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Flagstar Bancorp, Inc. (NYSE:FBC)

Q2 2010 Earnings Call

July 28, 2010 11:00 am ET

Executives

Joseph Campanelli - Chairman and CEO

Paul Borja - CFO

Matt Kerin - EVP and Managing Director - Corporate Specialities of the Company and the Bank

Matt Roslin - EVP of Company and Bank, CLO and CAO

Analysts

Brad Milsaps - Sandler O'Neill

Paul Miller - FBR Capital Markets

Bose George - KBW

Bryce McLoughlin - Private Investor

Zachary Prenske - Coyote Capital

Operator

Good morning. My name is Tiffany and I will be your conference operator today. At this time, I would like to welcome everyone to the Flagstar Bank second quarter investor relations conference 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) Thank you. I would now like to turn the conference over to Paul Borja.

Paul Borja

Thank you. Good morning. I would like to welcome you to our second quarter 2010 earnings call. My name is Paul Borja and I am the Chief Financial Officer of Flagstar Bank. Before we begin our comments, let me remind you about a few things that this presentation does contain some forward-looking statements regarding both our financial condition and our financial results and that these statements involves 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, competitor pressures within the financial services industry and legislative or regulatory requirements that may affect our businesses. For additional factors, we urge you to please review our press release and SEC documents, as well as the legal disclaimer on page 2 of our slides that we have posted on 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.

Joseph Campanelli

Thank you Paul and good morning everyone, and thanks for joining us for this call. I would like to also welcome you to our second quarter 2010’s earning call. We will be getting into the quarterly financial results in just a few minutes, but first, I would like to take a moment and talk about where we stand overall and what we have accomplished relative to the goals we laid out in prior quarters.

Today, Flagstar Bank continues to progress on our transformation initiatives. Our transformation leverages are established position as a leader in the residential mortgage business with the super community bank model that is at the foundation of our diversification plan. Since joining Flagstar around nine months ago, we established this as one of primary goals to maximize the value of the Bank’s entire franchise. And I am happy to say we are well on our way to achieving that goal. We sharpened the focus on our banking relationships, growing core deposits and placed the heavy emphasis on growing transaction accounts.

Our new enhanced retail strategy has already shown early signs of increased productivity to account acquisitions and cross-sell activity. Our new open architecture banking platform has proven to be everything we thought it would be. Account opening time has been reduced from approximately 30 minutes to under 10 minutes. It gives this ability to view the entire customer profile at the point of sale, improving cross-selling efforts in service quality.

Our customer satisfaction level was ranked the best in the five states, North Central Region in the United States, as ranked by J.D. Power and Associates for 2010. Overall, we rank number seven nationwide. We also rank number one in the country relative to branch appearance and branch customer experience, one of the key drivers to growing branch revenues and building a strong brand. Delivering a premium retail banking experience is important to Flagstar as it distinguishes our self in the marketplace. It also represents a very attractive opportunity as we position ourselves for growth for the branch network and compassing more than 3 million households.

In addition, there were over $145 billion in deposits within a 2 mile radius of the Flagstar branch, which provides a significant opportunity for us. We are also making significant progress in rolling out a new commercial banking platform that will allow us to be particularly responsive for the needs of small businesses and little market customers.

There are over 500,000 small businesses within a 5 mile radius of our existing branch network. Most of these do not currently have a significant relationship with Flagstar, so there is a tremendous potential for growth in this market segment. As our core deposits and revenues are growing, we continue to be disciplined in managing our expenses. Through the first six months of 2010, we have identified and implemented $16 million in cost savings to improve the efficiency in operations. We saw an 8% improvement in our efficiency ratio from the prior quarter, as we continue to work towards moving that ratio more in line with that of our peers.

As we have said in the past that folks across all operations is that we will constantly pursue ways to do things better, faster and cheaper without compromising the customer experience.

Let me take a moment to talk about capital and asset quality. We spent considerable amount of time and energy focusing on our legacy balance sheet. Our capital position continues to be strong with our Tier 1 capital ratio at the end of the second quarter at 9.24% and our total risk base capital ratio at 17.2%. During the second quarter, we experienced some positive developments in improving are asset quality. Total delinquent loans decreased by 14% on a shrinking balance sheet. Our ratio of non-performing assets or total assets fell from 9.3% to 9.1%.

Our loan for repurchase expense also declined during the second quarter. As you can see from these improvements our enhanced servicing capabilities and efforts to accelerate the resolution of problem loans of having a meaningful impact and underlying asset quality.

