Western Alliance Bancorporation - Q3 2024

Transcript

Operator (participant)

Hello, everyone, and a warm welcome to the Western Alliance Bancorporation Q3 2024 earnings call. My name is Emily, and I'll be coordinating your call today. After the presentation, there will be the opportunity for you to ask any questions, which you can do so by pressing star followed by the number one on your telephone keypad. I will now turn the call over to our host, Miles Pondelicek, Head of Investor Relations. Please go ahead, Miles.

Miles Pondelik (Head of Investor Relations)

Thank you, and welcome to Western Alliance Bank's third quarter 2024 conference call. Our speakers today are Ken Vecchione, President and Chief Executive Officer, and Dale Gibbons, Chief Financial Officer. Tim Bruckner, our Chief Banking Officer for Regional Bank, will join for Q&A. Before I hand the call over to Ken, please note that today's presentation contains forward-looking statements which are subject to risks and uncertainties and assumptions. Except as required by law, the company does not undertake any obligation to update any forward-looking statements. For a more complete discussion of the risks and uncertainties that could cause actual results to differ materially from any forward-looking statement, please refer to the company's SEC filings, including the Form 8-K filed yesterday, which are available on the company's website. Now, for opening remarks, I'd like to turn the call over to Ken Vecchione.

Ken Vecchione (CEO)

Good morning. As always, I'll make some brief comments about our third quarter earnings before turning the call over to Dale, who will review our financial results in more detail. After I discuss our outlook for the remainder of 2024, Tim Bruckner will join us for Q&A. Western Alliance delivered solid third quarter results and earned $1.80 per share. These results demonstrated the bank's ability to sustain diversified loan and deposit momentum, as well as grow earnings during a changing rate environment. We produced healthy deposit growth of $1.8 billion, or 11% annualized, and HFI loan growth of $916 million for 7% annualized, despite sluggish demand overall for credit in the economy.

Our national diversified credit origination and deposit platforms uniquely position us to sustain strong deposit growth and then deploy this liquidity into attractive commercial loans where we can provide deep segment and product expertise. During a transitional period for the rate cycle that began in Q3, net interest income grew 25% annualized due to higher average earning assets. Net interest margin compressed 2 basis points because of lower yields on variable rate loans. Continued interest rate cuts will enable Western Alliance to realize significant funding cost savings in both interest-bearing and ECR-related deposits going forward. We anticipate a more meaningful benefit from lower rates in Q4 from a full quarter impact of lower rates.

Q3 results were modestly impacted by $4 billion of mortgage warehouse deposit growth, driven by elevated mortgage refinance volumes, validating our operational excellence as we continue to win market share following several competitors retreating from the market. After the money center banks, Western Alliance is now the largest bank operating in this space. This excess deposit growth somewhat impacted Q3 earnings from elevated deposit costs, but these deposits have helped cement core customer relationships, which will continue to drive strong risk-adjusted loan volume and spread income. Typical seasonal declines in mortgage warehouse deposit balances are poised to push Q4 ECR-related deposit costs materially lower. Non-interest income increased $11 million or 10% quarter-over-quarter, but this growth was tempered by a decline in mortgage banking income. Our franchise remains poised to significantly benefit from a resumption of stronger mortgage volume.

Pre-provision net revenue grew marginally from Q2, while tangible book value per share climbed 19% year-over-year. Lastly, asset quality remained stable as non-performing assets to total assets declined 6 basis points to 45 basis points. Net charge-offs of 20 basis points landed within our street guidance range. Dale will now take you through the results in more detail.

Dale Gibbons (CFO)

Thanks, Ken. During the quarter, Western Alliance generated pre-provision net revenue of $286 million, net income of $200 million, and earnings per share of $1.80. Net interest income increased $40 million from Q2 to $697 million, equating nearly 25% annualized growth because of higher average earning asset balances driven by loan growth. Non-interest income of $126 million rose $11 million quarter-over-quarter from higher service charges and loan fees, benefiting from commercial banking fees and a new bank-owned life insurance policy, which, along with securities gains, helped mitigate lower mortgage banking income. Securities gains were taken as we sold collateral held for a large bankruptcy deposit as it went into distribution. Mortgage loan production rose 21% from Q2 and 10% year-over-year.

Loan servicing revenue was negatively impacted by prepayment speeds accelerating due to the declining rate environment, which caused a negative change in the MSR fair value net of hedging of $15 million. Non-interest expense for the quarter was $537 million. Deposit costs of $208 million drove the quarter-over-quarter increase due to strong demand in Mortgage Warehouse. In aggregate, net interest income growth exceeded deposit growth by $6 million this quarter. It is important to emphasize the recent 40-50 basis point reduction in the Fed Funds target rate occurred less than two weeks before the end of Q3. Consequently, rate reduction actions for ECR-related deposits were also backloaded.

