Luther Burbank Corporation (NASDAQ:LBC) Q2 2022 Results Conference Call July 27, 2022 11:00 AM ET
Company Participants
Simone Lagomarsino – Chief Executive Officer, President & Director
Laura Tarantino – Executive Vice President & Chief Financial Officer
Conference Call Participants
Matthew Clark – Piper Sandler
Woody Lay – KBW
Operator
Good morning, and welcome to the Luther Burbank Corporation Second Quarter 2022 Earnings Conference Call. [Operator Instructions] Before we begin, the company would like to remind you that discussions during this call contain forward-looking statements that do not relate strictly to historical or current facts.
Luther Burbank Corporation does not undertake any obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements.
For more information on those factors, please see the company’s periodic reports accessible at the Luther Burbank Corporation website and filed with the SEC. The presentation today contains certain non-GAAP financial measures that we believe provide useful information about our operational efficiency and performance relative to earlier periods and relative to other companies. For more details on these non-GAAP financial measures and their limitations, including presentation with and reconciliation to the most directly comparable GAAP financials, please refer to yesterday’s earnings release and the related investor presentation, which is available on our website at www.lutherburbanksavings.com.
I would now like to turn the conference over to Ms. Simone Lagomarsino, President and CEO. Please go ahead.
Simone Lagomarsino
Thank you very much. Good morning, everyone, and welcome to Luther Burbank Corporation’s earnings conference call. This is Simone Lagomarsino, President and CEO; and with me is Laura Tarantino, our CFO. Thank you for joining the call today to review our second quarter results. As is customary, we will focus on our actual financial performance, share our observations regarding recent trends and then open the line for analysts’ questions.
We reported net income for the second quarter of $22.6 million or $0.44 per diluted share as compared to $22.9 million or $0.45 per diluted share in the linked quarter. The decline in net earnings of $373,000 was primarily attributed to 3 key factors.
While our net interest income increased by $2.4 million and our noninterest expense decreased by $2.2 million, these 2 positive trends were more than offset by a $5 million fluctuation in the provision for loan losses between the first and second quarters of the year.
This is reflected in our pretax pre-provision net earnings, which improved by $4.9 million in the second quarter compared to the first quarter. Although we had a large swing in our loan loss provisioning, our credit metrics remain strong, and I’ll cover asset quality in detail a bit later in my presentation.
First, let me address the 2 factors that led to our 16.7% improvement in pretax pre-provision net earnings and our successful second quarter. As I mentioned, when compared to the first quarter, our second quarter net earnings benefited from a $2.4 million improvement in net interest income. Our net interest margin for the second quarter measured 2.62%, which was our best quarterly margin recorded since 2014.
Interest income grew $4 million from the prior quarter, primarily as a result of increases in the average balance of the loan portfolio and rising interest rates as well as improved earnings on certain of our interest rate swaps.
Interest expense also rose during the second quarter but to a lesser extent of $1.5 million as compared to the linked quarter, also chiefly attributed to rising market interest rates impacting the cost of deposits and borrowings.
Our real estate loans grew by $272 million or 4% from the prior quarter; and year-to-date, our annualized loan growth was 10.8%. The increase in our loans was due to both strong loan production as well as slowing in single-family residential loan prepayment speeds.
We entered the second quarter with a strong loan pipeline of $815 million as borrowers rushed to submit loan applications and lock-in their low rates during the first quarter of this year before market rates increased. Additionally, the interest — additionally, the rising interest rate environment benefited our single-family lending business in 2 distinct ways: first, prepayment speed has slowed, which is a welcome change from the prepayment headwinds we experienced last year when our single-family loan portfolio would have declined during calendar year 2021 had we not supplemented it with the purchase of a pool of single-family loans.
Furthermore, our Hybrid ARM loan product, which is our bread and butter of our single-family business, came back into consumer favor as interest rates on 30-year fixed rate mortgages increased significantly in comparison to the last couple of years.
Returning now to interest expense. I noted that this measure increased $1.5 million from the linked quarter, of which more than half was related to higher deposit costs also attributed to rising market interest rates. At the beginning of the year, we anticipated that deposit pricing would be slow to adjust to short-term interest rate increases during 2022, given the excess liquidity that existed in the market at the beginning of this year.
