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Edited Transcript of CFR earnings conference call or presentation 25-Jul-19 3:00pm GMT

Q2 2019 Cullen/Frost Bankers Inc Earnings Call

SAN ANTONIO Jul 30, 2019 (Thomson StreetEvents) -- Edited Transcript of Cullen/Frost Bankers Inc earnings conference call or presentation Thursday, July 25, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* A. B. Mendez

Cullen/Frost Bankers, Inc. - Director of IR

* Jerry Salinas

Cullen/Frost Bankers, Inc. - Group Executive VP & CFO

* Phillip D. Green

Cullen/Frost Bankers, Inc. - Chairman & CEO

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Conference Call Participants

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* Brady Matthew Gailey

Keefe, Bruyette, & Woods, Inc., Research Division - MD

* Brett D. Rabatin

Piper Jaffray Companies, Research Division - Senior Research Analyst

* Ebrahim Huseini Poonawala

BofA Merrill Lynch, Research Division - Director

* Jennifer Haskew Demba

SunTrust Robinson Humphrey, Inc., Research Division - MD

* Jon Glenn Arfstrom

RBC Capital Markets, LLC, Research Division - Analyst

* Michael Edward Rose

Raymond James & Associates, Inc., Research Division - MD of Equity Research

* Rahul Suresh Patil

Evercore ISI Institutional Equities, Research Division - Analyst

* Steven A. Alexopoulos

JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap & Small-Cap Banks

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by, and welcome to the Cullen/Frost Bank (sic) [Cullen/Frost Bankers] Second Quarter 2019 Earnings Conference Call. (Operator Instructions) It is now my pleasure to turn the floor over to A.B. Mendez, Senior Vice President and Director of Investor Relations, to begin.

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A. B. Mendez, Cullen/Frost Bankers, Inc. - Director of IR [2]

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Thanks, Lorie. This morning's conference call will be led by Phil Green, Chairman and CEO; and Jerry Salinas, Group Executive Vice President and CFO. Before I turn the call over to Phil and Jerry, I need to take a moment to address the Safe Harbor provisions. Some of the remarks made today will constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 as amended. We intend such statements to be covered by the Safe Harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, as amended.

Please see the last page of text in this morning's earnings release for additional information about the risk factors associated with these forward-looking statements. If needed, a copy of the release is available on our website or by calling the Investor Relations department at (210) 220-5234. At this time, I'll turn the call over to Phil.

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [3]

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Thanks, A.B. Good morning, everyone, and thanks for joining us. Today, I'll review second quarter results for Cullen/Frost. And our Chief Financial Officer, Jerry Salinas, will also provide some additional comments and then we're going to open it up for your questions.

In the second quarter, Cullen/Frost earned $109 million -- $109.6 million or $1.72 per share, which represented 2.4% increase compared with $1.68 per share reported in the same quarter last year. Our return on average assets was 1.4% in the second quarter when compared to 1.43% in the second quarter of last year. Average deposits in the second quarter were $26 billion, basically flat compared to the $26.1 billion in the second quarter last year.

Average loans in the second quarter were $14.4 billion -- this represents an increase of 6.2% versus the second quarter last year and growth was broad-based across all categories. Our provision for loan losses was $6.4 million in the second quarter compared to $11 million in first quarter of 2019 and $8.3 million in the second quarter of 2018.

Net charge-offs in the second quarter were $7.8 million compared with $6.8 million in the first quarter, $7.9 million in the second quarter of last year. Second quarter annualized net charge-offs were only 22 basis points of average loans.

Nonperforming assets were down $21 million to 7 point -- $76.4 million in the second quarter compared with $97.4 million in the first quarter of 2019, and $122.8 million in the second quarter of last year. Overall delinquencies for accruing loans at the end of the second quarter were $87.1 million or 60 basis points of period-end loans, and those numbers are well within our standards and comparable to what we've experienced in the past 3 years.

Our overall credit quality remains good. Total problem loans, which we define as risk grade 10 and higher, totaled $457 million, approximately 27% lower compared to the second quarter a year ago. Energy-related problem loans continue to move in the right direction, they totaled $93.6 million at the end of the second quarter compared to $119.3 million for the first quarter and $195.4 million in the second quarter of last year.

Problem energy loans peaked more than 3 years ago and they are at manageable levels at this time. Energy loans in general represented 10.2% of our portfolio at the end of the second quarter and are well below our peak of more than 16% in 2015.

Our focus for commercial loans is on consistent, balanced growth, including the core loan component, while maintaining our quality standards. New relationships increased 6% versus second quarter a year ago. New loan commitments in the second quarter were off by 2% compared to the second quarter last year, but the total remained roughly balanced between core and large deals. Similar to what we have seen in recent quarters, the commercial real estate market has become more transactional compared to C&I.

Of the deals we're losing, in CRE, most were lost to aggressive structures that don't fit our standards. As an example, for year-to-date 2019, we've looked at 4% more C&I deals and we've booked 4% more deals. However, on commercial real estate, we've looked at about 50% more deals and we booked about the same number of deals as last year in dollar terms.

