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Flagstar Bancorp, Inc. (NYSE:FBC)

Q4 2011 Earnings Call

January 25, 2012 11:00 am ET

Executives

Paul Borja - CFO

Joseph Campanelli - Chairman and CEO

Matt Kerin - EVP and MD

Mike Maher - EVP and CAO

Analysts

Kevin Barker - FBR Capital Market

Bose George - KBW

Mark Steinberg - Dawson James

John Lux - IMS

Operator

At this time, I would like to welcome everyone to the Q4 earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. Paul Borja, Chief Financial Officer. Mr. Borja, you may begin.

Paul Borja

Thank you. Good morning, everyone. I'd like to welcome you to our fourth quarter 2011 earnings call. My name is Paul Borja and I'm the Chief Financial Officer of Flagstar Bancorp.

Before we begin our comments, I'd like to remind you that the presentation today may contain forward-looking statements regarding both our financial condition and our financial results. These statements involve certain risks that may cause actual results in the future to be different from our current expectations. These factors include, among other things, changes in economic conditions, changes in interest rates, competitive pressures within the financial services industry and legislative or regulatory requirements that may affect our businesses.

For additional factors, we urge you to review the press release we issued last night. Our SEC documents such as our most recently filed 10-K and 10-Q, as well as the legal disclaimer on Page 2 of our earnings call slides that we have posted on our Investor Relations page today at flagstar.com.

During the call, we may also discuss non-GAAP measures regarding our financial performance. A reconciliation of these measures to like or similar GAAP measures is provided in a table through our press release, which we issued last night.

With that, I'd 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. I'd also like to welcome you to our fourth quarter 2011 earnings call.

Today I'll begin with an overview of the fourth quarter and for 2011, and then provide some detail on our legacy balance sheet and associated credit cost, including the strategies we have implemented to address and mitigate the risk embedded in these portfolios.

After I finish my remarks, I will turn it back over to Paul, who will help us and will take us through a more detailed financial review and our 2012 outlook. Paul and I along with the rest of the executive team will then take questions.

First of, I'd like to say that I am extremely proud of our over 3,000 employees for their efforts and for the passion and commitments they have demonstrated during this challenging economic environment. You will see in a moment that while we continued to be challenged by legacy credit cost, we've made significant progress in 2011 and achieved many of our established goals and objectives. We believe our core operations and the business strategies we've implemented have positioned us to achieve profitability in 2012.

During the year we generated over $337 million in pre-tax, pre-credit cost income, as you can see on Slide 6, and reduced our yearly net loss by 58% from 2010. We've made significant progress in transition to a more diversified full-service bank, including converting to a state-of-the-art retail, commercial and mortgage banking systems, providing a competitive suite of products and services and hiring approximately 100 experienced team members to service and expand the small business, middle market and especially customer base.

We completed the divestitures of Georgia and Indiana retail banking offices, a strategic move that has allowed us to focus on our core operations and build on the strengths we have in Michigan market. We fortified our balance sheet by adding reserves, maintaining strong capital and liquidity levels, and continuing to de-risk through sales for modifications and work also at non-performing assets.

We improved our net bank interest margin by 22% from the prior year, during a period where the industry in general was facing significant margin compression. We reduced total non-interest expense by 1.5% from the prior year, in spite of significant investments in infrastructure and new business initiatives.

We implemented new policies, procedures and risk management practices to address substantial changes in regulatory environment, arising primarily out of the Dodd-Frank legislation and continue to build our risk management function and pursue it strategies to put our legacy credit cost behind us.

Turning to the fourth quarter results. We reported net loss to common shareholders of $44.9 million or $0.08 per share, attributable primarily to elevate a level of credit-related cost. For the full year of 2011, reported net loss to common shareholders of $165.6 million or $0.30 per share. During the quarter we experienced a number of significant improvements in our core business and we believe the steps we took in the fourth quarter and throughout 2011 have positioned us for return of profitability in 2012.

Before getting into those, I'd like to first discuss credit cost. Our goal today is that in my comments along with the additional transparency provided in our earnings release and presentation slides and 2012 outlook Paul will supply, we'll provide you with a meaningful framework for better understanding our credit cost, both at the current quarter and for estimating future amounts.

Our fourth quarter net loss of $44.8 million includes $71 million in expenses for reestablishment of additional reserves on our balance sheet, which we believe will allow us to be even more proactive in addressing and reducing the overall level of non-performing loans of which the vast majority related to loans originated prior to 2009.

For the quarter, credit cost totaled $173.2 million as compared to $111.7 million in the prior quarter. This increase was driven by three specific items. First, a $26.9 million increase provision for loan losses. Second, a $30.3 million increase in provision related to representation warranty reserves, which we previously referred to as a secondary market reserve. And finally, a $5.8 million increase in impairment and available-for-sale securities.

First, let's discuss provision for loan losses. During the quarter, we implemented a program we referred to as winning and banking, which is a comprehensive series of initiatives implemented to encompass as best practices across the bank. These initiatives are expected to provide a meaningful financial impact to the bank, which we expect begin seeing in 2012 and will continue thereafter.

As a part of the winning and banking program, we've made significant investments and enhancements, and our default servicing and loss mitigation areas including leasing in new dedicated facility and closed proximity to our headquarters in Troy, Michigan, converting to a state-of-the-art servicing platform, increasing loss mitigation staff by over 20% to the addition of approximately 80 full time employees.

