Good afternoon, welcome to the TCBI Third Quarter 2018 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 zero. I would now like to turn the call over to Heather Worley, Director of Investor Relations. Please go ahead.
Thank you for joining us for the TCBI Third Quarter 2018 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 materially from these statements. Our forward-looking statements are as of the date of this call, 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 in subsequent filings with the SEC. 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, Phil, will facilitate a question and answer session. Now I will turn the call over to Keith, who will begin on slide three of the webcast. Keith?
Thank you, Heather. After I open, Julie will share her assessment of Q3. I will close and open the call for Q&A. Let's begin with slide three, as Heather mentioned. Traditional LHI growth was up 3% linked quarter on average balances, flat linked quarter on period end. Following the outsized growth in Q1 and Q2, third quarter totals are modest but expected. Year-over-year, average LHI was up 13% on average, 12% at period end. The loan pipeline appears healthy for the fourth quarter. Winning the highest quality loan opportunities remains our primary focus. Job number one is strengthening our loan portfolio quality for superior credit performance through the cycle. Mortgage finance average balances were up 11% linked quarter, 12% year-over-year. Period end balances were down 8% linked quarter as we moved into the usual softer fourth quarter seasonality.
Year-over-year period end was down 3%, far better than the national mortgage market contraction this year of approximately 8%, indicating that we continue to take market share. Average deposits were up 6% linked quarter, and 9% year-over-year. The deposit increases were in interest bearing deposits as the demand deposit trend continues to convert to more interest bearing deposits. We expect the continued rollout and maturation of new treasury deposit verticals will help us improve our deposit costs, deposit betas, and further diversify our funding. We now have two new treasury deposit verticals operational, with up to six more to be introduced in 2019. Net revenue grew 3% linked quarter and 15% year-over-year. Our operating leverage improved year to date. ROE increased to 14.68% for Q3, largely due to a more normalized loan loss provision.
We experienced a modest $2 million in net charge-offs in Q3. Overall asset quality remains good. Total credit costs in Q3 were $11 million as compared to $27 million in Q2. Before Julie shares her comments on the quarter, I want to address two topics in particular. First, as we emphasized in the first quarter, and again in the second quarter, we experienced extraordinary growth in loans. In fact, the first quarter loan growth was two times the dollar growth we have ever experienced in Q1 in our 20-year history. We followed this record-breaking growth with a second quarter well above the expectations we shared on the earnings call in April with the softer pipeline we thought we were going to have to execute on. Despite that softer pipeline, we had very strong growth in the second quarter. It came toward the end of the quarter.
It well could have spilled into the third, but it came at the end of the second. These loan growth numbers through Q2 were all the more outsized since our primary objective in 2018 was and remains a focus on upgrading our loan portfolio for optimum performance through the next credit cycle. We provided traditional LHI loan growth guidance for 2018 at low to mid-teens and have not deviated from our initial annual guidance. Further, we guided growth in our mortgage finance loans of mid-single digit % growth with an industry volume contraction forecast to be 8%. Today, we are increasing guidance for mortgage finance growth to low to mid-teens. We are solidly on track for our 2018 overall loan growth. Second, we provided annual guidance in January for net interest margin of 335-345. We increased the guidance to 360-370 in July.
Today, again, we are increasing NIM guidance to 370-375. While loan growth this quarter was slow as compared to Q1 and Q2, we are at or above our guidance and believe to grow faster than low to mid-teens in 2018 would be imprudent due to the aggressive credit market we see so late in this economic expansion. Also, while NIM declined sharply in the third quarter, we have anticipated for the past year and expressed our expectation that we could see a quarter in which LIBOR did not lead the Fed funds rate increase and deposit costs could continue to increase. We believe the occurrence of both LIBOR lagging and a stronger than normal move in deposit costs will not be a systemic change, but likely an occasional possibility.
Finally, NIM in the third quarter was meaningfully impacted by a squeeze in loan pricing in the mortgage finance category that we see moderating this quarter. The increased mix of mortgage finance average balances versus more modest traditional LHI growth further pressured NIM. I hope this context for our annual guidance and this overview on loan growth and the quarterly NIM contraction was helpful. Julie?
Thanks, Keith. My comments will cover slides 4 through 10. Our reported NIM decreased 23 basis points from the second quarter. The change in earning asset mix accounted for a portion of the decrease. An increase of $237 million in average liquidity assets since the second quarter, as well as a larger percentage of total loans coming from seasonally strong mortgage finance, which has a lower yield than traditional LHI. Net six basis points of negative impact to the NIM from earning asset shifts. Traditional LHI yields were up only one basis point from Q2, and there are several factors to keep in mind. The first is the lagging movement in LIBOR prior to the September Fed rate move as compared to the way it led prior to Fed rate moves in the first quarter and the second quarter.
Traditional LHI betas continue to be as expected and are reflected in September 30th ending LHI yields on our floating portfolio, which are up 15 basis points compared to yields at the end of June. Some of the LIBOR-based loans didn't reprice until early October. We do expect impact of the September move to be reflected in the fourth quarter. Additionally, Q3 was a weaker loan fee quarter compared to the very strong fee quarter in second quarter. There was a nine basis point swing and was really a combination of Q2 being much higher and Q3 back to a slightly lower than normal level. We experienced compression in mortgage finance yields as those decreased 23 basis points linked quarter. As we mentioned during the second quarter call and in meetings during the third quarter, we are addressing competitive pressures in that space.
