. Then maybe one last kind of clarifying question. I noticed the loan to cost for the RESG portfolio as a whole went up maybe couple 51% from 49.5% or something like that. Is that possibly due to that $300 million credit that appears to have gone away? Was that a really low loan to cost loan and that leaving pulled the average up? Can you give any commentary as to what pulled that number up slightly?
Well, it's a constant change in the mix of that portfolio. One comment I will tell you, probably the lowest loan to cost pieces of our portfolio were our Miami condos. Those, if I recall, average about a 37% loan to cost. When those get paid off, that tends to cause the average to go up. It's a change in mix and there's probably a slight tendency, I would say, for that loan to cost number to go up. I don't think it goes up a lot, but it wouldn't surprise me if in a quarter or two we saw that at 52% or 53%. I think one of the keys is to look at the loan to value number, and the loan to value number moved very little, and pretty flat down there around 43%.
We continue to feel very good about that. The reality is most of the guys, or a lot of the guys that we compete with are 15 points ± higher leverage, or 20 points higher leverage than we are. We continue to think we're probably the most conservatively leveraged guys in the space.
Yeah, for sure. Well, thank you guys for all the color and the transparency as always.
Thank you.
Our next question comes from Brock Vandervliet with UBS.
Oh, thank you. George, I wanted to circle back to that comment you made, which I think could be really telling in terms of the competitive environment. You're seeing some refinancings from pre-CO credits. I mean, that just seems amazing to me because I would think as a developer at that point, you're on the final approach to a CO. The last thing you're thinking of is refi, because you want to get over the line so you can lock in the permanent financing. Are these borrowers that are able to just bring that forward and get permanent financing even ahead of a CO?
We have seen a few competitors being very aggressive in acquiring some assets. Usually when a sponsor's in the middle of construction, they're focused on completing projects and selling or leasing.
Right.
Not refinancing and.
Yeah.
Our typical working premise has been is the earliest we would get paid off on an asset would be at TCO, temporary certificate of occupancy, or final CO, and that would be the earliest. In most cases, it would be somewhat after that. What is encouraging our sponsors to pay us off is a combination of lower rates and higher leverage. We've seen competitors come in and basically refinance out all or a large part of the equity, or mez debt plus us, and do it at a compellingly lower cost of capital to the sponsor. I don't think that's a trend that is going to affect a lot of deals, but it's affecting enough deals that it's moving our prepayment numbers faster than we expected. The reality is, Tim put a really nice little chart in there on page eight of our management comments document.
It's the figure number eight in the management comments document that just shows on an annual basis each year what the repayments have been from the loans we originated and what's still outstanding for those. We've talked a long time that our RESG portfolio is a construction and development portfolio, and these loans are going to pay off three years, more or less, after they originate. If it's a really simple, small, non-complex project, they may pay off in 24 months. If it's an average deal, they may pay off in three years. If it's a project that's really big, complicated, mixed use, hard to construct project, it may be a four-year timeline. The reality is, our three biggest years of RESG originations ever were 2015, 2016, and 2017.
You jump forward from that, 2018, 2019, and 2020 is kind of the natural cadence for those loans to pay off more or less a year or so. Seeing that natural cadence unfold and get accelerated just a touch by the fact that you're getting loans that are paying off even before TCO and CO is creating some headwinds to our growth. We work through that big chunk of payoffs and hopefully successfully diversify our portfolio and get more earning asset engines and get a reasonable uptrend toward RESG originations as compared to the $4.8 million or billion or so from last year. We ought to be able to get back into a decent positive growth story. We've got to work our way through this season of payoffs.
In terms of the competition you're seeing, among the banks, it seems like if they haven't backed out of the business years ago, they're tapering down construction. It can't be coming from there. Are these credit funds that have always been in the space, or is it new players? What do you see from the deals you're losing, or they're refinancing early?
Brock, it's a combination of big banks, foreign banks, debt funds. There are a lot of players in the space. Those players have been in the space the last year plus in large numbers. You go back to 2016, 2017, you saw a lot of banks pull out of the space. That created the formation and the raising of a lot of money and a lot of debt funds, credit funds that are targeting the space. A lot of the banks have come back into the space. It's a crowded space right now.
Got it. Okay. Thanks for the color.
Thank you.
Our next question comes from Matt Olney with Stephens.
