Welcome to the Texas Capital Bancshares third quarter 2019 earnings conference call. All participants will be in listen-only mode during the presentation. Please note this event is being recorded. If you need assistance, please signal a conference specialist by pressing the star key followed by 0. I would now like to turn the conference over to Heather Worley, Director of Investor Relations. Please go ahead.
Good afternoon. Thank you for joining us for the TCBI third quarter 2019 earnings conference call. I'm Heather Worley, Director of Investor Relations. Before we begin, please be aware this call will include forward-looking statements that are based on our current expectations of future results or events. Forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ material from these statements. Our forward-looking statements are as of the date of this call, and we do not assume any obligation to update or revise them. Statements made on this call should be considered together with the cautionary statements and other information contained in today's earnings release, our most recent annual report on Form 10-K, and subsequent filings with the SEC.
We will refer to slides during today's presentation, which can be found along with the press release in the investor relations section of our website at texascapitalbank.com. Our speakers for the call today are Keith Cargill, President and CEO, and Julie Anderson, CFO. At the conclusion of our prepared remarks, our operator, Andrea, will facilitate a Q&A session. I will turn the call over to Keith, who will begin on slide three of the webcast.
Thank you, Heather. I will open, then Julie will give her assessment for Q3. I will close before opening the lines for Q&A. Let's begin on slide three. In summary, we delivered a strong quarter in multiple key areas. Deposit growth was excellent. Credit improved. Controllable core expenses were up only modestly. mortgage finance was strong. Core LHI grew on average despite the significant paydowns we accomplished in leveraged loans. Net revenue grew linked quarter and year-over-year. Earnings per share grew 13% linked quarter and 3% year-over-year. Outstanding results from an extraordinary effort by our truly talented team across Texas Capital Bank. These excellent financial results were accomplished through executing our strategic initiatives to drive continued improvement in deposits, fees, efficiency, and an even more differentiated premier client experience.
I'm a fortunate CEO indeed to work with amazing talent, who wake up each morning excited to build the premier business and private bank in America. It is an aspiration we all own and expect to achieve in time. Julie?
Thanks, Keith. My comments will cover slides six through 13. Net interest income increased $8.6 million, or 3.5% from the second quarter, and is up $20 million, or 8.6% from the third quarter last year, continuing to demonstrate the resiliency of our balance sheet in the existing rate environment. mortgage finance has acted as a very effective hedge in an inverted or close-to-inverted yield curve scenario. Despite the fact that our NIM decreased on a linked-quarter basis, it's important to understand that it was primarily related to the earning asset shifts, specifically mortgage finance and liquidity. Honestly, we don't believe NIM is the best metric to assess relative profitability or future revenue generation in this rate environment. Traditional LHI yields were down, which is reflective of the continued decline in LIBOR.
Fees were slightly higher in the third quarter and are comparable to Q1 levels, but remain at levels meaningfully lower than we experienced in most of 2018. Our mortgage warehouse yields were down on a linked-quarter basis, and similar to last quarter, the decline is not related to any shift in competitive pressures, but rather resulted from volume pricing that was already in place. When we refer to volumes, that means loan volumes as well as deposits, both of which are positive for net interest income. Our NCA yields continue to be pressured, which was expected compared to actual mortgage rates. We continue to have growth in deposits, with growth in interest-bearing as well as non-interest-bearing. Overall deposit costs decreased by eight basis points from 129 basis points in the second quarter to 121 basis points in the third quarter.
The decrease resulted from continued growth in DDAs, as well as meaningful decreases in interest-bearing deposit costs. Our total funding costs were down 15 basis points, with decreased usage of FHLB borrowings. We continue to have a solid deposit top line, with some of the verticals getting traction. The launch of our escrow vertical with public to come in the next few months about other high-potential verticals. Recent sensitivity simulations indicate that net interest income would decline approximately 6%-9%, assuming 75 basis points of additional rate cuts over the next 12 months. This assumes that certain floors would kick in, as well as assumptions related to continued elevated mortgage finance volumes over the forecast horizon. We had a slight increase in average traditional LHI during the quarter, but balances were down as of period end. That is consistent with the continued runoff in our leveraged portfolio.
Traditional LHI average balances were down 1% from second quarter and up 3% from this time last year. The level of overall payoffs continue to be high, primarily in CRE, where we're continuing to replace runoff with fundings on existing commitments and some new originations. In contrast, the C&I leverage runoff is not being backfilled.
Payoffs in C&I leverage are in line with what we expected, and we would expect to see further reductions in the fourth quarter. Again, we had a strong average total mortgage finance balances, including MCA, driven by the seasonally strong quarter, which similar to the second quarter, was even stronger with lower mortgage rates. Average balances are up from this time last year about 54%. We would expect fourth quarter volumes to be strong with the continued low rates. We continue to experience good growth in linked quarter average total deposits with a mix of interest-bearing as well as non-interest-bearing. Our slower core loan growth is and will continue to be beneficial to our marginal cost of funding. We continue to see improvements in deposit mix with some contribution from verticals as well as from existing clients, including mortgage finance escrow accounts.
