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Flagstar Bancorp, Inc. (NYSE:FBC)

Q3 2010 Earnings Call

October 28, 2010 11:00 a.m. ET

Executives

Joseph Campanelli - Chairman and CEO

Paul Borja – CFO

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

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

Analysts

Terry Macalvoy [ph]

Bose George - KBW

Paul Miller - FBR Capital Markets

Bryce McLoughlin – Private Investor

Operator

My name is Mia and I will be your conference operator today. At this time I would like to welcome everyone to the quarterly conference call. All lines have been place on mute to prevent any background noise.

After the speakers remarks there will be a question and answer session. (Operator Instructions)

Mr. Paul Borja you may begin your conference.

Paul Borja

Good evening everyone. I’d like to welcome you to our third quarter 2010 earnings call. My name is Paul Borja and I’m 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 result and that these statements involve certain risk that may cause actual results in the future to be different from our current expectations.

These factors include, among other things, changes in economic conditions, changes in interest rates, competitive pressures within the financial services industry, and legislative or regulatory requirements that may affect our businesses. For additional factors, we urge you to please review our press release and SEC document, as well as the legal disclaimer on page two of our slides that we have posted tonight on our investor relations website for this call.

With that I’d like to turn the call over to Joseph Campanelli, our Chairman and Chief Executive Officer, Joe.

Joe Campanelli

Thank you, Paul, and good evening everyone. I would also like to welcome you to our third quarter 2010 earnings call.

Earlier this evening we filed perspective supplements related to a public offering of our securities. The security laws restrict our ability to discuss the public offering other than point you to our public filing. In that regards, we will not discuss the public offering or answer any questions relating to the public offering on this conference call.

I’m going to first talk to you a few minutes about the positive trends we see in our core business, a few industry developments, and then provide you with and update on where we stand in our transformation.

After that Paul’s going to discuss the detailed financial and then I will update the key drivers for the remainder of 2010 and for 2011. Paul and I will then take questions relating to our third quarter results.

Despite a sluggish economy and tighter margins for the industry, we were please with a number of positive trends we experienced during the third quarter. While others struggled to keep top line revenues flat we were able to increase our revenues. Exclusively with credit costs by 53% from the prior quarter.

During the quarter we lost $22.6 million, which is one of our lowest quarterly net losses since we experienced a gain in the second quarter of 2008. The $22.6 million loss also included an $11.9 million expense related to the prepayment of a $250 million FHLB advance as we continue our plan to restructure our balance sheet. The prepaid advance would have otherwise accrued interest at the rate of 4.825, well above current market conditions, through its maturity date in September 2011.

During the quarter we expect a number of improvements in our core business, combined with a significant declines in credit related expenses and a continuing improvement accretive quality.

These improvements came without having the benefit of any additional revenues and margin improvements from our transformation. I’d like to highlight a few of those core business trends to you.

Residential mortgage originations increased by 40% from the prior quarter, as recent activity increase and implementation of key initiatives in the first half of the year had a positive impact.

We also been pleased to see an increase in our third quarter gross lot market share, according to industry sources, which is typically a leading indicator of closing market share.

Gain on loan sales continue to be strong with margin for the quarter at 135 basis points. A 13 basis point improvement from second quarter.

Third quarter rate lock commitments we at the highest level this year, indicating fourth quarter origination should be strong.

Net Interest income is up just slightly for the third quarter as the decline in interest income from the refinancing of adjustable rate mortgage loans is being offset by the decline in interest expense for reduced funding costs.

At the end of the quarter, we took several steps towards improving the margin going forward. Including paying off the $250 million FHLB advance and restructuring seven other groups of advances, which we expect to see benefit in the fourth quarter. Paul will discuss those in more detail momentarily.

I’d like to now discuss asset quality and capital. During the third quarter we saw a continuation of the positive asset quality trend, which we experienced in the second quarter. As a result credit-related expenses declined in total by 30% from quarter to quarter. This was driven by the decline in provision along with decline asset and asset resolution expenses.