Yeah, thanks. Good morning. Just to piggyback off that last point about the early payoffs in RESG, I believe you now have the early prepayment fees in most, if not all of your RESG projects that allow the bank to capture at least a portion of the interest income the bank would have received. Given the heavy pay downs in 2Q, are we seeing more fees in 2Q, and should we continue to expect higher fees the next few quarters?
Well, of course, those prepayment fees you're alluding to, Matt, come through the interest line item as minimum interest on those loans. They show up as interest. We commented the last couple of quarters in the, not this management comments document, but the last two, that we had had some positive lift basis, one or two or three or four, I don't remember the numbers, to our NIM in those quarters from higher levels of loan fees related to prepayments. We didn't specifically comment on that in this management comments document. We did have several loans that had minimum interest in them when they paid off. We would expect that to continue.
Some of our sponsors are very attentive to that minimum interest number and don't want to pay it, so they will ride the loan to the day the minimum interest is earned and then pay it off very shortly after that. Some sponsors take a broader view of interest savings they might get it from a lower rate refinance or savings that they might get from cashing out a much larger loan with another sponsor that would let them cash out mezz debt or higher cost equity and factor that in. Sometimes we get minimum interest paid, sometimes the sponsors wait us out on the transaction.
My guess is that the experience we've had the last couple of quarters is probably reasonably likely to be consistent with the experience we would expect the next several quarters, which is why we made no comment about it in the management comments document. Those are chunky prepayment minimum interest numbers, and they're hard to predict. We think there's not a big delta between what we've experienced the last several quarters in that regard and what we would experience the next several quarters.
Okay. That's helpful, George. Also want to shift over to get your updated thoughts around a stock repurchase plan. I think it's not something you've done previously in the company history, but with the updated loan growth guidance a little bit softer, I guess capital will just continue to build. Would you reconsider the stance around stock repurchase activity?
Hey, Matt, this is Tim. It's an active dialogue with our board at each quarterly meeting. We've got, obviously given updated guidance on loan growth. To your point earlier, we have never done a stock buyback in our 22-year history as a public company. We would prefer to utilize that and leverage that capital to grow our bank, whether that's in short-term, medium-term, or long-term, we feel really good over the long term about being able to utilize that capital. I think our board would prefer us over the long term to utilize and leverage that capital. They'll continue to discuss it. I would guess their next major discussion regarding it would be early next year, when they add an updated financial projection and budget and strategic planning process that we do typically in the early part of it.
I would not anticipate much more of a change in their stance between now and then. Even then, they're going to have to evaluate what they think our long-term prospects are for a buyback. That basically is where we are today.
Okay, great. Thanks for the color.
Our next question comes from Catherine Mealor with KBW.
Thanks. Good morning.
Hey, good morning.
Good morning.
Tim, you mentioned that you've already lowered some of your promotional CD rates. Can you quantify maybe where promotional rates have peaked and maybe where you are currently?
Catherine, let me address that. I don't think for competitive reasons we're going to want to quantify that. We made a comment in the management comments document that competition in regard to deposits and our ability to moderate that pricing just was really not evident in the first quarter and a half of the year, as the second quarter wore on, and particularly as expectations regarding the direction of Fed action really finally began to settle in on the deposit guides. I guess some of the CEOs probably looked at what was happening with their loan yields with LIBOR and so forth, and we began to see some moderation in deposit pricing in the second quarter, and particularly the back half of the second quarter. We tried to get right in very actively and aggressively in that, and continued that into the start of the first quarter.
We're optimistic we're going to be able to get the cost of funds down, but for competitive reasons, I don't want to discuss details of that.
That's fair. Just kind of circling back on the RESG growth. You've talked a lot in the past about where we are in the cycle and that while we may be at peak commercial real estate values, which may squeeze your sponsors a little bit from a return perspective, from a first lien perspective, you're still in a great spot in terms of credit quality and credit risk. Is there anything that you can point to with the higher prepayments, or the kind of lower origination volume that is kind of a OZK-driven effort to take the foot off the gas a little bit to avoid certain credits or certain markets. Are you seeing less deal flow, and it really is kind of just the competitive dynamics that are really driving the slower growth?
I guess I'm trying to figure out how much of it is there any part that's OZK driven versus just really kind of responding to the macro?
