Western Alliance Bancorporation (NYSE:WAL) Q2 2023 Earnings Call Transcript
Western Alliance Bancorporation (NYSE:WAL) Q2 2023 Earnings Call Transcript July 19, 2023
Operator: Good day, everyone. Welcome to the Western Alliance Bancorporation’s Second Quarter 2023 Earnings Call. You may also view the presentation today via webcast or the company’s website at www.westernalliancebancorporation.com. I would now like to turn the call over to Miles Pondelik, Director of Investor Relations and Corporate Development. Please go ahead.
Miles Pondelik: Thank you. And welcome to Western Alliance Bank’s second quarter 2023 conference call. Our speakers today are Ken Vecchione, President and Chief Executive Officer; and Dale Gibbons, Chief Financial Officer; and Tim Bruckner, Chief Credit Officer. Before I hand the call over to Ken, please note that today’s presentation contains forward-looking statements, which are subject to risks, 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 statements, 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: Thanks, Miles, and good morning, everyone. As usual, I will make some brief comments about our financial results and action items, and then I will turn the call over to Dale who will review the quarterly results in more detail before opening the call for Q&A. Our Chief Credit Officer, Tim Bruckner, as Mile said, is here with us as well. In many ways, this quarter represented a transitional period for Western Alliance following the events of mid-launch as our firm and our clients increasingly return to a sense of normalcy. We continue to successfully execute on the balance sheet repositioning strategy we laid out last quarter, we exceeded our liquidity guidance by growing deposits by $3.5 billion and repaying over $6 billion in short-term borrowings.
For the second quarter, WAL generated total net revenues of $669 million, net income of $216 million and EPS of $1.96. We maintained strong profitability with return on average assets and return on average tangible common equity of 1.23% and 18.2%, respectively, which grew tangible book value per share by $1.53 to $43.09 or 18% year-over-year and we will continue to support building capital levels in the quarters to come. We achieved significant progress on the immediate- and short-term objectives identified last quarter to establish a sound foundation for WAL to sustain ongoing client and financial success. Notably, deposits grew $3.5 billion and exceeded our $2 billion quarterly guidance. Growth was diversified across business lines and included risk core deposit growth from new and returning customers.
Net liquidity growth of $2 billion allowed us to significantly reduce higher cost wholesale borrowings. WAL continues to expeditiously execute our balance sheet repositioning strategy and completed $4 billion in total asset dispositions in Q2, which included $3.5 billion of loan dispositions ahead of the $3 billion outlined in Q1. Meaningful deposit growth and asset disposition drove WAL’s loan-to-deposit ratio to 94% and allowed us to rapidly reduce reliance on higher cost FHLB borrowings by $6.1 billion over the quarter. I am proud to report core deposits have rebounded another $3.2 billion quarter-to-date, meaning WAL’s deposit levels are now $600 million above our year-end 2022 balance. CET1 capital of 10.1% increased from 9.4% on March 31st and 8.7% or 140 basis points since Q3 2022.
When we initially announced the Bank’s capital building initiatives through organic capital generation without equity issuance. Finally, we continue to focus on meeting our core client banking needs in order to cultivate strong long-term relationships, leveraging third-party products to significantly grow reciprocal deposits has lifted our insured and collateralized deposit levels to 81%, one of the highest among large U.S. banks. As we move through the back half of the year, we believe Bank investors will place more emphasis on balance sheet strength, stressing the fundamentals of growing capital, improved liquidity, deposit cost composition and granularity, stable asset quality, moderate and thoughtful loan growth and producing predictable and sustainable PPNR.
Bank diversified funding strategy continue to focus on growing attractive funds from a diverse set of clients and channels in order to prioritize repayment of the more expensive wholesale funding sources and then to optimize deposit balances of lower cost sources to deploy into superior risk-adjusted lending opportunities as we have done historically. Driving the $3.5 billion of deposit growth with significant new and return of customer activity throughout Western Alliance. In Q2, we attracted $1 billion from approximately 1,000 new and returning commercial relationships as an attractive average total deposit cost of 1.98% with notable contributions from mortgage warehouse, regional banking and settlement services. Over $400 million of net new deposit money was in non-interest-bearing DDA.
Our commitment to foster multiproduct customer relationships has been the key to onboarding new deposits in a very competitive environment. Additionally, we will utilize other diversified sources of projects to accelerate repayment of wholesale borrowings and returned to prudent DDA. Our recently launched online consumer channel is demonstrating steady progress, providing another source of uncorrelated liquidity and generated approximately $700 million this quarter at attractive rates compared to the marginal cost of repay borrowings. Going forward, continued deposit channel optimization and growth, new and returning core client commercial relationships will lower the proportion of funds generated in brokered CD volume. Now Dale will take you through our financials.
