Texas Capital Bancshares Inc (TCBIO) 2018 Q3 法說會逐字稿

Good afternoon, and welcome to the TCBI Third Quarter 2018 Earnings Conference Call.

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

(Operator Instructions)

I would now like to turn the call over to Heather Worley, Director of Investor Relations.

Please go ahead.

Thank you for joining us for the TCBI Third Quarter 2018 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 earnings 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, Phil, will facilitate a question-and-answer session.

And now I will turn the call over to Keith, who will begin on Slide 3 of the webcast.

Keith?

Thank you, Heather.

After I open, Julie will share her assessment of Q3.

Then, I will close and open the call for Q&A.

Let's begin with Slide 3 as Heather mentioned.

Traditional LHI growth was up 3% linked quarter on average balances and flat linked quarter on period end.

Following the outsized growth in Q1 and Q2, third quarter totals are modest but expected.

Year-over-year, average LHI was up 13% on average and 12% at period end.

The loan pipeline appears healthy for the fourth quarter.

Winning the highest quality loan opportunities remains our primary focus.

Job #1 is strengthening our loan portfolio quality for superior credit performance through the cycle.

Mortgage finance average balances were up 11% linked quarter and 12% year-over-year.

Period-end balances were down 8% linked quarter as we moved into the usual softer fourth quarter seasonality.

Year-over-year period end was down 3%, far better than the national mortgage market contraction this year of approximately 8%, indicating that we continue to take market share.

Average deposits were up 6% linked quarter and 9% year-over-year.

The deposit increases were in interest-bearing deposits as the demand deposit trend continues to convert to more interest-bearing deposits.

We expect the continued rollout and maturation of new treasury deposit verticals will help us improve our deposit cost, deposit betas and further diversify our funding.

We now have 2 new treasury deposit verticals operational with up to 6 more to be introduced in 2019.

Net revenue grew 3% linked quarter and 15% year-over-year.

Our operating leverage improved year-to-date.

ROE increased to 14.68% for Q3, largely due to more normalized loan loss provision.

We experienced a modest $2 million in net charge-offs in Q3.

Overall asset quality remains good.

Total credit costs in Q3 were $11 million as compared to $27 million in Q2.

Before Julie shares her comments on the quarter, I want to address 2 topics in particular.

First, as we emphasized in the first quarter and again in the second quarter, we experienced extraordinary growth in loans.

In fact, the first quarter loan growth was 2x the dollar growth we have ever experienced in Q1 in our 20-year history.

We followed this record-breaking growth with a second quarter well above the expectations we shared on the earnings call in April with the softer pipeline we thought we were going to have to execute on.

But despite this softer pipeline, we had very strong growth in the second quarter.

It came toward the end of the quarter.

They well could have spilled into the third, but it came at the end of the second.

These loan growth numbers through Q2 were all the more outsized since our primary objective in 2018 was and remains a focus on upgrading our loan portfolio for optimum performance through the next credit cycle.

We provided traditional LHI loan growth guidance for 2018 at low to mid-teens and have not deviated from our initial annual guidance.

Further, we guided growth in our mortgage finance loans of mid-single-digit percent growth with an industry volume contraction forecast to be 8%.

Today, we are increasing guidance for mortgage finance growth to low to mid-teens.

We are solidly on track for our 2018 overall loan growth.

Second, we provided annual guidance in January for net interest margin of 3.35% to 3.45%.

We increased the guidance to 3.60% to 3.70% in July.

And today, again, we are increasing NIM guidance to 3.70% to 3.75%.

Our loan growth this quarter was slow as compared to Q1 and Q2.

We are at all or above our guidance and believe to grow faster than low to mid-teens in 2018 would be imprudent due to the aggressive credit market we see so late in this economic expansion.

Also while NIM declined sharply in the third quarter, we have anticipated for the past year and expressed our expectation that we could see a quarter in which LIBOR did not lead the Fed funds rate increase and deposit costs could continue to increase.

We believe the occurrence of both LIBOR lagging and a stronger-than-normal move in deposit costs will not be a systemic change but likely an occasional possibility.

Finally, NIM in the third quarter was meaningfully impacted by a squeeze in loan pricing in the mortgage finance category that we see moderating this quarter.

And the increased mix of mortgage finance average balances versus more modest traditional LHI growth further pressured NIM.

I hope this context to our annual guidance and this overview on loan growth and the quarterly NIM contraction was helpful.

Julie?

Thanks, Keith.

My comments will cover Slides 4 through 10.

Our reported NIM decreased 23 basis points from the second quarter.

The change in earning asset mix accounted for a portion of the decrease, an increase of $237 million in average liquidity assets since the second quarter as well as a larger percentage of total loans coming from seasonally strong mortgage finance, which has a lower yield than traditional LHI, so net 6 basis points of negative impact to the NIM from earning asset shifts.

Traditional LHI yields were up only 1 basis point from Q2, and there are several factors to keep in mind.

The first is the lagging movement in LIBOR prior to the September Fed rate move as compared to the way it led prior to Fed rate moves in the first quarter and the second quarter.

Traditional LHI betas continue to be as expected and are reflected in September 30 ending LHI yields on our floating portfolio, which were up 15 basis points compared to yields at the end of June, and some of the LIBOR-based loans didn't reprice until early October.

So we do expect impact of the September move to be reflected in the fourth quarter.

Additionally, Q3 was a weaker loan fee quarter compared to the very strong fee quarter in second quarter.

There was a 9 basis point swing and was really a combination of Q2 being much higher and Q3 back to a slightly lower-than-normal level.

We experienced compression in mortgage finance yields as those decreased 23 basis points linked quarter.