Yeah. I would tell you, I don't think any of it is OZK driven. We have always had very conservative credit policy standards and practices. Those continue. We've not tightened them up. We have not liberalized those in the face of increased competition. I think all of the volume impacts that you see are a result of the fact of two things, as we've said earlier and as you articulated. One is it's a more competitive environment with more players in the space. Number two, we're at a point in the cycle where there are just less transactions that make sense to sponsors from an equity point of view to pursue, so there are less opportunities to do business. The opportunities that are getting done are percolating longer before they get to closing.
Sponsors are very cautious. Transactions that three or four years ago might have gotten closed in 60 days after you first saw it, sometimes may take a year and a half now, or a year, or three quarters to get done. Sponsors are taking their time and being cautious, appropriately so, in the economic environment we're in. It's had an impact on our volume and you don't want to force the volume. A lot of our competitors are doing that. They may get away with it and be richly rewarded for jumping in there and being more aggressive on credit. That's just not our style of doing business. We keep our discipline all the time.
Got it. Maybe one final question just on loan yields, kind of thinking about the margin. How much of the change in loan yields would you say is driven just by the impact of LIBOR versus the mix shift from going from RESG into the other verticals, the direct marine and RV, and your other verticals?
Well, I think you can pretty much gauge the LIBOR impact. Just take LIBOR at 630 versus 331 and look at that difference in one-month LIBOR and multiply that times the percent of our variable-rate loans tied to LIBOR, and you can derive a pretty reasonable tight estimate of the impact of LIBOR. LIBOR being down during the quarter, and we put a LIBOR chart in there on figure 16, I think it is, in our management comments document, that shows that downturn in one-month and three-month LIBOR during the quarter, and that weighed on our margins. There is also some impact from the changing mix of our portfolio.
As we mentioned in the management comments document, our RESG portfolio, being all variable-rate loans, has become our best yielding portfolio, whereas our community bank and indirect marine and RV portfolios, the indirect marine and RV is all fixed-rate. The community bank's a mixture of fixed and variable-rate. Those portfolios have lagged behind in their yield as the fed fund rate has gone up because of the fixed-rate component of those portfolios. If you go back to the time right before the Fed started raising rates, our community bank portfolio, the marine portfolio, the RESG portfolios all had very similar yields. Obviously, they perform differently because of the changing mix of variable and fixed -rate loans in those portfolios.
Got it. One more if I may, just really quickly. I saw substandard loans were down this quarter. Do you know what the direction of what watch list credits did this quarter versus last?
Could you repeat that? You broke up a little bit.
Substandard loans, it looked like they were down linked quarter. Do you have the direction of what watch list credits did this quarter versus last?
I don't know that off the top of my head.
I don't know. I don't envision it changing much. Obviously, we have the one watch credit at RESG that's still a watch credit. That's obviously our largest watch credit. I don't know the direction of the watch category either. I would not expect it to have a material difference from what it was at 331. Obviously, our substandard went down because we moved the two substandard loans at RESG to OREO during the quarter.
Great. Fair to say no large RESG watch credits moved in this quarter?
Yes. RESG had no new watch credits. The RESG still only has that one watch credit that we've talked about extensively for the last several quarters.
Got it. Okay. That's great. Thank you.
Our next question comes from Matthew Breese with Piper Jaffray.
Hey, good morning.
Good morning.
Just thinking about the variable nature of your loan portfolio juxtaposed with some of the early actions you've taken on the deposit side. With the Fed seemingly likely to cut, at the end of the month or at least by the end of the year, I was hoping for some color or expectations around the margin as we potentially go into a Fed-cutting environment. How do you expect it to behave?
Well, I think Tim included language in the management comments document that suggested that over multiple quarters, we expect a roughly parallel move in our core spread there from a decline in rates. He points to the fact that in our nine quarters of Fed increases, I think our cost of interest-bearing deposits were up four basis points more than our yield on non-purchase loans. We had quarters in there where the loans gained and core spread improved, quarters in there where deposit cost increased more and core spread decreased. Over that 15-quarter period of time, nine Fed increases, there was about a four-basis point difference. We would expect a similar sort of movement going down, that in the long term, over multiple quarters, they probably move pretty close to tandem. In the short run, you'll see quarters both directions, we would expect.
Certainly, we included in the management comments this time in Figure, Tim, is it 14?
