Live Oak Bancshares - Q1 2023

Transcript

Operator (participant)

Good morning, ladies and gentlemen, welcome to the Q1 2023 Live Oak Bancshares Earnings Call. At this time, all lines are in listen-only mode. Following the presentation, we'll conduct a question-and-answer session. If at any time during this call you require immediate assistance, please press star zero for the operator. This call is being recorded on Thursday, April 27th, 2023. I would now like to turn the conference over to Mr. Greg Seward, Chief Risk Officer and General Counsel. Please go ahead.

Greg Seward (Chief Risk Officer and General Counsel)

Thank you. Good morning, everyone. Welcome to Live Oak's first quarter 2023 earnings conference call. We are webcasting live over the Internet. This call is being recorded. To access the call over the Internet and review the presentation material that we will reference on the call, please visit our website at investor.liveoakbank.com and go to the Events and Presentations tab for supporting materials. Our first quarter earnings release is also available on our website. Before we get started, I would like to caution you that we may make forward-looking statements during today's call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from our expectations are detailed in the materials accompanying this call and in our SEC filings.

We do not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of today's call. Information about any non-GAAP financial measures referenced, including reconciliation of those measures to GAAP measures, can also be found in our SEC filings and in the presentation materials. I will now turn the call over to Chip Mahan, our Chairman and Chief Executive Officer.

Chip Mahan (Chairman and CEO)

Thanks, Greg, and welcome to our Q1 earnings call. We are obviously not pleased with a $0.01 a share, but let's look under the covers and see if there is more. Moving to slide 4, I'll make a few comments relative to these questions. What do deposits look like? How liquid are you? How's credit? What happened with earnings this quarter? Are you on a path to grow? I will then turn the call over to Huntley and BJ to dig in. It is my belief that the events surrounding the closure of Silicon Valley Bank and Signature Bank will prove to be a seminal moment for this industry. It has been almost 28 years ago, October of 1995, that we launched the first pure internet bank in the United States.

Since then, I have never seen the need for physical branches and the inherent cost to support that particular deposit franchise. Technology that affects bank infrastructure support has made exponential gains over the last several years. It almost feels like Moore's Law is creating banking 2.0. Many will recall that Gordon Moore, the co-founder of Fairchild Semiconductor and the former CEO of Intel, predicted in 1965 that fundamentally computing power or the number of components on an integrated circuit would double every year. He revised that in 1975 to double every two years. He was right. It feels like this decade-long presence of cloud-native API-first solutions is finally creeping into the day-to-day operations of commercial banks. four years ago, we spent a great deal of time perfecting online account opening at Live Oak Bank. Most banks can now do the same.

Since it is so easy to move money digitally, why leave your money in a bank that offers less than market rates? As deposit betas increase, as rates continue to rise, we are thankful the potential repricing of an entire book of lower-cost deposits is not part of our business model. That trend has begun, and it is irreversible. The customer deserves and will find market rates for their savings and operating accounts. Inside our own Canopy initiative that has raised over $1.5 billion from 70 banks, we see it every day. NextGen fintech companies are building software in a cloud-native API-first environment that can get to market very quickly and provide a wide range of solutions to everyday bank customers. Additionally, there is a massive amount of capital sitting on the sideline to reward the winners in this space.

It is fun to have a front row seat. Yes, what do deposits look like and how liquid are you? After the SVB and Signature event, it was published that the average bank in America had uninsured deposits of 44% of their total deposits. We were 18%. Many banks were scrambling to prepare for a run on their bank. In a matter of hours, we had between 3x and 4x the amount of all uninsured Live Oak deposits in cash. Check that box. Relative to deposits in general, Huntley and BJ are going to describe our growth for the quarter and immediately thereafter. Check that box. Relative to credit quality, all metrics remain positive. Non-accruals of 65 basis points and over 30-day past dues of only 13 basis points, which in dollar amount is just under $7 million for a 10 million dollar bank.

Not bad. Check that box. Lastly, on earnings and growth. I wish I had not taken accounting pass-fail in college. We had the best quarter ever for loan originations, which in large part caused another quarter with an outsized CECL provision. The last weeks of the quarter impacted fair value and servicing asset revaluations by $6.3 million. Whoops, here's another $3 million one-time increase in the reserve for unused lines of credit. Accounting black boxes and mumbo jumbo that translates into excuses. Tom Brown has a consulting firm and a hedge fund that issues weekly letter read by most of us on this call. Last week, he did a piece on my friend Terry Turner, co-founder of Pinnacle Bank in Nashville. Brown points out that Pinnacle, in its first decade, provided the second-best total return to shareholders of publicly traded banks.