The frequency and severity of the fallouts are also moderating along the lines we have projected. Our 90-day delinquent loans decreased overall from the first quarter, both in percentage in an aggregate dollar balance for total loans. Residential first mortgage delinquent loans decreased for four consecutive months after having peaked throughout February 2010. We are also seeing a pure 90-day plus delinquencies and second mortgages in HELOCs and delinquent commercial real estate loans are also decreasing from prior levels.

During the six days, delinquencies are also trending down. Overall, our non-performing assets continued to decline to the lowest level since peaking in June of 2009. Our second quarter results were adversely impacted by significant increase in asset resolution expense in loan loss provision, which increased by $28 million and $23 million respectively quarter-over-quarter. As we continue to enhance our loss mitigation efforts, we are also being proactive in evaluating in all our options available to us to reduce the level of non-performing assets on the balance sheet. Philosophically, I wont condone a practice of pretend and extend I will proactively dealing with the issues and putting our past behind us.

We are also working our ways to best position our balance sheet to generate net interest margins more in line with our peers. As part of that effort we pre paid 250 million of high cost advances at the end of June, and also paid up for $300 million repurchase agreement. In addition, we continue to focus on increasing core deposits, which will bring the overall cost of funding down. During the quarter, we saw an 8% increase in bank debt interest margin quarter-over-quarter.

Moving on to the mortgage banking business, we are proud of our solid position as one of the largest confirming merger originating in services in US. Flagstar continues to drive the majority of our revenues from mortgage banking operations as we diversify revenue streams in accordance with our strategic plan. We expect to see less earnings volatility because more revenue will be derived from a consumer and business banking loans, cash management and treasury services and other staples of the super community bank model.

As we said before, overtime our goals create a better balance of revenues of our mortgage business with revenues from banking operations. We are mainly committed to maintaining our position as a top mortgage originator, and indeed the second quarter, so the Flagstar Bank, mortgage banking business continues to be strong and an attractive business model.

Initiatives to grow mortgage banking revenues and profitability are also having a positive impact on operations. We also successfully implemented new procedures to ensure compliance with new RESPA regulations.

Our second quarter mortgage originations improved to $5.5 billion, a 26% increase quarter-over-quarter. As you will see in our presentation slides, loan rate locked commitments increased each month in the second quarter reaching their highest level so far in 2010. Early indication for rate lock commitments in July also remain strong as we continue to operate in a favorable rate environment.

Gain on sale margin was also higher than the previous quarter, both in revenues and margin. Second quarter gain on sale margin improved by 16% from the previous quarter. The favorable mortgage banking revenues combined with improvements in our net interest margin and improvements in asset quality translated into a $55.7 million in pre-tax, pre-credit cost income, which was 56% improvement over our prior quarter.

I would now like to turn things over to Paul Borja, who will take us through the financial results before we move on to the 2010 outlook and discuss our key drivers. Following that, we will open it up for questions.

Paul Borja

Thanks Joe. Good morning again everyone. What I would like to do is go through our financial results on a quarter-by-quarter basis and then also year-over-year.

From our P&L perspective, our net income for the quarter was $97 million loss versus a loss $81.9 million in the first quarter of 2010. This translates into a loss of $0.63 per share in Q2 versus a $1.5 per share loss in Q1. In Q2, the key drivers were positives of an improved net interest margin which we saw from higher net interest income from higher average balances of available for sale loans. We also saw an improved revenue from the gain on sales resulting from, as Joe mentioned, increased loan originations and increased loan sales. We saw an increase in revenue from loan fees earned on closed loans during Q2, we saw reduced level of delinquent loans and we saw continued improvement in compensation expense. These improvements were offset, as Joe mentioned, by an increase in the loan loss provision and by increase in the level of asset resolution expenses.

For the first half of 2010 versus the first half of 2009, we had a loss of $178.9 million in the first half of 2010 versus $144 million loss in the first half of 2009. The difference was due to lower loan loss provisions in the first half of 2010 that was offset by lower net interest income, and we also had in the first half of 2010 reduced gain on loan sale and reduce loan fee income due to the reduced production in 2010 versus 2009.

I’d like to go down the pieces of the P&L. Our net interest income in Q2 2010 versus Q1 2010 increased to $42.4 million versus $37.7 million, just a 12.5% increase. This increase reflected a higher average balance of available for sale loans on our books due to higher production in Q2. It reflected increased investment income due to the capital raises in the first quarter that we invested during Q2. It also reflected a slight decline in funding costs as one of our tranches of trust preferred $50 million converted to common stock in April, and as some of our trust preferred reduced their price because of the adjustment to LIBOR.

