HomeStreet, Inc.
Q1 2017 Earnings Call Transcript

Published: 25 Apr 2017

[Operator:]

Good day and welcome to the HomeStreet, Incorporate First Quarter 2017 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Mark Mason, CEO. Sir, please go ahead.

[Mark Mason:]

Hello and thank you for joining us for our first quarter 2017 earnings call. Before we begin, I would like to remind you that our earnings release was furnished yesterday to the SEC on Form 8-K and is available on our website at ir.homestreet.com under the news and market data link. In addition, a recording of this call will be available later today at the same address. On today's call, we will make some forward-looking statements. Any statement that isn't a description of historical fact is probably forward-looking and is subject to many risks and uncertainties. Our actual performance may fall short of our expectations or we may take actions different from those we currently anticipate. Those factors include conditions affecting the mortgage markets such as changes in interest rates that affect the demand for our mortgages, and the impact on our net interest margins and other aspects of our financial performance, the actions, findings or requirements of our regulators, which could impact our growth plans, our ability to meet our internal operating targets and forecasts, and economic conditions that affect our net interest margins. Other factors that may cause actual results to differ from our expectations or that may cause us to deviate from our current plans are identified in our earnings release and detailed in our SEC filings, including quarterly reports on Form 10-Q and our and our Annual Report on Form 10-K for 2016, as well as our various other SEC reports. Additionally, information on any non-GAAP financial measures referenced in today's call, including a reconciliation of those measures to GAAP measures, may be found in our SEC filings and in the earnings release available on our website. Please refer to our earnings release for a more detailed discussion of our financial condition and results of operations. Joining me today is our Senior Vice President of Corporate Development and Strategic Investments, Mark Ruh; Mark will be acting as the Interim Chief Financial Officer replacing Melba Bartels who has decided to leave us for another opportunity. We appreciate Melba's assistance and strong leadership while here at HomeStreet and we wish Melba well in her future endeavors. We are fortunate to have someone with Mark's background and experience to step into the role while we search for a permanent replacement. Mark is also a candidate for the permanent position. In just a moment Mark will present our financial results, but first I would like to give an update on recent events and review our progress in executing our business strategy. We are satisfied with the results for the first quarter of this year, as we continue to make progress on a strategy of growth and diversification with the goal of becoming a leading West Coast regional bank. Our mortgage banking segment recovered from the unexpected spike in interest rates and market dislocation experienced in the last quarter, and our commercial and consumer banking segment made significant progress toward our strategic goal of profitability and diversification. In January we opened our first Northern California bay area commercial banking office. We planned to open a full service retail deposit branch in San Jose later this year. Our bay area lending team is already making great progress in acquiring relationships and building a pipeline of new commercial loans and deposits. Last year we hired a commercial banking President for the State of California, since January this year we have hired Regional Commercial Banking Market President for the Bay Area and Orange County, San Diego. Since coming on board, these leaders have been recruiting relationship managers, credit officers and underwriters, while actively bringing new relationships to us. In total, we have hired six highly experienced commercial bankers in California. Our goal for this year is to build our commercial teams in the Bay Area, Orange County and San Diego. In this regard, we anticipate hiring five more professionals by year-end. In our mortgage banking business, we remained the number one mortgage lender of the Pacific Northwest for purchase transactions by volume during the quarter. We’re also proud to now be one of the top 25 lenders by volume in the major coastal markets of California as well as a Top 10 lenders by volume in Hawaii and in the Central Valley of California. In the quarter we added one single family lending center in Elk Grove, California. Strategically, we now have offices in nearly all of the major West Coast mortgage market of significance. As such this year any expansion will generally be focused on infill and be even more opportunistic. We still expect to grow this business overtime, but in the near-term our focus will be adding producers to existing offices and opportunistically hiring teams with strong production histories in our existing markets. We’ve invested substantially in the growth of this business over the years and with the completion of the installation of our new mortgage loan origination system, we will be focusing on getting the benefits and efficiencies flowing from that investment as well as the optimization of our original operations. Finally, on April 17th of this year we opened our latest retail deposit branch in Baldwin Park, California. This is our 15 branch in Southern California and it is located less than a mile from the Baldwin Park Kaiser Permanente Medical Center, our affinity partner. Before Mark reviews our financial results, I’d like to share some highlights from the quarter. Net income for the quarter excluding acquisition related items increased from $2.6 million in the fourth quarter of last year to $9 million. Total assets grew a $157 million or 3% during the quarter to $6.4 billion. Return on average tangible equity excluding acquisition related items was 5.81% for the quarter versus 1.47% in the fourth quarter of last year. Diluted earnings per share excluding acquisition related items increased from $0.10 per share last quarter to $0.33 per share in the first quarter. Tangible book value per share increased from $22.33 to $22.73 during the quarter. Net income for the commercial and consumer banking segment excluding acquisition related items declined to $9.3 million for the quarter compared with $12.3 million in the fourth quarter. Recall however that the fourth quarter of last year included $2.4 million of gains on security sales and $2.8 million of gain on the sale of a pool of single family mortgage loans. Adjusting for the after-tax impact of these items, net income for the segment increased by approximately $750,000 during the quarter and our efficiency ratio would have improved from an adjusted 73% in the fourth quarter of last year to 72% this last quarter. Loan total investment increased a $136.7 million or 4% during the quarter to $4 billion despite the first quarter generally being seasonally the slowest quarter for commercial loan originations. New portfolio loan originations, purchases and advances during the quarter, total $542 million compared to $584 million during the fourth quarter. The ratio of non-performing assets to total assets ended March at 0.38% down from the fourth quarters ratio of 0.41%, reflecting continuing excellent asset quality. Additionally, we continue to enjoy doing business of the strongest market in the United States, our early warning [ph] credit indicators are continuing to show strong fundamentals in all of our markets. Deposits increased 4% during the quarter to $4.6 billion and non-interest bearing commercial and consumer deposits grew 8% over the same period. We saw strong growth in our business-related deposit accounts in all markets and our California branch grew total deposits 5% during the quarter. Our mortgage banking segment net loss of $309,000 in the quarter decreased from a net loss of $9.8 million in the fourth quarter of last year. The disruption in the derivatives markets that we experienced in the fourth quarter normalized in the first quarter contributing to somewhat better than anticipated results in our mortgage servicing business for the quarter. Closed loan volume in our single-family mortgage banking segment totaled $1.6 billion in the first quarter of the year compared with $2.5 billion in the fourth quarter last year. Interest rate lock and forward sale commitments of $1.6 billion in the first quarter decreased from $1.8 billion in the fourth quarter. While the first quarter is typically a seasonally slow origination quarter, our origination business was also negatively impacted by the multi-year low levels of housing inventory in our markets. Despite this challenge we have improved our execution on the sales and securitization of mortgage loans, resulting in an increase in our composite margin from 334 basis points in the fourth quarter of last year to 349 basis points in the first quarter of this year. And now I’ll turn it over to Mark, who will share in more detail our financial results.

