Mechanics Bancorp (MCHB) 2017 Q1 法說會逐字稿

Good day, and welcome to the HomeStreet, Inc. First Quarter 2017 Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Mark Mason, CEO. Sir, please go ahead.

Hello, and thank you for joining us for our First Quarter 2017 Earnings Call. Before we begin, I'd 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 under the news and market data link. In addition, a recording of this call will be available later 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 and that impact our net interest margin and other aspects of our financial performance; the actions, findings or requirements of our regulators, which could impact our growth plans; our ability to meet our internal operating targets and forecast 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 identified in our earnings release and detailed in our SEC filings, including our quarterly reports on Form 10-Q and our annual report on Form 10-K for 2016, as well as our various other SEC reports.

Additionally, information on any non-GAAP financial measures referenced in today's call, including the reconciliation of those measures to GAAP measures, may be found on 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 Vice President of Corporate Development and Strategic Investments, Mark Ruh. Mark will be acting as the Interim Chief Financial Officer, replacing Melba Bartels, who has decided to leave us for another opportunity. We appreciate Melba's assistance and strong leadership while here at HomeStreet, and we wish Melba well in her future endeavors. We are fortunate to have someone with Mark's background and experience to step into the role while we search for a permanent replacement. Mark is also a candidate for the permanent position.

In just a moment, Mark will present our financial results. But first, I'd like to give an update on recent events and review our progress on executing our business strategy. We are satisfied with the results for the first quarter of this year, as we continue to make progress on our strategy of growth and diversification, with the goal of becoming a leading West Coast regional bank.

Our Mortgage Banking segment recovered from the unexpected spike in interest rates and market dislocation experienced in the last quarter, and our Commercial and Consumer Banking segment made significant progress toward our strategic goal of profitability and diversification.

In January, we opened our first Northern California Bay Area commercial banking office. We plan to open a full-service retail deposit branch in San Jose later this year. Our Bay Area lending team is already making great progress in acquiring relationships and building a pipeline of new commercial loans and deposits.

Last year, we hired a commercial banking president for the state of California. Since January this year, we have hired regional commercial banking market presidents for the Bay Area and Orange County, San Diego. Since coming onboard, these leaders have been recruiting relationship managers, credit officers and underwriters, while actively bringing new relationships to us. In total, we have hired 6 highly experienced commercial bankers in California.

Our goal for this year is to build our commercial teams in the Bay Area, Orange County and San Diego. In this regard, we anticipate hiring 5 more professionals by year-end.

In our Mortgage Banking business, we remained the #1 mortgage lender in the Pacific Northwest for purchase transactions by volume during the quarter. We are also proud to now be 1 of the top 25 lenders by volume in the major coastal markets of California, as well as a top 10 lender by volume in Hawaii and in the Central Valley of California.

In the quarter, we added 1 single family lending center in Elk Grove, California. Strategically, we now have offices in nearly all of the major West Coast mortgage markets of significance. As such, this year, any expansion will generally be focused on infill and be even more opportunistic. We still expect to grow this business over time, but in the near term, our focus will be adding producers to existing offices and opportunistically hiring teams with strong production histories in our existing markets.

We have invested substantially in the growth of this business over the years. And with the completion of the installation of our new mortgage loan origination system, we will be focusing on getting the benefits and efficiencies flowing from that investment as well as the optimization of our regional operations.

Finally, on April 17th of this year, we opened our latest retail deposit branch in Baldwin Park, California. This is our 15th branch in Southern California, and is located less than a mile from the Baldwin Park Kaiser Permanente Medical Center, our affinity partner.

Before Mark reviews our financial results, I'd like to share some highlights from the quarter. Net income for the quarter, excluding acquisition-related items, increased from $2.6 million in the fourth quarter of last year to $9 million. Total assets grew $157 million, or 3% during the quarter, to $6.4 billion. Return on average tangible equity, excluding acquisition-related items, was 5.81% for the quarter versus 1.74% in the fourth quarter of last year.

Diluted earnings per share, excluding acquisition-related items, increased from $0.10 per share last quarter to $0.33 per share in the first quarter. Tangible book value per share increased from $22.33 to $22.73 during the quarter.

Net income for the Commercial and Consumer Banking segment, excluding the acquisition-related items, declined to $9.3 million for the quarter compared with $12.3 million in the fourth quarter. Recall, however, that the fourth quarter of last year included $2.4 million of gains on securities sales and $2.8 million of gain on the sale of a pool of single-family mortgage loans. Adjusting for the after-tax impact of these items, net income for the segment increased by approximately $750,000 during the quarter, and our efficiency ratio would have improved from an adjusted 73% in the fourth quarter of last year to 72% this last quarter.

Loans sold for investment increased $136.7 million or 4% during the quarter to $4 billion, despite the first quarter generally being seasonally the slowest quarter for commercial loan originations. New portfolio loan originations, purchases and advances during the quarter totaled $542 million compared to $584 million during the fourth quarter.

The ratio of nonperforming assets to total assets ended March at 0.38%, down from the fourth quarter's ratio of 0.41%, reflecting continuing excellent asset quality. Additionally, we continue to enjoy doing business in the strongest markets in the United States. Our early warning and credit indicators are continuing to show strong fundamentals in all of our markets.