For the six months ended June 30, 2010, versus 2009, our net interest income declined to $18.1 million from a $116.7 million and that was principally due to lower average balances of held for investment loans during 2010. As those loans continue to pay off, a lower average balance of available for sale loans in 2010 versus 2009 due to lower year-over-year production and there is an offsetting decline in interest expense, our funding cost did decline due to the lower FHLB borrowings in 2010 versus 2009, as well as reduced deposits costs.

A loan loss provision increased in Q2 versus Q1 to $86 million from $63.6 million. It did decrease from the Q2 2009 provision of $125 million. Our Q2 2010 reserves actually declined by $8 million versus our Q1 of 2010 as our charge-offs exceeded our provisions for the quarter. The provision increase in Q2 reflects the effects of charge-offs during the prior 12 months, and our net charge offs during the course of the quarter of Q2 did increases versus Q1. Overall, our charge-offs for $94 million in Q2 2010 versus $49.6 million in Q1. These charge-offs included residential mortgage charge-offs of $60.7 million in Q2 versus $40.3 million Q1, due primarily to first mortgage short sales, third party sales.

Our commercial real estate mortgage charge-offs were $31.5 million in Q2 versus $8.1 million in Q1, due to reclassifications of loans as receiverships due to some charge-offs for specific reserves and also accelerated dispositions of loans.

Our first mortgages and commercial loans both had declining delinquencies for Q2 as compared to Q1. Even with the increased loan loss provision, our allowance for loan loss to held for investment ratio improved to 7.2% from 7.1% at Q1, and also our coverage ratio improved, that is the ratio of allowance for loan losses to our non-performing loan to 52% from 47% at the end of Q1.

Our non-interest income in Q2 increased to $100.3 million in Q2 versus $71.9 million in Q1 and this was principally due to the increase in Q2 and gain on loan sales, increased loan fees and also improved servicing revenue.

Our net gain on loan sales in Q2 increased to $64.3 million versus $52.6 million in Q1 of 2010. This increase reflected during the course of Q2, an increase in interest rate locks to $8.3 billion versus $6.1 billion in Q1, and increase in residential mortgage loan sales to $5.3 billion in Q2 versus $5 billion in Q1. An increase in the margin on our loan sales to 122 basis points in Q2 versus 105 basis points in Q1.

Year-to-date, our gain on loan sales declined to $116.8 million versus $300.4 million for the first six months of 2009, and this reflects reduced production in 2010 of $9.79 billion versus $18.8 billion in 2009. Reduced loan sales in 2010 of $10.3 billion versus $17.6 billion in the first half of 2009, and also reduced margin to 114 basis points in 2010 versus the first half of 2009 of 171 basis points.

Our loan fees and charges in Q2 2010 increased to $20.2 million versus $16.3 million in Q1 of 2010. And this reflects the increase in the origination embedded the loan closings that we experienced in Q2 of $5.5 billion versus $4.3 billion in Q1 of 2010.

Year-to-date for the first six months of 2010, our loan fees was $36.5 million versus $67.9 million in the first half of 2009, reflecting the lower production in 2010 versus 2009. Our net servicing revenue, which is our loan administration income that is our revenue from our servicing of loans for others, declined to $15 million in Q2 2010 versus $22.8 million in Q1 2010. This is the income from our servicing portfolio plus the effects of our hedging of that MSR portfolio. So, on the income statement, what you would want to do is net the loan administration income line item with the gain loss and trading securities line item. That second item is our own balance sheet hedge.

Even with the decline in Q2 versus Q1, it still provides us with an above average return of 12.6% for Q2 versus 12.3% for Q1 as compared to our overall target of about 6% and it still maintains our exposure well within acceptable risk tolerances.

We did have better hedge performance in Q1 versus Q2, and we did have a smaller MSR asset size in Q2 versus Q1. And we did have during the course of Q2 versus Q1 more hedge revenue, that is, on the balance sheet, hedge is recognized in our net interest margin which is reflected in the reduction in the overall net servicing revenue for Q2 versus Q1.

For the first half of 2010 versus the first half 2009, our net servicing revenue was $37.8 million versus a $5.3 million loss in 2009. And we attribute this to improve hedging results, as well as more hedge revenue being in the first half of 2009 versus 2010. Other fees and charges on non-interest income have reflected a loss of about $6.5 million in Q2 2010 versus $22 million in Q1 of 2010, and this is primarily due to a $15.4 million reduction in our secondary marketing reserve expense as our repurchases of loans from the secondary market in Q2 was reduced.

Our non-interest expense in Q2 increased to a $149 million versus $123 million for Q1 of 2010. Principally, this was due to increases from asset resolution expenses, as well as the prepayment of debt during Q2 as Joe mentioned earlier.