In Terry's first quarter call, he made the point that analysts go from one worry to another while Pinnacle Bank keeps running the company with its core principles. It feels remarkably the same here. Here's what I can tell you. We have the most technologically advanced small business lending franchise in America. The platform for growth is proven. The technology is proven. The results are proven. The culture is proven. As this next-generation technology and our folks walk across the balance sheet to the liability/deposit side, our future results will speak for themselves. Over to Huntley and BJ for more details.

Speaker 9

Thanks, Chip. Chip highlighted some of the questions in the industry right now around deposits, liquidity, and credit. We're gonna try to unpack those for you in a little more detail this morning. I'm gonna start with safety and soundness, focusing primarily on what happened since the middle of March and how we're positioned before turning over to BJ to go through the quarter and the outlook. Starting on slide 5, the stress that we've seen in the industry in the last, you know, 6 weeks highlighted what we've consistently said, that safety and soundness comes first always. We talk a lot about conservative credit underwriting, but safety and soundness also means making sure we have ample liquidity to protect our depositors, our borrowers, our employees, and our shareholders.

You can see some of the highlight metrics here, around the strength of our balance sheet. We ended the quarter with over $4 billion of cash and available liquidity, as Chip mentioned, over 3x coverage for our uninsured deposits, minimal borrowings, low overall levels of uninsured deposits, and no pledged securities. Despite the events of late March, we ended up growing our customer deposit portfolio for the quarter, and we've seen solid growth thus far in April. We'll talk a little more about credit metrics here shortly, but overall trends are consistent with our expectations. As Chip mentioned, NPAs and past dues are basically flat over the past year on a percentage basis at 65 and 13 basis points.

We did see a couple charge-offs in the quarter that BJ will talk about, but overall, we continue to feel really positive about how our borrowers are navigating this environment. As concerns have grown around investor commercial real estate, specifically in office buildings, we thought we'd highlight that we have basically no exposure there. Our CRE is over 70% SBA and USDA, and virtually all owner-occupied or in specific operating categories like senior housing and self-storage. After liquidity and credit comes capital, and our ratios remain solid across the board. You've all seen us talk about the Mahan ratio before, our Tier 1 Capital, plus fair value marks, plus reserves to unguaranteed loans. That ratio at over 20% continues to give us a lot of comfort that we can continue to support small businesses through an uncertain economy.

When BJ goes through the quarter, you'll see both a reserve build and a fair value adjustment on loans. While both of those impact earnings for the quarter, they're non-cash items that further support our capital position. On page six, just a quick recap of a few more liquidity metrics we've covered, especially when compared to the broader banking industry. We feel like we're in a really solid place. We'll probably continue to run cash balances and liquidity a little higher than usual for a while, which will impact margin a little bit, but feels like the prudent course. On page seven, we highlight some additional details on our deposit franchise. You can see on the top right that through mid-March, we were growing largely as planned, with customer deposit growth up over 6% with no changes in our savings rates.

You can also see the planned runoff of some of our broker deposits. The back half of March, we saw just over $250 million of runoff of uninsured customer deposits as funds shifted to banks deemed either too big to fail or into money markets. As a result of the increased competition in the market, we increased our savings rate fifty basis points in late March and added additional wholesale deposits to make sure we had ample liquidity to maintain our growth trajectory. We ended the quarter with customer deposits up 2.7% linked quarter, and that outflow had reversed itself by the end of March, and we've seen solid customer growth so far in April with growth up over 1.3% month to date.

The most significant contributor to that growth has been our business savings accounts, which have doubled since the start of 2022, the balances now exceed our consumer savings accounts. Our unique funding model, as Chip talked about, gathering deposits primarily through branchless savings and CDs, has been a highly efficient way to support the growth of our loan portfolio. Without the cost of a branch network, we've always focused on paying a competitive rate to our deposit customers. The implications of our replacing our market-based savings accounts with alternative sources, whether they be wholesale deposits or borrowings, has been much less impactful for us as they have others in the industry. Our model has also been built an extremely granular, diversified portfolio of deposit customers with low average balances and overall low level of uninsured deposits.

On page 8, Chip Mahan highlighted these metrics in his introductions in quarters past. The significant amount of government-guaranteed loans in our portfolio, our track record of credit quality with the SBA, and our loan loss reserves, all significantly better than the industry. We also added a few thoughts on our credit philosophy and how we take care of our portfolio. We continue to focus on government-guaranteed lending and lending to low-risk industries like professional services that are less cyclical and concentrated. We stay really close to our customers. No one talks to them as often as we do. We believe that our lack of sales commissions lead to better outcomes for our customers and our portfolio. All in all, we continue to feel confident in the quality of our borrowers and their ability to navigate an economic environment punctuated with higher interest rates and slower growth.