We would expect that to continue with meaningful improvement more evident in 2020 as verticals get more traction and we continue to deepen existing relationships. Overall, eight basis points linked quarter improvement in our deposit costs and 15 basis points improvement in total funding costs, with less reliance on FHLB borrowings. Our interest-bearing deposit costs were down six basis points, but excluding CDs, which are mostly brokered CDs, our interest-bearing deposits were down nine basis points on a linked quarter basis. As we've mentioned, index deposits have an assumed 100% beta, while all other interest bearing is assumed to be closer to 65%. Our playbook for stepping down rates was in place prior to the July move. We're being cautious but very proactive in applying rate reductions across the board. We expect repricing to remain at a similar level or perhaps faster for the next one to two Fed moves.
As for brokered deposits, they remain at $2.1 billion. With increasingly favorable pricing, the selective use of brokered CDs remains an option to supplement the funding stack as we gain traction in the new deposit-focused verticals. We continue to show positive trends in our core operating expenses, specifically looking at the changes in salaries and employee benefits, which represents over 50% of our total non-interest expense. Third quarter salaries and employee benefits were up less than 4% from the third quarter last year. Year to date, the increase is a little over 5%, levels that are unprecedented in our history. We're doing it at a time when we are focused on transformational changes in how we think about efficiency and client experience. We're being very deliberate with revenue-generating hires and are continuing to attract exceptional talent as our story continues to be extremely compelling.
We've discussed marketing expenses and the variable portion tied to deposits. About a third of the increase in that category this quarter was related to the variable portion. That expense peaked in Q3 as we're not focused on growth in that category of deposits. The remainder of the increase was normal business development, which can fluctuate from quarter to quarter, but is not a significant part of the total expense. Third quarter included an MSR impairment of $2.6 million, and that's compared to $2.8 million in the second quarter and $2.9 in the first quarter. A total of over $8 million of non-run rate expenses negatively affecting total non-interest expense for the year. We are in the process of putting instruments in place that will protect us from future downside risk with the MSR portfolio, assuming rates continue to fall.
Our efficiency ratio for the third quarter was elevated to 54.8% and was really related to a couple of MCA items, all of which are rate related and have been offset in net revenue, either this quarter or in prior quarters. The classifications of several of the MCA items, as well as the marketing costs related to deposits have been punitive to our efficiency ratio. If servicing costs were netted in non-interest income against servicing revenue and the related marketing fees were moved to interest expense, our efficiency would have been consistently in the 50-51 range, and would show an improvement year-to-date 2019 compared to 2018. We believe a more representative measure to focus on in evaluating our non-interest expense trends is non-interest expense to average earning assets, which has improved from 2.15% in the third quarter of 2018 to 1.86% in this quarter.
We are pleased with certain improvements in our credit in the third quarter, namely a lower provision level as well as a decrease in total criticized net of the charge-offs. Our non-accrual levels are still at a relatively low level of 0.49% of total LHI. Net charge-offs for the quarter are primarily related to energy and leverage, specifically $17 million in energy and $20 million in leverage. Similarly, year to date charge-offs of $61 million are comprised of $32 million in energy and $24 million in leverage. All of the quarter's charge-offs were related to existing problem credits that we've discussed in previous quarters. Additionally, we experienced a meaningful decrease in total criticized levels in the third quarter, and that's directly reflective of the actions taken over the past few quarters in actively managing each of these credits.
Our total criticized as a percentage of total LHI remains low and dropped to 2.2% this quarter compared to 2.6% in the second quarter. For all criticized loan relationships, we continue to be engaged and are forecasting additional paydowns in the fourth quarter. We had a meaningful drop in provision to $11 million from $27 million in the second quarter. Loans being charged off already had certain reserves allocated. Earlier in the year, we expected a larger portion of provision in the first half of the year, and our actions have translated into achieving that. There will still be resolutions to existing credits, and there could be migration within the criticized book. We do believe there are enough offsets in those forecasted recoveries of provision for us to lower our full-year guidance.
We continue to be focused on risk management of the problem credits, primarily in leverage and energy, to minimize downside impact. We're actively monitoring all portfolios in light of macroeconomic factors. Turning to the quarterly highlights. Our continued strength in linked quarter net revenue despite the punishing rate environment, that's resulting from our strong volumes in mortgage finance, which have continued to contribute in a meaningful way to the increase. First quarter and second quarter non-interest income had $8.5 million and $6.5 million related to a legal settlement, which was not recurring in the third quarter. That was the main driver of the decrease on a linked quarter basis. We continue to have some noise in the loss on sale of loans line in non-interest income, which has primarily resulted from holding MCA loans longer, which increases the hedging cost and is offset in additional spread income.
This quarter, that line also included an additional increased reserve component related to a spike in early loan payoffs resulting from refinance activity. We're continuing to improve run rate on core operating expense items. Year-over-year, 8% increase in non-interest expense compared to prior year Q3, excluding ORE recoveries last year. Excluding the increases in marketing related to deposit costs and the increases in servicing related to impairment, the year-over-year as well as year-to-date comparisons are 4%-5%, which, again, is unprecedented in our history and represents a significant improvement in managing our core operating expenses. ROE and ROA levels were improved in the third quarter as a result of the lower provision for loan losses. Our ROA levels will continue to be negatively impacted by the higher mortgage finance and liquidity balances. Loan loss provision levels will continue to be key to driving improved ROE.