Deposits increased 4% during the quarter to $4.6 billion, and noninterest-bearing commercial and consumer deposits grew 8% over the same period. We saw strong growth in our business-related deposit accounts in all markets, and our California branch has grew total deposits 5% during the quarter.

Our Mortgage Banking segment net loss of $309,000 in the quarter decreased from a net loss of $9.8 million in the fourth quarter of last year. The disruption in the derivatives markets that we experienced in the fourth quarter normalized in the first quarter, contributing to somewhat better than anticipated results in our mortgage servicing business for the quarter.

Closed loan volume in our single-family Mortgage Banking segment totaled $1.6 billion in the first quarter of the year compared with $2.5 billion in the fourth quarter last year. Interest rate lock and forward sale commitments of $1.6 billion in the first quarter decreased from $1.8 billion in the fourth quarter.

While the first quarter is typically a seasonally slow origination quarter, our origination business was also negatively impacted by the multiyear low levels of housing inventory in our markets. Despite this challenge, we have improved our execution on the sale and securitization of mortgage loans, resulting in an increase in our composite margin from 334 basis points in the fourth quarter of last year to 349 basis points in the first quarter of this year.

And now, I'll turn it over to Mark, who will share more detail on our financial results.

Thank you, Mark. Good morning, everyone, and thank you again for joining us. I'll first talk about our consolidated results and then provide detail on each of our segments.

Net income for the first quarter was $9 million or $0.33 per diluted share, compared to $2.3 million or $0.09 per diluted share for the fourth quarter of '16. The increase in net income from the prior quarter was primarily due to a $10.7 million decrease in noninterest expense from lower commissions on lower mortgage loan originations during the quarter.

Acquisition-related expenses were 0 for the quarter. Excluding after-tax acquisition-related items recognized in the fourth quarter of '16, core net income increased from $2.6 million or $0.10 per diluted share in the fourth quarter of 2016 to $9 million or $0.33 per diluted share in the first quarter.

Net interest income was $45.7 million in the first quarter compared to $48.1 million in the fourth quarter '16. The decrease was primarily due to lower interest income stemming from a decrease in mortgage loans held for sale, somewhat offset by higher interest income from loans held for investment.

Our net interest margin was 3.23%, a decrease of 19 basis points from fourth quarter '16 net interest margin of 3.42%. This expected decrease was primarily due to: one, the decline in mortgage loans held for sale; two, investing in lower-yielding securities as we temporarily deploy the proceeds of our December '16 equity offering; and three, an increase in the cost of our short-term Federal Home Loan Bank advances, following the 2 recent interest rate hikes by the Federal Reserve.

Noninterest income increased $1.2 million from the prior quarter, primarily due to higher mortgage servicing income, somewhat offset by lower net gain on mortgage loan origination and sale activities. Mortgage servicing income increased by $9.5 million from the prior quarter, while gain on mortgage loan origination and sale activities declined by $7.5 million. Noninterest expense was $106.9 million in the first quarter compared to $117.5 million in the fourth quarter.

Excluding acquisition-related expenses, noninterest expense was also $106.9 million in the first quarter compared to $117.1 million for the fourth quarter of '16. The decrease in core expenses was primarily due to lower incentive costs attributable to lower Mortgage Banking closed loan volume.

At March 31, the bank's Tier 1 leverage ratio was 10.03% and total risk-based capital ratio was 14.03%. The consolidated company's Tier 1 leverage ratio was 9.48%, and the total risk-based capital ratio was 11.65%.

I'd now like to share some key points regarding our Commercial and Consumer Banking business segment results. Commercial and Consumer Banking segment net income was $9.3 million in the quarter compared to $12 million in the prior quarter. Excluding after-tax net acquisition-related items, the segment recognized core net income of $9.3 million in the first quarter compared to $12.3 million in the fourth quarter of '16.

As Mark previously mentioned, the fourth quarter of '16 included a $2.4 million gain on the sale of securities, as we repositioned it to a lower-duration portfolio. The results also included a $2.8 million gain on the sale of a $67 million pool of single-family mortgage loans. Adjusting for the after-tax impact of these 2 items, core net income in the fourth quarter of '16 would have been $8.5 million.

Growth in current quarter core net income after adjusting for the 2 nonrecurring asset sales in the prior quarter was driven by an increase in net interest income, a decrease in provision for loan losses and an increase in noninterest income, offset somewhat by an increase in noninterest expenses. Net interest income increased to $40.9 million in the first quarter from $40.6 million in the fourth quarter of '16, primarily due to the growth of loans held for investment during the period.

Segment noninterest income decreased from $13.1 million to $9.4 million during the quarter. The $3.7 million decrease was primarily due to the previously mentioned $2.4 million gain on the sale of securities and the $2.8 million gain on the sale of mortgage loans. Excluding the gains taken in the fourth quarter of '16, the $1.4 million increase in the first quarter of the year was primarily due to the recognition of prepayment penalties on the early payouts of commercial real estate loans.

