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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Welcome to the M&T Bank Fourth Quarter and Full-Year 2017 Earnings Conference Call. It is now my pleasure to turn the floor over to Don MacLeod, Director of Investor Relations. Please go ahead, sir.
Thank you, Scott, and good morning. I would like to thank everyone for participating in M&T's fourth quarter and full-year 2017 earnings conference call both by telephone and through the webcast. If you have not read the earnings release we issued this morning, you may access it along with the financial tables and schedules from our website, www.mtb.com, and by clicking on the Investor Relations link and then on the Events and Presentations link.
Before we start, I would like to mention that comments made during this call might contain forward-looking statements relating to the banking industry and to M&T Bank Corporation. M&T encourages participants to refer to our SEC filings, including those found on Forms 8-K, 10-K, and 10-Q, for a complete discussion of forward-looking statements.
Now, I would like to introduce our Chief Financial Officer, Darren King.
Thank you, Don, and good morning, everyone. Before we get to the results, I want to take a moment to recognize and celebrate the story, career, and life of our late Chairman and CEO, Robert Wilmers or as we all knew him Bob. Simply stated, Bob was our leader, our mentor, and most of all our friend. As a leader, Bob's track record was unparalleled. Under his stewardship, M&T grew from its position as the fourth largest bank in Buffalo to a top 20 bank in the country, which is an accomplishment in and of itself.
To do so without suffering a quarterly loss and with the highest stock price appreciation amongst the 100 largest U.S. banks in existence in 1983 and which are still around today, says it all. He did the same thing with his vineyard in Bordeaux and was on a similar path with the newspapers in the Berkshires. Whether in civic or business life, Bob was truly a leader.
Bob’s approach to mentoring was not what one might call traditional. Rather than fill you with advice about how to handle certain situations, Bob peppered you with questions. There were times I thought Bob only knew one word, why. Over time, you learned to ask questions of yourself from many angles, trying to anticipate where Bob might take the conversation. In fact, he pushed each of us to be better.
Another favorite question of Bob's was who is the best at fill in the blank? No matter what your answer, you knew that there was a new benchmark against which your performance was going to be measured. As a friend, Bob was extremely loyal. Once you earned his trust and respect, you had a friend for life, no matter what circumstances you might encounter.
Bob liked to joke with his friends, poking fun at any of us on the management team at every opportunity he could find, but it wasn't a one-way street. Bob could take it as well as he could dish it out, and never held a grudge when you landed the occasional zinger. To say we will miss him is an understatement, but not long after Bob passed, my sadness turned to pride, proud for all that Bob had accomplished in business and his personal life, proud to have been a small part of it, and proud to help carry it forward. Bob was a great man, whose impact will continue to be felt for years to come. But as you would expect, we move ahead.
Our management team has decades of experience working together in banking at M&T. Rene, Rich, and Kevin have the full support of the Board, the management team, and all of our 17,000 colleagues. We have a business model that works and a culture that works. And we all believe the best way to honor Bob is by continuing his legacy well into the future.
Lastly before we get to the financials, I would like to take a moment to acknowledge all of those on today's call who reached out with the note acknowledging Bob's passing. Your thoughts, prayers, and condolences gave us comfort in our time of sorrow and we are truly grateful for your friendship.
Now let's turn to the results for the fourth quarter and for the year. M&T’s results for the fourth quarter were characterized by further modest expansion of the net interest margin and growth in net interest income. Trust fees remained a highlight, and expenses continued to be well controlled, and the credit environment remained solid.
Highlights for the year included 9% growth in net interest income, which was a result of the Federal Reserve's program to raise short-term interest rates combined with limited deposit repricing. Credit improved from the already strong levels seen over the past three years, but net charge-offs as a percentage of loans matching results seen in 2000 and 2006, otherwise the lowest since 1987. While loan growth did not meet our expectations that subdued growth enabled us to return the excess capital we generated back to our shareholders.
For the year, M&T repurchased $1.2 billion of common stock and paid an additional $457 million of common dividends to our shareholders. This resulted in a payout ratio for the year of 125%. The repurchase program resulted in a 3.4% decline in average diluted shares compared with 2016.
Now let's look at the specifics of the fourth quarter. Diluted GAAP earnings per common share were $2.01 for the fourth quarter of 2017, compared with $2.21 in the third quarter of 2017 and $1.98 in the fourth quarter of 2016. Net income for the quarter was $322 million compared with $356 million in the linked quarter and $331 million in the year-ago quarter.
On a GAAP basis M&T’s fourth quarter results produced an annualized rate of return on average assets of 1.06% and an annualized return on average common equity of 8.03%. This compares with rates of 1.18% and 8.89% respectively in the previous quarter. Included in the GAAP results in the recent quarter were after tax expenses from the amortization of intangibles assets amounting to $4 million or $0.03 per common share, down slightly from the prior quarter.
Consistent with our long-term practice, M&T provide supplemental reporting of its results on a net operating or tangible basis from which we have only ever excluded the after tax effect of amortization of intangibles assets as well as any gains or expenses associated with mergers and acquisitions when they occur.
M&T’s net operating income for the fourth quarter, which excludes intangible amortization was $327 million compared with $361 million in the linked quarter and $336 million in last year's fourth quarter. Diluted net operating earnings per common share were $2.04 in the recent quarter compared with $2.24 in 2017s third quarter and $2.01 in the fourth quarter of 2016.
