Independent Bank Group - Q4 2022

Transcript

Operator (participant)

Greetings, welcome to the Independent Bank Group Q4 2022 earnings call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ankita Puri, Executive Vice President and Chief Legal Officer for Independent Bank Group. Thank you. You may begin.

Ankita Puri (Executive VP and Chief Legal Officer)

Good morning, and welcome to the Independent Bank Group Q4 2022 earnings call. We appreciate you joining us. The related earnings press release and investor presentation can be accessed on our website at ir.independent-bank.com. I would like to remind you that remarks made today may include forward-looking statements. Those statements are subject to risks and uncertainties that could cause actual and expected results to differ. We intend such statements to be covered by safe harbor provisions for forward-looking statements. Please see page 5 of the text in the release or page 2 of the slide presentation for our safe harbor statement. All comments made during today's call are subject to that statement. Please note that if we give guidance about future results, that guidance is a statement of management's belief at the time the statement is made, and we assume no obligation to publicly update guidance.

In this call, we will discuss several financial measures considered to be non-GAAP under the SEC's rules. Reconciliations of these financial measures to the most directly comparable GAAP financial measures are included in our release. I am joined this morning by our Chairman and Chief Executive Officer, David Brooks, our Vice Chairman, Dan Brooks, and our Chief Financial Officer, Paul Langdale. At the end of their remarks, David will open the call to questions. With that, I will turn it over to David.

David Brooks (Chairman and CEO)

Thank you, Ankita. Good morning, everyone, and thanks for joining the call. In 2022, we reported full-year adjusted net income of $209.7 million and adjusted earnings per share of $5.02. Reflecting on 2022, we're pleased that our results illustrate the through-cycle nature of our business model of healthy loan growth, strong earnings, and excellent credit quality. We are in four of our nation's strongest markets, and we remain encouraged by the economic fundamentals in both Texas and Colorado. For the Q4, we reported adjusted net income of $49.4 million and adjusted earnings per share of $1.20. During the quarter, we were able to achieve continued loan growth across our markets while simultaneously maintaining resilient credit quality metrics.

Though deposit costs remain a near-term headwind, the sustained repricing of our fixed-rate book should provide consistent tailwind to the interest income as rates remain elevated over time, even as payoffs and pay downs slow. Notably, we entered the quarter with a deliberate focus on achieving better expense discipline. In pursuit of that objective, we undertook targeted expense reduction initiatives across our business to position the organization for an uncertain economic environment. We will continue to focus on strategically managing expenses into 2023. The strategic focus on discipline is consistent with our long-standing history of confronting macroeconomic challenges early on and conservatively positioning the bank to perform throughout the cycle. We also announced yesterday that our board of directors declared a dividend of $0.38 per share and reauthorized our stock repurchase plan for an aggregate amount of $125 million for 2023.

We believe these capital actions are consistent with our owner-led mentality of providing consistent returns to our shareholders. With that overview, I'll now turn the call over to Paul to discuss the financials.

Paul Langdale (CFO)

Thanks, David. Good morning, everyone. As David mentioned, full-year 2022 adjusted net income was $209.7 million or $5.02 per share. Q4 adjusted net income was $49.4 million or $1.20 per share. There were several one-time items during the quarter embedded in the non-interest expense line that I'll discuss momentarily. Net interest income before provision decreased by 3.7% or $5.5 million from the prior quarter to $141.8 million. While interest income increased by $16.1 million from the prior quarter, funding costs increased by $21.6 million versus Q3.

This more pronounced increase in funding costs drove the bulk of the differential in net interest income over the linked quarter as the FOMC raised rates 275 basis points in the last 155 days of the year. The increase in interest income versus Q3 was driven by floating rate loans repricing, as well as net loan growth combined with new production funded during the quarter to replace normal amortization, pay downs, and payoffs. The consistent repricing of maturing loans should continue to provide a sustained tailwind to interest income, even as deposit costs are expected to peak shortly after the FOMC reaches the expected terminal rate.

Our assumptions for modeling NII in 2023 include a peak in the Fed funds rate toward the end of the Q1, consistent with the FOMC dot plot. We expect the Fed funds rate to subsequently hold flat through year-end. In this scenario, our NII line should benefit from sustained fixed-rate repricing dynamics throughout the year, even as deposit costs present a near-term challenge. The overall yield on interest-earning assets jumped from 4.30% in the Q3 to 4.67% in the Q4, an increase of 37 basis points. The core average loan yield, net of accretion and PPP income, was 5.01% in the Q4, up 39 basis points from 4.62% in the Q3.

