Texas Capital Bancshares Inc (TCBI) 2019 Q2 法說會逐字稿

Good afternoon, and welcome to the Texas Capital Bancshares Second Quarter 2019 Earnings Conference Call.

(Operator Instructions) Please note this event is being recorded.

(Operator Instructions) At this time, I will turn the call over to Heather Worley, Director of Investor Relations.

Please go ahead.

Good afternoon, and thank you for joining us for the TCBI Second Quarter 2019 Earnings Conference Call.

I'm Heather Worley, Director of Investor Relations.

Before we begin, please be aware this call will include forward-looking statements that are based on our current expectations of future results or events.

Forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from these statements.

Our forward-looking statements are as of the date of this call, and we do not assume any obligation to update or revise them.

Statements made on this call should be considered together with the cautionary statements and other information contained in today's earning release, our most recent annual report on Form 10-K and in subsequent filings with the SEC.

Our speakers for the call today are Keith Cargill, President and CEO; and Julie Anderson, CFO.

At the conclusion of our prepared remarks, our operator, Andrea, will facilitate a question-and-answer session.

Now we'll turn the call over to Keith, who will begin on Slide 3 of the webcast.

Keith?

Thank you, Heather.

Let's begin with Slide 3. Extraordinary volume we drove in the mortgage warehouse produced strong net income for Q2 despite the effect on NIM.

Average mortgage warehouse loans increased 43% from Q1 to Q2.

Average mortgage finance loans including MCA increased 35% from Q1 2019 and were up 49% from Q2 2018.

Due to a continued imbalance in risk versus reward, which our bankers are facing in the core LHI market, we are gratified to have such a strong market-leading position in mortgage finance allowing us to generate solid net income with excellent credit supported by strong controls.

The exceptional mortgage finance results also serve to offset the continued intentional reduction in leveraged lending loans as we focus on strengthening our overall loan portfolio.

Net revenue increased 1% from Q1 2019 and was up 8% from Q2 2018.

Noninterest expense, similarly, increased 1% from Q1 and 7% from Q2 2018.

Net charge-offs average total LHI of 0.34% from Q2 increased from 0.09% in Q1 2019 and decreased from 0.73% for Q2 2018.

Nonaccrual loans to total LHI of 0.47% was down from 0.57% in Q1 2019, an increase from 0.37% in Q2 2018.

On Slide 4, we summarize the breakdown of the energy loan portfolio and C&I leveraged loan portfolio.

Energy loans make up approximately 6% of total loans or $1.6 billion as compared to 7% and $1.7 billion, respectively, at the end of Q1 2019.

Year-over-year, energy loans did not grow.

Nonaccrual energy loans were $61.1 million in Q2 2019 versus $76.7 million in Q1 2019.

Allocated reserves for energy totaled $49.4 million or 3% of outstanding energy loans.

Moving to C&I leveraged loans.

We saw a decline of $164.2 million or 13% from the end of 2018.

We are on track for an expected 30% reduction for the full year.

Nonaccruals for leveraged loans were $25 million at Q2 2019 as compared to $30.6 million in Q1 2019.

Allocated reserves of $67.5 million amounted to approximately 6% of outstanding C&I leveraged loans.

We have no significant industry concentration in the portfolio.

Also 1 of the 2 leveraged loans of greatest concern last quarter has markedly improved, and we are encouraged that the other loan has improved prospects as the sponsor continues to provide support.

On Slide 5, we present a profile of our mortgage finance LHI business.

As you can see in the lower left quadrant of the slide, the efficiency of this business is outstanding and even more significant in seasonally strong quarters like Q2.

The bottom right quadrant shows the combined yield when including fees.

The returns are higher still when associated deposits are included.

This business is especially valuable for us at times like the present when we find ourselves late in the economic cycle with overly aggressive credit and pricing terms being offered for most other LHI loan categories.

The scalability and low credit risk for mortgage finance enables us to deliver strong earnings with limited late cycle credit risk.

Julie?

Thanks, Keith.

My comments will cover Slides 6 through 13.

Our reported NIM decreased 32 basis points from the first quarter with 21 basis points related to the earning asset shift, specifically mortgage finance and liquidity.

Traditional LHI yields were down 9 basis points from the first quarter resulting from the decline in LIBOR in anticipation of a Fed rate cut.

These were slightly lower in the second quarter as compared to the first quarter but only accounted for 1 basis point of the decline.

Our anticipated mix and pace of loan growth for the remainder of the year will likely result in lower fee levels than we experienced in the past.

Mortgage warehouse yields were down 19 basis points on a linked quarter basis.

The decline is not related to any shift in competitive pressures but rather resulted from volume pricing that was already in place.

The increased volumes are very positive to net revenue, which includes interest spread as well as a noninterest income component.

MCA yields were down 40 basis points, which was expected with actual mortgage rates down in excess of 60 basis points since the 1st of the year.

There is a lag as we generally hold loans 60 to 120 days, which means we will see further decline in the yield with more recent production.

We're very pleased with the linked quarter increase in average total deposits with growth in interest bearing as well as noninterest bearing.

Our overall deposit cost decreased by 4 basis points from 133 basis points in the first quarter to 129 basis points in the second quarter.

The decrease resulted from good growth in DDA.

As previously discussed, with no rate increases, our index deposits remain flat, and with the Fed decrease, they will move down just as they moved up with the increases.

We have a continued solid deposit pipeline with some of the verticals getting traction.

We expect to be able to discuss more details later in the year.

During the second quarter, we did increase traditional brokered CDs by approximately $500 million as part of the expected surge in mortgage finance.

We have a total of approximately $2.1 billion at June 30.

As we previously communicated, while verticals ramp up, we're comfortable using brokered CDs as needed when pricing is more favorable than some of our higher-cost funding.

We would expect to see a small movement in NIM for the remainder of the year if the Fed moves down 25 basis points in July.

As you know, over 20% of our deposits are linked to Fed rates, so that would offset the decreases we're already experiencing on the loan side as those have been repricing with LIBOR moves ahead of the Fed.

Obviously, how LIBOR reacts after a July cut would have a direct effect on NIM as well as loan yields will move as LIBOR moves.