Net operating income yielded annualized rates of return on average tangible assets and average tangible common shareholders' equity of 1.12% and 11.77% for the recent quarter. The comparable returns were 1.25% and 13.03% in the third quarter of 2017.
In accordance with the SEC’s guidelines, this morning's press release contains a tabular reconciliation of GAAP and non-GAAP results, including tangible assets and equity. Both GAAP and net operating earnings for the third and fourth quarters of 2017, and the fourth quarter of 2016 were impacted by certain noteworthy items.
Included in the fourth quarter of 2017s results were $21 million of gains on investment securities, which arose primarily from the sale of preferred stock issued by the government sponsored mortgage enterprises, Fannie Mae and Freddie Mac. This amounted to $14 million after-tax effect or about $0.09 per common share.
Also included in the fourth quarter results was a contribution to the M&T Charitable Foundation amounting to $44 million. That contribution amounted to $27 million after-tax effect or $0.18 per common share. The contribution exceeded the securities gains recognized during the quarter and brought the total contributions to the foundation for 2017 to $50 million.
M&T’s effective tax rate for the quarter was also impacted by the changes to the U.S. corporate tax rates. M&T’s provision for income taxes for the fourth quarter was increased by approximately $85 million as a result of the new tax law changes reflecting a revaluing of the corporation's net deferred tax assets. This amounted to $0.56 per common share. In aggregate, these items lowered net income for the quarter by $98 million or $0.65 per diluted common share.
As a reminder, in the third quarter of 2017, we increased the reserve for legal matters by $50 million. That increase coupled with the non-deductible nature of the $44 million payment to the U.S. Department of Justice relating to issues at Wilmington Trust Corporation prior to its acquisition by M&T, reduced M&T's net income in the third quarter by nearly $48 million or $0.31 of diluted earnings per common share. In the fourth quarter of 2016, we contributed $30 million to the M&T Charitable Foundation, which amounted to $18 million after-tax effect and $0.12 per common share.
Turning to the balance sheet in the income statement, taxable equivalent net interest income was $980 million in the fourth quarter of 2017, up $14 million from the linked quarter. The net interest margin improved to 3.56%, up 3 basis points from 3.53% in the linked quarter. We estimate that the increase in short-term interest rates notably one-month LIBOR in anticipation of the Fed's December rate action added a benefit to the margin of as much as 4 basis points.
Cash interest received our non-accrual loans combined with interest collected on loans previously charged off added an estimated 3 basis points to the fourth quarter margin. A higher level of average balances of funds placed on deposit with the Fed had an estimated 4 basis point dilutive effect on the margin. The higher cash balances were the result of both increased trust demand deposits and slower reinvestment of MBS cash flows.
Average loans declined less than 1% with the previous quarter, while commercial loan originations in the quarter were by far the strongest of any quarter in 2017, continued high levels of paydowns of both C&I and CRE loans combined with the ongoing runoff of the acquired Hudson City mortgage loans more than offset originations.
Looking at the loans by category on an average basis compared with the linked quarter, commercial and industrial loans were about 1% lower in the linked quarter. While it did not affect the quarterly average, we did see $123 million seasonal increase in loans to auto dealers to finance their inventories at the end of the quarter, compared with the end of the prior quarter. Commercial real estate loans were down less than 1%, compared with the third quarter.
CRE growth continues to be challenged by loans funding construction projects. As those projects reached completion, they are being paid off with the proceeds from long-term often fixed rate permanent financing, not typically offered by M&T.
As noted, residential real estate loans which are largely comprised of mortgage loans acquired in the Hudson City transaction continue to paydown. The portfolio declined by about 3% consistent with previous quarters. Consumer loans were up 3%. Growth in indirect auto and recreation finance loans continue to outpace declines in home equity lines and loans. Regionally, no one region stood out with C&I and CRE softness across all of our geographies.
Average consumer deposits, which exclude deposits received at M&T’s Cayman Island office and CDs over $250,000 were up approximately 1% annualized compared with the third quarter. The higher levels of trust demand deposits I mentioned previously were partially offset by lower time deposits as the higher cost CDs acquired with the Hudson City acquisition continue to mature.
Turning to non-interest income. Non-interest income totaled $484 million in the fourth quarter, compared with $459 million in the prior quarter. Excluding the $21 million of securities gains I mentioned before, non-interest revenues grew slightly from the linked quarter. Mortgage banking revenues were $96 million in the recent quarter, compared with $97 million in the linked quarter. Residential mortgage loans originated for sale were $696 million in the quarter, down about 8% compared with the third quarter.
Total residential mortgage banking revenues including origination and servicing activities were $62 million compared with $63 million in the prior quarter. Commercial mortgage banking revenues were $34 million in the fourth quarter unchanged from the relatively strong results seen in the previous quarter. Trust income was $130 million in the recent quarter, up from $125 million in the previous quarter, and up 6% from $122 million in last year's fourth quarter.
New business generation continues to be strong, particularly on the institutional side of our business. Service charges on deposit accounts were $108 million, compared with $109 million in the third quarter, essentially unchanged.
