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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Ladies and gentlemen, thank you for standing by, and welcome to the Fifth Third Bancorp third quarter 2021 earnings conference call.
At this time, all participants are in listen-only mode. After the speakers’ presentation, there will be a question and answer session. To ask a question, please press star, one on your telephone keypad. Please be advised that today’s conference is being recorded. If you require further assistance, please press star, zero.
I would now like to turn the conference over to your speaker today, Chris Doll, Director of Investor Relations. Please go ahead, sir.
Thank you Operator. Good morning and thank you for joining us.
Today we’ll be discussing our financial results for the third quarter of 2021. Please review the cautionary statements in our materials, which can be found in our earnings release and presentation. These materials contain reconciliations to non-GAAP measures along with information pertaining to the use of non-GAAP measures, as well as forward-looking statements about Fifth Third’s performance. We undertake no obligation to update any such forward-looking statements after the date of this call.
This morning I’m joined by our CEO Greg Carmichael, CFO Jamie Leonard, President Tim Spence, and Chief Credit Officer Richard Stein. Following prepared remarks by Greg and Jamie, we will open the call up for questions.
I’ll turn the call over now to Greg for his comments.
Thanks Chris, and thanks to all of you for joining us this morning.
Earlier today, we reported third quarter net income of $704 million or $0.97 per share. On a core basis, we earned $0.94 per share. Once again, we delivered strong and steady financial results while fully supporting our customers, communities and employees.
During the quarter, we generated adjusted ROTCE of nearly 19%, which represents the fifth straight quarter exceeding 18%. We generated period-end C&I loan growth of 4% compared to the prior quarter, excluding the impact of PPP. Commercial loan production increased 5% from last quarter, representing the strongest quarter since the fourth quarter of 2019.
We generated strong consumer household growth of 3% compared to last year with growth in every region in our footprint, reflected in the continued success of our branch and digital initiatives, and as expected, we generated positive operating leverage on a year-over-year basis.
Our performance this quarter reflected strong business outcomes across our franchise, resulting in improved and diversified revenues. This was combined with disciplined balance sheet management, expense management, and yet another quarter of benign credit results. We closed the Provide acquisition and the sale of HSA deposits during the quarter to improve long-term growth and profitability. Provide, a leading fintech company serving healthcare practices, will further accelerate profitable relationship growth. The sale of our HSA deposits is part of our multi-year strategy to simplify the organization and prioritize investments in order to generate differentiated outcomes for our customers and shareholders.
Despite continued pressure from low interest rates, adjusted PP&R increased 4% compared to the year-ago quarter, highlighting the strong results from our fee-based businesses in retail, mortgage, commercial, and wealth and asset management. Excluding the impact of PPP, average total loans increased 4% compared to last quarter, reflecting strong commercial loan production as well as strength in our indirect auto and residential mortgage portfolios. Commercial loan production increased 5% sequentially with record quarters in corporate banking and middle markets.
Despite some of the challenges we have been hearing from our customers, including supply chain constraints and labor shortages, the strong production was led by our healthcare, renewable energy, and retail verticals, and was well diversified geographically. Our commercial lending production trends, pipelines, and retention of the client relationship all support continued loan growth.
As it relates to Provide, we are very pleased with the progress we’ve seen so far and we are even more excited about the opportunities for continued growth. As we have previously mentioned, we expect strong origination volumes in 2022, reflecting a robust pipeline, added product capabilities, and key talent hires. Provide supports a relationship approach with approximately two-thirds of customers having either a deposit account or a payments relationship with Fifth Third.
During the quarter, we recorded a net benefit to credit losses as well as historically low net charge-offs of 8 basis points, reflecting continued improvement in both our commercial and consumer portfolios. In addition to historical low credit losses, we experienced another quarter of improvement in criticized assets and NPAs. Our criticized assets declined nearly 20%. Our NPA ratio declined 9 basis points sequentially. Our NPA and NPL ratios this quarter have reverted back to pre-pandemic levels. Our strong credit performance reflects disciplined client selection, conservative underwriting, and continued support from fiscal and monetary government stimulus programs.
Our balance sheet and earnings power remain very strong. As we have said before, we remain focused on deploying capital into organic growth opportunities, evaluating strategic non-bank opportunities, paying a strong dividend, and share repurchases. Bank acquisitions remain a lower priority.
I’d like to once again thank our employees. I very much appreciate the way you have continually risen to the occasion to support our customers, communities, and each other.
I am very proud that in addition to producing strong financial results, we have also continued to take deliberate actions to improve the lives of our customers and wellbeing of our communities. For our customers, we are excited to roll out Genie [ph], our new AI-driven digital assistant in the fourth quarter. This will drive targeted marketing capabilities, digital engagement, and improved customer retention. For our communities, we made a $15 million contribution to our foundation this quarter as part of our $2.8 billion commitment to accelerate racial equity, equality and inclusion in our communities.