The total 90-plus days non-performing loans in our investment portfolio declined by 10% from quarter to quarter, to the lowest monthly level in 12 months. The decline was driven by declining levels of residential non-performing loans combined with our continued efforts to aggressively work out certain charge offs of non-performing loans in the commercial real estate portfolio.

Our Taxes ratio which measures delinquent and non-performing loans as they relate to tangible equity in our general loan loss reserves declined to 70.4% at the end of the third quarter.

During the quarter we will maintain historically high capital level with a Tier 1 ratio of 9.12% and total risk-based capital ratio of 16.87%. We also saw a 22% improvement in our efficiency ratio from the prior quarter as we continue to focus on ways to do things better, faster, and cheaper without compromising the customer experience.

Keep in mind that our third quarter non-interest expense include $34.2 million in asset resolution expense and the $11.9 million expense I referenced in the prepayment of the FHLB advance.

Last but certainly not least, I’d like to talk about the progress we’ve made in transformation to Super Community Bank.

We took a big step forward when we announced the launch of our small business banking line of products and services on October 4th. Flagstar’s on its way to being a -top shop for the nearly half million small businesses near our branches. And we can now better service those businesses by offering checking, lending, investment, treasury management, or online banking products.

I’m proud to say we can now offer all the products you would expect from a full service Super Community Bank. We also plan to launch consumer loans and programs to offer credit cards in the upcoming quarters. Flagstar’s able to leverage best-in-class customer service culture with an enhanced banking platform and a robust set of banking and lending products to offer small business owners; the same unparalleled banking experiences we have traditionally offered to retail customers.

We have hired a group of seasoned small business lenders to work with our branch managers in origination of these loans and relationships. As we continue to progress in our transformation our goal is to create a better balance of revenues to support our existing strong mortgage division. We remain committed to maintaining our position as the top mortgage originator and the third quarter mortgage banking trends prove that point.

I’d like to turn things over to Paul Borja, who will take us through the finance results before we discuss the drivers and open it up for questions.

Paul Borja

Thank you Joe.

I know you’ve all received a press release just a short time ago, so I’d like to take the opportunity to walk you through our Q3 financial results as compared to Q2 and highlight some of the key points.

From an overall net income perspective we had a $22.6 million loss, a 77% decline from the loss we had in Q2 of $97 million. Key among the reductions in the loss was a decrease in a loan loss provision, an increase in revenue from loan sales, an increase in our net servicing revenue, and as Joe mentioned, a decrease in the asset resolution expense.

As you go through the different items, net interest income, we had a decrease in net interest income to $41 million from $42 million in Q2. However, we did have an increase in net interest margins to 1.55% in Q3 versus 1.53% in Q2. Within this and the interest earning assets and interest bearing liability we had a higher average balance of available-for-sale loans due to higher production during the quarter, but we did have a lower balance of investment security balances due to some sales we had in the course of the quarter.

We also had a decline in the overall available-per- sale loan yields, but that was offset by a decline in the funding costs due to the lower retail deposit rates that we’re experiencing, also due to the prepayment of $250 million a FHLB advance at the end of Q2, and so we received the benefit of that during Q3.

In our loan loss provision, it decreased in Q3 to $51.4 million dollars from $86 million in Q2. Our reserves also declined to $474 million in Q3, at the end of Q3 versus $530 million at the end of Q2.

During the course of the quarter we saw declining delinquencies in all categories of first mortgages. We did have increased net charge offs during the course of the quarter; $174 million overall in Q3 versus $94 million in Q2. And in particular our first mortgages we had $38 million in charge offs versus $45 million in Q2. Our commercial real estate, we had $57 million of charge offs versus $31 million in Q2. Overall, charge offs exceeded our provision expense by $56 million and a result our allowance-to-loan lost to held-for-investment ratio decreased as well to 6.5% from 7.2% at the end of Q2.

Our net gain on loan sales increased to $103 million in Q3 versus $64.3 million in Q2. This reflects an increase during the course of Q3 and our interest rate locks to $11 billion from $8.3 billion in Q2. It also reflects an increase in our residential mortgage loan sales during the course of the quarter to $7.6 billion in Q3 versus $5.3 billion in Q2. And lastly an increase in the margin on our loan sales to 1.35% in Q3 versus 1.22% in Q2.

