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Flagstar Bancorp, Inc. (NYSE:FBC)

Q2 2014 Earnings Conference Call

July 23, 2014 11:00 AM ET

Executives

Paul Borja - EVP and CFO

Sandro DiNello - President and CEO

Lee Smith - EVP and COO

Analysts

Scott Siefers - Sandler O'Neill

Paul Miller - FBR Capital

Kevin Barker - Compass Point

Bose George - Keefe, Bruyette & Woods

Scott Siefers - Sandler O'Neill & Partners

Operator

Good day, and welcome to the Flagstar 2014 Second Quarter Earnings Call. Today’s conference is being recorded. 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 welcome you to our second quarter 2014 earnings call. My name is Paul Borja, and I’m the Chief Financial Officer of Flagstar Bank.

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

These factors include among other things, changes in economic conditions, changes in interest rates, the outcome of pending litigation, competitive pressures within the financial services industry, and legislative or regulatory requirements that may affect our 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 a legal disclaimer on page 2 of our second quarter 2014 earnings call slides that we 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, also with me today are Lee Smith, our Chief Operating Officer; Mike Flynn, our General Counsel and Steve Figliuolo, who recently joined Flagstar as a Chief Risk Officer subject to regulatory approval. Steve will be responsible for managing the office of enterprise risk management which oversees credit risk, operations risk, modeling and analytics, mortgage risk and loan review operations. Welcome Steve.

Let me first lay out the order of the call. I’m going to begin by reviewing the key items and actions we undertook during the first quarter which we believe position our company for growth and success during 2014 and beyond. I then want to go into the key drivers of our second quarter financial performance.

After my comments, Lee will update you on our operations areas, including the servicing business and non-interest expense initiatives. Paul will then take a deeper dive into the financial results for the second quarter and provide our outlook for the third quarter. With that, let’s begin

During the first quarter of 2014, we undertook specific actions that we identified during our last earnings call to reserve against future losses, to address regulatory matters, to prudently grow our balance sheet, to finalize the efforts to right size our non-interest expense and to begin the execution of revenue diversification initiatives. Our actions reflected our continued focus on de-risking as well as a new focus on positioning our company to prudently re-grow our balance sheet and to begin to explore diversifying our operations.

We believe our second quarter performance demonstrates that we have made good progress towards these goals. For the second quarter 2014, we leveraged our efforts from prior quarters to reach profitability by undertaking actions that achieve the following:

We maintain market share in a challenging mortgage environment while not significantly compromising margin. We continued down the path of establishing a formidable sub-servicing business. We continued the prudent growth of our loan portfolio particularly warehouse and C&I lending and I think it’s important to point out that the warehouse growth was not just seasonally related. Our team has been successful in growing relationships with larger TPOs that do not sell for Flagstar and this has fueled the warehouse loan growth.

We funded asset growth with the increased core deposits, we maintained our net interest margin by growing our higher yielding assets and focusing on growing our more cost effective funding sources and we monitored and addressed outstanding and emerging issues regarding our loan loss reserves particularly as it relates to our portfolio of interest only, residential first mortgages and end of term seconds and [indiscernible].

Now, let’s turn to slide three into our financial performance.

We are pleased to report second quarter net income and fully diluted earnings per share of $25.5 million and $0.33 per share respectively. Our results validate the hard work and careful efforts we have put in during 2013 and the first half of 2014 to reposition Flagstar. Apart from two non-core items that I will highlight momentarily, our second quarter results are consistent with the guidance we provided during our last call. In a very competitive market, we were able to execute in a manner that yielded both incremental and profitable growth.

As highlighted on slide four, a quick review of our results demonstrates this performance. We increased net interest income by 7.3% as compared to our 10% guidance. We earned as guided, a relatively flat bank net interest margin of 3.06%. We increased mortgage locks 38% compared to our guidance of 25%. We’ve realized a gain on sale margin of 82 basis points against guidance of 93 basis points, but this miss was largely offset by the higher than projected lock level.

We reduced the concentration of MSR assets to 24.3% of tier 1 capital, compared to our guidance of approximately 22.6%. We experienced charge-offs of $7.2 million below the guidance which was that we would be slightly below the Q1 level of $12.3 million and while total non-interest expense was within guidance, we did have asset resolution expenses that were approximately $7 million more than expected as the challenges associated with managing this expense have yet to obey.

Our strategic initiatives remain designed to enhance our core net interest margin primarily through the growth of our community bank, to improve our mortgage banking platform, to build the sub-servicing business and to deliver improved operating efficiencies system wide. We believe our continuing focus on these key strategies will serve to further develop the consistent sustainable earnings platform that we’ve previously discussed.

While we are certainly pleased with the progress we have seen which has been confirmed by our core results, our second quarter results were also favorably impacted by two non-core items totaling approximately $20 million pre-tax. About half of this was related to loan fees and charges, the other half was attributable to a change in the estimated timing of payments impacting the fair value of the liability associated with our previous DOJ settlement.