Our weighted current active pipeline in the second quarter was up by about 23% compared with the first quarter due to higher levels on both C&I and CRE. In consumer banking, our value proposition and award-winning service and technology continued to attract customers. The second and third of the 25 new financial centers planned over the next 2 years in the Houston area opened in the second quarter and the pace of openings will accelerate in the third quarter.

Overall, net new customer growth for the second quarter was up by 39% compared with a year ago. Same-store sales increased by 6.9% compared to a year ago. In the second quarter, about 27% of our account openings came from our online channel, which includes our Frost Bank mobile app, that's up from 22% a year ago. It also represents a 24% year-over-year increase in the total number of online openings, so they're growing both in number and in the proportion of overall account openings. The consumer loan portfolio averaged $1.68 billion in the second quarter, increasing by 4.9% compared to the second quarter of this year.

We've been focused on a lot of developments with Frost. With the expansion in Houston region that I mentioned as well as the move to our new corporate headquarters in San Antonio and our ongoing Opt For Optimism initiative, all of which are raising awareness at Frost among prospective customers. I think it's important to pay attention to some of the things that happened at Frost that we might otherwise take for granted like receiving the highest-ranking at customer satisfaction in Texas in J.D. Power's U.S. Retail Banking Satisfaction Survey for the 10th year in a row. That's something no other bank can say. We're receiving more Greenwich Excellence Awards and best brand awards for the small business and middle market banking than any other bank nationwide for the 3rd consecutive year.

We are expanding by opening beautiful new locations and that includes a financial center opening later this year in Victoria, Texas, which is a new market for Frost. At the same time, we continue to make improvements to our top-quality digital services, all while focusing our spending on investments in making our business better and moving forward in a manner consistent with our culture. Those things, together with the people that we put in place to execute our strategy, are Frost's competitive advantage. That has kept Frost growing for more than 150 years now and will keep Frost growing in the years ahead.

Now I'll turn the call over to our Chief Financial Officer, Jerry Salinas, for some additional comments.

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [4]

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Thank you, Phil. I'll make a few comments about the Texas economy before providing some additional information about our financial performance for the quarter, and I'll close with our guidance for full year 2019. Regarding the economy, Texas unemployment hit a new low for the second month in a row in June falling to 3.4% from 3.5% in May and 3.7% at the end of 2018. June's 3.4% level is the lowest level seen in employment statistics going back to 1976. Texas employment grew an annualized 3.9% in June following upwardly revised growth of 2.5% in May. And the Dallas Fed has increased their estimate of full year job growth from 2.3% to 2.5%. Employment growth in June was spread across most sectors and year-to-date Texas employment has expanded at a healthy 2.7% pace.

According to the Dallas Fed surveys, activities in the Texas manufacturing and services sectors accelerated in June, while energy industry activity was flattish from Q1 to Q2 after 3 years of growth. Looking at individual markets. Houston economic growth remains strong with the business cycle index growing 6% over the 3 months ending in May, driven by strong employment data. This represents an acceleration from the 4.8% growth rate seen in Houston in the second half of 2018. Year-to-date, Houston employment is up 3.3%, up from a 2% rate in the 3 months through February. All of the major sectors have increased year-over-year. Houston's unemployment rate held steady in May at a record low at 3.5%. The Dallas business cycle index maintained by the Dallas Fed expanded approximately at 5% annual rate in the second quarter, while the Fort Worth business cycle index expanded at about 2% annual rate.

DFW area unemployment stood at 3.1% in June, just slightly above the 3% range -- rate is seen in May, which was the lowest level since 1999. The Austin economy also remained healthy in May. The Austin business cycle index accelerated to a robust annualized rate of 8.2%, the strongest expansion since November 2015. Austin's unemployment rate declined from 2.6% in April to 2.5% in May. The Austin metro saw a 3.3% annualized gain in jobs during the 3 months ending in May -- growth was broad-based across multiple sectors.

The San Antonio economy expanded at a steady but subdued pace in May. San Antonio's economy expanded at a 3.1% annualized rate in May, slightly above the long-term average of 3%. San Antonio's unemployment rate decreased slightly for the fourth consecutive month to 2.8% in May. The Permian Basin economy continued its robust year-to-date performance. Employment growth has moderated in recent months, but the June unemployment rate of 2.2% remained near historical lows and well below the state figure of 3.4%.

Looking at our net interest margin. Our net interest margin percentage for the second quarter was 3.85%, up 6 basis points from the 3.79% reported last quarter. Factors driving this increase include higher loan volumes and higher rates for loans and securities combined with a lower proportion of earning assets related to balances at the Fed.

The taxable equivalent loan yield for the second quarter was 5.34%, up 1 basis point from the first quarter. Looking at our investment portfolio. The total investment portfolio averaged $13.3 billion during the second quarter, up about $550 million from the first quarter average of $12.8 billion.

The tax equivalent yield on the investment portfolio was 3.42% in the second quarter, up 5 basis points from the first quarter. Our municipal portfolio averaged about $8.2 billion during the second quarter, flat with the first quarter.

