Heritage Financial Corp (HFWA) 2021 Q4 法說會逐字稿

Hello, good morning. (Operator Instructions) And today's call is being recorded.

I'd now like to hand the conference over to the first speaker today, Jeff Deuel, CEO of Heritage Financial Corporation. Please go ahead. Thank you very much.

Thank you, Gemma. Hello, everybody. Sorry for the late start. We had a little confusion in some cases around the access code. Hopefully, you didn't have too much trouble getting on the call.

I'd like to welcome you all to our fourth quarter and full year 2021 performance update. Attending with me are Don Hinson, our CFO; Bryan McDonald, our President and Chief Operating Officer; and Tony Chalfant, our Chief Credit Officer.

Our earnings release went out this morning premarket. And hopefully, you have had an opportunity to review it prior to the call. We also posted an updated fourth quarter investor presentation on the Investor Relations portion of our website, which can be found at heritagebanknw.com. We will reference the presentation during this call. Please refer to the forward-looking statements in the press release.

We're pleased with our financial performance for the fourth quarter. While loan growth ex PPP was muted by quarter -- this quarter by payoffs, prepays and lower line utilization, we're pleased with the very positive trend we see in the number of new commitments. We are getting our fair share of new deals. And a good portion of the new transactions are coming from proactive outbound calling efforts, customer referrals and PPP recipients.

We continue to see deposits growing for the same reasons with very limited runoff from our branch consolidations in 2021. The pipeline is strong, and we expect it to continue to grow through the year. We maintained our focus on carefully managing expenses with good success as evidenced in the noninterest expense number. NIE is essentially flat year-over-year, and we expect NIE to stay relatively flat at about $37 million to $38 million per quarter through 2022.

Additionally, we have continued our focus on reducing our real estate footprint, and we wrapped up the year by completing the sale leaseback of our headquarters campus in Olympia, which closed at the end of the year.

Notably, our long-standing focus on credit quality and actively managing our loan portfolio continues to play out well for us as the pandemic recedes. Staying focused on our moderate risk profile has enabled us to continue to report improving credit trends throughout '21 and also recapture a significant portion of the reserve build from 2020. It's very exciting at this point to be facing a much more positive business environment for organic growth opportunities and potential M&A as we move through the new year.

We will now move to Don, who will take a few minutes to cover our financial results.

Thank you, Jeff. As Jeff mentioned, overall financial performance was very positive in Q4, and I'll be reviewing some of the main drivers of our performance. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the third quarter of 2021.

Starting with net interest income, there is a decrease of $3.5 million due mostly to a decrease of $3.1 million in income from PPP loans. Partially offsetting this was an increase in income from investment securities. This increase was due mostly to an increase in average investment balances of $119 million or 11% from the prior quarter. We have been and expect to continue to be very active in investment purchases due to our large overnight cash position.

The net interest margin decreased due mostly to the declining impact of PPP as well as lower core loan yields. In addition, overnight interest-earning deposits increased to 25% of average earning assets compared to 22% in the prior quarter. These overnight deposits, in addition to floating rate loans and investments, results in a balance sheet position to take advantage of a rising rate environment. Trends in the composition of average earning assets as well as asset repricing information are shown on Page 30 of the investor presentation.

Removing the impact of discount accretion and PPP loans, the yield on loans decreased 11 basis points as new loans in Q4 were being originated at rates lower than the current portfolio. Bryan will discuss low production and balances in a few minutes.

We had another strong quarter in deposit growth. Deposits grew $166 million or 2.7% in Q4 and grew $783 million or 14% for the year. When adding the growth for 2020, deposits have grown $1.8 billion or 39% over the last 2 years. During the same time, we have decreased our cost of deposits to 9 basis points, as shown on Page 27 of the investor presentation.

All of our regulatory capital ratios remain strongly above well-capitalized thresholds, and our liquidity position continues to increase. The combination of strong liquidity and capital gives us tremendous flexibility as we continue to grow the bank. You can refer to Page 32 of the investor presentation for more specifics on capital and liquidity.

Noninterest income increased $1.6 million from the prior quarter due primarily to an increase in the gain on sale of other assets. As Jeff mentioned, we completed the sale leaseback of our headquarters building in Olympia, and we recognized a $2.7 million gain as a result.