[Mark Ruh:]

Thank you, Mark. Good morning everyone and thank you again for joining us. I’ll first talk about our consolidated results and then provide detail on each of our segments. Net income for the first quarter was $9 million or $0.33 per diluted share compared to $2.3 million or $0.09 per diluted share for the fourth quarter of '16. The increase in net income from the prior quarter was primarily due to a $10.7 million decrease in non-interest expense from lower commissions on lower mortgage loan originations during the quarter. Acquisition related expenses were zero for the quarter, excluding after tax, acquisition related items recognized in the fourth quarter of '16 core net income increased from $2.6 million or $0.10 per diluted share in the fourth quarter of 2016 to $9 million or $0.33 per diluted share in the first quarter. Net interest income was $45.7 million in the first quarter compared to $48.1 million in the fourth quarter of '16. The decrease was primarily due to lower interest income stemming from a decrease in mortgage loan held for sale. Somewhat offset by higher interest income from loans held for investment. Our net interest margin was 3.23%, a decrease of 19 basis points from fourth quarter '16 net interest margin of 3.42%. This expected decrease was primarily due to one, the decline in mortgage loan held for sale; two, investing in lower yielding securities as we temporarily deploy the proceeds of our December '16 equity offerings; and three, an increase in the cost of our short term federal home loan bank advances following the two recent interest rate hike by the federal reserve. Non-interest income increased 1.2 million from the prior quarter, primarily due to higher mortgage servicing income, somewhat offset by lower net gain on mortgage loan origination in sale activities. Mortgage servicing income increase by $9.5 million from the prior quarter while gain on mortgage loan origination activities savings declined by $7.5 million. Non-interest expense was $106.9 million in the first quarter compared to $117.5 million in the fourth quarter. Excluding acquisition related expenses, non-interest expense was also $106.9 million in the first quarter compared to $117.1 million for the fourth quarter '16. The decrease in core expenses was primarily due to a lower incentive cost attributable to lower mortgage banking closed loan volume. At March 31st, the bank's Tier 1 leverage ratio was 10.03% and total risk based capital ratio was 14.03%. The consolidated company Tier 1 leverage ratio was 9.48% and the total risk based capital ratio was 11.65%. I would now like to share some key points regarding our commercial and consumer banking business segment results. Commercial and consumer banking segment net income was $9.3 million in the quarter compared to $12 million in a prior quarter. Excluding after tax acquisition related items, the segment recognized core net income of $9.3 million in the first quarter compared to $12.3 million in the fourth quarter '16. As Mark previously mentioned the fourth quarter '16 included a $2.4 million gain on the sale of securities as a reposition to a lower duration portfolio. The result also included a $2.8 million gain on the sale at $67 million pool of single family mortgage loans. Adjusting for the after-tax impact of these two items, core net income in the fourth quarter of '16 would have been $8.5 million. Growth in current quarter core net income, after adjusting for the two non-recurring asset sales in the prior quarter was driven by an increase in net interest income. A decrease in provision of the loan losses and the increase in non-interest income offset somewhat by an increase in non-interest expenses. Net interest income increased to $40.9 million in the first quarter from $40.6 million in fourth quarter of '16, primarily due to the growth of the loans held for investment during the period. Segment non-interest income decreased from $13.1 million to $9.4 million during the quarter. The $3.7 million decrease was primarily due to previously mentioned $2.4 million gain on the sale of securities and the $2.8 million gain on the sale of mortgage loans. Excluding the gains taken of fourth quarter '16, the $1.4 million increase in the first quarter of the year was primarily to the recognition of the prepayment penalties on the early payoff of commercial real-estate loans. Segment non-interest expense was $36.5 million an increase of $987,000 from the fourth quarter '16. Included in non-interest expense, for the first quarter of this year and the fourth quarter of '16 were acquisition related expenses of zero and $401,000 respectively. Excluding acquisition related expenses from both periods, the $1.4 million increase in non-interest expense is primarily due to growth in the business including offices, personnel and other administrative expenses. We recorded no provision for loan losses in the quarter compared to $350,000 