Earnings Transcript for PACW - Q2 Fiscal Year 2022

Operator: Good day and welcome to the PacWest Bancorp Second Quarter Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Mr. Bill Black. Please go ahead, sir.

Bill Black: Thank you. Good morning and welcome to PacWest second quarter 2022 earnings conference call. Investors have been eager for us to do a call for some time and we're excited to add this to our ongoing Investor Relations activities. With me and speaking today will be CEO, Matt Wagner; CFO, Bart Olson; COO and Leader of our Venture Banking business, Mark Yung; and our newly appointed President, Paul Taylor. Before I hand the call over to Matt, please note that we may make forward-looking statements during today's call that are subject to risks, uncertainties and assumptions. For more complete discussion of the risks and uncertainties that could cause actual results to differ materially from any forward-looking statements, see other companies SEC filings, including 8-K filed yesterday afternoon, which is available on the company's website. I'd now like to turn the call over to Matt.

Matt Wagner: Thank you, Bill and good morning, everybody. I just wanted to make one comment before we get into the results for the second quarter, I'd like to welcome Paul Taylor to the PacWest team. Of course, Paul has been on the board since May of 2021. So he's not new to the PacWest story. As announced on June 13, Paul joined PacWest as President, and will succeed me as CEO upon my previously announced planned retirement at the end of 2023. Paul and I have known each other for many years. And many of you probably know Paul from his days as CEO of Guaranty Bancorp here in Denver from 2011 to 2018 and at Opus Bank from 2019 to 2020. We're very excited to have completed the search for my successor earlier than planned. And I look forward to working closely with Paul during the transition over the next 18 months. Paul, would you like to say a few words?

Paul Taylor: Thanks, Matt and good morning, everyone. Like Matt, I'm very excited about the new opportunity. My time on the board has provided me with the opportunity to get to know both the board and the management team, which has allowed me to hit the ground running. I'm looking forward to building on the success of the company and leading it into the future.

Matt Wagner: Thanks, Paul. With that, let me turn it back over to Bill for a summary of the key highlights for the second quarter.

Bill Black: Thanks, Matt. We continue to focus on two strategic priorities, optimizing the balance sheet through re-mixing earning assets and rebuilding our capital ratios. The second quarter was marked by exceptional loan growth, which has been a combination of our colleagues' hard work over the last 12 to 18 months. That growth has had four material impacts on our second quarter. First and foremost, the loan growth help drive the $15 million of net interest income growth quarter-to-quarter. Second, the $2 billion increase in unfunded commitments led to a loan loss provision for the first time since the fourth quarter of 2020. Third, expenses were elevated due to higher bonus accruals and commissions as well as higher loan-related expenses. These items accounted for about $7 million of the Q-to-Q increase. Finally, the strong loan growth was a factor in upsizing our preferred capital rates. The second quarter saw an incredibly volatile rate environment and significantly more economic uncertainty, which has caused us to tap the brakes with the expectation of slower loan growth in the second half of the year. We expect the higher interest rates to benefit our earnings over time, and will start to show up in the second half of 2022. We saw continued deposit headwinds in our venture business with deposit outflows of $1.9 billion in the quarter, which was offset by increases in wholesale deposits. Our credit quality metrics remain near historic lows with net recoveries in the second quarter. We added to the ACL to be prepared for whatever the economic environment and greater uncertainty deliver. We strengthened our capital position with the $513 million preferred equity raise advancing our capital plan. We will continue to grow our capital ratios from here with increasing profitability and slower balance sheet growth. And with that, I'd like to hand it over to Bart for some specific commentary on the financial results before we go into Q&A.