Segment noninterest expense was $36.5 million, an increase of $987,000 from the fourth quarter of '16. Included in noninterest expense for the first quarter of this year and the fourth quarter of '16 were acquisition-related expenses of 0 and $401,000, respectively. Excluding acquisition-related expenses from both periods, the $1.4 million increase in noninterest expense is primarily due to growth in the business, including offices, personnel and other administrative expenses. We recorded no provision for loan losses in the quarter compared to a $350,000 provision last quarter. This reduction reflects net recoveries in the quarter, combined with lower expected loss rates due to improved credit performance.

We experienced net recoveries of $778,000 during the quarter compared with net charge-offs of $319,000 during the fourth quarter of '16. Gross charge-offs during the quarter totaled only $325,000, primarily from consumer loans, while recoveries totaled $1.1 million during the same period. The portfolio of loans held for investment increased 4% to $3.9 billion in the first quarter. We experienced strong growth in consumer loans, commercial real estate loans and multi-family loans. Construction loan balances declined during the quarter, primarily reflecting the seasonality of the building business and the conversion of construction projects to permanent financing. The resulting net loan growth was $137 million during the quarter.

Credit quality remains strong with nonperforming assets at 0.38% of total assets at March 31, and nonaccrual loans at 0.47% of total loans. Nonperforming assets were $24.3 million at quarter end, compared to nonperforming assets of $25.8 million at December 31. The decrease is primarily due to the upgrades to accrual status for borrowers now performing. These credit metrics represent the lowest absolute and relative levels of [ problem assets ] since 2006.

Deposit balances for the quarter were $4.6 billion at March 31, up from $4.4 billion on December 31. Deposit increased to nearly all account types. While the most significant increase in deposits was a $119.9 million increase in time deposits, noninterest-bearing demand deposit accounts and now accounts grew 8% and 10%, respectively, during the quarter. These increases were primarily offset by decreases in other noninterest-bearing accounts, primarily related to our mortgage servicing portfolio. Servicing deposits fluctuate seasonally with insurance and property tax payments.

Of note, our business deposit balances grew by over 5% during the quarter, and deposit balances in our California branches also grew by 5%. Notably, our de novo branches, specifically those opened since the beginning of 2012, grew deposits by 12% during the quarter. Deposits in the 2 branches that we acquired in the Los Angeles market during the fourth quarter of '16 increased by 6% during the first full quarter in our branch network.

I'd now like to share some key points from our Mortgage Banking segment results. The net loss for the Mortgage Banking segment was $309,000 in the first quarter compared to a net loss of $9.8 million in the fourth quarter of '16. The $9.4 million improvement in income from the fourth quarter was primarily due to a decrease in noninterest expense and an increase in Mortgage Banking servicing income, offset by lower gain on origination sale activities.

Gain on single family mortgage loan origination sale activities in the first quarter was $56.3 million compared to $61.1 million in the prior quarter. Single family mortgage interest rate lock and forward sale commitments totaled $1.6 billion in the first quarter, a decrease of $143.3 million or 8% from $1.8 billion in the fourth quarter of '16. Single family mortgage closed loans also totaled $1.6 billion in the first quarter, a decrease of $893.6 million or 36% from $2.5 billion in the fourth quarter of '16.

The gain on mortgage loan origination and sale composite margin increased to 349 basis points in the first quarter from the prior quarter's 334 basis points. This increase in composite margin is primarily due to improved execution on the sale and securitization of loans.

Mortgage Banking segment noninterest expense of $70.4 million decreased $11.7 million from the fourth quarter of '16. This decrease was primarily due to lower commissions and incentives due to the decline in closed loan volume. Overall, we grew Mortgage Banking personnel by only 4 FTEs in the quarter. Closed loans decreased in the quarter to 3.6 loans per loan officer compared to 5.3 loans per loan officer in the fourth quarter.

Single family mortgage servicing income was $8.3 million in the first quarter as compared with a net loss of $984,000 in the fourth quarter of '16. The quarterly results were comprised of $5.8 million of net servicing income and $2.5 million of risk management revenue. The disruption in the derivative markets that we experienced in the fourth quarter last year normalized in the first quarter, contributing to our return to positive results in our mortgage servicing business.

Our portfolio of single family loans serviced for others was $20.3 billion at March 31, compared to $19.5 billion at December 31. The value of our mortgage servicing rights relative to the balance of loan serviced for others remained at [ 116 basis points ] of unpaid principal balances at quarter end.

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

Thank you, Mark. I'd like to now discuss the national and regional economies, as they influence our business today. First, we're satisfied with our results for the quarter and are excited about our prospects for achieving the growth and diversification goals of our strategic plan for this year and beyond. We're fortunate to operate in some of the most attractive market areas in the United States today. These markets enjoy lower unemployment and substantially higher rates of population growth, job creation, commercial and residential construction and real estate value appreciation than the remainder of the country. The major markets that we focus on are substantially larger than most of the other markets in the United States, which gives us the opportunity to grow meaningfully without the necessity of acquiring a significant market share.

Together, the most distinguishing feature of the Washington, Oregon, Idaho and California economies continues to be their strong rate of job creation relative to the rest of the country. The impressive growth in payrolls has lowered unemployment rates across the board, though not as much as relative to the national economy. This is due to labor force additions from the strong rates of in-migration and population growth in our markets. The employment growth rates during 2016 for these states have averaged 3.1% compared with 1.8% for the nation as a whole.