The total cost of all deposits was 112 basis points in the Q4, compared to 57 basis points in the Q3, an increase of 55 basis points. The cost of all interest-bearing liabilities was 181 basis points in the Q4, up from 102 basis points in the Q3, an increase of 79 basis points. As slide 20 shows, we have been successful in playing both defense and incremental offense in our core deposit book, maintaining branch deposit balances despite a slight shift of non-interest-bearing balances to interest-bearing balances. Year-to-date fluctuation in specialty verticals is mostly a function of managing liquidity needs strategically in the current interest rate environment. Deposit competition remains intense as we near the Fed funds terminal rate, and we will continue to remain nimble and opportunistic in funding the balance sheet.

Deposits are likely to continue to be a headwind to near-term NII growth until the terminal rate is reached. Over the medium term, our loan book should continue to serve as a tailwind even after deposit costs peak. Provision for credit losses was $2.8 million for the Q4. Looking ahead, we are budgeting for provision that represents about 1% of net loan growth. This assumes all else being held equal in the CECL model and no material changes to the macroeconomic forecast and other model factors. Non-interest income decreased by $2.3 million compared to the Q3, which was mostly driven by lower net revenue from our mortgage warehouse businesses due to lower mortgage volumes across the industry, as well as lower other income. For the Q1, we expect mortgage fee income to remain flat at current levels.

Adjusted non-interest expense was $88.3 million for the Q4, which was down approximately $386,000 from the linked quarter. Adjusted non-interest expense excludes approximately $10.4 million of one-time charges related to the targeted expense reduction initiatives undertaken during the Q4. Of this, $7.1 million is related to severance and accelerated stock vesting, and $3.3 million is related to the write-off of certain assets related to discontinued technology projects, as well as the termination of a correspondent banking relationship. The Q4's expense reduction initiatives will help us achieve our goal of holding the quarterly expense run rate flat through 2023. As we enter the new year, we remain focused on strategically managing the expense line, and we will explore additional opportunities to realize savings over the coming quarters.

Slide 22 shows consolidated capital levels over time. All capital ratios, including the TCE ratio, increased slightly from the linked quarter, and capital levels remain well above regulatory well-capitalized minimums. These are all the comments I have today. With that, I'll turn the call over to Dan.

Dan Brooks (Chairman and CEO)

Thanks, Paul. Loans held for investment increased to $13.6 billion in the Q4, up from $13.3 billion in the linked quarter. Loan growth, excluding mortgage warehouse and PPP loans totaled $320 million or 9.6% annualized for the quarter. New production during the quarter was well distributed both geographically and by product type. We continue to underwrite with the same discipline that has guided us through past economic cycles. Average mortgage warehouse purchase loans decreased to $297.1 million in the Q4, down from $402.2 million in the prior quarter. Volatility and interest rate increases more broadly have resulted in decreased demand, lower volumes, and shorter hold times across the mortgage industry. Our expectation is for this business to remain flat at current levels through early 2023.

Credit quality metrics saw a notable improvement during the quarter, with several large commercial credits achieving final resolution with minimal losses. Total non-performing assets decreased to $64.1 million or 0.35% of total assets at quarter end. Other real estate owned was flat at $23.9 million during the quarter. Net charge-offs totaled just 2 basis points annualized during the quarter. Our loan book continues to be bolstered by a multi-decade history of strong underwriting, as well as the underlying strength of our markets in Texas and Colorado. Even so, we are continually stressing our portfolio for the impacts of higher rates and mindful of the evolving macroeconomic situation.

Currently, we remain very confident in the strength of our underwriting and the ability of our borrowers to navigate the current environment. We remain ever vigilant against emerging risks in the economy as we enter 2023. These are all the comments I have related to the loan portfolio this morning. With that, I'll turn it back over to David.

David Brooks (Chairman and CEO)

Thanks, Dan. As we enter 2023, we continue to be very encouraged by the strength and resilience of our markets across Texas and Colorado. We have been pleased to see sustained demand for high-quality business from our longtime customers, even as the FOMC approaches the expected terminal rate. This sustained borrower demand, combined with our strategic focus on the disciplined management of our expense base, helps fuel our continued pursuit of through-cycle performance and healthy growth. Our priority remains to deliver value to our shareholders by running a high-performance, purpose-driven company dedicated to serving our customers and communities each day. Thanks again for taking time to join us today. We'll now open the call to questions. Operator?

Operator (participant)

Thank you. At this time, we'll be conducting a question-and-answer session. If you'd like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. Our first question comes from the line of Brad Milsaps with Piper Sandler. Please proceed with your question.

Brad Milsaps (Managing Director and Senior Research Analyst)

Hey, good morning.

David Brooks (Chairman and CEO)

Hey, good morning, Brad.