Dale Gibbons: Thanks, Ken. For the quarter, Western Alliance generated net income of $216 million, EPS of $1.96 and pre-provision net revenue of $282 million. Net interest income decreased $60 million during the quarter to $550 million, mostly from elevated higher cost to return borrowings that were materially reduced near quarter end. Q2’s net interest income should be considered a trough in which Q3 and Q4 levels should ascend. Non-interest income increased to $119 million from an adjusted level of $102 million in the second quarter. As a reminder, loans marked in Q1 and a net loss of $141 million as part of our balance sheet repositioning efforts, responsible for negative fee income last quarter on a reported basis. On an operating basis, non-interest income was $18 million higher from Q1.
The green shoots we signed with mortgage last quarter were evident again in the second quarter as AmeriHome revenue increased to $13 million to $86 million. We remain cautiously optimistic, continued stabilization, improving margins and profitability momentum is sustainable as AmeriHome capitalizes on the exit of a major competitor from the correspondent lending channel earlier this year. Production margins widened closer to normalized levels of 43 basis points as the industry has rationalized and win rates continue to improve. Other non-interest expense growth was driven by higher insurance costs related to elevated insured and broker deposit levels, which also include core reciprocal deposits above a certain threshold. Recent expense of $22 million is indicated by return to a normalized credit environment, we remain conservative on macro assumptions and as a commercial bank and the outlook for commercial real estate is a key driver that informs our opportunity.
Our allowance for credit losses modeling assumes an 80% likelihood of a recession using Moody’s analytics scenarios. A lower tax rate was beneficial to earnings this quarter and we expect to go forward a normalized rate as an average of the last two. We made substantial progress in our balance sheet repositioning and surgical asset disposition efforts in the second quarter to accelerate higher capital and liquidity building. These dispositions complemented our organic earnings and contributed approximately 43 basis points of incremental CET1 capital. $4 billion of asset dispositions were completed, including loan sales and runoffs, primarily in equity fund resources, syndicated loans and mortgage warehouse businesses. The equity credit resource [Technical Difficulty] fully unwound.
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Loans held for investment increased $1.4 billion to $47.9 million and deposits increased $3.5 billion, which brought balances to $51 million at quarter end. Mortgage servicing rights balances of $1 billion rose 11% during the quarter. Total borrowings were reduced by $6.3 billion to $11.5 billion due mostly to paydowns of federal loan bank borrowings. At March 31st, the remaining EFR credit-linked note was also fully redeemed, which completed the unwind of $542 million of CLNs year-to-date. Deposit momentum has continued into the third quarter as deposits are $3.2 billion higher for June 30th. Total held for investment loan growth of $1.4 billion consisted of $700 million of organic loan growth, primarily from mortgage warehouse, regional banking divisions and resort finance.
Improved liquidity from deposit growth well in excess of loan growth allowed us to reclassify $100 million [ph] of held for sale loans back to held for investment, which will improve the company’s return profile. Deposit growth of $3.5 billion resulted from remixing the deposit base into interest-bearing DDA from savings and money market, as well as CD growth from client promotions and brokered CDs. Non-interest-bearing DDAs comprised a third of our total deposit mix with approximately half having no cash payments of earnings credits. Turning now to our net interest drivers. The securities portfolio grew $1 billion to $10.1 billion as we look to bolster our high quality liquid asset balances. The yield expanded 8 basis points to 4.76%, largely from floating rate produce benefiting from higher rates and should continue to benefit from higher reinvestment rates is approximately $1.3 billion securities are expected to mature in the second half of this year, $1.1 million additionally in 2024.
The spot rate for the entire portfolio was 4.85% at quarter end. Held for investment loans increased $1.4 million and the portfolio yield increased 20 basis points to 6.48% at quarter end, the spot rate was 6.74%. Interest-bearing deposit costs rose 33 basis points to 3.08% on a $3 billion or a $3 billion increase to $34 billion. The elevated costs resulted from a higher interest rate environment, which offset more tempered non-interest-bearing demand deposit growth. Total cost of funding rose 58 basis points to 2.5% from higher utilization of wholesale borrowings at an average cost of 5.6%, $6 billion of these borrowings were repaid, which gives a $3.4 billion difference between average and end of period of balances. Optimizing the funding mix with more core and reciprocal deposits in conjunction with the $6 billion of Federal Home Loan Bank of paydowns, which occurred later in the quarter.
