Flagstar Bancorp Inc. (NYSE:FBC)
Q4 2009 Earnings Call
February 2, 2010 11:00 am ET
Joseph Campanelli - Chief Executive Officer
Paul Borja - Chief Financial Officer
Sandro DiNello - Head of Retail Banking
Matthew Kerin - Executive Vice President, Managing Director & Corporate Specialties
Jessica Halenda - FBR
Bose George - KBW
[Michael Roman - JP Morgan]
Ladies and gentlemen, thank you for standing by and welcome to the Flagstar Bank fourth quarter, Investor Relations call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. (Operator Instructions)
I would now like to turn the conference over to Mr. Paul Borja, Chief Financial Officer. Sir, you may begin your conference.
Thank you. Good morning. My name is Paul Borja and I am the Chief Financial Officer at Flagstar Bancorp. I would like to welcome you to our fourth quarter earnings call. Before we begin our comments, let me remind you about a few things. This presentation does contain some forward-looking statements regarding both our financial condition and our financial 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, competitive pressures within the financial services industry and legislative or regulatory requirements that may affect our businesses.
For additional factors we urge you please see our press release that we issued last night and our SEC documents as well as a legal disclaimer on page two of our slides we have posted our Investor Relations website for this speech.
I would like to now turn the call over to Joseph Campanelli, our Chairman and Chief Executive Officer.
Thank you, Paul, and welcome everyone. I would like to first talk about where we stand overall the several initiatives we have underway. We were working to strengthen our competitive position, return to profitability, and maximize the value of the Flagstar franchise.
Our focus is threefold. First to deliver improved financial performance on a consistent basis, next to refine our business model and tried to focus and strategy and to better position Flagstar for long term stability and success. We have implemented a new organizational structure to better align profit centers, promote accountability, and improve corporate governance.
Our Executive Management Team, see considerable promise in the Flagstar franchise and strong potential for a return to profitable growth and diversification of earnings. I would like to take a few moments to discuss some of the highlights of our plan for 2010. We have developed a comprehensive business plan that focuses on the quality of our legacy loan portfolio, improved operating efficiencies, and new revenue sources.
This plan has been approved by our Board of Directors and has been reviewed without objection by our primary regulator. Great deals of resources have been allocated to addressing the elevated levels of delinquencies and problem loans in our residential and commercial real estate portfolios.
Significant losses have been incurred over the past several years as the markets we serve have been hard hit with higher unemployment, a weak housing market, and increasing vacancies in commercial real estate. We have increased our loan loss reserve to almost 6.8% of loans held for investment.
In addition, virtually no new loans have put on our balance sheet since 2007. Our forecast for loan loss division that would provide as one of our key drivers has been estimated assuming continued weakness in employment and housing values. As the portfolio continues to season, year-over-year non-performing assets increased to $1.3 billion at December 31, 2009, from $848 million at December 31, 2008, which led to both credit losses and a reduction in net interest margin.
We believe our asset quality issues are well understood and being managed appropriately. We continue to allocate additional resources to accelerate the disposition of problem assets and improve our servicing capabilities. We are projecting that these efforts will mitigate losses and improve net interest margin.
As I had mentioned, the increased delinquencies in our legacy balance sheet are attributable to a static pool of loans. In our commercial loan portfolio we believe that our substandard and otherwise classified assets peaked at September 30, 2009, at $462 million and have since been reduced by 10% to $415 million at December 31, 2009.
Similarly, the 30 and 60-day delinquent segment in our residential mortgage portfolio have shown some signs of improvement with the delinquency rate holding steady for much of 2009. The 90-day plus delinquent segment in our residential portfolio climb dramatically in 2008 and it continued to moderately increase throughout 2009.
However the rate of increase has flattened considerably during the second half of 2009. We have provided greater transparency relative to the composition and characteristics of the loan portfolios. The debt supporting our earnings release contains a variety of charts that may help you in getting more comfortable with the underlying portfolios and our ability to clean up the challenges of the legacy portfolios.