Brad Milsaps (Managing Director and Senior Research Analyst)

Thanks for, thanks for taking my questions. Maybe Paul, wanted to start with the margin and net interest income. You know, you kind of offered a lot of color there on kind of how you guys are thinking about it. Just, you know, maybe bigger picture, do you think most of the significant margin compression is behind you? You know, is there a chance that, you know, you could start to see, you know, maybe NII begin to trend up maybe in the back half of the year based on some of the fixed-rate asset reprice you have? Just kind of wanted to get a better sense of, you know, kind of how you're thinking about the trajectory of the NIM and NII as you move through 2023.

David Brooks (Chairman and CEO)

That's exactly the right way to think about it, Brad. As we went into the Q4, we were really trying to play incremental defense and offense in the deposit book. If you look at page 20 in our slide deck, we were really focused on ensuring we were able to grow those branch deposit balances, even though we knew there would be a bit of remix from non-interest-bearing to interest-bearing. We were successful in doing that and preserving our contingent liquidity options going into 2023. As we look through the directionality of NIM in 2023, we expect it to bottom out at current levels, flat to down just 2 basis points for the Q1. Then we should see that dramatic inflection in the Q2 accelerating through the Q3 as those fixed-rate repricing dynamics should offer us some significant lift in NIM for the year.

Brad Milsaps (Managing Director and Senior Research Analyst)

Thank you. Just maybe as my follow-up on the fixed-rate loan repricing, where are you seeing new loans and those loans reprice to in terms of rate? Just wanted to kind of get a sense of the potential pickup and, you know, maybe David or Dan, how are those new rates, you know, maybe impacting, you know, loan demand out there in terms of, you know, what I think you've, you know, sort of guided to, you know, 7%-8%-ish type loan growth? Just kind of curious how those rates are impacting appetite out there.

David Brooks (Chairman and CEO)

Sure. Brad, this is David. I'll talk about it from a high level. We're seeing rates come on in the mid-7s, upper 7s now, in the current environment. You know, we expect that will slow. The Fed will likely accomplish their purpose of slowing the economy, so that's kind of in our thinking that, you know, overall loan growth will slow a bit as we head into 2023 here.

One of the things, and I think you're alluding to, and I'll let Dan speak to this, but you know, one of the challenges will be if there are loans in the, you know, low 4s rolling to the mid-7s or upper 7s or 8s, if the Fed continues on here, you know, that may pose one-off challenges for certain borrowers and cash flows and things. I'll let Dan speak to the credit aspect of it.

Dan Brooks (Chairman and CEO)

Hey, good morning, Brad. Yeah, I think really I would think about it this way. You know, conservative underwriting on the front end is really the best defense against that risk. We have put material interest rate shock tests in our underwriting even, you know, 4 years ago when rates were in the 4s. Now they're rolling up for maturity. We're looking at every credit that's maturing this and the next year, stressing it for impact on higher rates. Our early look at those has been that we see very few issues. For the few credits where a conversation will be required, we'll do what we always have. We'll get in front of it with our borrowers early on.

Brad Milsaps (Managing Director and Senior Research Analyst)

Great. I'll back in the queue. Thank you.

David Brooks (Chairman and CEO)

Okay. Thanks, Brad.

Dan Brooks (Chairman and CEO)

Thanks, Brad.

Operator (participant)

Thank you. Our next question comes from the line of Brady Gailey with KBW. Please proceed with your question.

Brady Gailey (Managing Director)

Hey, thanks. Good morning, guys.

David Brooks (Chairman and CEO)

Good morning, Brady.

Brady Gailey (Managing Director)

If loan growth is gonna slow a bit here, you know, what does that mean for 2023? Are we thinking more of like a mid-single-digit level potentially for this year?

David Brooks (Chairman and CEO)

You know, it's seasonal as well, so it's a little tricky to try to forecast. I think, you know, 6%-8%, which is the guidance we gave, you know, at the end of the Q3 still looks about right to us for the entire year. It may be a little slower here in the Q1, just, you know, a lot of people are looking around here trying to figure out what their plan is for 2023. We've got good demand and good pipeline.

I expect based on what we know today, Brady, that, you know, we probably start out with a mid-single-digit here in the Q1, and then, you know, accelerate a little bit, you know, a little bit, emphasis on little, to, you know, in that 6, 7, you know, maybe 8% range. You know, look, there's a wide range of possibilities for 2023 and what happens with the economy. You know, as we've said over and over again, and I don't wanna, you know, say it ad nauseam, maybe we do, you know, the markets we're in should give us some insulation, right? Even if it's a pretty difficult overall economic slowdown, we still expect our loans will grow, it just becomes a magnitude of how much.

Brady Gailey (Managing Director)

Okay. All right. The decisions that were made on the expense base, what was the impact of those decisions? Like, how much annualized expenses were taken out of the bank?

David Brooks (Chairman and CEO)

Brady, this was really a prerequisite for us to meet our expense guidance of holding expenses flat from that run rate. If you think about expenses.