With regard to our net interest income and margin as shown on slide five, second quarter net interest income increased to $62.4 million, from $58.2 million in the first quarter and our bank’s net interest margin remains steady at 3.06% as compared to 3.05% in the first quarter. This is a result of our successful efforts to increase interest earning assets and to fund that increase in a way that didn’t negatively impact margin.

Now let`s turn to slide six and seven and talk about the mortgage business. During Q2, mortgage originations increased to $6 billion compared to $4.9 billion in the first quarter and fall out adjusted mortgage rate lock commitments increased to $6.7 billion compared to $4.9 billion in the first quarter. We again saw compression and gain on sale margins due to market forces and competitive dynamics. This caused our margin to decrease by 11 basis points during the quarter.

However, accepting this slightly lower margin allowed us to increase locks and in turn, gain on sale incomes during Q2 increased to $54.8 million from $45.3 million in the first quarter. Approximately half of the noted decrease in margin related to reduction in base pricing and the other half related to other costs associated with the volatility of interest rates. So despite the decrease in margin we are encouraged by these results as they clearly reflect our successful efforts to balance production against revenue.

As noted in trade publications, industry origination volumes are at cyclical lows, but did improve seasonally during the second quarter and we believe that Flagstar second quarter volumes improved proportionate to the industry. As discussed in previous calls, we have been working hard to reduce our MSR to tier 1 capital level in a way that does not significantly compromise our business model.

And now regarding while we have prudently managed our ratio from over 50% to 24.3% at June 30, 2014 when selling MSRs we have for the most part, been able to enter into companion sub-servicing agreements thereby maintaining customer relationships and supporting the growth of our sub-servicing business. This approach to managing our MSR levels has the potential to bear lots of fruit going forward as compared to simply selling MSRs on a servicing lease basis.

Moving to non-interest expenses, Lee will dwell into operating efficiencies a little later but we are pleased with the success we have had in reducing and managing our non-interest expenses. Our commitment to managing NIE will not win.

Turing to loan quality, please turn to slides 8 and 9. Our charge-offs declined again this quarter, another very encouraging metric and our reserve levels remain well above our levels of non-performing loans. Charge-offs were $7.2 million in the second quarter compared to 12.3 million in the first quarter, a decrease of 42%.

The provision for loan losses decreased to $6.2 million in the second quarter compared to 112.3 million in the first quarter. You may recall that a substantial portion of the first quarter provision resulted from an increase in the Company’s loss estimation period and from increase in the reserve related to the reset risk on interest-only, residential first mortgages.

Finally the ratio of allowance for loan losses to non-performing loans held for investment, still remain strong at 263% at June 30 compared to 287% at March 31. With respect to delinquencies, we saw a decline in the 30 to 89 days past due category of $15.1 million. This improvement was partially offset by a $9.4 million increase in the 90 plus days past due category.

Also though NPLs increased about $10 million, REO was unchanged as such we remain optimistic that we will continue to see improvements in the overall quality of our HFI portfolio.

Prior to my closing comments, I would like to take a moment to discuss our intentions regarding our TARP preferred securities. In that regard, we believe that there are three options available to us, refinance with our preferred, redeploy excess capital at returns in excess of 9% or repay the TARP preferred with existing sources of liquidity. It’s important to note that we may be limited in our current ability to repay TARP as a result of certain regulatory restrictions. Consequently we are focusing on the first two alternatives. We will evaluate these options carefully while taking into account the intrinsic value of the Flagstar platform over time.

In closing, I'd like to emphasize a few items. First, we remain committed to controlling non-interest expenses. Second, we remain committed to growing net interest income in a prudent fashion. Third, we remain committed to being a leader player in the mortgage industry in terms of both originations and servicing. And lastly, we continue to be optimistic about the future prospects for Flagstar as we build a company that we believe will produce consistently strong earnings and grow shareholder value. As I said last quarter, we are deeply dedicated to the task at hand.

With that my colleagues will take you through a more detailed discussion of our operations and financials. I'd like to now turn the call over to Lee.

Lee Smith

Thanks, Sandro and good morning everyone. During the quarter, we continue to execute on our cost optimization and de-risking initiatives as well as commence certain revenue enhancement strategies. As we previously articulated, the sequencing was critical in order to create a solid platform from which we can grow successfully and profitably across our mortgage origination, servicing and community bank business lines.

Please turn to slide 19, our total non-interest expense during the second quarter was 121.4 million. This compares to a 139.3 million for the first quarter and for the fourth quarter 150 million after normalizing for the prepayment adjustment with respect to the FHLB advances and the additional Departments of Justice estimated liability.

If we add back the 10 million non-core Department of Justice fair value adjustment to our non-interest expense, we get a normalized non-interest expense run rate of a 131.4 million this quarter.

We previously provided guidance for non-interest expense to range from 520 million to 540 million on an annualized basis. And our first and second quarter run rate puts us squarely within this range at approximately 534 million after subtracting the one-time severance and outplacement expense in Q1 of 3.6 million.

