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Banc of California, Inc. (BANC) CEO Jared Wolff on Q1 2019 Results – Earnings Call Transcript

Banc of California, Inc. (NYSE:BANC) Q1 2019 Earnings Conference Call April 23, 2019 1:00 PM ET

Company Participants

Jared Wolff – President, CEO Director

John Bogler – EVP CFO

Conference Call Participants

Jacquelynne Bohlen – KBW

Gary Tenner – D.

A. Davidson Co.

Matthew Clark – Piper Jaffray Companies

Timur Braziler – Wells Fargo Securities

Andrew Liesch – Sandler O’Neill + Partners

Ebrahim Poonawala – Bank of America Merrill Lynch

Stephen Moss – B. Riley FBR, Inc.

Donald Worthington – Raymond James Associates

Timothy Coffey – FIG Partners

Operator

Hello, and welcome to the Banc of California‘s First Quarter Earnings Conference Call. [Operator Instructions].

Today‘s call is being recorded, and a copy of the recording will be available later on the company’s Investor Relations website. A presentation management will reference on today‘s call is also available on the company’s Investor Relations website.

Before we begin, we would like to direct everyone towards the company’s safe harbor statement on forward-looking statements included in both the earnings release and the earnings presentation.

I would now like to turn the conference over to Mr.

Jared Wolff, Banc of California‘s President and Chief Executive Officer. Please go ahead.

Jared Wolff

Good morning, everyone. Welcome to Banc of California‘s First Quarter 2019 Earnings Conference Call.

This is a special call for me, as it’s my first earnings call since joining the bank as President and CEO just over 5 weeks ago. And I look forward to sharing updates on the performance of Banc of California with you for many quarters to come.

With me today is John Bogler, Banc of California‘s Chief Financial Officer.

Before I share some of my initial observations and vision for the bank, I will first ask John to talk about the results for the first quarter.

Following his comments, I will discuss my thoughts on where we want to take the bank going forward. John?

John Bogler

Thank you, Jared.

In the first quarter, we made progress in our efforts to optimize our balance sheet and remix our asset base, with total assets decreasing to $9.9 billion from $10.

6 billion at the start of the year. As mentioned last quarter, we expected to reduce assets in Q1 due to the $132 million sale of the CMBS portfolio.

And then as we saw favorable market conditions develop for certain assets, we made opportunistic asset sales that were in line with our overall balance sheet strategy.

In connection with these sales, which occurred late in the quarter, we also began to reduce our most expensive sources of funds and reduce our cost of funds.

Taking a closer look at assets. Securities decreased sequentially by $521 million, driven by the CMBS portfolio sale as well as a $386 million reduction within the CLO portfolio.

The CLO portfolio is now down to $1.04 billion versus $1.

42 billion as of the year-end 2018. We will continue to execute dispositions within the CLO portfolio at or above the book value of each position sold.

And as a result, we expect this portfolio to continue to shrink in the coming quarters. However, our ability to further reduce the CLO position is market dependent and will require market spreads on our positions to further tighten.

The loan portfolio decreased by $144 million during the quarter, driven by our stated goal to more closely align loan growth with core deposit growth. And additionally, we further emphasized relationship-based lending during the quarter.

For the overall loan portfolio, there was a $203 million decrease in SFR loans due mostly to a profitable $243 million sale, which settled in March.

As part of that SFR trade, there will be an additional $100 million-or-so anticipated to sell in the second quarter, and you will see that reflected in our Q2 ending balance in addition to further transactions related to reducing our concentration in lower yielding single-family and multi-family loans.

Loan production totaled $536 million for the first quarter with average production yields increasing from the prior quarter by 3 basis points to 5.29%, which is a much higher yield than the blended portfolio loan yield of 4.

76%.

In the coming quarters, as we sell lower yielding single-family and multi-family loans along with pulling back from broker source production, the overall loan portfolio yield should continue to increase, all else being equal.

The single-family sales drove the overall decline in net held-for-investment loan balances. However, total commercial loan balances provided an offsetting increase of $67 million for the linked quarter.

Included in the net commercial loan growth are increases in multi-family of $91 million and construction of $8 million with another $6 million coming through SBA. We did see decreases in commercial real estate of $1 million and CI of $37 million.

As of March 31, commercial loans make up 71.3% of our total HFI loan portfolio compared to 69.

1% last quarter and 66.9% a year ago.

As we continue to reorient the balance sheet towards being a relationship-based community bank, the mix of commercial loans is expected to increase.

Moving on to deposits.

We are strengthening our resolve to derisk our balance sheet and bring down the overall cost of deposits through carefully targeted deposit outflows. As a result, brokered CDs decreased by $248 million in Q1 and savings deposits reduced by $114 million.

The outflow of some of our transactional and higher interest-bearing deposits were partially offset by an increase of $97 million in noninterest-bearing checking deposits. Noninterest deposits are now at the highest level we’ve seen in the past 5 quarters.

Overall, there were smaller increases in interest-bearing checking, money market and nonbrokered CDs of $17 million, $26 million and $30 million, respectively. These changes contributed to an improvement in our wholesale funding mix down to 24% at quarter-end from 30% last quarter.

We are going to continue creating opportunities within the business to increase relationship-based deposit balances with special attention being paid to the cost of those deposits. Bringing the overall cost of deposits down is a long-term effort, and our March 31 balances are indicative of tangible actions taken to make progress toward that goal.

Core deposits or nonbrokered deposits now account for 83% of total deposits, up from 81% last quarter and 86% a year ago.

Shifting gears to the income statement.

Net income available to common stockholders for the quarter was $2.7 million or $0.

05 per diluted common share. The quarterly results were impacted by net nonrecurring expense items totaling $5.

8 million, including $7.7 million of legal and indemnification expenses and $2.

8 million of restructuring expenses, all partially offset by a $4.7 million insurance recovery related to ongoing legal and indemnification expenses.

