HomeStreet Inc (HMST) 2016 Q2 法說會逐字稿

Good afternoon and welcome to the HomeStreet, Inc. second-quarter 2016 earnings conference call.

(Operator Instructions)

Please note this event is being recorded. I would now like to turn the conference over to Mark Mason, President, and Chief Executive Officer. Please go ahead.

Hello, and thank you for joining us for our second-quarter 2016 earnings call. Before we begin, I would like to remind you that our earnings release was furnished yesterday to the SEC on Form 8-K and is available on our website at IR.HomeStreet.com. In addition, a recording of this call will be available today at the same address.

On today's call, we will make some forward-looking statements. Any statement that isn't a description of historical fact is probably forward-looking and is subject to many risks and uncertainties.

Our actual performance may fall short of our expectations or we may take actions different from those we currently anticipate. Those factors include conditions affecting the mortgage markets, such as changes in interest rates that affect the demand for our mortgages, the actions of our regulators, our ability to meet our internal operating targets and forecasts, and economic conditions that affect our net interest margins.

Other factors that may cause actual results to differ from our expectations or that may cause us to deviate from our current plans are detailed on our SEC filings, including our quarterly reports on Form 10-Q and our annual report on Form 10-K for 2015, as well as our various other SEC reports.

Additionally, information on any non-GAAP financial measures referenced in today's call, including a reconciliation of those measures to GAAP measures, may be found in our SEC filings and in the earnings release available on our website. Please refer to our earnings release for a more detailed discussion of our financial condition and results of operations.

Joining me today is our Senior Executive Vice-President and Chief Financial Officer, Melba Bartels. In just a moment, Melba will present our financial results, but, first, I'd like to give a brief update on recent events and review our progress in executing our business strategy.

During the quarter, we announced the acquisition of certain assets, deposits in two branches from the Bank of Oswego located in Lake Oswego, Oregon on the [Pulitz] suburb in Portland, Oregon. We expect to acquire approximately $40 million of loans, $50 million of deposits and two branch locations.

These branches will increase our retail branch count in the Portland, Oregon metro area to five. We expect to close this acquisition next month and we look forward to welcoming our new customers and employees. We are excited by the growth opportunities in Portland as a result of the area's strong employment and population growth.

Additionally, we announced the acquisition of two branches located in Granada Hills in Burbank, California, from Boston Private Bank & Trust. The branches have approximately $110 million in deposits. And this transaction is expected to close in the fourth quarter of this year. These branches are each located near offices of our Affinity partner, Kaiser Permanente, and will increase the number of our retail branches in Southern California to 12.

During the quarter, we opened two commercial small business lending offices in Carlsbad and Santa Ana, California. We also opened three single-family home loan centers during the quarter, one in Redlands, California, and two here in Washington in Oak Harbor and Billingham.

Finally on May 20, we completed the issuance of $65 million of 6.5% senior notes due in 2026. The majority of the net proceeds of $63.5 million will be used to support our growth and will be contributed over time to the Bank as capital.

Initially we've invested the net proceeds of the offering in our securities portfolio pending future growth. This net offering has also attracted a new set of institutional investors to our Company and we welcome their confidence in us.

Before Melba reviews our financial results, I'd like to share some highlights from the quarter. Total assets grew $524 million or 10% in the quarter to $5.9 billion. Net income for the quarter, excluding merger-related items, increased 129% to $22.4 million from $9.8 million in the prior quarter.

Return on average tangible equity, excluding merger-related items, was 17.3% in the quarter. Diluted earnings per share, excluding merger-related items, increased 120% from $0.41 per share in the first quarter to $0.90 per share in the second quarter. Tangible book value per share increased from $20.37 at March 31 to $21.38 at June 30. Net income for the commercial and consumer banking segment, excluding merger-related items, totaled $7.7 million, reflecting increases in non-interest income from the seasonal increases in commercial real estate and SBA loan sales and net interest income due to growth in our loan portfolio.

Loans held for investment increased $175 million or 5% during the quarter to $3.7 billion. New portfolio loan commitments during the quarter totaled $669 million, a record level for the Company. The ratio of non-performing assets to total assets ended the quarter at 0.45%, a slight increase from the first quarter's level of 0.43%, but still reflecting excellent loan quality.

