Popular, Inc. (BPOP) Q2 2022 Earnings Report, Transcript and Summary

Good morning. Thank you for attending today's Popular, Inc. Second Quarter Earnings Call. My name is Francis, and I'll be your moderator today. All lines will be muted during the presentation portion of the call with an opportunity for questions-and-answers at the end. [Operator Instructions] I would now like to pass the conference over to our host, Paul Cardillo, Investor Relations Officer at Popular.

Good morning, and thank you for joining us. With us on the call today is our CEO, Ignacio Alvarez; our CFO, Carlos Vazquez; and our CRO Lidio Soriano. They will review our second quarter results and then answer your questions. Other members of our management team will also be available during the Q&A session. 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. You may find today's press release and our SEC filings on our webpage at popular.com I will now turn the call over to our CEO, Ignacio Alvarez.

Good morning and thank you for joining the call. The second quarter was another strong one in which we achieved net income of $211 million. Our results reflect the strength of economic activity in our markets, our diversified sources of revenue, and prudent risk management. Reported net income was in line with the first quarter and $7 million lower than the same quarter of 2021. Compared to the first quarter, second quarter results were characterized by positive variances in net interest income and fee income, which were offset by higher provision for credit losses, operating expenses and tax rate. During the quarter, loan growth was solid and broad base, both geographically and across most loan segments. Commercial loan growth was particularly healthy during the period at both, Banco Popular and Popular Bank. Our margin in Puerto Rico improved in the second quarter, but continues to be impacted by our asset mix. We are positioned to benefit from higher market rates, although to a lesser extent due to lower asset sensitivity. Credit quality trends continue to be favorable during the period with a low level of net charge-offs and decreasing non-performing loans. On July 1st, we closed the previously announced agreement with Evertec to acquire key customer facing channels and to extend important commercial agreements. This transaction will allow us to continue to accelerate our ongoing digital and business transformation as we continue improving our clients' experience. With the ability to manage our key customer channels and greater flexibility to choose our technology partners, we will be able to enhance the service and customer solutions that we offer with greater agility. We will continue to enhance our omnichannel experience to meet the changing needs and expectations of our clients. Finally, we continue to return capital to our shareholders. On July 12th, we completed the previously announced $400 million accelerated share repurchase program. Please turn to slide four. Our customer base in Puerto Rico grew by approximately 6,000 in the second quarter to reach 1.96 million unique customers. Adoption of digital channels among our retail customers continues to be strong. Active users on our Mi Banco platform exceeded 1.1 million or 57% of our customer base. Additionally, we are now capturing nearly two-thirds of our deposits through digital channels. This trend remained significantly higher than pre-pandemic levels. Commercial loan growth was strong. Excluding PPP loans, commercial loan balances at BPPR and PB increased by $327 million and $275 million, respectively. Auto loan and lease balances at BPPR increased by $114 million or 2% versus the first quarter. The dollar value of credit and debit card sales of our customers remained at very healthy levels during the quarter, just 1% below the high watermark set during last year's second quarter. While there continues to be strong demand for housing in Puerto Rico, mortgage originations have been impacted by rising rates and limited inventory of available properties. The dollar value of mortgage originations at BPPR decreased by 42% compared to the second quarter of last year. Please turn to slide five for an update on the current macro environment in Puerto Rico. The local economy continued to perform well during the second quarter, as business activity and customer spending remained strong. The Puerto Rico Economic Activity Index, which includes total employment, cement sales, electricity generation, and gasoline sales has been steadily improving and has exceeded pre-pandemic levels for the last seven months. We remain encouraged by the strong employment levels. In the second quarter total non-farm employment in Puerto Rico reached its highest level in a decade. The June 2022 unemployment rate of 6.1% is the lowest for at least the past 60 years. It is especially encouraging the decrease in the unemployment rate was accompanied by continued stability in the participation rate. New auto sales decreased by 10% in the second quarter compared to the same period in 2021, but remained above pre-pandemic levels. The auto industry continues to be affected by supply chain product shortages. Despite these challenges, there continues to be remote demand for cars in Puerto Rico. The tourism and hospitality sector continues to be a source of strength for the local economy, as Puerto Rico is a proper destination for Mainland residents. Airport traffic has remained robust. Year-to-date, total passenger traffic has increased by 17% compared to 2021. Hotel demand has also remained strong. In June, occupancy rates in Puerto Rico were 77%. Year to date, the average daily room rate is nearly $300, which is the highest level in more than a decade. In short, we are very pleased with our results for the second quarter. While attentive to the evolving geopolitical and inflation risk and their impact on the economy and our clients, we continue to be optimistic about the prospects for the future. I’d now turn the call over to Carlos for more details on our financial results.