As we mentioned during the second quarter call and in meetings during the third quarter, we are addressing competitive pressures in that space.

Because of the multiple offerings that we provide, we have more flexibility in evaluating overall relationship pricing and making adjustments as needed to retain and grow market share.

We had a linked-quarter increase in average deposits.

Our overall deposit cost increased by 18 basis points from 81 basis points in Q2 to 93 basis points in Q3.

The increase was expected as Q2 numbers only included a few days of the June Fed rate move on index deposits.

Similarly, Q3 only includes a few days of the September move.

Overall increase of 18 basis points is compared to 15 basis points increase from Q1 to Q2 so not outsized and is consistent with our expectations.

It was a continued solid deposit pipeline but as we've said before, difficult to forecast exact timing and it can be lumpy in how it comes on.

And all is interest-bearing.

Our RMs are being incented to focus on deposits as well as loans.

During the third quarter, we chose to layer in an additional $500 million of traditional brokered CDs as we were able to lock in 6- and 12-month maturities at a cost slightly less than our index deposits.

As we've noted in the past, the use of brokered CDs makes sense from a balance sheet management perspective, but we don't plan to use an outsized amount of brokered CDs.

Important to note, as of the end of 9 -- at the end of September, 75% of our floating rate loans are tied to LIBOR and over 80% of that tied to 30-day LIBOR.

We had good growth in our traditional LHI during the quarter.

Second quarter growth was actually higher than expected, which impacted the growth from the end of Q2 to the end of Q3.

Year-to-date, it remains consistent with our annual guidance.

Traditional LHI average balances grew 3% from the second quarter and up 13% from Q3 2017.

The level of payoff continues to be high primarily in CRE and no sign that, that will slow.

Our fourth quarter pipeline looks positive, but we would expect a slower growth quarter than we experienced earlier in the year, which is consistent with our full year guidance.

During the quarter, we purchased a senior interest in a securitization trust that is collateralized by the cash flows of 4 municipal revenue bonds totaling $95 million.

While we view the transaction to be similar to any collateralized extension of credit, the structure of the transaction triggers GAAP rules that require the extension of credit to be characterized as a security on the balance sheet.

So basically, the $95 million increase in securities is more similar to C&I growth, and the yield reflects that.

We continue to see strong average total mortgage finance balances benefited from seasonality and are up from Q3 2017 by 12%.

Obviously, we expect fourth quarter volumes to be similarly lower and started to see that trend at the end of the third quarter.

As I mentioned, we did see some pickup in linked-quarter average total deposits with all of the growth in interest-bearing.

As I noted earlier, we added some additional traditional brokered CDs during this quarter because the pricing was still very favorable as compared to our index deposits.

This is proving to be an attractive bridge funding alternative as we work on our new deposit verticals and other initiatives we have underway.

Primarily interest-bearing deposits in the pipeline but we're also working hard on maintaining and growing existing relationship.

RMs are being incented to focus on deposit growth as well as loan growth.

Again, asset betas, especially as it relates to our traditional LHI portfolio, are an important part of the story for us and while we feel good about our balance sheet positioning going forward, we have seen those asset betas perform as expected.

We continue to react to specific customer situations, which are evaluated on a total relationship basis.

Our index deposit categories total about $5.5 million at the end of the third quarter.

Moving on to noninterest expense.

In looking at changes in linked-quarter non-interest expense, we are effectively slowing our core expenses, which is primarily salary expense.

We're doing a good job of managing this with a lower level of FTE additions year-to-date.

You'll note that we had $2.8 million in severance cost, which is related to some organizational changes that we made during the quarter.

These are consistent with the messaging we've been doing about focused efforts on better aligning the organization to improve efficiency and client experience.

The $2.8 million equates to $0.04 per share.

There's an increase in non-LTI and annual incentive pool from the Q2 levels, and that's driven by annual incentive accrual, which generally continues to ramp throughout the year based on overall financial performance.

Some fluctuation in FAS 123R expense in the third quarter as compared to Q2 primarily related to fluctuations in the stock price.

Our third quarter FAS 123R expense of $4.4 million is compared to Q2 expense of $5.6 million.

We had an increase in occupancy, which included $1 million related to a relocation of one of our main offices and the related expenses that were required to be expensed as a onetime charge and does not signal a new run rate.

As we noted in July, legal and other professional was abnormally high in Q2 with some nonrecurring expenses.

There was about $2.5 million in Q2 that was not normal run rate.

Our Q3 levels were down by that amount but offset by the new variable component added during the first quarter that is directly related to deposit services and was expected to ramp by $1 million to $1.5 million in each sequential quarter.

Net impact was Q3 expense down $900,000, but we would expect the normal ramp of $1 million to $1.5 million in Q4.

A portion of our marketing category is variable in nature and is tied to growth in deposit balances as well as increases in rate.

The trend in marketing over the last year or so is representative of the increase in run rate expected throughout the rest of the year.

While we didn't see any growth from Q2 to Q3, we would expect to continue to see some increases as we continue to grow deposits but not more outsized than we've experienced in the past and not every quarter.

We continue to be targeted about expense growth, and heading into 2019 planning season, that is even more evident.

We're focused on targeted growth for staff adds and holding most areas flat as we are improving returns in lines of business.

Our efficiency ratio for the third quarter was 53.6%, excluding the impact of OREO, which was slightly higher than our Q2 efficiency ratio of 53.1%.

But it was negatively impacted by the $2.8 million severance and the $1 million discussed earlier.

We continue to feel good about overall asset quality.

Criticized and classified to capital continue to trend down.