Our total compensation expense in commissions did decrease to $51.2 million versus $61 million in Q1 of 2010. And this reflected two things, a $10.6 million reduction in compensation expense as we reduced the number of salaried employees and as we had less expense related to stock base compensation in Q2 versus Q1 as a reversal of some bonus accruals. This was offset in part by an $800,000 increase in our commissions related to increased production during Q2.

Our asset resolution expense in Q2 increased to $45.4 million versus $16.6 million in Q1. This reflected principally about $17.9 million of increases in write-downs based on pending offers and based on updated appraisals on the properties we hold. $7.6 million of increase in allowances we hold on repurchased government-insured assets. And a $3.3 million increases in our foreclosure expenses as we continue our loss mitigation activities.

We did have a non-interests expense and income item related to warrant expense, this income item was $3.5 million in Q2 versus an expense of $1.2 million in Q1. This income arose primarily because of the decrease in the value of the warrants at the end of Q2 versus Q1, allowing us to reverse the expense. We also have a line item for loss and extinguishment of debt. We had a loss of $9 billion in Q2 2010 versus none in Q1 of 2010, and this resulted primarily from the repayment of high cost debt at the end of the quarter. $7.9 million of that loss was related to a prepayment of an FHLB advance which had a 4.86% rate and was due in February 2011, and another $1.1 million was related to our early payoff at some higher costing repurchasing agreements. With that, I will turn it back o Joe.

Joseph Campanelli

Thanks Paul. On page 29 of the presentation, we provided an outlook for 2010 for each of our key drivers. With respect to that targeted asset size, we are projecting in 2010 with an asset size between $13 billion and $14 billion, a modest reduction from our previous projection of 13.5 to 14.5. We continue our emphasis on maintaining solid capital levels and have taken the opportunity to prepay higher cost abilities which resulted in reduction on the liability side of our balance sheet. We also expect to continue to be selling virtually all of our residential mortgage loan productions, rather than growing the balance sheet for the remainder of 2010.

At June 30th, 2010, total asset size was $13.7 billion. We anticipate normal run-off offset by growth of our mortgage pipeline in warehouse lending business and rollout of the consumer micro-lending businesses as we execute a transformation plan. In addition, we also intend to continue reducing our wholesale deposits as they mature.

Moving on to the residential mortgage originations. We are reiterating our forecast for the range of $22 billion to $26 billion in residential mortgage originations for 2010. This reflects a pickup from year-to-date originations at $9.8 billion based on recent volume trends. Although industry projections for mortgage volume in 2010 continue to be considerably lower than 2009. We believe this will partially offset by an increase to our market share based on a number of initiatives that we’ve implemented and which are gaining traction. We continue to believe that we have a leadership position when it comes to utilization of technology and continue to invest, effectively originate in service residential mortgage loans. In addition, we believe that our competitive advantages will be evident as originators throughout the country continue to struggle with the recent implementation of RESPA reform, and the prospective regulatory changes as a result of the finance reform bill.

Loan sales are closely correlated to our origination targets as we continue to practice originating for sale. In the first half of 2010, we originated $9.8 billion of loans but had loan sales at $10.3 billion. The difference is the result of time lagging between origination and sale.

Margin on origination loan sales. We are increasing our 2010 estimate, the margin on origination sale of loans to a range of 100 to 115 basis points from our prior estimate of 85 to 105. Year-to-date, our margins had been 114 basis points, while this is a reduction from the record margin of 155 basis points that we enjoy in 2009. It is higher than we had initially estimated.

We believe that we would be able to continue to hold margin within the range and maintain the production levels that we have forecasted, largely due to our warehouse lending capability and what we believe to be the best in class platform for wholesale mortgage origination.

With respect to our net interest margin, we are reiterating a range for bank net interest margin 2010 to be 140 to 175 basis points. Year-to-date, our net interest margins are 148 basis points. We believe that our NIM will improve as a result of prepayment of higher cost FHLB debentures and other higher cost funding, but offset by replacing higher yielding adjustable rate mortgages and commercial loans, as well as the sale of higher yield and securities as it reduced our balance sheet. Going forward, we believe we improve NIM as we resolve and reduce and deliver non-performing loans and replace them with interest earning assets.

Finally, as part of the transformation, we are continuing to focus on core deposits to lower our funding costs and believe this will help our NIM, even if the yield curve flattens in future quarters.

With regard to provision expense, we reiterate our projection for provision expense to be between $200 million and $250 million in 2010, a reduction from the $504 million in 2009 as we build significant levels of loan loss provision. Although we continue to model the clients and real estate values, and high levels of our employment in line with the bearish market sediment, we had a static season portfolio and for observing reduction classified assets in our commercial real estate portfolio and a decline in delinquencies in our residential portfolio. Although considerable, we believe that our credit costs are both measurable and predictable, and that we will continue to aggressively manage our problems assets.