During the second quarter, we purchased about $1.1 billion in agency mortgage-backed securities yielding a rate of 3.35%. Additionally, during the quarter, we sold approximately $550 million of treasuries with an average yield of 1.71%. The municipal portfolio had a taxable equivalent yield for the second quarter of 4.06%, up 3 basis points from the previous quarter. At the end of the second quarter, about 2/3 of the municipal portfolio was PSF insured. The duration of the investment portfolio at the end of the quarter was 4.3 years, down slightly from 4.4 years the previous quarter.

Looking at our funding sources. The cost of total deposits for the second quarter was 41 basis points, down 1 basis point from the first quarter. The cost of combined Fed funds purchase and repurchase agreements, which consist primarily of customer repos, decreased to 1.69% for the second quarter from 1.72% in the previous quarter. Those balances averaged about $1.2 billion during the second quarter, up about $62 million from the previous quarter.

Regarding the outlook for 2019. Our current expectations for the interest rate environment for the remainder of 2019 have changed since our previous quarter's guidance. We were previously projecting flat rates for the remainder of 2019. Our revised projections now assume a lower rate environment. We are projecting 2 Fed rate cuts for the remainder of 2019, one cut at the end of July and one cut at the end of October.

Looking at the current range of analyst estimates for 2019, we see a range of $6.84 to $7.02. As a result of the changes in our assumptions related to the interest rate environment for the remainder of 2019, we are most -- more comfortable with the lower end of the current range of analyst estimates.

With that, I'll now turn the call back over to Phil for questions.

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [5]

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Thanks, Jerry. We'll now open up the call for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first us in terms on the line of Rahul Patil of Evercore ISI.

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Rahul Suresh Patil, Evercore ISI Institutional Equities, Research Division - Analyst [2]

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So just loan growth moderated quite a bit this quarter 5% year-over-year; last couple of quarters, it was in the 7% to 8% range, and the last year, it was 10%. Could you discuss the drivers behind this moderation? Is it because of conservative lending by Frost bankers? Or a more function of reduced loan demand in your markets? And then I realized, you've talked about expectations for high single-digit loan growth, could you maybe also give an update on that front?

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [3]

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Okay. Thank you. I think the main thing right now is competition. It's -- the market is still strong. It's moderating a little bit, but I mean there's still plenty of activity out there. And it really has to do a lot with what I pointed out in my comments about structure. And I think real estate is the best example. When you look at 50% more deals, that's $1.5 billion more deals, and then you book about the same amount of deals you did last year that gives you an indication of our ability to participate in some of those things. So I'd say that's one thing. Our consumer growth is down a little bit. It's still positive. I think it's running around 4% year-over-year. So it's a little below what our goals are. A lot of what we're seeing there is just reduced utilization on personal lines of credit. I think we went from like 41% to 38%, and we're also reducing some of the commitments there as we sort of make sure we're doing our work, keeping those things at reasonable levels and keeping an eye on the economy and the future. So -- but I would say, the biggest thing right now is competition, and it's -- the biggest part of that is structure.

For example, the deals we lost year-to-date this year, 62% have been lost due to structure, 38% during price -- 38% for price. We'll -- it's more price competitive as well, but we're more willing to compete on price than we are on structure. And -- so anyway, I'd say that's what is driving these numbers. And as far as what our goals are, high single-digit loan growth and that would be our goal. We're not posting that so far this year, but we are in solid single digits. But given where we are -- I mean, look, you can post any loan number you want as long as you don't care about getting paid back, and -- so we are focused on doing deals that meet with our risk parameters. And it's a little harder to do right now. We'll just have to see how that breaks going forward.

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Rahul Suresh Patil, Evercore ISI Institutional Equities, Research Division - Analyst [4]

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Got it. And then -- so the NIM came in better than what we were expecting, and I believe, last quarter, you indicated that the NIM should be relatively stable in coming quarters -- that was assuming no change in the Fed funds rate. Could you maybe talk about the trajectory and the drivers of the NIM versus the 3.85% this quarter, if the Fed does cut rates, assuming 2 rate cuts this -- in the back half of this year?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [5]

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Yes. You are correct, that's exactly what we did assume. So in this rate environment, I guess what we did was, we reported a 3.85% in the second quarter. As I look out for full year, given the current rate assumption, we're assuming that the NIM would probably closer to a 3.75% for the full year. So obviously that assumes some reduced rate there going forward. And again, we're getting -- even though Fed funds rate hasn't gone down and interest rates haven't gone down, I'm not telling you anything you don't know, but we've continued to see decreases in the yield curve, LIBOR continues to go down. So from our projected standpoint, we don't really know what to expect to be quite honest with you, but we are expecting them to go down.

Going forward, we'll be seeing some good increases in our loan yields. Phil mentioned that from a pricing standpoint, it's still very competitive. So we're going to have pressures there. I think that in today's environment from an investment security standpoint, there's pressure on finding the yields there also. So the drivers' going to have to be our ability to just -- to find a good loan growth with price reasonably, find investment alternatives and be able to manage our deposit costs. You did see that even though the Fed didn't cut current rates, we did have a decrease in our cost of total deposits, saw a decrease in our customer repo cost. So that's just something that we'll continue to look at. We said we're going to be competitive, but we are not afraid to decrease rates if we need to.

