Flagstar Bank, Inc. (NYSE:FBC)
Q1 2008 Earnings Call
April 23, 2008 11:00 am ET
Mark T. Hammond - Vice Chairman of the Board, President and Chief Executive Officer
Thomas J. Hammond, Chairman of the Board
Paul D. Borja - Chief Financial Officer and Executive Vice President
Kevin Flynn – Avalon Asset Management
[Mark Agga – MLP]
Annett Franke – Friedman, Billings and Ramsey
Randy Sternke – Merrill Lynch
Bose Gorge – KBW
Welcome to the Flagstar Bank Q1 2008 investor relations conference call. (Operator Instructions) This call is now being turned over to Flagstar Bancorp’s CEO Mark Hammond.
Mark T. Hammond
Welcome to Flagstar’s first quarter earnings conference call. My name is Mark Hammond and I am the Chief Executive Officer of Flagstar.
Please note that we will be using a PowerPoint presentation during this call and we recommend that you refer to it as we reference it throughout the call. This presentation, as well as our earnings press release that we issued last evening, which contains detailed financial tables, is posted on our website in the Investors Relations section at www.flagstar.com.
I am here today with Thomas Hammond, our Chairman of the Board, and Paul Borja, our Chief Financial Officer. Tom will provide prepared remarks about our first quarter, and then I will update our drivers and provide an outlook for 2008. Paul and I will then answer questions. Please note that we will be addressing the questions that we received by e-mail or questions that we have been frequently asked.
Before we get started, I would like to first direct your attention to the legal disclaimer on the second page in the presentation. The content of our call today will be governed by that language.
With that, I will turn the call over to our Chairman, Tom Hammond.
Thomas J. Hammond
Last evening, we announced our financial results for the first quarter of 2008. Three months ago, we told you about the positive trends we were starting to see in our underlying fundamentals, including increasing gain on sale spreads, higher loan production and an improvement to our net interest margin.
We also caution that we believe those positive fundamentals might be largely offset by weakening macro-economic conditions and a corresponding increase in credit costs, such as increase charge-offs, higher reserve levels and further asset write-downs. We have now seen that forecast come to fruition, the result of which is reflected in our first quarter financials.
Let’s turn to our earnings. Please turn to Page 3 of the presentation. During the quarter, we lost $10.6 million as compared to our loss of $30.1 million in the fourth quarter of 2007 and a gain of $7.8 million in the first quarter of 2007.
Earnings per share for the quarter were a loss of $0.17 per share as compared to a loss of $0.50 per share in the fourth quarter of 2007 and the trailing first quarter of 2007 earnings per share of $0.12 per share.
The strong gain in fundamentals we experienced was offset by three negative credit and market related charges. Those charges represent $62.4 million in pre-tax cost. The first item being an increase in credit cost, the second being further asset write-downs and the third being an initial startup of hedging loss as we adopted fair value accounting for our mortgage-servicing portfolio.
Item one, increased credit cost continue to weigh on our first quarter results. For the quarter, we increased our allowance for loan losses by $17 million to $121.4 million at March 31, 2008, from $104 million at December 31, 2007. This, combined with our charge-offs, resulted in a $34.3 million provision for losses in the first quarter.
Item number two, we had asset mark-downs of $11.1 million during the quarter. This was comprised of a $9.5 million unrealized loss on trading securities and a negative $1.6 million mark-to-market adjustment on our interest rate swaps.
Item number three, the adoption of fair value accounting for our MSR portfolio had a negative impact on earnings and contributed to our loss position, but we believe that it was an appropriate decision to offset extreme potential earnings volatility going forward now that we have decided to specifically hedge the vast majority of our MSR portfolio.
Our adoption of fair value for MSR has contributed to a loss on loan administration income activities of $17 million for the quarter. In the past, we have used our MSR portfolio as a hedge against rising interest rates.
We have historically recognized income in a rising rate environment by selling servicing rights, but capital constraints of traditional buyers have limited our sale opportunities to those entities in recent quarters. This has resulted in a larger MSR portfolio than we have historically maintained and has caused us to specifically hedge that portfolio.
Had we not adopted fair value and continued the use of the amortization method, it would have resulted in the recognition of losses on the hedge in a rising interest rate environment, but the inability to recognize gains in the same period on the value of MSRs absent of sale.