And restructuring and enhancing our servicing practices including establishment of single points of contact for customers who are seeking loss mitigation solutions from the bank. These investments will be an important factor in reducing the overall level of delinquencies and credit cost, which will be just discussed in more detail later in the call.

Our servicing enhancements provided us with ability to focus on creative ways to proactively service financially distressed borrowers. This both increases the probability that the homeowner continues to make payments and remain in their and decreases the bank overall exposure to a loss, a broader measure of loan modification options, a broader menu of loan modification options are available to be tailored to individual household characteristics to drive better outcomes.

We have already begun to see a resulting increase in loan modifications and loss mitigation activity, which in a near term increase the level of troubled debt restructurings or TDRs on our balance sheets. TDRs require greater level allowance for loan losses and as such we increased our reserves related to residential first mortgage loans during the quarter, which contributed to the increase in provision expense.

At December 31, 2011, our overall allowance for loan losses was $318 million or about 65% in non-performing loans as compared to $282 million or roughly 63% of non-performing loans as of September 30, 2011. Overall non-performing loans increased by $43.5 million from the prior quarter. While we are looking at Slide 18, you'll see that the pace of increase in the non-performing loan category continues to slow, while a level of 30-day and 60-day delinquencies declined in the fourth quarter.

Turning to Slide 19. You'll see that $32 million or approximately 75% of the increase in overall non-performing loans, which related to an increase in residential first mortgage performing TDRs, which are modified loans that occur in their payments, but must be classified as non-performing loans, until they are performed for six consecutive months after the modification date.

Excluding these performing TDRs, which were in the six month seasoning period, the level of non-performing residential first mortgage loans was essentially flat from the prior quarter. The growth in non-performing TDRs is consistent with our increased modification efforts, which is designed to provide vital solutions for our customers to remain in their homes. We believe that our non-performing residential mortgage loans have already peaked during the fourth quarter and anticipate quarterly declines throughout 2012.

Non-performing commercial loans increased by $8.5 million from the prior quarter, driven primarily by four new delinquent commercial real estate loans in legacy portfolio with an average size of $2.2 million. The balance of our pre-2009 commercial real estate portfolio continues to decline and we hold a significant level of reserves against it. At December 31, 2011, reserves related to commercial real estate loans represented 94% of commercial real estate non-performing assets.

Second, we experienced an increase in a provision related to our representation and warranty reserves. This elevated provision level was driven by a $35 million increase in reserve from prior quarter. At December 31, 2011, our representation and warranty reserve was $120 million as compared to $85 million as of September 30, 2011.

Turning to Slide 21. You'll see at the top left portion of the slide that we received $190 million repurchase demands this quarter, a decline of $19 million or 9% from last quarter. This slight decrease was entirely due to agency-related demands, most notably from Fannie and Mae loans. Overall, the reason for the demand is similar to those in previous quarters such as borrower misrepresentation or issues with appraisals.

The demands that we received have been more concentrate in loans that have already been to the foreclosure process and we have recently noticed some changes in the pattern of request relative to the delinquency status. The more recent request for poor loan files, which are a precursor to future demands, having more skewed towards the loans that are delinquent, but not yet in for closure. This suggests us that the agencies that work through the backlog of demands from prior years, which indicates that the continued demand in Q4 could be an acceleration of timing rather than growth in the overall population.

The top right part of the Slide 21, shows that the aggregate amount of pending demands decreased during the quarter from $352 million to $343, this is primarily due to decline in current quarter demands. The bottom left-hand part of the slide shows charge-offs for the quarter were $38 million, up by $3 million from the third quarter due to the high level of demand resolution activity. The quarterly provision of $70 million exceeded charge-offs, resulting an increase in the representation and warranty reserve of $35 million.

During the fourth quarter, the company made refinements to the process of estimating the representation and warranty reserve, due primarily to changes in the counterparty activity and our ability to estimate forecasted repurchase demands over the expected period of repurchase exposure. We believe the current reserve level of $120 million is appropriate in light of the continued elevated level of repurchase activity.

The bottom right-hand portion of Slide 21, arise a broad framework and key model attributes and assumptions for our representation warranty reserve. The four-key variables and the framework are the estimated loan file review rate, the repurchase demand rate, the actual repurchase rate based on the banks win/loss rate and loss severity.

Let's focus on the estimated loan file review and repurchase demand rates first. Repurchase request received to date and inverse correlation and the amount of time between origination and default. The shorter the timeframe between origination and default, the greater the request rate. And the longer the timeframe, the less likely it is that a request will be received.

It's also been a positive correlation between the current loan-to-value ratio and a request rate. The higher the current LTV, the higher the request rate and vice versa. The demands received has come from loans at one delinquent within the first 36 months after origination.

If this pattern continues in GSE and selections criterias do not change, it suggest that the full delinquent loans from which we will receive demands should be stabilizing, given that any performing loan from 2006 to 2008 vintages are most permanent repurchase vintage period is now passes three-year mark, the refinements to the reserve incorporating, we expected future demands from this delinquent population of loans.

Current LTV as one predictive variable for potential magnitude of the loan file pull requested by the GSEs. If housing values generally continue to decline, this could indicate the potential for a continuation of elevated request levels. However, we've been witnessing some patterns in demands and full file requests that suggest that the backlog of demands from prior years have been thinning.

Factors that point to more modest increases in a request rate out of passage of time, the shift in full file request from later stage for closed loans to earlier stage default status. In fact, the demands can only reasonably made on that portion of loans that did not meet underwriting guidelines.

