Flagstar Bancorp, Inc. (NYSE:FBC)
Q3 2008 Earnings Call Transcript
October 31, 2008, 11:00 am ET
Mark Hammond – President and CEO
Thomas Hammond – Chairman
Paul Borja – EVP and CFO
Good day, and welcome to the Flagstar Bank Q3 2008 investor relations conference call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Mark Hammond, Chief Executive Officer. Please go ahead, sir.
Thank you, and good morning, everyone. Welcome to Flagstar’s third quarter earnings conference call. My name is Mark Hammond, and I am the Chief Executive Officer of Flagstar.
Please note that we will be using a PowerPoint presentation during this call, and we recommend that you refer to it as we reference it throughout the call. This presentation as well as our earnings press release that we issued last evening, which contains detailed financial tables, is posted on our Web site in the Investors Relations section at www.flagstar.com.
I am here today with Thomas Hammond, our Chairman of the Board; and Paul Borja, our Chief Financial Officer. Tom will provide prepared remarks about our third quarter, and then I will talk briefly. Paul and I will then answer questions. Please note that we’ll be addressing the questions that we received by e-mail or questions that we have been frequently asked.
Before we get started, please direct your attention to the legal disclaimer on the second page in the presentation. The content of our call today will be governed by that language.
With that, I will turn the call over to our Chairman, Tom Hammond.
Good morning, everyone. Thank you for joining us.
Last evening, we announced our financial results for the third quarter of 2008. Our third quarter loss is reflective of the unprecedented market turbulence and continued macroeconomic deterioration, which has affected the banking industry.
During the quarter, we lost $62.1 million, as compared to a gain of $15.7 million in the second quarter of 2008. Earnings per share for the quarter were a loss of $0.79, compared to a gain of $0.22 per share in the second quarter of 2008.
Although we continue to have positive margins in our core operations, net interest margin, gain on sales, income from our servicing portfolio, those margins were more than offset by five significant credit and asset disposition charges. Those charges in total represent $162.7 million in pretax cost.
Item one, in the third quarter, we took an $89.6 million provision for loan losses, with the majority of that resolving in bolstered reserves. During the quarter, we increased our allowance for loan losses to $224 million at September 30th, from $154 million at June 30th, 2008. The remainder of the provision was applied to net loan charge offs, which were $19.2 million for the third quarter.
Net charge offs year-to-date were $47.7 million, which we believe represents a lower severity of loss rate that other lenders with similar assets due to the relatively low LTV and seasoning of our investment portfolio.
Item number two, we had $31.1 million of larger than anticipated credit and mortgage related cost flowing through our non-interest expense. The $31.1 million is comprised of $18 million of valuation adjustment related to our real estate owned portfolio, a $9 million charge related to our loss on commercial letters of credit, and a $4.1 million addition in premium reserves to our re-insurance subsidiary.
Item number three, earnings were impacted by a $12.9 million markdown on the value of residuals we hold from prior securitizations. These residuals are now valued at $23.1 million at the end of the third quarter, which represents a write down of $40.3 million over the last 12 months, or 64% reduction from the value recorded as of September 30th, 2007.
Item number four, we transferred $326.5 million in loans from our available for sale portfolio to our investment portfolio during the third quarter, which resulted in a $12 million write down. The $12 million loss is recorded through a LOCOM adjustment and reduced our gain on sales for the quarter. We do not anticipate further substantial LOCOM adjustments associated with the transfer of loans from our available for sale to held for investment portfolio. That is nearly all the remaining available for sale loans are committed to be sold through the GSEs.
Item number five, last week, we experienced a $17.1 million cost related to the failure of Lehman Brothers. More specifically, Lehman had committed to buy $65 million of net set servicing, which they did not honor. This position was committed for sale, the asset was not hitched. And unfortunately, the market moved against us before we were aware of the failure to purchase by Lehman. We did, however, re-commit the pool and closed the transaction to another firm in October.
