Flagstar Bank, N.A.

Good day and welcome to the Flagstar Bank second quarter 2020 earnings call. Today's conference is being recorded. At this time, I'd like to turn the call over to Ken Schellenberg. Please go ahead, sir.

Thank you and good morning. Welcome to the Flagstar second quarter 2020 earnings call. Before we begin, I would like to mention that our second 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 two of today's presentation, in our PREX release, and in our 2019 Form 10-K and subsequent reports on file with the SEC. We are 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 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.

Thanks, Ken, and good morning to everyone listening in. I hope all of you and your loved ones have been able to stay safe and healthy. I'm joined this morning by Jim Scioli, our chief financial officer, Lee Smith, our chief operating officer, and Steve Pigliolo, our chief risk officer. We're going to start the call by providing a high-level view of our performance for the quarter. Then I'll turn the call over to Jim, for details on our financial results. We will then follow with a review of our business segments and strategic initiatives, and then we'll open the line for your questions. Well, it was an absolutely fantastic quarter for Flaxar. In my opinion, the best in the company's history. Not only did we report outstanding earnings, far exceeding anyone's estimates, but we continued to build a fortress balance sheet. We've talked a number of times about how our results are validating the earnings power of the business model we built starting in 2013. They're having quarters when mortgage results fell off, when banking returns lagged, when interest rates soared and when they slumped, and still we produce strong returns quarter after quarter. A knock on Flagstar by many has been our mortgage business. It's too much of our revenue. It has regulatory risk. It's too volatile. I think we've laid those concerns to rest. Not that long ago, the mortgage business was challenging, as challenging as it has ever been. And the rest of the company carried us. Now we're in a recession, and the mortgage business is off the charts. But that's not the most important story of the quarter. The most important story is the expansion of our net interest margin. Yes, expansion. How did we do it? First and foremost, The yield in our warehouse portfolio held up well relative to the decrease in benchmark rates quarter over quarter, thanks to floor rates that protected a yield that was enhanced by significant growth in income from draw fees. In fact, the yield in our warehouse portfolio increased from 3.78% in May to 4.01% in June, and our overall net interest margin increased from 2.84% in May to 2.88% in June. We've also been diligent in establishing floor rates in many of our other commercial loans. What began as an extra layer of protection we opted to put into our term sheets has paid off well. Not only has our margin improved, but we've also grown that interest income by seizing the opportunity in the warehouse business. That's reflected in the outstanding growth we enjoyed in the quarter. ending with over $5 billion in outstanding warehouse balances for the first time. And it's a trend that's continued into July as our average balances thus far this month are above $5.1 billion. So, despite taking a very conservative stance on lending in all other commercial categories, we've succeeded in growing low-risk, high-return assets, and in turn, net interest income. As a reminder, The entire commercial portfolio at Blackstar is less than $5 billion net of warehouse loans, and total credit losses in our warehouse portfolio have been less than $5 million over the last 12 years. Thus, we have grown net interest income this quarter without increasing credit risk. The other important story from the quarter is the aggressive way we manage deposit costs and the makeup of our wholesale funding. Deposit costs dropped dramatically in the second quarter, And because we carry a large amount of wholesale funding where costs are tied to LIBOR, those costs drop in tandem with Fed action. Importantly, we think our margin will remain resilient. We also saw nice growth in banking deposits of about $650 million for the quarter. On to mortgage. What can I say? Over $300 million in gain-on-sale revenue, just $30 million less than all of last year. Pretty amazing. And that run rate is continuing as we are already over $100 million in gain on sale revenue thus far in July. And then quietly, the servicing business just keeps plugging along, supporting our mortgage business, providing efficient funding, and adding fee income. Finally, let me address credit. So far, so good. Everything is holding up. But I know that until we get to the other side of this virus, the credit story remains to be told. I've been a stickler about having a conservative credit allowance in my tenure as CEO, and I have no intention of wavering on that, especially now. You saw that we added $100 million to the ACL for the second quarter and improved our coverage ratios significantly. This has nothing to do with any specific concerns we have with our books. But given