U.S. Bancorp

Welcome to the U.S. Bancorp Fourth Quarter 2022 Earnings Conference Call. Following a review of the results, there will be a formal question and answer session. If you'd like to ask a question, please press 1 then 0 on your phone. If you'd like to withdraw, please press 1 then 0 again. This call will be recorded and available for replay beginning today at approximately 11 o'clock AM Central Time. I will now turn the conference call over to George Anderson, Senior Vice President and Director of Investor Relations for U.S. Bancorp.

Thank you, Brad, and good morning, everyone. With me today are Andy Cesari, our Chairman, President, and Chief Executive Officer, and Terry Dolan, our Vice Chair and Chief Financial Officer. During their prepared remarks, Andy and Terry will be referencing a slide presentation. A copy of the presentation, as well as our earnings release and supplemental analyst schedules, are available on our website at usbank.com. I would like to remind you that any forward-looking statements made during today's call are subject to risk and uncertainty. Factors that can materially change our current forward-looking assumptions are described on page two of today's presentation, in our press release, our Form 10-K, and in subsequent reports on file with the SEC. Following their prepared remarks, Andy and Terry will take any questions that you have. I will now turn the call over to Andy.

Thanks, George. Good morning, everyone, and thank you for joining our call. I'll begin on slide three. This quarter, we completed the acquisition of MUFG Union Bank on December 1st. In the fourth quarter, we reported $0.57 per diluted share, or $1.20 after adjusting for notable items related to the acquisition. This was a complex quarter that included one month of Union Bank results, merger and integration charges, and balance sheet optimization activity. Terry will provide more details on these notable items. Importantly, we ended the year with a common equity Tier 1 ratio of 8.4%. which was just above our expected level at deal close, and we delivered positive operating leverage for U.S. Bancorp legacy operations of 230 basis points for the full year. Strong year-over-year pre-tax provision income growth, as adjusted for notable items, was driven by net interest income growth and positive operating leverage. Credit quality remains strong, although credit metrics are starting to normalize as expected. Slide 4 details our reported and adjusted income statement results, as well as end-of-period balances and other performance metrics. End-of-period assets for the company totaled $675 billion, reflecting the acquisition of Union Bank and certain balance sheet optimization actions. Slide 5 highlights key performance ratios. This quarter, we delivered a return on average assets of 1.2%, a return of average common equity of 16.8%, and a return on tangible common equity of 23.4%, each as adjusted for notable items. Turning to slide six, the completion of the Union Bank acquisition marked a significant milestone for our company. With double-digit percent increases in loan and deposit balances, Union Bank adds meaningful scale to our business that enables us to better serve our customers and communities. Union contributes considerable small business and consumer market share in a demographically attractive California market, and we're excited about the potential to deepen existing unibank relationships by overlaying our leading digital capabilities and robust product set, including wealth management, consumer and business banking, and payments offerings across a loyal but underpenetrated consumer base. In many ways, this deal underscores our commitment to creating a stronger, more competitive regional banking organization in a rapidly evolving environment. One of the more attractive aspects of this transaction is Union Bank's high-quality, low-cost consumer deposit franchise, which will support continued loan growth and margins. Let me turn the call over now to Terry, who will provide more detail on the quarter.