Before we review the income statement, we would like to highlight page three. Unlike many mortgage lenders, we decided not to get into the subprime business because we felt the pricing of those loans could not justify the risk, and as a result, lost market share. However, as the industry began to shift back to conforming agency mortgages, we began to gain back market share. Given the current market turmoil, we have the opportunity to continue to gain significant market share in the agency residential mortgage market.
Looking at page four and five, you can see how much market position Flagstar has generated since the market has moved to a conforming loan environment. Our market position had fallen to approximately 24th in the country during the subprime boom as we did not originate that type of product. Page four is most impressive as Flagstar now is the country’s tenth largest originator of residential mortgages. With the amount of consolidation in the mortgage finance industry over the last 12 months, we expect that the remaining participants will operate with attractive margins that will be enjoyed for an extended period of time as new entrants to the industry will face significant various (inaudible).
Now let’s turn to our income statement. Please turn to page six.
In the third quarter, we continue to see an increase in our net interest margin. For the quarter, our bank net interest margin increased to 193 basis points from 189 basis points in the second quarter of 2008, and from 136 basis points in the third quarter of 2007.
Turn to seven, our gain on loan sale margin was 33 basis points for the third quarter. Our gain on sale margin reflects a $12 million rate down in the value of the loans that we transferred from our available for sale portfolio to our investment portfolio. The $12 million LOCOM adjustment resulted in 18 basis points reduction and a net gain on loan sale margin. Without that gain on loan sale margin would have been 51 basis points.
As mentioned earlier, we do not anticipate further significant LOCOM adjustments. We attribute the remaining difference relative to our anticipated gain on sale margin to challenges hedging our pipeline during an extremely volatile period of interest rates, which resulted in a $17.3 million increase in hedging cost.
Loan administration income was lower than expected at $25.7 million in the third quarter, down from $37.4 million in the second quarter. As mentioned previously, we lost $17.1 million related to the failure of Lehman Brothers. Without this, our third quarter loan administration income would have been $42.8 million in line with our expectations.
Our non-interest expense increased to $119 million in the third quarter, as compared to $94 million in the second quarter. However, as mentioned, our non-interest expense included several higher than anticipated credit and mortgage related costs, comprised of asset resolution charges on our real estate owned portfolio, a loss of commercial letter of credit, and additions to our premium related to our captive re-insurance business. Without these, our non-interest expense would have been $88 million. In addition, management is targeting $20 million in annual overhead reductions and fee income enhancements to begin in the fourth quarter.
Now let’s talk about loan production.
Turning to pages eight and nine, you’d see that our third quarter loan production was down from second quarter levels. In the third quarter, we originated $6.7 billion of residential first mortgages, of which richly all were sold to Fannie Mae or Freddie Mac, or insured through the FHA. As we have said in previous calls, we are not currently originating any loans with the intent of holding them on our balance sheet.
Pages 10, 11, and 12 provide our historical loan underwriting lock and closing volumes, respectively.
Now let’s turn to liquidity.
We maintained a number of reliable sources of funding. Our most notable being our retail deposits, which are outlined on page 13. During the quarter, our retail deposits decreased to $4.8 billion, from $5.0 billion in the second quarter of 2008, which was part of our previous well defined plan to shrink the balance sheet. By doing this, we allowed deposits with higher costs to run off, which resulted in a 5 basis points reduction in funding costs on deposits.
In the last month of the quarter, we refocused our strategy to increase total deposits, with the majority of the growth coming from retail deposits. As a result of this, our retail deposits have increased in September of 2008, and it increased even further in October, ending at $5.1 billion in October 30th, 2008.
Going forward, we will continue to focus on gathering core deposits in increasing our concentration in retail deposits. At October 30th, 2008, we have $1.3 billion in cash as well as several other funding facilities.