current economic projections, I think we are comfortably where we need to be. My guess, though, is that economic forecasts are likely to deteriorate. And if they do, they may require greater reserves. As always, we are hoping for the best, but we're prepared for the worst. And I believe we will be able to add reserves as appropriate should economic forecasts dictate without dipping into or raising capital. In closing, I think we're in a very good place, a very stable interest margin, outstanding non-interest income generation, and a fortress balance sheet. Let me now turn it over to Jim. Thanks, Sandra. Turning to slide six, net income this quarter was $116 million, $2.03 per share. This performance compared to the $46 million, or $0.80 per share, last quarter. The increase on a linked quarter basis is largely due to stronger mortgage results and a nice increase in net interest income, the result of higher earning assets, and growth in the net interest margin, only partially offset by $102 million credit provision this quarter. We had adjusted net income of $41 million or $0.71 per share in the same quarter last year. Diving deeper into this quarter's performance, our pre-tax Pre-provision earnings were $250 million this quarter compared to $70 million last quarter. Net interest income increased $20 million, or 14%. Average earning assets grew $2.5 billion. Net interest margin increased by seven basis points, excluding the two basis point impact of lower yielding PPP loans. This performance was primarily driven by the strength of our warehouse business that has rate floors in place to protect from margin compression due to lower rates and a strong core deposit, which benefited from higher custodial balances and also from maturities of higher-cost CDs and exploration of promotional rates on savings. We will view these numbers further on the next slide. Mortgage revenues were $295 million, an increase of $199 million compared to the prior quarter. During the quarter, we saw gain on margins increase significantly. as primary-secondary spreads remained wide and we worked to manage capacity. Asset quality remained strong. Net charge-offs were only 11 basis points, and non-performing loans were relatively flat to the prior quarter. Despite all of this, and reflecting our views on the uncertainties within the economy, our allowance for credit losses, or ACL, which include the reserve for unfunded loan commitments, with $250 million at quarter end, up from $152 million at the end of the first 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. All capital ratios remained above the stress buffers that we've established based on our DFAS models. Total risk-based capital was 11.3%. At June 30th, our CET1 ratio is 9.1%. and our Tier 1 leverage ratio was 7.8%. We'll go into more details on capital later, so let's turn to slide seven and dive deeper into the income statement. Net interest income increased $20 million to $168 million this quarter, up 14% from last quarter, primarily driven by warehouse loan growth and the impact of lower interest rates on borrowing costs, especially with core deposits, partially offset by lower yields on earning assets. Earning assets grew 4% led by warehouse lending and loans held for sale. Deposit costs came down 33 basis points, while average deposit balances increased $1.9 billion, led by a $1.4 billion increase in custodial deposits and retail deposit growth of $0.4 billion. We'll dive deeper into net interest income and our interest rate risk position on the next slide. Non-interest income increased $221 million, to $378 million due to higher mortgage revenues. Our gain on sale revenue of $303 million represented an increase of $213 million, while allowed adjusted locks increased 24% to $13.8 billion, and the gain on sale margin increased to 219 basis points. We saw extraordinary levels of gain on sale margin throughout the quarter and managed our volume levels to fit our fulfillment capacities. The purchase market returned later in the quarter, and demand continues to be strong. We also recognize the loss of $8 million on our MSR, the result of model changes that we believe are congruent with the economic forecast we used for CECL and higher prepayments. The MSR market is beginning to come back, as shown with the small MSR sale that we executed in July. Loan admin income improved $9 million due to a decline in the level of fixed credit that we provide to our subsequent customers for the custodial deposits that they control. Non-interest expense is $296 million, up $61 million from the prior quarter, primarily reflecting a $53 million increase in mortgage loan-driven expenses, largely commissions and loan processing expense, as mortgage loan closings increased 41%. Overall, mortgage expenses as a percentage of closings were consistent with the prior three quarters. Expenses also increased due to higher incentive compensation costs. We will provide more color on expenses later. Slide eight, which we added last quarter, provides details on our interest rate list position at the end of the quarter. There's a lot of information on this slide, and we added it last time to support our confidence in holding the net interest