Flagstar Bancorp Inc (FBC) CEO Discusses Q2 2013 Results - Earnings Call Transcript

Jul.24.13 | About: Flagstar Bancorp, (FBC)

Flagstar Bancorp Inc (NYSE:FBC)

Q2 2013 Earnings Call

July 24, 2013 11:00 AM ET


Paul Borja – EVP and CFO

Sandro DiNello – President and CEO

Lee Smith – COO

Matthew Kerin – EVP, Managing Director, Mortgage Banking and Warehouse

Mike Flynn – General Counsel


Paul Miller – FBR Capital Markets

Kevin Barker – Compass Point

Bose George – KBW

Ken Bauso – Elementum Management

Henry Coffey – Sterne Agee


Ladies and gentlemen, please stand by. We are about to begin. Good day everyone and welcome to the Flagstar Bank Second Quarter Investor Relations Conference Call. Today’s call is being recorded. At this time, I would like to turn the call over to Mr. Paul Borja. Mr. Borja, please go ahead, sir.

Paul Borja

Thank you. Good morning, everyone. I’d like to welcome you to our second quarter 2013 earnings call. My name is Paul Borja, and I’m the Chief Financial Officer of Flagstar Bank.

Before we begin our comments, I’d like to remind you that the presentation today may contain forward-looking statements regarding both our financial condition and our financial and operating results. These statements involve certain risks that may cause actual results in the future to be different from our current expectations.

These factors include among other things changes in economic conditions, changes in interest rates, the outcome of pending litigation, competitive pressures within the financial services industry, and legislative or regulatory requirements that may affect our business.

For additional factors, we urge you to review the press release we issued last night. Our SEC documents such as the most recent the Form 10-K and Form 10-Q, as well as the legal disclaimer on page 2 of our second quarter 2013 earnings call slides that we have posted on our Investor Relations page at flagstar.com.

During the call, we may also discuss non-GAAP measures regarding our financial performance. A reconciliation of these measures to like GAAP measures, is provided in a table to our press releases which was issued last night, as well as in the appendix to our earnings call slides.

With that, I’d like to now turn the call over to Sandro DiNello, our Chief Executive Officer.

Sandro DiNello

Thank you, Paul, and thanks to everyone for joining the call this good morning. In addition to Paul, with me today are Lee Smith, our Chief Operating Officer and Matt Kerin, our head of mortgage banking.

I’m very pleased to get a chance to talk with you this morning and I’m excited about my new role as CEO of Flagstar. I’ve been with this company for over 30 years, so my roots in Michigan run deep and my understanding of our markets and consumers is thorough. I’m confident in our team and I believe that together, we will drive an even stronger future for Flagstar. And I know these are just words to you right now. I get that.

So my job is to tell you how we are going to get there. It’s very simple. There are three things we need to accomplish to achieve our long term vision of this company. We need to increase revenues in all of our segments. We need to enhance efficiency and control expenses throughout the organization and we need to continue to work through legacy issues which will lead to lower credit cost.

We understand that revenues are meaningful if they are consumed by credit which has been the case for us over the last few years. So we have dedicated significant resources to cleaning up our balance. And while we are not ready to call bottom, we believe we have a good handle on these and we have a firm strategy to resolve the remaining legacy issues.

With that said, our number one goal is to grow revenue. We plan to accomplish this in a few ways. First and foremost, to continue to grow our national mortgage presence and not just status quo either. We believe we can get much more out of this business. We are not just refinance [inaudible]. We have always earned our fair share of the purchase market and we intend to grow that business even further. And Matt will discuss specific strategies on how we plan to do this.

Second, we intend to grow our performing servicing platform without increasing our mortgage serving asset concentration. We are very good service or mortgage performing loans and we can expand that into a meaningfully profitable sub-servicing business. We will discuss this more.

Further, we are looking to grow our mission and community bank. I’ve been a Michigan banker for over 34 years. I know the market and I know the bankers. We have a tremendous opportunity to grow this business and that it can become profitable on a standalone basis. There is no bank outside of Michigan that cares as much about this market as we do. And I believe we can leverage that fact. That’s the revenue piece of the pie.

In addition, we know that we have to continue to focus on reducing our credit cost. And we have to become a much more efficient operator. Lee and I will talk more about these strategies during the call. But before launching into my further remarks, I want to be very direct in reiterating our strategy, which is to deliver improving performance by leveraging our national mortgage banking business and our community banking operation to Michigan, all with a continued eye on risk management and compliance.

In the last quarter, we made numerous accomplishments aligned with a strategy. We were opportunistic in closing out our remaining legacy litigation matters, entering into settlement agreements with Assured and MBIA, which together resulted in a gain of approximately $44 million.

We also sold $341 million in UPB of non-performing loans and TDRs for a small loss, which significantly improved our asset quality ratios. And we grew our tier one capital ratio to 11% at the end of the second quarter. Our focus on risk management in putting the legacy issues behind us helps us clear the way for Flagstar’s next phase of growth and development. We have dedicated a significant amount of time and resources over the last several years to cleaning out some of Flagstar’s legacy issues and we are in a much stronger position today thanks to our efforts.

We now need to turn our attention to improving operational performance across the organization by reducing credit cost, driving improvements and efficiency and growing underutilized lines of business while managing expenses and creating a more variable cost structure. And we are starting to do that.

Let me be clear here. This organization will be built on a culture of accountability in accomplishing our objectives. If we tell you that we are going to undertake a strategy or initiative, we will accomplish it as fast as reasonably possible.

For example, we recently announced a decision to outsource our non-core default servicing business to a third party provider that specializes in this area. By focusing on our mortgage servicing business and core performing mortgages, we believe that we will be able to save potentially as much as $20 million per year, while better positioning ourselves for long term growth. We will talk more about these initiatives later in the call.

As we continue to execute in our strategy to further improve our financial performance and create shareholder value, a key are focus for me is to continue enhancing our transparency. We appreciate the feedback we have received from analysts and investors and look forward to sharing additional information to demonstrate our continued progress.

Looking into the future, Flagstar will remain committed to enhancing our culture of compliance and as we create new growth opportunities and pursue sustainable profitability. Thanks to our successful efforts to reduce risk and fortify the balance sheet, combined with the gradually improving economy and increasing home prices, we are well positioned to further reduce cost, diversify revenue and deliver value-enhancing growth for shareholders. I’m confident that together we will build the best in class mortgage business and Michigan Community Bank.

With that, I would now like to turn our remarks to the quarter. Let me begin by laying out the order of the call. I will start by talking about how we view risk in the organization and more importantly what we are doing to mitigate and address it. Then Lee and I will discuss the strategy in more detail including some of the initiatives we have completed or plan to undertake. After that, Matt is going to discuss the mortgage banking business and then Paul will take us through the financial results including an outlook for next quarter. Finally, we’ll be available to answer your questions.

Now, please turn to slide 3. For the second quarter, we reported a net income for $65.8 million or $1.10 per diluted share as compared to $22.2 million, excuse me, or $0.33 per diluted share in the prior quarter. On slide 4, you can see that this translated into a return on assets with 2.03% and a return on equity of 21.23%. Our book value also increased to $17.66 per share at June 30 2013 as compared to $16.46 per share at March 31, 2013.

At the end of the second quarter 2013, our DTA [ph] was $208 million which translates to an additional $5.49 per share in book value once we have reversed the valuation allowance.