Our loan fees and charges also increased during Q3 primarily due to an increase in loan closings during Q3. Our loan fees and charges increased to $24 million from $20 million in Q2, reflecting in the increase of originations to $7.6 billion during Q3 from $5.6 billion in Q2.

Our net servicing revenue, which is the income from our servicing portfolio plus the effects of our hedging of the portfolio increased to $23 million in Q3 versus $15 million in Q2. This portfolio continues to provide us with enough above average return 15.4% in Q3 and 12% in Q2 versus our internal 6% target while maintaining our exposure well within our acceptable risk tolerances.

Our other fees and charges gained slightly to a loss to a negative 7.9 million in Q3 versus a negative 6.8 million in Q2, reflecting a slight increase in our secondary marketing reserve provisions that we hold for repurchasing loans.

In the non-interest expense category our compensation expense increase to $59 million versus $51 million in Q2 and that includes overall increasing commissions, which increased $3 million and underwriting incentives another $1 million as we had increased loan provisions.

Note also that we had a slight reduction of our overall salary expense in Q3 versus Q2 due to some adjustments to our overall bonus accruals in Q2.

As Joe mentioned, we had a significant decline in our asset resolution expense to $34 million in Q3 versus $45 million in Q2. We had a decrease of $11.3 million in losses in the foreclosed property dispositions, we had a decrease of $1.2 million in evaluation allowances we hold on repurchased government assets. And we did have a 1.3 increase in foreclosure expenses offsetting that.

You’ll note also that we had in the warrant expense category, we had an income of $1.4 million in Q3. In Q2 that was income amount of $3.5 million. That reflects the decrease in the value of the warrants based on the decline in third quarter stock price.

We also had a loss in extinguishment of debt as Joe pointed out earlier. In Q3 our loss was $11.9 million as we prepaid a $250 million advance, with a 4.825% rate at the end of September.

In the end of June we also prepaid an advance of $250 million and we had a $7.9 million prepayment expense there, net advance had a 4.86% rate. We also prepaid in Q2 some repurchase agreements so overall we had a $9 million expense in Q2 versus 11.9 in Q3.

As Joe mentioned, in addition to prepaying the FHLB advance at the end of Q3 we also restructured several tranches of our existing FHLB advances. In restructuring those advances which total about $1.9 billion, we’re able to for 2011 in overall in the tranches we reduced our overall expense as to that tranche by about 123 basis points. In looking at the overall borrowings of $3.4 billion on post restructuring basis we’re able therefore – and in addition to the $250 million prepayment in the end of September, to reduce our overall cost of the FHLB advances for 4.25% down to 3.52%.

With that I’d like to turn it back to Joe.

Joe Campanelli

Thank you Paul.

On page 41 of the presentation, we provide an outlook for 2010 and we introduce 2011 for our key drivers.

In respect, the target asset side, we reiterate that we’ll end 2010 with an asset side between $13 and $14 billion. For 2011, assuming the closing of our equity offering we are expecting to grow the balance sheets to roughly $14.5 to $15.5 billion as we build out our super community bank strategy.

Moving over to residential mortgage originations we are reiterating our forecast for a range of $22 to $26 billion in residential mortgage originations for 2010. Our Q3 originations increased while industry sources reported decrease compared to Q2, which is evident of an increase in market share we had forecast last quarter through the various initiatives we have implemented.

Based on lock and closing volume in October we should trend towards a higher end as our range.

For 2011, we are forecasting $21 to $25 billion of residential mortgage originations. With the special loan sales, we still intend to sell virtually all of our production for 2010. Therefore loan sales for the year are also forecasted in a range of $22 to $26 billion. This obviously includes any bulk sales of legacy assets that we may consider if the equity offering is consummated.

For 2011, we are forecasting loan sales of $20 to $24 billion again, excluding any bulk loan sales of legacy assets.

Turning to our margins and origination sale loans, we are increasing 2010 estimate for margin and origination sale of loans to a range of 110 to 125 basis points, up from our prior estimates of 110 to 115.