In total, we have contributed $40 million in philanthropic support since the end of last year. We continue to make targeted investments to accelerate economic revitalization, as you may have seen in last week’s announcement of Fifth Third’s Neighborhood Investment Program. This innovative initiative further demonstrates our commitment to being an ESG leader in addition to other recent proof points, including [indiscernible] over $600 billion towards our $8 billion renewable energy goal to be achieved by 2025, announcing a new position as climate risk to focus on identifying, measuring and managing the physical and transition risk of our clients, and a robust transparent and peer-leading ESG disclosure.
In summary, we believe our balance sheet strength, diversified revenues, and continued focus on disciplined management through the company will serve us well into 2022 and beyond. We expect to generate positive operating leverage on a year-over-year basis in the fourth quarter and also for the full year in 2021. We remain committed to generating sustainable long term value and consistently producing through the cycle top quartile results.
With that, I’ll turn it over to Jamie to discuss our third quarter results and our current outlook.
Thank you Greg, and thank all of you for joining us today.
We are very pleased with our financial results this quarter, reflecting focused execution throughout the bank. Our quarterly results included solid revenue growth and continued discipline on both expenses and credit. The reported earnings included a $21 million after-tax benefit, or $0.03 per share from the three items noted on Page 2 of the release.
Our strong business performance throughout the bank is reflected in our return metrics. We’ve produced an adjusted ROA of 1.32% and an adjusted ROTCE excluding AOCI of 18.7%. Improvements in our loan portfolio credit quality resulted in a $63 million release to our credit reserves and an ACL ratio of 200 basis points compared to 206 last quarter. Combined with our historically low net charge-offs, we had a $42 million net benefit to the provision for credit losses.
Moving to the income statement, net interest income of approximately $1.2 billion increased 2% compared to the year-ago quarter, reflecting the benefits of our balance sheet positioning, continuing benefits from PPP income, and income from our Ginnie Mae forbearance loan purchases. Our NII results relative to the second quarter included a $6 million reduction in PPP income, a $4 million decline in prepayment penalties in our investment portfolio, and the impact of lower earning asset yields partially offset by a higher day count and a reduction in long term debt. Our allocation to bullet and locked-out structures is currently 60% of the total investment portfolio, which is expected to continue to provide ongoing NII protection in this low rate environment.
On the liability side, we reduced our interest-bearing core deposit costs another basis point this quarter to 4 basis points. With a highly asset sensitive balance sheet and over $30 billion of excess liquidity, we continue to be well positioned to benefit when interest rates rise while also remaining well hedged if rates remain low, given our securities portfolio and derivatives.
Total reported non-interest income increased 13% sequentially, impacted by a $60 million gain associated with the disposition of HSA deposits as previously communicated. Adjusted non-interest income increased 3%, driven by strong mortgage banking, treasury management, leasing, and wealth and asset management revenues. Commercial banking revenue, which achieved record results the past two quarters, remained solid as strength in M&A advisory fees, particularly in our healthcare vertical, was more than offset by lower corporate bond fees.
Compared to the year-ago quarter, adjusted non-interest income increased 13% with improvement in every single caption, reflecting both the underlying strength in our lines of business as well as the robust economic rebound over the past year. Our total non-interest revenue was 41% of total revenue in the third quarter.
Reported non-interest expense increased 2% compared to the second quarter, primarily due to the $15 million foundation contribution. Adjusted expenses were flat sequentially as an increase in marketing expense associated with Momentum banking and increased T&E expense were offset by a decrease in compensation and benefits expense. Compared to the year-ago quarter, adjusted non-interest expense increased 2% primarily driven by an increase in performance-based compensation, reflecting strong business results, servicing expenses associated with Ginnie Mae loan purchases, and the impact of the Provide acquisition. These items were partially offset by lower card and processing expense due to contract renegotiation and lower net occupancy expense. On a year-over-year basis, total adjusted fees have increased 13% compared to just 2% expense growth.
Moving to the balance sheet, total average portfolio loans and leases declined half of a percent sequentially, including the headwind from PPP loans. Excluding PPP, average loans and leases increased 1% with period-end loans up 1.5%, pointing to positive momentum as we head into the fourth quarter.
Average total consumer portfolio loans increased 2% as continued strength in the auto portfolio and growth in residential mortgage balances were partially offset by declines in home equity and credit card balances. While we did not retain incremental conforming mortgage originations in the third quarter, we have elected to retain approximately $400 million of our retail mortgage production for the balance sheet in the fourth quarter and will continue to evaluate the economic trade-offs, given our balance sheet capacity in this environment.
Average commercial loans declined 2% compared to the prior quarter, due entirely to PPP forgiveness. Excluding PPP, average commercial loans increased around half of a percent with C&I loans up 2%. Production was robust across the board, up 5% compared to the prior quarter with both corporate and middle market banking generating record production, which was well diversified geographically. As a result, period-end C&I loans excluding PPP increased 4%.
Revolver utilization of 31% was stable compared to the prior quarter; however, it is worth noting that total commitments have increased approximately $5 billion since the end of last year, driven by new client acquisition and an increase in demand from existing clients in anticipation of future business growth.
Average CRE loans were down 3% sequentially with lower balances in mortgage and construction, driven by elevated payoffs in areas most impacted by the pandemic, reflecting our cautious approach to those sectors.