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Rahul Suresh Patil, Evercore ISI Institutional Equities, Research Division - Analyst [6]

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All right. That's very helpful. And then maybe if I can just squeeze 1 more in. Last October, when you announced your Houston expansion plans, you had cited $1.5 million of cumulative loss before a new branch breakeven on average and that breakeven point on average comes in just after -- just maybe over 2 years after the branch opening. Given that the rate environment and the outlook is quite different today, could you talk about your updated thoughts on new branch profitability and breakeven time frame amid lower rates and assuming Fed rate cuts?

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [7]

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Well, if you go back to our initial comments about branch locations, we had looked at the 40 locations that we'd open over a period of -- gosh, it's over 10 years. And when branch reach -- when branches reached profitability historically on average, the rate environment that most of that period was in was actually lower than it is today, so I don't think it's made a material impact on it.

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Operator [8]

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Your next question comes from the line of Jennifer Demba of SunTrust.

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Jennifer Haskew Demba, SunTrust Robinson Humphrey, Inc., Research Division - MD [9]

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Question on the loan yield. Is there anything unusual in there this quarter?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [10]

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No. I didn't see anything that was unusual that would have caused that to have an impact on the loan yields.

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Jennifer Haskew Demba, SunTrust Robinson Humphrey, Inc., Research Division - MD [11]

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Okay. And can you just talk about a good expense run rate in the quarter?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [12]

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Let's see if I can give you some color. I was looking at some of our expense numbers preparing for the call. I was looking at kind of what we did in 2018 versus '17. If you recall though just to make sure that those comparisons were apples-to-apples, in 2018, the network cost associated with the interchange fees actually moved up as a reduction of noninterest income. So if you -- it was $12 million for us in '18 that moved out of expense and into income. So if you brought that expense back and did '18 to '17 apples-to-apples, we were up about 4.2%, 4.5% right around there.

And looking at our projections for 2019, we've given some clear guidance on our Houston expectations on the $0.19 impact. And we're still comfortable with that for our -- this year's impact, but if I exclude the Houston expansion and I exclude the impact of the move to our new headquarters here in San Antonio, we're really projecting to grow just about at that same rate, 4% to 4.5%. From a lease expense standpoint, we moved in June, so our current run rate only includes 1 month of expenses. I'm going to gauge those roughly at about $1 million a month. So hopefully, that kind of gives you some color of what we're talking about.

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Operator [13]

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Your next question comes from the line of Brady Gailey of KBW.

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Brady Matthew Gailey, Keefe, Bruyette, & Woods, Inc., Research Division - MD [14]

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So just to close the loop on the new headquarters. It's $1 million a month, you only have 1 month in there for 2Q. So as we look to 3Q, there should be about $2 million of incremental upward pressure related to the new headquarter building?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [15]

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Yes, that's right, Brady.

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Brady Matthew Gailey, Keefe, Bruyette, & Woods, Inc., Research Division - MD [16]

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Okay. All right. And then it's good to see the buyback authorization. I was looking at -- I know you all don't call it out, but your period-end share count went down a little bit in the second quarter. Maybe just comment on if you repurchased any stock in 2Q? And then your appetite on repurchasing stock in the back half of the year?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [17]

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Yes, we did. We purchased -- we did spend the last $50 million that we had available. We had spent $100 million in the fourth quarter of '18. And so we spent the remaining $50 million, bought about 500,000 shares in the second quarter and that's the decrease that you're seeing. What we've said is, we're -- and so we believe it's important from a governance standpoint and a good housekeeping standpoint to always have a buyback available. Certainly, we'll continue to look at it -- what we said in the past is, we want to be opportunistic. I like to say, I wish I had a crystal ball because I might have waited a little bit on the buyback. But we will continue to be opportunistic. I think for us, it's a good way to manage capital. It's a good way to manage the shares outstanding. We went back and looked over a 10-year period from 2008 to 2018, and we roughly issue about 750,000 shares a year related to compensation type plans. So our goal will be to at least try to offset those through the buyback program.

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Brady Matthew Gailey, Keefe, Bruyette, & Woods, Inc., Research Division - MD [18]

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All right. And then finally, for me, it looks like other fee income was a little light this quarter? I know there's various things that can go in and out of that bucket, but was there anything driving that number to be a little lower than normal?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [19]

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What I would say and I was looking for a summary here, but can't find it. But what I would say is that it really relates more to what we saw in the second quarter last year. If I remember correctly, we had a -- we were in an FBIC and we got a payment of over $1 million in this quarter last year. We had [building] gains in the second quarter last year. We don't have anything in this quarter. And then we also had an unusual amount of recoveries of things that we had previously written off, I think, over $2 million. So it's more driven by, yes, the balances in 2018.

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Operator [20]

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Your next question comes from the line of Ebrahim Poonawala of Bank of America.