Criticized loans to Tier 1 capital plus the allowance decreased from 16.4% at Q3 2017 to a current end of Q3 13.8%.

Nonaccrual levels are still at a very acceptable level of 0.49% of total LHI.

This late in the cycle, we believe that being aggressive with grading is the right thing to do.

As we expected, Q3 provision level is more normalized and it's driven by provisioning for 3 relationships, move to nonaccrual this quarter and some additional reserves from 1 of the health care loans we discussed in the second quarter.

We expect fourth quarter provision levels to continue to be normalized and within our annual guidance.

The provision of $13 million for Q3 compares to $27 million in Q2 and $20 million in Q3 of last year.

Our total credit cost for the quarter were really less than the $13 million as we sold the only meaningful OREO property we had, and that resulted in a $2 million recapture of the valuation allowance we took in the first quarter as well as a $2 million of additional gain that's included in non-interest income.

While accounting rules require us to account for it as a gain, it's really a recovery as we had previously taken some charge-offs related to this deal.

So the $13 million in provision less the $4 million related to the OREO sale resulted in net credit-related charges of $9 million for the quarter.

Charge-offs for the quarter were minimal at $2 million.

Looking at quarterly highlights.

We continue to have growth in our linked-quarter net revenue.

We've experienced strong traditional LHI growth year-to-date, and the portfolio is benefiting from improved margins as a result of a continued move in LIBOR.

While there was an earlier impact from LIBOR moves in the first quarter and the second quarter, the later LIBOR move in Q3 will show up in improved traditional LHI yield in Q4.

We continue to improve run rate on core operating expense items, specifically salaries and a continued focus on improving efficiency while enhancing client experience.

ROE and ROA levels improved in the third quarter as a result of the more normalized level of provisioning.

The expectation of the ROE trajectory is positive, and we expect Q4 to be stable.

We continue to benefit from interest rate moves despite the fact that the timing of the improvements can be impacted by how LIBOR moves in comparison to the Fed move.

Current lower liquidity levels have been beneficial for ROA.

But we're comfortable holding higher liquidity levels, and we expect balance increases during the fourth quarter as mortgage finance moves into the seasonally weaker part of the year.

Lastly, I'll cover the guidance slide.

No change in our outlook for average traditional LHI growth of low to mid-teens percent growth.

We had a slight improvement in our outlook for average mortgage finance growth of low to mid-teens percent growth, which reflects the strong balances year-to-date; a slight improvement in MCA guidance to $1.4 billion for average outstandings for the year and a slight change in our outlook for average total deposits as we think growth will be in the high single-digit growth and all interest-bearing.

We're improving our outlook for NIM to 3.7% to 3.75% to include the impact from the September rate move.

Our guidance is still assuming no additional rate increases for the remainder of the year.

We're also taking into consideration that our deposit growth is coming in interest-bearing, and it also assumes we have higher liquidity levels in the fourth quarter with the shift from mortgage finance.

No change in net revenue of mid- to high-teens percent growth; no change in provision expense guidance at low to mid-$60 million level and no change in non-interest expense at low-teens percent growth; and finally, no change in guidance for efficiency ratio at the low-50s.

Keith?

Thank you, Julie.

Please move to Slide 11.

We're very pleased with our strong earnings and increased ROE this quarter.

Traditional LHI growth remains on target for 2018, while mortgage finance growth resulted in an increase in guidance.

While deposit levels increased, the continued rollout and then maturing of our new treasury management deposit verticals are expected to reduce deposit betas and overall funding costs while also further diversifying our funding mix.

We benefited from a more normalized loan loss provision in Q3 and remain in line with full year guidance.

While we have been focused for some time on upgrading our loan portfolio and addressing credit issues early before the next credit down cycle, it remains job 1 so we can perform well above peer through the next recession.

Again, we're not predicting an imminent economic decline, but we know that upgrading a loan portfolio requires a disciplined focus well ahead of the next recession.

The time to upgrade is when capital is still active and there are aggressive lenders.

I'm excited about the work my colleagues are undertaking to streamline our organization, improve efficiency and further build on our premier client experience differentiation.

We continue to invest in rebuilding our technology infrastructure and delivering better technology tools from my colleagues so we might create even better service for our clients and increase value for our investors.

Managing NIE growth includes investing wisely in both young and experienced talent and developing these outstanding new colleagues in our collaborative, energizing culture.

This keeps us on course to remain a winning business of the future, not just an outperformer over the past 20 years.

The focus on improving ROE the past 2 years is producing positive results.

Building the strongest loan portfolio through credit cycle is a key to increasing ROE for years to come.

We continue to leverage our treasury management capabilities to improve our funding mix and lower deposit betas with the new deposit verticals.

All in all, we're fully engaged in building the premier business for the next decade that we hope you find attractive today and tomorrow.

At this point, we can open it up for Q&A.

(Operator Instructions) The first question comes from Peter Winter with Wedbush Securities.

Two questions.

The first one, you talked about you're targeted for better expense growth or managing expenses better for 2019.

I'm just wondering if you can give a little bit more color around that; and then secondly, if you maybe have some type of expense growth number for next year.

Yes.

We're early to give guidance on that, Peter, as far as expense growth next year, but the investments we've been making for now 2.5 years and continue to make in some of our -- rebuilding some of our infrastructure, technology infrastructure, they finally begin to converge and become integrated, fully integrated midyear next year.

Now we think that will be a little tailwind, but in the meantime, we have an initiative underway here at the bank that we launched about 6 weeks ago to just look at how we optimize the work structure and deliver even better client experience while picking up efficiencies.