I'll discuss rate impacts in more detail later in my comments.

We had a slight reduction in average traditional LHI during the quarter, and that was consistent with the runoff in our leveraged loan portfolio as well as some decline in energy.

Traditional LHI average balances down -- were down 1% from the first quarter and up 6% from this time last year.

The level of payoff continues to be high primarily in CRE where we're continuing to replace runoff with fundings on existing commitments and new originations.

In contrast, the C&I leveraged runoff is not being backfilled.

We would expect payoff in C&I leveraged to pick up during the remainder of the year.

We had a very strong average total mortgage finance balances driven by the seasonally strong quarter, which was even stronger with lower mortgage rate.

Average balances were up from the second quarter of last year by 49%.

We would expect Q3 volumes to be quite strong with the continued seasonality and low rate.

We're very pleased with the good growth in linked quarter average total deposits with the mix of interest bearing as well as noninterest bearing.

Our slower core loan growth is and will continue to be beneficial to our marginal cost of funding.

We started to see improvement in deposit mix in the second quarter with some contribution from verticals as well as from existing clients including mortgage finance escrow accounts.

We would expect that to continue with meaningful improvement more evident in 2020 as verticals get more traction and we continue to deepen existing relationships.

Moving to noninterest expense.

We continue to show positive trends in core operating expenses specifically looking at the changes in salaries expense.

The second quarter salaries and employee benefits were up about 6% from Q2 in 2018.

We're managing at a much lower level of FTE additions but ensuring that we're still being very opportunistic in targeted areas.

As a reminder, a portion of the marketing category continues to be variable in nature and is tied to growth in certain deposit balances.

We expect the Q3 and Q4 expense levels to be fairly flat with Q2.

Q2 level was consistent with the high end of our previously discussed range from $1 million to $2.5 million increase depending on volume.

Those volumes are expected to be flat for the remainder of the year.

The second quarter includes an MSR impairment of $2.8 million, and the first quarter had an MSR impairment of $2.9 million, so total of almost $6 million of nonrun rate expenses negatively affecting total noninterest expense for the year.

Our efficiency ratio for Q2 was 52.8%, which is consistent with Q1 levels.

We expect similar levels for the remainder of the year.

Turning now to asset quality.

We continue to be positive about overall credit quality despite the higher level of charge-off and provisioning in Q2.

Nonaccrual levels are still a relatively low level of 0.47% of total LHI.

Charge-off primarily related to 2 energy deals, and both were part of the increase in nonaccruals discussed in the first quarter.

While each of these credits discussed last quarter had unique characteristics, poor development results were common along with other challenges unique to each and not necessarily indicative of the rest of the energy book.

We believe each were adequately reserved at the end of the first quarter, but additional information on realizable asset values driven by market liquidity worsened our position, which resulted in additional reserve needed.

Additionally, we experienced an uptick in total criticized levels in the second quarter, which was not expected but was related to only one energy deal downgraded to special mention not classified or substandard.

Important to note that the significant increase in total criticized since the end of the year has been primarily in the special mention category.

Our total criticized as a percentage of total LHI remains low at 2.6%, and we have rigorous action plans for problem loans.

For all criticized loan relationships, we have ongoing dialogue with borrowers to understand client performance.

In general, no new information was revealed from the receipt of third-party audits throughout the quarter that would point to further deterioration or issues that were not otherwise known.

As you know from our history, we're always focused on being proactive with grading and especially late cycle, which can drive higher provisioning and classifications early.

The $27 million in second quarter provision is driven primarily by additional reserves needed for the 2 energy loans and some limited migration.

$14 million of the $27 million related to those 2 energy deals.

As we've mentioned, we expected a larger portion of provision in the first half of the year, so Q2 provision level is consistent with the overall guidance but was related to a different loan category than originally expected.

Generally, we remain positive that provision for the second half of the year will be in line with guidance, $20 million or 34 basis points of charge-offs in the second quarter with $15 million of that related to the 2 energy deals.

We continue to see strength in linked quarter net revenue.

Strong volumes in the mortgage finance contributed to that increase.

The second quarter noninterest income also includes $6.5 million related to a legal settlement, which is obviously, nonrecurring but is consistent with the $8.5 million in the first quarter.

No future amounts are expected.

We have a loss on sale of loans and noninterest income resulted from holding some MCA loans longer, which increases the hedging cost and is offset in additional spread income.

Our noninterest expenses are continuing to improve the run rate on core.

Year-over-year, 7% increase in noninterest expense compared to prior year Q2 and compared to 8% net revenue growth.

Our ROE and ROA levels were lower in the second quarter as a result of the higher provision level, and ROA levels were negatively impacted by the higher mortgage finance and liquidity levels.

We could see some lift in ROE levels later in the year if provision levels come in lower than guidance.

We are constantly evaluating opportunities to improve returns for the long term.

Looking now to our 2019 outlook.

We're decreasing our guidance for average traditional LHI growth slightly mid-single-digit growth from the previous mid-to-high single digit.

We're being very diligent about growth, and we're very open to growing if the opportunities are right.

We're listening to our people about what they're saying in the market related to risk versus reward and our focus on maintaining strong franchise value as we head into what could be a challenging point in the cycle.

For average mortgage finance, we're increasing our guidance to low to mid-20s percent from high-teens percent.

That takes into consideration the additional growth so far this year and an expected strong Q3.

Obviously, this is the lowest risk asset category for us, so we're happy to exploit the opportunities available with lower mortgage rates even if it means temporary dilution to some of our performance metrics.

No changes to our MCA guidance of $2.5 billion for average outstandings for '19.

The MCA will continue to benefit from additional volumes from the lower rate.

We're increasing our guidance for average total deposits to low double-digit from high single-digit percent growth.

That's reflective of the DDA growth that we experienced in the second quarter.

We still believe that most of the growth from the year will be from interest bearing, but DDA should be flat to slightly up compared to 2018.

We're decreasing our guidance for NIM to 3.35% to 3.45% from 3.60% to 3.70%.

The decrease is driven primarily by the earning asset shift we've experienced and we'll continue to have from total mortgage finance, which is relatively a lower yielding asset.

While slightly punitive to NIM, the added growth is very positive to net revenue.

