Cullen/Frost Bankers, Inc. (NYSE:CFR) Q1 2024 Earnings Call Transcript

Cullen/Frost Bankers, Inc. (NYSE:CFR) Q1 2024 Earnings Call Transcript April 25, 2024

Cullen/Frost Bankers, Inc. misses on earnings expectations. Reported EPS is $2.06 EPS, expectations were $2.12. Cullen/Frost Bankers, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Greetings. Welcome to Cullen/Frost Bankers Inc. First Quarter 2024 Earnings Conference Call. [Operator Instructions] Please note, this conference is being recorded. I will now turn the conference over to A.B. Mendez, Senior Vice President and Director of Investor Relations. Thank you. You may begin.

A.B. Mendez: Thanks, Jerry. This afternoon’s conference call will be led by Phil Green, Chairman and CEO; and Jerry Salinas, Group Executive Vice President and CFO. Before I turn the call over to Phil and Jerry, I need to take a moment to address the safe harbor provisions. Some of the remarks made today will constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 as amended. We intend such statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 as amended. Please see the last page of text in this morning’s earnings release for additional information about the risk factors associated with these forward-looking statements. If needed, a copy of the release is available on our website or by calling the Investor Relations department at 210 220-5234. At this time, I’ll turn the call over to Phil.

Phil Green: Thanks, A.B., and good afternoon, everyone. Thanks for joining us. Today, I’ll review the first quarter results for Cullen/Frost and our Chief Financial Officer, Jerry Salinas, will provide additional comments before we open it up to your questions. In the first quarter, Cullen/Frost earned $134 million or $2.06 per share compared with earnings of $176 million or $2.70 a share reported in the same quarter last year. The first quarter results were affected by an additional FDIC insurance surcharge accrual of $7.7 million or $0.09 a share associated with the bank failures that happened in early 2023. Our return on average assets and average common equity in the first quarter of 1.09% and 15.22%, respectively, and that compared with 1.39% 22.59% for the same period last year.

Solid earnings from the first quarter demonstrate the success of our organic growth strategy and the hard work of our bankers. Our strength and stability, combined with our core values and strong corporate culture allow us to continue providing world-class service to our customers which results in sustained long-term growth. Our balance sheet and our liquidity levels remain consistently strong. Also, as was the case in previous quarters, Cullen/Frost did not take on any Federal Home Loan Bank advances, participate in any special liquidity facility or government borrowing access any broker deposits or utilizing reciprocal deposit arrangements to build uninsured deposit percentages. And additionally, our available-for-sale securities, representing more than 80% of our portfolio at year-end – at quarter end.

Average deposits in the first quarter were $40.7 billion, down 4.8% from the $42.8 billion in the first quarter of last year. Average loans grew 10.4% and $19.1 billion in the first quarter compared with $17.3 billion in the quarter a year ago. We continue to see excellent results in our organic growth program. For example, we combined our Houston locations and the expansion, they stand at 104% deposit goal, 164% of loan goal and 122% of our new household goal. For the Dallas market expansion, we stand at 174% of deposit goal, 212% of loan goal and 185% of our new household goal. Just after the first quarter closed, we opened the second new location on our 17-site Austin expansion project. Our next new Austin region location will open just after the Memorial Day.

At the end of the first quarter, our overall expansion efforts had generated $2 billion in deposits, $1.5 billion in loans and added over 46,000 new households. And it helps me to put this in perspective, when I remember that the largest acquisition in our history was a company with $1.4 billion in deposits. Our consumer banking business continues to build momentum from the 2023s record net new household growth, and we added 6,600 net new checking accounts for households to the quarter, and we had an annual growth rate there of 6.5%, which we believe continues to put us among the top growing banks in the country. Average consumer loans saw steady growth in the first quarter, increasing an annualized 13% on a linked-quarter basis and hit a milestone of $3 billion in average balances outstanding.

And we remain excited about the prospects for our new mortgage product, which is approaching 200 loans with about half coming in the first quarter. Looking at our commercial business. On a linked-quarter basis, average loan balances increased an annualized 10.5% for C&I and 13.4% increase CRE. Our new commitments booked in the first quarter were 24% less than the level booked in the first quarter of 2023. Our new commercial relationships were up 10% year-over-year and at 825 represented our highest level of first quarter relationships ever. This coincided with us achieving our highest level ever for calling activity in the first quarter. New loan opportunities in our pipeline were up 15% year-over-year and were second only to the last year’s spike after SBD’s failure.

Our weighted average pipeline stood at $1.46 billion, up by 24% from the fourth quarter and by 17.5% from the first quarter last year. And regarding those 825 new relationships in the first quarter that I mentioned, about half of those continue to come from the two big failed banks. We continue to use discretion as we look at our new loan opportunities. And as an example, I’d point out that in the first quarter, our deals lost were up by 24% year-over-year and 82% of those deals lost were due to structure. Credit quality is good by historical standards with net charge-offs and debt and new nonaccrual loans at healthy levels. We’re seeing some normalization in credit risk ratings. And as we come off the historic lows and problems experienced in the years immediately following the pandemic.