For the first six months of 2013, our annualized non-interest expense run rate was 742 million, so in 12 months we've been able to reduce non-interest expense cost by 208 million or 28% on an annualized basis of which approximately 138 million have been fixed cost reductions and 70 million have been variable cost reductions because of reduced mortgage origination volumes.

From a fixed cost perspective, our cost optimization efforts have been focused around optimizing headcounts and structure, centralizing vendor management and procurement, outsourcing non-core operations, containing asset resolution cost and realigning our real estate footprint. The significant cost reductions were necessary given the decrease in mortgage origination volumes and margins over the last 12 months. We generated approximately 100 million of gain on loan sale during the first six months of this year versus 282 million during the same period last year. This is a reduction of 65% on a relative basis. So as you can see we needed to right size that cost base in order to properly align overall expenses with revenue projections before any one time adjustments. And we believe we’ve done exactly that.

Our reported adjusted efficiency ratio for the quarter was 71.3% versus 91.3% last quarter. However, after adjusting for the 20 million in pre-tax non-core items that Sandro discussed earlier, we get an efficiency ratio with 82% versus 91.3% last quarter. The improvement in efficiency is predominantly the result of the 8 million quarter-over-quarter improvement in non-interest expense after excluding the non-core DOJ item.

Higher interest income and higher gain on loan sale income. We believe we’ve now right sized the cost structure of the organization to the point where we can generate profitable pre-credit cost earnings at any time during the mortgage banking cycle. But just because we’ve hit our non-interest expense target does not mean we’re going to stop looking for additional efficiencies.

We continue to work diligently on various initiatives to further optimize our cost base and make our sales more efficient across the entire organization. We continue to be active in terms of de-risking and positioning the balance sheet for future growth during the quarter.

If you turn to slide 20, you will see that we have 802 million of interest only loans on our balance sheet that is yet to reset. Of this, 117.5 million are due to reset during the remainder of the year. The anticipated payment shock associated with these resets versus current mortgage payments is approximately 100%.

During the last earnings call, I mentioned that we would be sharing considerably more information around the I/O portfolio and that’s exactly what the next few slides are intended to do.

If you turn to slide 21, you will see that since January 1, 2013 and through June 30, 2014, we have experienced 695 I/O resets. Of these 695, 144 have paid in full, 117 have been sold or modified, 47 have been charged-off or foreclosed on, 21 are delinquent and has been referred to default servicing, 297 are cash flow in resets, of which 284 have been paying for three months or more and 69 are in the process of being resolved, the majority of which we anticipate will be cash flow in resets.

As I’ve mentioned, we’ve put a dedicated team together to get ahead of these resets. We want to make our borrowers aware of the upcoming event and layout of various options available to them. It’s allowing us to get ahead of the reset dates and be proactive in refinancing or modifying such loans if that’s something our borrowers are interested in doing.

Another key metric is the right party contact rate which measures how often our team is getting in touch with the borrower directly. For Q2, we had the right party contact rate of 99.8%. We're already at 97.4% for Q3, where we have a 151 I/Os resetting, and 82.6% for Q4, where we have a 151 I/Os resetting, an 82.6% for Q4 where we have 438 I/Os resetting.

Here is what else we're tracking and noticing. If you turn to page 22, you will see the 47% of that I/O portfolio our loans on properties in either Californian or Florida, two of the top five states the house price appreciation over the last 12 months.

Page 23 shows the aging of all cash flowing resets. And as you can see, 96% of all cash flowing resets have been paying for three months or more and 30% have been paying for six months or more.

With respect to overall quality page 24 shows that 83% of all remaining I/Os have FICO scores greater than 660, and 80% of those same loans have LTVs less than a 100%. The rolling 12 month average loss severity on the I/O portfolio is lower than on the non-I/O portfolio through June 30, 2014 based on historical data. At the end of Q2, we had a fast five ALLL reserve against our I/O portfolio of 91.1 million versus 101.5 million at the end of Q1. The reduction in the reserve of 10.4 million can be directly attributed to lower loss rates of more granular reporting.

We’re very pleased with the proactive way we are managing this portfolio and the strong metrics and statistics surrounding it and we intend to update these metrics on future earnings calls.

During the quarter, we sold approximately 9 billion of MSRs and retained the sub-servicing on 5 billion of these sales or 22,000 loans. As of June 30, 2014, we had 289 million of MSR assets on our balance sheet, represented by 25.3 billion of underlying loans and an MSR tier 1 ratio of 24.3%. 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 of the loans from such sales.

As we’ve said before in a perfect world and everything else being equal, if you value the MSR actually correctly there should be no gain and no loss on sale other than the associated transaction cost. The value of our MSR asset is estimated using fair value accounting. And our MSR book contains many products with different interest rights and entities. The asset is also hedged. As a result, you cannot back into a blended valuation of this asset given the different characteristics of each MSR cohort that rollup to the consolidated MSR valuation, the mark-to-market movements and associated hedging risks.