As always, our guidance assumes no Fed changes in rates for 2019.

However, it's important to understand how we believe rate cuts will impact us, and we're focused on it in terms of income.

With the 25 basis point move in July, we estimate the impact to income over the next 12 months would be less than 1.5% with little impact for the remainder of 2019.

Assuming 50 basis points with 25 in July and 25 in September, that 12-month impact moves to 3% to 5%.

Finally, assuming 50 basis points in July and 25 in September, the impact could be closer to 6% to 8%.

What none of these scenarios take into consideration is the additional volumes in mortgage finance other than those we've already assumed for the remainder of 2019.

We also don't take into consideration any stimulus to the economy this might drive, which could change core growth assumptions going forward.

Lastly, this doesn't have the full impact of initiatives already underway that better position our funding mix during 2020.

Our guidance for net revenue remains a constant at high single-digit percent growth.

The same for guidance for provision expense, which remains at high -- mid- to high $80 million level.

We're increasing our guidance slightly for noninterest expense to mid-single-digit to high single-digit percent growth from the previous mid-single-digit percent growth.

We continue to feel very good about the slowing of our core operating expenses, but the impact of MSR impairment charges as well as more of the variable marketing cost in the first half of the year have driven some upward pressure on that range.

Our guidance for efficiency ratio remains at the low 50s.

Finally turning to our longer-term outlook.

We are committed to these long-term goals, and we'll be validating them as part of our 3-year process, which is kicking off in the third quarter.

As you know, the initiatives we have in place are focused on repositioning our balance sheet to be more stable through a rate cycle.

Certainly, there can be variability at different points in the cycle, but these are the right targets, and we're committed to achieving them.

We're confident we have the right initiatives underway, and historically, we have been very successful at repositioning as needed and expect the same success this time.

Keith?

Thank you, Julie.

I'll close with a few comments and then open the call for questions.

Our business model has always been and will continue to be winning and developing exceptionally talented business partners.

While technically we are employees of Texas Capital, we've never recruited colleagues who thought of themselves as merely an employee.

We place the highest priority in selection of a new colleague on whether or not they have a passion for building a premier industry-leading business.

Then we focus on skills and experience.

The same holds true in our renewed strategic focus on selecting clients who see the value in the premier strategic banking relationships we offer.

Today, we offer many new products and services through collaborative specialists who deliver multi-faceted client solutions alongside our relationship managers.

We can and do punch above our weight, and at $30 billion in assets, we are a force in the Texas market as well as the national markets.

And we are never satisfied but always pushing to be one of the very few elite banks in the U.S. able to successfully compete in our targeted niches with any bank for decades to come.

The substantial strategic investments we have made in recent years and will continue to make in the future will position us to be the premier financial services company of the next 2 decades, not merely a bank who moves too slowly to win tomorrow only focused on next quarter's profit or growth.

We understand the importance of growing profits but also wisely investing a portion of today's profits for sustainably higher profits in the future.

Those banks who set themselves apart as transformational leaders in the industry will win the premier clients who similarly are bold in investing in their company's future also.

Texas Capital Bank will continue to be a transformational leader, and my colleagues will continue to engage our business owner clients in a business builder to business builder relationship.

This is a powerful advantage we intend to further accentuate as we continued to invest in the finest talent, technology and strategic initiatives to ensure a bright future for our clients, colleagues, investors and communities.

The strategic initiatives in flight are building a stronger deposit base, loan portfolio and more efficient premier client experience.

The results will elevate our profit and ROE for years to come.

We are very optimistic that the smart, collaborative hard work we are accomplishing will deliver superior financial performance over the years ahead.

We are preparing to exploit overly aggressive short-term competitors as we focus on quality first in building a premier business of the future in every decision we make.

We are fortunate indeed to be Texas-based and benefit from the prosperous economy all around us.

We have never had such outstanding talent join our bank as we have experienced this past year.

It is a powerful combination to add such strong new talent to the extraordinary veteran talent developing into franchise players as we all build the Texas Capital Bank of the future.

This time, let's open the lines for Q&A.

(Operator Instructions) And our first question will come from Brady Gailey of KBW.

I wanted to start with energy.

We saw the couple of credits move into the nonperforming bucket.

Last quarter, you took some losses on this quarter.

Now we have another loan that has been classified special mention.

I think as we headed into this year, we were all concerned about levered lending, but now most of the noise you're seeing is really on the energy side.

I've heard you say these are kind of one-off deals and not TCBI's typical energy loan.

But can you just give us some color on what's happened with these 3 credits, why are they problematic and maybe some color specifically on the new special mention energy loan?

Well, the new special mention energy loan, we're very encouraged has a low probability at this point certainly of further downward migrations.

So it is one we've identified.

We're working closely with the client but feel good about the prospects on that holding up on its quality as is.

The other 2 loans were instances where our borrowers entered into very aggressive drilling programs, and in a couple of cases, they were trying to prove up some large prospects.

And rather than only drill in the heart of the prospect properties, they stepped out a little bit, and as a result, it created some cash flow challenges.

And while we don't typically run into this kind of situation, we're very alert that with all the activity in this industry over the last 2.5 years, a lot of it being, Brady, private equity investors, we're going to be just more intense than ever at taking a careful look at the operating of the properties and not simply be convinced that we have a really great borrowing base scenario because the decline curves are so steep on these shale properties, even though the good news is you get your capital back very quickly on these quick decline curves, you have to be confident that the operator has a sound strategy on how to use that money on existing production we're loaning against to backfill and create that ongoing cash flow on future production.

And in these cases, that was not the case.

So we feel like these are one-off deals, but again, as we did a year ago, I think we have been early to identify an energy situation.

I think there are a couple of other banks beginning to experience some of this, this quarter.

And I think we're ahead of the curve taking a careful look at how our clients are executing on their plans and that they're sound plans.

All right.

And I know when you saw some credit noise in your levered lending portfolio, you decided to shrink that portfolio like you're doing.

When you look at energy in this noise, maybe just talk about longer term your commitment to the energy lending space and if you would feel more comfortable having less energy exposure at TCBI longer term.

Well, it's premature to say longer term, Brady.