In fact, during the last quarter, Greater Seattle employment grew by over 2%, or more than 8% annualized. The most recent Mortgage Bankers Association monthly forecast projects total loan originations to decrease 16% this year over last year and to decrease by 0.3% in 2018. The forecast of decline from 2016 to 2017 is driven by a 43% decline in expected refinancing volume. However, we do not expect the forecasted decline in refinance volume to impact our business to that degree, as our origination focus has always been on the purchase market. The Mortgage Bankers Association forecasts that purchase mortgage originations are projected to increase by 9% nationally in both this year and next year.

During the first quarter, purchases comprised 59% of originations nationally and 48% of originations in the Pacific Northwest. We continue to perform at levels above the national and regional averages, with purchases comprising some 67% of our closed loans and 73% of our interest rate lock and forward sale commitments in the quarter.

Despite the increase in long-term interest rates in the fourth quarter, interest rates remain low on an absolute basis, and long-term rates have actually declined since then. While the 10-year treasury yield increased following the November 2016 presidential election, it has fallen since then and continues to remain low on an absolute basis at approximately 2.3%. These low rates should continue to support housing affordability.

Nationally, purchases are expected to comprise 68% of mortgage loan volume this year. However, purchase originations in our markets are being constrained by a lack of housing inventory. We've seen a recent downward trend in the supply of homes in all of our major metropolitan markets.

During 2016, the Seattle market was already tight, trending in the 1.5 months of supply range. But during the first quarter, the supply of homes fell to only 3 weeks of sales. Similar drops were also noted in the Portland, San Francisco, Los Angeles, San Diego and Honolulu markets.

On the commercial side, Seattle's office market absorption slipped in the fourth quarter of 2016, but not enough to derail the market's first place performance. Puget Sound region absorbed 3.5 million square feet in 2016, more than any market in the United States. It was the region's best performance since 2005.

Vacancy rates increased slightly from the previous quarter, increasing from 9.3% in the third quarter of 2016 to 9.9% in the fourth quarter, but still below 11.1% in the year-ago quarter. Large employers, such as Amazon and Facebook, are continuing to sign deals for additional space, supporting strong demand and a positive outlook for future growth.

Portland absorbed over 28,000 square feet of office space in the first quarter, and asking rents averaged $25.91 per square foot, up from $24.88 in the prior quarter, and $24.30 in the year-ago period. Vacancy ended the fourth quarter at 10.5% compared to 10.3% in the prior quarter.

Stable vacancy and increasing rents are supporting robust construction, with 1.2 million square feet of office space currently under construction there.

In Los Angeles, almost 364,000 square feet of positive net absorption in the first quarter marked the 15th straight quarter of net occupancy gains there. Vacancy increased slightly to 14%, compared with 13.9% in the fourth quarter of last year, as over 900,000 square feet was delivered, 35% of which was leased upon completion.

The construction pipeline is at 1.7 million square feet, down from 2.4 million square feet in the prior quarter. Average asking rents increased by 2% during the quarter to $37.80 per square foot.

Looking forward to the next 3 quarters on our Mortgage Banking segment, we currently anticipate single family mortgage loan lock and forward sale commitment volume of $2.3 billion, $2.5 billion and $1.9 billion in the second, third and fourth quarters, respectively. We anticipate mortgage held for sale closing volumes of $2.1 billion, $2.6 billion and $2.2 billion during the same periods, respectively.

We are currently in the beginning of the home-buying season, and increasing mortgage lock volumes should be expected as the second and third quarters are typically our strongest quarters for loan origination.

For the full year of 2017 then, we anticipate single family mortgage loan lock and forward sale commitments to total $8.4 billion and loan closing volume to total $8.5 billion. These volumes will be subject to the typical seasonality we experienced, generally lower volumes in the first and fourth quarters of the year and higher volumes in the second and third quarters.

Volumes will also be highly dependent on inventory levels in these markets in which we do business, local conditions affecting employment growth and wages as well as prevailing interest rate. Additionally, we expect our mortgage composite profit margin to settle into a range of between 330 and 340 basis points over the next 2 quarters, and then fall into a range of 325 to 335 basis points in the fourth quarter.

We expect the increased TRID-related costs we experienced last year to continue through the next several quarters until we complete the installation of our new loan origination system later this year. In our Commercial and Consumer Banking segment, we expect average quarterly net loan portfolio growth to continue to approximate 4% to 6% during this year.

Reflecting the increase in interest rates and absent changes in our market rates and loan prepayment speeds, we expect our consolidated net interest margin to increase from the 3.23% in the first quarter. As we redeploy the proceeds of our December 2016 common stock offering from lower-yielding securities into higher yielding loans, we expect the net interest margin to increase to between 3.40% and 3.50% by the end of this year.

During 2017, our noninterest expenses are expected to grow, on average, approximately 2% per quarter, reflecting the continued investment in our growth and infrastructure. This growth rate will vary somewhat quarter-over-quarter, driven by seasonality in our single family closed loan volume, and in relation to the timing of future investments in growth in all of our segments.

This concludes our prepared comments. Thank you for your attention today. Mark and I would be happy to answer any questions you have at this time.

(Operator Instructions) And our first question comes from Jessica Levi-Ribner with FBR.