margin stable. It shows that we are still positioned well. While the majority of loans have variable rates, many of those have rate floors, which provide us protection from lower rates. Consequently, the years in our loan portfolio held up rather well this past quarter, and we expect them to hold up well for the future, too. On the deposit side of the balance sheet, we benefited from the full quarter impact of the pricing changes we made in March when the Fed dropped short-term rates. Additionally, as we observed last quarter, Deposits continue to reprice into the new curve environment, which provided support for our net interest margin. I also mentioned that approximately 85% of our custodial deposits, those controlled by our subsurface and clients, naturally price down as those rates are based on LIBOR. In summary, we believe the deposit rates will continue to be a care win for the remainder of the year. Also, in doing the unique interest rate positioning that a mortgage business gives us, we've locked in future funding rates at these lower levels. To do this, 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 $1.7 billion of this strategy, securing long-term funding at an average cost of 57 basis points, well below our cost of funding. While it's difficult to predict where rates might be in the future, We feel that our interest rate risk position is in a good place. We feel that we can protect our net interest income and net interest margin in this rate environment and believe that our NIM should be relatively flat, excluding the impact of higher levels of loans with government guarantees. More on that in a minute. We've sold our portfolio of PPP loans, and that sale should close by tomorrow. As in the first quarter, we finished the quarter with a stronger net interest margin than the net interest margin would be averaged during the quarter. June NIM was 2.91%, excluding the impact of the lower-yielding PPP loans. We do expect that loans with government guarantees will increase. To help explain this, we've added slide 40 to the appendix, which provides more details. In summary, where we own an MSR for June May loans, we have the option to repurchase those loans after the loans have gone three months without a payment. due either to delinquency or forbearance. At June 30th, we had $1.1 billion of such loans that we have not repurchased, for which the accounting rules made us reconsolidate under the balance sheet with an offset to other liabilities. These assets had a yield of 1.97% last quarter, and so their reconsolidation will likely reduce our net interest margin, but not reduce our net interest income. At June 30th, we had Ginnie Mae MSRs covering $15 billion of principal Of that amount, 20%, a total of $3 billion, was in forbearance, and $1.1 billion of that amount had not had payments for three months, making those loans eligible to repurchase. As I said before, we have not yet repurchased the loans. We do not believe there is significant downside to holding the loans, either by buying them or through this accounting gross-up. If we were to repurchase these loans, we can pledge them to the FHLB and they are a 20% restated asset. Further, if we do repurchase the loans, we could resell those loans at a later date, which is attractive for us, and they remain government guaranteed. Let's now turn to slide 9, which highlights our average balance sheet this quarter. Average earning assets increased $2.5 billion from last quarter. This resulted from a $1.5 billion increase in warehouse loans and a $0.4 billion increase in loans held for sale. PPP loans, which are included in CNI loans, averaged $0.3 billion for the quarter. Average deposits increased $1.9 billion from last quarter. Custodial deposits drove $1.4 billion of this increase. We also saw growth of $0.3 billion in non-interest-bearing retail deposits, a 21% increase from last quarter. 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 FHLV facilities. On June 30th, we had ready liquidity of $6 billion, not including the ample access we have to borrow at the Fed discount window. Finally, we continued to demonstrate significant capital generation capabilities with growth in our tangible book value per share of $31.74. up $2.22 from March 31st and $5.58 from one year ago, a 21% increase. So let's now turn to asset quality on slide 10. Credit quality in the loan portfolio remains strong. Early-stage delinquencies continue to be relatively low. Only $15 million of total loans were over 30 days delinquent and still accruing as of June 30th, down from $26 million from March 31st. Our allowance for credit loss has covered 1.7% of total HFI loans. This coverage reflects 35% of the HFI loans being warehouse loans, so excluding warehouse loans from the denominator, given their relatively clean credit loss history, and considering that substantially all of these loans are collateralized with agency and government-backed residential mortgage loans, our coverage ratio would now stand at 2.6%. As required by CFO, this level of ACL coverage considers our economic forecast over the next two years and lifetime losses on the portfolio. On slide 11, we can see that the end of the quarter