Flagstar Bank, N.A.

We're about to begin today, and welcome to the Flagstar Bank First Quarter 2020 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ken Schellenberg, VP, Investor Relations. Please go ahead, sir.

Thank you, Rochelle, and good morning. Welcome to the Flagstar First Quarter 2020 Earnings Call. Before we begin, I'd like to mention that our first quarter earnings release and presentation are available on our website at flagstar.com. I would also 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 slide number two of today's presentation, in our press release, and in our 2019 Form 10-K and subsequent reports on file with the SEC. We're also discussing GAAP and non-GAAP financial measures, which are described in our earnings release and in the presentation we made available for this earnings call. You should also refer to these documents as part of this call. With that, I'd like to now turn the call over to Sandro Dinello, our President and Chief Executive Officer.

Thank you, Ken. Good morning to everyone listening in. My apologies for the delay in getting this going today, and fortunately our conference call company was having some difficulties. I don't think it has anything to do with all of us being remote, so hopefully the rest of this goes much smoother than it has thus far. And I hope that all of you and your loved ones have been able to stay safe and healthy. And as I said, in the spirit of proper social distancing, I'm joined remotely this morning by Jim Scioli, our Chief Financial Officer, Lee Smith, our Chief Operating Officer, Christy Furco, our President of Mortgage, and Steve Figueroa, our Chief Risk Officer. I'm not going to spend much time today on our results. except for some commentary on our provision. I think it's more important to tell you how we've adjusted our operations in the face of COVID-19 and how I think we'll operate going forward, given the uncertainty of the length of this pandemic. With respect to our results, it was a strong quarter with earnings of 80 cents per share, stronger still if you look at our pre-provisioned net revenue. Details will come from Jim and Lee in their remarks. So let me start with some comments about our provision, which totaled 14 million for the quarter. Admittedly, the provision for the quarter was difficult to estimate. We had no option but to use an immature model to estimate life of loan losses in perhaps the most uncertain economic time in our history. And when you add the unknown impact of government assistance programs to the mix, it was a daunting endeavor. Frankly, I don't think there is a model that exists that can accurately predict the life of loan loss at this stage of the game. That said, based on our current data, we're comfortable with our analysis. We have a strong commercial portfolio that at the end of the quarter had no non-performing loans, and thus far we've seen no weakness. As you know, our portfolio is diversified with no outsized exposure to any geography or industry, including little exposure to the auto industry. Our loan concentration policy is highly granular and conservatively structured, built to be resilient to a recession. Now we find ourselves in a recession, perhaps a deep one, that may linger for the next 18 months. A hallmark of our lending philosophy has been to bank only proven operators, and the 11th commandment, that's like starters, thou shall not lend to anyone that has walked away from the bank obligation. These principles, coupled with the fact that virtually all our borrowers are recession-hardened, will help mitigate credit concerns going forward. Finally, I remind you that while we're a $27 billion bank in terms of assets, Our commercial credits, net of warehouse loans, total less than $5 billion. Thus far, every borrower is working with us, and to date, they are all positive about their ability to weather the storm and remain a growing concern. Thus far, 252 commercial borrowers representing $548 million in unpaid balances, just 11% of our commercial book, have requested payment deferrals, and all were in good standing prior to their request. Business banking requests account for $71 million. with CNI and CRE representing $287 and $190 million, respectively. It's worth noting that we received no deferral requests from our HomeBuilder clients thus far. We are on top of every one of our credits, closely monitoring and actively managing for the slightest blip. We have assisted many of these customers with a PPP loan, and we will be assisting even more through the means-through lending program. We are being careful in connection with new commercial loan requests outside of our warehouse business, and we are pulling back on commitments wherever it's prudent and the opportunity presents itself. Even inside warehouse lending, we've taken a more conservative approach, essentially accepting no jumbo or non-QM loans as collateral and requiring a tighter credit box for government loans and lower advance rates for loans that we believe are at higher risk. As to our consumer loan portfolio, it consists largely of low LPV, high FICO mortgage loans, and high FICO or HELOCs. Thus far, we've seen no material weakness in those loans. I think it's a given that the economic forecast at June 30 will be weaker than those at March 31. So I fully expect that our ACL model will suggest a significant allowance adjustment for Q2, but just how much is impossible to predict. My opinion