provision last quarter. This reduction reflects net recoveries in the quarter combined with lower expected loss rates due to an improved credit performance. We experienced net recoveries of $778,000 during the quarter compared with net charge offs of $319,000 during the fourth quarter of '16. Gross charge offs during the quarter totaled only $325,000 primarily from consumer loans, while recoveries totaled $1.1 million during the same period. The portfolio of loan held for investment increased 4% to $3.9 billion in the first quarter. We experienced strong growth in consumer loans, commercial real-estate loans and multi-family loans. Construction loan balances declined during the quarter primarily reflecting the seasonality of the building business and that conversion of construction projects to permanent financing. The resulting net loan growth was $137 million during the quarter. Credit quality remains strong, with non-performing assets at 0.38% of total assets at March 31, and non-accrual loans at 0.47% of total loans. Non-performing assets were $24.3 million at quarter end compared to non-performing assets of $25.8 million at December 31. The decrease was primarily due to upgrades to accrual status for barrowers now performing. These credit metrics represent the lowest absolute and relative levels from problem assets since 2006. Deposit balances for the quarter were $4.6 billion at March 31, up from $4.4 billion on December 31. Deposits increased in nearly all account types. While the most significant increase in deposits was a $119.9 million increase in Time deposits, non-interest bearing demand deposit account and our accounts grew 8% and 10% respectively during the quarter. These increases were primarily offset by decreases in other non-interest bearing accounts primarily related to our mortgage servicing portfolio. Servicing deposits fluctuate seasonally with insurance and property tax payments. Of note, our business deposit balances grew by over 5% during the quarter and deposit balances in our California branches also grew by 5%. Notably our De Novo branches specifically, those opened since the beginning of 2012 grew deposits by 12% during the quarter. Deposits in the two branches that we acquired in our Los Angeles market during the fourth quarter '16 increased by 6% during the first full quarter in our branch network. I'd now like to share some key points from our mortgage banking business segment results. The net loss for the mortgage banking segment was $309,000 in the first quarter compared to a net loss of $9.8 million in the fourth quarter of '16. The $9.4 million improvement in income from the fourth quarter was primarily due to a decrease in non-interest expense and an increase in mortgage banking servicing income, offset by lower gain on origination sale activities. Gain on single family and mortgage loan origination sale activities in the first quarter was $56.3 million compared to $61.1 million in the prior quarter. Single family mortgage interest rate lock and forward tail [ph] equipment totaled $1.6 billion in the first quarter a decrease of $143.3 million or 8% from $1.8 billion in the fourth quarter of '16. Single family mortgage closed loans also totaled $1.6 billion in the first quarter, a decrease of $893.6 million or 36% from $2.5 billion in the fourth quarter of '16. The gain on mortgage loan origination in sales composite margin increased to 349 basis points in the first quarter from the prior quarter's 334 basis points, this increase in composite margin is primarily due to improved execution on the sale and securitization of loans. Mortgage banking segment, non-interest expense of $70.4 million decreased $11.7 million from the fourth quarter of '16, this decrease was primarily due to lower commission and incentive due to the decline in closed loan volume. Overall, we grew mortgage banking personnel by only 4 FDEs in the quarter. Closed loans decreased in the quarter to 3.6 loans per loan officer compared to 5.3 loans per loan officer in the fourth quarter. Single family mortgage servicing income was $8.3 million in the first quarter as compared with the net loss of $984,000 in the fourth quarter of 2016. The quarterly results were comprised of $5.8 million of net servicing income and $2.5 million of risk management revenue. The disruption in the derivative markets that we experienced in the fourth quarter of last year normalizing the first quarter contributing to our return to positive results in our mortgage servicing business. Our portfolio of single family loan service for others was $20.3 billion at March 31 compared to $19.5 billion at December 31st. The value of our mortgage servicing rights relative to the balance of loan service or others remained at 116 basis points of unpaid principle balance at the quarter end. I'll now turn it back over to Mark to provide some insides on the general operating environment and outlook.

[Mark Mason:]