As a reminder, legal expenses associated with indemnification of past and current directors and officers is generally eligible for insurance reimbursement, and reimbursement is recorded as a contra expense as it is received. We expect to continue to incur legal and indemnification expenses for the next several quarters, with the insurance reimbursement naturally lagging.

After adjusting for these nonrecurring items, along with the amortization expense associated with our solar tax equity program, our operating expenses for the fourth quarter were $54.1 million, of which we have provided reconciliations on Slide 7 of today‘s deck.

After excluding the nonrecurring items for the first quarter and normalizing our tax rate to 20%, adjusted operating earnings for continuing operations were $0.18 per diluted common share for the first quarter, the reconciliation of which is detailed on Slide 8 of today‘s deck.

The bank’s net interest margin decreased by 7 basis points during the first quarter to 2.81%.

In the quarter, we significantly reduced our CLO portfolio and sold $243 million of lower yielding single-family loans with the sales occurring late in the quarter. The proce from the asset sales were used to reduce high costing FHLB advances and coupled with other planned asset sales in the second quarter, we expect the net interest margin to improve in future periods.

Average interest-earning assets were up slightly from the linked quarter at $9.8 billion, with the average yield increasing 6 basis points over the same period to 4.

59%, including a 2 basis point increase in average loan yields to 4.76%.

The securities portfolio average yield increased 25 basis points to 4.13%.

As a reminder, the CLO investments reset quarterly and are indexed to the 3-month LIBOR. The cost of interest-bearing liabilities increased 15 basis points to 2.

12%, mostly due to the CD deposit cost increasing 16 basis points to 2.35% and money market deposit cost increasing 32 basis points to 1.

89%.

FHLB borrowing cost did increase 10 basis points over the quarter to 2.

59%. However, the income statement impact was muted due to recent efforts to reduce FHLB advances within our funding profile.

Net interest income decreased by $2.9 million from the prior quarter to $67.

8 million. For the first quarter, loan interest income increased by $2.

3 million due to $314 million increase in average balances and 2 basis point increase in the average yield. This was partially offset by a decline of $2 million in interest income on securities as these average balances declined by $281 million.

We expect the average balances of securities to come down further next quarter as we continue to transition the balance sheet.

On the liability side, interest expense on deposits increased by $2.

5 million as the average balance increased by $118 million and the average rate increased by 15 basis points. Interest expense on FHLB advances were basically flat quarter-over-quarter due to a mix of 10 basis point increase in rate versus $25 million decrease in average balances.

With the decline in the first quarter ending balance for FHLB advances, interest expense for this category is expected to decline in the second quarter. The composition of interest income should continue to improve as we accelerate the optimization of the balance sheet towards a traditional community bank profile.

Commercial loan interest income now represents 59% of total interest income in the quarter compared to 57% last quarter. Loan interest income now comprises 82% of total interest income in the quarter, up from 79% in Q4.

The provision for loan losses in the quarter was $2.5 million and reflective largely of deterioration in forward credit.

A single leverage loan credit totaling $17 million was downgraded to substandard and accounted for $1.8 million of the provision, and 3 SBA loans were deemed impaired with a specific reserve of $1.

1 million. It should be noted that we hold just 2 leverage loans.

Additionally, $819,000 of net charge-offs were recorded in the quarter.

These provision increases were offset by $1.

7 million of general reserve decreases, driven primarily by the $144 million decline in the loan portfolio for the quarter. The ALLL balance coverage ratio of nonperforming loans is 224%, while the overall ALLL ratio was 85 basis points.

Total noninterest expenses for the quarter were $61.8 million, which included the previously discussed onetime expenses of $5.

8 million and $2 million of expense from solar investments. The quarter also included $2.

9 million of elevated professional fees related to projects that will be completed in the second quarter. Our current solar tax investment commitment is completed, and we expect the annual HLBV depreciation to wind down toward immateriality in future periods.

Noninterest expenses included a number of items, which we do not consider to be core operating expenses. Adjusted for those items and the depreciation from solar investments, core operating expenses came in at $54.

1 million or 2.09% of average assets on an annualized basis.

We are working on a plan to normalize our run rate expense base to a level that is aligned with our size and footprint, but recognize the operating expense reductions will naturally lag any asset reductions. In the short term, we can see expenses remain in the current level and then come down toward the end of 2019.

This likely will translate into an increase in our operating expense ratio initially, then begin to decline.

Our capital position remained solid as the common equity Tier 1 capital ratio was 9.

72% and Tier 1 risk-based capital totaled 13.03%.

As we continue the transition of our asset base to resemble that of a strong community bank, we expect that our capital position will remain solid.

Lastly, let’s move on to credit and asset quality metrics.

Our nonperforming asset ratio for the quarter was 29 basis points, up 8 basis points from the prior quarter. Although we saw an increase in Q1, we still have a very low level of nonperformers, which is indicative of the credit culture at the bank.

The credit performance of the portfolio is in line with expectations, and we do not see any indication of broad deterioration in our portfolio.

Nonperforming assets to equity continues to remain strong at 3%.

Delinquent loans increased $18.9 million during the quarter, resulting in a delinquent loans-to-total loan ratio of 79 basis points for the quarter.

Subsequent to the quarter-end, the level of delinquent loans returned to the level at the end of the fourth quarter 2018, with two loans totaling $21 million returned to current payment status. Finally, net charge-offs for the quarter were $819,000 or only 4 basis points annualized based on average loans and consistent with our expectations.

With that summary of our first quarter financials, I’ll now turn the call back over to Jared.

Jared Wolff

Thank you, John.

First off, I want to express how impressed I am with the people at Banc of California. Having been in the Southern California banking market for over 17 years, I knew many of the colleagues here before I joined and I knew how much talent exists at the bank.