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Ebrahim Huseini Poonawala, BofA Merrill Lynch, Research Division - Director [21]

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Just first question, Phil. Just wanted to go back to your comments around the competitive dynamics in the CRE market. If you could elaborate on that in terms of -- is this competition coming from your peer banks? Or is it the nonbanks where you're seeing this? And I'm just thinking of it in terms of what does this mean in terms of the loosening in credit and the downside risk if we actually have some slowdown in the economy? Like how do you assess that just from your seat when you look at this behavior from the competitors?

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [22]

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Ebrahim, it's everywhere really. I mean I look at a list of the deals we lose, and whether it's pricing versus structure and -- you'll see -- I see small community banks in small Texas towns. I see too big to fail banks. I see regional competitors. And -- so it's everywhere. I don't think I can -- and they'll probably point a finger to me, right? It's just everywhere.

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Ebrahim Huseini Poonawala, BofA Merrill Lynch, Research Division - Director [23]

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Got it. And as you think about the, sort of, the back half of the year, so I heard your goal of high single digits. But when -- and when we sort of look at the -- I think you mentioned in your prepared remarks that the pipelines were up 23% quarter-over-quarter -- does that imply just as a function of the increase in the pipelines, we should see a pickup in loan growth in the third quarter relative to what we've seen in second?

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [24]

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If I had to guess, I would say that the third quarter would be pretty consistent with the second. I mean it's been -- we're pretty much a month into it now. We've [seen some] growth. So I mean it's a tougher road like I described competitively, but I think, right now, if I had to guess, I'd say it'd be sort of in line with the second.

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Ebrahim Huseini Poonawala, BofA Merrill Lynch, Research Division - Director [25]

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Understood. And just moving Jerry in terms of your comments around the margin outlook and with the 2 rate cuts, can you give us a sense just in terms of how to best think about what a rate cut means for the margin, given your view on how quickly you can reduce deposit costs? Just how you're thinking about that?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [26]

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Yes, you are right. A lot of it's going to be dependent on what happens. I think that, in a roundabout way, I guess what we -- the way we think about it is if you've got a 25 basis point cut, I mean it cost us probably somewhere in the range of $1.2 million to $1.3 million a month, all things being equal. Of course, there has been some volatility just as we said on the yield curve and LIBOR has been moving down, but roughly, that's kind of the way we think about it.

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Ebrahim Huseini Poonawala, BofA Merrill Lynch, Research Division - Director [27]

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Got it. And just 1 last question around the expense growth. So you talked about 4%, 4.5% excluding the couple of items -- you had the lease you mentioned, $1 million per month, going forward as well as I'm guessing about 100 to 200 basis points somewhere in that range tied to the Houston expansion. It gets you to about 6% to 7%, is that kind of the right way to think about it?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [28]

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Yes. I would say that's probably right. I think the number as I think about it, probably it's closer to that 7% range that you're talking about. I kind of think of 7%, north of 7%, really dependent on some other things that are going on. But yes, you're not too far off there. That's the way that we tend to think about it.

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [29]

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You know there is pressure on expenses around -- Jerry pointed out a number of things. I mean another thing to keep in mind is just IT costs are continuing to increase. We've spent a lot of money on additional cyber capability. And really, also it's tough to hire IT talent. We are behind the curve on that. It's one of the things I'm focused on right now. I'll probably tell you we're 50 people behind. If I can wave a magic wand, I think, I would and bring them in. And we have just got to be aggressive and bring that in because it's just tough to find talent. And you don't want to let your technical debt grow too high. So yes, there are pressures on expenses. I wish we could do -- I wish we could be in an environment where we've got wind at our back and not wind at our face now, but we're going to do the things we need to keep the company moving forward regardless of where rates happen to be. But I agree with Jerry. It will be more on the higher side of that in my estimation.

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Ebrahim Huseini Poonawala, BofA Merrill Lynch, Research Division - Director [30]

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And that's off the 7.75% base we had last year just to make sure -- looking at the starting point correctly?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [31]

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Yes, whatever the reported expenses were, that's the way we look at it. My previous conversation really just had to do with trying to make the '17 to '18 comparison apples-to-apples, but '18 to '19 should be fine just as reported.

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Operator [32]

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Your next question comes from the line of Brett Rabatin of Piper Jaffray.

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Brett D. Rabatin, Piper Jaffray Companies, Research Division - Senior Research Analyst [33]

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Wanted to talk about credit quality. You managed NPAs lower and charge-offs were fairly reasonable, but a lot of people have been talking about energy and just some difficulties that, that space has seen. Can you talk maybe about energy a little bit? And what you're seeing in that space? And how you manage that portfolio?

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [34]

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Yes, I think the portfolio is doing well. I mean we keep saying, we got credits that are moving through the snake -- it's an awfully long snake for some of those credits. But energy loans for the quarter were down by about 5% on a period-end basis, that's not annualized, so obviously, annualized is a higher number than that. It's down about [$1.481 billion.] We saw some improvements, payoffs in the portfolio of some problem loans. We saw probably about over $50 million of what we call problems which are risk grade 10 or higher. And we saw some deterioration in a couple. One has been there for a really long time. Another that was moved on and it had to -- that one has to do with natural gas. It was a Permian deal, but it was a gas deal, so that was the weakness there.