This is Tim for Jessica. So you guys came up just a little short of your lock in sale volume for the quarter, and going -- much appreciated the guidance going forward, but does that include any kind of pull-through from last quarter? Was there anything that's getting pushed out in the second quarter, which is why you came up a bit late? Or what exactly was the delta there?

Well, we think that the delta or the difference between expected volumes and what we actually did in what we are now in turn expecting for the year really is solely involved in the inventory issues. Our volume of loans without properties or prequalifications for people shopping for homes is up substantially over last year. And sometimes, at some points in the quarter, over 20% over the prior year, and so we know demand for homes is even stronger than last year, but the pull-through or the conversion of prequalifications to loans with properties pending closing has fallen far behind last year's rate. Now we've had some pretty rough weather this winter in the Pacific Northwest, and that can contribute to less people putting their homes on the market, less people shopping. That may turn around in the second quarter, and we may, in turn, increase our estimates the next time we talk. But for now, we are trying to be a little more circumspect about our expectations until we see inventory levels return to at least what we thought were relatively low levels last year.

Got it. And then, you'd mentioned hiring some additional lenders throughout the course of the year, but what's your appetite for M&A at this point? Are you still seeing some good value out there? Would you look more on the mortgage side, or the commercial side? Would you be kind of focused on your core West Coast markets? Any just color around this would be appreciated.

Sure. We remain in the market for whole banks, whole commercial banks or branch acquisitions. It's highly unlikely that we would consider a mortgage-related acquisition. We're very comfortable with our mortgage business, with the quality of it, the consistency of it, the risk management of it. But it is our objective to continue to grow our commercial business faster, and so acquisitions in the mortgage business are probably not in the cards for us. In terms of general appetite, our appetite remains strong, though we are most focused along the coast, from Puget Sound all the way to the Mexican border, we continue to look at acquisition opportunities literally in all of those markets. Our greatest interest is infill. It has the greatest efficiency, and we, even in the last quarter, looked at between 3 and 5 different potential opportunities in those markets. And so I think that the M&A market, I would term as active. I think that pricing, or at least in the seller's eyes, has come up, and very competitive, particularly in the market that we're interested in, right, the large markets of the West. And so I can't predict when we might next announce a transaction, but we remained very interested in acquisitions from anywhere as small as $100 million to $150 million to above $1 billion.

Our next question comes from Jeff Rulis with D.A. Davidson.

Mark Mason, I guess, I should clarify, on the -- just interested on the deposit side, seeing your cost on CDs, money markets up a bit, interest-bearing and savings down, kind of what you're seeing in the market for competition and your strategy going forward, a little more detail there?

Sure. We've taken the opportunity to extend the liabilities a little bit, both on a retail basis and on a wholesale basis, so some of that increase in time deposits is brokered at really, really attractive rates, maybe as much as 25 or 35 basis points. On the consumer side, we have done a little more promotional deposit acquisition. That is generally associated with the opening of new branches. And generally, 2 years and less in duration, and the rates are still attractive to us. Plus, when you're opening new branches, it is common to see those branches with some promotional money to get people to come experience your system, get to know your people, and so on. And we opened a fair number of branches near the end of the year last year, right? So you're going to see a little more of this initial promotional money come through. Now that promotional money lasts a year, typically, in money market accounts, or most of the time deposits are generally about 1 year, 18 months. The money market promotional rates roll off after a year and then come back down to our lower day in, day out rates. And our retention of those accounts, after the promotional burn off, has been very good at this point. So not all of this is permanent. Cost increase, some of it is time-sensitive, but because we're going to continue to open branches and grow, this will be a continuing part of the deposit growth.

Okay. And then, maybe a little bit of housekeeping on the income statement. The 2 line items, the provision and then the Windermere fee income, both have been pretty volatile. Any expectations for the rest of the year or commentary on kind of future direction?

Yes, so first, Windermere, that is going to be very seasonal with the mortgage season. Windermere has an even higher level of purchase volume, right? So their seasonality is going to be more significant. You'll see that line item jump up in the second quarter substantially, and then, by the fourth quarter, fall back down. I'm sorry what was the other part of the question?

What is the other question, please?

The other line item?

The provision expense.

Oh, provisioning. Like most other folks, we are not seeing or experiencing expected charge-offs. Our allowance models, of course, project expected charge-offs based upon historic experience. Our markets are very strong, our credit underwriting remains consistent and conservative, and so instead of experiencing material levels of charge-offs, we're still experiencing recoveries. And so we required no provision for the quarter. The -- we were frankly challenged by conserving -- recovering some of the allowance, the performance was so good. Of course, we're going to be growing, and in the future, we'll need more, but it is appropriately stated for the quarter. For the rest of the year, we generally anticipate provisioning. If you grow your loan portfolio at the pace that we're expecting to grow, you should expect continuing similar levels of coverage from the allowance and then the provision will grow accordingly. So if we're growing the portfolio, let's say, 4% or 5% a quarter, the allowance should grow a similar amount, generally.

And the visibility on future recoveries is, I guess, as NPAs drift lower, I guess, the thought is that those would reduce over time, but any specific outlook on outflow for the rest of the year?