Thanks, Andy. If you turn to slide seven, as Andy mentioned, we reported diluted earnings per share of 57 cents for the quarter, or $1.20 per share, after adjusting for notable items related to the acquisition. Notable items related to union bank acquisition are comprised of three primary elements that reduced earnings per share by 63 cents related to balance sheet optimization, merger and integration costs, and the impacts on provision expense related to acquired loans and actions taken to optimize the balance sheet. During the fourth quarter, the company recognized a one-time $399 million pre-tax loss on a net basis related to several actions taken to optimize the balance sheet manage the interest rate volatility impact on capital levels, and position the company for future growth. Subsequent to obtaining regulatory approval for the transaction, we entered into interest rate hedges to manage rate volatility and its related impact on regulatory capital from the date of approval to the closing of the transaction in December. During that timeframe, long-term interest rates increased nearly 50 basis points before declining approximately 65 basis points. The interest rate swaps were terminated at the time of closing and the losses recognized through earnings largely offset the interest rate marks recorded into the balance sheet through purchase accounting. In addition, the company optimized its balance sheet by selling certain loans and repositioning its investment portfolio on certain equity investments. Within non-interest expenses, we incurred merger and integration related charges of $90 million that primarily included the impact of specific deal closing costs, professional services, and employee-related expenses. We also incurred a $791 million charge to the provision for credit losses, which reflects an initial provision impacted by the acquisition of $662 million and a net loss of $129 million related to the securitization of approximately $4 billion of legacy indirect auto loans. Again, these moves enabled us to more effectively position the balance sheet for profitable growth and optimize returns. Slide eight provides a more detailed earnings summary. Union Bank, which was included in our consolidated results for one month, contributed $302 million of revenue, $221 million of non-interest expenses, $81 million of operating income and $44 million of net income to the company representing three cents per diluted share. On slide nine, end of period loans increased 13.3% on a linked quarter basis to $388 billion which included core loan growth and acquired loans from Union Bank. Union Bank contributed ending loan balances of $54 billion net of purchase accounting adjustments partly offset by a reduction in balances of $15 billion related to balance sheet optimization actions, including loan sales and securitizations. Slide 10 provides end-of-period deposit balance composition. End-of-period deposits increased 11.4% on a linked quarter basis to $525 billion, driven by the acquisition, which contributed $86 billion of lower-cost deposits, and actions taken as a result of the deal to optimize our funding sources. On a core basis, we saw deposit balances decline slightly this quarter. Turning to slide 11, the investment securities portfolio grew 4.2% linked quarter to $170 billion. The addition of securities from Union Bank were offset by balance sheet optimization actions. Slide 12 highlights revenue trends. Adjusted net revenue totaled $6.8 billion in the fourth quarter, which included revenue contribution of $302 million from Union Bank, primarily representing net interest income. For legacy U.S. Bancorp, net interest income grew 5.5% on a linked quarter basis and 29.2% year-over-year, driven by strong earning asset growth and net interest margin expansion, which benefited from rising interest rates. Results were partially offset by higher deposit pricing and short-term borrowing costs. Non-interest income, as adjusted for the legacy company, declined 3.0% compared to the third quarter, driven by seasonally lower payment service revenue and lower commercial product revenue offset by stronger mortgage banking revenue. Year-over-year legacy-adjusted non-interest income declined 5.5% driven by lower mortgage banking revenue from reduced refinancing activity and lower servicing charges offset by stronger payment services revenue and trust and investment management fees. Turning to slide 13, adjusted non-interest expense totaled $4.0 billion in the fourth quarter, including $221 million from Union Bank. Included in expenses was approximately $42 million of intangible amortization due to core deposit intangibles established at the time of the acquisition. Legacy non-interest expense, as adjusted, increased 3.8% on a linked quarter basis, largely driven by higher compensation-related expenses, as well as higher expenses related to professional services, marketing, technology, and tax credit amortization. Slide 14 shows credit quality trends. We reported total net charge-offs for the quarter of $578 million. After adjusting for acquisition impacts and the balance sheet optimization activities, net charge-offs totaled $210 million, or 0.23% of average loans, up from 0.19% in the third quarter, which reflected the continuing normalization of credit losses. Non-performing assets for the legacy bank increased slightly, while Union Bank contributed $329 million to the total. On a combined basis, the reported ratio of non-performing assets to loans and other real estate was 0.26% at December 31st, compared with 0.20% at September 30th and 0.28% a year ago, reflecting a continued strong credit quality. The provision for credit losses was $1.19 billion, which included a provision of $791 million related to the acquisition and balance sheet optimization activities. This provision includes an initial provision impacted by the acquisition of $662 million and $129 million related to our balance sheet optimization activities. The allowance for credit losses as of December 31st totaled $7.4 billion, or 1.91% of period end loans, which reflects increased economic uncertainty and the incorporation of the union bank portfolio. Slide 15 highlights the drivers of our linked quarter common equity tier one capital position. As of December 31st, our CET1 capital ratio was 8.4%. Acquisition impacts of 180 basis points included an increase in goodwill and other intangible assets that reflected the impact of credit and interest rate marks, the initial provision for credit losses, balance sheet optimization actions, as well as the increase in risk-weighted assets with the addition of Union Bank. These impacts were partially offset by an increase to equity related to shares issued to MUFG as part of the purchase price of Union Bank. Slide 16 provides our current expectations of certain financial metrics related to the transaction. The financial and strategic merits of the deal remain intact and are very attractive. Earnings per share accretion is now expected to be 8% to 9%, in 2023, which is higher than originally estimated. While our tangible book value per share dilution is higher than initially estimated due to the significant impact of rising interest rates on the interest rate marks at close, our estimated earned back period is only slightly longer than our original estimate at two years versus our original estimate of 1.5 years. Slide 17 provides a comparison of credit and net fair value marks from the time of our announcement to closing. Credit marks are lower due to favorable changes in portfolio composition and credit quality, partially offset by economic deterioration. Interest rate marks, inclusive of loans, securities net of sales, and debt are higher than anticipated at announcement due to higher interest rates. But we expect that to accrete quickly back through earnings. The core deposit intangible is also higher than originally estimated, reflecting the increased value of lower cost core deposits in a higher rate environment. I will now provide first quarter and full year 2023 forward-looking guidance, which is provided on slide 18. Starting with the first quarter 2023 guidance, we expect average earning assets of between $605 and $610 billion in the first quarter and a net interest margin that is 5 to 10 basis points higher than the fourth quarter level. Total revenue is estimated to be in the range of $7.1 to $7.3 billion, including approximately $100 million of purchase accounting accretion during the quarter. Total non-interest expense, as adjusted, is expected to be in the range of $4.3 to $4.4 billion, inclusive of approximately $125 million of core deposit and tangible amortization related to Union Bank. Our income tax rate, as adjusted, is expected to be approximately 22 to 23 percent on a taxable equivalent basis. We anticipate merger and integration charges of between $200 and $250 million for the quarter. I will now provide guidance for the full year. For 2023, average earning assets are expected to be in the range of $610 to $620 billion with net interest margin expansion of between 5 to 10 basis points compared with the fourth quarter of 2022. Total revenue is expected to be in the range of $29 to $31 billion, inclusive of between $350 to $400 million of full-year purchase accounting accretion. Total non-interest expense, as adjusted for the year, is expected to be in the range of $17 to $17.5 billion, inclusive of approximately $500 million of of core deposit and tangible amortization related to Union Bank. Our estimated full-year income tax rate on a taxable equivalent basis, as adjusted, will be approximately 22% to 23%. We expect to have $900 million to $1 billion of merger and integration charges in 2023. I will now hand it back to Andy for closing remarks.