But in the near term, we're taking a much more deliberate approach on what we're managing today as opposed to having our bankers and our teams actively looking for that next brand-new client.

We'll pick up new clients here and there, but they're going to be outstanding top-quartile kinds of opportunities, which is definitely the case in leveraged lending.

In fact, we just picked up 1 of the best leveraged loans we've had in 20 years that we closed I think here in just the last week or so, but it's a very different high-quality, top-tier opportunity.

And the same will be the case in this energy category.

We'll only look for very, very high-tier opportunities.

And we'll let some of the other credit run off or plateau.

We're not focused on growing categories that we're not 100% comfortable with, and right now we're just taking a little bit of a more cautious look at energy as we did leveraged lending.

That's paid off for us on leveraged lending, and we think it will on energy as well.

But long term, we've always been in the energy lending business and we have no plans to not be.

Our next question comes from Brett Rabatin of Piper Jaffray.

Wanted to talk about the margin for a second and just -- I want to make sure I understood the guidance relative to there was commentary about a further decline in yield on the warehouse and just wanted to make sure I understood, Julie, what the guidance is relative to both the further decline in the mortgage book and then just how you're sort of responding to LIBOR and if you plan on taking additional action on -- you talked about stemming some of the asset sensitivity?

Sure.

So the guidance that we gave we're lowering the NIM, that's just assuming nothing else changes.

That's assuming that there aren't -- that the Fed doesn't move.

And so that's taken into consideration the shift that we've seen and that we'll continue to see in Q3 with the outsized volumes from mortgage finance.

But then what I tried to do is give you a little bit of color on, if the Fed moves in July, if they do a 25 basis points move in July, we'd expect that to affect us for the next 12 months about 1.5% decrease in income.

So -- but again, that doesn't factor in other things.

That's just looking at the math as it is right now.

That doesn't factor in that, that could change some of our growth aspirations.

None of that's factored in.

It also doesn't factor in what we expect to happen later in 2020 related to some of the deposit initiatives.

So as far as doing other things right now, I think at this point, it's the economics of doing any kind of hedging doesn't make sense.

Certainly, there are things like that, that we will continue to actively look at, but we don't think at this point that makes any sense.

Okay.

And then I wanted to make sure I understood.

So the DDA growth in the quarter, you had really nice bounce back there.

It didn't sound like you're expecting that to continue.

Can you, one, talk about the growth in the quarter?

Was that a function of mortgage or other businesses?

And then I want to make sure I understood sort of how you're thinking about DDA growth from here and how it relates to the margin guidance.

Yes.

Sure.

Yes, the growth in the second quarter, it was mainly from existing clients, and that did include some mortgage.

Q3, we think Q3, we think, there, we could see a little more growth in Q3.

I said for the year what's changed is now for the year year-over-year, we think that DDAs could be flat to actually up a little bit, and that's definitely a change in what we were seeing in January.

We're beginning to see, as Julie mentioned earlier, Brett, some contribution too from some of our new verticals and then also this core treasury where there have been these opportunities.

We really didn't mind as deeply because we grew the company so rapidly.

In some cases, we had loans to clients that we had not really gone back and worked as hard on the treasury.

So we're picking up steam on all those categories, but some of the recent seasonality also was partly due to the mortgage business.

Okay.

And then maybe just on the businesses, I've asked in the past and I think you gave me a number one time on the new businesses on how much they contributed.

Any update on that?

And then just any update on how you're thinking about what they could contribute over the next year?

I think we're poised to have a very significant pickup in their contribution over the next 12 months.

We have our 3 biggest initiatives teed up to launch in the fourth and very early first quarter.

And the ones that we've launched to date are making good progress, but they're just so young that, in some cases, we're testing the pricing, Brett, and not interested in just driving volume.

We're trying to find the sweet spot and be sure we're not only creating diversified funding but also lower-cost funding.

And early on, it's an experiment because you want to go get your name known.

These are national verticals, so you tend to pay a little more.

And now we're trying to get that just right.

And we're pleased with the progress.

Not all of them are going to be home runs.

We knew that and saw that from the beginning.

But we're highly confident that we're on the right track, and these 3 coming up will be our 3 biggest.

Our next question comes from Ebrahim Poonawala of Bank of America Merrill Lynch.

So Keith, just wanted to go back to credit, right?

So I hear everything you're saying in terms of being early, but at the same time, when you talk to investors, there's very little confidence around credit outlook from every quarter after quarter.

The stock's at, where it is, which is 5 years ago from a valuation standpoint, 1.1 tangible book, so it is expressing a lack of confidence.

And when I hear you talking about making higher-quality loans going forward, as someone who followed the company for a long time, I think part of the appeal of owning the stock has been that you guys have been known to be conservative underwriters.

So I'm having a hard time to reconcile the book that we have today, the surprise on the energy fund that we are seeing and just your level of confidence that we are getting towards the end of addressing some of these credit issues.

Would love to sort of get your thoughts around this.

Well, I think the improvement we're seeing in leveraged lending, and that's the case in our numbers this quarter, should be encouraging to you, Ebrahim.

But I hear you.

The energy is -- we identified a couple of them.

Now we had this larger charge-offs, and it really contributed to our provision coming in as we guided.

We just didn't expect it to come from this.

We expect it to come from leveraged lending.

But we're making so much headway on being all over managing that leveraged lending portfolio.

And again, the same is true just a couple of quarters later when we identified a couple of these energy deals that I don't believe it's going to turn into something that's prolonged.

But honestly, until we post just a clean-as-a-whistle quarter, and I hope that's the third quarter, I hear you.

And I think we're on the right track, and it's going to be solid on the balance of the back half of the year.

But you and I will be even more confident when we're talking quarter from now.

But I can tell you all the indications from my team, and I've got the best team around, is that we're all over this energy portfolio.

And I don't expect us to find some systemic, very significant issue.

We could surface another deal or 2. It's possible, but I don't see that at this point in time today.

And just you mentioned that you didn't expect charge-offs to come from here.

Does that imply that there's potential for some upward drift on the provisioning guidance as we look into the back half?

Or do you feel extremely confident in terms of the mid- to high $80 million?

I'm as confident as I can be.