And looking at some of the details. Net charge-offs for the first quarter were $7.4 million compared to $10.9 million last quarter and $8.8 million a year ago. Annualized net charge-offs for the first quarter represented 15 basis points of period end loans. Nonperforming assets totaled $72 million at the end of the first quarter compared to $62 million last quarter and $39 million a year ago. The quarter end figure represents a 37 basis points of period in loans and 15 basis points of total assets. Problem loans, which we define as risk grade 10 or OAEM, totaled $809 million at the end of the first quarter. And that’s up from $571 million at the end of the fourth quarter and $347 million at the same time last year. 3/4 of the increase was due to company’s specific C&I loans with the remainder being CRE credits of various types.

And this growth in first quarter was fairly evenly split between loans and the OAEM or risk grade 10 and classified a risk grade 11 categories and was mainly attributable to a few larger credits, some of which we expect relatively quick resolution for. Less than 20% of our problem loans overall are tied to investor commercial real estate. About 50% are related to C&I credits with most of the balance in owner-occupied real estate, which are closely related to C&I loans. Regarding commercial real estate lending, our overall portfolio remains stable with steady operating performance across all asset types and acceptable debt service coverage ratios and loan to values. Within this portfolio, what we consider to be the major categories of investor CRE, office, multifamily, retail and industrial, for example, totaled about $4 billion or 46% of total CRE loans outstanding.

Our investor CRE portfolio has held up well with the average performance metrics stable quarter-over-quarter exhibiting an overall average loan to value and underwriting of about 53% and average weighted debt service coverage ratio of about $1.47. The investor office portfolio, specifically had a balance of $983 million at quarter end, and that portfolio exhibited an average loan-to-value of 53% and healthy occupancy levels and the average debt service coverage ratio of 1.53, which has slightly improved for the second consecutive quarter. Our comfort level with the office portfolio continues to be based on the character and experience of our borrowers and sponsors and the predominantly Class A nature of our office building projects. In our last conference call, I mentioned that we had just introduced the new Frost Bank marketing campaign and brand refresh designed to emphasize our great customer experiences.

We saw the proof points of that in the first quarter when Frost achieved the highest scores nationwide and the Greenwich Excellence Award for the eighth consecutive year and the highest ranking for banking customer satisfaction in Texas in J.D. Power’s retail banking satisfaction study for the 15th consecutive year. These are unprecedented achievements. No other bank can say those things. And I hope no other bank ever will. But when you think about it, that level of service is why our customers have come to expect from Frost. That’s what we deliver on a daily basis, and it’s what we mean when we talk in the new campaign about real-life examples of extraordinary customer service with the description, exactly what you unexpected. And none of this is possible without the dedication of our employees across Texas, their commitment to our culture and their optimistic experience, make all of our success as possible and I’m proud of everything that our Frost teams are accomplishing across all our communities.

And now I’ll turn the call over to our Chief Financial Officer, Jerry Salinas, for some additional comments.

Jerry Salinas: Thank you, Phil. Let me start off by giving some additional color on our overall expansion results. As Phil mentioned, we continue to be very pleased with the volumes we’ve been able to achieve. Looking at the first quarter, growth in both average loans and deposits was approximately 9% when compared to the previous quarter. And for the first quarter, the profitability of the Houston expansion offset the costs associated with the additional expansion efforts in Dallas and Austin. Now moving to our net interest margin. Our net interest margin percentage for the first quarter was 3.48%, up 7 basis points from the 3.41% reported last quarter. Some positives for the quarter include higher volumes of both loans and balances at the Fed and higher yields on loans and investment securities.

These positives were partially offset by higher cost of interest-bearing deposits compared to the fourth quarter. Looking at our investment portfolio. The total investment portfolio averaged $19.3 billion during the first quarter, down $510 million from the fourth quarter. During the first quarter, investment purchases totaled $187 million with $112 million of that being Agency MBS securities and $75 million in municipals. The net unrealized loss on the available for sale portfolio at the end of the quarter was $1.59 billion, an increase of $199 million from the $1.39 billion reported at the end of the fourth quarter. The taxable equivalent yield on the total investment portfolio in the first quarter was 3.32%, but up 8 basis points from the fourth quarter.

The taxable portfolio, which averaged $12.5 billion down approximately $582 million from the prior quarter had a yield of 2.83%, up 8 basis points from the prior quarter. Our tax-exempt municipal portfolio averaged about $6.8 billion during the first quarter, up about $73 million from the fourth quarter and had a taxable equivalent yield of 4.27%, up 1 basis point from the prior quarter. At the end of the first quarter, approximately 70% of the municipal portfolio was pre-refunded or PSF insured. The duration of the investment portfolio at the end of the first quarter was 5.5 years up from five years at the end of the fourth quarter. Looking at deposits. On a linked-quarter basis, average total deposits of $40.7 billion were down $459 million or 1.1% from the previous quarter.

We did continue to see a shift — a mix shift during the first quarter as average non-interest-bearing demand deposits decreased $720 million or 4.9%, while interest-bearing deposits increased $261 million or 1% when compared to the previous quarter. Based on first quarter average balances, non-interest-bearing deposits as a percentage of total deposits were 34.3% compared to 35.7% in the fourth quarter. The cost of interest-bearing deposits in the first quarter was 2.34% up 7 basis points from 2.27% in the fourth quarter. Looking at April month-to-date averages for total deposits through yesterday, they are up about $134 million from our first quarter average of $40.7 billion with interest-bearing up $332 million and non-interest-bearing down $198 million month-to-date.