With respect to the other variables, our overall repurchase rate has been fairly consistent in the 40% to 45% range, while the severity rate over the last 12 months has been about 44%. This substantial loss severity rate is due to the impact of declining home buys have had on severity as well as the higher proportion of demands coming from the 2007 vintage, which was the peak of the housing market.

In conclusion, while repurchase demands remain somewhat contingent on third-party behavior, we do expect them to slowly abate in the coming quarters. Moreover, if the assumptions that led us to believe that why we're seeing an acceleration of demands prove correct, and if the GSEs don't otherwise modify their repurchase methodologies, then we would expect that overall representation warranty reverse were $120 million, as of December 31, 2011, sufficient to reasonably absorb the expected losses from such activities in future periods.

Lastly, during the fourth quarter we recognized $7.1 million impairment and our investment securities available-for-sale. These impairment losses incurred during the quarter related to expected future credit losses in those securities backed by prime mortgage collateral. The deterioration in collateral performances is a result of continued macroeconomic weakness and is in line with industry expectation for mortgage defaults on prime collateral.

I'd like to talk about some of the significant progress we've experienced in our business. That progress was reflected in strong revenue we generated in the fourth quarter, as evidenced by $131.6 million in pre-tax, pre-credit cost income, 28.4% increase from the prior quarter. We continue to leverage our industry position in mortgage banking to originate performing residential mortgages and generate strong revenues.

Competitors continue to exit the wholesale mortgage business for very reasons, which we view as an opportunity to selectively gain market share. During the fourth quarter, we'll take advantage of a strong refinance activity and believe we are well-positioned to gain market share in the wholesale market. As a result, fourth quarter gain on loan sale income increased from the prior quarter to $106.9 million with the margin of 102 basis points.

Full year 2011 gain on sale income was approximately $301 million as compared to $297 million in 2010. We originated $10.2 billion of residential mortgages in fourth quarter, a 48% increase from the prior quarter. Full year 2011 mortgages originations were $26.6 billion, virtually identical to the 2010 level. Even as mortgage originations for the industry as a whole decreased year-over-year.

We have forecast and continued variable interest rates, and strong refinance activity well into 2012. Currently the mortgage mix is primarily refinance volume, but we are well-positioned through our home lending presence to prudently expand with expectation that you will be in eventual shift towards purchase volume. We fully intend on participating in enhanced HARP 2 for a refinance program and plan to capture our proportional share of the anticipated volume.

Currently we are awaiting necessary technology changes to the GSE automated underwriting platforms, which are expected to be available over the next 60 days. Since the program became effective, we've been on limited number of manually underwritten HARP 2 loans for previously originated Flagstar loans. We also continue to originate jumbo mortgages on a selective basis. In 2011, we originated almost $300 million in jumbo mortgages, the majority of which were shorter duration arms, which originated for our balance sheet.

Our bank net interest margin remains positive for us improving to 2.43% for the fourth quarter, a 13 basis point improvement from the prior period, and 25 basis points improvement from the same period a year ago. The improvement from prior quarters was driven by loan growth and the decline in overall cost of funds.

First, turning to loan growth. Average interest earning assets increased from the prior quarter by $1.1 billion or 9.2%, reflective our increases are available-for-sale warehouse lending and commercial lending portfolios. The increase in our available-for-sale and warehouse portfolio is tied to the strong origination market largely in the second half of 2011. And the increase in our commercial lending portfolio is tied to the success of our commercial banking division, just started in earnest in February this last year.

Our commercial and specialty groups continue to grow as we acquired new commercial customers consistent with our strategic plan. As you can see on Slide 13, we have strong growth in our commercial loan balances during each quarter of 2011. We also continue to cross-sell other fee-related products and services for our business banking, middle market and specialty lending groups. And we expect we'll provide meaningful fee income generation and growth in 2012.

Turning now to liability side of balance sheet. We funded our new loan growth primarily to core deposits and short-termed FHLB advances, both of which carry relatively low interest rates. Overall fourth quarter cost to funds declined to 1.81% from 2.09% in prior quarter, that decline was reflect of a lower cost to deposits, which we continue to enjoy the success in our efforts to attract new core deposits and a full quarter benefit realized on refinancing of $1 billion in long-term FHLB advances that we restructured towards the end of the third quarter of 2011.

During the quarter, we continued to generate low cost to zero cost core deposits, which contributed to 13 basis point decline in the average cost of deposits from the prior quarter. A part decline in the cost of deposits was due to the sale of associated deposits in Georgia and Indiana branches, which carry higher average funding cost than our remaining core deposit franchise.

During December we closed the previously announced sale of our Indiana and Georgia retail banking offices, which result in the combined gain of $21.4 million. These transactions allowed us to focus our resources on a continued execution of our super-community banking strategy, servicing in the Michigan and Southern New England markets.

Our retail banking strategy in 2012 has optimized the bank's branch network in its core markets. We have been successful throughout the years in growing the level of retail core deposit at Michigan, both in dollar and as a percentage of total deposits. In 2012, we will continue our retail strategy of gathering branch banking deposits and commercial business banking deposits, thus reducing our reliance and non-core funding.

Our strength in Michigan and our plans to further grow in this important market, essentially to our business plans and overall strategy. And we like the signs that we're seeing in Michigan economy. The states unemployment rate recently declined to a slowest level in 28 months and Michigan added 83,000 private sector jobs over the past year.

Further, auto industry employment in the U.S. is projected to increase by 150,000 jobs by 2015, most of which we sent it in Michigan. A recent Bloomberg Business Week article also mentioned that Michigan has projected to finish the 2011, 2012 fiscal year with a surplus, its first in 10 years. New England is also a market that we know and understand well. And we believe we are well-positioned to capitalize new relationships there.