We continue to see nice improvement in our overhead ratio due to a combination of expense management measures and asset growth. Our overhead ratio decreased to 2.06% compared to 2.30% in Q4 of 2020. Noninterest expense increased from the prior quarter due mostly to elevated costs related to severance payments and a quarter-over-quarter increase in incentive compensation accruals. These 2 expense items accounted for approximately $1.2 million in Q4, $500,000 due to severance payments and about $700,000 due to increased incentive compensation accruals.

Even with these elevated Q4 expenses, total noninterest expense for the year 2021 increased only 0.2% over 2020 levels. In addition, through our initiatives over the past 2 years, we have decreased FTE by 12% from Q4 2019 levels. Our efficiency initiatives will continue to benefit us in 2022 and beyond.

As occurred throughout 2021, a significant impact to our earnings for Q4 was a reversal of provision for credit losses in the amount of $5 million. Factors for the provision reversal included a decrease in nonaccrual loans; a continued improved economic outlook; changes in the loan mix, most notably decreases in C&I and construction loan balances; and improvement in overall credit quality metrics.

I will now pass the call to Tony, who will have an update on these credit quality metrics.

Thank you, Don. Consistent with what we experienced last quarter, we're pleased to report continued improvement in our credit quality for the fourth quarter. At year-end, our key credit quality metrics reflected significant improvement over year-end 2020.

For the fourth quarter, nonaccrual loans declined by $2.1 million or 8% from the prior quarter. Nonaccrual loans are now down 59% from our December 31, 2020, levels. As of year-end, nonaccrual loans totaled $23.8 million or 0.62% of total loans.

The significant year-over-year improvement was due to 3 primary factors. First, we had a number of significant paydowns or payoffs on loans that were the result of successful long-term workout strategies. Generally, these loans were not COVID impacted, and the problems have begun well before the start of the pandemic.

Second, there were very few loans placed on nonaccrual status during the year. Loans placed on nonaccrual in 2021 totaled just $1.5 million. The average yearly additions to nonaccrual status in 2018 and 2019 was just over $25 million.

As a third factor, there was one significant and a few smaller COVID-impacted borrowers that were placed on nonaccrual status in 2020. Their improved performance in 2021 allowed us to move them back to accrual status during the year.

Criticized loans, those risk-weighted special mention and substandard, declined by approximately 16% or $34 million since the end of the third quarter. Over the last 12 months, criticized loans have dropped by $107 million or almost 37%. We're getting close to a level that we consider normal in a good economy. As of year-end, criticized loans were $41 million higher than December 31, 2019, or what we consider to be at pre-pandemic level.

The lingering COVID impact on our hotel portfolio is the largest contributor to this remaining elevated level. Within this portfolio, we have approximately $66 million of criticized loans. While the underlying properties continue to demonstrate improving cash flow, they're not yet at a level of performance that warrants a return to a pass rating. With the expected continued improvement in the travel industry in 2022, we should be able to upgrade many of these loans in the second half of the year.

There's a new slide in our investor presentation that shows the trends in our criticized loan levels, and that slide is on Page 25. During the fourth quarter, we experienced net charge-offs of $466,000. Total charge-offs were $679,000 and were partially offset by $213,000 in recoveries, spread between our commercial and consumer portfolios.

For the year, we experienced $526,000 in net charge-offs. This represents a very low 0.01% of average loans. As a comparison, average annual net charge-offs for the 3-year period 2018 through 2020 was approximately $2.9 million.

Despite some remaining COVID headwinds, including the related supply chain and labor shortage issues, the economies of both Washington and Oregon performed very well in 2021. With our strong credit culture, we expect our loan quality to outperform in a challenging economy. We were very pleased to see this reflected in our strong credit quality metrics at year-end. Heritage Bank is very well positioned as we move into 2022.

I'll now turn the call over to Bryan, who will give us an update on loan production.

Thanks, Tony. I'm going to provide detail on our fourth quarter loan production results, starting with our commercial lending group. For the quarter, our commercial teams closed $329 million in new loan commitments, up from $271 million last quarter and up from $164 million closed in the fourth quarter of 2020. Please refer to Page 18 in the Q4 investor presentation for additional detail on new originated loans over the past 5 quarters.