Additionally, the bank has a tremendous reputation with its clients for exceptional service and execution. We have deep expertise in real estate, commercial banking, warehouse lending, treasury management, private banking and an outstanding branch team.

Our non-client-facing team members are true professionals. The bank benefits from solid credit, a very strong capital base, a terrific brand and deep talent pool.

I’m honored to have the opportunity to lead Banc of California and look forward to working with the team to achieve great results in the quarters and years to come.

Let me take a step back for a moment and give you a quick refresher on the recent history of the bank’s business.

While Banc of California is a community bank with a terrific footprint in one of the most vibrant banking markets in the country, the company’s earnings profile and balance sheet had not historically resembled that of a community bank. In 2017, the company began to refocus more on traditional loan production in business banking.

The increase in loan volume outpaced deposit growth, which put pressure on the liability side of the balance sheet, causing a faster than industry rise in deposit costs.

Beginning late in 2018, various steps were initiated to reduce expense and margin pressure, including targeted asset sales, divesting noncore businesses and expense reduction programs.

Many of these initiatives are currently in place and we plan to continue them through 2019. However, I’m going to task our team with accelerating the transformation toward being a true community bank, which will create long-term value for our stockholders.

In order to accomplish this, it’s crucial that our lending and deposit resources are focused on franchise enhancing opportunities that foster long-term banking relationships. Our North Star will be the focus on relationship-centric lending and deposit gathering that is supported by the deep expertise of our team, tightened service and best-in-class execution for our clients.

We are a community bank and the business that we conduct will be reflective of that. In the simplest terms, we make loans to businesses, entrepreneurs and individuals within our footprint where we have relationships that come with deposits.

We will focus on providing solutions where clients value our execution service. We should command a premium.

We don’t need to do everything, just a few things well: real estate, local CI lending and private banking.

This concept in its simplest form is core to my vision for Banc of California strategy.

This also impacts the nature of our lending. We will prioritize lending in our footprint and doing loans that are appropriate for bank our size, while gathering deposits from our clients.

As a community bank, our lines of business will be concentrated in the following areas: real estate, which includes commercial real estate and multi-family lending; commercial and industrial lending, which includes commercial and middle market banking as well as warehouse lending; and private banking. All of this is supported by the service-focused branch network of our community bank and the superior expertise of our treasury management team, which works with deposit clients with sophisticated ne.

Having deep expertise is essential to providing the best service to our clients.

Consistent with our relationship focus, we are going to deemphasize loan generation that is brokered or commoditized.

At the end of the first quarter, we decided to exit our brokered single-family loan business, which generated approximately $100 million per month in origination volume, but at a very low margin. The pipeline for that business is being funded or wound down and should be completed by the end of May.

Finally, as market conditions permit, we will continue to make opportunistic and strategic reductions to our CLO portfolio. While we believe having a strong investment portfolio is consistent with our overall strategy, we want to normalize the nature of such investments as well as reduce the concentration and reliance on earnings from such sources.

These important balance sheet initiatives that we hope to complete by year-end will put pressure on earnings in the short term, since we can’t replace assets as quickly as we sell them. But I believe they are the right long-term decision for the company and the shareholders.

Importantly, these balance sheet initiatives will reduce pressure on the liability side of the balance sheet as well and help us reduce our cost of funds. The transition of our asset base to resemble that of a traditional community bank will help us realign our liability funding sources toward the lower costing balances.

For instance, we will target the exit of higher costing time deposits initially, then look at high cost speciality deposits, which do not have a term structure. You can expect to see a decrease to wholesale funding as well.

Decreasing our overall cost of funding and our cost of deposits in particular will be key to our success.

To further our focus on relationship-oriented lending and deposit taking, we are working with each line of business to really zero in on business clients within our market who have a need for expertise and execution abilities.

Further, we are ensuring that we are serving existing clients in the best possible way. Emphasizing our expertise on the deposit side and increasing our outreach to business clients will be a process, but we have already implemented some changes to accelerate that timetable and I’m confident we will be successful.

As we accelerate our transition to a community bank, we will need to rightsize our expense base to align with our size and footprint. This isn’t something that can be done at the flip of a switch without causing disruption to the business and to our clients.

So we need to be very surgical in identifying areas to reduce expenses and methodical in our analysis and timing.

As we execute on many of these asset transitioning initiatives, our operating expenses should decline by the end of the year, and our goal is to end the year with a better run rate to ensure 2020 starts off on the right footing.

We have a lot of work in front of us, and 2019 will be a year of transition as we execute on these transformative priorities. The result of this hard work will be a banking franchise with a balance sheet and income statement resembling that of a traditional community bank that concentrates on relationship-oriented banking.

As I mentioned, there has been some work already completed to get us to this point, but I’m intent on accelerating the pace of this change to build long-term shareholder value.

As CEO, a top priority for me is to ensure that we are a responsible steward of our stockholders’ capital and that we deploy that capital into areas where we are reasonably confident we’re achieving the highest possible return balanced against an appropriate level of risk.

Having the flexibility to assess all potential options available for capital utilization will be a substantial part of our transformation. For example, some options could involve paying down the preferred equity, authorization for common stock buyback program, investing into our business operations where we have identified way to improve how we service our clients, potential MA down the road and a number of other potential uses of our capital.

Maintaining this flexibility is going be very important to our success. In addition to strategically reducing our balance sheet and improving our deposit cost and low margin, we will be resetting our quarterly dividend to $0.

06 per common share. Combined with our other strategic initiatives, this will enable the company to build excess capital to redeploy into more useful and core aspects of the business in the near term.

To summarize, we will be measuring our near-term progress by closely monitoring the following: first, the overall reduction in the cost of deposits within our overall deposit profile; second, the successful disposition of our noncore assets through deliberate market execution; third, normalizing our run rate expenses by the end of the year to a level that is aligned with our size and footprint.

Longer term, our progress will be measured by an improved margin and increased earnings.