The $65.8 million, a net income during the second quarter, included several significant non-recurring items which I will highlight. First, the settlement agreements we signed with Assured and MBIA resulted in $44.2 million. Second, we recorded an $18.2 million gain from the sale of MSRs completed during the quarter. And third, these were partially offset by a loss of $3 million related to NPL and TDR sales.

In total, this represents $59.4 million, a non-recurring income for the quarter. When you back that out of our net income, it translate to a run rate of $6.4 million. This amount include on sale loan income of $144.8 million. So what that means is, assuming that everything in our P&L is run rate, we need to generate at least $138.4 million in our sale income during the second quarter to break even. But that does not mean you should assume everything else in our P&L is a run rate. We believe we have upside in other revenue lines and expense base.

On the revenue side, as I mentioned earlier, we believe we can grow other lines of business such as performing, servicing and commercial and consumer lending. We also think we can right-size the cost structure and achieve significant expense aids. Further, there is the potential for reduced credit cost especially as we continue to derisk the balance sheet and work through legacy issues.

Our second quarter performance reflects two overarching themes which are both consistent with unlocking the potential upsides of our P&L that I just mentioned. First, an emphasis on resolving legacy issues and addressing any remaining risk in your organization.

Second, segmenting the business lines and developing strategies including efficiency optimization and right-sizing the cost structure to ensure that each is comparable on a standalone basis.

Let me first discuss how we view our key risks and then discuss what we are going to do to address and mitigate each. These risks translate into real dollars. While levels have to come down from their peak, we are still experiencing significant credit cost each quarter which are offsetting, in part, our overall results.

It is important to me that our shareholders or any stakeholder for that matter, fully understand what risks are embedded in the company and how we plan to mitigate and address those risks. To do that, we have to do a better job of articulating them so that you understand that we have a good handle on the remaining risks and that there is potential upsides to our P&L.

We view risk in two categories; on and off balance sheet. On balance sheet risk is grouped into four main buckets; non-performing loans, troubled and restructuring or TDRs, interest-owning mortgages and our second mortgage and HELOC portfolio. Well, let’s start with the non-performing loans.

I’m going to skip ahead now to slide 17. As of June 30th, 2013, we had a total of non-performing loans, which are 90 or more days past due of around $258 million, a 30% decline from the prior quarter and a 40% decline from the same period a year ago. As you can see from the slide, the second quarter amount includes about $72 million of TDRs, which are currently performing but have yet seasoned for six months.

While the chance of re-default is higher on TDRs and they carry a larger reserve, these are loans that are currently paying [inaudible] and carry less risk in a not normal non-performing loan.

Non-performing loans are broken into two types, consumer and commercial. Consumer loans comprised about 75% of our overall non-performing loans and are predominantly residential first mortgages. These loans are backed by the underlying property, taking the severity of loss obviously better than a commercial loan. This is one reason we believe our portfolio of non-performing loans is comprised of better-quality loans relative to those of our peers.

Another reason is geographic diversification. Looking at slide 18, you can see that one quarter in one year, HPR [ph] growth rates for California, Florida, and Michigan which are the top-three states in our first mortgage loan portfolio; these three states make up 45% of the total non-performing mortgage loans in our portfolio. As you can see from the chart, these states have performed significantly better, averaging a growth rate of 12.2% over the last year, which is almost double the average of the United States over the same period.

On slide 19, you can see the trending consumer non-performing loans and the consumer reserves over the last several quarters. Consumer non-performing loans declined significantly from the prior quarter, decreasing by $109 million or 36%. This decline was driven by our sale during the second quarter of $167 million in UPB of residential first mortgage non-performing loans which had a [inaudible] of $110 million.

The driving force behind these sales was to significantly improve our asset quality ratios. Now that we have, going forward, we can seek to opportunistically dispose of these assets, it’s going in [ph] all of alternatives, including modifications, workouts, and sales.

As you can see at June 30, 2013, the total level of consumer non-performing loans was at approximately $194 million with reserves of $214 million, which translates to a consumer coverage ratio of about 110%.

Now, let’s discuss TDRs. TDRs represent the portfolio on balance sheet of loans that have been modified as part of our loss mitigation efforts. Under the accounting rules, after modification, the loan is not considered a performing loan until the borrower has made six consecutive on-time payments under the new loan terms. And given the high propensity to default associated with these loans, we take a large upfront reserve against them. We seek to modify these loans generally when it is economically beneficial for us as compared to the alternative of allowing the loans to go into non-performing status and then pursuing a drawn out foreclosure process.

Turning to slide 20, total TDRs declined to $547 million at June 30, 2013, as compared to $744 million at March 31, 2013. And the bottom half of the slide, we prepared a roll [ph] forward of our TDRs for both the performing and non-performing portfolios. As you can see, around $33 million of additions came in to the performing TDR bucket from the prior quarter.

For the first six months of 2013, the inflows of performing TDRs have decreased by about 43% when compared to the first six months of 2012. This decrease is consistent with the decrease in the level of total delinquent loans in our portfolio over the same period.

We also saw an increase in transfers out, driven by sales of $157 million of performing TDRs completed during the quarter. This significantly brought down the total balance of these loans which are viewed as inherently more risky than true performing loans. We generally reviewed the – view the TDRs as an attractive alternative to a drawn out foreclosure process. On average, we earn around a 3% yield on TDRs and our percentage mix of TDRs is mostly performing.

At June 30, 2013, you can see that 95.6% of the total TDR portfolio was currently paying [ph] as agreed. In addition, the geographic concentration of our TDR portfolio is more heavily weighted in markets we like.

Similar to the mix of our non-performing loans, about 45% of the overall portfolio is in California, Michigan, and Florida. As I mentioned earlier, these states were among the highest in home price appreciation over the last year, averaging about 12% HPI growth.

Now, let’s turn to interest-only loans which are one of our primary areas of focus. We have about $1.1 billion in interest-only loans on our balance sheet which are broken out by reset year on slide 21. As you know, once borrowers hit their reset date, both the principal and interest payments become due and the payments will rise; some more significantly then others. This is commonly referred to as payment shock.

The blue line in the chart on slide 21 represents the average borrower payment shock which is 138% in 2014. Although we have not experienced issues with this portfolio so far, these payment shocks could potentially represent a higher chance of default. So we are using this year to get out ahead of this. We have assembled a dedicated team which is responsible for mitigating the risk in this portfolio. This will be accomplished in a number of ways including through sales and through modifications and refinances using both calling campaigns and direct mailings.

But let’s dig a little deeper. The majority of these loans were underwritten on a fully amortizing basis and were originated prior to 2008 which was a significantly higher interest rate environment. This means that the borrower has a benefit of lower payments over the last few years. Therefore, when you compare the recasted monthly payments versus the original payment, which is the green line on the chart, the payment shock is not quite as severe; for example, decreasing from 138% to 58% for 2014.

Another mitigating factor in this portfolio is the borrower credit quality. In slide 22 you can see that the credit statistics of this portfolio are pretty good with an average current FICO of 7.31 and average HPI adjusted LTV of 90%. This is evidenced in the performance of the portfolio where the majority of these loans can seem to perform.

While the average LTVs in our interest-only loans have declined since origination, they remain above water [ph], which we believe could mitigate some of the severity of loss in the portfolio. And we have also established reserves for this portfolio and we’ll continue to evaluate as more information comes available.