Our commercial lending group continues to experience success as evidenced by the new commercial loans we've originated over the past year. We closed the fourth quarter with continued strong capital levels with a Tier-1 ratio of 9.19%, and a total risk-based capital ratio of 17.07. During the fourth quarter we invested $18 million in capital from the holding company to the bank, to ensure that bank maintained sufficient capital to effectively manage its ongoing business opportunities and to continue to grow market share.

Finally, as part of our earnings release last night, we announced that we would be exercising our contractual right to deferred dividend payments on a preferred stock issued to the U.S. Treasury and interest payments on trust preferred securities. Under the terms of the TARP preferred stock, we can defer up to six quarters of payments without default or penalty. We can also defer up to 20 consecutive quarters of trust preferred payments without default or penalty.

We believe it is prudent to capital to defer such dividends and interest payments until our financial conditions improved and we restore the company profitability and we continue to retain the funds to support our continued execution of our strategic plan.

I'd like to turn over the presentation to Paul for the detail on the financial side.

Paul Borja

Thanks, Joe. As Joe mentioned we had a $44.9 million loss during the fourth quarter. This is primarily attributable to a $71 million increase in our reserves for loan losses and for loan repurchases from the GSEs.

Last quarter, we mentioned that we would talk on some four key items during the fourth quarter, improving our net interest margin, leveraging our mortgage banking business, reducing and mitigating credit cost and controlling expenses. These things focused around three key areas of our operating results, revenue generation, expenses and credit costs.

In fourth quarter, the bank's revenue generation capability was reflected in its net interest margin, its gain on loan sales and its revenue from mortgage servicing rights. The bank's net interest margin increased to 2.43% during the fourth quarter from 2.30% in the third quarter.

From a revenue perspective, our net interest income increased to $75.9 million during the fourth quarter from $65.6 million during the third quarter. This resulted from both an increase in our interest income and a decline in our interest expense.

Our interest income increased during the quarter, reflecting higher average balances we carried for available-for-sale mortgage loans and our warehouse loans. Yields on these assets were lower than in the third quarter, reflecting a decline in the 10-year treasury rate to near record lows at 1 point during the fourth quarter.

However, the increase in the average bearing asset sufficiently offset the reduction in yields to generate more interest income than in the prior quarter. At the same time we were successful in reducing our funding cost during the fourth quarter. This was attributable to both the restructuring over our long-term federal home loan bank advances to lower rates at the end of the third quarter and to a focus on generating lower cost retail deposits.

Despite the sale of our Indiana and Georgia branches, our percentage of retail core deposits to total deposits improved during the fourth quarter. While our retail deposit funding cost actually declined as compared to the cost of those deposits during the third quarter. For the entire year 2011, our bank net interest margin was 2.13% as compared to the 2010 net interest margin of 1.75%. The improvement over the year primarily reflected the improvements in our funding costs, both on our deposit costs and FHLB advance costs.

For the first quarter of 2012, we would expect our net interest income to be between 5% and 10% above our fourth quarter 2011 amounts, with a slight increase in average interest earning assets. As such, we would expect our net interest margin to increase although to a lesser extent in the fourth quarter.

While, we do not expect to see the growth in such asset during the first quarter as well the case during the fourth quarter. We expected our continuing levels in mortgage production will maintain our current average levels of available for sale of mortgage loans and warehouse loans both of which are higher yielding assets.

Further, we expected our commercial lending operations, which recommends in February 2011. We'll continue to build our portfolios and thereby contribute to the reduced volatility in our net interest income. We also expect to continue to transition of our deposit base towards more core accounts and business accounts, especially as our wholesale CDs continue to runoff and to use lower cost short-term FHLB advances periodically to fund the growth and the mortgage loans and warehouse loans, while our deposit base grows.

Our ability to meet this estimate of net interest income for the first quarter 2012 depends upon a number of factors including the continuing robust activity of the residential mortgage market. Our ability to meet our lending goal despite an expected industry-wide declined in the overall mortgage volume during 2012. A continuation of the current low interest rate environment and no substantial increase and are non-performing loans.

The bank's mortgage business during the fourth quarter gave variety to gain on loan sales even larger than a near record amount of the third quarter principally from mortgage refinancing activity. We've experienced continued strength of the refinancing activity in a marketplace since the beginning in 2012, and believe we are well-positioned to experience continued increase in our overall industry market share during 2012, despite industry estimate that project a slowdown in overall mortgage production for the year.

For the first quarter 2012, we expected our production will be similar to that to the fourth quarter. Accordingly, it would be reasonable to expect that our gain on sale income for the first quarter of 2012 will approximate that of the fourth quarter of last year.

Our estimate is based on a number of factors, including that there are no significant increases or volatile movements in the current interest rate environment that could affect consumer demand or hedging costs. And the operating environment from mortgage banking activity does not significantly change. And the expected trend in mortgage originations industry-wide for the fourth quarter does not decline beyond current industry projections and if there were no regulatory or other legal impediments to our full participation in mortgage banking.

Our expectation for mortgage loan loss and originations during the first quarter of 2012, which would drive our mortgage gain on loan sales does not include our participation in the recently announced HARP 2 mortgage refinance program. We've underwritten a minimal amount of these loans to date that are waiting a launch by the GSEs of the automated underwriting process in April. At that time, we can provide more guidance as to the extent to which we would expect to participate in the HARP 2 program.