Our second-quarter mortgage banking segment net income increased to $14.7 million from $4.9 million in the first quarter, reflecting an increase in interest-rate lock and forward sale commitments, an increase in our composite margin, and an increase in our servicing income. Our mortgage origination volume and profit margins in the quarter benefited from the historically low rate environment.

Close loan volume in our single-family mortgage banking segment totaled $2.3 billion in the second quarter compared to $1.6 billion in the first quarter. Interest-rate lock and forward sale commitments of $2.4 billion in the second quarter increased from $1.8 billion in the first quarter.

I'd also like to take a quick moment to mention the recent performance of our joint venture with various owners of Windermere real estate company franchises, Windermere Mortgage Services, or WMS. We own 50% of WMS and it offers single-family home loans through 41 Windermere real estate offices in Washington and Oregon.

During the quarter, WMS earned net income of $2.4 million. The results this quarter represent a quarterly return on equity of 60% or approximately 240% annualized. As 50% owner, we will receive a $1.2 million distribution this quarter in addition to the mortgage volume with the joint venture sales to HomeStreet. The President of WMS, Erik Hand, does a great job for us there.

The cost of the recently implemented TRID requirements continue to adversely affect our results during the quarter. While our processing times for loans have normalized, we expect processing times to lengthen on refinances due to the recent drop in rates coupled with the seasonal increase in originations.

We continue to carry additional support staff to facilitate compliance with TRID. This condition will moderate as our loan origination system becomes fully compliant with the new requirements over the remainder of this year.

Now I'll turn it over to Melba who will share some additional details on our financial results for the quarter.

Thank you, Mark. Good morning, everyone. I would like to first talk about our consolidated results and then provide detail on each of our segments.

Second-quarter net income was $21.7 million, or $0.87 per diluted share, compared to $6.4 million for $0.27 per diluted share for the prior quarter. The increase in net income for the prior quarter was primarily due to a $24.4 million increase in the net gain on mortgage loan origination and sales.

Excluding after tax merger-related items, core net income for the second quarter was $22.4 million or $0.90 per diluted share compared to $9.8 million or $0.41 per diluted share in the first quarter. Merger-related expenses totaled $1 million for the quarter, primarily due to the residual expenses related to the Orange County Business Bank acquisition completed in the first quarter.

Net income for the first half of 2016 was $28.2 million or $1.15 per diluted share, compared to $22.7 million or $1.14 per diluted share for the first half of 2015. The increase period over period was primarily due to $16.2 million higher in net interest income.

Average loans held for investment grew by 35.2% from the year-ago period from $2.6 billion to $3.5 billion. Excluding after tax merger-related items, core net income for the first half of 2016 was $32.2 million or $1.32 per diluted share, compared to $26.1 million or $1.32 per diluted share for the first half of 2015. Included in non-core items for the first half of 2016 was $6.2 million of merger-related expenses compared with $15.4 million of merger-related expenses and a $6.5 million bargain purchase gain for the first half of 2015.

Net interest income was $44.5 million in the second quarter compared to $40.7 million in the first quarter. This increase was primarily due to higher interest income from growth in average interest earning assets, primarily a $277.9 million or 8.2% increase in average loans held for investment.

Our net interest margin was 3.48%, a decrease of 7 basis points from the first quarter, primarily due to an increase in the cost of interest-bearing liabilities. The impact of the senior notes issued in May contributed 4 basis points of the quarterly decline. Average interest-earning assets increased by a larger amount than average interest-bearing liability, increasing the impact of non-interest-bearing sources to 15 basis points in the second quarter from 12 basis points in the first.

Non-interest income increased $30.8 million or 42.9% from the first quarter due primarily to higher net gain on loan origination and sale activities, as well as an increase in mortgage-servicing income. Net gain on mortgage loan origination and sales activity increased $21.6 million from the prior quarter and mortgage-servicing income increased $4.6 million.

Non-interest expense was $111 million in the second quarter compared to $101.4 million in the first quarter. Excluding merger-related expenses, non-interest expense was $110 million compared $96.2 million for the first quarter, an increase of $13.9 million. The increase in core expenses was primarily due to higher commissions paid as a result of the 43.8% increase in single-family close loan volumes.

At March 31, the Bank's tier 1 leverage ratio was 10.28% and total risk base capital was 14.3%. The Consolidated Company's tier 1 leverage ratio was 9.88% and total risk-based capital ratio was 12.2%.