Thanks, Terry. We accomplished a lot this past year, including the completion of the Union Bank acquisition and a strong legacy PPNR growth supported by positive operating leverage on an adjusted basis. Union Bank adds significant scale to our business and deepens our commitment to serving customers and creating economic opportunities for communities across the West Coast. We continue to target a Memorial Day weekend systems conversion, incorporating a lift and shift approach to our applications, which mitigates risk, and allows us to more quickly capture meaningful cost synergies. There is still a tremendous amount of economic and geopolitical uncertainty, and we are preparing for any scenario. I believe we will perform well because of the strength of our business, a strong balance sheet, and the great team we have. As we've proven during previous economic downturns, our business model is resilient and recession ready, in large part due to our discipline through the cycle credit underwriting standards and robust risk management infrastructure. Our consumer clients are predominantly prime, super prime, and our commercial book is generally investment grade, and we have very little leveraged lending commitments. We are focused on prudent balance sheet growth, high return, high margin opportunities, and the prudent allocation of capital to lines of business and products best served to deliver on our strategic objectives. Our growth strategy is focused on creating value for our customers, communities, and shareholders, which allow us to generate industry-leading performance. Let me close by saying thank you to our 77,000 employees across the company, including our newest colleagues from Union Bank. Your dedication and commitment are what make U.S. Bank special and a destination of choice for all the constituents we serve. We'll now open up the call for Q&A.

We'll now begin the question and answer session. If you have a question, please press 1 then 0 on your phone. If you wish to be removed from the queue, please press 1 then 0 again. Once again, if you have a question, please press 1 then 0 on your phone. And we can first go to Scott Ciphers with Piper Sandler. Please go ahead.

All right, Scott. Scott.

I have a question for you, just sort of at a top level. I was hoping you could speak to what sort of balance sheet and capital management will look like for you. So you're still under $700 billion in assets, but You know, any thought on sort of limiting growth or will there be additional sales or securitizations to help keep you under there? And then I guess on repurchase, I know we're on pause until we get back to the common equity tier one target. But with the sort of looming category move up, would there be any thought to hold off longer than that just to sort of see what happens? Just any thoughts on either of those would be great, please.

Scott, I'll start. This is Andy and Terry will head in. So first of all, we're not limiting growth in the company. One of the reasons we positioned the balance sheet and took the optimization actions we talked about, Terry went through, was to allow for profitable growth. It also was related to the credit box that we manage within as well as the returns that some of those categories of assets that we securitized were returning. So those are all allowing us to grow in a profitable way in the future. As we talked about before, we would not expect to cross the threshold of a Cat 2 until the earliest at the end of 24, and that's into the new category at that time. And if we have any further balance sheet optimization actions and securitizations, they would be very nominal and not material in nature. Terry, what would you add?

Yeah, no, I would just, again, reiterate, you know, we're ready to be able to adopt Category 2 by the end of 2024, but, you know, there's no real cap. We wouldn't expect any real significant balance sheet optimization from here. We spent a lot of time positioning the balance sheet for growth as we go forward.

Wonderful. And then just sort of thoughts on repurchase as well. I know we're on pause for now, but it's still sort of a question mark, so I would be curious to hear your thoughts.

Yeah, Scott, so, you know, as we've said and we continue to expect that, you know, we are starting at a good spot, about 8.4% CET1. You know, we expect that to accrete up to at or above 9% by the end of next year, and it continued to accrete at 2023, and, you know, continued to move up from that particular point. So, you know, one of the things we'll do is, you know, once we get to, you know, above 9%, you know, we'll have to make an assessment as to, you know, all the different things that are happening out there from a regulatory perspective. I mean, you have, you know, the regulators looking at Basel III and, you know, having to think about Category 2 and all sorts of things. But I think it's really going to be based upon, you know, what the landscape at that particular point in time looks like. But, you know, certainly in terms of our core

uh cet1 it'll it'll create nicely uh throughout 2023. wonderful all right i appreciate all the thoughts thank you thanks scott next we can go to erica negerian with ubs please go ahead hi good morning and thank you for all the details that you gave us on the slides um my first question is on you know the cadence of the cost synergies as it relates to your expected memorial day weekend conversion So first clarification question, the 35% cost synergies, is that a target for full year 2023? And what is that cadence like? Do we expect very little in cost synergies until Memorial Day weekend and then an acceleration in cost synergy capture as the systems converge?

Yeah, Eric, a great question. And just to confirm, our expectation is that of the $900 million of cost synergies, we'll see about 35% of that next year in 2023. And so from a cadence standpoint, with the Memorial Day conversion, the vast majority of those cost synergies will start to really kick in. subsequent to that system conversion. So smaller during the first half of the year, much more significant of that 35% in the second half of the year.

Got it. So in other words, we should anticipate an exit rate by 4Q23 of well above 35%.

By the time we get to the end of the fourth quarter, we will have incorporated the vast majority of the cost synergies such that by the time we get to 2024, we will be in a good position to have achieved 100%.