Thank you, Ignacio. Good morning. Please turn to slide six. As usual, additional information is provided in the appendix to the slide deck. Today's earnings press release details variances from the first quarter. Net interest income for the second quarter was $534 million, an increase of $40 million from Q1. The variance was driven by higher yield on investment securities, as well as higher income from loan growth at both banks. This was somewhat offset by lower PPP related income and slightly higher interest expense on deposits. Non-interest income increased by $3 million to $157 million. Other service fees increased due to higher credit and debit interchange fees resulting from growth in purchasing activity during Q2. This was partially offset by lower income from investments held under the equity method by $3 million. We expect that the average level of quarterly non-interest income will remain at around $155million to $160 million for the rest of 2022. The provision for credit losses for the second quarter was an expense of $5 million compared to a benefit of $16 million in the first quarter. Total operating expenses were $406 million in the quarter, an increase of $4 million from Q1. The increase was driven primarily by three factors: higher professional fees by $6 million due to higher processing and service charges; credit and debit card processing expenses were up by $4 million due to increased customer activity; and personnel costs were $2 million higher, driven mostly by profit sharing plan accruals. These expense increases were partially offset by a $6 million decrease in other operating expenses, primarily due to lower legal reserves and lower OREO expenses by $5 million due to gains on the sale of OREO properties. For the remaining two quarters of this year, we now expect expenses to average $445 million per quarter. This brings the total average quarterly expenses for 2022 to $425 million, up from the previous guidance of $415 million. The increase is driven by the following: First, given our results year-to-date, we anticipate a full year 2022 net income will exceed the threshold required to trigger employee profit sharing. As such, we are now including the anticipated expense for the year into our outlook. Second, during the quarter, we undertook a broad-based market review of employee compensation to ensure that we remain competitive. The outcome of this process led to higher employee salaries across the Corporation, which will increase our personnel expense run rate starting in the second half of this year. Third, the evolution of market and regulatory expectations, as well as increased customer activity will require us to continue to increase expenditures at certain areas such as compliance, fraud, and cyber security. And finally, given the pace of change in the financial services sector, we will incur additional expenses as we invest in our digital offerings and launch other early stage initiatives to enhance our customer experience. Our effective tax rate for the quarter was 23% compared to 19% in the first quarter. This increase was primarily due to higher mix of taxable income. For the full year 2022, we expect the effective tax rate to be between 17% and 20%. This range includes the impact of mark-to-market accounting on our Evertec Holdings resulting from the expected reduction in our boarding interest in Evertec. The gains resulting from mark to market are taxed at a preferential rate. Please turn to slide seven. Net interest income on a taxable equivalent basis was $596 million, $47 million higher than in the first quarter. Net interest margin increased by 34 basis points to 3.09% in Q2. On a taxable equivalent basis, NIM was 3.45%, an increase of 40 basis points. The improved net interest margin is driven by the higher interest rate environment and by improved asset mix, specifically a lower proportion of money market investments and the increase in higher yielding loans. Higher yield on money market and investment portfolio by 44 basis points and an increase in loan yield by 8 basis points to 6.14%. PPP income in Q2 was $5 million, down from $11 million in the prior quarter, due to lower recognition of fees upon loan forgiveness and lower balances. The yield of the portfolio was 15% compared to 17% in Q1. The outstanding quarter end balance of PPP loans was $89 million. The remaining unamortized portion of fees for this portfolio is $3.3 million, most of which we expect to recognize during the third quarter. Excluding Puerto Rico public deposits, deposit balances grew by $255 million in the quarter. As of the end of the second quarter, public deposits were roughly $17 billion, an increase of $2 billion from Q1. At this time, we continue to expect that public deposits will return to a range of $11 billion to $15 billion by year-end. While we remain asset sensitive, this position has been reduced significantly by our deployment of cash balances, initially to the bond portfolio and more recently to fund loan growth. Given the rapid shift to higher short-term rates, moving forward, we expect the cost of public sector deposits to start moving in tandem with market rates, albeit with a lag. As a result of these factors, each 25 basis point change in Fed Funds rate now corresponds to an increase of approximately $2 million in NII per quarter. We expect our interest rate sensitivity to become relatively neutral to higher rate scenarios in the coming quarters. Our ending loan balances increased by $787 million or 3% compared to Q1 and are up by $1.1 billion or 4% year to date. The quarterly increase occurred despite a decrease of $85 million in PPP loans. All segments except for mortgage in Puerto Rico were higher with commercial loan growth being particularly strong. We are encouraged by the demand for credit at BPPR and at PB. We will continue to take advantage of opportunities to extend credit, to improve the use and yield of our existing liquidity. Please turn to slide eight. Our return on tangible equity was 16.7% in the quarter. Capital levels remained strong. Our common equity Tier 1 ratio in Q2 was 16.4%, roughly unchanged from Q1. On July 12th, the Corporation completed the previously announced $400 million ASR. In total, we repurchased approximately 5.1 million shares at an average purchase price of $78.94 per share. Tangible book value at quarter end was $46.18 per share, an 11% decrease, driven mostly by higher accumulated unrealized losses on debt securities available for sale of $563 million, a result of rising interest rates. This was partially offset by net income in the quarter. The decrease in fair value of the investment portfolio should be temporary. Our investment portfolio is nearly entirely comprised of treasury and agency mortgage bank securities, which carry minimal credit risk. The bond portfolio has duration of approximately four years. As the positions roll down the yield curve, there are fair value will converge to par and the mark down to zero. During the quarter, new purchases of debt securities in the investment portfolio were categorized as held to maturity. The lower mark to market valuation of our investment portfolio does not have an impact on our regulatory capital ratios. On July 1st, we completed the previously announced agreement with Evertec to acquire key customer facing channels and to extend important commercial agreements. As consideration for the transaction, BPPR delivered to Evertec approximately 4.6 million shares of Evertec common stock, valued at the closing at $169 million. This resulted in after tax gain of approximately $112 million. In terms of capital, the transaction resulted in a negative impact to tangible book value of approximately $55 million, due to the net effect of the after-tax gain of the Evertec shares used as consideration for the transaction, minus approximately $167 million in goodwill and other intangible assets recognized in connection with the transaction, and finally, the effect of purchase accounting-related adjustments. As a result of the transfer of the shares used as consideration, Popular's ownership in Evertec was reduced from approximately 16.3% to approximately 10.6% at closing. Popular has agreed to further reduce its voting interest in Evertec to no more than 4.5% weather through selling shares of Evertec common stock or a conversion of such shares into non-voting stock by the end of the third quarter. We expect to sell down the stake in Evertec to no more than 4.5% depending on market conditions. Subject to the receipt of regulatory approvals, we then plan to return to shareholders via common stock repurchases, any after-tax gains resulting from such sale. We also intend to complete the remaining $100 million worth of buybacks under our 2022 capital plan by year-end. Our normal capital planning schedule should result in an announcement of Popular's 2023 capital actions no later than our January 2023 webcast. We will continue to explore opportunities to manage our capital structure during the remainder of 2022 and in future periods. With that, I turn the call over to Lidio.