Because of the multiple offerings that we provide, we have more flexibility in evaluating overall relationship pricing and making adjustments as needed to retain and grow market share. We had a linked quarter increase in average deposits. Our overall deposit cost increased by 18 basis points from 81 basis points in Q2 to 93 basis points in Q3. The increase was expected as Q2 numbers only included a few days of the June Fed rate move on index deposits. Similarly, Q3 only includes a few days of the September move. Overall increase of 18 basis points is compared to 15 basis points increase from Q1 to Q2, not outsized and is consistent with our expectations. There's a continued solid deposit pipeline, as we've said before, difficult to forecast exact timing and it can be lumpy in how it comes on, all is interest bearing.
Our RMs are being incented to focus on deposits as well as loans. During the third quarter, we chose to layer in an additional $500 million of traditional brokered CDs as we were able to lock in six and 12-month maturities at a cost slightly less than our index deposits. As we've noted in the past, the use of brokered CDs makes sense from a balance sheet management perspective, but we don't plan to use an outsized amount of brokered CDs. Important to note, as of the end of September, 75% of our floating rate loans are tied to LIBOR, and over 80% of that tied to 30-day LIBOR. We had good growth in average traditional LHI during the quarter. Second quarter growth was actually higher than expected, which impacted the growth from the end of Q2 to the end of Q3.
Year to date, it remains consistent with our annual guidance. Traditional LHI average balances grew 3% from the second quarter and up 13% from Q3 2017. The level of payoffs continues to be high, primarily in CRE, and no sign that that will slow. Our fourth quarter pipeline looks positive, but we would expect a slower growth quarter than we experienced earlier in the year, which is consistent with our full year guidance. During the quarter, we purchased a senior interest in a securitization trust that is collateralized by the cash flows of four municipal revenue bonds totaling $95 million. While we view the transaction to be similar to any collateralized extension of credit, the structure of the transaction triggers GAAP rules that require the extension of credit to be characterized as a security on the balance sheet.
Basically, the $95 million increase in securities is more similar to C&I growth, and the yield reflects that. We continue to see strong average total mortgage finance balances benefited from seasonality and are up from Q3 2017 by 12%. Obviously, we expect fourth quarter volumes to be seasonally lower and started to see that trend at the end of the third quarter. As I mentioned, we did see some pickup in linked quarter average total deposits with all of the growth in interest-bearing. As I noted earlier, we added some additional traditional brokered CDs during this quarter because the pricing was still very favorable as compared to our index deposits. This is proving to be an attractive bridge funding alternative as we work on our new deposit verticals and other initiatives we have underway.
Primarily interest-bearing deposits in the pipeline, but we're also working hard on maintaining and growing existing relationships. Our RMs are being incented to focus on deposit growth as well as loan growth. Again, asset betas, especially as it relates to our traditional LHI portfolio, are an important part of the story for us and why we feel good about our balance sheet positioning going forward. We have seen those asset betas perform as expected. We continue to react to specific customer situations which are evaluated on a total relationship basis. Our index deposit categories total about $5.5 million at the end of the third quarter. Moving on to non-interest expense. In looking at changes in linked quarter non-interest expense, we are effectively slowing our core expenses, which is primarily salary expense. We're doing a good job of managing this with a lower level of FTE additions year to date.
You'll note that we had $2.8 million in severance cost, which is related to some organizational changes that we made during the quarter. These are consistent with the messaging we've been doing about focused efforts on better aligning the organization to improve efficiency and client experience. The $2.8 million equates to $0.04 per share. There's an increase in non-LTI and annual incentive pool from the Q2 levels, that's driven by annual incentive accrual, which generally continues to ramp throughout the year based on overall financial performance. Some fluctuation in FAS 123R expense in the third quarter as compared to Q2, primarily related to fluctuations in the stock price. Our third quarter FAS 123R expense of $4.4 million is compared to Q2 expense of $5.6 million.
We had an increase in occupancy, which included $1 million related to a relocation of one of our main offices and the related expenses that were required to be expensed as a one-time charge and does not signal a new run rate. As we noted in July, legal and other professional was abnormally high in Q2 with some non-recurring expenses. There was about $2.5 million in Q2 that was not normal run rate. Our Q3 levels were down by that amount, offset by the new variable component added during the first quarter that is directly related to deposit services and was expected to ramp by $1 million to $1.5 million in each sequential quarter. Net impact was Q3 expense down $900,000, we would expect the normal ramp of $1 million to $1.5 million in Q4.
A portion of our marketing category is variable in nature and is tied to growth in deposit balances as well as increases in rate. The trend in marketing over the last year or so is representative of the increase in run rate expected throughout the rest of the year. While we didn't see any growth from Q2 to Q3, we would expect to continue to see some increases as we continue to grow deposits, not more outsized than we've experienced in the past and not every quarter. We continue to be targeted about expense growth, heading into 2019 planning season, that is even more evident. We're focused on targeted growth for staff adds and holding most areas flat as we are improving returns in lines of business.
Our efficiency ratio for the third quarter was 53.6%, excluding the impact of ORE, which was slightly higher than our Q2 efficiency ratio of 53.1%, it was negatively impacted by the $2.8 million in severance and the $1 million discussed earlier. We continue to feel good about overall asset quality. Criticized and classified to capital continue to trend down. Criticized loans to Tier 1 capital plus the allowance decreased from 16.4% at Q3 2017 to a current end of Q3 13.8%. Non-accrual levels are still at a very acceptable level of 0.49% of total LHI. This late in the cycle, we believe that being aggressive with grading is the right thing to do.