So I mean it continues to improve. I feel good about our underwriting. I feel really good about how servicing has performed throughout this whole cycle and it continues to. We've seen some reductions in servicing in the quarter in terms of problems. But that's tight. And so I know you're seeing some layoffs with even the big players on the servicing side. So it's something we keep our eye on. I think the -- but overall, I think it's going well. We continue to manage that exposure down and my guess, it will probably continue to go down some as a percentage. But I'm not really worried about. We're focused on it, but it's not something I'll lose a lot of sleep on.

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Brett D. Rabatin, Piper Jaffray Companies, Research Division - Senior Research Analyst [35]

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Okay. And then the other thing I wanted to talk about was just the securities portfolio and you mentioned the purchases you did during the quarter. What are you guys thinking about, in the back half of the year, I know it's partly market rate driven, but are you planning additional purchases in the back half of the year in the securities book? And then maybe just how you want to manage that portfolio with where the rates are?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [36]

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Yes. Certainly, we wish, there were more opportunities there. I think last time I looked at our projections, I think we're still projecting that we would buy another $1 billion in securities roughly. And we're still -- I think I've mentioned before, we've got a significant amount of treasuries that are maturing primarily close to the end of the year. But I think that number's probably about $1.5 billion. So some of this would replace some of that, but we're talking about splitting it between treasuries and agency. You saw I mentioned that we did a big chunk of agencies there, $1 billion. We kind of figured that given our outlook on rate being flat to down that it makes sense to go ahead and get a little ahead of that, so we did do that and wish we could have done more, [but] given today's rate. So we'll continue to try to be opportunistic, but we do have about $1 billion planned. I expect we'll purchase some munis. We've got some room there. We'll continue to purchase agencies and probably treasuries at current expectation. Again, a lot of it will be dependent on what makes sense for us given the yield curve and what rates are available.

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Brett D. Rabatin, Piper Jaffray Companies, Research Division - Senior Research Analyst [37]

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Okay, Jerry, and to clarify that, does that mean -- so you're purchasing a $1 billion or you plan to -- how much of that is going to be "replacing existing securities that are maturing versus adding net new portfolio?"

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [38]

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I guess I'm just thinking through the numbers in my head. Since we've got -- I can easily say, we've got $1.5 billion in treasuries that are maturing towards the end of the year. So if I am only replacing $1 billion, we still have some -- we're going to -- we continually look every month, obviously, at what our investment plan is. So right now I would say, given the things that are maturing, we're replacing a big chunk of it, but haven't completely included all of that into our projections as far as replacing the full $1.5 million -- $1.5 billion.

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Brett D. Rabatin, Piper Jaffray Companies, Research Division - Senior Research Analyst [39]

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Okay. So you can actually see a net reduction in securities book in the back half of the year?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [40]

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We could, but again it's something that we just continue to look at. It's going to be dependent on what kind of investment alternatives that are out there to be quite honest with you. In the case of $1 billion in agency, we just decided it makes sense to do that. We sold those treasury securities. They were at a lower yield and we found an opportunity to be able to replace those at a higher yield. We sold some munis also during the time -- during the quarter. I think it was around $500 million roughly that were yielding on a TE basis less than the overnight rate. So we're just continuing to reevaluate our portfolio, doing what we need to do. Just continue to add value to the company from the investment portfolio group.

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Operator [41]

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Your next question comes from the line of Steven Alexopoulos from JPMorgan.

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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap & Small-Cap Banks [42]

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I want to first follow-up on the comment you gave to Ebrahim's question, when you said, you would lose $1.2 million to $1.3 million cost per month for a 25 basis point cut. What was the deposit beta you were assuming there?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [43]

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It's about a 20% beta overall. I think that's kind of what we've done historically. But again what we've always said is that it's really dependent on what we're seeing in the market. We continue to say we want to be competitive. I certainly think that when we look at rate across our markets and I guess across the competitors, we're not the highest rate, but we're certainly very competitive. But we'll just have to make sure that we're looking at that, but it assumes that sort of a total beta if you will.

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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap & Small-Cap Banks [44]

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Okay. And then on the money market deposit accounts, the balances came off linked quarter and the rate also came down. Can you give some color on what happened there?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [45]

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I think that what we've seen is, from the rate standpoint, really, we're just trying to be competitive. What we've said is if there is room, we were quick to increase our rates. We started in July of '17, so we were higher -- we were quicker and higher than most. But what we said on these calls is that we're going to react. We are not going to be afraid to increase rates or decrease rates if we have to, so we just saw an opportunity from a competitive standpoint to make some movements there. I think on the money market, I think that generally what we're seeing is, we're just continuing to see -- we continue to bring new customer growth in, but we just -- there is diminishment from the current customer base is what we see. But we're glad that we continue to see good growth. And really, in a lot of cases, that money market, which includes both commercial and consumer, the commercial customers really can tend to use that in a manner [to just in and out] with some of their excess funds, so I would assume that some of that is related primarily to the commercial side.