In both the near and long term, we will strive to maintain our excellent credit discipline and optimize our use of the company’s capital.

Over the past 5-plus weeks, I’ve been focused on helping Banc of California reevaluate what it means to be a community bank in Southern California, what that business will look like, how we can best serve our clients and how we can achieve that vision while building more long-term value for our stockholders.

Our balance sheet is going to be strengthened through the initiatives we have outlined. We are and will remain strong from a regulatory capital perspective.

Our credit quality remains very high. And we’re seeking to further reduce risk within our balance sheet going forward.

We have tailwinds from significant brand awareness in one of the best banking markets in the country. Our employees are extremely talented professionals that provide the best possible service to our clients.

I am confident that the path I’ve laid out will in due time result in Banc of California becoming one of the premier community banking franchises in California, enhancing shareholder value for the long term.

As I mentioned earlier, I’m very excited to be leading Banc of California into its next chapter.

My first 5 weeks have been tremendous, and it is clear that we have significant opportunities in front of us. And I hope you come away from this call with a much clearer idea of the strategic course that we have plotted for the company.

In the coming months, I will be speaking and meeting with many of our investors personally, and I anticipate meeting some of you at upcoming investor conferences. Thank you for your participation on today‘s call.

I look forward to updating you again in a few months on our second quarter results.

Operator, let’s go ahead and open up the lines for questions.

Question-and-Answer Session

Operator

[Operator Instructions]. And our first question today comes from Jackie Bohlen with KBW.

Jacquelynne Bohlen

Just touching first on asset dispositions and understanding that there is a lot of uncertainty related to timing and when you might complete all of that. How does the first quarter‘s activity compare to your intentions for additional quarters? Meaning, was this a quarter where a lot happened and it might not be quite as much in future quarters? Or should we expect this pace over the next couple of quarters?

John Bogler

Jackie, the first quarter was probably larger than what we would expect to see on a go-forward basis.

And just to back up a little bit, within the CLO portfolio, we had some spread widening that took place at the end of last year, and then those spreads came in quite a bit during the first quarter. So that gave us an opportunity to exit a number of CLO positions.

We would need some — to see some additional spread tightening to be able to continue to sell out some of the CLO securities. And so we’re a little bit market dependent there.

The SFR categories, again, we would be looking for opportunities to exit as well as some multi-family, and that will be chunky as we go forward. And maybe to more kind of the question that you’re asking is how do we see the overall balance sheet size.

We think that by the end of the year, we’re somewhere between $9 billion and $9.5 billion.

Jacquelynne Bohlen

And with that in mind and understanding that there is a lot of moving parts here, how much of that is a reduction from where you stand today versus what portion of that reduction is offset by intended growth?

John Bogler

Well, the $9 billion to $9.5 billion would be the net number.

So if I try to break those down into categories, which I don’t really want to do, because we’re really going to be much more of a market taker in terms of what the pricing that we can receive on — as we market CLOs, single-family and multi-family loans. So I can’t really give you kind of specifics around those categories.

I can just say that overall, our intent is to be somewhere down between $9 billion and $9.5 billion.

Jared Wolff

We’re generating — Jackie, we’re generating new loans. We’re growing our portfolio internally.

So but for the sales, our portfolio would be growing. The good news is that our production is at the same or higher yields than what we’re selling.

So we expect the overall portfolio yield to grow. We’ve got great pipelines, but we have the opportunity to dispose of our lower-yielding stuff right now.

And so we’re going to take the opportunity to do that.

Jacquelynne Bohlen

Okay.

And I guess, part of where I was getting at with my question was — and understanding that, that’s a net balance sheet size. But looking to what kind of organic growth, I know that there has been a small shift in strategy.

And I just want to see how much of an impact you think that the exit of some of the brokered and nonrelationship businesses will be if it was only about $100 million that was quantified or if there is any additional declines that would come as a result of that. And what you growth outlook would be, given that there are some historical loan portfolios that you may not be as focused on in the future?

Jared Wolff

Yes.

Well, we have a terrific team of people here in the different areas, and it hasn’t been too large a shift for some of our teams to focus on relationship-oriented lending. Many of them had already started to do that.

As in prior quarters, they had started tightening the requirements from a yield standpoint. As you do that, it narrows your box in terms of what you’re willing to do.

So we expect to continue to have growth organically in each of our areas, but I think the pace of our growth will be a little bit slower than it has been, for example, at the end of last year.

John Bogler

And Jackie, you mentioned $100 million.

I want to make sure you hear Jared’s comment. Roughly, that’s $100 million a month of single-family.

..

Jared Wolff

Those are the SFR.

John Bogler

In the SFR book of business.

Jacquelynne Bohlen

Yes, yes. I understand.

Roughly, call it, $300 million a quarter and around $1 billion a year, right?

John Bogler

Correct.

Jacquelynne Bohlen

Okay.

And then just one last one from me, and I’ll step back. understanding that there are a lot of factors that go into the reshuffle and the downward trend of the securities portfolio, what is an ideal level of securities assets that you’re looking to have by year-end?

John Bogler

I think we had a mix that looks like 10% to 15% would be appropriate.

More globally, the CLO portfolio is still larger than what we would ultimately like for it to be. And so again, we’ll continue to work down that portfolio as we can.

And at some point, we’ll have to start building up the portfolio with the other types of investment securities. But initially, we will be working down the size of CLO portfolio.

Operator

And our next question comes from Gary Tenner with D.A.

Davidson.

Gary Tenner

A follow-up on Jackie’s question.

Is it the fair read then to say that you’ve got a target in your mind of what you’d like the CLOs to get to. But as you said, you’re subject to the market.

So if the market is not conducive to disposing those at the pace you want, do you sell or dispose of more single-family to get to the balance sheet to the size you wanted? Or is it really going to be a balance of the 2 along the way?

John Bogler

I would say it’s a balance of the three categories. So the — our ability to sell out CLOs, our ability to sell out the single-family as well as our ability to sell out multi-family.