Bart Olson: Thanks, Bill, and good morning, everyone. Hopefully you've all had a chance to review the press release and the earnings release deck. So I thought I'd just touch on a couple items before we go into the Q&A portion of the call. As Bill mentioned, we booked a provision for credit losses of $11.5 million in the second quarter, $10 million related to loans and $1.5 million related to our held-to-maturity investment portfolio which I'll talk about in a few minutes. The loan loss provision was due primarily to the significant increase in unfunded commitments of $2 billion. The ACL remains a robust 1.07%, down slightly from the 1.12% as of the end of the first quarter, and above our CECL adoption date ACL of 97 basis points. Looking at non-interest income, there was really nothing unusual here in the second quarter, warrant income was $1.6 million in line with the historical quarterly averages when excluding the significant record gains from the fourth quarter of 2020 to the fourth quarter of 2021. Non-interest expenses were higher than the prior quarter. But keep in mind that the first quarter included $3.4 million in OREO gains and a lower commission expense of $2.4 million related to the significant valuation write-downs of equity investments during Q1. So adjusting for these items, the first quarter non-interest expenses would have been about $173 million compared to the $183 million in the second quarter, or an increase of $10 million. This increase was primarily driven by an increase in compensation expense, including commissions by about $2.5 million, bonus accruals by about $2.5 million, both due to the strong loan growth. The remainder was largely due to a core full quarter of annual merit increases, along with an increase of an FTE 95. The FTE increase was primarily related to Civic, the Community Bank and our digital and innovation strategy. I now want to turn to the balance sheet for a couple of comments and actions taken during the quarter. On June 1, we moved $2.3 billion of available for sale securities held-to-maturity to mitigate the impact on accumulated other comprehensive income for future increases in interest rates. As previously mentioned, at quarter end, we booked $1.5 million provision for credit losses on this HTM portfolio. The OCI related to this portfolio at the time of transfer was about $217 million. During the quarter, we also sold approximately $393 million of investments out of our bond portfolio at a loss of $1.2 million. We used those proceeds and the normal cash from the portfolio to fund loan growth, while not making any significant new bond purchases. As mentioned, venture banking deposits declined $1.9 billion during the quarter for many of the same reasons as they declined in the first quarter. As a reminder, most of our venture banking deposits are related to late-stage companies, which are highly impacted by the capital markets, which again saw virtually no IPO activity during the quarter, and the lowest level of venture investments in three years. This lack of capital market activity is a key driver in the decline in deposit balance. Other contributors to the decline included normal cash burn of the underlying clients, cash used for acquisitions and cash management activities, which could be transfer to a money center bank or transfer to our off balance sheet entity, Pacific Western Asset Management or PWAM. In the second quarter transfers to PWAM were about $500 million. From a capital perspective, the preferred stock offering drove an increase in capital, despite the strong growth in both loans and unfunded commitments, which increased risk weighted assets by $2.7 billion. At quarter-end, this puts our Tier 1 capital at 10.15%, up from 9.07%. And put our total risk based capital at 13.12% up from 12.27%. This increase in capital aligns with our strategy to increase capital and operate at levels more similar to those in the first half of 2021. This concludes our prepared remarks. Operator, could you please open the line for questions?

Operator: Yes sir. Thank you. [Operator Instructions]. And we'll take our first question from Jared Shaw with Wells Fargo Securities.

Jared Shaw: Could you just spend a little time on the outlook for funding growth in deposits, I hear the headwinds on the venture side. And it seems like that's likely to be there for a little while. What other sources could you tap to start to see growth there and would you look to growing, continue to grow brokered to fund loans here?

Bart Olson: Yes, Jared, this is Bart. Yes, we actually saw during the quarter, we did use some wholesale deposits to fund some of the loan growth, wholesale deposits were about $2.9 billion. As we look into the second half of the year, we talked about the slower loan growth that we anticipate but with the deposit outlook, I expect we'll have some further increases in wholesale deposits during the quarter looking ahead.

Jared Shaw: Okay. And then when we look at the deposit base, what's the expectation for beta if we assume 350 Fed funds in some of these changes, should we expect to see an accelerating beta as we go into the end of the year here?

Bart Olson: Yes. The second quarter beta on total deposits was 15%. And I think looking forward, we'd expect that to increase to roughly within the first year, probably north of 22%, then probably move towards 30% if you look out over a two year horizon.