Paul Langdale (CFO)

Heading into 2023, I would expect them to remain in that $89 million-$90 million a quarter range. This was a crucial part of heading off some of the expense headwinds we're gonna have in terms of increased FDIC assessment and things like that in 2023.

Brady Gailey (Managing Director)

Okay. Should we expect you guys to consider continued, you know, changes in the expense base or do you feel kind of good with where expenses are at this point?

Paul Langdale (CFO)

We're going to continue to look, you know, across the footprint for opportunities to have targeted reduction of expenses. I wouldn't expect anything programmatic like we did in the Q4. Obviously, as we navigate what David mentioned is shaping up to be a very uncertain economic environment, we want to be really mindful and disciplined about managing the expense base on an ongoing basis.

Brady Gailey (Managing Director)

All right. The $125 million of buybacks, you know, the stock's at 1.9 at tangible book value. tangible common equity is kind of in the high 7% range. Do you expect to be, you know, active on that 125 this year?

David Brooks (Chairman and CEO)

I think a lot of that depends, Brady, on, you know, what happens with the markets and the economy and stock prices. We'll be opportunistic and continue to look for opportunities to buy our stock at attractive prices. I say that, obviously, we're all watching to see what's gonna happen. Capital is precious. We do like the way our balance sheet has held up, you know, with tangible equity, as you mentioned, still in the upper sevens. That's quite different than a number of banks in our peer group. You have 3 handles and 4 handles on their tangible capital ratio. We do think we've got some room, and we'll be opportunistic, but we're not anxious to give away capital in this environment either.

Brady Gailey (Managing Director)

All right. Last question from me is just, you know, I know you guys have been focused on improving the profitability profile of the bank. Any color on, you know, where you would like to get ROA or ROE or efficiency ratio or whatever metric you're focused on? Any color on, you know, what the targeted profitability ratios are for Independent?

David Brooks (Chairman and CEO)

Sure. Again, every question I guess we answer, and I'll quit saying it in a minute, Brady, but every question we answer is, you know, in light of everything we don't know about 2023 to come. Our discussion around here has been about being nimble in everything we do from expense base to growth to, you know, the credit side, all of that, just being nimble, watching what is coming our way and reacting accordingly. You asked the question last quarter, and I appreciated it, which is, you know, you guys have historically been a high, a high-performing bank. Your numbers right now wouldn't fit in that category and, you know, what are you gonna do about it? That's not exactly how you asked it, but it was...

I think the answer is, Brady, you can't turn, you know, a ship on a dime, so to speak. We've been undertaking the things that we believe will return us to the kinds of metrics that we want to be at, that we have traditionally been at. I would expect that our return on, you know, tangible common equity to be mid-teens and up, you know, from there, and our ROAs to be in the, you know, 120s and 130s and rising. You know, we won't be there in the Q1 of this year given the continued, you know, pressure on deposit rates and things.

I think when you get to the back half of this year, Brady, those are the kinds of numbers, you know, come Q4, Q4, we should be able to generate given our base economic assumptions of, you know, what's gonna happen this year. I think, you know, if you had a ROA in the 120s and 130s and returns on tangible equity in the 15%-18% range, that would be where we've been traditionally and where we expect to be back to by this year.

Brady Gailey (Managing Director)

Okay. Great. Thanks for all the color, guys.

David Brooks (Chairman and CEO)

Yeah. Thanks, Brady.

Operator (participant)

Thank you. Our next question comes from the line of Michael Rose with Raymond James. Please proceed with your question.

Michael Rose (Managing Director, Equity Research)

Hey, good morning, everyone. Thanks for taking my questions. Just wanted to go back to slide 20. I appreciate the color here, but the, you know, the loan-to-deposit ratio is, you know, out to the warehouse is creeping up there a little bit. Just, you know, can you walk us through in more specific detail some of the strategies? Yeah, I know there's a push-pull with the, you know, non-primary sources of deposit funding. You know, can you just update on some of the initiatives you have in place? You know, maybe if you've changed incentive structure or, you know, just anything that you're doing more specifically on the deposit side to, you know, kind of balance, you know, that loan-to-deposit ratio with the funding needs as you continue to grow. Thanks. Sure.

Paul Langdale (CFO)

Thanks for the question, Michael. I will say this, you know, we were very deliberate in the Q4 about preventing runoff in our core deposit book, and we were successful at doing that and defending with rate some of our core deposit relationships that we've had. As a relationship bank, we're always keen to make sure that if we have to pay for deposits, we're paying it to our customers, and we're taking care of them. That being said, we have incentivized the teams with very explicit deposit goals heading into 2023. It's an all-hands-on-deck approach in terms of ensuring that everyone is focused on, you know, making sure that we keep our costs down on the deposit side of the house as much as possible.

