Zions Bancorp. (ZION) Harris H. Simmons on Q2 2016 Results - Earnings Call Transcript

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Zions Bancorp. (NASDAQ:ZION)

Q2 2016 Earnings Call

July 26, 2016 5:30 pm ET

Executives

James Richard Abbott - Senior Vice President, Director of Investor Relations

Harris H. Simmons - Chairman & Chief Executive Officer

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Scott J. McLean - President & Chief Operating Officer

Michael P. Morris - Chief Credit Officer & Executive Vice President

Analysts

Geoffrey Elliott - Autonomous Research LLP

Joe Morford - RBC Capital Markets LLC

David Eads - UBS Securities LLC

Ken Usdin - Jefferies LLC

Marty Mosby - Vining Sparks IBG LP

Paul J. Miller - FBR Capital Markets & Co.

Brad Milsaps - Sandler O'Neill & Partners LP

John Pancari - Evercore Group LLC

Jack Micenko - Susquehanna Financial Group LLLP

Gary Peter Tenner - D. A. Davidson & Co.

Terry J. McEvoy - Stephens, Inc.

Operator

Good day, ladies and gentlemen, and welcome to your Zions Second Quarter Earnings Results Webcast. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference is being recorded.

I would like to introduce your host for today's conference, James Abbott, Director of Investor Relations. Sir, you may begin.

James Richard Abbott - Senior Vice President, Director of Investor Relations

Thank you, Esther, and good evening. We welcome you to this conference call to discuss our 2016 second quarter earnings. Our primary participants today will be Harris Simmons, Chairman and Chief Executive Officer; Scott McLean, President and Chief Operating Officer; and Paul Burdiss, Chief Financial Officer.

I would like to remind you that during this call, we will be making forward-looking statements, although actual results may differ materially. We encourage you to review the disclaimer in the press release or the slide deck dealing with forward-looking information, which applies equally to statements made in this call.

A copy of the full earnings release, as well as a supplemental slide deck, are available at zionsbancorporation.com, and we will be referring to the slides during this call.

The earnings release, the related slide presentation, and this earnings call contain several references to non-GAAP measures, including pre-provision net revenue and the efficiency ratio, which are common industry terms used by investors and financial services analysts.

Certain of these non-GAAP measures are key inputs into Zions' management compensation and are used in Zions' strategic goals that have been and may continue to be articulated to investors. Therefore, the use of such non-GAAP measures are believed by management to be of substantial interest to the consumers of these financial disclosures and are used predominantly throughout the disclosures. A full reconciliation of the difference between such measures and GAAP financials is provided within the published document, and participants are encouraged to carefully review this reconciliation.

We intend to limit the length of this call to one hour, which will include a question-and-answer section. We ask each of you to limit your questions to one primary and one related follow-up question, in order to enable other participants to ask questions also.

I will now turn the time over to Harris Simmons.

Harris H. Simmons - Chairman & Chief Executive Officer

Thank you very much, James, and we welcome all of you to our call this afternoon to discuss our 2016 second quarter results. On slide three are some highlights for the quarter. Earnings per share increased to $0.44, a loss of $0.01 per share a year ago. By using the same adjustments that we used to compute our efficiency ratio, which primarily adjusts for the loss on the sale of our remaining collateralized debt obligation portfolio a year ago and the preferred stock redemption expense in the second quarter of this year, earnings per share increased nearly 17% over the prior year second quarter.

We're pleased with the continued trend of strong increases in pre-provision net revenue, which is the result of solid net interest income growth and adjusted non-interest expense levels that were well-controlled and that remained within the parameters of our stated expense initiative.

Adjusted for the same items mentioned earlier, we achieved positive operating leverage for the fifth consecutive quarter. We're tracking well with our efficiency initiative, with the efficiency ratio declining to 64.5% in the second quarter from 68.5% in the prior quarter. Recall that our goal for 2016 was to achieve an efficiency ratio of less than 66%.

We also experienced improved loan growth. The second quarter loans increased 2.6% from prior quarter, so it was a good quarter for loan growth.

Credit quality is a little bit of a tale of two cities. We consistently tried to be very transparent about the credit quality challenges of the oil and gas portfolios through this energy cycle. It remains challenged, and we'll discuss that in a little more detail later.

Outside of oil and gas, the loan net charge-offs were only $1 million on a portfolio of approximately $40 billion of non-oil and gas loans. So when you get outside of the oil and gas portfolio, we're actually really, really pleased with quality that we're seeing there.

Turning to slide four, our adjusted pre-provision net revenue was improved by a strong 32% over the past year. The adjustments to the GAAP numbers are detailed at the end of the slide deck, but the major exclusion is the effect of securities gains and losses.

We have been successful in improving both revenue and trimming expenses. We expect to continue to post continued growth in adjusted pre-provision net revenue, although we expect the rate of growth for the next 12 months to be somewhat less than the very strong 32% we saw this quarter.

On slide five, we display our loans and deposits. Relative to the first quarter, we experienced an acceleration of loan growth in the second quarter with loans held for investment increasing 2.6% as previously noted. Deposit balances increased an annualized 3.1% from the prior quarter without an increase in the cost of deposits. On slide six, there's a graphical representation of our loan growth by type. The size of the circles represents the relative size of the loan types.

We remain pleased with growth in areas that are targeted for growth. Although, we've experienced strong growth in term commercial real estate, we expect growth in that category to moderate going forward. We also expect non-energy commercial and industrial loans and residential mortgage loans to experience solid growth and to be the primary drivers of loan growth over the next few quarters. We continue to expect a decline in the National Real Estate portfolio that we've discussed on prior occasions.

I might add one additional note regarding overall loan growth going forward. The second and fourth quarters are typically seasonally a little stronger than the first and third quarters, so while we are particularly pleased with the second quarter's growth, we expect more tempered growth in the third quarter.