Customer repos for the first quarter averaged $3.8 billion, basically flat with the fourth quarter. The cost of customer repos for the quarter was 3.76%, up 1 basis point from the fourth quarter. The month-to-date April average balance for customer repos was down approximately $42 million from the first quarter average. Looking at non-interest income expense on a linked quarter basis. I’ll point out a couple of items. Trust and investment management fees were down $1.1 million or 2.7% impacted by lower estate fees down $1.5 million. A state fees can be lumpy as they are based on the value and number of estates settled. Insurance commissions and fees were up $5.6 million or 44%. Property and casualty and benefit company bonuses, which are typically received in the first quarter contributed $3.4 million to the increase.

Benefit commissions were up $2.1 million as the first quarter is typically the strongest quarter for those commissions. As a reminder, the second quarter is typically the weakest quarter for insurance commissions and fees, given our typical yearly renewal cycle. The other non-interest income category was down $6.9 million primarily related to $4.4 million in card-related incentives, as those incentives are received in the fourth quarter each year and a $3.5 million fourth quarter recovery of a previous loss accrual. Salaries and wages were up $1.4 million as increased salaries and higher incentive accruals were mostly offset by stock compensation expense, which was lower by $8.2 million. As a reminder, our stock awards are granted in October of each year and some awards by their nature, require immediate expense recognition.

Benefits expense was up $7.9 million, impacted by higher payroll taxes and 401(k) expenses related to annual bonuses paid during the first quarter and impacted by the normal trend for FICA taxes and 401(k) limits reset at the beginning of the year. Other non-interest expense was down $6.4 million or 9.6%. The decrease was driven primarily by donations expense which was down $3.5 million and professional services down $2.9 million. Regarding our guidance for full year of 2024. Our current projections include two 25 basis point cuts for the Fed funds rate over the remainder of 2024 with one cut in September and another one in November. This is down from five cuts in our January guidance. For the full year of ’24, we currently expect full year average loan growth in the high single digits.

That’s up from our previous guidance of growth in the mid- to high single digits. Full year average deposit growth in the range of flat to 2%, that’s down from our previous guidance of growth in the range of 1% to 3%. Net interest income growth in the range of 2% to 4%, that has not changed from our previous guidance, with the net interest margin percentage expected to trend slightly upward each quarter for the remainder of the year. Non-interest income could be flat to up 1%, impacted by the pressure facing the industry on interchange revenues and OD fees, and also impacted by our high level of sundry income in 2023. That represents a slight improvement from our previous guidance of basically flat. Non-interest expense growth in the range of 6% to 8% on a reported basis, this has not changed from our previous guidance.

Regarding net charge-offs, we still expect those to go up to a more normalized historical level of 25 to 30 basis points of average loans. Regarding taxes, our effective tax rate for the full year of ’23, was 16.1%, and we currently expect a comparable effective rate in 2024. No change to this guidance. With that, I’ll now turn the call back over to Phil for questions.

Phil Green: Thanks, Jerry. We’ll now open up the call for questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question is from Casey Haire with Jefferies. Please proceed.

Casey Haire: Yes. Thanks. Good afternoon, everyone. I guess starting off with the NII guide. So you guys are leaving it intact despite you’re getting less cuts, the loan growth sounds like its coming in a little bit stronger than even your revised high single-digit guide. So I guess it’s just – it’s the higher the higher funding cost pressure that’s keeping it intact? Just a little more color on the NII dynamics?

Jerry Salinas: Yes. That’s certainly some of that. And also, we’re talking about higher for longer – as we’ve talked about the competitive field out here for deposits, I think the higher that – the longer that rates stay higher, I think we’ll continue to see more pressure on deposits. We’ve been talking obviously for a while now about customers looking for higher yields. And I think that pressure will just continue. We continue to see that, especially in the non-interest bearing side where people are continuing to move their deposits. We continue to see a little bit downward trend there, and I think just the uncertainty there is going to make us just stay with our original guidance, even given the cuts – reduction of a couple of cuts.

Casey Haire: Okay. Great. And maybe just following up on that. So what is your NII guide assume in terms of DDA mix, I believe it fell to 34%. And then – what about betas from here?

Jerry Salinas: Yes. The betas is really, at this point, we’re not assuming, because we don’t have any rate hikes and then we’re not assuming any significant movement in the betas. I think our cumulative beta moved up from, if I remember correctly, we were at a 42 and we moved up to 43. I’d expect that we’d have that sort of potential pressure. We’re not seeing a lot of movement in the interest-bearing, the non-time accounts. We tweaked some downward actually a little bit. So at this point, you may see that same sort of increase of 1% quarter-over-quarter, but I don’t expect that to change drastically. Of course, we’ll continue to keep an eye on what’s going on in the market. I don’t hear nearly as much, crazy CD pricing as we’ve heard, call it, four, five, six months ago. But there’s still some stuff out there going on. So, from that standpoint, I expect some pressure on the beta, but I wouldn’t expect it to change significantly.

