Texas Capital Bancshares Inc (TCBI) 2016 Q1 法說會逐字稿

Good afternoon, and welcome to Texas Capital Bancshares first-quarter 2016 earnings conference call.

(Operator instructions)

Please note this event is being recorded.

I would now like to turn the conference over to Heather Worley. Please go ahead.

Thank you for joining us for the Texas Capital Bancshares first-quarter earnings conference call. I'm Heather Worley, Director of Investor Relations. Should you have any follow-up questions, please call me directly at 214-932-6646. Before we get into our discussion today, I'd like to read the following statement.

Certain matters discussed within or in connection with these materials may contain forward-looking statements as defined in Federal Securities Laws, which are subject to risks and uncertainties and are based on Texas Capital's current estimates or expectations of future events or future results. These statements are not historical in nature and can generally be identified by such words as believe, expect, estimate, anticipate, plan, may, will, intend and similar expressions. A number of factors, many of which are beyond our control, could cause actual results to differ materially from future results expressed or implied by such forward-looking statements.

These risks and uncertainties include but are not limited to the credit quality of our loan portfolio, general economic conditions in the United States and in our markets, including the continued impact on our customers from declines and volatility in oil and gas prices, rates of default or loan losses, volatility in the mortgage industry, the success or failure of our business strategies, future financial performance, future growth and earnings, the appropriateness of our allowance for loan losses and provision for credit losses, the impact of increased regulatory requirements and legislative changes in our business, increased competition, interest rate risk, the success or failure of new lines of business and new product or service offerings, and the impact of new technology.

These and other factors that could cause results to differ materially from those described in the forward-looking statements, as well as the discussion of risks and uncertainties that may affect our business, can be found in our annual report on Form 10-K and in other filings we make with the Securities and Exchange Commission. Forward-looking statements speak only as of the day of this presentation. Texas Capital is under no obligation, and expressly disclaims any obligation, to update, alter or revise its forward-looking statements, whether as a result of new information, future events or otherwise.

With me on the call today are Keith Cargill, President and CEO, and Peter Bartholow, CFO and COO. After a few prepared remarks, our operator Amy will facilitate a Q&A session.

At this time, I will turn the call over to Keith, who will begin on slide 3 of the webcast. Keith?

Thank you, Heather.

Welcome to our first-quarter earnings call. As Heather mentioned, I'm Keith Cargill, President and CEO of Texas Capital Bancshares. Following my opening remarks, Peter Bartholow, our CFO and Chief Operating Officer, will offer his assessment of results and our guidance update. Then I will close before opening for Q&A.

The first quarter of 2016 was solid by most measures. If not for the elevated loan loss provision, earnings would have been $0.68 per share. I will speak in some detail about the relative health of our energy portfolio and energy loan loss reserve as compared to other energy banks.

The decision to post this front-loaded provision in the first quarter of 2016 does not change the previous guidance offered on January 20 for the full-year 2016 provision. [For] traditional LHI, excluding mortgage finance, grew 12% year over year and 3% linked quarter. However, loan fees were weak in Q1 on a linked quarter basis.

Q1 mortgage finance outstandings were flat on average, following the market share improvement throughout 2015. The relatively new MCA business showed balances increasing in line with our plan and guidance.

Expected seasonal effects in escrow balances resulted in a small reduction in DDA and total deposits. Texas Capital experienced solid net revenue growth, with continued strong operating leverage. The increase in interest rates late in the fourth quarter of 2015 generated approximately $4 million in Q1 2016 net revenue. MCA, or the mortgage correspondent aggregation business, will offer both an increase in contribution to earnings in Q3 and Q4, as well as a growing capital efficient asset class for our company.

Credit quality remains acceptable, despite continued energy loan migration in the criticized and non-performing categories. We address the weakening in commodity prices, including natural gas, with internal downgrades and SNC Exam downgrades by increasing our reserve attributed to energy by $19.5 million the linked quarter. Because of the high concentration of E&P and minimal exposure to energy services, the increased provision was primarily a function of commodity price declines on future net revenue values and related borrowing basis, combined with somewhat more prescriptive regulatory guidance in determining loan classification, as we learned from the recent OCC Shared National Credit Exam.

Specific to the SNC Exam, over 80% of our energy SNC loans were examined, resulting in only four loans being downgraded. These downgrades totaled $70.9 million, or only 16% of the energy SNC book. No charge-offs resulted from the SNC Exam.

While the spring re-determinations are underway, we're a few weeks away from completion. With commodity prices lower than last fall, borrowing base availability will decline. After reviewing our energy book, unfunded commitments are less than $10 million related to loans currently criticized.

On slide 4 and slide 5, we have updated our energy portfolio characteristics and trends. Outstanding energy loans now make up slightly over 6% of total loans, as the energy portfolio contracts while non-energy loans continue to grow.

At quarter end, total energy reserves are approximately $51.5 million, or 5% of energy loans outstanding, after incurring $5.9 million of energy charge-offs during the quarter. Non-accrual energy loans increased $20.9 million linked quarter. Criticized energy loans increased to just 21%, from 17% of energy loans in the fourth quarter.

Total criticized energy loans equals $229 million. The energy loan loss reserve now equals 23% of criticized energy loans. We believe these statistics compare most favorably to other results posted by banks serving the energy sector.

Next, let's review the other 94% of our business, beginning with slide 6. Houston footprint CRE remains approximately 4% of total loan sale for investment. We continue to find no slippage in credit quality in this category. The only criticized loan remains special mention, and has slightly reduced in size to $9.1 million.