The last major bucket of our balance sheet risk is our second mortgage and HELOC portfolios which were originated prior to 2009. As you can see on slide 23, at June 30, 2013, we had about $482 million in the second mortgage and HELOC loans that were originated prior to 2009. Although the average loan rate is higher than a first mortgage, the loans carry significantly smaller balances so the monthly payment may not be overly burdensome.

There were a number of underwriting guidelines for these loans at that time, including FICO scores in the range of 620 to 720; CLTV ceilings of 100% or 90% depending on whether Flagstar originated the first claim [ph] and debt-to-income caps of 50% if we did not own the first claim [ph]. The majority of these loans were closed in connection with us closing on the first claim [ph]. As you can see the average original FICOs for these loans were pretty strong.

Similar to interest-only loans, these portfolios are currently performing pretty well. The delinquency rates on our second mortgage and HELOC portfolios at June 30, 2013 were 1.63% and 2.50% respectively. While we know the LTVs on these loans have increased over time, we are aware of what we have on the balance sheet and we believe we are ahead of this issue. We have also assembled a core team who will be focusing on mitigating risk in the second mortgage and HELOC portfolios. We are first focusing on loans that have matured or are maturing in 2013. Again, we plan to use a number of strategies including calling campaigns and direct mailings to seek modifications and refinances.

Now, let’s turn to our [ph] balance sheet risk, which includes a litigation with MBIA and Assured who recently settled and the agency repurchases. First, the litigation portion; as I mentioned earlier, we settled both MBIA and Assured during the quarter which we were the two key material litigation issues that were pending against Flagstar. Paul will discuss the financial impact of these during his comments.

Slide 24 shows further detail on our representation and warranty reserve. As you can see on the top left chart, the representation and warranty reserve remain flat from the prior quarter at $185 million and now stand significantly above the level of the didactic [ph] pipeline. The chart on the top right shows the total repurchase pipeline which declined to $115 million at June 30, 2013, as we continue to aggressively work through the existing population of repurchase request.

The chart on the bottom right shows our audit file pulls from the GFCs [ph] which increased by 34% from the prior quarter. Audit file pulls have been a leading indicator of new demands for repurchases, and as you can see, they have remained heightened [ph] since the fourth quarter of 2012. This trend has not translated into material increases in repurchase demands or an increase in the open pipeline. However, we continue to monitor this closely.

Now I want to turn to our second overarching theme which is individual business line profitability. Though we are just beginning our efforts, our goal is to have each of our core business lines profitable on a stand-alone basis. We are beginning to segment each as an individual unit and then we’ll look at ways to maximize efficiency and right-size the cost structure to be more variable with the revenue drivers?

We are beginning to look at strategies in trying to elaborate more in future quarters. The way we do the business internally – and I think this provides a good framework for how you can do it just by looking at the three primary revenue generating areas; mortgage originations, mortgage servicing and the retail commercial bank. I’m going discuss the retail and commercial bank strategy and Lee will talk about the mortgage servicing strategy which ties into expense management. And Matt will then discuss the mortgage origination strategy.

Our net interest income has continued to decline over the last few quarters which is outlined on slide 10. This is really driven by two items; the slowdown in the mortgage business and the amount of liquidity we currently have on the balance sheet. As we have completed transactions to derisk our balance sheet over the past few quarters, in particular, the Northeast based commercial loan sale, several block MSR sales and now the MP on TDR sales, our liquidity has grown.

In addition, the mortgage business has slowed down and we have not needed the cash to fund the mortgage reductions to the extent we originally had anticipated. Although we have been successful in significantly reducing our wholesale deposits and since we are reluctant to reduce core deposits, we have a limited ability to shrink the liability inside the balance sheet given our long term FHLB advances. That is evidenced by the flattening of our cost of funds this quarter as outlined on slide 11.

While certainly it’s negatively impacting our net, we believe this is a good time to be cash rich. We are proactively looking at opportunities to invest some of the excess cash shareholding on the balance sheet with a [inaudible] we have the opportunity to deploy the cash prudently by having well underwritten, high-yield in assets and we expect to do so once we have had a chance to properly evaluate alternatives with our board.

As I mentioned, we are limited in our ability to shrink the liability side of the balance sheet. So our focus has been on improving the mix of the [inaudible]. This will continue to be driven by our ability to bring in core deposits, which we classified as demand, savings and money market. You can see the positive trends we have been able to accomplish highlighted on slide 12.

We have grown core deposits by over $800 million since June 30, 2012 and our percentage to core deposits to retail deposits has increased from 49% to 64% over the same period.

Core deposits will continue to be a significant part of our strategy especially as we look to prudently grow the balance sheet. One of the key ways we plan to accomplish this strategy is through a completion of a new account system which we believe will reduce the time to open new accounts, improve cross-sell opportunities and enhance overall relationship management.

We have completed installation and are currently into the process of growing it out to five grants [inaudible]. We have also seen good traction from our partnership with the University of Michigan athletics. About 10% to 20% of our new segment has been from this partnership. We also currently in the process of evaluating other partnerships which we think we can also leverage to grow core deposits.

With that, I would like to now turn the call over to Lee.

Lee Smith

Thanks, Sandro and good morning everyone. I want to echo Sandro’s enthusiasm and excitement about the vision, strategy and future prospects for Flagstar. Please turn to slide 25.

The top chart shows our efficiency ratio trends over the last five courses. As you can see, our efficiency ratio was in the mid-60s during the peak of the mortgage cycle, and then began to increase as origination volume and gain on sale margin declined. When you normalize our efficiency ratio and adjusted it showed an MBIA settlement, we would be around 77% for the second quarter 2013.

Year-to-date 2013, we are averaging about 79%. When you dig deeper into the numbers, it is not hard to see that revenues have come down and expenses have remained relatively flat. Meaning, we are at fixed cost during 2012 to deal with the increased reduction volumes.

I’m missing something – got starting to look at more closely during my time at Flagstar. My number one priority has to be to look for opportunities to maximize the productivity efficiencies and optimize the cost structure of the organization. Now, that doesn’t mean we’re going to cut cost to the bone and forego future growth opportunities or be the lowest cost producer. But we do need to get leaner and ensure that cost structure is scalable with mortgage production volumes in particular.

As such, we need to make our expense base more variable so that it tracks revenues and ensures we can be profitable at any stage of the mortgage cycle. We also need to ensure all business lines are profitable on a standalone basis. To do this, we’re implementing detailed KPI reporting that focuses on the real value drivers, productivity and efficiency measures and cost controls across every major business unit.

We’re going to challenge the status quo, undertaking a process because it’s always been done a particular way is not the right answer. We’re going to look to improve our existing thought processes and methods to better differentiate ourselves from the competition. Assuming the income remains relatively constant, our immediate goal would be to get our efficiency ratio back to somewhere in the 65% to 67% range. This would equate to achieving approximately $80 million to $100 million of cost savings on an annualized basis.

When we break down our efficiency ratio between the mortgage business and community banking in Q2, we found that mortgage banking was around 60% and community banking was around 108% on fully loaded basis. For community banking to be profitable on a standalone basis, we would need to take approximately $12 million in cost on an annualized run rate basis.

The remaining $68 million to $88 million that we’ve targeted would come out of mortgage banking and the various support functions. We believe we can get this run rate by mid-2014.