Casey Haire: Okay. And the DDA mix at 34%, it sounds like there’s more pressure. Just wondering how much…?

Jerry Salinas: Yes, I would think yes. I would think – there’ll continue to be pressure there. I don’t expect it to – I expect that it would move down a little bit, but I going to expect a drastic change at this point. You kind of heard the movement that we have in that category was down a couple of hundred million year-to-date. And as a reminder, for us, the first half of the year historically, and maybe these are not historical times, but historically – the first half of the year is always softer for some DDA. And so, that’s not really unusual to us. I think I mentioned in the January call we were already seeing DDA down, call it, $400 million between the time of the call, compared to the fourth quarter average. I think what we continue to do is we just continue to be focused on growing relationships.

I think we really feel very comfortable with what we’re doing, the successes that are being reported out there. And we’ll just continue to keep plug along with that, there’s not a lot we can do. The customers are looking for higher averages, and we’re going to do what we can. But I would expect back to your question, I would expect that might get a little bit of pressure, because that could go down a little bit as well.

Casey Haire: Thank you.

Operator: Our next question is from Steven Alexopoulos with JPMorgan. Please proceed.

Steven Alexopoulos: Hi, everyone. Maybe to start, so to follow-up on Casey’s question on NII. Jerry, last quarter, I thought you said that NII up 2% to 4%. I was assuming five rate cuts. But if we didn’t get any cuts, we would add like 1.5% to that increase. Is it still the same? If we get no cuts as you’re thinking 1.5% above? Or has that potential improvement lessen now?

Jerry Salinas: It probably lessens a little bit now. A part of it again is when we’re talking – this whole conversation is about the noninterest-bearing deposits. And obviously, that’s a big impact on that number. So given what the pressure that we saw there, a little bit more than we expected in the first quarter. And as I responded on the previous question, not really ready to increase our guidance, it’s really more related to what happens there. And I think that will really drive a lot of it. The month of April, like I said, doesn’t look unusually bad and it’s a little tough to really address all of this because for us, from a cyclical standpoint, this is where we would typically be. We’d be a little bit softer and we’ve kind of said that for a while now that the first half of the year will be softer. So yes, at this point, we’re, we’ll just kind of have to see where it plays out. But yes, I think the big swing factor is what happens with those DDA volumes.

Steven Alexopoulos: Got it. Okay. Thank you. And then on the loan growth side, you guys had solid loan growth and really in a quarter where the industry has not much loan growth to speak of at all. How much of the loan growth is coming from current customers borrowing more, really a sign of the health of the markets, versus just pure market share gains? Like new customers to the bank?

Phil Green: Steven, I don’t have that number at hand, I can tell you what some of the new customers have done to loan growth, Jerry can help me out with that. But just to talk a little bit about the – the thing is interesting that a lot of the activity we saw in pipeline increased was customer related. And as opposed to prospects, I thought that was interesting. And I think also an area that we saw is that core loan growth be under 10 million relationships. I think is the activity there was better than the large loan deals. And I think that reflects our expansion growth. And so – it’s pretty broadly based, and so that’s what we’re seeing. One second, I might be able to get some info on the relationship impact.

Jerry Salinas: Yes. I guess what I’d say is, from the numbers that I’m looking at, it looks like maybe about a let’s talk about the period end growth between December and March. About a quarter of it, I’m going to say, is related to new customers.

Steven Alexopoulos: Got it. Okay. And while – go ahead?

Phil Green: So I just did find what I was looking for. In the first quarter, we added $145 million in new loan balances and $100 million in deposits from new relationships, over the last 12 months. That’s about a quarter.

Steven Alexopoulos: About a quarter. Yes, part of the reason I asked even the industry has fairly modest growth this quarter. Quite a few banks are coming out pretty bullish to seeing pipelines build, and you guys are already up low double-digit in terms of year-over-year on loan growth. Jerry, I know you said high single-digit, but if you’re seeing the same pipeline build, it would seem that puts you in a pretty good position to maybe even do better than high single-digit. Do you just want to be conservative here?

Jerry Salinas: I think, I guess, if you’re asking, could it move up to the low double-digits. I think what we’re hearing in some of it is we could, obviously, but just hearing some of the conversations with the regional presidents, I mean there is a little bit of slowness going out there. Some of this growth is coming from commitments that were originated last year. So although everybody is still pretty bullish, there’s a little bit still of concern about what happens through the rest of the year. So, could it happen? Yes, I mean the numbers are trending really well, both on a linked quarter and year-over-year. I think we were – both of them were north of 10%. So, we could kind of tweak up into instead of 9%, could we be a 10% or 10.5%, certainly. But again, we are getting – we are hearing a little bit of a word of caution from some of our guys out in the field.

Phil Green: Steven, I’d say there are a couple of forces, are there a few forces that are on the positive side, someone on the negative. And I just talked to some of our people, about how it looks, just done some calls yesterday, got back from it. And there their opinion was that they’re seeing good activity. And there’s kind of a bifurcation of the high end of the market is doing really well and some of the low end is under some pressure. But those offset – themselves a little bit, but activity is good, but we’re also being careful on what we’re seeing in structure. Like I said, we lost 82% of the deals lost were from structure. So, I think as we see some of the banks getting back in the game, they’re getting back to where they were before, I guess, and a little bit more aggressive than we’d like to be.