So the combination of using technology more than we have in the past and being more mindful about where we're focused on driving more core loan growth and core deposit growth in key businesses, I think, is really going to give us, again, a running start, which should pick up some tailwind by midyear as we integrate all our new systems integration.

Peter, it's Julie.

It's really -- and like I said, in my commentary, we've been very focused on managing headcount increases.

We've always -- we've traditionally added a lot of headcount, and we're just being more focused on where we add headcount.

And we're certainly looking at that closely in '19.

You would expect the efficiency ratio to drop next year.

Would that be fair?

Yes.

Okay.

And then could I just ask about credit?

The -- if you could just give a little bit more color about the 3 relationships that you moved to NPA and then also 90-day loans past due also increased.

I'm just wondering how you got comfortable.

You mentioned also that you're upgrading the loan portfolio to prepare for the next recession, but this will be -- you have the big increase in charge-offs in the second quarter, and then we're seeing an increase in NPAs this quarter.

And I'm just wondering if you could just talk about what's going on, on the credit side?

You're accurate in saying NPAs increased very, very modestly, and if you look at our overall NPAs, they're really quite good relative to industry.

Back on your earlier question, yes, we've had 3 new credits that got moved to NPA.

Again, it's not consistent with what we saw industry-wise in the second quarter.

One thing we have noticed and we're taking a closer look at is there is some commonality in some of the credits being more levered, and so we're taking a harder look at just what we're doing in that portfolio.

We have less than 5% in our leveraged lending portfolio or sponsored finance portfolio.

But the only thing we see, it's not really an industry issue at this point but could be a bit of an issue, is the more highly leveraged companies.

And I don't think that's unique to us.

What we tend to do, and I think you know this having followed us for years, is get more critical and more challenging in looking at our credit early enough before the downturn, Peter, so that we do have ways to move some of that credit.

Now when they move to nonperforming, you're late.

So that's not optimum.

But you are going to see some of that activity occur with us and you should earlier than some banks just as you did with the energy book.

Peter, on the over 90, that's predominantly our premium finance loans, and those are basically cash secured.

But they will have a fair amount that's always in over 90 days, and so sometimes, that spikes up.

So there's nothing that we think problem in the over 90 because it's primarily the premium finance loans.

The next question comes from Brady Gailey with KBW.

So we have the net interest margin for the first 3 quarters of the year.

And you've given us the full year guidance, so we can kind of back into what you think the 4Q NIM will be.

And if you back into that, it's a range of 3.45% to 3.65% roughly, so the midpoint is 3.55%.

That's another 15 basis points lower than this quarter.

And it just seems to me LIBOR will catch up this quarter.

You'll have the mix shift with a lower mortgage warehouse, which will be beneficial.

It just seems like the margin should be stable, if not, higher in 4Q.

So the one thing that's really important to factor in, you got most of that right for sure, is the mortgage warehouse softening, it goes to liquidity.

Now we'll have some pickup in traditional LHI, Brady, from that slowdown in seasonality and warehouse but more of it will go to liquidity than goes to LHI.

And so that's the dynamic.

We think we'll be on the higher end of that range, but it's too early to say.

But that is the big -- that's the bigger shift, Brady, is the -- is it going from warehouse to liquidity assets.

Got it.

Okay.

And then so you bought another $500 million of brokered CDs.

That's on top and I think last quarter in 2Q, it was about $1 billion.

So now you're at $1.5 billion now.

Sorry, go ahead Julie.

What's that?

It's about $1.5 billion at the end of the quarter.

It's actually very competitive, slightly better than some of our higher-priced index cost of funds.

And we're really using that, Brady, to bridge us a bit while we get these new deposit verticals ramped up.

And while we have 2 out there operational now, they're young and we've got 6 more coming online next year.

But when you look at overall optimum cost of funds, for now, this brokered CD money is actually more attractive, slightly less costly than some of our most highly priced money.

Okay.

So it's $1.5 billion now.

That's about 7% of your deposits.

I mean, do you think that, that'll continue to increase in the near term before the new deposit verticals start getting speed and then we'll see it go back down?

It's hard to say.

I mean, it could.

It's not going to increase significantly.

But if we see that as a better cost of funds near term, it makes sense to us to actually deploy some of it.

But I don't see it increasing significantly.

Julie, do you?

No.

Probably what's more likely to happen and some of that -- those are shorter terms, 6 to -- I think the remaining maturities are 2 to 9 months.

So as some of that rolls off, we might choose to replace it.

But yes, I don't think you're going to see us add too much more if any.

Okay.

And then lastly for me, I mean, you're talking about slowing the pace of expense growth.

You're talking about managing the headcount increase.

We saw some severance charges this quarter.

Are you thinking about doing a headcount reduction at this point as a way to slow expense growth?

No, that's really not in the cards.

We have made some adjustments to get a more efficient org structure set up, Brady.

That was the key reason for that, primary severance charge, the primary reason.

And then as we go forward, again, we think we have a much better feel or a handle on how we use existing headcount to redeploy some of that headcount maybe in the same division but not incrementally keep adding at the pace we have over the years.

And really we add -- we had 150-plus FTEs a year.

If we can tip that down to 100 or even 80 or 90, that's a meaningful pickup in efficiency.

And I think we're really getting a lot better at that these last couple of months.

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

So the first question, just trying to better understand loan betas as we think about fourth quarter given the noise we've had both on the mortgage warehouse and the traditional LHI.

So if you can help me, Julie, if we think about, one, the LHI for the mortgage warehouse growth, that 3.62% means it's been all over the place in terms of the loan beta earlier?

