Good day, and welcome to the Popular, Inc. Q2 2017 Earnings Conference Call and Webcast. [Operator Instructions] Please note, this event is being recorded. I would like to turn the conference over to the Investor Relations Officer, Brett Scheiner. Please go ahead, sir.

Good morning, and thank you for joining us on today's call. Today, I'm joined by our Executive Chairman, Richard Carrión; our CFO (sic) [ CEO ], Ignacio Alvarez; our CFO, Carlos Vázquez; and our CRO, Lidio Soriano. They will review our second quarter results and then answer your questions. They will be joined in the Q&A session by other members of our management team. Before we start, I would like to remind you that on today's call, we may make forward-looking statements that are based on management's current expectations and are subject to risks and uncertainties. Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today's earnings press release and are detailed in our SEC filings, our financial quarterly release and supplements. You may find today's press release and our SEC filings on our web page at popular.com. I will now turn the call over to Mr. Richard Carrión.

Good morning, and thank you for joining the call. As we shared with you on our last webcast call, on July 1, I became Executive Chairman; and Ignacio Alvarez, who had been President and COO since 2014, stepped in as the new CEO. Since the second quarter was my last one as CEO, I wanted to make some brief comments and then hand the call over to Ignacio, who will lead this and all webcast calls moving forward. As I said last quarter, we are carrying out this transition at a point when Popular is in a solid position in terms of capital, performance and management. We are aware of the challenges we face, the Puerto Rico situation being the most important one. As we have said repeatedly, using a three-legged stool analogy, an effective long-term solution must include fiscal discipline, debt restructuring and economic growth. We believe that the first 2 are being addressed, though the processes will certainly be bumpy at times. We're more focused on the third and most important aspect in the long run, economic growth. As the largest financial institution on the island, we will keep on pressing the issue and finding ways to help get the Puerto Rico economy back on the path of sustainable growth. As Executive Chairman, I will continue working with Ignacio in areas, such as innovation and technology, social responsibility, government and client relations and other strategic growth initiatives. I'm proud to see how everyone is handling this transition. Ignacio has assumed his new role with enthusiasm and confidence. And his management team is united and energized. Therefore, I have absolute confidence that Popular is in great hands and will keep forging ahead. So let me turn it over to Ignacio to discuss the results of another strong quarter.

Thank you, Richard. I accept this new role with much humility. Following the footsteps of such an iconic leader as Richard, who in many ways, is the Founder of the modern Popular. Fortunately, he has agreed to remain as Executive Chairman, and I look forward to working with him in the areas he mentioned. I also look forward to working closely with our senior management team and with more than 8,000 colleagues who are at the heart of this organization. As Richard said, Popular has come a long way, a result of everything we have achieved in recent years. We are in a strong position to take advantage of the opportunities that may develop. We intend to focus on maximizing the unique retail franchise we have in Puerto Rico and continue enhancing our U.S. business. We also have an opportunity to tap our existing infrastructure on the island to obtain efficiencies and generate additional sources of revenue. The transfer of support functions from the U.S. to Puerto Rico that we completed 2 years ago is an excellent example of these opportunities. Also, we can further leverage technology and simplify our processes to deliver our customers' simple and effective solutions to meet their financial needs. We are fully aware of and prepared to manage to the challenges presented by the current operating environment. We have in place the team that is key to executing on our priorities. And we will continue to strengthen all of our people-related processes to ensure that we attract, develop and retain the best talent in our markets. Now let me direct the highlights of the second quarter. Please turn to Slide 2. In the second quarter, Popular reported net income of $96 million, up from last quarter's net income of $93 million, reflecting strong top line…