So that will be a little bit of a limiter on us if the market gets out of hand. But overall, I think it’s a – I think it’s got a good outlook and one of the reasons is because look, that pipeline information that I showed you, I mentioned a few minutes ago, just the – growth in the linked quarter pipeline was strong. A number of new relationships are strong. So, we’re doing well competitively. And I think the market in Texas is still reasonably good. I think Jerry is right. Some people are continue to be a little bit circumspect around the election, probably might impact, but some people are willing to do so they get the lay of the land regulatorily, what they’re going to be looking at. But I – probably felt that a little bit more cautious last quarter.

But interestingly, what I’ve heard recently has been pretty good.

Steven Alexopoulos: Sounds good. Thanks for the color.

Phil Green: Thanks.

Operator: Our next question is from Dave Rochester with Compass Point. Please proceed.

Dave Rochester: Hi. Good afternoon, guys. Back on the NII guide, I was just wondering what your assumptions are for liquidity trends you’re baking into that? It sounds like you made some securities purchases this quarter. Is the plan to grow that book some from here, to reduce some of that cash and take some of the asset sensitivity off the table? And if you have those purchase yields on those different segments, that would be great.

Jerry Salinas: Sure. Yes, on the – let me give you those purchase yields first. I have those right here. So in the agencies, we bought at a 549 kind of the municipal at a 518 TD. What we’re doing right now is I don’t see liquidity moving very much during the year. Loan growth has obviously been better than we expected. We have been targeting investment purchases of about $1.6 billion is I think the guidance that I’ve given. $1.5 billion, $1.6 billion for the year. We’re talking about scaling that back somewhat. Part of it is, we just want to continue to be opportunistic in this environment. And so, you’ll probably see us – I don’t know that it will affect the liquidity number much. But I’m thinking that we probably won’t reach that number this year.

We’ll probably be a few hundred million shy of that. Like I said, loan growth has been better deposits, like I said, a little bit softer than we expected even in that – on the noninterest-bearing side. So all things being equal, I think the net-net of it is you won’t see a whole lot of change in the liquidity. And if there’s a bias, it’s probably a small bias to increasing that somewhat.

Dave Rochester: Okay. And then just on your comment of less NII upside, and a higher for longer type of scenario. I was just curious where that NII sensitivity is now on delaying a cut. I think last quarter, you mentioned something like roughly $1 million of benefit each month. What is that now roughly?

Jerry Salinas: Yes. I think a lot of it depends on timing. When we look at it, again, the cuts that we’ve got in our models are in the second part of the year. And so again, depending on what’s happening with balances at the Fed, I’d say that number is probably at again, assuming they happen later in the year, it’s probably closer to $1 million for a month benefit.

Dave Rochester: Okay.

Jerry Salinas: And maybe that space.

Dave Rochester: Yes free. Okay. Great. And then on just credit, you mentioned maybe if I heard this right, a few larger credits impacting the problem loan trends this quarter. I was just hoping to get some detail on those. And then where are you on your office reserve ratio at this point?

Phil Green: Okay. Well, let me take the question with regard to the increased problems along with the risk rate tenant higher. As I said, it was just industry or company-specific related, there was – and I’ve talked about some of these before. There was a large construction company that missed some bids in the one segment, they’re looking for – actively looking for refinance now, but we need to recognize at a risk rate 10 in the interim period. There was a factoring company that we increased risk rate 10, just because of some perspective on borrowing base computation et cetera, we decided we’re not on the same page and that was one of them. There was a truck hauler. We saw have some issues with regard to volume. There was a company that moved into a brand-new facility fairly significant facility.

They’re getting used to that. They had an operating loss in the near term as they move that over. So, I need to recognize that until they turn that around. Those are the things that are – they’re more, like I said, company specific. They’re not really so much interest rate-related except for the things that relate to used cars primarily, the buy here pay here dealers. That’s true both the consumer on the car side and also on the trucking side. That’s the closest thing to an interest rate impact that we’ve seen. So, we’ve had some of that, but that’s not new for us. We’ve been talking about that for the last few quarters. But that’s the kind of thing that we’re seeing.

Dave Rochester: Appreciate the color. And then just on the office reserve ratio at this point, if there’s any update there?

Jerry Salinas: Sure. I would just – yes, would just see in the 10-Q, is we don’t give a very detailed view there. I think the commercial real estate reserve coverages like at 148. But some of what we do with the overlays, just to give you a little bit of the inside baseball there is that for – and this is for a non-owner occupied and construction office building at of construction. So the highest or the best – or the worst, I guess, I should say, pass rate credits that we give them a 5% reserve. So – and then anything worse than that. So if you start getting into a 9%, which is a watch and no and worse, they actually get a 10% reserve. So as I look at these numbers on a combined basis, that brings the – and this again, this is only investor office. And any office buildings under construction that combined reserve would be at a 372 production.

Dave Rochester: Great. All right. Thanks for all the color guys. Appreciate it.

Operator: Our next question is from Peter Winter with D.A. Davidson. Please proceed.