With that said, let me turn the discussion back over to Paul to open it up for question-and-answer session.

Paul Borja

At this time, we are here for anybody with any questions on the line.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from the line of Brad Milsaps of Sandler O'Neill.

Brad Milsaps - Sandler O'Neill

Just maybe a question on asset quality. Do you guys have a sense of where your non-performing, let’s maybe first start with the one to four family mortgage loans are marked on your balance sheet versus appraised value than versus maybe the loan amount outstanding, kind of on average?

Joseph Campanelli

Well, isn’t that caring. I think as a practical math, we wouldn’t mark our held for investment portfolio.

Brad Milsaps - Sandler O'Neill

I am talking the non-performing loans that…

Joseph Campanelli

On the NPLs?

Brad Milsaps - Sandler O'Neill

That’s right.

Joseph Campanelli

So, as a practical matter, with respect to the NPLs, what we do for a lot of the commercial real estate loans and what we do also for the larger residential loans is we obtain appraisals, and those appraisals are reflected in our general or specific reserves that we establish for the loans. So, with respect to the other loans what we do, general reserves, that’s modeled off of our actual charge off rates, and so we would expect that the loan loss allowance that you see in our financials would generally reflect the net value of the NPLs.

Matt Kerin

Yes. This is Matt Kerin. I think if you were to look at it from a perspective realm, perhaps what you are getting in that BPO, and if you are looking at it or suggestion kind of an accelerated disposition, we have got very high concentration in California which would be relatively strong in terms of a BPO value for an expedited bulk type of a transaction relative to our carrying value, which would correlate to the provisions that we have against, say from a normal asset resolution strategy versus an accelerated disposition play.

Joseph Campanelli

All right. And from a policy standpoint, we market based on that value in the expected time we would take to actually realize against the collateral various state timelines.

Paul Borja

We don’t typically look at marking our assets from an accelerated disposition perspective.

Brad Milsaps - Sandler O'Neill

Okay. Can you talk a little bit more about the charge-offs activity this quarter versus last quarter? I mean it sounds, in a lot of your categories you’ve showed improvement in delinquency budgets, but just kind of curious with what kind of happened from the first quarter to the second, such a large increase, I guess particularly in the CRE category.

Matt Roslin

Yeah, Brad. This is Matt Roslin. On the CRE category as long as migrated to the loss mitigation cycle, we’ve been using more receiverships and some loans came back into REO. As a drift, we use SDAs, so a lot of that wishes converting a specific reserve into a charged-off, it doesn’t slow additionally to the income statement. So, that was largely the reason for the second charge-offs on the CRE portfolio in the quarter.

Joseph Campanelli

Plus we are looking at aggressive ways to keep marking and moving them out. One of the problems of the balance sheet is the heavy weight of the NPAs than in that interest margins area. So, our goal is really to push those along so we can move forward with some of the other strategies we’ve talked about.

Brad Milsaps - Sandler O'Neill

Would you guys consider sort of the second quarter as heavy in terms of OREO costs kind of one of your heavier quarters in terms of what you are able to move out versus maybe the first quarter or previous quarters, and you might see that calm down some over the next few quarters?

Joseph Campanelli

Yeah. I mean I am focusing on all aspects of the balance sheet and looking at ways that we can accelerate processes in place and sometimes to do that you want to make sure you’ve got the adequate reserves in place to be more time sensitive as opposed to taking a longer restructuring perspective. We have seen so many industries, the practice of pretending extending and that’s a philosophy I really don’t embrace. So we just want to step it up.

Brad Milsaps - Sandler O'Neill

Okay. And then final two questions: one, do you guys happen to have the restructured loan balance at June 30, and then second, maybe just talk a little bit more about the margin. It looks like maybe you did some of that repositioning with some of the security sales maybe later in the quarter if I am kind of comparing period and balances to average balances. I’m just kind of curious what that’s going to mean for your margin in net interest income in the third quarter? Thank you.

Joseph Campanelli

Well, Paul is calculating that. You are absolutely right, we did do a prepayment of those towards the end of the quarter, so we didn’t have the benefit in our NIM. However, it reflects our strategy to really go back to a core deposit growth as a primary funding tool, and reduce our reliance on FHLB and repo funding sources.