I would now like to share some key points from our commercial and consumer banking segment results. The commercial and consumer banking segment net income was $7.1 million in the quarter compared to $1.5 million in prior quarter. Excluding after tax net merger-related items, the segment recognized core net income of $7.7 million in the second quarter compared to $4.9 million in the first quarter. Growth in core net income was driven by improved operating efficiencies as revenue growth outpaced expense growth.

Net interest income increased from $38.4 million in the second quarter from $35.6 million in the first primarily due to the increase in loans held for investment and investment securities. Segment non-interest income increased from $4.6 million in the first quarter to $8.2 million in the second quarter due to higher net gain on sales of loans primarily from the seasonal increase in Fannie Mae DUS as well as from higher SBA loan origination and sales. Typically the first quarter of the year is the seasonal low for DUS and SBA loans originated for sale.

Segment non-interest expense was $34.1 million, a decrease of $2.5 million from the first quarter. Included in non-interest expense for the first and second quarters of 2016 were merger-related expenses of $1 million and $5.2 million, respectively. Excluding merger-related expenses from both periods, the $1.6 million increase in expense is primarily due to the Orange County Business Bank acquisition impacting the entire quarter, as well as the investment in lending offices opened during the quarter and higher expenses to support our growth.

We recorded a $1.1 million provision for credit losses in the second quarter of 2016 compared to a provision of $1.4 million recorded in the first quarter in 2016, reflecting the continued growth in the balance of loans held for investment, offset somewhat by $478,000 of recoveries during the quarter. The portfolio of loans held for investment growth increased 5% or $175 million to $3.7 billion in the second quarter. New loan commitments totaled $669.1 million and originations totaled $439.9 million during the quarter.

Credit quality remains strong with non-performing assets at 0.45% of total assets at June 30 and non-accrual loans at 0.42% of total loans. Non-performing assets were $26.4 million at quarter end compared to non-performing assets of $23.3 million at March 31. This increase was primarily due to an increase in single-family, other real estate owned.

We continue to enjoy positive charge-off experience of net recoveries of $478,000 in the quarter. Deposit balances were $4.2 billion at June 30, up from $3.8 billion on March 31. Transaction accounts increased 8% during the quarter of which non-interest bearing accounts increased 12%.

Additionally, certificates of deposit increased $237 million to support the strong asset growth of the Company. Transaction accounts grew by 7.9% during the quarter. Notably, our de novo branches, those open since the beginning of 2012, grew deposits by 41.9% during the quarter.

I'd now like to share some key points from our mortgage banking business segment results. Net income for the mortgage banking segment was $14.7 million in the second quarter compared to net income of $4.9 million in the first. The $9.8 million increase in net income from the first quarter was primarily due to higher net gain on single-family mortgage loan origination and sale activities due to higher interest rate lock and forward sale commitments during the quarter.

Net gain on single-family mortgage loan origination and sale activities in the second quarter was $81 million compared to $59.5 million in the prior quarter. Segment ROTE was 69.5% for the quarter. Single-family mortgage interest rate lock and forward sales commitments totaled $2.4 billion in the second quarter, an increase of $558 million or 30.9% from $1.8 billion in the first quarter.

The gain on sale composite margin increased to 347 basis points in the second quarter from 336 basis points in the first quarter. Single-family mortgage closed loans totaled $2.3 billion in the quarter, an increase of $688.5 million or 43.8% from $1.6 billion in the first quarter.

The volume of interest-rate lock and forward sale commitments was higher than closed loans designated for sale by 4.4% this quarter, which positively affects reported earnings as a majority of mortgage revenue is recognized at interest lock, while the majority of origination costs, including commissions, are recognized upon closing. If rate lock and forward sale commitments during the first quarter would have equalled closed loan volume, it would have resulted in approximately $1.9 million lower net income for the segment. Similarly, if closed loan volume had been the same as interest rate lock and forward sale commitments, net income would have been approximately $800,000 lower as a result of higher variable costs.

Mortgage banking segment non-interest expense of $76.9 million increased $12.2 million or 18.9% from the first quarter. This increase was primarily due to higher commission and incentives due to increased closed loan volumes.

TRID is still having an adverse impact on our expenses for the segment, with a higher percentage of segment FTE in operations relative to sales compared to the second quarter of 2015. Overall, we grew mortgage personnel by 3.5% in the quarter. Closed loans increased in the quarter to 5.3 loans per loan officer compared to 4 loans per loan officer in the first quarter.