Thank you, Carlos and good morning. Overall, Popular continue to exhibit strong credit quality trends and low credit costs with low levels of net charge-off and decrease in non-performing loans. We continue to closely monitor changes in borrower performance under macroeconomic environment, given potential economic headwinds, rising interest rates, and geopolitical uncertainty. However, we believe that the improvement over the last few years in the risk profile of the Corporation's loan portfolios positions Popular to operate successfully under more difficult economic conditions. Turning to slide number nine. Non-performing assets decreased by $40 million to $570 million this quarter, mainly driven by an NPL decrease of $42 million. The decreasing NPLs was mainly in Puerto Rico. This was driven by lower mortgage NPLs of $22 million, primarily due to the combined effects of collection efforts, increased foreclosure activity, and the ongoing low levels of early delinquency compared with pre-pandemic trends, coupled with lower commercial NPLs of $21 million, primarily due to the return to accrual status of $11 million commercial relationship. In the US, NPLs remain flat quarter-over-quarter. Compared to the first quarter, inflows to NPLs, excluding consumer loans decreased by $5 million. In Puerto Rico, total inflows decreased by $6 million, driven by lower commercial inflows of $4.5 million and lower mortgage inflows of $1.5 million. In the US, inflows remain flat quarter-over-quarter. The $2 million OREO increase in the quarter was driven by the resumption of a closer activity in the Puerto Rico mortgage portfolio. At the end of the quarter, ratio of NPLs to total loans held in portfolio was 1.6% compared to 1.8% in the previous quarter. Turning to slide number 10. Net charge-offs amounted to $6 million or annualized 8 basis points of average loans held in portfolio, compared to $4 million or 5 basis points in the prior quarter. In Puerto Rico, net charge-offs were $5 million, flat quarter-over-quarter. In the US, net charge-off reflected a negative variance of $2.5 million as the prior quarter was a net recovery of $1.7 million compared to an expense of $800,000 this quarter. The corporation allowance for credit losses increased by $4 million to $682 million. The increase was mainly in Puerto Rico, driven by portfolio growth and changes to macroeconomic scenarios. In the US, the ACL was flat quarter-over-quarter. The ratio of allowance for credit losses to loans held in portfolio decreased by 5 basis point to 2.24%. The ratio of allowance for credit losses to NPLs held in portfolio was 123% compared to 130% in the prior quarter. The provision for credit losses was an expense of $10 million, compared to a benefit of $14 million in the previous quarter. In Puerto Rico, the provision for credit losses was an expense of $9 million compared to a benefit of $13 million. While in the US, the provision was an expense of $1 million compared to a benefit of $2 million. Please turn to slide number 11. As discussed in prior webcast, we leveraged Moody's Analytics for US and Puerto Rico economic forecasts. Moody's baseline forecast expects growth to continue in 2022 and 2023 with some slowing occurring as the economy reaches full employment, monetary policy becomes tighter, COVID-19 fiscal stimulus ends, and the Russia war in Ukraine affects energy and food prices. However, Moody's Analytics push the odds of the economy, but the economy will suffer a downturn beginning in the next 12 months at one in three with near even odds of a recession in the next 24 months. As a result, we continue to assign the highest probability to the baseline scenario, followed closely by the more pessimistic S3 scenario. To summarize, our loan portfolio continued to exhibit strong credit quality trends in the second quarter with low net charge-offs and decreasing non-performing loans. We continue to closely monitor changes in borrower performance under macroeconomic environment. However, we believe that improvements over time and the risk profile of the corporation loans portfolios positions Popular to operate successfully under more difficult economic environments. With that, I would like to turn to turn the call over to Ignacio for his concluding remarks. Thank you.