As we expected, Q3 provision level is more normalized, and it's driven by provisioning for three relationships moved to non-accrual this quarter and some additional reserves for one of the healthcare loans we discussed in the second quarter. We expect fourth quarter provision levels to continue to be normalized and within our annual guidance. The provision of $13 million for Q3 compares to $27 million in Q2 and $20 million in Q3 of last year. Our total credit costs for the quarter were really less than the $13 million as we sold the only meaningful ORE property we had, and that resulted in a $2 million recapture of the valuation allowance we took in the first quarter. As well as a $2 million of additional gain that's included in non-interest income.
While accounting rules require us to account for it as a gain, it's really a recovery as we had previously taken some charge-offs related to this deal. The $13 million in provision less the $4 million related to the ORE sale resulted in net credit-related charges of $9 million for the quarter. Charge-offs for the quarter were minimal at $2 million. Looking at quarterly highlights, we continue to have growth in our linked quarter net revenue. We've experienced strong traditional LHI growth year to date, and the portfolio is benefiting from improved margins as a result of the continued move in LIBOR. While there was an earlier impact from LIBOR moves in the first quarter and the second quarter, the later LIBOR move in Q3 will show up in improved traditional LHI yields in Q4.
We continue to improve run rates on core operating expense items, specifically salaries, and a continued focus on improving efficiency while enhancing client experience. ROE and ROA levels improved in the third quarter as a result of the more normalized level of provisioning. The expectation of the ROE trajectory is positive, and we expect Q4 to be stable. We continue to benefit from interest rate moves, despite the fact that the timing of the improvements can be impacted by how LIBOR moves in comparison to the Fed move. Current lower liquidity levels have been beneficial for ROA, but we're comfortable holding higher liquidity levels, and we expect balance increases during the fourth quarter as mortgage finance moves into the seasonally weaker part of the year. Lastly, I'll cover the guidance slide. No change in our outlook for average traditional LHI growth of low to mid-teens % growth.
We had a slight improvement in our outlook for average mortgage finance growth of low to mid-teens % growth, which reflects the strong balances year to date. A slight improvement in NCA guidance to $1.4 billion for average outstandings for the year, and a slight change in our outlook for average total deposits, as we think growth will be in the high single-digit growth in all interest-bearing. We're improving our outlook for NIM to 3.7%-3.75% to include impact from the September rate move. Our guidance is still assuming no additional rate increases for the remainder of the year. We're also taking into consideration that our deposit growth is coming in interest-bearing, and it also assumes we have higher liquidity levels in the fourth quarter with the shift from mortgage finance. No change in net revenue of mid to high teens % growth.
No change in provision expense guidance at low to mid $60 million level. No change in non-interest expense at low teens % growth. Finally, no change in guidance for efficiency ratio at the low 50s. Keith?
Thank you, Julie. Please move to slide 11. We're very pleased with our strong earnings and increased ROE this quarter. Traditional LHI growth remains on target for 2018, while mortgage finance growth resulted in an increase in guidance. While deposit levels increased, the continued rollout and maturing of our new treasury management deposit verticals are expected to reduce deposit betas and overall funding costs, while also further diversifying our funding mix. We benefited from a more normalized loan loss provision in Q3 and remain in line with full year guidance. While we have been focused for some time on upgrading our loan portfolio and addressing credit issues early before the next credit down cycle, it remains job one so we can perform well above peer through the next recession.
We're not predicting an imminent economic decline, but we know that upgrading a loan portfolio requires a disciplined focus well ahead of the next recession. The time to upgrade is when capital is still active and there are aggressive lenders. I'm excited about the work my colleagues are undertaking to streamline our organization, improve efficiency, and further build on our premier client experience differentiation. We continue to invest in rebuilding our technology infrastructure and delivering better technology tools for my colleagues so we might create even better service for our clients and increase value for our investors. Managing NIE growth includes investing wisely in both young and experienced talent and developing these outstanding new colleagues in our collaborative, energizing culture. This keeps us on course to remain a winning business of the future, not just an outperformer over the past 20 years.
The focus on improving ROE the past two years is producing positive results. Building the strongest loan portfolio through credit cycle is a key to increasing ROE for years to come. We continue to leverage our treasury management capabilities to improve our funding mix and lower deposit betas with the new deposit verticals. All in all, we're fully engaged in building the premier business for the next decade that we hope you find attractive today and tomorrow. At this point, we can open it up for Q&A.
Okay. We will now begin the question and answer session. To ask a question, please press star then one on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. At this time, we'll pause momentarily to assemble the roster. The first question comes from Peter Winter with Wedbush Securities. Please go ahead.
Great. Thank you. I have two questions. The first one, you talked about your targeted for better expense growth or managing expenses better for 2019. I'm just wondering if you could give a little bit more color around that. Secondly, if you maybe have some type of expense growth number for next year.
Yeah. We're early to give guidance on that, Peter, as far as expense growth next year. The investments we've been making for now two and a half years and continue to make in rebuilding some of our infrastructure, technology infrastructure, they finally begin to converge and become integrated, fully integrated, mid-year next year. We think that'll be a little tailwind, but in the meantime, we have an initiative underway here at the bank that we launched about six weeks ago to just look at how we optimize the org structure and deliver even better client experience while picking up efficiencies.
The combination of using technology more than we have in the past and being more mindful about where we're focused on driving more core loan growth and core deposit growth in key businesses, I think is really going to give us, again, a running start, which should pick up some tailwind by mid-year as we integrate all our new systems integration.
Hey, Peter, it's Julie. Like I said in my commentary, we've been very focused on managing headcount increases. We've traditionally added a lot of headcount, and we're just being more focused on where we add headcount, and we're certainly looking at that closely in 2019.
You would expect the efficiency ratio to drop next year. Would that be fair?
Yes.