Seasonal outflows in Mortgage Warehouse from Q4 tax and insurance payments and a full quarter impact of lower rates make us confident Q3 will prove to be the high water mark in ECR-related deposit costs for this rate cycle. Provision expense of $34 million resulted from sustained loan growth and $27 million of net charge-offs. The balance sheet remained at approximately $80 billion as solid loan and deposit growth were offset by securities and cash, declining $2.4 billion quarter-over-quarter, and a further $2.6 billion reduction in fed funds and borrowings. A large distribution of bankruptcy settlement funds drove a notable decline in Juris Banking deposits, which allowed us to sell the collateralizing securities. Loans held for investment grew $916 million to over $53 billion, while deposits grew $1.8 billion to $68 billion at quarter end.

Tangible book value per share continues its expansion, rising 6.5% quarter-over-quarter to $51.98, and was aided by a large improvement in our AOCI position. Loan growth of $916 million resulted from large contributions from regional banking as well as Mortgage Warehouse and MSR lending. We continue to diversify the loan portfolio, as shown by C&I loans growing over $4 billion year-over-year, and now accounting for 42% of the held for investment loan portfolio, compared to 37% one year ago. At the same time, we lowered the overall allocation for commercial real estate investor and CLD categories from 29% to 27%.

Deposit growth of $1.8 billion was generated from seasonal inflows at Mortgage Warehouse, which grew $4.1 billion, while our Consumer Digital Channel increased $1.3 billion and continued to add more granular deposits uncorrelated with our commercial banking business lines. Owners association deposits also posted growth in a seasonally softer quarter. As mentioned before, Juris Banking deposits decreased $2.7 billion. Overall, core deposit growth was $2 billion, as we modestly reduced wholesale broker deposits by approximately $200 million. Turning to our net interest drivers, the yield on total securities increased 2 basis points to 4.89%. Our liquidity position remains solid, as unencumbered, high-quality liquid assets were 64% of securities and cash, while securities and cash were 24% of total assets.

HFI loan yields decreased 14 basis points to 6.65% due to asset repricing for SOFR-tied loans in advance of the Fed's rate decision. The cost of interest-bearing deposits was three basis points higher as a result of $1.3 billion of quarterly deposit growth in our Consumer Digital Channel. The total cost of funds declined 12 basis points to 2.67% due to the deposit mix shifting toward non-interest bearing and a smaller proportion of earning assets funded by borrowings. If you compare the difference between the period end spot rates and average rates for the quarter, you'll see that the difference is wider for interest-bearing deposits compared to HFI loans. In other words, we are seeing funding cost tailwinds emerge outside of just ECR-related funding. In aggregate, non-net interest income increased $40 million from higher average earning asset balances and loan growth.

Net interest margin compressed 2 basis points from Q2 to 3.61, which would have been flat, but for the new BOLI policy, as $800 million of earning assets were deployed for this purpose. Regarding interest rate sensitivity, Western Alliance is liability sensitive on an earnings at-risk basis. With a dynamic balance sheet, a -100 basis point rate ramp analysis indicates pre-tax interest-sensitive earnings should increase 1.5%. In this scenario, the expected negative impact on net interest income would be more than offset by expected reductions in ECR-related deposit costs, as well as a pickup in mortgage banking income that a lower rate environment should unleash. Our adjusted efficiency ratio for the quarter was 53%. Modestly higher operating expense growth compared to revenue growth drove the 120 basis point increase from last quarter.

Excluding the impact of the FDIC special assessment rebate in Q2, this ratio would have remained flat quarter over quarter. Asset quality continues to remain relatively stable. In Q2, criticized assets rose $60 million, as special mention loans declined $30 million, while classified assets increased $90 million. Criticized assets are up only $33 million from a year ago. We expect the total criticized asset pool to remain relatively stable. Non-performing assets as a percentage of total assets declined 6 basis points to 45 due to payoffs and sales. Our non-performing assets consist primarily of CRE office loans, which is unsurprising given the environment characterized by still elevated interest rates and lower office property valuations. Quarterly net loan charge-offs were $26.6 million, or 20 basis points of average loans. Provision expense of $34 million added reserves in concert with loan growth, in addition to replenishing net charge-offs.

Our ACL for funded loans rose $5 million from the prior quarter to $357 million. The total loan ACL to funded loan ratio of 74 basis points was unchanged and covers 113% of non-performing loans. Slide 14 shows the updated ACL walk we have regularly provided to add more context behind our allowance methodology relative to peers. Our ACL lifts from 74 basis points to 1.31% when incorporating the effect of credit linked notes, which have provided a pool of prepaid insurance money to us to cover charge-offs, as well as low- to no-loss loans like Equity Fund Resources or low LTV and high FICO residential our residential portfolio and Mortgage Warehouse loans.

Compared to the $50 billion-$250 billion asset peer banks, we benefit from a greater CLN support, as well as a greater percentage of loans in low to no loss categories. Our CET1 ratio increased approximately 20 basis points to 11.2%. Our tangible common equity to total assets ratio moved up approximately 50 basis points from Q2 to 7.2%, as our all other comprehensive income loss position recovered substantially due to a lower rate environment. Given the conversation about Basel III endgame capital, I'd also mention that our CET1 ratio, including AOCI and our loss reserve, is 11.1%, which is 50 basis points above the second quarter adjusted CET1 ratio of 10.6% and ranks in the top quartile of our asset class peers.