Thank you, Mark. I’d now like to now discuss the national and regional economies as they influence our business today. First, we’re satisfied with our results for the quarter and are excited about our prospects for achieving the growth and diversification goals of our strategic plan for this year and beyond. We’re fortunate to operate in some of the most attractive market areas in the United States today, these markets enjoy lower unemployment and substantially higher rates of population growth, job creation, commercial and residential construction and real estate value appreciation and the remainder of the country. The major markets that we focus on are substantially larger than most of the other markets in the United States, which gives us the opportunity to grow meaningfully without the necessity of acquiring a significant market share. Together, the most distinguishing feature of the Washington, Oregon, Idaho, and California economies continues to be their strong rate of job creation relative to rest of the country. The impressive growth in payrolls has lowered unemployment rates across the board, although not as much as relative to the national economy. This is due to labor force additions from the strong rates of in migration and population growth in our markets. The employment growth rates during 2016 for these states have averaged 3.1% compared with 1.8% for the nation as a whole. In fact during the last quarter, Greater Seattle employment grew by over 2% or more than 8% annualized. The most recent Mortgage Bankers Association monthly forecast projects total loan originations to decreased 16% this year over last year and to decrease by 0.3% in 2018. The forecast to decline from 2016 to 2017 is driven by a 43% decline in expected refinancing volume. However, we do not expect the forecast to decline and refinance volume to impact our business to that degree as our origination focus has always been on the purchase market. The Mortgage Bankers Association forecast that purchase mortgage originations are projected to increase by 9% nationally in both this year and next year. During the first quarter, purchases comprised 59% of originations nationally and 48% of originations in the Pacific Northwest. We continue to perform at levels above the national and regional averages with purchases comprising some 67% of our closed loans and 73% of our interest lock and forward sale commitments in the quarter. Despite the increase in long term interest rates in the fourth quarter, interest rates remained low on an absolute basis and long term rates have actually declined since then. While the 10-year treasury yield increased following the November 2016 Presidential Election, it has fallen since then and continues to remain low on an absolute basis at approximately 2.3%. These low rates should continue to support housing affordability. Nationally purchases are expected to comprise 68% of mortgage loan volume this year. However, purchase originations in our markets are being constrained by a lack of housing inventory. We have seen a recent downward trend in the supply of homes in all of our major metropolitan markets. During 2016 the Seattle market was already tight, trended in the 1.5 months of supply range, but during the first quarter the supply of homes fell to only three weeks of sales. Similar drops were also noted in the Portland, San Francisco, Los Angeles, San Diego and Honolulu markets. On the commercial side, Seattle's office market absorption slipped in the fourth quarter of 2016, but not enough to derail the market's first performance. Puget Sound region absorb 3.5 million square feet in 2016, more than any market in the United State. It was the region's best performance since 2005. Vacancy rates increased slightly from the previously quarter increasing from 9.3% of the third quarter 2016 to 9.9% in the fourth quarter, but still below 11.1% in a year ago quarter. Large employers such as Amazon and Facebook are continuing the sign deals for additional space supporting strong demand and a positive outlook for future growth. Portland absorbed over 28,000 square feet of office space in the first quarter and asking rents averaged $25.91 per square foot up from $24.88 in the prior quarter and $24.30 in the year ago period. Vacancy end of the fourth quarter at10.5% compared to 10.3% in the prior quarter. Stable vacancy and increasing rents are supporting robust construction with 1.2 million square feet of office space currently under construction there. In Los Angeles almost 364,000 square feet of positive net absorption in the first quarter marked the 15th straight quarter of net occupancy gains there. Vacancy increased slightly to 14% compared with 13.9% in the fourth quarter of last year as over 900,000 square feet was delivered, 35% of which was leased upon completion. The construction pipeline is at 1.7 million square feet, down from 2.4 million square feet in the prior quarter. Average asking rents increased by 2% during the quarter to $37.80 per square foot. Looking forward to the next three quarters in our mortgage banking segment, we currently anticipate single family mortgage loan lock and forward sale commitment volume of $2.3 billion, $2.5 billion and $1.9 billion in the second, third and fourth quarters respectively. We anticipate mortgage held for sale closing volumes of $2.1 billion, $2.6 billion and $2.2 billion during the same period respectively. We are currently in the beginning of the home buying season and increasing mortgage lock volumes should be expected as the second and third quarters are typically our strongest quarters for loan originations. For the full year of 2017 than, we anticipate single family mortgage lock and forward sale commitments to total $8.4 billion and loan closing volume to total $8.5 billion. These volumes will be subject to the typical seasonality we experienced, generally lower volumes in the first and fourth quarter of the year and higher volumes in the second and third quarters. Volumes will also be highly dependent on inventory levels in these markets in which we do business, local conditions affecting employment growth and wages as well as prevailing interest rate. Additionally, we expect our mortgage composite profit margin just settle into a range of between 330 and 340 basis points over the next two quarters and then fall to a range of 325 basis points to 335 basis points in the fourth quarter. We expect to increased TRID related cost we experienced last year to continue through the next several quarters until we complete the installation of our new loan origination system late this year. In our commercial and consumer banking segment we expect average quarterly net loan portfolio growth to continue to approximately 4% to 6% during this year. Reflecting the increase in interest rates and asset changes in our market rates and loan prepayments speeds we expect our consolidated net interest margin to increase from the 3.23% in the first quarter. As we redeploy the proceeds of our December 2016 common stock offering from lower yielding securities into higher yielding loans, we expect the net interest margin to increase to between 3.40% and 3.50% by the end of this year. During 2017 our non-interest expenses are expected to grow on an average approximately 2% per quarter reflecting the continued investment in our growth and infrastructure. This growth rate will vary somewhat quarter-over-quarter driven by seasonality in our single family close loan volume and in relation to the timing of future investments in growth in all of our segments. This concludes our prepared comments thank you for your attention today. Mark and I'll be happy to answer any questions you have at this time.

[Operator:]

[Operator Instructions] And our first question comes from Jessica Levi-Ribner with FBR. Please go ahead.

[Unidentified Analyst:]

This is Tim for Jessica. You guys came up just a little short of your lock and sales volumes for the quarter and going -- much appreciated the guidance going forward, but does that include any kind of pull through from last quarter, was there anything that’s getting pushed out in the second quarter which is why you came up a bit late? What exactly was the delta there?

