Flagstar Bancorp Inc. (NYSE:FBC)
Q4 2008 Earnings Call
January 30, 2009 11:00 am ET
Mark Hammond – President and Chief Executive Officer
Thomas Hammond – Chairman
Paul Borja – Executive Vice President and Chief Financial Officer
Bose George – Keefe, Bruyette & Woods
Annette Franke – Friedman, Billings and Ramsey
At this time I would like to welcome everyone to the Q4 2008 investor relations conference call.
(Operator Instructions) Mr. Hammond, you may begin you conference.
Welcome to Flagstar’s fourth 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 website in the investor’s relations section at www.flagstar.com.
I’m here today with Thomas Hammond, our Chairman of the Board, and Paul Borja our Chief Financial Officer. Tom will provide prepared remarks and then I will talk briefly. Paul and I will then answer questions. Please note that we will be addressing the questions that we received by email or questions that we’ve been frequently asked. Before we get started, please first 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.
Last evening we announced our financial results for the fourth quarter of 2008. Despite the virtual shutdown of the capital markets for investments and financial institutions, this morning we are in the process of closing our previously announced transactions in which MP Thrift Investments, a newly formed affiliate of Maitlin Patterson Global Advisers LLC, will invest $250 million and management will invest $5.32 million into Flagstar Bank Corp.
In addition, the U.S. Treasury will invest $266.6 million pursuant to the TARP capital purchase program for a total investment of $523 million. We have also been successful on obtaining a commitment from MP Thrift Investments to inject an addition $100 million in capital in the Flagstar Bank Corp during the first quarter.
Approximately 90% of the funds from these transactions will be down streamed to Flagstar Bank as Tier 1 regulatory capital. We plan to use the additional capital to increase our Fannie Mae, Freddie Mac, and Jenny Mae lending by capitalizing on market opportunities created through the industry consolation and the low interest rate environment.
In addition, we are going to look for opportunities to invest in mortgage-backed securities with attractive yields. Further, we plan to operate at regulatory capital levels higher than we have had in the last couple years. The fourth quarter of 2008 was an especially challenging period for most banks as the economy and residential home value continued to deteriorate.
Our fourth quarter financial results are reflective of those challenges. As the fourth quarter developed, we shifted our focus away from new loan production to focus on capital preservation and increase liquidity. During the period, we substantially increased our reserves and took significant credit charges and asset write-downs. Those items totaled $292 million in pre-taxed costs, which are outlined on page three of the presentation.
Item 1, in the fourth quarter we had a provision for loan losses of $176.3 million, of which $24.3 million were charge-offs with remaining $152 million being used to increase our allowance for loan losses. Item 2, we wrote down the value of our mortgage servicing rights by $270 million mostly offset by hedging gains, contributing to a loss on loan administration income of $46.2 million.
Item 3, we had a $43.7 million other than temporary impairment related to two of our available for sale non-agency securities. Item 4, we also had $26.2 million of credit and mortgage related costs flowing through our non-interest expense. That is comprised of $16.4 million evaluation adjustment related to our real estate owned portfolio and a $9.8 million reserve for anticipated mortgage insurance losses in our reinsurance subsidiary.
Please turn to page four. In 2008, we increased our full year bank net interest margin by almost 18% from 150 basis points in 2007 to 178 basis points in 2008. For the fourth quarter, our bank net interest margin decreased to 161 basis points from 193 basis points in the third quarter. The decrease in net interest margin from the previous quarter is the result of the following four factors. First, the Federal Reserve dramatically lowered interest rates by 175 basis points during the quarter. As a result, our prime rate based assets re-priced faster than our liabilities causing our margin to compress.
Second, our fourth quarter net interest margin was negatively impact by our significantly cash balances. During the period, we maintained a daily average cash and cash equivalent position of approximately $1 billion, which created a negative spread. This resulted in a significantly higher liquidity position then we have had historically. Third, we experienced lower interest income due to a reduced available for sale balance. Fourth, the increase in non-performing assets put additional strains on our margin.
Turning to page five, our gain on loan sell margin was 29 basis points for the fourth quarter as compared to 33 basis points in the third quarter. Full year 2008 gain on sale was 53 basis points as compared to 24 basis points for 2007. As of December 31st, we estimate there was an embedded gain of approximately $40 million in our closed loan inventory that we anticipate to recognize subject to market changes over the course of the first quarter. In addition, for loans closed on or after January 1, 2009, we have elected fair value accounting for our closed loan inventory, which should mitigate the accounting lag associated with the gain on sale of loans previously held at lower of cost or market.
In December, our gain on loan sell margin was 138 basis points and preliminary indications are that the gain on loan sale margin for January will be strong. In the fourth quarter, we had a loss of net loaned administration income of $46.2 million. Although we lost money on our mortgage servicing rights, by writing it down by $270 million, there is less asset at risk. Recent government intervention, including the Federal Reserve lowering interest rates by 175 basis points and the treasury announcing that they we’re going to purchase $500 billion of mortgage-backed securities, created an extremely challenging environment for hedging this asset.