Our securities portfolio was stable sequentially. We continue to reinvest portfolio cash flows but will remain patient on deploying the excess liquidity. Assuming no meaningful changes to our economic outlook, we would expect to begin our excess cash deployment when investment yields move north of the 200 basis point level. We remain optimistic that continued GDP growth and the Fed’s eventual tapering of bond purchases will present more attractive risk-return opportunities in the future.
Average other short term investments, which includes interest-bearing cash, remain elevated, reflecting growth in core deposits since the onset of the pandemic, which are up 6% year-over-year.
Moving to credit, our strong credit performance this quarter once again reflects our disciplined client selection, conservative underwriting, prudent balance sheet management, and the continued benefit of fiscal and monetary stimulus programs and improvement in the broader economy. As Greg mentioned, the third quarter net charge-off ratio of 8 basis points was historically low and improved 8 basis points sequentially. Non-performing assets declined 15% with the NPA ratio declining 9 basis points sequentially to 52 basis points.
The decline in criticized assets reflected significant improvements in retail non-essential and leisure, consistent with the reopening of the economy and higher activity in those sectors as well as improvements in our energy and leveraged loan portfolios. We continue to focus on segments of non-owner occupied commercial real estate, particularly central business district hotels as activity has not yet returned to pre-pandemic levels.
Moving to the ACL, our base case macroeconomic scenario is relatively similar to last quarter, which assumes the labor market continues to improve and job growth continues to strengthen, with unemployment reaching 4% in the first quarter of 2022 and ending our three-year reasonable and supportable period at around 3.5%. We did not change our scenario weights of 60% to the base and 20% to the upside and downside scenarios; however, our ACL release was lower this quarter as the improvement in the underlying economic forecast decelerated from the second quarter. Additionally, the ACL requirement in the downside scenario worsened compared to the second quarter due to a forecasted slower pace of recovery and a larger increase in unemployment. If the ACL were based 100% on the downside scenario, the ACL would be $788 million higher. If the ACL were 100% weighted to the baseline scenario, the reserve would be $176 million lower.
While the favorable economic backdrop and our base case expectations point to further improvement in the economy, there are several key risks factored into our downside scenario which could play out, given the uncertain environment. In addition to COVID, we continue to monitor the economic and [indiscernible] implications of the supply chain and labor market constraints that currently exist. Our September 30 incorporates our best estimate for the economic environment with lower unemployment and continued improvement in credit quality.
Moving to capital, our capital levels remain strong in the third quarter. Our CET-1 ratio ended the quarter at 9.8%. During the quarter, we completed $550 million in share repurchases which reduced our share count by 14.5 million shares compared to the second quarter. We also raised our common dividend $0.03 or 11% to $0.30 per share. Our capital plans support approximately $300 million of share repurchases in the fourth quarter of 2021, and we continue to target a 9.5% CET-1 by June 2022.
Moving to our fourth quarter outlook, we expect average total loan balances to increase 2% sequentially, excluding the PPP headwind. Including the PPP impact, we expect average total loans to increase approximately 1%. Our outlook reflects half a point of improvement from commercial revolving line utilization, continued strength in commercial production given our record pipeline, and a continued stabilization in pay downs based on activity that we are seeing so far in October.
We expect average C&I growth of 4% to 5% excluding PPP in the fourth quarter, and CRE balances to decline around 1% or so primarily due to construction constraints. As a result, we anticipate total average commercial loan growth of around 3% sequentially, excluding PPP.
We expect average total consumer loan balances to increase around 1% sequentially, including the impacts of Ginnie Mae forbearance pool purchases in our held-for-sale portfolio. We purchased $300 million during the third quarter and an additional $700 million in early October.
Given our loan outlook, we expect NII to be down 1% sequentially in the fourth quarter, assuming stable securities balances and a $17 million reduction in PPP income. Excluding PPP, we expect fourth quarter NII to be up slightly relative to the third quarter.
Our guidance indicates full year 2021 NII declines less than 1% compared to full year 2020, despite no meaningful growth in investment securities balances throughout the year and an average decline in one-month LIBOR of approximately 40 basis points. We expect NIM to decline 3 to 4 basis points in the fourth quarter primarily due to loan yield compression.
We expect fourth quarter fees to increase around 6% compared to the third quarter and to be up around 8% on a year-over-year basis, excluding the impacts of the TRA. This results in full-year 2021 fee growth excluding the impacts of the TRA of approximately 10% compared to 2020.
Our outlook assumes a continued healthy economy resulting in a record full-year commercial banking revenue led by 20% growth in capital markets fees, record wealth and asset management revenue up double digits, and double digit growth in card and processing revenue. We expect private equity income to be in the $40 million area in the fourth quarter. Our outlook assumes a sequential decline in top line mortgage revenue of approximately 40% with roughly half of that decline due to seasonally lower fourth quarter volumes and declining spreads, and half to our decision to retain $400 million in retail production that I mentioned earlier.