Single-family mortgage servicing income was $12 million in the quarter, a $4.6 million increase from the prior quarter. This increase was primarily the result of a $4.7 million increase in risk-management results during the quarter.

Single-family mortgage servicing fees collected in the second quarter increased by $442,000, primarily due to higher average balances in our loan service for others portfolio. The portfolio single-family loan service for others was $17.1 billion at June 30 compared to $16 billion at March 31.

I'll now turn it back over to Mark to provide some insight on the general operating environment and outlook.

I'd like to now discuss the national and regional economies as they influence our business today. First, I would like to remind everyone that we're fortunate to operate in some of the most attractive market areas in the United States today. Strategically, we're focused on the major markets in the western United States, which today enjoy lower unemployment and substantially higher rates of population growth, job creation, commercial and residential construction and real estate value appreciation from the remainder of the country.

The most recent Mortgage Bankers Association monthly forecast projects total loan originations to increase 6.8% this year over last year and to decline by 20% in 2017. The forecasted decline from 2016 to 2017 is driven by a 51% decline in refinancing volume.

However, our focus has always been on the purchase market. The Mortgage Bankers Association forecast is purchase mortgage originations are projected to increase 8% in the third quarter and 3% in 2017.

Despite the increase in short-term interest rates by the Federal Reserve in December, long-term interest rates have fallen along with mortgage rates and continue near historic lows. The 10-year treasury yield fell to a record low 1.3% recently following the Brexit vote, and remains low, hovering around 1.5% to 1.6%. This should keep interest in refinancing strong and support housing affordability.

Nationally, purchases are expected to comprise 59% of mortgage loan volume this year. Housing starts for this year are expected to be up 10% over 2015 levels. And home sales, both new and existing, are expected to increase 6% during the same period.

During the second quarter, purchases comprised 54% of originations nationally and 55% of originations in the Pacific Northwest. HomeStreet continues to perform at levels above the national and regional averages, with purchases accounting for 69% of our closed loans and 65% of our interest lock and forward sale commitments in the quarter.

Home price increases in Washington, Oregon and California, based on FHFA data, accelerated across the board in the latest quarter, with year-over-year rates ranging from 8.2% in California to 11.4% in Oregon. According to the most recent Case-Shiller 10-city composite home price index report, which measures the change in value of residential real estate in 10 metropolitan areas, the index gained 4.7% from a year earlier. Seattle gained 10.7% over the last 12 months, Portland gained 12.3%, San Francisco gained 7.7%, and Los Angeles was up 5.9%.

The rate of job growth in Washington, Oregon, and California averaged more than 3% last quarter, 58% higher than the US growth rate of 1.9%. The average unemployment rate in the same three states averaged 5.4% last quarter, slightly more than the national average of 4.9%. This difference appears to be due to new job seekers migrating to our faster-growing western states. People are, again, moving to where the jobs are.

Looking forward over the remaining two quarters in 2016 in our mortgage banking segment, we currently anticipate single-family mortgage loan lock and forward sale commitment volume of $2.4 billion for the third quarter and $1.7 billion in the fourth quarter of this year. We anticipate mortgage held for sale closing volumes of $2.6 billion and $2.0 billion in the third and fourth quarters of this year, respectively.

As Melba stated, seasonality is expected to produce greater variation in reported results due to the timing of recognition of related revenues and expenses and the expected imbalance between locks and closings. This imbalance is expected to negatively impact the quarters where closings exceed locks, and vice versa.

Additionally, we expect our mortgage composite profit margin to come back down to a range between 320 and 330 basis points over that period, and range between 315 and 325 basis points during 2017. As the increased refinancing activity wanes, our composite margin will also fall. We expect the increased TRID-related costs we experienced in the first and second quarters to continue through the next several quarters until we complete the installation of a new loan origination system in the first quarter of 2017.

Looking to 2017, we anticipate single-family mortgage-loan lock and forward sale commitments and loan closing volume of $9.1 billion. These volumes will be subject to the typical seasonality we experience, the highest production coming in the second and third quarters of the year, offset by the lowest production in the first and fourth quarters of the year. Volumes will also be highly dependent upon the housing markets in which we do business, local economic conditions affecting employment growth and wages as well as prevailing interest rates.