I'm encouraged that we're not seeing the kind of continued follow-through on leveraged lending.

I'd have a lot more concern if I was still seeing the leveraged lending not performing much better, Ebrahim, and that I saw some systemic issue in the energy portfolio.

I really believe we're derisking the balance sheet early compared to some banks, but we've done it because we've had a couple of bad deals in these categories get our attention early, but we didn't just assume they were one-off deals.

We look more deeply at how we're running the business.

We got our bankers really focused on being very thorough in how they're looking at go-forward business plans with our clients in these areas.

And I believe these are 2 of the higher risk categories that banks are going to face over the next few quarters, and I think we're ahead.

But we'll have to prove it to you, and I think we will in the very near term.

Understood.

Okay.

Because I think that obviously the view around The Street -- the expectation is we are on sort of a slippery slope on credit, so as you said, I guess we'll have to wait for a quarter to see better results before that can be proven or disproven.

And just separately, in terms of the strategic targets, I think I heard Julie talk about you going into sort of off-site to discuss these targets.

Now do we -- is there any realistic possibility that you can get below 50% efficiency ratio in a 12- to 18-month time frame or -- because I feel like we are on the other side of the rate cycle, so you have that headwind to deal with going forward.

If you can just talk about how you see the bank getting to sustainably a sub-50% efficiency ratio and in your sense, what's the time frame we can get there.

Well, it'll be 2 things.

You mentioned the headwind of the rate scenario.

Again, we were talking about a whole different rate scenario of 7 months ago.

I think all of us.

So these things can ebb and flow, and we'll have to see how that plays out.

But if it in fact turns into a downward 2 or 3 ticks, that'll be challenging to get there as soon as you're projecting or asking.

Secondly, it's the pace of investment.

And we have a number of initiatives that are going to deliver extraordinarily improved and sustainably higher profits and better ROEs, but in the near term, they are added expense.

And that's one of the things that we're choosing to do, is invest in setting up the company with better, more granular and lower-cost funding and deposit base while the economy is we think in the later innings.

But I hope it lasts a long time.

We don't see any clouds that are on the horizon that give us great heartburn.

There a lot of positives about our economy particularly in Texas but even nationally.

However, we're just more conservative about how we're preparing so that we can exploit whenever opportunities pop up in a down cycle or otherwise.

And this funding, getting it right is super important, but also the opportunities we see, Ebrahim, in some niches in the C&I world that we're exploring, I think have great opportunity for us and we think we can over time, over the next few quarters begin to generate some very strong diversified growth with clients that are going to be full relationship clients.

And again, that's been part of our shift this last year, is not focusing on a transactional loan-only client, and that's part of our strategy to, again, build a stronger long-term earning power in the company.

So I think it's going to be a while is the bottom line unless we see this rate scenario stabilize sooner than some are concerned it won't.

There's not an immediate change we can create there, but I will tell you, we have a -- this added advantage in the rate scenario where we typically get outsized volume in our mortgage finance, and it's just great credit quality when we get it.

And when we get it in such large volumes, it does put pressure on them, but it creates an enormous amount of earnings.

And they're very high-quality, low credit risk earnings.

So that is a positive, and it certainly is, as you can tell from one of our exhibits, a very efficient business.

So that'll help us as we invest and get set up for the next strong growth run we're going to have over the next several years.

And just on that last if I may squeeze a follow-up.

Do you anticipate the mortgage warehouse spreads to widen if the Fed cuts and we see 1 or 2 cuts?

We saw obviously spread tightening on the way up.

Just wanted to see what your view was around that.

Well, it seems to be stable, and we think probably that'll be the scenario.

But there isn't a lot of room to go anywhere but up, but I'm not going to predict it will get necessarily wider margins until we can report that to you.

But we are confident that it's going to stay at least stable, if not, improve a little.

Our next question comes from Jon Arfstrom of RBC Capital Markets.

One simple one, Julie, for you.

When you talked about your Fed funds scenarios, do you mean net income or net interest income?

Net interest income.

Net interest income.

Okay.

I just want to make sure I heard that correctly.

And then on the NIM guidance just very big picture with the 3.35% to 3.45% range and everything we know today, I think you're saying low 3.30s in that range for the rest of the year, but a lot of the pressures really already occurred on the margin.

Is that a fair way to look at it?

Right.

What we saw -- yes, what we saw with the -- just the mix shift in the second quarter, we expect that to continue in the third quarter.

Fourth quarter, we would assume that that's when kind of seasonality ends, becomes seasonally a little bit weaker.

But yes, we would expect to see something similar for the next -- for the rest of the year.

Okay.

All right.

That helps.

And then Q3, you just -- I know there's a lot of focus on leveraged lending and energy.

And you talked about this risk/reward balance in the core LHI, but I see some rundown in leveraged and energy as well.

So it seems like maybe there's some decent activity in core LHI.

Can you maybe talk about that balancing act and what kind of activity you're seeing there?

Well, there is definitely decent activity.

It's just, John, a couple of years ago when we would go to market in our core C&I, the deals we wanted, we would win a very high number of those, 50-plus percent even with a lot of competition.

Today, we're taking ourselves out of the process fairly early because the terms just simply don't make sense, and so our hit rate is just lower.

It's not that we couldn't grow those loans quite a lot faster.

It just wouldn't be a very wise move to book such incredibly underpriced risk/reward.

And again, we're seeing credit terms that just don't make sense to us, advance rates that are much too rich and weak collateral basis if any.

And it used to be covenant light.

Now it's covenant gone in so many cases.

And of course, everyone's after high-quality credit as they should be.

But still high-quality credit, you got to be sure you're going to win if you win the deal, and I think you're losing in a lot of cases because of return.

It's just so poor, and you have very little, if any, protection.

So that's the scenario.

So our guys are just having to work a lot harder to win deals, and they're growing modestly.

They're backfilling a lot of the paydowns.

But normally with the effort we're putting forward and the best talent we've ever had on the line, we just keep attracting phenomenal new talent.

We should be growing much faster if we had the right risk/reward terms.

Our next question comes from Peter Winter of Wedbush Securities.