So how have we started to address this in the second quarter of 2013? You heard Sandro mentioned that we recently announced the decision to outsource our non-core default servicing business to a third party provider that specializes in this area.

During the second quarter of 2013, we did a deep-dive analysis into the cost of service between performing, everything current through 59 days delinquent and defaulted loans, which is everything, 60 plus age of delinquent. And we found that we were much more efficient at servicing performing loans.

In July, we made the decision to outsource or sub-service the default servicing book, which is everything 60 plus delinquent and represents less than 4% of our overall servicing book. We expect that this move should generate approximately $20 million in annualized cost savings.

This transaction would also allow us to focus more on the performing servicing platform, which we believe will help diversify revenues without materially increasing that concentration levels. Flagstar currently services approximately 350,000 performing loans and we are optimistic that we could, given time and investment, get back to a million loans. We believe we can be a sub-service or a performing loans for other organizations as well as the loans we originate ourselves.

We’ve also been busy in a number of other areas. During the quarter we sold approximately $341 million of unpaid principal balance in NPLs and TDRs. We are carrying valued $278 million, so 99% of both. Not only did this give us confidence in our marks but it also helped us to read the balance. I’m bringing – there are actually quality coverage ratios more in line with our peers.

We will continue to review opportunities to further derisk our balance sheet as we move forward, provide each instructions make economic and operational sense for the bank.

Going forward – and since his plans will be appropriately aligned company’s goals and objections. Previously, we had as many 22 separate incentive plans in place at any one time, which was confusing. I didn’t lead to a common approach throughout the organization.

We have now fixed this and are excited about the about the new program, that we’re about to rule out, as I’m sure our employees will be. We’re also working on a better management and procurement initiative that should centralize the process, eliminate in efficiencies and stream line the way we deal with third party vendors.

When you consider, we’ve spent in excess of $400 million over the last 18 months on third party vendors. We believe this as significant opportunity in this area. We’re also looking at ways to maximize our existing real estate portfolio. We currently have 186 rail estate proprieties, owned and released and we’re exploring ways and opportunities to unlock value.

As you can see, we’re currently working through a lot of initiatives and we’re excited about the opportunities and future potential for Flagstar.

I’ll now turn it over to Matt to talk about the mortgage business.

Matthew Kerin

Thank you, Lee, and good morning everyone. I’m looking forward to the opportunity to speak with you today. I think I’d start by saying we had a pretty good quarter from an originations and gain-on-sale margin perspectives.

If you look at slide 13, you can see that our net gain on loan sales increased from the previous quarter but trails on a year-over-year basis. The increase from the prior quarter was driven primarily to an improvement in our capitalization rates supported by our recent MSA transaction as well as secondary marketing hedge performance combined with a flat level of locks.

As you can see from the bottom chart on slide 13, the level of locks remain flat from the prior quarter but gain-on-sale margin increased over the same period. Nonetheless, we are experiencing competitive pressures in the marketplace from new entrants focusing on the emerging correspondent segment of the business as we and other competitors compete for business in a shrinking market. As you likely have heard on other calls, industry mortgage originations were strong in April but then declined in May and June as interest rates increased around 100 basis points. You can see this highlighted on slide 14.

While Treasury experienced its high rally since rates peaked, we may well be at a new normal for production as we refinance activities expected to contract throughout the remainder of this year. Consistent with our production activity, we are continuously assessing our staffing in non-interest expenses while being mindful of the production swings inherent in the mortgage business, especially during periods like this of great volatility.

Please turn to slide 15. You’ll see some additional stratifications on our residential first mortgage originations; as you can see they’re all very high quality loans with an average LTV of 75% and an average FICO of around 750. If you look at the chart on the bottom of slide 15, I’d also like to point out that we increased – we experienced a 34% increase in purchase volume which was offset by a 23% decline in refinance activity. We mentioned on the last call that we expected purchase activity to grow significantly during 2013. And now we expected to continue to be a major player in that space.

As such, we’ve been working on various strategies as we prepare for the anticipated return for a more traditional purchase-driven market. While the refinance market will continue to be a meaningful part of our overall originations, growing our share of the purchase side of the business is a key component of our mortgage strategy, and that strategy is for growth.

We aim to continue to deliver strong product offerings. We have a renewed focus on excellent technology platform which we’ll continue to combine with a reputation for service. That service level includes access to knowledgeable underwriters which is unique to the industry we believe. And this provides us a heightened level of ability to deliver certainty of closing to our GPOs, our realtors, our homebuilders and our borrowers alike.

According to recently published data from Inside Mortgage Finance, we were the fifth largest seller of purchase money mortgages to the GSEs so far in 2013.

It’s important to note that unlike many of our peers, we originate through our PPO [ph] network largely and do not rely upon a large retail distribution network to get purchase business. In fact, if you look at the chart on the bottom left, you can see that our home lending center retail originations comprise only 5% of our total.

Our GPO [ph] dominant distribution network continues to generate purchase mortgage business and we believe that will continue. We have proven that from a historical perspective as well. Looking at the top chart on slide 16, you can see that we have tracked historically to the industry mix of purchase originations. Looking closer, this has been true for each of our channels as well as evidenced by the bottom chart.

Flagstar’s mortgage strategy has been built around service and saleable products at fair price and we’re going to continue with that strategy. Going back to late 2009, we did begin to develop and execute on our long-term strategy to better focus on the purchase market in anticipation of rising rates and then return to a traditional purchase refi mix.

We have enjoyed a slightly higher than normal share of the whole purchase business market historically but we recognized then the need to be ahead of the pack so that we can earn more business from those who are proactively building relationships with realtors, home builders, and other purchase money mortgage referral sources.

More specifically, steps we’ve been taking to generate a greater share of the purchase market included the following. We’re continuing to improve and maintain superior service. Underwriting term and time [ph] speed to closing reliability, all key factors impacting our ability to land home purchase business. We’re focusing on generating more mortgage referrals from real-estate agents and home builder market. Work is underway to develop builder and purchase bundles based on best practices we’ve experienced across the country.

We are increasing our marketing efforts and training to those forward-looking TPOs [ph] actively making contact with traditional referral sources of realtors and builders in an effort to gain a larger share of a smaller market. And this would include previous customers.

We prioritize purchase applications for timeliness of review and approval, something we think is critical in today’s environment when so many people are chasing such few inventory for purchases. Further, on our large part of our business today, we continue our controlled expansion of our home lending centers with a focus on purchase money mortgage originators in those markets, markets we deem to be attractive and where we believe we’re underrepresented in the PPO [ph] space.

Appropriate product expansion and refinement of underwriting overlays consistent with an improving economy are also contributing to our value proposition. These include construction products, jumbo, hybrid and combination second loans. As well, we’re creating broad awareness amongst the TPOs [ph] and our loan officers of our loan down payment options, including private mortgage insurance, FHA, VA, and USDA, GRH programs where we had a very strong presence today.

Further, we’ve also recently reintroduced our TVD loan reviews on properties which will allow brokers and non-delegated correspondents to better compete against local large lenders offering pre-approval prior to home purchase contract signings. These are just a number of the many strategies we’re executing on today.

The focus of many of the new entrants in the TPO [ph] arena has been a replication of the Flagstar emerging correspondent offering. We assess the market and given our longstanding investment in technology, people, and our strong distribution network we can expect to continue to earn our customers’ business.