was $250 million of allowances for credit losses, consisting of $229 million of allowances for loan loss and $21 million in the reserved unfunded loan commitments, which is included in other liabilities. In total, our allowances for credit losses at quarter end increased by 64% over what we reported at the end of the first quarter of 2020. In our adoption of CECL, we used three different economic forecasts in the next few 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, which was added to 30%. However, on March 31st, we used only the baseline forecast, due to the significant amount of uncertainty in the economy at that time, and judgmentally added $4 million of reserves to that base forecast at March 31st. This quarter, we returned to using three different Moody's forecasts over the next two years. An S1 growth forecast weighted at 30%, their baseline forecast weighted at 40%, and their S3 adverse forecast weighted at 30%. All of the forecasts use the June release. The resulting composite forecast for Q2 is worse than what we assumed at Q1. Unemployment ends the year at 10% and recovers only slightly in 2021. GDP recovers only slightly by the end of the year from current levels and doesn't get back to the pre-COVID level until mid-2022. HPI drops about 2% from early 2020 through 2021. The worsening of our economic forecast increased the ACL by $31 million on March 31st. In addition to this increase, we judgmentally increased qualitative reserves by $39 million, primarily in our CRE and C&I portfolios, guided by the seasonal allowance model output using the Moody's adverse scenarios to provide coverage for industries and customers that we believe could be more exposed to the stressful conditions in our forecasts. Finally, we reviewed our loans and deferral status. And while we do not have any non-performing loans in these categories at this time, we proactively downgraded 170 million loans to watch status during the quarter. These downgrades and other credit changes increased the output from our CECL model by 24 million. We've provided a portfolio-by-portfolio breakdown of the resulting ACL coverage ratios in our appendix. On slide 12, we've updated our exposure to those industries that we believe are more likely to be the most impacted by COVID. In total, we have a billion outstanding loans in this category, representing less than 7% of our total loan portfolio. In our commercial and industrial loan portfolio, these balances total $0.3 billion. You can see that the exposure here is relatively low, especially as the referrals in these portfolios total only $63 million. We have no oil and gas exposure. In our commercial real estate portfolio, we have $0.7 billion outstanding in the areas most likely to be impacted by COVID, including CRE loans secured with hotels, retail properties, and senior housing. Of the loans in this category, our average LTV is 56%, and our average debt service coverage ratio was 1.6 times. We've taken a deeper dive into our portfolio this past quarter and reexamined borrower strength and liquidity. Importantly, We didn't identify any loans that we believe will default. While we believe that we will have losses, we continue to see strong borrower support across the portfolio. We feel relatively good about our credit risk in this portfolio as we are starting from a position of strength, from our carefulness about who we lend to to the disciplined underwriting of those credits in the pre-COVID LTVs and debt service coverage ratios in the CRE portfolio. While we know this will be a challenging time for many of our customers, we believe that we have a low level of exposure to those industries most impacted by COVID as a result of our well-diversified loan portfolio and the discipline and experience of the team of experienced bankers that we have. Turning to slide 13, our capital ratios remain solid and nicely above our stress buffers. Total risk-based capital with 11.3% at June 30th at 14 basis points while our CET1 ratio of 9.1% is relatively unchanged. As expected, our Tier 1 leverage ratio of 7.8% decreased 33 basis points this quarter as it's based on average assets. It's interesting to see that between one 12% on a warehouse loan portfolio, we have approximately 750 basis points of total risk-based capital and 450 basis points of Tier 1 leverage capital dedicated to these two asset categories that have very low risk content. If you add the $1.1 billion of unpurchased loans with government guarantees that we've had to reconsolidate, we have over 770 basis points of total risk-based capital dedicated to low-risk portfolios. In warehouse lending, which has 100% risk rate, we've had under $5 million of losses cumulatively over the last 12 years. I'd remind you that we also hold a collateral for those loans while they are on our lines, and that collateral consisted almost entirely of agency and government-backed residential mortgage loans. Lone Star for Sale also has very little risk content, and this portfolio is carried at fair value. In summary, we believe that we are operating at strong capital levels given our low-risk balance sheet composition. I will now turn to Lee for more insight into each of our businesses.