You know, our expectation heading into the Q1 is that as the Fed hits the terminal rate, we'll see the deposit cost pressures abate, and we'll be able to, especially as the curve points a little bit further down in both the brokered and the FHLB arenas, we'll be able to selectively take some different tenors of deposit there. We obviously want to keep the deposit book short, but we're gonna be opportunistic in using the significant capacity we have in both the brokered, the specialty, and the other wholesale verticals in order to maximize our rate outlook on deposits for 2023.

Michael Rose (Managing Director, Equity Research)

Okay, that's helpful. Just maybe separately, just on the loan growth outlook. You know, obviously keeping the guide just about the same, but it does seem from the tone that, you know, maybe things are going to get a little bit more challenging just with, you know, rates, as you mentioned, David, in the 4s going up to the 7s or 8s. How much of the, you know, the growth is kind of intentionally maybe pulling back a little bit just given uncertainty in the economy? Or is it truly just, you know, rates moving a lot higher and, you know, your customers may be looking for alternative options out there for funding their own growth?

Then, just separately, if you can just give us an update. I know this has been a multi-year process, but where you stand on some of the C&I initiatives. You know, looks like growth was double-digit annualized. If you back out, or excuse me, energy loans, you know, looks to be a little bit softer. I know a lot in there, but just any color would be great. Thanks.

David Brooks (Chairman and CEO)

Yeah. Thanks, Michael. I may not remember all the questions embedded in that question, so you may have to help me remember some of them. Yes. We believe overall at the highest level, the amount of economic activity and the amount of deal flow is going to slow. It is already slowing. Deals, you know, income-producing real estate investments don't pencil as well at 8% as they do at 4%. You know, that's going to be a bit of a drag. The positive side of that has been, the payoffs and refinancings and sale of assets and all that have slowed, so therefore we don't have the payoff headwind that we had, you know, the last couple of years.

We won't have to generate as many loans to net, you know, that mid 5, 6, 8, 7, 8% that we expect for the year. That's it at a high level. You know, we continue to be committed to, you know, diversifying our balance sheet. You mentioned the energy loans. We think that's a positive for us. We're seeing great opportunities there. We, you know, we still only about 4% of our, the overall loan book in energy. We think that's, you know, an area that could continue to grow a little bit as we go forward. We'll continue to look at other, you know, lines of business.

It's not as easy as snapping your fingers and making it happen. Yes, we're committed to continuing to diversify our lines of business. Your other one comment, Michael, was embedded around are we intentionally, you know, being cautious? The answer to that is yes. You know, in this environment, heading into the uncertainties ahead, there's no easy button here. As longtime shareholders and owners of this company, we've been running for 35 years, and we're not going to start in our 35th year, 36th year here looking for an easy button to go, oh gosh, let's go hire a team and book a bunch of this kind of loan or this kind of loan. We're, you know...

obviously our credit sizes being lower, generally our hold sizes being well lower than our peer averages. Those are things that are core to our credit philosophy and risk management philosophy, and we're not going to change that in our 36th year. you know, yes, there are avenues, Michael, out there which some banks may take, where you can go book a lot of really big loans, or you can get into lines of business that you haven't been in historically. We just think that's a uniquely bad thing to do at this point in the cycle. We're not going to be doing those kinds of things. We're going to be growing our loan book with our customers and our markets and continue to watch our risk.

Michael Rose (Managing Director, Equity Research)

Okay. Great. Maybe one last one for you. I'm gonna try. I don't think you're going to answer it. I know you guys are involved in the Stanford Group litigation, which another bank in the southeast just settled. Just wanted to get any comments from you, see if there's any update. I know a trial's for one of the classes is set for February 27th. Again, I don't think you'll comment, but I thought I'd try. Thanks.

David Brooks (Chairman and CEO)

Hey, thanks for the question, Michael. You're correct, we don't comment on pending litigation, as you know. We always assess what's in the, you know, best interest of our company and our shareholders, as I said a moment ago. There are details and on this specific case that you asked about in our normal public disclosures and filings, and you can read up on that, you know, as well, and we'll continue to update that, you know, quarterly.

Michael Rose (Managing Director, Equity Research)

Great. Thanks for taking my question.

Operator (participant)

Thank you. Our next question comes from the line of Brett Rabatin with Hovde Group. Please proceed with your question.

Brett Rabatin (Director of Research and Managing Director)

Hey, guys. Good morning.

David Brooks (Chairman and CEO)

Hey, Brett. Good morning.

Brett Rabatin (Director of Research and Managing Director)

Wanted to first circle back to fee income. You know, you mentioned that you think mortgage banking will be flat in the Q1. Wanted to see, you know, one, if you think, you know, obviously the market's hoping for a pivot. You know, we'll see. Wanted to see if past that, you felt like there could be some optimism for that to maybe pick up a little bit. Also, you know, the decline in the other bucket due to the correspondent piece, if that had fully run its course or if there could be any additional atrophy related to that. Then if you just basically saw any other opportunities to maybe have growth in fee income lines of business.