We'll turn to the outlook for the remainder of 2019. We're maintaining our guidance for average traditional LHI growth at mid-single digit % growth. This is reflective of the growth we experienced earlier in the year and incorporates our current focus of positioning our balance sheet to be as strong as possible as we head into what could be a challenging point in this cycle. We're increasing our guidance for average mortgage finance growth to mid to high 30s from low to mid 20s%. That takes into consideration the additional growth so far this year and an expected strong Q4. This is the lowest risk category for us, we're happy to exploit the opportunities available with lower mortgage rates, even if it means temporary dilution to some of our performance metrics. No changes to our MCA guidance of $2.5 billion for average outstandings.
MCA will continue to benefit from the additional volumes with lower rates. We're increasing our guidance for average total deposits to high teens% growth from low double-digit% growth, reflective of the DDA growth that we experienced in the second and third quarters. We're decreasing our guidance for NIM to 3.2%-3.3%. That's down from 3.5%-3.45%. Decrease is driven primarily by the earning asset shift we've experienced and will continue to have from the total mortgage finance, which is a relatively lower yielding asset. While punitive to NIM, the added growth is very positive to net revenue and offsets some of the impact from rate decreases. Our guidance assumes no Fed changes in rates as the probabilities for those continue to move dramatically from week to week.
However, it's important to understand how we believe rate cuts will affect us, and we're focused on it in terms of net interest income, which will be negatively affected by future rate decreases. As I noted earlier, the decrease to net interest income could be 6%-9% over the next 12 months, assuming 75 basis points of additional rate cuts. Our guidance for net revenue remains at high single-digit % growth. Because of the lower level of provision in the third quarter, coupled with continued relationship-specific strategies on our leverage lending and energy portfolios, we're reducing our guidance for provision expense to high 60s to high 70s, and that's down from mid to high 80s. Our guidance for non-interest expense remains at mid-single-digit to high single-digit % growth.
As we've noted, we continue to feel very good about the slowing of our core operating expenses. The impact of MSR impairment charges, as well as the variable marketing costs, have driven upward pressure on the range. Our guidance for efficiency ratio remains in the low 50s. Lastly, we'll turn to our longer-term outlook. These are the right goals. We're committed to achieving them. The timeline will be more challenging in the existing rate environment. As you know, the initiatives we have in place are focused on repositioning our balance sheet to be more stable through a rate cycle. Certainly, there can be variability at different points in that cycle. We are confident that we have the right initiatives underway for the long term. Historically, we have been very successful at repositioning as needed. We expect similar success this time. Keith?
Thank you, Julie. We are committed to delivering an even more premier differentiated client experience to our current business and private clients while developing new, best-in-class specialized industry verticals. Elevating our client experience delivery and opening new specialized industry businesses will create untapped opportunities to attract clients in a more favorable ROE and self-funding categories. Helping us overcome with growth some of the shrinkage we continue to experience deliberately in our leveraged lending. Mortgage finance continues to give our company a high-performance growth engine with essentially U.S. government credit risk. This business allows us to grow net interest income despite late cycle challenges in pricing and structure in other core LHI categories. It also provides significant self-funding through the mortgage finance treasury management deposits, and the fee income from the mortgage finance business covers our cost of operating the business.
Beyond the success of the mortgage finance deposit growth, we have seen strong growth in core C&I treasury management deposits, as well as early growth in some of our new deposit verticals. In combination, the core treasury deposits and new deposit vertical funding has grown by over $1 billion so far in 2019. Our final two deposit verticals, launching in the first quarter of 2020, are expected to be the most significant new deposit growth initiatives of all. We are bullish on our deposit growth prospects for the next few years as these verticals mature and our bankers and treasury management partners drive increased core treasury growth as well as cross-sell new deposit vertical products. It was most encouraging, to see not only loan loss provision decline meaningfully, but also to see a significant decline in criticized classified loans.
The credit team, loan review team, relationship managers, and their group heads have all worked as one team for the past year to understand the loan portfolio at a deep, granular level and de-risk the portfolio before an eventual economic slowdown sometime in the future. Their hard work continues, and we expect to deliver an improving trend for several quarters ahead. We are seeing significant improvement in process efficiencies and the resulting improvement in more responsive client service and lower core operating expense growth. We are working diligently and with confidence to deliver a great long-term investment for our shareholders and premier service and products for our clients. Operator, if you would, let's please open the lines for Q&A.
To ask a question, press star then one on your touch tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, press star then two. At this time, we will pause momentarily to assemble the roster. Our first question comes from Ebrahim Poonawala of Bank of America Merrill Lynch. Please go ahead.
Good afternoon, guys. I think the first question, Keith, just based on feedback I've received over the last one hour, would love to get a little more color on credit and how we should read you lowering the provisioning guide. Would love to get in terms of your comfort on migration trends in the leverage lending, the energy book, and just the risk of things again surprising to the downside three or six months from now. If you could talk to that would be helpful.
Well, we're encouraged. It's early to declare victory. We really believe we have a much deeper understanding, Ebrahim, of our portfolio, and not just leverage lending and energy, than certainly we had a year ago. It's taken a tremendous amount of work by all the groups I mentioned, our loan review team, credit team, our bankers, our group heads. Everyone has really pitched in, and it is most encouraging to me that we're seeing this trend, this tipping down that's meaningful linked quarter. We need to put two or three of these together, and I believe we will. It's taken a while to be confident that we really have our arms around the portfolio, but I believe we are in that kind of situation. Things can happen on a given credit in a given 90 days.
