US Bancorp (USB) Q4 2022 Earnings Call Transcript

US Bancorp (NYSE:USB) Q4 2022 Earnings Call dated Jan. 25, 2023.

Corporate Participants:

George Andersen — Senior Vice President and Director of Investor Relations

Andy Cecere — Chairman, President and Chief Executive Officer

Terry Dolan — Vice Chair and Chief Financial Officer

Analysts:

R. Scott Siefers — Piper Sandler — Analyst

Erika Najarian — UBS — Analyst

Mike Mayo — Wells Fargo — Analyst

John Pancari — Evercore ISI — Analyst

Ebrahim Poonawala — Bank of America — Analyst

Gerard Cassidy — RBC Capital Markets — Analyst

Betsy Graseck — Morgan Stanley — Analyst

Vivek Juneja — JPMorgan — Analyst

Matt O’Connor — Deutsche Bank — Analyst

Ken Usdin — Jefferies — Analyst

Chris Kotowski — Oppenheimer — Analyst

John McDonald — Autonomous Research — Analyst

Presentation:

Operator

Welcome to the U.S. Bancorp Fourth Quarter 2022 Earnings Conference Call. [Operator Instructions] This call will be recorded and available for replay beginning today at approximately 11 o’clock am. Central Time.

I will now turn the conference call over to George Andersen, Senior Vice President and Director of Investor Relations for U.S. Bancorp.

George Andersen — Senior Vice President and Director of Investor Relations

Thank you, Brad, and good morning, everyone. With me today are Andrew Cecere, our Chairman, President and Chief Executive Officer; and Terry Dolan, our Vice Chair, and Chief Financial Officer. During their prepared remarks, Andy and Terry will be referencing a slide presentation. A copy of the presentation as well as our earnings release and supplemental analyst schedules are available on our website at usbank.com.

I would like to remind you that any forward-looking statements made during today’s call are subject to risk and uncertainty. Factors that could materially change our current forward-looking assumptions are described on Page 2 of today’s presentation, in our press release, our Form 10-K and in subsequent reports on file with the SEC. Following their prepared remarks, Andy and Terry will take any questions that you have.

I will now turn the call over to Andy.

Andy Cecere — Chairman, President and Chief Executive Officer

Thanks, George. Good morning, everyone, and thank you for joining our call. I’ll begin on Slide 3. This quarter, we completed the acquisition of MUFG Union Bank on December 1. In the fourth quarter, we reported $0.57 per diluted share, or $1.20 after adjusting for notable items related to the acquisition. This was a complex quarter that included one month of Union Bank results, merger and integration charges and balance sheet optimization activity. Terry will provide more details on these notable items.

Importantly, we ended the year with a common equity Tier 1 ratio of 8.4%, which was just above our expected level at deal close, and we delivered positive operating leverage for U.S. Bancorp legacy operations of 230 basis points for the full year. Strong year-over-year pre-tax provision income growth as adjusted for notable items was driven by net interest income growth and positive operating leverage. Credit quality remains strong although credit metrics are starting to normalize as expected.

Slide 4, details our reported and adjusted income statement results as well as year end up period balances and other performance metrics. End of period assets for the company totaled $675 billion, reflecting the acquisition of Union Bank and certain balance sheet optimization actions. Slide 5 highlights key performance ratios. This quarter, we delivered a return on average assets of 1.2%, a return of average common equity of 16.8% and a return on tangible common equity of 23.4% each as adjusted for notable items.

Turning to Slide 6. The completion of the Union Bank acquisition marked a significant milestone for our company with double-digit percent increases in loan and deposit balances, Union Bank adds meaningful scale to our business enables us to better serve our customers and communities.

Union contributes considerable small business and consumer market share in a demographically attractive California market, and we’re excited about the potential to deepen existing Union Bank relationships by overlaying our leading digital capabilities and robust product set, including wealth management, consumer and business banking and payments offerings across a loyal, but underpenetrated consumer base. In many ways, this deal underscores our commitment to creating a stronger, more competitive regional banking organization in a rapidly evolving environment. One of the more attractive aspects of this transaction is Union Bank’s high quality, low cost consumer deposit franchise, which will support continued loan growth and margins.

Let me turn the call over now to Terry, who will provide more detail on the quarter.

Terry Dolan — Vice Chair and Chief Financial Officer

Thanks, Andy. If you turn to Slide 7, as Andy mentioned, we reported diluted earnings per share of $0.57 for the quarter or $1.20 per share after adjusting for notable items related to the acquisition. Notable items related to Union Bank acquisition are comprised of three primary elements that reduced earnings per share by $0.63 related to balance sheet optimization, merger and integration costs, and the impacts of — on provision expense related to acquired loans and actions taken to optimize the balance sheet.

During the fourth quarter, the company recognized a one-time $399 million pre-tax loss on a net basis related to several actions taken to optimize the balance sheet, manage the net — the interest rate volatility impact on capital levels and position the company for future growth. Subsequent to obtaining regulatory approval for the transaction, we entered into interest rate hedges to manage rate volatility and its related impact on regulatory capital from the date of approval through the closing of the transaction in December.

During that time frame, long-term interest rates increased nearly 50 basis points before declining approximately 65 basis points. The interest rate swaps were terminated at the time of closing, and the losses recognized through earnings largely offset the interest rate marks recorded into the balance sheet through purchase accounting.

In addition, the company optimized its balance sheet by selling certain loans and repositioning its investment portfolio on certain equity investments. Within non-interest expenses, we incurred merger- and integration-related charges of $90 million that primarily included the impact of specific deal closing costs, professional services and employee-related expenses. We also incurred a $791 million charge to the provision for credit losses, which reflects an initial provision impacted by the acquisition of $662 million and a net loss of $129 million related to the securitization of approximately $4 billion of legacy indirect auto loans. Again, these moves enabled us to more effectively position the balance sheet for profitable growth and optimize returns.

Slide 8 provides a more detailed earnings summary. Union Bank, which was included in our consolidated results for one month, contributed $302 million of revenue, $221 million of non-interest expenses, $81 million of operating income and $44 million of net income to the company, representing $0.03 per diluted share.