Turning to expenses; operating expenses for the fourth quarter, which exclude the amortization of intangible assets, were $789 million. As I mentioned earlier, the fourth quarters operating expenses included a $44 million contribution to the M&T Charitable Foundation. While the third quarter included the $50 million addition to the reserve for legal matters, excluding those items, operating expenses declined slightly as legal expenses started to subside. The efficiency ratio which excludes intangible amortization from the numerator and securities gains from the denominator was 54.7% in the recent quarter. That ratio was 56% in the previous quarter and 56.4% in 2016s fourth quarter.
Now let's turn to credit. Our credit quality continues to exceed expectations. Annualized net charge-offs as a percentage of total loans was just 12 basis points for the fourth quarter, compared with 11 basis points in the third quarter. The provision for credit losses was $31 million in the recent quarter exceeding net charge-offs by $4 million. The allowance for credit losses was $1 billion at the end of December, and the ratio of the allowance to total loans increased slightly to 1.16%.
Non-accrual loans increased by $13 million at December 31, compared with the end of the prior quarter. The ratio of non-accrual loans to total loans increased by 1 basis point ending the quarter at 1%. Loans 90 days past due on which we continue to accrue interest excluding acquired loans that had been marked to a fair value discounted acquisition were $244 million at the end of the recent quarter. Of these loans, $235 million or 96% are guaranteed by government related entities.
Turning to capital. M&T’s common equity Tier 1 ratio under the current transitional Basel-III capital rules was an estimated 10.93% compared with 10.98% at the end of the third quarter and which reflects earnings retention during the fourth quarter share repurchases and the impact from the net decline in end of period risk weighted assets. M&T repurchased $224 million of its common stock during the quarter.
As noted earlier, for the year M&T repurchased $1.2 billion of common stock and paid an additional $457 million of dividends to our common shareholders resulting in a 125% payout ratio for the year.
Next, I would like to take a moment to cover the key highlights of 2017s full-year results. GAAP based diluted earnings per common share were $8.70, up 12% from $7.78 in 2016. Net income was $1.41 billion improved from $1.32 billion in the prior year. These results produced returns on average assets and average common equity of 1.17% and 8.87% respectively.
Net operating income which excludes intangible amortization and merger-related expenses incurred in 2016 was $1.43 billion improved from $1.36 billion in the prior year. Diluted net operating income for common share was $8.82, up 9% from $8.08 in 2016. Net operating income for 2017 expressed as a rate of return on average tangible assets and average tangible common shareholders' equity was 1.23% and 13% respectively.
Turning to the outlook. Looking forward into 2018, we are as optimistic as we were at this same time last year. The economy appears poised to grow at a faster pace, unemployment remains low, and tax reform has been approved. While there has been little tangible progress in rolling back some of the post-crisis regulatory restrictions on the banking sector what we are seeing and hearing from Washington is very encouraging.
However, with the caveat that the events never unfold entirely in the manner you expect, there are a few thoughts on the coming year. Loans at the end of 2017 declined about 3% from the end of the 2016. This reflected a 13% decline in residential mortgage loans predominately those acquired with Hudson City, combined with the 4% decline in C&I loans, flattish CRE loans and 9% growth in consumer loans. While as noted, commercial originations in the fourth quarter were strongest of any quarter last year, paydowns continue to be elevated. Our pipeline is solid as we entered 2018.
The CRE market is active in areas such as multifamily and warehousing and distribution facilities to support the evolving retail sector. But as was the case in 2017, CRE loan growth will be impacted by our ability and appetite for providing permanent financing as construction projects reach completion.
We expect continued runoff of the mortgage loan portfolio likely at a double-digit pace, although the dollar amount of the decline will lessen as the portfolio continues to get smaller. And we continue to see attractive pricing and underwriting standards in the consumer area, not unlike last year. Given these trends, we expect 2018 overall to look much like 2017 with total loans flattish to growing at a low single-digit pace with payoffs and paydowns being the wildcard.
As has been the case, since the Fed began to raise interest rates late in 2015, our outlook for the net interest margin is dependent on further rate actions. A flat rate scenario should lead to some expansion of the margin as the benefit from last month's Fed action becomes fully embedded in the run rate, offsetting core margin compression. Further actions by the Fed in 2018 will potentially offer additional upside. Of course deposit pricing reactivity remains the unknown factor. Our projections reflect more pressure on deposit pricing than has been the case over the past two years.
Our outlook excludes the potential impact from cash balances brought in through Wilmington Trust, which could have an impact on the reported margin, but would only have an incremental effect on revenue. The level of cash on deposit at the Fed was lower at the end of the year than the average for the quarter.
Based on the current level of rates and reflecting the impact of interest rate hedges we entered into during this past year, we estimate that hypothetical future 25 basis point increase in short-term interest rates would result in a 5 basis point to 8 basis point benefit to the net interest margin. This also embeds an assumption on result in deposit pricing reactivity.
Based on those balance and margin assumptions, we expect modest year-over-year growth in net interest income, a higher interest rate environment will likely challenge mortgage banking in 2017, specifically with respect to residential mortgage loan originations. As we've noted previously, we have the capacity and appetite for additional servicing or sub-servicing business should opportunities present themselves. This could offer a potential offset to slower originations.