The commercial loan pipeline ended the fourth quarter at $462 million, down from $547 million last quarter and up from $413 million at the end of the fourth quarter of 2020. We have been seeing an increase in new loan requests from customers and prospects since July of 2021 when the governors of Washington and Oregon lifted many of the pandemic restrictions. And we are seeing this trend continue into the first quarter of 2022.

Loans, excluding SBA PPP, declined $17 million during the fourth quarter. The decline was due to the higher loan production during the quarter being offset by increased prepays, payoffs and a higher percentage of the new loan volume during the quarter being unfunded construction commitments. Specifically, outstanding construction loan balances decreased $69 million, while unfunded construction loan commitments increased $98 million during the fourth quarter. Please refer to Slide 19 in the investor presentation for additional details on the utilization rate of construction loans, which shows a decline from the high 50% range down to 42% at the end of the fourth quarter.

As these new construction loans begin to fund in 2022, we will see the utilization rate approach historical averages and recapture the balance declines that occurred in the fourth quarter. Consumer loan production, the majority of which are home equity lines of credit, was $23 million for the fourth quarter, down from $30 million last quarter and up from $18 million in the fourth quarter of 2020.

As a reminder, we discontinued our indirect consumer lending business in the fourth quarter of 2020. And the balances continue to run off, including an $18 million decline in the fourth quarter.

Moving to interest rates. Our average fourth quarter interest rate for new commercial loans was 3.71%, which is up 20 basis points from 3.51% last quarter. In addition, the average fourth quarter rate for all new loans was 3.48%, up 6 basis points from 3.42% last quarter.

The mortgage department closed $45 million of new loans in the fourth quarter of 2021 compared to $44 million closed in the third quarter of 2021 and $57 million in the fourth quarter of 2020. The mortgage pipeline ended the quarter at $29 million versus $55 million in the third quarter and $33 million in the fourth quarter of 2020.

Refinances made up 80% of the pipeline at quarter end. With interest rates rising, we anticipate refinance volumes will decrease and overall mortgage volume will be lower in 2022.

Moving on to SBA PPP forgiveness. The process continues to progress smoothly. As shown on Slide 22 of the Q4 investor presentation, of the original $1.3 billion in PPP loans originated, at quarter end, we had only 11% of the original PPP balances still outstanding at $146 million. In addition, to the limited extent we have filed claims with the SBA, these have been processed and paid very quickly.

I will now turn the call back to Jeff.

Thank you, Bryan. As mentioned earlier, we're pleased with our performance as we emerge from the pandemic. We're seeing a nice upswing in organic production across the bank with deals coming from existing customers and new high-quality prospects.

We are prepared for high single-digit growth. And we're optimistic we will get back to that level of historical loan production as the year progresses. We believe that there are opportunities to add talent to the team, new customers to the book as a result of dislocation in our markets. However, we don't expect to see that dislocation begin to materialize til later in the year.

We rationalized our expense base last year, and we will continue to focus on expense control in '22. We have also continued to focus on our technology strategy, which is designed to support more efficient operations, a more consistent customer experience and positions us well to pivot as bank technology continues to evolve, and we continue to grow.

For reference, on Page 7 of the investor deck, we have included a new overview slide of our technology strategy. And you will see that several segments of that strategy went into production last year with more segments coming online in '22 and beyond. We are prepared to pursue acquisitions in the 3-state area when we see the right deals for us.

As Don mentioned earlier, our capital levels and our robust liquidity provides us with a strong foundation to address challenges and take advantage of opportunities. That's the conclusion of our prepared comments. So Gemma, we're ready to open up the call to any questions that folks on the call might have.

(Operator Instructions) We've had our first question in from Jeff Rulis of -- sorry, that question has now been moved. Sorry, Jeff Rulis from D.A. Davidson, you're line is now open.

Question on -- maybe for Jeff. I think you outlined the loan puts and takes pretty well. I guess as we enter '22 with less auto runoff, your construction line of credit expected to increase. You've got demand in originations picking up. I guess you mentioned your high single-digit loan expectation. I guess just the big piece is the payoffs, which you've done a little [sneak bid], and some of that positive in terms of the credit side.