On page nine, credit normalization is a phrase that we've heard a lot this earnings season. You'll see a time series of our provision, our charge-offs, and our allowance as a percentage of unguaranteed loans. COVID created an unusual period where reserves quickly built up only to decline as a percentage of loans, given the government's efforts to stabilize the economy and support small businesses. Over the last year, we've largely seen our reserve levels return to pre-pandemic levels, although given our growth, we did not release any reserves like many did in the industry. Again, in this quarter, our provision significantly outpaced our charge-offs primarily to support our continued loan growth. Overall, we feel like we're reaching a stable level of reserves given what we see in the macro environment.

Over the past two months, banks' balance sheets have been tested, and I'm proud to say that we passed the test with flying colors. While we expect to see some increased competition in the near term on deposits, overall, the opportunity for us to serve small businesses is as robust as ever, and we're excited as ever to continue on our mission. Your turn, BJ.

BJ Losch (President and CFO)

All right. Thanks, Huntley and Chip. Good morning, everybody. Let's start a discussion on earnings on slide 11 with a recap of the major drivers in Q1. To state the obvious, this was quite a quarter for the banking industry. For Live Oak, it was really the tale of two distinct phases, January 1st through about March 8th, and March 8th through March 31st. In the first phase through early March, we saw continued strong customer loan and deposit growth, continued improvement in the secondary market environment for gain on sale premiums and asset marks, good expense discipline, and stable credit quality.

In the second phase, post the industry panic of the SVB and Signature Bank issues, we saw significant reversals of secondary market pricing improvement we had been experiencing, and we took action to further ensure the safety of our customers and our balance sheet. All of that netted to not a lot of earnings in the quarter. Actions we have taken to ensure safety and soundness, coupled with our strong customer growth, puts us on a path to much improved earnings trajectory going forward. I'll quickly hit some highlights here on slide 11, but get into a bit more detail on each over the next several slides.

Our loan production engine continues to generate profitable growth, with the $1 billion in loan production in the quarter being the highest Q1 production level in the history of Live Oak at average yields of 8.54% versus current portfolio yields of 7% and driving loan growth up 4% quarter-over-quarter and 21% year-over-year. As Huntley said, deposit growth was up nicely as well. The customer deposit growth was still up almost 3% in the quarter despite the March disruption, and continues to grow nicely even through April tax season.

I'll get into a bit more detail on our NIM compression this quarter in a few minutes, but we'll say that while the trial of the NIM is now lower due to industry stress in March, the resiliency of our NIM and resulting net interest income in the second half of the year should be aided by the strong net loan growth, higher loan production yields we are booking, and an anticipated flattening of deposit costs. Expenses are moderating as we discussed on the fourth quarter call, we expect further discipline here throughout the rest of the year. On reserves, we leaned into the provision for both growth, which I consider good provision, and conservatism given the economic environment. Finally, the impacts of those notable items, which I'll hit on the next slide, had a pretty outsized impact of about $0.20 in the quarter.

Turning to slide 12, let's take a look at those notable items that added up to that $0.20. In non-interest income, we had two notable items, the largest of which was for our loans held at fair value, which are marked at the end of each quarter. Given the disruption in March, we saw a significant swing in that valuation in just 30 days. We now have roughly a 5% mark on that portfolio over 2x our current allowance for credit losses, so this seems quite conservative. In non-interest expense, we refined our assumptions to be more conservative in how we reserve for unfunded commitments, resulting in a one-time step-up of $2.4 million.

Finally, we had a discrete tax item of $2.8 million, which resulted in an abnormally high effective tax rate in the quarter, which we expect will normalize into the 15%-20% range over the course of the year. Turning to slide 13, our one day in a loan production in the quarter was again diverse across multiple areas with particular strength in our middle market sponsor finance vertical, solar vertical, and numerous small business areas. As others pull back on lending, we expect to see good opportunities for new business going forward. Let's turn to our net interest income and margin trends on slide 14. Given the market disruption and the decline in our NIM this quarter, I'll go through the dynamics in a bit more detail than usual.

You may recall that in a response to a question on the fourth quarter earnings call about our NIM in 2023, I said that deposit pricing ramped up significantly in the back half of 2022 and showed no signs of slowing. We expected to see downward pressure on the NIM in the first half of the year because the accelerated deposit pricing would be more rapid than the loan repricing. In the back half of the year, however, as our loan repricing flowed through the balance sheet and the Fed neared the end of its rate increase cycle, we would expect NIM expansion. All of those things are still true, but the March industry stress further increased deposit pricing pressures in the near term. The loan repricing tailwinds are still to come, which should help with NIM improvement in the back half of the year.

Said a different way, while we expected a V shape to our NIM trajectory in 2023, given recent events and our desire to ensure continued customer deposit growth, the decline is steeper than we expected in the first half. However, we still anticipate steady improvement in the NIM and net interest income in the second half of 2023. Let's put a few data points behind what I just said. Let's take the deposit side first. You see that we provided more information on both Live Oak and the top digital competitors as it relates to deposit pricing and betas, along with the ending Fed funds upper rate for reference. Two things you will notice in the first half of 2022. Our quarterly and cumulative savings betas were tracking with the top digital competitors through the first half of 2022.