Got it. My follow-up question is on the economic outlook. If you could remind us what is being captured in the legacy U.S. bank reserves in terms of, you know, the GDP outlook and the unemployment outlook. And how are you thinking, you know, based on that outlook, charge-offs for legacy U.S. bank would trend? You know, as we anticipate, it seems like a lot of your peers are anticipating a mild recession from here.

Yeah, I would say that, you know, our expectations are probably consistent with that sort of a thought process. When we are thinking about the reserve, our base case is that there is a mild recession probably in the second half of the year and that unemployment ticks up and GDP is either relatively flat or down a bit. When we go through the reserving process, as we said in the past, we end up looking at five different potential scenarios all the way from a base case to a severe sort of recession and And I would say that from a reserving perspective, you know, we're a little bit weighted toward that downside scenario, you know, so a little bit more conservative. From a charge-off perspective, you know, our expectation, you know, kind of using the baseline of about 23 basis points in the fourth quarter, you know, that that will continue to normalize, you know, throughout the year. You know, we'll see both delinquencies and charge-offs, you know, moving up. But, you know, to kind of give you some perspective, you know, our pre-pandemic was at 50 basis points. You know, we probably don't see that until sometime into 2024. Got it.

Thank you.

Thanks, Erica.

And next we go to Mike Mayo with Wells Fargo Security. Please go ahead. Morning, Mike. Hi.

Hey, good morning. I just wanted to clarify. So you made your positive operating leverage in 2022 over 200 basis points. If you back into the numbers, I'm getting positive operating leverage year over year all in somewhere between, I don't know, 100 to 900 basis points. I'm not sure if that's correct. If you back in the numbers, what do you get? And why is there such big variance in the revenue guide? That's $29 billion versus $31 billion in And why is the margin still increasing five to ten base points in the fourth quarter? That's a bit more of an improvement versus others.

So I'll start on a couple of things that Ontario will add in. So let me sort of go backwards on your questions. The margin is increasing principally because of the value of the low-cost deposits that Union Bank brings on. We talked about that a lot, Mike, and, you know, $85 billion of principally consumer low-cost stable deposits in this environment is very valuable in driving up that margin on a quarterly basis, and that's reflected in that 5 to 10 basis points. We did achieve 230 basis points of positive operating leverage in 2020.

Give me a little bit of background. Hey, Mike, we're getting a little background.

Can you get your line? Thanks.

We did achieve 230 basis points of positive operating leverage in 22. We would expect to achieve continued positive operating leverage into 23. But 23 is going to have, you know, the merger-related charges in it as well. So I'm looking at it on a core basis. And, Terry, what would you add?

Yeah, I just maybe kind of coming back to the net interest margin, you know, we expect to see a lift related to Union Bank coming on, you know, that 5 to 10 basis points. And then from there, kind of flattish to maybe moderate increase or expansion in net interest margin through the rest of the year. But clearly, deposit betas and things like that are going to accelerate a bit in 2023.

And as a follow-up, look, U.S. Bancorp had been a low-cost producer for a long time. It looks like you're going to trend back in that direction. So it sounds like you still have no change in expected synergies between I get it. Union Bank is performing better, and that's why the accretion you had brought higher to 8% to 9%, but still no change in expected synergies from the acquisition. And then separate from that, Andy, you mentioned in December that the big kind of tech investment cycle is now turning positive versus being a drag for the last five or so years. If you could elaborate on that, thank you.

Sure, Mike. And you're right. We still are projecting, as Terry went through, $900 million of cost savings, 35% in 2023, 100% fully implemented in 2024. Importantly, we have not, in the guidance that we provided, provided any revenue synergies. So it's without revenue synergies, which we think there are going to be some, particularly after the integration and conversion process. We are past the heavy spend on tech. You're right. We're more of at a flat line and starting to gain the benefits of that. And part of the benefit of this transaction is leveraging the investments we've made in the company over the last three or four years to allow us to lift and shift to our technology platform in a very low-cost way. So that benefit is driving through the synergies that we talk about.

Thank you.

Thanks, Mike.

Mike? And now we'll go to John Fanchari with Evercore ISI. Please go ahead.

Good morning, John. Good morning. So on the credit metrics, I know you indicated that you're starting to see normalization in charge-offs and delinquencies. I want to see if you can elaborate a bit more on what income cohorts are you seeing the normalization? We're hearing from some of the consumer finance players that they are seeing some normalization impacting or moving beyond just the non-prime and low income, but into prime and super prime? And also, what asset classes are you seeing the normalization most obviously? Is it just on the card side or in other asset classes? Thanks.

Yeah, I mean, this is Terry. So, you know, maybe to address your first question in terms of where we're seeing it, and maybe as kind of a reminder, you know, from an underwriting perspective, we focus on prime, super prime, really in all of our consumer portfolios. You know, to the extent that we're seeing delinquency starting to tick up, you know, it's more so in the credit card space. And, you know, you're right, it would be probably on the lower bands as opposed to the upper bands at this particular point in time. But, you know, one of the things we talked about is that, you know, when you look at savings or excess savings from a consumer perspective, you know, they're fairly significant. That is coming down. As that's coming down, people are revolving more on their credit cards. And, you know, I think it's just kind of a natural progression that we are seeing. And again, starting more with the unsecured and the credit card portfolio, not as much with respect to the other portfolios yet. But, you know, as things continue to normalize, we would expect that too.