On slide 7, we show Texas Capital Bank loans and deposits, broken down by Texas regions and national business. Because we have succeeded in developing four lending businesses and multiple depository businesses in the national footprint businesses, we now have over 50% of loan exposure and similar deposit diversification outside of Texas by customer and collateral, providing significant geographic diversification.

Peter?

Thank you, Keith.

In the first quarter, the Company produced net income of $25 million and EPS of $0.49. As Keith has addressed, the increase in provision to $30 million was obviously a key factor in results for the quarter. Growth in traditional LHI loans and total MFL loan balances, including MCA, represented meaningful improvements in market position relative to peers. MCA is on track in building average balances provided in the previous guidance.

Year-over-year increase in net interest income and net revenue of 11% and 10%, respectively. Net interest income and net revenue increased from Q4 by almost 2% in both cases.

Consistent with plan and guidance, MCA loss decreased slightly from $0.04 in the fourth quarter to $0.03 in Q1. And MCA is now entering a period where we expect meaningful build in volumes over the course of 2016.

Keith mentioned total deposits fell about 1%, due to seasonal mortgage finance escrow balance contraction. Those are balances for taxes and insurance payments.

A reduction in deposits was offset by a linked quarter reduction in liquidity assets, with a favorable impact on NIM. We saw year-over-year growth in DDA of 20%, representing almost the same dollar amount of total growth in traditional held for investment loans.

In terms of NIM review, we saw improved core yield on traditional LHI and mortgage finance loans, due to the December rate increase. The pickup in the quarter was just over $4.5 million, and is consistent with expectations.

We saw a reduction in fees incorporated in yield from the fourth quarter. We saw stability throughout 2015 in this category in both dollars and yield impact, with a seasonal decrease in Q1 resulting from reduction in syndication activity and new commitments on CRE.

Yield trends have actually remained quite favorable, especially given the magnitude of our growth and the competitive environment that still remains very intense. As noted, we experienced growth of 2% in average traditional held for investment loan balances, up from Q4 2015 and 13% year over year. Again, that's solid growth consistent with the guidance, despite the high level of pay-down activity we still experience and declining contributions to growth from CRE and energy.

Total energy loans were decreased by $100 million at quarter end compared to year end 2015. And for the last half of 2016, we expect further reduction in the rate of growth -- in the contribution to rate of growth from CRE, including builder finance and energy. Our mortgage finance business clearly benefits from Texas Capital's position in this important business sector.

The balances remained high, with significant $1.3 billion spike at the end of March. Average balances were matched from Q4 at $3.7 billion, well ahead of industry trends.

Part of making room for the growth in MCA at quarter end, participations were 515 million, compared to 455 million at year end 2015, with an increase in commitments to 825 million at quarter end, compared to 719 million at the end of 2015. Consistent with the past, mortgage finance loans represented 24% of average total loans for the quarter, and average participation balances were flat linked quarter.

MCA balances grew to $124 million, again consistent with the guidance provided in January, and on a path to higher average balances in coming quarters. With MCA, the total average for all mortgage finance lending activity was up 4% from Q4, with a small improvement in the capital efficiency associated with MCA.

On slide 8, you see the benefit of the Fed rate increase was, as anticipated, a meaningful contributor to net interest income. We saw an increase in net interest income of $2.6 million and 12 basis points in NIM. Linked quarter NIM increased after a $3.3 million or 7 basis point reduction in the fee component of NII and NIM, and offsetting the benefit of the result in liquidity assets. Funding costs remain highly favorable, and we believe duration will continue to increase, with relatively low deposit beta because of deposit composition.

On slide 11, the component -- we've described the components of the increase, or in this case decrease, in net interest income. Net -- excuse me -- net interest expense from Q4. The MCA loss, as I said, $0.03 a share compared to $0.04 in Q4.

We had flat NIE from Q4 2015, mostly as a result of the reduced cost of 123R expense. The efficiency ratio actually declined slightly with the flat expense and growth in net revenue, and it remains consistent with the guidance that anticipates improvement in the last half of 2016.

Slide 12, the quarterly highlights obviously reflect the effect of higher provision on ROE and ROE. All other measures are consistent with the guidance. On slide 14 and our 2016 outlook, we still believe traditional LHI balances will grow as indicated, based on our view of market conditions in all of our lines of business.

It does, as I said, reflect planned reduction in growth rates for CRE and a contraction in energy loans. We see a continuation of relatively high level pay-down over the course of 2016.

We expect growth in mortgage finance loans, excluding MCA, to remain modest. It remains too difficult to estimate the potential benefit from the flattening yield curve, and the strength that we saw in Q1 reflects an improvement in refinancing activity that may not be sustainable, but we are entering a more productive Q2 and Q3.

MCA balances for the year remain, we expect, to be -- exceed $300 million on average balances. Customer acceptance rates are high. [Trade] impact is declining, and we expect a meaningful ramp in balances.

We see a broader product opportunity that will improve yields, and we will factor into net revenue and net interest -- non-interest expense guidance that are already provided. We still anticipate becoming profitable on a monthly basis in the second quarter, and being profitable for the full year based, on the contributions in the last half of 2016.

Deposit growth will continue, but as we've indicated, at a lower pace, still building on average, over the course of the year, a small increase in liquidity balances. On a net revenue basis, we still see mid to high teens, based on the ramp in MCA, good growth in loans, and a benefit from the rate increase that we saw in December. In terms of year-over-year comparisons, we obviously rate it by contribution from MCA that were negligible in 2015. We also expect a return to improvement in added swap revenues and syndication fees to be reflected in the latter case in NIM for the last three quarters.