Paul Borja

And certainly with respect to the net interest margin, a lot of it had to do with the increase of the average balances of the available for sale loans also as we deployed the capital that we received through the end of Q1 into some of the high yielding securities. It also is going to be affected to the extent that we hedge our MSRs, using on balanced sheet hedges versus off balance sheet. If we use off balance sheet hedges, the value of that which is affectively the NIM on the off of those would be reflecting the value of the increase in the value of the MSRs. So, it’s a combination of balance sheet repositioning investments and is also the handling of the MSR strategy.

With respect to the structure that Joe was referring to as you reduce your FHLB funding cost as we continue to allow wholesale deposits to run off as we continue to focus on core. The liability side, the cost side will definitely be affected. It will take some time, especially as you build towards core. With respect to the earning side of it, we will continue to see, to the extent we have a static season portfolio. We will have run off of held for investment loans, and we are also seeing a phenomenal where we are seeing commercial real estate loans, as well as held for investment loans that arms re-pricing down in the current interest rate environment. And we are working in and we believe that will be offset as we continue to focus on some of our higher yielding investments, including warehouse lending, as well as our loan production.

To the restructured loan balances, now that’s something that we would later explore in more detail in the course of the 10-Q, which we expect to be filed before the end of next week or by the end of next week.

Operator

(Operator Instructions) Your next question is from the line of Paul Miller of FBR Capital Markets.

Paul Miller - FBR Capital Markets

Just a follow-up on the last question. You hadn’t really changed your guidance of provision expense of 200 to 250, but for the first six months you were roughly at 162. So, and you feel that the march you have taken I guess with all this other stuff that your provisions will drop by roughly 30%, 40% going in the next few quarters?

Joseph Campanelli

Well, looking at it as a static tool, Paul, which is rather unique relative to other companies, and these loans have been on the book since no later than 2007. So there has been a fair amount of stress scenarios that they have been subject to relative to the accumulative loss curves in the residential side. And looking at the current environment we are in commercial real estate and what’s embedded in that portfolio. We provided a lot of transparency on both portfolios, it especially relates to commercial real estate. That really provides a break down between asset type in geographical distribution. Unfortunately, in that space, each loan is unique relative to underwriting structures and guarantor support and collateral enhancements, et cetera. But, so it’s hard to put in a chart on a graph. But we have a pretty robust process in place that we do our best to analyze the facts and circumstances as they exist and are provisioned accordingly.

So, well, we don’t have a great crystal ball given everything that we are today and where you are expecting us to go. We believe we are well provisioned with the resources to deal with it.

Matt Kerin

The only thing I would add is in looking at our roll rates without making forward-looking comments, we can’t make the decisions on our monthly trend, but if you look on rolling average, they look good.

Paul Borja

And Paul, this is Paul Borja. So, we’ve got about $149 million in loan loss provisions through Q2. As Matt Kerin mentioned, we do have roll rates that we would put in the slides. If you take a look at those you will see how we have a decline in sort of the trend that we are looking at. While we have a bearish sediment, we are seeing as indicated in the slides an improvement in the overall quality. We do have in Reg-E side about $2.8 billion of seasoned loans that haven’t been delinquent in over 36 months. So we have, within their Reg-E side, a core of very well performing loans.

On the commercial real estate side, we have a fair amount of provisions against the non-performing loans, and sometimes it’s helpful to remember that the commercial real estate non-performing loans you see are net of some charge-offs you already taken in the past. So that the provision as against the non-performing loans is till rather significant. And overall, as percentage of the overall commercial real estate loans, I believe it is well over 10%.

Joseph Campanelli

The cumulative write-downs over the last couple, they have been significant.

Paul Borja

So question answers are, we are comfortable with the drivers that we are the loan loss provision, not withstanding the amount that you see through first half of 2010.

Paul Miller - FBR Capital Markets

And then, correct me if I’m wrong Paul, but is most of your commercial real estate on loans in the state of Michigan?

Paul Borja

No. About 54% of them are. I think we have a slide on that. But there are other states. And that’s down from I think a high of 92%.

Joseph Campanelli

You grabbed their highest concentration. Is it roughly 50% plus Michigan, the second state would be Georgia and then moving down to California. But as Paul mentioned, there’s a pretty good disclosure, both coming in okay in a queue rather in these slides.

Paul Miller - FBR Capital Markets

And I mean everybody knows Michigan is still probably struggling more than most states, but have you seen any improvement or stabilization in the Michigan economy and also the Georgia economy?

Joseph Campanelli

Yeah, relatively new to the region, I spend a lot of time reconciling my expectations versus reality, and I actually see some clearly lesser rate of decline. We are seeing some positive signs under the classification within the economy. I think it’s showing in the unemployment levels and pricing stability. That being said, there are still significant imbalances between supply and demand on various asset classes. So overall, we don’t expect any material improvement. But I do believe the rate of decline has varied significantly.