The outlook for the remaining fee businesses remains stable with growth in the low-to-mid single-digit range in the potential for trust revenues to exceed that pace. For the most part, we expect low nominal growth in total operating expenses in 2018, compared to 2017. That said, we anticipate investing some of the savings from lower taxes into our employees, technology and our communities. In the aggregate, this could amount to about 15% to 20% of the benefit from lower taxes spread over the next couple of years.
I'll remind you that we expect our usual seasonal increase in salaries and benefits in the first quarter of 2018, which primarily reflects annual equity incentive compensation as well as a handful of other items. Last year that increase was approximately $50 million. While dependent on the level of the stock price at the time the equity grants vest we could see and a benefit to the tax line in the first quarter as was the case last year, although likely to smaller.
Our outlook for credit remains little changed. They’re continue to be some modest pressures on non-performing and criticize loans, but there are no apparent pressures on particular industries or geographies. Our outlook for credit losses remains relatively stable.
Net charge-offs amounted to just 16 basis points last year, following 18 basis points in 2016 and 19 basis points in each of 2014 and 2015. All of which, are roughly half our long-term average of 35 basis points. In fact, 16 basis points of losses matched the levels we reported in 2006, but are otherwise the lowest we've experienced since 1987. But as we've said on this call last year and the year before, our conservatism won’t let us count on beating that figure in 2017.
Regarding taxes, we believe the best way to illustrate how the new tax law might impact our results is to estimate what our effective tax rate would have been if the new laws had been in place at the beginning of 2017. We estimate that rate would have been 24.9% for full-year 2017. An effective tax rate in the range of 25% to 26% is a reasonable expectation for 2018.
As to capital, the combination of higher than expected earnings combined with slower than expected balance sheet growth has resulted in our capital levels remaining in excess of what we believe is necessary to operate in a safe and sound manner given our long history of low earnings and low credit volatility. And even though our total payout ratio for 2017 was 125%, the capital ratios are still higher than they were at the end of 2016.
We remain committed to returning capital that we can't deploy intelligently to our shareholders. And while we expect to continue to participate in the consolidation of the industry, we don't believe in warehousing capital until an opportunity presents itself. Of course, as you are aware, our projections are subject to a number of uncertainties and various assumptions regarding national and regional economic growth, changes in interest rates, political events, and other macroeconomic factors which may differ materially from what actually unfolds in the future.
Now let's open up the call to questions before which Scott will briefly review the instructions.
[Operator Instructions] Your first question comes from the line of Steven Alexopoulos with JPMorgan. Your line is open.
Hey, good morning, Darren.
Good morning, Steven.
I want to start – can you talk about – give more color on the C&I loan growth? You talked about paydowns being elevated, maybe can you quantify that? And what's your view how tax reform impacts loan growth in 2018?
Okay. And we'll go through those in turn. So C&I loan growth, when we look at the fourth quarter and we talked about this on the third quarter call, fourth quarter originations were very strong, best quarter of the year, and when we entered the quarter, the pipeline at the end of the third quarter was as strong as we had seen all year. So those two things made a lot of sense to us.
What we've been seeing really throughout or had seen throughout 2017 was elevated paydowns in both CRE and C&I. When we have looked specifically at what we saw in C&I, we saw the increased activity largely from private equity whereby we had customers who were selling all our parts of their business because asset prices have been pretty inflated given the abundance of capital chasing deals.
And so that activity was a little higher than what we have historically seen, probably 5 to 10 percentage points higher than we had historically seen in terms of payoffs and paydowns as a result of that. So when we talk about that as a wildcard that's kind of where our thinking is, how much that continues, at what pace that continues a little bit hard to predict.
When you think about the impact of tax reform on lending and loan growth in 2018, it’s hard to believe that it won't have a positive impact. To me and to us, the question is more the timing of how quickly that happen? I think if you – everyone is I believe trying to figure out what the impact of the tax reform means to them. For many businesses, what it means for their cash position, for their repatriating cash? How much of that cash they're going to use? What their current capital structure looks like, whether they're over the 30% or 35% limit on interest deductibility?
So there's a number of factors that I think people are just going to work their way through. And for us, we're not expecting a big up tick in the next quarter, but we expect as the year goes on and as the GDP growth takes hold and employment stays where it is or potentially gets better that you'll see some of that demand start to pick up as the year goes on.
Okay. That's helpful. If I could ask you one other question on deposits, you guys have really put up one of the lowest beta as we've seen in the industry, give us some color on the lack of deposit pressure or your commercial customers just not demanding more? Is there any pent up pressure where we might see a larger adjustment at some point? Thanks.
Yes. So I guess a couple things on our deposit and overall cost of funds. You need to keep in mind that we’ve continue to have our run down and repricing of our Hudson City time portfolio. So that's something that we have. That's a little bit unique to us compared to others in the industry. So that's helping our funding costs.
The other thing is we've done very well with maintaining non-interest bearing deposits and we've seen some migration into those accounts and a mix shift has helped with our overall cost of funding.
When you look underneath and you see where some of the pricing movement is happening, certainly our trust demand deposits and our mortgage escrow balances are typically linked to the index, so those ones are 100% reactive.
When we look underneath at our private banking and our commercial, we saw a bigger uptick in our pricing in the third quarter than we did in the fourth. The fourth quarter prices moved up a little bit in those two categories, but not as much as we had seen in the third quarter.