Okay. Could I just ask about credit? If you could just give a little bit more color about the three relationships that you've moved to NPA. Also, 90-day loans past due also increased, and I'm just wondering how you got comfortable. You mentioned also that you're upgrading the loan portfolio to prepare for the next recession, but you had the big increase in charge-offs in the second quarter, and then we're seeing an increase in NPAs this quarter. I'm just wondering if you could just talk about what's going on on the credit side.
Well, you're accurate in saying NPAs increased, but very modestly. If you look at our overall NPAs, they're really quite good relative to industry. Back on your earlier question, yes, we've had three new credits that got moved to NPA. Again, it's not consistent with what we saw industry-wise in the second quarter. One thing we have noticed, and we're taking a closer look at, is there is some commonality in some of the credits being more levered. We're taking a harder look at just what we're doing in that portfolio. We have less than 5% in our leverage lending portfolio or sponsored finance portfolio. The only thing we see, it's not really an industry issue at this point, that could be a bit of an issue is the more highly leveraged companies, and I don't think that's unique to us.
What we tend to do, and I think you know this, having followed us for years, is get more critical and more challenging in looking at our credit early enough before the downturn, Peter, so that we do have ways to move some of that credit. Now, when they move to non-performing, you're late. That's not optimum, but you are going to see some of that activity occur with us, and you should earlier than some banks, just as you did with the energy book.
Peter, on the over 90, that's predominantly our premium finance loans, and those are basically cash secured, but they will have a fair amount that's always in over 90 days, sometimes that spikes up. There's nothing that we think is a problem in the over 90 because it's primarily the premium finance loans.
Got it. Great. Thank you.
Welcome.
The next question comes from Brady Gailey with KBW. Please go ahead.
Hey, good afternoon, guys.
Hey, Brady.
Hey, Brady.
We have the net interest margin for the first three quarters of the year. You've given us the full year guidance, so we can kind of back into to what you think the 4Q NIM will be. If you back into that, it's a range of 345-365, roughly. The midpoint is 355. That's another 15 basis points lower than this quarter. It just seems to me, LIBOR will catch up this quarter. You'll have the mix shift with a lower mortgage warehouse, which will be beneficial. It just seems like the margin should be stable, if not higher in 4Q.
The one thing that's really important to factor in, you got most of that right for sure, is the mortgage warehouse softening, it goes to liquidity.
Yeah.
We'll have some pickup in traditional LHI, Brady, from that slowdown in seasonality in warehouse, but more of it will go to liquidity than goes to LHI.
Right.
That's the dynamic. We think we'll be on the higher end of that range, but it's too early to say.
That's the bigger shift, Brady, is it going from warehouse to liquidity assets.
Got it. Okay. All right. You bought another $500 million of brokered CDs. That's on top of, I think, last quarter in 2Q, it was about $1 billion. Now you're at $1.5 billion now.
Right.
Sorry. Go ahead, Julie. What'd you say?
It's about $1.5 billion at the end of the quarter.
It's actually very competitive, slightly better than some of our higher priced indexed cost of funds. We're really using that, Brady, to bridge us a bit while we get these new deposit verticals ramped up. While we have two out there operational now, they're young, and we've got six more coming online next year. When you look at overall optimum cost of funds, for now, this brokered CD money is actually more attractive, slightly less costly than some of our most highly priced money.
Okay, it's $1.5 billion now. That's about 7% of your deposits. Do you think that that'll continue to increase in the near term before the new deposit verticals start getting speed, and then we'll see it go back down?
It's hard to say. It could. It's not going to increase significantly. If we see that as a better cost of funds near term, it makes sense to us to actually deploy some of it. I don't see it increasing significantly. Julie, do you?
No, probably what's more likely to happen is some of that, those are shorter term. I think the remaining maturities are two to nine months. As some of that rolls off, we might choose to replace it. I don't think you're going to see us add too much more, if any.
Okay. Lastly from me, you're talking about slowing the pace of expense growth. You're talking about managing the headcount increase. We saw some severance charges this quarter. Are you thinking about doing a headcount reduction at this point as a way to slow expense growth?
No, that's really not in the cards. We have made some adjustments to get a more efficient org structure set up, Brady. That was the key reason for that primary severance charge, the primary reason. As we go forward, again, we think we have a much better feel or a handle on how we use existing headcount to redeploy some of that headcount, maybe in the same division, but not incrementally keep adding at the pace we have over the years. Really, we add 150+ FTEs a year. If we can tip that down to 100 or even 80 or 90, that's a meaningful pickup in efficiency, and I think we're really getting a lot better at that just the last couple of months.
Got it. Thanks, guys.
You're welcome.
Thanks, Brady.
Okay. The next question comes from Ebrahim Poonawala with Bank of America Merrill Lynch. Please go ahead.
Good afternoon, guys.
Hello, Ebrahim.
For the first question, just trying to better understand loan betas as we think about fourth quarter, given the noise we've had both on the mortgage warehouse and the traditional LHI. If you can help me, Julie, if we think about, one, the LHI for the mortgage warehouse growth, that 362 means it's been all over the place in terms of the loan beta all year. Given that we've already had the Fed funds and the LIBOR, if you can talk about your best guesstimate for traditional and the warehouse yield going into 4Q, or what level of pass-through you expect, I think that would be extremely helpful.
Okay. On the traditional LHI, I mentioned that the ending rate on the floating part of the book is up 15 basis points at 930 compared to 630. Part of that book doesn't reprice until It repriced in early October. You'll see all of that come through. We're assuming in our estimate, we're assuming no further, that LIBOR doesn't lead, assuming there's a December increase. We would see the full impact of the December LIBOR moves come through in the fourth quarter.