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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap & Small-Cap Banks [46]

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Okay. And just one final one. It's helpful commentary around commercial real estate, the deals you're losing, structure versus price. How does that compare to C&I in terms of losing deals on structure versus price?

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [47]

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Yes, it's a different ballgame. Commercial real estate is looking for capital and terms, and it centers mainly around guarantees, burndowns, and interest-only periods, all those structure things. When you're dealing with a C&I [credit,] it's much more of a relational situation, and we see less of those kinds of issues there just by its nature. So I think that's just -- it's just what it is.

It's interesting how you're also seeing something I think that private equity, limited partners are really, I think, putting pressure on developers to avoid guarantees. They don't want to be in a position where they have to step in and all of a sudden they're liable on these things. So I mean -- and that's a little bit new angle that we've seen, so you got a lot of competing forces there in the commercial real estate world. Whereas, I used to be a CFO for 19 years or whatever. I would -- the last thing I want to do is change my banking relationship, if I didn't have to. And to do it on a few basis points or some small structure things, really wouldn't move me to move that relationship. It's got to be a deeper thing than that, so just my historical perspective on it.

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Operator [48]

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Your next question comes from the line of Michael Rose of Raymond James.

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Michael Edward Rose, Raymond James & Associates, Inc., Research Division - MD of Equity Research [49]

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Just wanted to get an update on the deposit growth that you've seen out of the Houston expansion so far? And if you have any expectations for what that could generate over the next couple of years?

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [50]

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Well, we have a -- it's -- so it's early on, right? So I mean I don't have numbers at the tips of my fingers. If I did it wouldn't be impressive to you because it's really, they're really new. And I think the main thing I would say is that we don't see anything in the locations that we've opened up that have caused us to believe they are going to be anything different on average than what we've seen historically. And so we look to be reaching those profitability levels, say, around 2.5-year plus or minus period of time. And -- so nothing new there. We're all happy with that. We're happy with how it's going.

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Michael Edward Rose, Raymond James & Associates, Inc., Research Division - MD of Equity Research [51]

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Okay. Maybe 1 follow-up question on the insurance business. I would have thought given kind of the relative strength in the market that you would have done a little better year-on-year. Any sort of color there as to what happened? And what the outlook is?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [52]

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Yes. The big driver in the second quarter was really primarily related to employee benefit, that was really where we saw the weakness. And really we had some impacts from some of our existing client base where some of the employee counts were reduced there, which results in a significant reductions, which affects then our commission. And then also we saw lower life commissions in the quarter compared to the second quarter last year. You know we really had a strong first quarter. First quarter is typically our strongest quarter. Second quarter is actually typically our weakest quarter. But that employee benefit was a little bit of a surprise to us, but they had a great year in 2018, and we're kind of projecting them to continue to have a good growth going forward.

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Operator [53]

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Your next question comes from the line of Jon Arfstrom of RBC Capital Markets.

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Jon Glenn Arfstrom, RBC Capital Markets, LLC, Research Division - Analyst [54]

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A couple of follow-ups. Back to commercial real estate, Phil, one of the things you said early on is, you've looked at 50% more deals compared to about I think you said 4% for C&I. What drives that 50%? Is it just more flow? Are you looking more for attractive commercial real estate? What -- I'm curious on that.

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [55]

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It's -- again, it has to be kind of the nature of the beast. Commercial real estate deals are in the market and they are -- whereas people who are running businesses are not out there trying to change their bank, right? So that's a long sales cycle on that and it's -- you've got to develop relationship. So we're seeing good activity. I mean there is activity with the people. We're banking -- first of all, we're banking people, not things, right? And so -- now the people that we are banking, they've got some great opportunities and so we're seeing those. But it's just that -- it's just structure-wise, we're just not able to do as many as we look at by a long shot.

So -- but Texas has got a great job growth. I mean it's still growing. I mean if you look at the North Texas market, it's extremely strong. Houston, and then, really there's not a weak market, so there are opportunities. And we have got great people in our commercial real estate. People I would argue are the best in the state. And so they have great relationships. We'll get to see a lot of deals. And so when there's lots of activity, we'll get to see a lot. It's just we're not really getting to do as many as we'd like to just because the structure is -- just isn't fitting our risk parameters right now. Make sense?

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Jon Glenn Arfstrom, RBC Capital Markets, LLC, Research Division - Analyst [56]

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Yes. Makes sense. And then the commercial pipeline, the flip side of it, up 23%. My assumption is that's more C&I-driven, is that right?

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [57]

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Actually, that pipeline is fairly well spread out. I mean C&I, I mean it's up 23%. And C&I is up 20%. Commercial real estate is up 24%. And then consumer and consumer real estate is up a lot higher percentage, but it's a pretty small number. So I think it's pretty good. If you look at the -- public finance pipeline is up. They have been a little bit weak recently, but it's up 50%. And the energy pipeline is down about 17%. So this looks pretty broad-based, right?

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Jon Glenn Arfstrom, RBC Capital Markets, LLC, Research Division - Analyst [58]

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Okay. And then Jerry, 1 for you, back on the margin. I think you talked about a 3.75% full year margin, I heard that correctly, is that right?