As you know, Flagstar, as one of the largest conforming mortgage originators in the United States, originating over $32 billion of residential mortgages in 2009.Currently, our mortgage banking operations comprised almost the entirety of Flagstar as well in generation. Absent a more diverse mix of revenue sources, such as consumer banking products, business loans, cash management, and treasury services, Flagstar has historically been subject to significant volatility from changes in the interest rate environment.
New home purchases and refinancing activities are key drivers of our current business model and are tightly correlated to interest rate movements and economic activity. As we look to lessen our volatility, we see a significant opportunity to diversify our product mix. As part of our plan for 2010, Flagstar has begun the process to rebalance our revenue streams and reduce our reliance on the mortgage business. Make no mistake we were absolutely committed to maintaining our position as a top national mortgage originator.
However, overtime it’s our goal that new incremental revenue streams from small business banking, cash management services, middle market commercial and specialty banking, along with government banking will continue to add significantly to our business model. New additions to our management team, knows these businesses well and have vast experience in building these platforms.
Our research indicates that with 500,000 small businesses reside within close proximity to our community banking offices making it’s a right market for us. Additionally, Flagstar intends to capitalize on our 162-branch network, to increase cross sells in areas of retail and consumer banking. We are well positioned to felt the vision of a real community bank in the markets we serve.
We are confident, we can prudently expand our share of customers wallet through effective cross selling of multiple products, including credit and debit cards, consumer and commercial loans, cash management, and merchant services. This revenue stream diversification is an important part of Flagstar’s long-term strategy. We are committed to being an industry leader in mortgage origination and have already began to integrate mortgage banking into our strategy for growing revenues through our branch network.
During the fourth quarter of 2009, an initiative was kicked off to begin originating mortgage loans in Flagstar’s banking offices. As we work to improve cross-sale ratios with existing customers, we have developed a group of primary products around which we have focused our sales and marketing efforts.
Our goals and objectives are focused on growing the rate of new customer acquisition along with a number of products and services we provide. We are well on our way to building a top quality leadership team. The new organizational structure, which is provided in the appendix of our slides, has been established to provide appropriate alignment with our strategy and improve accountability and transparency.
Sal Rinaldi, in addition to his responsibility as Chief of Staff, is responsible for leading the project management office or PMO. The PMO provides a systematic review and approval process for all key projects and initiatives within the company. I’ve had the pleasure of working with Sal for close to 30 years. He played a critical role in helping me lead the transition of Sovereign Bank from a traditional regional thrift to an $80 billion full service bank.
This past October, Marshall Soura joined our team to head IT, operations and product development. Marshall brings over 40 years of experience in retail and commercial banking. He’s lead similar transitions and implementations throughout his career, most recently at Sovereign Bank.
In this past quarter Matthew Kerin, has joined Flagstar and is responsible for leading our mortgage banking, capital markets, and warehouse lending activities. I’ve also had the pleasure of working with Matt for almost 20 years. Matt is a veteran banker, bringing with him substantial experience developed through his leadership at Sovereign Bank, Bank of America, and Fleet Bank.
Most recently, we announced the appointment of Todd McGowan as our new Chief Risk Officer. Todd is a 22 year veteran of Deloitte & Touche. He has worked with a wide range of companies assisting them in the development and implementation of best practices in enterprise wide risk management. The new members of our executive team are great complements to the strong foundation formed by Paul Borja, our Chief Financial officer; Matt Roslin, our Chief Legal Officer; and Sandro DiNello, our Head of Retail Banking.
Since joining the company I’ve been extremely impressed with its deep culture and values and the engagement of the entire work force. I’m excitedly working alongside a team of dedicated and experienced professionals. While we, like many, have significant challenges, we also have substantial opportunities.
Our competitive strength and resilience is deeply rooted in the commitment of all team members to work together to build a better bank. We are fortunate we have an executive team that has successfully implemented similar strategies and is prepared and capable of beating the challenges we face.