The single-family and multi-family, those two categories combined comprise nearly 60% of the loan portfolio, and there are elements within that portfolio that are very low yielding. So we will look to continue to sell out some of the low-yielding product out of both of those portfolios and help to rightsize the amount of what are otherwise two very low-yielding asset categories.

Gary Tenner

Okay. And then as it relates to expenses, you talked about rightsizing the expense run rate by the end of the year to be appropriate to the balance sheet.

I’m just wondering if you give us a sense of if you look at it on an expense to average asset basis or something along those loans, where that target might be?

John Bogler

Yes, we’ve — given that we’re looking to do a more accelerated restructuring of the balance sheet, we’re not going to be in a position where we can kind of talk about NIE to asset type ratio. We do think that by the time we get to the fourth quarter this year, we can get the operating expense down into the $52 million range.

Gary Tenner

Great. And then last question from me.

You’ll notice that the long-term profitability targets that have been in the slide deck for the last year plus were not there. I’m just wondering what kind of — what that suggests in terms of the goals or how you would kind of position any changes to the previous targets?

Jared Wolff

Gary, I took the opportunity to do a refresh and establish kind of 3 very specific priorities for the team for 2019.

And the first is our cost of deposits. Obviously, we’ve talked about rightsizing the balance sheet.

And third is the operating expenses. We just need to take pressure off the liability side and make sure that we can bring our cost of deposits down.

I think that from a franchise enhancing standpoint in terms of value for stockholders standpoint, our cost of deposits has to be way up there. And so we’re going to prioritize those 3 things for this year.

Operator

And our next question comes from Matthew Clark with Piper Jaffray.

Matthew Clark

Just wanted to clarify the $9 billion to $9.

5 billion, whether or not those are total assets or earning assets?

John Bogler

That is total assets.

Matthew Clark

Okay.

And then just on the cost of interest-bearing deposits and the desire to bring that cost down, I heard some of your preliminary comments, but wasn’t sure whether or not that overall cost has actually declined since quarter-end or if there’s some expectation that we might peak in terms of the overall cost sooner than later?

John Bogler

Yes, we — if you — the comments that we made around the timing of the CLO dispositions and the SFR sale was very late in the quarter. And so we were able to then take out some of the high-cost liabilities.

And so we’ll get the full quarter benefit of that in the second quarter. And then we’ll continue to adjust pricing across the entire deposit portfolio, not just CDs, but other product categories as well.

So we would look for the cost of funds to decline. And then as we have additional asset sales and we’re able to take out higher-cost funding, whether it’s brokered CDs or whether it’s retail CDs, that will also take the pressure off the cost of funds.

Matthew Clark

Okay. Great.

And then just on the — one of the items in the longer-term goals was to get that margin back to 3% or above 3%. I assume that’s still realistic.

But just your updated thoughts on maybe the margin outlook, given all the changes you expect in the mix of the balance sheet and size?

Jared Wolff

We fully expect to get there. I mean, we’re using both levers to do it.

So on the production side, our portfolio yield should be rising. And then on the deposit side, hopefully, we’ve peaked.

As John said, the actions that we took in terms of disposing of assets occurred late in the quarter, so we didn’t get the full benefit of some of the higher-cost deposits that we took out. We have a whole initiative — initiatives on the deposit side right now both on the gathering side as well as reducing our — the cost of our existing portfolio.

And so we expect that to bear out at the — by the end of the year and improve the NIM. And so that certainly remains our target, if not to do better than that.

Matthew Clark

Okay. Great.

And then maybe just one last one on the tax rate, John. Beginning here in the second half whether or not we normalize that 20% to 25% or not?

John Bogler

Yes.

We will continue to look at tax planning strategies. We didn’t undertake anything here in the first quarter.

We’re looking at various other initiatives with the ultimate intent for the full year being down around 20%.

Operator

And our next question comes from Timur Braziler with Wells Fargo Securities.

Timur Braziler

Sticking with deposits, again, looking at growth in demand deposits linked quarter is pretty impressive. I guess, A, what drove that? Was any of that growth coming from the new initiatives that you mentioned? And what are the thoughts on kind of the trajectory of noninterest-bearing deposits going forward?

Jared Wolff

So I would agree that, that was a pretty large move in the quarter.

Having only started in March 18, I can’t take credit for it. But the team worked really hard, and that’s an expression of the focus that we have.

We’re focused on low-cost deposits. So it’s not just noninterest-bearing.

Business interest checking is something, which is a real product and valuable for many businesses. But I think we have a real opportunity to bring our entire cost of deposits down.

Not sure if you’re looking for — to more color there, but the focus on business deposits, I think, is really where we’re going to make the biggest impact using leading earnings credit rate, having the right analysis products in place. Gathering deposits takes a lot of time.

It’s more of a process that an event, and I had done it at a couple of different institutions. And you have to start now, and the lead time is much longer than with loans.

So we’re putting in place all of the right tools to make our team successful and reorienting everybody around gathering deposits. And we talked earlier about generating loans and bringing in deposits with loans and not doing loans that don’t come with deposits.

So we expect to see this process take hold and will show the results over many quarters. It’s not something that shows a big clip right away.

I think what happened last quarter was great. It would be hard to say that, that’s going to replicate itself every quarter at this point.

But certainly, we appreciate having that bump.

Timur Braziler

It’s good color.

Maybe taking a step back. Like you said, it’s been a little bit over a month since you’ve joined.

How far along, I guess, are you in reviewing and putting your own stamp on the balance sheet business lines and the strategic focus? Are the things that you outlined — are you kind of done looking at that, or are there any other obvious business lines that either don’t fit or business lines that might be missing from executing on the strategy laid out?

Jared Wolff

No, I think we have all the right tools in place, and I think we have the right bodies in the right seats. It’s a process as we go through this through the course of the year, but I think I got through 60 days in the first 30, it felt like it, which was great.