Adjusting just for improving funding cost to support our net interest margin line. Moving down further into our funding base we have actively utilized reciprocal deposit channels to drive growth and provide greater insurance coverage to larger depositors. 62% of broker deposits consist of sticky reciprocal deposits. We believe these core client relationships have been fortified through this product enhancement, making them exceptionally stable. Overall, net interest income decreased approximately $60 million or 9.8% over the prior quarter due to compressed net interest margin and average earning assets declining $562 million, mostly stemming from balance sheet repositioning actions. Net interest margin compressed 37 basis points to 3.42% with a higher interest expense from outsized higher cost borrowings.
This excess liquidity is generated with deposit growth greater than loan growth in non-AmeriHome held for sales are liquidation. We expect to paydown additional repo lines costing SOFR plus 2% that should contribute to funding cost tailwinds. The effect of these dynamics can start to be seen in the expansion of the June NIM to 3.5%. Our efficiency ratio of 57% improved by about 500 basis points from the second quarter though our adjusted efficiency ratio increased from 50% -- to 50% from 43% in the prior quarter. Higher insurance costs and elevated brokered and insured deposits, as well as lower net interest income from increased interest expense were the main reasons for this change. We still view mid- to upper 40s adjusted efficiency at the right level and expect expenses to align with our core run rate of revenue as we look to optimize additional work streams throughout the bank.
Pre-provision net revenue was $282 million during the quarter. Solid profitability was sustained with the Q2 return on average assets of 1.23% and return on average tangible common equity of 18.2%. Strong PPNR provides capital flexibility to absorb provision expense and credit losses support, while still growing the balance sheet and attaining higher CET1 capital levels. Given the increased attention on the commercial real estate sector, we are providing additional details on our CRE investor and office portfolios, as well as our overall early identification and elevation credit mitigation strategy. This proactive migration approach has historically produced lower loss convergence. Our CRE investor underwriting strategy rests on a foundation of low loan-to-cost underwriting in submarkets where we have deep experience with strong financial sponsors.
As a reminder, our financing structures carry no junior liens or mezzanine debt, which enables maximum flexibility in working with clients and sponsors. We have low uncovered tail risk since 92% of the portfolio has LTVs below 70% and these LTVs are based upon the most recent appraisals and assuming commitments are fully funded. Within commercial real estate office [Technical Difficulty] Within commercial real estate office accounts for just 5% of total loans. We have previously discussed our focus on shorter term bridge loans repositioning office projects in the suburban areas. Our exposure in two central business district areas that we believe are most vulnerable to overall risks are minimal to just 3% of office loans. We have re-designated some midterm exposure away from the CBD classifications as in our view the [inaudible] in these markets make them less susceptible to work from home risk present in larger cities.
For example, we do not have CBD office loans in New York, Boston, Chicago, Atlanta, Houston or Dallas. Looking at LTVs, you will know there’s only 3% of office and then 80% or greater loans of value in the line with our central business district exposure, primarily focused on in-demand Class A to B+ office properties and 94% of Class A properties have LTVs below 17%. The entire office book carries an LTV of 55%. Finally, we are not facing a large maturity and while is approximately three quarters of the loans that come due in 2025 or later. Turning to asset quality trends in light of the present environment and due to the sharp increase in interest rates over the past 12 months, we have completed a proactive comprehensive review of our commercial real estate portfolio which is reflected in loan migrations this quarter.
As part of our early identification and early application trend and mitigation strategy, it has served us well. We proactively move loans into special mention when cash flow may be curtailed in the present environment despite having well-supported collateral values and access interest rates sponsorship remaining strong and the loan still turn. We do this to ensure attention in monitoring the highest levels within our credit organization as we require the sponsors to re-margin the loan that was established or satisfactory cash reserves to support our cash rating. This is an important element of our credit control process and established process for more than 10 years. As a result of these efforts, the special mention loans increased to $694 million, or 1.45% of funded loans with $250 million or two-thirds of the migration coming from office and hotels.
Classified assets increased to $145 million to 89 basis points of total assets. Half of the increase in classified assets was driven by one $75 million office loan in Downtown San Diego, which makes up the preponderance of the central business district office exposure I mentioned. We don’t anticipate meaningful losses as this property is 82% leased, current appraisal exceeds the outstanding loan amount and all cash flow will go to pay down this credit. Our proactive identification and resolution process results in lower realized losses over the last 10 years, less than 1% of special mention loans have become losses and within commercial real estate investor properties less than 10 basis points of those special mentioned loans have migrated to loss.
