Flagstar Bancorp's CEO Discusses Q4 2013 Results - Earnings Call Transcript

| About: Flagstar Bancorp, (FBC)

Flagstar Bancorp Inc. (NYSE:FBC)

Q4 2013 Earnings Call

January 23, 2014 11:00 AM ET


Paul Borja – CFO

Sandro DiNello – President and CEO

Lee Smith – COO


Bose George – KBW

Scott Siefers – Sander O’Neill & Partners

Paul Miller – FBR

Kevin Barker – Compass Point


Please stand by. Good day, everyone, and welcome to the Flagstar Bank Fourth Quarter Investor Relations Conference Call. Today’s call is being recorded. And at this time, I would like to turn the conference over to Paul Borja, Chief Financial Officer. Please go ahead, sir.

Paul Borja

Thank you. Good morning, everyone. I’d like to welcome you to our Fourth Quarter 2013 Earnings Call. My name is Paul Borja, and I’m the Chief Financial Officer of Flagstar Bank.

Before we begin, I would 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 rate, the outcome of pending litigation, competitive pressures within the financial services industry, and legislative or regulatory requirements that may affect our businesses.

For additional factors, we urge you to review the press release we issued last night. Our SEC documents such as our most recent Form 10-K and Form 10-Q, as well as the legal disclaimer on page 2 of our fourth quarter 2013 earnings call slides that we have posted today 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 similar GAAP measures is provided in the table to our press release which we 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 President and Chief Executive Officer.

Sandro DiNello

Thank you, Paul, and thank you everyone for joining us today. In addition to Paul, Lee Smith, our Chief Operating Officer and Mike Flynn, our General Counsel, are here with me today.

Let me first lay out the order of the call. I’m going to begin by discussing the initiatives we executed during 2013 which I believe have positioned our company for growth and success in 2014 and beyond.

I then want to go into the key drivers of our fourth quarter financial performance. After my comments, Lee will update you on our operations areas, including the servicing business and non-interest expense initiative. Paul will then take a deeper dive into the financial results, including our outlook for the first quarter of 2014. After our prepared comments, we are happy to answer any questions you may have.

So let me begin. Over the past year, we addressed declining levels of revenue by aggressively managing non-interested funds by being proactive in completing transactions to improve asset quality and decrease credit-related costs by capitalizing on improving market for mortgage servicing and by continuing to improve our funding profile and lower our interest expense.

And what I have [ph] to say that all of these actions we took were guided by our commitment of becoming a highly efficient and best-in-class operator in each of our businesses while generating value for our shareholders. This management team has demonstrated that it moves quickly and aggressively to implement the initiative that we determined will enhance shareholder value.

In 2013, we worked tirelessly to address risk, exposed the legacy [ph] assets, optimized the cost structure and eliminated valuation overheads. We made important strategic and operational progress that have helped position our company for sustainable growth over the long term.

I’d like to walk you through our 2013 accomplishments and initiatives, understanding that the narrative of this progress will help frame our strategy for 2014 and beyond. Let’s start with the fourth quarter.

We’ve previously announced during the quarter that we had reached settlement agreement with both Fannie Mae and Freddie Mac over pre-2009 mortgage repurchased obligation. In December, we also announced that we entered into an agreement with Matrix Financial Services Corporation, a wholly-owned subsidiary of Two Harbors Investment Corporation.

We’ve done mortgage servicing rights with underlying loans that have a UPB of $40.7 billion while remaining the subservicer on these loans. Combined with other bulk sales, we sold $53.4 billion in total servicing rights this quarter which reduced our MSR-to-Tier 1 ratio from 56% at the end of Q3 to 23% at the end of Q4.

After careful analysis with our finance and accounting team, as well as with our auditors and independent accounting advisers, we reversed the valuation allowance on 100% of our federal-deferred tax asset and a portion of our state-deferred tax asset. This contributed to a substantial increase in the company’s book value per share.

We also prepaid all of the long term Federal Home Loan Bank advances on our balance sheet, creating a much cleaner and more flexible funding profile which should be significantly – which should significantly improve net interest income going forward.

In addition, the estimated fair value liability for our February 2012 Department of Justice settlement was increased from $28.5 million to $93 million. This amount represents the cut in [ph] value of future cash flows based on the current projected contingent payment schedule. This estimated liability could increase or decrease going forward depending on various factors that influence the projected contingent payment schedule.

Turning back to the first quarter, we completed the sale of our Northeast-based commercial loan portfolio [indiscernible] within our business so we could focus on our mortgage banking franchise and Michigan community banking operation. Then in the second quarter, we resolved the two outstanding legacy litigation matters, assured MBIA. And we completed the bulk sale of $341 million in UPB of non-performing loans and dealt with that especially [ph].

We also began to implement a series of initiatives to optimize our cost structure and better manage efficiency. As part of those efforts, we announced the decision to outsource our default servicing business.

During the third quarter, we completed an additional sale of non-performing loans and TDRs, disposing of $167 million in UPB. As part of our cost optimization efforts, we reduced full-time equivalents by about $330 million [ph] and non-interest expense declined by $16 million from the prior quarter level.

All these actions taken together and coupled with the workforce reductions and organizational restructuring we announced last week aimed at further reducing costs provide for a much less volatile and choppy P&L going forward, and support the long term sustainability of earnings while simultaneously reducing risks, strengthening the balance sheet and removing many of our valuation overheads.

With these larger one-time items mostly behind us and with the continued commitment to building our culture of compliance, our focus in 2014 has shifted to prudently redeploying interest capital, leveraging the balance sheet within our forecasts, specifically on mortgage origination franchise, our newly broadened servicing business and our community banks, and increasing our share allowance and providing best-in-class service for our mortgage and community banking customers.

So let’s now turn to our financial performance. During the fourth quarter, we reported net income to common stockholders of $160.5 million or $2.77 per diluted share. For 2013, we reported net income to common stockholders of $261.2 million or $4.37 per diluted share. Our book value for common share increased from $16.12 per share at year-end 2012 to $20.56 per share at year-end 2013.