Thank you. Lidio and Carlos for your updates. Our results for the first half of 2022 were strong, driven by solid earnings, robust loan growth, improved credit quality, and continued customer growth. Our capital and liquidity position provides us the flexibility to invest for growth, while continue returning capital to our shareholders. Despite the possible negative impacts of inflation, higher interest rates and the war in Ukraine, we are still seeing growth in the US and Puerto Rico with a historically strong employment market and healthy consumer deposit and spending levels. In the case of Puerto Rico, in addition to the unprecedented level of federal stimulus related to COVID, there is still a significant amount of hurricane recovery funds that are yet to be dispersed. We expect that a combined impact of these factors will generate considerable economic activity in many sectors for the coming years and we are well positioned to benefit from such activity. In June, we released our corporate sustainability report, which is available on our website. We have continued to further our ESG efforts with a focus on promoting sustainable finance, supporting our communities, and fostering a strong culture of diversity, equity, and inclusion. We are mindful of the responsibility we have to Puerto Rico as the leading banking institution and to all the communities that we serve. I am thankful to our entire team who have continued to perform at a high level and deliver results under adverse conditions. We recently completed a comprehensive market analysis that resulted in a significant investment in compensation. Our employees are Popular's greatest asset. And it is a priority for us to invest in their continued growth and success. We are confident in our ability to continue to deliver results for our shareholders, at the same time as we invest in our people, business and communities. We are now ready to answer your questions.

Thank you. [Operator Instructions] The first question comes from Brett Rabatin with Hovde Group. Please go ahead.

Hey, good morning everyone.

Good morning, Brett.

Good morning, Brett.

Congratulations on double-digit loan growth. I didn't think I'd be saying that about the Puerto Rican environment, but obviously strong growth and the economy continues to move along. I wanted to make sure I understood what the outlook was in the back half of the year for loan growth. I know that year-over-year auto sales were down 9% in June, but they continue to be pretty robust and the commercial activity was notable this quarter. Maybe, Carlos, any thoughts on, or Ignacio, any thoughts on back half loan growth from here.

The commercial loan growth, we said it before, it's kind of lumpy. So it's hard for us to predict it, but I can definitely say that we are continuing to see strong interest from our clients in the commercial sector regarding demand for loans. So we're not seeing any decrease in that. As you saw, the consumer balances increase across those lines also. So we're not seeing any negative impact there. In terms of auto, I'd like to point out that although they are down from previous year, the local dealers association is still predicting new auto sales of 111,000 vehicles for the year, which is very high number for Puerto Rico. And we had -- and June was our highest month of originations in history for auto and lease financing. So we continue to see strong demand for auto in Puerto Rico. Obviously, the supply chain issue is an issue here as it is many places in the state, but we still see us at a very healthy mark.

Okay. That's helpful color. And then wanted to make sure I understood the decline in the asset sensitivity of the balance sheet, it would seem to me like the margin -- and I appreciate the $2 million guidance for 25 basis points, but it would seem to me like the margin would continue to move upward. I am not sure if I fully understand how it's becoming -- the balance sheet becoming neutral in terms of interest rate sensitivity. And I’m just hoping maybe you could give some color on deposit betas from here and what is making the balance sheet more neutral?

Well, a couple of things are affecting it. One, we're putting a lot of the immediately repricing assets to work, right? We are extending some of our cash into the investment portfolio. And more importantly, we are now also extending the cash into the loan portfolio, which is what we prefer to do. So that will naturally reduce our asset sensitivity. The other factor that affects this is, as I mentioned, as you know, government deposits in Puerto Rico, which is a big chunk of our deposit book is market linked, but it is not necessarily market linked instantaneously, it is market linked with a lag. So, we have not seen that market linkage evident yet necessarily in our cost of deposits, but it will become more evident over the next three months or so or next four months to the point where they will become fully market linked, meaning that, we will have lived -- used up the lag in repricing at some point in time and that will reprice or move to repricing a big chunk of our deposit book on a market-linked basis. We will continue to be able to earn a nice margin on those deposits. So they will still be accretive, but that margin will not continue to increase as it may increase for deposits that are not linked to market. So I think that's probably are the two biggest drivers, Brett.

Okay. That's helpful, Carlos. And then maybe just lastly if I heard it right, $444 million of expense quarterly guidance in the back half of the year. I was curious how much of that might be the stock-based incentive compensation versus other pieces?