Thank you, Ignacio, and good morning. Slide 3 presents our financial results for the second quarter. Additional information is provided in the appendix. Today's earnings press release details variances from the first quarter, driven by higher net interest income and lower operating expenses, somewhat offset by higher provision for loan losses. Net interest income for the second quarter was $374 million, up $12 million from the first quarter, mostly due to higher revenues from higher volume of money market and investment securities, as well as higher yields on securities and loans. Our net interest margin was 4.02%, down from 4.08% last quarter, mostly due to additional short-term investment balances caused by increased public deposits. The average yield of our $1.7 billion Westernbank loan portfolio increased to 8.73% from 8.53% last quarter. Run-off in this portfolio has slowed considerably in recent years. Over time, we expect this yield to decline as a result of repayments and loan resolutions. The cost of our interest-bearing deposits was down 3 basis points to 53 basis points. We continue to deliver organic commercial loan growth in our U.S. operation with growth of 4% in the second quarter and a continued strong pipeline. We also saw some loan growth in Puerto Rico for the second quarter. For the remaining -- remainder of 2017, we anticipate slight growth in overall loan balances with U.S. growth more than compensating for Westernbank run-off and limited growth in Puerto Rico. On the island, we have offset limited organic growth with selective loan portfolio purchases over the last few years. We will continue to pursue this acquisition strategy if attractive opportunities become available. The second quarter noninterest income line includes an $8 million OTTI charge from our Puerto Rico securities exposure to COFINA bonds. Subsequent to quarter end, these bonds were…

Thank you, Carlos, and good morning. Despite the continued challenging economic and fiscal conditions in our main market, overall asset quality remains stable during the second quarter of the year. In Puerto Rico, credit quality metrics reflect lower NPLs, lower NPAs, lower NPL inflows and higher net charge-offs. In the U.S, credit metrics reflect strong portfolio growth, stable NPLs, stable NPL inflows and stable net charge-offs. Please turn to Slide #5. As Ignacio covered earlier, our current outstanding current exposure to the Puerto Rico government, municipalities and other instrumentalities is $517 million, relatively unchanged compared to the prior quarter. After quarter end, we sold the remaining central government exposure. Our municipality exposure consists mainly of senior priority loans to a select group of municipalities, whose revenues are independent of the central government. In most cases, the good faith, credit and unlimited taxing power of each municipality is pledged to the repayment of the loans. Our top 4 exposures are to Carolina, where the airport and several major tourist hotels are located; San Juan, the capital of Puerto Rico; Guaynabo, the municipality with the highest per capita income; and Bayamón, the second most populous municipalities. These municipalities comprise 77% of our total exposure. As discussed in previous webcasts, the oversight board certified an amended 10-year fiscal plan for Puerto Rico in February. Among other things, the fiscal plan provides for reduction of general fund subsidies to Puerto Rico's municipalities. Such subsidies constitute a material portion of the operating revenues of certain smaller municipalities, though only representing 7% of revenues for the largest municipalities that make up our portfolio. We also have indirect lending facilities in which the government acts as a guarantor. The largest such exposure is in the form of residential mortgage loans to individual borrowers in which the government…

Thank you, Lidio, and please turn to Slide 9. Before we open the lines to questions, let me conclude today's remarks by reviewing our progress and our outlook. This quarter was characterized by strong revenues and stable credit, with loan growth in both Puerto Rico and the United States. Our unique Puerto Rico franchise and healthy market share continue to produce strong results. Notwithstanding the environment, we have continued to grow our customer base. We have also maintained low deposit costs despite several increases in short-term interest rates. We are convinced that while the Puerto Rico economic situation presents challenges, it also presents opportunities that we intend to pursue. At the same time we managed through the local economic situation, we continue to make long-term investments and new business initiatives in both the U.S. and Puerto Rico as we pursue our goal of continuing to evolve toward a stronger and more diversified institution. We also benefit from our EVERTEC ownership and our stake in Banco BHD Léon, the second largest bank in the Dominican Republic. In addition, to participating in our proportionate share of these companies' earnings, the value of our EVERTEC position significantly exceeds its book value. We continue to pursue capital deployment and distribution opportunities, as evidenced by the increase in our quarterly common stock dividend from $0.15 to $0.25 a share and a common stock repurchase plan of $75 million executed early this year. We remain confident that Puerto Rico will emerge from the current challenges with a more vibrant and diversified economy, and we are working hard to achieve this outcome. With more financial and human capital than ever before in our history, I am confident that Popular's best days lie ahead. We look forward to updating you on this progress over the coming months. And with that, I'd like to open up the call for questions.