During the quarter, we opened three new banking centers, bringing our total to 173 at September 30th, 2008. All three of these were opened in Georgia. We have opened two new branches in the fourth quarter, bringing a year-to-date 2008 total to 13. One of these new facilities was opened in Michigan, the other in Georgia.
We remain focused on attracting quality relationships in each of our markets. At this time, we only intend on opening banking centers under contract in 2009, which we anticipate will be three. This decision will be reviewed at a time when we witnessed more stability in the market and real estate values level off or start to trend upward.
Now let’s talk about our assets. Please turn to page 14.
In the third quarter, we continue to shrink the balance sheet increasing our total assets to $14.2 billion at September 20th, down from $14.6 billion at June 30th, 2008. This decrease came from loan runoff and the timing of loan sales.
During the quarter, we transferred $326.5 million of loans from our available for sale portfolio to our held for investment portfolio, which accounted for the increase in our held for investment portfolio. We do not anticipate transferring any other significant amount of mortgages from our available for sale to our held for investment portfolio. The balance at available for sale portfolio is almost entirely ready to sell and conforming residential Fannie, Freddie, and FHA mortgages.
Page 15 to 18 provides further analysis of our residential first mortgage portfolio by state, current loan to value, FICO score, and Vintage year. Of the loans with an 80% LTV or higher, virtually all are covered by mortgage insurance.
As we have mentioned before, our securities available for sale portfolio consist of two types of assets. First, we have agency securities, which are in the process of being sold; second, we have $795 million in non-agency securities. Page 19 provides a breakout of those non-agency securities. While four of the twelve of these securities have been downgraded by one of more rating agencies, we have not suffered any losses on them. And in each case, we’ve invested in the highest trench of bonds for the respective pool.
Page 20 provides information on our real estate owned portfolio. As mentioned before, we took an $18 million valuation adjustment related to our real estate owned portfolio. When a property goes to foreclosure sale and the redemption process starts at some states, we obtain a current appraisal on the property. Historically, every quarter, the value of the property at 90% of that appraised value, with the 10% reduction being applied to marketing and holding cost. With the continued deterioration of the residential real estate market, we have adjusted our methodology to reduce the value to 85% of the appraised value. This sum adjustment is recorded to non-interest expense, and since we value majority of the portfolio. For this new approach, it had a relatively dramatic impact as prior to the third quarter was affected.
Going forward, individual properties may sell for more or less than booked value. But absent significant further declines in values or a bulk sale of the portfolio, we do not anticipate further expenses of the magnitude that we recorded in the third quarter.
Now let’s discuss asset quality.
Page 21 provides our key asset quality ratios. In the third quarter, we added significant reserves, increasing our allowance for loan losses to $224 million at the end of the period. Our third quarter provision for loan losses of $89.8 million reflects an increase and general and specific reserves, which are broken out of page 22. As you can see, the majority of the specific reserves are related to our commercial real estate portfolio.
Charge offs, net recoveries in the third quarter were primarily due to the residential first mortgages at $12.8 million, commercial real estate at $4.1 million, and HELOCs and second mortgages at $1.9 million. As we are not generally adding new loans on the investment portfolio, our investment portfolio can be viewed as a static pool. And our cumulative loss assumptions for that pool are manageable even in the most severe macroeconomic scenario that we and our advisors have modeled. Due to the seasoning and low original LTVs of the portfolio, we believe that we are experiencing less severity of loss than many of our other lenders with similar assets.
In the appendix, we provide a variety of additional asset quality metrics, both in our residential first mortgages and commercial real estate portfolios.
Now let’s turn to capital.
Turning to page 23, we are well capitalized under the bank regulatory capital ratios. As of September 30th, 2008, our core capital ratio is 6.29%, and our risk-based capital ratio is 11.1%.
With that, let me turn things over to Mark.
Thanks, Tom. Although we are well capitalized, we are currently looking at opportunities to raise additional capital, including to the TARP Capital Purchase Program. We believe that with the additional capital, we will be able to fortify our balance sheet, while at the same time availing the company of opportunities to grow market share in the prime residential mortgage finance arena.