And I think on the commercial side, there's certainly some pressure there. I’ll remind you that that's earnings credit, which kind of shows up as an offset to fees. And generally balances are still strong, folks haven't put that those balances to use yet in the business. So they have more than enough fee offsets that they're not demanding as much from an earnings credit rate at the moment.
We've got our eye on that. It's something we pay a lot of attention to and we're always considering what the impact is of earnings credit rates versus balance diminishment, and those two things cannot offset each other, and we pay a lot of attention to that. But it's something I think us and the industry are all expecting to see, but we take a 25 basis point increase by 25 basis point increase.
Great. Thanks for all the color.
Your next question comes from the line of John Pancari with Evercore. Your line is open.
Good morning.
Hi, John.
Darren, I wondered if you can talk a little bit more about the – on the expense growth. I believe – just want to confirm, you indicated nominal expense growth for 2018 and then also what would that equate in terms of the amount of positive operating leverage that you could expect for the year? Thanks.
So here's how I would think about expenses. If you look at the third and second quarter of 2017, those would be more normal expenses, so third quarter you want to take out the legal settlement, but otherwise those quarters kind of give you a good sense of where the run rate is on average. And starting from that base, we anticipate expense growth less than 2%.
And then we announced last night that we plan to invest some of the tax savings in our hourly employees, many of those are the face of the bank. There are tellers and our telephone center reps, and we expect that to increase the expenses a little bit beyond that 2%-ish growth rate that I mentioned prior, and if you put those together that's kind of where the expenses are to come out for the year.
When you think about operating leverage, I would expect, we would be 1% to 2% positive operating leverage over the course of the year and that could move depending on when and by how much the Fed changes Fed funds rates.
Okay. Thanks. And then separately on the capital side, I heard you on the – that you're not going to warehouse until opportunities come up, but on that opportunistic angle, can you give us your updated thoughts around acquisitions on the whole bank side and non-bank? What are you seeing and what do you think is likely to materialize for 2018? Thanks.
Sure. So our thoughts about acquisition and what makes sense for us hasn't changed from what we’ve talked about in the third quarter. Obviously, we’re interested in whole banks. We’d be interested in branch networks, but we'd also be interested in wealth and asset management as well as mortgage servicing. So it's pretty broad, the types of things we would consider.
I guess I would describe the market right now is fairly quiet. I think everyone is digesting what tax reform means for them, what it might mean for their business. Their digesting the current credit environment and what that looks like? And so from what we've seen right now, there's a lot of activity, which is why we've made the comment that we wouldn't sit and wait for something to come around before we deployed capital back to our shareholders.
Okay, thank you.
Your next question comes from the line of Ken Zerbe with Morgan Stanley. Your line is open.
Great, thanks. Just go back to the comment that you said you're going to reinvest, called 15% to 20% of the tax savings back into the business. Obviously, I saw the $25 million you talked about, which is probably a little less than the 15% to 20%. But what are their actions are you thinking about that you could be taking that you're referring too in terms of following it back into expenses? Thanks.
Sure. So as you mentioned, we talked about the increase to the hourly rates once fully implemented. Those will be worth about $25 million, we think on a run rate. There is other actions that we are considering for employees like 401(k), match increases things like that. So investing in our employees will continue to invest in our communities. Traditionally we've given [1.9%] of net income every year to our communities and with the tax increase. We would expect to benefit our communities a little bit with that.
And then the other thing is continued increase in our infrastructure in particular technology. And so we described an increase of 15% to 20% of the savings over the next couple of years, but these things will feather in over the course of 2018 and 2019, as we do our work and we think about what ways of investing that those dollars will be most impactful for our business.
Obviously technology is something that's important and we will continue to invest in. But it's not one of those things that you can just write a check tomorrow and pay for software off the shelf and then go back to a different run rate. It starts to embed in your expense base and will be thoughtful about how we do that, but we thought it was important to signal where our intentions were going.
Got, understood. And then just – in terms of credit, I think you said the outlook is relatively stable, obviously your first half credit was different from the second half credit. Are you talking about full-year stable or stable from sort of fourth quarter levels?
I think in stable more from like the last four years, stable and I'm thinking more – both the third quarter was very strong. The fourth quarter was strong and impacted by recoveries. So if you look at where we had been in the prior three years that's kind of where our head is that.
Got, understood. And then just last question, in terms of the CRE growth or lack of CRE growth, I think you mentioned that the growth going forward is going to depend on your willingness to offer more perm financing, which you've been hesitant to do. What does that depend on? Is just the yield? Are you seeing bad structures in the market, but why are you not in that market today and what might get you in there?
So primarily it's pricing. That the yields and the rates that are being offered by our competitors are lower than we think make economic sense for us over the long-term, obviously there's a relationship involved. Those are mortgages that we will do. But this year has been particularly active. We've seen the insurance companies particularly active in the 10-year space with a lot of interest only option. So it's just not something we've generally participated in. If the pricing changes and returns change, then our activity in that space would likely change as well.
But the big issue for us on the construction or the commercial real estate is we had that run up through 2015 and 2016 in construction and as those projects come to completion they paydown, which is – it actually a good thing because that's what we're really hoping for when we do those loans is that they'll get completed and people will take over the permanent financing if it's multifamily or the condo owners obviously accept their units and pay us down, but take out a personal mortgage so.
Right.
Not expecting any material change, given what we see out there in the world right now, but obviously if rates change, we would be willing to participate.