In our commercial and consumer banking segment over the remaining two quarters of this year, we expect to continue net loan portfolio growth of approximately 4% to 6% quarterly, and also remain within that range during 2017. Reflecting the further flattening of the yield curve since last quarter, we now expect our consolidated net interest margin to trend down further to 3.30% to 3.35% by the fourth quarter, and remain in this range of 3.30% to 3.35% during 2017 absent changes in market rates and loan prepayment speeds.

Reflecting the seasonal peak of origination and sale activities, we believe that non-interest expense growth in the second quarter represented a peak for the year. Therefore, consistent with our full-year guidance on average of 3% growth per quarter for the full year, we do not expect our non-interest expense to meaningfully increase for the remainder of the year. In fact, we expect non-interest expense to decline somewhat in the fourth quarter of this year.

During 2017, our non-interest expenses are expected to again grow on average approximately 3% per quarter, reflecting our planned continued investment in growth and infrastructure. This growth rate will vary somewhat quarter over quarter driven by seasonality in our single-family closed loan volume and relation to the timing of our investments in growth in both of our segments.

This concludes our prepared comments. We appreciate you joining our call today and your patience during our presentation. Melba and I would be happy to answer any questions you have at this time.

(Operator Instructions)

And our first question comes from Paul Miller with FBR Capital Markets. Please go ahead.

Hey, Mark, good quarter. When you're looking at this going forward and trying to model this out, I know you're not giving too much guidance. But you had about a 17% ROE but you had some benefits in there. I say benefits -- this is operational benefits, hedging and things like that. Should we be looking at those ROEs between 13% and 15% or you think you can exceed that 15% ROEs going forward?

We had some help this quarter from higher than normal refinancing activity, and in turn that produces somewhat higher composite profit margins in the mortgage segment. That we don't expect to repeat except periodically when we get one of these mini refinancing booms. So, 17% annualized ROE this quarter is a little higher than we expected at this point.

We do expect, again, through the cycle, to average around 15%. Our target, absent refinancing, is a little lower than that over the next couple of years, in part because we are growing our non-mortgage business into a larger part of the returns, and those businesses carry somewhat lower ROEs, even fully profitable.

You did note on the call today, Melba mentioned that the return on tangible equity for the mortgage banking segment was 69.5% annualized this quarter. That's pretty high. But as we look out over the next couple of years, something between 30% and 40% for that segment is expected. And that's how we can get to consistently mid teens return on equity.

So, we had a somewhat better quarter than expected. I would expect that we could in the next couple of years operate in the 11% to 15% range without material unusual refinancing activity.

And then on the commercial bank, you did get some decent loan growth. Some of that is you've been hiring a lot of commercial teams over the last couple years, I believe. Where do you stand -- do you think you still need to add, not just in Seattle but you've entered the San Bernardino market or Los Angeles market. Are you continuing to hire down there? And when do you think that employment level starts to become stabilized?

We have a significant interest in California, obviously. And when you look at the distribution of our originations, the weakest area is still C&I lending. It is the most challenging area to grow. It has the longest sales cycle of our businesses.

We are a somewhat new commercial bank in many of our markets. So, we are going to be investing in personnel somewhat across all of our footprint but more significantly in California this year and next year. And that is going to require some investment before revenue. We are about to announce the hiring of a market president in California with significant commercial banking experience to spearhead that effort. That will be a little bit of drag initially on the commercial and consumer earnings. We don't expect it to keep us from hitting our efficiency targets ultimately, but we have to invest to build that business down there.

It's been more challenging for us to acquire the quality C&I smaller banks that we would like in California really because of pricing. Given where we trade and with the concern for excess dilution, we have not been able to be competitive and grow as quickly through acquisition with the better quality properties. And so we find ourselves continuing to build, and that has a cost.

Okay. Thanks a lot, Mark.

Our next question comes from Jeff Rulis with DA Davidson. Please go ahead.

Thanks. Good morning. Mark, the guidance on margins, the 3.30% to 3.35% by Q4 -- you discussed the negative impact of the debt offering this quarter assuming those funds are redeployed into higher yielding assets. Is that guidance, are you seeing any positive offset as that is deployed, or is it all baked into the consolidated guidance that you put out there?