Sure. Let me walk you through that. As you know, we have -- we had guided to average quarterly expenses of $415 million, our quarterly expenses tend to be seasonal. So they usually tend to be lower in the first two quarters of the year and higher in the second two quarters of the year. And that's what happened this quarter. We're running lower than our guidance of $415, which means by definition that the last two quarters of the year, we're going to be higher anyway for us to hit that $415 million. So that -- some of what's happening is just the normal seasonality in our expenses. The change here is -- with the first thing you mentioned that we now believe given our performance year-to-date that the profit sharing payment will be triggered. So we have added that to our outlook. That is normally not part of our outlook, because we don't assume profit sharing will be triggered. We have to actually perform for that to happen and that will add something that looks like $30 million to the outlook. And the other piece that addresses the increase is what Ignacio mentioned and I mentioned of the review of compensation of Popular, we've done a very comprehensive review of compensation that ended up increasing compensation expenses for something that looks like in the ballpark of $7 million a quarter or something like that, that will be fully effective starting on this quarter and the third quarter of the year and moving forward. And the combination of those two things are what explains the delta between this $415 million and the new average part of the expenses of $425 million. So the average quarterly expenses are going up by $10 million, but the nominal expenses in the last two quarters would be up by a higher number, but it's just math. Obviously, they would have gone up anyway even if these last two events I mentioned had not happened.

Okay, great. That's good color. Appreciate it.

Thank you.

Thank you, Brett. The next question comes from Timur Braziler with Wells Fargo. Please go ahead.

Hi, good morning.

Good morning, Timur.

Maybe just following up on the expense line of questioning, does the back-end include the Evertec transaction? And I guess what does that in and of itself due to the expenses?

Yes, it does. I think, hold on for a second. I'm getting my numbers here. Yeah, it does include the Evertec transaction and the effect of that is net reduction of [operating] (ph) expenses already included in our outlook.

Net reduction of $10 million. Okay. And then you had made a comment that a component of the increased spend was to fund compliance, fraud, cyber security type initiatives, is there anything specific that kind of drove that narrative or is that just the cost of doing business and as economic activity continues to ramp higher you need to ramp those initiatives up to kind of keep pace?

Your explanations were as good as mine were going to be. Yes, it is because of doing business. I mean, the regulatory environment, as you know, is not getting any more complacent or any more flexible, number one. And number two, we simply have more clients doing more transactions with us, which means that there's going to be more events, there is going to be more alerts, there is going to be more fraud alerts that need to be investigated, there is going to be more chances of more clients that cyber criminals can try to use their credentials to get into our systems. So the growth of the business is the other part that’s driving it. So your explanation was on point.

Okay. And then just lastly on expenses, what does that assume as far as OREO outlook?

It assumes OREO at breakeven.

OREO is breakeven. Okay, great. And then just on the remaining Evertec transactions, the sell down of 4.5%, that gain that's going to be returned to shareholders, is that a 2022 event? Does that happen in the fourth quarter or does that need to go through the same type of capital plan and that should be included kind of incremental in the '23 plan?

I mean, it depends. I mean we'll make the decision where we want to go or not go depending on what's happening with the market first of all. And that is the first part of what has to happen, which is for us to actually sell the shares. Once we have sold the shares, then we need regulatory approval to actually do the additional -- redeploy those gains as a buyback and the regulatory approval takes the time that it takes. I think there is -- whether all that can happen in this quarter, I don't know it. It's probably unlikely. So more than that, it looks like something that's probably more of a fourth quarter event.

Okay. And then just lastly, just following up on the government deposit. The lag that you referenced, is that a lag on hikes or is that just a lag on timing when those hikes are passed along to the customer? And maybe if you could just talk through kind of how long that lag is and any kind of color you can provide on the beta that you're expecting there.

Yeah. I mean it's just the way the formula works on how we reflect market rates on the rate that applies to the customers. So, again -- there again, you're comment was correct. And it applies over time and the lag is something that looks like three months, or something in that ballpark. Is that a -- a step function three months. So we will saw gradually -- we will average into -- through a period of about three months.

Okay. And do you have the exit deposit costs at end of June given that spot rate?

What deposit costs?

The cost of deposits at the end of June.

We have it, but we don't disclose it publicly.

Okay.

You mean public deposits?

No, just total deposit costs at the end of June.

Yeah. Total deposit costs, we have it. Give me a -- for the quarter, yes. We have it for the quarter, give me a second. I think it was 17 basis points, give me a second. I think its 17 basis points, Timur. Total deposit cost for the quarter, give me a second. Actually, I have it for BPPR and PB separately, I don't have it for Popular, Inc. Do you have Popular, Inc.? BPPR is -- it was 14 basis points and Popular Bank was 42 basis points. And so the number of our Popular, Inc. is 17 basis points.

Okay. Thank you.

Thank you.

Thank you for your questions. The next question comes from Gerard Cassidy with RBC. Please go ahead.

Hi, Ignacio. Hi, Carlos.

Hello, Gerard.

Hi, Gerard.

Can you guys share with us, there is, obviously, a number of cross currents going on in the economy today as we saw with the real GDP print this morning. And one of the concerns or one of the topics of conversation is end of cycle loan growth and the industry like you folks as well. So good loan growth this quarter. Can you somehow give us some color or reassurances that a year from now we're not going to be looking back and seeing maybe some regrets that the loan growth was too strong in the early part of ‘22 when the evidence again the cross currents in the economy is starting to show maybe a slowdown?