To summarize, the key to our long-term success is as it has always been, service delivery. I’d now like to turn the presentation over to Paul Borja.

Paul Borja

Thank you, Matt. This morning we’ve discussed key strategic issues and specific operational opportunities as a result of our 2013 second quarter results, and also based upon our view of the near-term outlook of Flagstar.

At this time I’ll review components of our overall second quarter 2013 results and touch on key areas that affect our outlook for financial performance during the third quarter of 2013.

Please turn to slide five which provides the condensed income statement of our second and first quarter results as well as results as well as results for the same period last year. This slide and slide six together provide more detail of our income statement and balance sheet along with our regulatory capital ratios on slide seven.

We’ve also prepared an income statement bridge on slide eight which highlights the key items that changed during the second quarter as compared to the first quarter. In total, we earned $65.8 million for the second quarter 2013 or $1.10 per share on a fully diluted basis. This compares to our earnings in the first quarter of 2013 of $22.2 million or $0.33 per diluted share.

And as you can see on slide five; our net interest income for the second quarter of 2013 declined by 18% as compared to the first quarter. This was due primarily to the decline in interest income as the average balances declined for both our mortgage loans held available for sale and the warehouse loans we originate as part of our mortgage banking business.

We discussed earlier that our locks during the second quarter were approximately the same as in the first quarter. However, our level of originations decline from $12.4 billion in the first quarter to $10.9 billion in the second quarter. This decline reduced the average balance of our available for sale mortgage loans, and because of their linkage reduced the balances of our warehouse loans.

For the third quarter, we expect that our overall earnings on our loan portfolio will not differ materially from that of the second quarter. We expect that any declines in average balances that it will be more than offset by the overall rate improvement, given a higher interest rate environment that arose during the middle of the second quarter and that we expect will continue during the entire period of the third quarter.

Also on slide five, non-interest income increased by 19%. As noted in more detail in our earnings release today, this increase reflects a number of different items. An increase in our gain on loan sales as the level of our loan locks remain steady and our margin increased by 7 basis points.

An increase in our loan administration income as we realize an $18 million gain on the sale of recent vintage mortgage servicing rights, which was offset in part by the challenges we experienced during the quarter in hedging the significant and sudden increases in market rates at the end of May and again at the end of June.

And increases in our other category also reflecting our settling the Assured and MBIA litigation; we settled the Assured and MBIA litigation items during the quarter and I’d like to take a few minutes to discuss them because the financial impact to us is contained in different parts of the income statement.

And to Assured, we paid $105 million and so reverse the remaining $5 million of litigation reserve that had been set aside for this litigation. As such, that $5 million was a benefit to us and was treated during the quarter as a credit against our legal and professional expenses.

We also recognized a $44 million gain at the time of the Assured settlement. This is because the settlement agreement allowed us to control the servicing of the loans contained in the two securitization trusts at the heart of this litigation. Under accounting rules, that control requires us to bring the assets of the trust back on to our balance sheet at fair value.

At the same time, we also brought back the related liabilities, also at fair value. The excess in fair values or the assets over the liabilities created this $44 million gain. Overall, we recognized a $49 million gain from settling this litigation.

As to MBIA, we paid $110 million and similarly reversed a further $5 million of litigation reserves we have set aside for this litigation. Just as with the assured settlement, this reversal was applied as a credit against legal and professional expenses.

So, for the quarter, legal and professional expenses decreased by $10 million from the prior quarter due to these two sets of reversals. Because the terms of the settlement lifted the MBIA insurance from the securitization trust that we already held in our balance sheet, under the available for sale securities category, we had to recognize a credit loss that had previously been covered by it. That created the $8.8 million OTTI expense you see on the income statement.

Finally, after reaching the MBIA settlement, and because we already owned that securitization, we took steps to effectively dissolve the trust and bring those loans back on to our balance sheet. With this final step, we were able to recognize a $6.1 million tax benefit which you see on our income statement under the income tax line.

But we also had to recognize a $7.2 million loss related to a reversal of other [ph] comprehensive income or OCI entry in equity section of our balance sheet. Overall, these different pieces which are in different parts of our income statement resulted in a loss of $4.9 million for the MBIA litigation settlement. Taken together, our efforts to resolve these two key legacy litigation matters during the second quarter led to a $44 million gain.

The non-interest income category also reflected declines in several items including the following, loan fees and charges which typically decline as loan closings decline. Note though that this is offset in part by decline in our commission expense.

And also OTTI, which we just discussed and which is the expense associated with the credit risk of a security, as noted, this particular expense arose as part of our overall MBIA litigation settlement.

So as you can see several of these items are non-recurring. However, gain-on-loan sales and loan administration income are key parts of our mortgage banking business. With respect to gain-on-loan sales, we’re mindful of the current view by industry analysts that mortgage loan production volumes may decline by 10% to 15% or more during the third quarter and fourth quarter of this year. We believe this level of decline is reasonable given the recent and significant increase in interest rates that has caused a rapid drop off in loan refinancing activity.

Further, based on our experience over the years in the mortgage business, we’re aware that the period of transition from a refinanced market to a purchase market can result in lower overall volumes during that time. However, the financial effect of this volume decline might be offset in part by the reduced price sensitivity or purchase oriented borrowers whose focus is generally on monthly payments rather than merely rate comparisons to an existing loan.

For the third quarter, we would expect that production volume would decline and that such decline would be directionally consistent with the general movement of the overall industry. However, we would expect that the rate of decline would be less than the industry decline due to the initiatives previously discussed by Matt. We would also expect that our margin on these loans would be slightly compressed as a result.

With respect to loan administration income, we would expect that our earnings for the third quarter would reflect our target return of 4.5% as discussed in last quarter’s call. We target this as we hedge the MSR to manage interest rate volatility which is required of all regulated depository institutions. And as such, we would expect that our earnings would be similar to that of the first quarter 2013 but adjusted for a higher balance of mortgage servicing rights as we continue to originate and sell mortgage loans during the third quarter.

In that regard, if we dispose of mortgage servicing rights during the third quarter, this outlook would be affected by any gain or loss associated with that disposition and a lower income stream thereafter because of a reduced earnings base.

Our credit costs are comprised of three items, loan loss provisions for our loans held for investment; representation and warranty expense which relates to potential put back losses from loans we sold over the years into the secondary market; and asset resolution expenses which relate to our foreclosure expenses from our healthcare investment and insured government loan portfolios as well as expenses associated with GSE loans.

As noted earlier, we have seen improvements in the credit quality of our health investment portfolio as our credit delinquencies have declined. Also, the potential loss severities of those loans are expected to diminish to the extent that home prices rise and thus increase the value of our collateral.

We did during the second quarter increase our provision by $11 million, most of which was to reflect the emerging risks associated with defaults by borrowers with interest-only loans once their loan payments reset and they then have to pay both principal and interest. As noted earlier, we are continuing to monitor this portfolio closely and we’ll include consideration of any further developments into our overall analysis of the allowance for loan losses.

Our provisions for the representation and warranty reserve by which we reserve potential losses from loan put backs increased by $11 million in the second quarter. This resulted in the provision of approximately $29 million for the second quarter and allowed for a reserve of $185 million at June 30. We evaluate this reserve every quarter, and based on our reviews to date would expect a similar or lower provision for the third quarter and could expect a decline thereafter.