Our second biggest driver of mortgage banking revenue is our net servicing revenue, which is a combination of income we earn, servicing loans and the net effect that it hedges on mortgage servicing rights on our balance sheet. In total, our net loan administration income was $29 million for the fourth quarter of 2011, an increase from $16.9 million for the third quarter of 2011. Our goal is to earn a 6% return on the value of that asset. And we've done a good job of that over the last nine quarters.

For the first quarter of 2012, we expect that net servicing revenue will be at a midpoint between the amounts earned in the third quarter and the fourth quarter. This assumption is predicated on the interplay between the 10-year treasury and mortgage rates as well as the absence of significant volatility in mortgage rate and interest rate curves.

Non-interest expense excluding asset resolution was $140.6 million in the fourth quarter of 2011 as compared to $116.2 million in the third quarter of 2011. The increase from the prior quarter was reflective of increased commissions due to higher loan sales in the fourth quarter $10.5 billion than in the third quarter $6.8 billion. It also reflects increases in salaries, as we've increased our staffing to grow the commercial banking business, assist in the underwriting process and enhance our mortgage servicing operations, especially to those areas that work directly with customers and help mitigate loan losses.

We anticipate first quarter 2012 non-interest expense to be flat, slightly below than the fourth quarter 2011 level. This assumes that the FDIC assessment rate remains unchanged and mortgage volumes remain at levels experienced in the fourth quarter. And that upcoming regulations or governmental directives do not require changes in service levels or business operations.

Turning to our credit costs, Joe discussed earlier our loan loss provision and our provision for the representation in warranty reserve. Our loan loss provision increased to $63.5 million for the fourth quarter 2011. This increase allowed us to build our loan loss reserves and increased our coverage ratio. It is the loan loss reserves divided by our non-performing loans to approximately 65% and the ratio of our loan loss reserve to our total loans to 4.52%. The increase in the loan loss reserves generally reflects an increase in our historical loss rates as well as an increase in the level of our over 90-day consumer loans including mortgages.

Over 90-day consumer loans increased by approximately $35 million as compared to the end of the third quarter. However, of that amount approximately $32 million of loans were classified as troubled debt restructurings or TDRs. In fact, in accounting designation for loans we modify to help out homeowners in financial distress. These types of loans usually have a higher loss rate than non-modified loans. TDRs must be held in the over 90-day category for the first six months after originations, even if they are paying.

A key part of loss mitigation strategy is to modify loans for homeowners and so we would expect that the overall amount of TDRs in our portfolio would increase. Note, however, that our 30-day and our 60-day loan balances for consumer loans have declined, reflecting our loss mitigation efforts. This is slowing pace of inflow should help us reduce our over 90-day delinquent residential mortgages during 2012.

We expect to continue to enhance our overall loan loss reserve methodology during 2012, by incorporating more granular and segmented data. At this time, we anticipate the provision for loan losses for the first quarter 2012 will be lower than the fourth quarter 2011 and more aligned with the midpoint of the provisions recorded in the first and third quarters of 2011.

This estimate assumes among other things, the current trends of unemployment and housing prices remain unchanged. And if the growth rate of TDRs in short sales remain flat. It also assumes that our historical loss rates, which we continually review for validity against current trends and historical experience, do not change significantly.

As Joe mentioned earlier, in fourth quarter we made refinements to the process, we used for estimating a representation and warranty reserve. These refinements increased the reserve from the prior quarter. A key component is assessing the potential expense arising from this area is the activity of the GSEs.

As discussed earlier by Joe, we are now focused on the loan file request from the GSEs and a more appropriate indicator of the nature and extent of any possible repurchases. To that end, we analyze data on an ongoing basis, given the uncertainty and taking into account our historical losses, we increased our reserves during the fourth quarter. We will continue to evaluate our exposure in light of recent GSE activity.

Asset resolution expense decreased slightly to $32.4 million during the fourth quarter. We anticipate the first quarter of 2012 to remain close to its current fourth quarter run rate. Both our estimates for provision and asset resolution expense do not reflect the benefit of the improvements we anticipate, receiving from the restructure of mortgaged servicing area that Joe discussed earlier.

With that, I'd like to turn it back to Joe.

Joseph Campanelli

Thank you, Paul. If you could open up the line of questions for me, Paul or any member of the executive management team that'd be great.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of Paul Miller from FBR Capital Market.

Kevin Barker - FBR Capital Market

This is Kevin Barker filling in for Paul Miller today. Could you walk us through some of the thought process of deferring TARP? Are you going to have to pay again in six quarters when it comes to that? I understand keeping capital in place and bringing some of the capital down to the bank to keep capital ratio stable, but could you just walk us through that all process-wide?

Joseph Campanelli

Yes, Kevin, we believe we'll see 2012 continue to be flatter growing balance sheet, given the business activity and commercial banking, the growth we're experiencing there in mortgage banking. And the best is to capitalize as what our growth and transition of profitability, which we see coming in 2012.

There wasn't a lot of upside and continued payment in a sense that there is no penalty to step-up an interest rate doesn't occur until early 2014. So that the prudent use of capital allocation will be to support activities that will help us transform the bank into more full-service in our ongoing strategies.

Kevin Barker - FBR Capital Market

So this would help you with new mortgage originations, and possibly going in the like HARP 2.0 and so forth?

Joseph Campanelli

Yes. As you saw in the fourth quarter, a lot of activity in our warehouse lending business, our available-for-sale to support the residential mortgage business. And if you looked at one of the chart, we're seeing very nice development of our commercial banking practices, building relationships there. So not only the size of the balance sheet most importantly the composition of balance sheet continues to improve and we believe that's a best allocation of capital.