Peter Winter: Thanks. Good afternoon. I just wanted to, Phil, if I could follow-up on the problem loan discussion. Just if we’re in this higher for longer rate environment? Because I heard your comments that these aren’t interest rate related yet, but the longer that we are in this higher for longer rate environment. Do you see more pressure on like C&I loans and continued increases in the problem loans sector?

Phil Green: I don’t see anything that’s significant, or a trend for the higher for longer on the C&I piece. To be honest, I think that again, with the exception of some of the auto dealers that I talked about, who are running portfolios, credit and having some issues there. I don’t really see that so much. I think the impact is going to be more on real estate, commercial real estate, and what people – what they were financing at before, and where they are today. And those things are going to have to be solved by borrowers and sponsors coming in and supporting their projects when they come to maturity. And so forth, we’ve had a really good experience, a really good performance by our borrowers. But we could create scenarios where interest rates went higher, and created more pressure, but we’re not seeing that right now.

Peter Winter: Okay. And then just separately, the insurance commissions, it had really nice growth in ’23. It was up almost 10%. But the first quarter year-over-year, it was down 3.5%. Is there anything unusual this quarter? Or just how are you looking at that on a full year basis?

Jerry Salinas: Yes. The one thing I’ll say on the comparison to a year ago. So, the first quarter last year had a very strong life insurance commission. So, we were probably unfavorable this quarter in that comparison, by about $1.1 million. And the commissions on those policies are just one-time you’re in a one-time fee. It’s not like benefit commissions are property and casualty that tend to be a little bit more of an annuity. So that was a little bit lumpy. That was probably the biggest thing that affected us negatively, compared to the first quarter last year. Although I’ll say that benefits commissions was softer than I expected as well.

Peter Winter: Okay. Thanks, Jerry.

Jerry Salinas: Sure.

Operator: Our next question is from [Catherine Miller] with KBW. Please proceed.

Unidentified Analyst: Thanks. Good afternoon.

Phil Green: Hi Catherine.

Unidentified Analyst: A question on expenses. I know that you left your expense guidance unchanged at the 6% to 8% growth rate year-over-year. Curious I know you mentioned that FICA taxes and some kind of 1Q seasonality drove the higher expenses this quarter. Should we assume that we kind of fall back from this first quarter level, as we go into second quarter and then grow from there? Or do you still think you grow from this run rate into next quarter?

Jerry Salinas: Yes. I think a couple of things I’ll say is that we did get the additional surcharge of $7.7 million, right, from the FDIC that we didn’t know anything about when we gave the guidance in January. And we’ve been really trying to run a tight ship here in this first quarter on expenses. Again, we are certainly impacted by the expansion that we’re doing. And so, we kept our guidance the same, even though we were basically saw an additional almost $80 million in expenses that we haven’t expected. And your question was a little muffled, but I think I heard you say that maybe the first quarter was higher from the benefits maybe. I think benefits tends to go down during the year. A lot of it has to do with things like 401(k) contributions, matches that we have to make for payroll tax matches.

In certain cases, employees, especially on the 401(k) side may reach that limit pretty quickly, intentionally or unintentionally. And so, then our – we match up to 6%. If they reach that level, then the match stops. The same thing for the FICA after they reach a certain level, of course, there’s no more contribution there. But so it benefits will go down certainly just trend-wise, I don’t see the trajectory that we have other than – if you take the $7 million out, I would expect that you’ll see a little bit of growth quarter-over-quarter in expenses based on what we’re seeing today. But like I said, I feel good about where we’re at. I think we’ve done a good job this first quarter and continue to try to do that. But I would expect that they will continue to grow up just a little bit quarter-over-quarter.

Unidentified Analyst: Yes, that’s helpful. And to be clear, that 6% to 8% includes the $7 million FDIC assessment?

Jerry Salinas: Exactly. Yes, we just – we assume is operating, if you will, for those purposes. So the $51 million is in the number in 2023, because it’s on an as reported and the $7 million number included in our ’24 numbers.

Unidentified Analyst: Okay. Great. And then next question on fees, service charges, I mean, seasonally also is usually lower in the first quarter, but I know you’ve talked about interchange and some other things being softer in the first quarter. So would you expect that to also increase as we go into the next couple of quarters? Or is this also a good kind of lower run rate for service charges?

Jerry Salinas: Yes. I think that the thing with service charge is the upside to it has been the commercial service charges. In some cases, it works against you, right? Because in some cases, customers may hold decide to pay more for services through hard dollar charges rather than to keeping the balances. So some of that’s some of it. And so that’s been impacting the growth. But the – we’ve done a lot of things I will say, in favor of the customer as it relates to – especially on the consumer side, on the OD fees. And we continue to see good growth there. But a lot of it, as Phil mentioned, we’re just buying those accounts pretty significantly. And I really kind of try to say that I don’t expect those are going to grow. And obviously, there’s some guidance out there potentially that, have a lot of pressure – on that – on those fees.

And so, we’ve really been I will say, in some ways, pleasantly surprised, but I don’t see that having a lot of growth from where we are today. I think, it will just continue to be pressure in that category for the rest of ’24. It’s kind of the numbers that I’m seeing right now.

Unidentified Analyst: Very helpful. Thank you.