Operator

Your next question is from the line of Bose George of KBW.

Bose George - KBW

I wanted to start on the delinquency numbers. Obviously it was nice to see those numbers good down so well. I was just wondering of you could talk about how you treat residential mortgage modification so again in terms of when they go back to the incurrent, and also more broadly do you think modification are helping the residential mortgage market at all?

Matt Kerin

Matt, here. I think in terms of how we treat them from an accounting perspective, where the convention is that you modify and then use them for six months on a non performing status and then they would migrate to a performing TDR status. Correct me if I am mistaken, Paul. With respect to the modifications program, I am going to give you my personnel view, and it may not be the politically correct view but…

Paul Borja

Also Matt Kerin.

Matt Kerin

This is Matt Kerin speaking. I guess I would say that while our performance from the modification perspective seems to be materially better than what you read about in the industry, I think you’ll see overall trends are improving on the re-default rates. I think that’s largely a function of the economy continuing to improve and housing prices beginning to stabilize and improve in certain areas. I personally don’t believe its benefiting the overall industry and I am more of a believer in utilization of short sales and deal new practices one, because I mitigate losses that will accelerate and perhaps but I think at the end of the day there are certain people that no matter what you so just aren’t going to be able to stay in their homes. So I think it’s creating a lot of expense and that’s my personnel view there.

Bose George - KBW

Great and thanks for that color. And actually just switching to your rep in warranty reserve, is that primarily being driven by the GSEs or is FHA in there much, and is there any non-conforming stuff that’s?

Matt Kerin

For the FHA and the Ginnies there really isn’t a really a repurchase liability per se. It’s largely driven by Fannie, in our case and to a lesser degree, Freddy. We certainly have some small amounts of repurchase requests coming from legacy portfolio that were sold in 2004, 2005, 2006, but for the most part it’s generated by the GSEs. And you will see, I am not sure if it’s in here, but, you know we do an awful lot of analysis and a lot of work around. So as you can imagine in today’s environment and if you look at our trends, we seem to have peaked in the February-March timeframe in terms of overall repurchase requests and they have flattened since that time or slightly down.

Operator

(Operator Instructions) Your next question is from the Bryce McLoughlin, a Private Investor.

Bryce McLoughlin - Private Investor

Kind of a follow-up to my question on the last two quarterly conference calls just with regards to any view to return to profitability, and just from the recent comments about measurable and predictable credit loss. Are we now in a position to give any guidance towards when the company may return to profitability?

Paul Borja

Well, this is Paul Borja. I think that what we are trying to convey during the course of this is that the major impediment for us for the last few quarters has been the credit side of it, and not withstanding the increase in the provision loss for Q2. I think what we are seeing here is we are suggesting that this main impediment is now turning favorably given the metrics there. I think a lot of it is going to be what we have talked about before which is how well we continue to last mitigate without taking these, without taking higher losses than expected. We do have a decline in our overall non-performing assets, but still have about $1 billion of non-performing assets.

One of the things that we are looking for in the normal course of the loss mitigation activities is ways to get rid of these assets because they are a significant drag on NIM, as well as to get rid of the higher costing kind of advances and restructure. So, I guess to that point the answer is going to be that’s it’s still a work in progress, we are optimistic about these turns, because this occurs at a point where we think it’s a right time in the economy. I think we talked about this about three or four quarters ago, and so we think we are moving towards it, but we don’t think that we are close enough yet to be able to give you that kind of precise date.

Joseph Campanelli

I think one of the things we tend to do is we give you sort of the key drivers and you can build your own model, but I think on each front we are looking to put behind us the legacy issues and take steps to move us in line with our peers relative to the net interest margin efficiencies, balancing a revenue stream that becomes sustainable. We’ve made those investments. We’ll be rolling out micro-lending products very shortly to enhance the revenue stream coming out of our branches. Those are all some of the key elements in addition to dealing with the legacy credit costs that will put us back on the track for profitability and sustainability. But I can assure you that everyone in management and all of the company are working vigilantly to move us as fast as we can along that track in a prudent manner.

Bryce McLoughlin - Private Investor

Fair enough.

Operator

Your next question is from the line of Zachary Prenske of Coyote Capital.

Zachary Prenske - Coyote Capital

Let me ask you a question in terms of the new originations. Can you sort of comment as to whether you are building up exposure in some of the other markets, some of the more traditional markets or is the new loan origination going to mirror somewhat of our existing loan originations look like?