Kevin Barker - FBR Capital Market

I believe you touched on it, but as far as they revise the HARP program, why can't you mind your own servicing portfolio right now, as opposed to wait until April?

Matt Kerin

Kevin, this is Matt Kerin. We actually are rolling out for our manual underwritten loans, the HARP 2.0. The primary driver for waiting until the automated tools have get put in places, because that's a vast majority of how people do business today to the automated underwriting. And it's also an added benefit with respect to the rep and warranty issue associated with the manual versus the automated underwriting. And we had to make some changes to our own systems in order to do the manual underwriting as well, because of the changes in the program. So there is multiple factors that influenced that decision.

Kevin Barker - FBR Capital Market

Is there a risk in April of other originators mining your servicing portfolio as part of HARP? Or do you already see that in your defensive announcement?

Matt Kerin

Given our position in the industry and our pretty broad distribution base, I am not only worried about all this lending our portfolio. There is a lot of business out there that people are trying to figure out what they were going to do. I think we have a pretty good strategy around it right now.

Kevin Barker - FBR Capital Market

And I've got one final question on the TDRs, as you transferred the classification of those TDRs. What level of redefault rates are you seeing on that restructured loans?

Mike Maher

Kevin, this is Mike Maher. I would tell you that our redefault on modifications over the last year or so has been in the mid-to-upper teens, essentially our target in 2012 wouldn't expected, redefault rates would kind of center around 20%. I think that's in line with industry experience and certainly as part of our disclosure from our third quarter queue.

Our volumes of modifications have ramped up substantially in the fourth quarter. So we are talking about relatively unseasoned portfolio. But we would expect that the overall redefault rate to be along the lines of the industry average is in the upper teens.

Joseph Campanelli

Yes, well TDRs are unique in a sense that they're not all created equal. And we've spent a lot of time with Mike and his team, looking at what causes the redefaults and look ways to improve the structuring that there's more efficient and more tools to help increase the probable success of keeping homeowner in the house and reducing the net loss impact of the banks. So there has been a lot of effort and work getting a better understanding of those strategies that become effective and those that's really classified TDRs that don't have a meaningful modification of results in a changing performance.

Kevin Barker - FBR Capital Market

Have you seen borrowers be very receptive to these modifications? Did those include some principal write-down or is it more extending the length of a loan and bringing down the interest rate. Could you just provide little bit color on that?

Paul Borja

Certainly, the vast majority of our loan modification solutions and the primary acceptance by the customers has been in the form of term extension first and then interest rate reduction on top of that. To date we've done very little principal reduction, principal forgiveness in response to modifications on first.

We have begun to look at, we have a relatively inconsequential second mortgage portfolio on the balance sheet. And we began to look at forgiving some level of principal, especially on delinquent HELOCs and second mortgages in an attempt to mitigate losses. The vast majority of those assets in the second mortgage portfolio would have already been charged-off due to delinquency. But to date, the customer acceptance of our term extension and rate reduction has been quite positive.

Matt Kerin

Yes. They have that's attributable to the terms of the modification. The other part that is equally attributable to a single point of contact winning and banking strategy where the decision making process is much more fluid, quicker turnaround times.

Operator

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

Bose George - KBW

So the first question, I just want to follow-up on the TDR issues. Just to understand the reserving, are some loans going straight from current into TDR? Is that what's creating the need for the additional reserve in there?

Joseph Campanelli

Certainly, some of the modifications that we have done have gone from either 30 or 60 day delinquencies into TDR. The majority of our modifications in the fourth quarter were actually of the more delinquent or seriously delinquent population, 90 plus into TDRs. The additional reserves that we've put aside was a combination of the 30 and 60s that we indeed did modify as well as to see overall loss historical loss rate increase on our overall first mortgage portfolio.

Bose George - KBW

And then just switching over to, I just wanted to revisit the rep and warranty issue again. You noted that there was an acceleration of the GSE or the GSEs are looking more at pre-foreclosure loans, but your claims were down quarter-over-quarter. So I was just wondering, I mean does this suggest that we could see an increase in the first quarter? Or how is the change in the GSE behavior going to play out in your numbers, do you think?

Paul Borja

This is Paul Borja. When we took a look at GSE and we take a look at that particular slide, what we're trying to do is, is make sure we've captured our predictive loss basis. The activity of the GSE has been (inaudible). So from December 31, 2011 perspective we're comfortable that based upon the activities in the GSEs and what we expect in the pull and using of assumptions on the bottom right-hand side that we have the reserve appropriate to absorb the kinds of losses we're talking about.

Bose George - KBW

And just to clarify that. You have the reserves appropriate for the claims to date basically?

Paul Borja

No. I think it's more than we've start with, the universe of those loans that we sold to the marketplace. We take a look at what's left and we apply our ratios against those.

Bose George - KBW

So I mean, if those are right then there should be a pretty meaningful decline in the rep and warranty reserve net going forward?

Paul Borja

That would be a correct assumption.

Bose George - KBW

And then just, lastly on the gain on sale margin. I'm a just little confused about how to calculate that number. I mean should we look at the denominator as being interest rate loss or loans sold? Because looking at loan sold you get on to a margin, went down this quarter quite a bit, but if you're looking at rate locks it looks kind of different. So what would you suggest to look at?

Paul Borja

What you have in front of you is a bit of a hybrid. When we first had that calculation we looked at loans sold. We switched to a fair value method for available-for-sale of loans, it then became appropriate to look at the derivatives on a fair value basis. Interest rate locks forward and the fair value available for sale mortgages.