David Brooks (Chairman and CEO)

Let me say from a high level, I'll let Paul comment on some specifics, Brett, of your question. At a high level, our view of the mortgage business right now is that it's hitting its lows and will linger there for a long period of time. In our numbers and assumptions, we don't have any increase or acceleration, you know, in 2023. Obviously, you know, that would be great for everyone if it, if it happened. In our decision-making in the Q4 of last year about around our cost base included our view that it was, you know, going to be a very difficult year in mortgage. We've got great teams running both of those businesses, and, you know, we feel good about it long term, but we think it's going to be very hard in 2023 and maybe longer.

Until we see real evidence that, you know, there's some environment that will allow a return to, you know, normal kind of volumes, we don't bake that into any of our forecasts. In terms of the correspondent and specific things you asked about, I'll let Paul comment. Yeah, Brett, that was just a one-time charge related to the severing of a correspondent banking relationship that won't recur in future quarters. As far as the other fee income items, we expect them to remain relatively stable over the coming quarters.

Brett Rabatin (Director of Research and Managing Director)

Okay. That's helpful. Then wanted to make sure I understood, you know, kind of the flavor, so to speak, of the commentary around the cost of funds from here. It sounds, if I'm getting it right, it sounds like you feel like you've maybe taken some of a big chunk of the pain, so to speak, in what it took to keep deposits, you know, to keep relationships on balance sheet and maybe the deposit beta, so to speak, you know, might slow on a relative basis going forward. Is that a fair assessment that you feel like you've taken some of the lion's share of the pain in terms of the cost of funds increase? Maybe any thoughts on how we should think about the deposit beta from here?

David Brooks (Chairman and CEO)

Sure, Brett. We've been very deliberate in making sure that we play defense in our core customer base. Consistent with our history as a relationship bank, that's been a focus of ours. I think there's still going to be continued pressure on deposit costs near term until the Fed hits the terminal rate. Our expectation, though, is that once the Fed hits the terminal rate, we should see some significant abatement of pressure on deposit costs that help us in the back half of the year.

Brett Rabatin (Director of Research and Managing Director)

Okay, fair enough. Maybe a question for Dan. You know, you guys mentioned, you know, you look at the commercial real estate loan portfolio, and I think a lot of investors are worried about commercial real estate and maybe there's a couple credits to think about from a loan repricing perspective that you'll get in front of. Wanted just to hear, you know, if you look at slide, I think it's 17, you know, your credit has historically been much better than peers. Wanted to hear maybe, you know, what you might worry about in terms of the environment. Maybe not even your own loan portfolio, but just the environment around commercial real estate. If it's, if it's rents, if it's, you know, something else, if it's the change in rates, what's the big factor you're kind of concerned about for the environment?

David Brooks (Chairman and CEO)

Yeah, Brett, great question. I think in general, let me say it this way, it might help you as you think about certain asset classes that we think are under pressure and will continue to be under pressure this year. Spec industrial, spec office, those may seem a bit obvious to you. I would say there's been a lot of that activity in the last couple of years. As a rule, we've just stayed away from that type of lending in keeping with our core principles here. Yeah, I would say in general, people are watching certainly occupancies in the office space. I think, you know, rents certainly continue to be pretty solid, it seems, on the multifamily side. I don't think there are any primary concerns there that we're seeing.

In general, I think we're just continuing to be very vigilant about stressing our portfolios for the rate increases and then mindful about what could happen in a downturn. I think in general, again, our structure with the granular book, which is limits exposure on any individual credit, and the way we've underwritten those with the same standards we have over the last three decades, I think positions us as good as we can be. While we're watching that, I think we feel very good about our portfolio at the present and, you know, continuing to monitor what that would look like. I guess that's the way I would answer that for you. Yeah. I, and I would say from at a high level- Okay. Brett, this is David.

At a high level, Brett, one of the things as we thought about, you know, these loans rolling five years in, you know, that were underwritten at 4% interest rates, one of the things that has really helped in our markets, if you know, thinking about the markets that we're in and the in-migration of people, whether it's office or multifamily or professional office buildings, the demand and the rents have increased materially in the last five years. The cash flows that we underwrote five years ago are much higher today in almost every property. That goes to our philosophy, doing high-quality, you know, property in great locations and great markets. It just has risen, if you will, with the tide of the economic activity in our markets.