With respect to our asset resolution expenses, we are monitoring our foreclosure expenses carefully especially in light of our recently announced outsourcing of our default servicing. Once such outsourcing is complete, we would expect significant savings in this area. However, given the transition time necessary to fully effect the outsourcing process, we do not expect any significant declines in this expense for the third quarter.

Asset resolution expenses are part of our overall non-interest expense category. And total non-interest expense decreased by $22.2 million from the prior quarter, primarily reflecting lower compensation and benefits, lower commissions and lower legal and professional expense. The decline in compensation was related to the timing of payroll taxes in the prior quarter. The decline in commission was tied to the decrease in mortgage reduction volume we experienced during the second quarter, and so this expense decline was offset by the decline in loan fee income.

And the decrease in legal and professional expense was driven by the $10 million credit arising from the release of reserves for pending and threatened [ph] that we discussed earlier relating to settlements with Assured and MBIA.

For the third quarter, we would expect that our efficiency ratio would be similar to that of the second quarter. While we would not expect that non-interest expense would be reduced the reversal litigation reserves as was the case during the second quarter, we expect that similar benefit could be achieved with a lower legal and professional fees post litigation as well as by the enhanced cost reductions discussed earlier by Lee.

With that, I’ll turn it back to Sandro DiNello for the question-and-answer session.

Sandro DiNello

Thanks very much, Paul. I guess, we’ll get Rufus [ph] back on the line to get the questions that are on the queue.

Question-and-Answer Session


(Operator instructions) And for our first question, we go to Paul Miller with FBR.

Paul Miller – FBR Capital Markets

Yeah, thank you. Thank you very much. On selling on the NPAs, is there any thoughts of continuing to sell into the third and fourth quarter just to clear them out? Hello?

Sandro DiNello

Yeah, I’m sorry, we had a little trouble with our speaker here. Yes, that’s something that we’re considering and it could be a possibility. We’re going to continue to evaluate those opportunities. And if something that makes sense comes along, we won’t be afraid to pull the trigger.

Paul Miller – FBR Capital Markets

And then with the MSR sales, there’s a lot of rumors out there. I don’t want you to comment on rumors, but can you just give me your – I mean, you say you want to be a primary servicer but there’s – we keep on hearing that you’re going to sell a big chunk of these MSRs away. But on the non-performing servicing by our calculations it’s only roughly $4 billion or $5 billion of UPB, am I correct?

Lee Smith

Yes. So, yeah, I mean, look, Paul, there have been a lot of rumors. All I can say right now is we’re still evaluating our options when it comes to the MSR strategy. But I do want to make it clear that we have no intention of exiting the performing service in business, as I mentioned. That’s a business that we feel we’re good at and we want to grow.

Paul Miller – FBR Capital Markets

And then, can you talk a little bit about your mortgage originations? I think a lot of people – I think more of the reason why the stock is down or the negative commentary, yeah, we know refi is down 50%; yeah, we know that gain-on-sale margins and whatnot is going to decline, but I think a lot of people in the industry feel that in the second half of the year a lot of these mortgage banks – like you would not be able to make money and the gain-on-sale margins will get annihilated to a point where it would be barely – you’d be – you won’t make any money.

And again, on top of that, can you talk a little bit about your variable cost associated with the origination business? That will probably be taken out also.

Matthew Kerin

This is Matt, Paul. How are you?

Paul Miller – FBR Capital Markets

How are you doing?

Matthew Kerin

Good. I think that, obviously, with the rate move-in that occurred in the April, May, early June timeframe, we saw a lot of volatility and we saw a pretty precipitous decline in the refinance activity. I guess, the good news or the silver lining there was that we had the opportunity to experience a pretty good uptick in the purchase business. And in particular, Flagstar, I think, there was a recent publication that showed us as the number five purchase originator in the first six months of the year to the GSE. So, clearly, there is going to be an expectation.

I think Fannie just came out with some new estimates for the second half that show roughly a – I don’t know, somewhere between a 10% and a 15% decline over their previous estimates for the second half.

We have seen some stabilization or leveling off with rates over the last months and we’ve seen the refinance activity kind of pick up as people in defense [ph] come back into the market. We think there’s ample room to grow. Obviously, when you have an overcapacity situation, margins do get stressed. But I think what you have to do is be well positioned as we’ve tried to be in the purchase market with the product offerings, and the credibility from the service levels and ease of doing business perspective to leverage our footprint and our network to increase our share.

So I would say that we’re guardedly optimistic if I could use the phrase when I’m [ph] making a forward-looking comment that we’re doing all the right things to generate growth in the production activities. From a variability of cost perspective, obviously there’s always room for refinement in your efficiency.

We have always been a utilizer of third-party providers. We have used that to manage our overflows. We’ve also been fairly diligent in using over time and weekend work. We are one of the few shops who does provide direct access to our underwriters, which on the one hand may seem to be inefficient but on the other hand it adds a heightened degree of certainty at closing when you can talk to the people and get conditions understood there. So I think it will continue to manage through that. We have actually reduced the number of contractors over the course of the last several weeks, whether they’re MI underwriters or internal reviewers or the like, and we still have room – opportunities to do that further should the situation warrant.

We are very efficient in terms of our production on mortgages from a number of units internally; always room for improvement. We’re looking at IT and other methods and with the help of Lee and some of the other resources we’ll continue to look at our workloads and processes to maintain a diligent and regimented expense base.

Sandro DiNello

Paul, this Sandro. Let me just add and I think I’ve said this in the comments but I want to reiterate this, and we’re going to be aggressive about gaining greater share in the purchase market. We’ve got capacity to do that. I’ve personally been out to three of our markets – Washington, California, Texas, and I can tell you that customers love doing business with Flagstar.

So, if we provide the service that they need to be able to close their deals, we will get their business and I can tell you too that there’s nobody out there that’s knocking out the ball out of the park, so we think we can take advantage of that position and all the things that Matt just talked about. So, we’re going to be after it hard and fast and I know it’s just talk but we’re going to get there.

Paul Miller – FBR Capital Markets

Okay, guys, thank you very much. Great quarter.

Matthew Kerin

Thank you.

Sandro DiNello

Thank you, Paul.


And for our next question, we go to Kevin Barker with Compass Point.

Kevin Barker – Compass Point

Good morning everyone. During the quarter you reported a unadjusted increase on the gain-on-sale margin from 107 [ph] to roughly 130 [ph]; could you talk about how much of this gain was related to MSR capitalization versus cash gain-on-sale? And could you breakout the different gain-on-sale margins that you’re seeing between the correspondent wholesale and retail channels?

Paul Borja

Hi, Kevin, Paul Borja, how are you? When we take a look at our gain-on-sale first of all, I appreciate what you’re saying with respect to channel profitability, that’s something that we look at internally but we haven’t yet publicly disclosed. We’re working on that. We’d be happy to include that down the road but at this point we’re not looking at gain-on-sale channel profitability disclosures. But it is something we monitor.

With respect to the MSR capitalization rate, our MSR capitalization is part of our overall gain-on-sale is, we believe, reflected of the overall marketplace. I think if you take a look at the earnings release, we do have within there our basis points and also our cap value. And from there you can see that our current cap rate is 3.7 which compares to 3.3 in the prior quarter. Really, 3.7 is very – on a blended basis is competitive and consistent with the marketplace. And as much as we do fair value all of our mortgage servicing rights. So we don’t breakout the cash versus non-cash value but we can certainly consider that as additional disclosure.