I -- we don't believe it's going to be significant. We look at the uncollected deficiency notes, as an example, that remained after the recession. Those have been substantially collected. We do have a few specific reserves, but in terms of charged-off recoveries, we don't expect it to be too meaningful the rest of the year. There will be some. The fact that we've had virtually no charge-offs makes the recovery seem more significant. I mean, even last quarter, I think, our recoveries were $700-and-some-thousand, it's in the report, which, pretax basis, is not that meaningful to the bottom line, but we only had charge-offs in the $300-and-some-thousand range, right? So we expect credit quality to remain good. We see nothing in our portfolio that is suggesting growing weakness. And we really don't see any weakness in the markets in which we do business. We don't see weakness in real estate or in the commercial sector either, so it would have to be a borrower-specific issue that we don't currently see.

Our next question comes from Jackie Bohlen with KBW.

Mark, I wondered if you could provide an update? I know you did a little bit in your prepared remarks on some of the commercial bankers you've been hiring, but just kind of how you're thinking about hiring over the next couple of quarters, both in the commercial segment and the mortgage segments, particularly in light of so few additions in mortgage over the last quarter?

Well, thanks for that question. We have, over the last several years, grown at a pretty significant pace in personnel and, in turn, in operating expenses. And this year is going to be a somewhat lower year in personnel growth. We anticipate -- I mean, I gave a couple of numbers in California (inaudible) our commercial banking business, and while that is small growth in numbers of people, those are relatively expensive people, well-experienced commercial bankers of track record and pedigree, rightly earned substantial compensation. And so that is a meaningful investment for us. And while we may only hire another 5 individuals by the end of this year, that will, in total, be a pretty meaningful investment. In the mortgage area, we will probably only grow maybe a net 20 people in the second quarter. And by year-end, probably, in total, maybe another 50 to 70 people. So this year, we do not expect to be significant growth year in personnel. Part of the reason for that, though, is that we will be redeploying a meaningful number of operations personnel who are involved in implementing our new loan origination system. And so we expect them to be absorbed into normal positions with normal ratios of cost to mortgage loan origination as we grow our business and we finish the task of implementing the software. All of that is premised though on achieving our loan volume this year. And if we continue to see weakness, more than we currently projected, we could see no growth in personnel for this year, or even a decline if the mortgage market is not as strong as we expect. In the rest of the business, we would expect to grow just slightly. Total headcount this -- from the first quarter to the end of this year is expected to grow by a little over 200 people, but of course, part of that's involved in new branch openings, which we expect to open 5 this year. Each of those branches has about 5 FTE and a few more support personnel in the infrastructure and more lenders in the markets other than California, and so that growth in the commercial business is spread out over a number of lending and deposit-taking areas.

Okay. That's very helpful. And as you're redeploying the staff within the mortgage banking division, does that play into the increase in your composite costs estimates, just those efficiencies there? Or if not, your composite margin estimates?

No, that's really unrelated to the operations personnel. It's related to some real solid progress we've made in the secondary marketing area. Our secondary marketing personnel, as our volume has grown, have become more sophisticated in creating specialized pools of loans for sale and securitization, which garner higher prices. They may be high or low balances, they may be CRA-related loans, these spec pools, or specialized pools, generally trade at premiums of 25 to 50 basis points higher than base market values. And it's really due to some really great work by folks in that area.

Our next question comes from Tim O'Brien with Sandler O'Neill.

Jackie ripped that question that I had for the composite margin expansion right out of my mouth there, right, but maybe you could expand on that. That's just a fascinating area, and I think that your quarter partially turned on that expansion and that composite margin and that was a huge boon, and I think that credit is deserved there. So I guess, 1 question I'd have for you just to extend that is, what kinds of loans, specifically this quarter, were you able to sell that allowed you to strengthen that margin?

What, I think, I alluded to a second ago...

CRA?

CRA for sure. One second, my guy is giving me a hand signal.

Some of it is Freddie, Fannie competition. Between those 2, (inaudible) much more in our favor, so we've been able to do that, take advantage of that relationship.

Right. So things like CRA or low balance loans, right? Low balance loans are more valuable because they typically have much longer loan lives, right? They don't prepay as quickly, so they're more valuable. Part of it though is, frankly, due to more competition between Fannie Mae and Freddie Mac. They both have become more aggressive at the margin in seeking, near the end of the month or the end of the quarter, extra volume based upon specific attributes they're looking for, and it could just be regional by regional diversification. So a combination of pools we create and competition between the agencies has done it.

And differences between cash, delivery and security delivery.

Okay. Now, we're going to get super technical.

No, I've heard this before, cash.

Right. So there's cash delivery, there's creation of securities or delivering into the forward sales that you have essentially pitched your pipeline with. So a fair amount of our sales, I don't know, 80% to 90%, goes strictly into filling the TBAs that we have sold to hedge the pipe, right? Very easy, your profit margin is locked in, there should be no issues. But a certain amount of it we hold back intentionally now to trade on a cash basis, meaning, we sell the whole loan to Fannie or Freddie, and they securitize with others into their own deals, and that's where it becomes really competitive. You just got to be careful because that just can go both ways, right, depending upon their appetite, and you have to kind of read the market.