Matt Wagner: Yes, Jared just keep in mind the absolute level of interest costs that are there. So, a beta of X on a very low cost of deposits is not as impactful. It's just the overall thing. And as we're looking at it, we're looking to grow net interest income. And if the beta is X, but your overall cost of deposits is still low, naturally, the foundation of the business, right.

Jared Shaw: Yes, great. Okay, thank you. I'll sit back. And actually, what's the rate that you're paying right now in brokered and on new CDs?

Bart Olson: Yes, the brokered ranges from during the quarter ranks anything from 50 basis points to about 185. And it's up slightly, obviously more recently.

Operator: And we will now take our next question from Andrew Terrell with Stephens.

Andrew Terrell: Maybe just sticking on the kind of core deposit growth outlook. I'm curious if we don't see any kind of improvement in capital markets and kind of private fundraising heading into third quarter versus the second quarter, do you think we could see a similar level of core deposit declines as you saw in 2Q or should have moderated here?

Matt Wagner: Do you want to take it Bill?

Bill Black: No.

Matt Wagner: No, I think we're starting to see it moderating already. But it's pretty hard to predict, Andrew.

Bart Olson: Yes Mark, I don't know if you want to add to that?

Mark Yung: Yes, I mean again, what we've seen here in Q2 even versus Q1 is a continuing reduction and fundraising activity. I mean, I think we've all seen the data at this point coming out of the venture capital community, we are in the low, the summer months as well, that we get part of it here through Q3. So that probably should continue in terms of transaction level that, but we are seeing some deal activity in our portfolio that is encouraging, some larger round sizes for companies that still had plenty of cash on hand. So I think that's an encouraging sign. But to Matt's point, I mean I do think as opposed to Q1, there's a little bit more sensitivity, obviously around yields, we saw a larger movement towards PWAM and example Bart spelled it out, $500 million in the quarter. Obviously, that's something that we're working very closely with our portfolio companies to make sure that they see all of our liquidity products opportunities to obviously keep those monies on balance sheet.

Andrew Terrell: Okay, thank you. And if I can move over, I know when you first closed the Civic deal; we talked about how you were comfortable with the credit quality there. I guess, just given what we've seen, kind of in the real estate market has a comfort level changed at all? And what gives you kind of confidence in the underwriting the business?

Matt Wagner: Well, we've got a track record of performance that we've been buying alone since 2017. And I mean, since inception, we've originated a significant amount of assets and had de-minimis levels of any real issues. We feel good in the underwriting. And we've been able to prove that out, Andrew just from the ins and outs of loans that we've had. So we feel really good about that.

Bart Olson: Yes, Andrew, we've always been aggressive in downgrading loans, where there might be an issue here or there. But it doesn't mean that there's necessarily charge-off implications to that. And I think if you look at the track record over the past two-and-a-half years, you'll see that and I don't see that changing. The underwriting is very strong. Even our venture business, which as you know, lots of those portfolio company loans could be sort of air balls. We've had zero charge-offs literally for the last two-and-a-half years, net charge-offs I should say.

Operator: We'll now take our next question from Brandon King with Truist Securities.

Matt Wagner: Hey, Brandon.

Brandon King: Hi, good morning. Just wanted to touch on the loan broker guidance, it's been smaller loan growth back after a year. I know Civic is surprising expectations as far as your production levels, I just want to know what the present takes are for loan growth in the back half of the year, what categories you are seeing slowing more than others, and kind of where you see figures running there in back half of the year?

Bart Olson: Yes, Brandon, I think you're going to see slowing overall, higher rates, more economic uncertainty. I think you're going to see a natural slowdown at a real high-level. But obviously, we will continue to monitor and really try to optimize the balance sheet. So I think you're going to see slowdowns in general. And I think from here, we will be clearly more selective and I think when you look at putting that together, you'll see that slowdown from the pace, we saw it in the second quarter. Now, what does that mean business by business? I mean, what there's not a prescribed limit but I think you would imagine that, it would be, if you're looking to optimize the balance sheet, you could probably figure out where that is.