NIM was higher than guidance, net of the effect of liquidity, adjusted just over 3.6%. We do reflect, still, an increase in the guidance because of the Fed rate increase, and adjusted for the liquidity levels, they should be comfortably within that range or better. We do see a smaller composition in mortgage finance loans to the total, which will also help. And the pricing competition in C&I is still intense, but incremental pressure on yields seems to have abated to some degree.

We maintain guidance on the efficiency ratio in the mid-50's and comparable to 2015. As Keith mentioned, we have seen no change in the guidance on provision and net charge-offs at this time. Provision in the mid-60's range, even with the Q1 provision of $30 million and the increase in the allowance for loan loss of almost $23 million, seems to be satisfactory for the remainder of the year. Guidance given at the end of the quarter fully anticipated exposure to credit migration, and actually -- that was actually experienced in Q1.

Net charge-offs in Q1 were 25 basis points, consistent with our full-year outlook, and of that, 20 basis points was from energy. We believe the methodology is driving a reserve -- that drives a reserve of more than $50 million should cover identified exposure to net loss, even in a more stressed environment.

The SNC Exam, as Keith mentioned, was a factor in Q1, but it was more driven by forward commodity prices and internal grade changes. Not surprising, that the first half would bear most of the provision expense, given the profile of the forward curve that we experienced this quarter.

In response, I would suggest also that with a remaining use of provision that might be $6 million for growth and traditional health for investment balances, it still produces another $30 million plus in reserve that is available to deal with other unforeseen changes in conditions.

Keith?

Thank you, Peter.

Slide 14 highlights our asset quality metrics. Of the $190 million in non-performing assets, energy makes up $141 million, or 74%. Energy MPAs increased $21 million linked quarter, although total MPAs increased by only $10 million.

Net charge-offs totalled $7.4 million, with the energy charge-offs of $5.9 million comprising 80% of the total charge-offs. With our front-loaded provision in Q1, we believe we are well reserved overall. The Q1 provision allowed us to build an energy designated reserve of 5% of total energy loans and 23% of criticized energy loans.

Our criticized energy loans increased from 17% of total energy loans to only 21%. These criticized percentages, we believe, compare quite favorably against other energy banks.

With slide 15, I'll close. Traditional LHI growth for Q1 was strong, at 3% linked quarter. We believe that we continue to manage our energy portfolio fully engaged with the clients, and conservatively addressing loan migration and energy reserve bill, in line with our somewhat healthier energy portfolio.

Although the first-quarter provision was elevated from Q4 2015, we are not changing full-year guidance for provision or net charge-offs. Energy portfolio migration increased criticized energy loans to 21%, but this percentage, as I mentioned, compares favorably against others in the energy sector. We remain asset sensitive. Future rate increases will translate into even more favorable lift in income, since the Q4 rate increase essentially overcame a meaningful component of our loans with floors.

The relatively new MCA business is building as planned, and will be a positive contributor to earnings and return on equity during the last half of 2016. MCA's much improved capital efficiency, as compared to traditional mortgage finance loans, sets up for strong growth in its new high growth asset class, but consumes far less capital to fuel the growth. Texas Capital Bank continues to build a stronger C&I growth capability with the expansion of our franchise finance footprint and continued talent acquisition.

At this time, I will open the call for questions.

(Operator Instructions)

Ebrahim Poonawala, Bank of America Merrill Lynch.

Good afternoon, guys.

Welcome, Ebrahim.

I think, Keith, if you can just start off on energy and your provisioning this quarter. As we look out for full-year guidance for mid-60's, how are you thinking about one, the outlook for oil prices and migration within your own book, which gives you comfort around that mid-60's full-year guidance? I'm just trying to understand whether you, when you gave this guidance in January, you did anticipate it being so 1Q heavy? Or did that change over the course of the quarter? And what is the downside to this forecast, as we look out for the next three quarters?

We felt, and still do, that we were adequately reserved at the end of the year, Ebrahim. What changed were two things, primarily, the shift in the forward curve. And what that did is, we reset price decks and assumptions and re-ran our future net revenue valuations on the portfolio. And secondly, what we learned going through the SNC exam, that we have begun to apply across the portfolio, and that is new guidance that is somewhat more prescriptive from the regulators than we've used in the past.

And that combination of those two things caused us to go ahead and decide that while the year guidance does still look solid to its own provisioning, we should go ahead and address this first quarter and be sure that we can represent we're adequately reserved in this environment, with the prices and so on. So we're not presuming any prices getting better. We look at the forward curve. We don't speculate on our price deck assumptions and all. And because it is so quantitative in how we drive valuations, that's really what drove the reserve.

Understood. And I guess as you look at the non-energy book, and tie that into the provisioning guidance, what is the sense right now, when you look across your markets? Are you seeing the pressure points where you start seeing the contagion from energy flowing into the rest of the portfolio? Or you're not seeing those signs yet?

You would think, if you're going to see that leakage, it would be first in Houston CRE real estate. And we presented that slide, that we've provided the last couple of quarters, that shows that that footprint is actually no different. It is slightly better. The loan that we had is special mention, for $9.3 million or $9.4 million a quarter ago, is now $9.1 million, still special mention. And that is out of a total, in that footprint, of over $700 million of CRE.

As far as C&I leakage from the oil and gas decline, we're not seeing that yet. It's not that we don't have, from time to time, a C&I credit that has some issues, but we're not seeing it related as a direct function of what's happening in the oil patch. It is typically something to do with Management decisions or a strategy that has not been kept up to date. So thus far, perhaps because we have so much of our loans not in the Houston footprint and C&I, too, that also helps us, perhaps, on not seeing as much effect. But I think Houston has proven to be much more resilient, even for banks that have a bigger footprint in Houston than certainly we did.

