Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2019
☐
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 1-31987
Hilltop Holdings Inc.
(Exact name of registrant as specified in its charter)
Maryland
84-1477939
(State or other jurisdiction of incorporation or
(I.R.S. Employer Identification No.)
organization)
2323 Victory Avenue, Suite 1400
Dallas, TX
75219
(Address of principal executive offices)
(Zip Code)
(214) 855-2177
(Registrant’s telephone number, including area code)
Securities registered pursuant to section 12(b) of the Act:
Title of each class
Trading symbol
Name of each exchange on which registered
Common Stock, par value $0.01 per share
HTH
New York Stock Exchange
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ◻
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ◻
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ⌧
Accelerated filer ◻
Non-accelerated filer ◻
Smaller reporting company ☐
Emerging growth company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ⌧
The number of shares of the registrant's common stock outstanding at July 25, 2019 was 92,775,411.
HILLTOP HOLDINGS INC.
FOR THE QUARTER ENDED JUNE 30, 2019
TABLE OF CONTENTS
PART I — FINANCIAL INFORMATION
Item 1.
Financial Statements
Consolidated Balance Sheets
3
Consolidated Statements of Operations
4
Consolidated Statements of Comprehensive Income
5
Consolidated Statements of Stockholders’ Equity
7
Consolidated Statements of Cash Flows
8
Notes to Consolidated Financial Statements
9
Schedule I - Insurance Incurred and Cumulative Paid Losses and Allocated Loss and Loss Adjustment Expenses, Net of Reinsurance
51
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
52
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
86
Item 4.
Controls and Procedures
89
PART II — OTHER INFORMATION
Legal Proceedings
90
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Item 5.
Other Information
Item 6.
Exhibits
91
2
HILLTOP HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)
(Unaudited)
June 30,
December 31,
2019
2018
Assets
Cash and due from banks
$
342,001
644,073
Federal funds sold
521
400
Assets segregated for regulatory purposes
151,271
133,993
Securities purchased under agreements to resell
50,660
61,611
Securities:
Trading, at fair value
601,524
745,466
Available for sale, at fair value (amortized cost of $999,798 and $886,799, respectively)
1,009,924
875,658
Held to maturity, at amortized cost (fair value of $368,546 and $341,124, respectively)
365,905
351,012
Equity, at fair value
19,592
19,679
1,996,945
1,991,815
Loans held for sale
1,609,477
1,393,246
Loans held for investment, net of unearned income
7,202,604
6,930,458
Allowance for loan losses
(55,177)
(59,486)
Loans held for investment, net
7,147,427
6,870,972
Broker-dealer and clearing organization receivables
1,707,249
1,440,287
Premises and equipment, net
208,975
237,373
Operating lease right-of-use assets
123,832
—
Other assets
602,143
580,362
Goodwill
291,435
Other intangible assets, net
33,934
38,005
Total assets
14,265,870
13,683,572
Liabilities and Stockholders' Equity
Deposits:
Noninterest-bearing
2,598,253
2,560,750
Interest-bearing
5,864,826
5,975,406
Total deposits
8,463,079
8,536,156
Broker-dealer and clearing organization payables
1,531,891
1,294,925
Short-term borrowings
1,338,893
1,065,807
Securities sold, not yet purchased, at fair value
45,447
81,667
Notes payable
231,923
228,872
Operating lease liabilities
132,750
Junior subordinated debentures
67,012
Other liabilities
403,070
435,240
Total liabilities
12,214,065
11,709,679
Commitments and contingencies (see Notes 13 and 14)
Stockholders' equity:
Hilltop stockholders' equity:
Common stock, $0.01 par value, 125,000,000 shares authorized; 92,775,411 and 93,610,217 shares issued and outstanding at June 30, 2019 and December 31, 2018, respectively
928
936
Additional paid-in capital
1,473,599
1,489,816
Accumulated other comprehensive income (loss)
7,862
(8,627)
Retained earnings
544,275
466,737
Deferred compensation employee stock trust, net
788
825
Employee stock trust (8,579 and 11,672 shares, at cost, at June 30, 2019 and December 31, 2018, respectively)
(171)
(217)
Total Hilltop stockholders' equity
2,027,281
1,949,470
Noncontrolling interests
24,524
24,423
Total stockholders' equity
2,051,805
1,973,893
Total liabilities and stockholders' equity
See accompanying notes.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
Three Months Ended June 30,
Six Months Ended June 30,
Interest income:
Loans, including fees
114,325
103,924
225,195
203,868
Securities borrowed
15,517
17,486
32,376
33,786
Taxable
14,684
12,516
30,300
23,469
Tax-exempt
1,513
1,697
3,011
3,469
Other
4,017
4,417
9,214
8,808
Total interest income
150,056
140,040
300,096
273,400
Interest expense:
Deposits
18,036
10,136
35,142
18,811
Securities loaned
13,470
15,075
28,208
28,814
6,897
6,466
12,368
10,509
2,629
2,437
5,270
4,934
986
918
1,987
1,740
162
160
314
324
Total interest expense
42,180
35,192
83,289
65,132
Net interest income
107,876
104,848
216,807
208,268
Provision (recovery) for loan losses
(672)
340
279
(1,467)
Net interest income after provision (recovery) for loan losses
108,548
104,508
216,528
209,735
Noninterest income:
Net gains from sale of loans and other mortgage production income
131,173
132,478
227,312
238,245
Mortgage loan origination fees
33,409
29,318
55,282
49,944
Securities commissions and fees
34,142
38,320
70,111
77,037
Investment and securities advisory fees and commissions
22,859
21,965
43,019
40,319
Net insurance premiums earned
33,466
34,105
66,669
68,420
57,822
23,248
102,946
40,612
Total noninterest income
312,871
279,434
565,339
514,577
Noninterest expense:
Employees' compensation and benefits
215,743
200,632
405,641
383,232
Occupancy and equipment, net
28,219
27,893
56,242
55,723
Professional services
23,753
26,020
46,695
50,724
Loss and loss adjustment expenses
24,981
24,409
39,907
39,941
50,981
59,563
104,277
117,099
Total noninterest expense
343,677
338,517
652,762
646,719
Income before income taxes
77,742
45,425
129,105
77,593
Income tax expense
17,951
11,034
29,537
18,522
Net income
59,791
34,391
99,568
59,071
Less: Net income attributable to noncontrolling interest
1,980
1,311
2,971
1,550
Income attributable to Hilltop
57,811
33,080
96,597
57,521
Earnings per common share:
Basic
0.62
0.35
1.03
0.60
Diluted
Weighted average share information:
93,399
95,270
93,533
95,625
93,418
95,358
93,534
95,727
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
Other comprehensive income:
Net unrealized gains (losses) on securities available for sale, net of tax of $2,574, $(602), $4,782 and $(2,495), respectively
8,924
(2,148)
16,473
(8,851)
Reclassification adjustment for gains included in net income, net of tax of $0, $0, $5 and $0, respectively
16
Comprehensive income
68,715
32,243
116,057
50,220
Less: comprehensive income attributable to noncontrolling interest
Comprehensive income applicable to Hilltop
66,735
30,932
113,086
48,670
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
Accumulated
Deferred
Total
Additional
Compensation
Employee
Hilltop
Common Stock
Paid-in
Comprehensive
Retained
Employee Stock
Stock Trust
Stockholders’
Noncontrolling
Shares
Amount
Capital
Income (Loss)
Earnings
Trust, Net
Equity
Interest
Balance, March 31, 2018
96,048
960
1,526,867
(9,698)
404,260
857
11
(254)
1,922,992
2,464
1,925,456
Other comprehensive loss
Stock-based compensation expense
2,385
Common stock issued to board members
124
Issuance of common stock related to share-based awards, net
152
(1,039)
(1,037)
Repurchases of common stock
(1,634)
(16)
(26,232)
(10,923)
(37,171)
Dividends on common stock ($0.07 per share)
(6,734)
Deferred compensation plan
Net cash distributed from noncontrolling interest
1,145
Balance, June 30, 2018
94,571
946
1,502,105
(11,846)
419,683
(252)
1,911,493
4,920
1,916,413
Balance, March 31, 2019
93,821
938
1,491,585
(1,062)
499,452
827
(213)
1,991,527
23,604
2,015,131
Other comprehensive income
141
(1,013)
(1,011)
(1,215)
(12)
(19,499)
(5,469)
(24,980)
Dividends on common stock ($0.08 per share)
(7,519)
(39)
(2)
42
Net cash distributed to noncontrolling interest
(1,060)
Balance, June 30, 2019
92,775
6
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (continued)
Balance, December 31, 2017
95,982
1,526,369
(394)
384,545
848
12
(247)
1,912,081
2,726
1,914,807
4,549
10
248
281
(1,732)
(1,729)
(1,702)
(17)
(27,329)
(11,531)
(38,877)
Dividends on common stock ($0.14 per share)
(13,453)
(1)
(5)
Adoption of accounting standards
(2,601)
2,601
644
Balance, December 31, 2018
93,610
16,489
4,739
15
365
(1,738)
(1,734)
Dividends on common stock ($0.16 per share)
(14,983)
(37)
46
Adoption of accounting standards (Note 2)
1,393
(2,870)
CONSOLIDATED STATEMENTS OF CASH FLOWS
Operating Activities
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation, amortization and accretion, net
(256)
3,412
Net change in fair value of equity securities
(1,466)
512
Deferred income taxes
1,528
734
Other, net
5,228
4,926
Net change in securities purchased under agreements to resell
10,951
(42,635)
Net change in trading securities
143,942
96,488
Net change in broker-dealer and clearing organization receivables
(258,976)
(172,846)
Net change in other assets
(17,446)
2,897
Net change in broker-dealer and clearing organization payables
138,310
52,574
Net change in other liabilities
4,064
(90,078)
Net change in securities sold, not yet purchased
(36,220)
18,760
Proceeds from sale of mortgage servicing rights asset
9,303
Net gains from sales of loans
(227,312)
(238,245)
Loans originated for sale
(6,783,246)
(7,308,972)
Proceeds from loans sold
6,790,418
7,286,188
Net cash used in operating activities
(130,634)
(319,378)
Investing Activities
Proceeds from maturities and principal reductions of securities held to maturity
25,726
24,047
Proceeds from sales, maturities and principal reductions of securities available for sale
77,146
90,950
Proceeds from sales, maturities and principal reductions of equity securities
1,860
Purchases of securities held to maturity
(40,789)
(21,634)
Purchases of securities available for sale
(191,108)
(170,328)
Purchases of equity securities
(307)
(492)
Net change in loans held for investment
(267,006)
(49,003)
Purchases of premises and equipment and other assets
(14,935)
(12,252)
Proceeds from sales of premises and equipment and other real estate owned
9,777
8,172
Net cash paid for Federal Home Loan Bank and Federal Reserve Bank stock
(11,301)
(16,626)
Net cash used in investing activities
(410,937)
(147,163)
Financing Activities
Net change in deposits
25,579
(94,730)
Net change in short-term borrowings
273,086
404,311
Proceeds from notes payable
365,270
267,194
Payments on notes payable
(362,255)
(248,167)
Payments to repurchase common stock
Dividends paid on common stock
Net cash received from (distributed to) noncontrolling interest
Taxes paid on employee stock awards netting activity
(1,726)
(215)
(363)
Net cash provided by financing activities
256,898
274,833
Net change in cash and cash equivalents
(284,673)
(191,708)
Cash, cash equivalents and restricted cash, beginning of period
778,466
673,960
Cash, cash equivalents and restricted cash, end of period
493,793
482,252
Reconciliation of Cash, Cash Equivalents and Restricted Cash to Consolidated Balance Sheets
353,432
403
128,417
Total cash, cash equivalents and restricted cash
Supplemental Disclosures of Cash Flow Information
Cash paid for interest
80,880
65,349
Cash paid for income taxes, net of refunds
12,504
966
Supplemental Schedule of Non-Cash Activities
Derecognition of construction in progress related to build-to-suit lease obligations
29,195
Conversion of loans to other real estate owned
2,931
4,846
Additions to mortgage servicing rights
4,408
9,729
Hilltop Holdings Inc. and Subsidiaries
1. Summary of Significant Accounting and Reporting Policies
Nature of Operations
Hilltop Holdings Inc. (“Hilltop” and, collectively with its subsidiaries, the “Company”) is a financial holding company registered under the Bank Holding Company Act of 1956. The Company’s primary line of business is to provide business and consumer banking services from offices located throughout Texas through PlainsCapital Bank (the “Bank”). In addition, the Company provides an array of financial products and services through its broker-dealer, mortgage origination and insurance subsidiaries.
The Company, headquartered in Dallas, Texas, provides its products and services through three primary business units, PlainsCapital Corporation (“PCC”), Hilltop Securities Holdings LLC (“Securities Holdings”) and National Lloyds Corporation (“NLC”). PCC is a financial holding company that provides, through its subsidiaries, traditional banking, wealth and investment management and treasury management services primarily in Texas and residential mortgage lending throughout the United States. Securities Holdings is a holding company that provides, through its subsidiaries, investment banking and other related financial services, including municipal advisory, sales, trading and underwriting of taxable and tax-exempt fixed income securities, equity trading, clearing, securities lending, structured finance and retail brokerage services throughout the United States. NLC is a property and casualty insurance holding company that provides, through its subsidiaries, fire and homeowners insurance to low value dwellings and manufactured homes primarily in Texas and other areas of the southern United States.
Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States (“GAAP”), and in conformity with the rules and regulations of the Securities and Exchange Commission (the “SEC”). In the opinion of management, these financial statements contain all adjustments necessary for a fair statement of the results of the interim periods presented. Accordingly, the financial statements do not include all of the information and footnotes required by GAAP for complete financial statements and should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018 (“2018 Form 10-K”). Results for interim periods are not necessarily indicative of results to be expected for a full year or any future period.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Estimates regarding the allowance for loan losses, the fair values of financial instruments, reserves for losses and loss adjustment expenses (“LAE”), the mortgage loan indemnification liability, and the potential impairment of assets are particularly subject to change. The Company has applied its critical accounting policies and estimation methods consistently in all periods presented in these consolidated financial statements.
Hilltop owns 100% of the outstanding stock of PCC. PCC owns 100% of the outstanding stock of the Bank and 100% of the membership interest in Hilltop Opportunity Partners LLC, a merchant bank utilized to facilitate investments in companies engaged in non-financial activities. The Bank owns 100% of the outstanding stock of PrimeLending, a PlainsCapital Company (“PrimeLending”).
PrimeLending owns a 100% membership interest in PrimeLending Ventures Management, LLC (“Ventures Management”), which holds an ownership interest in and is the managing member of certain affiliated business arrangements (“ABAs”).
PCC also owns 100% of the outstanding common securities of PCC Statutory Trusts I, II, III and IV (the “Trusts”), which are not included in the consolidated financial statements under the requirements of the Variable Interest Entities
Notes to Consolidated Financial Statements (continued)
(“VIE”) Subsections of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) because the primary beneficiaries of the Trusts are not within the consolidated group.
Hilltop has a 100% membership interest in Securities Holdings, which operates through its wholly owned subsidiaries, Hilltop Securities Inc. (“Hilltop Securities”), Hilltop Securities Independent Network Inc. (“HTS Independent Network”) (collectively, the “Hilltop Broker-Dealers”) and Hilltop Securities Asset Management, LLC. Hilltop Securities is a broker-dealer registered with the SEC and Financial Industry Regulatory Authority (“FINRA”) and a member of the New York Stock Exchange (“NYSE”), HTS Independent Network is an introducing broker-dealer that is also registered with the SEC and FINRA, and Hilltop Securities Asset Management, LLC is a registered investment adviser under the Investment Advisers Act of 1940.
Hilltop also owns 100% of NLC, which operates through its wholly owned subsidiaries, National Lloyds Insurance Company (“NLIC”) and American Summit Insurance Company (“ASIC”).
In addition, Hilltop owns 100% of the membership interest in each of HTH Hillcrest Project LLC (“HTH Project LLC”) and Hilltop Investments I, LLC. Hilltop Investments I, LLC owns 50% of the membership interest in HTH Diamond Hillcrest Land LLC (“Hillcrest Land LLC”) which is consolidated under the aforementioned VIE Subsections of the ASC. These entities are related to the Hilltop Plaza investment discussed in detail in Note 13 to the consolidated financial statements and are collectively referred to as the “Hilltop Plaza Entities.”
The consolidated financial statements include the accounts of the above-named entities. Intercompany transactions and balances have been eliminated. Noncontrolling interests have been recorded for minority ownership in entities that are not wholly owned and are presented in compliance with the provisions of Noncontrolling Interest in Subsidiary Subsections of the ASC.
Certain reclassifications have been made to the prior period consolidated financial statements to conform with the current period presentation, including reclassifications due to the adoption of new accounting pronouncements. As previously disclosed, the quarterly report on Form 10-Q for the period ended June 30, 2018, filed with the SEC on July 26, 2018, incorrectly included the change in assets segregated for regulatory purposes in the operating section of the statements of cash flows. Previously disclosed net changes in assets segregated for regulatory purposes of $58.2 million for the six months ended June 30, 2018, should have been excluded from the cash flows from operating activities and the beginning-of-period and end-of-period balances of assets segregated for regulatory purposes are included in total cash, cash equivalents and restricted cash in accordance with Accounting Standards Update (“ASU”) 2016-18. Accordingly, net cash used in operating activities for the six months ended June 30, 2018, originally reported as $(261.2) million, is $(319.4) million. In preparing these consolidated financial statements, subsequent events were evaluated through the time the financial statements were issued. Financial statements are considered issued when they are widely distributed to all stockholders and other financial statement users, or filed with the SEC.
Significant accounting policies are detailed in Note 1 to the consolidated financial statements included in the Company’s 2018 Form 10-K. As a result of the adoption of ASU 2016-02 and related amendments and technical corrections (collectively, the “Leasing Standard”), the Company has included a new significant accounting policy related to lease accounting as summarized below.
Leases
The Company determines if an arrangement is a lease at inception. Operating leases with a term of greater than one year are included in operating lease right-of-use (“ROU”) assets and operating lease liabilities on the Company’s consolidated balance sheets. Finance leases are included in premises and equipment and other liabilities on the Company’s consolidated balance sheets. The Company has lease agreements with lease and nonlease components, which are generally accounted for as a single lease component. Leases of low-value assets are assessed on a lease-by-lease basis to determine the need for balance sheet capitalization.
ROU assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent its obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized on the lease commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit rate, the Company uses the incremental borrowing rate commensurate with the lease term based on the information available at the lease commencement date in determining the present value of lease payments. No significant judgments or assumptions were involved in developing the estimated operating lease liabilities as the Company’s operating lease liabilities largely represent the future rental expenses associated with operating leases, and the incremental borrowing rates are based on publicly available interest rates. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. The Company’s lease terms may include options to extend or terminate the lease. These options to extend or terminate are assessed on a lease-by-lease basis, and the ROU assets and lease liabilities are adjusted when it is reasonably certain that an option will be exercised. Rental expense for lease payments is recognized on a straight-line basis over the lease term and is included in occupancy and equipment, net within our consolidated statements of operations.
2. Recently Issued Accounting Standards
Accounting Standards Adopted During 2019
In July 2018, the FASB issued ASU 2018-09 which clarifies, corrects and makes minor improvements to a wide variety of topics in the ASC. The amendments make the ASC easier to understand and apply by eliminating inconsistencies and providing clarifications. The transition and effective dates are based on the facts and circumstances of each amendment, with some amendments becoming effective upon issuance of the ASU, and others becoming effective for annual periods beginning after December 15, 2018. The Company adopted the amendments as of January 1, 2019, which did not have a material effect on the Company’s consolidated financial statements.
In August 2017, the FASB issued ASU 2017-12 which provides targeted improvements to accounting for hedging activities. The FASB has issued various updates, improvements and technical corrections since the issuance of ASU 2017-12. The purpose of the amendment is to better align a company’s risk management activities with its financial reporting for hedging relationships, to simplify the hedge accounting requirements and to improve the disclosures of hedging arrangements. The amendment is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018. The Company adopted the standard on January 1, 2019. The Company has not historically applied hedge accounting to its derivative transactions, so the provisions of the amendment did not have a material effect on the Company’s consolidated financial statements.
In February 2016, the FASB issued the Leasing Standard, which is codified in ASC 842, Leases, and is intended to increase transparency and comparability among organizations and require lessees to record an ROU asset and a liability representing the obligation to make lease payments for long-term leases. Accounting by lessors remains largely unchanged. The Company adopted the standard on January 1, 2019, using the modified retrospective transition under the option to apply the Leasing Standard at its effective date without adjusting the prior period comparative financial statements. The Company elected the package of practical expedients to not reassess: (i) whether any existing contracts are or contain a lease, (ii) the lease classification of any existing leases and (iii) initial direct costs related to existing leases. The Company also elected to apply an additional practical expedient to include both the lease and nonlease components of all leases as a single component and account for it as a lease. The Company implemented internal controls and key system functionality to enable the preparation of financial information upon adoption. The implementation of the Leasing Standard had a material impact on our consolidated balance sheets but did not have a material impact on our consolidated statements of operations. On January 1, 2019, the Company recorded operating lease liabilities of $121.8 million and ROU assets of $111.9 million upon adoption of the Leasing Standard. The lease liabilities (at their present value) represent predominantly all of the future minimum lease payments required under operating leases. The balance sheet effects of the new lease accounting standard also impacted regulatory capital ratios, performance ratios and other measures which are dependent upon asset or liability balances. In addition, the Company reassessed its accounting ownership of the Hilltop Plaza assets under construction as of January 1, 2019, under the build-to-suit provisions of ASC 842 and concluded it is not the accounting owner. As such, the assets and liabilities of the project were derecognized during the first quarter of 2019, with the $1.4 million offset representing deferred expenses
recognized on the project to date through January 1, 2019, recorded as an increase to retained earnings. Refer to Note 13 for more details regarding the Hilltop Plaza transaction.
Accounting Standards Issued But Not Yet Adopted
In August 2018, the FASB issued ASU 2018-15 which aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software licenses). The accounting for the service element of a hosting arrangement that is a service contract is not affected by the amendments in this update. The amendment also includes presentation and disclosure provisions regarding capitalized implementation costs. The amendment is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2019. Early adoption is permitted. The Company is currently evaluating the provisions of the amendment and the impact on its future consolidated financial statements.
In August 2018, the FASB issued ASU 2018-13 which includes various removals, modifications and additions to existing guidance regarding fair value disclosures. The amendments are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2019. Early adoption is permitted. The Company is currently evaluating the provisions of the amendments but does not expect the amendments to have a material impact on its future consolidated financial statements.
In June 2016, the FASB issued ASU 2016-13 which sets forth a “current expected credit loss” (CECL) model which requires entities to measure all credit losses expected over the life of an exposure (or pool of exposures) for financial instruments held at the reporting date based on historical experience, current conditions and reasonable and supportable forecasts. The FASB has issued various updates, improvements and technical corrections to the standard since the issuance of ASU 2016-13. The new standard, which is codified in ASC 326, Financial Instruments – Credit Losses, replaces the existing incurred loss model and is applicable to the measurement of credit losses on financial assets measured at amortized cost and applies to some off-balance sheet credit exposures. The new standard also requires enhanced disclosures to help financial statement users better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an entity’s portfolio. The new standard is effective for annual periods, and interim reporting periods within those annual periods, beginning after December 15, 2019 with a cumulative-effect adjustment to retained earnings as of the beginning of the reporting period of adoption. The Company does not intend to adopt the provisions of the new standard early. The Company’s cross-functional team is continuing to implement and test new credit forecasting models and a credit scoring system that will be utilized to estimate the likelihood of default and loss severity as a part of its credit loss estimation methodology in accordance with the new standard. The Company is working to produce parallel credit loss calculations during the remainder of 2019, with a focus on calculating a potential range of financial impact. In addition, the Company continues to identify and assess key interpretive policy issues, as well as design and build new and modified policies and procedures that will be used to calculate its credit loss reserves. New and revised internal controls and processes are also being designed. The Company expects that the CECL model will require a material increase in the allowance for credit losses upon adoption on January 1, 2020. However, the magnitude of the increase in allowance for credit losses upon adoption will depend on, among other things, the portfolio composition and quality at the adoption date, as well as economic conditions and forecasts at that time.
3. Acquisition
BORO Acquisition
On August 1, 2018, to expand its Houston-area banking operations, the Company acquired privately-held The Bank of River Oaks (“BORO”) in an all-cash transaction (the “BORO Acquisition”). Pursuant to the terms of the definitive agreement, the Company paid cash in the aggregate amount of $85 million to the shareholders and option holders of BORO. The operations of BORO are included in the Bank’s operating results beginning August 1, 2018. BORO’s results of operations prior to the acquisition date are not included in the Company’s consolidated operating results.
The BORO Acquisition was accounted for using the acquisition method of accounting, and accordingly, purchased assets, including identifiable intangible assets, and assumed liabilities were recorded at their respective acquisition date fair values. The resulting fair values of the identifiable assets acquired and liabilities assumed from BORO at August 1, 2018 are summarized in the following table (in thousands).
21,756
Securities
60,477
Loans held for investment
326,618
25,912
Total identifiable assets acquired
434,763
376,393
10,000
2,996
Total liabilities assumed
389,389
Net identifiable assets acquired
45,374
Goodwill resulting from the acquisition
39,627
Net assets acquired
85,001
The goodwill of $39.6 million resulting from the BORO Acquisition represents the inherent long-term value expected from the business opportunities created from combining BORO with the Company. The Company used significant estimates and assumptions to value the identifiable assets acquired and liabilities assumed. The amount of goodwill recorded in connection with the Company’s acquisition of BORO is not deductible for tax purposes.