Now let’s talk about loan production. Turning to page six, you see that we have increased our residential first mortgage loan production in each of the last two years. For 2008, we originated $28 billion of residential first mortgages as compared to $25 billion in 2007 and $20 billion on 2006. Since 2006, we have increased our residential first mortgage production by an average of approximately 20% per year.
Please turn to page seven. Our fourth quarter loan production trended downward from the prior quarters as we were not as focused on the production volume as we were in prior quarters. In the fourth quarter, we originated $5.4 billion of residential first mortgages as compared to $6.8 billion in the third quarter. As has been the case for the majority of 2008, we only intend on originating Fannie, Freddie or FHA insured residential first mortgages for sale. In late 2008 as mortgage rates dropped to historic lows, we saw a spike in locked volume. If you take a look at page eight, nine and ten, you see that December loan rate lock commitments were at historic highs.
Recent publications ranked Flagstar as the tenth largest residential loan originator in the country, the fifth largest FHA loan originator in the country, and the fourth largest residential wholesale lender in the country. Given the industry consolidation, we anticipate further market share gain.
Overhead expenses before FASB 91 and credit costs, which are reflected as non-interest expense, were lower by $9.8 million compared to the third quarter even as we continue to add loan servicing collection and lost mitigation staff. We will continue to aggressively manage overhead. In addition, we intend to seek additional fee revenue enhancements.
Now let’s turn to liquidity. Please turn to page 11. During the fourth quarter, our retail deposits increased to $5.4 billion from $4.9 billion in the third quarter. For the year, retail deposits increased by 5.5% from $5.1 billion at the end of 2007 to $5.4 billion at the end of 2008. We were able to increase core deposits in a difficult market by maintaining our focus on customer service and through our effective advertising efforts.
Although we increased our retail deposit portfolio, we did not do so at the expense of our funding cost. For the quarter, our retail deposit funding cost decreased from weighted average cost of 348 basis points for the quarter ending September 30, 2008 to 340 basis points for the quarter ending December 31, 2008. We see these trends continuing as January retail deposit growth has been strong and funding costs continue to decrease.
During the fourth quarter, we opened two new banking centers bringing our total to 175 at December 31, 2008. Of these, one was in Michigan and one was in Georgia. For 2008, we opened 13 new banking centers. At this time, our goal is to continue to manage overhead and as such, we intend on opening only three banking centers in 2009, which are already under contract. In the fourth quarter, we opened over 2,200 net new checking accounts and over 340 net new savings accounts. For 2008, we opened over 11,000 net new checking and over 4,400 net new savings accounts. At the end of 2008, we had opened over 300,000 total retail accounts.
Now let’s talk about our assts. Please turn to page 12. For the quarter, our balance sheet remained relatively flat with total assets of $14.2 billion at December 31, 2008 from $14.1 billion at September 30, 2008. Our available for sale portfolio decreased to $1.5 billion at December 31, 2008 from $1.9 billion at September 30, 2008. Our held for investment loan portfolio decreased to $9.0 billion at December 31, 2008 from $9.1 billion at September 30, 2008, as we are not originating any loans intended for our investment portfolio.
Slides 13 through 16 provide 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. Page 17 provides further detail on our non-agency securities portfolio and page 18 provides information on our real estate owned portfolio.
Let’s now discuss asset quality. Page 19 identifies our key asset quality ratios. In fourth quarter we had significant reserves increasing our allowance for loan loss to $376 million at the end of the period. Our fourth quarter increase in provision was mostly to increase our allowance for loan losses as charge-offs were $24 million for the quarter.
Our asset quality by loan type, including breakout of general and specific reserves, are identified on page 20. As you can see, the majority of the specific reserves are related to our commercial real estate portfolio. We also increased our secondary marketing reserve for losses on repurchased loans by $12.5 million to $42.5 million at December 31, 2008.
Turning to page 21, you can see that our 30-day and 60-day delinquency rates had been relatively flat over the last six months, however, the 90-day delinquency rates still continue to rise. One contributing factor to the increase in 90-day delinquencies is a reduction in foreclosure activity.
In November, we matched Fannie Mae and Freddie Mac in our decision to stay virtually all residential foreclosures until January 31, 2009 in an effort to provide additional outreach to customers who may benefit from loan modification or other workout alternatives.
Our collections specialists perform a detailed analysis and when appropriate assist customers with modifying their payments. We believe that those efforts are working as evidenced by the fact that our re-default rates have thus far been quite low.