As I mentioned on one of the sides, we now have over half of our loans that are outside the state of Texas. And then the predominant amount of our loans in Texas tend to be north Texas and central Texas oriented. Houston is growing rapidly, and we're very proud of Houston. We still think it will still be, on a percentage basis, if not the highest growth percentage of all of our five regions in Texas, it will be number one or number two again this year. But we have a small market share in Houston, and that allows us to still grow quite nicely, and thus far avoid any major problems.

Got it. And just as a follow-up, you recently announced a new senior hire coming from Wells Fargo, to help on the energy and the SNC loans. Any background on what led to that? And why that move -- I'm assuming there is a lot going on, managing the energy book right now. What were the circumstances that led to this announcement?

That was entirely a function of the fellow that has built the business with us, been with us for, I guess, 14 years now, and has run it the last 10 years, Chris Cowan. He has toyed with going into private equity for years, and he believes he'll make a lot of money with his timing of going in today, and I would not bet against him. And particularly since he has really had a desire to do this for several years. So it certainly had nothing to do with our deciding that we wanted to make a change.

However, with Chris making that decision and working very well with us, very thoughtfully with us, on transitioning appropriately, we were successful in hiring our number one candidate, Lester Keliher. Lester just could not be a better person to step in, after Chris's transitioning the next couple of months, with his experience. He helped build the national business, energy business, for Wells Fargo for the last couple of decades, and he is very, very knowledgeable. This is not his first rodeo. He has been through many, many cycles.

He is highly regarded by industry, and our clients have been extremely supportive and embraced Lester coming into this role. So we were just very fortunate that we were able to attract him. At a time when he had left banking a couple of years ago, he actually was doing some work for a very, very wealthy individual, looking for distressed opportunities in energy to invest in. And he, like a couple of us that started Texas Capital, he missed building a bank and being in a banking company that is regarded as highly as we are, particularly in the energy space.

Lester has a great reputation, and I think it is a testament to what Chris has built and our credit team has helped to oversee as we built it, that our energy talent is thought of so highly, and our reputation is so good, that Lester wanted to step in and lead that effort for us. He is also assuming the syndications business, which Chris had overseen, as well as financial institutions.

Got it. Thank you very much for taking my questions.

You're welcome.

Dave Rochester, Deutsche Bank.

Good afternoon, guys.

Hello, Dave.

On your expense guidance, it seems like you really need a big step up in expenses to hit that mid to high teens expense growth in 2016. Is that really what you're expecting? And if so, in what lines are you expecting that big bump up?

Dave, so much of that has to do with the fact that it was all expenses in 2015 were ramping up over the course of the year. We didn't have a full year of MCA expense in 2015. Obviously, there are other components, regulatory and otherwise, but it's really more geared to a run rate of mid to upper teens off of fourth quarter, and now first quarter annualized.

Got you.

But if you take that number and look at it relative to full year 2015, that's what you get.

Okay. And then I just wanted to make sure I heard this right. MCA becomes profitable on a monthly basis in 2Q? Is that what you were saying?

Correct.

Okay. And then on the provision outlook, I know next year is far off at this point, but do we have to start thinking at all about extra reserving you might need to do, once we hit the period where the hedges really start to roll off in a more meaningful way? I know that, that is something you consider in the borrowing base for your determinations already. But does anything change once the current cash flows actually take a hit next year when that happens?

All that is taken into account in our methodology. That's how that is driven. But -- and as we're going through the spring re-determinations, while we're not through that process yet, this will give you some indication of what we're seeing, at least on the energy component, going forward, is we'll probably see a shrinkage in commitments available to be drawn, Dave, in the range of mid-20s, relative to the re-determination last fall. So as you have seen in just the last quarter, our outstandings came down about 10% in energy.

So as the energy portfolio and available commitments to be drawn continue to come down, with the pricing that we're looking at today, at least, we would expect that the migration will continue, but begin to taper. And as far as next year is concerned, I would say a lot has to do, next year, with just what the overall economy might be doing. And presuming that we continue to have some good housing demand, and the overall economy is doing okay, and we're not faced with a premature recession, I think we'll see much more modest ability to provide.

But it's early to give you anything. I don't think you're asking for any specificity around that, but our instincts are that next year will be more modest on provisioning.

Okay. And then, how far along through that re-determination process are you this quarter?

We're about halfway through, and that is why I can at least give you a ballpark on the decrease and available to draw commitments, because at least I have a pretty good feel it will be somewhere in the mid-20s, is every indication halfway through. So it is a couple of weeks away from actually getting ramped up, but I think you probably are going to hear that type of thing from other banks, if they're heavy E&P banks, as we are.

Okay. And then just switching gears to the NIM, you mentioned the decrease in loan fees impacted the NIM by 7 bps. I was just wondering how much more fee contribution there is in the margin in the first quarter? And you mentioned that was seasonally lower. Are you expecting that to rebound in 2Q?

Some of it is, we're slowing the pace of growth in CRE, but it was still an odd quarter, abnormally soft quarter, because of a combination of a very strong fourth quarter in syndication deals that closed and CRE credits that closed. But CRE generally is going to be more modest on new originations this year, as we have been telegraphing for over a year, and we're slowing the pace of growth.

So we'll still be growing CRE, and we'll be replacing runoff with new credits that will have fees associated with it. The biggest impact this quarter was syndications, and that is lumpy. It is hard to predict, quarter by quarter, when syndications are going to close.

Got you. Okay. And then just one last one, on MCA. Can you update us on the quality of that paper you're seeing in the legacy mortgage business, as it relates to TRID? I know that was an issue that you talked about last quarter. Is that paper quality improving? And could you just update us on the fee income outlook for that business, if that has changed at all? And the competitive dynamic there?