Okay, thanks, Terry. That's helpful. And then I guess related, how does this development in consumer behavior and your macro assumptions as well, how does that impact your expectations for your payments revenue and your card revenue and merchant processing revenue as you look out through the year considering the macro dynamics? Thanks.

Yeah, so the payments revenues you saw still is well above pre-COVID levels. The card spend is 25% above. On a year-over-year basis, we're plus 5%. So spend continues to be strong. The categories of spend are shifting a little bit. And we would expect continued strong spend, but moderating a bit as we go into the rest of 2023 for the reasons that Terry mentioned. But still expect growth, but again, probably more moderate in nature as we go forward and the savings levels start to normalize and the consumer behavior starts to change.

Yeah, the thing that I would end up adding, John, is that, you know, one of the things we've talked about in the merchant processing is that, you know, we think that business is kind of a high single digits. And, you know, when we look at 2023, you know, that's kind of our expectation for that particular business. You know, relative to 2022, you know, we anticipate that our credit card revenue will strengthen a bit in terms of year-over-year comparisons. And that is primarily because prepaid sales and prepaid revenue, which has been a drag, kind of starts to moderate. And then on the corporate payment card business, we continue to think that that's going to be reasonably strong, certainly high single digits, if not low double digits. And we're continuing to see travel and entertainment recover. very nicely in that particular space. So, you know, we feel pretty good about the payment revenue trends for 2023. Great.

Thank you, Terry. Appreciate it.

Yep. Next, we go to Abraham Punwala with Bank of America. Please go ahead. Hey, good morning, Abraham.

Well, I just want to follow up one on credit. So you talked about consumer. Looking at the CRE slide, If you don't mind sharing your perspective around the CRE book, if you're beginning to see any softening either in certain markets, maybe California or within the office CRE book, which is about 10% of loans.

Yeah, maybe at a high level, certainly from a CRE perspective, valuations I think are moderating to some extent. You know, the areas that we have had probably the, you know, greatest focus on, if you will, is really office space. And that is really probably as much tied to return to office sort of behaviors or patterns. And I think that that is probably a longer term sort of structural adjustment that's going to end up happening. We're just going to have to watch it over time. But when we just kind of look at the core CRE portfolio, it continues to perform pretty well from a credit perspective at this particular point.

Got it. And I guess just one separate question around payments. When you think about in your slide, you mentioned about some of the tech investments and partnerships. Just give us a sense of, remind us around competitive positioning for USB, how you're thinking about just market share outlook. And from these partnership standpoint, like areas of like secular growth that you see in this business.

As you mentioned, we've made a lot of investments in tech-led activity, and our tech-led investments have led to that being the principal area of growth for the merchant processing categories. And then on the card side, the partnerships component continues to be an important strength for us and a point of growth as we look forward. So those two areas, tech-led on merchant and partnerships on card, are doing well, and it's partly due to the investments we've made over the past few years.

And is the strategy there to just build this in-house or do you see more kind of bolt-on acquisitions within that business?

Many of the investments we've made are internal investments that we've developed our capabilities and our platforms to allow for different activities and allow for integration with some of the software that the companies use to run their business. We've added as well, as you know, miscellaneous M&A acquisitions that you said bolt-ons like Italic or Bento acquisitions that add capabilities around the edges. And I think we'll continue to do a little of both as we look forward.

Thank you.

Sure.

And we can go to Gerard Cassidy with RBC. Please go ahead.

Hi, Gerard.

Hi, Gerard.

Hi, Andy. Hi, Terry. Congratulations on closing the deal. question for you terry on the balance sheet optimization where you guys decided to you know sell off certain loans that were required can you give us some color on what types of credits were in those sales and um why would they chose you know i know they didn't meet your credit profile but what was the driver of that i mean some of the details of the credit profiles yeah uh maybe as a starting point you know when we thought about the balance sheet optimization

The things that we were thinking about is really repositioning the balance sheet to position ourselves for growth going forward, to be able to optimize or improve profitability and looking at profit margins across the various portfolios. And returns and then the risk profile. So maybe from a risk profile perspective, you know, we ended up looking at Union Bank, you know, portfolios that we ended up acquiring. There were a couple of different areas that we focused on. One is that they had acquired a number of loans related or through a lending club channel, if you will. And, you know, that was something that we had planned to run off over time originally when we, you know, looked at the deal and we made a decision that, you know, when we looked at the kind of the credit risk profile, how it originated, et cetera, that we thought that, you know, taking care of that up front made a lot of sense. The other area that we ended up selling was some commercial real estate in, you know, in their particular portfolios. in order to be able to kind of bring that concentration down a bit. And then the other areas of optimization was more on the U.S. bank side. We ended up looking at lower margin indirect auto loan portfolio. We securitized about $4 billion associated with that particular portfolio. And then the other things that we ended up looking at in the CNI book of business and across kind of our corporate space It was just relationships that maybe had lower returns associated with it where we could optimize that. And so we allowed some of that to run off, so to speak, during the quarter. And those were the primary areas of focus with respect to the balance sheet optimization. The last thing I would maybe say on the investment portfolio side is that we ended up selling about $15 billion of securities, the vast majority of that coming from Union Bank, and that was really to kind of think about it from an interest rate risk perspective, HTM perspective, et cetera. But that was the other area where we did some balance sheet optimization.