Operator: Our next question is from Manan Gosalia with Morgan Stanley. Please proceed.

Manan Gosalia: Hi. Good afternoon. I wanted to ask about deposit pressure. And most banks spoke about how deposit pressure eased in the first quarter. Do you think there’s something related to your specific customer mix, or the fact that you are accelerating growth in new markets, what do you think is driving that incremental pressure on deposit costs for you guys relative to what we’re seeing in the broader market?

Jerry Salinas: From a cost standpoint, I will say that we’re really not feeling from a market standpoint, not feeling a lot of pressure on the deposit cost side. We need to be competitive and we are. I think we’ve got a – we’ve decided we’re competing primarily on the 90-day CD. It’s really more of the pressure is coming on the non-interest-bearing. And I think it really just continues to be the scenario where rates at these higher levels continues to put pressure both on commercial customers and consumer customers of looking for balances. I will say that when we look at the balances, especially on the interest-bearing side, and it’s true, I think, both in consumer and commercial is that we have seen increases in – from February to March, small increases and then March to April as well on that interest-bearing side.

So I think competitively pricing wise, I think things are going right, I think historically, like I said, our balances just tend to be softer in this first quarter. But we’re going to compete on the pricing. We’re not going to be the highest. We’ve never intended to be the highest. But we do keep an eye on what’s going on there, and we take decisions, obviously, on where we want to compete. But as I said earlier, we’re not seeing a lot of pressure on what I’ll call the interest bearing the non-CDs, if you will. So the MMAs specifically, not seeing a lot of pressure there yet competitively. So, we really haven’t moved those rates for a while now.

Manan Gosalia: Got it. And then maybe on the loan side, you spoke about the deals lost being up, because of structure – where are you seeing this competition coming from? Is it private credit? Is it other banks? And is part of the reason for maybe the weakness in NIM, because you’re skewing to higher quality and lower yielding loans right now?

Phil Green: Well, first part of your question, I’d say it’s mainly banks that we’re seeing structure. It is the same old story. It is guarantees. Its loan values, its terms all that. So, there’s some of that. I don’t know. We’re – it could be – certainly, vis-a-vis private credit, we’re getting lower yields that they’re able to achieve, but albeit at higher risk from your case. But yes, you’re probably going to see that we’ve got a little bit lower yield on average, but not by a lot, because we tend to be on the higher quality piece of the credit group.

Manan Gosalia: Got it. Okay. And if I could just have a clarification on one of your comments on the security side. I think you said duration of that book was up about half a year to 5.5 years. Is that in tally from the move up in rates? Or are you taking on a little bit more duration to lock in the benefits of higher rates?

Jerry Salinas: No, like I said, we really didn’t do a lot of purchases in the first quarter. I think some of it was that we had about $1 billion and treasuries that were the end of the year, let’s say, call it $750 million of it that we’re maturing first few days of January. So that was affecting it. And I think there might be a little bit more extended duration on the mortgage banks. But we haven’t added a whole lot of duration of anything that we’ve done in the first quarter.

Manan Gosalia: Great. Thank you.

Operator: Our next question is from Jon Arfstrom with RBC Capital Markets. Please proceed.

Jon Arfstrom: Hi, thanks. Good afternoon, guys. A couple of questions. Phil, should we expect the potential problem loans to continue to migrate higher? Or is that not necessarily true?

Phil Green: Yes, Jon, first of all, I’ll say problem loans, right? The old potential problem loans is a category that we don’t use anymore. But the risk rate 10 and higher, could we expect the increase I would say maybe. And the reason I say that is, because we were at such low levels. Really, the industry is at unsustainably low levels with everything coming out of the pandemic for credit quality, right? And so, we’re still not where we are, I would say, normal. And so – but we are seeing some, what I would call, some reversion to me. So that would tell me, yes, we probably ought to expect it to go up some. But at the same time, some of these that we’ve added, we’re looking for some reasonably quick turnarounds on it. I mean we just trying to be realistic with these risk rates that we’re adding.

And then, it’s not a best tenets or anything. It’s just recognizing that we perceive some elevated risk, but we do work on them, they work to get to correct the company’s work to correct. And so, I’m hopeful that with some of these that we brought on this time, we’ll see that move out, but we can also see some more move in, because again, we’re really coming off with pretty unsustainably low levels. So – that’s why I say maybe. I’m not concerned with credit quality. I mean, I am paid to worry as a broad spanker. And so I guess there’s that part of me that’s always going to be concerned with it. But I think credit quality is good, and we spent a lot of time looking at our commercial real estate portfolio, and a very granular level. And I’ll just tell you that – probably somebody said Austin office building, they would run for the hills.

But I would tell you, I think our Austin office building portfolio is solid, man. And I’ve looked at the – I’ve looked at, I’ve looked at the multifamily deals. People would say, Oh, man, Austin. It’s got reduction in the interest rates, the housing prices to come up 11%. And got a lot of supply coming on, et cetera, et cetera. But I look at our multifamily in the Austin market, I feel great about it. And so, it depends on the deal. It depends on your sponsors, how they’re operating. As far as the Austin house prices being down 11%, they’re up 50% over the two years before that, right? So I mean there’s this headline stuff. And then if you really look below it and you spend time on it, I mean, I feel great about the commercial real estate portfolio for – and our people have done a heck of a job underwriting it.