We expect fourth quarter expenses to be stable to up 1% compared to the third quarter, reflecting continued growth in technology investments, servicing expenses associated with the Ginnie Mae loan purchases, and continued marketing support related to our roll-out of Momentum, offset by disciplined expense management throughout the company and initial savings beginning from our process automation program. As a result, our full-year 2021 total core revenue growth is expected to exceed the growth in core expenses despite the rate environment. We will have achieved positive operating leverage in a year in which the vast majority of the industry will likely experience an erosion in efficiency.
We expect total net charge-offs in the fourth quarter to be in the 10 to 15 basis points range, which would result in full-year 2021 charge-offs of 15 basis points or so.
In summary, our third quarter results were strong and continue to demonstrate the progress we have made over the past few years toward achieving our goal of outperformance through the cycle. We will continue to rely on the same principles of disciplined client selection, conservative underwriting, and a focus on a long term performance horizon which has served us well during this environment.
With that, let me turn it over to Chris to open the call up for Q&A.
Thanks Jamie. Before we start Q&A, as a courtesy to others, we ask that you limit yourself to one question and one follow-up, and then return to the queue if you have additional questions. We will do our best to answer as many questions as possible in the time we have allotted this morning.
Operator, please open the call for questions.
[Operator instructions]
Your first question comes from the line of Scott Siefers with Piper Sandler.
Morning guys, thanks for taking the question.
Morning.
Just wanted to ask a couple questions on loan growth, which looks like it’s coming back nicely. First, I was hoping you could talk about any differences you’re seeing in demand between your larger and smaller customers. Jamie, I think you had mentioned that production, it sounded pretty strong in both corporate and middle markets, any additional color there? Then second, was just wondering if you could speak to the dynamics you’re seeing in terms of book pricing and structure; in other words, changes to the competitive environment.
This is Greg. Let me start off, and then I’ll flip over to Tim and maybe Jamie.
First off, we’re very encouraged with what we’re seeing from a production perspective. We’ve got commercial production in third quarter [indiscernible] was strong at $5.4 billion - that was up from $5.1 billion in second quarter and $5.2 billion in third quarter 2019. We expect that production to continue to be stable going into the fourth quarter, so that’s encouraging. We expect average loans up 1% with PPP and 2% up without PPP, so that’s some strength there. We’re also seeing line utilization tick up a little bit more in our core middle market, which is nice to see that for a change.
When you think about our geographies and what we’re seeing right now, from a geography perspective, North Carolina, Texas, Cincinnati, Columbus were our top four markets for commercial loan growth in Q3, which is encouraging. If you look at six regions that had all-time highs, which were very encouraging, with Chicago, Grand Rapids, Columbus, Kentucky, North Carolina and Texas, so that felt really good and we’re starting to see once again some good momentum out there.
Net new relationships, something we watch very carefully, brought in 419 new commercial relationships year-to-date. Most of that was in core middle market and some of that in large core, so net-net we’re seeing good progress out there, good performance, encouraged by what we’re seeing to date as we go into the fourth quarter and then into 2022.
Yes, to add a few points to what Greg mentioned, I had the chance to be out in eight of our 14 regions this past quarter. I think you get really excellent color when you have an opportunity to sit with clients and with bankers. They’re all feeling the shortages as it relates to labor and supply chain. We have hotel operators who are now only cleaning rooms when people leave, as an example. I visited an electronics client out west and asked to see their demo room, and there was nothing but holes in the wall. I said, where’s the equipment, and they had sold all the inventory because they are struggling to get the parts in to be able to fill orders, so all those issues are still real.
I think the good news is we are seeing M&A as a catalyst, we’re seeing capex now as a catalyst in particular for businesses that are able to substitute equipment and automation for manual processes, and then bluntly, as Greg mentioned, I think we feel pretty confident that a lot of the improvement we’re seeing is just coming from taking share. The relationship count Greg mentioned would be higher than where we were at prior to the pandemic, so we’ll have taken more new relationships on board this year through nine months than we had in all of 2018 or 2019, just as an example.
So there’s good general pick-up there. It would be great to continue to see a little bit more activity as it relates to utilization as folks try to build inventories, and otherwise that’s going to be the wildcard for us.
Jamie, let me add one thing. Scott, also if you look at our verticals, which I should have mentioned this, our largest production, the areas we’re seeing the largest strength in right now is technology and media telecom. Our retailers and financial institutions are all doing well, so we’re seeing some good momentum in those spaces.
Then Scott, to answer the second part of your question in terms of the segments, I think Greg and Tim did a nice summary there. What we’re seeing from a line utilization perspective is that the middle market line utilizations are up almost 1%, whereas corporate banking continues to trend down, so quarter-over-quarter that utilization was stable, and if we want to go into the decimals, it was 31.3 at the end of June and 31.1 as we sat here on September 30, but we are starting to see more borrowing demand and pick-up in the middle market space as opposed to the corporate banking.