[Mark Mason:]

We think that the delta or the difference between expected volumes and what we actually did and what we are at now, in terms of expecting for the year, really is solely involved in the inventory issues. Our volume of loans without properties or prequalification's for people shopping for homes is up substantially over last year. At some point in the quarter over 20% over the prior year and so we know demand for homes is even stronger than last year, but the pull thorough or the conversion of prequalification's to loans with properties pending closing has fallen far behind last year rate. Now we've had some pretty rough weather this winter in the Pacific North West and that can contribute to less people putting their homes on the market, less people shopping, that may turnaround in the second quarter and we may in-turn increase our estimates the next time we talk. But for now we are trying to be a little more circumspect about our expectations until we see inventory levels return to at least what we thought was relatively low levels last year.

[Unidentified Analyst:]

Got it thanks for the color, and then you had mentioned hiring some of additional lenders throughout the course for the year, but what's your appetite for M&A this point? Are you still seeing some good value out there? Would you look more on the mortgage side or the commercial side? Would you be focused on your core west coast markets? Just any color around there should be appreciated.

[Mark Mason:]

We remain in the market for whole banks -- whole commercial banks or branch acquisitions. It's highly unlikely that we would consider our mortgage related acquisition. We're very comfortable with our mortgage business, with the quality of it, the consistency of it, the risk management of it. But it is our objective to continue to grow our commercial business faster. And so acquisitions in the mortgage business are probably not in the cards for us. In terms of general appetite, our appetite remains strong though we are most focused along the Coast from Puget Sound all the way to the Mexican border, we continue to look at acquisition opportunities literally in all of those markets. Our greatest interest is infill, it has the greatest efficiency, and we even in the last quarter looked at between three and five different potential opportunities in those markets. So I think that the M&A market I would still term as active. I think that pricing or at least in the sellers eyes has come up, and very competitive particularly in the market that we’re very interested in, right the large markets of the west. And so, I can’t predict when we might next announce a transaction, but we remain very interested in acquisitions from anywhere as small as a $100 million to $150 million to above a $1 billion.

[Operator:]

Our next question comes from Jeff Rulis with D. A. Davidson. Please go ahead.

[Jeff Rulis:]

Mark Mason, you guys issue a clarify on the -- just interested on that deposit side, seeing your cost on CDEs money market is up a bit, interest bearing and savings down. Just kind of what you're seeing in the market for competition in your strategy going forward, a little more detail there?

[Mark Mason:]

Sure. We’ve taken the opportunity to extend the liabilities a little bit both on a retail basis and on a wholesale basis. So, some of that increase in time deposits is broker at really, really attractive rate maybe as much as 25 basis points or 35 basis points. On the consumer side, we have done a little more promotional deposit acquisition that is generally associated with the open into new branches. And generally, two years and less in duration and the rates are still attractive to us. Plus when you're opening new branches it is common to seed those branches with some promotional money to get people to come experience your system, get to know your people and so on and we open a fair number of branches near the end of the year of last year, right. So, you're going to see a little more of this initial promotion money come through. Now that promotional money lasts a year typically in money market accounts or most of the time deposits have generated a lot a year or 18 months. The money market promotional rates roll off after a year and then come back down to our lower day-in, day-out rates and our retention of those accounts after the promotional burn off has been very good to this point. So, not all this is permanent, cost increase, some of it is time sensitivity, but because we’re going to continue to open branches and grow this will be a continuing part of the deposit growth.

[Jeff Rulis:]

Okay. And then maybe a little bit of housekeeping in the income statement. The two line items, the provision and then the Windermere fee income both have been volatile. Any expectations for the rest of the year commentary on kind of future direction?

[Mark Mason:]

Yeah. So, first on Windermere that is going to be very seasonal with the mortgage season, Windermere has an even higher level of purchase volume right, so their seasonality is going to be more significant, you will see that line item jump up in the second quarter substantially and then by the fourth quarter fall back down. I'm what was your other question please, the other line item.

[Jeff Rulis:]

Yeah. The provision expense?

[Mark Mason:]

The provisioning, like most other folks we are not seeing or experiencing expected charge-offs. Our allowance models of course project expected charge-offs based upon historic experience. Our markets are very strong, our credit underwriting remains consistent and conservative. And so, instead of experiencing material levels of charge-offs, we’re still experiencing recoveries. And so we require no provision for the quarter. We were frankly challenged by conservative recovering some of the allowance the performance was so good. Of course we’re going to growing and in the future we’ll need more, but it is -- its appropriately stated for the quarter. For the rest of the year, we generally anticipate provisioning, if you grow your loan portfolio at the pace that we’re expecting to grow, you should expect continuing similar levels of coverage from the allowance and then the provisional would grow accordingly. So if we are growing the portfolio let's say 4% to 5% a quarter, the allowance should grow a similar amount generally.

[Jeff Rulis:]

And the visibility on future recoveries is -- I guess as MPAs drift lower, I guess the thought is that those would reduce over time, but any specific outlook on that flow for the rest of the year?

[Mark Mason:]

We don’t believe it's going to be significant, we look at the uncollected deficiency note, as an example, that remained after the recession. Those have been substantially collected, we do have a few specific reserves, but in terms of charged-off recoveries, we don’t expect it to be too meaningful to rest of the year, there will be some. The fact that we've had virtually no charge-off makes the recovery seem more significant. I mean even last quarter, I think our recoveries were 700-and some thousand dollars, it's in the report, which on a pre-tax basis is not that meaningful to the bottom line. But we only had charge-offs in the 300-and some thousand dollars range, right. So we expect credit quality remain good. We see nothing in our portfolio that is suggesting growing weakness and we really don’t see any weakness in the markets in which we do business, we don’t see weakness in real estate or in the commercial second either. So we would have to be a borrower specific issue that we don’t currently see.