Year-to-date loan margins have been 123 basis points, an obvious reduction from the record margin of 155 basis points we enjoyed in 2009. It is higher than we had anticipated.

We believe that we’ll be able to continue to hold margins and maintain a production levels that we have forecasted, largely due to our wholesale lending capacity on what we believe to be a best-in-class platform for the wholesale mortgage origination.

In 2011, we are forecasting margin on origination sale of loans to range of 95 basis points to 115 basis points.

On a net interest margin we are reiterating our range of bank and interest margins for 2010 to be 140 to 175 basis points. Year to date our net interest margin is approximately 150 basis points and for Q3 it was 155.

We believe that our NIM will improve as result of the prepayment restructuring of our higher cost FHLB advances and our asset liability strategies that we are deploying. For example, if the FHLB prepayment restructuring had occurred at the beginning of Q3 and the repaid advance had been replaced by 2% deposit funding our NIM for the third quarter would have been 182 basis points.

For 2011, we are forecasting a net interest margin in a range of a 175 to 210 basis points, assuming the consummation of the equity offering.

Going forward we believe that we can improve our NIM as we dispose and reduce on the level of non-performing loans and replace them with interest earning assets.

Finally as part of our transformation, we are focusing on growth in our core deposits to use for our lower cost funding and believe our net interest margin will improve, even if the yields go flat in the future quarters.

With respect to our provision, we are projecting for provision expense to be between 200 and 250 million for 2010, a reduction from over $500 million in 2009.

For 2011, we are forecasting a provision expense of $100 to $150 million. Although, we continue to mild declines in real estate values and higher levels of unemployment, in line with a bearish market sentiment we have static season loan portfolio and have been observing a reduction in classified assets in of course your real estate portfolio and observed a decline in delinquencies in our residential portfolio.

As with other drivers, our projection assumes the consummation of the equity offering, which will allow us to accelerate our transformation by disposing non-performing assets.

With that said, let me turn our discussion back over to Paul for question and answer session.

Paul Borja

Thank you Joe. And now we’ll go ahead if there’s any questions or answers we’d like to go ahead and take them at this time.

Operator

(Operator Instructions) We have a question from Terry Macalvoy [ph].

Terry Macalvoy [ph]

Good evening.

Paul Borja

Good evening, Terry.

Terry Macalvoy [ph]

And I apologize because I haven’t read all of the filings, I’ve just had a chance to listen to this call, but will MP be a part of the capital raise or this be completely non-Matlin Patterson investors?

Matt Roslin

Terry, this is Matt Roslin, due to security restrictions we can’t speak about the offering on this call.

Terry Macalvoy [ph]

Got you, okay. And then I guess if I look at the new capital from you commentary earlier, it sound like that would accelerate the disposition of some of your problem assets alone. You’d have bulk sale some of those MPAs. As you look at your kind of 2010, 2011; I appreciate the provision estimate, but any estimate or forecast on charge offs, where do you see MPAs heading, to give us a sense of where the reserve could trend over the next five quarters.

Matt Roslin

Before I have Paul get into specifics, I’d like to give you a little color on it. Obviously, we’ve been working this portfolio aggressively for coming up to a year now and we feel good about the trends, our ability to reduce delinquencies in bulk portfolios. I think the third quarter really shows some positive results from aggressive servicing both on a residential and commercial real estate side. So, we would expect in spite of a sluggish economy to continue to work the portfolio and looking at opportunities to accelerate the disposition through a variety of strategies, quite candidly.

Paul you want to give a little color on it?

Paul Borja

And I think we’re not at this time prepared to give exact numbers, but what we’re anticipating at this point is a continued flow of charge offs and that we would expect that over the course of the next four to five quarters that the charge offs would be exceeding provision, so that you would have a steady decline in the overall reserves. This depends, of course, in large part to a number of things. One is our continued servicing and loss mitigation efforts on these loans. Secondly, the overall economy, and thirdly it will be influenced to the extent that we do fine opportunities to mitigate assets, to mitigate loss through any kind of transactions that might come up. But at this time what we’re looking at here is just the opportunity to continue to work our assets down as efficiently as possible.