Yes. Our clients have really navigated and figured out TRID far better. That learning curve has really plateaued quite a bit. I want to emphasize the technology and filter that we built on our system has been spectacular on catching any defects or glitches before it ever ends up owned by Texas Capital on the MCA business. And we're batting virtually 1,000 on how that system is working, in regard to any defect.

And the clients like that, because we're catching any defect before it actually ends up later in a securitization. And as the mortgage client we have is the first ever to have put-back risk, we would be secondary. So it is not just good for the bank; it is good for our client. And -- but the TRID issue is working its way out. It is smoothing out.

So that just means more paper that MCA can effectively purchase, right?

That is exactly right.

Okay.

The defect rate we see tapering.

Great. All right. Thank you, guys.

You're welcome.

Michael Rose, Raymond James.

Hi, good afternoon, guys. How are you?

Just fine. How are you doing, Michael?

Good. Hey, wanted to go back to the scenarios that you talked about last quarter for energy losses. If you remember, I think you guys said that you'd expect energy losses to be somewhere in the $10 million to $15 million range if oil prices remain at current levels, and then $20 million to $30 million if prices trended towards $20 a barrel. We're pretty far from those levels at this point. So can you provide any updates to how that might change with oil where it is? And then if it actually trends higher in the back half of the year?

I think it is more toward the second bracket, the $20 million to $30 million, with prices that have adjusted since fourth quarter, Michael. But that's through cycle, not necessarily through 2016. So we're talking about spillover before those charge-offs get realized into next year.

Okay. Because that would translate into a [accum] loss somewhere in the 1% to 2.5% range. So is that still a fair accum loss target, given the dynamics of your portfolio and higher E&P exposure?

That is our best visibility now.

Okay. And then maybe just switching gears a little bit, to loan growth. You guys have done a pretty good job taking advantage of lending hires over the years, and given the pull-back that we're seeing from some competitors in Houston. Can you talk about how many lenders you might hire this quarter? And maybe what the pipeline looks like? Thanks.

We actually had a slight contraction of a couple of people, and that is likely to change over the next few quarters, in potentially a very nice way. I don't mean back to record hiring levels, but we've never had better talent in the pipeline than we have currently. And we're seeing it across the board, C&I, but also in private wealth advisor talent. And so that is coming also at a good time. Now that we have the platform up and really running well, it is time to begin to add some more client advisors on that platform, as well as on our C&I platform.

So we're quite optimistic, but we're very disciplined over the last year, year and a half. We're very thoughtful. We want to be sure we get the starting lineup of the all-star team. And we hired new bankers, and we have been very fortunate in picking up the gentleman that we hired just in the last 45 days to run our franchise finance business. He's just top caliber, having spent 11 years at GE Capital in this space, and the last couple of years at TD Bank. So he has all of the experience, and just a fabulous, talented fellow to come in and really lead that C&I effort that is becoming a vertical.

As we -- as Michael, over the years, we find these outsized opportunities and niches in our broad C&I book, and then do some deep research and investigation on, could this be a sustainable, higher quality, higher return, for the risk taken category? And we've made that decision on franchise finance, and we have spent some time finding Brian, but we're so glad we were patient and looked on a national basis for him. And when we have businesses like franchise finance, that are going to move beyond Texas and into a national footprint, we definitely are taking a look across the country at best talent, and we have been successful attracting those people over the last year and a half.

So we feel good about the go-forward on C&I growth.

Okay, that is helpful. And then just one last one for me. If you can help reconcile the decline in non-accrual loans? Obviously, energy non-accruals were up. What was the offset? I'm sorry if I missed it.

It really was a credit that moved from non-accrual into ROE. So it was just a shift in category. That is why MPAs were up 10, although overall MPAs up only 10 and energy MPAs were up more than that, about 20, 21. We had some resolution of a non-performing asset -- two, actually. Two payoffs with no loss.

Rather than pay-downs.

Yes.

All right. That's it for me. Thanks, guys.

You're welcome.

Brad Milsaps, Sandler O'Neill.

Good afternoon, guys.

Hello, Brad.

Just to follow up on the expense question, Peter and Keith, you alluded to some of this with the hiring. But just curious how much of that number, maybe $50 million some-odd, looks like, could grow year over year. How much of that would be variable? Or is that pretty much fixed expense that you expect to see, no matter what you do in terms of new hires, or in terms of overall hitting profitability goals, et cetera?

Brad, it is built around unit-driven plans for possible hires. They don't necessarily get to hire those people as part of the recruiting process that gets reviewed, basically, at the senior executive level, whether they're going to qualify or not. So there is always variability about what talent is available, and what we're willing to take when it becomes available. The other part, the year over year, is primarily an issue of MCA for their first full year of operation.

We saw the biggest increases there in the third, and really the end of the third, and then through the fourth quarter, gearing up for production in 2016. So that's why I say that the more relevant comparison, in our view, is what's -- where we are today, annualizing that level, compared to the fourth quarter of 2016 -- 2015, I'm sorry. So it comes out in the mid to upper teens on that basis.

And the MCA ramp on salary expense is highly variable. As Peter says, it is a unit growth production driven model. Any new hire we do, before we extend an offer, as Peter alluded to, part of our organic growth recruiting strategy from day one, we really work with the prospect, and have them develop a two-year forecast, what they think they can produce.

And so again, before we even hire an RM on the C&I side or wherever, we have a pretty good idea how that cost, while it is somewhat front end loaded the first 6 months, how we're going to recover that negative cash flow and capital for our shareholder. And have a producer turn profitable, both on cash flow basis and a net income basis, within 12 to 18 months.