Yeah. I think right -- we feel very confident that we as opposed to perhaps other people we have never really relaxed our credit standards. So really the growth there were coming from were being -- will continuing maybe I think very prudent and very disciplined. The shift in the economy, especially in Puerto Rico is strong and we're starting to see economic activity, which we haven't seen for a long time. So there is a lot of pent-up demand, but we really, really never relax our underwriting standards to try to create that loan growth sort of artificially. So, we feel we're very well positioned. As Lidio has mentioned, various times the industries we are in, we think our industries will withstand some deceleration in growth well. Our FICO scores in the consumer book are strong. So again, we're looking out for these tailwinds that everyone knows that’s possibly out there, but I'm not very concerned. I mean, we have not done anything that would lead us to believe we are unduly relaxed and now we have to tighten. And I think we have been very consistent and the loan growth we’ve seen is just a reflection of the pent-up demand and the economic growth, especially in Puerto Rico.

The other thing to consider with your question, Gerard, is the concept of end of cycle. There is a number of very well-respected local economies here in Puerto Rico that believe that the using credit things are affecting the Puerto Rico economy, which this time tend to be in our favor actually versus the last 10 years that were against that. Meaning that, the effect of the federal fund expansion, but also the fact that we have the extra lever of hurricane assistance that the rest of the country doesn't have, but that differential could mean that Puerto Rico may perform slightly better than the national average moving forward. So some of the local economist believe that there is a reasonable chance that even if the US goes into recession as long as that recession is short and shallow, that it may just be a Puerto Rico never gets into recession because of the positive effects of that investment. So we'll have to see. Of course, it depends on -- and if there is a recession in the US and how long and how deep it is, but there is a perception that we may perform slightly better in the island and that is, we haven’t been able to say that for about 12, 13 years now. So, it's really, -- we work on the chance that we actually have a possibility of performing slightly better than the US economy for once.

Very good. And then as a follow-up to that, are you seeing any new entrants into the market for lending mainland banks that might be coming in that weren't there 12 months ago?

Not really, I think we have seen some of the bigger banks, the JP Morgan's of the world and the Goldman Sachs being interested in some of these big transactions that they are hopeful will happen or like perhaps the privatization of the ports, which is ongoing and things like that. I haven't seen any new activity of US players, some of the local players like Venesco got a lot of money from that statue that benefited minority institutions, which they be a little bit more aggressive in the small and medium size, but they're very small institution. But not really, I mean, they've always been here in certain deals, but nothing unusual, other than I do think that you're seeing more people who do project finance being interested in Puerto Rico.

Keep in mind that for large commercial transactions, Gerard, we have always competed with mainland bank, mainland pension funds, and mainland hedge funds to fund them. So, there is actually -- it is not a not a delta from how we've done. This is all the time. Any transaction that is significant large or the underlying client is a US-based client, we have to compete with US banks for them anyway.

Okay, thank you. And then just finally, with the acquisition back a few years ago of the Wells Auto portfolio, you're obviously a bigger auto lender on the Island. Can you tell us what percentage of the auto loans are for used cars versus new cars if you break that out?

[indiscernible]

[indiscernible] so I would say there is about half and half new and used.

[indiscernible] there is about half and half new. Origination, but in the portfolio?

I don't think we have the portfolio number right now, Gerard, but we can get that.

But it is an important market in Puerto Rico.

Yeah. We can get that, but we don't have it right now.

And are you in Puerto Rico seen the used car price inflation similar to what we've seen in the states, which may if the new car market comes back in two years, used car prices could be lower two years from now than today. Are you guys seeing that elevation? Thank you.

Yes. I'm not sure at the same level but definitely used car prices have gone up in Puerto Rico. So obviously, we're maintaining our discipline regarding, again, I said our underwriting standards, we are not -- we're very happy with the originations we're getting with our existing underwriting standards. So we haven’t found a necessity to lower them. Keep in mind that one of the things that is a bit of an offset in Puerto Rico that we have very high taxes on cars, especially new cars. So that helps a little bit the used car because when you go buy a new car, you have to pay a very high, we call it [indiscernible] tax and therefore used car markets still has a little bit of a cushion in that sense in Puerto Rico, but we're watching it.

Very good. Thank you.

Thank you for your question. The next question comes from Alex Twerdahl with Piper Sandler. Please go ahead.

Hey, good morning guys.

Good morning, Alex.

Yeah. First off, can you just maybe help us get a sense for the ebbs and flows in the government deposits now that we're out of bankruptcy, sort of the expectation -- the seasonality there that gets you back to that 11% to 15% range by the end of the year?

I mean, I’ll let Carlos talk about it more, but when we put out estimate, it’s usually based on our conversations with the Treasury Department and what their estimates are. And they've been all over the place. On a positive side, the economy in Puerto Rico has done better, so they have generated a lot more tax revenues that they were anticipating. On the expense side, there are some funds that we estimate around maybe $2 billion that are COVID-related funds that are classified as public funds that have been slower to be dispersed than we would have anticipated and maybe than they would have anticipated. So, the ebbs and flows traditionally, we live in a very unique world now with the pandemic and all these funds. As you know, the taxes come in April and then they pay the bonds in July, July 1st is the principal payment. Those are the big ebbs and flows, but -- and with the pandemic, we've had big inflows of money for COVID relief and other situation. So it's very hard for the government to predict and we sort of rely on them to predict the flows, but over time those COVID funds have to be spent or we're going to lose them, for example. So that will have to go out. And I think the government will have a better idea. Again, we haven't been on a bankruptcy for that long. So they are trying to stabilize their finances, but I don’t know Carlos you want to add anything to that?