Overhead cost increased by $8.7 million during the quarter to $89.4 million in the first quarter of 2008 from $80.6 million in the fourth quarter of 2007. Of that, $7 million was attributable to compensation cost. Included in that was the resumption of FICA taxes for high-income earners and annual raises which were effective in the January 1 pay for all employees.
In addition, we added credit staff to handle the increased loan production, especially in FHA production. We also accelerated the hiring of branch personnel to implement a bank system conversion, as well as increasing staff levels for loss mitigation and collection efforts. Other business units have seen staff reductions. We will continue to monitor overhead closely and adjust staffing levels to the appropriate levels as necessary.
Now let’s talk about some of the positives. Please turn to Page 4. Gain on loan sale margin improved to 89 basis points for the first quarter of 2008, up from 32 basis points in the fourth quarter of 2007 and 44 basis points in the first quarter of 2007. Our first quarter gain on sale margin was the highest quarterly margin we have experienced since 2003.
In August of last year, we limited residential mortgage production to almost exclusively originating loans to be sold. These loans have been and will be sold through Fannie Mae, Freddie Mac and/or Ginnie Mae securities which we retain the servicing rights.
Turning to Page 5, we have increased our loan production and experienced increased pricing power, which was reflective of our core competency as an agency loan aggregator, our high level of customer service and our technological advantages.
We also have a large FHA underwriting staff which allowed for significant increases in FHA volume. In addition to increased production, these factors also led to positive spreads on originations, thus significantly improving our gain on sale margin.
Turning to Page 6 for the quarter, we originated $7.8 billion residential first mortgages as compared to $6.5 billion in the fourth quarter of 2007 and $5.5 billion in the first quarter of ‘07. Of the $7.8 billion originated in the quarter, virtually all was committed for sale as agency securities.
Pages 7 and 8 provide some historical loan lock in closing volumes. In the beginning of 2007, we estimated our mortgage market share to be approximately 1% of the total United States mortgage industry. Based on our estimates of current market share, we believe our 2008 market share will be closer to 2%.
Another positive trend we experienced was the improvement in net interest margin. For the first quarter, our net interest margin increased to 166 basis points from 162 basis points in the fourth quarter of 2007. The increase is attributable to several factors.
First, the steepening shape of the yield curve and wider agency credit spreads have resulted improved spreads on our available per sale assets.
Second, lower rates in our Federal Home Loan Bank advances and the continued reduction of deposit rates have contributed to decline in funding cost.
Now let’s turn to liquidity. We maintained a number of reliable sources of funding, most notably, our growing retail deposit base, which is outlined on Page 9. For the first quarter, we increased our retail deposits to $5.2 billion, up 2.3% from the fourth quarter of 2007.
We also opened four new banking centers in the quarter, bringing our total to 167 at March 31, 2008. Of those, two were in Michigan; one was in Indiana, and the last one in Georgia. While the growth of our actual deposits is limited by the economic conditions in our footprint states, we are still attracting new relationships.
During the first quarter, we opened a total of 6,544 net new retail accounts, including 4,092 net new checking accounts and 1,446 net new savings accounts. This is the largest growth of new retail accounts in the last four quarters. We continue to believe in the importance of our retail banking franchise and remain focused on building more new branches in 2008.
In addition to our retail deposit base, we have a $7.5 billion line of credit with the Federal Home Loan Bank, an unused line of credit with the Federal Reserve Discount Window, borrowing capability in the form of federal funds, and unencumbered agency and AAA-rated mortgage-backed securities that we could borrow against through the repo market.
Now let’s talk about our assets. Please turn to Page 10. In the first quarter our held for investment portfolio increased by $422 million. The increase primarily resulted from a transfer of non-agency loans from our available for sale portfolio into our held for investment portfolio. Without this transfer, growth in our held for investment portfolio would have been flat. Going forward, we plan to only originate loans for sale and we expect to significantly shrink the balance sheet during the remainder of 2008.
Turning to our available for sale portfolio, we feel this has been one of our stronger performing mortgage assets. The increase in our available for sale portfolio reflects the increased production that we talked about earlier. We have also added to reserves, increasing our allowance for loan losses to $121.4 million at the end of the first quarter.
We’ve closely monitored delinquency trends and loss mitigation patterns in the real estate own portfolio and we believe that we are adequately reserved. We realize there is still risk of further credit deterioration and increased credit cost. It is difficult to predict how severe and how long lasting the current economic slow down will be, but we are actively monitoring and planning for multiple scenarios.