Now let’s look at some of the key drivers. Like others in the mortgage industry, we were not immune to volume declines caused by steadily increasing [ph] interest rates during 2013. As a result, last year was a challenging one for mortgage related revenue. We experienced reductions in gain on loan sale income, interest income and loan fees, all of which are primarily driven by mortgage originations.

In 2013, we originated $37.5 billion of residential mortgages as compared to $53.6 billion in 2012. The margin we earned also declined. For 2013, our gain on sale margins based on fallout-adjusted locks declined to 127 basis points from the 196 basis points we had in 2012. As a result, net gain on loan sales decreased from $991 million in 2012 to $402 million in 2013.

Loan fees also decreased by almost $40 million from the 2012 level. And our interest income, which in 2013 was largely tied to mortgage production, decreased by $150 million in 2012.

In the fourth quarter, we continued to experience lower gain on sale income as the rise in mortgage interest rates since lower home purchase activity due to seasonality created a difficult mortgage origination environment. Fourth quarter net gain on sales decreased to $45 million as compared to $75 million in the prior quarter.

The margin we earned in our fallout-adjusted relocks [ph] also declined to 85 basis points from 114 basis points in the third quarter. And based on recently issued industry exponents for mortgage originations, we anticipate that 2014 will be a challenging year. As you know, total mortgage originations for the industry were $1.8 trillion in 2013.

And for 2014, Fannie has lowered its mortgage origination estimates to $1.3 trillion while Freddie and the MBA have revised their estimates downward to $1.1 trillion. These estimates underscore the importance of all the transactions we completed during 2013 which have prepared us for the reality of the 2014 mortgage market.

Turning to commercial banking, we had an outstanding year of having solid for our [ph] commercial relations network. Our new commercial loan portfolio which consists of commercial loans originated in 2009 and after increased by 83% from the end of 2012. And while still a small portion of overall revenue, we are seeing similar growth in treasury products and commercial deposits.

We also experience outstanding growth in core deposits and find nice transaction from our partnerships with the University of Michigan Athletics and the Detroit Red Wings. Our core deposit ratio calculated as a percentage of retail deposits improved from 50% at year-end 2012 to 79% at year-end 2013.

Now let’s take a look at why the initiatives we completed in the fourth quarter first in a position to be consistently possible going forward. Please turn to Slide 21.

As I noted earlier, interest expense will be lower in 2014 as a result of the prepayment of our Federal Home Loan Bank advances. At the end of the fourth quarter, we prepaid $2.9 billion in long term fixed advances which have an average coupon of about 3.3%.

Though we have replaced and will likely continue to replace some of these violence [ph] going forward, the average coupon is expected to be significantly less. As a result, we believe that net interest income will be higher by between $15 million and $20 million per quarter versus the Q4 level.

Beginning in 2014, we plan to expand [ph] growth in our lending and investment portfolios with increased deposits. Keep in mind, this does not include any benefit from the deployment of interest capital which I will discuss shortly.

As I mentioned, we sold a significant portion of our mortgage servicing rights during the quarter. We did retain the subservicing rights and a good portion of those and we will discuss how to think about the impact of that to the P&Ls during this conference.

Turning to non-interest expense, we believe there is a potential for further savings from our fourth quarter 2013 run rate. Lee will discuss this in more detail. But beginning in Q2 of 2014, we believe overall non-interest expense should average less than $140 million per quarter, so we know a significant deviation from the mortgage industry, as I discussed earlier.

Given the settlement’s substantial earnings [ph] during the quarter, we believe our current reserve is adequate and any incremental representation and warranty provision for repurchases going forward will be negligible, assuming no change in our current environment. And finally, we believe we will see lower provision for loan losses going forward.

So let’s now talk about where we see incremental opportunity for earnings per share growth from our fourth quarter revenue level in each of our three core businesses. Please turn to Slide 23.

First, we think there is an opportunity to leverage the balance sheet and redeploy excess capital to grow interest earning assets, generating additional net interest income. Assuming sustained yields in our commercial loan portfolio and a similar cost of [indiscernible] compared to the fourth quarter 2013 level, we could expect to generate an additional $0.27 in annualized earnings per share for every $2 billion in commercial loans deployed. This will be incremental to the fourth quarter 2013 run rate.

Second, our goal is to remain profitable from the origination of sale of mortgage loans no matter what the market size is. We believe we are now staffed appropriately to deal with the volatility of the business.

Assuming gain on sale margin returned to the third quarter 2013 level and assuming our current market share, we can expect to generate an additional $2.24 in annualized earnings per share and a $2 trillion mortgage market. This again would be incremental to the fourth quarter 2013 run rate.

And third, we believe we can have significant income from our mortgage servicing business. As Lee mentioned on previous calls, our goal is to take this business up to 1 million loan serviced from the 356,000 or so loans currently serviced. Assuming we get to 1 million loans served, we believe we could earn an incremental $0.40 of additional annualized earnings per share from the fourth quarter 2013 run rate.

To summarize, we believe that the actions we took in 2013 should allow us to remain profitable in 2014 even given the current forecasted lower levels of mortgage originations. And as you can see, we believe there is significant further upside for our earnings per share as we redeploy capital within our existing mortgage and community banking businesses and add a recurrent stream of revenue from the less capital-intensive servicing business we set up.

Before I turn the call over to Lee, I want to highlight a few metrics that I think encapsulate our progress in 2013. As you can see on Slide 4, we are working hard to improve the financial condition of this bank and to increase shareholder value.

As I mentioned earlier, our book value per share increased by over 28% from the prior year. All of our asset quality and allowance coverage ratios improved dramatically from 2012 levels as you can see highlighted on the bottom half of Slide 4. As an example, non-performing loans to total loans declined from 7.4% to 3.6% and our allowance coverage of non-performing loans improved from 76% to 146%.