Great, thank you very much.
Your next question comes from the Ken Usdin with Jefferies. Your line is open.
Thanks. Good morning. Darren, I want to ask you about a mix of the balance sheet. I notice that the securities portfolio has shrunk over the course of the year, offset on the wholesale borrowing side. Just can you help us understand just where your comfort zone is both in absolute levels of that securities book and whether or not that changing rate environment will cause you to think about adding – to turning the corner on that going forward?
Sure. So the securities portfolio, the primary driver is liquidity coverage ratio. And what we need to have in securities to make sure that we're compliant with the coverage ratio. When you look at the last little bit or over the course of the year, given how the balance sheet has evolved, we haven't needed the securities portfolio to be as big and that moves around a little bit with our cash balances, which are affected by trust demand, but then also how we choose to reinvest the mortgage-backed securities payoffs that sit within the securities portfolio.
And really over the last quarter, maybe the last two quarters a little bit given where short rates were when we looked at what was running off and where rates were likely going, we've felt better just keeping that in cash because the premium you were getting to invest it for two years wasn't really worth it.
So as you go forward, I'd be looking at cash and securities together and where we need to see some – have a better feeling about what the shape of the curve is going to look like before we make any decisions to change that reinvestment rate or change the mix of what we’re investing in.
Okay, got it. And then to follow-up on that deposit side, you mentioned that the Hudson City loan book might start slowing its rate of decline. Can you help us understand the offsetting side of that on the time deposits, like how much – how fast and how much of that is still left to runoff that how fast do you think that will be running down?
So the rate of decrease is slowing just in dollar certainly because the portfolio is smaller. When you look at what's left to reprice, we're down to less than a third of the balances that need to reprice. Much of the book has shifted towards shorter duration CDs typically six months or a year. And when we're in the market most of the activity is in that one-year space.
We are starting to see a little bit of movement into two-year, but really it's all been around one-year is where all the activity is. So what's out there are some longer dated CDs that were three and five years back at origination and as those come due obviously they'll reprice and they'll either likely go short, which is what has been typical if they stay on the balance sheet or the runoff.
I would be thinking $1 billion to $2 billion of additional runoff and time in those CDs that are Hudson City related over the next 12 to 18 months. The offset to that is when you come out of a lower interest rate environment, generally the place where balances move first is into the time deposit. So while there might be some decrease in legacy Hudson City time deposits. When you look at the total time deposit category, it might not decrease by that same amount because we expect we'll see some shift of money market in the time over the course of 2018.
Okay. I understood. Thanks for that Darren.
Your next question comes from the line of Geoffrey Elliott with Autonomous Research. Your line is open.
Good morning. Thanks for taking the question. Back to technology, you touched on that briefly earlier scenario where you'd like to invest. How do you think you stock out there relative to peers and competitors?
Well, it's a good question. I don't have a great benchmark for what others look like. You have the most obvious ones, which are your mobile devices which are probably the most benchmark of anything. When I look at our online and in branch capabilities, I think we stack up well. I think on the mobile we're competitive, but we will be looking to improve in our mobile channel through time.
We're teed up to implement Zelle this year, which will be a big positive, and we're looking forward too. But I guess when we think about mobile technology across all of our lines of business, our view is that mobile is now regular cost of doing business and it's not a technology event, right.
So when you think about you see on your phone, the little red circle in the corner of an app that says by the App Store there's an update available. That's the mentality that we're bringing to mobile. It’s something that you're going to be constantly providing updates and new feature functionality, which will really become an embedded expense.
When you look across the rest of the franchise that what's datacenter versus what's cloud and core applications. Our core applications are pretty much the same as everyone else, and in fact, we believe that we have fewer of them than others because our acquisition history was not to maintain dual system environments, but to consolidate always to one.
But we're always investing and maintaining those core systems or investing in infrastructure like data, investing in security, cyber security obviously being a big one and making sure that our environment is safe. So there's a number of places where we're investing technology dollars. Some of them very visible to the outside world, but many of them inside to the bank and making sure that we're stable and safe.
And when you think about potential M&A, do you think you could do M&A to acquire new tech capabilities is not something you’d look out?
That’s a really good question. I think when we look at technology, we would be open to talking to people to bring technology capability to our customers, but to acquire another bank just to get their systems is probably a tough one. And the reason I say that, I would never say never, but the reason I say that is typically you're buying a bank that's smaller than you. And if you’re going to convert M&T on to a smaller bank systems and technology architecture and infrastructure, you'd want to be really certain that it was ready to handle that kind of volume, right.
Typically we're very conservative and worried about risk, and to that end, we've generally converted others on to our systems because as a percentage of the business it's small and we know that we can handle it from an infrastructure perspective, and it minimizes the risk should something go bad. But are we looking more at partner opportunities to deploy new technology? Absolutely. And could that mean investments in some of those? We'd be open to it, if it makes sense.
Great. Thank you very much.
Your next question comes from the line of Brian Klock with Keefe, Bruyette & Woods. Your line is open.
Hey. Good morning, Darren.
Good morning, Brian.
On the expense side, I just want to kind of catch back up and just make sure I understand the guidance. When you look at the last three quarters on an operating basis, taking out the Wilmington Trust and the charitable donation in the fourth quarter, it’s averaging about $755 million a quarter. So that's the base we should be thinking about quarterly and then grow that by 2% when we think about 2018, is that the right way to think about that?