Second, it was at a lower beta, about 40%, than what we have been consistently sharing with you about our expected through-the-cycle beta of about 70%. In the second half of 2022, deposit competition started to heat up significantly. Take a look at the two gray boxes on this slide. In the third quarter, top competitors started moving much higher at a 78% beta in Q3 2022, as you can see in the gray box. Our deposit growth trajectory, however, was still strong and fully supportive of our loan growth, we remained disciplined about rate increases and our beta remained lower at 63%. In the fourth quarter, however, top competitors moved up at almost a 100% beta. We had to move accordingly to maintain our balance growth.

In the 1st quarter, we saw moderation in deposit rate movements from competitors with very little movement through mid-March. We were growing our customer deposits on our desired pace, so we had no expectation of moving deposit rates up in Q1. When the industry crisis hit in mid-March and we saw customer outflows, we decided to move proactively and aggressively to reverse the trends we were seeing, moving savings rates up a full 50 basis points to move modestly ahead of top digital competitors. As you can see, it worked quite well to put us back on a positive customer deposit growth path. We sit here today at a modestly higher through the cycle beta of about 74% versus the 70% or slightly less we had expected, but are back on track for healthy customer deposit growth to support our continued loan growth.

Let's take a look at the loan side. Here we provided you with an additional data point, our loan production yields from Q1. I'll reference that in a minute. Our loan yields have been moving up nicely as you can see in the table, but obviously cannot move as rapidly as the deposit betas we just discussed as about 40% of our current loan portfolio is variable rate. Two points to make on loan yields going forward. Number one, loan production yields are currently being booked at rates greater than 150 basis points higher than our portfolio rates. See the 8.54% on new loan production yields in the upper right of the slide versus the 7% on portfolio loan yields in the upper right of the table. The majority of our variable rate loans are quarterly, not monthly adjusting.

This means that unlike deposit rate changes, which happen intra-quarter, we don't see intra-quarter increases in loan yields. They move up the full change in the prime rate over the prior quarter on the first day of the following quarter. As of April first, our quarterly adjusting loans saw another 50 basis point increase in rate. Therefore, as our newer loans replace older loans over time, our portfolio yields will continue to rise, supporting stabilization then improvement in our net spread. What does all this mean for the NIM, and how does that relate to the 350-375 range that had been discussed?

Pre-crisis, we would have expected NIM to bottom out in the 3.50%-3.55% range in Q1 and to end Q4 2023 in the 3.75%-3.80% range, resulting in a full year 2023 NIM in the 3.65% range. With the March events driving deposit costs higher than anticipated, we now expect NIM to bottom out at about 25-30 basis points below the prior range one quarter later in Q2 and end Q4 2023 in the lower to middle part of the 3.50%-3.75% range. This remains an uncertain environment. Let me be crystal clear and transparent with our current assumptions here. The Fed moves 25 basis points in May. Pauses for the rest of the year. Deposit betas move in the 60%-70% range for that increase. Flatten.

Deposit growth continues on pace with the above beta assumptions. Healthy loan growth continues on pace with current pricing. No further major industry disruption related to deposits or liquidity. Remember that if we do decide to hold more on balance sheet liquidity, it may have an impact on the NIM, but will have minimal impact on net interest income. To recap, deeper V in NIM trajectory in the first half of the year for more rapid deposit rate changes due to the industry stress events. NIM and net interest income improvement in the back half of the year as deposit costs moderate, loan yields continue to improve, and earning assets continue to grow. I hope this helps. Let's turn to slide 15 and take a look at net interest income trends.

As I mentioned before, we had been seeing improvement in secondary market conditions, premiums, and valuations before the mid-March events. Our SBA sales activity increased in Q1, as did our gain on sale premium, resulting in $10 million in net gain on sale income versus $7 million in Q4. Though the majority of what we sold was variable rate, we did see some fixed-rate SBA sales activity, which was encouraging. All of our sales activity occurred before mid-March. As you can see in the upper right, from February 28 to March 31, our servicing asset reval and fair value mark was down almost $6 million or over $6 million, reversing a net gain position we had on those assets as of the end of February.

While there will be continued variability as these assets are valued quarterly based on market pricing, spot rates on 3/31 were obviously heavily influenced by the events of mid-March. We do not expect this level of volatility going forward. Turning to expenses on slide 17. As we discussed on the fourth quarter call, we have worked through what I call our hiring bubble. First, to rightsize our lender support to accommodate the significant step up in balance sheet growth over the past few years. Second, to accelerate our technology build-out in 2022, thanks to the FinTech gain. Going forward, while we will continue to be opportunistic on hiring for revenue producers, we are tightly managing our expense growth to improve our operating leverage. Our core expenses were essentially flat to Q4, with our head count up only seven people or 1%.

