$OZK Bank OZK Q3 2025 Earnings Conference Call

Yeah, let me take that last part of your question and then I'll turn it over to Brandon for some more general commentary on what we're seeing. In regard to the three loans that migrated, one from substandard to substandard non-accrual. That loan had a significant charge-off on it that recognized our exposure on that. We had a significant reserve for it last quarter, but that did manifest itself in a charge-off. And that's a good example to answer your question: when does a reserve on a loan become a charge-off? That is when it becomes evident that we're moving forward with a liquidation or other resolution of that as an ongoing loan. The second project you mentioned, the Chicago project, when we moved that from special mention to substandard non-accrual, we took the charge-off on that, reducing it to what we consider a liquidation value on that asset. The third asset you mentioned moved from special mention to substandard, and we put a sizable reserve on that, representing what we think is a wide range of potential outcomes on that. Those sponsors are continuing to actively work a really good lease prospect and maybe others I'm not aware of, but I know they've got one really good lease prospect that they're far along with. Hopefully they'll be the winning proponent on that. They're also evaluating how to recapitalize that project and go forward. I think by the end of this next quarter or into Q1, we'll have more clarity on that. Now, with that said, I've read some of the analyst reports that have already been written on our release last night, and it seems that the universal characterization is it was a mixed bag on asset quality. I would certainly agree that's an accurate picture. We did have those three migrations and a couple of charge-offs on that. None of those were surprises; they were all either substandard or special mention assets. But the flip side is, on the positive side, we had our largest foreclosed asset, which constituted more than half of our foreclosed assets, Lincoln Yards Land in Chicago, sell during the quarter at the book value we had it on the books for. So that was a big win. The second and third largest OREO assets that we had at June 30, which are now our first and second largest OREO assets, are both under contract as of October 2nd with expected closings this quarter. Those will have neutral to positive gains on sale, break-even to gain on sale, assuming they close. We never know they're going to close until they do, but if they do close, we'll have a positive outcome. So I think we're doing a really good job of resolving credits that come into the foreclosed asset category in a very effective way, and I feel good about that. The other thing that's a positive: if you look at our combined special mention, substandard, and foreclosed assets, that aggregate number was actually down modestly during the quarter, reflecting pretty stable asset quality. The third or fourth point I would make is on page 29 of our management comments, we've talked for years now since the beginning of the COVID-19 pandemic about the importance of sponsor support. We had an outstanding quarter in sponsor support. We had 41 loans that reached a maturity that were extended and modified. We had almost $70 million of additional reserve deposits posted in connection with those modifications and extensions. We collected $13.5 million of fees. We had over $80 million of unscheduled paydowns on those loans and $14 million of unfunded balances that were curtailed as a result. Some of those numbers are among the highest over the 13 quarters that we've been tracking and reporting that data. So while you did have three loans migrate risk rating-wise, which you'd always prefer not to see, they were identified credits. We had a number of really strong sponsor support examples in our modifications and extensions. The final point I'd make before I turn it over to Brandon is that you've seen an infusion of liquidity into the CRE space, as evidenced by the record level of RESG paydowns in the quarter just ended. We've been communicating for some time that we expected a high level of elevated RESG paydowns for a number of quarters. That reached a new height in the quarter just ended. That should not have been a surprise to anybody because we've been talking about it for a number of quarters now. But it does reflect the fact that there is a growing degree of liquidity for refinance options and that sponsors are reaching the point where they're willing to grab onto some of those refinance options. So that's my view on the credit quality front. I'll let Brandon address what he's seen at the ground level.