The MSR asset is high yielding and whilst we will look for opportunities to reduce our concentration further assuming it makes economic sense to do so, we wouldn’t want to ever entirely eliminate the MSR asset we carry on our balance sheet. Our asset quality ratios remain strong relative to peers with our ALLL to NPL coverage ratio being 263.1% versus 94.2% 12 months ago. The improvement is a result of selling approximately 540 million in UPB of MPLs and CDRs during the last 12 months, and the increase in the ALLL reserve last quarter.

If you turn to page 10, our R&W pipeline has declined to UPB 53.7 million at the end of the second quarter, down from 69.4 million at the end of the first quarter and 115 million 12 months ago. As you can see, we continue to work aggressively and diligently to eliminate legacy risks from the balance sheet and to provide transparency and visibility into where the remaining risks are and how we’re working to resolve and mitigate those risks.

I’d now like to talk briefly about some of our strategic growth initiatives. When we think about the bank, we break it down into three business line verticals; the mortgage origination business, which comprises our wholesale and retail origination platforms; our servicing platform; and the community bank that includes both commercial lending and the retail branches. As everyone is aware, the origination market has decreased significantly from the height of the refinance boom in 2012 when the market was estimated to be 2 trillion in size. In 2014, the Mortgage Bankers Association, Fannie Mae and Freddie Mac are estimating a market size of approximately 1.1 trillion.

This reduction in size has led to market duplication that we believe we can benefit from. We’re the eighth largest mortgage lender in the country and we’ve already done a lot of heavy lifting around cost optimization and derisking the balance sheet, so we can focus on growing our current 2% market share.

We’ve recently introduced some new products and processes such as the construction to permanent loan, a piggyback second loan, flexible jumbo loan and the pipeline advocate program. We also sold approximately 234 million in unpaid principle balance of jumbo loans during the quarter for a gain of 3.7 million at the transaction cost. This is something that fits in with our core competency of originating mortgage loans and selling them. There is a lot of private capital that's interested in buying these type of products, and we’ve set up the same flow process we have with the GSEs on conforming loans.

As a result, such loans stay on our balance sheet for short period of time before we sell them. Not only does this keep our capital turning it enables us to establish key relationships with private buyers. We also have the capacity to portfolio such loans if the economics associated with any transaction do not make financial sense.

We continue to be excited about what we’re doing on the servicing side of the business. And during the quarter, we signed a contingent subservicing agreement with Fannie Mae for loans that are current and performing up through 59 days delinquent. As mentioned earlier and during the quarter, we executed on the sale of 5 billion in aggregate UPB of residential MSRs where we will act as sub-servicer. We’re currently servicing approximately 367,000 loans. Of which, 213,000 are subserviced for others and 154,000 are either own bias or we own the mortgage servicing asset.

As we have discussed before, 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. To that end, we intend to leverage our unique servicing platform as quickly and effectively as possible.

The servicing industry landscape is changing as private capital continues to enter the market looking for yield opportunities together with the ever increasing regulatory scrutiny and oversight. Operationally, costs are increasing particularly as it relates to risk management, compliance and regulatory oversight. And as a result organizations are leveraging existing infrastructure through the developments of strategic partnerships. We believe we are well positioned to prospering this rapidly changing landscape given our retool servicing platform, the fact we’re a bank and already have a large infrastructure in place that’s focused on risk management and regulatory matters. And as an originator of mortgages and seller of MSRs, we know the market.

With respect to the community bank, during the first six months of this year, we have grown C&I lending by 123 million, CRE lending by 140 million and warehouse lending by 260 million, for net increase in new loans of almost 500 million. It is our intention to continue to grow this side of the business in a controlled, safe and sound manner as we have been doing to-date. We continue to focus on the Michigan market and are looking at new products that leverage existing skill sets within the bank. As you can see, it’s been another busy quarter but I firmly believe we created a platform from which we can push to grow existing and new lines of business and we continue to be excited and energized by the progress being made here at Flagstar.

With that I'll hand it over to Paul.

Paul Borja

Thank you, Lee. I am going to now review the key components of our overall second quarter financial results and update you on our third quarter outlook for the key drivers of our financial performance. In that regard please refer to slide 11 which provides an income statement bridge and highlights the key items that changed during the second quarter as compared to the first quarter. We have also prepared a summary income statement on slide 12 and balance sheet highlights on slide 13. We reported earnings of $25.5 million for the second quarter. This compares to a net loss in the first quarter of $78.9 million.

Please turn back to slide 5. Our net interest income increased to $62.4 million for the second quarter as compared to $58.2 million for the first quarter. As you can see on the bottom left chart, interest income increased by $5.6 million from the first quarter. This was offset by a $1.3 million increase in interest expense as shown on the bottom right chart. From a rate volume perspective, the increase in interest income was primarily attributable to increases in average interest earning balances of investment, securities, mortgage loans available for sale and warehouse loans offset by a decrease in first mortgage loans held for investment.