Moving to slide seven, we are well on our way to achieving another key measure of our commitment to shareholders, which is to reduce the efficiency ratio to less than 66% for the full year of 2016. As noted, year-to-date efficiency ratio was 66.5%, quarterly level was 64.5%. I'd also note that we are achieving all of this while investing substantially in enabling new technology and modernizing our core deposit and loan systems, which we expect will provide benefits for years to come and will be a really important competitive strength for us once we complete these projects over the next two years or three years.

On slide eight is our scorecard highlighting the commitments we made to shareholders back in June of 2015. I'm pleased with the progress made in a number of these areas in a relatively short period of time. All of the major initiatives are tracking to the targeted budgets and timelines. I'm pleased to report that we've completed the preferred equity dividend reduction a year earlier than our commitment.

My concluding comment will be regarding credit quality. In previous presentations to investors, I've highlighted that Zions' loan quality, as measured by net loan losses, has been superior to most regional peer banks through multiple cycles. This is largely attributable to the collateralized nature of our lending. On slide nine, my high-level comment on energy lending is that we have turned from cautious to cautiously optimistic. We believe there will continue to be losses in that portfolio, but with our strong reserve at present, we expect to experience average quarterly provisioning for loan losses over the next year at a level that is relatively consistent with that of the second quarter. Excluding energy loans, credit quality is really strong across the company, as noted, and this is true by both loan type and geography. About $40 billion of the $42.5 billion loan portfolio consists of non-energy loans and the total net charge-off ratio on that portfolio during the last five quarters has a median of only one basis point annualized.

Non-performing assets were stable relative to the prior quarter, and non-energy classified loans declined. And 90-plus day delinquencies also declined. So, some good metrics there.

With that overview, I will turn the call over to Paul Burdiss to review the financial results. Paul?

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Thank you, Harris, and good evening, everyone. I'll begin on slide 10. For the second quarter of 2016, Zions reported net earnings applicable to common shareholders of $91 million, or $0.44 per share. Relative to the second quarter of last year, net interest income increased about $41 million or 9.7%.

Customer-related fees, which is the bulk of non-interest income, improved about 5% from the second quarter of 2015. At $382 million, non-interest expense was lower in the second quarter of 2016 when compared to the year-ago quarter, although the year-ago quarter included seasonal stock-based compensation which was incurred in the first quarter in 2016, for this fiscal year. However, even considering this, we continue to make solid progress on our non-interest expense commitment.

Turning to the provision for loan and lease losses, at our last earnings call, we provided an outlook for provisions for the next four quarters that were consistent with the first quarter of 2016. Overall, loan losses in the second quarter were roughly in line with that forecast.

Also in the second quarter, we observed higher and more stable energy commodity prices, improved sentiment by oil and gas borrowers and sponsors, and improved capital markets activity in that industry.

However, because we remained cautious on the outlook for losses in that portfolio, we maintained the dollar amount of the oil and gas reserve. The resulting reserve, as a percentage of oil and gas loans, increased slightly as a result of the decline in oil and gas balances outstanding.

Additionally, continued improvements in the rest of the loan portfolio and minimal non-oil and gas net charge-off have resulted in lower overall reserve and provision levels in the second quarter when compared to the first quarter.

Slide 11 outlines our recent trends in net interest income, which continued to demonstrate strength in the second quarter. On a year-over-year basis, net interest income was up 9.7% when compared to the second quarter of 2015, driven by growth in loans and in the investment portfolio. The linked quarter increase was due to various factors. Most of the increase was due to a strong average loan growth and continued deployment of cash into higher yielding, highly liquid investment securities.

We remain positioned to benefit from rising rates, particularly short-term rates, as shown in the box at the bottom right hand side of the slide. Although we have deployed a substantial amount of cash into securities and loans, the interest rate risk characteristics of those assets, combined with continued deposit growth, have resulted in a somewhat stable interest rate sensitivity position. Using the midpoint of the range shown, a 25-basis point rate increase would improve annual net interest income by $25 million to $30 million, we expect.

As a reminder, our performance objectives that were initially communicated in June 2015 assume one additional 25-basis point federal funds target rate increase in December of 2016. Recently, the market was pricing in about a 50% chance of this occurring, approximately back to where it was prior to, and up substantially from the low of 8% in the wake of the Brexit vote.

Slide 12 provides additional information regarding our active management of the investment portfolio. We continue to add high quality liquid securities to our investment portfolio in the second quarter, reflecting the need for a permanent, high quality liquid asset position in order to manage our balance sheet liquidity more effectively, and in light of the liquidity coverage ratio rule.

Our efforts to build out the investment portfolio are expected to add revenue in current and downside economic environments, when compared to holding liquidity in the form of cash. During the second quarter, the available-for-sale investment portfolio increased $879 million, on average, when compared to the prior quarter.

We continue to exercise caution with respect to the impact on overall balance sheet interest rate sensitivity, as we purchase fixed-rate investments, and with respect to the duration extension risk inherent in that investment portfolio. The mortgage-backed securities we are adding are relatively short in duration, right around three years, with duration extension risk being only about a half a year, if rates increased by 200 basis points.

The duration of the entire securities portfolio, including our floating rate SBA securities, is about 2.7 years today. If rates were to rise 200 basis points across the curve, our models estimate that the duration of the portfolio would extend only slightly to 2.8 years.

A minor footnote to the disclosure on this extension risk. In previous iterations, we assumed a static prepayment rate for the SBA securities. In April, we made a change to the model to assume dynamic prepayment speed assumptions, and these securities behave in the opposite fashion when compared to residential mortgage-backed securities. We believe the SBA securities are expected to generally experience higher prepayment as rates rise, thus in some sense, offsetting the minor extension risk continued within the residential mortgage-backed securities portfolio.

Another key component of net interest income, the rate or yields of the investment portfolio, and the loan production, can be found on slide 13. This slide breaks down key components of our net interest margin. Top line, the loan yield, which expanded two basis points from the prior quarter, to average 4.16% and this was primarily attributable to commercial real estate loans that matured or re-priced during the quarter.