Like given that we've already had the Fed funds and the LIBOR, if you can talk about your best guesstimate for traditional and warehouse yield going into 4Q, what level of FAS do you expect?

I think that will be extremely helpful.

Okay.

So on the traditional LHI, I mentioned that the ending rate on the floating part of the book is at 15 basis points at 9/30 compared to 6/30.

And then part of that book doesn't reprice until early -- it repriced in early October.

So you'll see all of that come through.

The other -- and we're assuming, in our estimate, we're assuming no further that LIBOR doesn't lead assuming there's a December increase.

So we would see the full impact of the December LIBOR moves come through in the fourth quarter.

You mean the third quarter?

The third quarter -- well, that happened in the third quarter, but it's going to come through in our fourth quarter LHI yield.

The other thing is the fluctuation in the loan fees.

It was up -- from Q1 to Q2, it was up about 7 basis points.

Q2 to Q3, it was down about 9. Generally, we don't see anything more than maybe a 3 to 5 basis point fluctuation from quarter-to-quarter.

So I would say, had we had a more normalized fee quarter, we would have added another 4 or 5 basis points to the LHI yield in the third quarter.

So...

It's very -- it's seasonal in that a lot of the biggest deals, as you well appreciate, those get syndicated and launched in the second quarter, Ebrahim.

I guess, the important thing to remember is that in looking at our ending 9/30 yields and what's going to -- what's repricing early October, we're still seeing the same kind of betas that we've seen on the core book to date.

On warehouse?

Yes.

On warehouse, we started talking on the second quarter call and then in Q3 on different meetings that we had that we were starting to see competitive pressures.

So that was kind of an outsized catch-up from Q2 to Q3.

We could see a little more pressure, but I think that's going to flatten as we go forward.

And if LIBOR continues to move up in the future, we could see a portion of that come through in the warehouse yield.

There's a real struggle in that space, Ebrahim, to hold market share.

Now we're still taking market share, but those that are just trying to stay in the business at a reasonable run rate, it's put pressure on that yield.

But we really think we're close to bottoming out on fourth quarter or early next year on that pressure.

So it's also important to remember that all you can see for that line of business is just the loan yields.

What's also tied in there is a whole relationship with deposits or an MSR facility, and all you can see is this.

So we don't cut yields across-the-board.

We look at each relationship.

Understood.

And I guess, just moving in terms of -- I guess, deposit growth should be the driver of balance sheet growth given where we are and your comments around being conservative on credit.

And if that's going down to high single-digit percentage growth, is that kind of what you expect on -- with all these verticals coming through next year?

Is high single-digit type balance sheet growth environment that we are in today?

And it's one thing for growth in interest-bearing deposits.

Do you still expect non-demand deposits to continue to decline at the rate we've seen year-over-year this year?

It's early to give you a guidance on next year.

But generally, yes, I wouldn't be surprised once we get into January to be talking with all of you about high single digits on loan growth and deposit growth because we're not interested even as the verticals get traction and just absolutely growing.

We want to optimize our cost of funds, which means some of our highest cost of funds, we would envision replacing with some of these better beta, lower beta new vertical deposits, too.

So again, could we grow double digits next year in loans and deposits?

We could.

I don't think that necessarily optimizes our earnings and ROE, Ebrahim.

And Ebrahim, on the DDAs, I think you'll see -- I mean, we're still working hard at increasing DDAs to offset some of the migration that's happening there to interest-bearing.

And I think if you look from Q2 to Q3, we didn't have much net runoff, so that's -- I don't -- the year-over-year decrease, like if you look at averages from third and fourth quarter of last year down to where it is this third quarter, I don't expect to see anything that pronounced.

I think it's going to be much smaller, similar to what you saw from Q2 to Q3.

The next question comes from Michael Rose with Raymond James.

I followed you guys for a long time, and it seems like pulling off the hiring is kind of a little bit different from where your D&A has been historically.

I mean, is this kind of a secular shift for you guys as you've gotten bigger?

And I understand the commentary about the environment, where we are and all the external pressures out there from nonbank lenders.

But it seems like this would be the type of environment where you guys would continue to hire well-seasoned lenders, well-positioned lenders looking for a new home.

One of the things we've really accomplished just in the last 3 years, Michael, is building a team of young talented people, hiring undergrads right out of school and MBA students and bringing them through a training program.

And we're having really good success with those folks, and they're really contributing and beginning to sprinkle them across our businesses in all areas.

So yes, we're continuing to hire experienced bankers, but we also, importantly, are shifting our overall age to be more a company that has another 20-year run as we shift over the next 10 to 15 years some of our business owner clients and CFOs to be millennials.

We want to have our young people be ready to take those handoffs, and they're doing a great job.

The other thing we're doing is org structure wise, we're looking at being a flatter, more horizontal company than adding more vertical layers.

And we just think that's the way companies have to organize to be more responsive and efficient and be able to react fast enough to market demand and client experience.

So those are some fundamental things we're doing.

I'm excited because we have leaders across our company and then teams under our leaders that have really taken this initiative and run with it.

So it's not something just coming from Julie and me or our NEO team.

It's something everyone buys into as a way to improve client experience but also efficiency.

And this should enable us to hire fewer new people but actually increase the value of our existing people as we leverage them with technology and get them in the optimum seat to contribute value.

Maybe just one follow-up question.

Just wanted to get your longer-term thoughts on the warehouse business.

It's clearly going through some changes.

Dwell times, at some point, are going to go down, electronic mortgage.

How should we think about the future of that business?

I know it's 30% of loans.

I mean, what's the longer-term play here?

We think it has a great future for us.

I don't think it necessarily has a great future for everyone.

