Veritex Holdings, Inc.

Good day and welcome to the Veritex Holdings Second Quarter 2022 Earnings Conference Call and Webcast. All participants will be in a listen-only mode. Please note, this event will be recorded. I will now turn the conference over to Ms. Susan Cottle, Investor Relations Officer and Secretary to the Board of Veritex Holdings. Please go ahead.

Thank you. Before we get started, I would like to remind you that this presentation may include forward-looking statements, and those statements are subject to risks and uncertainties that could cause actual and anticipated results to differ. The company undertakes no obligation to publicly revise any forward-looking statements. At this time, if you are logged into our webcast, please refer to our slide presentation, including our safe harbor statement beginning on slide two. For those of you joining us by phone, please note that the safe harbor statement and presentation are available on our website, veritexbank.com. All comments made during today's call are subject to that safe harbor statement. Some of the financial metrics discussed will be on a non-GAAP basis, which our management believes better reflects the underlying core operating performance of the business. please see the reconciliation of all discussed non-GAAP measures in our filed 8K earnings release. Joining me today are Malcolm Holland, our Chairman and CEO, Kerry Early, our Chief Financial Officer, and Clay Reby, our Chief Credit Officer. I will now turn the call over to Malcolm.

Good morning, everyone, and welcome to our second quarter earnings call. Before we get started, I'd like to congratulate and thank my dedicated team on producing yet another exceptional quarter for Veritex. We're proud to serve Texas as a whole, and specifically the DFW and Houston markets, which are two of the strongest and most resilient markets in the U.S. Texas' focus on promoting growth, a pro-business environment, and increased job opportunities aligns to our core culture and mission. Slide four of our deck provides a small glimpse into the incredible statistics of our market we serve, which continue to provide ongoing opportunities to further our profile and scalability. Now let's jump into the earnings for the second quarter. For the quarter, we had net operating income of 30 million, or 55 cents per share, and a pre-tax pre-provision operating income of 46.7 million, or 85 cents per share. This pre-tax pre-provision is an increase of 5.1 million over the previous quarter, despite lower non-interest income of 4.7 million. The increase was fueled by a surge in net interest income of over $11 million. Obviously, this increase in net interest income was a result of some outstanding loan growth. As I mentioned last quarter, the loan growth came late in Q1, which started this quarter with a great deal of momentum. This momentum only got stronger during 2Q. For the quarter, Loans net of mortgage warehouse grew $791 million, or 44% annualized, and $1.16 billion for the first half of the year, or 35% annualized. This quarter was a perfect storm of many of our lending teams surpassing our expectations, payoffs reducing, and candidly, good old-fashioned relationship building. The quality of our growth was exceptional. It should be noted that between 25% and 30% of our growth in 2022 was from newly hired talent since the start of the pandemic. We look at this growth as an increase in market share versus economic growth as these lenders move their books of business. I've been saying for two years now how we are committed to new hires and looking to increase our talent, our experience levels, and investment in quality relationships. As you can see, these efforts are paying off. You can see on slide 7 the breakdown of the loan categories that stratifies the growth for the second quarter. I do wish to address the notion that this level of growth is headed into what many describe as a weakening market. Our credit underwriting over the past several quarters has only become more stringent with increased stress analysis and continued large equity contributions. The Texas economy continues to produce outstanding results and outperform national numbers. The best metric I've found is that Texas sales tax was up 16% over the prior June. For the first 10 months of the state's fiscal year, sales tax revenue topped $35 billion, a year-over-year gain of 20%, which is more than double the rise in inflation. Understand that these are backward-looking metrics, but we have not seen the distress with our clients at this point in time. We have seen a few projects pause due to rising rates or supply chain costs. With that said, we expect our loan growth to slow in the back half of the year to 16% to 18% range. Our deposit growth for the year has also been exceptional, with 2Q growth of 630 million, or 32% annualized, And for the first half of the year, 1.2 billion are 32% annualized. Our non-interest bearing deposits have consistently stayed in the 35% of total deposit range, even in this rising rate environment. I couldn't be prouder of the job our relationship managers and our support functions have done to continue to build our bank. Like growth, our credit metrics continue to trend in a positive direction. NPAs fell for the seventh consecutive quarter and now stand at 40 bps, down from a high of 111 bps at 3Q2020. Chargeoffs for the quarter were virtually nil at $909,000 for the quarter. Our ACL remained at 1.02% after a loan reserve expense of $9 million, primarily driven by our strong growth quarter. We have and will continue to be diligent and conservative in our underwriting standards and the selection of new credit opportunities. I'll now turn the call over to Terry.

Thank you, Malcolm. Before I get started in specific pages and results, it's important to remember that Q2 was the first full quarter since our capital raise in March. This capital raise was critical given our anticipated loan growth for Q2. However, the capital raise inherently makes earnings per share, and return on tangible common equity metrics more challenging. Starting on page six, Q2 was a very strong quarter for Veritex with one exception. Net interest income grew almost 16% on a linked quarter basis, and expenses were in line with previously provided guidance, which include the talent investments we've been making since the beginning of the pandemic. Additionally, credit metrics continued to improve. Our weak spot, which is largely out of our control, was fee income. I will discuss this more later in my commentary. We don't have a presentation table on operating leverage, but let's start our discussion there. Revenue growth since Q2 21 has been 19.2% even with weaker fees in Q2. Expense growth over the same period has been just under 15%. This results in about 4.5% of positive operating leverage. If you back out the impact of $1.6 million in PPP fees during Q2 2021, then operating leverage improves to 7%. Those are strong results that indicate our investments in talent, which are a significant factor in our growth profile, are generating strong returns. Our operating return on average tangible common equity was down to 12.8% in Q2 due to capital raise and lower fee income. Return on tangible common equity has averaged 16.6% over the last four quarters. Veritax's pre-tax pre-provision operating return on average assets was 1.76% for Q2 and has averaged 1.82% for the last year, reflecting a growing but efficient company. Tangible book value per share has grown by 10.7% over the last four quarters after adding back the impact of the dividend. On slide seven, Malcolm has already mentioned our loan growth for the quarter. This loan growth includes the purchase of $137 million in owner-occupied mortgages. On slide 8, advances on the ADC portfolio are approximately $400 million per quarter. Average mortgage warehouse balances increased 13.6% in the second quarter, and we're certainly pleased with these results given what is going on in the mortgage industry. This portfolio represents 6% of average total loans in Q2. Skipping to page 10. Net interest income increased by $11.5 million, or almost 16%, from Q1 to $84.5 million in Q2. The two biggest items in the increase are growth, which accounted for $7.4 million of the increase, and the Fed raising short-term interest rates, which represents about $2.4 million. The net interest margin increased 20 basis points from Q1 to 3.42%. The NIM got stronger as the quarter progressed. given the timing of the Fed rate hikes and the lag in the reset of one-month SOFR and LIBOR-based loans. The NIM for the month of June was 3.55% and has strengthened further in July as contractual loan yields on the portfolio have increased another 31 basis points through mid-month. Our internal modeling indicates that we should achieve five bps of NIM expansion for every 25 basis points in Fed move. As you look to model net interest income in future periods, keep the following in mind. First, the ending balance in earning assets are $582 million above the average earning assets for Q2, creating significant positive jump-offs. Given market expectations of 175 basis points and additional Fed rate hikes in 2022, this will add significantly to net interest income. Veritex's asset sensitivity has decreased slightly since Q1, but so has our down rate risk. We have intentionally putting on fixed rate assets on the balance sheet to mitigate falling short rates in 2023. Skipping to slide 12. As I said earlier, fee income was the one weak point for Veritex during Q2. Non-interest income declined by 4.7 million to 10.4 million for the quarter. Revenue related to our government-related businesses drove the decline. Gain on sale income declined $4.1 million. Additionally, there was a 1.3 million write-down on our SBA and USDA servicing assets. Partially offsetting these declines were increases in deposit fees, equity investment income via the investment in Thrive Mortgage, and interest rate swap fees. In fact, Q2 swap income was the highest in Bear Texas history. Turning to slide 13. Q2 was a bumpy quarter for North Avenue Capital as the USDA centralized all funding decisions into Washington after loan demand outstripped federal government budget allocations. This significantly impacted our ability to get loans closed. This was compounded by rising interest rates and economic uncertainty, which resulted in gain-on-sell premiums going down approximately 40% to 50%. Additionally, the rising interest rate resulted in the valuation impairments of those assets, the servicing assets I noted previously. As it relates to Q322, it's our understanding that the USDA has found hundreds of millions of dollars of additional funding for their B&I program, which improves our chances of getting a few USDA loans closed. The new fiscal year for the government starts in Q4, so funding should not be a problem from that point forward. Our SBA business was also impacted by lower gain on sale premiums in the same range as they were in the USDA business and also a servicing impairment. It is likely that if gain-on-sell premiums in the USDA and SBA market remain under pressure, that Veritex will choose not to sell a portion of our production. Rather, we will portfolio the loans given their strong pricing and favorable capital treatment. Know this, we're going to make the right long-term economic decision for Veritex, even if it means foregoing short-term revenue. Moving to Thrive. Funded volume increased approximately 19% in Q2, while the MBA is forecasting a 2% decline for the same period. Thrive has been able to maintain their gain on sale margins due to the high percentage of volume coming from Sunbelt states and a great reliance on purchase business versus refi. They're aggressively managing cost and staffing levels while successfully hiring strong origination teams in different parts of the country that could add meaningfully to forecasted closed loan volumes going forward. It's been one year since we made the investment in Thrive. Over that period of time, we've generated a pre-tax return on our investment of between 13% and 14% in what has been a very turbulent mortgage market. Operating expenses on slide 14 increased $2 million from Q1. The biggest driver of the increase is marketing costs associated with the Veritex Bank Corn Ferry Golf Championship, which is a tournament held in Arlington, Texas, during the month of April. So far in 2022, we've incurred just under $94 million in operating expenses. We remain confident in our expense guidance of $185 to $195 million for the full year. Moving forward to slide 15, a strong quarter on the deposit front with growth of $628 million, with growth being driven by our community bank at 13.7% link quarter annualized, where we run a sub 53% loan to deposit ratio. The rest of the growth is from our mortgage warehouse business, interlink and broker time deposits, offsetting outflows in our correspondent banking division. Total deposit costs increased 11 basis points to 28 basis points in response to the Fed increasing rates by 125 basis points during the quarter. On slide 16, Total capital grew $36 million during the quarter to $1.3 billion. CET1 ratios have expanded by 22 basis points year over year. As of quarter end, we had significant excess capital above the regulatory minimums plus the capital conservation buffer. Looking forward on capital, we believe that moderating loan growth coupled with higher earnings from rising interest rates will strengthen the capital ratios. Additionally, we are evaluating a credit risk transfer on our mortgage warehouse portfolio to lower risk-weighted assets. This transaction should add approximately 30 basis points to our CET1 level when it's complete. With that, I would like to turn the call back over to Malcolm.

Thank you, Terry. We had an exciting quarter and very focused on the positive momentum we have created by our upgrade in talent and focus on scale. As I've mentioned many times, our focus has always been on hiring top quality talent. For the quarter, we hired 65 new employees, 16 of which are on the production side. Our hiring of producers will slow a bit now that we have many of our teams at full capacity, but our overall investment and talent for Veritex will continue. We've added a new pipeline of potential bankers with our first class undergoing the Veritex Banker Development Program. We have 16 participants. five internal and 11 external that are part of a one-year development program that focuses on building future talent. We also have 13 college students in our Veritech summer intern program, which is now in its fourth year. We are committed to developing the banking leaders of the future and know this pipeline of talent will benefit us for years to come. A quick update on the interlink transaction. We continue to have detailed dialogue and work with our regulators with full expectation of a 3Q closing as previously communicated. Interlink continues to grow and perform very well. The future continues to be bright for our company. We have the right team and the right markets, and we continue to feel strongly that we have a firm hand on building continued value. With that, I'd like to open the line up with any questions.

As a reminder, to ask a question, you will need to press Tar 1 on your telephone. Again, that is star one on your telephone.

Please stand by while we compile the Q&A roster. And our first question.

is from Brett Ravittian from Hoffman Group. Your line is now open.

Thanks. This is actually Taylor stepping in for Brett. A question on the government guaranteed. Just a reminder, you know, maybe that's slowing off and balance sheeting that. Is there any sort of read through on the expense side that we should think about going forward?

No, I mean, this is a temporary thing. We strongly are committed to the business. If anything, we're investing in talent and building that business more. We're just right now with rates going up and with this temporary blip in funding from D.C. and our government, it's business as usual for us. Pipelines are full, and we continue to hire in that business space. So, you know, look, if the gain on sale margin is going to stay weak, these are great balance sheet assets given that you've got a 20% risk waiting for capital purposes. So if the economic, long-term economic decision is the best for us to hold, we're going to hold and we're going to keep building the business because it doesn't use much capital.

Great. Thanks. Also, on the marketing expense, maybe I missed that.

um what would you attribute that the benefit from that would it be both sides of the balance sheet or anything else specific from ramping that up you know we're we're we have a nice marketing budget we'll continue to market the way we market we we have spent heavily in the golf industry and continue to uh to do that despite some of the changes in the in the tours right now okay very good and um

And the hires, anything specific? I know obviously that's been easing, as you mentioned earlier, but any sort of specialty focus or just general producers that you've been onboarding?

Yeah, I mean, we've kind of got somewhat of a full team across the board with the exception of a few areas. You know, our commercial areas we continue to invest in, but we feel really good with the folks we have. You know, the recent hires in Houston have been very, very positive, and the momentum down there is just starting to build. And, again, I just reiterate that a lot of the new business that we have is market share grab, and for us that's a real positive. But, you know, I think we're in a good place on the hiring, but we still have 40-something open positions, so we'll always be hiring. Okay.

Thank you for the commentary. Appreciate it.

And your next question comes from the line of Brady Gailey with KBW.

Your line is open.

Hey, thanks. Good morning, guys.

Hey, Brady. Morning, Brady.

So the gain on sale premium, You know, coming in in the second quarter, you know, is that something that was that more just a sign of the times? Is that related to the rising interest rates? You know, do you expect that to bounce back? And what's the forecast on how you think about gain on sale premiums for that business? Or is it just kind of up to the market and it's hard to forecast?

Well, I mean, I think a lot of it is driven by rising rates and economic uncertainty, and that's making, even with strong prepaid protection in the USDA space, I think it's making the buyers and investors in that paper less aggressive in their bidding. And so I think that's what's contributing to it. Now, I think once there's the terminal rate for Fed funds and the timing of the rate curve moving or short-term rates moving down, It's what I think is going to be key and just greater economic certainty on the, you know, are we going to have a recession? How deep, how short, et cetera, is it going to be? I think that's when premiums start to strengthen. So my general view is that premiums will probably remain weak through the balance of the year. I expect them to start strengthening as we get into 2023. So that's on the premium side. On the funding, I think we'll be closing loans. The question is, are we just going to hold or are we going to sell? And so I expect closed volume now that the USDA is getting its funding lined up and we're heading into a new fiscal year starting October 1. I expect a really strong back half of the year on the funding side, but may just all end up in portfolio, which has got really good implications for net interest margin, growth, etc., And if that's the way it happens, so be it. We have a way looking at the present value of the cash flow of sell versus hold. You're discounting at our cost of capital. And when that length of time for it to sell in your break-even period, if it gets too short, we just hold. And we're going to stay to that methodology because it's the right long-term economic decision for Veritex.

Yeah, that makes sense. But just for expectations, I mean, 1Q was such a great quarter. I mean, $5 million of fees there. 2Q was closer to $1 million or a little under $1 million. Do you think the 2Q rate is kind of what we should expect for the back half of the year, or do you think it could be better?

I think I would expect that it will be a little better, but I don't think it's back to – I think Q3 will be the weakest. I think Q4 will get better. Will it get back to Q1 levels? Hard to know, Brady. But I think this is true for the SBA business as well. I don't think it's going to be great. I mean, roughly right now, only half our production meets our hurdles to sell when we look at the gain on sale premium. So I would be pretty conservative on that. But the thing I feel the best in terms of what's going to offset that, we made a big strategic hire at the beginning of the quarter and interest rate swaps, and we had the best quarter ever in Q2. Trust me, it's going to be even better than that in Q3 because we can see what's in the pipeline there. So there's some offsets, but I wouldn't go crazy, especially in Q3, getting overly optimistic that, I mean, I think we're going to have better than Q2 overall in fee income. because of interest rate swaps, I think the government guaranteed business is going to stay weak on the gain on sell side through the quarter and then improve more in Q4. Okay.

All right. That makes sense. Then finally, for me, you know, growth is slowing here. It's still going to be great growth. You know, growth is slowing. Your profitability is enjoying the benefit from higher rates. You know, it sounds like you're about to get a little boost to capital from the CRT mortgage warehouse deal. So, you know, the stock's at eight times earnings. So, you know, do you start thinking about reengaging in the buyback at this point, given all those dynamics?

No, no, it's just not the right time. And, you know, candidly, investors rather have us invest in the future growth and earnings of the company, and that's where we're focused. But I would not model in any buybacks.

definitely an attractive valuation and historically before we had such a strong growth profile the answer would have been different we'd have been saying yes but that's not where we find ourselves now and so we'll deploy all our capital generation even you know even you know you saw that CET1 went down to 925 you know I need that moving back up and so I you know with the growth profile I that we're talking about, it's pretty neutral to capital, but it doesn't build, and I need it to be a little bit higher. And CET1 is up year over year. It is up year over year, 22 bps.

Okay. All right, great. Thanks for the color, guys.

Thank you, Greg.

And your next question comes from the line of

Matt Olney with Stevens Inc. Your line is open.

Hey, thanks. Good morning, everybody. Hey, guys. Hey, Matt. So it sounds like the loan growth pipeline remains strong the back half of the year. We'd love to hear more about the plan for funding the growth. Good core deposit growth in 2Q. You took on a little FHLB. I guess you also had the Interlink deal closing at some point in the third quarter. So just You wrote all together. Just would love to hear kind of the thoughts on funding the growth of back half the year. Thanks.

Yeah, that's a great question. You know, we have started to participate as a downstream bank and interlink even before we had it closed. And we started doing that in the second quarter. The optics with the broker dealers to have us as the acquirer going ahead and participating is just pretty compelling from their perspective. So that's what we did. So I would expect, you know, we've been saying all along that we, you know, we thought we'd probably fund up to $1.5 billion with Interlink in 2022. And so I expect that to be a big contributor. I also think that our mortgage warehouse business continues to see good opportunities in the deposit space there. The escrow deposits, those type things where we're seeing we're able to achieve good spreads of our ECR rate. And then, you know, our community bank continues to really produce great results for us on the deposit side. Got a strong emphasis on Treasury. So I think it's going to be a combination of all those things, Matt, that are going to fund the growth in the back half. All I can say is with the growth that the industry is seeing, I'm glad that we have Interlink pretty close to closing because without it, it would be a much more different and challenging quarter.

We redid our incentive plans for our bankers on the deposit side, and we're starting to see some payoff from that. And so we'll continue to focus on incentives on the deposit side. But the community bank had an unbelievable growth. quarter and expect that that will move into the corporate side here also since we've changed that plan up some. And we changed that at the beginning of the year. Yeah. Before we ever knew that funding was going to get. Right. Just a much greater emphasis on the value of deposits.

Yeah. Yeah. Agree on the timing of this. Should be good. Any color on how much of the deposit growth in 2Q is were from some of those participations that you mentioned, Terry?

I mean, it's spread across, I mean, I mentioned four intentionally, and they're all pretty significant drivers with the one downside being our correspondent banking division. And you can see the correspondent banking division because of what's happening with growth across, loan growth across the industry and the Fed pulling liquidity out of the system. So we've seen a pretty steady decline in that. And earlier in the first quarter, it was public funds. So, Matt, they're all significant contributors to this quarter, $628 million. Probably the largest was Interlink, but the rest are awfully, awfully significant and big-time contributors.

Okay, that's helpful. I guess just taking a step back, but kind of the same discussion with Interlink, how should we think about how much of the future growth, not just in 3Q, but next year and thereafter, how much of the loan growth do you expect to be funded by the interlink?

I would say a third to a half, probably something in that range. If we're growing loans in the mid-teens, you know, I think through our banking initiatives and treasury initiatives, community bank, et cetera, we can fund, you know, high single, low double digits, something like that, and then the rest to come through Interlink. Interlink is never the sole answer. It's just a funding gap to make up the difference because in these two markets we operate in, of DFW and Houston, the loan growth opportunities with strong credit are far outstripped the deposit funding opportunities.

Okay. And just lastly, you mentioned the community bank also had some really good deposit growth this quarter. How would you characterize the bank's deposit pricing within the metro market? In other words, how does it compare to some of the other peers within the Houston and DFW markets?

I would say it's pretty well. It's in line with the market right now. I think Y'all have heard me say for the past few years, going back a few years pre-pandemic, I called it hand-to-hand combat. And that I felt like DFW was the most irrational deposit pricing market I've seen in my career, which covers a long time and a lot of geography. And it's just incredibly competitive. My personal view is that that level of competition will return. Will it be Q4? Will it be early next year? I'm not exactly sure. But I think you have too many competitors, so I think it's going to be pretty intense. But right now, that hasn't manifested itself yet. Pretty rational at the current time.

Okay. Thanks, guys.

Thanks, Matt.

And your next question comes from the line of Brad Millses from Piper Sandler.

Please proceed with your question. Brad, I'm sorry, Brad seems to have disconnected. We'll go to the next question. Your next question is from Michael rose from Raymond James.

Your line is now open.

Hey, good morning guys. Thanks for taking my questions. Just a follow up on the, Good morning. Just to follow up on the funding question with Interlink, and I understand there's a lot of moving pieces, obviously good core deposit growth this quarter, as you talked about. I think you guys have talked about, you know, getting the loan to deposit ratio somewhere down to kind of the mid, low to mid 80s, if I remember correctly. Is that still the outlook? And then I think in response to the mask question, you said, you know, a mid 80s,

uh teens growth rate might be acceptable it sounded like for for next year is that kind of still what we're what you're thinking uh at this point thanks uh yeah so mid mid-teens is what we're looking at for next year um you know call it 14 to 16 something along those lines a lot a lot of that is already embedded if you look at our unfunded commitments But no, we feel very confident that we can meet those numbers. Like I said earlier, the economy here has not slowed down much. There are a few projects they've pulled off the table or a few things maybe have been put off, but for the most part, it's still kind of crazy. The first question on Interlink, I forgot exactly what you were asking, Michael. I apologize. Just around the interlink.

targeted kind of loan-to-deposit ratio.

Oh, yeah, yeah, yeah.

I think you talked about low to mid-80s as kind of being a guy.

Yeah, our goal is to totally get it in the mid-80s. Absent warehouse. Yeah, absent warehouse. We think that, you know, it's just a really stout balance sheet. And so, yes, the answer is absolutely you remember correctly.

One tag on to Malcolm's comment, you know, with... earnings, their earnings profile going into 23, coupled with growth range he just gave you, that will allow us to accrete capital, CET1, et cetera. And so that's a pretty good, that's a good place for Veritex, is that type of loan growth, that type of earnings profile, that type of capital CET1 growth.

Got it. And then maybe just to follow up with I appreciate the updated rate sensitivity in the deck, but as the Interlink deposits grow and you find out that the beta is obviously going to increase, can you just give us an update on what your beta assumptions would be over the next couple quarters? Thanks.

For the whole company or for Interlink?

Yeah, for the whole company. Okay.

You know, cumulative, we believe, as we get through the end of this year and in the next, starting the first few quarters of next year, we see a cumulative deposit beta in the low to mid-40s. That's what we believe right now, and that's factoring in Interlink. So that's why, you know, if we've got a beta cumulative in that range, we're off our floors on the loan side, given what the Fed's already done. That's what gives us confidence in the NIM expansion we think we can see. And, you know, as I said, the NIM in June was 355, and we've already seen a 31 BIP increase in our contractual accrual rates on our loan book through the first half of the month. So we're feeling pretty good. And you see that in the table on the interest rate sensitivity, just the absolute growth in dollars. So pretty encouraging and a good –

positive operating leverage going forward very very helpful and then maybe just finally one for me just you know it sounds like uh maybe the expense uh trends are going to slow because you're going to hire a little bit less i think malcolm you said the the teams are pretty staffed up at this point um i i guess moving into 2023 i'm not trying to pin you down here because i know you're going to continue to be opportunistic but your hiring costs have have gone up you mentioned that the teams are relatively full at this point It would seem like expense growth, you know, could really decelerate, and you guys could get some really strong kind of positive operating leverage as we think about next year, just given, you know, the NII trend and the, you know, the move in earning assets that you talked about, Terry. Is it plausible to think we could see a pretty big, you know, step down in the efficiency ratio as you get that leverage? Thanks.

Yeah. You can expect – to see meaningful improvement in the efficiency ratio over the next four to six quarters with what's going on. And I mean, you know, I could ask a fair amount, well, what do you think about your expense growth? I mean, you know, it's sitting here at 14.7% year over year, but when you're generating close to 22%, backing out the effect of PPP fees, you know, in 2021, you know, I don't really, I don't think I'll say a whole lot about expense growth as long as we can generate that revenue growth. You know, and the other thing is even if you back out the effect of rising rates, our operating leverage is still close to five. So expenses are going up, but we're driving the revenue. And I'm talking about operating leverage in an incredibly weak fee income quarter for us. So I think the model is working. But I do think you can see significant improvements in efficiency as we move through the balance of this year heading into 23.

We like our expense guidance. We've been at 185 to 195. You asked about 2023. I mean, we don't have any huge things on tap, candidly. Our teams are quite full. I will be opportunistic, especially in a couple of different areas. But I think there's a chance that we're going to be fairly flat. There's going to be some wage inflation, obviously. I think at the first of the year, all of us are going to have to deal with that. When I say all the industry, you're going to have to deal with some wage inflation. I saw yesterday, I think it was Google or somebody said, we're going to go ahead and give raises right now, knowing they're going to give them just to keep everybody around. So all that stuff may start happening. But I feel pretty good about our expenses. And, you know, candidly, you start looking out forward and we look at our efficiency ratio and go, well, there's no way we could be that good. Because there's going to be some expenses and some costs. But, you know, you may see some technology things next year. You may see some treasury investments, those types of things that will drive some deposit growth. But I feel pretty good. I mean, 23 looks pretty good. And Terry's right. I hate to, you know, beat a dead horse, but the increase in revenue is not just a rate thing by any stretch of the imagination. It's really kind of a 75-25 deal historically this last quarter. And so that's the gift that keeps giving when it's on the growth side.

And I'll just tag on on the expense side. Mike, we do have to keep in mind the interlink cost will come in. But that's not huge. Don't get me wrong. I'm just saying that revenue should outweigh Strip that, too, on the interlink side. Yeah, for sure.

I appreciate all the call, guys. Thank you.

Thanks, Michael.

And your next question comes from the line of Brad Millsops with Piper Sandler.

Your line is now open, Brad.

Hey, good morning, guys.

Good morning. We're glad to have you back.

Yeah, I don't know what happened there. Call dropped or something. It wasn't us. We didn't put you back. Redheaded tactic. I don't know. Let's see. I apologize if I missed this when I dropped, but the chart that you guys added on slide 10, I think it's really good. I just want to make sure I understand kind of some of the assumptions there. The base case is, of $405 million of net interest income, which would imply over $100 million a quarter. Is that if you do nothing? That's just if you just leave, just let the balance sheet kind of run where it is, no further rate increases, no further growth. And then as we move up the scale there, that would reflect rate increases, but not necessarily growth. Is that how I need to think about those numbers?

Absolutely, assuming a shock, yes, but as opposed to a ramp. So, but no, you're thinking about, look, we did $95 million roughly. Well, we did $85 million, I'm sorry, in net interest income. But when you think about what the margin's doing in June versus what it was, you know, that's 13 BIPs higher, and every BIP is about a million dollars. So our run rate just on the static balance sheet is not 84 and it's not 84 and 13 is annualized. So, so, so don't misunderstand, but it's significantly, that's another four, four and a quarter million dollars just right on the jump off, if you will. So, yeah, that's, you know, getting to a hundred million, you know, getting over a hundred million dollars in quarterly net interest income is, is pretty, pretty doable, pretty fast. if you will. Getting over $100 million in quarterly net interest income is pretty doable pretty fast.

You've got growth on top of that, which we've already seen some growth in 3Qs.

Sure. And that chart on page 10, would that include your 40% to 45% kind of cumulative beta assumption as well? Absolutely. Okay. And then just as a follow-up, maybe on the provision, it looked like on new growth, you were provisioning it sort of a rate of around 90 basis points. Do you think that makes sense going forward? Obviously, over time, that would continue to kind of bring? Sure. And that chart on page 10, would that include your 40 to 45% kind of cumulative beta assumption as well? Absolutely.

Yep. Yep.

Okay. And then just as a follow-up, maybe on the provision, it looked like on new growth, you're provisioning it sort of a rate of around 90 basis points. Do you think that makes sense going forward? Obviously, over time, that would continue to kind of bring, you know, the reserve down depending upon charge-offs and obviously, you know, other, obviously you can make adjustments, you know, for other factors. But is that kind of the way you guys are thinking about it?

I'm thinking about the reserve staying pretty flat from where it is now. I think we're heading into a period.

Percentage-wise.

Percentage-wise, yeah, yeah, 102, somewhere in that range feels good to me. and knowing there's so much economic uncertainty. And even though I'm in the camp of, I believe the U.S. is either in or about to be in a recession, I don't think that recession is going to come to Texas because as you look forward at the GDP forecast from Moody's. So I think, but I do think we have to be cognizant of deteriorating forecasts. And so we're going to have to continue to provide for that to a degree. So, you know, that's the best advice I can give is, is, Our goal is to kind of keep the reserve level in that 102 range. And if we need to provide a little bit more to do that, so be it. Perfect. Thank you, guys. I really appreciate it.

Thank you, Brad.

And your last question comes from the line of Gary Tanner from DA Davidson. Your line is now open.

Thanks. Good morning. I want to ask about the long growth in the back half of the year. You talked about kind of what you think from a percentage basis, but just thinking of the main categories of growth, I assume construction continues to fund up at a fairly steady pace given the unfunded commitments. But between commercial real estate and single family, which were the big drivers of growth this quarter, any shift in kind of where the mix might come from beyond construction?

Yeah, I mean, our commercial teams are ramping up. Their pipelines are really quite full. The industries that they're represented are quite diversified. You know, the Houston team is just getting some sea legs under them. We've already looked at a couple of three deals for them. You know, there's a big deal in Dallas that we're going to close or have closed in the insurance space that's a solid, solid relationship. Um, there's some more of that coming. So I, I really think I look for the commercial side to really be the driver of it. You, you're absolutely accurate. We are already embedded on the, on the ABC space. And so those deals are booked in. Uh, but we also look for a, we look for a pretty, pretty big payoff back half of the year forecast. Um, I don't know how other banks forecast their pipelines, but I've never seen one like what we're doing. The level of granularity in funding and payoffs, we're serial forecasters as it relates to that. We meet every week and we're looking at every deal granularity on whether it's going to happen or not happen. you know, I think the commercial real estate space is going to slow and is slowing. And part of it is underwriting. I mean, we've moved our underwriting rates up a couple of points. I mean, we were running, you know, some stress analysis in the mid-fours, and now we're running them in mid-sixes. And so some deals don't pencil out as nicely at those rates. So that's kind of a forced slowdown, if you will. But I candidly look for the commercial space to be pretty active, the back half. And, again, this is a market share move, in my opinion, from these new hires that we've made.

I would tag on. Don't expect resi real estate, one to four family, to do as much. Using that has been one of the key drivers in getting your down rate protection close to 5%. So expect that to slow down. I agree with Malcolm on ADC that we've got funding, but slow there. Term real estate, though, there's some really good-looking, stabilized opportunities out there. And I think we're starting to see pricing get a little bit better. But, yeah, I just want to really make the point about the residential real estate. You won't see us be as active there buying stuff as we have been the first half of the year.

Okay, I appreciate that. And just to be clear, Malcolm, when you were talking about forecasting the payoffs, is that really starting to see some of these construction projects kind of come to fruition and convert? Okay, so that's in that line. Okay.

Appreciate it.

Yes. Okay. And on the deposit side, Terry, do you have offhand the kind of June 30 spot rates on interest-bearing or total deposits?

Okay. You know, they were definitely, just like I talked about, somewhere in the, you know, interest-bearing or total?

Either.

Interest-bearing is probably better. Interest-bearing is going to be in the 70s. At June 30th. At that date.

Yes. Okay, perfect. And then just one last question, and it may be sort of an elementary question, so I apologize, but the valuation allowance on the servicing asset, you know, I usually think a servicing asset is becoming more valuable as rates are moving higher, so am I missing something there? What's the thought around that?

That's a good question, by the way.

I had the same one. Well, in the mortgage space, you're absolutely right. As rates go up, lives extend, cash flow streams that, you know, you value in the servicing assets, get longer and better. Unfortunately, in the USDA and SBA space, as rates go up, given it's all virtually floating rates, default risk goes up, meaning from an investor standpoint, the government's going to buy back your loan at par, not at the premium you paid. So life's shortened from that. And refi risk goes up as well, because the banks who have, or the borrowers whose businesses have continued to grow and mature in season are will look to jump out of that space quicker and into typical bank lending space. And so I think both of those contribute to shorter lives, and that's what drives the servicing valuation down.

Great. And is that valuation allowance sort of embedding the forward curve as well? Or again, you know, in the third quarter, more rate moves, would you expect another allowance?

My understanding is it embeds the on the queue, so this concludes the .

So, but we'll see what the, given how forward the volatile curve has been of late, we'll have to see where it ends up at the end of the month of September. So, but I'm not expecting it, but we'll see. All right, great. Thanks, guys. All right. Thanks, Gary.

And we don't have any other questions on the queue, so this concludes today's conference call. Thank you for participating.

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