Included within the fair value of other assets in the table above are $10.0 million of identifiable core deposits intangible assets recorded in connection with the BORO Acquisition which are being amortized on an accelerated basis over an estimated useful life of six years. The fair value of the core deposit intangible assets was estimated using the net cost savings method, a variation of the income approach. This involved the use of the following significant assumptions: cost of deposits, customer attrition rate, and discount rate.
In connection with the BORO Acquisition, the Company acquired loans both with and without evidence of credit quality deterioration since origination. The acquired loans were initially recorded at fair value with no carryover of any allowance for loan losses. Acquired loans were segregated between those considered to be purchased credit impaired (“PCI”) loans and those without credit impairment at acquisition.
The following table presents details on acquired loans at the acquisition date (in thousands).
Loans, excluding
PCI
Total Loans Held
PCI Loans
Loans
for Investment
Commercial real estate
119,188
5,350
124,538
1 - 4 family residential
55,487
39
55,526
Construction and land development
37,134
Commercial and industrial
98,259
2,127
100,386
Consumer
9,021
13
9,034
319,089
7,529
The following table presents information about the PCI loans at acquisition (in thousands).
Contractually required principal and interest payments
10,730
Nonaccretable difference
2,859
Cash flows expected to be collected
7,871
Accretable difference
342
Fair value of loans acquired with a deterioration of credit quality
The following table presents information about the acquired loans without credit impairment at acquisition (in thousands).
381,551
Contractual cash flows not expected to be collected
15,286
Fair value at acquisition
4. Fair Value Measurements
Fair Value Measurements and Disclosures
The Company determines fair values in compliance with The Fair Value Measurements and Disclosures Topic of the ASC (the “Fair Value Topic”). The Fair Value Topic defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. The Fair Value Topic defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The Fair Value Topic assumes that transactions upon which fair value measurements are based occur in the principal market for the asset or liability being measured. Further, fair value measurements made under the Fair Value Topic exclude transaction costs and are not the result of forced transactions.
The Fair Value Topic includes a fair value hierarchy that classifies fair value measurements based upon the inputs used in valuing the assets or liabilities that are the subject of fair value measurements. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs, as indicated below.
Fair Value Option
The Company has elected to measure substantially all of PrimeLending’s mortgage loans held for sale and retained mortgage servicing rights (“MSR”) asset at fair value, under the provisions of the Fair Value Option. The Company elected to apply the provisions of the Fair Value Option to these items so that it would have the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. At June 30, 2019 and December 31, 2018, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.48 billion and $1.26 billion, respectively, and the unpaid principal balance of those loans was $1.43 billion and $1.21 billion, respectively. The interest component of fair value is reported as interest income on loans in the accompanying consolidated statements of operations.
The Company holds a number of financial instruments that are measured at fair value on a recurring basis, either by the application of the Fair Value Option or other authoritative pronouncements. The fair values of those instruments are determined primarily using Level 2 inputs. Those inputs include quotes from mortgage loan investors and derivatives
14
dealers and data from independent pricing services. The fair value of loans held for sale is determined using an exit price method.
The following tables present information regarding financial assets and liabilities measured at fair value on a recurring basis (in thousands).
Level 1
Level 2
Level 3
June 30, 2019
Inputs
Fair Value
Trading securities
5,204
596,320
Available for sale securities
Equity securities
1,418,277
56,799
1,475,076
Derivative assets
72,783
MSR asset
53,695
Securities sold, not yet purchased
14,897
30,550
Derivative liabilities
38,939
December 31, 2018
7,947
737,519
1,207,311
50,464
1,257,775
35,010
66,102
33,000
48,667
26,355
The following tables include a rollforward for those financial instruments measured at fair value using Level 3 inputs (in thousands).
Total Gains or Losses
(Realized or Unrealized)
Balance at
Included in Other
Beginning of
Purchases/
Sales/
Transfers to
Included in
Period
Additions
Reductions
(from) Level 3
Net Income
End of Period
Three months ended June 30, 2019
57,844
14,053
(11,108)
(612)
(3,378)
62,049
2,547
(10,901)
119,893
16,600
(14,279)
110,494
Six months ended June 30, 2019
29,480
(18,084)
425
(5,486)
(16,815)
116,566
33,888
(22,301)
Three months ended June 30, 2018
43,483
8,071
(8,538)
(2,235)
40,781
63,957
3,068
(9,303)
(349)
57,373
107,440
11,139
(17,841)
(2,584)
98,154
Six months ended June 30, 2018
36,972
20,550
(12,513)
(4,228)
54,714
2,233
91,686
30,279
(21,816)
(1,995)
All net realized and unrealized gains (losses) in the tables above are reflected in the accompanying consolidated financial statements. The unrealized gains (losses) relate to financial instruments still held at June 30, 2019.
For Level 3 financial instruments measured at fair value on a recurring basis at June 30, 2019 and December 31, 2018, the significant unobservable inputs used in the fair value measurements were as follows.
Range (Weighted-Average)
Financial instrument
Valuation Technique
Unobservable Inputs
Discounted cash flows / Market comparable
Projected price
-
96
%
(
95
%)
Discounted cash flows
Constant prepayment rate
13.67
10.51
Discount rate
11.12
11.11
The fair value of certain loans held for sale that cannot be sold through normal sale channels or are non-performing is measured using Level 3 inputs. The fair value of such loans is generally based upon estimates of expected cash flows using unobservable inputs, including listing prices of comparable assets, uncorroborated expert opinions, and/or management’s knowledge of underlying collateral.
The MSR asset, which is included in other assets within the Company’s consolidated balance sheets, is reported at fair value using Level 3 inputs. The MSR asset is valued by projecting net servicing cash flows, which are then discounted to estimate the fair value. The fair value of the MSR asset is impacted by a variety of factors. Prepayment rates and discount rates, the most significant unobservable inputs, are discussed further in Note 7 to the consolidated financial statements.
The Company had no transfers between Levels 1 and 2 during the periods presented. Any transfers are based on changes in the observability and/or significance of the valuation inputs and are assumed to occur at the beginning of the quarterly reporting period in which they occur.
The following table presents those changes in fair value of instruments recognized in the consolidated statements of operations that are accounted for under the Fair Value Option (in thousands).
Three Months Ended June 30, 2019
Three Months Ended June 30, 2018
Net
Noninterest
Changes in
Gains (Losses)
Income
17,179
22,604
Six Months Ended June 30, 2019
Six Months Ended June 30, 2018
3,855
7,724
The Company also determines the fair value of certain assets and liabilities on a non-recurring basis. In particular, the fair value of all assets acquired and liabilities assumed in an acquisition of a business are determined at their respective acquisition date fair values. In addition, facts and circumstances may dictate a fair value measurement when there is evidence of impairment. Assets and liabilities measured on a non-recurring basis include the items discussed below.
Impaired Loans — The Company reports individually impaired loans based on the underlying fair value of the collateral through specific allowances within the allowance for loan losses. PCI loans were acquired by the Company upon completion of the merger with PCC (the “PlainsCapital Merger”), the FDIC-assisted transaction whereby the Bank acquired certain assets and assumed certain liabilities of Edinburg, Texas-based First National Bank (“FNB”) on September 13, 2013 (the “FNB Transaction”), the acquisition of SWS Group, Inc. (“SWS”) in a stock and cash transaction (the "SWS Merger"), whereby SWS’s banking subsidiary, Southwest Securities, FSB, was merged into the Bank, and the BORO Acquisition (collectively, the “Bank Transactions”). The fair value of PCI loans was determined using Level 3 inputs, including estimates of expected cash flows that incorporated significant unobservable inputs
regarding default rates, loss severity rates assuming default, prepayment speeds on acquired loans accounted for in pools (“Pooled Loans”), and estimated collateral values.
Estimates for these significant unobservable inputs and the resulting weighted average expected loss on PCI loans were as follows.
PlainsCapital
FNB
SWS
BORO
Merger
Transaction
Acquisition
Weighted average default rate
84
30
71
59
Weighted average loss severity rate
28
43
Weighted average prepayment speed
0
Resulting weighted average expected loss on PCI loans
49
20
25
81
34
63
48
26
The Company obtains updated appraisals of the fair value of collateral securing impaired collateral dependent loans at least annually, in accordance with regulatory guidelines. The Company also reviews the fair value of such collateral on a quarterly basis. If the quarterly review indicates that the fair value of the collateral may have deteriorated, the Company orders an updated appraisal of the fair value of the collateral. Because the Company obtains updated appraisals when evidence of a decline in the fair value of collateral exists, it typically does not adjust appraised values.
Other Real Estate Owned — The Company determines fair value primarily using independent appraisals of other real estate owned (“OREO”) properties. The resulting fair value measurements are classified as Level 2 inputs. At June 30, 2019 and December 31, 2018, the estimated fair value of OREO was $20.8 million and $27.6 million, respectively, and the underlying fair value measurements utilized Level 2 inputs. The amounts are included in other assets within the consolidated balance sheets. During the reported periods, all fair value measurements for OREO subsequent to initial recognition utilized Level 2 inputs.
The following table presents information regarding certain assets and liabilities measured at fair value on a non-recurring basis for which a change in fair value has been recorded during reporting periods subsequent to initial recognition (in thousands).
Total Gains (Losses) for the
Impaired loans held for investment
65,660
(1,295)
(602)
(1,195)
(725)
Other real estate owned
12,885
(119)
(694)
(613)
(1,800)
The Fair Value of Financial Instruments Subsection of the ASC requires disclosure of the fair value of financial assets and liabilities, including the financial assets and liabilities previously discussed. There have been changes to the methods for determining estimated fair value for financial assets and liabilities as described in detail in Note 3 to the consolidated financial statements included in the Company’s 2018 Form 10-K.
17
The following tables present the carrying values and estimated fair values of financial instruments not measured at fair value on either a recurring or non-recurring basis (in thousands).
Estimated Fair Value
Carrying
Financial assets:
Cash and cash equivalents
342,522
Held to maturity securities
368,546
134,401
570,377
6,818,592
7,388,969
71,833
70,724
1,109
Financial liabilities:
8,464,697
Debt
298,935
296,724
5,640
644,473
341,124
135,471
578,363
6,445,810
7,024,173
69,720
68,573
1,147
8,528,947
295,884
293,685
3,482
18
The Company held equity investments other than securities of $36.3 million and $35.8 million at June 30, 2019 and December 31, 2018, respectively, which are included within other assets in the consolidated balance sheets. Of the $36.3 million of such equity investments held at June 30, 2019, $19.9 million do not have readily determinable fair values and each is measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. The following table presents the adjustments to the carrying value of these investments during the periods presented (in thousands).
Balance, beginning of period
20,477
21,906
20,376
22,946
Additional investments
1,411
Upward adjustments
101
2,836
202
3,108
Impairments and downward adjustments
(1,314)
Dispositions
Balance, end of period
19,906
26,151
5. Securities
The fair value of trading securities is summarized as follows (in thousands).
U.S. Treasury securities
5,203
7,945
U.S. government agencies:
Bonds
6,194
1,494
Residential mortgage-backed securities
246,943
309,455
Commercial mortgage-backed securities
2,204
4,239
Collateralized mortgage obligations
149,449
206,813
Corporate debt securities
54,729
59,293
States and political subdivisions
116,202
126,748
Unit investment trusts
15,919
19,913
Private-label securitized product
1,267
5,680
3,414
3,886
Totals
The Hilltop Broker-Dealers enter into transactions that represent commitments to purchase and deliver securities at prevailing future market prices to facilitate customer transactions and satisfy such commitments. Accordingly, the Hilltop Broker-Dealers’ ultimate obligations may exceed the amount recognized in the financial statements. These securities, which are carried at fair value and reported as securities sold, not yet purchased in the consolidated balance sheets, had a value of $45.4 million and $81.7 million at June 30, 2019 and December 31, 2018, respectively.
19
The amortized cost and fair value of available for sale and held to maturity securities are summarized as follows (in thousands).
Available for Sale
Amortized
Unrealized
Cost
Gains
Losses
10,559
197
(11)
10,745
85,311
1,210
(14)
86,507
467,661
5,925
(1,453)
472,133
11,595
540
12,135
333,415
3,061
(2,206)
334,270
47,824
1,710
49,534
43,433
1,170
(3)
44,600
999,798
13,813
(3,687)
11,552
(44)
11,538
85,492
552
(433)
85,611
391,428
608
(6,962)
385,074
11,703
189
(120)
11,772
281,450
385
(5,436)
276,399
53,614
268
(580)
53,302
51,560
(206)
51,962
886,799
2,640
(13,781)
Held to Maturity
9,961
9,980
39,019
(71)
38,948
20,031
203
20,234
113,570
3,170
(98)
116,642
130,326
300
(1,271)
129,355
52,998
650
(261)
53,387
4,342
(1,701)
9,903
9,906
39,018
(1,479)
37,539
21,903
(263)
21,640
87,065
271
(1,462)
85,874
142,474
(5,000)
137,474
50,649
(2,049)
48,691
(10,253)
Additionally, the Company had unrealized net gains of $0.7 million and unrealized net losses of $0.9 million from equity securities with fair values of $19.6 million and $19.7 million held at June 30, 2019 and December 31, 2018, respectively.
The Company recognized net gains of $0.2 million and $0.1 million during the three months ended June 30, 2019 and 2018, respectively, and net gains of $1.5 million and net losses of $0.5 million during the six months ended June 30, 2019 and 2018, respectively, due to changes in the fair value of equity securities still held at the balance sheet date. During the three and six months ended June 30, 2019 and 2018, net gains recognized from equity securities sold were nominal.
Information regarding available for sale, held to maturity and equity securities that were in an unrealized loss position is shown in the following tables (dollars in thousands).
Number of
U.S. treasury securities:
Unrealized loss for less than twelve months
2,586
1
981
Unrealized loss for twelve months or longer
3,556
4,537
45
Bonds:
24,772
9,986
30,472
428
55,244
433
Residential mortgage-backed securities:
8,355
66,791
432
106,815
1,445
27
194,228
6,530
115,170
1,452
35
261,019
6,962
Commercial mortgage-backed securities:
4,953
120
Collateralized mortgage obligations:
55,481
153
44,394
498
24
106,528
2,054
140,483
4,938
33
162,009
2,207
184,877
5,436
Corporate debt securities:
3,009
16,256
282
2,407
15,665
297
5,416
31,921
579
States and political subdivisions:
822
29
8,590
1,223
9,029
179
2,045
47
17,619
206
Total available for sale:
70,253
171
60
161,784
1,250
44
226,959
3,516
88
398,386
12,531
58
297,212
3,687
148
560,170
13,781
21
29,248
1,479
8,411
13,229
174
263
1,601
4,973
12,551
59,670
1,435
14,152
98
64,643
1,462
2,051
95,659
1,271
135,423
4,974
5,000
6,431
56
41
19,683
261
32,909
1,993
39,340
2,049
Total held to maturity:
21,866
198
157,141
1,684
130
278,770
10,055
61
158,742
1,701
142
300,636
10,253
During the three and six months ended June 30, 2019 and 2018, the Company did not record any other-than-temporary impairment (“OTTI”). While some of the securities held in the Company’s investment portfolio have decreased in value since the date of acquisition, the severity of loss and the duration of the loss position are not significant enough to warrant OTTI of the securities. Factors considered in the Company’s analysis include the reasons for the unrealized loss position, the severity and duration of the unrealized loss position, credit worthiness, and forecasted performance of the investee. The Company does not intend to sell, nor does the Company believe that it is likely that the Company will be required to sell, these securities before the recovery of the cost basis.
Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. The amortized cost and fair value of securities, excluding trading and equity securities, at June 30, 2019 are shown by contractual maturity below (in thousands).
Due in one year or less
39,783
39,797
11,356
11,376
Due after one year through five years
88,357
90,942
26,042
26,055
Due after five years through ten years
39,142
40,024
5,392
5,414
Due after ten years
19,845
20,623
59,188
59,470
187,127
191,386
101,978
102,315
The Company recognized net gains of $2.5 million and net losses of $6.8 million from its trading portfolio during the three months ended June 30, 2019 and 2018, respectively, and $10.7 million and $1.9 million during the six months ended June 30, 2019 and 2018, respectively. In addition, the Hilltop Broker-Dealers realized net gains from structured product trading activities of $30.4 million and $0.4 million during the three months ended June 30, 2019 and 2018,
22
respectively, and $55.7 million and $17.4 million during the six months ended June 30, 2019 and 2018, respectively. All such realized net gains and losses are recorded as a component of other noninterest income within the consolidated statements of operations.
Securities with a carrying amount of $612.3 million and $612.3 million (with a fair value of $615.6 million and $600.0 million, respectively) at June 30, 2019 and December 31, 2018, respectively, were pledged by the Bank to secure public and trust deposits, federal funds purchased and securities sold under agreements to repurchase, and for other purposes as required or permitted by law. Substantially all of these pledged securities were included in our available for sale and held to maturity securities portfolios at June 30, 2019 and December 31, 2018.
Mortgage-backed securities and collateralized mortgage obligations consist primarily of Government National Mortgage Association (“GNMA”), Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”) pass-through and participation certificates. GNMA securities are guaranteed by the full faith and credit of the United States, while FNMA and FHLMC securities are fully guaranteed by those respective United States government-sponsored agencies, and conditionally guaranteed by the full faith and credit of the United States.
At June 30, 2019 and December 31, 2018, NLC had investments on deposit in custody for various state insurance departments with aggregate carrying values of $9.3 million and $9.5 million, respectively.
6. Loans Held for Investment and Allowance for Loan Losses
The loans acquired in the FNB Transaction were subject to loss-share agreements with the FDIC. During the fourth quarter of 2018, the Bank and the FDIC entered into a Termination Agreement pursuant to which all rights and obligations of the Bank and the FDIC under the FDIC loss-share agreements were resolved and terminated. Accordingly, loans which were previously referred to as either “covered loans” if covered by the loss-share agreements or otherwise “non-covered loans” are now collectively referred to as “loans held for investment.” Disclosures associated with loans that were previously covered by the FDIC loss-share agreements during the three and six months ended June 30, 2018 are included in the “covered” portfolio segment in the applicable tables that follow. The majority of the loans previously covered by the FDIC loss-share agreements are comprised primarily of commercial real estate and 1-4 family residential loans. Loans held for investment summarized by portfolio segment are as follows (in thousands).
2,937,243
2,940,120
1,448,221
1,508,451
950,628
932,909
1-4 family residential
696,535
679,263
Mortgage warehouse
555,327
243,806
44,273
47,546
Broker-dealer (1)
Total loans held for investment, net of allowance
In connection with the Bank Transactions, the Company acquired loans both with and without evidence of credit quality deterioration since origination. The following table presents the carrying values and the outstanding balances of PCI loans (in thousands).
Carrying amount
86,200
93,072
Outstanding balance
155,749
172,808
23
Changes in the accretable yield for PCI loans were as follows (in thousands).
72,172
93,686
80,693
98,846
Reclassifications from nonaccretable difference, net (1)
4,909
3,136
5,443
10,265
Disposals of loans
(337)
(703)
Accretion
(7,439)
(9,514)
(16,128)
(21,514)
Transfer of loans to OREO (2)
(656)
(847)
69,305
86,652
The remaining nonaccretable difference for PCI loans was $59.6 million and $64.2 million at June 30, 2019 and December 31, 2018, respectively.
Impaired loans exhibit a clear indication that the borrower’s cash flow may not be sufficient to meet principal and interest payments, which generally occurs when a loan is 90 days past due unless the asset is both well secured and in the process of collection. Impaired loans include non-accrual loans, troubled debt restructurings (“TDRs”), PCI loans and partially charged-off loans.
The amounts shown in the following tables include loans accounted for on an individual basis, as well as acquired Pooled Loans. For Pooled Loans, the recorded investment and the related allowance consider impairment measured at the pool level. Impaired loans, segregated between those considered to be PCI loans and those without credit impairment at acquisition, are summarized by class in the following tables (in thousands).
Unpaid
Recorded
Contractual
Investment with
Related
Principal Balance
No Allowance
Allowance
Investment
Commercial real estate:
Non-owner occupied
35,163
7,332
12,748
1,331
Owner occupied
28,977
6,965
5,636
12,601
639
25,825
4,767
1,141
5,908
7,791
67
96,746
1,623
53,249
54,872
1,895
Broker-dealer
196,397
18,819
67,381
3,989
Non-PCI
199
5,106
3,943
26,210
9,950
2,245
12,195
838
1,536
919
492
10,460
7,625
144
43,662
22,670
2,737
25,407
850
240,059
41,489
70,118
111,607
4,839
42,668
5,549
7,540
13,089
1,125
36,246
11,657
2,967
14,624
304
27,403
5,491
1,068
6,559
72
10,992
74
390
464
92
106,503
646
57,681
58,327
1,299
2,185
225,997
23,426
69,646
2,892
5,231
4,098
22,277
9,891
11,631
721
3,430
2,711
535
3,246
31
8,695
6,922
149
39,782
23,664
2,275
25,939
752
265,779
47,090
71,921
119,011
3,644
Average recorded investment in impaired loans is summarized by class in the following table (in thousands).
13,097
30,245
13,018
31,998
17,380
17,633
7,887
17,284
24,056
18,147
24,206
1,619
1,673
2,594
1,768
63,279
63,873
54
116
Covered
83,471
86,763
112,700
144,472
115,310
152,738
Non-accrual loans, excluding those classified as held for sale, are summarized by class in the following table (in thousands).
1,333
1,226
14,870
1,413
3,278
7,700
7,026
28,575
30,539
At June 30, 2019 and December 31, 2018, non-accrual loans included PCI loans of $4.4 million and $4.9 million, respectively, for which discount accretion has been suspended because the extent and timing of cash flows from these PCI loans can no longer be reasonably estimated. In addition to the non-accrual loans in the table above, $3.4 million of real estate loans secured by residential properties and classified as held for sale were in non-accrual status at both June 30, 2019 and December 31, 2018.
Interest income, including recoveries and cash payments, recorded on impaired loans was $0.3 million and $0.2 million during the three months ended June 30, 2019 and 2018, respectively, and $0.7 million and $0.4 million during the six months ended June 30, 2019 and 2018, respectively. Except as noted above, PCI loans are considered to be performing due to the application of the accretion method.
The Bank classifies loan modifications as TDRs when it concludes that it has both granted a concession to a debtor and that the debtor is experiencing financial difficulties. Loan modifications are typically structured to create affordable payments for the debtor and can be achieved in a variety of ways. The Bank modifies loans by reducing interest rates and/or lengthening loan amortization schedules. The Bank may also reconfigure a single loan into two or more loans (“A/B Note”). The typical A/B Note restructure results in a “bad” loan which is charged off and a “good” loan or loans, the terms of which comply with the Bank’s customary underwriting policies. The debt charged off on the “bad” loan is not forgiven to the debtor.
Information regarding TDRs granted during the three and six months ended June 30, 2019, is shown in the following table (dollars in thousands). There were no TDRs granted during the three or six months ended June 30, 2018. At June 30, 2019 and December 31, 2018, the Bank had nominal unadvanced commitments to borrowers whose loans have been restructured in TDRs.
Extension
7,993
7,973
There were no TDRs granted during the twelve months preceding June 30, 2019 for which a payment was at least 30 days past due. The following table presents information regarding TDRs granted during the twelve months preceding June 30, 2018, for which a payment was at least 30 days past due (dollars in thousands).
Twelve Months Preceding June 30, 2018
3,294
3,206
An analysis of the aging of the Company’s loan portfolio is shown in the following tables (in thousands).
Accruing Loans(Non-PCI)
Loans Past Due
Current
Past Due
30-59 Days
60-89 Days
90 Days or More
Past Due Loans
811
1,140
1,653,557
1,667,445
1,526
2,527
4,053
1,253,144
1,269,798
3,604
5,257
1,055
9,916
1,432,397
2,719
839
3,558
947,003
4,444
1,257
2,856
8,557
633,106
555,288
188
44,081
13,292
7,522
6,637
27,451
7,088,953
1,174
1,373
1,708,160
1,722,622
1,364
4,173
5,537
1,197,337
1,217,498
75
1,792
1,049
11,051
13,892
1,488,000
3,549
928,896
5,987
2,484
1,950
10,421
610,515
254
147
401
47,136
14,120
3,879
17,174
35,173
6,802,213
78
In addition to the loans shown in the tables above, PrimeLending had $77.4 million and $83.1 million of loans included in loans held for sale (with an aggregate unpaid principal balance of $78.5 million and $84.0 million, respectively) that were 90 days past due and accruing interest at June 30, 2019 and December 31, 2018, respectively. These loans are guaranteed by U.S. government agencies and include loans that are subject to repurchase, or have been repurchased, by PrimeLending.
Management tracks credit quality trends on a quarterly basis related to: (i) past due levels, (ii) non-performing asset levels, (iii) classified loan levels, (iv) net charge-offs, and (v) general economic conditions in state and local markets.
The Company utilizes a risk grading matrix to assign a risk grade to each of the loans in its portfolio with the exception of broker-dealer margin loans. A risk rating is assigned based on an assessment of the borrower’s management, collateral position, financial capacity, and economic factors. The general characteristics of the various risk grades are described below.
Pass – “Pass” loans present a range of acceptable risks to the Company. Loans that would be considered virtually risk-free are rated Pass – low risk. Loans that exhibit sound standards based on the grading factors above and present a reasonable risk to the Company are rated Pass – normal risk. Loans that exhibit a minor weakness in one or more of the grading criteria but still present an acceptable risk to the Company are rated Pass – high risk.
Special Mention – “Special Mention” loans have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in a deterioration of the repayment prospects for the loans and weaken the Company’s credit position at some future date. Special Mention loans are not adversely classified and do not expose the Company to sufficient risk to require adverse classification.