We've set ourselves up to be able to scale, and we've proven we can over the years.

But we're positioned to scale significantly as the market over time begins to shift to more electronic payment.

And again, if you're not investing heavily in technology -- and again, we were the leader in the industry to offer e-notes, so we've been at this for several years.

It just hasn't had wide adoption yet but it's coming.

You better be set up to scale, or you're not going to be able to generate the kind of returns on this very credit safe asset that you need to generate.

But it is going through a cycle now with headwinds yet again in '19 on mortgage volumes, the latest from the MBA as of the last 2 days, or they think it could be another 10% plus down year next year.

And we could well see an 8% to 10% this year.

It's running about 8% down versus a year ago.

So cumulative down, 3 years in a row, it's going to cause a lot of consolidation, to further address your question, Michael.

I would expect we'll even have some fewer customers, but most of our customers will be beneficiaries of the consolidation.

Therefore, overall, we think we'll continue to take market share in a challenged environment.

So we like the business, but we've worked hard to position ourselves to handle what's coming.

And we believe we're in a good shape to do it.

Okay.

So fair to assume that this is a mid- to high-teens ROE business and given the investments you've made, the market share you're trying to grab, fair to say that, that's the assumption short term to medium term.

That's right.

And you are going through this period where there's some winnowing out that's going to happen both of the non-bank clients and prospects as well as of the banks that are going to serve that group.

We think we're well positioned to benefit as the cycle runs its course.

But we're definitely in a cycle where everybody's scrambling to hold on to market share.

The next question comes from Brett Rabatin and with Piper Jaffray.

Wanted to first just ask, there's been some consternation this quarter through the earnings season so far with ending period DDA versus averages.

And I was curious, was there anything unusual that affected your end-of-period DDA versus kind of the average for the quarter?

And how should we think about the difference there?

I think, average -- I think I always say average is a better indicator of what's going on.

We do have some fluctuations.

We got deposits in several different industries that lend themselves to sometimes run off at end of -- at the end of the month but then build back up.

So I think, overall, the averages are just a better indicator of what's going on.

Okay.

And then you briefly addressed the new verticals.

Maybe could you give us any color on kind of what you're seeing so far with the platforms in terms of balances and what the average cost is?

Are we getting to a point where we can maybe get a look at those numbers?

Well, I see my team shaking their head no, but I'm going to give you a little color.

So I'll be in trouble after the call.

I'm not going to tell you what category they're in of course, and you will appreciate that.

We're still getting launched.

But with 1 vertical having been up for a good part of the year and the other just recently getting launched, we're around $600 million in new deposits in those 2 new verticals.

I would say that's an awfully strong start.

These are not the ones that we think will be even stronger growers.

We don't know if we'll sustain this rate of growth, but we're off to a good start.

Okay.

And then I want to make sure I was clear on one last thing, just the closing comments in the PowerPoint, you say, "selective about growth areas in positioning our portfolio." This quarter, were there things that you specifically exited versus payoffs in the quarter that affected kind of the net growth?

Or how do we think about your comment there?

Are you actually kind of exiting positions into what you kind of see as peakish credit?

No, not exiting positions but we're being very, very deliberate about pipelines in terms of do we really want to pursue and close a deal.

Do we want to win the deal?

If we win the deal, is that really an above-average credit in that part of our portfolio?

I mean, this late in the cycle, it needs to be as opposed to just something that, yes, we're okay with.

It's a 30th percentile kind of quality, but we think it's going to work out.

That's not a good bet this late in the cycle for new credit.

So I think we're just being more selective, and you have to be early.

Again, it's challenging because you want to grow in a healthy way, but the best loans, everybody's after and some of them are just unbelievably cheap relative to even the good quality that it offers.

So we're going to have to be thoughtful about always looking better-than-average quality as we go forward.

We hope we have another couple of years with expansion.

We just can't bet on it.

Now is the time, while there's so much capital chasing assets and loans included, especially nonbanks chasing loans that are so aggressive, now is your opportunity to miss some of the late vintage credits that you'll really regret you did in a year or 2 when we get into the down cycle.

So we're certainly open for business.

We had a great first half.

Again, had that second quarter that came on so late and outstanding, some of that spilled into the third quarter and I think everybody would be happy as a lark because we told you at April we had the soft pipeline going into the second quarter, and our team was just so good, they closed a lot of deals in June.

And it kind of pulled some of that volume that might have normally fallen into the third quarter into the second.

We're happy with where we are, and we think it's the right pace of growth at this stage of the cycle.

Brett, I think it's really consistent with what we've been saying, what Keith has been saying for a while about certain categories that we were being very cautious about.

And then just a reminder, for kind for our history, our growth has been lumpy.

In this year, it was just a little more lumpy toward the front end.

We are seeing continued rapid, paydowns, all banks are these days on CRE.

And our CRE numbers relative to capital continue to go down.

We're now in the low 80s as a percent of capital.

At one time, we're in the 120s, just 1.5 years, 2 years ago.

But the things we're doing to replace that runoff are all about quality.

Be sure that we get the right better-than-average quality in the portfolio.

And I'd be fine if that goes back to 95-or-so percent of capital, but it has to be because we're finding the best quality that we've seen.

The next question comes from the Dave Rochester with Deutsche Bank.

Wait, before I answer your question, Dave, my guys are shaking their head.

It wasn't 18 months ago we were at 120% of capital.

That was what, Randy, 3 years ago?

Yes, C&D.

That's the category.

The subcategory's C&D, construction and development so -- but we're continuing to bring that down.

I mean, we're just reducing our risk overall.