Matt Kerin

Well, I guess I’ll approach you. This is Matt Kerin. Thank you. It is really virtually 100% of our production, with the exception of some CRE product that we are doing, I mean CRE product is conforming. So, in terms of building up a profile, it’s consistent with what we have doing the last couple of years. We have never been historically much of a deviator from the conforming product. We have always been a prime, maybe a prime minus shop in certain years in 3, 4, 5, 6 timeframe. So, the answer would be no. I don’t believe that would be the case.

Joseph Campanelli

And one of the things we’ve done over the last several quarters really enhance our whole risk management philosophy focus and underlying controls. When Todd McGowan joined us at the beginning of this year, he has really been the Chief Risk Officer really making sure that we have got all the policies he sees in place, referring to what type of assets and what type of liabilities we engage in and various business practices.

Zachary Prenske - Coyote Capital

Okay. That’s fair enough, and then one more additional question. In terms of building out core deposits as you spoke about, perhaps it’s a little bit early to talk about some of the respective acquisitions, but I was taking a look at some of the banks down in the Indianapolis are where we have a small exposure and the price of books are very, very reasonable and the books are for the most part clean and they seem to have transitioned very nicely there from the old automotive supplier markets to a more diverse market. Are there any sort of some small tuck-in acquisitions that could be done at around a book or book less that might allow you to build up the core deposits or are you focused on more spending money in marketing, advertising and growing existing branch-to-branch deposits?

Joseph Campanelli

Well, I am anxious to be. When the quarter comes, I could be talking to you specifically about those opportunities in activities. Right now I am a big believer that you need to need to earn the right to be an acquirer and we are taking significant steps to really to enhance the investment we have today in all our branch and various distribution channels. Once we fix what we have, the opportunities will be obviously wholly evaluating which I agree with you, there’s some very attractive price to book opportunities out there.

Zachary Prenske - Coyote Capital

Can you give us a bit of timeframe on when that focus will shift?

Joseph Campanelli

I think as the earlier caller asked, it will be right when we are talking about positive earnings and positive momentums. So we’re generating self-generating our growth capital, the re-deployed both on an organic strategy an acquisitive.

Zachary Prenske - Coyote Capital

Right. But I mean by that time these things will not be trading below book. I mean that I was kind of looking, cat kind of grabbed your own tail you run circles. I mean the Indianan markets recovering a lot better than Michigan is terms of diversifications. It’s a good place for us to deploy capital. So, if you could deploy $100 million which was kind of a rounding error to grab a $1 billion of deposits. Why would you so that today versus waiting till 2011?

Joseph Campanelli

I think it’s important that all of our stakeholders understand their commitment to address the legacy issue, but I agree totally that there is a significant opportunity cost in times of the essence and we put a management team in place that, I don’t want to say we are in a hurry, but we are certainly motivated to be an active participant at the appropriate time.

Zachary Prenske - Coyote Capital

All right. Well, time is of the essence, I’d like to hear that. Thank you very much.

Operator

Your next question is a follow-up from the line of Bose George.

Bose George - KBW

I just had a follow-up on how we should think about the asset resolution expenses going forward?

Joseph Campanelli

Yes, why don’t we break that question to two pieces, because we you really have to look at it, one from a residential standpoint, a resi mortgage perspective and the other from a commercial real estate perspective, and Matt, maybe you want to take it.

Matt Kerin

Yeah, I think if you look at the quarter, there was a significant jump in the asset resolution expense related to the repurchase of the Ginnies, which effectively covers the, we are not getting into too much detail, and two months interest foregone and we had a rather sizeable amount of Ginnies that were on the balance sheet in the quarter. So, clearly it’s not anticipated that we would incur that level of expense related to the Ginnies, which quite frankly is, we are not getting into details, it is a good economic trade for us in this environment. I think with respect to the expenses as we work through our over 120 day category of assets. We will continue to do things internally that will reduce those level or expenses whether it’s through reducing curtailments, more effectively managing the foreclosure process OREO that’s gone into the bankruptcy or foreclosure process.

A number of undertakings with respect to just the whole loss we did that effectively fully implemented beginning this quarter to convert or loss made activities in bankruptcy efforts with the combination to make it more of a workout group, so that we can be more effective in our expense management there. So, I would expect without having particulars and not knowing what’s going to happen with the portfolio, but where I sit today and looking at our rates and the stabilization in prices we went through the kind of declines in housing values that we have seen in REO perspective from the day we take it in. In those types of activities, we think we’ve got a better handle on that whole process and activity. So I would expect those would come down, I guess, in the summation.

Operator

There are no further questions at this time.

Paul Borja

Thank you Tiffany and thank you all for joining us this afternoon and we look forward to seeing you all when we make our road trips.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Flagstar Bancorp, Inc.Q2 2010 Earnings Call Transcript
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