We’ve cut our MSR-to-Tier 1 concentration in half from 56% in Q3 2013 to 23% in Q4 2013. We significantly improved our regulatory capital ratios which provide us with balance sheet flexibility going forward. Finally, we’ve managed through a difficult mortgage environment in 2013 and were able to remain profitable.

In conclusion, I want to take a moment to thank all of our employees for their hard work and dedication. Our achievements over the last year are very satisfying and they are a testament to the ongoing commitment of this team. With that, I’ll turn the call over to Lee to discuss operations.

Lee Smith

Thanks, Sandro, and good morning, everyone. As Sandro mentioned, it’s been another busy quarter as we continue to build the foundations of the future growth and success. The sequencing of our actions has been pivotal in laying such foundations as we continue to optimize the cost structure of the organization and further derisk the balance sheet.

Please turn to Slide 5. Our total non-interest expense during the fourth quarter was $388.7 million. After you normalize the run rate by subtracting the prepayment adjustment of $177.6 million on the FHLB advances and the additional Department of Justice estimated liability of $61 million which represents the incremental amount based on the DTA reversal, you get a normalized run rate of $150 million for the fourth quarter 2013. This compares to $158 million in Q3 and $174 million in Q2.

If you remember from our last earnings call, we provided guidance for non-interest expense to range from $552 million to $597 million on an annualized basis. Our fourth quarter run rate of $150 million puts us at the lower end of the expense savings range.

However, the recently announced workforce reductions which we estimate will lead to approximately $40 million of annualized cost savings have not been factored into our fourth quarter run rate. If you include those, that would give us an annualized non-interest expense run rate of $560 million for the year which is at the high end of the expense saving guidance we provided last quarter.

And remember, this run rate is based on actions already effectuated. To put this into context, for the first six months of 2013, our annualized non-interest expense run rate was $742 million. So in eight months, we’ve been able to reduce non-interest expense costs by $180 million or 24% on an annualized basis, of which $125 million have been fixed cost reductions and $55 million have been variable cost reductions because of reduced mortgage origination volumes.

Last week, we announced that we had implemented a company-wide organizational restructuring which resulted in approximately 600 full-time equivalents being eliminated from our September 30 level. These reductions which will be completed by the end of the first quarter will result in $40 million of annualized savings for which the bank will incur a pre-tax charge of approximately $5.2 million. $1.4 million of this amount was incurred in the fourth quarter.

The decision to restructure the organization and eliminate these positions was not taken lightly, but was necessary given the significantly reduced mortgage origination market and the need to properly align overall corporate support expenses to our revenue projections.

Together with the 331 reductions in Q3, a natural attrition in the second half of 2013, total full-time equivalents have been reduced by approximately 1,000 or 26% since June 30 of 2013. Over the same period, we have also reduced the number of permanent subcontractors by 187 for a total reduction of almost 1,200 in eight months.

Please turn to Slide 6. As a result of our actions, we’re increasing our 2014 guidance on compensation and benefit savings unrelated to the outsourcing of default servicing from $30 million to $40 million to $45 million to $50 million on an annualized basis.

The new vendor management and procurement initiative is now in full swing and the team has already been able to achieve some meaningful wins. We continue to believe the annualized savings from this initiative will be in a $40 million to $60 million range from the first half of 2013 run rate when we were on track to spend over $300 million annualized on third party vendors.

Following the outsourcing of default servicing in 2013 and the sale of a significant part of our MSRs during the fourth quarter, we continue to believe that savings in asset resolution costs will be in a $17 million to $32 million range on an annualized basis.

With the headcount reductions, we continue to look at our real estate portfolio of 181 properties, both owned and leased and rationalize and realign that portfolio accordingly. When you account for the FHLB prepayment adjustment and the incremental expense for the Department of Justice estimated liability, our consolidated efficiency ratio for the quarter was 97.3% versus 89.5% in the prior quarter.

The increase in our efficiency ratio was driven entirely by a reduction in pre-tax revenues. Gain on loan sale was down $31 million from the previous quarter and is down $100 million from the second quarter or $400 million on an annualized basis, which emphasizes how important it’s been for us to act quickly and decisively with our cost reduction actions.

As a result of the reduction in gain on loan sale, the mortgage efficiency ratio was 18.5% in the fourth quarter versus 68.9% in the previous quarter. Community banking increased slightly in the quarter to 115.7% versus 113.1% in the third quarter. This change was driven by lower warehouse loan interest as a result of the reduced mortgage origination volumes.

What is interesting to note here, if you factor in the one-time items identified on Slide 21 which includes the quarterly cost savings associated with the recent reduction in force of $10 million per quarter together with the savings on the interest expense of approximately $18 million as a result of our restructuring of the FHLB funding, our consolidated fourth quarter efficiency ratio would have been 87.1%.

We believe that shows we have rightsized the cost structure of the organization to the point where we can be profitable at any time during the mortgage banking cycle. Actions we have taken to derisk the balance sheet over the last six months, and which I will talk about in more detail shortly, have also helped in this regard. And we will continue to look at ways to make ourselves more efficient across the entire organization.

Just because we’ve hit the targets we set for ourselves does not mean we’re going to stop focusing on being as efficient as we can whilst also becoming a best-in-class provider for all of our products and services.

We continue to be extremely active during the quarter in terms of further derisking the balance sheet. As Sandro mentioned, we entered into agreements with both Fannie Mae and Freddie Mac to resolve substantially all of the repurchase requests and obligations associated with loans originated between January 1, 2000 and December 31, 2008 and sold to those GSEs.

When you combine the two agreements, the total settlement amount was $132.3 million. And after paid claim [ph] credits and other adjustments, we paid $102.4 million to the GSEs. The R&W reserves specific to the loans covered by the agreements exceeded the payments by almost $25 million.