Terry Macalvoy [ph]

Again, I appreciate you giving me the outlook for this year and next year. What I don’t see is kind of expenses. Could you just talk about maybe a core expense level you see heading into the fourth quarter into 2011 and I guess simply put, do you think the company will be profitable in 2011 based on your expense guidance?

Paul Borja

Well we’ve, this is Paul. We’ve not given expense guidance out in the past. We normally have talked though over time about achieving and efficiency ratio that we believe is appropriate for a shop of our size and that would be anywhere from 80% down to the 60% size. From the profitability perspective we used to give out as you know actual indications of EPS, we stopped that awhile and have stayed with drivers. We may be revising the list and types of drivers in the future, but at this point we don’t comment on future profitability.

Joseph Campanelli

To give you a little color, we’re excited about the direction of that the third quarter shows a lot of progress and addressing problem loan resolution with about 35% reduction in the overall cost of provision and asset resolution.

So we expect those efforts to continue to be productive and improve efficiencies on that front and we believe those trends will continue. Our goal stated from day one is to restore Flagstar Bank to a sustained of profitability as quickly as possible so all our efforts have been really around addressing both the expense side of the equation in addition to the revenue side.

We’re excited to see a lot of the initiatives on the mortgage side really coming to fruition now with some good upside there and some excellent work on our team maximizing again on sale margins, productivity levels. Also, we’re starting to get the benefit of the investment we made on the small business front rolling out a good hefty cash management and credit product and we expect to continue to accelerate that transformation while being very disciplined on the expense side. So essentially finding ways to be more efficient in our current operation and using those efficient gains to invest in revenue opportunities that lack somewhat, but we’re excited about the efficiencies and productivity gains that are out there and continued opportunities to enhance them.

Terry Macalvoy [ph]

Appreciate it, thank you guys.

Joseph Campanelli

Sure.

Operator

Your next question comes from Bose George.

Bose George - KBW

Good evening. I don’t know if you can answer this either since it is on the capital raise, but in terms of the deployment is it, I know we can think about what will be used for loan resolution versus other purposes.

Matt Roslin

Bose this is Matt again, I think we’d just direct you to the press set that’s going to be filed.

Bose George - KBW

Okay. Then I’ll switch attacks and move more to mortgage banking. Just wanted to touch on all the noise that’s going on in terms of foreclosure moratoriums and all that stuff. Just wondering if there is any sort of meaningful slowdown in foreclosure timelines, does that have any impact on you guys as a servicer and how do you see this whole thing playing out?

Matt Kerin

This is Matt Kerin. I think from the perspective of the timeline while you hear anecdotally that people are saying it could be anywhere from six months to a year in terms of their horizon. We really have not seen much of an impact and I don’t think you’ve seen it in the capital markets with respective trading on CNBS and others.

Clearly there are a number of firms, us included, that have taken the time to go back and make sure that our policies and procedures were appropriate for the activities that were being undertaken and satisfy ourselves that we’re in compliance with the servicing guidelines and alike. So I think from an expense perspective certainly we’re spending some time and effort making sure that everything’s being done right. We’ve been fortunate that we were not in a bulk acquire of assets, all of our loans are largely underwritten by our staff on site, we’ve got seasoned people and managers in the various roles and activities related to the collections and the lost mitigation, and our foreclosure activity. So we’re not seeing any signs at this juncture.

Bose George - KBW

Great. One more specific question that. In terms of the GFCs and their schedule of reimbursing on service or advances, is that connected to the foreclosure timeline at all or do they just reimburse you after whatever certain period of time.

Joseph Campanelli

They’ll reverse if appropriately submitted I think the bigger issue is if they determine that the guidelines weren’t followed as directly as they could be, they decide they’re going to invoke penalties for failure to live up to their standards, which hasn’t happened to us yet per se.

Bose George - KBW

Okay and then there’s one last thing. You did comment on the rep and warranty costs I think earlier, but what was that number this quarter, was that the trend on that, is that stable, up, down?

Joseph Campanelli

Our rep and warranty expense is pretty much been flat since March. There’s been some up and down volatility over the months, but I think if you looked at it over that six months it’s pretty much average in the $8 to $10 million range.