Then in terms of pricing, while NIM came in as expected, in line with our July guide, we do have the headwind in the C&I yield portfolio because it is very competitive out there. I think for the most part, banks are competing on price and non-banks are competing on structure, so for us, the price headwind comes in just a little bit tighter spreads but also some of the reduction in the LIBOR floor, so you lose some of that excess earnings in this environment but you can perhaps recapture the yield benefit as the Fed starts to move on the front end of the curve, hopefully in the next year to 18 months, so as expected but certainly a headwind when it comes to pricing.
Yes, okay. Good, thank you very much for all the color.
Your next question comes from the line of Peter Winter with Wedbush Securities.
Good morning. You guys have done a phenomenal job on the securities yields with the rate locks on the cash flows and the bullets, but I’m wondering is this type of securities yield sustainable into next year with the rate locks continuing?
I would say, Peter, we’re inoculated from the rate environment but we’re not immune to it, so as you saw in the numbers this quarter and as we look out even next quarter, it is a steady grind down as we reinvest the cash flows, so that hurts the yield a bit, 10, 15 basis points or so.
If you look out on the bullets themselves, they’re at a 2.65 yield with cash flows--I think we’re projecting about $7 billion of cash flows in that portfolio over the next five years, so there will be a step down should rates stay where they are today. Reinvestment yields right now, I think are in the 1.70 to 1.80 range, so barring a curve steepener, it will be a slow but definitely downward trend on the portfolio yield.
The good news for us is we’re very well positioned and it is pretty insulated from the environment relative to how the peers have positioned their portfolios.
Okay, thanks. If I could just follow up on expenses, you’ve had the benefit of those expense initiatives this year, which clearly benefited when looking at the fee income growth relative to the expense growth. Can you just talk about some of the expense opportunities going forward as we go into next year, or has a lot of the low-hanging fruit been realized, and if you could also talk about any inflation pressures looking into next year.
Sure, thanks for the question. One update we have on expense savings in our program for 2022 is that we are targeting $125 million in savings for 2022, and that’s a combination of the lean process automation and intelligent operations, the branch closures - we have 42 branches closing in the first quarter of 2022, and then some smaller vendor savings bundled together, so we’ve tightened the range on that bundle of savings from $100 million to $150 million to $125 million, and then obviously we’re not getting into expense guide for 2022 because we’ll continue to evaluate how much of those savings will be reinvested into sales force expansion on commercial, as well as wealth and asset management.
But we feel good about the progress we’re making on the LPA program; in fact, if you look in the press release, buried, I think, at the bottom of Page 14 is an FTE count, and we’re down a couple hundred FTE, even with adding about 100 from the Provide acquisition, and that’s starting to show the benefit of that LPA savings.
We’ve made progress, we’ve had some success. There’s about $6 million of savings in our fourth quarter forecast tied into that program, but then the $125 million for next year.
And the headcount there doesn’t even reflect the benefit from the offshore, right - the automation savings on offshore processes that were completed by JV partners, where we’re, I think, north of 20% at this point of the processes that were offshore now fully automated.
The other part of your question on inflation, in terms of wage inflation and other things, we’ve been able to manage through the environment from an employee and cost structure and still deliver fairly stable expenses this quarter. We continue to see opportunity to do the same while there is the wage inflation and other pressures. We do have those other opportunities ahead of us, and so perhaps some of the $125 million would be absorbed by some inflationary pressure but ultimately a moderate amount of inflation would ultimately be very positive for the bank in terms of PP&R and interest income capabilities.
That’s great, thanks Jamie.
Your next question comes from the line of Gerard Cassidy with RBC.
Good morning everyone.
Morning Gerard.
Greg, when you look at your CET-1 ratio, you’re targeting to bring it down to 9.5% by June of next year. It looks like, if I recall correctly, your required number is 7% by the Fed. What would it take for you guys to bring it down from 9.5% to something lower, or is it no, the 9.5% is set in stone and you’re just not going to budge off of that?
Well, there’s nothing set in stone, Gerard, but at the end of the day, we think that’s the prudent place to be. It’s multi-faceted as we think about that level. Obviously we believe we could run the bank at a much lower level, but also we watch what the market’s doing, the environment we’re operating in, what our peers are doing. We just think that’s the prudent target point to shoot for at this point.
Very good, and then maybe Richard, we could talk about credit quality. Obviously your numbers, similar to some of your peers, are quite strong, particularly in the net charge-off area, and I suspect that this is unusually good and it’s not sustainable, just due to normal seasoning of portfolios. How long do you think you guys could see net charge-offs stay at this extremely low level, and when do you think they start creeping up to a more normal level? I know normal is hard to define, but when do they start to creep up?
Yes Gerard, thanks for the question. Clearly we’re pleased with the 8 basis points this quarter, and like you said, we don’t think that’s going to repeat. But given the economic outlook, we do expect charge-offs to be better than our through-the-cycle average, and probably certainly into ’22 and into ’23 for a couple reasons.
One, it’s going to be simply the amount of liquidity that’s out there. Two, inflation, collateral values continue to be strong, and when we run our mid-cycle stress tests, we’re seeing 25 to 35 basis points as a charge-off range for the bank through ’22 and ’23. Now, that graph, as I said, it’s a little bit lower than what we think the long term average is. If you recall, we think through-the-cycle average is somewhere between 35 and 45 basis points, but given our approach, given the way we manage the balance sheet, the way we think about client selection and underwriting, we think it’s a grind through ’22 and ’23 back to something that feels a little bit more normal.