No. We have been very consistent on our forecast of growing deposits by being wrong every quarter over nine quarters. So again, it's not a lack of trying. It is, as Ignacio said, everything we communicate is our best guess given all the information we have from our clients. Remember, the balance is not a single client too, there is hundreds of clients in there as well. So it's our best guess given the information, but sometimes the clients themselves don't have those information as they think. The tax revenues being much higher this year is a good example of that. So, our best guess given all that we know today is that, again, we'll be back to the range that we expected by year-end. I have no idea whether the agreement that was announced today for some climate legislation will have money attached to it and whether some of that money will come to us and will changed the forecast. So there's all kinds of things like that that affected. So, it's our best informed estimate given everything we know as of today, but, again, we've missed it a few times.

Got it. And then, I mean I guess sort of a corollary or a follow-on question to that is, how do you think about your normalized level of liquidity? Obviously, you got this chunk of deposits that could be anything in a given quarter, but how much of that can actually be invested in a way that either into loan growth or into longer duration securities that you feel comfortable?

Well -- No, it is easier to focus on the government deposits, because they are the biggest chunk in the deposit book. But I think the answer to your question is a more holistic answer on what's going to happen with the deposit flows moving forward. We fully expect that commercial deposits -- you have seen it already. In most banks in the mainland you've seen deposits go down already. So we're a little bit of an outlier that we have deposits going down this quarter. I think, in the commercial front, you will probably see a lot of pressure on deposits moving forward, meaning, that deposit outflows as our commercial clients have active who have treasury activities will look for better yield on their liquidity. So the commercial sector might actually see some outflows moving forward. We haven't seen it yet, but that might be coming. I think that's going to be much slower in the retail side, the retail side tends to respond less quickly, while some high net worth clients may move some deposit to higher yielding alternatives. I think the majority of clients will move slowly given the change -- the retail clients move slowly. So, the big two pieces are going to be what is happening with commercial, which again we shouldn't ignore, you've seen the commercial deposits coming down in many banks in mainland already. And then the government if we happen to be correct this time in our [BAAS] (ph) prediction, then they'll probably be down between $2 billion and $4 billion and $5 billion by year-end.

Okay. Are you able to break out the portion of your deposits that you consider to be not super-sensitive to rates, either the retailer or the stuff that's not going to have that deck of treasury management?

Well, the most of the raise is the government deposits, and again, with a lag, but that's going to move in tandem to market. So again, keep in mind as I mentioned earlier, we do earn a margin on that, the difference of three months for now is that margin will not continue to increase, it will stay. It has increased for the last couple of months, but it will not continue to increase once we reach that point where the deposits are pegged to market changes in the market. So, again, that are still be accretive. We have a margin on them, but the margin will get cut when the linkages is fully in place.

Got it. I mean, when I think about the rate sensitivity and sort of the change in the guide this quarter. I mean there is another way to think about it just relative to last quarter that you've just pulled forward. I'm calculating around five rate hikes by deploying $1.5 billion into held-to maturity securities.

Yeah, I mean we've -- if there is increasing rates, right? So the question of what do you do about it. If you're bank, you try to capture those higher rate into the balance sheet and we have done quite a bit of that by extending the bond portfolio and more importantly now also growing the loan portfolio. So we've taken the action that we think makes sense to capture that increased margin moving forward, but you can’t do it twice, right? Once you did it, you done it. So, that reduces the [indiscernible] moving forward. And so, I think your description is accurate, Alex, that is part of what has happened already. Yes.

Okay, great. And then, if I remember correctly part of the Evertec transaction was actually to recognize some revenue shares as well. And I couldn't remember if that was something that was going to impact this year or if that is a '23 event? Maybe you can just remind us kind of on the fee side how Evertec is going to impact the complexion of the fee income in your guide for the next two quarters, as well as how that's going to change next year with that revenue share component?

Yeah. It impacts the results immediately, but the flip side of that is by reducing our equity stake. We also give up equity -- the business through the equity income that also comes into that line. So you don't see the change in the line, Alex. But yes, there is a plus and minus. They happen to be about the same size this year. Obviously, part of the logic behind the transaction is that, we don't think they'll stay the same size and we think that the revenue linked or the fees linked to the merchant business will actually outpace in growth the other side of the equation.

Okay, great. And then just final question for me, just back to the margin. On the new loan yields that you're getting today, loan yields in Puerto Rico seem to be at decent margin above US yields or at least they have been when rates were zero. Are you seeing loan betas or -- how is higher rates actually impact new origination yields on commercial product?