Terry, in the corporate loans, were there any shared relationships, meaning you had an exposure to XYZ Company as did Union Bank? and the total was maybe too much, and you guys decided to take that down as well?

Yeah, exactly. So maybe from a risk perspective, looking at hold levels or concentrations with respect to specific customers, yes, that was a part of the strategy.

Very good. And then just as a follow-up, you guys obviously gave us very good detail in your slides. And on the credit quality, slide 14, you give us the breakout and the net charge-offs, and you show us the reported number at 64 BIPs. versus your core legacy number of 23 basis points. If I pull out the 189, you know, from the optimization, it looks like the net charge-off ratio is around 43 basis points, including the union bank numbers. Is that kind of the level we should kind of gear ourselves to for 2023, now that union will be, you know, fully implemented into your business?

Yeah, let me... clarify, so it's 64 basis points on a reported basis, 23 basis points on a core basis, and there's two components to that core. The balance sheet securitization that I talked about that you articulated, but then under CECL, what you end up having to do is you have to recapture loans that they have charged off you have to make an assessment. And then if you believe that that charge-off was appropriate, you have to charge that off on day one, so to speak. And there was about $173 million of charge-offs related to that kind of day one effect associated with CECL. So there's really kind of three components. But 64 on a reported basis, 23 on a core basis. And when we think about going forward, I would use the 23 basis points as kind of the start point. And that's about $210 million worth of core charge-offs.

Thank you for clearing that up. I appreciate it. Yep.

And next we can go to Betsy Grisek with Morgan Stanley. Please go ahead.

Hi, good morning. Hi, and congratulations from my end, too. And the deck is super clear. I really appreciate all the effort to make it simple and straightforward. So a couple questions for me, just to follow up on the discussion we just had. Could we also talk a little bit about how we should think about the reserving level as we go through 23 and, you know, into 24? Because, you know, like you said, you've got the fair value marks. You had to do the day. You had to do the add. as per the CECL rules. So does reserve ratio stabilize from here? Does it actually inch down? Is there a scenario in which it would move higher? Could you just frame out how we should think about that? Thanks.

Yeah, I mean, obviously it's impacted by a lot of different things in terms of how economic uncertainty ends up changing and, you know, the mix of the portfolio, how it might change. But, you know, as we kind of think about 2023, I think that that 191 basis points is probably a good metric throughout the year. It might inch down a little bit, but I think that by and large, we feel pretty comfortable with that as we think about 2023 based upon our kind of base case, so to speak.

Okay. And then I have one other question on the growth of the balance sheet. I know you addressed this a bit before. But when I look at the 23 guide versus, you know, 1Q23, it's a slower growth rate than I think we're used to seeing at USB. So maybe you could help us understand, you know, is this a moderated growth rate during the integration phase and maybe second half, you know, that should accelerate up? Or is this the level of growth that we should anticipate? And then if you don't mind, I have just a couple of ticky-tackies on that. the purchase accounting and the CDI and how we should expect that steps down into 23 and 24. Sure.

Betsy, this is Andy. So first on the growth rate, I think 22 had exceptional loan growth across many categories led by commercial as well as CRE. So what we would see is that more normalizing. You're starting to see that in the fourth quarter. And I think the other fact is that the growth rates are impacted by average balances and some of the optimization activity that we took down in the fourth quarter. It was a partial quarter in the fourth quarter, full quarter in the first quarter, and the rest of 23. But the principal driver is the function of loan demand, which is moderating a bit across most categories. So it's still growing, but a little less than what we saw in 22.

And then, Bessie, maybe related to your second question, which was around the recognition of the core deposit intangible over time, probably the way that I would think about it is that it will amortize into income over about a 10-year period. It will step down in probably a good way of just modeling that is assuming kind of a sum-of-the-years digit sort of approach.

And same thing for PAA, or how should we think about that? I mean, I know it's different.

Yeah, so that's tied, obviously, to the life of the loans, and it'll end up being impacted by prepayments and all sorts of things. If you end up looking at their portfolio that we acquired, about half of it is residential mortgage and half of it is corporate in shorter terms. So You know, probably if you ended up looking at an average life of, you know, four or five years, four to six years, that sort of timeframe. And, of course, that will also, you know, accrete probably a little bit faster on the front end.

Okay.

Thank you for that.

Yep. Thanks, Betsy.

And next we'll go to Vivek Jeneja with J.P. Morgan. Please go ahead.

Morning, Vivek. Morning. Congratulations. A couple of questions. The tangible book value recovery, the crossover and the fact that you'd recover that back quickly, can you just give any color on sort of what's the key driver of that? Is it just simply earnings or is there something else underneath that also that's going to help that come back so quickly?

Yeah, it's principally the accretion effect that we're going to see with respect to Union Bank, the marks, and the underlying earnings of the company.

Okay. So because I just heard you say the accretion, the question that Betsy asked, the purchase accounting accretion, that half the loans are mortgages. So that will come down, I guess, more slowly. So is that part of it, that repurchase accounting accretion is going to stay high for longer?

Yeah, no, I really think it's just, it really is the kind of the 8% to 9% accretion levels that we're expecting, you know.