Bose George - KBW

Okay, great. Well thanks a lot.

Joseph Campanelli

Thank you Beau.

Operator

And your next question comes from Paul Miller.

Paul Miller – FBR Capital Markets

Hey guys, how you doing? I’m in Cincinnati on the road, so I have not seen any of the filings and I’m going by just listening to the call. The question I have is, where are you on PA stand now, I know you went over it a little bit and there was a lot of speculation that you guys are trying to selling $1 billion, it looks like you sold roughly $500 million. Are you continuing trying to sell other non-performing assets or this the sale and then you’re trying to get and you’re going to try to work through the rest through the balance sheets?

Joseph Campanelli

Paul you’re probably traveling so I’m not sure where your data points source is, but through the third quarter we’ve been working through our loans organically. All of the declines and NPAs and reduction of delinquencies really make our asset resolution strategies both under residential side working our loans organically, so to date I have not done any bulk sale of assets or anything else.

Paul Miller – FBR Capital Markets

I apologize, like I said I’m on the road, but so where’s you NPA stand right now then?

Joseph Campanelli

Well right now as of September 30th, our NPAs are $1.14 billion down from $1.24 billion at the end of Q2 and our over 90 day non-performing loans are at $911 million, down from $1.13 billion at the end of Q2.

Paul Miller – FBR Capital Markets

And then I know there’s been a lot of speculation of you guys trying to market those assets. I know it’s been in the media, I don’t know if you want to make any comments about that or can you add any color or are you trying to sell these assets?

Joseph Campanelli

We don’t comment on rumors and that’s about the jest. Paul you have anything to add.

Paul Borja

I think what we’re doing right now Paul is in the same thing we’re doing over the last few quarters, is through our loss mitigation area working to working these assets down as efficiently as we can so we can free up room on the balance sheet for higher earning assets.

Paul Miller – FBR Capital Markets

And did you disclose where you’re carrying these assets are in the releases today?

Joseph Campanelli

Well we have tables in the back of the release that show the book values of these, we have book values of these assets and then we have appropriate reserves with them, so that would get us to our overall value.

Paul Miller – FBR Capital Markets

And can you, I mean, I just don’t have access to Paul to those, can you tell me what those numbers are?

Paul Borja

With respect to the overall reserves?

Paul Miller – FBR Capital Markets

Yes.

Paul Borja

Well our overall reserves declined to I think 470, but I don’t believe we have them, we’ll have the 10Q soon, which will break out and actually we have, Paul?

Paul Miller – FBR Capital Markets

Yeah, I’m here.

Paul Borja

We do have in one of the tables a description of each of the loan categories, we have a general certificate reserves that go with each of those to total to $470 million in reserves. And this is one of the schedules to the original release.

Paul Miller

Okay, I’m sorry about that because I just don’t have the releases. Thank you very much for the call.

Paul Borja

Okay, thank you Paul.

Operator

(Operator Instructions) And we have a question from Bryce McLoughlin.

Bryce McLoughlin – Private Investor

Good evening everyone. Can you comment on the release Thursday, comment about the evaluation of a firm offer of $473 million of non-insured, non-performing residential first mortgage loans, that price at 44% of book value before reserves, is there any time frame you can guide us to as to when that decision would be made?

Joseph Campanelli

I don’t know, Matt Roslin would you like to address that?

Matt Roslin

Yeah, I mean, as it indicates in the release the company will be evaluating the decision following consummation of the offer.

Joseph Campanelli

So at this time it’s something out there that we’re looking at, but nothing has been decided upon, so we can’t give you a timeframe right now.

Paul Borja

Would there be another question?

Operator

At this time there are no other questions.

Paul Borja

Well thank you everyone for joining us on our call this evening. We look forward to future conversations.

Operator

Excuse me Paul.

Paul Borja

Yes.

Operator

I’m sorry, there is another question that just came in to queue from Terry Macalvoy [ph]..

Paul Borja

Go ahead.

Operator

Okay, I’m sorry he withdrew his question.

Paul Borja

Okay, thank you everyone.

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