Substandard – “Substandard” loans are inadequately protected by the current sound worth and paying capacity of the obligor or the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Many substandard loans are considered impaired.
PCI – “PCI” loans exhibited evidence of credit deterioration at acquisition that made it probable that all contractually required principal payments would not be collected.
The following tables present the internal risk grades of loans, as previously described, in the portfolio by class (in thousands).
Pass
Special Mention
Substandard
1,599,634
5,935
49,128
1,222,925
34,272
1,383,938
447
57,928
948,148
2,413
623,710
371
17,582
44,188
6,948,247
6,753
161,404
1,673,424
36,109
1,175,225
2,083
25,566
1,433,227
15,320
53,345
929,130
3,315
601,264
393
19,279
47,416
121
6,681,855
17,796
137,735
Allowance for Loan Losses
The allowance for loan losses is subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance. The Company’s analysis of the level of the allowance for loan losses to ensure that it is appropriate for the estimated credit losses in the portfolio consistent with the Interagency Policy Statement on the Allowance for Loan and Lease Losses and the Receivables and Contingencies Topics of the ASC is described in detail in Note 5 to the consolidated financial statements included in the Company’s 2018 Form 10-K.
Changes in the allowance for loan losses, distributed by portfolio segment, are shown below (in thousands).
Balance,
Provision (Recovery)
Recoveries on
Beginning of Period
for Loan Losses
Charged Off
Charged Off Loans
26,845
(1,731)
25,114
21,268
1,254
(2,430)
322
20,414
(1,512)
4,396
4,331
1,447
(871)
4,924
409
(128)
(10)
283
58,809
(3,311)
351
55,177
Charged Off loans
27,100
(1,986)
21,980
1,712
(4,248)
970
6,061
(1,665)
3,956
1,836
(899)
267
458
(464)
122
(76)
59,486
(5,611)
1,023
27,193
(1,143)
(18)
26,032
23,269
1,815
(2,233)
666
23,517
7,449
(178)
7,271
2,107
376
(6)
2,552
276
(75)
(30)
36
207
77
417
2,823
(795)
(57)
1,974
63,194
(2,344)
780
61,970
26,413
23,674
119
(3,416)
3,140
7,844
(573)
2,362
99
103
311
(109)
(43)
353
64
2,729
(704)
63,686
(3,546)
3,297
The loan portfolio was distributed by portfolio segment and impairment methodology as shown below (in thousands).
Loans Individually
Loans Collectively
Evaluated for
Impairment
3,559
2,908,335
25,349
11,362
1,430,951
1,317
949,244
641,055
44,269
16,846
7,099,558
3,909
2,908,498
27,713
10,741
1,491,151
3,241
929,204
620,936
47,537
17,891
6,819,495
The allowance for loan losses was distributed by portfolio segment and impairment methodology as shown below (in thousands).
23,144
1,970
19,547
4,381
2,937
50,338
25,671
1,429
21,187
5,938
2,657
55,842
7. Mortgage Servicing Rights
The following tables present the changes in fair value of the Company’s MSR asset, as included in other assets within the consolidated balance sheets, and other information related to the serviced portfolio (dollars in thousands).
Sales
Changes in fair value:
Due to changes in model inputs or assumptions (1)
(8,739)
1,032
(13,772)
4,673
Due to customer payoffs
(2,162)
(1,381)
(3,043)
(2,440)
Mortgage loans serviced for others
5,027,953
5,086,461
MSR asset as a percentage of serviced mortgage loans
1.07
1.30
The key assumptions used in measuring the fair value of the Company’s MSR asset were as follows.
Weighted average constant prepayment rate
Weighted average discount rate
Weighted average life (in years)
5.8
7.1
A sensitivity analysis of the fair value of the Company’s MSR asset to certain key assumptions is presented in the following table (in thousands).
Constant prepayment rate:
Impact of 10% adverse change
(3,097)
(2,512)
Impact of 20% adverse change
(5,977)
(4,980)
Discount rate:
(1,988)
(2,677)
(3,826)
(5,139)
This sensitivity analysis presents the effect of hypothetical changes in key assumptions on the fair value of the MSR asset. The effect of such hypothetical change in assumptions generally cannot be extrapolated because the relationship of the change in one key assumption to the change in the fair value of the MSR asset is not linear. In addition, in the analysis, the impact of an adverse change in one key assumption is calculated independent of any impact on other assumptions. In reality, changes in one assumption may change another assumption.
Contractually specified servicing fees, late fees and ancillary fees earned of $6.6 million and $6.1 million during the three months ended June 30, 2019 and 2018, respectively, and $12.9 million and $11.8 million during the six months ended June 30, 2019 and 2018, respectively, were included in net gains from sale of loans and other mortgage production income within the consolidated statements of operations.
8. Deposits
Deposits are summarized as follows (in thousands).
Noninterest-bearing demand
Interest-bearing:
NOW accounts
1,495,785
1,358,196
Money market
2,428,191
2,725,541
Brokered - money market
Demand
325,105
393,685
Savings
180,747
184,700
Time
1,429,998
1,308,284
9. Short-term Borrowings
Short-term borrowings are summarized as follows (in thousands).
Federal funds purchased
124,050
100,100
Securities sold under agreements to repurchase
508,843
576,707
Federal Home Loan Bank
475,000
200,000
Short-term bank loans
231,000
189,000
Federal funds purchased and securities sold under agreements to repurchase generally mature daily, on demand, or on some other short-term basis. The Bank and the Hilltop Broker-Dealers execute transactions to sell securities under agreements to repurchase with both customers and other broker-dealers. Securities involved in these transactions are held by the Bank, the Hilltop Broker-Dealers or a third-party dealer.
Information concerning federal funds purchased and securities sold under agreements to repurchase is shown in the following tables (dollars in thousands).
Average balance during the period
621,268
721,167
Average interest rate during the period
2.54
1.63
Average interest rate at end of period
2.57
2.43
Securities underlying the agreements at end of period:
Carrying value
516,067
587,609
Estimated fair value
554,160
618,231
32
Federal Home Loan Bank (“FHLB”) short-term borrowings mature over terms not exceeding 365 days and are collateralized by FHLB Dallas stock, nonspecified real estate loans and certain specific commercial real estate loans. Other information regarding FHLB short-term borrowings is shown in the following tables (dollars in thousands).
159,945
117,956
2.47
1.91
2.32
2.65
The Hilltop Broker-Dealers use short-term bank loans periodically to finance securities owned, margin loans to customers and correspondents and underwriting activities. Interest on the borrowings varies with the federal funds rate. The weighted average interest rate on the borrowings at June 30, 2019 and December 31, 2018 was 3.28% and 3.35%, respectively.
10. Notes Payable
Notes payable consisted of the following (in thousands).
Senior Notes due April 2025, net of discount of $1,313 and $1,393, respectively
148,687
148,607
FHLB notes, including premium of $179 and $222, respectively, with maturities ranging from September 2020 to June 2030
4,037
4,391
NLIC note payable due May 2033
NLIC note payable due September 2033
ASIC note payable due April 2034
7,500
Ventures Management lines of credit due May 2020
51,699
48,374
11. Leases
Hilltop and its subsidiaries lease space, primarily for corporate offices, branch facilities and automated teller machines, under both operating and finance leases. Certain of the Company’s leases have options to extend, with the longest extension option being ten years, and some of the Company’s leases include options to terminate within one year. The Company’s leases contain customary restrictions and covenants. The Company has certain intercompany leases and subleases between its subsidiaries, and these transactions and balances have been eliminated in consolidation and are not reflected in the tables and information presented below.
Supplemental balance sheet information related to finance leases is as follows (in thousands).
Finance leases:
Premises and equipment
7,780
Accumulated depreciation
(3,883)
3,897
Operating lease rental cost and finance lease amortization of ROU assets is included within occupancy and equipment, net in the consolidated statements of operations. Finance lease interest expense is included within other interest expense in the consolidated statements of operations. The Company does not generally enter into leases which contain variable payments, other than due to the passage of time. The components of lease costs, including short-term lease costs, are as follows (in thousands).
Three Months Ended
Six Months Ended
Operating lease cost
10,599
21,130
Less operating lease and sublease income
(663)
(1,050)
Net operating lease cost
9,936
20,080
Finance lease cost:
Amortization of lease assets
295
Interest on lease liabilities
150
302
Total finance lease cost
597
Supplemental cash flow information related to leases is as follows (in thousands):
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows from operating leases
19,810
Operating cash flows from finance leases
Financing cash flows from finance leases
290
Right-of-use assets obtained in exchange for new lease obligations:
Operating leases
24,188
Finance leases
Information regarding the lease terms and discount rates of the Company’s leases is as follows.
Weighted Average
Lease Classification
Remaining Lease Term (Years)
Discount Rate
Operating
5.9
5.35
Finance
7.0
4.78
Future minimum lease payments under the Leasing Standard as of June 30, 2019, under lease agreements that had commenced as of or subsequent to January 1, 2019, are presented below (in thousands).
Operating Leases
Finance Leases
18,039
595
2020
32,798
1,197
2021
27,089
1,212
2022
21,209
1,241
2023
17,077
1,280
Thereafter
41,660
3,460
Total minimum lease payments
157,872
8,985
Less amount representing interest
(25,122)
(3,189)
Lease liabilities
5,796
As of June 30, 2019, the Company had additional operating leases that have not yet commenced with aggregate future minimum lease payments of approximately $0.6 million. These operating leases are expected to commence between July 2019 and September 2019 with lease terms ranging from two to five years.
A related party is the lessor in an operating lease with the Bank. The Bank’s minimum payment under the lease is $0.5 million annually through 2028, for an aggregate remaining obligation of $4.6 million at June 30, 2019.
The Company adopted the Leasing Standard on January 1, 2019, using the modified retrospective transition under the option to apply the new standard at its effective date without adjusting the prior period comparative financial statements. As such, disclosures for comparative periods under the predecessor standard, ASC 840, Leases, are required in the year of transition. Future minimum lease payments under ASC 840 as of December 31, 2018, under lease agreements that had commenced as of December 31, 2018, are presented below (in thousands).
Capital Leases
36,171
1,186
29,109
21,058
16,386
12,361
18,264
133,349
9,576
Amount representing interest
(1,221)
Present value of minimum lease payments
12. Income Taxes
The Company applies an estimated annual effective rate to interim period pre-tax income to calculate the income tax provision for the quarter in accordance with the principal method prescribed by the accounting guidance established for computing income taxes in interim periods. The Company’s effective tax rates were 23.1% and 24.3% for the three months ended June 30, 2019 and 2018, respectively, and 22.9% and 23.9% for the six months ended June 30, 2019 and 2018, respectively, and approximated the applicable statutory rates for such periods.
13. Commitments and Contingencies
Legal Matters
The Company is subject to loss contingencies related to litigation, claims, investigations and legal and administrative cases and proceedings arising in the ordinary course of business. The Company evaluates these contingencies based on information currently available, including advice of counsel. The Company establishes accruals for those matters when a loss contingency is considered probable and the related amount is reasonably estimable. Any accruals are periodically reviewed and may be adjusted as circumstances change. A portion of the Company’s exposure with respect to loss contingencies may be offset by applicable insurance coverage. In determining the amounts of any accruals or estimates of possible loss contingencies, the Company does not take into account the availability of insurance coverage, other than that provided by reinsurers in the insurance segment. When it is practicable, the Company estimates loss contingencies for possible litigation and claims, whether or not there is an accrued probable loss. When the Company is able to estimate such probable losses, and when it estimates that it is reasonably possible it could incur losses in excess of amounts accrued, the Company is required to make a disclosure of the aggregate estimation. As available information changes, however, the matters for which the Company is able to estimate, as well as the estimates themselves, will be adjusted accordingly.
Assessments of litigation and claims exposures are difficult due to many factors that involve inherent unpredictability. Those factors include the following: the varying stages of the proceedings, particularly in the early stages; unspecified, unsupported, or uncertain damages; damages other than compensatory, such as punitive damages; a matter presenting meaningful legal uncertainties, including novel issues of law; multiple defendants and jurisdictions; whether discovery has begun or is complete; whether meaningful settlement discussions have commenced; and whether the claim involves a class action and if so, how the class is defined. As a result of some of these factors, the Company may be unable to
estimate reasonably possible losses with respect to some or all of the pending and threatened litigation and claims asserted against the Company.
While the final outcome of litigation and claims exposures is inherently unpredictable, management is currently of the opinion that the outcome of pending and threatened litigation will not have a material effect on the Company’s business, consolidated financial position, results of operations or cash flows as a whole. However, in the event of unexpected future developments, it is reasonably possible that an adverse outcome in any matter could be material to the Company’s business, consolidated financial position, results of operations or cash flows for any particular reporting period of occurrence.
Indemnification Liability Reserve
The mortgage origination segment may be responsible to agencies, investors, or other parties for errors or omissions relating to its representations and warranties that each loan sold meets certain requirements, including representations as to underwriting standards and the validity of certain borrower representations in connection with the loan. If determined to be at fault, the mortgage origination segment either repurchases the affected loan from or indemnifies the claimant against loss. The mortgage origination segment has established an indemnification liability reserve for such probable losses.
Generally, the mortgage origination segment first becomes aware that an agency, investor, or other party believes a loss has been incurred on a sold loan when it receives a written request from the claimant to repurchase the loan or reimburse the claimant’s losses. Upon completing its review of the claimant’s request, the mortgage origination segment establishes a specific claims reserve for the loan if it concludes its obligation to the claimant is both probable and reasonably estimable.
An additional reserve has been established for probable agency, investor or other party losses that may have been incurred, but not yet reported to the mortgage origination segment based upon a reasonable estimate of such losses. Factors considered in the calculation of this reserve include, but are not limited to, the total volume of loans sold exclusive of specific claimant requests, actual claim settlements and the severity of estimated losses resulting from future claims, and the mortgage origination segment’s history of successfully curing defects identified in claim requests. While the mortgage origination segment’s sales contracts typically include borrower early payment default repurchase provisions, these provisions have not been a primary driver of claims to date, and therefore, are not a primary factor considered in the calculation of this reserve.
At both June 30, 2019 and December 31, 2018, the mortgage origination segment’s indemnification liability reserve totaled $10.8 million and $10.7 million, respectively. The provision for indemnification losses was $0.8 million and $1.0 million during the three months ended June 30, 2019 and 2018, respectively, and $1.3 million and $1.7 million during the six months ended June 30, 2019 and 2018, respectively.
The following tables provide for a rollforward of claims activity for loans put-back to the mortgage origination segment based upon an alleged breach of a representation or warranty with respect to a loan sold and related indemnification liability reserve activity (in thousands).
Representation and Warranty Specific Claims
Activity - Origination Loan Balance
30,112
32,321
33,784
33,702
Claims made
6,504
5,361
9,686
12,350
Claims resolved with no payment
(1,579)
(5,892)
(7,266)
(11,753)
Repurchases
(1,478)
(1,245)
(2,645)
(3,334)
Indemnification payments
(485)
(420)
33,074
30,545
Indemnification Liability Reserve Activity (1)
10,721
23,332
10,701
23,472
Additions for new sales
792
1,014
1,281
1,743
(127)
(85)
(209)
(245)
Early payment defaults
(97)
(41)
(239)
(188)
(92)
(4)
(95)
(121)
Change in reserves for loans sold in prior years
(364)
(306)
(606)
(751)
10,833
23,910
Reserve for Indemnification Liability:
Specific claims
732
676
Incurred but not reported claims
10,101
10,025
Although management considers the total indemnification liability reserve to be appropriate, there may be changes in the reserve over time to address incurred losses due to unanticipated adverse changes in the economy and historical loss patterns, discrete events adversely affecting specific borrowers or industries, and/or actions taken by institutions or investors. The impact of such matters is considered in the reserving process when probable and estimable.
Hilltop Plaza Investment
On July 31, 2018, Hillcrest Land LLC purchased approximately 1.7 acres of land in the City of University Park, Texas for $38.5 million. Hillcrest Land LLC is owned equally between Hilltop Investments I, LLC, a wholly owned entity of Hilltop, and Diamond Ground, LLC, an affiliate of Mr. Gerald J. Ford, Chairman of the Board of Directors. Each of Hilltop Investments I, LLC and Diamond Ground, LLC contributed $19.3 million to Hillcrest Land LLC to complete the purchase. As the voting rights of Hillcrest Land LLC are shared equally between the Company and Diamond Ground, LLC, there is no primary beneficiary, and Diamond Ground, LLC’s interest in Hillcrest Land LLC has been reflected as a noncontrolling interest in the Company’s consolidated financial statements. Therefore, the Company has consolidated Hillcrest Land LLC under the VIE model according to the “most-closely associated” test. The purchased land is included within premises and equipment, net in the consolidated balance sheets. Any income (loss) associated with Hillcrest Land LLC is included within other noninterest income in the consolidated statements of operations. Trusts for which Jeremy Ford, President and Chief Executive Officer, and the wife of Corey Prestidge, Executive Vice President, General Counsel and Secretary, are a beneficiary own 10.2% and 10.1%, respectively, of Diamond Ground, LLC.
In connection with the purchase of the land, Hillcrest Land LLC entered into a 99-year ground lease of the land with three tenants-in-common: SPC Park Plaza Partners LLC (“Park Plaza LLC”), an unaffiliated entity which received an undivided 50% leasehold interest; HTH Project LLC, a wholly owned subsidiary of Hilltop, which received an undivided 25% leasehold interest; and Diamond Hillcrest, LLC (“Diamond Hillcrest”), an entity owned by Mr. Gerald J. Ford, which received an undivided 25% leasehold interest (collectively, the “Co-Owners”). The ground lease is triple net. The base rent from the Co-Owners under the ground lease commences 18 months after the ground lease was signed at $1.8 million per year and increases 1.0% per year each January 1 thereafter. The ground lease was classified as an operating lease, and the accounting commencement date was determined to be July 31, 2018, the date the land was available to the Co-Owners.
Concurrent with the ground lease, the Co-Owners entered into an agreement to purchase the improvements currently being constructed on the land, which is a mixed-use project containing a six-story building (“Hilltop Plaza”). HTH
37
Project LLC and Diamond Hillcrest each own an undivided 25% interest in Hilltop Plaza. Park Plaza LLC owns the remaining undivided 50% interest in Hilltop Plaza. Park Plaza LLC has agreed to serve as the Co-Owner property manager under the Co-Owners Agreement; however, certain actions require unanimous approval of all Co-Owners. Funding for Hilltop Plaza includes a $41.0 million construction loan from an unaffiliated third party bank, as well as cash contributions of $5.3 million from each of HTH Project LLC and Diamond Hillcrest. HTH Project LLC’s undivided interest in Hilltop Plaza is accounted for as an equity method investment as the tenants-in-common have joint control over decisions regarding Hilltop Plaza. The investment is included within other assets in the consolidated balance sheets and any income (loss) is included within other noninterest income in the consolidated statements of operations.
Hilltop and the Bank entered into leases for an aggregate of approximately 72,000 of the total 119,000 square feet of rentable space in Hilltop Plaza to serve as the headquarters for both companies. Affiliates of Mr. Gerald J. Ford also entered into leases for approximately 11,000 square feet of office space in the building. The two separate 129-month office and retail leases have combined total base rent of approximately $35 million with the first nine months of rent abated. The accounting commencement date of both leases was determined to be June 29, 2019, the date the building was delivered in order for tenant improvement work to commence. The combined operating lease liability, net of lease incentives, recognized during the second quarter of 2019 as a result of the commencement of these leases was $18.9 million. The office and retail leases were considered under the build-to-suit provisions of ASC 840, and the Company was determined to be the accounting owner of the project as its affiliate, HTH Project LLC, has an equity investment in the project. As such, the assets of Hilltop Plaza were recognized during the construction period through December 31, 2018, as costs were incurred to construct the asset, with a corresponding liability representing the costs paid for by the lessor (the Co-Owners). At December 31, 2018, the $27.8 million of costs incurred to date were included within premises and equipment and other liabilities, respectively, in the consolidated balance sheets. The Company reassessed its accounting ownership of the Hilltop Plaza assets under construction as of January 1, 2019, under the build-to-suit provisions of the newly adopted Leasing Standard and concluded it is not the accounting owner. As such, the assets and liabilities of the project were derecognized on January 1, 2019, with the $1.4 million offset representing deferred expenses recognized on the project to date through December 31, 2018, recorded as an increase to retained earnings.
All intercompany transactions associated with the Hilltop Plaza investment and the related transactions discussed above are eliminated in consolidation.
14. Financial Instruments with Off-Balance Sheet Risk
The Bank is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit that involve varying degrees of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. Such financial instruments are recorded in the consolidated financial statements when they are funded or related fees are incurred or received. The contract amounts of those instruments reflect the extent of involvement (and therefore the exposure to credit loss) the Bank has in particular classes of financial instruments.
Commitments to extend credit are agreements to lend to a customer provided that the terms established in the contract are met. Commitments generally have fixed expiration dates and may require payment of fees. Because some commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. These letters of credit are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.
In the aggregate, the Bank had outstanding unused commitments to extend credit of $2.3 billion at June 30, 2019 and outstanding financial and performance standby letters of credit of $92.4 million at June 30, 2019.
The Bank uses the same credit policies in making commitments and standby letters of credit as it does for on-balance sheet instruments. The amount of collateral obtained, if deemed necessary, in these transactions is based on management’s credit evaluation of the borrower. Collateral held varies but may include real estate, accounts receivable, marketable securities, interest-bearing deposit accounts, inventory, and property, plant and equipment.
38
In the normal course of business, the Hilltop Broker-Dealers execute, settle, and finance various securities transactions that may expose the Hilltop Broker-Dealers to off-balance sheet risk in the event that a customer or counterparty does not fulfill its contractual obligations. Examples of such transactions include the sale of securities not yet purchased by customers or for the accounts of the Hilltop Broker-Dealers, use of derivatives to support certain non-profit housing organization clients and to hedge changes in the fair value of certain securities, clearing agreements between the Hilltop Broker-Dealers and various clearinghouses and broker-dealers, secured financing arrangements that involve pledged securities, and when-issued underwriting and purchase commitments.
15. Stock-Based Compensation
Pursuant to the Hilltop Holdings Inc. 2012 Equity Incentive Plan (the “2012 Plan”), the Company may grant nonqualified stock options, stock appreciation rights, restricted stock, restricted stock units (“RSUs”), performance awards, dividend equivalent rights and other awards to employees of the Company, its subsidiaries and outside directors of the Company. In the aggregate, 4,000,000 shares of common stock may be delivered pursuant to awards granted under the 2012 Plan. At June 30, 2019, 680,623 shares of common stock remained available for issuance pursuant to awards granted under the 2012 Plan, excluding shares that may be delivered pursuant to outstanding awards. Compensation expense related to the 2012 Plan was $2.5 million during both the three months ended June 30, 2019 and 2018, and $5.0 million and $4.8 million during the six months ended June 30, 2019 and 2018, respectively.
During the six months ended June 30, 2019 and 2018, Hilltop granted 14,895 and 10,024 shares of common stock, respectively, pursuant to the 2012 Plan to certain non-employee members of the Company’s board of directors for services rendered to the Company.
Restricted Stock Units
The following table summarizes information about nonvested RSU activity for the six months ended June 30, 2019 (shares in thousands).
RSUs
Weighted
Average
Grant Date
Outstanding
1,270
22.44
Granted
578
19.18
Vested/Released
(456)
17.70
Forfeited
(28)
25.78
22.58
Vested/Released RSUs include an aggregate of 90,867 shares withheld to satisfy employee statutory tax obligations during the six months ended June 30, 2019. Pursuant to certain RSU award agreements, an aggregate of 17,692 vested RSUs at June 30, 2019 require deferral of the settlement in shares and statutory tax obligations to a future date.
During the six months ended June 30, 2019, the Compensation Committee of the board of directors of the Company awarded certain executives and key employees an aggregate of 570,361 RSUs pursuant to the 2012 Plan. Of the RSUs granted during the six months ended June 30, 2019, 479,112 that were outstanding at June 30, 2019, are subject to time-based vesting conditions and generally cliff vest on the third anniversary of the grant date. Of the RSUs granted during the six months ended June 30, 2019, 91,249 that were outstanding at June 30, 2019, provide for cliff vesting based upon the achievement of certain performance goals over a three-year period.
At June 30, 2019, in the aggregate, 1,126,126 of the outstanding RSUs are subject to time-based vesting conditions and generally cliff vest on the third anniversary of the grant date, and 238,145 outstanding RSUs cliff vest based upon the achievement of certain performance goals over a three-year period. At June 30, 2019, unrecognized compensation expense related to outstanding RSUs of $17.7 million is expected to be recognized over a weighted average period of 1.87 years.
16. Regulatory Matters
Banking and Hilltop
PlainsCapital, which includes the Bank and PrimeLending, and Hilltop are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory — and possibly additional discretionary — actions by regulators that, if undertaken, could have a direct, material effect on the consolidated financial statements. The regulations require PlainsCapital and Hilltop to meet specific capital adequacy guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company performs reviews of the classification and calculation of risk-weighted assets to ensure accuracy and compliance with the Basel III regulatory capital requirements as implemented by the Board of Governors of the Federal Reserve System. The capital classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the companies to maintain minimum amounts and ratios (set forth in the following table) of Tier 1 capital (as defined in the regulations) to total average assets (as defined), and minimum ratios of common equity Tier 1, Tier 1 and total capital (as defined) to risk-weighted assets (as defined).