Keith, I was wondering, it's my understanding that there's a internal concentration limit where you don't want to see mortgage-related loans kind of -- I guess you wanted to be more in the low 30s percentage, and this quarter, it's at 40% if I include the MCI loans.

I'm just wondering if that's -- what your thought is on how big you want this portfolio or how big you're willing to let this portfolio get.

It's a little above the guidance, and again, we use guidance terms.

And we feel like because it's just such a great piece of paper still today that we're able to finance and the liquidity is so excellent in this product too turning over every 2 or 3 weeks that it's just the right place to deploy our loan growth right now.

But no, we do not want to see this.

We're not looking at raising that guidance range that we have of roughly 25% to 35%.

We actually pushed it up I think to 38% here about a year ago, and we're just right a little above that.

But it is not our plan to expand that over the long run.

We like the 25% to 35% range, but it's just the place we think is the safest and best to generate earnings at the moment.

Okay.

And then if I could just ask one more question on credit with energy.

So we had a regional bank report this morning that took some charges on energy.

They said it was getting tougher to liquidate some of these troubled energy loans, just less demand from the capital markets.

So I'm just wondering are you guys seeing that as well.

And could it result in some charges maybe over the next 2 quarters?

I don't see that as anything about to happen to one of our clients, but they are accurate in their description of capital markets not being very fluid for energy.

There was just an avalanche of money pouring into this category over the last 2.5 years after the long down trough we experienced, huge amounts of private equity and even foreign sovereign fund money coming in to invest in this asset play.

And we don't see that kind of dry powder out there coming after buying the assets today.

So we feel good about overall the staying power and the ability of our clients to operate, but they're not going to be able to, if they want to just sell their assets, get the kind of price that they might have gotten a year or 2 ago.

And so they need to be able to operate, maintain their cash flow and manage their expenses, run their business well.

And over time, this would become attractive again.

There's just so much concern apparently in the -- with the overall world economy that private equity is becoming anxious.

They're also more concerned here about looking at their true cash flow out of these shale plays.

The money is very, very significant when you go drill these horizontals, and then these shale plays, particularly the Permian, you can have 4 to 10 or 12 layers of pay zones.

And when you start stacking 6 or 8 horizontal wells in the 1,250-acre kinds of templates, I mean you quickly get to $60 million or $80 million for 1 layer and you're at $0.25 billion almost for 4. And so it's significant money.

And it's going to continue to think attract bigger and bigger players, and I think that's what we're going to see over the next few years, is some of the very biggest worldwide oil companies are going to become the bigger players over time in the Permian.

And so you're comfortable then where your energy loans are marked if you wanted...

We are.

We are.

And we think again, at some point, some of the bigger players are going to want to buy our clients' properties, and they'll make a nice profit.

But if you have to go to market today and find buyers, it's a pretty shallow capital market.

Our next question comes from Jennifer Demba of SunTrust.

Keith, can you just give a little more color on why you chose not to raise the provision guidance for this year?

And what gives you real confidence that you guys have a handle on that?

And then my second question is on your interest in buybacks.

Your stock still remains much cheaper than your peers.

Let's start with your first question.

We don't take lightly reaffirming that guidance because it's -- it is a very significant number relative to how our earnings will come in for the year.

We do believe we have a handle on our energy portfolio and that we don't have significant other problems there.

And we're very, very comfortable as we can be at this point, Jennifer, things can change on a dealer too but that we're ahead of the curve on our leveraged lending.

That's performing quite a bit better than we expected.

And so that, I would say, is kind of the counterpoint that causes us to feel like we're still good on provision.

But if we do find something new that's a significant deal in either leveraged lending or energy, it could change the game.

We just don't see it today.

And we have a really thorough loan review process but more importantly, we've got the entire line.

Each of their RMs and their portfolio managers, I mean, it's across the company.

We're all over our loan portfolio, and in particular, leveraged lending and energy, we've been concerned about a slowing economy for longer than probably I want to admit.

So I think we have a pretty good grip on it.

And we put any more out there, it would just be a guess to give you a higher number than what we're giving you.

Okay.

And your interest in share repurchases?

Well, again, it is still a tool that we think about.

We also believe we have other opportunities that we should examine on how we use our capital that could be much better for our shareholder, and we're looking at different opportunities both organic growth opportunities but also possible fee businesses that may have opportunities for us to take a look at.

And those are the reasons why we have not yet used that tool.

What kind of fee business opportunities would you be examining?

We've mentioned before and that would still be the case today but something related to private wealth advisory business.

That's doing extremely well for us, but to simply grow it organically, it's going to be hard to make it big enough to make as big an impact if we don't look at the possibility of some M&A.

But we got to be very thoughtful about how we go about that because we're -- as everyone knows, we're very bought in to organic growth is really the most sound way to go.

But it's one of those opportunities our team is doing so well that we think we probably can integrate the right size opportunity and still have the outstanding culture to pick up some other great talent and make that work.

Another one that we've kicked around is something in the capital markets area.

Our clients -- we're getting to a point where our clients have more needs than they did when we were smaller.

Just a few years ago, be very rare we'd have a client that'd have a need other than senior debt or their treasury management and maybe swaps and things of this sort.

But there are other things that we think we may be able to do there, and so we've added some talent there.

And we might even look beyond simply talent, but it's too early to make that call.

We know we need to continue to move the needle on our mix of income to have more fee income and not be as reliant over the next 4, 5 years on just net interest income spread.

Our next question comes from Steven Alexopoulos of JPMorgan.

I wanted to start out for Julie.

Regarding the impacts you're providing from rate cuts, which was very helpful, what's the deposit beta you're assuming in those scenarios?

We don't usually talk too much about betas.

I'll give you some color on it though.

We -- the index deposits that we have, which is about 20% of our book, we would assume that, that's something close to 100% going down just like it was going up.

Some of the other areas -- I mean we've made some assumptions, but I don't want to talk too much about those.

Obviously, as rates moved up, we were evaluating client relationships.

We would do the same thing going down, but it could vary.

So that's probably all that I'll say on that at this point.

Okay.

When I look at those scenarios, they seem to be not as dramatic of a negative impact as what you disclosed in the 10-Q.

What's the difference?

Yes, there -- we get that question.