The securities portfolio yield dipped this quarter, largely due to increased premium amortization which was in turn due to higher prepayment rate. We expect some additional pressure on the securities portfolio yield in third and fourth quarters of 2016 as a result of the recent increase in mortgage refinancing activity. At the bottom of this chart is a line depicting our cost of funds as a percent of our earning assets which continues to be quite low, at 16 basis points and was stable relative to the prior quarter. The combination of all of these components and the continued deployment of cash into better yielding, highly liquid investment, resulted in a four-basis point increase in the net interest margin this quarter.

Although we do expect increased premium amortization from the residential mortgage-backed securities portfolio as well as increased refinance activity on a portion of our residential loan portfolio, we estimate the effect on the net interest margin to be less than five basis points in the near-term. This may be offset by continued shift of cash into loans and securities. Over the longer-term, as cash balances reach minimal levels, we expect to require additional funding for loan growth. Although, most sources of funding would result in lower incremental margins per dollar of loans produced, the overall effect could be a modestly compressing net interest margin, but a continued increase in net interest income.

Turning to slide 14 and non-interest income, because of the seasonality of results, we think year-over-year comparison is most relevant. We were able to increase customer-related fee income by 5% over the year-ago period. The areas experiencing the most significant growth include treasury management, which was up 8%, wealth management, which was up 9%, and mortgage, up 16%.

Notably, in the current quarter, there was a $1.7 million gain in the loan sales and servicing line item that is related to the increased valuation of mortgage loan, held for sale at quarter-end. That valuation increase was attributable to the sharp decline of interest rates at the end of the month of June. As such, we do not expect that specific gain to be repeated, although we continue to expect relatively strong growth in our mortgage business.

Non-interest expense on slide 15 declined 4.3% from the prior year, and if adjusted for items such as severance as displayed in the GAAP to non-GAAP table in the back of our slide deck, the decline was 2.6% from the year-ago period. Although, I will note that about half of that improvement is due to the timing of stock-based compensation which we have discussed previously.

For 2016, we are tracking to an adjusted non-interest expense level that is consistent with our stated goal of less than $1.58 billion. Relative to the prior quarter, the decline in non-interest expense was predominantly due to a decline in salary and benefits. As you know, in the first quarter, we incur seasonal expenses which taper or are not present for the balance of the year. Specifically, severance declined $3 million; stock-based compensation and retirement plan matching declined $9 million, and payroll taxes declined $4 million when we observed the second quarter compared to the first quarter.

Turning to slide 16, we're pleased to announce last Friday that we are actively pursuing our capital plan. To that end, the board has increased the quarterly dividend rate by 33% to $0.08 per share. Additionally, we have been authorized to initiate our common equity buyback plan, which calls for $180 million over the course of the next four quarters. By doing so, we will be actively managing our capital to our lower level in order to align the capital structure to the risk profile of the company. We expect this to enhance return on equity as well as accelerate the growth rate of earnings per share.

With that, I'll turn the call over to Scott McLean to discuss energy lending and recap our commitment to investors. Scott?

Scott J. McLean - President & Chief Operating Officer

Thank you, Paul. On slide 17, we show on the left side of the slide the oil and gas loans broken down by upstream services and other. Other is essentially midstream and downstream. Energy loan outstanding balances decreased about $73 million from the prior quarter with declines principally in upstream and the services portfolio, offset by a small amount of growth in the midstream portfolio.

Parenthetically, you will note on slide 22 that energy loan commitments declined more than $270 million from the prior quarter and are down $875 million from the prior year. Looking at the problem loan metrics, again on slide 17, for the oil and gas portfolio, classified energy loan balances increased about $99 million during the quarter. This compares to a $194 million increase in quarter one, which indicates a slowing trend in new problem outstandings. Also of note and easier to see on slide 22, criticized balances actually declined $20 million from Q1.

Finally, non-accrual loan balances were flat relative to the prior quarter. It may be helpful to understand that the vast majority of criticized, classified and even non-accrual loans are still current on their contractual payment.

On slide 18, regarding our loss expectations, if oil were to hold in the mid-$40s or higher, we currently expect energy losses for 2016 to be approximately $125 million. We expect most of these losses to come from our services portfolio, an area where a substantial number of borrowers remain challenged. Although, oil and gas net loan losses may remain elevated, we anticipate the second half of 2016 to be less than the first half of 2016 in terms of energy net charge-offs, which were approximately $73 million in the first half of 2016. Most of the balance of the loans that we flagged as high risk for loss, already have substantial specific reserves set aside against them. As Harris noted earlier, we have approved (21:55) our outlook on energy to what we would describe as cautiously optimistic. Our conversations with borrowers and sponsors suggest that sentiment has improved, as you can imagine, given the increase in the underlying oil and gas commodity prices.

Also highlighted on this slide, we maintained our energy loan loss reserve relatively flat, equaling slightly more than $200 million and more than 8% of outstanding balances. We consider this a very strong reserve, particularly relative to various measures of problem loans and loss expectations.

If you turn to slide 19, this is a list of our key objectives and our fundamental commitments to shareholders. We're fully committed to achieving the positive operating leverage we described, and I think at this point, with more than 30% year-over-year growth in PPNR, we can declare that our actions are making a very noticeable difference. We remain committed to the substantial simplification of all operational processes and upgrading our technology systems, which will position us with perhaps the most modern loan, deposit and customer information infrastructure in the United States. When complete, this investment will significantly simplify our back office, provide data on a real-time basis to bankers and customers, improve our new product time to market, position us well to more aggressively adopt enhanced digital capabilities and many additional advantages.

Regarding the capital with which shareholders have entrusted us, we're targeting much more substantial returns on capital than what can be seen today. And we are tracking well with those goals as discussed earlier.

Regarding returns of capital, we're pleased with the non-objection by the Federal Reserve to increase our return of capital to shareholders.