On Slide 9, end-of-period loans increased 13.3% on a linked-quarter basis to $388 billion, which included core loan growth and acquired loans from Union Bank. Union Bank contributed ending loan balances of $54 billion net of purchase accounting adjustments partly offset by a reduction in balances of $15 billion related to balance sheet optimization actions, including loan sales and securitizations.

Slide 10 provides end-of-period deposit balance composition. End-of-period deposits increased 11.4% on a linked-quarter basis to $525 billion driven by the acquisition, which contributed $86 billion of lower cost deposits and actions taken as a result of the deal to optimize our funding sources. On a core basis, we saw deposit balances decline slightly this quarter.

Turning to Slide 11. The investment securities portfolio grew 4.2% linked quarter to $170 billion. The addition of securities from Union Bank were offset by balance sheet optimization actions.

Slide 12 highlights revenue trends. Adjusted net revenue totaled $6.8 billion in the fourth quarter, which included revenue contribution of $302 million from Union Bank, primarily representing net interest income. For legacy U.S. Bancorp, net interest income grew 5.5% on a linked-quarter basis and 29.2% year-over-year driven by strong earning asset growth and net interest margin expansion, which benefited from rising interest rates. Results were partially offset by higher deposit pricing and short-term borrowing costs.

Non-interest income, as adjusted for the legacy company, declined 3.0% compared to the third quarter driven by seasonally lower payment service revenue and lower commercial product revenue, offset by stronger mortgage banking revenue. Year-over-year, legacy adjusted non-interest income declined 5.5% driven by lower mortgage banking revenue from reduced refinancing activity and lower servicing charges, offset by stronger payment services revenue and trust and investment management fees.

Turning to Slide 13. Adjusted non-interest expense totaled $4.0 billion in the fourth quarter, including $221 million from Union Bank. Included in expenses was approximately $42 million of intangible amortization due to core deposit intangibles established at the time of the acquisition. Legacy non-interest expense, as adjusted, increased 3.8% on a linked-quarter basis largely driven by higher compensation-related expenses as well as higher expenses related to professional services, marketing, technology and tax credit amortization.

Slide 14 shows credit quality trends. We reported total net charge-offs for the quarter of $578 million. After adjusting for acquisition impacts and the balance sheet optimization activities, net charge-offs totaled $210 million or 0.23% of average loans, up from 0.19% in the third quarter, which reflected the continuing normalization of credit losses.

Non-performing assets for the legacy bank increased slightly, while Union Bank contributed $329 million to the total. On a combined basis, the reported ratio of non-performing assets to loans and other real estate was 0.26% at December 31 compared with 0.20% at September 30 and 0.28% a year ago, reflecting a continued strong credit quality.

The provision for credit losses was $1.19 billion, which included a provision of $791 million related to the acquisition and balance sheet optimization activities. This provision includes an initial provision impacted by the acquisition of $662 million and $129 million related to our balance sheet optimization activities. The allowance for credit losses as of December 31 totaled $7.4 billion or 1.91% of period-end loans, which reflects increased economic uncertainty and the incorporation of the Union Bank portfolio.

Slide 15 highlights the drivers of our linked-quarter common equity Tier 1 capital position. As of December 31, our CET1 capital ratio was 8.4%. Acquisition impacts of 180 basis points included an increase in goodwill and other intangible assets that reflected the impact of credit and interest rate marks, the initial provision for credit losses, balance sheet optimization actions as well as the increase in risk-weighted assets with the addition of Union Bank. These impacts were partially offset by an increase to equity related to shares issued to MUFG as part of the purchase price of Union Bank.

Slide 16 provides our current expectations of certain financial metrics related to the transaction. The financial and strategic merits of the deal remain intact and are very attractive. Earnings per share accretion is now expected to be 8% to 9% in 2023, which is higher than originally estimated. While our tangible book value per share dilution is higher than initially estimated due to the significant impact of rising interest rates on the interest rate marks at close, our estimated earn-back period is only slightly longer than our original estimate at two years versus our original estimate of 1.5 years.

Slide 17 provides a comparison of credit and net fair value marks from the time of our announcement to closing. Credit marks are lower due to favorable changes in portfolio composition and credit quality, partially offset by economic deterioration. Interest rate marks, inclusive of loans, securities net of sales and debt, are higher than anticipated at announcement due to higher interest rates, but we expect that to accrete quickly back through earnings. The core deposit intangible is also higher than originally estimated, reflecting the increased value of lower-cost core deposits in a higher rate environment.

I will now provide first quarter and full year 2023 forward-looking guidance, which is provided on Slide 18. Starting with the first quarter 2023 guidance. We expect average earning assets of between $605 billion and $610 billion in the first quarter and the net interest margin that is 5 basis points to 10 basis points higher than the fourth quarter level. Total revenue is estimated to be in a range of $7.1 billion to $7.3 billion, including approximately $100 million of purchase accounting accretion during the quarter.

Total non-interest expense as adjusted is expected to be in the range of $4.3 billion to $4.4 billion, inclusive of approximately $125 million of core deposit intangible amortization related to Union Bank. Our income tax rate as adjusted is expected to be approximately 22% to 23% on a taxable-equivalent basis. We anticipate merger and integration charges of between $200 million and $250 million for the quarter.

I will now provide guidance for the full year. For 2023, average earning assets are expected to be in the range of $610 billion to $620 billion with net interest margin expansion of between 5 basis points to 10 basis points compared with the fourth quarter of 2022. Total revenue is expected to be in the range of $29 billion to $31 billion, inclusive of between $350 million to $400 million of full year purchase accounting accretion.

Total non-interest expense as adjusted for the year is expected to be in the range of $17 billion to $17.5 billion, inclusive of approximately $500 million of core deposit intangible amortization related to Union Bank. Our estimated full year income tax rate on a taxable-equivalent basis as adjusted will be approximately 22% to 23%. We expect to have $900 million to $1 billion of merger and integration charges in 2023.

I will now hand it back to Andy for closing remarks.