That's the right way to think about it. Yes, and obviously you've got the first quarter increase that is pretty typical, and then the $25 million that we disclosed yesterday that would be the run rate of investments in our employees.
So that $25 million would be additive to the 2% growth on top of that?
That's right. But you won’t see the full $25 million likely in 2018, it'll come in over the course of the year, and the full $25 million would be more likely in 2019s run rate.
Okay. And then really the other cost of operations in the fourth quarter that typically can be seasonally higher for you guys in the fourth quarter and when you adjust it for the Wilmington Trust and the charitable donation, it was down about $15 million sequentially. And usually, the first quarter is when you see it come down from the fourth quarter, so is there any seasonality we should look at in that line item? If we adjust to $212.9 million for the $44 million, is that something you expect to be flat or is that something we’ll see this normally seasonally slower or lower first quarter out of that line item?
There's movement in that and it's not really seasonality per se. It can just be timing of when certain expenses hit. I think the safest thing to do is to look at our annual other costs and divide it by four and we're not anticipating anything that's going to drive it up materially in 2018 or down. The one thing to keep in mind is in their professional services expenses some relating to technology and some relating to legal, and we're hoping that we're going to run at a slightly lower legal costs in 2018, but we do have the next wave of trial coming up in the spring. So it might not move down quite as much as we would like early in the year, and then we'll see what happens from there. So I would take the total year number and think about that averaged on a quarterly basis.
I got and just the last follow-up on the end of period balances and you talked about the excess liquidity at the Fed is down, end of period versus the average. It looks like a lot of that came out of interest-bearing deposits. If can talk about that end of period, the balance trend and with a lot of that from Hudson City time deposits that $1.5 billion that came out of interest-bearing deposits on end of period base?
It's a combination of trust and there's some mortgage escrow and there as well that moves around, say about $0.5 billion is mortgage escrow and some of its time probably $300 million to $400 million and then other just normal movement up and down in the quarter. And I guess partly we made the comment about the cash at the Fed, when thinking about first quarter margin that the increase in cash reduced the margin in the fourth quarter even though it was a very visible by about 4 basis points just because of the rate there right. So if it goes away, the market is going to go the other way in the first quarter, but doesn't necessarily mean that net income is going to go correspondingly higher.
That’s exactly great. All right, thanks for your time, appreciated Darren.
No problem.
Your next question comes from the line of Matt O'Connor with Deutsche Bank. Your line is open.
Hi, you guys have addressed, so I think most of the kind of guidance questions that I would have had. But maybe from the strategic point of view, if you look at the fee businesses, you've obviously had some good momentum in trust and you talked about building out the mortgage servicing. How about in the capital markets side? This is an area that we've seen some of your peers build-out and it does seem like it provides a little bit of hedge from C&I loans going and CRE going to the capital markets instead of loan balance sheet. Maybe you could remind us like what your capabilities are there and just the thoughts of organic growth or I guess bolt-on deals in that broader space?
Sure. We do some M&A advisory of a small operation that operates at a Baltimore that helps our customers when they're considering M&A activity and we also have a debt capital markets business that also operates at a Baltimore. Those businesses both had some modest increases year-over-year in terms of their fees that we’re in. So it's a space that we're in.
We think there's upside there, probably lean a little bit more right now in the debt capital markets side than in M&A. But really when we look at where other parts of our fee business have been, it's been in the commercial mortgage space and when you think about our balance sheet with our heavy commercial real estate focus at our expertise there that's a good feeder system for our commercial mortgage fee business.
And at the end of last year, we added a team in Philadelphia that complements that business that their specialty is more dealing with insurance companies and placing business with insurance companies where we've been in Fannie and Freddie DUS lender and that's a place where we saw some nice growth this year in fees and we expect to continue to see that happening in 2018 as well, and it's a nice complement to our commercial real estate business.
So there's a few places where we try to participate on the fees side to your point as a complement to the balance sheet part of our business. We don't have any specific plans to grow aggressively in debt capital markets or M&A, but it's something we certainly pay attention to given the commercial orientation of our balance sheet.
Okay, that's it for me. Thank you.
Your next question comes from the line of Frank Schiraldi with Sandler O'Neill. Your line is open.
Hi, Darren. Just two quick ones, first on the NIM, I think you noted 5 to 8 bps of NIM benefit from a 25 basis point hike is a good way to think about things. So for the December rate hike, does it make sense to further adjust that range by the 4 bps you kind of noted on LIBOR getting ahead of itself, does that make sense?
So the 5 to 8 bps that we noted earlier is really on a go forward basis and we have been talking about 6 to 10 bps is where we had been and the last rate hike would fall more in the 6 to 10 bps. So I would think about the 4 as along the path to that 6 to 10 bps and we'll get a little bit – the rest of it in January depending on what happens with deposit pricing.
Okay, gotcha. And then just on the effective tax rate you cited. The lower relative percentage decrease, I guess M&T expects to see versus just the statutory federal reduction from 35% to 21%. Is that basically all due to just the impact from state and local taxes or is there anything else in there that's somewhat meaningful offset?
You nailed it. It’s pretty much all the states we’re in and the impact of state and local tax.
Okay. All right. Great. Thanks.