is that GDP will contract perhaps as much as 10% in Q2, so as much as 40% on an annualized basis, followed by slow growth in the ensuing quarters. Unemployment might reach 20% in Q2, then gradually declining as GDP improves. So not quite what I would call it, the recovery. I realize this opinion is probably on the pessimistic side of the universal thinking, but my view is that it's most prudent to prepare for the worst and hope for the best, and that's exactly what we're doing. Next, I'd like to speak to how our company responded to the pandemic, and I'll start by saying I could not be more proud of our team and how we've adjusted. It could not have gone much better. We prepared for a possible pandemic in our business continuity plan. As part of that plan three years ago, we moved a vast majority of our people to laptops. Additionally, we had secured enough VPN licenses and bandwidth to move quickly, and so the transition went really well. Today, over 80% of our employees are working remotely, and interestingly, productivity has not dropped. In fact, in the last two weeks of the month, we processed over $2 billion of mortgage loans. increased warehouse balances by over a billion and a half, worked out arrangements with every commercial customer seeking a deferral, accepted thousands of requests for mortgage forbearance, and built a new technology platform literally overnight to launch the Paycheck Detection Program and got it up and running 36 hours after the guidelines were released. We took and processed over 3,000 applications for $400 million in loans. Remarkably, all these processes were performed and managed remotely, Additionally, on March 16th, we eliminated in-branch service at select bank branches, and then a few days later moved to drive-up service only with lobby access by appointment, and not one customer complaint has reached my desk. In fact, deposit growth has been encouraging. We reduced rates aggressively following each Fed move and still saw deposit balances increase about $900 million during the quarter. And we've seen a further increase in deposits in April of over $350 million from our banking customers. Well, I don't know when normal will return or what it will look like. I can tell you we will be very conservative in moving people back to our facilities. That's the right thing for our team, and given how smoothly we are operating, there's no need to get ahead of a clear flattening of the curve. As always, we've always been there for our communities. To date, we've contributed almost $600,000 in markets across the country to support the COVID-19 cause. including 300,000 to a cut-and-sew company that shifted to manufacturing masks that are being donated to hospitals. Only 17 of our 4,700 Flagstaff employees and contractors have tested positive for COVID-19, and best of all, we all have either recovered or appear to be on the road to recovery. We believe that's in large part because we started our social distancing early on March 13th. Also very pleased to tell you that we surveyed our team and 98% felt that Flagstaff responded effectively to both employee and customer needs and concerns. As difficult as the last six weeks have been, I do think we are seeing the resilience of our business model in action. Here's why. First, I think we can sustain net interest income on the back of our warehouse business, which currently has outstanding balances of approximately $3.8 billion, with a month-to-date average balance of over $4 billion. Warehouse lines are now almost entirely secured by conforming agency and government product. The portfolio provides strong returns with virtually no credit risk, and 91% of these loans have rate flows. Even without booking new commercial loans outside of warehouse, we expect to grow net interest income. Second, the mortgage business continues to be strong. By being on sale month to date, is over $90 million and shows no signs of weakening, with over 95% of the locks representing conforming agency loans. While I want to pine on how long this performance will continue, I think it demonstrates the power of this business in the current environment. While we're not guiding on net interest income or locks for Q1, with Fannie Mae's most recent projection of a 10% increase in originations for 2020, as compared to 2019 holds true, our warehouse and mortgage businesses will thrive and we will be in a position to build a credit war chest without dipping into capital should it be needed. To put it mildly, giving guidance right now is too much guesswork. However, I believe Flagstar is well positioned to weather the storm and come out stronger on the other side. Our profitability is strong, our capital is strong, our allowance is strong, Our liquidity is strong and our business model is working precisely as we designed it. Finally, I'd like to make it clear that we don't expect to change our dividend posture in the near term and we're not contemplating stock buybacks at this time. Obviously, my comments today have been unlike anything before because we are in unprecedented times. My goal has been to give you my perspective on how I see FLAGSAR performing in the near future in the context of the SEC's recent guidance in safe harbor protections. In doing so, I'm drawing on more than 40 years of experience at Flagstar and a deep understanding of the company and the quality and caliber of its employees. We are committed to doing the right thing for