The increase in interest expense was primarily attributable to a 7 basis point increase in the average rate of deposits. As a result, having improved asset mix and higher yielding assets particularly warehouse, commercial real estate and C&I loans, offsetting slightly higher rates for deposits. Our net interest margin for the bank improved to 3.06% during the quarter from 3.05% during the first quarter.

Turning to slide 14, you can see that we continue to do a good job of gathering core accounts and improving our deposit mix. Overall core deposits increased 4.6% and the percentage of core deposits were steady at 81% in the second quarter compared to 80% in the first quarter.

On the bottom half of slide 14, our overall deposit funding increased $334 million or 5.3%. We will continue to focus on growing our core deposit base to maintain a strong net interest margin as our need for funding increases.

On slide 15, we highlight some of the trends in commercial loans. Our commercial loan portfolio continues to look legacy commercial loans which are originated in 2009 and prior and newly originated commercial loans which we consider core. We have been able to grow the portfolio of new commercial loans during the second quarter by 17%. As noted by Lee, this remains a major component of our balance sheet growth strategy and we continue to see good results.

For the third quarter, we expect our net interest income before provision for loan losses will increase between 2% to 4% as compared to net interest income in the second quarter. Our view of such improvement in net interest income arises primarily from an expected seasonal growth in mortgage origination volume and growth in our commercial loan portfolio.

Turning back to slide 7, net gain on loan sales increased to $54.8 million for the second quarter as compared to $45.3 million for the first quarter. This increase was attributable to an increase in volume of our mortgage locks offset by a decline in gain on loan sale margin. Flagstar has been committed to maintaining rigorous price discipline and will continue to do so going forward.

Turning back to slide 6, we provide some additional details on our first mortgage originations including by channel and product. As you can see, purchase originations continue to become a bigger percentage of our overall mortgage production. For the third quarter, we expect that the volume of mortgage loss will increase by 5% or more as compared to the second quarter as we conclude the summer season. However, we would expect that the gain on sale margin will decrease slightly compared to the second quarter resulting from continued market pressure on margins.

We expect that this decline will be offset by the projected increase in volume of mortgage locks. Loan administration income was $13.9 million, a decrease from the $19.6 million recorded in the first quarter. For the third quarter, we intend to continue to seek opportunities for the disposition of the MSR asset from time-to-time, so that we maintain concentration levels appropriate for risk management. We expect that the amount of MSRs will continue to fluctuate but that through planned transactions, Flagstar’s MSR to tier 1 ratio at the end of the third quarter should be at or slightly above the ratio at the end of the fourth quarter of last year.

Please turn to slide 16, with respect to credit cost, we focused on three key areas, loan loss provisions for our loans held in our investment portfolio, rep and warranty provision expense which relates to potential put back losses from loans we sold over the years into the secondary market and asset resolution expenses, which primarily relate to our foreclosure expenses from our held-for-investment loan portfolio and the expenses associated with managing down our insured government loan portfolio. As you can see on this slide, these three credit costs for the second quarter reflected an expense of $29.3 million as compared to a $122.1 million for the first quarter. Loan loss provision decreased to $6.2 million, as compared to a provision of a 112.3 million in the first quarter.

Turning back to slide nine, you can see that non-performing loans have come down significantly from levels a year ago. Our overall allowance coverage of non-performing loans was 263.1% as of June 30, 2014. For the third quarter, we do not expect that a significant amount of net loans will be added to or decreased from the HFI portfolios. We expect a stable performance which expect the net charge offs and do not expect any meaningful change in our reserve level from the second quarter.

Our provision for rep and warranty expense, by which we reserve for possible losses from loan put backs, was $5.2 million for the second quarter as compared to income of $1.7 million for the first quarter. The first quarter reflects a release of hold back reserves from prior MSR sales.

On slide 10, we provide further details on our rep and warranty reserve. During Q2, we updated our analysis to reflect loss rates from our repurchase loans, which are affected when loans are repurchased in a higher interest rate environment than when originated. This impact has been offset somewhat by our declining trend of repurchase demands and our lower repurchase pipeline. For the third quarter, we would expect to provision that is slightly lower than the second quarter.

Second quarter asset resolution expense was $17.9 million as compared to $11.5 million in the first quarter. For the third quarter, we expect asset resolution expense to be more consistent with the level we experienced in the first quarter of this year.

Lee has already discussed non-interest expense in detail and consistent with the guidance he provided last quarter, our expectation is that total non-interest expense should be between 520 million and 540 million for 2014.

Finally, turning to slide 17, you can see that we continue to maintain capital and balance sheet flexibility so that we can fund the initiatives necessary to drive future earnings as Sandro highlighted earlier.

With that, I will turn it back to Sandro.

Sandro DiNello

Thanks, Paul. So now we're ready to take some questions and I'll turn it over to Erica to get that started

Question-and-Answer Session

Operator

(Operator Instructions). We will take our first question from side of Scott Siefers from Sandler O'Neill. Please go ahead.