Okay. And then just one follow-up on the deposit side. If we do get another Fed rate increase this year, or whenever it may happen, would you expect that you would absorb a similar amount, in terms of deposit rates, as you did with the December Fed rate increase? Or would you anticipate that might be a little higher or a little lower?

It could be a little bit lower, Brad. There are deposit categories where we have an understanding with the depositor base that we will move in conjunction with the Fed rate moves. Those are less than, obviously, where we are on the movement in the loan balances. We also, even with only one quarter's increase, one quarter point increase, we have burned through a meaningful portion of the loans where there were limitations based on floors. So we would expect the overall to improve slightly with the next one quarter point increase.

Okay. Thank you, guys.

You're welcome.

Kevin Fitzsimmons, Hovde Group.

Hi, good evening, guys.

Hello, Kevin.

Been a lot of talk on energy, and I recognize the lumpiness that can come from the SNC Exam. But can you help us with how you view the regulators' behavior? Or maybe how you perceive their behavior is going to be in the future? Because I think a lot of folks like us on the outside, we're looking at different banks, particularly the larger banks that are regulated by the OCC, like you all, and they're getting put up at energy reserve ratios up in the 8% and 9% range.

And I guess what we're trying to get our arms around is, is there a risk, as we look out a few quarters, that the regulators could start pushing and come to a conclusion? Or sending a message to you that, hey, 5% looks below where the other banks are, and we need you to take that up? And is that something that is even out there, as a risk for you all? Or is it something where they just don't look at it that way?

We don't see that as a risk to us. We have a very good relationship with the regulators. And while they're evolving how they're giving guidance on classification and rating of energy credits, it is not without rationale. It is just that we don't have a lot of those credits, Kevin, that are most exposed to much higher reserve requirements under this new guidance. There have been some.

And so from what we learned in the SNC Exam, we have really endeavored to apply that new learning, that new guidance, across the other non-SNC portfolio, to the extent we have been able to work through much of that. And that has caused us to move some ratings, internal movement. And as we mentioned, the SNC Exam, out of all of the credits that were reviewed, there were only four that were downgraded in the SNC Exam. And so it wasn't completely inconsequential. It was about $70 million that was affected, but none of it involved charge-off.

And we've not experienced any irrational behavior by the regulators at all. We think they worked really quite closely with industry, with the banks, on learning how we risk and underwrite credit in this space. But it's evolving some, and we've just made that adjustment to understand where they're going. We think we've addressed where they're going, not just where they might go. And there should not be this big forward risk of us having to move from a 5% type reserve to something meaningfully higher. We don't have that kind of risk in our portfolio that would cause that, even under the new guidelines.

Okay. Great. That's helpful. Just one additional follow-up, just on the capital level and the capital cushion and your comfort there. The TCE ratio ticked down this quarter, but you're still intending to grow the balance sheet. Just to get -- trying to get a sense for your comfort with that level, or whether you're looking at potentially pulling back the reins a little bit on the growth, given where that ratio stands today? Thanks.

So much of that ratio, Kevin, is driven by the $1.3 billion surge at quarter-end in the warehouse. And I think we've made clear no one would be -- no one would rationally build capital to support something that's going to dissipate in the next 10 or 12 days. So we look at it very carefully on an average basis, where the average is moving, whether that would change our risk profile in any way that would suggest capital would be needed.

And except for the outsized effect of the provision for loan loss, we're actually contemplating growing within the ROE, and that is our view, going forward, in 2016. We saw linked quarter growth of just 2% in average balances in traditional health for investment loans, and a little under that in the total loans. So we're living within what we believe is a reasonable rate of growth, relative to our return on equity.

The number I had mentioned earlier -- I'm sorry, Peter, to interrupt.

And all of that is planned, based on our view of exposure in out years -- not in 2016 and hopefully not in 2017 or 2018 -- but to the possibility there will be a recession in coming years. And in our focus on CRE, and obviously the reduction in energy exposure, is driven by those issues, not by a change in what we think is the opportunity in our marketplace.

The linked quarter growth I mentioned was the 3%, and that's period to period end. So that just says we have got a lot of wind in our sails going into the second quarter. But Peter's number of 2% was the average shift for the quarter.

Got it. (multiple speakers)

We're very cognizant what we have to work with, and we feel quite good that our highest growth asset category is going to be at the most efficient capital consumption level we've ever experienced, with the new MCA business. So that's going to help us, too.

Got it. Those are all fair points. And one last one. I took note that you had a comment about that a little more than 50% of your loans are now outside Texas. When you look long term, and take into account what we've gone through here the past year or two with energy, is that something where you're comfortable where that is today? Or do you think, longer term, you'd -- as good of a market, and robust as a market Texas has been, that you would aim to take that ratio up? Or are you just comfortable where it is today?

We're very comfortable where it is today. We think, long term, that Texas economy provides phenomenal upside growth for us, just in the five cities we're located in. Those five cities where we do business still account for almost 80% of the targeted clients we go after for business -- as business clients. And we have a very tiny market share, even with the growth we've experienced the last 18 years. So we would be extremely comfortable at this kind of level.

But we sometimes find when we do things exceedingly well with an industry that, that word travels. And as we follow our clients and attend trade shows, conventions for their industry with them, and they introduce us to other CEOs, it is not a casual introduction. They're just enthusiastic about the differentiated, much better high touch service and knowledge that our bankers have, and the low turnover and on and on. And that sometimes has created, for us, the capability to take it national footprint.

But we've accomplished the geographic diversification we thought was important over the last few years, and we would be entirely fine with this kind of mix as we go forward. We'll just have to see where the best return for the risk that we're willing to accept exists. Is it in the national footprint and a new vertical? Or an existing vertical? Or is it in Texas?