You mean the third quarter.
The third quarter. That happened in the third quarter, but it's going to come through in our fourth quarter LHI yields. The other thing is the fluctuation in the loan fees. It was up from Q1 to Q2, it was up about seven basis points. Q2 to Q3, it was down about nine. Generally, we don't see anything more than maybe a three to five basis point fluctuation from quarter to quarter. I would say had we had a more normalized fee quarter, we would have added another four or five basis points to the LHI yield in the third quarter. The-
It's very seasonal-
Yeah
in that a lot of the biggest deals, as you well appreciate, those get syndicated and launched in the second quarter, Ebrahim.
I guess the important thing to remember is that in looking at our ending 9/30 yields and what's repriced in early October, we're still seeing the same kind of betas that we've seen on the core book to date.
Got it.
Go ahead. On warehouse?
Yep.
On warehouse, we started talking on the second quarter call and then in Q3 on different meetings that we had, that we were starting to see competitive pressures. That was kind of an outsized catch-up from Q2 to Q3. We could see a little more pressure, but I think that's going to flatten as we go forward. If LIBOR continues to move up in the future, we could see a portion of that come through in the warehouse yield.
There's a real struggle in that space, Ebrahim, to hold market share. Now, we're still taking market share, but those that are just trying to stay in the business at a reasonable run rate, it's put pressure on that yield. We really think we're close to bottoming out in the fourth quarter or early next year on that pressure.
It's also important to remember that all you can see for that line of business is just the loan yield. What's also tied in there is a whole relationship with deposits or an MSR facility, and all you can see is this. We don't cut yield across the board. We look at each relationship.
Understood. I guess just moving I guess deposit growth should be the driver of balance sheet growth, given where we are and your comments around being conservative on credit. If that's going down to high single-digit % growth, is that kind of what you expect with all these verticals coming through next year, is high single-digit type balance sheet growth environment that we are in today? It's one thing for growth coming in interest-bearing deposits. Do you still expect non-demand deposits to continue to decline at the rate we've seen year-over-year this year?
It's early to give you guidance on next year. Generally, I wouldn't be surprised once we get into January to be talking with all of you about high single digits on loan growth and deposit growth because we're not interested, even as the verticals get traction, in just absolutely growing. We want to optimize our cost of funds, which means some of our highest cost of funds, we would envision replacing with some of these better beta, lower beta, new vertical deposits, too. Again, could we grow double digits next year in loans and deposits? We could. I don't think that necessarily optimizes our earnings and ROE, Ebrahim.
Hey, Ebrahim, on the DDAs, I think you'll see, we're still working hard at increasing DDAs to offset some of the migration that's happening there to interest bearing. I think if you look from Q2 to Q3, we didn't have much net runoff. The year-over-year decrease, if you look at averages from third and fourth quarter of last year down to where it is this third quarter, I don't expect to see anything that pronounced. I think it's going to be much smaller, similar to what you saw from Q2 to Q3.
Got it. Thanks for taking my questions.
You're welcome.
Thank you.
Okay, the next question comes from Michael Rose with Raymond James. Please go ahead.
Hey, good afternoon.
Hi, Michael.
Hey, Michael.
Hey. It seems like pulling off the hiring is kind of a little bit different from where your DNA has been historically. Is this a kind of a secular shift for you guys as you've gotten bigger? I understand the commentary about the environment and where we are and all the external pressures out there from non-bank lenders, but it seems like this would be the type of environment where you guys would continue to hire well-seasoned lenders, well-positioned lenders looking for a new home.
One of the things we've really accomplished just in the last three years, Michael, is building a team of young talented people, hiring undergrads right out of school and MBA students, and bringing them through a training program. We're having really good success with those folks, and they're really contributing and beginning to sprinkle them across our businesses in all areas. Yes, we're continuing to hire experienced bankers, but we also, importantly, are shifting our overall age to be more a company that has another 20-year run as we shift over the next 10 to 15 years some of our business owner clients and CFOs to be millennials. We want to have our young people be ready to take those handoffs, and they're doing a great job.
The other thing we're doing is org structure-wise, we're looking at being a flatter, more horizontal company than adding more vertical layers. We just think that's the way companies have to organize to be more responsive and efficient, and be able to react fast enough to market demand and client experience. Those are some fundamental things we're doing. I'm excited because we have leaders across our company, and then teams under our leaders that have really taken this initiative and run with it. So it's not something just coming from Julie and me or our NEO team. It's something everyone buys into as a way to improve client experience, but also efficiency. This should enable us to hire fewer new people, but actually increase the value of our existing people as we leverage them with technology and get them in the optimum seat to contribute value.
All right. That's fair. Thanks for the color. Maybe just one follow-up question. Just wanted to get your longer term thoughts on the warehouse business. It's clearly going through some changes. Its turn times at some point are going to go down. Electronic mortgage. How should we think about the future of that business? I know it's 30% of loans. What's the longer term play here?
We think it has a great future for us. I don't think it necessarily has a great future for everyone. We've set ourselves up to be able to scale, and we've proven we can over the years, but we're positioned to scale significantly as the market over time begins to shift to more electronic payment. Again, if you're not investing heavily in technology, again, we were the leader in the industry to offer eNotes, so we've been at this for several years. It just hasn't had wide adoption yet, but it's coming. You better be set up to scale, or you're not going to be able to generate the kind of returns on this very credit-safe asset that you need to generate. It is going through a cycle now with headwinds yet again in 2019 on mortgage volumes.
