The Bank of NT Butterfield & Son Limited (NTB) Q3 2021 Earnings Call Transcript

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The Bank of NT Butterfield & Son Limited (NTB 1.37%)
Q3 2021 Earnings Call
Oct 28, 2021, 10:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning. My name is Tom, and I will be your conference operator today. At this time, I would like to welcome everyone to the Third Quarter 2021 Earnings Call for The Bank of N.T. Butterfield & Son Limited. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Noah Fields, Butterfield's Head of Investor Relations. Please go ahead.

Noah Fields -- Vice President of Head of Investor Relations

Thank you. Good morning, everyone, and thank you for joining us. Today, we will be reviewing Butterfield's third quarter 2021 financial results. On the call, I'm joined by Butterfield's Chairman and Chief Executive Officer, Michael Collins; and Chief Financial Officer, Michael Schrum. Following their prepared remarks, we will open the call up for a question-and-answer session. Yesterday afternoon, we issued a press release announcing our third quarter results. The press release and financial statements, along with a slide presentation that we will refer to during our remarks on this call are available on the Investor Relations section of our website at www.butterfieldgroup.com.

Efore I turn the call over to Michael Collins, I would like to remind everyone that today's discussions will refer to certain non-GAAP measures, which we believe are important in evaluating the company's performance. For a reconciliation of these measures to U.S. GAAP, please refer to the earnings press release and slide presentation. Today's call and associated materials may also contain certain forward-looking statements, which are subject to risks, uncertainties and other factors that may cause actual results to differ materially from those contemplated by these statements. Additional information regarding these risks can be found in our SEC filings.

I will now turn the call over to Michael Collins.

Michael W. Collins -- Chairman and Chief Executive Officer

Thank you, Noah, and thanks to everyone joining the call today. Butterfield's results in the third quarter of 2021 continued to demonstrate the bank's earnings power and resilience in an ultra-low interest rate environment and health and credit uncertainty in most of our markets. So far in 2021, Butterfield has performed really well through a difficult period in our small and wealthy island market. During the recent fourth COVID wave, people and businesses were better prepared and have learned to live with it. We anticipate this to continue and sense our local economies taking on more of a business as usual approach without the need for further economywide lockdowns.

I will turn now to slide four, where we provide a summary of third quarter highlights. Butterfield reported net income for the third quarter of $39.8 million or $0.80 per diluted common share, and core net income of $40 million or $0.80 per diluted common share. This represented a core return on average tangible common equity of 17.9%. The Board of Directors maintained a $0.44 per share dividend rate, which reflects the stability of our earnings and targets a through-cycle dividend payout ratio of approximately 50%. In addition to the quarterly cash dividend, we continue to evaluate share repurchases and utilize our share buyback authorization as part of our broader capital management program. Opportunities for organic growth such as the Channel Islands mortgage product and M&A pipeline also remain important factors.

During the third quarter, the bank reached a resolution with United States Department of Justice concerning the inquiry into Butterfield's legacy business with U.S. clients that was first reported in November 2013. The resolution is in the form of a non-prosecution agreement with a three-year term. The bank paid $5.6 million in respect of forfeiture and tax restitution amounts, which were in line with the provision that was included in the bank's financial statements as recorded in 2015 and 2016. While we are required to comply with obligations under the non-prosecution agreement, we are pleased to have this investigation resolved.

I will now turn the call over to Michael Schrum to provide more details on the third quarter.

Michael L. Schrum -- Group Chief Financial Officer

Thank you, Michael. I'll begin with slide six, which provides a summary of net interest income and margin. In the third quarter, we reported net interest income of $75.7 million, an increase of $1 million as we were able to increase the volume of interest-earning assets in the investment portfolio, which saw average balances increased by $342.3 million or 2.3% compared to the prior quarter. Net interest margin of 1.97% was four basis points lower than the 2.01% in the prior quarter due to lower-yielding interest-earning assets. Loan yields were down six basis points in the third quarter due to lower yields on new loan originations due in part to lower-yielding production volumes in the Channel Islands.