That's -- and suffice to say, in a lower demand environment, more competition, more pressure on margins, was that -- was your success this quarter in the face of that headwind? Did that -- was that headwind more pronounced in the marketplace this quarter, from your perspective?

Well, I think, it is.

On margins?

I think, it's always that way in the first and fourth quarters, right, the base margin declines because of competition. It shows you how significant -- I don't have the numbers as we sit here today, the extra execution by pooling, but part of it did make up for what could have been lower margins. But we expect the pooling opportunities to continue sort of going forward and not be seasonal.

Fantastic. Glad to hear it. And then, just moving on more quickly on FHLB, do you guys anticipate -- do you have a lot of room to use that facility for funding here through the end of the year and in '18? And how do you plan to manage kind of that resource?

Well, it's an important funding resource for us. It's our base funding vehicle for funding loans held for sale balances because it's so well-matched. They give us really attractive 7 to 21-day money. In fact, it's cheaper than the repo market by 7 basis points today or day in, day out. So that's our base utilization. However, starting at the end of last year, we began to do a little term financing with them to extend our liabilities a little bit to mitigate some rate risk. And it helps us hedge the asset side and helps us match the durations a little better. We have to be careful, though, because in the regulatory world, non-core funding, of which FHLB advances are considered, is a hot button of sensitivity issue to regulators, and they would like to not see institutions become more than 30% funded by non-retail deposits essentially. And so while we are typically under that number in the, say, 20% to 25% range, we have some realistic limit to how much we could do.

So that's the drawer right there, that's going to -- that's the regulator that's going to keep you from drawing on that aggressively, either this year, as needed, I guess. And really, you're going to tap the retail branch network and really focus on that more, I guess.

Well, right. I mean, ultimately, our goal is to be 100% retail-focused, right, whether it be commercial or consumer loans. And our commercial deposit acquisition has been phenomenal. It was -- noninterest-bearing commercial deposits were up 8% last quarter. So I don't want to forget we're doing well there, but we have a voracious funding appetite. Today, we still have funding capacity. If you look at the FHLB or Fed fund lines of almost $0.75 billion, so we've got lots of availability, it's kind of a dynamic dance of liquidity and capital ratios, right, as to the size of our balance sheet. And we dynamically manage all of those on a daily basis.

Great. Good color. And then, last question, changing gears again. On the commercial hires that you guys plan and also the hires that you've done, our -- as far as first commercial relationship business is concerned and C&I operating line underwriting is concerned and perhaps ABL or some of those other product types, are you guys pursuing that kind of business, the relationship C&I line? And if so, can you give a little color on the kind of operating lines that are going to be the bread-and-butter of this build out that you plan?

Sure. This is middle market business, Tim. I mean, we expect and plan to be in the middle of the street here. It is typical middle market commercial banking, so it is lines of credit, it's term credit, it's equipment financing, it's owner-occupied real estate, which is not an insubstantial part of it. Those are the bread-and-butter products. Some of those will be structured as ABL, or asset-based lines of credits, some of them will be structured differently for stronger companies. As you know, we do a lot of SBA lending, some of the risk year lending will be done through SBA lending, either 7a or 504 real estate loans. We have a big SBA group already in Southern California, which is having a good year already. And so I would expect it to be middle of the market normal stuff. In terms of sizes, the range of relationships may be as small as $150,000 or $200,000 to very, very small businesses, but the lines and relationships will probably average in the $2 million to $7 million range, with some reaching above $10 million, $10 million to $20 million, but the majority of that business will probably be in the $2 million to $7 million or $10 million range.

And the folks that you have on staff and position now are actively making those loans and pursuing that business in San Jose and Southern California and such, and in Puget Sound?

And San Diego. Yes, the Puget Sound is, of course, is very mature, right? I mean, we've been in that business here well before I came. We've just grown it here pretty substantially. So we're in that business here in Puget Sound, in Central and Eastern Washington, in Portland, and now, more substantially, as we grow California.

And is there authority -- what kind of authority do your regional managers have for underwriting authorization?

Well, they have the obligation, but they have no credit authority. Our credit approval process here provides no authority to line lenders or to management. That authority vests in business unit credit administrators who ultimately report to the Chief Credit Officer here in Seattle. There are size limitations that range from $5 million to $7 million to $10 million of authority in a credit unit administrator for commercial lending, up to the Chief Credit Officer, who can approve individually up to $15 million relationships. And we have a management credit committee that approves up to $20 million, and then, it goes to our Board of Directors. So again, no line authority in that business, but stratified levels of credit review and authority.

Our next question comes from Tim Coffey with FIG Partners.

Mark, was the investment that you're going to be doing on the commercial side of the business, the branches, the commercial lenders, some of the FTEs, do you have kind of a target efficiency ratio or something that you're aiming for this year?

Well, we always have targets. This year, we hope to improve -- and I assume you're talking about in the commercial segment, Tim?

Right, yes. Just the Commercial segment, not the entire company.

Right. Our target is to remain ultimately below 65% and ultimately below 60% efficiency ratio. The -- our ability to do that is going to be premised upon or dependent upon the pace of investments versus the size of our portfolio on the growth and net interest income, of course. Our efficiency ratio this year will fall again below 65% by the fourth quarter. Maybe you'll see sort of successive improvements as we sort of restart that decline because of the investments we're making. Next year, 2018, we expect to be able to take that number below 60%. Now that's going to be dependent, again, on the pace of investment versus growth in the portfolio, but those are the goals we've set for ourselves, and we think it's possible, as long as we can generate the good quality loan growth and find the great personnel to make that happen. And that's in the face of opening branches.