Finally, tangible book value per share increased $3.19 quarter-over-quarter to $51.98 from earnings growth and our negative AOCI accretion improving by almost one-third. Our consistent upward trajectory in tangible book value per share has outpaced peers by tenfold since the end of 2013. Even when incorporating Q3 data for peers, which is not yet available, our relative performance will still be well in excess of their TBV growth. I'll now turn the call back to Ken.

Ken Vecchione (CEO)

Thanks, Dale. Following our Q3 results, we update our 2024 and Q4 guidance as follows: We expect loan growth of approximately $1.25 billion next quarter to be achieved in a safe, sound, and thoughtful manner. Our current 78% HFI loan to deposit ratio provides ample flexibility to selectively originate attractive loans. Deposits are expected to temporarily decline $2 billion in Q4 due to typical seasonal outflows of property tax and insurance payments in mortgage warehouse, and active management of our deposit mix to maximize deposit betas and lower the cost of interest bearing and ECR-related deposit costs. Turning to capital, we reiterate that our CET1 ratio will remain at 11% as loan growth continues. Net interest income is expected to decline approximately 3% next quarter due to market tied variable loans repricing slightly ahead of funding costs.

This dynamic is a function of the transitional period to a lower rate environment that got underway in Q3. However, ECR-related deposit costs are expected to significantly decline by approximately 25% quarter-over-quarter in Q4 and outpace a decline in net interest income. We expect net interest margin incorporating ECR costs to have bottomed in Q3 and to experience continued expansion into future periods. Non-interest income should increase around 8%-12% next quarter from traction in cultivating commercial banking fee opportunities and firming mortgage banking income. Non-interest expense should decline between 5% and 9%, mostly from the expected drop in ECR-related deposit costs, given the pivot in the rate environment and the typical Q4 seasonal factors previously discussed. Asset quality remains in line with our expectations.

We expect steady net charge-offs in Q4 in the 20 basis point area, which implies full year 2024 net charge-offs should be no greater than 20 basis points. We believe this will still rank among the best of our peers. Lastly, the effective tax rate for full year 2024 is now estimated to fall between 20% and 22%. At this time, Dale, Tim, and I look forward to answering your questions.

Operator (participant)

Thank you. As a reminder, if you would like to ask a question today, please do so now by pressing star followed by the number one on your telephone keypad. If you change your mind or you feel like your question has already been answered, you can press star and then two to remove yourself from the queue. Our first question today comes from the line of Ebrahim Poonawala with Bank of America. Please go ahead.

Ebrahim Poonawala (Managing Director)

Hey, good morning, so I guess, first question around deposits. Trying to understand, so we've—I'm assuming you were aware of the seasonality last quarter when you raised the deposit guidance for the year. So I'm just trying to understand, if you can give us a little color on the settlement, that impact, and, how pronounced is the seasonality versus just some of these chunkier outflows? And are there more such deposits that could leave the bank that could have some meaningful impact on near-term NII trajectory? Just if you can address NII both in terms of larger outflows, and then how impactful is the full Q seasonality? Because I'm not sure it was that prevalent in the fourth quarter of last year. Thanks.

Ken Vecchione (CEO)

Yeah, thank you. I think you've confused a few things, so let me straighten that out. Number one, in Q3, we did see a very large settlement out of our Juris Banking group that was a little bit earlier than our expectations. We had expected it to happen in 2025. The settlement moved up earlier. Always hard to forecast when those things are going to happen, dependent on the court system, and it depends on lawyers agreeing to what the settlement terms are. So that came out. And so absent that, we would have grown deposits in Q3 by $5 billion. So we actually grew deposits $2 billion.

We paid down $200 million of broker deposits, and that got us to the net growth of $1.8 billion. In Q4, that's when you'll see the seasonal decline of Warehouse Lending group, which we always have in terms of deposits flowing out for escrow, insurance, and P&I payments that happen at the end of the year. And that's why we've said that outflow will push Q4's deposit levels down $2 billion. However, our balance sheet deposit growth, or I'll say our balance sheet growth all in as you move forward into 2025, certainly for deposits, remains unchanged which is we expect to have $2 billion per quarter, on average, $2 billion per quarter of deposit growth. We have a good line of sight into that.

We've got clarity into that because of the number of homegrown deposit platforms that we have built over the years, starting with our granddaddy, which is the HOA business. Also, our warehouse lending group has a very strong deposit business, and we added Business Escrow Services in the last two years, Settlement Services, sometimes known as Juris Banking, and our consumer digital platform as well, and also Corporate Trust. So these are all homegrown deposit businesses that a couple of years ago really never existed inside of our bank and now are beginning to perform admirably. In addition, we've got good deposit growth that comes from our commercial lines of business, or previously known as our as the regional business. So that's sort of the deposits.

Just on balance sheet, I'll just say, and we also expect as we move forward into 2025 to see deposit on loan growth average $1 billion or so per quarter. And we're running a very much lower deposit loan-to-deposit ratio. So if we have the opportunity to put on, as we say, good, safe, and thoughtful loan growth, we have the liquidity to do that, and we could increase our loan growth throughout the year. Dale, some of these businesses report to you. You want to add any comments?