Andy Cecere — Chairman, President and Chief Executive Officer

Thanks, Terry. We accomplished a lot this past year, including the completion of the Union Bank acquisition and a strong legacy PPNR growth supported by positive operating leverage on an adjusted basis. Union Bank adds significant scale to our business and deepens our commitment to serving customers and creating economic opportunities for communities across the West Coast.

We continue to target a Memorial Day weekend systems conversion, incorporating a lift-and-shift approach to our applications, which mitigates risk and allows us to more quickly capture meaningful cost synergies. There is still a tremendous amount of economic and geopolitical uncertainty, and we are preparing for any scenario.

I believe we will perform well because of the strength of our business, a strong balance sheet and the great team we have. As we’ve proven during previous economic downturns, our business model is resilient and recession-ready in large part due to our disciplined through-the-cycle credit underwriting standards and robust risk management infrastructure. Our consumer clients are predominantly prime, super prime, and our commercial book is generally investment-grade, and we have very little leverage lending commitments.

We are focused on prudent balance sheet growth, high-return, high-margin opportunities and the prudent allocation of capital to lines of business and products best served to deliver on our strategic objectives. Our growth strategy is focused on creating value for our customers, communities and shareholders, which allow us to generate industry-leading performance.

Let me close by saying thank you to our 77,000 employees across the company, including our newest colleagues from Union Bank. Your dedication and commitment are what make U.S. Bank special and the destination of choice for all the constituents we serve.

We’ll now open up the call for Q&A.

Questions and Answers:

Operator

[Operator Instructions] And we can first go to Scott Siefers with Piper Sandler. Please go ahead.

Andy Cecere — Chairman, President and Chief Executive Officer

Good morning, Scott.

Terry Dolan — Vice Chair and Chief Financial Officer

Hey, Scott.

R. Scott Siefers — Piper Sandler — Analyst

Maybe a question for you. Just sort of at the top level, was hoping you could speak to what sort of balance sheet and capital management will look like for you. So you’re still under $700 billion in assets. But any thought on sort of limiting growth? Or will there be additional sales or securitizations to help keep you under there? And then, I guess, on repurchase, I know we’re on pause until we get back to the common equity Tier 1 target. But with the sort of looming category move up, would there be any thought to hold off longer than that just to sort of see what happens? Just any thoughts on either of those would be great, please.

Andy Cecere — Chairman, President and Chief Executive Officer

Scott, I’ll start. This is Andy and Terry will add in. So first of all, we’re not limiting growth in the company. We — one of the reasons we positioned the balance sheet and took the optimization actions we talked about, Terry went through, was to allow for profitable growth. It also was related to the credit box that we manage within as well as the returns that some of those categories of assets that we securitized were returning. So those are all allowing us to grow in a profitable way in the future.

As we talked about before, we not expect to cross the threshold of a Cat II until the earliest at the end of ’24, and that’s into the new category at that time. And if we have any further balance sheet optimization actions in securitizations, they would be very nominal and not material in nature. Terry, what would you add?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. No, I would just again reiterate, we’re ready to be able to adopt Category II by the end of 2024. But there’s no real cap. We wouldn’t expect any real significant balance sheet optimization from here. And we spent a lot of time positioning the balance sheet for growth as we go forward.

R. Scott Siefers — Piper Sandler — Analyst

Wonderful. And then just sort of thoughts on repurchase as well? I know we’re on pause for now, but it’s still sort of a crush mark, so would be curious to your thoughts.

Terry Dolan — Vice Chair and Chief Financial Officer

Yes, Scott. So as we’ve said in that, we continue to expect that. We are starting about a good spot, about 8.4% CET1. We expect that to accrete up to at or above 9% by the end of next year, and it continue to accrete 2023 and continue to move up from that particular point. So one of the things we’ll do is once we get to above 9%, we’ll have to make an assessment as to all the different things that are happening out there from a regulatory perspective. I mean you have the regulators looking at Basel III and are having to think about Category II and those sorts of things. But I think it’s really going to be based upon what the landscape at that particular point in time looks like. But certainly, in terms of our core CET1, it will create nicely throughout 2023.

R. Scott Siefers — Piper Sandler — Analyst

Wonderful. All right, I appreciate all the thoughts. Thank you.

Andy Cecere — Chairman, President and Chief Executive Officer

Thanks, Scott.

Operator

Next, we can go to Erika Najarian with UBS. Please go ahead.

Erika Najarian — UBS — Analyst

Hi, good morning, and thank you for all the details that you gave us on the slides. My first question is on the cadence of the cost synergies as it relates to your expected Memorial Day weekend conversion. So first clarification question, the 35% cost synergies, is that a target for full year 2023? And what is that cadence like? Do we expect very little in cost synergies until Memorial Day weekend and then an acceleration in cost synergy capture as the systems converge?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes, Erika, great question. And just to confirm, our expectation is that of the $900 million of cost synergies, we’ll see about 35% of that next year in 2023. And so from a cadence standpoint, with the Memorial Day conversion, the vast majority of those cost synergies will start to really kick in subsequent to that system conversion. So smaller during the first half of the year, much more significant of that 35% in the second half of the year.

Erika Najarian — UBS — Analyst

Got it. So the — so in other words, we should anticipate an exit rate by 4Q ’23 of well above 35%?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. By the time we get to the end of the fourth quarter, we will have incorporated the vast majority of the cost synergies such that by the time we get to 2024, we will be in a good position to have achieved 100%.

Erika Najarian — UBS — Analyst

Got it. And my follow-up question is on the economic outlook. If you could remind us what is being captured in the legacy U.S. Bank reserves in terms of the GDP outlook and the unemployment outlook. And how are you thinking, based on that outlook, charge-offs for legacy U.S. Bank would trend as we anticipate — it seems like a lot of your peers are anticipating a mild recession from here.

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. I would say that our expectations are probably consistent with that sort of a thought process. When we are thinking about the reserve, our base case is that there is a mild recession probably in the second half of the year and that unemployment ticks up and GDP is either relatively flat or down a bit. When we go through the reserving process, as we’ve said in the past, we end up looking at five different potential scenarios all the way from a base case to a severe sort of recession. And I would say that from a reserving perspective, we’re a little bit weighted towards that downside scenario, so a little bit more conservative.