Right. And that actually led to my next question, so is that 60% target or goal, is that by year-end? For the entire year?

So for 2018, we would hope to get there in the -- sometime in the third or fourth quarters.

And if you're going to be opening branches, so you said 5 this year, right? How many are you looking at for next year?

I think, we have 4 or 5 in our current plans, so I would expect at least 4, probably not more than 6.

Okay. Those mostly California targeted?

No. We continue to have markets here in the Pacific Northwest that we have already investments in and planned openings for this year and some that will go into next year, so we have several more in the Greater Seattle area, north of Seattle and east of Seattle. We're also now looking at Portland. We only have 3 branches in the Greater Portland area, and that is a historically important market to us and a very strong economic market. In addition to which, of course, there's the entirety of California, right? And we're trying to be opportunistic there and acquire more than we opened de novo, but we will no doubt open some branches in California. In particular, we're looking at Santa Clara. That was an area where simplicity had some substantial amount of deposits, had a branch at one point, closed it, and we feel the need to make sure we reopen a physical branch to retain and grow those relationships. As I mentioned, we're going to be opening a branch in San Jose later this year, and so between Northern California and Southern California, I would expect to see us open branches on a continual basis.

And you're talking full-service branches, not like loan production offices, right?

Yes, exactly, deposit-taking branches.

All right. Just wanted to clarify that. And then, the number of FTEs that you're thinking about hiring this year outside of the mortgage business, what was that number again?

It's really kind of going to be a range, right? There's retail banking. The retail system will probably grow almost 40 people by year-end, and really associated with opening branches, right? And then, the rest of the system, and this is across a wide variety of infrastructure positions, may grow 50 or more positions by the end of the year. Unfortunately, there's a cost of growth from an infrastructure standpoint. Part of that is simple ratios of personnel to total personnel or to offices or somewhat, part of it is growth in things like finance and accounting to support growth in areas preparing to go above $10 billion, as an example, which is a multiyear initiative for us, information systems, I mean, really, across the spectrum.

Right. Okay. And then, with the loan -- or once you complete the kind of the loan processing software platform that you're building out, how much is that adding to expenses on a quarterly basis?

It's interesting, on a run rate basis, it's actually going to be less expensive, ironically. But the cost of development and installation that will be amortized over what we expect to be its useful life will add a little bit to the run rate, but it's not really material. I mean -- and we think that the efficiencies that we gain by reduction in manual processes, particularly around TRID, would more than offset that additional cost. So we think net the installation will be a savings.

Okay. And then, the ratio of closed loans to locked loans in the first quarter, I mean, typically, we see a wider gap than we did this quarter, is there anything to read through on the fact that it's closer to 100%, when it's usually closed loans are 85% of lock loans?

Well, the last couple of years, we've head extra refinancing. I think that's the biggest issue in the last couple of years. Typically, the first quarter, if there's no refinancing, and you have to go back several years because the last 2 years, we had small bubbles of refinancing in the first quarter, but if you go a little further back, the first quarter is pretty close to even. The fourth quarter is bad because you're drawing down your pipeline in the face of low new originations. First quarter is typically even, and then, the second, third quarters, you have -- typically, second quarter, you have more new loans, more locks than closings. Third quarter, it get closers to even. And then, fourth quarter, you're back in the cycle.

Okay. And so it was the kind of targets or ideas that you put out there about kind of where locked and closed loan volume could be the rest of the year. Is the read through that it's going to be relatively more expensive for you to produce mortgage loans this year than it has been in the past because of closed volume versus the locked volume?

From a fixed cost standpoint, of course, mechanically, that's yes, but the true fixed costs are not that significant, so it's up to us to realize the efficiencies that we gain by the installation of our new loan origination system to get past all the manual workarounds we've had to deal with and the QC related to TRID disclosure. And so we think that our cost structure is going to be what it is through the first half of the year, maybe through July. And then, we're going to start realizing the efficiencies we're expecting to get. And so I think, on the year, you won't see a net increase. You'll see, I'm hoping, a net decrease, though it may not be as meaningful this year as we expect it the following year.

Okay. And of course, it helps to be nimble on the execution as well?

Sure. I mean, revenue, obviously, improvement helps everything. And we're going to focus this year much more substantially on better optimizing our profitability in the segment.

Right. And then, my final question was, what was your -- can you give me the number again for what your expectations are for locked loans for '17?

Sure.

Mortgage lock, forward sale, $2.3 billion, $2.5 billion and $1.9 billion in the second, third and fourth quarters, respectively, for lock.

For a total of $8.4 billion on locks for the year and $8.5 billion on closings. And it's in the transcript, if you want to look later.

(Operator Instructions) And we have no further questions at this time, so this concludes our question-and-answer session. I would like to turn the conference back over to Mark Mason for any closing remarks.

Thank you again for your patience and great questions today. We appreciate the interest and attention, and we look forward to talking to you again next quarter. Thank you.

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