Again, I'm not here to declare victory, but I do believe we're on the right path, and we're going to see hopefully multiple successive quarters with the right trends, not just one.
Got it. Is it fair to assume that the quarter end included, as other banks have talked about their CCAR exam having an impact, is all of that reflected?
Yes. It did include that. In fact, we had no surprises on the CCAR exam. Our team was on top of it, and so that came out just fine for us.
Perfect. Just moving on to, in terms of capital, when we look at TCE, means in the high sevens, just talk to us in terms of how you're thinking about how low can capital ratios go, or just your strategy around participation of the mortgage warehouse loans, and how CECL, if at all, may impact capital ratios toward the end of the year.
Ebrahim, I think we talked about earlier in the quarter that we're comfortable with taking advantage of what we're getting with the warehouse growth, we're comfortable with doing additional participation. We ended the quarter, the participation commitments were a little over $1 billion. We're comfortable with that. We want to make sure that we can continue to take good care of our clients. We're comfortable. That TCE ratio, that's comfortable for us. We're very comfortable with that. CECL, we're not saying too much about CECL. I guess what I would say is what we have said in the past, that for commercially focused institutions like ourselves. We don't expect a material change in our overall provisioning. I think that we're comfortable with that.
By the way, Ebrahim, that move and what we had in actual funded participations at second quarter-end versus third quarter-end was close to a half billion dollars. We could have taken that on balance sheet, we're being very disciplined to take care of clients without putting it all on balance sheet, and I think that's the right move. Had we put it on balance sheet, it would've been about a 23% growth linked-quarter. I think we're doing the right thing to have a strong business, but also to manage it, and not let it.
Got it. If I can sneak in one last question. Demand deposit growth was extremely strong. Is that sustainable? Do you expect to hang on to these balances as we look into the fourth quarter? Have we seen any early results from the one or two big deposit verticals that are either online or in the process of coming online?
We're very encouraged by what we're doing with our deposit verticals and our core treasury efforts. Our bankers have done just as we ask, and really taken their treasury partners out far more on calls, and we're filling in some of the gaps in relationships where we only had loan relationships, and that's really contributing along with our new deposit verticals. As I mentioned, just this year, in nine months, we're up over $1 billion in those two categories. We don't want to drill down a lot at this point. I think you can tell there is always seasonality that comes from our mortgage warehouse deposits, and we experienced it in the second quarter and again in the third.
I wanted you to also hear about that north of $1 billion growth, that came from verticals and also just core treasury growth, which is awesome to have alongside those seasonal balances.
Hey, Ebrahim, typically we can see some downward impact from seasonality in our deposits in the fourth quarter and the first quarter.
Got it. Thanks for taking my question.
Our next question comes from Brady Gailey of KBW. Please go ahead.
Hey, good afternoon, guys.
Hello, Brady.
Hey, Brady.
The mortgage warehouse and MCA combined continue to perform really nicely here. It's up again off a strong 2Q. It feels like we're getting close to the levels where you start hitting concentration limits. I forgot exactly how you all look at it, but I know you have a limit out there. As MCA and the warehouse continues to be robust and potentially grow from here, will most of those balances move into the participation program you have through other banks, or is there still capacity to let the balances grow on Texas Capital's balance sheet?
As we move into the 4th quarter, while the volumes will be very good compared to most seasonally softer 4th quarters, I don't anticipate it being higher. I don't believe that's going to impact us, Brady, in the 4th or 1st quarters. As we grow the overall balance sheet between now and the 2nd quarter next year, I think we'll be fine and in good shape and not have to lay off all of the growth once we get a couple of quarters down the road.
All right. One more on credit. If you look at non-performing loans, they're pretty much stable, up a little bit linked quarter. The net charge-offs obviously would naturally reduce that. Maybe just talk about any sort of inflows into the NPL bucket in the quarter.
There was one energy deal. That was the bogey that got us slightly over. I think it was like $2 million higher, as I recall, from prior quarter overall on NPA. Still quite modest NPAs, though.
Got you. Great. Thank you, guys.
You're welcome.
Thanks.
Our next question comes from Brett Rabatin of Piper Jaffray. Please go ahead.
Hey, good afternoon, everyone.
Hello, Brett.
Hey, Brett.
wanted just to go back to, Julie, the NII guidance and the 69% downside for 75 basis points. Can you just talk about how you're modeling that in terms of the verticals for growing deposits, how the mortgage warehouse factors into that, as presumably that declines, it would seem like you'd have a net benefit to the margin? Can you just walk through the modeling for how you're doing downside for Fed cuts?
Sure. We're focused on net interest income because you're right, there can be some variability in NIM with mortgage finance balances. As I said, we're assuming 100% of beta on the index deposits and 65% on the other interest bearings. That also assumes that mortgage finance growth still continues to be pretty strong. Not elevated, but certainly still strong over that four-quarter horizon.
Okay. Wanted to talk about the LHI growth for a second. As you overcome the declines in leveraged lending, I'm just thinking about the growth path for the next year or so. Does that improve notably or can you give us any additional color on how you see that trending once you've gotten past running down some of the leverage book and then obviously not growing energy as well?