The latest from the MBA as of the last two days, they think it could be another 10%+ down year next year. We could well see an 8%-10% this year. It's running about 8% down versus a year ago. Cumulative down three years in a row is going to cause a lot of consolidation. To further address your question, Michael, I would expect we'll even have some fewer customers, but most of our customers will be beneficiaries of the consolidation. Therefore, overall, we think we'll continue to take market share in a challenged environment. We like the business, but we've worked hard to position ourself to handle what's coming, and we believe we're in a good shape to do it.
Okay, fair to assume that this is a mid to high teens ROE business, and given the investments you've made, the market share you're trying to grab, fair to say that's the assumption short to intermediate term?
That's right. You are going through this period where there's some winnowing out that's going to happen, both of the non-bank clients and prospects, as well as of the banks that are going to serve that group. We think we're well positioned to benefit as the cycle runs its course. We're definitely in a cycle where everybody's scrambling to hold on to market share.
All right. Thanks for taking my questions.
You're welcome.
Thanks, Michael.
Okay. The next question comes from Brett Rabatin with Piper Jaffray. Please go ahead.
Hi, good afternoon, everyone.
Hello, Brett.
Hey, Brett.
Wanted to first just ask, there's been some consternation this quarter through the earnings season so far with ending period DDA versus averages. I was curious, was there anything unusual that affected your end of period DDA versus kind of the average for the quarter? How should we think about the difference there?
No, I think average. I always say average is a better indicator of what's going on. We do have some fluctuations. We've got deposits in several different industries that lend themselves to sometimes run off at the end of the month, but then build back up. I think overall, the averages are just a better indicator of what's going on.
Okay. Then you briefly addressed the new verticals. Maybe could you give us any color on kind of what you're seeing so far with the platforms in terms of balances and what the average cost is? Are we getting to a point where we can maybe get a look at those numbers?
Well, I see my team shaking their head no, but I'm going to give you a little color, so I'll be in trouble after the call. I'm not going to tell you what category they're in, of course, and you well appreciate that. We're still getting launched. With one vertical having been up for a good part of the year and the other just recently getting launched, we're around $600 million in new deposits in those two new verticals. I'd say that's an awfully strong start. These are not the ones that we think will be even stronger growers. We don't know if we'll sustain this rate of growth, but we're off to a good start.
Okay. I want to make sure I was clear on one last thing. Just the closing comments and the PowerPoint, you say selective about growth areas and positioning our portfolio. This quarter, were there things that you specifically exited versus payoffs in the quarter that affected kind of the net growth? Or how do we think about your comment there? Are you actually kind of exiting positions into what you kind of see as peak-ish credit?
No, we're not exiting positions, but we're being very deliberate about pipelines, in terms of do we really want to pursue and close the deal? Do we want to win the deal? If we win the deal, is that really an above average credit in that part of our portfolio? And this late in the cycle, it needs to be. As opposed to just something that, yeah, we're okay with. It's a 30th percentile kind of quality, but we think it's going to work out. That's not a good bet this late in the cycle for new credits. I think we're just being more selective, and you have to be early. Again, it's challenging because you want to grow in a healthy way, but the best loans, everybody's after, and some of them are just unbelievably cheap relative to even the good quality that it offers.
We're going to have to be thoughtful about always looking better than average quality as we go forward. We hope we have another couple of years with expansion. We just can't bet on it. Now's the time while there's so much capital chasing assets and loans included, especially non-banks chasing loans that are so aggressive. Now's your opportunity to miss some of the late vintage credits that you'll really regret you did in a year or two when we get into the down cycle. We're certainly open for business. We had a great first half. Again, had that second quarter that came on so late and outstanding. Some of that spilled into the third quarter, and I think everybody'd be happy as a lark because we told you April we had a soft pipeline going into the second quarter, and our team was just so good.
They closed a lot of deals in June, and it kind of pulled some of that volume that might have normally fallen into the third quarter into the second. We're happy with where we are, and we think it's the right pace of growth at this stage of the cycle.
Hey, Brett, I think it's really consistent with what we've been saying, what Keith has been saying for a while about certain categories that we were being very cautious about. Just a reminder, kind of for our history, our growth has been lumpy, and this year it was just a little more lumpy toward the front end.
We are seeing continued rapid pay downs. All banks are these days on CRE. Our CRE numbers relative to capital continue to go down. We're now in the low 80s as a % of capital. At one time, we were in the 120s, just a year and a half, two years ago. The things we're doing to replace that runoff are all about quality. Be sure that we get the right, better-than-average quality in the portfolio. I'd be fine if that goes back to 95 or so % of capital, it has to be because we're finding the best quality that we've seen.
Okay. That's great. Really appreciate all the color.
You're welcome.
Thanks, Brad.
Okay. The next question comes from David Rochester with Deutsche Bank. Please go ahead.
By the way, before I answer your question, Dave, my guys are shaking their head. It wasn't 18 months ago we were at 120 of capital. That was, what, Randy, three years ago? Yes, C and D. C and D.
Couple years ago. Yeah.
That subcategory.
A couple years ago, yeah.
The subcategory C&D-
Yes.
Construction and Development. We're continuing to bring that down, and we're just reducing our risk overall. For an asset class, it's still really great in our portfolio, but we know it's more cyclical in a downturn than other asset classes, typically. I'm sorry, Dave?
Sure. No problem. Thanks for taking the questions. Regarding NIM on the guidance, I just wanted to make sure I had this right. It sounds like you're expecting the loan fees to potentially be up a little bit in 4Q, the mortgage warehouse yield maybe down a little bit to flattish at this point, with the LHI yields up decently. Is that roughly right?