Matt Wagner: I mean, we're hearing that from our customers too Brandon. Projects that maybe penciled out at 4.5% interest rates, don't really pencil out a date, or whatever, you might be anticipating rates going to. That in terms of how it relates to construction projects, and then also your supply chain issues and just cost and materials. Rarely have we seen a project that's been completed in the last 12 months that didn't have some cost overruns in one line item or another.

Brandon King: Okay. Got it. And then, I wanted to touch on up taking classified loan. I was wondering if you could provide some color there what the source of that was if there is even notes?

Matt Wagner: Yes, no problem. So yes, you did see a tick up in some of the credit metrics, it was a few credits, where we had some administrative type issues. I think these are things where we feel really good about them. We're very well secured. And we expect those credits to be either remediated or resolved in the coming months or months, month or months. I would tell you that the risk rating downgrades here, I think, are more of an indication of our conservative credit culture more than anything else. As you saw in 2020, we certainly were aggressive in downgrading things, but that didn't lead to losses, and certainly not a sign of a -- of any form of credit deterioration. We feel really good about where credit is, right now.

Brandon King: Okay. So it's very interesting all the time just one-off issues and that's sort of a result of deteriorating macroenvironment?

Matt Wagner: Yes. Yes. And you're going to get a little extra activity from Civic, as you can imagine, as those loans become near completion or whatever, one of the customers could opt not to make payments, make his last couple of payments, because the properties under contract or whatever. We're going to put that loan on special mention for sure. And you can get a handful of those. Again, they're granular, they do get resolved. We've seen -- we haven't had to charge off yet. I don't think we burning up now.

Brandon King: Thanks. And that's my questions.

Operator: We'll now take our next question from Matthew Clark with Piper Sandler.

Matthew Clark: Hey, good morning guys.

Matt Wagner: Hi, Matthew.

Matthew Clark: First one for me, just on the expense outlook. Understand what contributed to the increase in comp this quarter, but can you give us a better sense of where you think the run rate will be in the second half?

Bart Olson: Yes, sure, Matthew, this is Bart. I think it's good to be in that upper 170s, lower 180s. I think if you kind of normalize, like I mentioned in my opening comments. Q1 and Q2, it's been what we talked about during the year thus far, which was starting in the low ones, and working its way up to about 180. And loan growth and the pace of that will affect that. But again, with the loan growth expected to recede a little in the second half of the year, I'd expect some of those expenses to go down. And so I'd say something around the 180ish area.

Matthew Clark: Okay. And then just on the credit risk transfer, any update there in terms of potential timing, just overall plans there?

Bart Olson: Yes. We're still working through that plans are it'd be something in the third quarter. And so that's what I would anticipate at this point.

Matthew Clark: Okay. And then last one for me, just maybe for Paul, you've been on the board for some time now. I know it's still a little early, but it'd be great to get your kind of initial thoughts on, on how you think the, what might change when you formally take over in terms of the way that the banks managed? Thanks.

Paul Taylor: Yes. Good morning. I've known Matt for almost 20 years, and I've known John for the same period of time. And this was a great bank. I mean, this in many respects, is an easy job to take over, because the bank is very well run. I think that it's just -- it's more of the same and then improving various products and pieces where [Technical Difficulty]. Yes, technology is one of the big pushes today. It's a pretty huge project. PacWest has been through a number of acquisitions. And in doing that there's some holes in the technology, and we're working hard to get a much better technology platform for the company.

Operator: [Operator Instructions]. We'll now take a question from Gary Tenner with D.A. Davidson.

Gary Tenner: Thanks guys. Good morning.

Matt Wagner: Good morning.

Gary Tenner: Just thinking about, hey, just thinking about the commentary on optimizing the balance sheet and outlook for some lighter loan growth of the back half of the year. To what degree, do you think you would continue to run down the securities portfolio or cash balances to kind of offset maybe some of the possible deposit headwinds that may still gathered during the back half of the year. You have optimal levels that you'd like to have the mix look like, I guess, is the question?