From a charge-off perspective, our expectation kind of using the baseline of about 23 basis points in the fourth quarter that, that will continue to normalize throughout the year. We’ll see both the delinquencies and charge-offs moving up. But to kind of give you some perspective, our pre-pandemic was at 50 basis points. We probably don’t see that until sometime into 2024.

Erika Najarian — UBS — Analyst

Got it. Thank you.

Andy Cecere — Chairman, President and Chief Executive Officer

Thanks, Erika.

Operator

And next, we can go to Mike Mayo with Wells Fargo Securities. Please go ahead.

Andy Cecere — Chairman, President and Chief Executive Officer

Good morning, Mike.

Mike Mayo — Wells Fargo — Analyst

Hi. Hey, good morning. I just wanted to clarify. So you made your positive operating leverage in 2022 over 200 basis points. If you back into the numbers, I’m getting positive operating leverage year-over-year all in of somewhere between, I don’t know, 100 basis points to 900 basis points. I’m not sure if that’s correct. And if you back in the numbers, what do you get? And why the such big variance in the revenue guide? That’s a $29 billion versus $31 billion. And why is the margin still increasing 5 basis points to 10 basis points in the fourth quarter? That’s a bit more of an improvement versus others.

Andy Cecere — Chairman, President and Chief Executive Officer

So I’ll start on a couple of things and then Terry will add in. So let me sort of go backwards on your questions. The margin is increasing principally because of the value of the low cost deposits that Union Bank brings on. We talked about that a lot, Mike, and $85 billion of principally consumer low cost, stable deposits in this environment is very valuable in driving up that margin on a quarterly basis. And that’s reflected in that 5 basis points to 10 basis points. We did achieve 230 basis points of positive operating leverage in 2020 — hearing a little bit of background.

George Andersen — Senior Vice President and Director of Investor Relations

Hey Mike, we’re getting a little background. Can you mute your line? Thanks.

Andy Cecere — Chairman, President and Chief Executive Officer

We did achieve 230 basis points of positive operating leverage in ’22. We would expect to achieve continued positive operating leverage into ’23. But ’23 is going to have the merger-related charges in it as well. So, I’m looking at it on a core basis. And Terry, what would you add?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. Just maybe kind of coming back to the net interest margin, we expect see lift related to Union Bank coming on, that 5 basis points to 10 basis points and then from there, kind of flattish to maybe moderate increase or expansion in net interest margin through the rest of the year. But clearly, deposit betas and things like that are going to accelerate a bit in 2023.

Mike Mayo — Wells Fargo — Analyst

And as a follow-up, look, U.S. Bancorp had been a low cost producer for a long time. It looks like you’re going to trend back in that direction. So it sounds like you still have no change in expected synergies. I get it, Union Bank is performing better, and that’s why the accretion you had brought higher, the 8% to 9%. But still no change in expected synergies from the acquisition? And then separate from that, Andy, you mentioned in December that the big kind of tech investment cycle is now turning positive versus being a drag the last five or so years. If you could elaborate on that. Thank you.

Andy Cecere — Chairman, President and Chief Executive Officer

Sure, Mike. And you’re right, we still are projecting, as Terry went through, $900 million of cost savings, 35% in 2023, 100% fully implemented in 2024. Importantly, we have not in the guidance that we provided any revenue synergies. So it’s without revenue synergies, which we think there are going to be some particularly after the integration and conversion process. We are past the heavy spend on tech. You’re right, we’re more of a flat line and starting to gain the benefits of that. And part of the benefit of this transaction is leveraging the investments we’ve made in the company over the last three or four years to allow us to lift and shift to our technology platform in a very low cost way. So that benefit is driving through the synergies that we talk about.

Mike Mayo — Wells Fargo — Analyst

Thank you.

Andy Cecere — Chairman, President and Chief Executive Officer

Thanks, Mike.

Terry Dolan — Vice Chair and Chief Financial Officer

Thanks, Mike.

Operator

And now we’ll go to John Pancari with Evercore ISI. Please go ahead.

Andy Cecere — Chairman, President and Chief Executive Officer

Good morning, John.

Terry Dolan — Vice Chair and Chief Financial Officer

Hey, John.

John Pancari — Evercore ISI — Analyst

Good morning. So on the credit metrics, I know you indicated that you’re starting to see normalization in charge-offs and delinquencies. I want to see if you can elaborate a bit more. In what income cohorts are you seeing the normalization? We’re hearing from some of the consumer finance players that they are seeing some normalization impacting — or moving beyond just the non-prime and low income but into prime and super prime? And also what asset classes are you seeing the normalization most obviously? Is it just on the card side or in other asset classes? Thanks.

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. I mean I — this is Terry. So maybe to address your first question in terms of where we’re seeing it and maybe as kind of a reminder, from an underwriting perspective, we focus on prime, super prime really in all of our consumer portfolios. To the extent that we’re seeing delinquencies starting to tick up, it’s more so in the credit card space. And you’re right, it would be probably on the lower bands as opposed to the upper bands at this particular point in time. But one of the things we talked about is that when you look at savings or excess savings from a consumer perspective, they’re fairly significant. That is coming down. As that’s coming down, people are revolving more on their credit cards. And I think it’s just kind of a natural progression that we are seeing. And again, starting more with the unsecured and the credit card portfolio, not as much with respect to the other portfolios yet. But as things continue to normalize, we would expect that too.

John Pancari — Evercore ISI — Analyst

Okay. Thanks. Terry, that’s helpful. And then I guess related, how does this development in consumer behavior and your macro assumptions as well, how does that impact your expectations for your payments revenue and your card revenue and merchant processing revenue as you look out through the year, considering the macro dynamics? Thanks.

Andy Cecere — Chairman, President and Chief Executive Officer

Yes. So the payments revenues, you saw, still is well above pre-COVID levels. The card spend is 25% above. On a year-over-year basis, we’re plus 5%. So spend continues to be strong. The categories of spend are shifting a little bit. And we would expect continued strong spend but moderating a bit as we go into the rest of 2023 for the reasons that Terry mentioned. But still expect growth but again, probably more moderate in nature as we go forward, and the savings level start to normalize and the consumer behavior starts to change.