That is correct.
That is right.
That is correct.
Okay.
The only other thing is as we go into the fourth quarter where mortgage finance is seasonally weaker, that shift is going to go into liquidity assets.
Yep.
Which is obviously a lower rate.
Some growth again in.
Yes
traditional LHI.
Yeah, absolutely.
That sounds right. Thank you. On the increase in deposit costs for the quarter, this quarter, is that generally the pace that you're expecting, in quarters in which we have rate hikes going forward?
We think it was a little elevated this quarter, we'll just have to see as things move ahead. It was more the other factors Julie pointed out than just a way outsized move in deposit costs.
Yeah.
We've been talking about this for over a year. We could have a quarter where we have real outsized deposit costs move. We just haven't seen that in a big way yet, that still could happen in a quarter.
Yeah, I think if you compare the move from Q1 to Q2 and Q2 to Q3, it was up a couple of basis points.
Yep.
Yeah, nothing outsized. I think it's a fair run rate.
Okay. There's no partial catch up embedded in this or anything. Okay, gotcha. Then, I guess, just bigger picture question on asset sensitivity. Going forward, or maybe with just the September hike, I guess you've kind of given us the components, but just bigger picture, how much do you expect NIM to benefit from rate hikes, ex any kind of liquidity build? For the next rate hike, what do you think?
Here's why we hesitate. You know all the dynamics.
Right
that we deal with.
Yep.
That shift in mortgage warehouse seasonally, lumpy growth, traditional LHI.
Yep.
Let us say it this way, we are continuing to see some expansion, particularly in traditional LHI. Near term, in the third quarter in particular, it was tough on yield competition in the warehouse space.
Yep.
Again, as we said earlier, we think that trajectory of downward push on yield is going to flatten some over the next couple of quarters and bottom out soon. Okay?
Yep.
I'm not sure that answers exactly your question, but I'm trying to give you the right context.
Sure.
The NIM expansion is still going to happen with rate moves, but like what we saw in the third quarter, how traditional LHI yields moved up, that's going to be lagged because of what happened with LIBOR.
Right.
There can be some timing considerations that you have to take into account to see all of that expansion.
Gotcha. Okay. Great. Just switching to expenses. I know you're not talking about headcount reductions or anything like that, but it looks like your expense guide for the low double digits this year points to something maybe lower expense level in 4Q. Is that what you're expecting at this point?
Fourth quarter, we are expecting fourth quarter expenses to be lower than Q3. We had those kind of one-time things in Q3.
Yep.
Yes, that's exactly what we're planning.
Gotcha. Great. All right, thanks guys.
Thanks, Dave.
Okay, the next question comes from Geoffrey Elliott with Autonomous Research. Please go ahead.
Hello, thanks for taking the question.
Sure.
When you're seeing those non-interest-bearing deposit balances decline, do you have a sense of where they're going? Are they going into interest-bearing balances with you? Are they going into interest-bearing accounts with other banks? Are they going into off-balance sheet products? Are they getting deployed? From your discussions with clients, kind of where is that money going?
It's really virtually all staying with us. It's converting to interest bearing. We're watching that carefully. We're not seeing DDA migrate out, and go somewhere else. Now, some of it, I will tell you, is being deployed in the businesses, those that are growing, and some of them are beginning to do some CapEx expenditures, Geoffrey. With the tax incentives. There is some of that going on, and with GDP running as hot as it is, you would expect a little of that. It's not migrating out of the bank. We expected some of that to convert. It's going to convert quicker, of course, with our commercial banking focus, without the brick and mortar retail business. That's what's occurring so far.
Thanks. Can you help us think about what portion of the remaining DDA is potentially going to convert into interest bearing versus what you think is pretty sticky and stays within the DDA category, even if rates keep on moving up?
Well, we still believe that the trajectory or pace at which it's converting is going to begin to tip down, that others that have so much of the retail are going to then begin to experience a little steeper trajectory dealing with online bank competitors. I just can't tell you when. I don't think the pace is increasing. I think it is decreasing some, but it'll continue for still a while until we can put together two or three quarters and be convinced, all of us, that that's slowed. We don't see that becoming a bigger issue near term than what we've experienced the last few quarters.
Hey, Geoffrey, it's important to remember that we're very treasury management focused, a large percentage of those DDAs are tied to some kind of treasury services. There's a certain amount that they're going to keep to cover their charges. We think that certainly helps slow that.
We have over 90% of our clients on our treasury system, that was only in the mid 50s four or five years ago. We've worked hard to make that stickier because of the future rate increase environment that we're experiencing now.
Great. Thank you very much.
You're welcome.
Sure.
Okay. The next question comes from Brad Milsaps with Sandler O'Neill. Please go ahead.
Hey, good evening, guys.
Hello, Brad.
Hey, Brad.
Hey, Keith, just to attack maybe the NIM question a different way. If your guidance holds as you expect this year, it looks like you'll generate about 20 or 25 basis points of year-over-year NIM expansion compared to about 35 in 2017. If the Fed raises rates again in December and then maybe a couple times next year and LIBOR sort of follows as expected, would you expect to get a similar amount of expansion in 2019? Do you think the environment is such that it's super competitive and maybe on the asset side, it's just going to be more difficult to generate the increases in spread that maybe you've been able to in 2017 and 2018?
You're teasing me, Brad. You're taunting me to answer this off the top of my head as I did a few quarters ago when I got in trouble with Julie. I want to crow a little bit. I was pretty close on that estimate.
Yes.