Although the federal funds rate increased by 150 basis points during the first half of this year, our average cost of interest-bearing deposits originally decreased by 4 basis points in the first quarter and then increased by 5 basis points during the second quarter, yielding a year-to-date increase of only 2 basis points.
As I mentioned, the other significant element contributing to the improvement in our second quarter pretax pre-provision net earnings was a $2.2 million reduction in noninterest expense as compared to the prior quarter. The key factors that contributed to this decline were related to strong loan production and rising market interest rates.
Strong loan volume increased our level of capitalized salaries by $1.2 million as compared to the linked quarter, while higher long-term interest rates reduced our post-retirement benefit liability by $1.4 million during the second quarter.
Our first quarter net income resulted in a second quarter return on average assets of 1.23% and a return on average equity of 13.41%, both measures which we consider strong. We do believe, however, that rapidly rising short-term interest rates will challenge our results over the next few quarters.
So let me share with you more recent trends. We expect loan production to moderate in the third quarter of this year. Current loan offer rates exceed the weighted average coupon on our loan portfolio as well as typical market offer rates that existed for the past 2 years, both of which will dampen refinancing activity.
In comparison to the linked quarter, our loan pipeline totaled $455 million at June 30, a level which is much more typical of our bank. While production volume will slow, the ultimate size of our loan portfolio may benefit from additional slowing in loan prepayment speeds, particularly related to our income property prepayment rates, which remained elevated during the second quarter, in large part due to the volume of our in-house refinancing activity.
In addition, increases in deposit costs began to accelerate at the end of the second quarter and based on deposit rates advertised by several of our competitors as well as interactions with our customers, we anticipate that the cost of our deposit portfolio will rise much faster in the second half of this year as compared to the first half of 2022.
As a result, our projections are that increases in our funding costs will outpace improvements in our yields on our earning assets. And as a result, our net interest margin will decline beginning with the third quarter of this year, particularly in light of the expected pace of further short-term interest rate increases communicated by the Federal Reserve and anticipated by the market.
Now turning to credit quality. During the second quarter, we recorded a loan loss provision of $2.5 million to account for both strong growth in our loan portfolio, as previously discussed, as well as a higher level of classified assets.
Our classified assets increased by $8.7 million during the quarter. Three multifamily loans comprise the majority or 73% of this increase. These loans were downgraded due to issues related to the borrower’s ability to demonstrate debt service capacity. However, all 3 loans were paying as agreed at quarter end.
The balance of the classified asset downgrades during the second quarter was comprised of 3 single-family loans, and each of these loans demonstrated some stage of delinquency. We believe that issues exhibited in the 6 recent classified credits are property or borrower specific rather than reflective of the general trend in rents, occupancy and in the case of the single-family loans, employment.
Based on original appraisals and/or updated values, these 6 loans have a weighted average loan-to-value ratio of 68%, and as such, we do not expect to incur any losses on them. Nonetheless, based on our model for our allowance for loan loss reserves methodology, approximately half of the $2.5 million loss provision recorded for the quarter was attributed to these downgrades, while the balance of the provision was primarily recorded for net loan growth.
Our classified assets measured 34 basis points of the loan portfolio at June 30. At the same date, we had 7 delinquent loans totaling $7.1 million or just 11 basis points of total loans, while nonaccrual loans measured 8 basis points of total loans. We believe that each of these measures compare favorably to the industry and exemplify our continued strong credit culture.
At June 30, our allowance coverage ratio was 54 basis points of the portfolio. And as a reminder, our bank still operates under the incurred loss methodology for the loan loss allowance. We expect to adopt CECL in the first quarter of 2023. And based on our ongoing results of our CECL model test work, we believe that the implementation of CECL will not result in a significant change to the level of our allowance. Of course, the ultimate impact of adoption will be dependent on our portfolio composition and the economic forecast at the time of adoption.
Now we’ll turn to the balance sheet. Our total assets at quarter end grew by $270 million or 4%, and year-to-date, we’ve grown almost 10% on an annualized basis. As I previously noted, this expansion was attributed to strong real estate loan originations as well as a slowing in our prepayment speeds. Our asset growth was supported by both FHLB advances, some of which also serve as hedging positions for interest rate risks and deposits.