But could you engage with that a little bit more, Jeff, in terms of if you think the payoffs are somewhat lumpy and maybe higher rates minimizes that? Any thoughts on the net growth in '22?

I'm sure Bryan has some comments that he'd probably like to add. But Jeff, it actually has been pretty lumpy, and it's a little bit of a hard thing for us to forecast. And part of it ties back to the robust environment we're in with the customers being able to sell properties, businesses at rather high prices. It's hard to turn that down when it presents itself.

The one thing I will tell you, though, is when we see the payoffs occurring, we're also seeing that money or those loans coming back to us in another form as they reinvest in another business or another building. So I think we're probably going to be facing prepayments as we have for the past couple of years. It's just hard to know what quarter they're going to be up and what quarter they may be down.

I think the more important thing for us is to keep the origination team focused on developing all of those new prospects to help offset the net impact of those payoffs. Bryan, anything you want to add?

Just Jeff, just picking up on your last point, Q3, Q4, if you look at Page 18 in the investor deck, we did $600 million of new production after the governors eased the restrictions and $100 million a month or a little bit more, Jeff, with the prepays we're seeing now is really the target. So we'd love to get the pipeline up a little higher than where it ended the quarter.

But the deal flow that we're seeing right now is strong. We're seeing good -- we've seen good deal flow since July, and that's continuing. So getting that $100 million or maybe $110 million a month in new production with maybe a bit more normalized funding mix in there, we're pretty close at least looking at the results for the second half of the year and what we're seeing so far this quarter.

The prepays, payoffs, as Jeff said, we're in a strong market, and customers are selling businesses and selling real estate. And we would expect that that's going to continue based on how strong the economy is here in the Northwest.

But we're not far off on the gross production numbers, at least looking at the last couple of quarters. We'd like to get the pipeline up a little higher based on that elevated payoff volume we saw as we went through the year last year.

Jeff, I would add, and you're familiar with the region we're in, but we've been pretty much buttoned down here in our 2-state area longer than a lot of other parts of the country. And none of us are experienced in predicting how we come out of a pandemic in any form.

But what we are facing, too, which makes it hard to predict is we still have customers and prospects that are essentially locked down where they're not making contact in person with anybody. So we still got a little bit of that factor to deal with and sort out. And that also makes it difficult to predict.

Yes. Appreciate it. Maybe just checking in on the expense line. Don, I think you itemized about $1.2 million in sort of severance and increased incentives. I mean, maybe some of that sort of recur, maybe not the severance but in the incentives. I guess that would -- well, if you back that out, you get into the low $37 million range. And just wanted to kind of see that's -- if you're $37 million, $38 million for the run rate of '22, am I thinking about that right? If the rate backs down, then you just kind of hold expenses from there?

Well, I think it always grows a little bit during the year. People raises -- there's going to be, I think, wage -- some wage pressure this year. But overall, I think you're right that if you back out the $1.2 million from Q4, you're kind of back down in a decent run rate starting in Q1.

But that's why we say between $37 million and $38 million for the year because there, obviously, could be some growth in expenses throughout the year. But for Q1, that's where our run rate should be.

Jeff, we've got a little bit of an interesting dynamic with that incentive piece from the standpoint that the programs benefiting from the recapture of the reserve, which is earnings we created in '20 but really didn't see it present until '21. So there's a bit of a timing difference there, and there's also a bit of a timing difference with regard to how those new commitments play out.

Incentives get paid on commitments when they close, and we're going to see the funding probably in the first part of the year. So there's a little timing difference there. And I think that that's just the impact of how we're coming back as an economy and timing. And I think that will also contribute to settling down a bit as Don said.

Got it. That's helpful. Maybe a little bit of a lag and some leverage in the model.

Our next question comes in from David Feaster of Raymond James.

I just want to follow back up on the growth outlook. I guess kind of thinking about the high single-digit growth run rate, I guess we have 2 avenues to get there, right? We either see accelerating originations or see a slowdown in payoffs and paydowns.

I guess, could you just maybe walk through some of the puts and takes with both of those? What kind of things that you guys are doing to accelerate originations and productivity?