Finally, we're absolutely committed to our history of doing business with a local community bank approach. Perhaps the best acknowledgment that our commitment to doing business locally really is the strategic differentiator is the superlative results we received again this year in the nationwide survey conducted by Greenwich Research. As you know, we've received more awards for the highest level of national distinction than any other bank, and we are only one of four banks that have performed at industry-leading level since the initiation of this survey approximately eight years ago.

Paul, with that, I'd like to turn the call back to you.

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Thanks, Scott. Slide 20 depicts our outlook for the next 12 months relative to the most recent quarter. We are downgrading our loan growth outlook to moderately increasing from increasing, due primarily to internal decisions to constrain some of the commercial real estate growth we have recently experienced, although the quality of what we're producing remains very strong.

We're going to remain disciplined in our concentration risk management avoiding too much in any one geography, loan type, or single vintage. We expect net interest income to increase in the mid-single-digit to high single-digit growth rate driven primarily by loan growth and additional growth in the investment portfolio.

Given the right market conditions, we may also add interest rate swaps to assist with the reduction of our asset sensitivity. Although, our efficiency target includes the assumption of one additional quarter-point rate hike, we believe we can achieve a mid-single-digit to high single-digit growth rate in net interest income without an increase in the target federal funds rate.

We expect a quarterly provision for credit loss which includes the provision for both funded loans and unfunded loan commitments to be roughly stable relative to the second quarter assuming no significant adverse change in market conditions.

We expect the customer-related non-interest income, which excludes dividend income and securities gains and losses, will increase slightly to moderately as we continue to focus heavily on this area.

We continue to be encouraged by the efforts of our teammates to manage our cost of doing business. Our collective efforts allow Zions to remain on track toward our goal of adjusted non-interest expense at less than $1.58 billion for 2016.

For the next four quarters, we expect non-interest expense to run approximately similar to the first half of 2016 annualized, with similar seasonal variation in the first quarter of 2017 as was seen in the first quarter of 2016.

The effective tax rate for the second quarter returned to its more typical level. Recall in the first quarter we recognized some one-time tax credit. We expect our effective tax rate to be in the range of 34% to 36% over the next 12 months. We expect preferred dividends to continue to decline. With the successful tender completed in the second quarter, preferred dividends are expected to be approximately $45 million over the next 12 months.

This concludes our prepared remarks. Esther, would you please open the line for questions?

Question-and-Answer Session

Operator

Absolutely. Our first question comes from the line of Geoffrey Elliott with Autonomous Research. Your line is now open.

Geoffrey Elliott - Autonomous Research LLP

Hello. Thank you for taking the question. Could you give a bit more detail about the growth in commercial real estate that you saw this quarter? Are there particular geographies that have been driving that? Are there particular types of loan, and it looks like the yield stepped up a bit, so where would be opportunities to add yield? Thank you.

Harris H. Simmons - Chairman & Chief Executive Officer

Go ahead.

Michael P. Morris - Chief Credit Officer & Executive Vice President

This is Michael Morris. I'm the Chief Credit Officer. I'll comment on that briefly. The term commercial real estate growth that we saw in Q2 was driven partly by slower paydowns, some conversion of construction to term loan and other value-add transactions in the income property space, all of which are well underwritten, safe DCRs, well-defined and lower LTBs (28:24), equity and transaction. So it was a little bit unusual, but we're very satisfied with the credit quality of that particular portion of the loan growth in CRE.

James Richard Abbott - Senior Vice President, Director of Investor Relations

And, Geoff, this is James Abbott. I just might add a couple, we looked at the underwriting statistics of the production for the quarter, and just kind of as a general comment, the average loan-to-value was in the mid-50%s, and the average debt service coverage ratio would be around two times coverage, so very good underwriting statistics on the growth that we did see, but again, as we mentioned earlier, we're concerned about too much in one vintage (29:05) or one particular loan classification.

Scott J. McLean - President & Chief Operating Officer

Geoff, this is Scott. I would also note that geographically, there was really nice dispersion across California, Arizona, and Nevada and Washington, with a small, modest amount of growth in Texas on the term side, but the term has been pretty well-balanced across the portfolio.

Geoffrey Elliott - Autonomous Research LLP

And the step-up in yield on CRE?

Michael P. Morris - Chief Credit Officer & Executive Vice President

Yes. I'll comment briefly on that as well. The capital markets have backed up a little bit in CMBS. Borrowers are finding it a little tougher to place CRE terms, so in response, the line bankers and the business units facilitating CRE have upped the pricing of the overall coupon.

Geoffrey Elliott - Autonomous Research LLP

Great. Thank you very much.

Harris H. Simmons - Chairman & Chief Executive Officer

Thank you.

Operator

And our next question comes from the line of Joe Morford with RBC Capital. Your line is now open.

Joe Morford - RBC Capital Markets LLC

Thanks. Good afternoon, everyone.

Harris H. Simmons - Chairman & Chief Executive Officer

Joe.

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Joe.

Joe Morford - RBC Capital Markets LLC

I thought it was a pretty solid performance on the fee side. Is it still early yet, or are you starting to see some results from some of your initiatives there? And, excluding the loan sale valuation thing you talked about, is this a pretty good base to build off, going forward here?

Scott J. McLean - President & Chief Operating Officer

Joe, this is Scott, and, yes, I think our initiatives are showing nice progress. Our treasury management activities are still – it's our largest fee income stream. It's about 30%, and it's growing in the mid-single-digit to high single-digit rates, which is really good for that business.

Our other bank card products, business card, consumer card, are growing at high single-digit rates, which is – we've talked about repeatedly over the last couple of years, basically trying to get the same sort of penetration in our other markets that we currently achieve for those products in Zions First National Bank, our bank in Utah.

And then wealth management, which we've been concentrating on, it's growing high single digits. Mortgage, the fee income component is not growing, even though our origination volume is up, it was up 30% last year. Our origination volume will be up about 30% this year, but we are keeping more of that on the books, and consequently, it's not having the fee income benefit that we thought it would. But those would be just some things I would highlight.