Our loan-to-deposit ratio remains in a typical range for our business model and measured 117% at quarter end. Our total equity increased by $3.6 million since the prior quarter. Our capital position during the second quarter benefited from our net earnings of $22.6 million, but was partially offset by $9.3 million of unrealized losses on our available-for-sale security portfolio net of tax, as a result of the interest rate environment.
Our net unrealized loss position on our investment portfolio totaled $21.3 million as of June 30, and we expect that this full amount will be recovered over time as we both have the intent and the ability to hold these securities until maturity. Importantly, during the quarter, we returned $6.1 million and $4.1 million to shareholders in the form of cash dividends and stock repurchases, respectively, and grew our tangible book value per share by 1.2% to 13.9% — I’m sorry, $13.09 per share.
Our capital ratios with the Tier 1 leverage ratio of 10.2% and a total risk-based capital ratio of 19.1% demonstrate our strong capital position and our conservative balance sheet. Our capital position will — excuse me, our capital position will support future growth and provide some protection for our next eventual economic downturn.
Finally, yesterday, our Board of Directors declared a $0.12 per share dividend — $0.12 per common share dividend that will be paid on August 15. And with that, I’ll now turn the call over to Laura for some additional comments.
Laura Tarantino
Thank you, Simone. In a typical fashion, I intend to give you some brief but more granular information that we consider as we’re annualizing trends. In the second quarter, our new loan volume was funded at a weighted average coupon of 3.55%. We have mostly worked through our pipeline of loans with lower rates. And in the third quarter, we expect new volume to be added at coupons exceeding 4.25%.
The spot rate on our loan portfolio was 3.6% at the end of the second quarter. Therefore, although new loan originations are expected to slow in the second half of this year, new volumes should help pull loan yields in a positive direction, particularly if loan payoffs continue to slow and the recognition of deferred loan costs abate.
As Simone indicated, with continued rising interest rates, we have recently seen accelerated increases in deposit repricing. Although the cost of interest-bearing deposits only rose 5 basis points during the second quarter, our deposit portfolio spot rate increased 25 basis points between March 31 and June 30 from a level of 43 basis points to 68 basis points as of the same day.
This change reinforces Simone’s message that the competitive environment for deposits has only more recently emerged. During the third quarter of this year, we have $824 million of term deposits carrying a weighted average cost of 44 basis points scheduled to mature. Based on our current deposit offer rates, we would expect that these certificates will be priced higher by as much as 1% to 1.5%.
With the further Federal Reserve interest rate increase expected today, it would be reasonable to expect further deposit pricing pressure. Our second quarter results benefited from some of the existing interest rate swaps we had on our books.
Net swap income totaled $463,000 for the quarter. At June 30, the notional amount of our pay fixed swaps was $950 million with a weighted average net positive carry to us of 64 basis points. As Fed funds continues to rise, these derivative positions will improve. Of course, depending on where rates go and the future shape of the yield curve as well as our level of new loan growth, we may add additional positions to hedge interest rate risk, which would at least initially cost us some yield.
Bottom line, we expect the increase in our cost of liabilities to outpace upward movements in the yield on our earning assets and therefore, exert downward pressure on our net interest margin for the balance of this year. Our latest forecast, which included an estimate of Fed funds reaching 3.25% by year-end projects that our net interest margin may initially decline by 20 to 30 basis points per quarter.
Lastly, when we think about our noninterest expense run rate, a level of $16 million per quarter is still anticipated. As Simone noted earlier, our second quarter expenses benefited from a $1.4 million retirement liability decrease due to higher long-term interest rates, and our compensation expense was $1.2 million less than the linked quarter related, primarily to record high pace of loan volume for the quarter. Backing out those 2 events, our second quarter noninterest expense approximated $16 million.
And with that, we’ll conclude our prepared remarks, and we’ll ask the operator to open the line for questions.
Question-and-Answer Session
Operator
[Operator Instructions] Our first question will come from Matthew Clark with Piper Sandler.
Matthew Clark
Maybe first just on the deposit beta outlook. I think in your slides, you show 88% last cycle. What are your thoughts this time around, given the improvements you made on the deposit side? I assume it would be less than that. But what are you assuming for kind of a cumulative deposit beta for this cycle?
Laura Tarantino
For our forecast, we tend to just use our historical average. It’s pretty difficult to determine. We would have said slower in the first half of this year, and it was slower. But, I don’t know, I think there’s a lot going on and it’s hard to put a specific number to it. But again, we kind of rely for forecasting on our historicals.