our employees, customers, and their communities. Protecting their health will secure Flagstar's health. We will focus on the opportunities this environment gives us, and though we will continue to manage the risks we face conservatively, we will not dwell on them. If we do that, I firmly believe we will produce the best possible results for our shareholders. With that, I'll turn it over to Jim. Thanks, Sandro. Turning to slide seven, our net income this quarter was 46 million, or 80 cents per share. This performance compares to the 58 million, or a dollar per share, last quarter. The decline on our linked quarter basis is largely due to the $14 million credit provision this quarter. We had adjusted net income of $37 million or $0.64 per share in the same quarter last year. Diving deeper into this quarter's performance, our pre-tax, pre-provision earnings were $70 million this quarter compared to $69 million last quarter. Net interest income was down $4 million or 3% over the prior quarter. Average earning assets grew $442 million. In line with our expectations, the net interest margin decreased significantly basis points despite 150 basis points of rate cuts in March that were unexpected. This performance was driven both by our strong core deposit franchise consisting of granular retail customers and by a well-positioned, well-diversified loan portfolio that has a large composition of fixed rate assets and floors on many of its variable rate loans. We'll review these numbers further on the next slide. Mortgage revenues were $96 million, a decrease of 2 million or 2% compared to the prior quarter. During the quarter, we saw gain-on-sale margins increase significantly as primary-secondary spreads widened to historic levels and lenders worked to manage capacity. However, in the second half of March, extreme market dislocation and volatility occurred, and we experienced $45 million of hedge losses, which I'll discuss further in a moment. Asset quality remained strong. Net charge-offs were eight basis points, and non-performing loans were relatively flat to year end. Our allowance for credit losses, or ACL, which includes the reserve for unfunded loan commitments, was $152 million at quarter end, up from $110 million at year end. At this level, our coverage of loans HFI is 1.5%. This was the result of our January 1st CECL adoption, and the $14 million credit provision this quarter. We'll provide more details when we get to the asset quality slide and take a deeper dive into CECL. Capital also remains solid. Despite our balance sheet ending the quarter at $27 billion, up from $23 billion at year-end, all capital ratios remained above the stress offers that we've established based on our DFAS models. Total risk-based capital was 11.2% at March 31st. Our CET-1 ratio was 9.2%. and our Tier 1 leverage ratio was 8.1%. We'll go into more details on capital later, so let's turn to slide 8 and dive deeper into the income statement. Net interest income decreased $4 million to $148 million this quarter, which was 3% lower than last quarter. Nearly half of this decline resulted from having one less day in the quarter. The results reflect a 2% increase in average earning assets led by investment security, loans held for sale, and commercial real estate loans. Deposit costs came down nine basis points while average deposit balances were relatively flat quarter over quarter, excluding a decline in broker deposits. We'll dive deeper into net interest income and our interest rate risk position on the next slide. Non-interest income decreased 5 million or 3% to 157 million due to lower mortgage revenues. Our gain on sale revenue of 90 million represented a decrease of 11 million or 11% from the prior quarter. Fallout-adjusted locks increased 36% to $11.2 billion, and the gain-on-sale margin decreased to 80 basis points. Channel margins were strong, especially in our delegated bulk channel. The Fed's buying of mortgage-backed securities, beginning on March 16th, pushed prices on MBS much higher. This price change impacts the values of the TBA mortgage-backed securities that we sell short to hedge our pipeline and close loan sell-for-sale. As the pipeline and closed loans did not experience the same level of price appreciation, the short position declined in value more than the long position increased in value, creating $45 million of hedge losses. We've added slide 40 in the appendix to provide more details on what we and the industry experienced. We reacted quickly to this phenomenon, took actions to rebalance our hedge profile, and made pricing changes which improved our position by month end. In April, the Fed modified their purchases and our actions took hold, which stabilized our gain-on-sale. Through last Friday, we recorded over $90 million of gain-on-sale revenue for April. While we won't forecast what the second quarter gain-on-sale revenue will be, this partial month's result indicates that the hedging issues have not persisted. We also had a $9 million improvement in the MSR return, the result of hedging gains this quarter. Loan administration income improved $4 million due to higher average loan service and a decline in the LIBOR-based credit that we provide to our subservicing customers for the custodial deposits that they control. Non-interest expense was $245 million, down $10 million from the prior quarter. The decrease was primarily related to $5 million of balance sheet cleanup and