[Operator Instructions] The first question comes from Alex Twerdahl. [Technical Difficulty] The first question comes from Joe Gladue.

I guess actually, I guess just start with just one question on the residential product project that came from -- with Doral. You mentioned there's structural damage. Can you just elaborate a little bit on what happened there?

Yes. Well, Joe, this is Ignacio. There's some ongoing legal controversies around that situation. But just these are residential mortgages that we purchased from Doral. And there -- within it, one specific residential project that we just -- there were some structural issues that -- can affect actually the value of the homes. And as a result, we decided to take a charge on that.

And we've completely charged off, the exposure that we had.

Okay. Let me touch on your comments on the municipality portfolio and the potential cutoff of funds from the central government. Have you -- I guess, you still feel confident that there's enough cash flow there? Or do you consider exiting those loans, disposing of those loans? And if so, is there any appetite for that kind of troubled asset?

This is Ignacio. I'll turn it over to Lidio, but I would not characterize them as troubled assets. Those are -- there are assets that we feel comfortable with. They're performing. And we had no current intention to dispose them. So I'll let Lidio comment any more if he wants to.

Just maybe to add. As we have mentioned numerous times, our portfolio is mostly comprised of the larger municipalities, but are less dependent on the central government. As we alluded to in the prepared remarks, they are -- they only depend on about 7% of the total revenues from the central government. We feel comfortable. We think they have the flexibility to withstand the fact that they are not going to receive additional funds on a going-forward basis.

Okay. Let me turn a little bit to net interest margin. And just if you could comment a little bit, I guess, both on the Puerto Rico and mainland markets, just in terms of deposit pricing pressures.

I'll let Carlos comment on that. But we haven't actually seen a lot of deposit pricing pressure in Puerto Rico so far. Our margins were affected by the increase in Puerto Rico government deposits. But I'll let Carlos cover more detail...

As we reported, our cost interest-bearing deposit has actually came down slightly, Joe, for the quarter. We do have a dynamic that is in our balance sheet that is almost exactly the opposite of that of many banks for the quarter. Many banks in the quarter have reported slower deposit growth, higher loan growth and the corresponding reduction in cash balances. We've actually had the opposite in each one of those categories. And that we continue to have healthy deposit growth, more muted loan growth, and therefore, growth in cash balances. So the dynamics of our margin were exactly the opposite as that of many other banks. But if you go to the levels and yields in our press release, you will note that the asset yields have actually held very well or actually increased in many categories. So this is not a -- that margin is an issue, almost completely a balance sheet composition and a higher level of lower-earning cash or cash equivalent, and not an issue of building our assets.

The next question comes from Alex Twerdahl.

A couple of questions here. It's been a couple of months since we've seen the fiscal plan. And I believe the budget has been presented and approved at this point for 2018, for fiscal '18. Have you seen anything in the budget that would cause you to reassess your provisioning levels or your credit outlook over the next couple of quarters?

No, I think the budget came in around what we expected. Obviously, the biggest change in the budget from prior years is that a substantial amount of the pension obligation is now what they call a pay-as-you-go, which is in the budget. So if you take into account that pay-as-you-go, an additional funding for health cost, it's probably about $2 billion that had to be -- so we had to take out expenses from other government expenses. We were anticipating a decrease in government spending. We're watching the situation very carefully. So far, credit has held up very stable. We're not seeing any early signs of trouble. Obviously, this is the first budget under the board, so we're going to continue to monitor it very carefully. I don't know if Lidio, you want to add anything else to that.

No.