Yes, Stephen, I think you've correctly understood how we view the future here. Obviously, 2022 was RESG's record origination year. We originated $13.8 billion that year. We give that cadence chart in our management comments document and have for years. Tim, what page is that on? Page 13, figure 13. That shows that cadence. We have told people for years that most of these loans have a three to four-year life cycle. So it's no surprise to anyone that's been following our stock that we would have an exceptionally high level of payoffs in 2025, probably late 2025. You certainly saw that in the quarter just ended and in 2026 as those loans reach that three to four-year time frame. We've known since we were celebrating the extraordinary level of originations in 2022 that we were going to have to pedal hard to keep up in 2025 and 2026. That realization was a strong impetus behind our effort to really ramp up our CIB group and diversify and build its origination capabilities so that we could achieve a handoff with the growth baton from RESG as it was absorbing that payoff wave to another business unit that could match the quality we've traditionally had in RESG, that 12 or 13 basis point life-of-portfolio net charge-off number, that high asset quality, and also originate in significant volume. Our timing there, I think, was very good. If I were criticizing my leadership as CEO, I would have said we should have started CIB a year sooner and the timing would have been perfect. But we started it when we had the human resources lined up and felt like it was time to go. We're pretty close to spot on there. So what I think happens is that RESG repayment wave continues through 2026 as we grind through the natural payoff cycle from all those 2022 originations. Of course, there will be a few older and a few newer originations that will pay off next year, and some of the 2022 will slide to 2027. But next year is going to be the big payoff wave if the normal expected cadence holds true. CIB is growing. We've really ramped up the staff there. So I think those guys are going to carry the growth ball for us next year. Of course, we would expect our high-quality indirect marine and RV business to continue to grow at a similar rate to what it has grown this year. We would expect our commercial banking business to grow. With that big payoff wave, we think that gets us to a mid-single-digit loan growth rate next year. But once that payoff wave is behind us and RESG is beginning to contribute positively to future growth and we're not absorbing all those payoffs, we think we've got all of those growth engines really contributing in a meaningful way. That is going to lead us to some nice, very diversified growth in the portfolio in 2027 and years thereafter. At that point, you know, I think you're 40%, 30%, 38%, 32%, whatever. It's a much more balanced, almost three parts of the portfolio that are more or less equal, with RESG being the legacy dominant part, CIB being almost equal if not equal to RESG, and the commercial banking and indirect piece really filling in the final third part of that equation. I think that diversification is good for asset quality, good for eliminating some of this concentration risk that's weighed on our valuation, and good for growth. So we're really excited. I think we've positioned ourselves well to be in a really good place at that point from a growth perspective. We'll grind through with mid-single-digit growth next year, and a lot of banks out there would be happy with mid-single-digit loan growth. So we're feeling good about it.

Yes. And the CIB guys are very cognizant of that. They're focused on opportunities that not only meet our high asset quality and returns but also have high utilization rates because we're very sensitive from our history with RESG where we got almost as many unfunded as funded. That capital burden of all those unfunded loans really impairs our ability to be as efficient with capital allocations as we would like to. We've had those conversations. Of course, Jake and his team are a bunch of really smart guys. They didn't need to have that explained to them. So they are actually working to weed out some of our older legacy business in those books that has a very low utilization rate in preference to new business that's very high quality but going to have a higher utilization rate and less unfunded. So we're focused on that as part of the strategy.

Thank you.

Good morning.

Jake, you want to take that?

Yeah, I might add, you were talking about the NDFI loans, Jake, from your CIB group, but a chunk of our NDFI loans that show up on our call report are actually RESG loans. This goes back to our long-standing relationships with a lot of the debt funds that do commercial real estate lending. We compete with those guys. A lot of times, if they win a unit deal, they'll bifurcate it into a senior and mezzanine, and we're the senior lender and they're the mezzanine. Sometimes they want to hold that whole loan on their books but leverage it with a loan from us, and we do a loan to lenders or an NDFI loan to those guys. We underwrite our loan to them exactly and service it and manage it exactly as if we were the senior lender on that and if we were making the senior loan. So in our view, there is no difference in the way we rate or evaluate those loans or the risk profile of those loans versus us being senior and them being mezzanine in the transaction. So that's a big chunk of our NDFI loans. We feel really good about that. It's business we've been doing for many years with an exemplary track record. In CIB, we are looking at the portfolios of the lenders that we're leveraging. As Jake said, our attachment points are very low in those. It gives us a lot of comfort and insulates us from a lot of risk. I was appalled when I was listening to one of the news programs the other day and one of the executives from one of the lenders that has been caught in one of these situations was on there and he said, frankly, we just need to do better underwriting. I thought, my gosh, you're making loans to complex entities out there and you just now figured out you need to do better underwriting? We are thoroughly vetting and doing very diligent underwriting on these things. Jake really emphasized that, talking about a lot of our deals where we're a single lender or small group lender so that we're able to really influence that and dig in there and look at the underlying portfolios in great detail. Of course, we've got lockboxes and third-party servicers and other protections there that ensure we're doing those things the right way.

And that conservatism and thorough underwriting is evident in our pull-through rates. Jake, what are we running now, kind of rate?