On page 24 of the presentation, we provided an outlook for the remainder of 2008 and 2009 for each of our key drivers. It is important to note that our 2009 drivers are based on an assumption that we will participate in the TARP Capital Purchase Program, and that we raise private capital at an amount equal to that, which is invested by the government to the program.
Branch openings, as Tom mentioned, we have opened 12 branches thus far in 2008, and still plan to open 13 for the year. For 2009, however, we have completed our review and intend to only open three branches, all of which are under contract.
Asset growth, we still plan to end the year with total assets between $14.0 and $14.2 billion. For 2009, we anticipate asset growth of between 10% and 25% based on the assumption that we successfully raise additional capital.
Residential mortgage originations, we are lowering our estimate for residential mortgage originations for 2008, $28 billion to $31 billion. For 2009, we are raising or expanding our prior estimate of $32 billion to $36 billion, to $32 billion to $42 billion. The wide range is due to a lack of clarity with macroeconomic factors that will not be unique to Flagstar. We do believe, however, that our share of the agency merit will continue to increase.
Loan sales, as we plan to sell virtually all of our production, loan sales for 2008 have been lowered to $28 billion to $31 billion. 2009, we plan to sell the majority of our production with an estimate of $29 billion to $39 billion in loan sales. With the remainder of loan originations being outdated to replace runoff and asset growth, assuming that we are successful in raising additional capital.
Net interest margin at the bank level, we are widening our estimate range of net interest margin for 2008 from 191 basis points to 201 basis points, to a new range of 187 basis points, to 201 basis points. For 2009, we are maintaining our estimate of 195 basis points to 205 basis points.
Gain on loan sales, we are maintaining our 2008 and 2009 estimates for gain on loan sales.
Retail deposit growth, we are raising our estimate of retail deposits to between shrinking 2% and growing 2%. October will be one of our strongest months ever for retail deposit growth. We are maintaining our prior estimates of retail deposit growth for 2009.
Net loan administration income, we are lowering our estimates for net loan administration income to between $70 million and $90 million for 2008, and maintaining our 2009 estimates. We have removed mortgage servicing right sales as a key driver as we account for the MSRs at a fair value basis. So any gains would be reflected to adjustment to net loan administration income. We expect, however, to maintain our balance of the MSR asset between 50% and 80% of our tier one capital.
Loan charge offs, we are maintaining our guidance on loan charge offs.
Finally, allowance to held for investment, we are raising our estimate to 245 basis points to 260 basis points for 2008, and 245 basis points to 300 basis points for 2009.
With that, let me turn it over to our CFO, Paul Borja, for question-and-answer session.
Thank you, Mark. Good morning. This is Paul Borja. Before we get to the specific questions, we have received a number of questions regarding Flagstar and the TARP Capital Purchase Program. And in response to those questions, we have applied to participate in the Capital Purchase Program. And the maximum we may receive, if approved, is approximately $260 million.
Next question’s come from Terry McEvoy [ph], a question about our calculation of the earnings per share. And I believe that – this question came from someone else, I believe Terry is using the number we have inside the press release. The average share count in the press release is actually our nine-month average share count. You would need to use the quarterly average share count, which is 78,473 shares. And that number will also be in our 10-Q.
The next question, “Is there any additional risk to Lehman that can result in future losses?” At this time, we’re not aware of any additional risks.
Our next question, “Why were loans held for investment and MSR refitted for two – second quarter of ’08?” This will be – first of all, there was no restatement of any of the prior numbers. I think we’re looking at an aggregation in the earnings release. When the second – when the third quarter 10-Q shortly, I think you’ll see that all the numbers are pretty much where they were in the second quarter of ’08.
The next question from Terry, “Is Flagstar interested in participating in a voluntary capital of purchase program?” And I think we already talked about that.