Scott Siefers - Sandler O'Neill

Lee, I think first question is probably actually I appreciate the detail on the I/O portfolio and just on the numbers you gave on slide 21. So looks like about 65% of what’s already reset through the end of the second quarter, looks like it’s basically fine, either has meaningful or has reset presumably as expected for that remaining roughly 35% of so, what’s been the loss as a percent of the unpaid principal balance?

Lee Smith

Yes, I think so what I would say Scott is without getting into detail, when you look at slide 21, I think the numbers that I am focused on are the number loans that have been charged off or foreclosed on. And then the ones that are with the default servicing team at the moment and we're obviously working those hard. The losses on the I/O portfolio as I mentioned in my speech are less than the losses on the non-I/O portfolio and that was one of the big reasons we were able to release 10 million of ALLL reserve as it relates to the I/O portfolio during the second quarter.

Scott Siefers - Sandler O'Neill

And then let’s see Paul, I was just hoping you could help me with the size of the negative MSR fair value adjustment that hit loan administration income in the second quarter?

Paul Borja

Well during the second quarter, you saw some differential and really it’s a combination of just overall transactions and so when you look at the delta, I think the entire portion that we're talking about there is what we look into negative fair value Scott and that includes hedging cost, that includes some transaction, that includes mark to market movements. So we view all of those pieces which we see in the normal course as negative fair value adjustments.

Scott Siefers - Sandler O'Neill

And then let’s see, Sandro you made the comments about the three options for former TARP capital and it sounds like you are more focused on refinancing or redeploying. Wondering if you are able to provide any more detail on the kinds of tactics you'd be looking at more specifically.

And then as a follow on to that, given that you are focused on the first two as opposed to repaying, I mean does that say anything about when you would hope the regulatory restrictions that consent orders specifically would come off and what else do you feel like you guys have to do given all the changes you’ve made to get rid of that?

Sandro DiNello

Okay. So, I think that’s three different things. So first of all there were no signal intended relative to the comments on our TARP analysis related to regulatory aspects in any particular way. And with respect to further detail on what we might do in connection with those first two options, I think at this point we’re going to leave it at what was in the speech and over the next few months we’ll be looking at those options more specifically and maybe in a position to report further on that after Q3.

With respect to just the whole regulatory situation in general I think we’re pretty satisfied with the way things are going. We’re making progress and addressing all of the issues in a consent order. Its one of those things that we can’t be very specific on but I can say that I am comfortable with the progress that we’ve made, and I am optimistic that in due course we’ll get in a position where the regulators will consider listing the orders.

Operator

And we’ll go next to the side of Paul Miller from FBR. Please go ahead.

Paul Miller - FBR Capital

Thanks a lot guys. On the really slide 15 but overall in your balance sheet the commercial loan originations. I know that one of the focus is, I know you guys still want to be a major player in the mortgage banking world but I also know with conversations that you want to increase your commercial exposure. Can you talk a little bit how you have been able to grow originations? Have you brought on more teams in the area? And what are some of the areas you’re focused on?

Paul Borja

Yes, hi Paul. So sure what I think the success is not that complicated. Number one is you’ve got to hire the right people and we’ve been able to do just that. And in the commercial business we’ve been really focused on developing full relationships with clients. And so when they look at the interest that we have in Michigan and the quality of people that we’ve brought aboard the relationships that they have with sponsors, I think that we just have seen a really good result there. It’s basically a blocking and tackling in the commercial arena here in Michigan. I mean it’s originating, maintaining, growing those relationships, getting experienced bankers that can capitalize on the fact that we make our decisions locally.

So, there isn’t anything really special about it except that when you look at who Flagstar is in Michigan as compared to who the other players are, there are some things we bring to the table just because we’re here located in Michigan that are of interest to both strong commercial borrowers and strong commercial lenders.

Paul Miller - FBR Capital

And I mean what are some of the businesses or industries that’s you're just focused on and is it mainly all Michigan? Is there anything outside of Michigan?

Paul Borja

It is mainly Michigan, our Michigan sponsored and some fashion, Paul. So we have successful businesses that are anchored here in Michigan but that end up doing business in other parts of the country. So, we’ll venture outside of the Michigan world for that sort of thing. In terms of business that has no Michigan connection, it’s a relatively small amount of the business that we do.

Paul Miller - FBR Capital

And then your warehouse line and it grew very nicely, probably more-so than the origination market in general. And you said that that’s areas that you’ve been focused on. Can you just talk about that a little bit?

Paul Borja

Yes, couple of things there. So, I think we’re getting the normal share of Flagstar a base business so the loans that we’re buying, we’re continuing to provide warehouse lines at historic levels there. But the two things that are different, one I mentioned in my speech which is that our team over the last year has been working really hard on developing relationships with larger originators that don’t sell to Flagstar. We had not really played in that space before. And so we’ve had some very-very good success in that arena.

And then secondly, we’re much more open these days than we used to be to those lines that are financing loans that are not coming to Flagstar from our own customer base. So those customers that did sell to us but now we’re financing some of the business that they sell to others at a level that’s much more significant than we used to do.