As we've said earlier, we're looking for CIB to become 30 to 40% of our loan book over the next several years. Obviously, even if we were 3 or 4%, we would be paying close attention to it, but realizing that it's going to become a book that we expect to rival our RESG book as far as volume, we're certainly intent on doing this right.

Happy to address that. If Cindy were here today, and she's off and not with us today, but if she were here, she would tell you that our predominant interest-bearing deposit product is a 7-month CD special. We have other maturities, but probably 80% or more of our CD issuance is in that 7-month time frame right now. So our variable rate loans typically tend to reprice around the time of a Fed cut. Those CDs are going to reprice 7 months later, more or less. So that's a good example, Matt, of why there's a two-quarter lag more or less. You see spread getting compressed a little bit for a couple of quarters after a Fed cut until that deposit pricing catches up. You certainly will see that this quarter. I would expect with the September Fed cut and likely one or two more this quarter, we're going to be chasing those loan yields for a couple of quarters with our deposit costs until the Fed stops, and a couple of quarters after that we should catch up. Now, the other side of that equation is important, and we've included in our management comments on page 19, figure 20, the floor rates in our variable rate loans. At September 30, 22% of those variable rate loans were at their floor. If the Fed cuts a quarter more, 36% will be at their floor, and 50 basis points, 41%. So as we get to that 36% and then into the 40% numbers, those floor rates significantly slow down the repricing or stop the repricing of some portion of our variable rate loans. That gives us the ability to catch up that margin differential much more quickly. So I would tell you, given where the floors are now, it's probably a couple of quarters of compressed margin following Fed cuts to catch up. But as we go through more Fed cuts, if we end up with three or four or five Fed cuts, we're going to begin to derive some meaningful benefit and shorten that catch-up period because we'll have a lot of those loans that will no longer adjust downward.

Yes, I think that's an accurate interpretation. We think that we can achieve record net interest income and record EPS next year. It's going to require a lot of work to do that, and probably the year-over-year gains will be relatively small, as they've been this year, while we've been building out a lot of this infrastructure for the future and absorbing the beginning of a lot of these payoffs. But we're putting up positive numbers year-over-year. We would expect to do that next year and then to really see the benefits of all that investment kick in significantly in 2027 and future years.

All right, thank you.

That's a good question. Obviously, on our CIB book, we typically have a little lower spread than we do on our RESG book. We do get some fees and more treasury management opportunities and other miscellaneous fees on that book. Jake mentioned that as our customers go to capital markets, whether for bond issuance or equity issuance, we now have through our CIB team a unit that shares in those fees and lets us participate in that. So net-net, I think CIB's revenue generating capability is not far off on a pound-for-pound basis. Where we really will equalize or actually benefit from CIB is as CIB becomes a bigger part of our book, and particularly if they can achieve the higher utilization rates on their credit lines that we are striving to achieve there. We will not have as much unfunded loan commitments on that portfolio, and the diversification and elimination of our CRE concentration will let us be a little more judicious in our allocations of capital. So I think on an ROE basis, CIB will help us actually improve our return on equity, even if on an ROA basis there's a slight deterioration in ROA, because I think it will allow us to be much more judicious in the use of our capital.

The one item that Jake and I both neglected to mention that's really super important is our deposit opportunities for non-interest-bearing deposits or low-interest-bearing deposits, low-cost deposits through CIB is really an important part of the return on equity equation on that book of business. Obviously, we strive to get deposits with our RESG loans, but commercial real estate loans just don't have anywhere near the same level of deposit opportunities for low-cost deposits that you get with a CIB type of book. So that's a big part of the equation as well.