Your next question comes from the line of Chris Spahr with Wells Fargo Securities. Your line is open.
Thank you. Good afternoon. I was wondering, is it possible to eliminate your bank holding company charter, given how your businesses are structured particularly if the bank regulatory relief doesn't really come down to the states at $100 billion threshold that some have suggested recently?
I think the answer technically is yes. It's possible, anything's possible, but when you look through the businesses that we have underneath of it and the way they're structured, right now we don't really see the benefit. Something we looked at after the announcements from Zions earlier this year and concluded it didn't make sense for us at that point, especially given some of the proposed legislation of relief for banks less than $250 billion. So we're – for the moment watching that with interest and we can see what happens. It's something we would consider, but at the moment, we don't have any plans to make any changes to our structure.
And given that your balance sheet hasn't been growing recently, is that safe to assume at least for 2018 that long-term debt will remain flattish this coming year?
Well, we've got some debt rolling off, and obviously we’ll be watching where the loan growth is and what's going on with deposits. And then our capital structure and the amount of capital that we have, we commented a couple times about where we feel our capital ratios are relative to where we think they should be and so there might be some mix shift on the balance sheet between debt and equity as well. So those will be the factors to consider when thinking about debt for the year.
Thank you.
Your next question comes from the line of Peter Winter with Wedbush Securities. Your line is open.
Thank you. Darren, in regards to capital return just given the valuation of M&T, I'm just wondering what your thoughts are looking at share buyback versus dividends?
So when you look at our history and you look at the mix of distributions through time that are between dividends, stock buyback, and M&A, those tend to move around a little bit depending on the environment we're in. But as we look into 2018, given the change in tax rate and the appreciation our stock price, our dividend yield and our dividend payout ratio is likely to – both going to be down.
So we'll be looking at what our dividend yield is and what the dividend payout ratio is and thinking about that in conjunction with our distributions and the rest we would look at as capital returns. But over time that mix between dividend and share repurchase, we don't expect to change that much.
So we will make our adjustments, and as we go through our CCAR work, and obviously we've got to increase in the dividend planned for next quarter in the second quarter of 2018, and we'll obviously look at the mix as we go through CCAR and look to return capital in the most friendly way for the shareholders.
Okay. Thank you. And just on a separate note, net interest income in the first quarter, I'm just wondering – assuming that the interest recoveries don't reoccur, which I think is about $8 million and then two less days in the quarter, do you think, net interest income would be down slightly from fourth to first?
Maybe I’ll touch. You definitely got two less days, that’s important. And then it will be about – our calculations, $3 million to $5 million of recovery. So you've got those two things working against you, but we'll have the full quarter of the hike helping on the other side. So I guess when we look at it, we're thinking flattish or flattish to slightly down first quarter versus fourth quarter.
Got it. Thanks very much.
Your next question comes from the line of Kevin Barker with Piper Jaffray. Your line is open.
Thank you. I just wanted to follow-up on some of your commentary on mortgage servicing and potential M&A there. Why do you view that business to be attractive right now given that we've seen many banks shy away from mortgage servicing and have issues with it through the cycle?
So I guess when we look at the mortgage servicing business, we think about both service and sub-servicing. And the number one thing that we like about the business is the returns and the return on equity. And we think that that is helpful to our overall return profile, and if it's servicing, we're not tying up the balance sheet – if it’s sub-servicing I should say, we're not tying up the balance sheet.
But we're selective. When you look at – if we look at the pricing and we look at what the return measures look like of any business we might do and like any investment decision we make, whether it's a new loan, buying another bank or investing in sub-servicing, it has to make sense for our shareholders. And over time, particularly during the aftermath of the crisis, it proved to be a business that people were shying away from mainly because of reputational risk and some of the fines that were out there.
So it placed a premium on operational excellence. And we've been through a number of reviews with our regulators, both the Fed and the CFPB, and proven to be a pretty clean shop in terms of our operations. And therefore, we believe we can manage the reputational risk and the operational risk. And if we can get paid for it, which we were able to, then we like the business. If those dynamics change and the returns change, then we won’t like it as much, but from where we've been over the last five years, it's been a great source of fee income and return for us.
Okay. And then a follow-up on that. Is there a certain size you are targeting where you start to see the returns on those portfolios that you could acquire start to hit peak margins or to really grow to a level where scale really matters?
From what we see, we're far from that. At our peak, we’re servicing about $99 billion worth of mortgages. There's not a circumstance that we currently envision that takes that to $200 billion anytime soon. It's been when we've acquired servicing. It's tended to come in smaller chunks and kind of $15 million to $20 million – $15 billion to $20 billion size lots, which is easier to integrate, easier to manage the transition, and doesn't get us over our skis in terms of the size of portfolio we're trying to manage and the risk we're trying to manage.
But it's really – we're looking at each potential deal, what the mix of mortgages looks like, how challenged it may or may not be based on delinquency, the mix of Freddies and Ginnies that are in the portfolio and the regional mix. There’s a whole bunch of things that we consider before going forward. But at this point, it's not something we're looking to make a major business, but given our experience in mortgage and our ability to service it's been a nice complement to businesses that we're in, and again, a nice source of fee income in return for us.
Okay. Thank you for taking my questions.
End of Q&A
There are no further questions at this time. I will turn the call back over to Mr. MacLeod.
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