Dale Gibbons (CFO)

Yeah, no, I think that's pretty fulsome, Ken, but maybe in addition. Yeah, so we see that we have the liquidity that we need to be able to proceed, and as such, you know, pushing up our loan-to-deposit ratio, you know, into the eighties from below eighty presently on an HFI basis, we should be able to do that. And there isn't anything like this, Ibrahim, on the balance sheet sale. I mean, this was our largest depositor in the whole bank, and so there isn't maybe follow-through, you know, coming in Q4, Q1 or whatever.

Ken Vecchione (CEO)

Yeah, Ebrahim, I think we might have left out one of the last pieces of your question. You asked, did I hear correctly, sort of directionally, what's going to happen with net interest income? Was that one of your questions as well?

Ebrahim Poonawala (Managing Director)

It was going to be my follow-up. So yes, please, I think we've given the guidance. Just talk to us how that goes, NII plus ECR, deposit cost, with or without rate cuts.

Ken Vecchione (CEO)

I kind of feel like I asked your question for you. I might as well answer it. All right,

Ebrahim Poonawala (Managing Director)

And I appreciate it.

Ken Vecchione (CEO)

So as we look forward, first, our rate look is for two more cuts this year, November and December, and then we have four scheduled for next year at the end of each quarter is the way we've forecasted it. All right? So what you'll see overall when you look at our balance sheet, inclusive of deposit costs, we are liability sensitive. So our adjusted net interest margin, that's net interest margin less deposit costs, will rise in Q4 and will continue to rise throughout 2025. And net interest income, less deposit costs, okay? Those dollars will continue to rise steadily in 2024 in the Q4, and then as you roll forward into 2025. For the obvious reasons, deposit costs are declining, okay?

So that helps, plus the balance sheet growth is going to still remain robust, and you'll get some volume pickup in that as well for the net interest income, less deposit costs growing throughout 2025 from 2024. And actually, Q4 2024 should be higher than Q3 twenty 2024 as well, if I wasn't clear enough on that. Okay?

Ebrahim Poonawala (Managing Director)

Okay. All very clear. I'll let Jon ask you whether or not you can earn $9 plus next year. Thanks for taking my questions.

Operator (participant)

Our next question comes from Chris McGratty with KBW. Chris, please go ahead.

Chris McGratty (Managing Director)

Hey, good morning. Dale, I was wondering if you could help or Ken, on the outlook for non-interest income for the fourth quarter. I know this quarter had a MSR adjustment, but maybe unpack the 8%-12% growth in fees for Q4, because some of the line items moved around a little bit. Thanks.

Dale Gibbons (CFO)

Yeah. So I mean, the MSR piece, you know, I mean, a lot of that was really related to the turn in rates. So we saw a 50% increase in constant prepayment rates on our mortgage book, just at the initiation of kind of lower mortgage rates, which is to a significant degree, kind of, you know, backtracked presently. You know, we don't see that happening again, but maybe there was a little more pent-up behavior than we thought. And, you know, so the result of that is the value of that asset fell more than what the gain we had on what we'd put against it to hold the valuation constant. And then going forward, you know, we talked about a couple of things.

So, one of them is, you know, we did a BOLI transaction. That's going to continue, that's, you know, and that will, those new revenues will be consistent there. You can see what we have in terms of, you know, kind of service charges. You know, it's, it was up from the second quarter. We think that number is also consistent. We had some securities gains. We do have some other collateralized deposits, not nearly of the magnitude that we talked about with the one that, you know, that went into distribution in the third quarter. So I think we're probably going to have some more security gains, too, as we sell off the collateral related to those. All of that really actually improves our liquidity, because when you have a collateralized deposit, you really can't do anything else with it.

As these things, as we're able to move that and substitute different deposit situations for that, it gives us an opportunity to really push into, you know, higher return assets than the, than what it's in presently.

Chris McGratty (Managing Director)

Okay, and then just, I guess my follow-up, the securities gains you mentioned, is that in the guide, and I guess the similar magnitude?

Dale Gibbons (CFO)

It would be in the guide for a smaller magnitude than what we had in the third quarter.

Chris McGratty (Managing Director)

Okay.

Operator (participant)

Our next question comes from Jared Shaw with Barclays. Jared, please go ahead.

Jared Shaw (Managing Director)

Hi, good morning. Yeah, maybe looking at the loan growth that you referenced, especially on the C&I side, where are you seeing opportunities for that? And maybe if you could just give us a little bit of early look at 2025 in terms of sort of the pipelines and the expectation for the sustainability of that growth.

Ken Vecchione (CEO)

Yeah. So, so as I said, this quarter, we grew $900 million. That's about 7% annualized to total loans of about $53.3 billion. It really came from three or four segments of our portfolio. The regional group grew all in about $300 million. Warehouse lending grew almost $400 million. Some leverage finance and some resort financing, when you combine those together, grew another $300 million. So it was almost three, or three, four, and three, that got us to nearly a billion dollars of loan growth for this quarter. So as we look going forward, we see a couple of areas that give us confidence to continue to restate and reiterate the guide of $1 billion in quarterly loan growth.