For an asset class, it's still really great in our portfolio, but we know it's more cyclical in a downturn than other asset classes typically.

I'm sorry, Dave?

Just regarding NIM on the guidance, I just want to make sure I had this right.

It sounds like you're expecting the loan fees to potentially be up a little bit in 4Q, the mortgage warehouse yield maybe down a little bit to flattish at this point with the LHI yields up decently.

Is that roughly right?

That is correct.

That is right.

That is correct.

And the only other thing is as we go into the fourth quarter where mortgage finance is seasonally weaker, that shift is going to go into liquidity assets, which is obviously for a lower rate.

And some growth again in traditional LHI.

Yes, absolutely.

Yes, yes, that sounds right.

And then that increase in deposit costs for the quarter -- this quarter, is that generally the pace that you're expecting in quarters in which we have rate hikes going forward?

We think it was a little elevated this quarter, but we'll just have to see as things move ahead.

It was more the other factors Julie pointed out than just a way outsized move in deposit cost.

But we've been talking about this for over a year.

We could have a quarter where we have real outsized deposit cost move.

We just haven't seen that in a big way yet, but that still could happen in a quarter.

Yes.

Because I think if you compare the move from Q1 to Q2 and Q2 to Q3, we were -- it was up a couple of basis points, but yes, nothing outsized.

So I think it's a fair run rate.

Okay.

Okay, so there's no like partial catch-up embedded in those or anything.

Okay, got you.

And then, I guess, just bigger-picture question on asset sensitivity.

Going forward or maybe with just the September hike, I mean, I guess, you've kind of given us the components.

But just bigger picture, how much do you expect NIM to benefit from rate hikes ex any kind of liquidity build?

So for the next rate hike, what do you think?

Here's why we hesitate.

You know all the dynamics that we deal with, and that shift, mortgage warehouse seasonally, lumpy growth, traditional LHI, so let us say it this way.

We are continuing to see some expansion but particularly in traditional LHI near term in the third quarter in particular, it was tough on yield competition in the warehouse space.

But again, as we said earlier, we think that's going to really -- that trajectory of downward push on yield is going to flatten some over the next couple of quarters and bottom out soon, okay?

I'm not sure if that answers exactly your question, but I'm trying to give you the right context.

And the NIM expansion is still going to happen with rate moves.

But like what we saw in the third quarter, how core -- how traditional LHI yields moved up, that's going to be lagged because of what happened with LIBOR.

So there can be some timing considerations that you have to take into account to see all of that expansion.

Got you.

Okay.

Great.

Just switching to expenses.

I know you're not talking about headcount reductions or anything like that, but it looks like your expense guide for the low double digits this year points to something maybe lower expense level in 4Q.

Is that what you're expecting at this point?

Or are you expecting...

We had several -- yes, fourth quarter, we are expecting fourth quarter expenses to be lower than Q3.

We had those kind of onetime things in Q3, so yes, that's exactly what we're planning.

The next question comes from Geoffrey Elliott with Autonomous Research.

When you're seeing those non-interest-bearing deposits -- deposit balances decline, do you have a sense of where they're going?

Are they going into interest-bearing balances with you?

Are they going into interest-bearing accounts with other banks?

Are they going into off-balance sheet products?

Are they getting deployed?

From your discussions with clients, where is that money going?

It's really virtually all staying with us, but it's converting to interest-bearing.

We're watching that carefully.

We're not seeing DDA migrate out and go somewhere else.

Now some of it, I will tell you, is being deployed in the businesses, those that are growing.

And some of them are beginning to do some CapEx expenditures, Geoffrey, with the tax incentive.

So there is some of that going on, and with GDP running as hot as it is, you expect a little of that.

But it's not migrating out of the bank.

So we expected some of that to convert.

It's going to convert quicker, of course, with our commercial banking focus without the brick-and-mortar retail business, and that's what's occurring so far.

And can you help us think about what portion of the remaining DDA is potentially going to convert into interest-bearing versus what you think is pretty sticky and stays within the DDA category even if rates keep on moving up?

Well, we still believe that the trajectory or pace at which it's converting is going to begin to tip down and that others that have so much of the retail are going to then begin to experience a little steeper trajectory dealing with online bank competitors.

I just can't tell you when.

I don't think the pace is increasing.

I think it is decreasing some, but it'll continue for still a while until we put together 2 or 3 quarters and be convinced, all of us, that, that's slowed.

But we don't see that becoming a bigger issue near term than what we've experienced the last few quarters.

Geoffrey, it's important to remember that we're very treasury management focused, so a large percentage of those DDAs are tied to some kind of treasury services.

So there's a certain amount that they're going to keep to cover their charges.

So that -- we think that certainly helps slow that.

We have over 90% of our clients on our treasury system, and that was all the way in the mid-50s 4, 5 years ago.

We've worked hard to make that stickier because of the future rate increase environment that we're experiencing now.

The next question comes from Brad Milsaps with Sandler O'Neill.

Keith, just to attack maybe the NIM question a different way, if your guidance holds as you expect this year, it looks like you'll generate about 20 or 25 basis points of year-over-year NIM expansion compared to about 35 in 2017.

If the Fed raises rates again in December, then maybe a couple of times next year and LIBOR sort of follows as expected, would you expect to get a similar amount of expansion in '19?

Or do you think the environment is such that it's super competitive and maybe on the asset size is just going to be more difficult to generate the increases in spread that maybe you've been able to in '17 and '18?

Well, you're teasing me, Brad.

You're tossing me to answer this off the top of my head as I did a few quarters ago when I got in trouble with Julie.

But I want to crow a little bit.

I was pretty close on that estimate.