Joe Morford - RBC Capital Markets LLC

Okay. And I guess, as a follow-up along those lines, I saw you purchased $104 million of loans or so in the quarter. I was curious what drove that decision, and do you see doing more of that going forward?

Scott J. McLean - President & Chief Operating Officer

It was a modest purchase with a really strong correspondent that we have a lot of respect for. We are, as you know, still significantly underweighted on exposure to 1-4 Family, and even though we're originating really nice volumes with our mortgage initiative, we thought at least having this as an alternate source is a good thing. The yields are significantly higher than what we could buy into our investment portfolio, and the credit statistics are on par with our own originations, with yields principally on par with our own originations. So it's just a real nice relationship, and we'll probably continue it at a very modest pace. But it's clearly not a key driver of our results.

Joe Morford - RBC Capital Markets LLC

Yes, no, I understand. Okay. Thanks so much, Scott.

Operator

And our next question comes from the line of David Eads with UBS. Your line is now open.

David Eads - UBS Securities LLC

Hello.

Harris H. Simmons - Chairman & Chief Executive Officer

Hey.

David Eads - UBS Securities LLC

Just kind of curious, obviously you've had good deposit growth, kind of kept the cash balance pretty high. At this point, how much further do you expect the cash balance to come down?

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

I'm sorry?

Harris H. Simmons - Chairman & Chief Executive Officer

How much further do you expect the cash balance to come down?

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Oh, right. So, we're going to continue to work that down as we invest. Obviously, deposit ebbs and flows are going to impact that. It's hard for me to give you a precise number, although I will say that, despite the very good loan growth we've had in the first half of the year, we continue to be on track with respect to our investment portfolio target, which is purchasing another, sort of, $1.5 billion or so over the next two quarters.

David Eads - UBS Securities LLC

Right. With respect to, if you keep having the deposit growth, would you expect to increase that? Or would you be kind of happy where that, you know, just getting to that point?

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

If the question is about the cash balance, I would expect to continue to whittle that down. Ultimately, as I said in my prepared remarks, I do expect for us to get into a position where we are going to incrementally go out and need to fund loan growth. When that happens, then you can assume that our cash balance has reached sort of its low point, and the point that we're most comfortable with.

David Eads - UBS Securities LLC

Okay. Thanks. Then just a quick one on the mortgage book, or particularly in the (34:51), it looks like you kind of have broad-based growth in all the geographies. I'm curious, you know, is that just kind of a function of growing off of a low base? Or is there something you guys are, you know, doing to generate that loan growth in a – where most of the peers are struggling, to generate that loan growth there?

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Now, that's been kind of the focus of the very specific campaign to, that's been focused on home equity lines of credit. So I think you're seeing results of that kind of marketing push.

David Eads - UBS Securities LLC

All right. Thanks.

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Yes.

Operator

And our next question comes from the line of Ken Usdin with Jefferies. Your line is now open.

Ken Usdin - Jefferies LLC

Hey, thanks. Good afternoon. On the expense side, you guys are doing a great job and certainly marching towards that sub-$1.58 billion this year, and I was just wondering, you gave that plus-$1.58 billion number for next year a long while ago and you've tracked so much better already. Just wondering what kind of line of sight you have on that at this point and if you think you can maybe have more flexibility than you had originally thought on any increases that would have come after this year?

Scott J. McLean - President & Chief Operating Officer

Right. This is Scott. And basically what we said was $1.58 billion for this year, slightly increasing in 2017, and I think fundamentally we feel we're going to be able to stay fairly close to the $1.58 billion next year as well. So we're continuing to find new ways to reduce expense in light of – and fund those areas that are growing.

Ken Usdin - Jefferies LLC

Yes. And has...

Harris H. Simmons - Chairman & Chief Executive Officer

I expect we'll have a little more to say about it as we get closer toward the end of the year, so I would agree with what Scott just said. I mean I – to the extent that it's north of $1.58 billion, it won't be much in excess of that, maybe better than it, but I think it's a little early still.

Ken Usdin - Jefferies LLC

Yes. Okay. Well, I'll ask my follow-up just related to it, which is if you were to do better than it, do you think it's because you're finding more or is it because the cresting of some of the prior spend is just coming in better than expected?

Scott J. McLean - President & Chief Operating Officer

I think it would principally be because we're finding more opportunities to simplify how we do business, and those opportunities we're digging into literally every day, we have been. The adoption of common practices in back office activities and middle office activities is just continuing to show us opportunities to reduce cost. So it'll be more related to that than any kind of cresting of previous activities.

Ken Usdin - Jefferies LLC

Okay. Understood. Thank you.

Operator

And our next question comes from the line of Marty Mosby with Vining Sparks. Your line is now open.

Marty Mosby - Vining Sparks IBG LP

Thanks. Good afternoon.

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Hi, Marty.

Scott J. McLean - President & Chief Operating Officer

Hey.

Marty Mosby - Vining Sparks IBG LP

Wanted to ask you, as you think back over the last year in your incremental purchase of $5 billion, how much do you think you've increased the benefit from that versus doing it today? So since you had higher rates over the last year, if you're looking at 10 basis points for every $5 billion, it would be $5 million that you'd be able to generate annually. So how much do you think now you're buying compared to what you were buying yield about a year ago?

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Are you asking about the incremental yield of bonds we're putting on?

Marty Mosby - Vining Sparks IBG LP

The difference between what you bought over the last year and what you're buying today.

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Yes. There are a couple of things there; one is rate and one is volume. And I think you can probably look at MBS rates in the marketplace or kind of the 5-year treasury and kind of come up with an estimate of that differential in yield, between what we're buying then and what we're buying now.

The other thing I would point out, though, and I'm sure you've noticed, is that we bought a lot of bonds in the second half of last year. We did okay in the first quarter; in the second quarter, we really slowed that down. We slowed it down because of the shape of the curve, and I think we've been pretty clear about telegraphing our intentions.