As there has been more notoriety concerning the automobile industry, we have seen an increased scrutiny placed on some Michigan banks. We want to emphasize that our exposure to the automobile industry is limited and we have not seen a significant direct impact on our business. Despite the market environment, we have been able to increase our retail deposits. In addition, we are a national mortgage lender and have limited Michigan mortgage exposure. Only 9% of our residential mortgage investment portfolio is in Michigan.
Further, although approximately 55% of our commercial real estate loan portfolio was in Michigan, only 4% of that has automobile-related tenets, which is highlighted on page 22. In the appendix, we provide a variety of additional asset quality metrics both in our residential first mortgage and commercial real estate portfolios.
Now let’s turn to capital. As mentioned earlier, we plan on receiving today a total of $523 million from the U.S. Treasury TARP Program, MP Thrift Investments and Management, of which $474 million will be immediately invested into Flagstar Bank to improve capital levels and to fund additional lending activity. On a pro forma basis, at December 31, 2008 our Tier 1 capital ratio with these investments would have been 8.32% and our risk-based capital ratio would have been 14.78%.
I would like to thank our shareholders to know that our board of directors and management team continues to work hard to navigate through this most challenging environment. We do not take dilution lightly, and we would not have agreed to raise capital under these terms unless we believed that it was in the best interest of shareholders.
As the economy continues to struggle, we believe that this infusion will provide us with both the considerable capital base to sustain future losses and to allow us to prudently increase our asset base and income stream. We believe the MP Thrift Investments will prove to be a knowledgeable investor with a shared vision on the success of Flagstar.
They have acquired a majority investment stake on what our management and even our most respected competitors know to be a great institution with an assembly of some of the industry’s best talents. The transition to working with MP Thrift Investments has thus far been smooth, which forecasts a strong relationship going forward and we look forward to returning Flagstar to profitability and long-term success.
In conjunction with the closing of the investment, Flagstar is changing its constitution of its board of directors so that there will be 11 members on both the Bank Corp. and the bank board of directors. As such, Charles Bazzy, Frank De’Angelo, Richard Elsea, Kirstin Hammond and Robert Rondeau have resigned from the Bank Corp. board of directors, and Charles Bazzy, Richard Elsea, [John Curstan] and [Mary K. Verticelli] have resigned from the bank board of directors. Robert Rondeau will also be resigning as an officer of the bank and the Bank Corp.
New directors for both the Bank Corp and the bank board of directors are [David Maitlin], [Mark Patterson] and [Gregory Ang]. We welcome our new board members. I will remain as Chairman and Kirstin Hammond will continue to serve in her current role as President of Flagstar Capital Markets Corporation and a valued member of the executive management team.
In conclusion, I want to thank the departing board members for their service and dedication to the success of Flagstar over the years. I want to further thank our management team and all the Flagstar employees, including the front line associates who have personal contact with our customers for their confidence, hard work and dedication to this institution. You are the people who will take Flagstar to new levels of achievement. I also want to particularly thank Robert Rondeau for his long and continuous service and wish him the very best in his new endeavor.
With that, let me turn things over to Mark.
On page 23 of the presentation, we provide an outlook for 2009 for each of our key drivers. First the driver branch openings, as Tom mentioned for 2009 we intend to only open three new branches all of which are under contract.
Asset growth, we anticipate increasing the balance sheet to between $17 billion and $18.5 billion by the end of 2009. We intend to operate at higher regulatory capital levels than we have in recent years but intend on increasing our balance sheet to put some of the additional capital to work.
Residential mortgage originations, we are raising our prior estimate from a range of $32 billion to $42 billion to arrange a $36 billion to $44 billion. We anticipate our market share will continue to increase as we see significant consolidation and competition exiting the mortgage origination business. The additional capital will allow us increase in production.
Loan sales, in so far as we plan to sell virtually all of our production in 2009, loan sales for 2009 have been increased to match originations to a range of $36 billion to $44 billion.
Net interest margin at the bank level, we are increased on our [inaudible] range of net interest margin for 2009 from a range of 195 basis points to 205 basis points to a new range of 240 basis points to 270 basis points. We anticipate significantly lower funding costs as competitive pressure on deposits have eased and borrowing costs have fallen. Additionally, we anticipate significantly higher spreads on new assets coming on the balance sheet throughout the year.
Gain on sale margin, we are maintaining our estimates for gain on sale margin. Recent gain on loan sale margins have been the highest we’ve seen since 2003 as pricing discipline is returned to the market.
Retail deposit growth, we are raising our 2009 estimate of retail deposits to a range of 5% to 10% from a range of 2% to 6%. Deposit growth has been strong in recent months. If congress makes the $250,000 FDIC insurance a permanent change, we will most likely revise our estimate upwards.
Net loan administration income, we are widening our 2009 estimates for net loan administration income to a range of $60 to $80 million.
Loan charge-offs, we are widening our 2009 guidance on loan charge-offs to a range of $90 million to $150 million. Charge-offs are very difficult to estimate, and are highly dependent on future property depreciation, macroeconomic conditions and potential legislative changes.