During the third quarter, the blended rate for loan originations was 3.42% for $278 million of new loans, down from 3.57% for $234 million of originations in the second quarter of 2021 in U.S. treasuries and agency securities. New money yields averaged 1.13% in the third quarter of 2021 or 53 basis points lower than the 1.66% in the prior quarter as we added around $400 million of two- and three-year treasuries. As we expect longer-term rates to rise over the medium term, we made a decision to invest in shorter-term treasuries to retain some flexibility and add some protection from unrealized marks in the available for sale portfolio.

Turning to slide seven. Noninterest income continued to show stability with a modest increase to $49 million compared to $48.8 million in the prior quarter. Banking fees and foreign exchange revenues grew during the quarter as we continue to see improved economic activity. The bank's higher non-interest income resulted in a fee income ratio of 39.3% in the third quarter of 2021, which continues to represent a stable and capital-efficient revenue stream for the bank. slide eight provides a summary of core non-interest expense, which increased to $84.2 million in the third quarter of 2021 compared to $83.4 million in the prior quarter. The slight increase in core expenses was made up of a relative -- relatively small value items.

In particular, there was an increase in technology and communications cost as we have upgraded our desktop access platform during the quarter. In addition, we saw increased professional and outside services fees, supporting some longer-term strategic initiatives, including some spend on our broader ESG strategy. Finally, there continues to be some additional cost associated with the three-year non-prosecution agreement with the U.S. Department of Justice as we continue to meet the ongoing terms of the agreement. We do expect core non-interest expense to settle back in the $82 million to $83 million range per quarter over the next few quarters, which is already evident from the exit run rate this quarter.

Pipeline summarizes regulatory and leverage capital levels. Butterfield maintains conservative regulatory capital levels that continue to be well above statutory requirements. The bank's elevated deposit levels kept our TCE to TA ratio at 5.8%, slightly below our targeted range of 6% to 6.5%. We continue to expect this to build back over the coming few quarters. Turning now to slide 10. Butterfield's balance sheet continues to be strong and conservatively managed with a high degree of liquidity. Deposit levels have stabilized with a slight reduction to $13.9 billion this quarter from $14.2 billion in the second quarter. We were able to continue to deploy excess liquidity during the third quarter into the investment portfolio.

On slide 11, we show that Butterfield's asset quality remains exceptionally high with low credit risk in the investment portfolio, which continues to be 99% comprised of AAA-rated U.S. government-guaranteed agency securities. Consistent underwriting continues to result in 2/3 of the loan assets in full recourse residential mortgages in Bermuda, Cayman and the U.K. We've also made a great start in our first year of our residential mortgage offering in the Channel Islands and expect that book to continue to build to around $500 million over the next four to five years.

Nonaccrual loans have improved further and are now down to 1.2% of gross loans. We remain vigilant and continue with outbound calling programs and are actively working with any borrowers who may experience difficulty. On slide 12, we discuss average cash and securities balance sheet with a summary interest rate sensitivity analysis. Butterfield's weighted average life in the AFS investment portfolio increased to 5.3 years from 5.0 years last quarter due to a moderately slower prepayment speed. Consistent with prior quarters, Butterfield continues to expect a potential increase to net interest income in both up and down grade scenarios.

I will now turn the call back to Michael Collins.

Michael W. Collins -- Chairman and Chief Executive Officer

Thank you, Michael. This September marked the fifth anniversary of Butterfield's IPO and listing on the New York Stock Exchange. Since our listing, we have been clear about our strategy to be a leading independent onshore bank and trust company with limited credit exposure, consistent non-interest income generation, prudent expense management and high risk-adjusted returns. We have achieved growth organically and through acquisitions, including the 2016 purchase of HSBC's trust and asset management operations in Bermuda. In 2018, we successfully acquired Deutsche Bank's Global Trust Solutions business, which helped us establish a licensed trust operation in Singapore as well as a mid-market corporate banking business in Jersey.