Okay. And then just to expand on the margin question from previously. I understand that the balance sheet complexion plays a big role in how the margin looks. And you guys are sitting with the pretty outsized cash position right now, not earning what it potentially could if you were to go out and purchase something a little bit longer duration. And previously, it's been a lot of government deposits. We're not sure how they're going to behave, the behaviorization of those and whether or not they're not going to flow out at any point in time. Do you have a better sense now for whether or not those can be invested at all? Or do you think we're just going to stick with higher levels of liquidity for the next -- or at least for the foreseeable future?

We don't have a very clear outlook on exactly how the funds are going to move, Alex. We -- it is our expectation that we should be close to peak levels since most of the tax revenue just came in during the second quarter. And that as a result, those balances should start coming down for the rest of the year. But again, this is the first time we'll go through this part of the cycle under the new budget with the fiscal board involved. So we'll have to watch it. It is our expectation that the balances should start coming down through normal cycle of inflows and outflows for the government.

Okay, great. And then just a final question on the M&A outlook for North America. I know we've talked in the past about sort of what the criteria is. But I'm just curious, as you look out and you have this DTA valuation allowance still outstanding in North America and potentially could be recaptured in the deal, how important is that? And is it something that plays into the conversations of what you would or would not do in terms of an acquisition in North America?

I think the way we -- the DTA is a part of how things are considered, but it doesn't drive any decisions. The decisions have to make sense on their own basis. And if they do, then the potential positive effect of DTA is an additional benefit, but it doesn't drive any.

The next question comes from Scott Valentin.

This is actually Jesus Bueno for Scott Valentin. It was positive to see a postperiod end loan growth and it was both in the Puerto Rico and on the mainland as well. I guess I -- could you provide some color around there, especially as it relates to kind of Puerto Rico and commercial consumer trends there?

I think that in the U.S., the loan growth has been consistent. And we continue and we expect it to continue to grow. The changes from quarter-to-quarter may vary, but we consider -- Puerto Rico is going to be more lumpy. We had a large loan in the quarter that helped us achieve loan growth. So again, I think the earlier comments that Carlos has made earlier, we expect the U.S. loan growth to compensate for basically stable balances in Puerto Rico. We -- in the long run, we don't expect -- loan -- short to medium term, we don't expect consistent loan growth in Puerto Rico. The environment still is challenging here.

That's fair, I appreciative that. And I guess as it relates to the U.S. loan growth, obviously, commercial has been one of the areas you've been growing there. But on a consumer portfolio, it looks like it was up a bit, but I know you've been supplementing that with purchases. I guess that just going forward, I guess the strategy behind there is the intention there to grow the consumer portfolio through additional purchases? Or is it more kind of maintaining that -- those balances?

Yes, I mean as you recall, we had done a number of purchases from Lending Club in the past. That activity stopped in the middle part of last year. But we've revaluated the performance of portfolio and make sure we've cleared up anything else that needed to be cleared up. We did restart purchases earlier this year. A lot of those purchases are reflected in the consumer portfolio in PCB in our U.S. operation. So there's some of that. It is important though to remind you that we essentially are -- we think of this Lending Club purchased as simply as a different channel origination. This is not a new product for Popular. It is personal loans. We have been in personal loan business for a long time. It's a product we think we know well. We are also not purchasing a portion of everything that Lending Club originates. We are purchasing things that fit our own underwriting criteria within the things that they originate. So the right way to think about it is that it is another channel for us to originate the same type of loans that we would do on our own. But some of the loans in the quarter was linked to our restart of the -- of those purchases. So balances are slightly higher on that. We have purchased a bit more than has been maturing over the last quarter.

That's helpful. And if I can just ask a follow-up on the LC loans you've been purchasing. Have those -- I guess relative to your initial expectations when you started the program, how have the loans performed?

I think generally, they have performed as expected. I think when you look at it on a grade business, the lower grade has performed a little bit worse or worse than we expected and the better grades have performed better than expected.

The next question comes from Brett Rabatin.

One, just point of clarification, just first. How much were loan purchases in the quarter? And then if we think about the back half of the year, how much are you planning additionally?