First, our note financing, MSR lending. Our warehouse lending group businesses are showing good pipelines. And we like this type of financing because they're generally shorter duration loans, good risk reward, and they also allow us to evaluate credit decisions and collateral on a continuous basis, which goes to, you know, our allowance for loan loss reserves, and it goes to our lower credit losses that we have. That this is good collateral, but also, we've never taken a loss in any of those categories since we've been in these businesses.

Then, I would say lot banking, resort financing, and our regional commercial lending provides the additional value or added value of growing our loans, but also provides loan growth that comes along with more treasury management fee income, and also allows us to gather lower cost operating accounts. And so that's another area that we like. Overall, if you look at our performance year to date, we really have focused more on the C&I side, and you see our total growth for the year has been all on C&I, and we've downplayed construction lending and development, and we've also kept our CRE owner-occupied flat as well, and that hasn't grown. And we've also taken down our residential loans, which carry a lower yield to it.

So, we'll have some opportunity to put some, when we put new loans on the books, to have them come in at a higher yield. So I hope that kind of gives you a sense of how we're thinking about 2025 and what we're doing to prepare for it.

Jared Shaw (Managing Director)

Okay, that's good. Thanks. And then just as my follow-up, you know, looking at capital with the 11%, sort of, you know, I won't call it target, but, you know, calling out 11%, we're above that. Should we expect you to continue to grow CET1 from this 11.2, or would there be other capital management alternatives that you'd utilize here?

Ken Vecchione (CEO)

Yeah. Yeah, I understand the question. So, for our forecasting for 2025, we are assuming CET1 stays at or above 11% and stays there modestly above 11%. Because, you know, we think there's going to be or there could be more loan growth coming our way than $1 billion per quarter. And we want to have that CET1 dry powder to support that. And that's sort of our going-in program. In addition, as we get bigger, okay, I know we're $80 billion, and our total assets came down a little bit from Q2 to Q3. But as we get bigger, and we get closer to the category four bank comparisons, which we do today, we look at other measurements of where adjusted CET1 is.

That's CET1 less the AOCI, plus the allowance for loan loss reserves. And we want to target being in that upper quartile that Dale discussed in his prepared remarks. And so we're looking at that as well as a way to guide us as we continue to grow.

Operator (participant)

Our next question comes from Matthew Clark with Piper Sandler. Matthew, please go ahead.

Matthew Clark (Managing Director)

Hey, good morning, everyone. Thank you. First question around the ECR-related cost. Given the volume and rate dynamic going forward, and assuming either your rate assumptions that you laid out earlier or the forward curve, what is a good range of expectations for customer service cost dollars in 2025?

Dale Gibbons (CFO)

The reason why it's been increasing is really related to it's become skewed more toward the Mortgage Warehouse, which has about 100% beta. So we expect that to unwind in a similar fashion as it came in. Hence, you know, Ken's comment that we believe we're going to see, you know, a 25% reduction in these ECR costs in the fourth quarter relative to the third quarter, and that should continue as we go into next year. Again, you know, we've had a scenario whereby our HOA deposits have consistently risen year in, year out. We expect that to continue, while the growth in our Mortgage Warehouse is going to be tempered.

You're going to see an outflow primarily related to insurance payments that are made in the fourth quarter, and that's what's going to pull the total deposit number down, but it's also going to be an area of less focus for us kind of going forward in terms of growth, so in other words, we're going to have an opportunity to be able to lower those costs, you know, kind of in lockstep to FOMC action and in fact, in some cases, above 100%.

Ken Vecchione (CEO)

Yeah. And then, to answer, because you asked a dollar question, they, Dale gave you a percentage answer, but, you know, that 25%-ish for Q4 is about a $40 million decline.

Dale Gibbons (CFO)

$50 million.

Ken Vecchione (CEO)

$50 million. I'm sorry. My bad. $50 million dollar decline from Q2 to Q3. All right? Just remember, Q2 to Q3. Sorry, Q3. I'm sorry, Q3 to Q4, I meant to say. It's about $50 million dollars. And remember, you got that 50 basis point bang that came out of Q3. So don't model that as $50 million per quarter, but model it as rates coming down in a very methodical way.

Matthew Clark (Managing Director)

Okay, so it sounds like it's more rate-driven, not volume-driven kind of, and then just on your kind of a blended question around loan yields. I know SOFR came down ahead of the Fed cuts, and I'm sure that hurt a little bit. It also looked like your loan fees came down to 15 basis points from 24 basis points in the prior quarter, and they had been running around that level for a few quarters. I guess, just what happened there, and then how do we think about the overall NIM in the near term?

Dale Gibbons (CFO)

Yeah, I think the low fee number is really. I mean, you should go with the kind of the current run rates that we had in that period. You know, in terms of the NIM, I mean, we you know, we mentioned in our in our slide that you know, that on a net interest income basis alone, we're expecting to see a contraction in the fourth quarter, but that will be more than made up for. So as Ken talked about earlier, we're looking for a combined NIM, including the ECRs, which you know, as we expect that the low watermark was actually in the third quarter of 2024 and will increase in each successive quarter through next year.

Operator (participant)

The next question comes from the line of Bernard von Gizycki with Deutsche Bank. Bernard, please go ahead.