On the EBS side.

Yep. Yep.

Okay. Got it. Okay. A couple of other little ones. Deposits, the decline that you had in the balance sheet optimization, I think it's pretty sizable, 24 billion. Is it all UB or is it some of yours and which types of deposits? Yes.

Yeah, it's a great, great question. You know, it's from a deposit standpoint, you know, when you think about kind of the optimization that we went through, you know, we had kind of a focus on a couple of different things. We ended up looking at LCR ratios. We ended up looking at higher cost deposits. whether that would be, you know, brokerage-type deposits or euro-dollar deposits, those sorts of things. We made a very conscious decision after getting regulatory approval to kind of reposition that. On the union bank side, the one thing that I would point out is that, you know, there's about $8 billion to $9 billion worth of deposits that came over that were more transitionary. And over time, those will transition back to... back to their global investment bank as those customers kind of migrate. So about half of that migrated in the fourth quarter, and I would expect probably the other half of that to migrate in early 2023. But those were kind of the things we ended up looking at with respect to deposit and deposit flows. So I was really looking at trading out low-cost deposits, or high-cost deposits for low-cost deposits that were coming over from Union Bank and then some of the Union Bank effect.

And what was the OCI number at the end of the year? So as we think about going to Category 2, how quickly do you expect that to come down so that you can be in better shape?

Yeah, so OCI at the end of the year is about $8 billion. $8 billion. And, you know, the duration of the portfolio is a little over five, you know, so if you can kind of take a look at that. Obviously, that's assuming that, you know, rates don't move from here. You know, our positioning from an investment portfolio perspective is about 52%, 53% HTM. We've also entered into some pay fixed swaps that, in effect, kind of get that up to the high 50s. So we feel like we're in a pretty good position to be able to deal with, you know, if rates move up a bit or if rates come down, we have some flexibility there as well. So we feel like we're in a pretty good spot.

All right. Thank you.

And next we can go to Matt O'Connor with Deutsche Bank. Please go ahead.

Good morning. Can you talk about the pace of the capital build from the 8-4 to around 9 by the end of the year? Sure. And then also, you know, if the macro is worse than expected and you have to build reserves more, I realize that doesn't move the capital that much. But, you know, obviously everyone else is starting at a higher point of capital. And, you know, there is focus on how quickly you can get to that nine or even higher. So I guess the question is, like, what levers can you pull here? that kind of aren't that painful if you need a little bit more, such as issuing preferreds or some other assets that you could kind of exit without hitting earnings that much? Thank you.

Yeah. I mean, obviously, Matt, from a balance sheet optimization perspective, we're going to be very focused on profitability, returns, and capital is precious. So we want to make sure that we are dedicating our resources effectively from an asset growth perspective in the right spots. You know, the pace of growth from 8.4 to, you know, a little above 9% by the end of 2023 is fairly rateable across the four quarters. Obviously, first quarter is going to be a little bit lower simply because we will not have seen the cost synergies and we will be going through and incurring more merger-related costs probably in the earlier part of the year, simply because of the timing of the system conversion. So the pace is probably a little bit more weighted toward the back end, but that hopefully kind of gives you some perspective. Again, I'd kind of come back from a reserve point of view. You know, we feel like, you know, we look at a lot of different scenarios. We look at the five different approaches, one of which is, you know, a severe recession. We take that into consideration. You know, we can see unemployment move up to around 6%, 6.5%, and we still feel like we would be in a pretty good spot from a reserving point of view. So if it ends up being at a level that's higher than that, then we'll have to kind of focus on other balance sheet optimization activity.

Okay. Thank you very much.

Thanks, Matt. Thanks, Matt.

And we'll go to Ken Usden with Jefferies. Please go ahead.

Hi, Ken.

Hey, good morning, guys. First question I just wanted to ask is just to follow on the outlook for the year. Can you two walk us through just your underlying assumptions for kind of how NII just projects? If we just think about kind of the core business in terms of what deposit costs and betas do and how that impacts the kind of underlying trajectory, you know, from the fourth quarter of NII?

Yeah, you know, so obviously the net interest income is going to be driven by the earning asset growth that we have in here as well as the margin expansion. You know, we expect that margin expansion to take place, you know, five to ten basis points in the first quarter because of the union full quarter kind of effect of union bank. And then, again, our modeling is that the margin is reasonably moderates from there, reasonably flat, maybe up just a little bit. You know, from a deposit point of view, you know, clearly deposit betas are going to accelerate. I think that's the reason why, you know, you'll see the moderation in terms of net interest income or net interest margin expansion in the second half of the year. You know, but keep in mind, you know, and again, this is kind of, we see that in the first quarter, the union bank effect associated with the value of those deposits that we're bringing on, and we'll continue to look at opportunities to kind of optimize the deposit portfolio.

Okay. And then just one follow-up on the deal impact. Can you just remind us what type of like amortization period you're using for both the purchase account increase and the CDI in terms of like, is this the run rate that we keep around for a few years or does that change as you look past 23? Thanks.