That's a great question. Obviously, all that RESG book is variable rate loans. There are a lot of floors in there, but we're not at the floors unfortunately on a lot of those loans. So our sponsors will in large number benefit from additional Fed rate cuts. A lower rate environment also creates additional opportunities for them to go to a permanent loan or go to a bridge lender that may be loaning them higher leverage money or cheaper money that will be attractive. So Fed cuts will tend to magnify to a small extent the rate of RESG loan repayment. So it's a good thing on the quality side, good for our customers. It's a bad thing on the repayment side, but all these loans are going to pay off sooner or later, one way or the other. So we're happy for our customers to get a good exit if market conditions allow that. Your other question about what else is out there and what are we watching? I would tell you we have guys that watch every loan in our portfolio every day. So we're looking at everything all the time. That's part of the secret of the success we've had over our history as a company and certainly our 28 years since we went public where we beat the industry's charge-off ratio every year. We're paying attention and servicing our loans in a very effective manner. As far as how do you know when something is going to migrate to those problems? Deteriorations in value, deteriorations in market conditions, failure to lease, all really are kind of summarized on page 29 of our management comments where we talk about sponsor support. That really is the key. Are our sponsors going to continue to support their projects until they get them leased or get them sold? We've said this. We said when the COVID pandemic started that we expected most of our sponsors would continue to support their projects until conditions normalized. We've reemphasized every quarter since the Fed started raising interest rates 13 quarters ago that we expected most of our sponsors would continue to support their projects until conditions normalized. Now there are obviously a handful of exceptions, and sponsor fatigue and energy and resources to support projects gets exhausted over a prolonged period of time. So we've seen some examples of that, but they've been a limited number of examples. When we've seen those examples, that's when loans become special mention, that's when loans become substandard, that's when loans move into the OREO book and then get liquidated out. So I would say the same thing I said at month one of the COVID-19 pandemic and after the first Fed increase: we expect the majority of our sponsors, the vast majority of our sponsors, will continue to support their projects until they get a successful conclusion. They'll do it because they're high-quality sponsors. They have high-quality assets and they have a ton of money invested in them, and that keeps them engaged in the projects. We will have some along the way where they'll just become exhausted in their ability and energy and resources to support a project. We'll deal with those when we do. I think we're very well reserved for what we think is a plausible set of scenarios in that regard.

Brandon, you want to talk about life science?

Good morning.

We certainly don't want to get ahead of our sponsor here in their negotiations. They are working hard on leasing. They're also evaluating how to recapitalize that project for a longer runway. Our reserve on it, as I said in my preliminary comments to the initial question, reflects a wide range of scenarios here. So I think we're very well reserved on this, and we're going to let our sponsor continue to work this and endeavor to execute on it, and we'll see how that plays out over the next couple of quarters.

Yes, you are correct in surmising that our expectation for continued decline in RESG commitments is really driven by the payoffs. I think it is very likely that our very low volume of originations in the quarter just ended was an anomaly. You can never say that for sure. We'll be glad to put up another quarter of results and prove that. Hopefully we will. What I can tell you is that we've already originated in the first two weeks or so of the current quarter about half the origination volume or a little more that we originated in the whole quarter last quarter. Those transactions, I think there are three of them that we've already closed this quarter, would have been transactions we actually expected to close last quarter, but for one reason or another, they got pushed into this quarter. So we hope we'll return to a much more typical and normal level of originations in Q4 and future quarters. As I mentioned and as we mentioned in the management comments document, there are not as many new CRE projects being originated, just reflective of all the various market conditions out there. There are a lot of lenders chasing those projects. So you've got a situation where you've got too many lenders chasing too few projects. That is leading to some structures and pricing and leverage points that we would not go to. That is having an impact on our origination volume. But even with that, I do think we will return, more likely than not, to a better, more typical origination volume in Q4 and future quarters.

Thank you.

Brian.

Let me tell you that we have a wonderful leadership team in our CIB group, and it's not just Jake but the leadership team under him. They are doing a great job of recruiting top-tier veteran talent to the team. They're being very careful about it, but they're also being very active out there in the market. Jake, I'm going to come to you and let you unmute and talk about that and give a little additional color.

Let me add, Jake is operating this addition and expansion of his staff under a gating metric that Brandon and I are monitoring. That metric is really volume and revenue generation. As his volume grows and revenue from his business line grows, he can add the next guy or the next three guys. There's a gating metric on that. We are adding very high-level team members. They're very well paid. They're veteran people. So you're paying for the experience and the knowledge and the relationships that they built over decades in most cases. It's not inexpensive to build this team. It's expensive to build this team, but we're being very disciplined about the way we do it. We're getting revenue in place to generate positive leverage before we add the next person or the next group of people. We get positive leverage on that group, then we get the next group. So Jake is growing it in a very responsible manner. We're building it with high-asset people in a very professional manner. That's why I think we talk about 2027 being these guys really hitting full stride. We will have added a lot of additional people to their world between now and 2027 that will generate a lot of additional growth opportunities across a very diverse first book of business. CIB, we're talking a lot about our desire to diversify our portfolio more. CIB is inherently internally diverse in what they're building, and that's another big plus out of that.

Hey, thank you guys all for being on the call today. We greatly appreciate it. We look forward to talking with you in about three months. Thank you. Have a great day. This concludes our call.