And looking at the next two slides, you will see the results of our early identification, elevation, negotiation resolution process has resulted in best-of-class loss rates over the last 10 years. For us, the Western Alliance, it’s about the process, which sometimes produces earlier criticized and classified designations, but at the end of the day, leads to low net charge-offs. On average, we have ranked in the top third among asset peers of adversely graded loans as a percentage of total loans and will be the best ranking on losses. The difference between our ranking on adversely graded loans compared to our number one position of historical credit losses highlighting the success of our proactive credit mitigation strategy. Quarterly net loan charge-offs were $7.4 million or 6 basis points of average loans compared to net loan charge-offs of $6 million or 5 basis points in the first quarter.
Our total loan ACL rose almost $13 million in the prior quarter to $362 million due to higher provisioning and lower loan loss rates. Total loan allowance for credit losses of funded loans increased 1 basis points to 76 basis points in Q1, but is 94 basis points when loans covered by credit linked notes are excluded. The allowance was 141% in non-performing loans at the end of the quarter. We feel well positioned in an uncertain economic environment based on the business transformation since the global financial prices. Our loan portfolio is diversified across risk segments with almost a quarter of either credit protected, government guarantee or cash security and over half of the portfolio is either insured or resistant to economic volatility.
These percentages aligned with ratings reported before we embarked on our balance sheet repositioning initiative late in the first quarter. Of note, our lower average loss rates in the resilient and more sensitive categories are indicative of conservative underwriting and highly responsive remediation actions. We discussed reprioritizing cap -- and building capital back to premerger levels on our Q3 2022 earnings call. Since then, CET1 capital has grown from 8.7% to 10.1% and is up over 70 basis points since the first quarter. Our tangible common equity to total assets rose 50 basis points from the first quarter to 7%. We remain committed to achieving a medium-term CET1 target of 11%, which we view as prudent considering the heightened regulatory attention regarding appropriate capital levels.
We also expect increased excess capital will provide more financial and strategic optionality in the future. Looking at the strong combination of insured deposits and high capital to make depositors comfortable with the stability of their financial institution, Western Alliance has materially moved it sure deposit levels to among the highest in the nation compared to the largest banks. Capital has also listed as a top third even adjusting for fair value marks in both the available for sale and held to maturity securities portfolios. Inclusive of our quarterly cash dividend payment of $0.36 per share, our tangible book value per share increased to $1.53 in the quarter to $43.09. Western Alliance has compelling long-term intangible book value per share divergence from peers remains intact.
This increased over 6 times out of the peer group since the end of 2013, which compound -- which leads to a compound annual growth rate of nearly 20% from economic cycles and market disruptions. This outperformance is still 4 times that of peers when adding common dividends back. I will now hand the call back to Ken to conclude with closing comments.
Ken Vecchione: Thanks, Dale. Our guidance for the rest of 2023 continues to be driven by the strategies and priorities laid out in our prior earnings calls. So let me tell you what you can expect from here. Regarding capital, having exceeded our immediate CET1 target of 10% in Q2, we expect continued, although, more gradual growth in our capital ratios towards a medium-term CET1 ratio target of 11% in 2024. This will be driven by our continued strong return on average tangible common equity and capital generation. Core deposits are expected to grow at approximately $2 billion per quarter and exceed more muted loan growth by approximately 1.5 -- $1.5 billion. This will lower our loan-to-deposit ratio over time towards a mid-80% target.
Net interest margin is expected to rise modestly from our Q2 trough of 3.42% and land in the range of 3.5% to 3.6% for the second half of 2023 based on our successful repayment of borrowings this past quarter and the cost of new deposit funding. Our efficiency ratio, excluding the impact of deposit costs should decline slightly to the high 40s given the reduced borrowing costs and higher asset yields. Asset quality remains manageable as it returns to more normalized levels. We expect credit losses to be 5 basis points to 15 basis points through the economic cycle. Overall, for the second half of 2023, we expect quarterly operating PPNR to remain consistent to Q3 results and begin to climb as we exit the year. As we continue to reposition the balance sheet and continue to reestablish our core deposit and loan growth trajectory, we see Western Alliance as an even better institution and well positioned future.
We view our earnings performance being driven by balance sheet growth, improving margins and efficiency, along with continued strengthening in our mortgage operations that should result in quarterly operating PPNR consistent to Q2 2023 results and then grow thereafter. At this time, Dale, and Tim and I are happy to take your calls -- your questions.
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