In order to avoid limitations on capital distributions, including dividend payments, stock repurchases and certain discretionary bonus payments to executive officers, Basel III requires banking organizations to maintain a capital conservation buffer above minimum risk-based capital requirements measured relative to risk-weighted assets. The phase-in of the capital conservation buffer requirements began on January 1, 2016 for PlainsCapital and Hilltop, and the requirements were fully phased in as of January 1, 2019.
The following tables show PlainsCapital’s and Hilltop’s actual capital amounts and ratios in accordance with Basel III compared to the regulatory minimum capital requirements including conservation buffer in effect at the end of the period and on a fully phased-in basis as if such requirements were currently in effect at December 31, 2018 (dollars in thousands). Based on actual capital amounts and ratios shown in the following table, PlainsCapital’s ratios place it in the “well capitalized” (as defined) capital category under regulatory requirements.
Minimum Capital Requirements
Including Conservation Buffer
In Effect at
Fully
To Be Well
Actual
Phased In
Capitalized
Ratio
Tier 1 capital (to average assets):
1,235,458
12.53
4.0
5.0
1,747,412
13.00
N/A
Common equity Tier 1 capital (to risk-weighted assets):
13.84
6.5
1,700,823
16.32
Tier 1 capital (to risk-weighted assets):
8.5
8.0
16.77
Total capital (to risk-weighted assets):
1,292,852
14.48
10.5
10.0
1,786,441
17.14
40
1,183,447
12.47
1,680,364
13.90
6.375
1,634,978
16.58
7.875
17.04
1,245,177
14.63
9.875
1,722,602
17.47
Broker-Dealer
Pursuant to the net capital requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), Hilltop Securities has elected to determine its net capital requirements using the alternative method. Accordingly, Hilltop Securities is required to maintain minimum net capital, as defined in Rule 15c3-1 promulgated under the Exchange Act, equal to the greater of $250,000 and $1,000,000, respectively, or 2% of aggregate debit balances, as defined in Rule 15c3-3 promulgated under the Exchange Act. Additionally, the net capital rule of the NYSE provides that equity capital may not be withdrawn or cash dividends paid if resulting net capital would be less than 5% of the aggregate debit items. HTS Independent Network follows the primary (aggregate indebtedness) method, as defined in Rule 15c3-1 promulgated under the Exchange Act, which requires the maintenance of the larger of minimum net capital of $250,000 or 1/15 of aggregate indebtedness.
At June 30, 2019, the net capital position of each of the Hilltop Broker-Dealers was as follows (in thousands).
HTS
Independent
Network
Net capital
225,288
3,072
Less: required net capital
9,971
250
Excess net capital
215,317
2,822
Net capital as a percentage of aggregate debit items
45.2
Net capital in excess of 5% aggregate debit items
200,359
Under certain conditions, Hilltop Securities may be required to segregate cash and securities in a special reserve account for the benefit of customers under Rule 15c3-3 promulgated under the Exchange Act. Assets segregated under the provisions of the Exchange Act are not available for general corporate purposes. At June 30, 2019 and December 31, 2018, the Hilltop Broker-Dealers held cash of $151.3 million and $134.0 million, respectively, segregated in special reserve bank accounts for the benefit of customers. The Hilltop Broker-Dealers were not required to segregate cash and securities in special reserve accounts for the benefit of proprietary accounts of introducing broker-dealers at June 30, 2019 or December 31, 2018.
Mortgage Origination
As a mortgage originator, PrimeLending and its subsidiaries are subject to minimum net worth and liquidity requirements established by HUD and GNMA, as applicable. On an annual basis, PrimeLending and its subsidiaries submit audited financial statements to HUD and GNMA, as applicable, documenting their respective compliance with minimum net worth and liquidity requirements. As of June 30, 2019, PrimeLending and its subsidiaries’ net worth and liquidity exceeded the amounts required by both HUD and GNMA, as applicable.
Insurance
The statutory financial statements of the Company's insurance subsidiaries, which are domiciled in the State of Texas, are presented on the basis of accounting practices prescribed or permitted by the Texas Department of Insurance. Texas has adopted the statutory accounting practices of the National Association of Insurance Commissioners (“NAIC”) as the basis of its statutory accounting practices with certain differences that are not significant to the insurance company subsidiaries’ statutory equity.
A summary of statutory capital and surplus and statutory net income (loss) of each insurance subsidiary is as follows (in thousands).
Statutory capital and surplus:
National Lloyds Insurance Company
58,905
78,637
American Summit Insurance Company
19,041
17,908
Statutory net income (loss):
(2,633)
(409)
1,134
299
394
716
1,283
Regulations of the Texas Department of Insurance require insurance companies to maintain minimum levels of statutory surplus to ensure their ability to meet their obligations to policyholders. At June 30, 2019, the Company's insurance subsidiaries had statutory surplus in excess of the minimum required.
The NAIC has adopted a risk based capital (“RBC”) formula for insurance companies that establishes minimum capital requirements indicating various levels of available regulatory action on an annual basis relating to insurance risk, asset credit risk, interest rate risk and business risk. The RBC formula is used by the NAIC and certain state insurance regulators as an early warning tool to identify companies that require additional scrutiny or regulatory action. At June 30, 2019, the Company's insurance subsidiaries' RBC ratio exceeded the level at which regulatory action would be required.
17. Stockholders’ Equity
Dividends
During the six months ended June 30, 2019 and 2018, the Company declared and paid cash dividends of $0.16 and $0.14 per common share, or an aggregate of $15.0 million and $13.5 million, respectively.
On July 25, 2019, the Company announced that its board of directors declared a quarterly cash dividend of $0.08 per common share, payable on August 30, 2019, to all common stockholders of record as of the close of business on August 15, 2019.
Stock Repurchase Program
In January 2019, the Hilltop board of directors authorized a new stock repurchase program through January 2020, pursuant to which the Company is authorized to repurchase, in the aggregate, up to $50.0 million of its outstanding common stock, inclusive of repurchases to offset dilution related to grants of stock-based compensation.
During the six months ended June 30, 2019, the Company paid $25.0 million to repurchase an aggregate of 1,214,843 shares of common stock at an average price of $20.54 per share. These shares were returned to the Company’s pool of authorized but unissued shares of common stock. The purchases were funded from available cash balances. The Company’s stock repurchase program, prior year repurchases and related accounting policy are discussed in detail in Note 1 and Note 22 to the consolidated financial statements included in the Company’s 2018 Form 10-K.
18. Derivative Financial Instruments
The Company uses various derivative financial instruments to mitigate interest rate risk. The Bank’s interest rate risk management strategy involves effectively managing the re-pricing characteristics of certain assets and liabilities to mitigate potential adverse impacts from changes in interest rates on the Bank’s net interest margin. PrimeLending has interest rate risk relative to interest rate lock commitments (“IRLCs”) and its inventory of mortgage loans held for sale. PrimeLending is exposed to such interest rate risk from the time an IRLC is made to an applicant to the time the related mortgage loan is sold. To mitigate interest rate risk, PrimeLending executes forward commitments to sell mortgage-backed securities (“MBSs”) and Eurodollar futures. Additionally, PrimeLending has interest rate risk relative to its MSR asset and uses derivative instruments, including interest rate swaps and U.S. Treasury bond futures and options to hedge this risk. The Hilltop Broker-Dealers use forward commitments to both purchase and sell MBSs to facilitate customer transactions and as a means to hedge related exposure to interest rate risk in certain inventory positions. Additionally, Hilltop Securities uses both U.S. Treasury bond and Eurodollar futures to hedge changes in the fair value of their securities.
Non-Hedging Derivative Instruments and the Fair Value Option
As discussed in Note 4 to the consolidated financial statements, the Company has elected to measure substantially all mortgage loans held for sale at fair value under the provisions of the Fair Value Option. The election provides the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without applying complex hedge accounting provisions. The fair values of PrimeLending’s IRLCs and forward commitments are recorded in other assets or other liabilities, as appropriate, and changes in the fair values of these derivative instruments are recorded as a component of net gains from sale of loans and other mortgage production income. These changes in fair value are attributable to changes in the volume of IRLCs, mortgage loans held for sale, commitments to purchase and sell MBSs and MSR assets, and changes in market interest rates. Changes in market interest rates also conversely affect the value of PrimeLending’s mortgage loans held for sale and its MSR asset, which are measured at fair value under the Fair Value Option. The effect of the change in market interest rates on PrimeLending’s loans held for sale and MSR asset is discussed in Note 4 to the consolidated financial statements. The fair values of the Hilltop Broker-Dealers’ and the Bank’s derivative instruments are recorded in other assets or other liabilities, as appropriate.
Changes in the fair value of derivatives are presented in the following table (in thousands).
Increase (decrease) in fair value of derivatives during period:
PrimeLending
(783)
(3,141)
17,405
6,865
Hilltop Broker-Dealers
12,581
2,991
10,774
(2,237)
Bank
(146)
Derivative positions are presented in the following table (in thousands).
Notional
Estimated
Derivative instruments:
IRLCs
1,530,535
33,584
677,267
17,421
Customer-based written options
31,200
(49)
Customer-based purchased options
Commitments to purchase MBSs
3,323,653
21,730
2,359,630
10,467
Commitments to sell MBSs
5,583,795
(21,406)
3,711,477
(19,315)
Interest rate swaps
7,663
(64)
15,104
82
U.S. Treasury bond futures and options (1)
309,000
367,200
Eurodollar futures (1)
120,000
104,000
(1) Changes in the fair value of these contracts are settled daily with the respective counterparties of PrimeLending and the Hilltop Broker-Dealers.
PrimeLending had cash collateral advances totaling $18.8 million and $11.9 million to offset net liability derivative positions on its commitments to sell MBSs at June 30, 2019 and December 31, 2018, respectively. In addition, PrimeLending and the Hilltop Broker-Dealers advanced cash collateral totaling $2.5 million and $3.4 million on U.S. Treasury bond futures and options and Eurodollar futures at June 30, 2019 and December 31, 2018, respectively. These amounts are included in other assets within the consolidated balance sheets.
19. Balance Sheet Offsetting
Certain financial instruments, including resale and repurchase agreements, securities lending arrangements and derivatives, may be eligible for offset in the consolidated balance sheets and/or subject to master netting arrangements or similar agreements. The following tables present the assets and liabilities subject to enforceable master netting arrangements, repurchase agreements, or similar agreements with offsetting rights (in thousands).
Gross Amounts Not Offset in
Net Amounts
the Balance Sheet
Gross Amounts
of Assets
Cash
of Recognized
Offset in the
Presented in the
Financial
Collateral
Balance Sheet
Instruments
Pledged
Securities borrowed:
Institutional counterparties
1,569,362
(1,517,772)
51,590
Interest rate options:
Customer counterparties
Interest rate swaps:
Reverse repurchase agreements:
(50,575)
85
Forward MBS derivatives:
21,732
(21,732)
1,641,757
(1,590,079)
51,678
1,365,547
(1,307,121)
58,426
(61,390)
221
10,469
(10,469)
1,437,764
(1,378,980)
58,784
of Liabilities
Liabilities
Securities loaned:
1,459,218
(1,410,580)
48,638
66
Repurchase agreements:
488,042
(488,042)
20,801
(20,801)
21,647
21,408
(11,061)
10,347
1,989,775
1,989,536
(1,930,484)
59,052
1,186,073
(1,136,033)
50,040
533,441
(533,441)
43,266
(43,266)
19,331
(15)
19,316
(7,728)
11,588
1,782,166
1,782,151
(1,720,468)
61,683
Secured Borrowing Arrangements
Secured Borrowings (Repurchase Agreements) — The Company participates in transactions involving securities sold under repurchase agreements, which are secured borrowings and generally mature one to thirty days from the transaction date or involve arrangements with no definite termination date. Securities sold under repurchase agreements are reflected at the amount of cash received in connection with the transactions. The Company may be required to provide additional collateral based on the fair value of the underlying securities, which is monitored on a daily basis.
Securities Lending Activities — The Company’s securities lending activities include lending securities for other broker-dealers, lending institutions and its own clearing and retail operations. These activities involve lending securities to other broker-dealers to cover short sales, to complete transactions in which there has been a failure to deliver securities by the required settlement date and as a conduit for financing activities.
When lending securities, the Company receives cash or similar collateral and generally pays interest (based on the amount of cash deposited) to the other party to the transaction. Securities lending transactions are executed pursuant to written agreements with counterparties that generally require securities loaned to be marked-to-market on a daily basis. The Company receives collateral in the form of cash in an amount generally in excess of the fair value of securities loaned. The Company monitors the fair value of securities loaned on a daily basis, with additional collateral obtained or refunded, as necessary. Collateral adjustments are made on a daily basis through the facilities of various clearinghouses. The Company is a principal in these securities lending transactions and is liable for losses in the event of a failure of any other party to honor its contractual obligation. Management sets credit limits with each counterparty and reviews these limits regularly to monitor the risk level with each counterparty. The Company is subject to credit risk through its securities lending activities if securities prices decline rapidly because the value of the Company’s collateral could fall below the amount of the indebtedness it secures. In rapidly appreciating markets, credit risk increases due to short positions. The Company’s securities lending business subjects the Company to credit risk if a counterparty fails to
perform or if collateral securing its obligations is insufficient. In securities transactions, the Company is subject to credit risk during the period between the execution of a trade and the settlement by the customer.
The following tables present the remaining contractual maturities of repurchase agreement and securities lending transactions accounted for as secured borrowings (in thousands). The Company had no repurchase-to-maturity transactions outstanding at both June 30, 2019 and December 31, 2018.
Remaining Contractual Maturities
Overnight and
Greater Than
Continuous
Up to 30 Days
30-90 Days
90 Days
Repurchase agreement transactions:
U.S. Treasury and agency securities
38,670
Asset-backed securities
470,173
Securities lending transactions:
Corporate securities
113
1,459,105
1,968,061
Gross amount of recognized liabilities for repurchase agreement and securities lending transactions in offsetting disclosure above
Amount related to agreements not included in offsetting disclosure above
131,848
444,859
1,185,960
1,762,780
20. Broker-Dealer and Clearing Organization Receivables and Payables
Broker-dealer and clearing organization receivables and payables consisted of the following (in thousands).
Receivables:
Securities failed to deliver
24,310
16,300
Trades in process of settlement
96,247
32,993
17,330
25,447
Payables:
Correspondents
29,700
29,311
Securities failed to receive
37,562
75,015
5,411
4,526
21. Reserve for Losses and Loss Adjustment Expenses
A summary of NLC’s reserve for unpaid losses and LAE, as included in other liabilities within the consolidated balance sheets, is as follows (in thousands).
Reserve for unpaid losses and allocated LAE balance, net
20,189
16,498
Reinsurance recoverables on unpaid losses
1,184
3,214
Unallocated LAE
894
840
Reserve for unpaid losses and LAE balance, gross
22,267
20,552
A summary of claims loss reserve development activity is presented in the following table (dollars in thousands).
Total of
IBNR Reserves
Plus Expected
Cumulative
Accident
Development on
Year
Paid
Incurred
Reported Claims
2016
83,452
83,961
20,092
2017
86,913
87,737
538
20,656
69,260
74,593
2,992
15,164
24,716
37,898
5,382
7,757
264,341
284,189
341
All outstanding reserves prior to 2016, net of reinsurance
Reserve for unpaid losses and allocated LAE, net of reinsurance
22. Reinsurance Activity
NLC limits the maximum net loss that can arise from large risks or risks in concentrated areas of exposure by reinsuring (ceding) certain levels of risk. Substantial amounts of business are ceded, and these reinsurance contracts do not relieve NLC from its obligations to policyholders. Such reinsurance includes quota share, excess of loss, catastrophe, and other forms of reinsurance on essentially all property and casualty lines of insurance. Net insurance premiums earned, losses and LAE and policy acquisition and other underwriting expenses are reported net of the amounts related to reinsurance ceded to other companies. Amounts recoverable from reinsurers related to the portions of the liability for losses and LAE and unearned insurance premiums ceded to them are reported as assets. Failure of reinsurers to honor their obligations could result in losses to NLC; consequently, allowances are established for amounts deemed uncollectible as NLC evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. At June 30, 2019, total reinsurance recoverables and receivables had a carrying value of $1.7 million, which is included in other assets within the consolidated balance sheets. There was no allowance for uncollectible accounts at June 30, 2019, based on NLC’s quality requirements.
The effects of reinsurance on premiums written and earned are summarized as follows (in thousands).
Written
Earned
Premiums from direct business
35,562
31,727
35,801
33,372
66,352
63,463
68,886
66,740
Reinsurance assumed
3,622
3,256
3,567
3,111
6,751
6,448
6,609
6,111
Reinsurance ceded
(1,517)
(2,335)
(2,378)
(3,242)
(4,345)
(4,431)
Net premiums
37,667
37,033
69,861
71,150
The effects of reinsurance on incurred losses and LAE are as follows (in thousands).
Losses and LAE incurred
23,959
23,869
38,943
37,321
Reinsurance recoverables
1,022
964
2,620
Net loss and LAE incurred
Catastrophic coverage
At June 30, 2019, NLC had catastrophic excess of loss reinsurance coverage of losses per event in excess of $8 million retention by NLIC and $2 million retention by ASIC. ASIC maintained an underlying layer of coverage, providing $6 million of reinsurance coverage in excess of its $2 million retention to bridge to the primary program. The reinsurance for NLIC and ASIC in excess of $8 million is comprised of three layers of protection: $17 million in excess of $8 million retention and/or loss; $30 million in excess of $25 million loss; and $50 million in excess of $55 million loss. NLIC and ASIC retain no participation in any of the layers, beyond the first $8 million and $2 million, respectively. At June 30, 2019, total retention for any one catastrophe that affects both NLIC and ASIC was limited to $8 million in the aggregate.
Effective July 1, 2019, NLC renewed its catastrophic excess of loss reinsurance coverage for a one-year period. Changes from the coverages described above were limited to the reinsurance in excess of $8 million now being comprised of the following three layers of protection: $12 million in excess of $8 million retention and/or loss; $25 million in excess of $20 million loss; and $50 million in excess of $45 million loss.
Effective January 1, 2019, NLC renewed its underlying excess of loss contract that provides $10 million aggregate coverage in excess of NLC’s per event retention of $1 million and aggregate retention of $15 million for sub-catastrophic events. As of January 1, 2019, NLC retains 37.5% participation in this coverage, up from 17.5% participation during 2018.
23. Segment and Related Information
The Company currently has four reportable business segments that are organized primarily by the core products offered to the segments’ respective customers. These segments reflect the manner in which operations are managed and the criteria used by the chief operating decision maker, the Company’s President and Chief Executive Officer, to evaluate segment performance, develop strategy and allocate resources.
The banking segment includes the operations of the Bank, and since August 1, 2018, the operations acquired in the BORO Acquisition. The broker-dealer segment includes the operations of Securities Holdings, the mortgage origination segment is composed of PrimeLending and the insurance segment is composed of NLC.
Corporate includes certain activities not allocated to specific business segments. These activities include holding company financing and investing activities, merchant banking investment opportunities and management and administrative services to support the overall operations of the Company.
Balance sheet amounts not discussed previously and the elimination of intercompany transactions are included in “All Other and Eliminations.” The following tables present certain information about reportable business segment revenues, operating results, goodwill and assets (in thousands).
Mortgage
All Other and
Banking
Origination
Corporate
Eliminations
Consolidated
Net interest income (expense)
93,423
11,410
(1,031)
592
(1,331)
4,813
(670)
Noninterest income
10,742
105,559
164,548
36,151
665
(4,794)
Noninterest expense
58,251
94,870
141,721
39,589
9,274
Income (loss) before income taxes
46,584
22,101
21,796
(2,846)
(9,940)
186,113
24,260
(1,499)
1,236
(2,661)
9,358
355
21,362
196,865
282,580
72,643
1,390
(9,501)
118,977
182,677
256,398
69,926
24,836
(52)
88,143
38,524
24,683
3,953
(26,107)
(91)
87,958
12,890
704
793
(2,482)
4,985
Provision for loan losses
10,644
73,589
162,759
36,546
1,436
(5,540)
65,542
77,967
150,026
39,712
5,340
(70)
33,060
13,437
(2,373)
(6,386)
174,596
25,441
1,645
1,580
(4,573)
9,579
(1,531)
20,823
142,135
289,862
71,564
724
(10,531)
124,913
155,743
280,729
70,725
14,743
(134)
72,037
11,769
10,778
2,419
(18,592)
(818)
247,368
7,008
13,071
23,988
10,411,934
3,345,345
1,876,091
252,848
2,333,835
(3,954,183)
10,004,971
3,213,115
1,627,134
253,513
2,243,182
(3,658,343)
24. Earnings per Common Share
Net earnings, less any preferred dividends accumulated for the period (whether or not declared), is allocated between the common stock and participating securities pursuant to the two-class method, if applicable. Basic earnings per common share is computed by dividing net earnings available to common stockholders by the weighted average number of common shares outstanding during the period, excluding participating nonvested restricted shares. The Company calculated basic earnings per common share using the treasury method instead of the two-class method since there were no instruments which qualified as participating securities during the three or six months ended June 30, 2019 or 2018.
Diluted earnings per common share is computed in a similar manner, except that first the denominator is increased to include the number of additional common shares that would have been outstanding if potentially dilutive common shares, excluding the participating securities, were issued using the treasury stock method. During the three and six months ended June 30, 2019 and 2018, RSUs were the only potentially dilutive non-participating instruments issued by Hilltop. Next, the Company determines and includes in the diluted earnings per common share calculation the more dilutive effect of the participating securities using the treasury stock method or the two-class method. Undistributed losses are not allocated to the nonvested share-based payment awards (the participating securities) under the two-class method as the holders are not contractually obligated to share in the losses of the Company.
The following table presents the computation of basic and diluted earnings per common share (in thousands, except per share data).
Basic earnings per share:
Net earnings available to Hilltop common stockholders
Weighted average shares outstanding - basic
Basic earnings per common share
Diluted earnings per share:
Effect of potentially dilutive securities
102
Weighted average shares outstanding - diluted
Diluted earnings per common share
50
SCHEDULE I – Insurance Incurred and Cumulative Paid Losses and Allocated Loss Adjustment Expenses,
Net of Reinsurance
(dollars in thousands)
Incurred Losses and Allocated Loss Adjustment Expenses, Net of Reinsurance
But Not
Reported
Reserves Plus
Development
On Reported
Claims
84,771
85,189
84,076
87,899
88,025
75,217
Cumulative Paid Losses and Allocated Loss Adjustment Expenses, Net of Reinsurance
71,543
81,682
83,169
77,675
86,319
61,922
Reserve for unpaid losses and allocated loss adjustment expenses, net of reinsurance
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion should be read in conjunction with the consolidated historical financial statements and notes appearing elsewhere in this Quarterly Report on Form 10-Q (this “Quarterly Report”) and the financial information set forth in the tables herein.
Unless the context otherwise indicates, all references in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, to the “Company,” “we,” “us,” “our” or “ours” or similar words are to Hilltop Holdings Inc. and its direct and indirect wholly owned subsidiaries, references to “Hilltop” refer solely to Hilltop Holdings Inc., references to “PCC” refer to PlainsCapital Corporation (a wholly owned subsidiary of Hilltop), references to “Securities Holdings” refer to Hilltop Securities Holdings LLC (a wholly owned subsidiary of Hilltop), references to “Hilltop Securities” refer to Hilltop Securities Inc. (a wholly owned subsidiary of Securities Holdings), references to “HTS Independent Network” refer to Hilltop Securities Independent Network Inc. (a wholly owned subsidiary of Securities Holdings), Hilltop Securities and HTS Independent Network are collectively referred to as the “Hilltop Broker-Dealers”, references to the “Bank” refer to PlainsCapital Bank (a wholly owned subsidiary of PCC), references to “FNB” refer to First National Bank, references to “SWS” refer to the former SWS Group, Inc., references to “PrimeLending” refer to PrimeLending, a PlainsCapital Company (a wholly owned subsidiary of the Bank) and its subsidiaries as a whole, references to “NLC” refer to National Lloyds Corporation (a wholly owned subsidiary of Hilltop) and its subsidiaries as a whole, references to “NLIC” refer to National Lloyds Insurance Company (a wholly owned subsidiary of NLC) and references to “ASIC” refer to American Summit Insurance Company (a wholly owned subsidiary of NLC).
FORWARD-LOOKING STATEMENTS
This Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”), as amended by the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact, included in this Quarterly Report that address results or developments that we expect or anticipate will or may occur in the future, and statements that are preceded by, followed by or include, words such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “forecasts,” “goal,” “intends,” “may,” “might,” “plan,” “probable,” “projects,” “seeks,” “should,” “target,” “view” or “would” or the negative of these words and phrases or similar words or phrases, including such things as our business strategy, our financial condition, our revenue, our liquidity and sources of funding, market trends, operations and business, taxes, information technology expenses, capital levels, mortgage servicing rights (“MSR”) assets, stock repurchases, dividend payments, expectations concerning mortgage loan origination volume and interest rate compression, expected levels of refinancing as a percentage of total loan origination volume, projected losses on mortgage loans originated, loss estimates related to natural disasters, total expenses and cost savings expected from PrimeLending’s cost reduction efforts, the effects of government regulation applicable to our operations, the appropriateness of, and changes in, our allowance for loan losses and provision for loan losses, including as a result of the “current expected credit losses” (CECL) model, anticipated investment yields, our expectations regarding accretion of discount on loans in future periods, the collectability of loans, cybersecurity incidents and the outcome of litigation are forward-looking statements.