Jeff, this is Melba. I'll respond to that. The short answer is it is all baked into the guidance and primarily -- the change quarter over quarter does reflect the flattening of the yield curve further during the quarter. The debt offering in terms of our loan yields, our total portfolio, our total average interest earning yields did decline due to the flatter yield and the investment in the securities. However, over time that will be redeployed into higher earning loan products, which will help offset some of that compression. But it is all baked into the guidance.

Got you. And then maybe just on the merger-related costs of $1 million this quarter, is that anticipated to go away? Have you got anything coming up with the branch acquisitions? What would be the expectations for Q3?

We had about $1 million this past quarter which was primarily related to the OCBB. And we do expect approximately the same level for the third and fourth quarter, and third quarter related to Lake Oswego, and then in the fourth quarter related to the Boston Private & Trust branch acquisition.

Okay. And then, Melba, the tax rate has been pretty volatile over the last little while. Any expectation to finish the year at an average rate or Q3 or Q4 expectations?

Yes. Good question. During the quarter we did update our estimate of the impact of California on our marginal rate, and so you saw the impact of that in the quarter. Also, the catch-up of that updated estimate from the first quarter, as well. But going forward in the second half, our total expectation with respect to the effective rate will be right around 35%.

Great. Thank you.

Our next question comes from Jacque Chimera from KBW.

Hi Mark, hi Melba. A question on the TRID related employees that you mentioned. Am I inferring correctly -- did you mean to imply that we could see some costs trend down there after the conversion in 1Q 2017?

Yes, relatively. What we anticipate is not a net reduction of personnel but a decline in the increase in personnel as we redeploy people doing what I would call TRID workaround work and QC work into normal processing and funding positions. So, our efficiency should improve.

We are expecting originations to grow even next year, so we would have a need for additional operations personnel. It should be redeployment and greater efficiency.

Okay. That makes sense. And can you give us an update on the employee growth that you expect in both the consumer and commercial division and then mortgage banking division in the latter half of 2016 and then 2017, as well, just in terms of headcount?

Sure. It's not going to be as significant as it has been. In the mortgage banking segment, we may add roughly five originators a month for the remainder of the year, which translates to a similar number of operations personnel right now, give or take a couple. So, not nearly as significant as in prior quarters or prior years. I will only qualify that with the potential that we would have some opportunistic opportunity to bring some office of larger folks in that's not currently identified today.

On the commercial and consumer banking side, we think that over the next couple of quarters personnel will rise in the commercial and consumer segment somewhere in the 5% or 6% range. We have planned next quarter two branch openings -- as an example, two new retail branches in California. I believe one more before the end of the year in another location. Each of those adds 4.5 FTE roughly.

We are going to be adding commercial banking staff, not only in California but in Oregon, as we close the acquisition of the assets and liabilities of the Bank of Oswego in the greater Portland area, and then to support our growth in both Northern and Southern California.

And then, Jacque, I would just add, looking forward into next year, that the expectation in terms of average FTE growth would be in line with our expectation of non-interest expense growth on average for the quarters [of the] 3%.

Okay. That's very helpful. Thank you. And then just one last quick one, if you could provide an update on -- obviously you had really good sales with the Fannie Mae in the quarter, but other commercial sales were strong, as well. Just an update on how those new groups, or relatively new groups, are doing and what your outlook is for future growth out of them.

We had a record quarter for Fannie Mae DUS originations in sales this quarter, in part because we had a couple pretty large loans. In fact, we did our largest Fannie Mae multi-family loan in our history, some $65 million for a beautiful multi-use, mostly a multi-family project here in Seattle. And another $35 million loan. A big piece of the quarter for Fannie Mae was made up really just in two loans.

But we had a whole bunch of smaller loans. We have a lot of momentum with that business. And we are trying to introduce that to California at this point. We finally have a loan in process, a Fannie Mae loan in process in California.

And we think the opportunity there is, of course, really significant, given the size of the market. It has not been our traditional Fannie Mae multi-family market. So, we think the opportunity is great.

The operation in California, our small balance commercial real estate operation, is above plan in volume for the year. And the yields consistently are 25 to 40 basis points higher than we get in the rest of our commercial real estate business here in the Pacific Northwest. We're very happy with that business.

Our commercial real estate business in the Pacific Northwest overall continues strong. The construction projects that we financed are all primarily on budget and on time. And the market here continues to be very strong.