When you consider that we incurred $256 million in 2012 and $36 million in 2013 after accounting for the $25 million release in R&W provision expense, these settlements should lead to a significantly reduced R&W provision expense in 2014 and beyond.

During the fourth quarter, we sold $40.7 billion in aggregate UPB of residential MSRs to Matrix Financial Services Corporation. This represented 55% of our mortgage loans serviced for this portfolio as of September 30, 2013.

Essential component of this transaction is that Flagstar will act as a subservicer on all of the mortgage loans underlying the MSRs being sold. And as a result, we will receive subservicing income and retain a portion of the ancillary fees.

This transaction was significant on two levels. One, it significantly reduced our MSR concentration risk. And two, we were able to utilize our newly reconfigured servicing business to generate ongoing servicing revenue and diversify the company’s operations.

As you know, we made the decision in 2013 to outsource our default servicing unit to Selene Finance in order to create a single servicing platform that could offer servicing excellence in both the performing and default areas. We set it up as a private label structure whereby Flagstar remains the master servicer and the transition is seamless to the borrower.

This structure is beginning to be noticed in the market, as can be seen from the recent transaction with Matrix. We also sold $12.7 billion of MSRs during the course where we did not retain a subservicing, including a $1.8 billion forward flow deal. As of December 31, 2013, we had $285 million of MSR assets or $25.7 billion of underlying loans on our balance sheet and an MSR-Tier 1 ratio of 22.6% which was down from 56.8% at September 30, 2013.

We will continue to sell MSR assets if we believe it makes economic and operational sense to do so. And when economically advantageous, we will retain the subservicing on the loans from such sales.

In a perfect world and everything else being equal, if you value the MSR asset correctly, there should be no gain and no loss on sale, other than the associated transaction costs. The value of our MSR asset is estimated using fair value accounting. And our MSR book contains many products with different interest rates and vintages. The asset is also hedged.

As a result, you cannot back in to a blended valuation of this asset given the different characteristics of each MSR cohort that roll up to the consolidated MSR valuation, the mark-to-market movements and associated hedging risks. The MSR asset is high yielding and thus we will look for opportunities to reduce that concentration further. Assuming it makes economic sense, we wouldn’t want to ever entirely eliminate the MSR asset we carry on our balance sheet.

In terms of the $53 billion of MSRs we’ve sold during the fourth quarter and assuming a return on asset of 6%, the amount of net income foregone on this asset is approximately $19 million to $22 million annualized after the factoring in what we will recapture from subservice single loans to Matrix.

However, our mark-to-market and hedging risks have been significantly reduced as a result of the MSR sales. We’re currently servicing approximately 356,000 loans of which 198,000 are subservice for others and 158,000 are either owned by us or we own the mortgage servicing asset.

For every 100,000 loans we grow our servicing book, we expect to generate between $5 million and $7 million of incremental operating profit before any allocation of indirect expense. We will therefore need incremental 270,000 to 300,000 loans to replace the loss of income from the MSR asset sales during the fourth quarter.

To that end, we intend to leverage our unique servicing platform as quickly and effectively as possible. Our goal is to grow that to where we service 1 million loans as we’ve previously stated. And at the same time, we will also remain focused on driving further cost of efficiencies in servicing and the rest of the organization.

In terms of other balance sheet activities, we have a team dedicated to minding our interest earning and HELOC books before the respective loans reset or mature. We want to make our borrowers aware of the upcoming event and lay out the various options available to them. It’s allowing us to get ahead of the IR [ph] reset and HELOC maturity dates and be proactive in refinancing such loans if that’s something our borrowers are interested in doing.

As you can see, it’s not just been a busy quarter but it’s been a busy eight months since Sandro and I assumed our positions. And I firmly believe we’ve made excellent progress in our goals to derisk the balance sheet and rightsize the organization.

This sequencing has created the foundation from which we can grow existing and new lines of business. And we continue to be excited and energized by the opportunity here at Flagstar. With that, I’ll hand you over to Paul.

Paul Borja

Thank you, Lee. I am going to now review the key components of our overall fourth quarter 2013 financial results and update you on our Q1 2014 outlook for the key drivers of our financial performance.

On Slide 22, we have prepared an outlook for the full year 2014 but I will focus on the first quarter during my comments. Please turn to Slide 7 which provides an income statement bridge and highlights the key items that changed during the fourth quarter as compared to the third quarter. We’ve also prepared a summary income statement on Slide 8 and balance sheet highlights on Slide 9.

We reported $160.5 million in net income for the fourth quarter 2013 or $2.77 per share on a fully diluted basis. This compares to net income in the third quarter of $12.8 million or $0.16 per diluted share.

It’s important to note that our fourth quarter financial results were impacted by four key items. First, we reversed the entire valuation allowance of our deferred tax asset related to federal taxes and a substantial portion of the allowance that relates to state taxes.

The overall effect was a fourth quarter 2013 tax benefit to our bottom line of $410.4 million. If you recall, we established a full valuation allowance against our deferred tax asset in the third quarter of 2009. During the fourth quarter of 2013, we evaluated our ability to earn enough to use the net operating losses that underlined the DTA. After a lot of work analyzing the key accounting factors that affect our decision, we concluded that Flagstar was likely to be able to realize the benefits of the deferred tax assets.

Second, we prepaid all of our $2.9 billion in long term FHLB advances which resulted in a prepayment adjustment that we were charged and which totaled $177.6 million. These advances carried an average coupon of 3.3%, so we expect to see a significant benefit in the form of lower funding costs and a more flexible funding structure beginning in the first quarter of 2014.

Third, we incurred an incremental $61 million in non-interest expense above our normal estimated liability and related to the settlement with the Department of Justice we entered into in February 2012. We recorded that settlement as a fair value liability and have been adjusting for it in accordance with accounting standards. That brought the total estimated liability to $93 million as of December 31st 2013.