Great. Thank you.

You're welcome.

Steve Moss, Evercore ISI.

Good afternoon, guys.

Hello, Steve.

I wanted to ask, just wondering, how much of this quarter's loan loss provision was from the application of the new regulatory guidance?

It is hard to give a specific breakdown. Some of it -- not as much of it as the price shift -- so if I had to pick, I would say probably two-thirds to 70% was the price shift. And maybe 25%, 30% was the application of the new learning that took place on regulatory guidelines through the SNC Exam that we have now extended across our portfolio, most of the portfolio. We're working through it.

Got you. And in terms of the energy charge-offs experienced this quarter, just wondering if you could give us some additional color as to what went on there?

We had two credits, and they reached a point on liquidity, and being outside the borrowing base, that it was incumbent on us to take the charges. And even though we're not having the implosions that you might experience with energy service, some of these E&P companies have really fatigued, and there are going to be some charge-offs that occur.

Now, I would tell you, that because they're E&P companies, we had a prospect in many cases of recovering that money over time. But if it hits a past-due status, and they're over borrowing base for a long enough period of time, it is incumbent on us to take the charge. One of the credits involved a field that shut down. So there was just no cash flow that we could look to, to realistically to get that paid back in full.

Got you. And wondering what was the charge-off rate or the loss rate on those credits?

On those specific two credits?

Yes.

I can't say right off. It would be significant. I would estimate close to half, even more, more than half. I'm getting a signal here from our Chief Risk Officer. More than that. So it could be 60%, 70%.

Those are going to curve from time to time, but generally there are better ways to navigate. But they're going to have to have the ability to find buyers for part of their properties, and shrink their gap on the borrowing base, being out of compliance on borrowing base, and buy more time to generate liquidity through the sale of some of those assets. And in this case, they were not able to do that with the field shutting down.

Okay. And also just wondering --

I got some specifics. One was 75% and the other was 55%.

Okay. And wondering, what is the hedge position of your energy clients at this point?

I'm sorry, I didn't hear you on that.

What was the hedge position of your clients at this point? What percentage of production is hedged?

We're at about 50% through the balance of the year, on average, hedged. It is bleeding down as time ticks off, but that's very close.

Okay. And then lastly, just wondering, on deposit pricing here, it seems like deposits repriced a bit faster than what we've seen from other banks this quarter. Wondering if some of those deposits are indexed, by any chance?

No. As I said a minute ago, Steve, we have a couple of deposit categories and I'll mention one in particular, money market accounts, from our downstream correspondent bank. Those banks agreed to leave deposits with us, provided we will pay a small increment, leave it with us for a long period of time, if we will pay a small increment to the Fed fund's rate. That category by itself moves, but then we saw no meaningful movement in DDA balances or any other categories that are really the core of our asset sensitivity.

Okay. Got you. Thank you very much.

You're welcome.

Emlen Harmon, Jefferies.

Hi, guys. Good evening.

Hello, Emlen.

Just a couple of small follow-ups at this point. The loan fees had a negative effect on the NII this quarter. Could you give us a sense of what portion of NII is still tied to loan fees? And what the characteristics of the loans were that drove the lower fee income?

Yes, it is just the lack of -- it's just the timing, as Keith mentioned, of variability and timing on SNC -- not SNC fees -- on syndication fees. Typically, they're going to run 10 to 12 basis points, quarter in, quarter out. And this quarter, they were down. So it is unusual for us to have a movement of that size, but we do get monthly and quarterly movements that tend to average out at 10 to 12 basis points to the good, as net pluses to NIM.

This was a particularly odd quarter. I think it is the weakest quarter we've had in two years on loan fees. So we don't expect that to repeat itself. But it just so happened that the timing was off on syndications. And there is some amount of that, that as I mentioned before, we're not going to be originating, at the same pace, new CRE loans. But we will be replacing runoff, and we're still going to grow CRE, just not at the pace we did a year or two ago. We're just tapering the growth rate.

Got you. Okay. Thanks. And then just comparing the SNC portfolio versus your non-SNC portfolio, what does the distribution of the credit grades look like? The stuff that's SNC, is that higher along the grading scale versus the rest of the book? Or just trying to get a sense of the differences there.

Excluding energy, yes. And even within the overall energy portfolio, SNC versus not, yes.

So, yes, there -- you're saying that they're evenly distributed?

On average. Yes.

The larger companies more typically --

Relatively more criticized in the SNCs for energy.

Energy got more criticism in the SNCs because of some of this junior debt and the new guidance from the regulators. But as far as the overall SNC book, particularly the non-energy, it is going to be a better grade, on average, than our overall C&I, our overall CRE, and so on. But the SNCs in energy are getting more criticism because of the -- again, the new look at overall debt. Not just your senior debt position and coverage, but the new guidelines from the regulators look at total debt and the ability to repay total debt.

Including commitments whether or not they can be drawn upon re-determination.

Right. Okay. Got you. So to summarize, the energy SNC book, typically higher on the grading scale because of more leverage at the credits, the non-energy SNC book tends to be better graded.

That's right. And by the way, I'm not saying because the energy SNCs are getting more criticism, that we will lose more money there, but they are going to drive more provisioning and reserve if the ratings are more critical ratings with this new approach. We'll have to see how that plays out. But we feel very comfortable with our senior position in most all of our SNC energy credits. So it ultimately gets paid, but you're going to have these rating classification issues, and that does drive more reserve or more provisioning.

Thank you.

You're welcome.

John Moran, Macquarie.

Hi, how is it going?

Doing well. How are you, John?