I think in the past we've talked about how we monitor the forward line of sight on concerns about market stability and pricing valuation, and we continue to see and operate in markets that are characterized by an imbalance of demand and supply. Demand continues to grow, job creation and household formation continues to support high levels of construction in our markets. New project absorption continues to be well short of projected amounts. Rents continue to rise at levels in excess of pro formas on these projects.

It's a little frightening, honestly, if you think about being a renter or a home buyer in these markets today, because there is not a lot to choose from, and it's getting increasingly expensive. I'd just refer you to some of the statistics I talked about earlier, on home price appreciation in these markets. The same is true for rental rates. So, all of those businesses continue to operate at levels in excess of our plan for this year and the profitability is consistent or better than plan. Our biggest challenge, honestly, with those businesses is balance sheet capacity and an ability to process all of the business in front of us.

The SBA business continues to be a good business. We are in the process of hiring a couple more SBA specialist originators, one in the north and one in the south. And so we look forward to increased production in that business, as well.

Great. Thank you for all of the added color.

Our next question comes from Tim O'Brien with Sandler O'Neill & Partners. Please go ahead.

Good morning. To follow-up on Jacque's question about Fannie Mae DUS lending, you talked about a couple of big loans. Are those outliers? Can you characterize how big the average size of a loan that you underwrite there and sell is typically? And is that going to grow with your expansion of the business, that franchise in Southern California? Are we going to continue to see -- could you fund a bigger loan still, maybe a $100 million loan? How big can you go?

Theoretically we can under our house limits. They get larger in California. You know the market, right? The apartment complexes in California tend to be much larger in unit size. So, theoretically that may happen.

I will tell you, we are generally more focused on the small balance market. Fannie Mae, as you're familiar with their restrictions under the FHFA, they have a cap on large balance loan originations. But they are uncapped on small balance. And part of their mission, in addition to supporting senior housing and low income housing, is small balance lending.

So, I expect our average balance on Fannie Mae loans to be much smaller than the $35 million to $65 million range. Today it's probably in the $67 million range because of the focus on smaller balances. Now, while it's more expensive to process more loans, they're also more profitable, which more than offsets the additional processing cost.

And what's the typical spread on sales there these days?

There's a pretty big range. On the larger loans, the profit margin could be in the 250 basis point range. And the smaller loans it can rise to 400 to 600 basis points. For the quarter, it was roughly 370 basis points.

Thanks for the color, Mark. That's great. And then as far as the CD attracting, you guys grew CDs this quarter, and it looks like average rate was up a little bit. Can you talk about the outlook there for tapping that part of the deposit world to fund your growth going forward through the end of this year and in 2017?

I'll let Melba start and then I'll finish with a comment.

Yes, thanks, Mark, I'll jump in. So, yes, our CDs as a percent of total deposits rose to 27% in the quarter, which is certainly up sequentially but it's actually pretty consistent to where we were in the year-ago quarter. We do manage our percent of brokered CDs with respect to total deposits to a limit of 10% or less. So, we are well below that.

The time deposit market is one that we've historically utilized. The Company used to be much more concentrated in time deposits. We got down to a low, about 15% of deposits, knowing that that would really be a low watermark.

Our asset growth rate requires a significant growth rate in funding. And while we have been growing deposits well, and almost exclusively retail deposits, that has required the use of some time deposits. And while, from a cost of funds standpoint, that's not optimal, understand we use that as a way to help build our customer base in new offices and new markets.

Typically new offices need some promotional products to bring in the initial group of new customers. Over time you convert those single-product customers to multi-product customers for which you hold their primary operating checking account.

So, it's actually useful for us during a time when we're active opening new branches, still building branches we've opened in recent quarters, to have a need for time deposits and to be able to run some specials to help grow the deposits in those branches faster and populate those branches with new customers. If you think about the branches we're opening in California, where we are really an unknown name, it's helpful to have some specials. And we need.

And then last question, Mark, did you guys give efficiency guidance or outlook for 2017? If so, I didn't catch the number.

I don't think we have other than our general target for the Company is to reach an efficiency ratio in the mid 70% range on a consolidated basis. We expect to achieve that next year. Thinking about the opportunity for improved efficiency, that primarily lies in the commercial and consumer segment.