These forward-looking statements are based on our beliefs, assumptions and expectations of our future performance taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If an event occurs, our business, business plan, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. Certain factors that could cause actual results to differ include, among others:
For a more detailed discussion of these and other factors that may affect our business and that could cause the actual results to differ materially from those anticipated in these forward-looking statements, see “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2018 (“2018 Form 10-K”), which was filed with the Securities and Exchange Commission (the “SEC”) on February 15, 2019, this Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” Part II, Item 1A, “Risk Factors” herein and other filings we have made with the SEC. We caution that the foregoing list of factors is not exhaustive, and new factors may emerge, or changes to the foregoing factors may occur, that could impact our business. All subsequent written and oral forward-looking statements concerning our business attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements above. We do not undertake any obligation to update any forward-looking statement, whether written or oral, relating to the matters discussed in this Quarterly Report except to the extent required by federal securities laws.
OVERVIEW
We are a financial holding company registered under the Bank Holding Company Act of 1956. Our primary line of business is to provide business and consumer banking services from offices located throughout Texas through the Bank. We also provide an array of financial products and services through our broker-dealer, mortgage origination and insurance segments. The following includes additional details regarding the financial products and services provided by each of our primary business units.
PCC. PCC is a financial holding company that provides, through its subsidiaries, traditional banking and wealth, investment and treasury management services primarily in Texas and residential mortgage loans throughout the United States.
Securities Holdings. Securities Holdings is a holding company that provides, through its subsidiaries, investment banking and other related financial services, including municipal advisory, sales, trading and underwriting of taxable and tax-exempt fixed income securities, equity trading, clearing, securities lending, structured finance and retail brokerage services throughout the United States.
NLC. NLC is a property and casualty insurance holding company that provides, through its subsidiaries, fire and homeowners insurance to low value dwellings and manufactured homes primarily in Texas and other areas of the southern United States.
53
During the three and six months ended June 30, 2019, our net income to common stockholders was $57.8 million, or $0.62 per diluted share, and $96.6 million, or $1.03 per diluted share, respectively. We declared total common dividends of $0.08 and $0.16 per share during the three and six months ended June 30, 2019, respectively, which resulted in dividend payout ratios of 12.92% and 15.49%, respectively. Dividend payout ratio is defined as cash dividends declared per common share divided by basic earnings per common share.
We reported $77.7 million and $129.1 million of consolidated income before income taxes during the three and six months ended June 30, 2019, respectively, including the following contributions from our four reportable business segments.
At June 30, 2019, on a consolidated basis, we had total assets of $14.3 billion, total deposits of $8.5 billion, total loans, including loans held for sale, of $8.8 billion and stockholders’ equity of $2.1 billion.
Factors Affecting Results of Operations
Changes in Management
On February 21, 2019, we entered into a Separation and Release Agreement (the “Separation Agreement”) with Alan B. White, our Vice Chairman and Co-Chief Executive Officer, in connection with his retirement effective April 1, 2019 (the “Retirement Date”). Pursuant to the Separation Agreement, effective as of the Retirement Date, Mr. White resigned from all positions with Hilltop and its subsidiaries, including, without limitation, Vice Chairman of our Board of Directors and Co-Chief Executive Officer of Hilltop. The Separation Agreement also provides that Mr. White’s retention agreement with the Company, as amended, terminated on the Retirement Date, except for certain provisions that addressed, among other items, non-competition, non-solicitation, confidential information and arbitration. Effective April 1, 2019, Jeremy B. Ford became Hilltop’s sole Chief Executive Officer, Chairman of the Executive Committee of the Board of Directors of Hilltop and the Chairman of the Bank. The Separation Agreement, in accordance with Mr. White’s retention agreement, provided for aggregate payments of $12.4 million to Mr. White, subject to any delay required under Section 409A of the Internal Revenue Code. During the six months ended June 30, 2019, our financial results included the recognition within corporate of a pre-tax charge within employees’ compensation and benefits of $5.8 million in the first quarter of 2019 associated with Mr. White’s retirement. We do not intend to replace Mr. White.
On February 19, 2019, we entered into a retention agreement with Hill A. Feinberg (the “Feinberg Retention Agreement") to set forth the terms of his ongoing role with the Company. As disclosed in our current report on Form 8-K filed on December 12, 2018, we appointed M. Bradley Winges to succeed Mr. Feinberg as President and Chief Executive Officer of Hilltop Securities effective February 20, 2019. The Feinberg Retention Agreement provides that, as of February 20, 2019, Mr. Feinberg resigned as President and Chief Executive Officer of Hilltop Securities and from all other positions with Hilltop and its subsidiaries, other than as Chairman of the Board of Directors of Hilltop Securities, as a member of the Board of Directors of Hilltop and a member of Executive Committee of the Board of Directors of Hilltop. Pursuant to the Feinberg Retention Agreement, Mr. Feinberg served as the Chairman of the Board of Directors of Hilltop Securities until June 30, 2019, at which time he became Chairman Emeritus of Hilltop Securities and resigned from his membership on the Executive Committee of the Board of Directors of Hilltop. The Feinberg Retention Agreement provides for aggregate payments of $1.4 million to Mr. Feinberg upon his termination, resignation or death, of which $0.9 million was paid during the first quarter of 2019. Mr. Feinberg may resign or be terminated at any time. In connection with the appointment of Mr. Winges, Hilltop and Mr. Winges entered into an employment agreement providing for a sign-on cash bonus of $1.5 million, among other benefits, on the effective date of his employment. During the six months ended June 30, 2019, the broker-dealer segment’s financial results reflect aggregate pre-tax
charges within employees’ compensation and benefits noninterest expenses of $2.2 million related to these items, all of which were recognized in the first quarter of 2019.
During the six months ended June 30, 2019, the total impact of the above noted changes in management was $8.0 million before income taxes, all of which was recognized during the first quarter of 2019. These changes and the related impact on our results of operations are collectively referred to as the “Leadership Changes.”
Technology Enhancements and Corporate Initiatives
In furtherance of our goal of building a premier, diversified financial services company, we regularly evaluate strategic opportunities to invest in our business and technology platforms. Such investments are intended to support long-term technological competitiveness and improved operational efficiencies throughout our organization. During 2018, we began the significant investment in new technological solutions, substantial core system upgrades and other technology enhancements. Such significant investments specifically include single, enterprise-wide general ledger and procurement solutions, a mortgage loan origination system and a core system replacement within our broker-dealer segment (collectively referred to as “Core System Improvements”). In combination with these technology enhancements, we are continuing our efforts to consolidate common back office functions. We believe that costs incurred related to these Core System Improvements and the consolidation of common back office functions will continue to represent an increasingly significant portion of our noninterest expenses in the near term, but we are making such investments with the expectation that they will result in cost savings over the long term. Costs related to our Core System Improvements, disaggregated by segment between internal-use software costs that were capitalized as premises and equipment and costs that were recorded to noninterest expense, were as follows (in thousands).
703
2,367
1,083
748
2,005
1,786
3,115
1,093
5,994
1,854
4,368
7,555
2,126
1,770
358
4,254
3,980
6,138
1,691
11,809
1,018
769
1,787
761
794
1,896
1,779
1,110
3,683
989
2,136
1,976
1,343
411
3,730
3,123
1,400
5,866
55
Factors Affecting Comparability of Results of Operations
Prior Year Acquisition
On August 1, 2018, we acquired privately-held, Houston-based The Bank of River Oaks (“BORO”) in an all-cash transaction (the “BORO Acquisition”). Pursuant to the terms of the definitive agreement, we paid cash in the aggregate amount of $85 million to the shareholders and option holders of BORO. The fair value of the assets acquired was $434.8 million, including $326.6 million in loans, while the fair value of liabilities assumed was $389.4 million, consisting primarily of $376.4 million in deposits. The operations of BORO were included in our operating results beginning August 1, 2018. The estimated fair value of the core deposit intangible asset acquired as of August 1, 2018 was $10.0 million and resulting goodwill was $39.6 million. In connection with the acquisition, we merged BORO into the Bank, and all customer accounts were converted to the PlainsCapital Bank platform.
Termination of FDIC Loss-Share Agreements
In the fourth quarter of 2018, the Bank terminated its loss-share agreements with the FDIC which were entered into in connection with the FNB Transaction, resulting in a $6.26 million payment from the FDIC to the Bank. Prior to the termination, the Bank recorded “true-up” accruals of $0.1 million and $0.3 million during the three and six months ended June 30, 2018, respectively, with respect to the FDIC-assisted transaction whereby the Bank acquired certain assets and assumed certain liabilities of Edinburg, Texas-based First National Bank (“FNB”) on September 13, 2013 (the “FNB Transaction”). The true-up accrual was based on a formula within the loss-share agreements, pursuant to which we agreed to reimburse the FDIC if actual losses incurred and billed to the FDIC through loss sharing were below a stated threshold. During the three and six months ended June 30, 2018, the Bank also recorded $1.9 million and $5.8 million, respectively, of amortization of excess book value of its receivables under the loss-share agreements (the “FDIC Indemnification Asset”) due to lower projected collections from the FDIC than were initially estimated at the acquisition date.
Segment Information
We have three primary business units, PCC (banking and mortgage origination), Securities Holdings (broker-dealer) and NLC (insurance). Under accounting principles generally accepted in the United States (“GAAP”), our business units are comprised of four reportable business segments organized primarily by the core products offered to the segments’ respective customers: banking, broker-dealer, mortgage origination and insurance. Consistent with our historical segment operating results, we anticipate that future revenues will be driven primarily from the banking segment, with the remainder being generated by our broker-dealer, mortgage origination and insurance segments. Operating results for the mortgage origination segment have historically been more volatile than operating results for the banking, broker-dealer and insurance segments.
The banking segment includes the operations of the Bank, and since August 1, 2018, the operations acquired in the BORO Acquisition. The banking segment primarily provides business and consumer banking services from offices located throughout Texas and generates revenue from its portfolio of earning assets. The Bank’s results of operations are primarily dependent on net interest income. The Bank also derives revenue from other sources, including service charges on customer deposit accounts and trust fees.
The broker-dealer segment includes the operations of Securities Holdings, which operates through its wholly owned subsidiaries Hilltop Securities and HTS Independent Network. The broker-dealer segment generates a majority of its revenues from fees and commissions earned from investment advisory and securities brokerage services. Hilltop Securities is a broker-dealer registered with the SEC and the Financial Industry Regulatory Authority (“FINRA”) and a member of the New York Stock Exchange (“NYSE”). HTS Independent Network is an introducing broker-dealer that is also registered with the SEC and FINRA. Hilltop Securities, HTS Independent Network and Hilltop Securities Asset Management, LLC, a wholly-owned subsidiary of First Southwest Holdings, LLC, are registered investment advisers under the Investment Advisers Act of 1940.
The mortgage origination segment includes the operations of PrimeLending, which offers a variety of loan products and generates revenue predominantly from fees charged on the origination and servicing of loans and from selling these loans in the secondary market.
The insurance segment includes the operations of NLC, which operates through its wholly owned subsidiaries, NLIC and ASIC, in Texas and other areas of the southern United States. Insurance segment income is primarily generated from revenue earned on net insurance premiums less loss and loss adjustment expenses (“LAE”) and policy acquisition and other underwriting expenses.
Corporate includes certain activities not allocated to specific business segments. These activities include holding company financing and investing activities, merchant banking investment opportunities, and management and administrative services to support the overall operations of the Company.
The eliminations of intercompany transactions are included in “All Other and Eliminations.” Additional information concerning our reportable segments is presented in Note 23, Segment and Related Information, in the notes to our consolidated financial statements. The following table presents certain information about the operating results of our reportable segments (in thousands). This table serves as a basis for the discussion and analysis in the segment operating results sections that follow.
Variance 2019 vs 2018
Percent
Net interest income (expense):
5,465
11,517
(1,480)
(1,181)
(1,735)
(246)
(3,144)
(191)
(201)
(25)
(344)
(22)
1,151
1,912
All Other and Eliminations
(172)
(221)
Hilltop Consolidated
3,028
8,539
Provision (recovery) for loan losses:
1,886
123
(342)
(101)
(140)
(219)
(1,012)
(298)
1,746
539
31,970
54,730
1,789
(7,282)
(395)
1,079
(771)
(54)
746
1,030
33,437
50,762
(7,291)
(5,936)
16,903
26,934
(8,305)
(24,331)
(9)
(123)
(0)
(799)
3,934
10,093
68
5,160
6,043
Income (loss) before income taxes:
13,524
16,106
13,929
170
26,755
227
8,359
62
13,905
129
(473)
(20)
1,534
(3,554)
(56)
(7,515)
(40)
532
110
727
32,317
51,512
57
How We Generate Revenue
We generate revenue from net interest income and from noninterest income. Net interest income represents the difference between the income earned on our assets, including our loans and investment securities, and our cost of funds, including the interest paid on the deposits and borrowings that are used to support our assets. Net interest income is a significant contributor to our operating results and is primarily earned by our banking segment. Fluctuations in interest rates, as well as the amounts and types of interest-earning assets and interest-bearing liabilities we hold, affect net interest income. Net interest income increased during the six months ended June 30, 2019, compared with the six months ended June 30, 2018, primarily due to an increase within our banking segment and, to a lesser extent within corporate, partially offset by decreases within our mortgage origination, broker-dealer and insurance segments.
The other component of our revenue is noninterest income, which is primarily comprised of the following:
The increase in noninterest income noted in the segment results table previously presented was primarily due to an increase of $59.9 million in gains from derivative and trading portfolio activities primarily within our broker-dealer segment, partially offset by a decrease of $10.9 million in net gains from sale of loans and other mortgage production income within our mortgage origination segment.
We also incur noninterest expenses in the operation of our businesses. Our businesses engage in labor intensive activities and, consequently, employees’ compensation and benefits represent the majority of our noninterest expenses.
Consolidated Operating Results
Net income applicable to common stockholders during the three months ended June 30, 2019 was $57.8 million, or $0.62 per diluted share, compared with net income applicable to common stockholders of $33.1 million, or $0.35 per diluted share, during the three months ended June 30, 2018. Net income applicable to common stockholders during the six months ended June 30, 2019 was $96.6 million, or $1.03 per diluted share, compared with net income applicable to common stockholders of $57.5 million, or $0.60 per diluted share, during the six months ended June 30, 2018. The six months ended June 30, 2019 included costs incurred during the first quarter of 2019 associated with significant Leadership Changes and other efficiency initiative-related charges which, in the aggregate, totaled $8.7 million before income taxes.
Certain items included in net income for the three and six months ended June 30, 2019 and 2018 resulted from purchase accounting associated with the merger of PlainsCapital Corporation with and into a wholly owned subsidiary of Hilltop on November 30, 2012 (the “PlainsCapital Merger”), the Federal Deposit Insurance Corporation (“FDIC”) -assisted transaction (the “FNB Transaction”) whereby the Bank acquired certain assets and assumed certain liabilities of FNB, the acquisition of SWS Group, Inc. in a stock and cash transaction (the “SWS Merger”) and the BORO Acquisition (collectively, the “Bank Transactions”). Income before taxes included the following purchase accounting items related to the Bank Transactions (in thousands).
PlainsCapital Merger
FNB Transaction
SWS Merger
Net accretion on earning assets and liabilities
558
4,405
445
1,003
6,411
Amortization of identifiable intangibles
(1,001)
(174)
(714)
(1,965)
1,102
9,938
1,006
2,980
15,026
(2,002)
(152)
(348)
(1,428)
(3,930)
412
6,917
657
7,986
(1,418)
(106)
(193)
(1,717)
940
15,294
1,230
17,464
(2,904)
(212)
(387)
(3,503)
We consider the ratios shown in the table below to be key indicators of our performance.
Return on average stockholder's equity
11.63
6.95
9.86
6.07
Return on average assets
1.74
1.48
0.90
Net interest margin (1) (3) (4)
3.49
3.46
3.59
Net interest margin (taxable equivalent) (2) (3) (4)
3.47
3.50
We present net interest margin in the table above, and net interest margin and net interest income below, on a taxable equivalent basis. The interest income earned on certain earning assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than taxable investments. To provide more meaningful comparisons of net interest margins for all earning assets, we use net interest income on a taxable- equivalent basis in calculating net interest margin by increasing the interest income earned on tax-exempt assets to make it fully equivalent to interest income earned on taxable investments.
During the three months ended June 30, 2019 and 2018, purchase accounting contributed 23 and 29 basis points, respectively, to our consolidated taxable equivalent net interest margin of 3.49% and 3.47%, respectively. During the six months ended June 30, 2019 and 2018, purchase accounting contributed 27 and 33 basis points, respectively, to our consolidated taxable equivalent net interest margin of 3.59% and 3.50%, respectively, and primarily related to the following purchase accounting items associated with the Bank Transactions (in thousands).
Accretion of discount on loans
687
413
939
6,444
Accretion (amortization) of discount (premium) on acquired securities
(129)
(58)
1,440
949
2,852
15,179
(338)
128
(196)
749
677
8,343
Amortization of premium on acquired securities
1,687
1,290
18,271
(747)
The tables below provide additional details regarding our consolidated net interest income (dollars in thousands).
Annualized
Earned or
Yield or
Balance
Rate
Interest-earning assets
1,307,251
15,041
4.60
1,589,149
18,241
4.59
Loans held for investment, gross (1)
7,078,807
99,284
5.57
6,374,873
85,683
5.34
Investment securities - taxable
1,733,536
14,654
3.38
1,663,257
12,486
3.00
Investment securities - non-taxable (2)
227,953
2.96
252,591
3.03
Federal funds sold and securities purchased under agreements to resell
69,369
369
2.13
228,786
859
1.51
Interest-bearing deposits in other financial institutions
325,130
1,982
2.44
419,006
1,890
1.81
1,598,063
3.84
1,544,235
4.48
68,990
1,682
9.77
69,297
Interest-earning assets, gross (2)
12,409,099
150,216
4.81
12,141,194
140,248
(59,437)
(63,944)
Interest-earning assets, net
12,349,662
12,077,250
Noninterest-earning assets
1,414,227
1,286,608
13,763,889
13,363,858
Interest-bearing liabilities
Interest-bearing deposits
5,792,236
1.25
5,366,535
0.76
1,462,370
3.69
1,382,984
4.37
Notes payable and other borrowings
1,389,295
10,674
3.06
1,588,132
9,981
2.51
Total interest-bearing liabilities
8,643,901
1.95
8,337,651
1.69
Noninterest-bearing liabilities
Noninterest-bearing deposits
2,549,792
2,492,253
551,333
620,900
11,745,026
11,450,804
Stockholders’ equity
1,995,811
1,910,316
Noncontrolling interest
23,052
2,738
Net interest income (2)
108,036
105,056
Net interest spread (2)
2.86
2.90
Net interest margin (2)
1,161,938
27,529
4.74
1,442,512
32,854
4.56
6,961,727
197,666
5.66
6,341,997
171,014
5.38
1,762,856
30,238
3.43
1,638,570
23,414
224,795
3,344
2.98
255,644
3,942
3.08
67,866
756
2.25
209,312
1,340
1.29
414,857
5,133
2.49
525,276
1.68
1,522,656
4.23
1,540,790
4.36
65,148
3,353
10.35
70,071
3,143
9.02
12,181,843
300,395
4.92
12,024,172
273,861
4.55
(59,493)
(64,569)
12,122,350
11,959,603
1,416,638
1,257,495
13,538,988
13,217,098
5,808,968
1.22
5,430,242
0.70
1,379,149
4.12
1,374,082
1,228,258
19,939
3.26
1,393,146
17,507
2.52
8,416,375
1.99
8,197,470
1.60
2,535,007
2,456,189
587,323
650,557
11,538,705
11,304,216
1,977,274
1,910,736
23,009
2,146
217,106
208,729
2.93
2.95
The banking segment’s net interest margin exceeds our consolidated net interest margin shown above. Our consolidated net interest margin includes certain items that are not reflected in the calculation of our net interest margin within our banking segment and reduce our consolidated net interest margin, such as the borrowing costs of Hilltop and the yields and costs associated with certain items within interest-earning assets and interest-bearing liabilities in the broker-dealer segment, including items related to securities financing operations that particularly decrease net interest margin. In addition, yields and costs on certain interest-earning assets, such as warehouse lines of credit extended to subsidiaries by the banking segment, are eliminated from the consolidated financial statements.
On a consolidated basis, net interest income increased during the three and six months ended June 30, 2019, compared with the same periods in 2018, primarily due to changes attributable to both volumes and yields within our banking segment, partially offset by a decrease in accretion of discount on loans. Refer to the discussion in the “Banking Segment” section that follows for more details on the changes in net interest income, including the component changes in the volume of average interest-earning assets and interest-bearing liabilities and changes in the rates earned or paid on those items.
The provision (recovery) for loan losses is determined by management as the amount to be added to (recovered from) the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level which, in management’s best estimate, is necessary to absorb probable losses within the existing loan portfolio. Substantially all of our consolidated provision (recovery) for loan losses is related to the banking segment. During the six months ended June 30, 2019, the provision for loan losses was impacted by the banking segment’s release of a $2.0 million reserve associated with previously estimated hurricane loss exposures due to improved customer performance. The provision for loan losses was comprised of the following (in thousands).
Charges (recovery of charges) relating to newly originated loans and acquired loans without credit impairment at acquisition
(1,189)
1,336
(698)
(205)
Charges (recovery of charges) on PCI loans
517
(996)
977
(1,262)
Consolidated noninterest income increased during the three months ended June 30, 2019, compared with the same period in 2018, primarily due to increases in noninterest income within our broker-dealer and mortgage origination segments, partially offset by decreases within our insurance segment and corporate. Consolidated noninterest income increased during the six months ended June 30, 2019, compared with the same period in 2018, primarily due to increases in noninterest income within our broker-dealer and insurance segments and corporate, partially offset by a decrease within our mortgage origination segment.
Consolidated noninterest expense increased during the three and six months ended June 30, 2019, compared with the same periods in 2018, primarily due to increases within our broker-dealer segment and corporate, partially offset by decreases within our banking, mortgage origination and insurance segments.
Consolidated effective income tax rates during the three months ended June 30, 2019 and 2018, were 23.1% and 24.3%, respectively, and for the six months ended June 30, 2019 and 2018, were 22.9% and 23.9%, respectively, and approximated the applicable statutory rates for such periods.
Segment Results
Banking Segment
The following table presents certain information about the operating results of our banking segment (in thousands).
Variance
2019 vs 2018
Income before income taxes increased during the three and six months ended June 30, 2019, compared with the same periods in 2018, primarily due to an increase in net interest income associated with net volume and yield changes, partially offset by an increase in deposit rates and a decline in accretion of discount on loans. Changes to net interest income related to the component changes in the volume of average interest-earning assets and interest-bearing liabilities and changes in the rates earned or paid on those items are discussed in more detail below.
The ratios shown in the table below include certain key indicators of the performance and asset quality of our banking segment.
Efficiency ratio (1)
55.92
66.47
57.35
63.92
1.43
1.09
1.38
1.20
Net interest margin (2) (4)
4.06
4.11
4.15
4.13
Net interest margin (taxable equivalent) (3) (4)
4.14
Net recoveries (charge-offs) to average loans outstanding
(0.18)
(0.11)
(0.14)
(0.01)
The banking segment presents net interest margin in the table above, and net interest margin and net interest income in the following discussion and tables below, on a taxable equivalent basis. The interest income earned on certain earning assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than taxable investments. To provide more meaningful comparisons of net interest margins for all earning assets, we use net interest income on a taxable equivalent basis in calculating net interest margin by increasing the interest income earned on tax-exempt assets to make it fully equivalent to interest income earned on taxable investments.
During the three months ended June 30, 2019 and 2018, purchase accounting contributed 31 and 42 basis points, respectively, to the banking segment’s taxable equivalent net interest margin of 4.06% and 4.12%, respectively. During the six months ended June 30, 2019 and 2018, purchase accounting contributed 37 and 47 basis points, respectively, to the banking segment’s taxable equivalent net interest margin of 4.15% and 4.14%, respectively. These purchase accounting items are associated with the Bank Transactions as detailed in the tables previously presented in the Consolidated Operating Results section.
The tables below provide additional details regarding our banking segment’s net interest income (dollars in thousands).
6,562,887
92,311
5.58
5,822,978
79,173
5.40
Subsidiary warehouse lines of credit
1,180,367
14,064
4.71
1,462,319
15,444
4.18
1,185,925
7,650
2.58
943,411
5,333
2.26
93,198
796
3.42
112,148
945
3.37
454
0.18
585
0.73
167,583
1,004
2.40
190,984
851
1.79
48,987
609
4.98
45,529
542
4.76
9,239,401
116,434
5.00
8,577,954
102,289
4.73
(59,363)
(63,044)
9,180,038
8,514,910
931,815
881,822
10,111,853
9,396,732
Liabilities and Stockholders’ Equity
5,523,716
19,940
1.45
5,029,042
12,479
1.00
494,439
2,918
2.34
455,002
1,660
6,018,155
22,858
1.52
5,484,044
14,139
2,517,946
2,459,643
74,802
45,262
8,610,903
7,988,949
1,500,950
1,407,783
Total liabilities and stockholders’ equity
93,576
88,150
3.48
3.70
6,461,968
183,621
5,808,832
158,364
5.43
1,059,085
25,149
4.72
1,338,227
27,143
4.03
1,150,060
14,742
2.56
924,125
10,159
2.20
95,383
1,625
3.41
114,839
1,925
3.35
435
0.15
0.57
241,540
286,140
2,325
1.64
45,057
1,153
5.12
45,981
1,048
9,053,528
229,208
5.05
8,518,684
200,966
4.70
(59,386)
(63,938)
8,994,142
8,454,746
938,574
886,028
9,932,716
9,340,774
5,524,537
38,935
1.42
5,088,835
23,655
0.94
338,028
3,851
2.27
368,932
2,322
5,862,565
42,786
1.47
5,457,767
25,977
0.96
2,503,017
2,436,115
83,503
47,580
8,449,085
7,941,462
1,483,631
1,399,312
186,422
174,989
3.58
3.74
The banking segment’s net interest margin exceeds our consolidated net interest margin. Our consolidated net interest margin includes certain items that are not reflected in the calculation of our net interest margin within our banking segment and reduce our consolidated net interest margin, such as the borrowing costs of Hilltop and the yields and costs associated with certain items within interest-earning assets and interest-bearing liabilities in the broker-dealer segment, including items related to securities financing operations that particularly decrease net interest margin. In addition, the banking segment’s interest-earning assets include warehouse lines of credit extended to other subsidiaries, which are eliminated from the consolidated financial statements.