The 10-Q, that's a pretty scripted, that's a pretty -- I don't know, it's a lot more regimented we -- what we report as a shock, and so we don't -- we pretty much -- that's at a given point in time and we just run the math.

With this that I've given guidance, we've taken a harder look at some of the things that I just talked about, looking at some of the client relationships, the different categories of our deposits, what we think some repricing that might happen because of things that we negotiated as the rates went up and things that might happen on them.

So we just do a little bit more.

There's a little more thought put to it and more finessing than what's reported in the 10-Q.

What's reported in the 10-Q is just kind of the quick math if it happened tomorrow and everything followed the rules.

So Steve, this is Keith.

We're -- you're going to fully appreciate this.

I'm sure you do, but we just don't have the category moves that a more retail bank would have on the deposit pricing, and that's what gives it a little more complexity.

We relationship price and we -- so if someone wants a better deposit price, fine, we need more business.

And how do we get more profitable business?

That might be fee business.

That might be loan business.

And then we look at the overall ROE and are we getting a deeper share of wallet.

And so that does add complexity except for that 20% Julie mentioned.

That moves in sync, 100% pretty much synced up with Fed funds.

And then on the loan side, you had a nice reduction in C&I leveraged loans including nonaccrual and criticized.

Did you guys sell loans in the quarter?

Or were these just normal payoffs?

These were normal payoffs with a little help in some cases.

But most of it were just normal portfolio turnover, and that's how we really build -- primarily how we built our forecast back in January for the year of about 30% runoff is the typical velocity of turn that we have been seeing of late on these private equity portfolio companies plus about 5%, as we work a little harder on not being as open to modifying deals and things of this sort so that we get others to refis while there's still a refi market.

And that continues to be the case.

Okay.

And one final one.

So if I look at loans ex mortgage, the decline seemed to be much more pronounced and just a headwind from running off leveraged loans.

Can you give more color why you saw that decline this quarter?

That was mainly the rundown of energy and leveraged lending.

That was about, if I remember, about $270 million combined.

So that was 80-plus percent of it I would say.

Is that right, Julie?

Yes.

I mean, if you look at -- and certainly, if you look at the ending balance, that was almost exactly what it was.

So year-over-year, the energy loans were flat, but from the first quarter, they actually came down $100 million.

Yes.

Our next question comes from Casey Haire of Jefferies.

Julie, just one more follow-up on the NIM.

The loan yields, I was wondering if you could provide the spot rates, where they were at June 30 for LHI, mortgage finance and MCA.

No, I didn't give that and I don't have that.

I mean the commentary that I gave just kind of give you the general direction.

Obviously, it will start with MCA.

MCA, the newer production that came -- has come on in the last 30 days, that's obviously going to be -- that's going to be related to what the -- what overall mortgage rates look like.

Warehouse, that's pretty stable as we said.

And then on the core LHI, I mean, that's going to move as LIBOR has moved.

So most of the pricing, when -- like we saw when it was going up, there will be some lag, so there were a few loans.

They don't reprice on the same day.

It takes about 30 days.

It can take up to 30 days to move.

So there could still be some repricing in core LHI, but again, it's -- I don't think it's going to be that -- there's not going to be that significant of a difference.

Okay.

I mean so on the MCA, specifically like what is new -- what is the new money yield on that production in the current environment?

I mean it's similar to whatever the 30-year mortgage rates are.

Okay.

All right.

And then just...

It's in the 4.25 range, somewhere in there, Casey?

Yes.

Okay.

And then the -- just I appreciate the expense guide.

But if -- what is the slowest you could grow expenses and still support your initiatives?

If we do get a tougher -- if we do get a more dovish -- we get a lot more Fed cuts, what's sort of the slowest you could grow expenses going forward?

I mean I think that we're -- I guess I would say what we talked about is what we feel comfortable with.

We are being very deliberate about -- we're not going to sacrifice opportunity to save a few dollars here and there.

So certainly, we're managing the overall hires a lot better, but we're still going to be opportunistic.

But I guess I would say that what you've seen -- what we feel that we've seen so far this year compared to last year and compared to years in the past, it's dramatically different.

So we'll continue to evaluate that.

Again, we're -- I think I've said we're about to go into our planning process, so we'll certainly look at those again and certainly take all of that into account of what we expect are going to happen with rates, kind of where our initiatives are.

But I would say that what we've given guidance is what we feel comfortable with for now.

Our next question comes from Michael Rose of Raymond James.

Just a couple of clarification questions.

So the noninterest expense guidance, does that include the MSR impairments that you've seen in the past 2 quarters?

It does.

That and then the variable deposit, that was really the reason that I know we've expanded the range, nothing else.

In the core, we feel good about that.

But yes, it does include that, so $6 million -- almost $6 million.

Yes.

Perfect.

And then just wanted to get a sense for if there was anything in other fee income this quarter.

It looks like it jumped up about $6 million and have been running at rate much lower than that.

Yes, that was a -- and I called that out in the commentary.

There was a $6.5 million related to a legal settlement.

We had $8.5 million in the first quarter, $6.5 million in the second quarter, but there'll be no more of that.

That's finished.

Okay.

So that comes out of the run rate.

And then just the -- I know it's variable from quarter-to-quarter but the gain or loss on sale, loans held for sale was up pretty dramatically as far -- again, I know it bounces around.

But is there a way to think about that or how we should project that on a go-forward basis?

As I tell people, we have all of the information, everything -- all the information and we have trouble forecasting it exactly like it is.

I guess all I can tell you is we're constantly evaluating the economics of the individual tranches.

Does the spread, does the additional carry outweigh the additional cost to extend the hedge?

And so it just can vary from quarter-to-quarter based on the volumes that we're seeing, based on what the market is doing.

Okay.

And then maybe just one final one for me just going back to the mortgage warehouse.

Just understand the question earlier about the percentage expense as a percentage of loans but as we think about next year rates, could you get a couple of Fed rate cuts and mortgage rates continue to tick lower.

I mean would you be comfortable operating above your range, so to speak, in the near term?

Because, historically, you guys have had much stronger LHI growth.

Obviously, it's a law of large numbers.

This is a good opportunity set.