Last week we were pleased to announce that MP Thrift Investments L.P. had substantially increased their investment in Flagstar through participation in our rights offering. They invested an additional $300 million. We anticipate maintaining a capital position in excess of 8% as we move forward. Once again the capital raise will be important as we manage through the balance of our loan portfolios and maintain desirable capital ratios.
We anticipate having a significant cushion above well capitalized levels for regulatory purposes for each of the three years 2010 through 2020, but this significant investment, as well as other participations and rights offerings, also served as an affirmation of the strong fundamentals of the Flagstar franchise. The rights offering, as we have previously announced, expires on February 8.
We also announced that we entered into supervisory agreements with the office of Thrift Supervision. Maintaining good relationships with our regulators is a high priority for us and we have worked very closely with the OTS on the items in our agreements, all of which we believe are based on tenants of good governance.
Our business plans is closely aligned with our regulatory agreements and reflect many discussions with the OTS so that we are able to develop a plan that addresses OTS concerns and keeps Flagstar moving in the right direction.
Closing out my opening comments this morning, I would say it’s clear that in order for Flagstar to return to profitability we need experienced and talented management, we need a strong vision and plan for a future, and we need the capital to execute the plan. I am happy to say that we are now well on our way to having all three of those components in place.
Now I would like to turn things back over to Paul Borja, so he can share with you our fourth quarter earnings results. Then I will provide an outlook for 2010 and a summary of our key drivers. Thank you.
Thank you, Joe. This is Paul Borja. I am going to touch on the 2009 overall results as well as Q4 2009 comparative linked quarter for Q3. Overall, our key themes during 2009 and during Q4 were the losses continued, to primarily due to credit losses, but they were offset by our gain on loan sale income.
In looking forward we expect lower loan production and tighter loan margins, deposit growth and composition challenges, and continuing Federal Home Loan Bank collateral challenges. However, we do expect that credit costs are expected to moderate by midyear and we also expect net interest margin to pick up because of Federal Home Loan Bank prepayments that we made during 2009.
Our focus will be on expense savings and diversifying revenue sources. On a linked quarter basis Q4 versus Q3 we had a loss in Q4 of $71.6 million versus a Q3 loss of $298.2 million, which is a 76% improvement. On a quarter-over-quarter basis Q4 of ‘09 versus Q4 of ‘08 we had a 67% improvement against a Q4 of ‘08 loss of $ million. Year-over-year our loss was $513 million against a 2008 loss of $275 million.
On a linked quarter basis our net interest income was before provision, was effectively flat due to the effective security sales, and reduced production of our available for sale loans. It was offset, however by lower deposit costs and lower amounts of FHLB advances. Our net interest income was also relatively flat on a linked year basis.
Our cost of funds in Q4 versus Q3; our Q4 cost of funds was 3.16% against 3.95% in Q3 and overall for the year it was 3.53% against 4.14% in 2008, so our cost of funds declined based upon our reduced deposit costs as well as Federal Home Loan Bank advance costs. Our provision declined $30.5 million to $95 million in Q4 versus Q3 reflecting lower reserves for our commercial real estate as well as lower charge-offs for first mortgages.
Some key ratios to consider as against other institutions our non-performing assets to total assets in Q4 were 9.24% against Q3’s 8.41%. You should note that this ratio for Q4 is off of a declining balance sheet in Q4 versus Q3 in addition to an increased NPA, had we taken the Q4 NPAs against the Q3 higher balance sheet, the Q4 ratio would have been 8.73% that is a 32 basis point increase. Our net charge-offs to average loans for Q4 was 1.24% against the Q3 of 87 basis points.
Our net charge-offs did increase and our loan balance decreased because, as we’ve mentioned before, we have a static pool of loans that pays down and there aren’t any significant originations. So the denominator in that ratio continues to decline. Overall, 2009 versus 2008, we had a 4.2% ratio against a 79 basis point ratio in 2008.