And fourth, we had a benefit of $24.9 million during the quarter associated with the previously announced settlements with Fannie Mae and Freddie Mac regarding pre-2009 loan originations that we sold to them.

Please turn to Slide 10. Our net interest income declined slightly to $ 41.2 million for the fourth quarter as compared to $42.7 million for the third quarter. As you can see on the bottom left chart on that slide, interest income declined by $7 million from the third quarter. This is partially offset by a $5.5 million decline in interest expense as shown in the bottom right chart.

From a rate volume perspective, the decline in interest income was primary attributable to declines in the balances of loans available for sale and warehouse loans as well as a lower average yield earned on loans repurchased with government guarantees.

These decreases are partially offset by increased income from investments as we invested excess liquidity into higher yielding agency investment securities as opposed to lower yielding cash. In addition, we benefitted from a declined deposit expense as higher costing retail CDs continued to roll off.

As a result of the lower cost of funds, our net interest margin at the bank level improved from 1.68% during the third quarter to 1.8% during the fourth quarter.

Turn to Slide 11. You can see that we continue to do a good job of gathering core accounts and improving our deposit mix. While overall core deposits remain relatively flat, the percentage of core deposit to retail deposit increased to almost 80% in the fourth quarter from about 73% in the third quarter.

On the bottom half of Slide 11, you could see that our need for overall deposit funding had declined along with decreased mortgage production.

One Slide 12, we highlight some of the trends in commercial loans. Our commercial loan portfolio contains both legacy commercial loans which were originated in 2009 and prior and newly originated commercial loans which we consider core.

The overall commercial portfolio had declined over the last year as we work out and dispose of legacy commercial loans. However, you can see we’ve been able to grow the portfolio of new commercial loans over the course of 2013. As shown on the slide, that portfolio has increased by 83% from the end of 2012.

As Sandro discussed, this is a major component of our balance sheet growth strategy and we’ve been seeing good results thus far.

For Q1 2014, we expected net interest income before provision for loan losses will increase by approximately 40% as compared to net interest income in Q4 2013. Our view of such improvement in net interest income arises primarily from our Q4 2013 pay down of a long-term fixed-rate FHLB advances.

We also expect that this will result in a net interest margin at the bank level by year-end 2014 of between 2.75% and 3% assuming overall asset growth during 2014 of between 8% and 10%.

Also, while we expect to continue to obtain FHLB advances as our needs require, we expect that such borrowings will be at much lower rates and with short and medium-term maturities.

Turn to Slide 13. Net gain on loan sales decreased to $44.8 million for the fourth quarter as compared to $75.1 million for the third quarter. This decline was attributable to a 20% decline in fallout adjusted mortgage locks and a 25% decline and a gain on load sale margin on if it [ph] locks.

The decline in locks was consistent with the overall industry decline in mortgage production during the quarter, reflecting both the interest rate environment and whole buying seasonality. The reduction in margin reflected mortgage rate lock volatility in the fourth quarter.

At Slide 14, we provide some additional details of our first mortgage originations including by channel and by product. As you can see, purchase originations continue to become a bigger percentage of our overall mortgage production as we transition with the industry given a current rate environment.

For Q1 2014, we expect that the volume of mortgage locks will decline by about 20% as compared to Q4 2013 consistent with the industry expectations. However, we would expect that the gain on sale margin will return to the levels experienced in Q3 2013 absent any intervening matters that’s occurred during Q4 2013.

Net volume [ph] administration income, also referred to as our net servicing revenue was $28.9 million relatively flat from the third quarter level. Our not interest income alto included $8.9 million of net transaction cost related to the MSR bulk sales of $53.4 billion in aggregate UPB which we sold during the quarter as Lee mentioned earlier.

For Q1 2014, we expect to continue to realize a 6% return on the MSR asset. We also attend to continue to seek opportunities for this position of the asset from time to time so that we maintain levels appropriate for regulatory compliance.

We expect that the amount of MSRs will continue to fluctuate, but that through planned transactions, Flagstar’s MSR-to-Tier 1 ratio as we enter Q1 2014 will be within our targeted range of 15% to 20%.

Please turn to Slide 15. With respect to credit costs, we focused on three key areas – loan loss provisions for our loans held in our investment portfolios, rep and warranty provision expense which relates to potential put-back losses from loans we sold over the years in the secondary market, and asset resolution expenses which primarily relates to our foreclosure expenses from our held-for-investment loan portfolio and the expenses associated with managing down our insured government loan portfolios.

And you see on the slide, these three credit costs for the fourth quarter totaled $2.1 million as compared to $25.6 million for the third quarter. Loan loss provision increased to $14.1 million during the fourth quarter as compared to $4.1 million in the third quarter, primarily reflecting increased residential first mortgage reserves as we continue to refine our allowance methodology to reflect probably losses embedded in the portfolio.

Turning to Slide 16, you can see that our non-performing loans have come down significantly from levels a year ago. At the same time, we continue to maintain strong allowance coverage on both our residential and commercial loan portfolios as outlined on Slide 17. Our overall allowance coverage of non-performing loans was 145.9% as of December 31st 2013.

For Q1 2014, we expect to see a continuation of improved credit quality metrics. We do not expect that a significant amount of net loans will be added to the held-for-investment portfolio. Accordingly, we would not anticipate that the provision expense for Q1 2014 would exceed the level in Q3 2013.

Our provision for rep and warranty expense by which we reserve for possible lawsuits from loan put-backs, was actually income of $15.4 million for the fourth quarter as compared to an expense of $5.2 million in the third quarter. This is driven primarily by $24.9 million release of reserves in the fourth quarter associated with the Fannie Mae and Freddie Mac settlements which we saw during Q4 2013.

On Slide 18, we provide further details of our rep and warranty reserve. For Q1 2014, we would not expect further provision other than through our normal loan sales process as we believe the reserve is appropriate based on our view of the remaining potential exposure.