That's making it actually much better than we had feared, you know, maybe 6 months ago as we began the process going, oh, gosh, you know, reunderwriting these credits. The great markets we're in. Dan and his team have done a great job of avoiding kind of the hot, you know, the hot idea, you know. Spec industrial, office warehouse, that kind of space has been across the country around every airport and everything, given what's going on with Amazon and delivery and all that has been just built by the tens of millions of sq ft. We're, you know, we're a little cautious around that as an example. We think there could be some pain in that if we have a significant economic slowdown.

We just have not, you know, bet the farm, so to speak, on any one asset class. You know, multifamily is great, it's strong here, but, you know, even then you have to be cautious not to overbuild submarkets within these, you know, good markets. Those are the kinds of things we think about and talk about.

Brett Rabatin (Director of Research and Managing Director)

That's really helpful. Thanks so much.

David Brooks (Chairman and CEO)

Thanks, Brett.

Operator (participant)

Thank you. Our next question comes from line of Brandon King with Truist Securities. Please proceed with your question.

Brandon King (Analyst)

Hey, good morning.

David Brooks (Chairman and CEO)

Good morning, Brandon.

Brandon King (Analyst)

Morning. Yes, could you please talk a little more about your confidence in the assumptions that deposit rates will peak soon after a Fed pause, in particular in an environment where we could be in a higher for longer rate environment, they could still be longer there, and a lot of your competitors are still fighting and scratching for deposits?

Paul Langdale (CFO)

Sure, Brandon. Back to what I had mentioned on the previous answer to a question, we were deliberate in getting in front of the rate increases, so we wanted to make sure we could retain our core deposit relationships, those relationships that we've had for sometimes upwards of 3 decades. The way that we did that is we were very focused on making sure we paid a higher rate as the Fed was hiking, not waiting for the noise after the Fed hit the terminal rate. As you mentioned, scratching and clawing and trying to play, you know, hand-to-hand combat for deposits, against our competitors who are trying to take our customers.

We've been more generous on the front end with deposit increases for those core customers with the expectation that once the Fed does hit and hold at the terminal rate, that that should provide us some alleviation of pressure on deposit rates as we continue to see that higher for longer environment that you mentioned.

Brandon King (Analyst)

Okay. Are you also assuming that kind of the not DDA, non-interest-bearing mix stays kind of constant from here, or are you also assuming kind of a mix shift from non-interest-bearing to interest-bearing as well?

Paul Langdale (CFO)

We're expecting a very slight mix shift in our forward forecasting.

Brandon King (Analyst)

Okay.

Paul Langdale (CFO)

It's not very meaningful.

Brandon King (Analyst)

Okay. Okay. A question on expenses, just as far as how you evaluate the expense burn rate going forward, how do you feel about kind of your current headcounts, and do you still see potentially room for there to get more efficient going forward?

David Brooks (Chairman and CEO)

Look, I think costs, Brandon, are gonna be on everyone's plate in 2023. Everyone's going to be... You know, our industry has been through a unique time where, you know, from PPP revenues to the liquidity in the system, keeping interest rate, deposit costs down, et cetera. We've had a season here the last two or three years where, you know, costs haven't people have been able to invest as we have in our infrastructure and building out business lines and things like that. We're entering a time now where, you know, if we're gonna have an economic slowdown, rates are gonna level out at a higher level, you know, the only other lever that financial institutions are gonna have are is their cost base.

We took a hard look at ours in the Q4 and trying to position ourselves for what, you know, to be nimble and be able to react to what could come our way in 2023. I think other, you know, banks will do similarly as the rates level out here in the Q2. I think our head count is, you know, right where we need it to be. We've invested in a lot of businesses. We have the best teams out, customer-facing teams we've ever had, and we're gonna take great care of our customers. We're gonna grow with our customers in our markets, and, you know, we'll invest and hire more people as we see the need to do it. We're, you know...

I think right now we're right where we need to be and, you know, looking good here as we go into 2023.

Brandon King (Analyst)

Okay. Thanks for taking my questions.

David Brooks (Chairman and CEO)

Hey, thanks, Brandon.

Operator (participant)

Thank you. Ladies and gentlemen, as a reminder, if you'd like to join the question queue, please press star one on your telephone keypad. Our next question comes from line of Matt Olney with Stephens Inc. Please proceed with your question.

Matt Olney (Managing Director)

Thanks. Good morning.

David Brooks (Chairman and CEO)

Good morning.

Matt Olney (Managing Director)

Wanna go back. Good morning. Wanna go back to the outlook for the NII. I appreciate all the comments on the funding. On the other side, you've mentioned the loan repricing tailwinds that should provide some offsetting benefits. Any more color you'd give us on how quickly this book will turn? Just trying to appreciate why this would be offsetting some of the funding headwinds as you move into, I think you said Q2 2023. The back half would offset some of the funding headwinds. Thanks.