Finally, let’s discuss allowances of percentage of loans held for investment. We are raising our estimate to a range of 400 basis points to 500 basis points from a range of 245 basis points to 300 basis points.
With that said, let me turn this discussion over to our CFO, Paul Borja for the Q&A session.
Our first question comes from Bose George. Mortgage application spiked towards the end of the quarter, can you discuss the current trend in applications? Also, what kind of pull-through rates are you seeing?
Paul, yes, if you turn back to page nine in the presentation, you’ll see that, as Tom mentioned, our new loan lock-ins or registrations are at a five-year high. Accordingly, we’re also seen quite a pickup in our underwriting volume and anticipate an increase in our post volume, although we did not see it in December.
Our normal pull-through rates are around 75% to 78%. However, in the recent months we’ve been running significantly lower and our pull-through rates have only been 60% to 65%. The main reason causing this is that on refinances appraisals are coming in lower as property continues to depreciate and people have not been able to have the equity in their home to allow them to refinance.
We do anticipate that this may change slightly as both Fannie and Freddie are in the process of amending their guidelines to allow refinances on loans even when property values have fallen as long as you resell the loan back to the original guarantor or re-guarantee it back to the original guarantor.
The next question is also from Bose George of KBW. If bankruptcy cram down legislation and goes through as written would FHA insurance cover the cram down of principle? And if not, is there a possibility that some of that cost gets pushed back to the servicer, is this something that the industry is trying to resolve before the legislation goes through?
Most likely on FHA we do not believe that the servicer is at risk. On conventional, the picture is a little less clear. We do not believe that the servicer will be at risk, but MI companies are positioning themselves to make the claim that they do not cover bankruptcy cram down and Fannie and Freddie are assessing their views of what that would mean.
More likely than not, our belief is Fannie and Freddie would have to cover those losses and [inaudible] have to seek assistance for the government to cover those losses. So it would probably be an indirect government subsidy to people declaring bankruptcy for those values.
On our own portfolio, if the MI companies are successful on conventional loans of taking the position that they will not cover the claim, then we do have some exposure on our own portfolio. We’re in the process of measuring that and there is the potential that we would have to increase our estimates of charge-offs if there is unfavorable legislation from that aspect.
And then the industry is clearing fighting this. Obviously the banking lobbying has been somewhat weakened in the last six months, but there is a lot of people continuing to lobby for the change in trying to put exclusions in limiting the amount of loans. And hopefully if congress does pass that it, it will be much more limited as far as it’s broadly been discussed. That ideal situation for us would be that it would be limited to sub-prime exposure, which would have very minimal impact on us since we did not originate sub-prime loans.
The next set of questions are from Annette Frank of Freidman Billings & Ramsey. Her first question, explain your new valuation of the MSR the mortgage servicing rights, which are now at 93 basis points. What is driving the lower valuation?
The majority of effect of the lower valuation is coming from being in a lower interest rate environment.
Annette’s next question, how are you seeing current demand in pricing trends in the market for mortgage servicing rights of sales?
We’re still seeing active buyers at decent valuations for flow sales. We are not seeing much demand for bulk sales.
The next question from Annette, with Maitlin Patterson getting a 70% stake in the company, would you foresee any changes to your current strategy for the firm?
Right now we’re not anticipating any significant strategic direction change or management change.
Annette’s last question, what is driving the net interest margin decline?
Like Tom mentioned in the speech, there’s four factors, the fact that we’ve been holding a lot higher cash and cash equivalent liquidity position of approximately $1 billion has been creating a negative spread situation on that aspect, Fed lowering interest rates to 175 basis points during the period. The lowering was so fast that it caused our prime rate-based assets to re-price slightly faster than the associated funding costs. We also have increased non-performing assets, which are creating a drag on net interest margin.
And we saw our AFS shrinking during the period and typically our AFS portfolio has a high margin. On a go forward basis, we’re looking to see an increasing AFS portfolio allow some of the margins to return. We’re also seeing that our funding costs now are coming down pretty significantly for the month and anticipate, as we mentioned earlier, giving guidance on the driver of that interest margin that we anticipate a pretty significant pick up, particularly when we put new assets on the balance sheet at higher margins that we’ve historically had.
This concludes the questions we’ve received. With that, let me turn things back to Mark.
During the call, we received word that our capital raises from both MP Thrift Investments and treasury have closed and are funded. We’d like to thank Flagstar’s Board of Directors and our co-workers who have all worked diligently and managed through a challenging market, and we welcome MP Thrift Investments to the Flagstar family.
We are confident that we have the capital, balance sheet, funding sources and season management team to execute our business strategy in which it continues to be an environment with economic uncertainty but plentiful opportunity.
Thank you and good afternoon everyone.
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