Paul Miller - FBR Capital

And then on your reps and warrant stuff, it looked like there was an uptick both in losses and also an uptick in file request a little bit. I know you’ve hopefully put this about a couple of quarters ago. But is that anything to be concerned about at this point or is that just expected given where we are today?

Paul Borja

Yes, I don’t think it’s anything to be concerned about. But let Lee get into the detail little bit more.

Lee Smith

Yes, I think the slight uptick you saw Paul was just it reflects the estimated impacts of changes in the fair value of repurchase loans at the time of repurchase. But if you see, if you look at the pipeline and what happened to that, it came down again in Q2 so it was 53.7 million versus 69.4 million last quarter and 115 million 12 months ago. So, I don’t believe it’s anything to be concerned about at all and I think as Paul alluded to in his guidance we actually expect it to come down slightly as well next quarter.

Operator

And we’ll go next to the site of Kevin Barker with Compass Point. Please go ahead your line is open.

Kevin Barker - Compass Point

Hi. Thank you. How do you -- given that you’re not going to address TARP rate now, how do you plan to handle the accrued dividend given its compounding at 9% rate right now and even if you don’t repay TARP, are you planning to catch up on the accrued dividend or continue to let it be deferred?

Sandro DiNello

Well Kevin, this is Sandro. I think that’s all part of the whole strategy related to what we do with the TARP repayment, so to have a specific strategy that addresses just the dividend, we're not at that point right now. So, what we're going to do is evaluate the three options and more specifically those two that we're focused on and I mentioned in the speech and I think together with that we'll come to rest relative to how we want to handle the deferred dividends or the accrued dividends.

Kevin Barker - Compass Point

And then correct me if I am wrong but you have roughly about $0.78 per share of deferred dividends that are not recognized as a liability on the balance sheet, is that right?

Sandro DiNello

I don’t know that number of the top of my head.

Kevin Barker - Compass Point

Okay and then you made a $10 million adjustment to your DOJ settlement this quarter, what is the net liability not recognized on the balance sheet regarding that settlement right now, is this going to go up by another $10 million to $38 million is that correct?

Paul Borja

This is Paul, so our net liability on the balance sheet is $78 million as of June 30, that’s what we have accrued so far.

Kevin Barker - Compass Point

And you still owe 118 right?

Paul Borja

That’s right and it’s a fair value accounting contest and so as we run the model and as we look at the timing of the cash flow payments that will eventually accrue towards that.

Kevin Barker - Compass Point

Okay and then the 5 billion servicing that you are planning to transfer for Fannie Mae, can you talk about the mechanics of that relationship that you set up going forward? If there is another counterparty involved, how does the negotiation happen between those 5 billion of MSRs that you are selling?

Sandro DiNello

Yes, so let me talk about that Kevin, so the 5 billion that we sold during the quarter in subservice pack that wasn’t a sale to Fannie Mae that was a sale to a REIT basically and we are subservicing those loans back approximately 22,000 loans. What we have actually engaged with Fannie Mae which I referred to in my speech, we signed a contingent subservicing agreement with Fannie Mae. So, what that means is if Fannie Mae chooses to use our servicing platform and have a subservice loans for them directly, we're now able to do that and we have a contract in place.

Kevin Barker - Compass Point

So Fannie Mae is essentially buying the MSRs from you?

Sandro DiNello

No, it’s totally separate. This would be loans that Fannie Mae either already owns or has control over and they are looking to have those loan service. It’s got nothing to do with the MSRs that we sell to other buyers. It’s a separate relationship.

Kevin Barker - Compass Point

So, it’s purely a subservicing contract that Fannie Mae [Multiple Speakers].

Sandro DiNello

Correct, that’s exactly what it is, purely subservicing contract with Fannie Mae.

Lee Smith

Basically Kevin, it puts us in a position to take on subservicing from Fannie Mae as they have say somebody they call servicing from for some reason or they purchase loans back or whatever reason that Fannie Mae might need a servicer, we're now in a position to take that business from them if we can win the contract.

Kevin Barker - Compass Point

Okay and then just one last question. With the gain on sale coming down slightly this quarter, was that primarily pressure from the correspondent channel or was that something else that played a part with the gain on sale coming down this quarter?

Lee Smith

Given the fact that 95% of our business comes from the correspondent channel there is obviously a lot more pressure that comes there to the gain on sale. So, the reasons that I articulated in the speech for the reduction in the margin, are consistent with the 95%-5% split between our correspondent and broker versus our retail business level. So, it is in particular one or the other just because of volume though there is more that comes from the correspondent and broker channel.

Kevin Barker - Compass Point

Were you seeing margins better in the correspondent or in the broker channel or basically were they moving at a similar direction?

Lee Smith

Well, generally speaking in the industry broker margins are better than correspondent margins. What I am saying is that in terms of positioning the pricing and determining what margin we accept, what we did was we accepted a lower margin and balanced that against the additional production and revenue that that would bring, so it isn’t any particular channel that had more pressure than another if that makes sense.

Operator

And we will go next to side of Bose George from Keefe, Bruyette & Woods. Please go ahead.