The next question, and this is for Mark Hammond, “Were there any commercial real estate loan sales in the quarter as the growth in non-performing commercial loans was just $2 million in Q3 of ’08?”
No. There is no sales. We have not been selling our commercial loans. And over the course of the year, we have exited our commercial lending business. So we are no longer doing commercial loans, except for refinances of existing portfolio. The same story is for our C&I loans, our small business loans, and our home equity, and consumer loans. We’ve exited all lending, except for loans intended to be sold to Fannie, Freddie, or FHA, with once again, the potential exception to refinance an existing loan on balance sheet.
The next questions come from Boss George [ph]. “In August, you would announce that about $167 million of your $780 million non-agency MBS available for sale portfolio had been downgraded. Had there been more downgrades since then? And will the downgrade necessitate any, other than temporary write downs, that could negatively impact capital?”
As to the first question, one of the already downgraded securities that we hold has been downgraded again in October by a different rating agency. And to the second question, no downgrades have resulted in OTTI. And we continue to analyze the securities, of course, for any accounting effect.
The next question, “Can you discuss the $17.1 million loss associated with Lehman’s value to purchase servicing? If you that servicing, can’t that value be realized through the income statement over time?” I think that we’ve covered the discussion of the Lehman transaction in the speech. And from the speech, the $17.1 million are the hedging costs of covering the asset after the failed purchase.
The next question, “Can you discuss the trend in mortgage volumes in October?” And for that, I’ll turn it over to Mark Hammond.
Yes. Under the mortgage business, we saw our new lock-ins start out slow during the month of October. And then, during mid month, picked up. And then by the third week of October, running at significantly high levels, higher than norm. And then, for the last of October, this week, we saw a significant drop in due loan registration and locks. And this closely nears the volatility that we saw with both the long term interest rates, particularly the volatility that we saw in the mortgage bank securities market.
As far as closings, we are anticipating to close approximately $2.15 billion in October, which is about the same pace we experienced for Q3.
The next questions come from Annette Frank. The first question, “Please breakup the charge offs and the commercial real estate loan portfolio. You’re reporting a $4 million charge off in other loans.” The commercial real estate charge offs are $4.1 million that we mentioned in the speech are comprised primarily of a mini storage warehouse, that’s about $2 million; and the retirement assisted living facility, about $1.2 million. That’s about $3.2 million to $4.1 million, with other loans included in there.
The next question, “What is the product type in your current loan production? And what geographic areas are you lending? Also, provide us with your current underwriting criteria.” For that, I’ll turn to Mark Hammond.
Yes. Everything we’re doing – originating right now, as we mentioned, is intended for sale at the Fannie, Freddie, Jenny Mae, with that (inaudible) insurance. The split has been approximately 60%, 40%; with about 60% of business going to Fannie, Freddie, Jenny, and about – or Fannie, Freddie; and about 40% of the business going to Jenny Mae, with the Jenny Mae business increasing.
So far, I’m up-to-date. In October, the lock-ins are about 57% for Fannie, Freddie; and about 43% for Jenny Mae. We’re doing business in all 50 states. If you reference page 15, it’ll show the break out and our FAS portfolio on the statements.
Credit criteria, even though we’re selling the loans, we have more restrictive credit criteria than Fannie, Freddie, or Jenny Mae, or FHA has. So just because Fannie and Freddie will buy it, doesn’t necessarily mean we originate it. Particularly, with FHA, we have FICO floors that FHA doesn’t require, and eligibility requirements like restrict the manufacture homes and other eligibility requirements that’s on the FHA side, so. We feel fairly conservative credit criteria.
This concludes the questions that we received, including those that have been asked on – by several folks. We’ve covered those questions as to these. So with that, I’ll turn it back to Mark Hammond.
I’d like to thank you all for participating today. And hope everyone has a happy Halloween. Thank you.
And with that, ladies and gentlemen, that will conclude today’s presentation. Thank you again for joining, and have a great day.
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