In 2019, we completed the acquisition of ABN AMRO Channel Islands, which expanded scale to banking operations in Guernsey and Jersey. We have grown significantly since the IPO in September of 2016 with a compounded annual growth rate of 7% for deposits and 6% for customer loans. During this time, we have managed through varied economic and interest rate conditions, while maintaining quarterly core returns on tangible common equity in the range of 15% to 25%. We have also improved tangible book value per share by compounded annual growth rate of 6% and created significant shareholder value, paying out over $400 million in cash dividends and repurchasing a total of 7.3 million shares, representing approximately a 14% concentration in share count.

Butterfield is well positioned to continue to grow and remain on this path. Our success is anchored in the strong balance sheet, capital-efficient fee businesses, prudent expense control, balanced capital management, low credit risk, relevant products and excellent customer service, which yields consistent return and long-term growth. We greatly appreciate the support of our shareholders, the Board of Directors, customers, colleagues and all the stakeholders who have helped contribute to the bank's journey thus far. Thank you. And with that, we'd be happy to take your questions. Operator?

Questions and Answers:

Operator

[Operator Instructions] And the first question comes from Tim Switzer with KBW. Please go ahead. Good morning. I'm on for Mike Perito. Thanks for taking my question. You guys had a little bit of NIM pressure on both the asset and liability side this quarter, it looks like. And you talked about kind of the new money yields in the securities portfolio being a little bit lower due to a shorter duration, that makes sense. Could you talk about what you're seeing on maybe the loan yield side if that is resulting in more pressure? And then also, what's kind of driving the higher deposit costs as well?

Michael L. Schrum -- Group Chief Financial Officer

Tim, it's Michael Schrum. So just starting with the loan yields. As you know, we saw a modest growth in period end balances, but most of the new originations shifted from -- actually from Bermuda, where we saw more pay downs and more new originations came on in the Channel Islands. So the Channel Islands is a lower-yielding activation of deposits in the sort of 3.25, 3.50 range. And it comes really from our new mortgage products that we've launched this year in the Channel Islands. So that sort of mix shift between dollars and Sterling and jurisdictional mix shift kind of caused that modest compression in the NIM on the loan side.

In terms of the investment yields, as you know, they continue to decline. We've had elevated, obviously, prepay speeds there. And I think we moderated the -- well, they moderated somewhat during the quarter. So the repayments actually came down to about $300 million in the quarter. And so we took a look and said where rates are right now, let's go into a little bit shorter duration to give us some flexibility while we wait for sort of clear indications of where and when longer-term rates are coming out. This will give us some more flexibility to redeploy or reladder over the next year or so.

And then finally, on the deposit cost, they sort of remained stable at 12 basis points, while interest-bearing demand deposits were actually negative three basis points. We've obviously taken a look at our longer-term fixed deposit offerings there. But I think we're sort of broadly in line with market, where we operate with slightly higher deposit costs in the Channel Islands and Bermuda and Cayman. But bearing in mind that we're sort of a growing bank in the Channel Islands, we want to remain somewhat competitive there. So I think they probably won't have much further to go than the 12 basis points, which is still a relatively cheap source of funding for us.

Mike Perito -- KBW -- Analyst

Yes. That makes sense. And if I could follow-up on the investment portfolio strategy. I understand waiting for higher yields to come. You think we'd begin them. I guess just how patient are you willing to be given your elevated cash levels? Do you -- I mean, would you continue just to point into short-term securities? Or is there any kind of macro environment that would maybe change your mind indicating the longer term, even without a substantial increase in yields?

Michael L. Schrum -- Group Chief Financial Officer

Yes. No, thanks for that. Maybe I should have been a little bit more clear. We did redeploy most of the runoff actually back into agency MBS. So you can see a duration extension there. But net new money we put into two and three year. So about $400 million went into two- to three-year and about $250 million went back into agency MBS at an average rate of around $125 million.

Mike Perito -- KBW -- Analyst

Okay. I got you.