While we need to continue to put money to work, we are going to try to be thoughtful around the timing of those purchases. And I think your question kind of points specifically to any incremental value we may have created there. So I can't give you kind of a specific dollar amount, Marty, but I think it's probably pretty easy to triangulate on, when you look at the change in the market and the volume of what we bought over the course of the last year.

Marty Mosby - Vining Sparks IBG LP

Yes. When I triangulate it, I get $20 million to $25 million annual earnings that you actually generated by starting about a year ago. So the other thing I was wondering is it looks like you're starting to use a little bit of municipals. Is that something you're adding more of? Or are you finding some opportunities there? It'd be kind of an interesting little twist on what you've been doing in the securities portfolio and kind of alleviates some of the pressure on yields that you would be getting right now.

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

We have a very long and successful history in dealing with municipalities and providing credit to the local markets. This is critically important to what we do as a very locally-oriented bank. I think we're successful across our footprint, have been for a very long time, decades, and continue to be. So I think that what you're seeing there, Marty, is just a continuation of the success that we've had as an organization.

Harris H. Simmons - Chairman & Chief Executive Officer

I would add that it is something that we are very focused on trying to step up somewhat, and do more of this particularly with smaller municipalities, where we think the risk/reward kind of trade-off is quite nice. And whereas Paul indicates, we have a very long, solid track record. So yes, there's some focus there. The growth you're seeing isn't primarily a result of that push yet, but I'm hoping that over the next couple of years, you'll start to see more of them.

Marty Mosby - Vining Sparks IBG LP

And then, Harris, one last question. When you look at the excess capital, we estimate it to be about $1 billion. Now that we're going into the next phase, which is being able to pull some of that capital and give it back to shareholders, if you had a free rein, let's say we went back to the days where you could pretty much look at your excess capital and do something with it, it would add 150 basis points to your returns if you could deal with that $1 billion. What would you do if you didn't have the constraints that you have today? I mean how would you strategically deal with that at this point?

Harris H. Simmons - Chairman & Chief Executive Officer

Well, I think the first thing I'd say is clearly this, the world has changed a lot from the days when you had free rein. But you're posing a hypothetical. I guess I would say, clearly, we would use everything we've done in building capabilities to stress test in a model to think about risk particularly in a downturn, to inform how we think about capital, and there are a lot of things that we have built risk management-wise here in the last five years or six years or seven years that I think are actually really useful tools. Yes. I think we would agree that we got more capital and we're at the north end of where our peers are.

I would note that we'll always want to be probably kind of to the strong side so long as we have somewhat higher exposures to both commercial real estate and energy. We know that those are both segments where you can see maybe a little more cyclicality than some other things. And so this – if you took all of the limits off, this wouldn't be a race to the bottom, if you will, in terms of draining the capital. But we want to kind of thoughtfully try to right size our capital and to grow into it, and I think we've got – it gives us a lot of flexibility in terms of what we can do.

I don't know, I hope that's helpful. We know that we have more preferred than we probably need right now. That's something we've talked about and that we continue to opportunistically deal with, but on the common equity too, we're heavy and that's something that increasingly I think you'll see us working at. It's very much on our minds.

Marty Mosby - Vining Sparks IBG LP

Thanks.

Harris H. Simmons - Chairman & Chief Executive Officer

Yes.

Operator

And our next question comes from the line of Paul Miller with FBR & Company [Capital Markets]. Your line is now open.

Paul J. Miller - FBR Capital Markets & Co.

Yes. I'm following a question on capital. I mean, you've done a great job over the last 12 months, 18 months getting your expenses down, getting the preferred down and whatnot, but your ROEs – and you do have more capital, I think, than you need, but your ROEs tend to still be stuck in that middle single-digit, and some of that I think is the credit costs associated with the oil and gas.

But what is your ultimate goal? What is your ultimate goal relatively speaking with your ROEs, to get it into the – how are you going to get it into the 10% to 12% range?

Harris H. Simmons - Chairman & Chief Executive Officer

Well I think, and I'd say that our goal is, over the next couple of years, to get it up into up around 10%, and we think that that's doable. There is some additional reduction in preferred that will help. I mean, obviously the cost of preferred is a drag on the ROE. I would expect that as we continue to see better results through CCAR, that we'll be able to be a little more aggressive in our capital repatriation ask.

And then there's still a lot of operating leverage. I think it's really important to focus on what we're accomplishing. If you look at pre-provision net revenue as operating leverage that you see playing out over the last few quarters, it takes not a whole lot of additional work in that area to start to make a real difference.

And then finally, I would say that as we get through the energy cycle, we've got a very strong reserve. We do think that, that – I expect we're going to be able to start to lessen the provision, as we said earlier. As we come out the other end, and I think short of real deterioration, significant deterioration of the rest of the economy, the other credit metrics around here are very strong. Our absolute reserves are strong.

And I think one of the competitive advantages we're going to have that will feed into ROEs is going to be a provision, when we get through the energy cycle, that is likely to be pretty low, and it'll also help with ROE, while we continue to build this operating leverage that I'm talking about.

Scott J. McLean - President & Chief Operating Officer

Paul, I'd just add that...

Paul J. Miller - FBR Capital Markets & Co.

And one quick – okay. Go ahead.

Scott J. McLean - President & Chief Operating Officer

I'd just add to that, that the reason we focus so much attention and communication about the positive operating leverage is that we really do believe that the basic assumptions about loan growth, redeploying cash, fee income growth, holding expenses flat, the resulting positive operating leverage that we model moves us a long way over a three-year period to a much more representative ROE. And then, depending on what assumptions you want to make about our ability to reduce capital or trim capital, we believe we can get back to the levels Harris described, with the plan that we have in place.