Well, I think that, again, in 2023 we expect the purchase accounting accretion to be $350 to $400 million and the CDI to be about $500. As I mentioned earlier, I think on the CDI it steps down over time, but if you use kind of a 10-year assumption and some of your year's digits, I think that will get you from a modeling perspective pretty close to how I think it will end up amortizing off. The purchase accounting is really going to be tied to the asset lives, you know, because about half of it is mortgage and half of it is, you know, corporate and commercial, et cetera, and shorter-lived assets. I think you can think about kind of that four- to five-year sort of timeframe, and it probably accretes down into kind of a similar sort of fashion, a little more front-end weighted.

Okay, got it. Thank you, Terry.

Yep.

And next we can go to Chris Kotowski with Oppenheimer. Please go ahead.

Good morning. Hi. Following up a bit on Mike and Ken's questions, if I look at your very helpful slide 18 on the guidance, and I take the midpoint of the 7.1 to 7.3 billion dollar revenue range, and I kind of day weight that to the full year, I kind of get the lower range end of the full year guidance. You know, 29.2 is actually what I get. So that implies like a, you know, couple percent growth in the back half of the year, which again, I guess is better than what a lot of banks are saying. And I'm wondering, is that just underlying loan growth? Or the income growth? Or is it the tag ends of the benefits of rising rates? Or what do you see driving that?

Well, again, I think you do see kind of the full-year effect associated with rising interest rates kind of come into play. You know, fee revenue on a legacy basis, as an example, you know, we should see, you know, a little bit more of a tailwind next year as opposed to what we experienced this year. So I think that those are kind of coming into play. And then I think that, you know, just, you know, timing of being able to get cost synergies on the expense side.

Yeah, and I'd add it's probably just mathematically, if you're talking about it, you're right. And it's a little bit of a growth in the earning asset that you see there going up from 605 to 610 to 610 to 620. That's number one. And then maybe going towards the high end of that range in that interest margin versus the mid or low end in the early quarters. Yeah.

Well, it's interesting because if I do the same analysis on the non-interest expense side, you're at the high end of that. So it implies kind of nice growth in pre-provision earnings through the course of the year. But anyway, that's it for me. All right.

And our last question in queue will come from Mike Mayo with Wells Fargo Securities.

Hey, Mike. Hey.

ASCI, I'm just going to remember you're $12 billion, now it's $8 billion.

And where is it as of today? Okay.

OCI overall is at 10 at the end of the year and expected to come down from there.

And at a lower level today, Mike.

And then, Andy, just can you pull the lens back a little bit? It's been a rough three, five, and ten years when you look at operating leverage and stock, not last year on the operating leverage. But that comment you made in December and you addressed briefly, But you've been in this investment cycle multi-years, and now you said that you're coming out of it or the drag's less or maybe the spending's less and the payoffs are more. Can you just give us more color on both the spending side and the payback side and where you've invested the most in and where you expect that payback? Because it sounds like you're crossing a line based on your comment from December that you reiterated today. Thanks.

Yes, thanks, Mike. I think that's a fair representation. So our spend levels on pure CapEx grew from about $800 million to $900 million to $1.2 billion, $1.3 billion. And that growth has been in the run rate for the last couple of years. So you would not expect to see additional continued expense increase related to CapEx. Importantly, we also migrated that spend from about 60% defensive to 60% offensive. So the spend is on activities like digital capabilities, reaching customers, products, and services, and so forth. So all of that is what's coming through right now. So a level set on the expense side plus a return on the investments from a revenue side, that coupled with overlaying all that on the union bank customer base is why we're projecting the numbers that we're giving you.

Okay, thank you.

Thanks, Mike.

We do have time for one more question. We'll go to John McDonald with Autonomous Research. Please go ahead.

Morning, John.

Morning, guys. Hey, just a couple quick follow-ups. So, Terry, where does the balance sheet repositioning and the merger leave you in terms of interest rate positioning? How would you describe it here? Fairly neutral, a little bit asset sensitive. Where are you ending up now?

Yeah, I would say that Legacy U.S. Bank is fairly neutral. When we add Union Bank on, it probably adds about 50 basis points of asset sensitivity in a 50-up sort of shock environment.

Okay. And then on the fee income, you said some more details. tailwinds this year, some helpers on legacy U.S. Bancorp. What are those on the fee income front? What are the helpers this year that you can grow fee income, maybe just puts and takes on fees real quick?

Yeah, well, if you just kind of look at the different components, I think the payments revenue continues to be reasonably strong. I think that the expectation is the market comes back a in terms of investment income. But deposit service charges, we saw a drag in 2022 because of some pricing changes we implemented in May. That starts to dissipate. You know, so I think it'll be kind of a combination of things, but probably one of the biggest ones is just mortgage banking revenue. You know, that has been a pretty significant drag, especially on a year-over-year basis. And in the fourth quarter, we actually started to see that inflection point with link quarter revenue starting to come up, and we would expect that to be a little bit stronger as we go into 2023. Okay.

Okay, got it. And then the last clarification, I think on reserves, you said the 1.9 ratio looks pretty good for this year. And even if unemployment went to six, six and a half, you'd be okay?

Yeah, again, we go through a lot of different scenarios. And we take that downside into consideration. And as part of kind of that weighted average process, we think six, six and a half percent unemployment is already incorporated into our reserving process. So But again, it all is going to depend upon what ends up happening, how severe the economic recession is, if there is one at all. So I think there's just a lot of moving parts.

Got it. Thank you.

And we have no further questions at this time. I will now turn it back to George Anderson. Please continue.

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