And part of I feel great is the same reason that we lost 82% of the deals, to structure this quarter. Our folks know how to book these things. It doesn’t mean we won’t have problems that I’ve talk to you about something that popped up at all, but it’s not something that gets me to worry. I think it’s interesting what’s happening with the company-specific stuff on the C&I side. We’re going to have to see where we continue to see things pop up there. And some of these guys may not be able to solve their problems. But most of them will – but that’s just banking. It’s a risk business, and I really think we have a handle on it anyway. Just felt the need to say that.

Jon Arfstrom: Okay. Yes. So it doesn’t sound like you guys feel the need to build reserves from here? I mean, I hear your charge-off guidance and I respect that, but it doesn’t feel like you have more pressure coming, at least in your mind in terms of credit.

Phil Green: Yes, I don’t feel that we know. I mean – can we see it get worse? Sure can. Jerry can speak to the formula, the better than I can. But I think we feel really good about where the reserve is today. And I think another thing I might say about the reserves. You might recall, we built it up during that COVID period, and we never took it out. And so, I think….

Jerry Salinas: Yes, I think that’s a little bit different than others. Yes, we pretty much stayed there. We really haven’t – if you look at our reserve coverage percentage, it really hasn’t moved around very much. And I wouldn’t expect that it will – it’s going to move a couple of basis points here and there, but I don’t envision at this point in any significant reason that we see that reserve number is increasing. Again, assuming a pretty normal sort of credit quality environment.

Jon Arfstrom: Yes. Okay. Jerry, as long as you have the mic, you changed the presentation of the expansion contribution for the quarter. What – if you can share, what kind of contribution did Houston 1.0 have this quarter?

Jerry Salinas: Yes. I think it was – last time we round it to seven, let me make sure I was going to say, I think we rounded to six this quarter, but let me just check. Yes, that’s exactly right. They were $0.07 last quarter, $0.06 this quarter.

Jon Arfstrom: Okay. And the — when you say Houston is funding Dallas and Austin, that’s 1.0 and 2.0, is that right together?

Jerry Salinas: Correct, yes. I would just netted the two and I was trying to keep it simple. Maybe I confused it Yes, Houston together is funding the other expansion. That was really, as we had talked about this and planning it out, that was certainly the way we hope things would going to work out that, if these financial centers began to mature, they would begin to pay for the future expansions and it certainly worked out that way.

Jon Arfstrom: Yes. Well, that’s great. That’s a great number. Okay. Thank you. I appreciate it.

Jerry Salinas: Thanks Jon.

Michael Spillane: Yes. One comment I will make that Catherine had asked about expenses. And one thing I wanted to clarify, and I made a comment in my comments about the linked quarter in salaries. So for us, a lot of the stock awards are given in October, and so they do affect the fourth quarter. And so typically, salaries for us are higher in that fourth quarter. And because by their nature, a lot of these stock awards immediately best, and as a result, they’re immediately expensed. So, I think if you looked at the growth in salaries expense, between the third quarter and fourth quarter last year, you’ll get some sort of expectation wise, what you might expect to see between the third – fourth quarter and fourth quarter of this year. Just to give a little bit of better color there so.

Operator: [Operator Instructions] Our next question is from Ebrahim Poonawala with Bank of America. Please proceed.

Ebrahim Poonawala: Hi, good afternoon. Just one quick one, Jerry for you. Around the securities book, sorry if I missed this, should we expect, one, the securities portfolio to grow from 1Q average levels or stay flat? And second, could you confirm — I think you mentioned you have another $1 billion of securities that you expect to buy, what the pickup in the yield is on reinvestment versus what’s rolling off? Thank you.

Jerry Salinas: Sure. Yes, I would expect all things being equal, we may be down a little bit, but it’s going to be relatively flat. We’re expecting cash flow, I think, of about $1.2 billion and the weighted yield of those are about a 2.26. And that’s impacted somewhat. We’ve got $500 million that doesn’t mature until the fourth quarter, and those are some treasury securities at 96 basis points. And right now, I think some of – you heard kind of what we were buying. I would expect that if you’re talking about something in the 5.5% versus that round it to 2.25, you’ve got some nice pickup potential there.

Ebrahim Poonawala: So does that imply, Jerry that NII should keep growing from the first quarter levels, as we move through the year? And fourth quarter, we’ll probably see a lift again from the securities yield going higher?

Jerry Salinas: Yes, that’s kind of what I would expect. Yes, the net interest income is on a little bit of a positive trajectory. I think for us, the low was probably last year sometime in the, I would say, the second – first, second or third quarter.

Ebrahim Poonawala: Perfect. Thank you.

Jerry Salinas: We should – we are kind of expecting small pickups for the rest of the quarters moving forward.

Ebrahim Poonawala: All right. Thank you.

Operator: We have reached the end of our question-and-answer session. I would like to turn the conference back over to Phil for closing remarks.

Phil Green: Okay. Well, thank you, everyone, for their interest and really adjourn. Thank you.

Operator: Thank you. This will conclude today’s conference. You may disconnect your lines at this time, and thank you for your participation.