Next year, I'm going to do this again, which I should learn from my mistakes. Next year, I do believe we'll have expansion. It'll be modestly less than what we saw this year. I just don't see things changing quickly enough on the conversion of DDA to interest bearing. I don't see the new verticals coming on fast enough to make a big difference on that other than slowing it some in 2019. I think that'll begin to change in 2020 as they mature and we have more experience with those new verticals and hopefully lower betas and lower costs there. In the near term through 2019, my best guess is we'll still see expansion, but it'll be more modest.
Which is pretty consistent with what we said from the beginning, that for each move, we would get just a little bit less.
Right. Just to follow up on the warehouse, I heard you say in answering one of the other questions, it should flatten out, maybe go down a bit in the fourth quarter. With each move in LIBOR, do you think you're going to have enough pricing power there to increase it as you move through 2019 like you did this year? What does your crystal ball say kind of on that environment?
The next couple of quarters, I don't think we will. I think we'll end up passing through most all of that benefit on LIBOR to the clients. It's just a highly competitive environment. The good news is I don't see us having to move our index down much over LIBOR, as we've had to do to a degree, relationship profitability base. Still, the last couple of quarters, we've had to do that more than I think we will going forward. I think we're still a couple of quarters away, Brad, from us being able to actually benefit on increases in rate on our warehouse yields.
Very helpful, Keith. Thank you.
You're welcome.
The next question comes from Brock Vander Leest with UBS. Please go ahead.
Good afternoon. Shockingly, I think virtually all my questions have been answered. Let's see. Something you remarked on in your opening remarks in terms of changing the incentives on deposit growth or looking at them. What have you been considering or been implementing there that could be a needle mover going forward?
Since inception, we've always tweaked RM incentives as we needed to. That's what we've done this year, is just tweaked it a little bit more to incent more deposit growth. Still incenting loan growth, but a portion of it is more focused on deposit growth.
What's largely driving that, Brock, is not just the importance of getting our funding improved overall on diversifying the funding, getting the costs in a better position. It's also our focus on growing loans very deliberately, well above average quality on any new loans we're doing. It all made sense for us to make that mid-year shift for our RM incentives.
In terms of that quality focus now, regarding the CRE pay downs, is this kind of a natural progression of a construction loan that goes to permanent financing elsewhere, or is this credits that have a balloon payment or whatnot, and you just don't want to keep in the bank?
No, we don't really do much term real estate. We've not been comfortable, really, Brock, with the low cap rates and high valuations in the market to loan 75%, 80% against those values. This is the normal C and D. The project's completed, rather than get to the more typical, three or four years ago, additional year or so for lease up after the project's done. These are just paying off very early, like shortly after completion and certificate of occupancy. There continues to be an extremely strong appetite for REITs and other financiers, including insurance companies, to do those term financings. That's happening at a faster pace than we experienced even two years ago.
Okay. Great. Thank you.
You're welcome.
Okay, the next question comes from Casey Haire with Jefferies. Please go ahead.
Thanks. Good afternoon, guys. One more on the mortgage warehouse. Just help me out with the strategy of continuing, in your words, Keith, to significantly scale this business, because it sounds to me like the incremental margin is 2% on it. I understand that it comes with deposits and the credit quality is strong, but, I mean, with your margin today at 370, growing this line is going to be extremely dilutive to margin. I'm not understanding why this is going to continue to be a point of emphasis for growth going forward.
One of the keys is we don't telegraph, for competitive reasons, what we have in DDAs and other products that we offer these folks. Some of that product and the DDAs are very meaningful contributors to overall margin. I'm sure you understand, we just can't telegraph all the details around that because our competitors would jump on it. From a scale standpoint, just to give you a little context, though, Casey, six years ago, we had 64 people handling about a half billion dollars a month in volume. Today, we have in the low 40s, handling up to $8 billion to $10 billion a month. This is before eNotes are widely adopted. We have capacity to significantly scale, even with today, how notes are handled, and that's not with as much electronic speed and efficiency.
We'll have to be able to scale it. All competitors will, as we move to more eNotes because they simply won't be on the line nearly as long. The labor cost and the speed at which we can service them will be far quicker and far lower on the labor cost if you have the technology scale potential. We've built that, so we won't have to add, again, headcount, lots of new costs, and we think that's going to help us sustain a really nice return for a wonderful credit quality asset.
Hey, Casey, a couple more points. There's no provision for loan losses that's allocated to these loans, so that certainly improves their overall returns. I guess the other point that we've said in the past that we do manage this portfolio to be 25%-30% of our loans. It's not like we're planning to grow that to an outsized amount. We've always managed that as a concentration. Quite honestly, we look at it as a better asset to invest in versus fixed rate investment securities. Works about better yield, shorter duration, but again, no credit cost, that kind of thing.
The real cost you have to incur, we think, and not every one of our competitors necessarily does this, but we think it's very prudent, is fraud risk. We lay that risk off to Lloyd's of London and have for years. Those premiums are quite competitive, and because of our great history in that regard, it's not a huge cost. It's an important risk to mitigate, we think, and we do that with Lloyd's.
Great. Thanks for the color.
You're welcome.
Okay, this concludes our question and answer session. I will turn the conference back over to President and CEO, Keith Cargill, for any closing remarks.
We thank you each for your interest and your time. We are optimistic about what we have underway. We have many strategic initiatives that we've kept you apprised of over the course of the year, and we're locked on to execution, and we're very excited about what the results are going to produce for all of us over the next few quarters. Again, thank you for your interest in our company, and good night.
Thank you for your participation in TCBI's third quarter 2018 earnings conference call. Please direct any requests for follow-up questions to Heather Worley at heather.worley@texascapitalbank.com. You may now disconnect.