And next year, I'm going to do this again, which I should learn from my mistake.

Next year, I do believe we'll have expansion.

It'll be modestly less than what we saw this year.

It -- I just don't see things changing quickly enough on the conversion of DDA to interest-bearing.

I don't see the new verticals coming on fast enough to make a big difference on that other than slowing it some in '19.

I think that will begin to change in '20 as they mature, and we have more experience with those new verticals and hopefully, lower betas and lower costs there.

But in the near term, through '19, my best guess is we'll still see expansion but it'll be more modest.

Which is pretty consistent with what we've said from the beginning that for each move, we would get just a little bit less.

Right.

And then just a follow-up on the warehouse.

I heard you say, in answering one of the other questions, that you flatten out, maybe go down a bit in the fourth quarter.

With each move in LIBOR, do you think you're going to have enough pricing power there to increase it as you move through '19 like you did this year?

Or what does your crystal ball say kind of on that environment?

The next couple of quarters, I don't think we will.

I think we'll end up passing through most all of that benefit on LIBOR to the clients.

It's just a highly competitive environment.

The good news is I don't see us having to move our index down much over LIBOR as we've had to do to a degree, relationship profitability base, but still the last couple of quarters, we've had to do that more than I think we will going forward.

But I think we're still a couple of quarters away, Brad, from us being able to actually benefit on increases in rate on our warehouse yields.

The next question comes from Brock Vandervliet with UBS.

Shockingly, I think virtually all my questions have been answered, but let's see.

Something you remarked on in your opening remarks in terms of changing the incentives on deposit growth or looking at them.

What have you been considering or been implementing there that could be a needle mover going forward?

We -- since inception, we've always tweaked RM incentives as we needed to.

And so that's what we've done this year, is just tweaked it a little bit more to incent more deposit growth.

Still incenting loan growth but a portion of it is more focused on deposit growth.

And what's largely driving that, Brock, is not just the importance of getting our funding improved overall, and diversifying the funding, getting the cost in a better position.

But it's also our focus on growing loans very deliberately well above average quality on any new loans we're doing.

So it all made sense for us to make that mid-year shift for our RM incentives.

And in terms of that quality focus now regarding the CRE paydowns, is this kind of a natural progression of a construction loan that goes to permanent financing elsewhere?

Or is this credits that have a balloon payment or whatnot and you just don't want to keep in the bank?

No, we don't really do much term real estate.

We've not been comfortable really, Brock, with the low cap rates and high valuations in the market to loan 75%, 80% against those values.

So this is the normal C&D.

The project's completed.

Rather than get to the more typical 3 or 4 years ago, additional year or so for lease up after the project's done, these are just paying off very early, like shortly after completion and certificate of occupancy.

And there continues to be an extremely strong appetite for REITs and other financiers, including insurance companies, to do those term financings.

And so that's happening at a faster pace than we experienced even 2 years ago.

The next question comes from Casey Haire with Jefferies.

One more on the mortgage warehouse.

Just help me out with the strategy of continuing, in your words, Keith, to significantly scale this business because it sounds to me like the incremental margin is 2% on it.

I understand that it comes from deposits and the credit quality is strong.

But I mean, with your margin today at 3.70%, growing this line is going to be extremely dilutive to margin.

So I'm just -- I'm not understanding why this is a -- this is going to continue to be a point of emphasis for growth going forward?

Well, one of the keys is we don't telegraph for competitive reasons what we have in DDAs and other products that we offer these folks.

And some of that product and the DDAs are very meaningfully meaningful contributors to overall margin.

But I'm sure you understand, we just can't telegraph all the details around that because our competitors would jump on it.

We -- from a scale standpoint, just to give you a little context, Casey, 6 years ago, we had 43 people -- I'm sorry, 64 people handling about $0.5 billion a month in volume.

Today, we have in the low 40s handling up to $8 billion to $10 billion a month, and this is before e-notes are widely adopted.

So we have capacity to significantly scale even with today how notes are handled, and that's not with as much electronic speed and efficiency.

We'll have to be able to scale it, all competitors will, as we move to more e-notes because they simply won't be on the line nearly as long.

But the labor cost and the speed at which we can service them will be far quicker and far lower on the labor cost if you have the technology scale potential.

And we've built that so we won't have to add, again, headcount, lots of new cost.

And we think that's going to help us sustain a really nice return for a wonderful credit quality asset.

Casey, a couple more points.

There is no provision for loan losses that's allocated to these loans, so that certainly improves their overall return.

And then, I guess, the other point that we've said in the past that we do manage this portfolio to be 25% to 30% of our loans.

So it's not like we're planning to grow that to an outsized amount.

We've always managed that as a concentration.

And quite honestly, we look at it as a better asset to invest in versus fixed-rate investment securities, works about better yield, shorter duration but again, no credit cost, that kind of thing so...

The real cost you have to incur we think, and not every one of our competitors necessarily does this but we think it's very prudent, is fraud risk.

And we lay that risk off to Lloyds at London and have for years.

But those premiums are quite competitive, and because of our great history in that regard, it's not a huge cost.

But it's an important risk to mitigate we think, and we do that with Lloyds.

Okay.

This concludes our question-and-answer session.

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

We thank you each for your interest and your time.

We are optimistic about what we have underway.

We have many strategic initiatives that we kept you apprised of as -- over the course of the year.

And we're locked on the execution, and we're very excited about what the results are going to produce for all of us over the next few quarters.

So again, thank you for your interest in our company and good night.

Thank you for your participation in TCBI's Third Quarter 2018 Earnings Conference Call.

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

You may now disconnect.