Paul Langdale (CFO)

Sure, Matt. thanks for the question. To echo a theme that David spoke to, there are a lot of potential outcomes for the broader economy in 2023, and obviously the macroeconomic picture is going to influence the payoff and paydown trends. But that being said, we have a, you know, bulk of our book is those fixed-rate 5-year CRE loans, and the contractual maturities for those will continue to provide a tailwind even in a, in an environment with subdued payoffs or paydowns. As we look back on the 4th quarter, we did see payoffs and paydowns slow a little bit. Some of that is typically a seasonally slower Q4 that we see, but some of it is a slowing of paydowns more broadly.

You know, our expectation is to see some blend of the 3Q and 4Q rates on a go-forward basis, from a payoff and paydown perspective. We are optimistic that we will continue to have a pretty good lift from the repricing of those fixed-rate loans, especially as contractual maturities, happen over the course of the next, you know, 4 to 8 quarters.

Matt Olney (Managing Director)

Okay. Appreciate that, Paul. I guess, David, in the past, you've talked about the bank's goal of achieving the positive operating leverage every year. Looking to 2023, is that still a reasonable goal to achieve this operating leverage given the macro headwinds that you're facing and the industry's facing?

David Brooks (Chairman and CEO)

We believe it is, Matt, given, again, everything we know today, we believe it is. We think our costs, we've got a very good handle on our cost structure now. We'll continue to look, as Paul said, for ways to incrementally improve. We're taking a hard look at all our contracts and, you know, all those things that, you know, you would expect a bank like ours to do, you know, on an ongoing basis. We'll continue to look for things like that will be helpful, I guess, as we, as we fight. There are so many things, as Paul mentioned, from FDIC to contracts and contractual increases in pricing and things like that.

Obviously, you know, increases, merit and pay increases to our teams and all of that, you know, creating the headwinds. We, we tried to get ahead of it in the Q4 by, you know, having some cost reductions across the company and then, you know, positioning ourselves to hold the line here, if you will, in 2023. It's a continued not only focus of ours, Matt, but it's a commitment we have to our shareholders to continue to improve, you know, the operating leverage of the company.

Matt Olney (Managing Director)

Okay. Appreciate that, David. I guess lastly, for a credit question for Dan. I think there was a sale of a non-accrual loan in the Q4. Would appreciate just any comments you have on the market appetite for loan purchases and how did the pricing of that loan sale compare to the appraised value? Thanks.

David Brooks (Chairman and CEO)

Yeah, good question. As you noted there, we did have an opportunity to move out to non-performing credits, large ones, large for us anyways. We tend to have small ones, which is a good thing. We also had some additional small ones, and one of those was in a note sale. It was an energy loan in particular. I would say the percentage of discount, which I think is what you're really looking for there, is gonna depend on the asset, right? Real estate assets, if you're selling those notes, could be different than C&I assets or others. I would say, relative to the value that we saw on that and the balance on it was, you know, a slight discount, really off of what we would have expected at that point.

I'm certain that other banks may be looking at or have done the same things. Again, depending on the asset class and the condition of the credit, it very much depends on those variables when you're trying to determine that.

Matt Olney (Managing Director)

Got it. Okay. Thanks, guys.

David Brooks (Chairman and CEO)

Okay. Thanks a lot, Matt.

Paul Langdale (CFO)

Thank you. Our next question is a follow-up from the line of Brett Rabess with Hovde Group. Please proceed with your question.

Matt Olney (Managing Director)

Yeah. Hey, just one follow-up on that repricing of loans question. I think last quarter you originated $326 million of commercial real estate and had $950 million reprice. Paul, do you happen to have those numbers maybe for the Q4? I think that CRE portfolio has a 3 years duration. Was just curious if that was still kind of an effective number.

Paul Langdale (CFO)

Those are the duration assumptions that we're using. As far as repricing is concerned, the bulk production in Q3 was higher than it was in Q4. You know, I don't have the exact number off the top of my head, Brett, but I would estimate that it was about 20% less. Again, some of that is seasonality, and some of that was an additional slowing of repayments as the Fed's [printed] up the forward curve. Our expectation, though, is for the future, forward rate of the fixed-rate repricing to be somewhat blended between what we saw in Q3 and Q4.

Matt Olney (Managing Director)

Okay. Thanks. Appreciate it.

Operator (participant)

Thank you. Ladies and gentlemen, that concludes our question and answer session. I'll turn the floor back to Mr. Brooks for final comments.

David Brooks (Chairman and CEO)

Yes. I appreciate everyone being on the call today and the active back and forth. I feel really incrementally positive as we enter 2023. I think we're well-positioned versus our, you know, our operating leverage versus our ability to continue to grow the company. I think we're well-positioned for whatever happens and excited to take on the challenges ahead. Thanks everyone for being on today, and I hope everyone has a great day.

Operator (participant)

Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.