Michael L. Schrum -- Group Chief Financial Officer

Yes, in terms of longer -- the broader question around, is there anything that would change our thinking? Obviously, I mean there is a lot of -- there's been a lot of volatility in the rates market at the moment. We're still very sensitive. So I think we're just being patient, getting a bit of running book yield, but retaining some flexibility while we see we're tapering and longer-term rates end up shaking out, yes.

Mike Perito -- KBW -- Analyst

Yeah, that's certainly it seems like the right approach. Right now.

Michael L. Schrum -- Group Chief Financial Officer

Okay, thank you.

Operator

The next question comes from Timur Braziler with Wells Fargo. Please go ahead.

Timur Braziler -- Wells Fargo -- Analyst

Hi, good morning. Maybe circling back to the Channel Islands, what's the loan balances at quarter end now?

Michael W. Collins -- Chairman and Chief Executive Officer

Yes. So I think we have the end-of-period balances in Note 12 to the financial segment reporting. But I think the new -- when we think about the net new product balances, so Channel Islands is both the U.K. and the Channel Islands, which includes the ex ABN book. The net new mortgages this year, I think we're around GBP50 million at the end of Q3. And we continue to expect that to grow to maybe $0.5 billion or so in four to five years. So it's a cautious approach, but I think, not a dial mover, but clearly accretive from our perspective.

Michael L. Schrum -- Group Chief Financial Officer

As you remember, this was our plan to get turned the channel out into more of a full-service retail bank. And actually, we were able to jump start the mortgage volume pretty quickly because we used our -- a lot of our people in our London office, the Butterfield Mortgages Limited. So we have a good team there. It focused on Central London mortgages, but they were able to really help with the Channel Islands mortgage book. And probably the first new residential lender there and sort of a generation, and it's been a really good start. So we're pretty excited about it.

Timur Braziler -- Wells Fargo -- Analyst

Okay. So I guess looking at the disclosure for U.K. loans, is that implying that the Central London book has been growing in '21 as well, or has that still been relatively flat after peaking last year?

Michael W. Collins -- Chairman and Chief Executive Officer

Yes. It's been relatively flat. As you remember, these are IOS, so three- to five-year duration, so kind of running fast to keep the balance flat. Obviously, London has just started opening up, so people actually are able to show properties again. It's a broker-introduced market there. So it's been relatively flat up until now. But the market overall is fairly vibrant with a pretty good pipeline.

Timur Braziler -- Wells Fargo -- Analyst

Okay. And then maybe switching over to the deposit side. The third quarter decline, I guess, how much of that was planned transitory exit? And then as you look ahead, what type of visibility do you have for the deposit balances in the coming quarters?

Michael W. Collins -- Chairman and Chief Executive Officer

Yes, a great question. So we spent quite a bit of time obviously looking client-by-client on deposits for anything that's over -- really over $10 million of deposits and flowing on and off balance sheet. I would classify the outflow as part of the search deposits that we had starting in December last year. And these are sort of intermediaries coming from law firms and some buildup from hedge fund cash balances in Cayman. As we head into the fourth quarter, we normally get a bit more seasonal increases in Cayman up toward year-end. And we are obviously continuing to dialogue with customers about how long are these deposits staying? Are you interested in term deposits or off-balance sheet items. But yes, I mean, the outflow was really the search deposit outflow. And I think we should expect some of that to continue, and that will obviously alleviate pressure on the TCE ratio.

Michael L. Schrum -- Group Chief Financial Officer

Yes. We're also doing a better job on directing some of the bigger clients with transitory money into our money fund. So the sweep was more effective this quarter than previous quarters. So I think we're -- it's starting to come off a bit, but I also think we're just managing the flows better.

Timur Braziler -- Wells Fargo -- Analyst

Okay. And then on, I guess, a corollary to the deposit question and the pressure that's adding to TCE ratio. We saw, again, kind of a lower level of buyback activity as TCE still under 6%. I guess, does that absolute TCE level also impacts your ability to do M&A? Or are those two kind of not binding to each other?