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. And the thing that I would end up adding, John, is that one of the things we’ve talked about in the merchant processing is that we think that business is kind of a high single-digits. And when we look at 2023, that’s kind of our expectation for that particular business. Relative to 2022, we anticipate that our credit card revenue or card revenue will strengthen a bit in terms of year-over-year comparisons. And that is primarily because prepaid sales and prepaid revenue, which has been a drag, kind of starts to moderate.

And then on the corporate payment card business, we continue to think that that’s going to be reasonably strong, certainly high single-digits if not low double-digits. And that’s — we’re continuing to see travel and entertainment recover very nicely in that particular space. So we feel pretty good about the payment revenue trends for 2023.

John Pancari — Evercore ISI — Analyst

Great. Thank you, Terry. I appreciate it.

Terry Dolan — Vice Chair and Chief Financial Officer

Yes.

Operator

Next, we can go to Ebrahim Poonawala with Bank of America. Please go ahead.

Andy Cecere — Chairman, President and Chief Executive Officer

Good morning, Ebrahim.

Ebrahim Poonawala — Bank of America — Analyst

Good morning. I just want to follow-up one on credit. So you talked about consumer. Looking at the CRE slide, just if you don’t mind talking — sharing your perspective around the CRE book, if you’re beginning to see any softening either in certain markets, maybe California or within the office CRE book, which is about 10% of loans.

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. I mean maybe at a high level, certainly from a CRE perspective, valuations, I think, are moderating to some extent. The areas that we have had probably the greatest focus on, if you will, is really office space. And that is really probably as much tied to return-to-office sort of behaviors or patterns. And I think that, that is probably a longer-term sort of structural adjustment that’s going to end up happening. We’re just going to have to watch it over time. But when we just kind of look at the core CRE portfolio, it continues to perform pretty well from a credit perspective at this particular point.

Ebrahim Poonawala — Bank of America — Analyst

Got it. And I guess, just one separate question around payments. When you think about in your slide, you mentioned about some of the tech investments and partnerships. Just give us a sense of — remind us around competitive positioning for USB, how you’re thinking about just market share outlook and from this partnership standpoint, like areas of like secular growth that you see in this business?

Andy Cecere — Chairman, President and Chief Executive Officer

Yes. As you mentioned, we’ve made a lot of investments in tech-led activity, and our tech-led investments have led to that being the principal area of growth for the merchant processing categories. And then on the card side, the partnership’s component continues to be an important strength for us and a point of growth as we look forward. So those two areas, tech-led on merchant and partnerships on card, are doing well and it’s partly due to the investments we’ve made over the past few years.

Ebrahim Poonawala — Bank of America — Analyst

And is the strategy there to just build this in-house? Or do you see more kind of bolt-on acquisitions within that business?

Andy Cecere — Chairman, President and Chief Executive Officer

Many of the investments we made are internal investments that we’ve developed our capabilities and our platforms to allow for different activities and allow for integration with some of the software that the company has used to run their business. We’ve added as well, as you know, miscellaneous M&A acquisitions that — you said bolt-ons like Atellic or Bento that add capabilities around the edges. And I think we’ll continue to do a little of both as we look forward.

Ebrahim Poonawala — Bank of America — Analyst

Got it. Thank you.

Andy Cecere — Chairman, President and Chief Executive Officer

Sure.

Operator

And we can go to Gerard Cassidy with RBC. Please go ahead.

Andy Cecere — Chairman, President and Chief Executive Officer

Good morning, Gerard.

Terry Dolan — Vice Chair and Chief Financial Officer

Good morning, Gerard.

Gerard Cassidy — RBC Capital Markets — Analyst

Hi, Andy. Hi, Terry, congratulations on closing the deal. Question for you, Terry, on the balance sheet optimization where you guys decided to sell off certain loans that were required. Can you give us some color on types of credits were in those sales? And why would they chose — I know they didn’t meet your credit profile, but what was the driver of that — I mean, some of the details of the credit profiles?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. Maybe as a starting point, when we thought about the balance sheet optimization, the things that we were thinking about is really repositioning the balance sheet to position ourselves for growth going forward to be able to optimize or improve profitability and looking at profit margins across various portfolios and returns and then the risk profile. So maybe from a risk profile perspective, we ended up looking at Union Bank portfolios that we end up acquiring, and there were a couple of different areas that we focused on.

One is that they had acquired a number of loans related — or through a lending club channel, if you will. And that was something that we had planned to run off over time originally when we looked at the deal. And we made a decision that when we looked at the kind of the credit risk profile, how it’s originated, etc., that we thought that taking care of that upfront made a lot of sense. The other area that we ended up selling was some commercial real estate in their particular portfolios in order to be able to kind of bring that concentration down a bit. And then the other areas of optimization was more on the U.S. Bank side. We ended up looking at lower-margin indirect auto loan portfolio. We securitized about $4 billion associated with that particular portfolio.

And then the other things that we ended up looking at in the C&I book of business and across kind of our corporate space is just relationships that maybe had lower returns associated with it, where we could optimize that. And so we allowed some of that to run off, so to speak, during the quarter. And those were the primary areas of focus with respect to the balance sheet optimization. Last thing I would maybe say on the investment portfolio side is that we ended up selling about $15 billion of securities, the vast majority of that coming from Union Bank. And that was really to kind of — think about it from an interest rate risk perspective, HTM perspective, etc. But that was the other area where we did some balance sheet optimization.

Gerard Cassidy — RBC Capital Markets — Analyst

Terry, were there — in the corporate loans, were there any shared relationships, meaning you had an exposure to XYZ company as the Union Bank and the total was maybe too much and you guys decided to take that down as well?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. Exactly. So maybe from a risk perspective, looking at hold levels or concentrations with respect to specific customers, yes, that was a part of the strategy.