Our non-performing loans to total loans in Q4 were 13.89% against a Q3 ratio of 12.98%, and against a Q4 2008 ratio of 7.95%. Our gain on loan sales in Q4 declined $7.9 million, reflecting the fair value effect of our increased rates on our mortgage pool as well as decline in locks. In Q4 our locks were $7.9 billion versus Q3 locks at $8.7 billion, and in Q4 our loan sales were $7.1 billion versus our Q3 loan sales of $7.6 billion.
For loan administration income which also serves as a key part of our overall drivers, our loan administration income increased by $35 million in Q4 versus Q3 due in large part to the change in the interest rate environment. Our Q4 net loan administration income was $26.9 million against a loss in Q3 of $8.6 million. As you look at the income statement in the press release and in the quarterly financials and the 10-Ks as filed, please remember our loan administration income is netted against our trading securities, which serves as an on-balance sheet hedge.
For Q4, our non-interest expense declined $16.2 million. Our compensation expense declined $5 million, which results from fewer employees, a reduction in our incentive compensation, and elimination of our employer 401(k) contribution. Other taxes declined by $12 million Q4 versus Q3, primarily due to the deferred tax asset valuation reserve, which we took in Q3, which we discussed last quarter.
We do have other expenses in G&A grouped into our income statement and that includes a warrant expense pickup in income of $4.2 million due to a stock price decline and that represents a $7.8 million change from Q3. Our G&A expense in Q4 also increased about $8.3 million due in part to a $16.5 million pre-payment that we made to pre-pay $650 million of FHLB advances. That increase in pre-payment was offset in part by a $4.6 million recovery that we had based upon termination of an agreement for our captive reinsurance subsidiary.
On a linked-year basis, our net interest income did decline by $10 million or a 4.8% decline based upon a decline in earning loan balances offset by a decline in deposit costs and FHLB borrowing costs, our provision for loan losses increased by $116 million as we looked at increased residential charge-offs during the earlier part of the year as well as updating of our commercial real estate appraisals.
Our gain on loan sales for the year, increased by $355 million as against 2008, please remembers that we now measure our gains using fair value. We made the election at the beginning of 2009 and now we look at the fair value changes in locks in our forward sales and in our available-for-sale mortgage pool, as well as our actual sales and related costs.
Our non-interest income declined. We had a write down within the non-interest income of residual and transfer interest of about $58 million. We also had a reduced OTTI expense, other than temporary income expense, of $41.6 million in 2009 versus 2008 due in large part to the new accounting standards that were implemented in 2009.
Our secondary marketing expense, which relates to our reserve for loans that we’ve repurchased in the secondary market, increased by $58 million during 2009 versus 2008; and our FHLB dividends on our stock that we hold as part of our arrangement with the FHLB declined by $12 million.
On the non-interest expense side on a linked year basis, our asset resolution, our overall non-interest expenses increased by $123 million. This is due in part to our asset resolution expense, which increased $50 million, including about $25 million related to valuation of some real estate owned.
Our FDIC expense for the year increased by about $28 million and this arises from the special assessment during the course of the year, as well as from the new assessment rules from the FDIC.
Our warrant expense was $23 million in 2009 versus none in 2008. This relates to the expense that arose from the Treasury warrants we issued in January of 2009, as well as change in value of warrants we had issued back in May of 2008.
Our commission expense declined by about $35 million as we implemented new commissions structure as well as restructured some of our home lending office reimbursements and finally, on a 2009 versus 2008 basis our other taxes declined increased about $12 million due in part to the deferred tax asset valuation reserved we discussed earlier.
With that I will turn this back to Joe.
Thank you, Paul. On page 25 of the presentation we provide an outlook for 2010 of each of our key drivers, the first of which is asset size. We are projecting that we will end 2010 with an asset size between $12.8 billion and $13.6 billion as we continue to emphasize our higher margin regulatory capital levels and selling virtually all of our residential mortgage production rather than growing the balance sheet.