I will tell you that overall, and when we take a look at gain-on-sale, what we do look at is the value propositions that comes in the door and then our value proposition in the secondary marketing desk as protect our profit – and I’ll tell you that our secondary marketing group has done a tremendous job in a very turbulent time during Q2 to protect and add to the profitability.

Kevin Barker – Compass Point

Okay. And then shifting to some of the MSR sales that you had and follow up with some of the questions Paul had; did I hear you right where you had $18 million gain on the sale – the $12.7 billion portfolio during the quarter.

Sandro DiNello

Yeah, that’s correct. What we want to do is make sure that when you take a look at the loan administration income on the income statement and compare it against Q1 that you’re aware of that particular amount so as to be able to properly model from a run rate perspective Q3.

So as we talked about and during the course of the call, our Q3 outlook really relates back to Q1 rather than Q2 so that you take that properly [ph] into account.

Kevin Barker – Compass Point

Okay. And then, related to the sale, the 4% of your service – the subservicing, the 4% of your total servicing portfolio, could you talk about, I mean, talk about the lost fee revenue given that you’re having roughly $20 million of expense saves [ph] related to that portfolio, could you talk about the other side of it?

Lee Smith

Sure, yeah. This is Lee. So the lost revenue is pretty small. So the $20 million is net savings. And to be totally candid with you, in 2012, we were losing in excess of $30 million on the default servicing side. So the revenue associated with that is actually less than $10 million.

Kevin Barker – Compass Point

Okay. And then finally, concerning your – the sales of your NPLs, is there specific buyers that are bidding for these assets and are you seeing a significant amount of competition for the sale of non-performers in the market right now?

Lee Smith

Sure, this is Lee again. Yes, there is significant competition. And we worked through an investment bank to action [ph] the two sales that we referenced in the second quarter. And as Sandro said, I mean, we will be opportunistic if a future transaction makes sense for us, both from a profitability and from an operational point of view, then we will look to execute on that. But the market is strong at the moment and there’s a lot of competition.

Kevin Barker – Compass Point

Are you selling particularly to one counterparty or is this several counterparties you’re looking to sell MPAs and TDRs?

Lee Smith

We’re open. I mean, we’re not just looking to sell to one particular counterparty. We’re looking to – we’re open to the best bidder basically.

Sandro DiNello

And let me be clear, Kevin, this is Sandro; we may not sell anything. We may determine that the best way to move ahead here is to work through these ourselves. We’ve been able to move our asset quality ratios to a level that we’re pretty comfortable with right now, so we don’t feel pressure to do anything. If the right opportunity exist, as I said earlier, we’ll pull the trigger on it, but we’re certainly not particularly anxious about doing another transaction. We don’t feel we need to. We will do it only if it makes sense.

Kevin Barker – Compass Point

All right. Thank you for taking my questions.


(Operator instructions) We’ll go next to Bose George with KBW.

Bose George – KBW

Hey, guys, good afternoon. Just a question on gain on sale margin trends. Can you comment on trends that over the course of the quarter and since the end of the quarter, how they’ve looked.

Paul Borja

Hi, Bo. It’s Paul Borja. How are you?

Bose George – KBW

Hey, Bo.

Paul Borja

As we’ve been going through and as we talk about it on the speech, we look at an inflection point during the course of the quarter as everyone else did from the refi to the purpose market. And consistent with that, what we did see were changes in the overall margins, which is why you’ve seen us be able to take advantage of some opportunities in the inflection point, but we don’t expect that those opportunities will continue to Q3.

If you take a look at a primary-secondary spread, you do see some consistency in a primary-secondary spread, but just at a higher level as we’ve seen because of a May and the June run-ups at month end, in respect to the month end on a 10-year Treasury and related on mortgage. So we do see with that inflection point and with the increases a shift to the purchase and our ability because of folks in late May and in June entering into refi arrangements prior to higher rate. We do see that we’re able to protect some of the margins in that context.

However, for Q3, Bose, we’re not going to be – we don’t foresee that same opportunity arising in mid quarter. And so that’s why our outlook was styled the way it was.

Matthew Kerin

Bose, this is Matthew. I think we had a lot of volatility rates in the last quarter and with all reference, obtaining jobs, the secondary folks did. But our base margin, if you will, is fairly consistent right now.

Bose George – KBW

And the base margin meaning just the spread at which you execute?

Matthew Kerin

Our primary pricing model, yes.

Paul Borja

Right, correct.

Bose George – KBW

Okay, great. And I just wanted to follow up on the servicing, the questions. In terms of growing that business, is that going to come from your own originations or is there a subservicing opportunities you’re exploring as well?

Lee Smith

Yes. So on the default side are you referencing or on the –

Bose George – KBW

No, actually on the performing side.

Lee Smith

Yeah, on the performing side, it would be both from – we’re looking at opportunities both from our own originations and subservicing loans for other organizations, as mentioned earlier in the call.

Bose George – KBW

Okay. And actually going back to the question on the product mix, do you guys break out just HARP mix quarter over quarter? Did that change much at all?

Matthew Kerin

Break it out, this is Matt Kerin.

Bose George – KBW

Hey, Matt.

Matthew Kerin

On slide 15, there is a mention. It’s been fairly consistent. We’re running in the 8.5%, 9% range. We peaked earlier on when the product first came out like everyone do with a pent-up demand. And then, that kind of a rate, it eroded a little bit. And then, when the program was reinvigorated, we stepped up a little bit. But it’s been a nice pleasant, steady piece of business for us, and we expect that to continue.

Bose George – KBW

Okay, great. Thank you.


And we go next with Ken Bauso with Elementum Management.

Ken Bauso – Elementum Management

Hi. Thank you for taking my question. My question is regarding normalized legal and professional expenses. So we’re coming out of this period which I would say is clearly some extraordinary legal cost hopefully coming out of it. So without asking for guidance as to when you think we’ll get there, how would you think of legal and professional expenses once we are through this period of downturn in ‘08, ‘09.

Paul Borja

Hi, it’s Paul Borja. With respect to legal and professional expenses, you’re correct, and we talked about it in the speech that we do expect with respect to the MBI and assured litigation, significant downtick in expenses led for those. It’s clear that over the prior periods we’ve had some significant expenses and as we talked about it, it’s been very – we did reach – it resulted some favorable result. It came to some favorable results in Q2.

In Q3 and Q4 and going forward as we are shifting our focus from the legacy litigation matters, we do want to make sure everyone understands there are still litigation matters out there. In fact, we expect to file our 10-Q later this month. And a key part of that overall exposure is going to be pending and threatened litigation matters. At this time, though, as Sandra has noted, from a remaining legacy litigation perspective, we believe we put those behind us. So as such, we would expect that you would see a downtick in the gross amount of legal and professional fees. Just a reminder though, if you do take a look at the breakdown both in the earnings call, as well as in more detail in the 10-Q, that the legal and professional expense line item does reflect the $10 million credit from the reversal of those reserves that we’ve previously put through there.

Mike Flynn

So this is Mike Flynn, General Counsel. I should also add that, one way out, when we complete our efforts to outsource our default servicing, depending upon the terms of the arraign that we make with the subservicer, some of our current litigation cost in that area we’d like to be transferred to that servicer. We can’t quantify that amount right now, but that’s an event that will happen.