We're really encouraged about a couple of new corporate verticals that we're looking at that are full-blown lending and deposit verticals. These would be separate from the deposit vertical initiatives we launched a year and a half ago. We have a team that's close to us announcing that we'll launch the first of those verticals, so we'll be able to talk about that in January. I'm very optimistic that with that new vertical, with some new talent we've been able to bring to the company, and our overall C&I business both in Houston and Dallas, that we're going to be able to more than backfill. It's just too early to give you that guidance for next year, but I'm very encouraged that we'll be even more diversified, certainly with lower risk growth than what we experienced the last few years when we were growing leverage lending.
I will have more for you in January, but we have yet another two corporate verticals we're contemplating to launch at some point in 2020. Between those three, I believe that we're going to have some good, solid, diversified, appropriate risk growth in our book.
Okay, great. Appreciate the call.
You're welcome.
Our next question comes from Steven Alexopoulos of J.P. Morgan. Please go ahead.
Hi, everybody.
Hello, Steve.
Hey, Steve.
I wanted to start on the new margin guidance. Is my math correct? The midpoint of the new guidance seems to imply a NIM in the 270 range for the fourth quarter.
No, no. We do expect NIM. That's why we try to focus on non-interest income, obviously, but we do expect NIM with a continued success in mortgage finance. It could tick down. It would tick down in the fourth quarter compared to the third quarter, and that would also factor in the full extent of the September move. Not that low.
Just so we're clear, what is the range that you expect NIM to come down in the final quarter?
The range that we updated was the 325, 320-330. That's the update for the full year, 320-330.
Just looking where you started 2019, it seems to imply a pretty dramatic reduction in NIM coming again in 4Q. Do you expect the pressure to be pretty consistent with what you reported this quarter?
I would expect the fourth quarter to still be in the low threes.
Okay, got you. Okay. Can you remind me, for your mortgage finance loans, they carry a lower yield than peers, which are just in the mortgage warehouse business, right? First Horizon reported a 5.3% yield. Just remind me why your yield is so much lower than just the mortgage warehouse business.
We really focus, Steve, on the QM business. Now, we have a little non-QM, but other competitors are more comfortable with non-QM than we are, and so that's the primary difference.
Oh, okay. Got you. Okay. Just finally, I'm trying to make sense of this very strong deposit growth, and I know Ebrahim asked the question. When we look at non-interest bearing and savings deposit growth, why were they both so strong this quarter? It was really off-the-charts growth.
It's primarily from existing clients. Some related to mortgage finance and then some related just to our core clients. There's also some, Keith mentioned there was some impact from some of the verticals, but most of it was from existing clients.
Got you.
We just had gaps, Steven. We grew so fast the last five years, we had some gaps where we did not gather up the treasury relationship. We've really been focused on that and it's bearing fruit, and it's really helping us along with the new verticals.
Okay. Now that you have this liquidity, do you plan to keep the loan to deposit ratio below 100?
We'll assess the liquidity levels that we have. Obviously, we've had some outsized success in the last couple of quarters in deposit generation. We've reduced what we're borrowing. That still leaves us with quite a bit of liquidity, so we will assess that. There will also be some seasonality in some of our deposits, primarily in DDA, we'll see some seasonality in the fourth quarter. We'll take all of that forecasting into assessment on what we're going to do with liquidity levels.
We're really looking any way we can at replacing higher cost funding too, Steve. Like the brokered deposits over time, we're going to be in a better position to take that out and improve our NIM.
Okay. Terrific. Thanks for taking my questions.
You're welcome.
Sure. Thank you.
Pardon me, this is the conference operator. If you were currently in the question queue, could you please re-queue? I have accidentally cleared the queue. If you would like to ask a question, please press star then one at this time, and we will pause for a brief moment to reassemble that roster. Our next question will come from Matt Olney of Stephens. Please go ahead.
Hey, thanks for taking my question. I want to stick with the deposit discussion. Julie, you mentioned downward pressure on deposit balances due to seasonality in the fourth quarter. If I look at the full-year guidance, I think it implies that the balances in the fourth quarter will drop pretty considerably, like 9% or 10%. Can you just confirm that I'm thinking about that right, for the fourth quarter deposit balance?
As you know, we try to be conservative with our guidance. We do expect some seasonality impact on deposits. We try to set that guidance so that it is conservative. I guess that's how I would leave it.
Matt, with the continued strong volume in warehouse, along with that, it does help offset the normal seasonality on the deposit side too, because they're building their mortgage servicing book, and so that helps keep it a little higher and more stable. We also look at historical seasonality, and we try to take what we know today along with historical and give you a more conservative guidance.
Got it. Okay. Going back to, I think it was Brady's question previously on the migration of loans from criticized into non-accrual. I think I see the migration that you mentioned, Keith, on the energy portfolio, but it also looks like there was some negative migration in the leveraged lending book. Non-accruals were flat there, but there were still some higher charge-offs in the third quarter. Any color you could tell us about that book?
We really have been able to address those charge-offs in prior quarters and built that provision, which we all know was pretty hard on us the first half of the year. We're seeing the overall criticized classified tip down, and then within that, I really think we're seeing improvement in the classified. It's not simply a matter of the criticized, which we got on the radar in the first quarter with these deep dives we've been taking on our loan portfolio over the last four quarters. It's also the actual classified component that's very encouraging at this point. Yes, there were a couple rated toward quarter end, but the overall trend on migration, we think, is favorable going into the fourth.