At December 31, 2009, our total assets were at $14.0 billion. We are not intentionally adding any new loans to our investment portfolio as we continue to shrink our assets to normal loan pay off. In addition, we also intend to continue reducing our wholesale deposits, Federal Home Loan Bank borrowings, and shrink the liability side of the balance sheet.
Our goal is to optimize the balance sheet to run at higher regulatory capital levels and ultimately replace non-performing loans that are resolved with a more diversified asset base and increased focus on core deposits as a long term funding source. Second residential mortgage originations we are forecasting a range of $24 billion to $28 billion in residential mortgage originations for 2010.
This reflects a projected decline in industry estimates for mortgage volume offset by an increase of roughly 15% of our market share based on a number of initiatives that we have implemented. These initiatives include the continued focus on the conversion of brokers to correspondents by capitalizing on our wholesale lending expertise, the origination of mortgages through our branch network, and reduced competition in the wholesale arena.
We believe that we have a leadership position when it comes to the utilization of technology to efficiently originate residential mortgage loans and that our competitive advantage in this respect will be evident as originators throughout the country struggle with the recent implementation of RESPA reform.
On loan sales, we still intend to sell virtually all of our production in 2010. Therefore, the loan sales for 2010 are also forecasted in the range of $24 billion to $28 billion. Margin on the origination and sale of loans, our 2010 estimate for margin on the sale and origination of loans is a range of 105 basis points to 125 basis points, a reduction from 155 in 2009.
Although we continue to see healthy spreads, we do not believe that historical high of 2009 will continue throughout 2010. However, we do believe that we will be able to hold margins and maintain the production levels that we have forecast largely due to our wholesale lending capability and what we believe to be a best-in-class platform for wholesale mortgage origination.
Net interest margin at the bank level; we are estimating our range for bank net interest margin for 2010 to be 200 basis points to 220, an increase from 165 basis points for 2009. We believe that our NIM will improve as a result of the influx of additional capital, as well as the prepayment in Q4 of $650 million of FHLB advances with a weighted average coupon of 4.38%.
In addition, as we resolve and reduce the level of non-performing loans we will be replacing them with solid interest earning assets. Finally, we are expecting our focus on core deposit growth to lower our funding costs and our NIM will improve even if the yield curve flattens somewhat throughout the year.
Provision expense; we project provision expense to be between $325 million and $375 million in 2010, a reduction from the $504 million we incurred in 2009. Although we are modeling continued declines in real estate values and high levels of unemployment inline with a bearish market sentiment, we have a static seasoned loan portfolio and we have been observing reductions of classified assets in our commercial real estate portfolio and a flattening of the delinquencies in our residential portfolio.
In addition, our provision methodology has taken into account the increased severity of loss with current appraisals and recent loss history being incorporated into the models. Although considerable, we believe that our credit costs are both measurable and predictable and that we can manage through them, particularly with the influx of new capital that we received.
With that said, let me turn the discussion back over to Paul for some questions and answers.
Thank you, Joe. We’re now available for any questions from the audience.
(Operator Instructions) Your first question comes from Jessica Halenda - FBR
Jessica Halenda - FBR
I was just wondering if you could talk a little bit more about the NIM extension that you expect. Are you repricing any do you have any CDs or anything that are coming due in the next couple quarters that are going to drive that as well?
Yes, Jessica, I think we’re anticipating improvement both on the asset and liability side. As we continue to reduce the level of non-performing assets and replace them with better yielding assets that will be a major contributor. Then Sandro, quite a job over the last quarter really repositioning our deposits to be focused more on core, do you want to add some color to that, Sandro?
Exactly, Joe, though we’ve had a decline in CDs you’ll see in the book that we’ve increased the level of core deposits quite significantly over the last 12 months and even in the last quarter. Our intention is to continue to focus on improving the mix of our deposits. Through expanding our lending relationships into our banking customers, I believe that we can further leverage those relationships into stronger and wider deposits, if we do that through both cross selling and new customer acquisition.