Ken Bauso – Elementum Management

Well, what do you think – using this quarter as an example, how much would you estimate do you spend this quarter on professional and legal expenses that were not related to the real estate downturn at ‘08, ‘09?

Paul Borja

Hi, it’s Paul Borja. I’m sorry, I just don’t have that off the top of my head. We can take a look at that and then chat with you offline.

Ken Bauso – Elementum Management


Paul Borja

And then certainly think about putting that in the 10-Q because that is an important question from the respect of moving past the legacy side. So why don’t we do that and we’ll look at the 10-Q, if that’s okay.

Ken Bauso – Elementum Management

Great, Paul. Thank you very much.


And we go next to Henry Coffey with Sterne Agee.

Henry Coffey – Sterne Agee

Yeah, good morning, everyone. And I’ve listened to these calls before and wanted to compliment you on the quality of what you’re doing here. It’s quite impressive. Help me out here. I may be making a mistake. You said the gain on the servicing sale was $18 million on $12.7 billion. That’s 14 bps or like 0.5x. Is that because it was – am I doing my sums wrong here or is that because it was delinquent servicing? I may be making a mistake or maybe need a little –

Paul Borja

Yeah, hi. This is Paul Borja. First of all, we wanted to make sure that we highlighted the $18 million so that from a run rate perspective, that wasn’t taken into account from going forward in Q3.

Henry Coffey – Sterne Agee

Well, yeah, I’m not worried about – I’m just trying to focus in on the MSR valuation on the sale.

Paul Borja

Sure. Secondly, it was a significant amount. As you know, over the course of the last few years, we’ve sold MSRs on an occasional basis. And generally what we do with conference calls, we indicate the amount of MSRs so that investors can reconcile the pluses and minuses. In this particular case, there was a rather significant gain with respect to this MSR portfolio. This was not older vintage. This was not old vintages, the legacy vintages. These were region vintages.

And so what it reflects, if you will, was an inflection point in MSR valuations as folks took a look at both, we believe, funding on the sidelines as well as a rising interest rate scenario. So in that context, we’re able to move forward and close that transaction.

Henry Coffey – Sterne Agee

I mean, no, no. You’re missing my question. $18 million gain divided by $12.7 billion in servicing is 14 basis points. Most people value servicing at about 100 basis points, or am I just doing my math wrong, which is totally possible, my advanced –

Paul Borja

Well, you’re –

Henry Coffey – Sterne Agee

I’m sorry. You said the gain in this – I’m just trying to get the right set of numbers, enumerators and denominators.

Paul Borja


Henry Coffey – Sterne Agee

So, sorry, but I’m just trying to get the numbers right. I understand the sale process.

Paul Borja

So I understand that. So I apologize. So I understand your question.

Henry Coffey – Sterne Agee


Paul Borja

The MSRs are carried fair value on a daily basis. And so we mark those deferred value.

Henry Coffey – Sterne Agee

Thank you.

Paul Borja

There’s an inflection in the marketplace that causes the value to go well above previously established valuations and, as such, that it creates this gain.

Henry Coffey – Sterne Agee

So it’s an $18 million gain over the carrying value of the MSR?

Paul Borja

Over the fair value of the MSR, which we carry.

Henry Coffey – Sterne Agee

Can you tell us what the gross sale was?

Paul Borja

I’m not sure if we have that much detail in there. Let me think about it.

Henry Coffey – Sterne Agee

We were told it was sold at north of 100 basis points. Can you put that into context for us?

Paul Borja

No. I think that what we could do, what we normally do is we’ll talk about movements within the MSR portfolio so you can reference the overall balances.

Henry Coffey – Sterne Agee


Paul Borja

And then we’ll highlight significant changes to the extent there’s a P&L affect that’s material so that it’s not going to affect run-rate analyses.

Henry Coffey – Sterne Agee

Right, right. No. But I was just looking at – a lot of us have been asking question about the MSR sales. No, your sale, you didn’t sell it for 14 basis points. You obviously sold it for something better than that. So thank you.

Paul Borja

You’re welcome.

Henry Coffey – Sterne Agee

Thank you very much.


And we go next to Kevin Barker with Compass Point.

Kevin Barker – Compass Point

Yeah, I just have a follow-up on your capital. Given that the Fed recently finalized the roles concerning Basel III, could you give an update on where your Basel III ratio would stand and how much of your MSR portfolio would potentially be for sale in order to get it to roughly the 7% tier one common equity ratio that’s required?

Sandro DiNello

Yeah, Kevin, let me just – thinking about your question, so yeah, as you know, the new rules were released just a few weeks ago, so we’re evaluating the impact that they’ll have both on the bank as well as the consolidated holding company. One of the largest impacts, one that will [inaudible] for us will be the permanent grandfathering of the trust preferred [ph]. This will be a big benefit for our consolidated ratios but there’s really no impact on the bank ratio if we don’t hold the preferred stock at the bank level.

The change in risk weighting on the residential mortgages that came in the final lieu [ph] also helped given the size of our residential portfolio of course. And then obviously, MSR deductions are key for us. But we think that we’ll be able to [inaudible] this to our earnings growth and by disposing our MSR as we’ve always done. So while we’re not ready to release any pro forma ratios yet, our initial estimate show that we are in compliance with – that we will be in compliance with all the required ratios on a fully [inaudible] basis as of June 30, 2013.

Does that answer your question?

Kevin Barker – Compass Point

Yes, it does. And then, concerning the OCC consent order and the capital plan that you’re working with the OCC, are they taking into account the Fed stress test that you have to go through and is that a main item that they’re looking at concerning how your capital plan is going to lay out over the next several quarters, even several years.

Sandro DiNello

This might surprise you that I can’t get in to too much detail about that. We have been working closely with the OCC and devoted significant attention and resources to addressing all of the matters identified in the consent order. We have delivered a capital plan that includes all the required stress testing and along with everything else in the consent order we’ve – we’re waiting for a complete review by the OCC, but we’re pretty confident that we’ll be able to achieve full compliance with the entire order as soon as possible. And although I can’t say any more about that, I can tell you that I am very pleased with the progress we’ve made on everything on the regulatory front.

Kevin Barker – Compass Point

All right. Are the regulators concentrating more on how you were looking from a Basel III perspective or a Basel I perspective?

Sandro DiNello

Well, they’re concerned about both of course. They’re concerned about where we’re at today from a Basel I perspective and where we will be on a projected basis on Basel III. So, I’m very comfortable that we’ll be able to meet all the requirements of Basel III and I think that the regulators will have to review that and time will tell whether we’re able to do it or not.

Kevin Barker – Compass Point

Okay. Thank you for taking my questions.


And with that, ladies and gentlemen, we have no further questions on our roster, therefore, Mr. DiNello, I will turn the conference back over to you for any closing remarks.

Sandro DiNello

Yes, thanks everyone. I hope you thought that our presentation today was helpful to you. We’ve obviously – we]re much transparent than we have been historically. We’re going to continue to be that way going forward. And we look forward to delivering better results for you going forward. That’s our goal. This management team is very committed to getting things right, growing revenues, controlling expenses, remaining compliant and we look forward to doing that.

Thanks for taking the time to listen to us today.


And, ladies and gentlemen, this will conclude today’s conference, thank you for your participation.

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