Bernard Von Gizycki (Equity Research Analyst)

Hey, guys. Good morning. Just on mortgage, you know, you previously obviously guided to 3Q being seasonally weaker, with the loan production volumes were up nicely versus 2Q, while the gain on sale margins declined, and obviously you called out the negative MSR mark. Could you just talk to the puts and takes on how high demand maybe needs to pick up to see a pickup in the gain on sale margins?

Ken Vecchione (CEO)

You know, that is something that is a little difficult to handicap, to be very honest with you. You know, coming into the quarter, mortgage rates at the end of Q2 were up around seven, right? And they declined during the quarter to about, you know, 6.05, and today they're in the 6.50 area. And so, for us to handicap that, that's been a little bit of a struggle. It's based on consumer behavior of cost, and it's also based on consumer timing, i.e., if you know there are a couple other rate cuts coming at you, would you go out today and buy a home when you know rates are coming?

And so what we say in the mortgage business is, at least what we have been saying, is people love their mortgage rate, they hate their home. And now we're trying to see if people want to find a new home and just rent their mortgage rate and then refi as they go forward.

Bernard Von Gizycki (Equity Research Analyst)

Okay. And then, just as we think about maybe mortgage more broadly, and just the dynamics like you mentioned with, mortgage rates coming down closer to six and then, backing up. You know, what really gets mortgage for you guys? I think in the past you've said maybe like the three, four rate cuts kind of help and, you know, maybe a low 6% is really what's meaningful, to increase, production. But just kind of wanted to get your thoughts like, you know, maybe the 6.5 hopefully comes down again, but, you know, it is based on, some of the pull forward of the, the rate cut expectations.

Just want to get your thoughts on maybe a mortgage rate level that you think the production volumes kind of pick up and revenues follow?

Ken Vecchione (CEO)

Yeah, I think if you start beginning to see a repeat of the early part of Q3, where rates coming down into the low sixes, that begins to pick up the volume. You then begin to gather some speed once you break the six barrier. The six barrier is the equivalent of the, for those that remember, the four-minute-- breaking the four-minute mile, okay? And once you break that four-minute mile of under six and have a five handle to begin with, then, we really think if the sweet spot is somewhere in that 550 to 575, that's, that's, you know, record. That, that's great opportunities for us, okay? And that's sort of how we think.

So we need to break the six barrier, and then, as it drops into that 550 area, that's when we think there's a lot more volume coming our way.

Dale Gibbons (CFO)

I might say a more tempered rate decline, we actually think works in our favor. And that is, if things fall really, really suddenly, I think it's going to, you know, maybe have almost a rush of refinance that may not last as much. And part of the reason why mortgage rates are elevated relative to the 10-year is we believe it's, you know, it's simply because there's an expectation that if you refi right now, you're going to refi again in six months, and it's not going to be worth all the processing costs to get that done. And so if that view were to dissipate a little bit, and frankly, I'm pleased that the number of expectations of rate cuts for 2025 has actually been cut a little bit in the futures market, at least.

That really makes it more sustainable over time, and with that, we think we can maybe see a reduction in the disparity between mortgage rates and the 10-year, you know, 10-year Treasury, for example, from what it's been historically.

Operator (participant)

The next question comes from the line of Timur Braziler with Wells Fargo. Timur, please go ahead.

Timur Braziler (Director)

Hi, good morning. I wanted to just get some clarity on the expectation for 4Q to be the NII trough. Is the expectation that 1Q, maybe you get some additional margin compression from the asset-sensitive balance sheet, and then volume makes it up, or should 4Q be the trough for NIM compression as well?

Dale Gibbons (CFO)

Yeah, I believe 4Q is going to be the trough as well on the NIM side.

Timur Braziler (Director)

Yes.Okay, and then just to maybe to put a finer point on Bernie's question. So for the earnings at risk analysis, I guess, what are you assuming for mortgage rates and kind of mortgage revenues within that earnings at risk analysis?

Dale Gibbons (CFO)

Yeah, so, I mean, that we would tail into maybe something that ticks into a five by the end of next year. A five handle, high five.

Timur Braziler (Director)

Great. And then just last thing for me.

Ken Vecchione (CEO)

I just want to add up.

Timur Braziler (Director)

Just Sure.

Ken Vecchione (CEO)

Sorry, I just wanted to add a point to Dale's comments when talking about NIM. He was referencing the adjusted NIM. Okay? And so that when you think about it, that's the way I think about it, is that adjusted NIM, which is net, you know, net interest income less the deposit cost. That is all going to flow upward or move upward throughout the year. Okay? I just want to make that a little clarification. Sorry, I didn't mean to interrupt.

Timur Braziler (Director)

No, I appreciate that clarification. Thank you. And then just lastly, for me, just thinking about HQLA deposits in a rate down environment, I'm assuming just that the short-term nature there is going to be a little bit punitive to NII. Just how are you thinking about HQLA levels growing, maybe commensurate with the asset base or asset growth, and then what that might look like from a rate perspective?