The following table summarizes the changes in the banking segment’s net interest income for the periods indicated below, including the component changes in the volume of average interest-earning assets and interest-bearing liabilities and changes in the rates earned or paid on those items (in thousands).
2019 vs. 2018
Change Due To (1)
Volume
Yield/Rate
Change
Interest income
Loans held for investment, gross
9,954
3,184
13,138
8,848
16,409
25,257
(2,937)
1,557
(1,380)
(2,808)
814
(1,994)
1,367
950
2,317
1,239
4,583
(159)
(149)
(163)
(137)
(300)
(104)
257
(182)
775
593
105
Total interest income (2)
8,162
5,983
14,145
6,923
21,319
28,242
Interest expense
1,227
6,234
7,461
14,262
15,280
1,116
1,258
1,626
1,529
1,369
7,350
8,719
921
15,888
16,809
6,793
(1,367)
5,426
6,002
5,431
11,433
Changes in the yields earned on interest-earning assets increased taxable equivalent net interest income during the three and six months ended June 30, 2019, compared to the same periods in 2018, primarily as a result of higher loan yields due to increased market rates, partially offset by decreases in accretion of discount on loans of $1.9 million and $3.1 million during the respective periods. Accretion of discount on loans is expected to continue to decrease in future periods as loans acquired in the Bank Transactions are repaid, refinanced or renewed. Changes in the volume of interest-earning assets, primarily due to increases in the loan portfolio as a result of the BORO Acquisition and seasonal increases in mortgage warehouse lending volume, increased taxable equivalent net interest income during the three and six months ended June 30, 2019, compared with the same periods in 2018. Changes in rates paid on interest-bearing liabilities decreased taxable equivalent net interest income during the three and six months ended June 30, 2019, compared with the same periods in 2018, due to increases in market interest rates. Our portfolio includes loans that periodically reprice or mature prior to the end of an amortized term. Some of our variable-rate loans remain at applicable rate floors, which may delay and/or limit changes in interest income during a period of changing rates. If interest rates were to fall, the impact on our interest income for certain variable-rate loans would be limited by these rate floors. In addition, declining interest rates may negatively affect our cost of funds on deposits. The extent of this impact will ultimately be driven by the timing, magnitude and frequency of interest rate and yield curve movements, as well as changes in market conditions and timing of management strategies. If interest rates were to rise, yields on the portion of our loan portfolio that remain at applicable rate floors would rise more slowly than increases in market interest rates. Any changes in interest rates across the term structure will continue to impact net interest income and net interest margin. The impact of rate movements will change with the shape of the yield curve, including any changes in steepness or flatness and inversions at any points on the yield curve.
65
The banking segment’s noninterest income increased during the three and six months ended June 30, 2019, compared to the same periods in 2018, primarily due to year-over-year increases in service charge income due to the restructuring of our products.
The banking segment’s noninterest expenses decreased during the three and six months ended June 30, 2019, compared to the same periods in 2018, primarily due to a reduction in net expenses associated with previously covered assets, including the FDIC Indemnification Asset discussed in the “Factors Affecting Comparability of Results of Operations” section above. Additionally, during the second quarter of 2018, the Bank was the victim of a “spear phishing” attack which resulted in a wire fraud loss of approximately $4.0 million and approximately $0.3 million of other related expenses. We have not recorded an accrual for future claims related to this matter as we have not concluded that such a loss is probable.
Broker-Dealer Segment
The following table provides additional detail regarding our broker-dealer operating results (in thousands).
Net interest income:
Securities lending
2,047
2,411
4,168
4,972
(804)
Structured finance
1,472
3,324
(1,852)
3,625
5,232
(1,607)
Clearing
3,085
3,107
5,736
6,168
(432)
4,806
4,048
758
10,731
9,069
1,662
Total net interest income
Securities commissions and fees by business line (1):
Capital markets
8,949
10,892
(1,943)
20,157
21,029
(872)
Retail
18,805
20,084
(1,279)
36,856
41,028
(4,172)
8,484
8,854
(370)
17,269
17,859
(590)
1,261
(513)
1,521
2,654
(1,133)
36,986
41,091
(4,105)
75,803
82,570
(6,767)
Investment and securities advisory fees and commissions by business line:
Public banking
14,099
15,088
(989)
26,772
27,144
(372)
1,814
800
3,742
1,750
1,992
4,688
472
9,703
9,050
653
1,433
1,059
374
2,154
1,714
440
320
285
577
(31)
2,700
Other:
37,819
5,336
32,483
61,547
9,900
51,647
7,648
4,863
2,785
15,558
7,324
8,234
247
334
(87)
2,022
(1,084)
45,714
10,533
35,181
78,043
19,246
58,797
Net revenue (2)
116,969
86,479
30,490
221,125
167,576
53,549
Variable compensation (3)
44,833
26,036
18,797
79,414
50,630
28,784
Non-variable compensation and benefits
25,500
26,382
(882)
53,994
54,053
(59)
Segment operating costs (4)
24,535
25,889
(1,354)
49,193
51,124
(1,931)
94,868
78,307
16,561
182,601
155,807
26,794
Income before income taxes increased during the three and six months ended June 30, 2019, compared with the same periods in 2018, primarily as a result of 35% and 32% respective increases in net revenues, most notably in trading gains earned from our derivative and trading portfolio activities, primarily from our structured finance and capital markets businesses. The increases in trading gains during the three and six months ended June 30, 2019, compared to the same periods in 2018, were primarily due to a more favorable market environment resulting in 10% and 17% respective increases in trading volumes, enhanced spreads and 25% and 18% respective increases in the structured finance business line’s to-be-announced (“TBA”) mortgage-backed securities volume. We have experienced a more robust business environment in 2019 than we observed in 2018 primarily as a result of recent decreases in interest rates (see other noninterest income discussion that follows), increased customer demand, improved product distribution, and other strategic enhancements. These increases were offset by $18.8 million and $28.8 million respective increases in variable compensation based on more robust financial results and, with respect to the six months ended June 30, 2019, the $2.2 million in pre-tax costs recognized in the first quarter of 2019 associated with Leadership Changes as noted in the “Factors Affecting Results of Operations” section above.
The broker-dealer segment is subject to interest rate risk as a consequence of maintaining inventory positions, trading in interest rate sensitive financial instruments and maintaining a matched stock loan book. Changes in interest rates are likely to have a meaningful impact on our overall financial performance. Our broker-dealer segment has historically earned a significant portion of its revenues from advisory fees upon the successful completion of client transactions. Rapid or significant changes in interest rates could adversely affect the broker-dealer segment’s bond trading, sales, underwriting activities and other interest spread-sensitive activities described below. The broker-dealer segment also receives administrative fees for providing money market and FDIC investment alternatives to clients, which tend to be sensitive to short term interest rates. In addition, the profitability of the broker-dealer segment depends, to an extent, on the spread between revenues earned on customer loans and excess customer cash balances, and the interest expense paid on customer cash balances, as well as the interest revenue earned on trading securities, net of financing costs.
In the broker-dealer segment, interest is earned from securities lending activities, interest charged on customer margin loan balances and interest earned on investment securities used to support sales, underwriting and other customer activities. Net interest income decreased between the three and six months ended June 30, 2019, and the comparable periods in 2018, resulting from decreases in net interest income from our structured finance operations due to a decline in pool inventory from June 30, 2018 to June 30, 2019 and decreases in net interest income from the segment’s stock lending activities due to 15% and 13% respective decreases in average stock lending balances. These decreases were partially offset by increases in net interest earned on trading securities.
Noninterest income increased between the three and six months ended June 30, 2019, and the comparable periods in 2018, primarily due to increases in other noninterest income and investment and securities advisory fees and commissions, partially offset by decreases in securities commissions and fees.
Securities commissions and fees decreased during the three and six months ended June 30, 2019, compared with the same periods in 2018, primarily due to decreases in commissions earned on municipal bond, over-the-counter securities and insurance transactions.
Investment and securities advisory fees and commissions increased during the three and six months ended June 30, 2019, compared with the same periods in 2018, primarily due to improved trading volumes.
Other noninterest income increased during the three and six months ended June 30, 2019, compared with the same periods in 2018, primarily as a result of $35.5 million and $59.9 million respective increases in trading gains earned from our derivative and trading portfolio activities, most notably in our structured finance business, which accounted for $32.5 million and $51.6 million of the respective increases, while our capital markets business accounted for $2.8 million and $8.2 million of the respective increases. The $32.5 million and $51.6 million increases in our structured finance business were primarily due to the 41 and 69 respective basis-point declines in the 10-year treasury bond yield during the three and six months ended June 30, 2019 compared to 11 and 45 respective basis-point increases during the same periods in 2018, and 25% and 18% respective increases in the TBA mortgage-backed securities volume. The $2.8 million and $8.2 million respective increases in our capital markets business is attributable to an improved market environment, improved spreads and 10% and 17% respective increases in trading volume.
Noninterest expenses increased during the three and six months ended June 30, 2019, compared to the same periods in 2018, primarily due to increases in variable compensation and, with respect to the six months ended June 30, 2019, the
$2.2 million in pre-tax costs recognized in the first quarter of 2019 associated with Leadership Changes as noted in the “Factors Affecting Results of Operations” section above.
Selected information concerning the broker-dealer segment follows (dollars in thousands).
Total compensation as a % of net revenue
60.1
60.6
60.3
62.5
FDIC insured program balances at the Bank (end of period)
1,304,744
1,278,694
Other FDIC insured program balances (end of period)
675,621
896,739
Customer margin balances (end of period)
336,729
355,561
Customer funds on deposit, including short credits (end of period)
325,427
354,277
Public banking:
Number of issues
350
368
563
604
Aggregate amount of offerings
14,347,624
15,066,403
26,139,362
25,715,524
Capital markets:
Total volumes
22,570,905
20,505,462
42,602,822
36,376,727
Net inventory (end of period)
553,586
376,388
Retail:
Retail employee representatives (end of period)
Independent registered representatives (end of period)
218
Structured finance:
Lock production/TBA volume
1,650,597
1,318,084
2,798,811
2,379,596
Clearing:
Total tickets
509,546
373,385
1,014,767
779,516
Correspondents (end of period)
Securities lending:
Interest-earning assets - stock borrowed (end of period)
1,491,182
Interest-bearing liabilities - stock loaned (end of period)
1,316,128
Mortgage Origination Segment
The following table presents certain information regarding the operating results of our mortgage origination segment (in thousands).
The mortgage lending business is subject to variables that can impact loan origination volume, including seasonal and interest rate fluctuations. Historically, the mortgage origination segment has typically experienced increased loan origination volume from purchases of homes during the spring and summer, when more people tend to move and buy or sell homes. An increase in mortgage interest rates tends to result in decreased loan origination volume from refinancings, while a decrease in mortgage interest rates tends to result in increased loan origination volume from refinancings. As average mortgage interest rates have decreased between the three months ended June 30, 2018 and the comparable period in 2019, refinancing volume as a percentage of total origination volume has increased from 12.0% to 15.9%. Refinancing volume as a percentage of total origination volume for the six months ended June 30, 2019 and the comparable period in 2018 was relatively flat at approximately 16%. Changes in mortgage interest rates have historically had a lesser impact on home purchases volume than on refinancing volume. We anticipate that recent decreases in mortgage interest rates will increase the percentage of refinancing volumes relative to total loan origination volume for the remainder of 2019.
The mortgage origination segment primarily originates its mortgage loans through a retail channel, with limited lending through its affiliated business arrangements (“ABAs”). For the six months ended June 30, 2019, funded volume through ABAs was approximately 7% of the mortgage origination segment’s total loan volume. Currently, PrimeLending owns a 51% membership interest in four ABAs. We expect production within the ABA channel to increase to between 8% and 10% of the total loan volume of the mortgage origination for 2019.
The following table provides certain details regarding our mortgage loan originations and selected information for the periods indicated below (dollars in thousands).
% of
Mortgage Loan Originations - units
15,760
17,007
(1,247)
26,038
(3,280)
Mortgage Loan Originations - volume
3,960,089
4,107,375
(147,286)
6,407,131
7,067,172
(660,041)
Mortgage Loan Originations:
Conventional
2,388,216
60.31
2,529,836
61.59
(141,620)
3,879,150
60.54
4,289,069
60.69
(409,919)
Government
976,733
24.66
998,786
24.32
(22,053)
1,574,915
24.58
1,754,865
24.83
(179,950)
Jumbo
334,708
8.45
354,275
8.63
(19,567)
529,848
8.27
629,884
8.91
(100,036)
260,432
6.58
224,478
5.46
35,954
423,218
6.61
393,354
29,864
100.00
Home purchases
3,329,024
84.06
3,615,991
88.04
(286,967)
5,379,784
83.97
5,974,683
84.54
(594,899)
Refinancings
631,065
15.94
491,384
11.96
139,681
1,027,347
16.03
1,092,489
15.46
(65,142)
Texas
758,016
19.14
764,337
18.61
(6,321)
1,227,468
19.16
1,328,961
18.80
(101,493)
California
376,086
9.50
449,994
10.96
(73,908)
613,820
9.58
836,232
11.83
(222,412)
Florida
288,711
7.29
309,413
7.53
(20,702)
485,798
7.58
526,721
7.45
(40,923)
Arizona
176,753
4.46
164,240
4.00
12,513
289,459
4.52
291,449
(1,990)
Ohio
174,581
4.41
184,169
(9,588)
278,118
4.34
300,960
4.26
(22,842)
South Carolina
151,620
3.83
138,012
3.36
13,608
250,331
3.91
233,635
3.31
16,696
Washington
158,251
155,215
3.78
3,036
245,004
3.82
261,855
3.71
(16,851)
135,191
121,339
13,852
212,234
210,538
1,696
Missouri
135,248
137,557
(2,309)
210,061
3.28
228,145
3.23
North Carolina
116,058
128,157
3.12
(12,099)
197,954
3.09
222,105
3.14
(24,151)
All other states
1,489,574
37.61
1,554,942
37.86
(65,368)
2,396,884
37.41
2,626,571
37.17
(229,687)
Mortgage Loan Sales - volume
3,338,070
3,526,603
(188,533)
6,049,184
6,712,041
(662,857)
The mortgage origination segment’s total loan origination volume during the three and six months ended June 30, 2019 decreased 3.6% and 9.3%, respectively, compared to the same periods in 2018, while income before income taxes during the three and six months ended June 30, 2019 increased 62.2% and 129.0%, respectively, compared to the same periods in 2018. The increase in income before taxes during the three months ended June 30, 2019, compared to the same period in 2018, was primarily due to a decrease in segment operating costs, and an increase in mortgage loan origination fees and other related income. These changes were partially offset by a decrease in the change in net fair value and related derivative activity of mortgage servicing rights asset. The increase in income before income taxes during the six months ended June 30, 2019, compared to the same period in 2018, was primarily due to a decrease in segment operating costs and variable compensation and increases in the change in net fair value and related derivative activity of interest rate lock commitments (“IRLCs”) and loans held for sale. These changes were partially offset by a decrease in net gains from sale of loans.
Net interest income (expense) decreased $1.7 million and $3.1 million during the three and six months ended June 30, 2019, respectively, compared to the same periods in 2018. Net interest income (expense) during the three and six months ended June 30, 2019 and 2018 was primarily comprised of interest incurred on warehouse lines of credit held with the Bank as well as related intercompany financing costs, partially offset by interest earned on loans held for sale. Year-over-year decreases in average mortgage interest rates contributed to a decrease in yield on loans held for sale in the mortgage origination segment. Also contributing to the decrease in net interest income was an increase in year-over-year average interest rates on mortgage warehouse lines.
69
Noninterest income was comprised of the items set forth in the table below (in thousands).
Net gains from sale of loans
110,996
111,719
(723)
200,347
217,824
(17,477)
Mortgage loan origination fees and other related income
29,618
3,791
50,544
4,738
Other mortgage production income:
Change in net fair value and related derivative activity:
IRLCs and loans held for sale
18,722
17,032
1,690
21,925
12,494
9,431
Mortgage servicing rights asset
(5,198)
(1,688)
(3,510)
(7,864)
(2,830)
(5,034)
Servicing fees
6,619
6,078
541
11,830
1,060
The decreases in net gains from sale of loans during the three and six months ended June 30, 2019, compared with the same periods in 2018, were primarily a result of decreases in total loan sales volume, partially offset by increases in average loan sales margin during the three and six months ended June 30, 2019, compared with the same periods in 2018. The increases in mortgage loan origination fees were primarily the result of increases in average mortgage loan origination fees, partially offset by decreases in total loan origination volume, during three and six months ended June 30, 2019, compared with the same periods in 2018.
Noninterest income included the impact of changes between periods in the net fair value of the mortgage origination segment’s IRLCs and loans held for sale and the related activity associated with forward commitments used by the mortgage origination segment to mitigate interest rate risk associated with its IRLCs and mortgage loans held for sale. The increases during the three and six months ended June 30, 2019, were primarily the result of increases in the volume of IRLCs and loans held for sale, partially offset by decreases in the average value of individual IRLCs and loans held for sale.
The mortgage origination segment sells substantially all mortgage loans it originates to various investors in the secondary market, the majority servicing released. During the three months ended June 30, 2019, the mortgage origination segment retained servicing on approximately 6% of loans sold, compared to 7% during the same period in 2018. During the six months ended June 30, 2019, the mortgage origination segment retained servicing on approximately 6% of loans sold, compared to 12% during the same period in 2018. The mortgage origination segment’s determination of whether to retain or release servicing on mortgage loans it sells is impacted by, among other things, changes in mortgage interest rates, and refinancing and market activity. The related MSR asset was valued at $55.2 million on $5.2 billion of serviced loan volume at June 30, 2019, compared with a value of $67.9 million on $5.3 billion of serviced loan volume at December 31, 2018. The mortgage origination segment may, from time to time, manage its MSR asset through different strategies, including varying the percentage of mortgage loans sold servicing released and opportunistically selling MSR assets. The mortgage origination segment has also retained servicing on certain loans sold to the banking segment. Gains and losses associated with such sales to the banking segment and the related MSR asset are eliminated in consolidation. The mortgage origination segment uses derivative financial instruments, including U.S. Treasury bond futures and options, Eurodollar futures and forward commitments to sell mortgage-backed securities, as a means to mitigate interest rate risk associated with its MSR asset. Changes in the net fair value of the MSR asset and the related derivatives associated with normal customer payments, changes in discount rates, prepayment speed assumptions and customer payoffs resulted in net losses of $5.2 million and $7.9 million during the three and six months ended June 30, 2019, respectively, compared to net losses of $1.7 million and $2.8 million during the three and six months ended June 30, 2018, respectively. Additionally, net servicing income was $3.5 million and $6.6 million during the three and six months ended June 30, 2019, respectively, compared with $2.9 million and $5.4 million during the same periods in 2018.
Noninterest expenses were comprised of the items set forth in the table below (in thousands).
Variable compensation
65,516
66,531
(1,015)
104,445
112,823
(8,378)
40,933
45,182
(4,249)
81,047
89,949
(8,902)
Segment operating costs
27,241
29,007
(1,766)
56,168
60,705
(4,537)
Lender paid closing costs
4,925
6,134
(1,209)
8,423
10,826
(2,403)
Servicing expense
3,106
3,172
(66)
6,315
6,426
(111)
During the third quarter of 2018, PrimeLending committed to close certain underperforming branches, while at the same time reducing its fulfillment and corporate support staff. The purpose of this initiative was to better align resources and
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lower PrimeLending’s cost structure. The decreases in non-variable compensation and benefits and segment operating costs during the three and six months ended June 30, 2019, compared to the same periods in 2018, were primarily the result of this initiative. Decreases in noninterest expense as a result of this initiative have been partially offset by costs related to the “Technology Enhancements and Corporate Initiatives” discussed in detail within the “Overview” above.
Total employees’ compensation and benefits accounted for the majority of noninterest expenses incurred during all periods presented. Specifically, variable compensation comprised 61.5% and 59.6% of total employees’ compensation and benefits expenses during the three months ended June 30, 2019 and 2018, respectively, and 56.3% and 55.6% during the six months ended June 30, 2019 and 2018, respectively. Variable compensation, which is primarily driven by loan origination volume, tends to fluctuate to a greater degree than loan origination volume because mortgage loan originator and fulfillment staff incentive compensation plans are structured to pay at increasing rates as higher monthly volume tiers are achieved. However, certain other incentive compensation plans driven by non-mortgage production criteria may alter this trend. The decreases in variable compensation and benefits between the three and six months ended June 30, 2019 and 2018 were partially offset by an increase in the average incentive rate paid.
While total loan origination volume decreased 3.6% and 9.3% for the three and six months ended June 30, 2019, respectively, compared to the same periods in 2018, the aggregate non-variable compensation and benefits and segment operating costs of the mortgage origination segment decreased 8.1% and 8.9%, respectively. The aforementioned decreases during the three and six months ended June 30, 2019, compared to the same periods in 2018, were primarily due to decreases in non-variable compensation and benefits, in addition to decreases in occupancy and advertising costs, partially offset by increases in software license and maintenance fees. In addition, during the three months ended June 30, 2019, compared to the same period in 2018, professional fees were relatively flat, while during the six months ended June 30, 2019, compared to the same period in 2018, professional fees decreased. The decreases in non-variable compensation and benefits and occupancy costs during the three and six months ended June 30, 2019, were due to a reduction in fulfillment and corporate staff and the closure of certain underperforming branches primarily resulting from PrimeLending’s cost reduction initiative discussed above and implemented during the third quarter of 2018.
In exchange for a higher interest rate, customers may opt to have PrimeLending pay certain costs associated with the origination of their mortgage loans (“lender paid closing costs”). Fluctuations in lender paid closing costs are not always aligned with fluctuations in loan origination volume. Other loan pricing conditions, including the mortgage loan interest rate, loan origination fees paid by the customer, and a customer’s willingness to pay closing costs, may influence fluctuations in lender paid closing costs.
Between January 1, 2010 and June 30, 2019, the mortgage origination segment sold mortgage loans totaling $113.7 billion. These loans were sold under sales contracts that generally include provisions that hold the mortgage origination segment responsible for errors or omissions relating to its representations and warranties that loans sold meet certain requirements, including representations as to underwriting standards and the validity of certain borrower representations in connection with the loan. In addition, the sales contracts typically require the refund of purchased servicing rights plus certain investor servicing costs if a loan experiences an early payment default. While the mortgage origination segment sold loans prior to 2010, it does not anticipate experiencing significant losses in the future on loans originated prior to 2010 as a result of investor claims under these provisions of its sales contracts.
When a claim for indemnification of a loan sold is made by an agency, investor, or other party, the mortgage origination segment evaluates the claim and determines if the claim can be satisfied through additional documentation or other deliverables. If the claim is valid and cannot be satisfied in that manner, the mortgage origination segment negotiates with the claimant to reach a settlement of the claim. Settlements typically result in either the repurchase of a loan or reimbursement to the claimant for losses incurred on the loan.
Following is a summary of the mortgage origination segment’s claims resolution activity relating to loans sold between January 1, 2010 and June 30, 2019 (dollars in thousands).
Original Loan Balance
Loss Recognized
Sold
207,260
0.18%
0.00%
Claims resolved because of a loan repurchase or payment to an investor for losses incurred (1)
199,918
9,380
0.01%
407,178
0.36%
For each loan it concludes its obligation to a claimant is both probable and reasonably estimable, the mortgage origination segment has established a specific claims indemnification liability reserve. An additional indemnification liability reserve has been established for probable agency, investor or other party losses that may have been incurred, but not yet reported to the mortgage origination segment based upon a reasonable estimate of such losses.
At June 30, 2019 and December 31, 2018, the mortgage origination segment’s indemnification liability reserve totaled $10.8 million and $10.7 million, respectively. The related provision for indemnification losses was $0.8 million and $1.0 million during the three months ended June 30, 2019 and 2018, respectively, and $1.3 million and $1.7 million during the six months ended June 30, 2019 and 2018, respectively.
Insurance Segment
The following table presents certain information regarding the operating results of our insurance segment (in thousands).
The increase in loss before income taxes during the three months ended June 30, 2019, compared with the same period in 2018, was primarily due to a decrease in net insurance premiums earned, including the effects of the non-renewal of commercial policies and the discontinuation of writing new policies five in non-core states, in addition to an increase in loss and LAE. The increase in income before income taxes during the six months ended June 30, 2019, compared with the same period in 2018, was primarily due to a larger increase in the fair value associated with the equity securities held by the insurance segment, partially offset by a decline in net insurance premiums earned, including the effects of the factors previously discussed.
The insurance segment is subject to claims arising out of severe weather, the incidence and severity of which are inherently unpredictable. Generally, the insurance segment’s insured risks exhibit higher losses in the second and third calendar quarters due to a seasonal concentration of weather-related events in its primary geographic markets. Although weather-related losses (including hail, high winds, tornadoes, monsoons and hurricanes) can occur in any calendar quarter, the second calendar quarter, historically, has experienced the highest frequency of losses associated with these events. Hurricanes, however, are more likely to occur in the third calendar quarter of the year.