Michael W. Collins -- Chairman and Chief Executive Officer

Yes, great question. So if we're buying a fee business, which is some of the opportunities that we've been looking at more closely, obviously, that doesn't impact the TCE ratio. If you're buying a bank or balance sheet, it could be either accretive depending on what your buying to TCE ratio. But I think, certainly, the quality of the regulatory capital stack is very high with a very high component of CET1. So there's other opportunities for funding or capital funding if we found a larger transaction, particularly in the fee business, we've talked about before. So I wouldn't really say it's a major constraint.

Timur Braziler -- Wells Fargo -- Analyst

Okay. And then one last one for me, if I can. Just looking at the fee businesses, the trust business, in particular. It seems like fees within trust have been fairly stable over the last couple of years. I guess -- what's the organic outlook for the existing trust business? And you've obviously been looking for a trust now for a little bit. Is that really the next step to start seeing higher trust fees is through M&A? Or are there levers to pull where you could start seeing some increased fee utilization from the organic platform?

Michael W. Collins -- Chairman and Chief Executive Officer

Yes. To actually see increased fees in trust, it really is inorganic. So it really is about M&A. So I think we've said in the past, the trust business really is very stable fee income, but it doesn't really grow. So in a normal year, you basically will take on about 1% or 2% additional fee income through new trust because it takes a long time to set up these very complex family trust. And then you lose 1% or 2% as sellers move on and the money is distributed down to the beneficiary. So it really is a flat business. It doesn't grow much on its own. So it will be through acquisition.

We're still having constructive discussions. As we've said in the past, it takes a long time, and probably the most important gating factor is really our own risk appetite from an AML perspective. So we are really stringent about what we will take on, and that often results in having to structure the trust acquisitions in various ways, which can be complex and time consuming. So still having constructive discussions. But as I said, it's a long lead time.

Timur Braziler -- Wells Fargo -- Analyst

Okay, great, thank you for taking my question.

Michael W. Collins -- Chairman and Chief Executive Officer

Thanks.

Operator

We have a question from Jeffrey Kitsis with Piper Sandler. Please go ahead.

Jeffrey Kitsis -- Piper Sandler -- Analyst

Good morning. I was wondering if you could give us an update on the M&A strategy. I know you gave some helpful commentary on sensitivity of M&A to capital levels, but can you give a broader update on what you guys are looking for right now?

Michael W. Collins -- Chairman and Chief Executive Officer

Yes, sure. So it hasn't changed. It's been consistent that our existing banks and particularly Bermuda and Cayman, produce a lot of capital, which -- and we have slow-growing markets, obviously. So it's very difficult to invest back into Bermuda and Cayman. So the strategy has been to use that capital generation to do two things. One is to acquire private trust companies, which we've shown we can do in the past to increase the size of that business, usually in our existing jurisdictions. And then the second part of the strategy is opportunistically to acquire banks in the Channel Islands, either Guernsey or Jersey. There really isn't much overlap acquisition possibilities in Bermuda and Cayman. So that's where we would grow.

I would say one of the strategies was to try to balance our exposures and our risk profile across the three jurisdictions, which we have substantially achieved at this point from a balance sheet perspective. So we feel like we're more diversified. But those are the two pieces of the strategy, trust acquisitions and banks in the channel islands.

Jeffrey Kitsis -- Piper Sandler -- Analyst

And I appreciate the commentary on the Channel Islands mortgage operation progress. Going into the 4Q, are there any other dynamics around loan growth that we should be aware of similar to the repayment of the government facility that we saw in 3Q?

Michael W. Collins -- Chairman and Chief Executive Officer

No. I mean, I think, obviously, we continue to monitor it. There are a number of -- as we come out of COVID, the discussions with some of the larger facilities that we put in place for particularly the Cayman government and the Jersey commitment that we made to the states of Jersey, have turned out to be not utilized. And so they're obviously evaluating, do they need the fiscal stimulus capacity that they had originally -- that we had signed up for at the beginning of the pandemic, and I think some of them are just reevaluating and reducing the exposure. But I think we should hopefully, see more activity in Central London in terms of transactions and refinancing.