Gerard Cassidy — RBC Capital Markets — Analyst

Very good. And then just as a follow-up, you guys obviously gave us very good detail on your slides. And on the credit quality, Slide 14, you give us the breakout in the net charge-offs, and you show us the reported number at 64 bps versus your core legacy number of 23 basis points. If I pull out the 189 [Phonetic] from the optimization, it looks like the net charge-off ratio is around 43 basis points, including the Union Bank numbers. Is that kind of the level we should kind of gear ourselves to for 2023 now that Union will be fully implemented into your business?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. Let me clarify. So it’s 64 basis points on a reported basis, 23 basis points on a core basis. And there’s two components to that core, the balance sheet securitization that I talked about that you articulated. But then under CECL, what you end up having to do is you have to recapture loans that they have charged off you have to make an assessment. And then if you believe that, that charge-off was appropriate, you have to charge that off on day one, so to speak. And there was about $173 million of charge-offs related to those — to that kind of day one effect associated with CECL. So there’s really kind of three components. But 64% on a reported basis, 23% on a core basis. And when we think about going forward, I would use the 23 basis points as kind of the start point, and that’s about $210 million worth of core charge-offs.

Gerard Cassidy — RBC Capital Markets — Analyst

Thank you for clearing that up. I appreciate it.

Andy Cecere — Chairman, President and Chief Executive Officer

Yes.

Operator

And next, we can go to Betsy Graseck with Morgan Stanley. Please go ahead.

Betsy Graseck — Morgan Stanley — Analyst

Hi, good morning.

Andy Cecere — Chairman, President and Chief Executive Officer

Hi, Betsy.

Betsy Graseck — Morgan Stanley — Analyst

Hi, and Congratulations from my end too. And the deck is super clear. I really appreciate all the effort to make it simple and straightforward. So a couple of questions for me, just to follow-up on the discussion we just had. Could we also talk a little bit about how we should think about the reserving level as we go through ’23 and into ’24? Because like you said, you’ve got the fair value marks, you had to do the day, you had to do the add as per the CECL rules. So does reserve ratio stabilize from here? Does it actually inch down? Is there a scenario in which it would move higher? Could you just frame out how we should think about that? Thanks.

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. I mean, obviously, it is impacted by a lot of different things in terms of how economic uncertainty ends up changing and the mix of the portfolio, how it might change. But as we kind of think about 2023, I think that, that 191 basis points is probably a good — is a good metric throughout the year. It might inch down a little bit. But I think that, by and large, we feel pretty comfortable with that as we think about 2023 based upon our kind of base case, so to speak.

Betsy Graseck — Morgan Stanley — Analyst

Okay. And then I have one other question on the growth of the balance sheet. I know you addressed this a bit before. But when I look at the ’23 guide versus 1Q ’23, it’s a slower growth rate than I think we’re used to seeing at USB. So maybe you could help us understand, is this a moderated growth rate during the integration phase and maybe second half, that should accelerate up? Or is this the level of growth that we should anticipate? And then if you don’t mind, I have just a couple of ticky-tackies on the purchase accounting and the CDI and how we should expect that steps down into ’23 and ’24?

Andy Cecere — Chairman, President and Chief Executive Officer

Sure. Betsy, this is Andy. So first, on the growth rate, I think ’22 had exceptional loan growth across many categories, led by commercial as well as CRE. So what we would see is that more normalizing. You’re starting to see that in the fourth quarter. And I think the other fact is that the growth rates are impacted by average balances and some of the optimization activity that we took down in the fourth quarter. It was a partial quarter in the fourth quarter, full quarter in the first quarter and the rest of ’23. But the principal driver is a function of loan demand, which is moderating a bit across most categories. So it’s still growing but a little less than what we saw in ’22.

Terry Dolan — Vice Chair and Chief Financial Officer

And then, Betsy, maybe related to your second question, which was around the recognition of the core deposit intangible over time, probably the way that I would think about it is that it’s — it will amortize into income over about a 10 year period. It will step down, and probably a good way of just modeling it is assuming kind of a sum-of-the-years digit sort of approach.

Betsy Graseck — Morgan Stanley — Analyst

And same thing for PAA? Or how should we think about that? I mean PAA, I know it’s different, but PAA change.

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. So that’s tied, obviously, to the life of the loans. And it will end up being impacted by prepayments and all sorts of things. If you end up looking at their portfolio that we acquired, about half of it is residential mortgage and half of it is corporate in shorter-term. So probably, if you ended up looking at an average life of four, five years, four to six years, that sort of time frame, then of course, that will also accrete probably a little bit faster on the front end.

Betsy Graseck — Morgan Stanley — Analyst

Okay. Thank you for that.

Andy Cecere — Chairman, President and Chief Executive Officer

Yes. Thanks, Betsy.

Operator

And next we’ll go to Vivek Juneja with JPMorgan. Please go ahead.

Andy Cecere — Chairman, President and Chief Executive Officer

Good morning, Vivek.

Vivek Juneja — JPMorgan — Analyst

Hi. Good morning. Congratulations. A couple of questions. The tangible book value recovery, the crossover and the fact that you’d recover that back quickly, can you just give any color on sort of what’s the key driver of that? Is it just simply earnings? Or is there something else underneath that also that’s going to help that come back so quickly?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. It’s principally the accretion effect that we’re going to see with respect to Union Bank, the marks and the underlying earnings of the company.

Vivek Juneja — JPMorgan — Analyst

Okay. So the — because I just heard you say the accretion — the question that Betsy asked, purchase account accretion that half the loans are mortgages. So that will take — come down, I guess, over more slowly? So is that part of it that pre-purchase accounting accretion is going to stay high for longer?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. No, I really think it’s just — it really is the kind of the 8% to 9% accretion levels that we’re expecting on…

Vivek Juneja — JPMorgan — Analyst

The NVR [Phonetic] side?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes.

Vivek Juneja — JPMorgan — Analyst

Okay. Got it. Okay. A couple of other little ones. Deposits, the decline that you had in the balance sheet optimization, I think it’s pretty sizable, $24 billion. Is it all UB? Or is it some of yours? And which types of deposits?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. It’s a great question. From a deposit standpoint, when you think about kind of the optimization that we went through, we had kind of a focus on a couple of different things. We ended up looking at LCR ratios. We ended up looking at higher-cost deposits, whether that would be brokerage-type deposits or euro dollar deposits, those sorts of things. We made a very conscious decision after getting regulatory approval to kind of reposition that.