Great, appreciate it. Thank you.
Your next question comes from the line of Ken Usdin with Jefferies.
Hi, thanks. Good morning.
Hey Jamie, I was just wondering if you could elaborate a little bit more on the portfolio structure. When you talk about the $7 billion that’s going to run off over the next several years, how high are you on that part of the book, and when you’re reinvesting the cash flows to keep the book flat, are you also buying back some new type of bullet structures or are you just more investing in plain vanilla today?
We’ve been buying a little bit of everything when we’re reinvesting. Portfolio cash flows have been running about $1.5 billion a quarter - you know, second quarter, third quarter, so depending on the day, we’ve added some level 1s, we’ve added some level 2s, but in total the mix hasn’t really changed a whole lot.
Then in terms of the bullets, over the next couple years it’s a very small number in terms of total cash flow, maybe a couple hundred million, and then over years 3, 4, 5, then you start to have cash flow portfolioing. But right now, the total book of bullets, as well as the cash flowing securities, we’re in a 2.75 yield, give or take, and then for the fourth quarter, yields should be a little bit better than that with a little bit of seasonal, mutual fund dividends in the N2DC [ph], plus a little bit of prepayment penalties that have occurred thus far in October.
Okay, got it. Thank you.
Just a follow-up, you guys have been really taking down the long term debt footprint, which is still even outsized the majority of your interest-bearing liability costs. Just wonder, where is the level that you need to keep it at and what’s the trade-offs versus the deposit base, the mix of deposits, and how much more could you potentially reduce that footprint? Thanks.
You know, we’re probably at the low point in terms of the long term debt outstanding. We had a maturity in September, $850 million that we’re perhaps look to replenish in the next quarter or two, but I think we’re at a good spot and we’re well positioned. We’ve been able to utilize the excess liquidity and take advantage of the environment to deliver some savings from a cost standpoint, both from long term debt as well as running off some of the CD book that certainly behaves more like wholesale funding than the core deposit book.
I think we’re in a good spot and we’ve probably reached the end of the line on the long term debt, but probably have a little bit more room on the CD book to run it down a little bit more.
Okay, got it. Thank you.
Your next question comes from the line of John Pancari with Evercore.
Morning. Greg, you mentioned some key talent hires that should help drive loan production into 2022. Can you provide a little bit of color on the areas where you’re hiring, particularly within the lending areas, and if that hiring is continuing? Thanks.
Absolutely, thanks for your question. Obviously the southeast markets, we’ve been adding to our relationship management bankers in that market with a lot of success there. We’re real pleased with the production we’re seeing in that market, so we’ll continue to add in that market. There’s great opportunities and we run a good franchise down there, and that’s obviously a focal point for our expansion.
In addition to that, I would say Texas, the west coast, California, the talent we’ve been able to acquire in those markets, the bankers that we’ve brought on, a significant increase in bankers in those markets over the last two or three years, and we’re seeing great progress from a production perspective, outstanding perspective.
Listen those were the strategies, we watch them very carefully. We invest when we see opportunities, and those areas continue to be great opportunities for us. More to come.
Let me just throw it over to Tim to see if he has any color he wants to add to that.
Yes, I think a couple other. I think Greg hit the geographic points. We also are in the process of building out a mortgage warehouse vertical - that’s a good business for us. It’s a business we’ve been in historically but it hasn’t been a point of focus, and we saw an opportunity there with some talent to go out and take some market share, so I think that’s an area.
We continue to add to the renewables team and are focused on how we expand what is already, I think, a pretty strong capability there and a good track record, and then we were pleased to be able to land some really important talent into Provide post the Provide acquisition, and have now formally launched the vet vertical there for veterinarians, which I think is going to be a really good source of growth to complement the strength we already had in medical, dental, and that business line.
Got it. All right, thank you.
Then secondly, if you could just update us where you stand on your core system upgrade. Can you maybe remind us of the timing of the project and the cost that you see tied to it, and then separately, do you see any risk to the cost that you had budgeted for the upgrade, given the wage inflation dynamics? Thanks.
First off, our tech budget, let me take that first, is about $700 million, and that’s been growing about 10% per year for the last five years. When you think about our core platforms, when we talk about the modernization effort, that’s been going on for a couple years. You saw that with our mortgage loan origination system, the resiliency platforms we put in place, the data architecture strategy that we rolled out. Next coming up is obviously FYS core deposits. We’re in the midst right now of turning on Encino, that’s going extremely well and something we’re very pleased with, so this is an ongoing effort. If you asked me, if it was a baseball analogy, we’re probably in mid-innings here, but it’s a long game and we’ll continue to invest prudently.