Got it. Thank you.
You're welcome.
Our next question comes from Michael Rose of Raymond James. Please go ahead.
Hey, thanks for taking my questions. I wanted to go back to something you said earlier in the call around expenses. Julie, I think you said the way you guys are looking at it now is expenses to average assets. Is that correct? If so, do you have thoughts? It's obviously come down. Do you have thoughts around how we should think about that moving forward?
We haven't given guidance on that. Michael, that's a thoughtful question, and we'll certainly think about that. We struggle with trying to explain how we really are doing a much better job on our core operating expenses, which is non-interest expense to average earning assets, just seems like a more representative metric of our progress. We haven't given any guidance on that. I think we feel comfortable that's going to continue to improve.
Yeah.
We haven't given any specific guidance on it.
Excuse me, Julie.
Sure.
I might add, Michael, over time, this gap between efficiency ratio, as Julie's described measuring it, and the traditional way we measure it, those lines will cross or meet, and that will be as we replace some of these marketing expense deposits. Those marketing expenses are what really throw us and make it hard to give you metrics that are comparable to other peers. Again, that's one of the key things we're working on is lowering overall cost of funding including those marketing expenses.
Okay, that's helpful. Then maybe just going back to the margin, not to beat a dead horse here, but I think the guidance you said doesn't include any future rate cuts this year. Looks like the futures are implying we get one. One-month LIBOR is already down 14 basis points this quarter. Is that kind of all, at least the drop in LIBOR, is that contemplated in the outlook, and why perhaps the range is so big? Then, if we do get a rate cut in October, December, with the dynamics around the stats that you quoted before in terms of the impact on NII, would that shift at all? Thanks.
What would already be factored into the guidance is where we ended the quarter. Those loans, how they had repriced with LIBOR at the end of the quarter, that would be included in the guidance. Then what we've assumed in the sensitivities that I gave you, what we've assumed is that there's another in the 75 basis points, we've assumed that there could be an August, there could be an October move, a December, and then again in June for that 12 months sensitivity. Does that help?
Okay. Yeah.
As we mentioned, of course, you have the 100% beta on the institutional funding, and then we're projecting a 65% beta on our other interest bearing.
Okay. Maybe just one more separate question on energy. I know it's been a topic of a lot of calls so far. You guys spoke last year, last summer that you guys had seen some issues back then, and the thought process was you were getting ahead of it. We're going to be perhaps first out of the chute. Do you still kind of feel that way? Maybe just as it relates to energy, why do you think we're seeing the issues that we're seeing now when oil prices are still pretty healthy? Thanks.
I do think we're as ahead of it as anyone. I say that because the market, the capital market, is just kind of locked up right now, and that is causing some of the stress on some of the energy companies that were not geared to be full-blown operating energy companies. It was more of an acquisition play when they thought prices were low and new capital came into that space, with the intention of proving up some of the unproven property that they acquired with drilling programs. Now they realize they're going to have to be generating drilling programs that are cash flow positive because the capital markets aren't active, and so they don't have access to the capital to have robust drilling programs.
I think it's just in that state where it's difficult to call, how long we might be in this mode of them working their way through it. I do think we're more on top of the portfolio, certainly, than many banks, and we had to be because it's something we've done at Texas Capital our entire history. Most of us that are involved in the credit process at the company have done this 35, 40 years. These cycles, every single one is unique, and you learn from each one. You have to be so aggressive in looking at each deal and each operator.
We're much more thoughtful now about looking more carefully at drilling plans, Michael, because some of the, again, operating know-how, with all that capital flowing in, was getting pushed to do some outlying drilling to try and elevate the price of the overall property. By doing that, they took some more risks than they should have. I think we've identified who those are, and it's more a matter with the rest of the portfolio of just grinding through this period where they have challenging access to capital. I mean challenging access to any capital because us banks, we're looking so carefully at our borrowing bases that we're taking a lot of the cash flow that they had hoped they'd be able to deploy in new drilling activity.
In order to be sure we keep our borrowing bases in line, we're having to capture more of that cash flow on debt paydowns. It's not simply a matter of equity capital that's kind of in a wait-and-see mode, but also debt capital, that they're having a challenging time to find it.
Very helpful. Thanks for all the color, Keith.
You're welcome.
Our next question comes from Jon Arfstrom of RBC Capital Markets. Please go ahead.
Hey, thanks. Good afternoon.
Hello, Jon.
Hi, Jon.
Hey. Couple of near-term and then longer-term question. Earning assets have been up quite nicely in Q2 and Q3. I'm just curious if you feel like Q4 earning assets can be up again?
It depends on warehouse volumes. We think they'll be good. I don't know that they're going to be up, because fourth quarter is seasonally a little slower. I don't know, Keith, I wouldn't say they would be up.
Well, we're still overcoming, on the net growth side, Jon, the bleeding down, the shrinking and de-risking of our balance sheet with the leverage lending portfolio. Actually, we're really quite optimistic that we'll have an even bigger paydown in leverage lending than we had on average the last three quarters. If that occurs, then you just have to make up that $100-plus million, roughly, in order to get back to zero. I think it'll be a modest growth, if any growth in the fourth quarter. You have to drill down to see if that's good. I think it may be good because we are de-risking our balance sheet.