It was a quick deep dive, looking at our budgeting process among other things. There’s no items that I could highlight for you right now, but we’re going to continue to look — I think, from an operating expense standpoint, it’s something that we’re continually looking at.

And both on the technology side, it’s going to make us more efficient when some of these initiatives come in, as John mentioned. There’s some stuff that we’re going to complete next quarter, but there’s other stuff that’s going to tail in at the end of the year.

And those are the opportunities to bring expenses more in line. And as we mentioned, we hope that our run rate for expenses at the end of the fourth quarter is really what’s going to start 2020 off the right way for us.

Timur Braziler

Okay, great. And maybe one more from me.

Just looking at asset quality, any additional color you can provide on those two leveraged loans that you mentioned? Maybe what are the size of the two and what drove down rate of the credit migrated this quarter?

John Bogler

Yes, the one that was downgraded this quarter was roughly a $17 million loan. It is a SNC deal and we — I’m hesitant to share any more color, I guess, about it at this time.

Jared Wolff

Yes, it was originated — it was — we think maybe this would be helpful. It was originated a couple of years ago, so it’s not a recent credit.

It is a large shared national credit. The sponsor is a local private equity firm who has put more money in the deal.

But it’s really a wait-and-see deal to see if it gets worse before it gets better. But we’re monitoring it very closely as we can as a participant in the deal.

Timur Braziler

Okay. And the provision that was taken this quarter, is that the only reserve established for this, or has there been something prior?

John Bogler

No, that was the first time that we put up any sort of — other than just kind of the general reserve.

And so it was downgraded that causes to post additional provisions on that single credit.

Timur Braziler

Okay.

And is the other loan of similar size?

John Bogler

Similar size, and it is a well performing loan, so no issues with that loan. And we’ve been on a path to try to exit out of all of our direct leverage loans as well as indirect leverage loans.

And we have just a very few number of credits of each of those left.

Operator

And our next question comes from Andrew Liesch with Sandler O’Neill.

Andrew Liesch

Thanks for the — some of the clarity around the end — ending balance sheet target for this year. But then with presumably improving loan yields and reducing deposit costs, as you said, margin goal to get back to 3%, is it possible to get it back this quarter up there or is it going to be more gradual in nature?

Jared Wolff

No, it’s going to be more gradual.

Andrew Liesch

Okay. And then it sounds like then with you wanted to between $9 billion and $9.

5 billion, the net pace of the loan portfolio is going to continue to decline, securities will continue to decline. And the $500 million-or-so of production this quarter, is that kind of what you’re thinking as far as what you’ll produce quarterly? Or is that going to be a little bit less, just given what you’ve seen so far here in the first couple of months?

Jared Wolff

We can do it.

I think we can produce that. We have a lot of leverage to pull.

It’s really going to depend on the pace of the asset sales. We — taking pressure off the liability side is so important to make sure that we keep our deposit costs low, which I think from a long-term value standpoint is among the most important things that we can do for the company.

It’s certainly not loan growth. Loans are important and we want to put on high-quality earning assets, and we have tremendous teams here that can do that.

But we want to make sure that our deposit costs come down fast enough. So we’re going to be looking at that very closely.

John and I have talked about it a lot. It’s a balancing act in terms of how quickly you increase your earning assets relative to the drop in the sales.

And so we’re going to just be pulling those levers carefully. But I think we could do — we could stay in the range where we are last quarter if we wanted to.

Operator

And our next question comes from Ebrahim Poonawala with Bank of America Merrill Lynch.

Ebrahim Poonawala

So just to follow up in terms of the guidance you gave for the asset reduction, when I look at Slide 13 and you call out the brokered, nonbrokered and the federal home loan bank deposit sort of high cost funding, is then — how much of that do you expect to run off? And what’s the incremental cost of funding that’s coming in? Like is the new deposits coming in close to 2%, higher than that?

John Bogler

Ebrahim, so as we look through the liability stack and as we receive asset proce, we will look to selectively take down these high-cost categories, and Jared had also mentioned speciality deposits.

The CDs have a natural term structure, so we will likely take them out as they come due. And then that gives us a little bit more flexibility to take down the specialty type deposits as well as any sort of overnight advances.

And so we will have to just continue to massage each of those categories as we go forward. And I would say the other comment that Jared made was that we will also look to reprice across the product set.

So that will help to bring in new funds at lower cost, and the emphasis is going to be on business products, whether it’s noninterest-bearing or interest-bearing checking. So there are a combination of levers that we will continue to pull.

Jared Wolff

I’ll give you an example. We took our April maturing CDs, and at the beginning of the month, we repriced them from, I think, 150 basis points down to 1% for the 12-month CD.

We’re monitoring now. There is a 10-day grace period, and people can pay a breakage fee.

If they miss it, the grace period, and want to exit the CD. But we’re monitoring what the retention is of those CDs.

But we literally overnight took down the higher costing product and put in the middle of the peer group for that product. And now we’re seeing what the retention is.

If people want to stick around for 1%, we’re happy to have them for the 1-year product, but I didn’t want them at 100, 150 basis points. So we’re going to monitor those things very closely.

And assuming we have — based on the feedback, we’re going to continue to make those changes to bring down our cost as quickly as we can.

Ebrahim Poonawala

That’s helpful.

And the $9 billion and $9.5 billion, is that something where you want the balance sheet to bottom out? Like I understand you can leverage and sort of remix things.

But is it kind of where you’d like the balance sheet to be at least be above $9 billion and remix that and then eventually begin to grow it on a net basis? Is that the right way to think about? No?

John Bogler

Yes, I would say not necessarily. We’ll continue to work the balance sheet to try to improve the net interest margin and ultimately arrive at the balance sheet that we think is highly profitable.