In addition to that, if you think about our tech spend, a lot of that tech spend is focused on being able to take cost out, so lean process automation has been a great focus of our business and an area we’ve made a lot of progress in. We’ll continue to invest for those opportunities, we’ll continue to stay focused on core platform replacement, our partnership with FIS, in fact we’re their largest processing customer. If you think about how we think about that business and the integration, what we’ve done with our core platform, we’ve been able to manage costs very efficiently and effectively through that exercise, so we’re very comfortable with what we think the new operating environment will look like from a cost perspective.
But if you think about our tech spend and how we think about our business, it’s really 50% keeping the business running, so to speak, 35% advancing the business, and then 15% protecting the business.
John, it’s Tim. One small point to add to that, and it came up earlier, there was a question about inflation and wages. Jamie said earlier we were immune but not inoculated on a--I’m sorry, inoculated but not immune on a different point. I think here again, we raised our minimum wage to $18 an hour in 2019 - I think we were the first of the regional banks, certainly of our peer group, to have made that move, and the by-product of that is we are watching, as I’m sure you are, the announcements coming out of many of our peers that they’re raising their minimum wage, but they’re getting to $18 an hour in nearly all cases, which is where Fifth Third is already at, and the by-product of that is a lot of that near term impact is kind of in our run rate.
Got it. All right, thanks for taking my questions.
Your next question comes from the line of Bill Carcache with Wolfe Research
Thanks, good morning. I’d like to follow up on your net charge-off rate commentary. As you think about the normalization of your NCO rates off these low levels to the 25, 35 basis points in ’22, ’23 that you mentioned, is the level of your reserve rate currently high enough such that the trajectory is also likely to be flat to down, even as NCO rates normalize higher? Any color that you could give on that dynamic would be helpful.
Yes, I think it’s a little tough to take a life of loan expected loss rate of the ACL and compare it to short term forecasts, because the loan maturities certainly are a swing factor in that. Obviously we’re comfortable with our ACL at 200 basis points - it’s 204 basis points excluding PPP, so yes, I’m comfortable that the ACL is adequate to cover the expected losses over the life of the loans. Then when Richard’s talking about those periodic charge-off levels for a point in time and with a fairly shorter duration portfolio throwing off some of those losses in the consumer side - you know, card and auto, I think we’re at a good spot.
Very helpful, thank you. Then following up on the utilization commentary, to the extent that supply chain problems were to extend further into next year, how much do you think that weighs on--you know, just given the make-up of your client base, how much would that weigh on the normalization of utilization rates versus the potential for those utilization rates to continue to improve, even if those supply chain problems were to extend a bit longer?
Yes, I think we’re seeing stable line utilization because of those supply chain constraints, so hopefully the worst case scenario would be stable. As we talked about in our guide, we expect a little bit of an uptick both from a seasonal and year-end positioning with our customers of about half a percent, so we’ve reduced our outlook on utilization because of the supply chain and labor constraints.
From a next year perspective, hopefully they get resolved and we’ll start to see inventory builds, and that should provide a little bit of a tailwind to our loan growth expectations.
Got it. Thank you for taking my questions.
Your next question comes from the line of Matt O’Connor with Deutsche Bank.
Good morning. I was wondering if you could dig a little bit more into some of the loan yield pressure that you were talking about earlier, and if you kind of just hold rates constant, when does that eventually flatten out?
Yes Matt, for our quarter, if you look in the tables and you look at the gross yield decline 2Q to 3Q, it’s really driven by three factors. One, 2Q had elevated prepayment loan fees that get recorded in the NII, so 2Q was high, so that was a portion. You have regular re-pricing front book, back book phenomenon, and I would characterize it as three basis points or so of NIM from that. I expect that should continue into the fourth quarter.
Then the other phenomenon on the LIBOR floor is more a consequence of getting through renewal season and some of the other things happening out of the second quarter, so that should dissipate, but that was, call it, a third half of that yield compression you see in the tables in the earnings release.
As we look ahead, I would expect a couple BP, 2 to 3 BP headwind from C&I loan yield compression for all of those factors into the fourth quarter, and that’s why we’re guiding the reported NIM down as well for the fourth quarter, similar to what we saw in the third quarter.
Then I guess beyond 4Q, is there still a fair amount of re-pricing between the back book and the front book and all that, or are you getting close to--sorry, go ahead?
No, thanks for the question. I think from a front book, back book perspective, the tailwind is the curve steepening we’ve seen in the third quarter, and should that continue we’ll hit that intersection. But until we get a little more lift, you do have the re-pricing effect continuing, where new loans are coming on at lower yields than the runoff and paydowns in the back book.
I think on top of that, we have done a nice job managing NII and the balance sheet through this environment, and we certainly have dry powder, whether it’s through the asset sensitivity or the $33 billion of excess cash, that we could choose to deploy to mitigate those effects if need be. But for now, we still think patience is still the way to go, and therefore if there’s a little bit of NIM compression along the way, that’s fine. Our focus is more on the long term and delivering the best performance we can over the next five years.
Okay, thank you.
Your next question comes from the line of Mike Mayo with Wells Fargo.