On the Union Bank side, the one thing that I would point out is that there’s about $8 billion to $9 billion worth of deposits that came over that were more transitionary. And over time, those will transition back to back to their global investment bank as those customers kind of migrate. So about half of that migrated in the fourth quarter, and I would expect probably the other half of that to migrate in early 2023. But those are kind of the things we ended up looking at with respect to deposit and deposit flows. So it was really looking at trading out low cost deposits or high-cost deposits for low cost deposits that are coming over for Union Bank and then some of the Union Bank effect.

Vivek Juneja — JPMorgan — Analyst

And what was the OCI number at the end of the year? So as we think about where — the going to Category II, how quickly do you expect that to come down so that you can be in better shape?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. So OCI at the end of the year is about $8 billion, and the duration of the portfolio is a little over 5%. So if you can kind of take a look at that, obviously, that’s assuming that rates don’t move from here. Our positioning from an investment portfolio perspective is about 52%, 53% HTM. We’ve also entered into some pay fixed swaps that in effect kind of get that up to the high 50s. So we feel like we’re in a pretty good position to be able to deal with — if rates move up a bit or if rates come down, we have some flexibility there as well. So we feel like we’re in a pretty good spot.

Vivek Juneja — JPMorgan — Analyst

All right. Thank you.

Operator

And next, we can go to Matt O’Connor with Deutsche Bank. Please go ahead.

Matt O’Connor — Deutsche Bank — Analyst

Good morning. Can you talk about the pace of the capital build from the 8.4% to around 9% by the end of the year? And then also, if the macro is worse than expected and you have to build reserves more, I realize that doesn’t move the capital that much. But obviously, everyone else is starting at a higher point of capital, and there is focus on how quickly you can get to that 9% or even higher. So I guess the question is like what levers can you pull to kind of aren’t that painful if you need a little bit more, such as issuing preferreds or some other assets that you could kind of exit without hitting earnings that much? Thank you.

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. I mean, obviously, Matt, from a balance sheet optimization perspective, we’re going to be very focused on profitability, returns. And capital is precious. So we want to make sure that we are dedicating our resources from an asset growth perspective in the right spots. The pace of growth from 8.4% to a little above 9% by the end of 2023, it’s fairly ratable across the four quarters. Obviously, first quarter is going to be a little bit lower simply because we will not have seen the cost synergies, and we will be going through and incurring more merger-related costs probably in the earlier part of the year simply because of the timing of the system conversion. So the pace is probably a little bit more weighted towards the back end. But that hopefully, Matt, kind of gives you some perspective.

Again, I’d kind of come back from a reserve point of view, we feel like we look at a lot of different scenarios. We look at the five different approaches, one of which is a severe recession. We take that into consideration. We could see unemployment move up to around 6%, 6.5%, and we still feel like we would be in a pretty good spot from a reserving point of view. So if it ends up getting — if it ends up being at a level that’s higher, then we’ll have to kind of focus on other balance sheet optimization activity.

Matt O’Connor — Deutsche Bank — Analyst

Okay. Thank you very much.

Andy Cecere — Chairman, President and Chief Executive Officer

Thanks, Matt.

Terry Dolan — Vice Chair and Chief Financial Officer

Thanks, Matt.

Operator

And we’ll go to Ken Usdin with Jefferies. Please go ahead.

Terry Dolan — Vice Chair and Chief Financial Officer

Good morning, Ken.

Ken Usdin — Jefferies — Analyst

Hey, good morning, guys. First question I just wanted to ask is just to follow on the outlook for the year. Can you just walk us through just your underlying assumptions for kind of how NII just projects, if we just think about kind of the core business and in terms of what deposit costs and betas do and how that impacts the kind of underlying trajectory from this first — from the fourth quarter of NII?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. So obviously, net interest income is going to be driven by the earning asset growth that we have in here as well as the margin expansion. We expect that margin expansion to take place 5 basis points to 10 basis points in the first quarter because of the Union — full quarter kind of effect of Union Bank. And then again, our modeling is that the margin is — reasonably moderates from there, reasonably flat, maybe up just a little bit.

From a deposit point of view, clearly, deposit betas are going to accelerate. I think that’s the reason why you’ll see the moderation in terms of net interest income — or net interest margin expansion in the second half of the year. But keep in mind — and again, this is kind of — we see that in the first quarter. The Union Bank effect associated with the value of those deposits that we’re bringing on, and we’ll continue to look at opportunities to kind of optimize the deposit portfolio.

Ken Usdin — Jefferies — Analyst

Okay. And then just one follow-up on the deal impact. Can you just remind us what type of like amortization period you’re using for both the purchase accounting accretion and the CDI in terms of like, is this the run rate that we keep around for a few years? Or does that change as you look past ’23? Thanks.

Terry Dolan — Vice Chair and Chief Financial Officer

Well, I think that, again, in 2023, we’re — we expect the purchase accounting accretion to be $350 million to $400 million and the CDI to be about $500 million. As I mentioned earlier, I think on the CDI, it steps down over time. But if you use kind of a 10 year assumption and sum-of-years digits, I think that will get you from a modeling perspective pretty close to how I think it will end up amortizing off. The purchase accounting is really going to be tied to the asset lives because about half of it is mortgage and half of it is corporate and commercial, etc., and shorter-lived assets. I think you can think about kind of that four to five year sort of time frame, and it probably accretes down into kind of a similar sort of fashion, a little more front-end weighted.

Ken Usdin — Jefferies — Analyst

Okay, got it. Thank you, Terry.

Terry Dolan — Vice Chair and Chief Financial Officer

Yes.

Operator

And next, we can go to Chris Kotowski with Oppenheimer. Please go ahead.

Terry Dolan — Vice Chair and Chief Financial Officer

Hi, Chris.