As you mentioned earlier, it's a good risk return at this point in the cycle.

Why one should continue to see average balances grow beyond 2019?

Well, we want to be sure we're optimizing our return too and so as much as we want to deploy our loan assets and capital well, we also just have to be really thoughtful about return on capital too, Michael.

And so we'll certainly take care of our clients.

We're not going to be out there trying to win a lot of market share in this environment, and I don't think we'll want to operate above the guidance over the next year or so.

But we'll have to evaluate that kind of quarter by quarter based on returns and just also overall strength of the balance sheet and our capital position.

We feel really good about where we are on capital, but it's important that we manage that really well.

So we have these other opportunities we're developing that we can exploit also.

Our next question comes from Brad Milsaps of Sandler O'Neill.

Just a follow-up on Michael's question, Julie, about the loss on the MCA loans.

I think you mentioned on the fourth quarter call that you would typically maybe see a bigger

(technical difficulty)

Brad, did we lose you?

Guess we'll move on and he'll call back in.

Our next question will come from Gary Tenner of D.A. Davidson.

And our next question will come from Chris Gamaitoni of Compass Point.

(technical difficulty)

Seems we're having technical problems.

Okay.

We will try the next question from Brock Vandervliet of UBS.

Can you hear me?

Yes, Brock, we've got you.

Yes, Brock.

That's great.

I just blew away the queue in front of me.

That's amazing.

Whatever it takes to get in a question.

Yes, it does seem like something wonky went -- happened with the call.

But anyway, just on the criticized loans, the increase here from $364 million to $629 million, is it that they're just kind of stuck in the pipe and you can't sell them?

Why are they -- why do they keep building up like this?

You're talking about the total criticized -- I mean we're not trying to sell the criticized.

I mean are you talking about just the overall criticized level?

Yes, and the criticized level and given other pressure in the portfolio, I would think you might try and work them down or take up your -- yes, I'm puzzled that the rate of increase in that you can't work those down more quickly.

So I'll make a couple of comments, and then Keith can add some color.

But one of the comments that I made in my commentary was that it's important to note that the big increase in criticized from the end of the year to $630 million, the biggest category that's increased is special mention.

So we're not -- I mean special mention means there's some identified weakness, but that doesn't necessarily mean that, that's something that's going to migrate.

So when we -- this is typical of what we do when we see a weakness in a particular category, is we maybe get a little harder on our grading and downgrade things because we want them to get that special attention.

So...

And we're conservative, Brock, on upgrading a credit once we do have a downgrade.

And so to your point, there will be movement in a number of these, but it's just going to take more time.

We want to see multiple quarters of improved performance before we say, hey, this is fine now.

And so we'll grant you that we're somewhat conservative on that, but it served us well over the years.

Yes.

And I realized these are at the beginning of the process of their criticized.

Is there a level of -- at which you would consider taking up your provision guidance given the increase?

Or you seem to be comfortable where it is at present.

We're comfortable.

We just don't see a significant migration from that special mention at this point.

So again, we've identified a number of these credits.

We're watching them carefully, but we don't see that those are going to move to the right and become substandard right away.

If we really believe there's going to be more migration, our methodology would address that and how we would provide.

And it's all built into how we go about coming up with that provision.

Okay.

And shifting back to the rate sensitivity.

There are a couple of different comments earlier in the call about this.

But relative to the disclosure that we see every quarter in the Q, is your -- is the sensitivity level likely to change much here in the second quarter?

So what you see in the Q, that's just kind of a regimented calculation.

What we -- what -- the guidance that I tried to give you is a more realistic view where we take into consideration more of the characteristics that we see in the different components both on the asset side and the deposit side.

That regimented calculation isn't likely to change that much.

Correct.

The disclosure's not going to change much.

Right, that's just kind of a -- that's a -- it's based on MCC guidance.

We kind of -- we do the math and it's a shock, and it happens you just don't put a lot of -- a lot more qualitative thought into that because we don't.

One size fits all and so we're trying to give you the more custom tailored view.

Yes.

What we think is more realistic and it's taken a little bit more brainpower to come up with that.

Our next question comes from Ebrahim Poonawala of Bank of America Merrill Lynch.

Just one quick one, Keith.

I think you brought up M&A from a standpoint of acquiring something.

I was just wondering how the Board and how you think about M&A from the standpoint of merging with an in-market or an out-of-market player.

And do you see that as an avenue to create shareholder value?

Or do you not think that the model like TCBI could work as part of a larger player?

Well, again, it's my job to be sure that I'm always looking at every option that would optimize shareholder return, Ebrahim.

But we find it very, very challenging to find other MOE type potential partners.

We find it very challenging that their model would actually give us a tailwind post merger in terms of higher performance, better performance.

One of the big challenges is we simply think the traditional brick-and-mortar distribution model is really going to be a headwind model for years and years to come.

While it has a place in most banks' template, we prefer our business model, and the initiatives we have underway on multiple new treasury verticals, we think, are going to set our model up as to be even more model for others to emulate rather than us again considering getting onboard with the model that I think's going to have a lot of headwind.

And also the talent acquisition approach that we take is very unique, and by organically growing and having this exceedingly high bar on any talent we bring on and then the talent development once they're here, we just don't see that as a common way to approach talent building and talent acquisition with other companies.

And we think talent and technology are going to be just vitally important to deliver this very premier strategic connection that is going to keep us an elite competitive company.

In fact, we want to be 1 of those top 5 right under the mega 5 that are the best at the markets we cater to, these private companies.

So it makes it difficult to see our way on a strategy that would be one that would succeed at that elite level, and we think our model has a path.

We have a path to get there.

This concludes our question-and-answer session.

I will turn the conference back over to President and CEO Keith Cargill for closing remarks.

Well, I'm very grateful to all my colleagues and all our clients for another strong quarter and for the progress we're making to create the Texas Capital Bank for the next 2 decades.

Thanks to each of you for your interest in our company, and we hope to talk with you soon.

If you have questions, please call us.

Thank you.

Thank you for your participation in TCBI's Second Quarter 2019 Earnings Conference Call.

Please direct requests for follow-up questions to Heather Worley at heather.worley@texascapitalbank.com.

You may now disconnect.