We expect continued lower levels of hiring and strong expense discipline going forward. Turning to credit trends on slide 18. As Chip and Huntley discussed earlier, credit metrics remain quite strong. We continue to actively monitor the existing portfolio and do not currently see any glaring weak spots. Past dues are down and non-accruals remain quite low. You can see that the credit quality trends across our 3 business segments are quite strong as well. About 5 of the $6.7 million net charge-offs in the quarter were driven by 2 relationships, leaving only $1.7 million in net charge-offs across the entire rest of the $8 billion portfolio. 2 relationships is not a trend. Steve can speak more on these and the overall strength of our portfolio during the Q&A.

Yet the provision remained flat as we leaned into building reserves for both the new loan growth and continued caution about the future economic outlook. Our reserves to unguaranteed loans remain well above the industry. About $7 million of our $19 million provision was for net new loan growth. That to me is good provision. Said a different way, if we weren't growing loans and customer relationships, our provision would have been $7 million lower. I'd rather be growing profitable loan relationships. With what we see, combined with a conservative outlook, we currently feel very well positioned with our reserve levels at over 2x industry averages. Slide 18 shows our overall capital strength, which gives us great comfort that we are well-positioned to thrive in whatever environment lies ahead. To wrap up on slide 19, here's what we are focused on for the rest of 2023.

We have and will always start with soundness, and that has served us quite well in the current industry stress. We will continue to do what we do well, know our customers, and keep our balance sheet strong. On the profitability front, we are absolutely focused on controlling what we can control, which is making high-quality loans, staying disciplined on pricing, and managing our expenses very tightly. On the growth front, we remain incredibly excited about the power of our business model. Our lending businesses continue to provide excellent value to our customers, resulting in strong loan production and growth, and we look for opportunities every day to add more revenue producers to our attractive platform. We have our first 10 customers up and running on our new treasury management platform with strong reviews.

More are being added each day. This is a big step in our journey towards fuller customer relationships and attractive lower cost operating accounts. Our people are ready to make this happen. We still remain very confident that our embedded banking platform and all the technology investments that we are making are going to be absolute game changers in this industry. With that, we can open it up for questions.

Operator (participant)

Thank you. Ladies and gentlemen, we'll now begin the question and answer session. If you'd like to ask a question, please press star followed by one on your telephone keypad. If you'd like to withdraw your question, please press star followed by two. If you're using a speakerphone, please lift the handset before pressing any keys. One moment for your first question. Okay, your first question comes from Brandon King from Truist Securities. Brandon, please go ahead.

Brandon King (Managing Director and Senior Equity Research Analyst)

Hey, good morning.

Speaker 9

Hey, Brandon.

David Feaster (Director)

Morning, Brandon.

Brandon King (Managing Director and Senior Equity Research Analyst)

Just wanted to start on credit and the two relationships. If you could elaborate on that to give some more context behind those two relationships.

Steve Smits (Chief Credit Officer)

Certainly, Brandon. This is Steve Smits. Good morning. Yeah, I'll talk about the first was a direct to consumer e-commerce business, had very specific challenges around the opt-out. Most of their marketing was focused on Facebook.

E-commerce marketing. With changes in the opt-out rules around that had a material impact to their revenue. I consider that very much isolated. I'll also note that we have very small exposure to businesses whose primary revenue driver is direct-to-consumer e-commerce. Less than half a dozen relationships, to be more specific. Every one of those is actually doing quite well with good cash flow. The second is very specific to supply chain challenges and more specifically, lumber costs. At the height of lumber costs, this business suffered a significant deterioration in their COGS, which they simply were not able to work through. That one we charged down. I would conclude that both are very much isolated situations. Overall, I don't see any systemic trends that are concerning to me.

Got it. Got it. I guess with that not being systemic, would you, I guess, assume that charge-offs kind of go lower from here, throughout the year?

While I don't have a crystal ball, and there's always, you know, a chance for an unforeseen, right now I feel very confident that the portfolio is quite stable. I also feel very confident that we for those of folks that are newer to Live Oak, I did want to stress comments made both by Huntley as well as BJ during his comments, is our very robust servicing philosophy and methodology. We stay incredibly close to our customers, so I feel like I have a very good pulse on the health of our borrowers, and can say that I feel the portfolio is quite stable and actually doing quite well.

David Feaster (Director)

Okay. Thanks for that. Just one more question. Could you give us an update on the small business checking and the treasury management products? Given the events that happened in March, does that provide either more challenges, or could you see more opportunities just given all the turmoil in the banking industry?