And then on the payoffs and paydown side, I mean, just what are you seeing there? It sounds like it's more asset sales and deleveraging. But do you find that you're passing on more deals from pricing or structural reasons?

I think, Bryan, I'll ask you to tackle this, but one of the things that I would say is we have not changed our approach from a credit standpoint. We talk in terms of a moderate risk profile. And I think to a certain degree, David, that's kind of self-limiting.

That's why you hear us typically say that our loan production that we're striving for is maybe something less than double digit because we think part of the impact is the parameters with which we operate in cause a certain limit. But no, I don't think that we're overextending or going beyond our normal parameters.

Bryan, maybe you could give some color around expectations with regard to volume and maybe some anecdotal stories about what we're seeing with the prepays.

Yes. And I think, David, Page 20 of the investor presentation is a good reference point just on what's going on within the portfolio. So in Q4, we originated $329 million, but the outstandings on that $329 million was $222 million so $107 million of it unfunded. If you look back to Q3, it was 100 -- it was $271 million originated and $195 million, so about $76 million unfunded.

And then if you look at the prepays and payoffs during Q3, there was $185 million of prepays and payoffs just over $60 million a month. But we had a little bit of an increase in net utilization, $21 million actually in Q3.

And if you look at Q4, we had even more in payoffs. Rather than $185 million, it went to $204 million. And then actually, we had a drop in utilization and payments of $38 million. So if you look at just the impact of the payoffs, prepays, paydowns and the change in the utilization, it was a big swing quarter-over-quarter.

The negative in Q3 was $164 million, and the negative in Q4 was $242 million. So you had a pretty big swing there on the prepaid payoff and what we'll call kind of that utilization side. A lot of that difference will come back because a lot of it was in those -- in the swing in construction commitments. So I think Q3 is a better indicator, and we're hoping we're kind of at that lowest level for utilization drops.

Just on our lines, we saw them go down about $11 million in Q4. Hopefully, we're at a bottom there. And at least, maybe it won't be -- maybe we won't see a big uptick in 2022. But hopefully, we won't see the drag.

If you go to -- in terms of the mix, we're still seeing more new customers come across with lots of deposit balances, some amount of term debt either on an owner-occupied real estate or equipment. And typically often, more often than not, a 0 balance on the line. And so a lot of the new opportunities in the market are construction, either owner or nonowner occupied. And that's where you saw the dollars being added in the quarter.

It's hard to predict exactly when we'll see that utilization rate tick up or just more what we'll call kind of core C&I request. But we are getting those in from the customers on a regular -- more regular basis than we were certainly this time last year.

So I think it's -- I think, again, if you look at the total production, $600 million for the last half of the year, $100 million a month average. That's a pretty good number, a little higher than that. But certainly, as the balance on the funding mix changes to something more normal, that's a pretty good number.

The market is competitive. Everybody is out there trying to get loans like we are, but we're certainly winning our fair share out in the marketplace.

Okay. That's helpful color. And then just maybe switching gears to the margin. Could you maybe just give us some thoughts on how you think about deploying excess liquidity? We're sitting at north of 23% of total assets are cash. I mean, is there an increased appetite to start deploying that into securities?

Obviously, loan growth is a top priority. And then just kind of as we see the loan growth accelerate in the earning asset mix, do you think we've troughed here? And then just any color on your rate sensitivity and how you'd expect the margin to react in the first couple of hikes?

Okay. Well, you have a...

It's a lot.

Yes. Yes. So let's start with the investments. We did purchase about $268 million in Q4, which is higher than usual. And we'll continue that, if not even more like going forward, at least until we start seeing some of the cash balances. Obviously, when the rate is higher, that's going to benefit us that much more. So we do need to -- if we don't have it in the loan growth, which we are planning on it, even so, we were sitting on $1.6 billion of cash, we are going to put more into investments.

The -- as far as the NIM itself, I think that we will probably see the bottom hit in Q1. Because of the PPP, I think that it's still going to have a decline in balances. It's still going to have kind of a material impact to our margin. But I think that we'll start seeing the margins then start increasing later in the year. And of course, we start getting rates -- rate increases depending on what they are. I think that will help.