Dale Gibbons (CFO)

Yeah, so we think we're, you know, we're kind of intact in terms of where we are on what we have in HQLA presently. You know, that number kind of came down a little bit, because we've, you know, disposed of some of these deposits that were collateralized, all with HQLA category. So from here, again, you know, it gives us latitude to grow our loan, our loans, commensurate with the growth rate we're going to show in deposits. And so, you know, as Ken mentioned, you know, so if we're going to grow deposits, you know, 2 billion on average, and that means that includes, like, the fourth quarter decline that's already built into higher growth earlier in those quarters.

And then if you can grow at, you know, 75%-80%, you're going to have, you know, $6 billion of deposit growth, you know, in that, you know, of loan growth, to match that. And then the rest of it is going to fall into other categories like HQLA.

Operator (participant)

Our next question comes from the line of Anthony Elian with JPMorgan. Please go ahead, Anthony.

Anthony Elian (Equity Research)

Hi, everyone. Does your 4Q deposit guide of down $2 billion include any additional pay downs of broker deposits, or is the decline really coming from the seasonality of warehouse?

Dale Gibbons (CFO)

It's really seasonality of warehouse. We expect our broker deposits to be fairly flat.

Anthony Elian (Equity Research)

Got it. Okay, and then my follow-up also on deposits. I understand the warehouse is going to seasonally outflow in 4Q, but I guess, are there not enough deposit opportunities from other areas of the company to be able to offset that seasonal headwind for this quarter specifically? Thank you.

Dale Gibbons (CFO)

So, the other areas, the other deposit channels do in fact negate some of that outflow that you're seeing, but the warehouse lending group is a larger contributor to deposit growth. And so, the other thing that's happening, and I really should emphasize this, is that in the warehouse lending group or the industry, we've had several competitors either leave the industry or retreat from it in a significant way. And we are just seeing more inflow than we would normally have expected. And that inflow came in Q3 and will kind of reverse out in Q4. So that's why it's harder to have the other deposit channels cover that larger inflow for us in Q4.

But after these deposits go on a hiatus, as we call them, they do come back starting in Q1, and will help us with our liquidity as we roll forward, throughout 2025.

Operator (participant)

The next question comes from the line of Gary Tenner with D.A. Davidson. Gary, please go ahead.

Gary Tenner (Managing Director and Senior Research Analyst)

Thanks. Good morning. I appreciate the forward thoughts on the combined NII and ECR costs. I just wonder if you'd be willing to, you know, put a finer point on just the GAAP NII outlook. Obviously, the fourth quarter is a lower guide. Based on your rate forecast for next year, kind of the 25 basis points per quarter, how deep into the year would you think it would be until you could turn dollars of GAAP NII from a bottom?

Dale Gibbons (CFO)

You know, at this point, I think we've given more clarity around 2025 and what we expect than any other conference call that I've read about so far. And we're going to leave it here. As we announce our Q4 earnings, we'll get into more detail on what that 2025 full year is going to look like. But I think we've given plenty of guidance here on how to kind of construct what to expect in 2025.

Gary Tenner (Managing Director and Senior Research Analyst)

All right. Thank you.

Operator (participant)

The next question comes from the line of Samuel Varga with UBS. Please go ahead, Samuel.

Samuel Varga (Associate Analyst)

Good morning. Dale, I just wanted to touch on the ECR rates again. I wanted to get your sense for if- let's say if Fed funds normalizes around the 3% that a lot of people are pegging, what would be the floor on ECR rates? I understand that the, you know, the beta, at least initially, is expected to be, you know, near 100%, but how- at what point does it just level off and not move lower?

Dale Gibbons (CFO)

You know, I mean, if you look to kind of where we were before, when rates were even lower than that during the pandemic, you know, our ECRs, you know, mostly bottomed out around 40 basis points. So there's still a lot of room to continue to push things down. And frankly, I mean, it's, you know, it's all about, you know, what's the alternative, you know, and money for money in these, you know? So it's like, okay, so they have these funds, you know, is some other financial institution going to be paying more than what, you know, if a 3% number in your example, are they going to be paying, you know, 3.50, 3.60? I doubt it, because that generally means that funds are available elsewhere.

So we have these diversified funding sources so that we've got all these channels so that we can meet, you know, kind of the credit demand that we have. So I don't see that there is a number there that, you know, that we're going to really, it's going to really get sticky in terms of pushing things lower, as they were much lower before. And there are alternatives, you know, not just for, but there are alternatives for us, you know, if, you know, we can go to other sectors as well and look for funds. So I mean, they're not going to move that far away from what the market rate for money is in terms of how low it can go.

Samuel Varga (Associate Analyst)

Got it. Thank you for that. And then just my follow-up on the earnings at risk. Can you give us a sense. Obviously, it's hard for us to know exactly what you're assuming on mortgage, but can you give us a sense for, I guess, what helps more in offsetting the NII compression? Is it the ECR rates or the mortgage benefit from AmeriHome on the fee income side?

Dale Gibbons (CFO)

What, what offsets the mortgage income on the fee income side? Well, you know, I mean, so I mean, they have funds that come from, you know, kind of their origination of mortgage servicing rights. So they manufacture these, and depending on what that estimated value is, kind of determines what the gain on sale is, and then we have the servicing rights that we, you know, value and amortize down. So that's why I look at them more in concert rather than, you know, kind of a singular element.