[Operator:]

Our next question comes from Jackie Boland with KBW. Please go ahead.

[Jackie Boland:]

Mark, I wondered if you could provide an update, I know you did a little bit in your prepared remarks on some of the commercial bankers you have been hiring, but just kind of how you are thinking about hiring over the next couple of quarters, both in the commercial segment and the mortgage segment, particularly in light of so few additions in mortgage over the last quarter?

[Mark Mason:]

Thanks for that question. We have over last several years grown at a pre-significant pace, in personal and in-turn in operating expenses, and this year is going to be a somewhat lower year in personal growth. We anticipate -- I mean I gave a couple of numbers in California just our commercial banking business, and while that is small growth in number of people, those are relatively expensive people, well experienced commercial bankers of track record and pedigree rightly earn substantial compensation, and so that is a meaningful investment for us. And while we may only hire another five individuals by the end of this year, that will in total would be a pretty meaningful investment. In the mortgage area, we will probably only grow maybe a net 20 people in the second quarter and by yearend probably in total maybe another 50 to 70 people. So this year we do not expect to be a significant growth year in personal, part of the reason for that though is that we will be redeploying a meaningful number of operations personal, who are involved in implementing our new loan origination system. And so we expect to them to be absorbed into normal positions with normal ratios of cost and mortgage loan origination as we grow our business and we finish the task of implement the software. All of that is premise though on achieving our loan volume this year, and if we continue to see weakness more than we currently projected, we could see no growth in personal for this year or even a decline if the mortgage market is not as strong as we expect. In the rest of the business, we would expect to grow just slightly. Total headcount from the first quarter to the end of this year is expected to grow by little over 200 people, but of course part of that's involved in new branch openings of which we expect to open five this year, each of those branches has about five FTE and a few more support personal in the infrastructure and more lenders in the markets others than California. And so that growth in the commercial business is spread over a number of lending and deposit taking areas.

[Jackie Boland:]

As you are redeploying the staff within the mortgage banking division, does that play into the increase in your composite cost estimates just those efficiencies there, or if not your composite margin estimates?

[Mark Mason:]

No that’s really unrelated to the operations personal. It's related to some real solid progress we have made in the secondary marketing area. Our secondary marketing personal as our volume has grown help become more sophisticated in creating specialized pools of loans for sale and securitization which garner higher prices. They may be high or low balances, they maybe CRA related loans. These spec pools are specialized pools, generally traded premiums of 25 to 50 basis points higher than base market values and it's really due to some great work by folks in that area.

[Operator:]

Our next question comes from Tim O’Brien with Sandler O'Neill. Please go ahead.

[Tim O’Brien:]

Great color on this Q&A, I was -- Jackie gripped that question that I had for the composite margin expansion right out of my mouth there right. But maybe you could expand on that. That’s just a fascinating area and I think your quarter partially turned on that expansion in that composite margin and that was a huge boon and I think the credit is deserved there. So I guess one question I would have for your just to extend that is, what kinds of loans specifically this quarter were you able to sell that allowed you to strengthen that margin?

[Mark Mason:]

I think I alluded it a second ago --.

[Tim O’Brien:]

CRA?

[Mark Mason:]

CRA for sure, one second, my guy is giving me hand signals.

[Mark Ruh:]

Some of it is Freddie Fannie competition [Multiple Speakers] much more in our favor. So we have been able to do that, to take advantage of that about relationship.

[Mark Mason:]

Things like CRA or low balance loans, low balance loans are more valuable because they typically have much longer loan lives, right, they don’t prepay as quickly, so they are more valuable. Part of it though frankly due to more competition between Fanny Mae and Freddie Mac, they both have become more aggressive at the margin in seeking near the end of the month or the end of the quarter extra volume based upon specific attributed they are looking for and it could just be regional, by regional diversification. So combination of pools we create and competition between the agencies has done it.

[Mark Ruh:]

And differences between cash delivery and security delivery.

[Mark Mason:]

Okay now we are going to get super technical.

[Tim O’Brien:]

No, I have heard about this before cash.

[Mark Mason:]

Right, there is cash delivery, there is creation of securities or delivering into the pool of sales that you have essentially pitched your pipeline with. So a fair amount of our sales, I don’t know, 80% to 90% goes strictly into filling the TBAs that we have sold to hedge the pipe, right very easy. Your profit margin is locked in, there should be no issues. But at certain amount of it we hold back intentionally now to trade on a cash basis, meaning we sell the whole loan to Fanny or Freddie and they securitize with others into their own deals. And that’s where it becomes really competitive. You just got to be careful because that can go both ways, right depending upon their appetite and you have to read the market.

[Tim O’Brien:]

And suffice to say in lower demand environment, more complication, more pressure on margins, was that -- was your success this quarter in the phase to that headwind, did that -- was that headwind more pronounced in the market place this quarter from your perspectives?

[Mark Mason:]

Well I think it is.

[Tim O’Brien:]

On margins?

[Mark Mason:]

I think it's always that way in the first and fourth quarters right, the biggest margin declines because of competition. It shows you how significant -- and I don’t have the numbers as we sit here today, the extra execution by pooling. But part of it did make up for what could have been lower margins. But we expect the pooling opportunities to continue sort of going forward and not be seasonal.

[Tim O’Brien:]

Fantastic. Glad to hear it. And then just moving on more quickly on FHLB. Can you guys anticipate, do you have a lot of room to use that facility for funding here through the end of the year into 2018 and how do you plan to manage kind of that resource?