Harris H. Simmons - Chairman & Chief Executive Officer

I'd also just note too that we've clearly been trying to – taking some asset sensitivity off the table, but there's still a fair amount there. And in this rate environment, I personally find myself asking, scratching my head and saying there's this 775-basis point premium to a risk-free rate. Should it continue to go north of that, beyond, to 12% or something like that, I think we ought to all worry about an industry where the expectations – in an industry where you've sort of doubled the common equity in it over the last decade, a 12% ROE is what used to be a 24% ROE. And I think that could involve stretching beyond the point that is actually prudent. So it's how I think about it.

Paul J. Miller - FBR Capital Markets & Co.

Then the second question, then with a follow-up question is, on the loan that you purchased on the residential side, were they mostly jumbos or were they just conforming-type loans?

Harris H. Simmons - Chairman & Chief Executive Officer

They're jumbos.

Paul J. Miller - FBR Capital Markets & Co.

Jumbos. Hey, guys, thank you very much.

Harris H. Simmons - Chairman & Chief Executive Officer

Yep.

James Richard Abbott - Senior Vice President, Director of Investor Relations

Thank you.

Operator

And our next question comes from the line of Brad Milsaps with Sandler O'Neill. Your line is now open.

Brad Milsaps - Sandler O'Neill & Partners LP

Hey. Good evening.

Harris H. Simmons - Chairman & Chief Executive Officer

Hey, Brad.

Brad Milsaps - Sandler O'Neill & Partners LP

I guess I'll ask maybe the first energy question, but just curious, Scott. I appreciate your comments on – it sounds like people became more positive, whether it be your borrowers or investors. We had a nice move in oil during the quarter, up close to $50. We've since come back I guess into the low $40s. What level in your mind, I guess, did you start to get concerned again, or do you think it starts to maybe lock – maybe create more gridlock or call into question maybe some of the deals that have been put in place thus far? Just kind of curious, any color around the more recent move, and I know it's been a short period of time, but just kind of curious what your thoughts would be there?

Scott J. McLean - President & Chief Operating Officer

Sure, Brad. Happy to respond to that. The other thing that I would note, we don't comment about it enough, but natural gas prices also have rallied significantly since early March. Recall that they declined quite a bit in the fourth quarter of last year and through the middle of March. Oil prices really declined kind of January-February and the first part of March, and then both have really made a very nice recovery since then. I only note that because, recall that in our reserve-based lending activity, about 50% of the reserve is – I mean of the borrowing bases are natural gas reserves. So you really kind of have to focus on both.

But what I would say is that the underwriting that we did in our spring redetermination generally had prices, oil prices, around kind of in the mid-$30s to high $30s. And the sensitivity would have been down – in the high $20s, excuse me. High $20s, $30ish. And so if prices retreated here back to the high $30s, I don't think that would really impact our reserve. If we saw prices go down into the low $30s, high $20s, well then it might change how we would think about it. But I think there's a lot of room between where we are and that kind of really negative environment because fundamentally, the supply and demand curves have improved since six months ago, and that's fundamentally driving the price changes.

So that would be my comment. I think we feel really pretty good about the reserve-based portion of our portfolio. The deficiencies that we experienced in the spring redetermination all have very firm repayment processes associated with them. So we didn't have any big surprises on the reserve-based side in the spring redetermination. And it really is just an oil field service question fundamentally, and how long that'll go on. And we believe it'll go on into next year, even if prices continue to improve.

Brad Milsaps - Sandler O'Neill & Partners LP

Great. Thank you.

Operator

And our next question comes from the line of John Pancari with Evercore. Your line is now open.

John Pancari - Evercore Group LLC

Thank you, guys. Good afternoon.

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Hi, John.

John Pancari - Evercore Group LLC

On the loan production side, I just want to see if you can elaborate a little bit on where exactly are you intentionally tempering production, given concentration limits? I mean is it all term CRE, or is it certain types of CRE underwriting, and is it by market, and is there certain concentration measures that you're looking at? If you can help us with how you quantify that. Thanks.

Michael P. Morris - Chief Credit Officer & Executive Vice President

Yes. This is Michael again. We have very well-defined concentration limits by asset class and asset types, and there are some historic assets that have proven not to do so well, and we obviously have low concentration limits set for those. We're not doing anything necessarily to stimulate production in any one of those categories. We think we might be a little heavy on multi-family, so we're tempering production there, both construction and term. And I hope that answers your question.

John Pancari - Evercore Group LLC

Okay. Yes, all right. So what parts of commercial real estate are you still willing to put on the portfolio?

Michael P. Morris - Chief Credit Officer & Executive Vice President

Well, selectively, any transaction that has a really strong metric, solid sponsor, guarantor support, good market, deeper MSA that can prove as a worthy takeout source. The retail is obviously, the online sales, has kind of tempered our belief, and we aren't too excited about putting on a lot of new retail. Industrial is an asset class that is in favor right now to us, especially in the markets that we serve. Hospitality we have historically de-emphasized, but we do select hospitality transactions. I would say, anything that is horizontal development like A&D, land, lots, that aren't associated with homebuilder production and vertical construction, is an asset class that we're definitely steering away from. Historically it was in our mix, but today and going forward, it's a relatively small piece of the book.

John Pancari - Evercore Group LLC

Okay. That's helpful. And then, sorry if this was already discussed. I might have missed it. But just want to get your overall thoughts on the NIM trajectory here, in terms of, should we expect that, given where the new production is coming on and competitive pressures that we see erosion from here, or could you see some relative stability? Thanks.

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Yes, John, this is Paul. What I tried to convey in my remarks is that we've got some countervailing influences. One as you described is sort of the ongoing grinding of margins that we see, and that obviously adversely impacts the net interest margin. In our case, though, we are helped by the fact that we continue to deploy cash into our highly liquid investment portfolio. And the result of that obviously is no increase in earning assets, the denominator, but an increase in net interest income. So net-net, that's helpful to the margin. So as I was trying to say in prepared remarks, we're looking at maybe a couple of basis points, we think, over the next couple of quarters. But as you know as an experienced observer of banks, that can be pretty hard to predict sometimes.