All the floor rates in our loans, stratification of the floor rates in our loans. We commented in the paragraph below that is, we have months where older variable-rate loans with floors that were set at the time those loans were originated, as those pay off with their lower floors, and we replace those with newly originated loans that have floors at or near the current rate. We build more protection into the variable-rate loan portfolio. I suspect the Fed will cut rates based on recent commentary at the end of this month. We would prefer that they wait another few months to do that because the evolving defensive nature of our loan portfolio to protect us from down rates improves every month as we roll off older loans and add on newer loans with floors closer to current rate.
Understood. Yeah, just trying to think and stepping back and thinking about the slower loan growth outlook and the margin, combined with the efforts to really increase net interest income growth, just trying to gauge or get an idea of when we could see that inflection point higher on net interest income growth, and if you have an idea of over the next 12 months or 18 months when we can start to see that?
Well, I think that is going to depend really on two things. Average earning assets, which will depend on the effectiveness of our programs to increase RESG originations without sacrificing credit quality, to continue to scale up marine and RV without sacrificing credit quality or pricing, and community bank vertical scaling up. Then, the other important component, as we said in the management comments, is our ability to better manage our cost of funds and get that down. I think those are the variables that hopefully we've got to solve to get to a positive net interest income number sooner rather than later. If we're very effective at solving those variables and we can generate more average earning assets and get our cost of funds down, I think that will help us get to a positive net interest income scenario much sooner.
If we languish in our efforts to achieve those goals, then that's going to push that out farther.
Okay. Then just to get a better idea of how competitive things are, when you do lose a deal or something is refinanced away from you and you look at the terms of the competitor, do you look at those and say, that individual or that funding source is really taking it on the profitability perspective? Or do you see a real building risk from a credit perspective on behalf of the new borrower?
Well, I don't want to speak for my competitors. I'll just tell you, we look at a lot of transactions that we lose and a lot of transactions that get refied away from us, and we make the comment that we would never do that loan at that leverage or on those credit terms. Oftentimes, we also make the comment, we would never do that loan at that pricing for that duration. We scratch our heads a lot at how aggressive some of our competitors are on both credit and pricing terms at times. Yet, despite the very competitive environment, our lenders are doing a very good job of generating positive loan growth in a crazy competitive environment.
Understood. Okay. Just last one for me, thinking about the New York City construction portfolio, and the exposure there across the different asset classes. Just wanted to gain a sense for that, given the new multifamily rent laws and whether or not that would or would not have a real impact on you.
We don't think that has any real impact on us at all. We've never been an active lender in that space on rent-regulated, rent-stabilized properties. Tim mentioned in the management comments document that a lot of our multifamily loans, I think it's about a half dozen of them in the New York area, have 421-a tax abatement provisions. The way that works is a sponsor can enter into a contractual agreement with the city or housing authority. I'm not sure who the counterparty to that agreement is, but a sponsor may be doing a 200-unit apartment project, and they may agree to make 15% of those units, 60% of them available at below -market rate to individuals that are making some percentage of the median income, maybe 85% of the median income.
In exchange for the contractual agreement to make those units, that part of the project available at below-market rates for 25 years, say, the sponsor may get a 25-year abatement reduction in the taxes on the project. It's simply a mathematical calculation from the sponsor's point of view, how much are they saving in taxes versus how much are they giving up in rental income to make a portion of the project available to people who meet a certain percentage of the median income threshold. Our sense is, and it's not absolutely clear, but our sense is that the new legislation that was passed for the state would limit those increases, rental increases on those below-market rate units, which again, is 10%-20% of a project, typically, would limit that to the 2% annual increase.
That has no effect on us, because, we didn't underwrite any increases in rents, either the below-market rate or the market rate rents in our economic analysis of the projects. We assume flat rents with no increases. We're not really affected by that. Of course, one of the more pernicious provisions of the new law is the fact that a landlord cannot recover capital expenditures more than 2% per annum, and which makes it infeasible for people who need to renovate these properties to renovate them and ever recover the renovation cost. That doesn't come into play at all on our 421-a projects because that's all new construction. There's no renovation at all. We had a tiny handful, and I'm going to ask Tim to give you the numbers.
$23 million.
We have $23 million of loans left over from our Intervest acquisition.
$25 maybe.
$25 million of loans. I'm sorry, not 23, but 25 left over from our Intervest acquisition. These are small multifamily projects that have one or more rent-stabilized units in them. Typically, these have more market rate units than rent stabilized, but there's one or more rent-stabilized or rent-subsidized units in each of these. We think that's a very old seasoned portfolio, very low leverage. The leverage in-
29% loan-to-value today.