I am doing well. I have got two housekeeping ones, and then one more just back on TRID. The Houston builder finance book, I think, last quarter was around $350 million. Where does that stand today?

Slightly smaller. That business has been very, very strong, and the quality is still quite good. But the builder community in Houston has really begun to throttle back their building programs, anticipating slower demand. Last year, the demand was phenomenal. It was as strong on new housing closings, it was as strong as the year preceding, which was remarkable.

But again, they're not pushing the chips in the middle of the table to do it this year. They're being more modest and thoughtful about it -- new growth. And so that is affecting our book down there. And it's not growing as -- at the pace it has. It's tapered.

Okay. Fair enough. And then the other housekeeping one for me was, the credit that moved on to OREO, what was the nature of that property and the location? It was not in Houston. We can tell that from the slide that you guys have on the Houston CRE. But if you could give us any more on that?

Yes, it is San Antonio.

Okay. And was it multi-fam or office or --

It was a commercial office. Medical office.

Okay. Medical? Okay.

Yes, medical, healthcare.

Okay. Got it. And then the -- just circling back on TRID. I know you said in MCA, you guys are batting like 1,000. There was news that went around some of the mortgage industry press about a large mortgage company, W.J. Bradley that shut down shop over TRID compliance issues. Wondering if you guys in fact had exposure there? And there was -- I guess there was some report that you had taken jumbos -- or that lenders had taken jumbos and sold them off scratch and dent. If that had happened, was that completed in this quarter? Or is that still outstanding?

There is a lot of misinformation that's been put out about what's happened there. At the end of the day, we're dealing with a couple of issues. It is not unique. We have done this multiple times. And in every instance, we have been able to resolve it with no loss, and we wouldn't expect a different outcome in this case. But it really hasn't been represented all that accurately in some of the media coverage on Bradley. There actually was a buyout that precipitated some of the decision later for them to wind it down. Not so much the TRID issue.

Got you. But is it -- is there exposure there, number one? And then number two, if the -- if in fact there is jumbos that need to be sold scratch and dent, has that sale been completed and reflected in this quarter's results?

As I said, John, we've dealt with these multiple times, similar situations, and we've always resolved them without loss, and we would expect the same in this case.

Okay.

Yes, I really don't want to talk in detail about any client relationship issue, but no, we don't expect to incur any kind of hit on this.

Okay. Understood, and appreciate that. Thanks.

You're welcome, certainly.

Gary Tenner, D.A. Davidson. Mr. Tenner? Jennifer Demba, SunTrust.

Thanks. On the franchise lending operation, what kind of balances do you think -- what kind of potential do you think that business has, in terms of balances [just for year] over the next one to two years?

I think it has excellent potential. Really, it's initially going to be the focus of Brian to fully exploit our existing RMs, Jennifer, in Texas, in the different markets. And bringing in high quality franchisee operators, and teaching them how to underwrite and being sure we use a common template, working with credit and Brian both, so that we can get the penetration improved in the five cities we operate in here in Texas.

But ultimately, Brian has run a national footprint operation in franchise finance. So in future years, after he's initially focussed more on our RMs that are here in Texas and getting them up the curve, we think it could grow very nicely. We think it could move the needle. It could be a $50 million to $150 million a year growth engine, but we've got to walk before we run. That's why he's focussed initially on existing RMs that we have on the payroll in Texas. Over time, he will begin to add people in other parts of the country, as well.

And what (multiple speakers) --

Jennifer, this is Peter. We do have meaningful experience in this business. We're not just all of a sudden deciding that franchise lending is a good way to grow.

As I mentioned earlier, this is typical Texas Capital. In our broad C&I portfolio, we find niches that we do really well at, and then we do the deep dive research and diligence to determine if we should make it a vertical. And then add the appropriate additional talent and know-how, both on the credit side and also the production side, to grow at an even faster rate in that vertical. And we have over $0.25 billion in franchise today. So as Peter said, we understand the space. It is something we've done for over a decade.

Thank you.

You're welcome.

Brett Rabatin, Piper Jaffray.

I think most things have been addressed, but just wanted to go back to thinking about MCA. And you guys have indicated that the market has been too competitive. Was just curious for an update, maybe, on how you view it, given what we've seen so far this quarter with mortgage servicing writes, write-downs, and other things happening that might help you guys?

In fact, what you just described is beginning to help. We're seeing some good traction now, Brett. We've had some really good conversion of existing clients that have been long-time mortgage warehouse clients. And we're beginning to add that next tier of direct clients that are primarily MCA clients that -- some of whom will eventually find their way into the mortgage warehouse space with us, as well.

So we're encouraged and on plan. But what you mentioned is in fact helping us. It is not as irrational as it was four to six months ago, because there has been a little bump in the night in the MSR. So everybody is a little more thoughtful about what they'll pay, and the market is getting somewhat more rational.

Would you give a number, from a basis point perspective, on what the dynamic has changed over the past few months, maybe?

I don't have that detail to offer, but I'm sitting in on some of the meetings at a higher level. It is -- again, we're getting traction, we're driving significant new client acquisition, and the volume of paper is improving as we had hoped. So it seems to be on track. As we mentioned earlier, we would expect that sometime this quarter -- it may be June, it may be May -- that division should turn profitable.

Okay. Great. Appreciate the color. Thank you.

You're welcome.

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

Thank you very much. We appreciate your interest in Texas Capital, and look forward to delivering the finest results we possibly can in upcoming quarter and balance of the year. Thank you.

The conference is now concluded. Thank you for attending today's presentation. If you have any questions, you may contact Heather Worley by phone 214-932-6646, or email heather.worley@texascapitalbank.com. Thank you for attending. You may disconnect.