The insurance segment periodically reviews the pricing of its primary products in each state of operation utilizing a consulting actuarial firm to supplement normal review processes resulting in filings to adjust rates as deemed necessary. The benefit of these rate actions are not fully realized until all policies under the old rates expire, which typically occurs one year from the date of rate change implementation. Concurrently, business concentrations are reviewed and actions initiated, including cancellation of agents, non-renewal of policies and cessation of new business writing on certain products in problematic geographic areas. The insurance segment has historically utilized rate actions to reduce the rate of premium growth for targeted areas when compared with the patterns exhibited in prior quarters and years and reduced the insurance segment’s exposure to volatile weather in these areas, but competition and customer response to
rate increases has negatively impacted customer retention and new business. The insurance segment aims to manage and diversify its business concentrations and products to minimize the effects of future weather-related events. We believe that current initiatives to evaluate product offerings and pricing, streamline business activities and expenses and mitigate the impact of future significant weather-related events are critical to improving the insurance segment’s long-term financial condition and operating results.
The insurance segment’s operations resulted in combined ratios of 113.0% and 111.1% during the three months ended June 30, 2019 and 2018, respectively, and 99.8% and 98.1% during the six months ended June 30, 2019 and 2018, respectively. The increases in the combined ratios during the three and six months ended June 30, 2019, compared with the same periods in 2018, were primarily driven by increases in the loss and LAE ratio. The combined ratio is a measure of overall insurance underwriting profitability, and represents the sum of loss and LAE and underwriting expenses divided by net insurance premiums earned.
Noninterest income during the three months ended June 30, 2019 and 2018, was primarily comprised of net insurance premiums earned of $33.5 million and $34.1 million, respectively. Noninterest income during the six months ended June 30, 2019 and 2018, was primarily comprised of net insurance premiums earned of $66.7 million and $68.4 million, respectively. The year-over-year decrease in net insurance premiums earned were driven by the effect of historical decreases in net premiums written.
Direct insurance premiums written by major product line are presented in the table below (in thousands).
Direct Insurance Premiums Written:
Homeowners
14,840
14,248
26,825
26,721
104
Fire
10,809
10,967
(158)
20,576
21,171
(595)
Mobile Home
9,913
9,848
18,951
19,579
(628)
738
(738)
1,415
(1,415)
(2,534)
The aggregate direct insurance premiums written for our three largest insurance product lines increased by $0.5 million and decreased by $1.1 million during the three and six months ended June 30, 2019, respectively, compared with the same periods in 2018. The decrease in total direct insurance premiums written during the six months ended June 30, 2019, compared to the same period in 2018, was due to competition, rationalization of product offerings, including the non-renewal of commercial policies, and continued review of geographic concentrations. In the fourth quarter of 2018, in connection with a strategic initiative to focus on our insurance segment’s key markets, we discontinued writing new insurance policies in five non-core states. The premiums written and earned related to the commercial policies and the five non-core states is included within “Other” in the table above and the table that follows. Approximately 2% of total net insurance premiums earned during both the three and six months ended June 30, 2019 were from these five non-core states, compared to 3% of total net insurance premiums earned during both the three and six months ended June 30, 2018. As our insurance policies are generally in effect for one year, we anticipate that the full impact of this initiative on premiums earned will be complete by the end of 2019.
Net insurance premiums earned by major product line are presented in the table below (in thousands).
Net Insurance Premiums Earned:
14,029
13,605
424
26,953
26,540
10,142
10,444
(302)
20,674
21,028
(354)
9,295
9,353
19,042
19,446
(404)
1,406
(1,406)
(639)
(1,751)
Net insurance premiums earned during the three and six months ended June 30, 2019 decreased compared to the same periods in 2018, primarily due to the decrease in direct insurance premiums written noted above.
Noninterest expenses during the three and six months ended June 30, 2019 and 2018 include both loss and LAE expenses and policy acquisition and other underwriting expenses, as well as other noninterest expenses. Loss and LAE are recognized based on formula and case basis estimates for losses reported with respect to direct business, estimates of unreported losses based on past experience and deduction of amounts for reinsurance placed with reinsurers. Loss and
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LAE ratios during the three months ended June 30, 2019 and 2018, were 74.6% and 71.6%, respectively, and during the six months ended June 30, 2019 and 2018, were 59.9% and 58.4%, respectively. The increases in the loss and LAE ratios during the three and six months ended June 30, 2019, compared to the same periods in 2018, were primarily driven by 0.1% and 2.3% respective increases in loss and LAE expense, while premiums earned decreased by 1.9% and 2.6%, respectively.
Policy acquisition and other underwriting expenses encompass all expenses incurred relative to NLC operations, and include elements of multiple categories of expense otherwise reported as noninterest expense in the consolidated statements of operations.
The following table details the calculation of the underwriting expense ratio for the periods presented (dollars in thousands).
Amortization of deferred policy acquisition costs
9,102
9,478
(376)
17,194
18,568
(1,374)
Other underwriting expenses
4,760
5,046
(286)
11,322
10,577
745
13,862
14,524
(662)
28,516
29,145
(629)
Agency expenses
(1,019)
(1,061)
(1,884)
(1,982)
Total less agency expenses
12,843
13,463
(620)
26,632
27,163
(531)
Expense ratio
38.4
39.5
(1.1)
39.9
39.7
0.2
Corporate includes certain activities not allocated to specific business segments. These activities include holding company financing and investing activities, merchant banking investment opportunities and management and administrative services to support the overall operations of the Company. Hilltop’s merchant banking investment activities include the identification of attractive opportunities for capital deployment in companies engaged in non-financial activities through its merchant bank subsidiary, Hilltop Opportunity Partners LLC.
As a holding company, Hilltop’s primary investment objectives are to support capital deployment for organic growth and to preserve capital to be deployed through acquisitions, dividend payments and potential stock repurchases. Investment and interest income during the three and six months ended June 30, 2019, was primarily comprised of dividend income from merchant banking investment activities, in addition to interest income earned on intercompany notes.
Interest expense during each period was primarily associated with recurring quarterly interest expense of $1.9 million incurred on our $150.0 million aggregate principal amount of 5% senior notes due 2025 (“Senior Notes”). Additionally, we incurred interest expense of $1.0 million and $0.9 million during the three months ended June 30, 2019 and 2018, respectively, and $2.0 million and $1.7 million during the six months ended June 30, 2019 and 2018, respectively, on junior subordinated debentures of $67.0 million issued by PCC (the “Debentures”).
Noninterest income during the three and six months ended June 30, 2019, included activity associated with our investment in the development of the land and an office building that will serve as our future headquarters. Noninterest income during the three and six months ended June 30, 2018, also included net noninterest income associated with activity within our merchant bank subsidiary.
Noninterest expenses during the three and six months ended June 30, 2019 and 2018, were primarily comprised of employees’ compensation and benefits, occupancy expenses and professional fees, including corporate governance, legal and transaction costs. Noninterest expenses increased $3.9 million and $10.1 million during the three and six months ended June 30, 2019, respectively, compared to the same periods in 2018. The increase during the three months ended June 30, 2019, compared to the same period in 2018, was primarily due to the technology enhancements and corporate initiatives discussed in the “Overview” section. In addition to costs incurred related to the aforementioned technology enhancements and corporate initiatives, the increase during the six months ended June 30, 2019, was due to costs incurred during the first quarter of 2019 of $5.8 million associated with the Leadership Changes and other efficiency initiative-related charges which, in the aggregate, totaled $6.5 million before income taxes.
Financial Condition
The following discussion contains a more detailed analysis of our financial condition at June 30, 2019, as compared with December 31, 2018.
Securities Portfolio
At June 30, 2019, investment securities consisted of securities of the U.S. Treasury, U.S. government and its agencies, obligations of municipalities and other political subdivisions, primarily in the State of Texas, as well as mortgage-backed, corporate debt, and equity securities. We may categorize investments as trading, available for sale, held to maturity and equity securities.
Trading securities are bought and held principally for the purpose of selling them in the near term and are carried at fair value, marked to market through operations and held at the Bank and the Hilltop Broker-Dealers. Securities classified as available for sale may, from time to time, be bought and sold in response to changes in market interest rates, changes in securities’ prepayment risk, increases in loan demand, general liquidity needs and to take advantage of market conditions that create more economically attractive returns. Such securities are carried at estimated fair value, with unrealized gains and losses recorded in accumulated other comprehensive income (loss). Equity investments are carried at fair value, with all changes in fair value recognized in net income. Securities are classified as held to maturity based on the intent and ability of our management, at the time of purchase, to hold such securities to maturity. These securities are carried at amortized cost.
The table below summarizes our securities portfolio (in thousands).
Trading securities, at fair value
Securities available for sale, at fair value
Securities held to maturity, at amortized cost
Equity securities, at fair value
Total securities portfolio
We had net unrealized gains of $10.1 million and net unrealized losses of $11.1 million at June 30, 2019 and December 31, 2018, respectively, related to the available for sale investment portfolio, and net unrealized gains of $2.6 million and net unrealized losses of $9.9 million associated with the securities held to maturity portfolio at June 30, 2019 and December 31, 2018, respectively. We had net unrealized gains of $0.7 million and net unrealized losses of $0.9 million at June 30, 2019 and December 31, 2018, respectively, related to equity securities.
The banking segment’s securities portfolio plays a role in the management of our interest rate sensitivity and generates additional interest income. In addition, the securities portfolio is used to meet collateral requirements for public and trust deposits, securities sold under agreements to repurchase and other purposes. The available for sale and equity securities portfolios serve as a source of liquidity. Historically, the Bank’s policy has been to invest primarily in securities of the U.S. government and its agencies, obligations of municipalities in the State of Texas and other high grade fixed income securities to minimize credit risk. At June 30, 2019, the banking segment’s securities portfolio of $1.3 billion was comprised of trading securities of $2.5 million, available for sale securities of $916.5 million, equity securities of $0.1 million and held to maturity securities of $365.9 million, in addition to $13.3 million of other investments included in other assets within the consolidated balance sheets.
The broker-dealer segment holds securities to support sales, underwriting and other customer activities. The interest rate risk inherent in holding these securities is managed by setting and monitoring limits on the size and duration of positions and on the length of time the securities can be held. The Hilltop Broker-Dealers are required to carry their securities at fair value and record changes in the fair value of the portfolio in operations. Accordingly, the securities portfolio of the Hilltop Broker-Dealers included trading securities of $599.0 million at June 30, 2019. In addition, the Hilltop Broker-Dealers enter into transactions that represent commitments to purchase and deliver securities at prevailing future market prices to facilitate customer transactions and satisfy such commitments. Accordingly, the Hilltop Broker-Dealers’ ultimate obligations may exceed the amount recognized in the financial statements. These securities, which are carried at fair value and reported as securities sold, not yet purchased in the consolidated balance sheets, had a value of $45.4 million at June 30, 2019.
The insurance segment’s primary investment objective is to preserve capital and manage for a total rate of return. NLC’s strategy is to purchase securities in sectors that represent the most attractive relative value. Our insurance segment invests the premiums it receives from policyholders until they are needed to pay policyholder claims or other expenses. At June 30, 2019, the insurance segment’s securities portfolio was comprised of $93.4 million in available for sale securities, $19.4 million of equity securities and $5.9 million of other investments included in other assets within the consolidated balance sheets.
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Loan Portfolio
Consolidated loans held for investment are detailed in the tables below, classified by portfolio segment and segregated between those considered to be purchased credit impaired, or PCI, loans and all other originated or acquired loans (in thousands). PCI loans showed evidence of credit deterioration on the date of acquisition that made it probable that all contractually required principal and interest payments would not be collected.
2,911,894
1,442,313
950,561
641,663
7,116,404
(51,188)
(3,989)
Loans held for investment, net of allowance
7,065,216
82,211
2,912,407
1,501,892
932,445
6,837,386
(56,594)
(2,892)
6,780,792
90,180
The loan portfolio constitutes the major earning asset of the banking segment and typically offers the best alternative for obtaining the maximum interest spread above the banking segment’s cost of funds. The overall economic strength of the banking segment generally parallels the quality and yield of its loan portfolio.
The banking segment’s total loans held for investment, net of the allowance for loan losses, were $8.0 billion and $7.5 billion at June 30, 2019 and December 31, 2018, respectively. The banking segment’s loan portfolio includes warehouse lines of credit extended to PrimeLending of $2.0 billion, of which $1.4 million and $1.2 billion was drawn at June 30, 2019 and December 31, 2018, respectively. Amounts advanced against the warehouse lines of credit are eliminated from net loans held for investment on our consolidated balance sheets. The banking segment does not generally participate in syndicated loan transactions and has no foreign loans in its portfolio.
At June 30, 2019, the banking segment had loan concentrations (loans to borrowers engaged in similar activities) that exceeded 10% of total loans in its real estate portfolio. The areas of concentration within our real estate portfolio were non-construction commercial real estate loans, construction and land development loans and non-construction residential real estate loans, which represented 44.3%, 14.3% and 10.5%, respectively, of the banking segment’s total loans held for investment (excluding warehouse lines of credit extended to PrimeLending) at June 30, 2019. The banking segment’s loan concentrations were within regulatory guidelines at June 30, 2019.
The loan portfolio of the broker-dealer segment consists primarily of margin loans to customers and correspondents. These loans are collateralized by the securities purchased or by other securities owned by the clients and, because of collateral coverage ratios, are believed to present minimal collectability exposure. Additionally, these loans are subject to a number of regulatory requirements as well as the Hilltop Broker-Dealers’ internal policies. The broker-dealer segment’s total loans held for investment, net of the allowance for loan losses, were $570.3 million and $578.2 million at June 30, 2019 and December 31, 2018, respectively. This decrease from December 31, 2018 to June 30, 2019 was primarily attributable to a decrease of $10.7 million, or 4.4%, in receivables from correspondents.
The loan portfolio of the mortgage origination segment consists of loans held for sale, primarily single-family residential mortgages funded through PrimeLending, and IRLCs with customers pursuant to which we agree to originate a mortgage loan on a future date at an agreed-upon interest rate. The components of the mortgage origination segment’s loans held for sale and IRLCs are as follows (in thousands).
Loans held for sale:
Unpaid principal balance
1,426,514
1,213,068
Fair value adjustment
48,562
44,707
IRLCs:
1,564,119
694,688
The mortgage origination segment uses forward commitments to mitigate interest rate risk associated with its loans held for sale and IRLCs. The notional amounts of these forward commitments at June 30, 2019 and December 31, 2018 were $2.4 billion and $1.4 billion, respectively, while the related estimated fair values were ($10.3) million and ($11.6) million, respectively.
The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses inherent in our existing loan portfolio. Management has responsibility for determining the level of the allowance for loan losses, subject to review by the Loan Review Committee of the Bank’s board of directors.
The allowance for loan losses is subject to regulatory examination, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance. While we believe we have an appropriate allowance for our existing loan portfolio at June 30, 2019, additional provisions for losses on existing loans may be necessary in the future.
For additional information regarding the allowance for loan losses, refer to the sections captioned “Allowance for Loan Losses” and “Critical Accounting Policies and Estimates” in Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our 2018 Form 10-K. There have been no significant changes in our application of critical accounting policies related to the allowance for loan losses since December 31, 2018.
The Bank acquired certain assets and assumed certain liabilities of FNB in connection with the FNB Transaction. The FNB Transaction is discussed in detail in Note 6 to the consolidated financial statements included in the Company’s 2018 Form 10-K. As discussed in the “Factors Affecting Comparability of Results of Operations” section above, the loss-share agreements with the FDIC were terminated during the fourth quarter of 2018. Accordingly, loans which were previously referred to as either “covered loans” if covered by the loss-share agreements or otherwise “non-covered loans” are now collectively referred to as “loans held for investment.”
The following tables present the activity in our allowance for loan losses within our loan portfolio for the periods presented (in thousands). Substantially all of the activity shown below occurred within the banking segment.
Loans Held for Investment
Recoveries of loans previously charged off:
Total recoveries
Loans charged off:
2,430
4,248
3,416
871
899
Total charge-offs
3,311
2,344
5,611
3,546
Net charge-offs
(2,960)
(1,564)
(4,588)
(249)
Allowance for loan losses as a percentage of gross loans held for investment
0.77
0.95
The distribution of the allowance for loan losses among loan types and the percentage of the loans for that type to gross loans, excluding unearned income, within our loan portfolio are presented in the tables below (dollars in thousands).
Gross
Reserve
40.78
42.42
20.11
21.77
13.20
13.46
9.67
9.80
7.71
3.52
0.61
0.69
7.92
8.34
Potential Problem Loans
Potential problem loans consist of loans that are performing in accordance with contractual terms but for which management has concerns about the ability of an obligor to continue to comply with repayment terms because of the obligor’s potential operating or financial difficulties. Management monitors these loans and reviews their performance on a regular basis. Potential problem loans contain potential weaknesses that could improve, persist or further deteriorate. If such potential weaknesses persist without improving, the loan is subject to downgrade, typically to substandard, in three to six months. Potential problem loans are assigned a grade of special mention within our risk grading matrix. Potential problem loans do not include PCI loans because PCI loans exhibited evidence of credit deterioration at acquisition that made it probable that all contractually required principal payments would not be collected. Within our loan portfolio, we had five credit relationships totaling $6.8 million of potential problem loans at
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June 30, 2019, compared with seven credit relationships totaling $17.8 million of potential problem loans at December 31, 2018.
Non-Performing Assets
The following table presents components of our non-performing assets (dollars in thousands).
Loans accounted for on a non-accrual basis:
5,276
5,324
(48)
(718)
(1,865)
11,136
10,437
699
(7)
32,011
33,950
(1,939)
Non-performing loans as a percentage of total loans
0.36
0.41
(0.05)
20,753
27,578
(6,825)
Other repossessed assets
(68)
Non-performing assets
52,764
61,596
(8,832)
Non-performing assets as a percentage of total assets
0.37
0.45
(0.08)
Non-PCI loans past due 90 days or more and still accruing
77,425
83,131
(5,706)
Troubled debt restructurings included in accruing loans held for investment
2,256
1,339
917
At June 30, 2019, non-accrual loans included 19 commercial and industrial relationships with loans secured by accounts receivable, life insurance, oil and gas, livestock and equipment. Non-accrual loans at June 30, 2019 also included $3.4 million of loans secured by residential real estate which were classified as loans held for sale. At December 31, 2018, non-accrual loans included 16 commercial and industrial relationships with loans secured by accounts receivable, life insurance, oil and gas, livestock, and equipment. Non-accrual loans at December 31, 2018 included $3.4 million of loans secured by residential real estate which were classified as loans held for sale.
Other real estate owned (“OREO”) decreased from December 31, 2018 to June 30, 2019, due to $9.6 million of disposals and fair valuation decreases related to 51 properties, partially offset by the addition of 25 properties totaling $2.8 million. At both June 30, 2019 and December 31, 2018, OREO was primarily comprised of commercial properties.
Non-PCI loans past due 90 days or more and still accruing at June 30, 2019 and December 31, 2018, were primarily comprised of loans held for sale and guaranteed by U.S. government agencies, including loans that are subject to repurchase, or have been repurchased, by PrimeLending. Loans past due 90 days or more and still accruing include Government National Mortgage Association related loans subject to repurchase within our mortgage origination segment.
At June 30, 2019, troubled debt restructurings (“TDRs”) were comprised of $2.3 million of loans that are considered to be performing and non-performing loans of $12.8 million reported in non-accrual loans. At December 31, 2018, TDRs were comprised of $1.3 million of loans that are considered to be performing and non-performing loans of $5.9 million reported in non-accrual loans.
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Current Expected Credit Loss (CECL) Standard
In June 2016, the FASB issued ASU 2016-13 which sets forth a “current expected credit loss” (CECL) model for measuring credit losses on certain exposures. The new model will require the measurement of expected credit losses to reflect the lifetime of an exposure (or pool of exposures) represented by certain financial instruments to be based on historical experience, current conditions and reasonable and supportable forecasts. Under the current “incurred loss” model, the allowance for loan losses is based only on estimates of loan losses that currently exist in the portfolio as of the reporting date. The new model will become effective on January 1, 2020, and applies to most debt instruments, trade receivables, lease receivables, reinsurance receivables, financial guarantees and loan commitments. Our ongoing CECL transition efforts include reassessing risk ratings, developing and validating the new model, collecting and processing new data and establishing internal controls and accounting policies. New model development has increased expenses associated with the collection and processing of data, and these increases in expenses will continue for the remainder of 2019 as we perform parallel calculations of our allowance for credit losses under both the current allowance model and under the CECL model. We expect that the CECL model will require a material increase in our allowance for credit losses upon adoption on January 1, 2020.
Insurance Losses and Loss Adjustment Expenses
At June 30, 2019 and December 31, 2018, our gross reserve for unpaid losses and LAE was $22.3 million and $20.6 million, respectively, including estimated recoveries from reinsurance of $1.2 million and $3.2 million, respectively. The liability for insurance losses and LAE represents estimates of the ultimate unpaid cost of all losses incurred, including losses for claims that have not yet been reported, less a reduction for reinsurance recoverables related to those liabilities. Separately for each of NLIC and ASIC and each line of business, our actuaries estimate the liability for unpaid losses and LAE by first estimating ultimate losses and LAE amounts for each year, prior to recognizing the impact of reinsurance. The amount of liabilities for reported claims is based primarily on a claim-by-claim evaluation of coverage, liability, injury severity or scope of property damage, and any other information considered relevant to estimating exposure presented by the claim.
NLC’s liabilities for unpaid losses represent the best estimate at a given point in time of what it expects to pay claimants, based on facts, circumstances and historical trends then known. During the loss settlement period, additional facts regarding individual claims may become known and, consequently, it often becomes necessary to refine and adjust the estimates of liability. This process is commonly referred to as loss development. To project ultimate losses and LAE, our actuaries examine the paid and reported losses and LAE for each accident year and multiply these values by a loss development factor. The selected loss development factors are based upon a review of the loss development patterns indicated in the companies’ historical loss triangles (which utilize historical trends, adjusted for changes in loss costs, underwriting standards, policy provisions, product mix and other factors) and applicable insurance industry loss development factors. Estimating the liability for unpaid losses and LAE is inherently judgmental and is influenced by factors that are subject to significant variation. Liabilities for LAE are intended to cover the ultimate cost of settling claims, including investigation and defense of lawsuits resulting from such claims.
The reserve analysis performed by our actuaries provides preliminary central estimates of the unpaid losses and LAE. At each quarter-end, the results of the reserve analysis are summarized and discussed with our senior management. The senior management group considers many factors in determining the amount of reserves to record for financial statement purposes. These factors include the extent and timing of any recent catastrophic events, historical pattern and volatility of the actuarial indications, the sensitivity of the actuarial indications to changes in paid and reported loss patterns, the consistency of claims handling processes, the consistency of case reserving practices, changes in our pricing and underwriting, and overall pricing and underwriting trends in the insurance market.
The banking segment’s major source of funds and liquidity is its deposit base. Deposits provide funding for its investments in loans and securities. Interest paid for deposits must be managed carefully to control the level of interest expense and overall net interest margin. The composition of the deposit base (time deposits versus interest-bearing demand deposits and savings), as discussed in more detail within the section entitled “Liquidity and Capital Resources — Banking Segment” below, is constantly changing due to the banking segment’s needs and market conditions.
The table below presents the average balance of, and rate paid on, consolidated deposits (dollars in thousands).
Year Ended December 31,
Rate Paid
Noninterest-bearing demand deposits
0.00
2,504,599
Interest-bearing demand deposits
4,250,036
1.04
3,849,009
4,025,259
0.66
Savings deposits
182,356
0.19
216,385
0.13
201,328
0.11
Time deposits
1,376,576
1.92
1,364,848
1,341,886
8,343,975
0.85
7,886,431
8,073,072
Borrowings
Our borrowings are shown in the table below (dollars in thousands).
2.62
2.15
5.14
4.95
3,051
5.98
5.47
1,637,828
3.24
1,361,691
2.70
276,137
Short-term borrowings consisted of federal funds purchased, securities sold under agreements to repurchase, borrowings at the Federal Home Loan Bank (“FHLB”) and short-term bank loans. The increase in short-term borrowings at June 30, 2019, compared with December 31, 2018, included an increase in borrowings in our banking segment primarily associated with the increased utilization of available internal funds partially offset by a net decrease in securities sold under agreements to repurchase and short-term bank loans used by the Hilltop Broker-Dealers to finance their activities. Notes payable at June 30, 2019, was comprised of $148.7 million related to the Senior Notes, net of loan origination fees, FHLB borrowings with an original maturity greater than one year within the banking segment of $4.0 million, insurance segment term notes of $27.5 million, and mortgage origination segment borrowings of $51.7 million.
Liquidity and Capital Resources
Hilltop is a financial holding company whose assets primarily consist of the stock of its subsidiaries and invested assets. Hilltop’s primary investment objectives, as a holding company, are to support capital deployment for organic growth and to preserve capital to be deployed through acquisitions, dividend payments and potential stock repurchases. At June 30, 2019, Hilltop had $67.0 million in cash and cash equivalents, an increase of $23.1 million from $43.9 million at December 31, 2018. This increase in cash and cash equivalents was primarily due to $71.3 million of dividends from subsidiaries, partially offset by $25.0 million of purchases under our stock repurchase program, $15.0 million in cash dividends declared, and other general corporate expenses. Subject to regulatory restrictions, Hilltop has received, and may also continue to receive, dividends from its subsidiaries. If necessary or appropriate, we may also finance acquisitions with the proceeds from equity or debt issuances. We believe that Hilltop’s liquidity is sufficient for the foreseeable future, with current short-term liquidity needs including operating expenses, interest on debt obligations, dividend payments to stockholders and potential stock repurchases.
