BANC OF CALIFORNIA, INC. annual report, FY2018

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Banc of California, Inc. — FY 2018 Form 10-K

Reporting period: Fiscal year ended December 31, 2018; comparisons are primarily with FY 2017. The company is a California-focused financial holding company whose principal subsidiary is Banc of California, N.A. It operated 32 branches and continued its transition toward commercial banking after selling its Banc Home Loans division in 2017.

Financial performance and condition

  • Earnings: Net income was $45.5 million, down from $57.7 million. Income from continuing operations was $42.1 million versus $53.5 million; diluted EPS from continuing operations was $0.38 versus $0.63. Net income available to common stockholders was $23.7 million, including a $2.3 million impact from preferred-stock redemption.
  • Revenue and margins: Interest income rose to $422.8 million from $389.2 million, but interest expense increased to $136.7 million from $85.0 million. Net interest income was $286.1 million, down 6.0%; reported net interest margin declined to 2.95% from 3.11%. Noninterest income fell 46.5% to $23.9 million, largely reflecting lower gains on security and loan sales.
  • Credit costs and expenses: The loan-loss provision increased to $30.2 million from $13.7 million. Noninterest expense fell 24.5% to $232.8 million, partly reflecting lower alternative-energy partnership losses, reduced staffing and expense-control measures. The efficiency ratio was 74.01%, compared with 88.52%.
  • Balance sheet and liquidity: Total assets were $10.63 billion, up 2.9%. Loans and leases were $7.70 billion, up 15.6%; deposits were $7.92 billion, up 8.6%. Cash and cash equivalents totaled $391.6 million. Operating cash flow was $123.0 million; investing cash flow was negative $469.7 million; financing cash flow was positive $350.6 million. Cash increased $3.9 million for the year.
  • Funding and debt: Brokered deposits were $1.71 billion, or 21.6% of deposits. FHLB advances totaled $1.52 billion, and senior notes had $173.2 million net carrying value ($175 million principal), bearing 5.25% interest and due in 2025. The company reported $1.35 billion of additional FHLB borrowing capacity, $60.6 million of Federal Reserve capacity and $210 million of unsecured federal funds lines.
  • Capital and credit quality: Total stockholders’ equity was $945.5 million, down 6.6%; tangible common equity to tangible assets was 6.34%. The bank’s CET1 ratio was 14.77% and total risk-based capital ratio 15.71%; the company-level ratios were 9.53% and 13.71%, respectively. Nonperforming assets were $22.7 million, or 0.21% of assets. The allowance for loan and lease losses was $62.2 million, 0.81% of loans and 282% of nonperforming loans.

Material changes and unusual items

  • Loan growth was led by commercial real estate and multifamily lending. Commercial real estate and multifamily loans totaled $3.11 billion; commercial and industrial loans totaled $1.94 billion. Management cautions that these commercial exposures generally carry greater credit risk than single-family residential loans.
  • Deposit costs rose amid higher rates and competition: the average cost of interest-bearing deposits increased to 1.46% from 0.88%, while average FHLB funding cost rose to 2.15% from 1.23%. The company described core-deposit growth as a strategic priority; brokered deposits also increased.
  • The securities portfolio declined to $1.99 billion from $2.58 billion as securities ran off or were sold and proceeds were redeployed toward lending. CLOs represented about 71% of the portfolio. Unrealized securities losses were $34.3 million; the company recognized a $3.3 million impairment after deciding to sell its commercial mortgage-backed securities portfolio, which it sold in January 2019.
  • A $13.9 million charge-off followed a $15 million line of credit supported by borrower representations and third-party bank statements later found to be fraudulent. The bank pursued recovery through litigation; success was not assured. Net charge-offs were $17.4 million, up from $4.8 million.
  • The company reduced its workforce by approximately 9%, completing the plan in Q4. It recorded $4.4 million in 2018 severance costs and estimated annual savings of approximately $15 million from the reduction and planned lower use of outside advisers; actual savings and costs could differ.
  • Tax credits from alternative-energy partnerships fell to $9.6 million from $38.2 million, contributing to a higher effective tax rate of 10.3%, versus a tax benefit and effective rate of negative 98.8% in 2017. The company reported a $49.4 million net deferred tax asset with no valuation allowance.
  • Common dividends were $0.52 per share for 2018. The reported dividend payout ratio was 115.56%. The company redeemed $40.3 million of Series C preferred stock in September.

Outlook, risks and contingencies

  • The filing provides no formal earnings or revenue guidance. Management’s stated priorities include expanding commercial banking relationships and core deposits, controlling expenses, and aligning the balance sheet toward lending. The stated $15 million annual cost-saving estimate is not a guarantee.
  • Key risks include execution of the commercial-banking transition; real estate and borrower credit deterioration; concentration in Southern California lending; interest-rate and funding-cost changes; competition for stable deposits; and reliance on brokered funding. A substantial majority of real-estate loans are adjustable-rate, and higher borrower payments could impair repayment.
  • CLO concentration creates potential credit, valuation and liquidity risks. The company held $1.42 billion of CLOs, reported them as rated AA or higher at year-end, and cautioned that some may be illiquid or lose value in adverse markets.
  • The SEC investigation initiated in 2017 remained ongoing. A securities class action had been certified, with trial scheduled for October 21, 2019 as reported in the filing. Other litigation included a dispute over access to cloud-stored documents, with trial scheduled for June 2019, and an employment claim in arbitration. The filing states the company intended to contest the principal claims; litigation could entail costs, sanctions or reputational harm. A former officer’s settlement in principle was stated not to be material.
  • CECL adoption was expected in 2020; management could not reasonably estimate its impact and warned the allowance and capital effects could be significant. Lease accounting adoption in 2019 was expected to add $23–$25 million of operating lease liabilities and reduce capital ratios by 2–5 basis points.
  • The $100 million stadium naming-rights and sponsorship commitment runs through 2032; $15.3 million had been paid by year-end 2018. The company also disclosed related-party transactions, including substantial legal-cost indemnification in connection with the investigations and litigation.

Investor verification priorities

  1. Review the trend in net interest margin, deposit pricing, brokered-deposit reliance and core-deposit growth.
  2. Assess commercial loan growth, Southern California concentrations, classified loans, charge-offs and the adequacy of the allowance, including the fraud-related recovery efforts.
  3. Evaluate CLO exposure, securities valuation and the effect of realized or unrealized losses on earnings, equity and regulatory capital.
  4. Track the SEC investigation and litigation, including potential costs, outcomes and any developments after the filing date.
  5. Verify delivery of the projected cost savings and monitor restructuring effects, the stadium commitment and other contractual obligations.
  6. Monitor CECL implementation, deferred-tax-asset realization and capital headroom after the fully phased-in capital conservation buffer.

Filing assurance: KPMG issued unqualified opinions on the consolidated financial statements and internal control over financial reporting; management also concluded disclosure controls were effective as of December 31, 2018.