Yep. Okay. That makes sense. It's just another way to think about the margin NII equation. My assumption would be flat to down, and I just want to make sure I'm thinking about that correctly.
I think that's correct.
I think you are.
Yes.
Okay. On the provision, appreciate the fact that that came down, but there's still about a $10 million swing factor in terms of a high and low level of the range. Just curious if you're leaning one way or the other. I know that a lot of this kind of depends on what happens at year-end, but how are you feeling about it right now?
I can tell you, I'm leaning more to the low- and some of my cohorts, a little more to being safe on the high. I think collectively, we agree on this range, and I'm still hopeful we'll come in in the high 60s or low 70s. I think our team feels like we certainly can come in within the range.
There's a small group in the room, and it's probably 50/50. We all agree, again, we all agree that we feel comfortable with the range.
Okay. All right. I hate to go back to this, but this 6%-9% decline in NII on the 75 basis points. The first part of the question is, what are you assuming in terms of growth? Is this just a static balance sheet, or are you assuming, like, a normal course of business to get to that number?
Our normal forecasted 12-month balance sheet. It would assume that warehouse is still pretty strong because we wouldn't see any reason why it wouldn't stay strong. Again, the leverage, some of the continued pay down in leverage, but as Keith said, in a couple of quarters from some of these new areas of growth, we would expect some growth. It's our normal 12-month forecast.
Again, even if the market, we anticipate the market next year, Jon, being somewhat softer than this year, we won't be doing linked quarter laying off of a half billion of the warehouse volume. That gives us that shock absorber capability as we manage how much we take on balance sheet, so that if we do see some backing off slightly next year on mortgage warehouse volumes, we still feel good about being able to take market share and grow it slightly.
On the deposit side, it does include some more deposits from some of the new verticals.
That's right.
More meaningful than we've seen in the last couple of quarters.
Okay. The last thing, maybe this is an obvious question, I'm assuming that the last cut would take the biggest bite. For example, if we get only 25 and the Fed is done, that that's not a terrible outcome for you, when we get to 50 or 75, that's where the biggest bite comes in terms of the NII guide?
I don't necessarily think so.
Yeah.
I'm very optimistic about our deposit trends.
Yeah
Our new verticals, but also just our core treasury trends. It won't be easy, and we're going to have to be better than we've ever been, even though we've been really good this year on core expenses. I really feel good about what we can do overall on our expense and efficiency next year. Yes, on the spread, it won't be easy, but I don't think it'll be as challenging as certainly if we hadn't done these initiatives two years ago and be into the process now with launching these biggest deposit initiatives in the next quarter or so.
Hey, Jon, something else that's important to remember is what happened with our deposits on the way up. We moved up really fast with a really high beta, which means we have a lot more to come down. The index deposits alone will continue to come down, and then in addition, as we continue to replace some of the higher cost deposits with some of these new verticals. We feel like we have a lot more runway on the deposits coming down.
We're not naive. I mean,
Absolutely
meaningful headwind, and we're certainly doing our planning around expenses and all accordingly.
Okay. All right. Thank you.
You're welcome.
Our next question comes from Brad Milsaps of Sandler O'Neill. Please go ahead.
Hey, good evening.
Hello, Brad.
Hey, Brad.
Hey, Julie, just to follow up on the warehouse. Just curious, of the 26 basis point decline yield on the warehouse this quarter, how much of that relates to volume discount versus just the move in LIBOR? I just want to get a sense, as volumes may weaken, as you move into 2020 a little bit versus the high this quarter, can you recover any of that lost yield on the warehouse?
I don't know how to best answer that. I mean.
Some of it's driven by volume discounts with these top clients. They've been coming in with such robust volumes. That certainly has contributed, but it's mostly LIBOR.
Yes.
Okay, that's helpful. I'm sorry if I missed this, relatively small numbers, but there was also an uptick in the loans 90 days past due, kind of X the impact of premium finance customers. Just kind of curious, any additional color there on what the driver was?
No, just a couple of bigger deals, but not ones that we feel uncomfortable with. Just some documentation things that didn't get done. Nothing of any consequence that we're concerned about migrating to a loan category.
We're not happy that it didn't get done.
That's correct.
on the documentation.
That's correct.
We don't have concern about the credits.
Got it. All right. Thank you, guys.
You're welcome.
Our next question comes from Peter Winter of Wedbush Securities. Please go ahead.
Hi. I just want to follow up on the expense question. I know you're not going to give specific guidance, but can you just talk about big picture, maybe some opportunities to maybe lower the expense growth rate next year?
We're looking at all things that we can leverage, including the technology investing we've been doing here for the last three years. That is beginning to show some opportunity where we can, in fact, hire fewer new people. That's been the case this year. I think it'll continue to give us opportunity to leverage that technology as we go into the new year. We're doing some really incredible work around process re-engineering and finding again, that we can lift the value of our people that have been doing work not as valuable as they are capable of doing by automating some of the things that are more rudimentary. We're looking at deploying bots to give us 24/7 capabilities to do some of that rudimentary work and looking at a number of different opportunities.
Thankfully, we have worked hard to get our technology grid in good shape up to date over the last three years, and now we're able to begin to do things that are more of a contributor to really giving tools to our people that'll substantially help their productivity. I'm encouraged we'll be able to take yet another really good step this next year on being able to hire fewer, and continue to hire even higher quality people each year. We've hired the finest quality people we've ever hired this year. The company is still just an amazing place on the ability to attract great talent. I think as we give our people more technology tools to use, that's going to improve productivity.