You see the fair value portion at the top part of that chart, you'll see the sale of loan, the actual income and expenses from sale loan at the bottom part. The reason to second part is important, because certain expenses such as commissions are triggered upon the sale of loan rather than just the locking of the loan.

So in combination then we've got both of those, which suggest a much lower margin for Q4 than Q3. Although, we can tell you that from Q4 versus Q3 perspective, Matt Kerin and his team have done a great job of protecting and bringing a pretty strong margins overall.

Bose George - KBW

So it means that it's fair to say that if you look at the loans sold in isolation it exaggerates the decline in real estate portfolio numbers.

Paul Borja

Absolutely, right. That's the way to look at it.

Operator

(Operator Instructions) And our next question comes from the line of Mark Steinberg from Dawson James.

Mark Steinberg - Dawson James

I was wondering if someone could address what measures are being taken or considered to help avoid the stock from being delisted?

Matt Kerin

Yes, our board and management is looking at a multiple of opportunities that we have available to us. We've had dialogues with NYSE as you put together these strategies. And over the coming quarters, we'd expect to bring something (inaudible) NYSE and our shareholder vote to avoid a delisting. And we haven't come to a final resolution on what specific actions we'll be taking. But we clearly have a couple of different variables available to us.

Mark Steinberg - Dawson James

Could you elaborate a little bit on what some of these variables are?

Matt Kerin

I mean one thing is execute on our plan and we can restore a company to profitability. I think that there as you become more profitable the valuations, when we close to our book value, which is well in excess of benchmark trading levels, in addition to traditional sources of any potential reverse stock split and a couple of other opportunities. But right now we're not prepared to get down into the the details. We still have a period of time that gives a sufficient planning and more detailing approach to talk to NYSE and others.

Mark Steinberg - Dawson James

What is the timeframe, sir? How much time do you have?

Mike Maher

We initially had a six months period following the time period, when we first received a notice from the New York Stock Exchange. We since contacted the exchange to discuss with them on some of the different strategies in an initial discussion and what we plan to do and we're still formulating that strategy. They're working with us and so we don't anticipate any sort of delisting activity in the near term. And a minimal we expect that we would have enough time through our annual meeting in order to either execute on the strategies to which Joe Campanelli was referring or be able to propose action for a shareholder meeting.

Mark Steinberg - Dawson James

Are they giving you an extension?

Mike Maher

There is an extension that's allowed and that they've allowed us to take advantage of through the annual meeting.

Operator

And your next question comes from the line of John Lux from IMS.

John Lux - IMS

We are monitoring some regional banks as (inaudible) and the American coal mines. And as a matter of fact, in relation to previous quarter results I'm missing the Texas ratio on your slide number 4. It was mentioned there as non-performing assets over Tier-1 capital for general reserves and that figure I am missing. It was rising in quarter two, it was 34%, in quarter three it's 28%, and now I have no clue what it should be.

But considering the arise of the non-performing residential mortgages of 90 plus days of almost 10% to with something like $44 million or $45 million, which hardly enough coincides also with the total net loss of about $44 million. Well, I am a bit worried concerning the Texas ratio continue to increase there, but I don't how much it is right now?

Paul Borja

We had normally included that calculation, whilst we admit it this time we will go ahead and include it, and we'll find a way to include it in our later filing today. The Texas ratio that we've computed based upon our calculations just for the sheet that you're used to seeing, we calculated it, 38.5% ratio. From the S&L financial perspective, the way they calculate it, it's about 92.18%. And then from our regulatory perspective, the way the OCC classifies it is 61.84%.

John Lux - IMS

Did I understand it, did it now rose from the last quarter 38% to 51% now?

Paul Borja

Our prior quarter was 35.9%, the way we calculate it to now 38.5%.

John Lux - IMS

You see on the previous quarter results it was mentioned, than in quarter three you had non-performing assets over Tier-1 capital for general reserves had a ratio of 38.58%.

Paul Borja

Yes sir. And that's in comparison to 35.9% from quarter three.

Unidentified Analyst

And now how much is it now?

Paul Borja

38.5% the way we calculated as of the end of Q4 versus 35.9% at the end of Q3.

Unidentified Analyst

And then you mentioned on the Slide 19 which is based on the figure on Slide 17 that you saw some kind of flattening of the 90-plus day residential first mortgages which are turned in delinquents. I am very sorry, but I continue to see they increased quarter-after-quarter between $40 million and $45 million and that's class of assets.

Especially when I look also to the figures of the 60 to 90 days past due, that remains on that level of $40 million, $45 million, and it continues quarter-after-quarter. So I assume that 60 to 90 days past due are the ones who will come into the 90-plus days residential first mortgages which turned delinquent.

Mike Maher

John, this is Mike Maher. The activities that we undertook throughout the fourth quarter and continued to ramp up as we go into 2012 in terms of loan modifications are activities that will reduce the overall level of nonperforming residential mortgage loans on a quarter-over-quarter basis beginning in 2012.

Indeed we did have an overall increase in non-performers in the fourth quarter, but it was driven primarily by the onset of our increased loan modification efforts with residential borrowers here in the States. So as we enter into 2012, I think you can look to see while there has been already an abatement of both 30 and 60 day delinquencies, as shown on Slide 18, you'll see as we begin the first quarter of 2012 and thereafter a downward trend in the overall level of delinquencies assuming that our efforts continue as successfully as they have in the fourth quarter of 2011.