Fourth quarter asset resolution expense was $3.4 million as compared to $16.3 million during the third quarter. Driven by gains from the sales of commercial real estate own properties and a decrease in foreclosure cost associated with loans the company services for others.

For Q1 2014, we expect that the structure for servicing loans or by defaulted loans will be transferred to a specialty servicer should lead to lower asset resolution expense. Thus, we would expect an asset resolution expense was for Q1 2014 be 40% to 60% less than such expenses was incurred in Q3 2013. Non-interest expense is also a critical part of our overall analysis. Lee has already discussed non-interest expense in detail and provided a revised range.

Finally, turn to Slide 19. You could see that we continue to maintain capital and balance sheet flexibility to fund the initiatives to drive future earnings that Sandro highlighted earlier. With that, I’ll turn this back to Sandro.

Sandro DiNello

Thanks, Paul. I think we’d now like to go and take your questions. So Vicky, we’ll turn it back to you.

Question-and-Answer Session


(Operator instructions) And we will take the first question today from Bose George with KBW. Please go ahead.

Bose George – KBW

Hi guys, good morning. I’ll start with a question on capital. What’s the best way to think about how much excess capital you have from like should we focus on level for your TCE or just tell us how to think about that?

Paul Borja

Hi, this is Paul Borja. I think the very first thing is to take a look at our tier 1 leverage capital because I think tier 1 leverage capital is how we’ve guided over the past years. As we talked about it, we talked in the past about looking at 9% to 10% tier 1 capital. It is something the board has considered to be an appropriate minimum level.

As we continue to expand and look at various risks as we grow the balance sheet, I think that the board and the management will continue to look at the composition, the quality of capital going forward in addition to focusing on Basel III.

So we manage both Basel I and Basel III in parallel and look at those. But I think that the ranges that we’re looking at provide us with the opportunity to stay as we said in the speech that we are looking for opportunities to invest excess capacity.

Sandro DiNello

Well, this is Sandro. And the only thing I would add about this is, obviously we have to keep in mind the stress testing requirements. But given the fact that we derisk the balance sheets so significantly this year, the impact of that going forward should be less than what maybe, what previously.

Bose George – KBW

Okay, great. And then if you also – so presumably, it’s probably early to start thinking about shared buybacks or TARP repayment or anything along those lines?

Paul Borja

Well, it’s certainly something that we’re going to be thinking about, but a little early for us to comment on it certainly.

Bose George – KBW

Okay, great. And then actually switching to gain on sale margin, the trends that you guy showed were different. Most of the banks that have reported so far showed an increase.

I’m just curious again of your thoughts on why your numbers are kind of different from what we see in terms of some of the others?

Sandro DiNello

Well, as – if you look at it from our point of view in our situation, it’s a combination of both the volume decline and some hedging challenges. So the volume decline I think was consistent with what the industry experienced. And I think we’ve appropriately dealt with the hedging challenges, we’ve addressed them. And so that’s why we’re giving guidance that we believe that going forward that the margin will be more close to the Q3 levels. I think that’s what Paul I think had gotten us [ph].

Bose George – KBW

Okay. Great. Actually I’ll [indiscernible] one small one. Just, is the effective tax rate going forward?

Paul Borja

So going forward, now that we reversed the valuation allowance, we’re looking at effective rate of 35% for moderate [ph].

Bose George – KBW

Great, great. Thanks a lot guys.


And we’ll take the next question from Scott Siefers with Sander O’Neill & Partners. Please go ahead.

Scott Siefers – Sander O’Neill & Partners

Good morning, guys.

Paul Borja

Hi, Scott.

Scott Siefers – Sander O’Neill & Partners

I appreciate all the information on the outlook. It’s good color, so thank you for that. Paul, I was wondering if you could – you have a lot of information, so I want to make sure I got it right and then was hoping for little more colors specifically on the margin in the outlook.

So if I heard correctly, it sounded like you said, 40% increase in the first quarter, net interest income versus the fourth quarter. One, was that right? And then, two, can you kind of just – so as I think we go through how you’re thinking about margin progression throughout the year, for example if, you know, most of it – most of that 2.75% to 3% bank margin outlook is based on the FHLB pre-payment, then it would come in very quickly. But if a portion of it is based on utilizing some of that excess cash that you guys have would maybe float throughout the year. So how should we be thinking about that statement?

Paul Borja

Hi, hi. Hi, Scott. Yes, so you’re right. I did say 40% for Q1 2014. When we think in terms of the math, we look at the FHLB pre-payments and although we would may be reborrowing FHLB advances, they’ll get a much lower rate, we did indicate that it was a 3.3% coupon that we’re able to take off.

So the delta between what we’re able to take off at the end of Q4 and what we’d be reborrowing and using given a smaller balance sheet is going to be substantial. So that’s where we’re going to get the 40%.

As we think in terms of a 2.75% to 3%, we think in terms of the margin, it is a combination of those factors. There’s actually three things going on. One is we reduced borrowing extensive – we no longer have the FHLB advances at the 3.3% coupon.

It’s also growing the asset base both – I mean total assets as well as the interest serving asset base.

And thirdly, it’s taking some of the excess cash as we generate through a growth in the balance sheet and look at opportunities beyond that 25 basis points of our capacity. So we think in terms of both investments and loans. And we did mention that we would look for loan growth.

Sandro DiNello

Scott, it’s Sandro. I’ll just add one thing to that. When you look at the earning assets that we projected we will add to the balance sheet in 2014, I think what our expectation is that the margin that we would earn on those additional earning assets would be in that 2.75% to 3% range.

Scott Siefers – Sander O’Neill & Partners

Okay, perfect. And then just one final clarification on that. So the 2.75% to 3%, that’s the average margin for the year or it’s kind of by the end of 2014? We hope to get there.

Paul Borja

For the year.

Sandro DiNello

For the year.

Paul Borja

For the year.