We see overall loan yields go up by 8 basis points in the quarter. So we are trying to reflect the change in rate into our origination. The loan yields, it also depends on mix and number of other things, obviously, but we are trying to reflect the new market conditions in our loan yield, the new origination will change the loan yield slowly though, because, again, we have a big base portfolio, so the new origination changes the overall yield only on our margin.

But, Alex, if your question was more directed to have these increases -- sorry, decreased demand for commercial loans, we haven't seen that yet?

Okay. So you are getting -- if a commercial loan had a five handle a year and a half ago, is it coming on today with still five handle or is it coming on today with a seven handle?

Neither. It's definitely higher handle, but I'm not sure if -- the beta is 100% or not. The clients are sensitive to this as well. So instead of five or seven year handle, they may choose to make the loan a bit shorter, so the handles become six, right?

Okay. Thanks for taking my questions.

Thank you.

Thank you, Alex. [Operator Instructions] The next question is from Kelly Motta with KBW. Please go ahead.

Hi, thank you so much for the questions, and good morning. It looked like they have been asked and answered, but I did want to -- now that you have Evertec close, I ask a question about what you're doing on the technology investment side? One of the strategic rationale for the deal was the flexibility it opens up, can you talk about some of the things you look to do now that you have that deal closed. And I think you cited increased tax spend is one of the areas of increase for expenses. So if that was within what you had been planning to do or if there is new projects on board that weren't previously in the guidance before.

I'm not sure in terms of which projects were in the guidance or not, definitely by taking these client-facing platforms, take them over and bring them back in, we now see we have greater ability to work on things that we had before. In general, what we're looking to do is improve the origination process, the digital origination processes, both on the consumer and on the commercial front, that’s something we are working on. We're also willing to be spending some money on our cash management systems, which we think we need to upgrade, this remain competitive. So some of the big projects working on there. So, I don't think that the Evertec transaction as such has increased our spending. What it has, it has allowed us to have greater flexibility to look at things that we wanted to do anyway and do them. So I don't know, Carlos you want to add any color to that?

Yeah. I mean we may have moved some stuff around and having closed transactions gives us the possibility of may be choosing to do some of the things we hadn't planned a bit quicker, but again we've only closed the transaction for a month now. So we have to give them a bit more time to put more numbers around that. But it is a possibility that things that we thought might – we may start it in the year and a half or two, we may now have the possibility or the option to start a bit faster or we may change around things when we want to do things. So, we may move a projects that had a spend of X and do it later and then move forward a product that have spent of half times or two times. But that is still early days in the process.

Got it. Thanks so much. And then I do appreciate all the color on the puts and takes of expenses in the second half of the year and kind of the noise around higher profit sharing, as you get out from that how should we be thinking about what a normalized run rate looks like now that you took a step up on employee expenses and everything like that as we move past the second half of the year?

That's an excellent question and we don't have the answer to that question yet. So we gave you what we can, I think, get our arms around. With sound degree of confidence, which is the next two quarters, we will provide you and the market with new average quarterly expense guidance for 2023 in our webcast in January of next year. We're not trying to be evasive or acute about this. What ends up driving our expense guidance is all the projects and efforts that we decided to embark on next year. That is a result of our budgeting and planning process and that process really doesn't end until sometime in late November. So we will actually not know the number until we decide which products we're going to do or pursue and which products we're not and things of those sort that we will decide it later this year. So, I don't have the number yet. We will give you guidance in January for full 2023.

Understood. Thank you so much for the color.

Thank you.

Thank you, Kelly. We now have a follow-up question from Timur with Wells Fargo. Please go ahead.

Hi, thanks for the follow-up. Maybe just adding on to Kelly's question and asking it a little different. Are you expecting kind of this $245 million range for both third quarter and fourth quarter or is it kind of ramping up towards the fourth quarter and how are you thinking about kind of the fourth quarter exit rate?

Yeah. I mean it could move around a little bit between the two quarters. Our best guess is that, those quarters will look very similar at $445 million, Timur. But it could be that it's $440 million or $450 million or $450 million and $440 million or something like that, it depends on when some things get going and get paid and that sort of stuff. So, we have a visible degree of confidence on the average for both quarters. If you actually wanted to the pin it down to one quarter or the other, I have a lesser degree of confidence on that.

Okay. And is there an expectation that earnings credit rate is a component of the higher expense base and then maybe if you can just provide any color on what component of the public funds will see higher rates through an ECR versus just higher deposit costs.

Yeah. I mean some of -- it’s a valid question. So, not all of the cost shows up through to the interest expense line, some of this cost is sort of in the fee section. We have never broken it up that way. It also will depend how they use -- how many services they use from us, right? That's part of the equation that goes in. If they are contracting services, then the mix between what goes into interest expense line and what goes in the fee portion of the changes, I don't have the number. We will try to figure out if we can do something that makes sense on that, but I don't have a number on top of my head.

Okay. Thanks again for the follow-up.

Thank you.

Thank you for your question. I would now like to pass the conference back over to Ignacio Alvarez for any further remarks.

Thanks again for joining us and for your questions. We look forward to updating you on our progress in October. Have a great day.

That concludes the Popular, Inc. Second Quarter Earnings call. Thank you for your participation. You may now disconnect your line.