Speaker 9

Sure, Brandon. It's Huntley. I'll start and others can chime in. We are, as BJ said, live with a full service checking operating account for small business with a full set of treasury management capabilities. We've got our first 10 customers live on it, moving money, and we're really excited. That's through our partner Apiture, who you all know we have investment in. They provide the front end service. They do that, a couple 100 banks use this product. We're really excited, and we're onboarding more customers and we're, you know, we obviously were somewhat strategic in how quickly we came to market because we wanted to make sure it worked and we're going through that with our first, you know, set of customers.

Throughout the year, we'll continue to ramp, and do more. We're really excited that we've gotten to where we are. In terms of the industry, I think there's a couple of things that we need to, you know, think about. One, you know, as Chip said, the need to pay competitive rates, we think is there, and actually is an advantage for us because, you know, we've got a savings product that is competitive, and that may be an attractor that then that customer comes and does the rest of their banking through their operating account with us. We like that.

On the flip side, you know, we saw customers who left us to go to one of the largest banks because they felt like there was that implicit too big to fail guarantee. Will there be people who are less willing to, you know, to transfer to a new bank? Does it, you know, reduce some of the switching? Maybe. We haven't seen it yet, but we're really early days.

David Feaster (Director)

Okay. That's all I had. I'll hop back in the queue. Thanks for taking my questions.

Steve Smits (Chief Credit Officer)

Thanks.

Chip Mahan (Chairman and CEO)

Thanks, Brandon.

Operator (participant)

Your next question comes from Crispin Love from Piper Sandler. Crispin, please go ahead.

Crispin Love (Director and Senior Research Analyst)

Thanks, good morning, everyone. First on growth. I'm just kind of curious what your views on growth are in the current environment based on the prepared remarks. You seem to be remaining constructive on growth. Just curious if you would expect any pullback or any deceleration in loan growth given the current environment, or do you believe you can still grow at kind of typical historical levels, especially as the SBA can have counter-cyclical tendencies?

Chip Mahan (Chairman and CEO)

Well, I'll start and then you guys can add on. It seems that when we talk to our leaders in the sales division, that they are saying as late as yesterday, the phones are beginning to ring. I take that as the credit guys running other banks are tightening the screws a wee bit. We have seen this from time to time, you know, over the last 15 years. We will be in the market. I think if we look at the pipe guys, it is relatively strong. I mean, our guys are not backing off their projections from 120 days ago.

Speaker 9

Yeah. No, that's right. I mean, I think we have seen some situations where a buyer and seller can't agree on value given the changing market conditions where somebody decides to pause on an expansion project. That is, you know, a bit of a headwind. To Chip's point, we're also seeing perhaps more opportunities in the space and in some areas more than others. It hasn't been sort of broad across the board. We'll just be opportunistic.

Crispin Love (Director and Senior Research Analyst)

Great. Thanks, Chip and Huntley. I appreciate the commentary there. Just on SBA gain on sale margin trends, I'm just kind of curious from kind of over the first quarter and then through April, how they've been as margins likely compress kind of following the bank turmoil. Just kind of trends in early April on gain on sale margins. Relatedly, do you expect any knock-on effects in SBA secondary markets, just from the bank closures earlier in the first quarter, that could impact SBA gain on sale over the near or longer term?

BJ Losch (President and CFO)

Hey Crispin, it's BJ. Good morning. You know, unfortunately, the mid-March stresses kind of stunted the improvement that we had been seeing over the course of the year in terms of premiums. You know, premiums were, you know, up probably, you know, 100 to 200 basis points or so from late last year. As I mentioned, in my prior comments, we actually sold some fixed rate SBA, which essentially had been closed for several quarters. The markets were really starting to heal up through mid-March, which was encouraging to see. You actually saw from fourth to first quarter, our average net gain on premiums was actually up from quarter to quarter. You know, that kind of backed up and paused as of the end of the quarter. Still a little bit of uncertainty through April.

There's, you know, certain disruption in the secondary markets and, you know, which buyers are going to be there going forward, et cetera. We're hopeful that, you know, the further we get away from mid-March, things start to normalize. We do expect premiums to continue to improve over the second half of the year, and that's what our expectation is.

Crispin Love (Director and Senior Research Analyst)

All right. Thanks BJ. I appreciate you all taking my questions.

BJ Losch (President and CFO)

Thanks, Crispin.

Operator (participant)

Your next question comes from Steven Alexopoulos from JP Morgan. Steven, please go ahead.

Steven Alexopoulos (Equity Analyst)

Hey, good morning, everybody.

Speaker 9

Hey, Steve.

Crispin Love (Director and Senior Research Analyst)

Good morning, Steve.

Steven Alexopoulos (Equity Analyst)

BJ, I want to make sure I have the new NIM guidance correct, because we're calculating different numbers on my team. What are you saying for the two Q NIM?

Speaker 9

down twenty-

Steven Alexopoulos (Equity Analyst)

Like the range.