discretionary expenses that took place in the fourth quarter and did not recur. Expenses were also down as mortgage loan closings declined 8%. Overall, mortgage expenses as a percentage of closings were consistent with the prior two quarters. We will provide more color on expenses later. We've added slide nine to provide more details on our interest rate risk position at the end of the quarter. While we won't provide guidance on net interest income, we feel that we're in a good position. Looking at our commercial loan portfolio, 95% of the loans are variable. As we parse that variable percent out, as Sandra mentioned, over 90% of our warehouse loans have floors in them. We also have floors in many of our CNI and CRE loans, either floors that don't allow LIBOR to reset below zero or floors with LIBOR at a higher level. Consequently, we don't see a lot of risk to spread compression coming from the asset side of the balance sheet. Looking at deposits, we have moved pricing down on our portfolio in reaction to the aggressive actions taken by the Fed to drop short-term interest rates. At quarter end, in the retail CD book, we had $1.8 billion of CDs that mature in the remaining nine months of this year and reset to lower rates. We also had $900 million of savings and money market accounts at quarter end, so we're under some level of promotional rate. It will come off that promotional rate, which has an average cost of 1.9%. and also repriced lower in the latter part of this year. Approximately 85% of our custodial deposits are controlled by our subservicing clients and naturally priced down as those rates are based on LIBOR. In summary, we believe that the deposit rates could be a tailwind for the remainder of the year. Also on the liability side, we've executed interest rate swaps and entered into long-term FHLB advances to lock in lower rate funding, laddering those out between three and seven years. We've now executed 1.5 billion of this strategy, securing long-term funding at an average cost of 61 basis points, so below our cost of funds in Q1. While it's difficult to predict where rates might be for the remainder of this year, we feel that our interest rate risk position is in a good place, especially considering the liability-sensitive nature of a mortgage business. We feel that we can protect our net interest income and net interest margin in this environment, and believe that our net interest margin should be relatively flat to the first quarter, This perspective also contemplates the impact of the PPP loans that we have originated under the referral of the SBACs on those loans. To illustrate how it's positioned us, I would share that while the first quarter net interest margin was 2.81%, March's net interest margin was 2.84%, showing the effectiveness of the actions we've taken to protect net interest income. Let's turn to slide 10, which highlights our average balance sheet this quarter. Average loan sales for investment declined $0.3 billion, driven by a decrease in average warehouse loans and residential first mortgages. Most of the decline in warehouse was seasonal, and the decrease in average residential mortgages was the result of loan prepayments. At corner end, we saw higher levels of warehouse loans and loan sales for sale. The higher levels of warehouse loans resulted from our actions to continue to support customers in the mortgage finance business, even as we took a more conservative approach with non-QM and jumbo loans and tightened the credit box on the government loans that we would support on our warehouse lines. The loans fell for sale. We saw elevated levels of newly created mortgage-backed securities that could not be sold at reasonable prices due to supply imbalances in the market. Ultimately, we delivered these bonds into our PBAs in April. While this inflated our balance sheet and compressed our spreads a bit, we were able to hold these assets without sacrificing execution. We expect that we'll continue to have relatively higher balances in our warehouse and mortgage loan and tell-for-sale portfolios in the second quarter. Average deposits decreased $0.1 billion driven by lower CD and wholesale deposit balances. Higher demand deposits partially offset this runoff. We continue to have a strong liquidity position driven by the strength of our deposit base and access to multiple sources of liquidity, both on balance sheet with our high-quality securities portfolio and off balance sheet with our undrawn FHLB facilities. We also plan to fund our PPP loans using the Fed's PPP facility and have ample access to borrow at the discount window. Finally, we continue to demonstrate significant capital generation capabilities with growth in our tangible book value per share at $29.52 at quarter end, up 95 cents from year end. Let's turn to asset quality on slide 11. Credit quality in the loan portfolio remains strong. Delinquencies continue to be relatively low. Only 40 basis points of total loans were over 30 days delinquent, up seven basis points from year end. Our allowance for credit losses covered 1.1% of total HFI loans. This coverage now includes a reserve for unfunded loan commitments, excluding warehouse loans for the denominator, given their relatively clean credit loss history And considering that substantially all of these are collateralized with agency and government-backed loans, our coverage ratio would stand at 1.5%, consistent with what we see other banks