Bart Olson: Yes, Gary, I think we ended the quarter with cash around 6% of earning assets, investments around 24% of earning assets. I can see the investment portfolio running down a little bit further. So I would see cash staying around that 5%, 6%. And so a little bit on the investment portfolio, you could see.

Gary Tenner: Okay. So as we think about the back half of the year, potentially overall, balance sheet growth is something lower than the amount of net longer it's been on the balance sheet.

Bart Olson: Yes, I think that's fair.

Operator: We'll now move to our next caller, who is Christopher Marinac with Janney Montgomery Scott.

Christopher Marinac: Hey, thanks, good morning. Thanks for hosting the call everyone. I want to dig into the pace of loan growth on some of the other lines, such as lender finance and equity fund loans, and et cetera. Is the pace of their kind of indicative of the macroenvironment and do you think that may be different in the next couple quarters?

Matt Wagner: Mark, do you want to take that?

Mark Yung: Yes, I can speak to that. I mean the pace of lender finance and equity. So let's start with fund finance, right. I mean, there was limited growth in the end of quarter. But that really honestly is more indicative of just one-off funding that can happen on individual transactions given our portfolio construction. As you see, fundraising activity has been very robust, about $120 billion raised in the venture market alone in the first half of the year. And so fund formation continues to be at a relatively healthy clip. Obviously, we're watching very closely. Fundraising is starting to become a little harder, especially for emerging managers. So that's something we're watching carefully. But given that dry powder, I would expect transactional levels to pick up here in the second half of the year, and fund finance to benefit from that. And I'll say lender finances kind of cut from same cloth in the sense that there's still a tremendous amount of dry powder out there $780 billion in the private equity landscape in the U.S. alone, and they're all looking for to deploy that capital. And obviously we provide in lending opportunities that enhance their these private credit fund returns, number one. And number two, we do provide a lot of warehousing facilities that are subject to the securitization market. That hasn't been a little kind of, I would say, intermittent in its activities. And so obviously, we're watching that very closely as for the remainder of the year. There are some securitizations that could happen that could quickly impact lender finance growth as well.

Christopher Marinac: So with higher interest rates do these become better, better spread businesses for you just because we're in this part of the cycle?

Mark Yung: Yes, absolutely. I mean, we're seeing opportunities here to enhance our spreads. It was specially in the lender finance side. I'd say fund finance that business is relatively commoditized. We play within a certain niche, more VC focus there, so we can capture a better yield vis-à-vis our competitors. But in lender finance, yes, we're seeing opportunities here to enhance our spreads and make some better yields in our new originations.

Christopher Marinac: Great. And then I guess one other question for you, Mark, just on the technology build. How much extra expense is out there for the expense run rate? Or is most of that technology built already in today's numbers?

Mark Yung: No. There's obviously some more expenses, as we indicated, Chris, early days, right. And Matt says the best I mean for as much as I love to spend more on technology. Today, it's -- you can't spend it overnight. So we're getting some good traction here in headcount growth and in terms of some of our milestones around technology but there's still obviously, additional investments to be made. I don't know, Bart, what we're indicating to the market here in terms of incremental vis-à-vis run rate.

Bart Olson: Well, I mean, it's, yes, I mean, I think it's in the numbers I talked about earlier. And again, the real change is just the pace of that we obviously highlighted that. We hired at a growth of FTEs of 95 during the quarter. Obviously, some of that is related to the digital technology strategy, and --

Mark Yung: I think about 15 if I remember.

Bart Olson: Yes around 15 so.

Mark Yung: And they're not cheap, necessarily, either.

Bart Olson: Correct. So but that's certainly the plan has more than 15 built into the plan. But it is not easy to hire those people. Obviously, everybody knows it's kind of the market conditions. Right now, it's challenging for certain skillsets. And so we'll continue to work on that initiative.

Mark Yung: And Chris, some of those expenses are going to be subject to capitalization as well, right? Because we're building software with longer shelf life here. So there's that dynamic as well.