Chris Kotowski — Oppenheimer — Analyst

Hi, good morning. Hi. Following-up a bit on Mike and Ken’s questions. If I look at your very helpful Slide 18 on the guidance and I take the midpoint of the $7.1 billion to $7.3 billion revenue range and I kind of day weight that to the full year, I kind of get the lower range end of the full year guidance. 29.2 is actually what I get. So that implies like a couple percent growth in the back half of the year, which again, I guess, is better than what a lot of banks are saying. And I’m wondering, is that just underlying loan growth or fee income growth? Or is it the tag-ins of the benefits of rising rates? Or what do you see driving that?

Terry Dolan — Vice Chair and Chief Financial Officer

Well, again, I think you do see kind of the full year effect associated with rising interest rates kind of come into play. Fee revenue, on a legacy basis, as an example, we should see a little bit more of a tailwind next year as opposed to what we experienced this year. So I think that those are kind of coming into play and then I think that just timing of being able to get cost synergies on the expense side.

Andy Cecere — Chairman, President and Chief Executive Officer

Yes. And I’d add, it’s probably just mathematically, as you were talking about it, you’re right. And it’s a little bit of a growth in the earning asset that you see there going up from $605 billion to $610 billion, to $610 billion to $620 billion, that’s number one. And then maybe going towards the high end of that range and net interest margin versus the mid or low-end in the early quarters.

Chris Kotowski — Oppenheimer — Analyst

Yes. Well, it’s interesting because if I do the same analysis on the non-interest expense side, you’re at the high end of that. So it implies kind of nice growth in pre-provision earnings through the course of the year. So — but anyway, that’s it for me.

Terry Dolan — Vice Chair and Chief Financial Officer

All right.

Operator

And our last question in queue will come from Mike Mayo with Wells Fargo Securities.

Terry Dolan — Vice Chair and Chief Financial Officer

Hey, Mike.

Mike Mayo — Wells Fargo — Analyst

Hey, [Indecipherable] before. AOCI, was it — I’m just going to remember here, $12 billion, now it’s $8 billion? And where is it as of today?

Terry Dolan — Vice Chair and Chief Financial Officer

OCI overall is at $10 billion at the end of the year and expect it to come down from there.

Andy Cecere — Chairman, President and Chief Executive Officer

At a lower level today, Mike.

Mike Mayo — Wells Fargo — Analyst

And then, Andy, just can you pull the lens back a little bit? It’s been a rough three, five and 10 years when you look at operating leverage in stock, not last year on the operating leverage. But that comment you made in December and you addressed briefly, but you’ve been in this investment cycle multi-years. And now you said that you’re coming out of it or the drag is less or maybe the spending is less and the payoffs are more. Can you just give us more color on both the spending side and the payback side and where you’ve invested the most and where you expect that payback? Because it sounds like you’re crossing a line based on your comments from December and that you reiterated today. Thanks.

Andy Cecere — Chairman, President and Chief Executive Officer

Yes. Thanks, Mike. I think that’s a fair representation. So we — our spend levels on pure capex were — grew from about $800 million to $900 million to $1.2 billion, $1.3 billion. And that growth has been in the run rate for the last couple of years. So you would not expect to see additional continued expense increase related to capex. Importantly, we also migrated that spend from about 60% defensive to 60% offensive. So the spend is on activities like digital capabilities, reaching customers, products and services and so forth. So all of that is what’s coming through to a level set on the expense side plus a return on the investments from a revenue side. That, coupled with overlaying all that on the Union Bank customer base, is why we’re projecting the numbers that we’re giving you.

Mike Mayo — Wells Fargo — Analyst

Okay. Thank you.

Andy Cecere — Chairman, President and Chief Executive Officer

Thanks, Mike.

Operator

We do have time for one more question. And we’ll go to John McDonald with Autonomous Research. Please go ahead.

Terry Dolan — Vice Chair and Chief Financial Officer

Good morning, John.

John McDonald — Autonomous Research — Analyst

Good morning, guys. Hey, just a couple of quick follow-ups. So Terry, where does the balance sheet repositioning and the merger leave you in terms of interest rate positioning? How would you describe it here, fairly neutral, a little bit asset-sensitive, where you’re ending up now?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. I would say that legacy U.S. Bank is fairly neutral. When we add Union Bank on, it probably adds about 50 basis points of asset sensitivity in a 50 up sort of shock environment.

John McDonald — Autonomous Research — Analyst

Okay. And then on the fee income, you said some more tailwinds this year, some helpers on legacy U.S. Bancorp. What are those on the fee income front? What are the helpers this year that you can grow fee income? Maybe just puts and takes on fees real quick.

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. Well, if you just kind of look at the different components, I think the payments revenue continues to be reasonably strong. I think that the expectation is the market comes back a little bit in terms of investment income. But deposit service charges, we saw a drag in 2022 because of some pricing changes we implemented in May. That starts to dissipate. So I think it will be kind of a combination of things. But probably one of the biggest ones is just mortgage banking revenue. That has been a pretty significant drag, especially on a year-over-year basis. And in the fourth quarter, we actually started see that inflection point with linked-quarter revenue starting to come up, and we would expect that to be a little bit stronger as we go into 2023.

John McDonald — Autonomous Research — Analyst

Okay. Got it. And then the last clarification. I think on reserves, you said the 1.9% ratio looks pretty good for this year. And even if unemployment went to 6%, 6.5%, you’d be okay?

Terry Dolan — Vice Chair and Chief Financial Officer

Yes. Again, we go through a lot of different scenarios, and we take that downside into consideration and as part of kind of that weighted average process. We think 6%, 6.5% unemployment is already incorporated into our reserving process. So — but again, it all is going to depend upon what ends up happening, how severe the economic recession is, if there is one at all. So I think there’s just a lot of moving parts.

John McDonald — Autonomous Research — Analyst

Got it. Thank you.

Operator

And we have no further questions at this time. I will now turn it back to George Andersen. Please continue.

George Andersen — Senior Vice President and Director of Investor Relations

Thank you for listening to our call. Please contact the Investor Relations department if you have any follow-up questions.

Operator

[Operator Closing Remarks]