Okay, just on this long-term outlook, I was just wondering what type of timeframe are you thinking about reaching these goals? Secondly, with the net charge-offs of 20-25 basis points, is that kind of the average through a cycle?
Yeah, absolutely. That's through a cycle. Obviously, year to date this year and last year, those were higher. If you look at some of our previous years where we had seven basis points, eight basis points, they were exceedingly low. That's through a cycle. Peter, when we put these out in January, we were talking about a three-year. It was under our three-year planning horizon. I think what has happened with rates was not what we thought in January. That's why I said I think it's going to take a little bit longer. I don't know exactly what that looks like. We're in the midst of updating our three-year planning cycle, we'll try to give a little bit more color on that in January when we do 2020 guidance and kind of update for the three years.
Obviously, we'll have some better visibility on this rate situation.
On the rate. Exactly.
Because that's what primarily is driving the timing.
It is. Absolutely.
Okay, just my last question. You had mentioned, the CECL , there shouldn't be much of a change, given the commercial short-term nature of the portfolio. I'm just wondering, does that include, I guess, a fairly positive economic outlook as well?
One of the things I've said is that I think that while I think commercially focused banks are not going to have dramatically different reserve levels, I think that the introduction of forecasting into that is going to drive more volatility. I don't know that it's going to be overall higher levels, but certainly that it could drive more volatility on a quarter-to-quarter and a year-to-year basis.
Right now, you guys still have a fairly positive economic outlook.
We do.
Yeah.
Texas is doing quite well. There are lots of mixed signals, but overall, we're positive on the economy.
Great. Thanks for taking my questions.
You're welcome.
Our next question is from Jennifer Demba of SunTrust. Please go ahead.
Thank you. Keith. Sorry, back to credit for just a second. Do the results you reported include a redetermination period for the E&P loans?
That is underway, and so it is something that takes 60 days or so, Jennifer. Some of that has been incorporated, but it's not been completed. We don't anticipate any significant change, but that is not put to bed.
Okay. You're still contracting your leverage loan book through the end of this year. What does leverage lending look like for TCBI going forward? What will you be doing differently than previously?
Well, before we started this process, talked and had many meetings to talk about the business we want for the long run. The business we want in this space for the long term are what we call our trophy sponsor clients. Of course, high quality, single run enterprises that happen to also fall under that leverage lending bucket. We're not inclined to take on new sponsors at the pace we did over the last five years. We like the sponsors that we've had a history of 10 or 15 deals with over the years, understand how they behave when portfolio companies don't go exactly as due diligence and plans suggest. We do like the business. We just believe we were too successful and took too much market share with some sponsors that we just didn't have the history with.
Some of the hiccups we had on deals were with these newer sponsors we've not had the history with. That is the approach we're taking. We certainly want to take great care of our longtime quality clients who are in the PE space and have a great track record. Think like operators, not just financial engineers. We have a wonderful core client base. Over the course of the next year or so, we likely will still dip it down some. It won't be at the same pace. We're not shooting for a 30% type runoff in 2020. It might be something closer to 10. Just fine-tuning it. We are not ready to give all that detail until January, but that's directionally where we're headed at this point.
Last question, Keith. Did the escrow team have any impact on third quarter results?
I'm sorry, Jennifer, I was reading a note someone gave me.
The escrow team.
The escrow team, will they have any-
Minimal.
Did they have-
Do they have any major impact? No.
Impact on third quarter results?
No, they haven't. They won't have their special black box that they've been working with our IT team on for the larger, more complex clients that we'll be bringing on board until the first quarter. They have several clients that we can take on and handle very capably. Those that are in more complex businesses where we need to have the best piece of technology, much like we understood 13 years ago we needed to build in mortgage finance, mortgage warehouse. We're doing the same type of thing where we're really listening to their clients and building something that'll be a great tool for us and the client, in those cases where we have larger, more complex clients in escrow. They'll have some impact in the fourth quarter, but it should be significantly accelerating as we get into next year.
Thank you.
You're welcome.
Our next question comes from Brock Vandervliet of UBS. Please go ahead.
Thanks. I was just wondering if you could kind of clarify the math on the energy credit flows. Energy NPAs, $61 million Q2. Energy net charge-offs, $16.5 Q3. I would think that would get to, therefore, NPAs, say, $46 million. Your NPAs at the end of Q3 were $63. Does that imply a new energy NPA of $17 million or $18 million or no?
That's exactly what it was, Brock.
Yeah, we mentioned that earlier on the call, that the uptick in total non-accruals was one energy deal.
Okay, got it. All right. Has that been reserved or is that a new credit?
Anytime a loan goes to non-accrual, there's an impairment analysis done and the appropriate reserve would've been put on it.
Okay. All right, got it. I understand the math now. Thank you.
You're welcome.
This concludes our question and answer session. I will turn the call back over to President and CEO, Keith Cargill, for closing remarks.
I'd like to thank all the call participants for tuning in, and we appreciate your interest and your support. Have a good evening.
Thank you for your participation in TCBI's third quarter 2019 earnings conference call. Please direct requests for follow-up questions to Heather Worley at heather.worley@texascapitalbank.com. You may now disconnect.