John Pancari - Evercore Group LLC

Got it. All right. Thanks, Paul.

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Okay.

Operator

And your next question comes from the line of Jack Micenko with SIG. Your line is now open.

Jack Micenko - Susquehanna Financial Group LLLP

Hey. Good afternoon. You talked about turning a little more cautiously optimistic on energy. Commodity prices are up. I think your exposure is down. But the cumulative charge-off number, it looks like it's been walking up. I think you were $75 million to $100 million, end of last year, and then kind of $100 million to $125 million. And it looks like on slide 18, we're now looking at $125 million. So is it a frequency issue? Is it a severity issue? I'm just trying to figure out what's changed there to kind of move that number higher.

Scott J. McLean - President & Chief Operating Officer

Sure, Jack. This is Scott. We had said $75 million to $100 million area. We comment on $125 million today. And as you noted, our energy net charge-offs were about $75 million through the first half of the year. And we're simply saying we think they will start to go down. We think they'll be less in the second half of the year. But it's very hard to know. We don't have a clear line of sight right now to those second half of the year charge-offs. We can see about half of them and then we're assuming others will materialize. So there is an opportunity for a favorable performance relative to the $125 million.

The other comment that I think is really important is how does this fit, as both Harris and Paul noted in their comments, how does this fit in terms of our overall thoughts about net charge-offs this year. Recall that we guided to 30 basis points to 35 basis points, $125 million to $150 million in net charge-offs. And clearly our energy charge-offs are going to be larger than what we thought, but we've only had $1 million in net charge-offs on the other 94% of the loan portfolio through six months and we are clearly going to have less charge-offs than we anticipated there.

So we continue to anticipate the same consolidated net charge-off experience that we guided to. It's just going to be a little more weighted to energy.

Harris H. Simmons - Chairman & Chief Executive Officer

I think I'd just also add, and I think, my perspective anyway. It's Harris. The most encouraging thing that I'm seeing is that we're not seeing new names popping up.

Scott J. McLean - President & Chief Operating Officer

Right.

Harris H. Simmons - Chairman & Chief Executive Officer

The list of deals where we expected that we might see some fraying, basically a year ago, hasn't really fundamentally changed. So some of the timing, to some extent perhaps even magnitude in some of these deals has been a little different, but we're not seeing new names coming out of the woodwork and I think that's a big plus in our thinking about it.

Scott J. McLean - President & Chief Operating Officer

It is. And I would also note because the vast majority of our charge-offs on to the energy side are coming from the oil field service fees. Recall that we've significant private equity sponsorship with our 70 some-odd service-based companies, our larger service-based companies that we finance. And to date, last year and through six months this year, they've injected about $250 million of capital into our borrowers. Just back of the envelope, that would be 15% to 25% in increased equity to those existing deals, which generally were 50% equity, 50% debt; I'm using some broad generalizations here.

So we've seen really strong performance from the private equity funds, when you think of 15% to 25% equity injections in an 18-month period. And with strengthening pricing in oil and gas commodity prices, we believe that'll continue.

James Richard Abbott - Senior Vice President, Director of Investor Relations

Okay.

Jack Micenko - Susquehanna Financial Group LLLP

That's helpful.

James Richard Abbott - Senior Vice President, Director of Investor Relations

As to we're out of time on the debt part of the – so we'd like to take the last few questions, but just limit it to one question at this point, and we'll try to keep our answers concise as well.

Operator

Our next question comes from the line of Gary Tenner with D. A. Davidson. Your line is now open.

Gary Peter Tenner - D. A. Davidson & Co.

Thanks. Paul, I was just hoping to clarify the comment you made on the margin. I would've thought that would be ongoing improving mix of earning assets that would certainly support stable, if not an expanding margin. Does that assume that the securities yields stay under pressure in the third quarter and fourth quarter, as they were in the second quarter from prepayment speeds?

Paul E. Burdiss - Chief Financial Officer & Executive Vice President

Yes. That's precisely correct. Not only are we buying new bonds, which is helpful, but the bonds that we do have are prepaying faster. There's premium attached to those bonds that decrease in the yield, and that happens, as you know. And so there's a little headwind there that we're dealing with, in addition to ongoing kind of grinding tighter of credit spreads.

Gary Peter Tenner - D. A. Davidson & Co.

All right. Thank you.

Operator

Our next question comes from the line of Terry McEvoy with Stephens. Your line is now open.

Terry J. McEvoy - Stephens, Inc.

Hi. Thanks. Good afternoon. I was wondering if you could expand on the compensation comments, where you say tighter incentive comp is linked to achieving the efficiency ratio target. I guess on mortgage wealth management, that's pretty clear. So my question is, how are you driving your commercial bankers to be more efficient? Is it something that we can track on the balance sheet, the pricing yields? Or is it also a function of some of the fee businesses, capital markets, treasury, et cetera?

Harris H. Simmons - Chairman & Chief Executive Officer

Well, I think what we're fundamentally referring to there is we've got an incentive plan that covers top, roughly 450 or so officers of the company, that is effectively very closely linked to how we do in terms of cost control and continuing to develop operating leverage, et cetera. But the cost control is just kind of a central theme to how we think about payouts under that plan. So some of you have heard me say before, but I'd tell all of our people here that every nickel they spend, consider it it's not coming out of shareholders' money, it's coming out of kind of the top 450 people in the company, because to the extent that we don't hit those targets, the funding for that incentive plan is reduced to the point that we do. So there's a very, very tight linkage in that respect.

Terry J. McEvoy - Stephens, Inc.

Thank you.

Harris H. Simmons - Chairman & Chief Executive Officer

Yes.

Operator

At this time, I'm showing no further questions. I would like to turn it back over to management for any closing remarks.

Harris H. Simmons - Chairman & Chief Executive Officer

I just want to thank all of you for your time and for your interest, and we look forward to talking to you the next time we see you or next quarter. Thanks so much.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program. You may all disconnect. Everyone, have a wonderful day.

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