Christopher Marinac: Sure. Does it all make sense? And Bart, the additional hires beyond the 15 and tech are those mainly in production stack roles?

Bart Olson: Yes.

Mark Yung: Yes, yes. Within Civic and community banks.

Christopher Marinac: Great. Thanks for all the information this morning.

Matt Wagner: Thanks, Chris.

Operator: [Operator Instructions]. Our next question will come from Chris McGratty with KBW.

Chris McGratty: Maybe Bart, a question for you. I know you guys don't like to talk about margin. Given them this then optics of just balance sheet size. But you mentioned in your prepared remarks, and I was up $15 million this quarter. Just given what you're doing with the balance sheet, and also what the feds doing? Should we think about that quarter-on-quarter growth accelerating from the second quarter levels in the back half of the year?

Bart Olson: Yes, I think so. And if you think about the timing of the different rate hikes, I mean, the last big hike was in mid-June. So what we've said all along, if you're really going to see more of the real benefits from the hikes and growth in net interest income in the second half of the year and into 2023.

Chris McGratty: Have you moved on to it?

Bart Olson: Adding the name as well. We got floors; we had about $6 billion of loans on every floor at the end of the first quarter, that's dropped to $1.9 billion with the rate moves during the quarter. And certainly the next move or two will take the majority of the remaining loans off their floors. So I would expect that by the end of the third quarter. The amount of loans on their quarter is very, very small. So that I would expect that to continue to grow like it has. Net interest income is growing nicely over the last several quarters. And we expect that to accelerate.

Chris McGratty: Great. On the question -- on the comment about slowing growth. You guys have made a huge effort to rebuild the growth profile last couple of years I guess. Do you worry about the messaging and talent loss given how competitive it is right now?

Matt Wagner: No, I don't think so. I mean, we -- did you say talent loss?

Chris McGratty: Yes.

Matt Wagner: I don't think that I'm concerned about that really crisp people seem pretty happy. I mean, people have, they've done such a great job in the first half of the year, they've pretty much made their bonuses which is good, and they got to stick around to get them. I think, we'll be back, I think you're going to see a change. We had this extraordinary deposit growth in 2020 and 2021, really driven by the venture business, but also the community bank had good solid, high single digit growth. And I think you're going to see nature of world that changing. Again, these companies have to raise money, it's going to come into the bank, it won't be at the level that we saw 2020 or 2021. But you're going to see that come back in, and we'll be able to kick certain businesses growth, and I think you're going to see a pullback definitely in construction. I mean, it's just, these projects become less feasible. There's still a great need, as you know, most of our construction lending is multifamily, there's still a great need for the housing out there. I just, I think it's tougher to finance the projects so the numbers don't work as well. So I talking to some of our biggest clients, and Paul and I are going to be meeting with some next week. They're predicting volumes of 50%, of what they did in 2021. And maybe down even as much as another half in 2023. So that's part of it. And that's a big sector of what we do. But I think when lender finance continues to grow, and other businesses continue to grow. And of course, we've had great luck with our guys at Civic.

Chris McGratty: Okay, just last. And thanks for that color, Matt. Just the last one on the tax rate is 25% about rate?

Bart Olson: Yes, I mean, I think, we've talked about a range 25% to 27%. And so I would still say in that range.

Operator: [Operator Instructions]. We'll now take a question from Matthew Clark with Piper Sandler.

Matthew Clark: Hey, just wanted to ask if you had the spot rate on interest bearing deposits at the end of June?

Matt Wagner: Yes, spot rate deposits end of June was 30 basis points.

Matthew Clark: 30, okay. Thank you.

Operator: And it appears there are no further telephone question. I'd like to turn the conference back over to our presenters for any additional or closing remarks.

Matt Wagner: Okay. Thanks, everybody. We appreciate your time and effort and we will talk to you soon. Thank you, Paul for [indiscernible].

Operator: And once again that does conclude today's conference. We thank you all for your participation. You may now disconnect.