I think it was more important in the third quarter, where they were more, I'll say, bifurcated in terms of the response, and that was really related to this 50% increase we had in constant prepayment rates that took place in August, that was in excess of, I think, what most models would've captured.

Operator (participant)

The next question comes from Chris McGratty with KBW. Please go ahead, Chris.

Chris McGratty (Managing Director)

Oh, great. Thanks for the follow-up. Dale, long, longer-term question about ROE potential in a down rate environment. How are you thinking about ROE over the next couple of years?

Dale Gibbons (CFO)

Yeah, so I don't, we don't think that our ROE potential is really that dependent upon the rate environment. That is, you know, we're, you know, based on the balance sheet that we have, the capital that we need, the spreads that we can obtain, that we can continue to efficiently manage the organization. We know our costs have, you know, come up, you know, for the past, you know, couple of years or so, but we believe we're going to get back to an efficiency ratio that begins with a four instead of a five on an adjusted basis, i.e., with the, you know, deposit costs netted against interest income. And so that should leave us with a ROTCE, you know, in the upper teens. And we believe we're on our way to get there.

That's where, you know, and frankly, that's kind of where we're headed. We're not going to get back to the twenties that we were at before because our leverage is lower with our higher CET1 ratio.

Chris McGratty (Managing Director)

Understood. Thanks a lot, Dale.

Operator (participant)

Our next question comes from Jon Arfstrom with RBC. Jon, please go ahead.

Jon Arfstrom (Managing Director)

Hey, thanks. Good morning.

Ken Vecchione (CEO)

Good morning, John.

Jon Arfstrom (Managing Director)

Ebrahim, Ebrahim set me up, I guess, but, Ken, I hear you on your 2025 thoughts. Are you more optimistic on 2025 with the recent rate cuts and the current rate outlook? Is this good for the company, generally?

Ken Vecchione (CEO)

Yeah. Yeah, I am. I'm you know my optimism comes first from the balance sheet. All right? And I you know we've given that guide of $1 billion for loans and $2 billion on average for deposits right? And we've been giving that guide for boy it seems like a couple of years now that we continue to do that. And I think we have these credit origination platforms that work well and over the years we've added the deposit platforms. And so my confidence is in. I feel very strongly about the guide that we can achieve the balance sheet.

The overall liability sensitive nature of the bank, I think within a falling rate environment, as Dale talked about, and we're talking about this on an adjusted net interest income basis, inclusive of deposit costs. You know, with rate cuts coming at us, we see that getting better, and so that gives me some confidence as well. Asset quality, as we see it today, is stable, knock on wood, and so, yeah, I always believe next year is always going to be both more difficult than the previous year, but I always tend to have a higher level of confidence that we can get there.

Jon Arfstrom (Managing Director)

Yeah. Okay. You guys use the word transitional a lot, and I understand that. It feels like this was kind of an unusual quarter for you, and I hear you on transitional, but do you have, like, a non-GAAP core EPS number in your mind for the quarter? I mean, I think you've got MSR, BOLI, I don't know, gains, lower gain on sale, ECR pressure. There's a lot going on. And I guess it'd be helpful if you have some kind of a shot at, like, a repeatable, sustainable quarterly EPS run rate in your mind, just because there was a lot, I think, a lot going on here.

Ken Vecchione (CEO)

Yeah, I think that's a fair question. You know, we kind of get to $1.80, which is what was reported. The decline from the mortgage business was offset by gains from the collateralized deposits that the securities helped collateralize deposits, and those two things kind of equal out for us, and as we don't think we're going to see that MSR valuation decline in Q4, and as Dale said, you know, we have other collateralized deposits and settlements that are rolling off, where we have gains in Q4, that I think it was Chris who asked the question that we think it's captured in the run rate.

Operator (participant)

Our next question comes from the line of Brandon King with Truist. Brandon, please go ahead.

Brandon King (Managing Director and Equity Research Analyst)

Hey, just one for me on core expenses. Stripping out, you know, ECR deposit costs, looks like the core growth run rate was around, you know, 5% in the quarter. And taking your commentary on deposit costs next quarter seems like another step higher, 4%. So that 5% to 4% quarterly run rate of growth, is that something we should expect over the foreseeable future? Or no anything temporary within that, core expense run rate over the next few quarters?

Ken Vecchione (CEO)

So the way I'd come at it is I think about it as the Adjusted Efficiency Ratio as we come out of Q4 through 2025, which excludes deposit fees. And we think over the course of the year that will get at or near, you know, 50% by the end of 2025. So we see the Adjusted Efficiency Ratio declining through 2025.

Brandon King (Managing Director and Equity Research Analyst)

Okay. And within that, any sort of commentary on, as far as, the infrastructure build as you continue to go towards being a category four thing?

Ken Vecchione (CEO)

No, that's embedded in there. That's embedded in there.

Operator (participant)

Those are all the questions we have, and so I'll turn the call back to Ken Vecchione for any closing remarks.

Ken Vecchione (CEO)

Thank you all for attending the call. We look forward to talking to you in January about our Q4 results. So thanks again.

Operator (participant)

Thank you, everyone, for joining us today. This concludes our call, and you may now disconnect your line.