Matthew Clark
Okay. And then just on the balance sheet growth outlook. What are you assuming for prepay speeds, in general? And I may not have heard if you updated your balance sheet growth outlook or not, if it’s still kind of that 3% to 5% range?
Laura Tarantino
Well, we’re ahead of 5% year-to-date. I think we’re at 6%, close to 7%. I do think it’s going to moderate and a lot of it has to do with where prepayments are going. Our income property prepayments were pretty high during the second quarter, but about 50% of that was in-house refis. So I would expect still prepayment speeds to slow down in the fourth quarter.
We’re thinking our growth for the year is still at least 5%, 6%, and I’m not sure we’re going to — I don’t expect us — if you were to annualize it and hit double digits, we’re not expecting that.
Matthew Clark
Okay. Great. And then just given what rates have done in the multifamily space, I think a lot of what you do on the multifamily side is on existing apartments and structures. But that we have heard from another bank that there’s an expectation that multifamily projects might slow pretty dramatically into next year, assuming rates are — remain at this level, if not increase. How do you — I guess, can you just kind of walk us through how that might impact your business, if at all?
Simone Lagomarsino
So I just want to clarify, Matthew. Are you saying multifamily projects as in new construction?
Matthew Clark
Yes, construction. I know you guys don’t do it — do construction, but just how that might permeate into what you do?
Simone Lagomarsino
Sure. Well, I’ll start with — we have a shortage of affordable housing in our region. And so we have seen actually double-digit increases in the rental rates of the properties, in general. I mean it’s not across the board, but in a number of regions, we’re still seeing multi — double-digit increases in the rental rates. And so how would it impact our business if new construction doesn’t happen?
We don’t do a lot of new construction on the multifamily. So I think on the existing multifamily that we lend on, I think that potentially makes it even stronger because of the fact that we just don’t have the affordable housing in our region. And again, you go back to what do we lend on? We primarily lend on multifamily projects that our average loan size is about $1.7 million, 13 to 14 units per apartment building.
So these are small suburban apartment buildings, and they really are what we call workforce housing, and there is a high demand and need, quite honestly, and not enough supply. So I think as we’ve seen in past cycles, our portfolio tends to perform extremely well.
And even when you think about, Matthew, in this last pandemic, this last kind of issue that we faced, the moratorium on evictions and some of the other steps that were put in place, we still really didn’t have a significant negative impact on our portfolio at all. Our borrowers did extraordinarily well through that.
Matthew Clark
Great. And then just given the slower production going forward, any thoughts on re-upping another buyback in light of the economic uncertainty as well?
Simone Lagomarsino
Well, capital management is always part of our ongoing review. At this time, we don’t have a thought of doing a share repurchase. I think we want to look forward a little bit and see what happens with the interest rates and possibility of a recession. But certainly, capital management is always part of our business, and we do it on an ongoing basis. So potentially in the future, but not in the near term.
Operator
One moment for our next question, that will come from the line of Woody Lay from KBW.
Woody Lay
I wanted to touch on expenses. And sorry if I missed it in the prepared remarks, but obviously, second quarter expenses benefited from some increased capitalized origination costs and retirement accruals. So just how should we think about the expense run rate in the back half of the year?
Laura Tarantino
Yes. I’m guessing an average of $16 million. So the volume is going to slow down, which means we won’t be capitalizing in as much as the current salaries expenses that we did in the second quarter. And if you look at what the curve has done in the last week or 2, I would expect that retirement liability maybe to go the other direction during the third quarter.
Unfortunately, that’s the accounting for these liabilities, they move with the changes in interest rates. So I’m expecting — if anything, we’re booking more liability for that retirement accrual in the third quarter. So $16 million is my estimated run rate.
Woody Lay
Got it. And then on the credit front, just with the tick up in the classified loans. Those 3 loans, were they from — were they made to 1 borrower or were they to multiple borrowers?
Laura Tarantino
Two of the three related entities.
Operator
And speakers, I’m showing no further questions in the queue at this time. I would now like to turn the call back over to you for any closing remarks.
Simone Lagomarsino
Thank you very much for joining us today, and this concludes our call this morning. Thank you very much.
Operator
Thank you. That completes our call today. A recorded copy of the call will be available on the company’s website. Thank you for joining, and you may now disconnect.
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