Jessica Halenda - FBR
If I could just ask one more question; on the charge-off in the second lien portfolio they declined last quarter and then jumped up back again this quarter. What’s happening there? What are you seeing in that portfolio?
I think what you’re seeing there is, first of all, inherent volatility in a very difficult asset. Secondly, you’re seeing just continued reevaluation of the overall portfolio. We don’t see Q4 as establishing a run rate going forward, but rather see it given it being a static portfolio as moderating going forward.
Jessica Halenda - FBR
Are you doing any loan modifications at all?
Yes, we are. This is Matt Kerin. From a loan mod standpoint we are capitalizing delinquencies and we are lowering rates. Much of the activity is around converting pay options ARM loans to five year fixed balloons or interest-only to five-year fixed-rate balloons, both at 30 year ends. Full documentation, typically no trial period for us, and our follow-up tends to be pretty timely.
Jessica Halenda - FBR
No principal reduction?
In certain cases we’ll capitalize delinquencies and we will reduce principal where appropriate. We basically look at the surplus-deficit budgeting and we’ll drive it from there.
Your next question comes from Bose George - KBW.
Bose George - KBW
Had a couple of questions, first, on the mortgage banking side, it didn’t appear that you had any meaningful charges related to reps and warranties. I was just curious how much of an issue this is and whether you think that will be more meaningful in 2010?
With respect to the charges we took in 2009 for reps and warranties, if you take a look at both our other expenses as well as and we’ll break it out further in the 10-K as well as the amount that we take through our gain on sales computations, we took in 2009 about $100 million in expenses. We believe that’s a rather significant charge given the kind of high quality underwriting we’ve done over the years.
As we’ve taken a look at our portfolio looking back several years, we’re pretty comfortable that it would not be a run rate and that from a 2010 perspective we expect that to moderate significantly.
Bose George - KBW
Paul that the $100 million in 2009, was that in terms of quarter-by-quarter, was a lot of it right at the end versus earlier on?
Actually, no, there was some of it towards Q4. Actually, we had a lot of it in Q4. Not a lot of it. We had more so in Q4, but we did have it spread out pretty much throughout the year. You’re probably familiar with, I think, the news reports that say that the agencies are pressing on some of the repurchases, and I think all of the participants in the marketplace have seen that.
Bose George - KBW
Then just switching to your tax rate, can we just assume a zero tax rate until profitability then the valuation allowance has to reverse and eventually run off is the tax rate have to remain zero till then?
The tax rate will remain zero until you see about six quarters of profitability. About that time from a generally from accounting purposes you would have an opportunity to consider whether to reverse the valuation accounting.
Bose George - KBW
Then just one final follow up on the modification issue. Have you done much through the HAMP program? Is that a source of either modifications or some fee revenue for you guys at all?
The answer is, yes, we are working with the agencies on the HAMP Mods and we pretty diligently involved and I think it’s pretty well known that the program is a challenge in terms of getting responsiveness from some of our customers given that the level of documentation that is required, but we are actively involved in that and have been for some time.
Your final question comes from [Michael Roman - JP Morgan]
Michael Roman - JP Morgan
Gentlemen, based on current economic conditions and forecasts, do we have an idea to which quarterly reporting period we will expect to return to profitability?
Hi, this is Paul Borja. One of the things that we have done over the course of the earnings calls the past few, number of quarters is to provide the public and provide the analysts with drivers, because each of the analysts and each of the public do have different models. We tend not to provide specific profitability estimates, either by quarter or by year.
At this time there are no further questions.
If there are no further questions, I would like to thank everyone for joining our fourth quarter call and I look forward to getting out on the road soon and meeting some of you face-to-face. Thank you. Have a great day.
Thank you. This concludes your conference. You may now disconnect.
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