having under CECL. Considering the economic uncertainties related to COVID, we're monitoring our entire loan portfolio, doing additional analyses within certain sectors and relationships, and staying in close communication with our significant borrowers. On slide 12, we wanted to share with you our exposure of those industries that we believe are more likely to be most impacted. In total, we have just under a billion of outstanding loans in this category, representing only 7% of our loan portfolio. In the commercial loan portfolio, these balances total 328 million. Within this group, we're focused on our exposures to automotive, hospitals, and leisure and entertainment businesses, which includes restaurants. You can see that the exposure here is relatively low. We have no oil and gas exposure. In our commercial real estate portfolio, we have 647 million outstanding in the areas most likely to be impacted by COVID, including loans secured with hotels, retail properties, and senior housing. Of the loans in this category, our average LTV is 55%, and our average debt service coverage is 1.6 times. We'll be analyzing all of our borrower relationships this quarter. While we know this will be a challenging time for many people, we believe that our low level of exposure to these industries is the result of our well-diversified loan portfolio and the strong LTV and debt service coverage ratios, the result of our credit discipline. So let's turn to slide 13. We wanted to walk you through how we implemented CECL, how we got to the CECL balance at the end of the quarter, and how we'll be thinking about CECL in light of the uncertain economic outlook that we have right now. Overall, we ended the quarter with $152 million allowance for credit losses consisting of $132 million of allowance for loan losses and $20 million in the reserve for unfunded loan commitments. The reserve for unfunded loan commitments is included in other liabilities on our balance sheet. Both are available to cover credit losses in the loan portfolio. In total, our allowance for credit losses at quarter end represents 38% increase over what we reported at the end of 2019. In our adoption of CECL, we used three different forecasts of the next two years, which then reverted to a long-term average over a one-year period. These forecasts included an adverse projection that reflected severe economic distress. We weighted that model 30% in our day one adoption. Our quarter-end estimates, we elected to use the March 27th Moody Baseline, which reflects the economic distress caused by COVID. and also contemplate some impact of the government actions taken to mitigate the stress. The forecast assumes that we are in a sudden, sharp, and severe recession, only partially recovering later in the year. In this scenario, GDP contracts 18% in Q2, HPI decreases 3% by the end of the year, and unemployment spikes to 9% and moderates to 7% by the end of the year. We also judgmentally increased reserves in our CRE, home builder, and CNI portfolios to provide additional coverage for industries and customers that we thought could be more exposed to the stressful conditions in our forecast. We provided a portfolio-by-portfolio breakdown of the resulting ATL coverage ratios in our appendix. We also continue to maintain reserves for our loans with government guarantees and specifically measured loans whose amounts are not impacted by the CECL methodology change. Finally, as you'd expect, we've elected to defer the regulatory capital impact of adopting CECL until the end of 2021, after which we phased in at 25% per year. Turning to slide 14, despite tremendous balance sheet growth, our capital ratios remain solid and nicely above our stress buffers. Total risk-based capital was 11.2% at March 31st, down only 31 basis points, while our CT1 ratio of 9.2% was relatively unchanged. Our Tier 1 leverage ratio of 8.1% actually increased nine basis points over the same ratio per formal with capital simplification, as this ratio is based on average balances, and the balance sheet growth in loans held for sale and warehouse loans happened toward the end of the quarter. I'd expect our Tier 1 leverage ratio to be lower next quarter. Between loans up for sale and our warehouse loan portfolio, we have approximately 540 basis points of total risk-based capital and over 400 basis points of Tier 1 leverage capital dedicated to these two asset categories that have very little risk content. In warehouse lending, which has 100% risk rate, we've had under 5 million of losses cumulatively over the last 12 years, and we took a more conservative approach during the quarter for certain product categories. I'd remind you that we also hold the collateral for those loans while they are on our lines, and that collateral consisted almost entirely of agency and government-backed loans. Loans held for sale also have very little risk content, and over $2 billion of these balances at quarter end were Fannie, Freddie, or Jenny securities and were reflected in our trading portfolio. In summary, we believe that we're operating at strong capital levels given our low-risk balance sheet composition as more than half of our assets at quarter end were in categories that have very low risk content. That is loans and trading securities up for sale, warehouse loans, investment securities, loans with government guarantees, and cash. I'll now turn to Lee for more insight into each of our businesses.