And so we’ll have that leverage to be able to continue to push. If you just look at the information there on that Slide 13 and if you just take those in the aggregate, you’re close to $4 billion of high-cost funds.

Now we want to — we’ll probably keep some of that, but that’s a fair amount of high-cost funding that we could look to move out over time.

Ebrahim Poonawala

Fair enough.

And just in terms of — I’m sorry if I missed this — if you disclosed like origination yields or what you expect new loans to come on, on the — my sense is the incremental balance sheet growth should be accretive to your margin, but would be helpful to get where new origination yields are coming on?

Jared Wolff

The coupon for new originations was 5.29% in the quarter versus 5.

26% in the prior quarter.

Ebrahim Poonawala

5.

29%, got it. Okay.

And just one last question. I think Jared mentioned about ample capital levels.

Just when I think of it from a tangible common equity perspective at 6.85%, can you talk about like your comfort level when you think about preferred redemption, et cetera, or buybacks? How low do you feel okay with taking that ratio, understanding that you’re really mixing the loan book more to CI high-risk weighted loans?

John Bogler

Yes, we often receive questions about the TCE ratio, and while we agree that we need to improve it, certainly from a regulatory perspective, we’re very comfortable with where our capital ratios are at.

And I think as we shrink down the size of the balance sheet, which will naturally free up capital as well as the dividend reduction, that certainly puts us in a position where we can start to look at our options around capital. And part of that would include either tendering proportion of the prep or waiving and exercising the call on the Series D, which becomes callable in June of next year.

So we want to maintain capital flexibility and really evaluate all those options.

Operator

And our next question comes from Steve Moss with B.

Riley FBR.

Stephen Moss

I was wondering if you could just kind of walk through the rationalization for the dividend cut here, what the board’s thought process was around it and if there is a targeted payout ratio you guys are seeking.

Jared Wolff

Well, we weren’t earning enough money. I mean, I just didn’t feel right to pay a dividend that was really higher than our earnings could support.

We didn’t want to have a floating dividend that was moved around based on a payout ratio. So we just had to come up with the number.

And based on where we think we’re going to be for a while, we thought this was right. I don’t want to back into a payout ratio and projected earnings, but we just felt like this was the right number for the foreseeable future.

Stephen Moss

Okay. That’s fair enough.

And then in terms of just the CLO wind down here going forward and liquidity, as you guys are able to unwind the CLOs, do we start thinking about that basically as a dollar-for-dollar exchange into more conforming mortgage-backed securities? Or just how do we think about your liquidity position, given that it’s not traditional these days?

John Bogler

Yes. I think that as we are able to sell out to the CLOs, those proce will be used to repay high-cost liabilities.

So it won’t be remixing within the securities portfolio. And if the securities portfolio as a percent of assets could come down a little bit more from where it’s at, recognizing that the overall balance sheet is going to be coming down, that gives us more room to also take down the CLOs further.

Stephen Moss

Okay. And then I realized you don’t want to take a loss necessarily on the CLOs, but the difference in mark-to-market that you disclosed in the deck is about $11 million.

It feels fairly small relative to the exposure and the potential risk. Just kind of wondering why the hesitancy not to be more aggressive in liquidation here and take a loss?

John Bogler

Yes.

That’s certainly things we look at. We look at that in some of our other securities as well.

But at this point, we still think that there is going to be some opportunities to bring down the size of the CLO portfolio as we go forward. So at this point, we just haven’t opted to pursue that path.

Jared Wolff

Steve, just sitting on one thing that you mentioned on in terms of what we do with proce from the CLOs, I mean, we — rather than investing them in other securities, we do think that the best opportunity for the bank is to bring down our cost of deposit. And if we were to reinvest in other securities, we’d be missing that opportunity.

And so I just want to emphasize that, that is one of our core priorities.

Stephen Moss

Okay.

That makes sense. And I guess, perhaps going down that a little further, I mean, obviously it sounds like you’re going to have a mix shift to — into CI loans.

But perhaps just as I think about — you get the balance sheet to $9 billion to $9.5 billion, is — I think you talked about targeted securities assets ratio of 10% to 15%.

Is that something that you’d like to do within the next 12 months, or is that just further along the term target?

John Bogler

That’s longer term. We would be a little bit of a market taker in terms of pricing for the CLOs, and we will take advantage of the opportunities as they come about.

Operator

And our next question comes from Don Worthington with Raymond James.

Donald Worthington

John, just want to clarify, when you’re talking about the alternative energy partnerships that, that’s completed, but that there might be some residual expenses.

Is that correct, did I hear that correctly?

John Bogler

That’s right. We have allocated depreciation expenses as part of those, and that calculation resets itself in January of each year, so there is a little bit of a catch-up that occurs.

And then it will largely reverse itself throughout the course of the year.

Donald Worthington

And then I know this is hard to kind of predict, but any feel for when kind of the legal expenses may significantly taper off?

Jared Wolff

I was going to ask you that question.

Seriously, we — I just got here and I did a deep dive on the litigation. You guys have been listening to these calls longer than me.

This was why I made that reference. But it looks like it’s moving in the right direction.

It’s very hard to predict litigation. It looks like it’s moving in the right direction.

And as we’ve said, we are — just about everything is reimbursable from the insurance companies. So it’s a lot of noise that we hope to be out of here sooner rather than later.

But I haven’t seen anything that makes me think this is going to — that’s moving in the wrong direction. So we’re optimistic that it’s going to continue to wind down.

Operator

And our next question comes from Tim Coffey with FIG Partners.

Timothy Coffey

A lot of my questions have been answered, but I do have some odds and ends that just kind of want to inquire you about.

The first one is, Jared, do you have like a targeted or comfortable loan-to-deposit ratio you’d like to operate the bank at?

Jared Wolff

That’s a good question. I mean, right now, most banks are pretty elevated, right? It’s hard to see — most banks are hovering in the 90s, even Citizens has gotten way up there with community.