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Jerry Salinas, Cullen/Frost Bankers, Inc. - Group Executive VP & CFO [59]

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Yes. I think that's what we -- well, let me go back to the margin page here for a second. Make sure I don't give you some bad information. Hold on just for a second. So yes, so we had a -- yes, we're at 3.85% in the second quarter. And given our expectations on rates and what we're seeing, yes, I think that our current projections will have us right at a 3.75% full year. So obviously, trending down for the remaining 2 quarters of the year.

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Jon Glenn Arfstrom, RBC Capital Markets, LLC, Research Division - Analyst [60]

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Okay. And just if you make it linear, you look at your first quarter at 3.79%, you draw a line, you exit the year at about 3.65% is the way my model works. And I'm just -- I pushed you on this last quarter, I don't really want to push you on this too much. But anything else you guys can do to defend that margin when you look out to 2020? Or is it just simply a product of the environment?

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [61]

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I think it's -- I think if we can defend it, we got to do it in the cash market, right? I just don't think that derivative-wise, you're seeing value there that would pay off for our shareholders to do it. I could be wrong on that, [or worst] thing you could go. But -- so I think [it didn't have] to be in the cash market, it would have to be, in my opinion, pre-investing some of the stuff that's coming off.

The problem is, like Jerry said earlier, I mean the yield curve is just -- it's down. What is it, 50 basis points from where we were last quarter? So it's just tough. It's hard to buy groceries on what the yield curve is giving you right now. So given where rates are, it's -- if these rate numbers happen the way we penciled them out, it'll be a rough patch for a while. And it's -- I mean the guy used to work for, Dick Evans. I mean when I used to say, we work hard, we're not magicians, right? And we are in a business where our commodity is money and the price of money, it looks like, is going down. But the way I thought about the business and what does that mean for us fundamentally, and really, I hope that you've seen that we've got a lot of good things going for us.

Commercial customer growth rate is up 4%. Our number of consumer customers is up by 3.2%. Last year, it's up by 2%. 3.2% doesn't sound like a lot, but that's in the top quartile, I'd say for sure of what banks are doing. You saw what I said about the growth in checking accounts. Checking accounts are 40% higher this quarter than they were a year ago in terms of new checking accounts. Here we did right under 3,600 this quarter. We had 2,600 last quarter.

So the thing I'm focused on is, are the fundamentals of our various businesses doing well? Okay. Is the consumer business growing? Do you see those kind of fundamentals with regard to account growth, market awareness, consideration in the market, both of which were up? They were up 10% last quarter. I haven't seen these numbers, but our Net Promoter Score is over 80% right now. You look at the commercial business, you saw the increases that we've had in new relationships, up 6%. We got a decent pipeline going. Do we have pressure on commercial deposits? Yes. Diminishment continues to be an issue as rates are higher. People are using money. Diminishment is down about 10% from what it was the quarter before. So I'm hopeful that, that's slowing, but it's still there.

But if you look at the fundamentals on, are we growing customers? And are we watching credit? And not doing anything stupid best we can. Then to me, I'll take that. I mean the business is doing well and I hate to be spending money on some things, but you know you just got to. And the things we are spending on really have improved our business. And yes, I mean, in retrospect, the headquarters is like it's been almost 6 years this thing started. The project, it'd been great if we didn't move in when the Fed's about to cut rates, but that is just the way it goes. But it's good for us. And it's a great building, iconic, that's increased and helped our brand here. And I think it will help the brand statewide. And things we've done with the Spurs have really helped our awareness.

Things we've done with the Rockets have really helped our awareness in Houston Rockets -- in the Houston market, so rates are what they are. It will be a bit of a rough patch but what we're focused on is are we still doing the stuff that will continue to drive the business forward. And I am convinced that we are. And you've been around us long enough, Jon, to know that there are really 2 things that continue to be the untapped operating leverage for our company: that's normalized interest rates and that's more efficient balance sheet in terms of loan-to-deposit ratio. We still have got both of those things that we can bring to bear.

We were hopeful of being able to take advantage of the rate movements, continue to get some wind at our back. That didn't happen. It looks like it's not going to happen. And -- but we still got -- one day, we will, and then also we're going to make progress on loan to deposits. So I feel good about the company and our fundamental outlook over the long term. And we're just -- just have got to weather what we're doing right now.

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Jon Glenn Arfstrom, RBC Capital Markets, LLC, Research Division - Analyst [62]

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Yes. Okay. Yes, I agree, you're controlling what you can.

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [63]

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Yes. Thank you.

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Operator [64]

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Thank you. I will now return the call to Phil Green for any additional or closing comments.

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Phillip D. Green, Cullen/Frost Bankers, Inc. - Chairman & CEO [65]

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Okay. Well, I think those were my closing comments. And I think -- we just want to thank everyone for their participation and interest in the company. Thank you. We're adjourned.

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Operator [66]

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Thank you for participating in the Cullen/Frost Bank (sic) [Cullen/Frost Bankers] Second Quarter 2019 Earnings Conference Call. You may now disconnect.