The pipeline is quite good there, and Channel Islands is well underway. Bermuda continues to be a lot of cash buyers. And so there's not much leverage put in and demand is relatively sluggish. I would say, Cayman is growing very fast, and we're just taking our time, making sure we stick with our risk appetite there. So I think what you've seen in the last couple of quarters, maybe a slightly better growth outlook than we had during the pandemic, certainly.

Jeffrey Kitsis -- Piper Sandler -- Analyst

Thank you for taking my question. Thank you.

Michael W. Collins -- Chairman and Chief Executive Officer

Thank you.

Operator

[Operator Instructions] We have a follow-up question from Timur Braziler with Wells Fargo. Please go ahead.

Timur Braziler -- Wells Fargo -- Analyst

Thank you, Maybe just looking at net interest margin, I guess, looking at the dynamics for both loans and securities with those new money yields coming on below the portfolio yield and some catch-up on the averages relative to period imbalances. Is it safe to assume that there's some incremental NIM compression coming in the following quarters? Or is there anything that I'm missing there that could kind of sum that off?

Michael W. Collins -- Chairman and Chief Executive Officer

Yes. I mean, we continue to deploy, as you can see, cash balances, but obviously, we're quite cautious around the search deposits and duration of those deposits. So we are in the process of updating behavioral analysis on the deposits as well. I think with the way the balance sheet is right now, we tend to focus more on net interest income than NIM and sort of keeping that at the 75 level, pending what happens in the rates market. Obviously, we continue to be very sensitive. And as a reminder, just 2/3 of that sensitivity is sitting at the front end of the curve. And 1/3 is kind of at the back end of that curve.

So we have seen a slightly more constructive 10-year recently, certainly. And I think we're just being -- we're just saying that's that's a little staging here in the two- to three-year. It does cause NIM compression, but running book yield. So it's a good trade-off from our perspective to just kind of keep that $75 million level on net interest income. And I think the NIM will be dictated by the potential reduction in deposits or normalization of deposits. And that really is coming -- sort of giving us a trajectory out of there without incurring a huge mark on the investment portfolio. So just adding that flexibility.

Timur Braziler -- Wells Fargo -- Analyst

Okay. And then as we think about deploying excess cash into securities, I know the number before had been around $150 million a quarter. Are the trends in the third quarter kind of indicative of what your plan is going forward? Or is there a unique opportunity given the runoff there to reinvest some of those yields, I guess, how should we be thinking about putting cash store in the securities book going forward?

Michael W. Collins -- Chairman and Chief Executive Officer

Yes. It's -- I think when we see opportunities, as we did in the second quarter to kind of lock some of that in, we did put $400 million out in the second quarter into MBS securities. And that's one of the reasons why we still have gains in that securities book today. And obviously, there's quite a bit of volatility in the 10-year right now, but I would expect us to -- we now have a platform where we have a two- and three-year ladder. And so we can stem the sort of NII compression really from additional volume in the investment portfolio and shorter duration. Now it doesn't -- it looks like a bigger NIM compression, but it does give us that flexibility while we wait for further guidance for the market really.

Operator

This concludes our question-and-answer session. I'll turn the conference back over to management for any closing remarks.

Michael W. Collins -- Chairman and Chief Executive Officer

Thank you, Tom, and thanks to everyone for dialing in today. I know it's a busy morning for calls for everyone. We look forward to speaking with you again next quarter. Have a great day.

Operator

[Operator Closing Remarks]

Duration: 33 minutes

Call participants:

Noah Fields -- Vice President of Head of Investor Relations

Michael W. Collins -- Chairman and Chief Executive Officer

Michael L. Schrum -- Group Chief Financial Officer

Mike Perito -- KBW -- Analyst

Timur Braziler -- Wells Fargo -- Analyst

Jeffrey Kitsis -- Piper Sandler -- Analyst

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