With having 38% of our interest-earning assets in basically floating rate, if you can see that on Page 30 of our investor presentation, it has a pretty material impact. If everything shifted up 25 basis points, that's about 9 bps to the NIM. So that's a big impact. So I think that's going to help us out quite a bit.

Okay. That's helpful color.

Do you have a follow-up on that?

No, no. You unpacked it all. It was a doozy. And then I appreciate the tech slide. Could you maybe just walk us through a bit of your tech strategy and kind of how you think about investments, what's on the docket? And then just -- we've got some of these initiatives that were implemented this year. Maybe help us think about some of the benefits in terms of either efficiency or productivity from some of these tech initiatives.

Sure. I think it's important to outline that the overarching premise of the plan is to integrate process and technologies to create that omnichannel customer experience. We think that's what our customers want and what they'll expect from us in the future.

And as we continue to grow the bank, we also wanted to make sure we can lose the community bank identity that we have because we believe that's what differentiates us from the big bank competition and the fintechs. The notion of preserving the community bank feel of Heritage is something we refer to as community banking at scale, which you see under the line on that slide.

But what we -- now some people have asked us, why are you building instead of buying? And we did look at several brand-name vendors for a solution, but we couldn't find exactly what we thought we needed to be successful. And we also wanted a certain amount of control over what we built.

So we also didn't want a platform that just monitored production and was a place to put information. We wanted a platform to be a place to go for information and a place to go to get things done, essentially a fulfillment engine. We call it a hub for relationship management and also, as importantly, service delivery.

So we developed this tech platform, which we hope and believe will become a primary resource for everybody on the team, whether you're on the production side or the support side. And our goal or our expectation is that it becomes the second place employees go to in the morning after they sign on to Outlook.

So if you look at the slide, it's all centered. You can see in that one box. Heritage360 is essentially the center point for everything. That's where you go to get information first and foremost and to service accounts. It's a place that no matter where you come to us, you can see over on the left side, those are the methods that our customers come in contact with us, but we're going to end up using that, the Heritage360 platform, to essentially service them, whether they start with online banking, get confused on setting up an account and they need to talk to somebody and calls come through the call center or whether they come to their relationship manager.

So we have developed a technology ecosystem with HeritageONE, which is what we call that ecosystem. And it allows us, from a proprietary standpoint, to create our own platform where we can develop process -- processes internally, but we can also tie ourselves through APIs to the vendors that we decide that we're going to use.

So as you look at this diagram, Heritage360, you've got the service engine, which is up in the right-hand corner. That's how we get things done. And then there's the sales pipeline where we're going to -- where we've tied our online account opening to that, for example. The Treasury Management 360, which is in the process of being launched now, is as much about service as it is about helping new customers get set up on treasury management products in a seamless fashion.

And you can see over on the right side the progression that we've gone through with getting that customer service engine up first, which we also have referred to as a CRM. And then the commercial loan origination system is in place now and being used across the bank and treasury management is being launched.

David, to get back to the other part of your question, eventually, as we implement all of these things, the savings will come in the form of how many times we have to touch a loan to originate it, how many people have to be involved in the closing process, allowing our service folks on the front line to not have to go to 7 different locations to get enough information to answer the question of the customer. It's all in one place.

So that's where we come to the efficiency and the better customer service experience. And we believe that tied -- tying that streamlined experience from a digital standpoint to the people who are interacting with our customers and prospects is a winning combination that will allow us to continue to present ourselves as a community bank regardless of how big we get. Hopefully, that wasn't too much information, and hopefully, it was clear enough.

Yes. No, that was great color.

And our next question comes in from Kelly Motta of KBW.

Just with that data processing line, it did jump up about $700,000. Was there -- is that a good run rate for that line item? Did that jump up? Or should that come back down more to the $4 million it had been running at prior to 4Q?

I'm going to let Don answer that specific question, Kelly. But wanted to also make a point that we started this build 3 years ago. So a lot of the cost of it has been in our expense base for a while now. Don, I don't know if there's some specific color on that increase that you could share to answer Kelly's question.

Sure. Part of that was due to some implementation fees, and the other part was just due to increased cost because of our investments in technology. So I would say it's probably about half and half.

Got it. Did something...

But some of it is going to be in the (inaudible)

Understood. And...

And Kelly, I would expect -- I'm sorry to interrupt you. I just wanted to add that we -- no, I just wanted to add to what Don said that we're in the process of doing some analysis around a look back around what it would have cost us to use a third party and what it has cost us to do this on our own.

And early-stage feedback is it's kind of about the same. So we're -- maybe if that proves to be true when we do the final analysis, I think we're going to be happy we took the path that we did because we have complete control, and we're getting exactly what we want.

Got it. Understood. I did want to switch to the buyback. It looks like your repurchases came down quarter-on-quarter. Just where your stock is and also given on the flip side that it seems like you're pretty confident about production volumes, how are you viewing the buyback as we enter 2022 and the relative attractiveness of the stock at these levels versus other avenues of capital returns?

Yes, we are hoping to, again, grow our loan portfolio quite a bit this year. So we're not anxious to buy back a lot of it. The price dropped to a level where it was very attractive. And we've mentioned that our earn-back on buybacks is probably within 5 years.

So when it hit that level, we did dabble a little bit last quarter, but it wasn't a lot. If that happens again, we may if it -- if the price gets down that low. But it's not really our first choice of capital deployment. We are just hoping to grow into it over time.

Got it. And then maybe just last nitpicking question on loan sales. Those were down a lot, and I know that the refi volume's drying up. Mortgage is going to come in substantially. Is this a good -- that $0.5 million, is that a good run rate on a go-forward basis with some seasonality in there? Or just trying to get my model buttoned up on these.

Jeff, you want me to take that one?

Yes, that would be great, Bryan. Thanks.

Yes, Kelly, we -- the volumes were actually really strong in the quarter, but we ended up with a significantly higher percentage of portfolio, just volume into the portfolio, either construction or jumbos. And I think we'll see that in Q1. A little hard to tell the rest of the year if it maybe doesn't normalize to a more even mix with secondary market sales.

It was really different in the fourth quarter than what we normally see, but again a little hard to predict going into next year. Also, just volumes in general, right, will the Q4 volumes in general hold up. So my guess is we'll end up with a higher ratio of secondary market sales than what we saw in Q4, but overall volume is down somewhat from 2021.

The next question on the line comes from Andrew Terrell of Stephens Inc.

Jeff, maybe just to start. I think last quarter, you mentioned that some of the recent M&A announcements in your footprint could potentially be a catalyst for more conversations for Heritage moving into 2022. I guess a question, have you seen that kind of materialize yet? And then just more broadly, can you just talk to us about your expectations for M&A potential in 2022?

Yes. As we've mentioned before, we spend a bit of time making sure that we stay acquainted with and stay close to the banks that are interesting to us in the region. And those conversations continue. I don't feel that there's anything that's imminent right now, Andrew, but I would not also be surprised if something presented itself during the year.

So we stand poised to move forward when the opportunities present. And we are going to -- like I said in my comments, we're going to pursue the ones that -- the deals that make good sense for us and follow the same parameters we have in the past.

The disruption around us is a little too early for us to see any benefit from it. There's obviously a number of banks combining that touch our region. There is the combination of Columbia and Umpqua, which is right in the heart of where we sit.

I think it will -- if there is disruption in the form of talent or potential customers, I think it will be closer to the end of the year. And I think what will trigger most of that will be leading up to a conversion, which I understand is not slated for -- it is slated for first quarter of next year.

So there's a many month lead with customer communication in a situation like that. And it may present some opportunities at that time. So I'd say in the summer and towards the end of the year is when -- if there's going to be opportunities, that's when I think we'll see most of them present.

Okay. That's very helpful. I appreciate it. And then maybe, Don, can you help us out with kind of tax rate heading into 2022? And should it follow kind of a similar trajectory as it did kind of walking throughout 2021?

Sure. It increased a little bit in Q4 as a result of some reversal of provisioning. So that impacted that quite a bit. I think it's going to be probably more in the 17% to 18% range heading into next year.

Matthew Clark of Piper Sandler, you have the next question.