Just looking at numbers, it’s hard to see us getting — I think we can get down into the 90s, but it’s hard to see us moving much past that right now. We want to keep our — we have a really high quality loan team and we want to keep making notes.

But given where we are with our funding and everything, I think that’s probably the best we’re going to do.

Timothy Coffey

Okay.

And then you mentioned about — you made changes to accelerate the timetable to remix this balance sheet. Has that included adjusting comp levels or compensation to encourage production of what you want to see on the balance sheet?

Jared Wolff

It does.

We’ve put in place some incentive programs that are directly tied to production related to bringing in lower-cost deposits. And so as those deposits come in, people can earn handsome incentive compensation around it.

Timothy Coffey

Okay. And you mentioned kind of the 3 business lines you want to start focusing on.

Are you anticipating that each of those will represent 1/3 of the business? Or do you have a..

.

Jared Wolff

Not at all.

And I really meant there to highlight, Tim, the teams that we already have in place that are doing an excellent job. So we have a very strong real estate function.

We have an exceptional multi-family team that really does an exceptional job and has figured out a way to turn a business into a true relationship-oriented business. They are able to get spreads a little bit higher than the market and bringing deposits.

It’s something that traditionally has been commoditized. We have the ability to turn that back on at any time and make very high-quality loans at a much faster clip right now.

We’ve asked them to look in — do loans at a little bit of a higher rate and bringing in deposits, and they are doing that and they are doing a fantastic job. We have a CRE team that does a great job as well with real estate.

And then on our CI team, whether it’s warehouse or our business middle market teams, they are already doing that. And private banking has always been a very strong franchise in Los Angeles and in Orange County, and that’s something that we’re looking to enhance.

It’s going to be key to what we do in terms of originating low-cost deposits.

We recently hired a lender who specializes in healthcare who worked with me for many, many years.

When you go after doctors’ offices and you’re lending to physician practice groups, those doctors really don’t want to spend much time opening deposit accounts. And so having that concierge-level banking to help them do it quickly to set them up on remote deposit loan for their business, working with their bookkeepers and their CFOs and their controllers.

But when you get to them personally, they really appreciate your ability to do that and streamline it for them. So our private banking team has already been doing a great job in a couple of verticals and now we’ve added health care.

Timothy Coffey

Okay. Right now, of the customers that you have, how many do you think or what percentage do you think would fit into that private banking bucket?

Jared Wolff

I’m not sure how to answer that question.

I mean, the private bank is designed to meet the ne of entrepreneurs and individuals that kind of meet the threshold of having enough to support that cost of service. And so given the focus of our bank around businesses, entrepreneurs and individuals, it’s going to be an increasing percentage of our portfolio, I can tell you that.

But I’m not sure I could tell you today how many owners of the businesses that we bank are with our private bank or what percentage of our entire population of clients could use the private bank, I don’t know, I could tell you that.

Operator

And our next question is a follow-up from Matthew Clark with Piper Jaffray.

Matthew Clark

When you dip below $9 billion — or $10 billion at the end of the year, can you just remind us whether or not you’ll capture that Durbin impact on service charges or not?

John Bogler

The Durbin Amendment had very little impact as it pertained to us. So there was really no sort of — we don’t expect there to be any sort of difference.

Operator

And our next question is another follow-up from Timur Braziler with Wells Fargo Securities.

Timur Braziler

Sorry, just one more from me.

Looking at the residential book, is there an ideal concentration that you’re looking to get to, I guess, say 28% of the portfolio now? How big would you want that book ideally? And as a corollary, what are the market conditions looking like as we start the second quarter?

John Bogler

Yes, we haven’t set any sort of kind of mix. My comments earlier about that we have roughly 59% of our loan book sits in multi-family and single-family, 2 of the lower-risk and lower-yielding product types.

We just want to have less concentration of those. So I haven’t necessarily said they’re interchangeable.

We probably have a little more emphasis on selling single-family than multi-family, but we want to bring down the overall mix of those 2 categories. And I would say in terms of kind of market disposition, we continue to see opportunities.

And the thing I’d point out is, similar to what we did in 2018, we’re not necessarily looking to sell out to achieve large gains in some instances. It’s more about interest rate risk management and taking out the lower yielding long duration type products.

And so we’ll continue to manage the portfolio in the aggregate, recognizing that we’re going to bring down the concentration of those 2 categories.

Jared Wolff

Timur, we are going to still continue to originate single-family loans for our clients in the branches and through the private bank, and we’re going to retain the capability of doing that.

We think it’s something that we can do well for our clients. But as John said, we’re exiting the larger lower-yielding portfolio.

And as we mentioned, we’re winding down the broker-originated business.

Timur Braziler

Okay.

And maybe just taking a step back, I guess, looking at the securities restructuring, looking at what’s going to be taking place on the remixing of the loan book, the normalization of the expense base, should much of that be in the numbers by year-end? Or is the expectation that some of that is going to carry over into the coming year?

John Bogler

We think that by the fourth quarter, we’ll be down to a kind of a reasonable run rate. But having said that, I also made a comment earlier that I wouldn’t necessarily think that we’re going to stop with the changing of the balance sheet and removing of high-cost liabilities and low-yielding assets.

That could continue into 2020 as well.

Timur Braziler

Okay.

So the deposit piece will take longer, but general balance sheet construction asset side should be pretty much wrapped up by year-end?

John Bogler

But again, I think it’s more kind of a — the current year target. We will continue to reassess the next date when we have roughly $4 billion of high-cost liabilities.

And there is going to be a need to continue to remake on the liability restructure. And as Jared has been commenting, our focus is on cost of deposits.

And we’re going to be moving towards having the most profitable balance sheet that we can construct. So that will be our focus.

Operator

And this will conclude our question-and-answer session, thus concluding today‘s conference. We’d like to thank everyone for attending today‘s presentation.

And at this time, you may disconnect your lines.

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