Speaker 9

Yeah. Yeah. Whereas we thought the bottom end of the range before was 350 to 375, we think we bottom out 25 to 30 basis points below that range, come back in the second half of the year and end more in the lower to middle part of that 350 to 375 range.

Steven Alexopoulos (Equity Analyst)

Did you give a range for two Q where you think, basically it's the exit margin out of this quarter, right? Given you took up savings rates. Let me just ask, what do you think for the second quarter margin? It sounds like you think NIM will drop in two Q and then improve in the second half, right? That's the outlook.

BJ Losch (President and CFO)

Yeah. Yeah. The margin will be down in the second quarter because the 50 basis point increase we made in mid-March is going to have an outsized impact in the second quarter. Second quarter NIM will be down. In the second half, loan yields will start to flow through the balance sheet, deposit costs will flatten, is our expectation. By fourth quarter, the margin will go back up towards the lower to middle part of that 350 to 375 range.

Steven Alexopoulos (Equity Analyst)

Okay. That's helpful. Then within that, what level do you assume, again, calling out the scenario you talked about for the Fed, right? One more hike, and then they go to pause.

BJ Losch (President and CFO)

Yeah.

Steven Alexopoulos (Equity Analyst)

What level do you see deposit cost peaking? Sounds like the timing of that... I'm just going to ask you, where do you see deposit costs peaking under that scenario, which is within the guidance you just gave us, and what's the timing to see the peak?

Speaker 9

Yeah. You know, to have this flow through, I would see the peak, based on the assumptions that I just gave in the third quarter, maybe the fourth quarter. The real step up would occur, second quarter, moderation in third quarter and fourth quarter.

Steven Alexopoulos (Equity Analyst)

Got it. Okay. That's helpful. I want to shift to the reserve for a minute. I don't know if you guys saw, but BankUnited did a, did a nice job in their slide deck this week. They put out a stress scenario for Commercial Real Estate loans, which basically showed that in a period of stress, their reserve on Commercial Real Estate would need to increase materially. I'm curious if you could share with us what does a stress scenario on the unguaranteed portion of your loans look like? If that played out, are you already reserved for that or would the reserve need to materially increase?

Steve Smits (Chief Credit Officer)

Yeah, Steve, this is Steve Smits. I'll start, BJ, you can certainly add because we did run some stress scenarios. I will say that we feel that we are properly reserved for a rockier macroeconomic environment. We feel we are well reserved right now, barring any unforeseens. We did run stress on a number of factors that we considered would be pretty catastrophic. BJ, I don't recall offhand, but I think that we still came to the conclusion that it wouldn't be a huge material impact to our provision expense going forward.

BJ Losch (President and CFO)

No, no. I think, you know, I mean, maybe if we stressed it across primarily four different types of stresses. One was that prepays declined, meaning we had higher average loan balances and therefore had to hold more reserve. That was one. The second was that unemployment spiked over 200 basis points in a year from where we are today. The third was our Probabilities of Default went up about 30% or so across the board. The fourth was Loss Given Defaults up 30% or so as well. We looked at those both in isolation and in total. I think, you know, our reserve levels would have gone up if all of those things happened. Armageddon would be up about 20%. not.

Chip Mahan (Chairman and CEO)

Not material.

BJ Losch (President and CFO)

not, you know.

Chip Mahan (Chairman and CEO)

Not catastrophic.

BJ Losch (President and CFO)

not catastrophic.

Chip Mahan (Chairman and CEO)

At all.

Speaker 9

So-

Chip Mahan (Chairman and CEO)

That's at all, if all of them played out.

BJ Losch (President and CFO)

That's if every single one of them-

Chip Mahan (Chairman and CEO)

Right

BJ Losch (President and CFO)

... played out, you know, in the next, you know, three quarters, which obviously is highly unlikely. Going back to Steve's point, you know, we already have what we believe is some conservatism and thumb on the scale around PDs, LGDs, where we think prepays are, where we think unemployment is, et cetera. You know, we feel very well-positioned with the reserve as we sit here today.

Steven Alexopoulos (Equity Analyst)

Okay. That's terrific color. BJ, if I could squeeze one more in. Just following up on your answer to the earlier question on the gain on sale. Given that the market appears to be somewhat disrupted, at least right now, do you think gain on sale revenue maybe goes back to where we were, I don't know, in the prior quarter, you know, 4Q 2022? Is that what you're thinking?

BJ Losch (President and CFO)

We do expect in the second half of the year continued premium improvement. I think that what we are, what we are producing is conducive to us being able to sell more in the secondary market. What I mean by that is, you know, I think in the quarter over 80% of our SBA production was variable rate. Variable rate is still very attractive on the secondary market. As we have more variable SBA-eligible loans coming into the company, we have more flexibility to sell. We can sell more even if there's a modest, you know, backup in premiums. If premium comes back, we can still sell a little bit more and at a higher premium.