Maybe just starting with -- on the rate sensitivity, Don, you had mentioned every 25 basis points, you get a 9 basis point benefit to the NIM. Was that just kind of using the kind of 30-plus percent that reprices within 3 months? Or is there more to it? And I guess what I'm trying to get at is, were you assuming some sort of deposit beta with that estimate or not?

No, it was just -- again, I'm not -- I don't think that the first rate -- a couple of rate increases we're going to see much in this -- for deposit rates. They're low. Some even CDs are still repricing a little bit down, although it's not materially -- material to the cost of deposits.

But looking at that, again, that 38% of interest-earning assets that's floating, we only have -- almost everything is off the floors. We only have like $45 million of loans that are below the floors, and we only have $25 million of liabilities that are -- that we price according to indices. So that's what I'm getting at.

Okay. And then just on the reserve at 1.15% ex PPP, I think your day 1 was 1.01%. I think pre-pandemic or pre-CECL, you guys were back in '18 in the mid- to high 90s. What's your sense for where that coverage ratio could stabilize? I know you still have some marks left, but kind of X marks.

Don, you want to take that?

The allowance percentage? I'm sorry. Yes, I think for the allowance percentage, I think, again, if we don't end up having losses and we get through the rest of this and get through variance, that then -- and we feel like there's less uncertainty, then we'll probably be back down and maybe even below where we were before because if you think about it, if you -- it's based off -- the models are all based off history of losses. And if you keep having for -- more periods without losses than your model says, well, you shouldn't have less.

So I can certainly see gaining down there. How long it will take to get down there will be just dependent on the losses we may take and the economic growth and potential uncertainty depending on what's going on.

Our final question on the line comes from Tim Coffey of Janney Montgomery Scott.

The -- in the kind of overhead expense ratio, that's been trending down nicely. What sort of likelihood you get under -- or the timing, rather, of getting under 2% on assets? Is that a 2023 event? And is it -- or is it kind of unknown given what's happening with kind of wage inflation right now?

I'm going to ask Don to grab that.

I think we kind of talked about the expense levels themselves. So for the overhead ratio to get below 2%, we're going to need to see probably continued strong asset growth. And that's a little uncertain right now because we've seen such strong deposit growth over the last couple of years.

And we keep expecting to see some outflow of deposits. And we may see some of that this year. And if that happens, of course, that impacts assets, which impacts the overhead ratio.

So I think it -- I'm still thinking we're going to be around 2%, maybe a little above over the next year or 2. And that's my best forecast right now because of the -- of what I mentioned about the asset growth not being as strong.

Sure. Sure. But some of the production -- loan production in the last 2 quarters was good. Yes, I'm sorry.

So again, it's the deposit growth that really drives the asset growth, right? It's just -- your loan growth is just taking cash and putting it in loans. So that's why I'm saying that it really depends on our deposit growth. That's what's going to drive that.

Okay. Understood. And that has, I guess, been slowing last couple of quarters. It wasn't as big as 1Q.

And then, Bryan, I mean, forecasting prepayments is always a bit challenging. But given that we're about to go into a higher rate cycle, do you think there could be a rush of prepayments ahead of that?

No, it's really mostly being driven by asset sales and values are still either business sales or sale of the underlying collateral. And the market is still really strong. And if you look over the whole year, all of 2021, we just -- we saw it move up every quarter.

We're back up to levels that we were at kind of pre-pandemic when the market, of course, was also very strong. So a couple of hundred million of payoffs and prepays per quarter wouldn't be unexpected even with rates rising unless you saw some softness in the economy. But right now, a lot of interest in the Northwest in whether it be real estate or companies.

And the other side of it has been the utilization rate, which, again, last quarter, net advances and payments was down $38 million. So even if that -- just say that stabilized at 0 or maybe moved up a little bit, that would help us quite a bit, which I'm feeling like we've gone to a pretty low level. Hopefully, we're at the bottom on that, and at least it's not a drag in future quarters.

We have no further questions on the line, so I'll hand back to the team.

Thanks, Gemma. If there's no more questions, then we'll wrap up the quarter's call. We thank you for your time and your support and your interest in the ongoing performance of Heritage Financial. We look forward to seeing and talking with many of you in the coming weeks. And we'll sign off now. Thank you.

Thank you very much for joining us today. You may now disconnect your lines. Have a good afternoon.