Hi. You mentioned positive operating leverage in 2021 even while you spend 10% more on tech, and that you’re in kind of the fourth or fifth inning of your tech transformation, so I guess the question is do you intend to continue to spend around 10% more on tech each year, and how is that changing, especially as you move off-premise as much as you are? Is there going to be a period where you have to run somewhat parallel systems and then you’ll get the benefit a few years out, and more generally, how do you think about the number of tech partners that you have, and if you can quantify the number, I’ll take that too.
Yes Mike, this is Greg. I think 10% is probably the right number for us. It’s not cast in stone. As you mentioned, operating leverage, positive operating leverage, that’s something we’re very focused on. We delivered it, we’ll deliver it in 2021. As we go into our planning process for 2022, our focus is on positive operating leverage.
As I mentioned earlier, some of that tech spend is going right to process efficiencies, where we’re able to take our 200-plus additional people and so forth, branch closures and things that we’re working on right now on the other expense side of the house that supports that positive operating leverage, and we continue to grow fees at a really robust rate, close to 10% CAGR over the last couple years.
Net-net, positive operating leverage, something we’re very focused on, believe we can continue to deliver on. In addition to that, the tech spend will roughly run around 10%-plus.
If you think about the core platform modernization, we talked about the fourth or fifth inning. I think of it more as a cricket test match - it’s been going on, it’s going to continue to go on for quite some time. We’re going to have to deal with that, but at the end of the day, I think as we put these new platforms in, we’re able to do it in a very systematic way with respect to how we turn these platforms in, so it’s not the big bang approach. We’re able to turn it on by geography, by product line, so we’re very insulated if we’re having to do a big bang impact.
With that said, you’d have some dual system platforms that are going to be run simultaneously until we get all markets, all products converted over in the case of some of our major implementations coming up, like our core deposit platform. That’s going to take a little bit of time, but at the end of the day we should be a lot more efficient, we should be able to bring through more enhancements at a different cage forward to our business. We should be able to continue to take out costs through our lean process automation and our investments in AI technology, so net-net tech is going to be a source of spend for us, in that range that I mentioned before as we go forward, but then I think we’re getting very well for it.
Our objective is to go head-to-head with the fintech players, the large bank competitors that we have to deal with, and be very successful, and we’ve been able to do that and demonstrate that. When you think about the fintech players that are out there, we’ve got the same capabilities if you look at our products like Momentum, but we’ve also got 53,000 free ATMs, 1,100 banking centers, and 10,000 service personnel that they don’t have, and we’ve got the core relationships.
So net-net, we’ll continue to stay focused, but that’s kind of the range we’re going to operate in.
That’s helpful. Just one more follow-up. One simple thought - I mean, there’s a debate of how much banks should keep on premise versus off-premise. Clearly you’re going more in the off-premise direction, and it seems like you’re accelerating that. What was the tipping point, what was the biggest factor to say, you know what, we want to have more of the open architecture be off-premise, even though some other banks are saying we want to keep a lot on-premise?
You know, I think we intend to transition. Basically, we shed 90% on-premise, and you think about that, sort of the next five years as we look at this, that’s going to shift, as you mentioned before, so 90% on-premise is going to shift to roughly 90% off-premise. Seventy percent of that will be hosted in a private cloud. When you think about platforms like FYS and C&F are all going to be private clouds, in the public cloud AWS about 20%, so you think about the shift, 90% will be an off-premise model and roughly 70% private, 20% public.
All right, thank you.
Your next question comes from the line of David Konrad with KBW.
Hey, I was hoping you could help us out with if there’s any constraint limitations on the balance sheet, meaning as we look at our earnings models over the next couple years and redeploy a lot of the excess liquidity, just wondering, some of your peers have mentioned maybe 30% of earning assets would be the limit of securities, regardless of rate. Just wondering if you thought about a constraint on the securities book, and then also embedded in the securities book, the CMBS portfolio has kind of crept up - now it’s just under 60% of the available for sale. Didn’t know if there--you know, it’s all agency or predominantly agency, but didn’t know if there’s a concentration limit that you’d have on that portfolio as well. Thank you.
Yes, thanks for the question, David. The short answer is that when we look at the excess liquidity, call it $30 billion, we expect a third of it to go into the securities portfolio, a third of it into loans, a third of it, we think while the deposits in the banking system may not decline, we do expect those deposits to find a more productive home, perhaps money market funds or other investment vehicles. For us, we’re running at 18% or so in the securities book as a percent of total assets, so if we take, call it $10 billion of the excess liquidity and put it into the book, we’re at 23, 24%. That’s where I’d like to operate, is somewhere 23 to 25% of total assets, but it’s not a capacity constraint. It’s more--I think given the environment, that’s a more productive place to be.
In terms of the CMBS, I think the heart of your question is what is the non-agency CMBS portion of the portfolio, and that’s $3.8 billion or so, and again for us it’s super senior tranches. We feel very good about the credit enhancement, 30%-plus there, so not a large credit risk position to have, whereas the rest of the CMBS book would be agency guaranteed.
Great, thank you.
At this time, there are no further questions. I would like to turn the floor back to management for any additional or closing remarks.
Thank you Angie, and thank you all for your interest in Fifth Third. Please contact the Investor Relations department if you have any further questions.
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