Scott Siefers – Sander O’Neill & Partners

For the year. Perfect. Okay. And then just I guess one technical question and I think you reversed everything except the portion of the date ETA. That is, one, is that correct? And then, two, what else would happen to – or what else would have to happen to reverse that? How meaningful is it if at all?

Paul Borja

Yes, this is Paul. First of all, that’s correct. We reversed a portion of it. Second, the reason we didn’t reserve all of it is because the states have different requirements for NOLs as far as time periods and assets or the vertex [ph] assets and liabilities. So we’ll continue to evaluate that if it’s done.

Scott Siefers – Sander O’Neill & Partners

Okay. And I’m sorry, how substantial is that number?

Paul Borja

From a sighting perspective, I believe we’re looking at about $12 million to $14 million more.

Scott Siefers – Sander O’Neill & Partners

Okay, quite small relative to what you’ve done already.

Paul Borja


Scott Siefers – Sander O’Neill & Partners

Okay. All right guys, I think that does it for me. So I appreciate all the color.

Paul Borja


Sandro DiNello



Next is Paul Miller with FBR.

Paul Miller – FBR

Yes, guys. Thank you very much. You guys have a done a lot and you get – I get it guys, I think Streets [ph] give you guys a lot of credit for selling TDR, selling MSRs, moving those MPAs down. Are we done selling assets? Are we now just going to work on internally driving down the non-performers or could we see some more asset sales on that fund both on the MSRs and the non-performing assets?

Sandro DiNello

Well I think, well, with respect to non-performing assets, Paul, it’s just a matter of execution. We’re certainly going to be working very hard at drawing them down ourselves and Lee will be very focused on that with respect to would we do any further sale? It’s certainly a possibility. It just depends on whether the right opportunity presents itself.

I think with respect to the MSR, we’ll give you a lot of guidance on what our expectation is for the sale of MSRs and both Paul and Lee’s comments. I don’t have anything more to add to that.

Paul Miller – FBR

And you talked about NM. There was a question about NM. And so the big question about you guys is where is your core earnings power? And I think it’s still difficult for us to – you give us a lot of guidance guys, I know that. I don’t know if you want to take that one step further.

But were you – I mean are you shooting for a 50% return on equity through the cycle? Are you shooting for a return on assets and 1% to 1.5% through the cycle? I mean what are your major goals from here? Because you’ve done a lot. I know that TARP [ph] probably gets taken cared of at some point. But what is your goal you’re setting up for this?

Paul Borja

Well our goal is sustainable profitability and after a while at the same time, meeting our regulatory expectations. So we’re looking at improving them. We’re looking at lower credit cost, predictable non-increase income, lower operating expenses. And we’re going improving in each and every one of those areas.

We have not given guidance specific to ROA or ROE, but we’ve given a lot of guidance. So I think at this point, I’m not prepared to comment specifically about what our goals are in the short-term for either ROA or ROE. But I think you can see that from an earning’s power point of view, we think it’s very significant in all three lines of our businesses.

If we’ve got this mortgage thing figured out right with our expenses and we will make money because of what’s going on in the market? I’m more confident that we can that. The banking business is growing very, very steadily and, a lot of good things happen in the banking side.

So often in a way of new loans, good solid, high quality loans and also in the way of improving our mix of core deposits and now they we’re in a position to grow the deposits a little bit. And you’ll see us go after that a little bit more aggressively.

And then finally, this mortgage or the servicing thing has got tremendous earnings power and you’re going to see that come. And we’re going to work very hard at that. We’ve laid out exactly what we’ve got planned there. And now we know that we have to execute. But I think you can see that we’ve done a pretty good job of executing on the things we told we’re going to do in the past and we’re in that – have that same kind of success going forward.

Paul Miller – FBR

And then one last question. And if it’s in the data, I apologize and maybe we keep calm. But the rate lock issue. How much of a negative was the rate lock issue this quarter in lower rate locks?

Paul Borja

You mean as far as impacting our gain on sale?

Paul Miller – FBR


Paul Borja

So I think it’s both the gain and sale. I think we’ve provided some of the data on Slide 13. So I think it’s a combination of both the decline which we indicated in the speech was consistent with the rest of the industry. And I think the issue more so with the gain on sale margin and whether or not we think that was out of sync and if it was, how we fix it.

What I think what we talked about was that we’ve identified the gain on sale margin Q4 issue and resolved it so we expect to return to Q3.

Paul Miller – FBR

When you say we’ve – like we’ve fixed issue, I mean you know there’s a clerk [ph] in the accounting because of the rate lock issue. Is that when you say, fix it? Is that the main reason why it was down?

Paul Borja

So I think what we talked about in the speech where there was some hedging volatility that impacted our gain on sale margin and that we believe that based on the process that we have in place that we should be able to return to our gain on sale margin from Q3 2013.

Paul Miller – FBR

Okay, thanks a lot guys.

Paul Borja

Thank you, Paul.

Sandro DiNello

Thanks, Paul.


And at this time, there is one name remaining in the roster. (Operator instructions). And we will now go to Kevin Barker with Compass Point.

Kevin Barker – Compass Point

You still have $54 million of reps and warrants reserve following the GEC settlements. How much do you expect to incur over the normal course of business? Or are you expecting to release some of these reserves over 2014? Just give us some colors and the puts and takes with the reps and warrants reserve.

Paul Borja

Hi, this is Paul. So I don’t know. I guess between Lee and Paul [ph] will talk about it. And I think as starting matter, we continue to add to the reserve through our normal loan sale process. As we sell, we put aside some amounts that go into the reps and warranty which we believe is the appropriate estimate and the potential losses based upon sales. And that’s just based on incurred losses.

And then from that perspective, the comment we had was whether we think that on a wholesale basis that we have enough reserves to cover and anticipate it for the put-backs. And I think what we referred to in part was that in Fannie and Freddie settlements and how putting the pre-2009 originations behind us really affects substantially our view of the reserve.