This is Jorge García. The growth loan purchases were about $150 million in -- on a year-to-date basis. So that's about half of that in the quarter. On a net basis, including run-off in the portfolio, the total was around $72 million, including both the U.S. and Puerto Rico.

Okay. And then what's your plan on dealing with the back half of the year?

I think we mentioned earlier that we're shooting to get back to the levels of where the Lending Club program peaked in the middle of last year. And that was around -- between [ $200 million and $220 million ].

Having said that, we have to reassess our position, the performance of the portfolio. And we make changes based on that.

And the purchases this year have been Lending Club related?

Yes.

Okay. And then wanted to just ask on expenses. They were lower than expected this quarter relative to your guidance, but you're kind of reiterating -- if I understood correctly, that same guidance for the back half of the year quarterly. So was there a timing issue with technology software spending in 2Q? Or can you give me more color around the expenses, which were a little lower than expected in the second quarter?

No, I think you got it right. There is a timing issues. There's ongoing, a number of ongoing projects or processes. Some of them were simply delayed within the year. So that ends up back ending into the year some expenses that were in our budget. And in the original version, they may have been partly in the first and second quarter. Some of them have moved to the third and fourth quarter. So it is mostly a timing issue. Again, we will always try to beat that number if we can. But when we look at rest of the year, it looks consistent with our prior guidance.

Okay. And then I wanted to just ask on the higher specifics -- reserves for the mortgage portfolio. Can you talk maybe about that allocation? And then I saw that the Treasury Secretary is asking for another $100 million out of the budget this week. And so I'm just curious to hear your thoughts on the portfolio as you see it kind of exposed to the pieces of the budget that are being cut.

In terms of the mortgage portfolio, I think we have had higher reserve in Puerto Rico this quarter. This was driven by the real performance of the portfolio, higher charge-offs and our reassessment of the expected realization upon sales of foreclosed properties quarter-over-quarter. And I don't have any more color to add than that.

Yes, with respect to mentioning the budget, I think what you're referring to is that upon the Governor's request, the Secretary Treasury asked almost every department for 5% additional savings in expenses. They're trying to build additional cash reserves with the aim of avoiding -- having to do any hour reduction of the -- one the things that the board had mentioned that they didn't meet certain target in terms of reserves and savings, that they may have had to have a reduction in the work week. So they're working hard to avoid that. So in effect, if they can avoid the work week, I think it would be -- have a less of an impact on the economy than reducing 5% of each, so that's what's driving that.

Okay. And then just to make sure I understand your -- it sounds like from a margin perspective, we've been talking about how high the deposit balances could be with the government. They continue to be higher than expected, but it sounds like you're not comfortable investing any of that large amount of excess cash and any kind of securities or do anything differently with it.

We have done some of that. The investment portfolio did go up slightly in the quarter. But again, we'll be a little bit cautious deploying it that way. But if some of that has actually happened -- again, if you combine that with what I expressed earlier, our expectation that this should be close to a peak level of deposit, but some of that should run off in the next 6 months.

The next question comes from Ken Zerbe.

Just kind of want to go back to the cost of funds. If you look at schedule or Table D of your press release, the NOW and money market deposits looks like they were up, whatever, they're $1.4 billion. The cost on those, and that's what I wonder about. The cost were down about 5 basis points. And presumably, that's where you put the government deposits, if I'm not mistaken. But did you have like a special negotiated rate on the government deposits? Is that why the deposit cost and that piece actually came down? Or did you make an across-the-board cut overall on your, on your market rates?

Ken, I think that the government deposit is actually spread in all this line. There's different relations with different entities. So they actually don't affect only one line, they affect a number of different lines and are negotiated -- or the commercial relationship with each entity or different entities will dictate some of the costs related to that. Some of that is also related to other services that we provide the government. So sometimes, the counterpart of some of the deposit balances are services that you don't see here as a deposit cost. But there may be fee income somewhere else. It has to do with deposit balances.

I think, in general, we've been holding steady our deposit cost across the bank. So it's not just government money market. I mean generally, we've had a lot of discipline in our deposit pricing.