Unidentified Analyst

But the 90-plus days will continue to rise?

Mike Maher

No, that the 90 days in our opinion will not as 30 and 60s have abated, the flow into 90s as well as our efforts to modify those customers that are in 90 are otherwise loss mitigation solutions, which includes deed in lieu or short sales, our projection are that the overall 90-day level of residential mortgage loans will show improvements in each of the quarters beginning in 2012.

Unidentified Analyst

And then something which is not mentioned in this report, but looking out of publications out of the company concerning shareholders and sales and something, I estimate that's about 5% to maybe 8% each year new shares are issued to the staff. And I see that practically all they continue to dump those receipt shares immediately on the stock markets, which gives to outsiders an impression that employees, they do not trust that evolution and the company.

Can I ask your comments on that, because 5% to 10% of additional shares which are practically immediately dumped on the stock markets, that comes to the issue which my collogue has already touched that is the matter of the delisting.

Paul Borja

The share transaction to which you're referring are most likely the ones that are being reported on Form 4 for the SEC. Those reflect for the different officers, but shares that they receive is part of their salaries. The shares that they receive as part of their salaries must for tax purposes be provided to them net. So that is that a number of shares equal to the tax they would otherwise pay to the IRS has to be withheld.

In prior filings, we would show that the total amount of the shares that were granted and then we would show the amount that we'd withheld. No shares are actually sold into the open market by the employee or by the company.

This question was raised by some other investors because of potentially confusing disclosure. Because of that, about a month ago, we began reporting the shares net. That is amount that actually goes to the individual. So that now for instance has recently as these past filings, you can clearly see that there are shares going to the employees as salary and that no shares are being disposed of. And that has been the case the whole time. It's been more a matter of disclosure.

I have not sold. Our CEO has not sold. Key members of management aren't selling. Or instead, allowing our sales with shareholders and we have shares as well everyone else. But there is not a dumping of shares or selling of shares by executive management.

Joseph Campanelli

And the magnitude of shares don't represent 5% to 8% of the bank at all. It's a much, much low percentage is outstanding shares.

Paul Borja

Right. And I would say at the outset in 2010, we raised capital and many members and executive team actually contributed and purchased shares in those offerings as well. So we are acquirers and holders of the stock. And we've worked to correct the form disclosure that has created confusion among a number of investors and rightly so. So we believe we've taken the appropriate action, talking with our outside securities counsel on how best to reflect that. And we believe we're doing so now.

Operator

And your next question comes from the line of (inaudible) from Market Group.

Unidentified Analyst

Just a clarification on the TDRs. Once they clear the six-month hurdle, they would right away go into the loans category and go up the whole delinquent model that you have here?

Paul Borja

That is correct. They would become essentially current loans as the vast majority of our modifications today that are less than six months are performing and paying as agreed.

Joseph Campanelli

Correct me. They will come out of the non-performing category. Once they're TDR, they're always a TDR and will stay in the classified under the S&L for Texas ratio. So when you look at our earlier conversation, we talked about the difference in our perspective, want you to season into performing and show desire capability continue to perform. There is still part of that classification.

Paul Borja

Always the trouble, that restructuring, but they will not be reflected in 90 plus which is where you're seeing the increase. They will be reflected in the appropriate delinquency bucket most likely in the current bucket given that the vast majority you're paying as agreed.

Unidentified Analyst

So in that case, the $22.7 million from Q3, assuming the 20% redefault rate on that, this should be expected to go out by end of Q1. Is that correct, like the remaining performing ones?

Paul Borja

Exactly.

Unidentified Analyst

And just wanted to pick your thoughts on the Fed's proposal of converting the foreclosed homes or the delinquent homes to some extent on the rental markets, how it's going to affect you or how do you see your markets being affected by that?

Joseph Campanelli

We really don't anticipate any director for that matter or significant indirect impact. I think overall, anything that stabilizes and improve the national housing market is good for Flagstar, good for every bank and good for all of us attached by this because we do need stability in housing to really get some traction under an economic recovery. It won't be a direct impact one way or the other. But I think a good housing agenda that is well thought out and transparent and will allow everyone to be making decisions in a better environment. Matt, do you have any other view?

Matt Kerin

No, I would concur, Joe. I think as you look at the level the other inventories are coming, they're continuing to come down. You've seen the number of foreclosures that picked up after the moratorium began to come back down. It's really reasonably-driven in terms of the impact it's going to be, and rental prices versus the ability to purchase in this rate environment are pretty much at a breakeven point right now. So it's going to depend on the housing policies that will hopefully stabilize, the values of housing that people look about homeownership.

Unidentified Analyst

Finally on the HARP to plan, if even though its too earlier right now, but just comparing how it has performed overall for the markets compared to the original HARP program. What kind of signs are you seeing there?

Matt Kerin

We're seeing a lot of interest in the program. I think the benefits to HARP to that didn't exist with respect to the original HARP program, where the cost of the homeowners in terms of their ability to get the mortgages on more affordable terms as well as the lessening of the underwriting.

We've been a significant modifier of loans under the initial program. And I would expect that we will continue to do so. We'll be less impacted than many, because we actually have been an active seller of our servicing over the years. And many the loans that we have sold would be those that are better candidates with the higher LTV, threshold that have been built into the HARP 2.0 versus the original HARP.

Operator

There are no further questions in queue.

Joseph Campanelli

Thank you, everyone for joining us this afternoon. We look forward to continue our dialogues. Have a great day.

Operator

And this concludes today's conference call. You may now disconnect.

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