You saw the efficiency improve this quarter. It didn't quite hit our targets. We were hoping that that would end up around 69%. It actually was 71% this quarter. We still expect the efficiency ratio in that segment to fall into the mid-plus 60% range by the fourth quarter of this year, and next year averaging below 65%, falling to the low 60%s by the end of next year. And we can accomplish this by the operating leverage that we're producing by growing revenue at a multiple of expense growth.

I feel like we're very much on target. It's a little volatile. But that opportunity to improve efficiency we think is very much intact. We think we're on track and [its matters] continue to execute at the growth rates that we have planned and have been experiencing.

Thanks for the feedback.

Our next question comes from Jordan Hymowitz with Philadelphia Financial. Please go ahead.

Hey, guys. Thanks for your question. Just because I'm not very good at complex math, you said you're targeting 11 to 15 ROE. Does that imply [$2.40 to $3.20] in earnings over the next year or two?

How many periods are you including? Are you saying per share? Or in total?

Yes.

I think the number is going to be higher than that probably if you think about next year. This year consensus has us at $1.95 or something. What is it this year?

I don't have it right at my fingertips.

We don't watch it that close. Maybe you know. And next year $2.50 or something. f you look at the growth rate --.

This year it's $2.15 consensus.

I'm sorry. $2.15. Okay. It will probably go up a little after this quarter because we exceeded the consensus. A $2.40 number, given our growth rate, seems like a reasonable expectation to be able to accomplish.

That was my point, is that if people think you're going to fall off the map next year if mortgage rises, basically guiding to at least flat earnings next year.

That's not what we expect. We've had some nice refinancing activity in the mortgage sector. But we expect to continue to grow our originations. We guided originations higher. And our composite margin, while we believe right now it will be slightly lower, we're expecting our mortgage earnings next year to exceed our mortgage earnings this year.

Okay. And then the other thing is you called out a couple of one-time things. You had a $14 million, or about a little over $0.30 hit of writing down the MSR. And I know some people think we're going to go to negative rates in this country, but if things are just stable, that's another $0.30 of earnings this quarter that won't be repeated next quarter -- $0.30 hit to earnings, that is.

Remember we hedge that away. And even in the corollary opposite impact, when our MSR goes up, we hedge that gain away, as well.

So the real impact of that loss in volume of MSRs will be realized over some future period if prepayment speeds really do increase over that period. And that's a pretty volatile number. Because we have a strong track record of effective hedging, the increases and decreases in our MSRs are largely hedged away in terms of the impact on current earnings.

I'm sorry. I completely missed the hedging. I apologize. Sorry about that.

And our next question comes from Bill Dezellem with Tieton Capital Management.

Thank you. That's Tieton Capital. A couple of questions. First of all, did you complete the Orange County Business Bank cost reductions here this quarter? Is that now done?

They are complete. In fact, we completed all of the cost reduction systems and personnel in mid April. And so this quarter, while not completely clean of transition expenses, largely done, and in the third quarter complete.

Great, thank you, Mark. And then if the current rate lock trends were to continue, incorporating in any seasonality that would be appropriate, what would be the mismatch between rate locks and closings in the third quarter?

We guided that. I'll refer you back to my comments. I'll reread them for you. And you can check the script later when it's published. So bear with me for a second. I'll find my notes.

In the third quarter we anticipate single-family mortgage-loan lock and forward sale commitment volume of $2.4 billion in the third quarter, and closings of $2.6 billion. So, closings expected to be higher than locks in the third quarter. And then in the fourth quarter, lock volume of $1.7 billion compared to close volume of $2.0 billion. So, again, close volume higher than lock volume in the fourth quarter.

And, of course, that does not anticipate any unusual level of refinancing activity.

Which it would be reasonable to expect an unreasonable level of refi activity given what rates did post Brexit.

It's so hard to tell. They have been coming up slightly from their lows. I know I've said this a lot of times on calls and in other meetings -- we have a healthy regard for not knowing what is going to happen with interest rates. I believe they can go up as easily as they can go down. I think there are a lot of conditions in the world today that create uncertainty. And the flight to safety in treasuries is always just one incident away internationally and nationally.

And while we think that rates, if you listen to current discussion, are going to stabilize from here and maybe rise, I don't think that can be assured. So, we create our plans based upon earnings as they are today, knowing that they could go up or down.

Great. Thank you both.

This concludes our question-and-answer session. I would like to turn the conference back over to Mark Mason for any closing remarks.

Again, we appreciate your patience and your great questions today. Look forward to talking to you next quarter.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.