Got it. Maybe a different or more pointed question. What rate are you paying on average on those government deposits?

We haven't disclosed that.

Yes. And we generally don't disclose when we pay specific price.

Understood. But you understand why I'm asking, just a sharp drop in rates on that particular piece. But I understand. Maybe a different question. Just in terms of -- going back to the muni exposures you have to the Puerto Rico. I heard your answers to an earlier question. But I guess I'm just trying to figure out like what are you playing for? Like why not sell the remaining Puerto Rico muni exposure? Like is it --are they at very attractive yields or underpriced or --? Because it just seems like a lot of headache and there's still a lot of issues that could potentially plague those securities irrespective of where they get the cash flows today.

Well, I think there, we would disagree. We have not had a lot of headaches again. Our 77% of our total exposure to municipalities come from 4 municipalities, which we have a long-term history of representing and providing services to and providing credit to. We don't really view it as a headache. And right now, given all the headline news, we would think it would be a very unwise position to sell it, probably would have sell on a discount on loans that we considered to be performing and doing well. So we monitor the situation. But it is not one, what I would call, a headache for us. They pay on time. And we provide a lot of services to them. And they're also our clients, important clients to the bank in terms of deposits and other services.

Ken, we have a pretty good track record of trying to identify credit issues when they exist and take action on them when we believe they exist. And you can look back on our treatment of PREPA, for example, where we were the first bank to reserve against it and to reserve against it to an extent that most other banks didn't. You can look at another example in the taxi medallion portfolio, where we have been very careful in how we have valued our portfolio, we have reserved our portfolio. Only now are some of the banks reserving to the point where we have reserved our portfolio. So we try to be very judicious on credit and take action when we think action is warranted. And in this portfolio, we don't think action is warranted.

The next question comes from [ Glenn Menna ].

One of the opportunities has been discussed in terms of dealing with the Puerto Rico government as it shrinks, is that there was the chance for some services to become privatized and private businesses to work more with the government. Could you give us an update on what role Popular's playing in that right now?

Well, right now, we are looking very closely at the opportunities that are going to develop. The government is really just beginning this process. But you're right, there will be opportunities in a number of services that the Puerto Rico government is offering. One of the most interesting maybe the administration of the pension. There's a pension reform going on. They're going to continue their evolution to more like a 401(k) type plan that's going to require administration, that's going to require a lot of recordkeeping and things. They have not come out with an RP yet or a bidding process, but we're watching that very carefully. We think there will be a lot of opportunities for us to help the government receiving payments for the different services the government offers. We have an unparalleled retail, reach around the island, we're in every municipality, except 2, including the island municipalities of Culebra and Vieques, so no one else can offer that kind of exposure that we can. We think there will be, in the area of infrastructure eventually, we got a new revitalization coordinator finally under the PROMESA statute. The person seems to be highly competent, highly experienced. So hopefully, we'll start to see private-public partnerships. And hopefully, we can play a role in that. So we're looking very carefully. It's at its early stages. Obviously, we believe that we have unique capabilities to many of these things because of our reach around the island. So we're going to be aggressively pursuing them as the government puts them out for bid or RFPs.

And last year, at this time, there was some suppliers to the government that were kind of in limbo with regards to the payment. What are you hearing from your suppliers now? And how are they getting paid from the government -- who supply to the government?

Ironically, every case is different, but since the government has had the litigation state, and it's not paying its debt, it's been slowly paying down its supplier debt. So the situation, I believe, is getting better from certain clients that we received they're getting their payments. So I think the government is slowly trying to bring that down. I don't know if you're aware, but one of the element, the key elements of the 10-year fiscal plan is a reduction in supplies -- debt to suppliers. So that's incorporated in the 10-year fiscal plan. And therefore, in every budget, there has to be some movement towards that end of paying it down. So the situation's certainly not getting worse. I think it's slowly getting better. And we'll see that discipline hold through.

[Operator Instructions] This concludes our question-and-answer session. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.