Bose George - Keefe, Bruyette & Woods

I just wanted to follow-up on the Fannie Mae contract, is that focused primarily on performing servicing?

Lee Smith

Yes, it’s focused on performing servicing through loans that are 59 days delinquent.

Bose George - Keefe, Bruyette & Woods

Okay, great and then actually just on the MSR again, to Paul’s comments earlier on the size of the MSR, as we sort of model it out into ’15, is the MSR to equity that ratio just going to fully trend down a little bit more over time?

Paul Borja

So I think the guidance we gave is that we were going to shoot for a level that was similar to where we were in Q4 and that was that 22.6%, so that’s basically what we’re looking at. I think you gave some guidance as well, the one you did right. Lee?

Lee Smith

Yes, I think we previously provided guidance this is going back to January of sort of being in the 18% to 22% MSR to Tier 1 range. And I think we still feel pretty good with that I think I would probably extend it slightly and say we’re probably going to be in the 18% to 23% MSR to Tier 1 range both.

Bose George - Keefe, Bruyette & Woods

And then actually switching to the Exhibit 21, the 695 loans so is it safe to say all of those are current as they went into the reset?

Paul Borja

So let me have Lee take a look at that. Go ahead Lee.

Lee Smith

Well, no they weren’t all current going into the reset, that's the issue. So some of the ones that were charged off were foreclosed on, the reset didn’t have necessarily anything to do with that so they could have already gone delinquent and being charged off prior to the reset. This just identifies the entire population of I/Os that we had from January 1, 2013 through June 30, 2014. But it’s not necessarily reflective of what happened as for after the reset date.

Bose George - Keefe, Bruyette & Woods

Okay, thank you. And I guess is there a way to think about how much of a catalyst the rest has been for delinquencies because it looks like some of these loans are delinquent already?

Lee Smith

Yes, that’s right. And the reset catalyst is actually not being that -- it’s not had that much of an impact. And you can infer that from the number of loans that are cash flowing following the reset on the strong percentages that are being paying for more than three months and six months. But maybe we can actually include that metric in the next earnings report I can understand why you’d want to see that. What I can tell you is the reset date has not been the reason of the 47 that you see that have been charged-off or foreclosed on. The reset date was not the reason for that happening in a large number of those.

Operator

And we’ll take our final question as a follow up question from Scott Siefers. Please go ahead.

Scott Siefers - Sandler O'Neill & Partners

Thanks guys. Paul I think someone might have eluded to this earlier but I was just hoping you could spend a second offering some color just on what’s the simply drives or drove the change in the fair value, the liability just at $10 million favorable change with the DOJ settlement? Can you go into a bit of detail about that please?

Lee Smith

Yes, we can touch on it just a bit. When we take a look at the DOJ liability every quarter because it’s a fair value accounting measure, part of the components there include the timing of the payment, the discount rates. And as we look at that every quarter we reevaluate the time of the scheduled payments according to the contracts and in the quarter as we looked at it and reevaluated it we determine its scheduled payments different from the change from what we had looked at earlier just in the normal course. And so when we run the fair value model we move the scheduled payments and then just from a present value perspective Scott the valuation changes. And so you’d expect over the course of any fair value liability or asset that you’ll have increases and decreases as the underlying assumptions change from quarter to quarter.

Sandro DiNello

But the reason we pointed it out Scott as sort of an unusual item is because that much of a change in a quarter is a bit unusual so we don’t want to send a message that that should be something that that can be relied upon going forward.

Scott Siefers - Sandler O'Neill & Partners

No, I definitely get that and appreciate the transparency there. And then I guess just final question Sandro maybe [indiscernible] sort of an M&A related top level question. And you had a large drift sold yesterday or I guess that’s pretty significant premiums where you guys are trading on a price tangible book basis. It’s generated at least on discussion. So I was just curious to hear kind of your updated thoughts if any on just sort of how you’re thinking about strategically and options things like that?

Sandro DiNello

Well, sure I saw that transaction yesterday and as I read more about it I guess you can understand from both sides why there might have been some motivation to do what they did. But from Flagstar’s point of view I mean we’re in the middle of building this company and I think for us our focus is just building this company growing our shareholder value and doing the best job we can with that. And those sorts of things will take care of themselves. Our focus here of this management team is continuing to grow our net interest income, continue improve on our non-interest income sources, keep those expenses disciplined and just build shareholder value and that’s what we’re going to keep doing.

Operator

And it appears we have no further questions at this time. So, I’d like to turn it back over to our speakers for any closing remarks they might have.

Sandro DiNello

Thank you, Erika. I appreciate everyone’s time listening to us this morning and the good questions. So thanks to everyone for your continued interest in Flagstar. This management team and the board are together working very hard to build a great company. We’ve made a lot of good progress in Q2, took us a little closer to where we need to be. But there is still a lot of work ahead and we look forward to reporting further progress to you in the future. Thank you and have a great day.

Operator

We’d like to thank everybody for their participation in today’s conference call. Please feel free to disconnect at any time.

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