Yeah, 29% loan-to-value, the debt service coverage on them is 2.0+, I think. The impact of the law on that relatively tiny bit of our portfolio is negligible, we don't think really there's any impact there given the low leverage and high debt service coverage and seasoned nature of that portfolio.
Understood. Very helpful. I appreciate it. Thank you.
Thank you.
Our next question comes from Brian Martin with Janney Montgomery.
Hey, good morning.
Good morning, Brian.
Hey, just a couple of things from me and to keep it short. Maybe I don't know if it's Tim or George, just on the deposit side, what percentage of the deposits are kind of rate sensitive that move without you guys doing anything versus where the opportunity is to take action, like Tim mentioned, where you've kind of been active already this quarter this far. What's the rate sensitive deposits to a day one change?
Brian, the deposit book falls into two categories. One is CDs that have a fixed-rate for the duration of the CD contract. Those will move and will move based on rates that we set when they mature. Then the others are administered-rate products that we make conscious decision to change the rate on it, such as a savings account or a money market account or whatever, and make the rate change on those administered-rate products. None of them, or very few, I guess we have a couple of deposit relationships that actually float with a small number, more than a couple, but a small number that actually float with fed funds target rate or fed funds effective rate or something like that. The vast majority of our deposits are either administered or fixed CD maturity deposits.
The equation there, paradigm there is how much can you adjust the rates and not meaningfully impair your relationship with the depositor.
Got you. Okay. Just on the loan side, just in kind of the community banking verticals. I know that outside of the boat or the indirect portfolio, where is the biggest opportunity to scale up in some of the other areas to help maybe offset some of the payoffs in RESG? Which areas are you seeing more traction in today or more optimistic about?
We've got several areas there that we're getting some traction in, and some will be more meaningful than others. We would really like to expand our government-guaranteed SBA lending business organically in our local markets through our local branches using our GGL team. We think we can do that. One of the increases in overhead as we've been trying to staff up in that unit to get more volume out of that. We think that helps us serve our communities in a very proactive way and provides good -quality, good -yielding loans for us at the same time. Our Business Aviation Group, we've added a couple more origination people there, and we think we've got some good opportunities there. In fact, that group is coming to see me right after this call to discuss a transaction they're working on that they would like for me to look at.
We're trying to get more traction in affordable housing and charter school verticals. Our subscription finance and kind of specialty C&I business, we've got a really good transaction that we're excited about there that would be almost a $100 million transaction that we're working on and been working on for a number of months, a couple of quarters now, that seems to be coming to fruition. They've got a couple of other things to close there. None of these is going to be an RESG or indirect marine RV type of volume business. Collectively, we're hoping that we can get just every quarter, a little bit more scale and volume out of these, and that over the course of 2020, they'll become much more significant contributors to our growth and the diversification of our portfolio.
Okay. That's helpful. Just the last items. Maybe I missed it. I joined a little bit late. I know it sound like they were talking about the expenses, but just is it fair to assume from the comments I heard in the tail end that the expense growth the next several quarters, particularly through 1Q, is kind of a similar type of pace, give or take, and then it maybe moderates a little bit thereafter? Is that kind of what I heard on that?
Brian, that's consistent with what we said earlier. Yes, we do think that we'll still have some growth in that expense line item over the next two or three quarters. We are hopeful that as we get into 2020, that we can, in our build out of some of these areas we've been focused on, it will allow us to see less increase on a quarter-over-quarter basis compared to what we've been seeing the last two or three quarters.
Okay, thanks, Greg. The last one was just on the margin and kind of core spread. I guess, is your outlook, I guess George or Tim, on the core margin? I guess just the margin versus the core spread, I guess that those will kind of follow one another, meaning, I guess maybe there's not a lot of risk to where the margin's at today over time, similar to what you're saying on the core spread. Those are, I guess, pretty connected. Is that how you guys are thinking about it or how we should be thinking about it?
Yeah, they're going to be mostly connected. Obviously, purchase loans is another big component of our margin.
Sure. Yep.
Securities is, too. How those move will impact margin. Today, the loan yields on non-purchased and purchased are fairly similar.
Yeah.
Those are the other two variables in the margin.
Okay. All right. That's all I had, guys. I appreciate it.
Thanks.
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All right. There being no further questions, we'll conclude the call. Thank you very much. We look forward to talking with you guys in about 91 or 92 days, something like that. Have a great quarter. Thank you.
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