[Mark Mason:]

Well, it's an important funding resource for us. It's our base funding vehicle for funding loans held for sale balances, because it's so well matched. They give us really attractive 7 to 21 day money, in fact it's cheaper than the repo markets by 6 or 7 basis points, today or day-in, day-out. So, that’s our base utilization, however starting at the end of last year, we begin to do a little term financing with them to extend our liabilities a little bit to mitigate some rate risk and it helps us hedge the asset side and it helps us match the duration a little better. We have to be careful though, because in the regulatory world non-core funding which FHLB advances are considered is a high button of sensitivity issue to regulators and they would like to not see institutions become more than 30% funded by non-retail deposits essentially. And so, while we are typically under that number in the say 20% to 25% range, we have some realistic limit to how much we could do this.

[Tim O’Brien:]

So that’s the throttle right there, that’s going to -- that’s the regulator that's going to keep you from drawing on that progressively, through this year as needed I guess. And really you're going to tap the retail branch network and really focus on that more I guess?

[Mark Mason:]

Well, right. I mean ultimately our goal is to be 100% retail focus, right whether it be commercial or consumer loans, and our commercial deposit acquisition has been phenomenal. Non-interest bearing commercial deposit were up 8% last quarter. So, I don’t want to forget we’re doing well there, but we have a voracious funding appetite. Today, we still have funding capacity if you look at FHLB or Fed fund lines of almost three quarters a billion dollars. So, we’ve got lots of availability, it's kind of a dynamic dance of liquidity and capital ratios, right for the size of our balance sheet and we dynamically manage all of those on a daily basis.

[Tim O’Brien:]

Great. Good color. And then last question changing gears again. On the commercial hires that you guys plan and also the hires that you’ve done, are -- as far as commercial relationship business is concerned and CNI operating line underwriting is concerned and perhaps ABL or some of those other product types. Are you guys pursuing that kind of business, the relationship CNI line and if so can you give a little color on the kind of operating lines that are going to be the bread and butter of this build out that you plan?

[Mark Mason:]

Sure. This is middle market business Tim. I mean we expect and plan to be in the middle of the street here, it is typical middle market commercial banking. So it is lines of credit, its term credit, its equipment financing, its owner occupied real estate which is not an insubstantial part of it. Those are the bread and butter products, some of those will be structured as ABL or Asset Based Lines of credit, some of them will be structured differently for stronger companies. As you know, we do a lot of SBA lending, some of the risk you're lending will be done through SBA lending, either 7A or 504 real estate loans. We have a big SBA group already in Southern California which is having a good year already. And so, I would expect it to be middle of the market normal stuff. In terms of sizes, the range of relationships maybe as small as a $150,000 or $200,000 to very, very small businesses. But the lines and relationships will probably average in the $2 million to $7 million range, with some reaching above 10 million to 20 million, but the majority of that business will probably been the $2 million to $7 million or $10 million range.

[Tim O’Brien:]

And the folks that you have on staff in position now are actively making those loans and pursuing that business in San Jose, and Southern California in and such and in Puget Sound?

[Mark Mason:]

And San Diego, yes the Puget Sound is of course is very mature right, I mean we have been in that business here well before I came, we've just grown it here pretty substantially. So we are in that business here in Puget Sound, in Central and Eastern Washington, in Portland and now more substantially as we grow California.

[Tim O’Brien:]

And is there authority -- what kind of authority do your regional managers have for underwriting authorization?

[Mark Mason:]

Well, they have the obligation, but they have no credit authority. Our credit approval process here provides no authority to line lenders or to management. That authority vests in business unit credit administrators, who ultimately report to the Chief Credit Officer here in Seattle, there are size limitations that range from $5 million to $7 million to $10 million of authority and credit unit and then a state of a commercial lending up to Chief Credit Officer who can approve individually up to $15 million relationships. And we have a management credit committee that improves up to 20 million and then it goes to our Board of Directors. So again no line authority in that business, but stratified levels of credit review and authority.

[Tim O’Brien:]

Thanks for all the color. Thanks for answering my questions, nice quarter.

[Operator:]

Our next question comes from Tim Coffey with FIG Partners. Please go ahead.

[Tim Coffey:]

Hi Mark, with the investment that you are going to be doing in the commercial side of the business, the branches, the commercial lenders, some of the FTEs, do you have kind of a target efficiency ratio or something that you are aiming for this year?

[Mark Mason:]

Well, we always have targets, this year we hope to improve -- and I assume you are talking about in the commercial segment Tim?

[Tim Coffey:]

Right, yes, the commercial segment, not the entire company.

[Mark Mason:]

Right, our target is to remain ultimately below 65% and ultimately below 60% efficiency ratio. Our ability to do that is going to be premised upon or depend upon the pace of investments versus the size of our portfolio on the growth and net interest income of course. Our efficiency ratio this year will fall again below 65% by the fourth quarter, maybe you will see sort of successive improvements as we sort of restart that decline, because of the investments we are making. Next year, 2018 we expect to be able to take that number below 60%, that’s going to be depended again on the pace of investment versus growth in the portfolio, but those are the goals we've set for ourselves and we think it's possible as long as we can generate the good quality loan growth and find the great personal to make that happen.

[Tim Coffey:]

Sure.

[Mark Mason:]

And that’s in the face of the opening branches.

[Tim Coffey:]

Right, that is actually going to be my next question, so does that 60% target or goal, is that by yearend, the entire year? For 2018.