Dividend Declaration
On July 25, 2019, our board of directors declared a quarterly cash dividend of $0.08 per common share, payable on August 30, 2019 to all common stockholders of record as of the close of business on August 15, 2019.
Future dividends on our common stock are subject to the determination by the board of directors based on an evaluation of our earnings and financial condition, liquidity and capital resources, the general economic and regulatory climate, our ability to service any equity or debt obligations senior to our common stock and other factors.
In January 2019, our board of directors authorized a new stock repurchase program through January 2020, pursuant to which we are authorized to repurchase, in the aggregate, up to $50.0 million of our outstanding common stock, inclusive of repurchases to offset dilution related to grants of stock-based compensation. Under the stock repurchase program authorized, we may repurchase shares in the open market or through privately negotiated transactions as permitted under Rule 10b-18 promulgated under the Exchange Act. The extent to which we repurchase our shares and the timing of such repurchases depends upon market conditions and other corporate considerations, as determined by Hilltop’s management team. Repurchased shares will be returned to our pool of authorized but unissued shares of common stock.
During the six months ended June 30, 2019, we paid $25.0 million to repurchase an aggregate of 1,214,843 shares of common stock at an average price of $20.54 per share. The purchases were funded from available cash balances.
Senior Notes due 2025
The Senior Notes bear interest at a rate of 5% per year, payable semi-annually in arrears in cash on April 15 and October 15 of each year, commencing on October 15, 2015. The Senior Notes will mature on April 15, 2025, unless we redeem the Senior Notes, in whole at any time or in part from time to time, on or after January 15, 2025 (three months prior to the maturity date of the Senior Notes) at our election at a redemption price equal to 100% of the principal amount of the Senior Notes to be redeemed plus accrued and unpaid interest to, but excluding, the redemption date. At June 30, 2019, $150.0 million of our Senior Notes was outstanding.
Junior Subordinated Debentures
The Debentures have a stated term of 30 years with maturities ranging from July 2031 to February 2038 with interest payable quarterly. The rate on the Debentures, which resets quarterly, is 3-month LIBOR plus an average spread of 3.22%. The total average interest rate at June 30, 2019 was 5.66%. The Debentures are callable at PCC’s discretion with a minimum of a 45- to 60- day notice. At June 30, 2019, $67.0 million of PCC’s Debentures were outstanding.
Regulatory Capital
We are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements may prompt certain actions by regulators that, if undertaken, could have a direct material adverse effect on our financial condition and results of operations. Under capital adequacy and regulatory requirements, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
In order to avoid limitations on capital distributions, including dividend payments, stock repurchases and certain discretionary bonus payments to executive officers, Basel III requires banking organizations to maintain a capital conservation buffer above minimum risk-based capital requirements measured relative to risk-weighted assets. The phase-in of the capital conservation buffer requirements began on January 1, 2016 for Hilltop and PlainsCapital, and the requirements were fully phased in as of January 1, 2019.
Bank holding companies with less than $15 billion in assets as of December 31, 2009 are allowed to continue to include junior subordinated debentures in Tier 1 capital, subject to certain restrictions. However, if an institution grows to above $15 billion in assets as a result of an acquisition, or organically grows to above $15 billion in assets and then makes an acquisition, the combined trust preferred issuances must be phased out of Tier 1 and into Tier 2 capital. All of the debentures issued to the PCC Statutory Trusts I, II, III and IV (the “Trusts”), less the common stock of the Trusts, qualified as Tier 1 capital as of June 30, 2019, under guidance issued by the Board of Governors of the Federal Reserve System.
At June 30, 2019, Hilltop had a total capital to risk weighted assets ratio of 17.14%, Tier 1 capital to risk weighted assets ratio of 16.77%, common equity Tier 1 capital to risk weighted assets ratio of 16.32% and a Tier 1 capital to average assets, or leverage, ratio of 13.00%. Accordingly, Hilltop’s actual capital amounts and ratios in accordance with Basel III exceeded the regulatory capital requirements including conservation buffer in effect at the end of the period.
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At June 30, 2019, PlainsCapital had a total capital to risk weighted assets ratio of 14.48%, Tier 1 capital to risk weighted assets ratio of 13.84%, common equity Tier 1 capital to risk weighted assets ratio of 13.84% and a Tier 1 capital to average assets, or leverage, ratio of 12.53%. Accordingly, PlainsCapital’s actual capital amounts and ratios in accordance with Basel III resulted in it being considered “well-capitalized” and exceeded the regulatory capital requirements including conservation buffer in effect at the end of the period.
We discuss regulatory capital requirements in more detail in Note 16 to our consolidated financial statements, as well as under the caption “Government Supervision and Regulation — Corporate — Capital Adequacy Requirements and BASEL III” set forth in Part I, Item I. of our 2018 Form 10-K.
Within our banking segment, our primary uses of cash are for customer withdrawals and extensions of credit as well as our borrowing costs and other operating expenses. Our asset and liability group is responsible for continuously monitoring our liquidity position to ensure that our assets and liabilities are managed in a manner that will meet our short-term and long-term cash requirements. Our goal is to manage our liquidity position in a manner such that we can meet our customers’ short-term and long-term deposit withdrawals and anticipated and unanticipated increases in loan demand without penalizing earnings. Funds invested in short-term marketable instruments, the continuous maturing of other interest-earning assets, cash flows from self-liquidating investments such as mortgage-backed securities and collateralized mortgage obligations, the possible sale of available for sale securities and the ability to securitize certain types of loans provide sources of liquidity from an asset perspective. The liability base provides sources of liquidity through deposits and the maturity structure of short-term borrowed funds. For short-term liquidity needs, we utilize federal fund lines of credit with correspondent banks, securities sold under agreements to repurchase, borrowings from the Federal Reserve and borrowings under lines of credit with other financial institutions. For intermediate liquidity needs, we utilize advances from the FHLB. To supply liquidity over the longer term, we have access to brokered time deposits, term loans at the FHLB and borrowings under lines of credit with other financial institutions.
Within our banking segment, deposit flows are affected by the level of market interest rates, the interest rates and products offered by competitors, the volatility of equity markets and other factors. The Bank regularly evaluates its deposit products and pricing structures relative to the market to maintain competitiveness over time.
The Bank’s 15 largest depositors, excluding Hilltop and Hilltop Securities, accounted for 8.21% of the Bank’s total deposits, and the Bank’s five largest depositors, excluding Hilltop and Hilltop Securities, accounted for 4.37% of the Bank’s total deposits at June 30, 2019. The loss of one or more of our largest Bank customers, or a significant decline in our deposit balances due to ordinary course fluctuations related to these customers’ businesses, could adversely affect our liquidity and might require us to raise deposit rates to attract new deposits, purchase federal funds or borrow funds on a short-term basis to replace such deposits.
The Hilltop Broker-Dealers rely on their equity capital, short-term bank borrowings, interest-bearing and non-interest-bearing client credit balances, correspondent deposits, securities lending arrangements, repurchase agreement financings and other payables to finance their assets and operations, subject to their respective compliance with broker-dealer net capital and customer protection rules. At June 30, 2019, Hilltop Securities had credit arrangements with five unaffiliated banks with maximum aggregate commitments of up to $725.0 million. These credit arrangements are used to finance securities owned, securities held for correspondent accounts, receivables in customer margin accounts and underwriting activities. These credit arrangements are provided on an “as offered” basis and are not committed lines of credit. In addition, Hilltop Securities has a committed revolving credit facility with an unaffiliated bank of up to $50.0 million. At June 30, 2019, Hilltop Securities had borrowed $231.0 million under its credit arrangements and had no borrowings under its credit facility.
PrimeLending funds the mortgage loans it originates through warehouse lines of credit maintained with the Bank which have an aggregate commitment of $2.0 billion, of which $1.4 billion was drawn at June 30, 2019. PrimeLending sells substantially all mortgage loans it originates to various investors in the secondary market, the majority with servicing
released. As these mortgage loans are sold in the secondary market, PrimeLending pays down its warehouse line of credit with the Bank. In addition, PrimeLending has an available line of credit with an unaffiliated bank of up to $1.0 million, of which no borrowings were outstanding at June 30, 2019.
PrimeLending owns a 100% membership interest in PrimeLending Ventures Management, LLC (“Ventures Management”) which holds an ownership interest in and is the managing member of certain ABAs. At June 30, 2019, these ABAs had combined available lines of credit totaling $120.0 million, $70.0 million of which was with a single unaffiliated bank, and the remaining $50.0 million of which was with the Bank. At June 30, 2019, Ventures Management had outstanding borrowings of $64.4 million, $12.7 million of which was with the Bank. In July 2019, Ventures Management entered into an additional $30.0 million line of credit with the aforementioned unaffiliated bank.
Our insurance operating subsidiary’s primary investment objectives are to preserve capital and manage for a total rate of return. NLC’s strategy is to purchase securities in sectors that represent the most attractive relative value. Bonds, cash and short-term investments of $130.6 million, or 83.8%, equity investments of $19.4 million and other investments of $5.9 million comprised NLC’s $155.9 million in total cash and investments at June 30, 2019. NLC does not currently have any significant concentration in both direct and indirect guarantor exposure or any investments in subprime mortgages. NLC has custodial agreements with an unaffiliated bank and an investment management agreement with DTF Holdings, LLC.
Impact of Inflation and Changing Prices
Our consolidated financial statements included herein have been prepared in accordance with GAAP, which presently require us to measure financial position and operating results primarily in terms of historic dollars. Changes in the relative value of money due to inflation or recession are generally not considered. The primary effect of inflation on our operations is reflected in increased operating costs. In management’s opinion, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate. While interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate. Interest rates are highly sensitive to many factors that are beyond our control, including changes in the expected rate of inflation, the influence of general and local economic conditions and the monetary and fiscal policies of the U.S. government, its agencies and various other governmental regulatory authorities.
Off-Balance Sheet Arrangements; Commitments; Guarantees
In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in our consolidated balance sheets.
We enter into contractual loan commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of our commitments to extend credit are contingent upon customers maintaining specific credit standards until the time of loan funding. We minimize our exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures. We assess the credit risk associated with certain commitments to extend credit and have recorded a liability related to such credit risk in our consolidated financial statements.
Standby letters of credit are written conditional commitments issued by us to guarantee the performance of a customer to a third party. In the event the customer does not perform in accordance with the terms of the agreement with the third party, we would be required to fund the commitment. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, we would be entitled to seek recovery from the customer. Our policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.
In the normal course of business, the Hilltop Broker-Dealers execute, settle and finance various securities transactions that may expose the Hilltop Broker-Dealers to off-balance sheet risk in the event that a customer or counterparty does not fulfill its contractual obligations. Examples of such transactions include the sale of securities not yet purchased by customers or for the account of the Hilltop Broker-Dealers, use of derivatives to support certain non-profit housing organization clients, clearing agreements between the Hilltop Broker-Dealers and various clearinghouses and broker-dealers, secured financing arrangements that involve pledged securities, and when-issued underwriting and purchase commitments.
Critical Accounting Policies and Estimates
Our accounting policies are fundamental to understanding our management’s discussion and analysis of our results of operations and financial condition. We have identified certain significant accounting policies which involve a higher degree of judgment and complexity in making certain estimates and assumptions that affect amounts reported in our consolidated financial statements. The significant accounting policies which we believe to be the most critical in preparing our consolidated financial statements relate to allowance for loan losses, reserve for losses and LAE, goodwill and identifiable intangible assets, mortgage loan indemnification liability, mortgage servicing rights asset and acquisition accounting. Since December 31, 2018, there have been no changes in critical accounting policies as further described under “Critical Accounting Policies and Estimates” and Note 1 to the Consolidated Financial Statements in our 2018 Form 10-K, except that we no longer consider estimates related to the FDIC Indemnification Asset to be a critical accounting policy.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Our assessment of market risk as of June 30, 2019 indicates there are no material changes in the quantitative and qualitative disclosures from those previously reported in our 2018 Form 10-K, except as discussed below.
The primary objective of the following information is to provide forward-looking quantitative and qualitative information about our potential exposure to market risks. Market risk represents the risk of loss that may result from changes in value of a financial instrument as a result of changes in interest rates, market prices and the credit perception of an issuer. The disclosure is not meant to be a precise indicator of expected future losses, but rather an indicator of reasonably possible losses, and therefore our actual results may differ from any of the following projections. This forward-looking information provides an indicator of how we view and manage our ongoing market risk exposures.
The banking segment is engaged primarily in the business of investing funds obtained from deposits and borrowings in interest-earning loans and investments, and our primary component of market risk is sensitivity to changes in interest rates. Consequently, our earnings depend to a significant extent on our net interest income, which is the difference between interest income on loans and investments and our interest expense on deposits and borrowings. To the extent that our interest-bearing liabilities do not reprice or mature at the same time as our interest-bearing assets, we are subject to interest rate risk and corresponding fluctuations in net interest income.
There are several common sources of interest rate risk that must be effectively managed if there is to be minimal impact on our earnings and capital. Repricing risk arises largely from timing differences in the pricing of assets and liabilities. Reinvestment risk refers to the reinvestment of cash flows from interest payments and maturing assets at lower or higher rates. Basis risk exists when different yield curves or pricing indices do not change at precisely the same time or in the same magnitude such that assets and liabilities with the same maturity are not all affected equally. Yield curve risk refers to unequal movements in interest rates across a full range of maturities.
We have employed asset/liability management policies that attempt to manage our interest-earning assets and interest-bearing liabilities, thereby attempting to control the volatility of net interest income, without having to incur unacceptable levels of risk. We employ procedures which include interest rate shock analysis, repricing gap analysis and balance sheet decomposition techniques to help mitigate interest rate risk in the ordinary course of business. In addition, the asset/liability management policies permit the use of various derivative instruments to manage interest rate risk or hedge specified assets and liabilities.
An interest rate sensitive asset or liability is one that, within a defined time period, either matures or experiences an interest rate change in line with general market interest rates. The management of interest rate risk is performed by analyzing the maturity and repricing relationships between interest-earning assets and interest-bearing liabilities at specific points in time (“GAP”) and by analyzing the effects of interest rate changes on net interest income over specific periods of time by projecting the performance of the mix of assets and liabilities in varied interest rate environments. Interest rate sensitivity reflects the potential effect on net interest income resulting from a movement in interest rates. A company is considered to be asset sensitive, or have a positive GAP, when the amount of its interest-earning assets maturing or repricing within a given period exceeds the amount of its interest-bearing liabilities also maturing or repricing within that time period. Conversely, a company is considered to be liability sensitive, or have a negative GAP, when the amount of its interest-bearing liabilities maturing or repricing within a given period exceeds the amount of its interest-earning assets also maturing or repricing within that time period. During a period of rising interest rates, a negative GAP would tend to affect net interest income adversely, while a positive GAP would tend to result in an increase in net interest income. During a period of falling interest rates, a negative GAP would tend to result in an increase in net interest income, while a positive GAP would tend to affect net interest income adversely. However, it is our intent to remain relatively balanced so that changes in rates do not have a significant impact on earnings.
As illustrated in the table below, the banking segment is asset sensitive overall. Loans that adjust daily or monthly to the Wall Street Journal Prime rate comprise a large percentage of interest sensitive assets and are the primary cause of the banking segment’s asset sensitivity. To help neutralize interest rate sensitivity, the banking segment has kept the terms of most of its borrowings under one year as shown in the following table (dollars in thousands).
3 Months or
> 3 Months to
> 1 Year to
> 3 Years to
Less
1 Year
3 Years
5 Years
> 5 Years
Interest sensitive assets:
4,751,017
1,215,740
1,562,396
271,849
229,779
8,030,781
166,968
155,199
306,038
147,853
508,127
1,284,185
Other interest sensitive assets
200,483
29,241
229,724
Total interest sensitive assets
5,118,989
1,370,939
1,868,434
419,702
767,147
9,545,211
Interest sensitive liabilities:
Interest bearing checking
3,992,288
400,974
862,871
105,698
9,450
51,004
1,429,997
620,192
505
3,528
580
4,879
629,684
Total interest sensitive liabilities
5,194,201
863,376
109,226
10,030
55,883
6,232,716
Interest sensitivity gap
(75,212)
507,563
1,759,208
409,672
711,264
3,312,495
Cumulative interest sensitivity gap
432,351
2,191,559
2,601,231
Percentage of cumulative gap to total interest sensitive assets
(0.79)
4.53
22.96
27.25
34.70
The positive GAP in the interest rate analysis indicates that banking segment net interest income would generally rise if rates increase. Because of inherent limitations in interest rate GAP analysis, the banking segment uses multiple interest rate risk measurement techniques. Simulation analysis is used to subject the current repricing conditions to rising and falling interest rates in increments and decrements of 1%, 2% and 3% to determine the effect on net interest income changes for the next twelve months. The banking segment also measures the effects of changes in interest rates on economic value of equity by discounting projected cash flows of deposits and loans. Economic value changes in the investment portfolio are estimated by discounting future cash flows and using duration analysis. Investment security prepayments are estimated using current market information. We believe the simulation analysis presents a more accurate picture than the GAP analysis. Simulation analysis recognizes that deposit products may not react to changes in interest rates as quickly or with the same magnitude as earning assets contractually tied to a market rate index. The sensitivity to changes in market rates varies across deposit products. Also, unlike GAP analysis, simulation analysis takes into account the effect of embedded options in the securities and loan portfolios as well as any off-balance-sheet derivatives.
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The table below shows the estimated impact of increases of 1%, 2% and 3% and a decrease of 0.5% in interest rates on net interest income and on economic value of equity for the banking segment at June 30, 2019 (dollars in thousands).
Change in
Interest Rates
Net Interest Income
Economic Value of Equity
(basis points)
+300
47,110
13.31
326,980
18.81
+200
31,738
8.97
260,963
15.01
+100
16,275
153,686
8.84
-50
(6,408)
(1.81)
(98,514)
(5.67)
The projected changes in net interest income and economic value of equity to changes in interest rates at June 30, 2019 were in compliance with established internal policy guidelines. These projected changes are based on numerous assumptions of growth and changes in the mix of assets or liabilities.
Our portfolio includes loans that periodically reprice or mature prior to the end of an amortized term. Some of our variable-rate loans remain at applicable rate floors, which may delay and/or limit changes in interest income during a period of changing rates. If interest rates were to fall, the impact on our interest income would be limited by these rate floors. In addition, declining interest rates may negatively affect our cost of funds on deposits. The extent of this impact will ultimately be driven by the timing, magnitude and frequency of interest rate and yield curve movements, as well as changes in market conditions and timing of management strategies. If interest rates were to rise, yields on the portion of our portfolio that remain at applicable rate floors would rise more slowly than increases in market interest rates. Any changes in interest rates across the term structure will continue to impact net interest income and net interest margin. The impact of rate movements will change with the shape of the yield curve, including any changes in steepness or flatness and inversions at any points on the yield curve.
Our broker-dealer segment is exposed to market risk primarily due to its role as a financial intermediary in customer transactions, which may include purchases and sales of securities, use of derivatives and securities lending activities, and in our trading activities, which are used to support sales, underwriting and other customer activities. We are subject to the risk of loss that may result from the potential change in value of a financial instrument as a result of fluctuations in interest rates, market prices, investor expectations and changes in credit ratings of the issuer.
Our broker-dealer segment is exposed to interest rate risk as a result of maintaining inventories of interest rate sensitive financial instruments and other interest earning assets including customer and correspondent margin loans and receivables and securities borrowing activities. Our exposure to interest rate risk is also from our funding sources including customer and correspondent cash balances, bank borrowings, repurchase agreements and securities lending activities. Interest rates on customer and correspondent balances and securities produce a positive spread with rates generally fluctuating in parallel.
With respect to securities held, our interest rate risk is managed by setting and monitoring limits on the size and duration of positions and on the length of time securities can be held. Much of the interest rates on customer and correspondent margin loans are indexed and can vary daily. Our funding sources are generally short term with interest rates that can vary daily.
The following table categorizes the broker-dealer segment’s net trading securities which are subject to interest rate and market price risk (dollars in thousands).
> 1 Year
or Less
to 5 Years
to 10 Years
> 10 Years
Municipal obligations
1,899
31,384
82,851
U.S. government and government agency obligations
499
4,380
(1,436)
395,379
398,822
Corporate obligations
2,017
8,942
6,973
7,515
Total debt securities
2,584
15,221
36,921
485,745
540,471
Corporate equity securities
(6,217)
19,332
15,699
Weighted average yield
1.96
1.82
1.88
3.18
2.81
2.10
1.98
2.05
5.29
2.45
2.64
3.27
5.33
Derivatives are used to support certain customer programs and hedge our related exposure to interest rate risks.
Our broker-dealer segment is engaged in various brokerage and trading activities that expose us to credit risk arising from potential non-performance from counterparties, customers or issuers of securities. This risk is managed by setting and monitoring position limits for each counterparty, conducting periodic credit reviews of counterparties, reviewing concentrations of securities and conducting business through central clearing organizations.
Collateral underlying margin loans to customers and correspondents and with respect to securities lending activities is marked to market daily and additional collateral is required as necessary.
Item 4. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
Our management, with the supervision and participation of our Principal Executive Officer and Principal Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report.
Based upon that evaluation, our Principal Executive Officer and Principal Financial Officer concluded that, as of the end of such period, our disclosure controls and procedures were effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act and are effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to the Company’s management, including our Principal Executive Officer and Principal Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting during the fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
For a description of material pending legal proceedings, see the discussion set forth under the heading “Legal Matters” in Note 13 to our Consolidated Financial Statements, which is incorporated by reference herein.
Item 1A. Risk Factors.
There have been no material changes to the risk factors disclosed under “Item 1A. Risk Factors” of our 2018 Form 10-K. For additional information concerning our risk factors, please refer to “Item 1A. Risk Factors” of our 2018 Form 10-K.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
On June 30, 2019, we issued an aggregate of 6,937 shares of common stock under the Hilltop Holdings Inc. 2012 Equity Incentive Plan to certain non-employee directors as compensation for their service on our board of directors during the second quarter of 2019. The shares were issued pursuant to the exemption from registration under Section 4(a)(2) of the Securities Act.
The following table details our repurchases of shares of common stock during the three months ended June 30, 2019.
Total Number of Shares Purchased
Average Price Paid per Share
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs (1)
April 1 - April 30, 2019
50,000,000
May 1 - May 31, 2019
962,408
20.51
30,235,802
June 1 - June 30, 2019
252,435
20.64
25,019,744
1,214,843
20.54
Item 5. Other Information.
Stockholder Proposals and Nominees for Director
We held our annual meeting on July 25, 2019 (the “2019 Annual Meeting”) and first released related materials to stockholders on June 13, 2019. Accordingly, stockholder proposals intended to be presented at our 2020 annual meeting of stockholders pursuant to Rule 14a-8 under the Exchange Act must be received by us at our principal executive offices no later than 5:00 p.m., Dallas, Texas local time, on February 14, 2020 and must otherwise comply with the requirements of Rule 14a-8 in order to be considered for inclusion in the 2020 proxy statement and proxy. However, pursuant to such rule, if the 2020 annual meeting is not held within 30 days of July 25, 2020, then a stockholder proposal submitted for inclusion in our proxy statement for the 2020 annual meeting must be received by us a reasonable time before we begin to print and mail our proxy statement for the 2020 annual meeting.
In order for director nominations and proposals of stockholders made outside the processes of Rule 14a-8 under the Exchange Act to be considered “timely” for purposes of Rule 14a-4(c) under the Exchange Act and pursuant to our current bylaws, the nomination or proposal must be received by us at our principal executive offices not before January 1, 2020, and not later than 5:00 p.m. Dallas, Texas local time, on January 31, 2020; provided, however, that in the event that the date of the 2020 annual meeting is advanced by more than 30 days or delayed by more than 60 days from July 25, 2020, notice by the stockholder in order to be timely must be received no earlier than the 120th day prior to the date of the 2020 annual meeting and not later than 5:00 p.m. Dallas, Texas local time, on the later of the 90th day prior to the date of the 2020 annual meeting or, if the first public announcement of the 2020 annual meeting is less than 100 days prior to the anniversary of the date of the 2019 Annual Meeting, the 10th day following the day on which public announcement of the date of the 2020 annual meeting is first made. Stockholders are advised to review our charter and
bylaws, which contain additional requirements with respect to advance notice of stockholder proposals and director nominations, copies of which are available without charge upon request to our corporate secretary at the address of our principal executive offices.
Item 6. Exhibits.
ExhibitNumber
Description of Exhibit
2.1
Termination Agreement among Federal Deposit Insurance Corporation, as Receiver of First National Bank, Edinburg, Texas, PlainsCapital Bank and Federal Deposit Insurance Corporation, acting in its corporate capacity, dated as of October 17, 2018 (filed as Exhibit 99.1 to the Registrant’s Current Report on Form 8-K file October 22, 2018 (File no. 001-31987) and incorporated herein by reference).
31.1*
Certification of Principal Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.
31.2*
Certification of Principal Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.
32.1*
Certification of Principal Executive Officer and Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS*
XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document.
101.SCH*
XBRL Taxonomy Extension Schema
101.CAL*
XBRL Taxonomy Extension Calculation Linkbase
101.DEF*
XBRL Taxonomy Extension Definition Linkbase
101.LAB*
XBRL Taxonomy Extension Label Linkbase
101.PRE*
XBRL Taxonomy Extension Presentation Linkbase
*
Filed herewith.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: July 25, 2019
By:
/s/ William B. Furr
William B. Furr
Chief Financial Officer
(Principal Financial Officer and duly authorized officer)