All of that to say is I still feel, you know, good about the levels of gain on sale income that we're at in the first quarter, and hopefully we continue to see growth and improvement over the course of the year.

Chip Mahan (Chairman and CEO)

Okay. Thanks for taking my questions. Appreciate it.

BJ Losch (President and CFO)

Thanks, Steve.

Operator (participant)

Your next question comes from David Feaster from Raymond James. David, please go ahead.

David Feaster (Director)

Hey, good morning, everybody.

Speaker 9

Hey, David.

Chip Mahan (Chairman and CEO)

David.

David Feaster (Director)

Maybe just moving back to the checking and the treasury management initiative that we talked a bit about earlier. Obviously, it's still early. Have your expectations changed for that at all? I mean, we previously talked about, you know, maybe $200 million coming on by year-end. Is that still the target? Just kinda hearing your comments on, you know, deposit costs, it sounds like that may be reasonable. I'm just curious if, you know, if that had changed at all.

Chip Mahan (Chairman and CEO)

Huntley, you can take this. Let me just give you a little background on the product itself, David. This product was created by FundsXpress in 1997, which is now Apiture today. Those guys in Austin, Texas lifted and shifted all that code out of a data center in Austin and made it fundamentally cloud-native API-first and transferred to AWS. Along the way, with the help of Terry Turner, right, who is a 10% equity holder-ish. Is that about right? What Pinnacle owns and Apiture, right? His guys basically said, "We need the software to do this and this." This is over the last two or three years. As we were lifting and shifting that code to a next generation environment, we did just that. Then they begin to win awards, right? Celent, others, I can't remember the name.

That is the product in the marketplace, primarily helping larger customers than ours. Our, our customers are mainly $2 million-$5 million revenue small businesses. Pinnacle's customers are substantially larger than that. We have a lot of excess capability as our customers use that software and move upmarket. Huntley, you clean that up.

Speaker 9

David, to your question, look, I think that number seems about right. We are excited. We're still early days, but you know, if we continue to lend out $1 billion a quarter, and that's 500+ new customers a quarter, those are great opportunities for us to convert on a proven platform. I think our estimates still feel about right as we sit here in terms of what we're trying to do this year.

David Feaster (Director)

Okay, that makes sense. We talked about, you know, the tightening of credit maybe pushing more folks in the SBA. You know, I think you still have a similar concept on the conventional side as well. Is that something that you're seeing? Maybe would you expect, you know, the proportionConventional lending to increase or would you kind of expect it to stay relatively, you know, the same? I guess, where are you seeing opportunities? You know, obviously, specialty finance specifically sponsored finance is really strong. Just curious where you're seeing opportunities more on the lending side.

BJ Losch (President and CFO)

I think the mix feels about right. You could make a case that we'd find more SBA opportunity. I think you could make a case to the contrary. Right now, it feels like the balance in the mix is about what we're seeing and will continue to as we look at pipelines. I think one of the areas that we think there's gonna be some opportunity. Obviously, we're not in, as we mentioned, the office sort of commercial real estate space, but there are places that are the secondary and tertiary where some people paint real estate with a giant brush, and so maybe that's senior housing, maybe that's self-storage.

Places that fall into a real estate bucket, we look at them much more as operating businesses, where we may find, some incremental opportunities as, you know, folks pull back, broadly speaking, from real estate. We're just kind of being opportunistic right now and we'll take what comes.

David Feaster (Director)

Okay. That's helpful. Then maybe we could just touch on the tech investment side. I'm just curious what you're seeing there. Obviously, valuations in the market are still a bit challenged. You know what I mean? Look, Canopy Services, you know, saw nice growth this quarter. Just curious some of the trends that you're seeing on, you know, the tech investments and within Canopy.

Chip Mahan (Chairman and CEO)

I would say that the guys at Canapi are still looking at three to five new opportunities a day. That said, somebody said earlier that, you know, those valuations of those businesses have dropped dramatically from, you know, 20 times forward revenues to 6. I would say that most of these companies are looking to trim overhead and get the profitability on their own. We're being very circumspect, but they're tickled to death that our second fund is in the process of wrapping up. We have about $800+ million of dry powder to pick the winners. So far so good.

David Feaster (Director)

Does the SIVB, you know, failure impact that business at all? I mean, maybe push more opportunities to you?

Chip Mahan (Chairman and CEO)

You know, to be determined. Hard to say there.

David Feaster (Director)

Okay. All right. Appreciate all the color. Thanks, everybody.

BJ Losch (President and CFO)

Thanks, David.

David Feaster (Director)

Sure.

Operator (participant)

There are no further questions at this time. I'll now turn it back for closing remarks.

Chip Mahan (Chairman and CEO)

No closing remarks, folks. We'll see you in 90 days. Thanks for joining.

Operator (participant)

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines.