Citizens Financial Group, Inc.

Good morning, everyone, and welcome to Citizens Financial Group First Quarter 2021 Earnings Conference Call. My name is Alan, and I'll be your operator today. Currently, all participants are in a listen-only mode. Following the presentation, we will conduct a brief question-and-answer session. As a reminder, this event is being recorded. Now, I'll turn the call over to Kristen Silberberg, Executive Vice President, Investor Relations. Kristen, you may begin.

Thank you Alan. Good morning everyone and thank you for joining us. First this morning our Chairman and CEO Bruce Van Saan and CFO John Woods will provide an overview of first quarter results referencing our presentation which you can find on our investor relations website. After the presentation we'll be happy to take questions. Brendan Coughlin, Head of Consumer Banking is also here to provide additional colour. John McCree, Head of Commercial Banking who usually joins us has a personal conflict today. Our comments today will include forward looking statements which are subject to risks and uncertainties that may cause our results to differ materially from expectations. These are outlined for your review on page two of the presentation. We also reference non-GAAP financial measures so it's important to review our GAAP results on page three of the presentation and the reconciliation in the appendix. With that I will hand over to Bruce.

Thanks Kristen. Good morning everyone. Thanks for joining our call today. We're pleased to get off to a good start to 2021 as our business model continues to demonstrate strength, diversification, and resilience, notwithstanding continuing impacts from the pandemic. We continue to focus on taking good care of customers, highlighted by $1.8 billion of PPP loans in the latest round of the program. We've kept our colleagues safe and productive, and we continue to drive benefits to our communities through various grants and strong levels of volunteerism. Our strategic initiatives remain on track and will lead to increasing differentiation and growth in franchise value versus peers over time. Our financial headlines are terrific, though they're flattered by a large reserve release given the improved economic outlook. We delivered underlying Q1 EPS of $1.41. and ROTCE of 17.6%, while our CET1 ratio grew to 10.1%, and our liquidity remains elevated with an 81% quarter-end loan-to-deposit ratio. The first half of the year can be thought of as a transition period for us in terms of PPNR as the record levels of mortgage revenues normalize. While we are still seeing strong levels of originations, both refi and purchase, elevated margins have been returning to historical levels as industry capacity has expanded and competition has intensified. We currently expect mortgage revenues broadly to bottom in Q2 and then stabilize in the second half. During the first quarter, we saw strength in capital markets and wealth fees, which partially offset the drop in mortgage fees. This should continue into Q2, and we should start to see loan growth pick up as well, which provides a further offset. The outlook for the second half PPNR is strengthening as we expect loan growth plus a stabilized NIM given the steeper curve to help deliver top-line growth. This combined with strong pull-through of our top benefits and overall expense discipline should result in healthy levels of positive operating leverage in Q3, Q4, and the second half, along with return to solid PPNR growth. The outlook for credit also continues to brighten. With a negative provision of $140 million in the first quarter, our ACL ratio XPPP loans is now 2.03%. This compares with our day one ACL upon CECL adoption of 1.47%, so there's likely still more to go on reserve for leasing, assuming the economic outlook continues to firm and clarify. All of our credit trends continue to be favorable, both on the consumer and commercial side. We've moved our charge-off guidance for full year 2021 to to 35 to 45 basis points from the initial guidance of 50 to 65 basis points. So to sum up, we feel we're off to a great start. The economic outlook continues to improve, and we are executing well on the initiatives that will position us over time as a top performing bank. With that, I'll turn it over to John.

Thanks, Bruce, and good morning, everyone. Let me start with the headlines for the quarter. We reported underlying net income of $626 million and EPS of $1.41. Our underlying ROTC for the quarter was 17.6%, which includes the impact of a sizable reserve release. Revenue of $1.7 billion was broadly stable year over year, strong fee income offsetting the impact of the low rate environment on NII. Highlights include continued strength in capital markets, record results in wealth, and well-controlled expenses. We recorded a negative provision for credit losses of $140 million, which reflects strong credit performance with lower charge-offs, an improving loan portfolio profile, and an improving macroeconomic outlook, with our ACL ratio now at 2.03%, excluding PPP loans. And finally, we are in a very strong capital position, with SET1 at 10.1% after returning $262 million to shareholders in dividends, and share repurchases during the quarter. We also continued to grow our tangible book value per share, which was $32.79 at quarter end, up 3% compared with a year ago. Next, I'll refer to a few of the slides and give you some key takeaways for the first quarter. I'll then outline our outlook for the second quarter and provide some comments on 2021. Net interest income on slide six was down 1% linked quarter given lower day count. Loan balances were broadly stable, and net interest margin was up slightly. The net interest margin improvement reflects a steepening yield curve and continued discipline on deposit pricing. Interest-bearing deposit costs are down 7 basis points to 20 basis points, which more than offset the impact of lower asset yields. We expect that elevated deposit levels from recent stimulus will continue to impact margin in the near term. We will continue to be proactive in pricing down deposits and pursuing attractive loan growth opportunities in areas like point-of-sale finance and education, as well as in attractive commercial segments. The steepening of the curve provided us with the opportunity to begin adding to our hedge positions to moderate our asset sensitivity. We added $7 billion of five-year receipt fixed cash flow swaps and terminated some pay fix swaps during the course of the quarter. Those actions, combined with expected balance sheet changes, reduced our asset sensitivity to about 8.5% from 10.8% at the end of the year. Referring to Slide 7, we delivered solid fee results again this quarter, reflecting our ongoing efforts to invest in and diversify our revenue streams. As expected, Mortgage fees were down approximately 15% this quarter, despite strong volumes, as heightened competition and increased industry capacity pressured gain on sale margins. Nonetheless, mortgage fees were still strong compared to a year ago, and we expect a continued strong level of originations across all channels over 2021 as the market shifts to being more balanced between refi and purchase activities. 2021 is expected to be the strongest home purchase market in history, only restrained by housing inventory. Wealth fees were a record of 12% linked quarter, reflecting an increase in AUM from net inflows and strong market levels with record sales. Capital markets fees remain robust, though they were down 8% from a record level in the fourth quarter, with lower M&A advisory fees partly offset by increased underwriting revenue. Foreign exchange and interest rate products revenue decreased 7 million linked quarter, given reduced client hedging as a result of less lending activity and lower volatility. Expenses on slide eight were well controlled, up 3% linked quarter driven by seasonality in salaries and employee benefits. We are continuing to focus on both the transformational and business as usual aspects of our top six program, and we are on track to deliver total pre-tax run rate benefit of 400 to 425 million by the end of 2021. Average loans on slide nine were broadly stable linked quarter as commercial payoffs and slightly lower line utilization of about 32%, compared with a historical average of roughly 37%, was partially offset by growth in our education, mortgage, and point-of-sale finance portfolios. Looking at year-over-year trends, average loans were up approximately 1% due to PPP, education, and mortgage. We executed the PPP lending program very smoothly, with $1.8 billion of loans secured as part of Round 2, taking the total PPP loans to $5.1 billion at period end. We expect that about 85% of the Round 1 loans will be forgiven by the end of the year, and for Round 2, which are five-year loans, about 20% could be forgiven by the end of 21, and about 70% forgiven after two years. Overall, the PPP program will help stabilize NII in the first half of the year, while the benefit will taper off a little in the second half. On slide 10, deposit flows benefited from the recent consumer-oriented stimulus, especially in low-cost categories, and our liquidity ratios remain strong. Average deposits were up 1% link order and 16% year-over-year as consumers and small businesses benefited from government stimulus and commercial clients built liquidity. We are very pleased with our progress on deposit repricing, with total deposit costs down 5 basis points to 14 basis points and interest-bearing deposit costs down seven basis points to 20 basis points during the quarter. We continue to drive a shift towards lower cost categories, with PDA now about 30% of average deposits, compared with only 23% a year ago. The strength of our deposit franchise is becoming very clear given all the investments we've made, including the launch of our digital bank, enhanced data analytics, and introducing new cash management tools for our commercial clients. At the end of the last low rate cycle in 2015, our interest-bearing deposit costs bottomed at about 34 basis points. This cycle, we were already at 20 basis points, and we expect these costs to decrease to the low teens by the end of the year as we execute our deposit playbook. Moving on to credit on slides 11 and 12, we saw strong credit results this quarter. Net charge-offs were down nine basis points to 52 basis points linked quarter. This is at the lower end of our guidance for the first quarter, and driven by a reduction in commercial. First quarter commercial net charge-offs included charge-offs in areas of market concern, including pre-retail, casual dining, and one large charge-off related to a financial sponsor. Non-accrual loans decreased $11 million linked quarter, with a $76 million increase in commercial driven by charge-offs, loan sales activity, and repayments. Retail non-accrual loans increased by $65 million linked quarter driven by mortgage loans coming off forbearance. However, given the strength of the housing market with inventories at historical lows and strong LTVs in our book, we expect little to no loss content in these mortgages. In addition, our commercial criticized loans continue to trend down this quarter, decreasing by $495 million or 11%. Given the improvement in the macroeconomic outlook and performance of the portfolio, our reserves decreased but remain robust, ending the quarter at 2.03% excluding PTP loans compared with 2.24% at the end of the fourth quarter. This is still significantly higher than our 1.47% day one CECL implementation coverage. We anticipate there likely will be further reserve releases assuming the macroeconomic outlook continues to strengthen and solidify. We have some detailed credit slides in the appendix for your reference, one on slide 22 covering commercial credit. Since the start of the COVID-19 crisis, we have been highlighting the commercial areas most impacted by the lockdown. As we continue to see improvements in the operating environment, these areas of concern have now decreased to 2.3% of the total CFG loan portfolio, down from 4.6% in 4Q20 and approximately 11% in 1Q20. The remaining areas of concern include Cree retail and hospitality, casual dining, and arts, entertainment, and recreation. And accordingly, we are maintaining prudent reserve allocations with a reserve coverage of about 10% for these areas. We maintained excellent balance sheet strength as shown on slide 13, increasing our set one ratio from 10% in 4Q to 10.1% at the end of the first quarter. which is slightly above our target operating range after returning $262 million in capital to shareholders in the quarter. Before I move on to our 2Q outlook, let me highlight some exciting things that are happening across the company on slide 14. On the left side of the page, we were very pleased to be able to provide about $1.8 billion in new PPP loans through the latest SBA program, providing critical funding to over 30,000 of our small business customers. On the consumer side, we recently announced the expansion of our national point-of-sell offering for merchants through our Citizens Pay offering. We are continuing to add new merchants to our point-of-sell platform, such as BJ's Wholesale Club, with more in the pipeline, and the portfolio is up 8% year-over-year. In addition, we continue to make great strides in our digital transformation, with our digital sales up 48% year-over-year. Clearly, our customers are demanding a different distribution model from us, one that allows for more efficient digital transactions and an advice-oriented focus in our branches. We launched our new mobile app on iOS in January, which is receiving great reviews with an average of 4.6 stars in the App Store. In commercial, we have built out a robust corporate finance advisory model, which is supporting our geographic expansion efforts. Our capital markets business delivered its second-best quarter ever in the first quarter, demonstrating the benefits of the investments we've made over the last three years. On the right side of the page, you can see a high-level view of our strategic priorities, all of which remain on track. And now for some high-level commentary on the outlook for the second quarter on slide 15. We expect NII to be up 2% to 2.5%, with MIM up modestly, more broadly stable, excluding elevated cash. We expect loan growth of 1.5% to 2% in the second quarter, followed by an acceleration in the back of the year. Earning assets are expected to be broadly stable in the second quarter. Fee income is expected to be down high single digits, reflecting lower mortgage banking fees as gain on sale margins decline further towards more normal levels, partially offset by strength across many of the remaining fee categories. Non-interest expense is expected to be down slightly. We expect net charge-offs will be in the range of 30 to 40 basis points of average loans, with a meaningful reserve release through provision. Before I wrap up, I'd like to provide some comments on this transition period towards economic recovery and our 2021 full-year outlook. First, we remain confident in our 2021 PINR outlook, with NII higher and fees slightly lower than our original guidance. Let me give you some further color on the puts and takes. We're expecting loan growth to really pick up in 2H21, driven by student, point of sale, auto, and mortgage, as well as commercial utilization starting to rise from historical lows as the economy finds stable footing and companies begin to invest for growth. Coupled with a steeper yield curve, this improves our NII outlook. Our outlook for fees is slightly lower, driven by mortgage, as we expect additional pressure on gain on sale margins as they begin to migrate lower. As the curve steepens, we should see a transition to greater contributions from purchase originations and servicing. We have included some additional detail in the mortgage landscape in the appendix on slide 20. We expect other key categories, namely capital and global markets and wealth, to continue to be strong as we leverage our investments and the economy rebounds. Other categories like car fees and service charges and fees should also benefit as consumer confidence and spending picks up. Given these dynamics, we expect PPNR to bottom in the second quarter and then rebound to levels higher than the first quarter for the remainder of the year, given strength in NII and fees, as well as well-controlled expenses. We also expect to be close to neutral operating leverage in 2Q compared to 1Q, followed by meaningful positive operating leverage in the second half. We are also expecting a substantially better credit outlook for the full year. Given the strong performance of the loan portfolio and improvement in the macroeconomic forecast, we are reducing our full-year charge-off guidance range to 35 to 45 basis points. And with this improvement, we could also see our ACL ratio decline meaningfully from the current 2.03% ex PPP. To wrap up, this was a strong start to 2021 for citizens as we begin to transition away from the effects of the pandemic to an improving outlook for interest rates and economic growth, all while staying focused on executing across our strategic initiatives. With that, I'll hand it back over to Bruce.

All right. Thanks, John. Operator, let's open it up to Q&A.

Thank you. Ladies and gentlemen, we will now begin the Q&A portion of the conference call. If you would like to ask a question, please press 1, then 0 on your touchtone phone. You'll hear an indication you've been placed into queue and you may remove yourself from queue by repeating the 1 then 0 command. If you're using a speakerphone, we ask you to please pick up your handset and make certain your phone is unmuted before pressing any buttons. Again, for questions, press 1 then 0 at this time. Our first question will come from the line of Matt O'Connor with Deutsche Bank. Go ahead.

Good morning. Your outlook for loan growth is a bit better than what we've heard so far from other folks. And I was just wondering if you could elaborate on the drivers, both in the near term and then how robust you think loan growth can be kind of when things fully reopen, you know, call it later this year into next year.

I'll start off with that, Matt. Others may weigh in here. But in the near term, I think that the strength that we're seeing is really attributable to our diversified consumer lending and retail businesses. When you see what we've been able to do in the mortgage portfolio, auto and education, I think those are areas that have been areas of strength in the past and will continue to be in the second quarter. I also believe that when we get into the second quarter, you're going to start to see, although across the industry we've seen utilization levels come down a bit in the first quarter, you know, I think we believe that that will start to moderate and stabilize and possibly start to head back up off of historic lows, historic low levels, so you can see commercial contributing as well in the second quarter. And as you – you know, that will create the – the staging ground, if you will, for what we see in the second half, where, you know, the continuing expectations for reopening, economic activity accelerating. On the commercial side, inventories building, you know, CapEx expenditures starting to, you know, recover and increase. So those are the forces that we see in terms of loan growth throughout the year.

On the consumer side, thanks, John. I'd offer a couple of thoughts. One, across all the asset categories, we've unwound credit tightening that we did through COVID. We haven't changed our risk appetite, but the temporary tightenings that we did, those are now broadly unwound. We should see originations tick up across all categories. We've also turned on marketing that we had artificially suppressed last year as well. Asset-by-asset I think I had mentioned last quarter, we had sort of put auto at a flat-ish trend intentionally. The market always allowed for us to grow, but we were optimizing our balance sheet with all the excess deposits we have now in the short duration. We're finding incredibly high returns in the auto business, so you should expect that to continue to moderately grow, assuming that the environment allows for outsized returns, which we're not seeing slow down. On the student side, we have... student loan refinance product at over $900 million in originations. That could moderate a tiny bit, but still at record levels giving high rates. And as the federal portfolio of student loans come off their forbearance in September, that will provide another opportunity for growth. And then seasonally, our in-school business, we're expecting a very big year. A lot of students took the year off given COVID, a big freshman class coming in, and just seasonal growth in the summer and the fall. And lastly, point of sale is an area that, you know, we've spent a lot of time and investment in. We've got great traction. We're up to about 15 partners, so we're in the build phase there, whereas these partners ramp, you're naturally getting sort of outsized growth, sort of lost small numbers as the portfolio gets to scale. So I've got a lot of confidence in the outlook in consumer growth, and underpinning that is obviously improvement in consumer confidence.

I would just add, Matt, just one last proof point on the commercial side. In addition to line utilization, we're just seeing activity start to build. So our pipelines are much stronger at this point than they were early in the first quarter. So that's a good sign of both economic activity backlogs in M&A. still pretty high so we see line utilization kicking in plus just fresh deals and we continue to add bankers and grow our market share.

And is most of the demand building commercial related to deals as you just referenced or is there also kind of some early signs of increased, call it organic, investment among commercial borrowers?

I think there's some of both, Matt, quite honestly. Right now, you can see the economic stats are fantastic, and so people are positioning to try to capture that demand. And so that means increasing supply, which requires some capital investment, and then also labor, bringing people back to work, which, frankly, when we talk to many of our corporate customers, has been a gating factor. It's hard to actually fill out their needs, and we're trying to be helpful on that with some initiatives around workforce development. But the animal spirits are starting to kick in here.

Okay, thank you.

We will move next to the line of Erica Najarian with Bank of America. Go ahead, please.

Hi, good morning. A follow-up to Matt's question, because I want to make sure the market really understands this. A lot of your larger peers where their consumer exposure is more credit card related, you know, really talked to us over the past couple days about how deal leveraging was going to negatively impact demand. And perhaps maybe give us a little bit more detail about why your consumer products are not necessarily going to be impacted the same as credit cards.

Yeah, Erica, thanks. It's Brendan. I'd say our credit card book is significantly smaller than our peers on an average basis to our overall loan book. And so we are seeing a little bit of those dynamics in our credit card portfolio. We're not calling for growth in credit card, but that de-levering of our card book with all the extra stimulus has a much more muted impact for us on our overall consumer lending portfolio than others just given the relative undersized nature of our card book. So we found opportunities to grow in more niche places like point of sale which is the demand is generated by purchase activity, and as the economy rebounds, consumer competence comes back, folks are out there buying bigger ticket items again, and the point of sale business is there to help, and it's very naturally lined up against the recovery of consumer spending on how we think about modern financing for consumers. While rates are going up, they are still very, very low. And so I look at student loan refinancing, as I mentioned before, something that's still going to be very, very strong. There's a lot of customers that are in the money. That's a product that our peers, generally speaking, don't have. And so that's generating outsized growth for us. And similarly in student, the in-school business, as I mentioned before, seasonally, just naturally that we're going to have some growth just by being in that business in the back half of the year, which most of our peers don't have. And auto, again, not to be too redundant, but we had intentionally sidelined auto. So we're back in growth mode there at a moderate level. So when you add all that up, I think we've got a lot of confidence that we're going to buck the trends that you're hearing from others here. and we're proving it. The numbers show in the last handful of quarters that we're already delivering it, even through the COVID period.

Yeah, I would just add to that, you know, diversification is important, and so we have probably more portfolios and some well-targeted portfolios and niches that should continue to still grow. So that's, I think, why we'll kind of buck the tide a little bit overall. And I would just add also the outlook for the so-called buy now, pay later, or installment financing, kind of tailoring products to people at point of sale is very, very positive. I think the industry forecast for that is 20% growth over the next five years. And on card, it's much, much lower. First, you have to get the rebound, but then I think that you're low single-digit in terms of the growth outlook there. So I think we've made a bet that this is going to be a burgeoning, attractive area. I think we're well-positioned to catch some wind here.

And my second question is on the margin outlook for the second quarter and perhaps a little bit beyond. Thank you for giving us an update on how you're expecting PPP to unfold for the rest of the year. I'm wondering in the NIMUp modestly guide, how much forgiveness is assumed for the second quarter? And also, you know, maybe give an outlook on how you're thinking about redeploying the excess cash for the rest of the year.

I'll go ahead and take that, Eric. I mean, I think just to focus on the second quarter, I think that the rate environment is favorable to us and others. But, you know, I think that we're seeing nice tailwinds from the rate, a long end rise. I'd also reference the fact that we added to our edge portfolio in the first quarter, and that's contributing. And we'll get a full quarter effect of that in the second quarter and just our overall mix. And, you know, on both the asset and deposit side. So greater DDA in the first quarter and that's flowing into the second quarter. And don't forget some of the comments I made earlier about our deposit costs. That's a lever that continues to contribute and those are some of the important, I think, drivers. into 2Q with more room to run there, the 20 basis points coming down to sort of into the teens, into the second quarter and into the low teens as you get to the end of the year. So those are some of the forces. PPP is less of a contributor. As we mentioned, it stabilizes overall NII. But in terms of NIM, there's no real meaningful difference between forgiveness last quarter versus this quarter or next quarter. So it's really not a driver over the last quarter or next.

Got it. Just to clarify, so the forces that are driving NIM higher in the second quarter are sort of core business trends. They are.

They are. Perfect. rates, balance sheet, balance sheet mix, deposit pricing, and loan growth. Those are the things that were really driving us.

Just a further word on PPP. I mean, John called it right, but that's been pretty stable through the back half of last year, through the first half of this year. You look at the yields on those loans with forgiveness baked in. It's not a big winner for the bank. So what we had anticipated was that we'd start to see some fall-off, but given the new program that was added, the glide path down in the second half of the year is much less severe. You know, I don't think the PPP this year will be a huge factor compared to last year on any sequential quarter that we would have to call out.

Got it. Thank you so much.

Yeah.

We will go next to the line of John Pancari with Evercore ISI. Your line is open.

Morning. Hi. Regarding your commentary on the operating leverage expectation for improvement and for, I think you referenced it as healthy level of operating leverage, any way you could help us think about the magnitude in terms of sizing that up, what type of level of operating leverage you think is achievable in the back half, and then what that could possibly mean for 2022 as you look out?

Yeah, so... And historically, if you look at what we were able to deliver since the IPO, we've probably been in a 300 basis points of operating leverage type mode, whether that was 6% or 7%. It's revenue growth and then 3% or 4% expense growth. It's kind of scaled with what the revenue environment is. We tend to compress the expenses to try to maintain something like that. And so clearly that would be our objective over time. And as John indicated, we're kind of working through a transitory phase where the mortgage revenue has to reset it was a huge boom for last year we did 400 basis points of operating leverage for all of last year which was fueled by mortgage so in the first half of the years that normalizes that makes it hard to deliver the positive operating leverage although we did state in our guidance that we should come pretty close to neutral in in the second quarter notwithstanding uh that kind of last leg to drop on mortgage revenues before it stabilizes Once we can get back to kind of having that mortgage bottom out and we're seeing nice growth in our fees, we're seeing our balance sheet grow, we're seeing good performance on NIM, then we should get back to having a nice top line and you can count on us to continue to constrain the expense growth. We've done, I think, a really good job with the top program of repositioning citizens to be much more equipped for the future in terms of our technology. So we have a next-gen technology element to that project. We have huge going digital, going to a digital-first business model, going to that. So it does require investment, but our mindset all along has been to self-fund, to try to find the inefficiencies in how we're running the place, wring those out, and then in turn go reinvest those. And I think we've demonstrated over time that we're quite good at that. So we're managing expense base tightly, but we're certainly keeping up with the investments that we need to position us for future growth.

Great. Thanks, Bruce. That's helpful. And then separately, on the consumer side, on the merchant partner side, kind of a two-parter. First, I just want to see if you can give us a little bit of color around the risk-adjusted returns you're able to get in that business in terms of maybe the loan yields that you're seeing on your partnerships, as well as the loss assumptions. And then separately, I know you mentioned buy now, pay later, Bruce. I'm interested if you believe you need more scale there to take advantage of the opportunity or if you need more capabilities on the digital front and therefore would you be open to an acquisition to give you greater scale or do you think the momentum you have already in the area is sufficient? Thanks.

Yeah, thanks for that, Brendan. I'd say the risk-adjusted returns on the point-of-sale business, the way you should think about it is it's equivalent to a credit card profile. The geography is a little different. The yields are a little bit lower and the losses are meaningfully lower, but the returns are equivalent to what you'd expect on a prime card portfolio, which is why we sort of disclose them all in the same way. bucket of other retail, which is great because if you think about that, if you're getting equivalent credit card returns but lower losses that are going to perform even better through the cycle, that's a very, very attractive place to play. And as I've shared in the past, when you look at the credit performance of point of sale through COVID, forbearance was basically non-existent and delinquencies were down from pre-COVID levels, so that portfolio was operating as if there was no recession or lockdown going on around us. And so we're incredibly excited about that dynamic, and we don't think it was artificially created. The customer experience is so slick and integrated into consumers' top wallet payment that really we're kind of getting that top payment position in that product. Very, very excited about that. Relative to acquisition, look, we're really bullish on our capabilities. We think it's very distinctive from what others offer in this space, either the old school traditional buy now, pay later players, and even relative to some of the FinTechs where we've got our unique niche that we also have a balance sheet. We don't have to upload these loans. It allows for a lot more creativity and innovation on how we structure the product. As an example, like the Apple product, where it's a revolving purchase where the customer gets the new phone every year. That's hard to do if you're reliant on capital markets to fund your business model. So we're excited about the business model. If there was an acquisition that could help us accelerate at the right price, of course we would look at it. But I don't think we need one to get scale.

Great. Thank you. Appreciate you taking the questions.

We'll go next to Peter Winter with Wedbush Securities. Go ahead.

Good morning. I wanted to ask about the average securities yield. I noticed it held steady quarter to quarter. And I'm just wondering what the new reinvestment rate is on the securities. And secondly, if you're extending duration on that portfolio.

Yeah, I mean, I'll take the last question first. I mean, I think that, as you know, most of our portfolio is in a mortgage-backed security agency space, and so really that's a rate-driven outcome and pretty typical, as you would see, as rates rise, prepayments slow, and so those mortgage-backs – will extend in duration. And so that's really what's going on there. We didn't actually, through our purchase activity, endeavor to extend duration. That was just an impact of the macro on the securities that we have. I mean, I think the way that you look at the securities book, it's It's basically, you know, a few weeks ago, I might have said that our reinvestment yields could have been in the neighborhood of 175 to 180 and might have been close to where the runoff yields would be. But over the last couple of weeks, as you've seen the rally in rates, you know, we're sort of in the, we'll call it 160 range. And so it'll be a... a negative front book back book uh probably in the early part of the second quarter but as you get into the end of the third quarter based upon what we see you can start to see securities portfolio being the first sort of term book that starts to get to neutral on front book, back book, and begins to become a positive contributor into the second half. And I'd say more broadly, that's the kind of dynamic you'll see with other loan categories as one by one you'll see improvements on that front. The other thing, again, back to this is a broader NII NIM story, but if we believe where rates are headed and the forces all indicate that we'll get to higher long-term rates as you get to the end of the year, we'll continue to layer in our swaps you know, our swap hedging program as well, which will also contribute to NII.

It can have a faster impact when you start to see the curve steepen. Exactly. Play it through swaps.

So front book, back book converts from a headwind to a sort of a tailwind as you get to the end and into the second half, and then you can see our playbook on rate management all contributing to NII and NIM.

Got it. Thank you. And then Just on the allowance for credit losses, I'm just wondering with the improvement in credit, how quickly do you think you can get back to that CECL Day 1 level? And does that level change just because of the composition of the portfolio changing with more growth from consumer?

Yeah, I'll go ahead and take that. I mean, you've seen us come down relatively meaningfully this quarter. The way CECL works, if you had perfect knowledge about where the macro is headed, all of that good news and all of that expected outcome would all be built into our results this quarter. But you also have to take into consideration the uncertainty around those expectations. The uncertainty as we're turning towards much more positive macro, that uncertainty in the range of potential outcomes is still very, very wide. And as a result, we have a number of overlays that are judgmental in nature that sort of work together with our model outputs to give you what our results are. So net-net, the balance would be that we have big releases happening now. If, in fact, the uncertainty around the base case begins to narrow, you could see our coverage getting closer to day one as you get into the second half and towards the end of the year.

Thanks.

We'll go next to the line of Ken Zerbe with Morgan Stanley.

All right, great. Thanks. Good morning. I guess the first question, just in terms of the swaps that you put on, can you just talk about the duration of those? I understand we're sort of in a low-rate environment, but at some point rates will rise. I'm just kind of curious how the timing of those swaps play out with your expectations for Fed fund hikes at some point.

Yeah, I mean, the duration is five years on the swaps that we put on with the $7 billion. And that's relatively typical. I mean, you sort of look at this on a dollar-cost averaging basis. When you see the five-year is really where a lot of this hedging happens. When you saw the five-year go from 40 basis points to 90 basis points in a very short period of time, that's a signal to trigger the first sort of tranche of hedging. that you will do over time. And really what you're doing is you are reducing your downside when you start to layer hedges in. And so our first tranche was triggered. It's contributing in a positive way. It takes away and reduces the risk to lower rates over time. But you pause after that first category of hedging and you wait for the next sort of range of rates before you get into the next tranche. And so $7 billion is a fraction of what our overall hedging will be as you get to the end of the cycle. And so rather than waiting to pick the perfect spot, you know, maybe a year from now and do all of our hedging all at once, you tend to do it over time.

Just to leg into it, it's akin to dollar cost averaging for you guys who are investing your portfolios.

And, you know, the last, you know, so the last tranche that you would do if and when the five-year hits its peak, and then if you have a big rally in rates, that'll widen out. the first tranche that you do as you get towards the end of the five years. If, in fact, rates continue to rise and rise and rise, then you have those turn negative, but those are more than offset by all the positives of the hedging that you do as rates continue to rise.

That makes perfect sense. And then just my second question, in terms of capital, obviously a very strong C2-1 at 10.1%. Can you just talk about your perspective plans or expectations? How does that eventually get absorbed? I mean, now you can't buy back stock, but it sounds like you're also going to have stronger balance sheet growth.

Yeah, I mean, I think we've said this before, our program here and our number one capital objectives are to support the dividend and to support organic growth and putting capital to work in support of our customers and clients. So that's really our first objective. And if we can do that in a way that is additive and returns exceed our cost of capital, we think that's the right thing to do for the franchise. That's our focus. As we mentioned earlier, we do have a transition to loan growth beginning in the second quarter. The average loan growth, 1.5% to 2%, but spot loan growth in the second quarter will be higher than that as things begin to accelerate. You could see 3% or better spot growth in the second quarter alone. and seeing those numbers go higher still if the environment unfolds the way we expect. So that's our focus. To the extent that, you know, we have excess capital even after supporting all of those things, then that's when you get into, you know, how we look at returning it to shareholders through the form of buybacks and thinking in parallel about, you know, bolt-on fee acquisitions.

All right. Thank you.

Our next question will be from Scott Seifers with Piper Sandler. Go ahead.

Thanks for taking the question. I think the first question is sort of a follow-up on the capital one from the prior question. Just given that the credit concerns are kind of melting away, is there any opportunity to maybe revisit your internal capital targets a little lower. They're a little higher than some of your peers. And of course, some of that I'm sure is just due to the complexion of the balance sheet. But nonetheless, with the risk profile improving, just would be curious to hear any thoughts there.

Yeah, it's Bruce. So we've, as you're aware, have inched down over time. So I think initially we had a 10 and a quarter target as our set one ratio. And then we went to 10 to 10 and a quarter. Now we're 975 to 10. So I think initially coming out of the IPO as a relatively new company without a long-term track record, having a little higher set one targets than peers made sense. You've seen through the CCAR work that our credit losses stress at median or slightly better than median, and so there's really not such a significant need any longer to carry that little extra cushion, although I do like to sleep well at night, and so having a strong capital ratio helps with that. But, you know, over time, we'll see where the peer group goes. And if the peer group continues to inch down, given a positive outlook for the foreseeable future, there's no reason that we couldn't do that as well. But at this point, we're locked in for this year with that 975 to 10 range. And I think that gives us plenty of firepower, given the capital we're generating, potential for future reserve releases. to pursue our agenda of the significant loan growth and potentially some fee-based acquisitions and also giving some back to our shareholders.

Perfect. All right. Thank you. And then maybe, John, just sort of a follow-up on some of the actions you took regarding rate sensitivity in the first quarter. I think I can sort of back into some of it based on kind of what you said about duration and things like that. But I think you guys have said in the past you're rate sensitivity is sort of 55-45 short end versus long end. Is there any meaningful change in how that looks now following some of those first quarter actions?

Yeah, not much of a difference. I'd maybe call it 60-40, but basically that's about where we are, 60 short, 40 long in terms of the complexion.

Okay, perfect. All right. Thank you very much, guys.

Sure. Next, we'll go to Ken Usain with Jefferies. Your line is open.

Hey, guys. This is Amanda Larson. I'm for Ken. I guess on the loan growth outlook for 1.5% to 2%, you did talk about the buckets, but if you can kind of just talk about the mix that you would expect of just commercial versus consumer in 2Q, that would be helpful.

Yeah, and I think that retail, I would describe it as, is really going to be leading the way in the second quarter as commercial maybe begins its march and as the recovery really contributes to higher utilization. And as those loan pipelines that you heard from Bruce earlier begin to, you know, sort of realize themselves. So I'd say in the second quarter it's probably, I don't know, something in the neighborhood of two-thirds, one-third of the majority coming from retail. But commercial clearly contributing and beginning to be a bigger contributor as you get into the second half of the year.

I think you've got some fun for average loan purposes. You've got to work through some of the dynamics of the first quarter. But what we're pretty excited about is on a spot basis, we see significant growth in the second quarter, which will set us up well for growth in the second half of the year. So the goal really in the second quarter is to really layer in that nice spot level of growth. It won't fully manifest itself in the average numbers, so therefore we're at the one and a half to two, but it does, if we achieve it, set us up extremely well for the third quarter.

Okay, super. And then, John, can you just frame the conversation on SWOT with how much you earned on cash flow hedges in the first quarter and then maybe what's expected for 2Q and beyond assuming LIBOR is flat from here?

Yeah, I mean, the way that we've talked about that in the past is really on a year-over-year basis, given that the portfolio is contractual and you can sort of see it. We've talked last year based upon the portfolio that was in place at the time, that year from 2021 would be about a, call it, $75 million to $80 million decline in in contribution from the swap portfolio versus 2020. You know, just with the $7 billion that we put on in the first quarter, that's been cut in half. And so the headwind from swaps is really declining. If rates continue to rise from here, you know, that number will continue to decline off of that level. I think the broader point, though, is you can't really look at it in isolation. You've got to look at overall, as we indicated, net interest margin being broadly stable. excluding excess cash and, frankly, rising if you consider what's going on with deployment of cash and what's happening with our expectations on loan growth. And another reminder on our deposit costs, that's a lever that's unique to us. We may have come down a little slower than others because we had a lot farther to come. And so at 20 basis points headed to so-called mid-teens in the second quarter, headed to low teens, to the end of the year. That's another driver. So the big picture, including all of the swap dynamics, net interest margin appears to be stabilizing and is an improving picture going forward.

It's funny that what was a gap versus peers, which are slightly higher deposit costs, turns into a lever, turns into an asset when you're going through this environment. So many of the peers have already reached levels that it's hard to improve upon on their interest-bearing deposit costs where you still have some room to run.

It's all cyclical. All right. Thank you so much.

We'll go next to the line of Bill Karkash with Wolf Research. Go ahead.

Thank you. Good morning. I wanted to follow up on some of your earlier comments. You guys have a unique view given your mix of consumer versus commercial lending. Can you give a bit more color on how you see pent-up demand dynamics playing out across both groups as we make further progress into the reopening? It sounds like you think there will be a bit more gearing initially on the consumer versus commercial side, but I was hoping you could just expand on that thought process. And how does the excess liquidity that both groups have available play into that thinking?

Yeah, I can start. Yeah, on the consumer side, I think the growth that we're projecting is sort of happening underlying right now. And we'll get a bit of a tailwind from the reopening and consumer confidence growing, but the structure of our products are so diversified and naturally set up to give us outsized growth. I mentioned earlier student loan refinancing. You should think about that a lot like mortgage. When rates are low, and even though they're ticking up a little bit, they're still historically low. That creates a boom of demand. It's almost like stimulus, another form of stimulus for customers that we're providing through restructuring their payments down. And so that just is naturally demanded now independent of reopening. Similarly with point of sale, I mentioned as the economy reopens, customers are starting to do big ticket purchases again. We're seeing our debit drop. transaction average ticket go up pretty significantly. Those transactions are now up year over year. Very clear consumers are starting to spend again, which means point of sale financing is well positioned for growth with the economy reopening. We're seeing that anyway, even independent of another tick up of the economy reopening. And auto has been a hot market, but auto industry sales are really, really high and the market is still bearing outsized returns. And so Eat well, eat good. We're gonna continue. We got a diversified auto business, number one J.D. Power in the country. In auto, we're very well positioned to grow that business in a well-controlled way with double-digit ROEs, which you don't typically see with auto. So, yeah, I think as the economy reopens, that should provide a bit of another nudge and a tailwind. But even at a moderately slow pace of the economy reopening, I still feel pretty good given the diversification of our business that we'll get the growth that we're calling for in consumer.

Yeah, and I would say we still would expect to see some elevated cash levels, and a lot of times that's kind of geared to folks who've worked in the service industries and have loss of employment and are still kind of holding on to the precautionary cash levels given circumstances. that will, I think, run down fairly gradually. But these other factors that Brendan mentioned are somewhat separate from that. They're not as impacted by kind of the stimulus money that's been paid out And then I think on the commercial side, it's really just a question of how fast folks take a positive view about the need to meet demand. If they see demand rising, then they can start investing. And then how do they finance that? They can use some of the big liquidity levels that they were able to amass. I think you'll see that corporate cash start to drop some, but then going back and borrowing on lines is kind of the next phase that you would expect to see, and then some special purpose facilities to build a new plant or things like that, or just the deals that continue to happen and the financing that goes with those acquisitions. we would expect to see, we're already starting to see that some of that cash is getting put to work and it really just depends on how fast the view about the economic improvement solidifies.

That's helpful. Thank you. If I could follow up, do you think that the elevated payment rates that we've been seeing really on the consumer side broadly have peaked based on what you guys are seeing or Yeah, particularly with the effects of the latest stimulus checks, or could those potentially remain elevated for a bit longer here before we start to see them come down and, I guess, contribute a bit more to some of that improvement and balances that you're expecting?

Yeah, so the elevated stimulus on prepayment rates is mostly felt on credit card, which we are, in our guidance, still calling for credit card to shrink slightly. Healthy purchase activity, but there's a lot of cash up in the environment, as you point out. Some of the prepay rates that we're seeing on other products are not necessarily stimulus-driven, like mortgage, with a lot of churn and refinancing where we're originating taking share, but the portfolio is growing, but there's a lot of underlying prepay risk. That will start to slow as interest rates go up moderately, although we still think volume and demand is going to be very, very heavy, but it's going to turn towards purchase versus refi. So we should see a natural slowing of prepay on the mortgage portfolio. I'd also say on home equity, we don't talk about that very often. It's a very big business for us, and it's been slowly shrinking over and shrinking faster in the industry, you've got a lot of the big banks that are sitting on the sidelines at the moment that have really curtailed or even shut down their home equity originations platforms. We're enjoying market share that's almost double what we naturally get, which we naturally get really high market share in this industry. I expect us to, at a minimum, be a slower decline than others on home equity for prepay speeds given the size and pace of our originations capacity. And there's some optimism potentially that we could start to see home equity flatten and not be a headwind anymore for us. So there's a lot of dynamics I think at play there, but really your question around stimulus would be most felt in credit card, and that is called for in our underlying guidance and more than offset by those other dynamics. Understood. That's very helpful. Thank you for taking my questions.

We'll go next to the line of Saul Martinez with UBS. Go ahead, please. Mr. Martinez, your line is open. Go ahead.

Sorry about that. I was on mute. Thanks for taking my question. You indicated that most of the expected decline in non-interest incomes coming from lower mortgage banking fees, but that it should sort of hit a floor in the second quarter. I guess I just want to understand the logic there a little bit better. What gives you confidence that we will see a floor and we'll start to see in 2Q and we won't see further compression in margins beyond that, that pressure is the overall fee line. And then secondly, I'll just ask my second question now. On the swaps, what receive rate are you getting on those? Because I guess I understand the logic of averaging in and legging into it, but maybe I guess the flip side of that is it does seem a little bit out of step on the surface to me with the view that you expect rates to continue to rise, whether it seems like maybe – you can argue that it's a bit premature to leg into it already. So you could just flesh that out for us a little bit.

Sure. You know, on mortgage, you know, what we've seen happen kind of starting in late third quarter into fourth quarter was the industry gearing up in terms of capacity, adding capacity to, really capture the whole refi opportunities. And then you had some of these big non-bank players going public and being pretty aggressive around market share. So the very high gain on sale margins that were kind of frankly amazing and unsustainable back in uh q3 uh have you know started to to normalize back to historical levels uh based on those factors those forces uh and so we kind of see that uh playing out uh through the second quarter and then uh restoring kind of getting restored to levels that we've seen historically and the current view is unlikely to go meaningfully below that so That's the assumption that we're making. The flip side to that is that there's also a strong outlook for originations. We're looking at over $3 trillion, which would be next to 2020, another record year in terms of originations. And we're probably seeing a shift from refi to a little bit more purchase in the mix. And we're very well positioned in our retail channel to capture that. So still looking at a strong level of origination. So there's really no headwinds there at all. And then the size of our servicing book and the MSR asset, all of that should offer somewhat of an offset to the fall in margins. So, you know, we'll see. I think we've been pretty good at forecasting these dynamics. But, you know, the market is the market. We'll see how it plays out. But I think we've thought pretty hard about the factors and tried to project those out. And so we feel pretty confident that that's the likely scenario for Q2 and then for the rest of the year. So I'll stop there unless you want to add anything, Brendan.

I think it's well said. The one maybe data point I would add to that, just to kind of accentuate the rebound in purchase offsetting some of the refi decline, is that over the last 45 days we've seen about a 30% growth rate in purchase volume coming through our retail channel. So it's not just hopes and dreams. We're seeing it actually in real momentum through the business. So we feel pretty good about the volume outlook, to Bruce's point. You know, the margins bottoming at 2019 levels is really the key assumption, that it doesn't go any deeper than historical levels, and we're seeing it starting to stabilize right now. Yeah, good.

So we'll flip the second question over to John.

Yeah, thanks. So I think the point here is, You know, we saw a pretty rapid rise in the five-year over the last several months. As I mentioned, I think at the end of last year it was around 40 basis points. It had gotten, you know, I think, frankly, north of 90, but I think it's settling in around 80 right now. That is really emblematic of the first sort of risk triggers that we think about. You know, basically this is an interest rate risk hedging program that And that hedging program really requires us to consider where our asset sensitivity is and what the downside exposures are. And so from that perspective, we have several sort of triggers and tranches of hedging that we'll do over time. This is the first one, and I think there would be another one as and if rates continue to rise. Although it's our expectation that rates will continue to rise, the last, you know, sort of couple of weeks is a reminder that things can deviate from your base case. And so we're just being prudent risk managers and taking our asset sensitivity from around 11% to something that's in the very high single digits. And as we get to the top of the rate cycle, we'll get back down to something that's in the lower single digits, similar to where we've been in the past. And that's a very prudent sort of approach versus waiting around for the perfect time to begin to hedge. The other question you asked was what the receive rate was during that range of 40 to 80 basis points. And the five-year region, most of that hedging towards the upper end of that range. But that'll give you the answer there.

Good. All right. I think there's no more questions in the queue. So, again, I want to thank everybody for dialing in today. We certainly appreciate your interest and support. Have a great day, and everybody stay well. Thank you.

Ladies and gentlemen, that concludes today's conference call. Thank you for your participation. You may now disconnect.