Lee Smith

Yes, I think that’s right Paul. I mean Kevin, I think we believe we’re adequately reserved today particularly following what we were able to release after the settlements and as Paul alluded to. We take a reserve for every loan that we originate and we think that we’re adequately reserved. I mean we’re not planning on releasing anything further as we move forward.

Kevin Barker – Compass Point

So would you have no reserve built even though you’re originating new loans? And that’s actually just – how should we think about that?

Paul Borja

Yes, the mechanics are that if you take a look at our rep and warranty reserve, we have the beginning balance plus provision minus charge ops equals our earning balance. That’s our jobs. And so the provision part of that map is coming from our loan sales. So as we sell a loan, we take a certain portion in for that in the reserve as we’ve done over the years. And I think we’ve described that mechanic to [ph] you.

And so you’re going to have a reserve that’s going to be added to and then you can have to be depleted through normal charge offs never been covered [ph].

Kevin Barker – Compass Point

Okay. And then do you have an estimate for what your tier 1 comment a clear ratio would be per Basel III standards following the sale of MSRs?

Paul Borja

We haven’t publicly released our Basel III specially since we don’t – it doesn’t apply to us except on a pacing [ph] basis beginning January 1, 2015. It’s probably not we’re looking at. But I do think that the guidance we gave which was where we expect our MSR to tier 1 ratio to be, from that perspective should be helpful and instructive as we look at that.

We’re below 20%. We’re currently at 22.8% or 23%. And we’re anticipating by the end of Q1 2014, between 15% and 20%. So picking in terms of the transition period when we only paid in 20% per year anyway beginning January on 2015. I think we’re well ahead of schedule.

Kevin Barker – Compass Point

Okay. And then could you help us understand the earnings power from subservicing versus servicing? How then to think about the fees you’re getting from that and the associated cost with the subservicing relationships.

Lee Smith

Yes. And what I would do, Kevin, is I’ll refer you back to my prepared comments where – and I said there, I mean for every $100,000 loans, we grow that we believe or we expect to generate between 5 and 7 a million of incremental operating profit.

Sandro DiNello

And Kevin, you might also look at Slide 23 where we give some guidance there as well on where we’re servicing [ph] on the earnings per share opportunity.

Kevin Barker – Compass Point

Okay. And then you’re currently operating under work where the capital plan with the OCC and that could send other [ph] – are there particular ratios besides the tier 1 leverage ratio that they are looking at before you could potentially prepay the series D preferred stock?

Sandro DiNello

Yes. So we’re not able to give you that kind of information. So I would just tell you what I have in the past with respect to the content order that we’re pleased with the progress we’ve made in connection with that, and I’m comfortable with where we stand.

Kevin Barker – Compass Point

Okay. Thank you for taking my questions.

Sandro DiNello

Thanks, Kevin.

Lee Smith

Thanks, Kevin.


And we’ll now go back to Bose George.

Bose George – KBW

Hi guys. Just a couple of follow-ups. Okay, in terms of the DOJ liability, the remaining marks that you can take, just the difference between the 93 million and the 118 million that is sort of the upside amount.

Paul Borja

Yes, that’s it.

Bose George – KBW

Okay, great. And then even last one on the MSRs again, on the subservicing. It’s a main focus there on purchases of prime MSRs that will use you as a sub-servicer or people, institutions that currently own MSRs, I’m just curious how the marketing of this developed?

Lee Smith

Yes. So it’s a good question. I mean I think what we’ve done and we, as you know, both we spend several months putting these platform together as I alluded to, that started out with outsourcing the both service into Selene Finance specially – special, actually the bulk servicer.

So we believe you’ve got with that platform, you’ve got the best of both worlds. You’ve got Basel [ph] on the performing side and then you’ve got Selene on the default side. And we’re both excellent at what we do.

We say [ph] that it’s a private label deal so we’re still the master servicer. And basically, some of the advantages of the therapies [ph] that Selene is on the same MSP system as we are. So we keep and retain full visibility of all loans. When I moved over to Selene [indiscernible] one.

In terms of where the business can come from, I think it’s [indiscernible]. One, it’s obviously this transaction is similar to what we did with Matrix. So MSRs we own, we sell and we subservice those loans back.

You then got as you know at the moment a very active market for MSR assets. There’s a lot of financial bias out there. And I think what we have now provided then is optionality. So they could be buying MSR, actually from anybody. And we can actually be sub-servicer of those loans. It doesn’t have to be or I don’t have to be serviced by the institution that originates them. So we’re giving them that option.

And I think the other thing that I would say and I’ll have these conversations with the GFCs. The GFCs are often looking for place, servicing books a bit, mix quickly, particularly if they’re moving them from the stress situations or troubled situations.

What they’ve told me is what you’ve created here is a one-stop shop. So we can bring a book of business to you whether it’s the performing or default lines with the portfolio. And you’ll take care of it. It’s not as if we have to think about splitting [indiscernible] it’s when the performing and the default side.

So there’s actually numerous ways that we can bring business in here. And as I mentioned in my speech, we do intend to leverage that because there’s also lot of good things we’re doing on the reporting side to make it as transparent as we possibly can to the people that we’re servicing for.

Bose George – KBW

Okay. Thanks a lot for the call.


And there are no other questions. I’d like to turn it back to Sandro DiNello for any additional or closing remarks.

Sandro DiNello

Thanks, Vicky. To conclude, 2013 was an important year of our strategic and operational progress. And we did what we said we were going to do. We reduced risk, strengthened the balance sheet, built the capital, eliminated valuation overhangs and optimize our cost structure.

With all we’ve done, it’s time to put the past behind us and focus on the company’s long-term earning power. That’s exactly what we will now be laser-focused on. We intend to grow this company in a safe, sound and profitable fashion.

I’m proud of our team for executing these initiatives. And I believe Flagstar is positioned for growth and success in the coming years. Thank you all. Have a good day.


Thank you very much. And that does conclude our conference for today. I’d like to thank everyone for your participation.

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