[Tim Coffey:]

Yes.

[Mark Mason:]

We would hope to get there sometime in the third to fourth quarter.

[Tim Coffey:]

And if you are going to be opening branches, so you said five this year right, how many looking are you looking at for next year?

[Mark Mason:]

I think we have four or five in our current plans, so I would expect to at least four, probably not more than six.

[Tim Coffey:]

Okay. Those are mostly California targeted?

[Mark Mason:]

No, we continue to have markets here in the Pacific North West that we have already investments in and plan to openings for this year and some that will go into next year, so we have several more of the greater Seattle area, north of Seattle and east of Seattle. We are also now looking at Portland, we only have three branches in the greater Portland area and that is historically important market to us and a very strong economic market. In addition to which of course there is the entirety of California, right, and we are trying to be opportunistic there and acquire more than we opened De Novo, but we will no doubt open some branches in California, in particular we're looking at Santa Clara that was an area where simplicity had some substantial amount of deposits, had a branch at one point closed it, and we feel the need to make sure we reopen a physical branch to retain and grow those relationships. As I mentioned, we are going to opening a branch in San Jose later this year. So between Northern California and Southern California I would expect to see us open branches on continual basis.

[Tim Coffey:]

You are talking full service branches, not like loan production offices right?

[Mark Mason:]

Yes, exactly deposit taking branches.

[Tim Coffey:]

Just wanted to clarify that. And then again, the number of FTEs, you are thinking about hiring this year outside of the mortgage business, what was that number again?

[Mark Mason:]

It's really kind of going to be a range right there is a retail banking the retail system will probably grow almost 40 people by year end and really associated with opening branches. And then the rest of the system and this is across a wide variety of infrastructure positions may grow 50 or more positions by the end of the year. Unfortunately, there is a cost of growth from an infrastructure standpoint. Part of that is a simple ratio of personal to total personal for the offices or somewhat, part of it is growth in things like finance and accounting to support growth in areas preparing to go above 10 billion as an example which is a multiyear initiative for us, information systems I mean really across the spectrum.

[Tim Coffey:]

And then was the loan -- the loan processing software platform that you are building out, how much is that adding to expenses on a quarterly basis?

[Mark Mason:]

It's interesting, on a run rate basis, its actually going to be less expensive ironically. But the cost of development and installation that will be amortized over, what we expect to be its useful life will add a little bit to the run rate, but it's not really material, I mean -- and we think that the efficiencies that we gain by reduction in manual processes particularly around TRID will more than offset that additional cost. So we think net the installation will be a savings.

[Tim Coffey:]

Okay and then the ratio of closed loans to lock loans, in the first quarter, I mean typically we see a wider gap than we did this quarter. Is there anything to read through on -- besides than it's closer to a 100%, when it's usually closed loans are 85% of locked loans?

[Mark Mason:]

Well the last couple of years we've had extra refinancing, I think that’s the biggest issue in last couple of years. Typically, the first quarter, if there is no refinancing and you have to go back several years, because the last two years we had small bubbles of refinancing in the first quarter, but if you go little further back, the first quarter is pretty closed to even. The fourth quarter is bad because you are drawing down your pipeline in the face of low new originations. First quarter is typically even, and then the second and third quarters you have -- typically second quarter you have more new loans more locks than closings, third quarter gets closer to even and then in fourth quarter you are back in the cycle.

[Tim Coffey:]

And we'll see targets or ideas that you would be put out there about kind of really locked and closed loans volume compete the rest of the year. Is the refill that its going be relatively more expensive for you to produce mortgage loans this year than it has been in the past, because closed volume versus locked volume?

[Mark Mason:]

From a fixed cost standpoint, of course mechanically that’s yes. But that the true fixed costs are not that significant. So, it's up to us to realize the efficiencies that we gain by the installation of our new loan origination system to get pass all the manual work arounds we’ve had to deal with in the QC related to TRID disclosures. And so, we think that our cost structure is going to be what it is through the first half of the year, maybe through July and then we’re going to start realizing the efficiencies we're expecting to get. And so, I think on the year, you won’t see a net increase, you'll see I'm hoping a net decrease, though it may not as meaningful this year as we expect the following year.

[Tim Coffey:]

Okay. That's because it's helps on the nimble on the execution as well.

[Mark Mason:]

Sure. I mean revenue are obviously improving helps everything, and we’re going to focus this year much more substantially on better optimizing our profitability in this segment.

[Tim Coffey:]

Great. And then my final question was, what was you get a number again for what your expectations are for locked loans for 2017?

[Mark Ruh:]

Sure. Mortgage lock forward sales 2.3 billion, 2.5 billion to 1.9 billion in the second quarter, third quarter and fourth quarter respectively of lock.

[Mark Mason:]

For a total of $8.4 billion on locks for the year and $8.5 billion on closings.

[Tim Coffey:]

Okay.

[Mark Mason:]

And it's in the transcript, if you want to look later.

[Tim Coffey:]

Great. I'll do that. Thanks a lot for all your time.

[Mark Mason:]

Thanks, Tim.

[Operator:]

[Operator Instructions] And we have no further questions at this time. So, this concludes our question-and-answer session. I would like to turn the conference back over to Mark Mason for any closing remarks.

[Mark Mason:]

Thank you again for your patience and great questions today. We appreciate the interest and attention and we look forward to talking to you again next quarter. Thank you.

[Operator:]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.