Let’s provide a little more color regarding asset quality.
Turning to Page 11, you see our historical asset quality ratios. The first quarter provision for loan losses of $34.3 million reflects both an increase in charge-offs and an increase in both general and specific reserves. During the quarter, charge-offs increased to $16.9 million from $12.2 million in the fourth quarter of 2007. Charge-offs net of recovery in the first quarter were primarily in commercial real estate loans at $8.2 million and residential mortgage loans at $5.4 million.
On a positive note, home equity loan and second mortgage charge-offs appear to be leveling off.
Our increase in general reserves was primarily in first mortgage loans, while our specific reserves were primarily to cover non-performing commercial real estate loans. In addition to our general and specific reserves, we also have a reserve for repurchased assets.
We believe that the actions we implemented to limit repurchase liability over the last couple of years have paid off. Even though loan investors and insurers have focused their loss mitigation efforts on finding ways to make sellers repurchase loans, our current level of repurchased requests are at a four year low.
Turning to Page 12, you see that delinquencies continue to rise. Embedded in our delinquent loans totals are loans that we were making efforts to mitigate losses. These efforts include forbearance plans, repayment plans, loan modification, short sales and, where appropriate refinances. While we are sympathetic towards certain borrowers with their financial challenges, we are taking aggressive steps to collect from those who have the means to pay, yet simply decided to walk away from their obligations.
On Page 13, we provide a breakout of asset quality by loan type. As you can see, commercial real estate loans have the highest delinquency rates. One thing to note, while the level of non-performing loans in our residential first mortgage portfolio has been deteriorating, the severity of charge-offs are still relatively low.
On Page 14, you will see that Michigan, Florida and California continue to be the worst performing states. While the three states combined represent 51% of our first mortgage investment portfolio and approximately 64% of our commercial real estate portfolio, they represent 69% of the non-performing loans.
Page 15 details our residential first mortgage portfolio non-performing loans by FICO score.
Turning to Page 16, we provide a breakout of our commercial real estate portfolio by property type. As you can see, the residential development loans have clearly been the worse performing property types in this portfolio. However it is important to understand that the exposure in that portfolio is capped at $173 million, which only makes up 11% of the entire portfolio.
Also keep in mind that the majority of the material non-performing commercial real-estate loans have had recent appraisals and corresponding write-downs to present values unless there has been a pledge of additional capital.
Additionally, nearly all the loans have personal guarantees attached. Page 17 and 18 provide further breakouts of our commercial real estate portfolio both by vintage and state.
Beginning in 2009, Fannie Mae and Freddie Mac plan to implement new appraisal ordering standards which will not allow originators to directly order their own appraisals. We plan to adopt this change later this year. In our opinion, this has been long overdue and will be the best way to improve long-term credit quality.
Before leaving asset quality, it is important to analyze more closely Page 19 and recognize that 84% of our non-performing loans and 100% of our non-performing commercial loans were originated in 2006 or earlier. While we believe that our underwriting criteria at that time was more conservative then our peers, it is clear that credit standards across the industry were too loose.
However, we believe that we were quick to tighten credit standards. For example, we halted residential development loans in Michigan in November 2006, and nationwide in early 2007, and suspended the financing of lot loans for all channels in August of 2007. In July of 2007, we ceased origination of all negative amortization loans and all second lien products from our wholesale division.
We have never maintained a credit card portfolio or otherwise been active in the non-residential consumer segment, but we have ceased any consumer lending activity, other than through our retail bank branches. By not originating these products, we do not have new production to dilute the effect of season non-performing loans, but we are hopeful that our more recent originations will continue to perform well and that the steps that we took to tighten credit will improve results.
Now let’s turn to capital. We remain well capitalized under bank regulatory capital rules. At the same time, we are closely monitoring the effect that credit quality issues and market induced asset write-downs may have on our operating results in capital levels.
At March 31, 2008, Flagstar Bank, our wholly owned subsidiary, was considered well capitalized for regulatory purposes with regulatory capital ratios of 5.64% for core capital and 10.47% for total risk based capital. We believe these capital levels are appropriate given the composition of the balance sheet, and especially considering that the loans we hold on our balance sheet for sale compromise a significant portion of our balance sheet, over 13% of our assets at the end of the first quarter 2008.
These loans are closed with delivery commitments and this is a much higher percentage of total assets than any of our peers. However, until such time as the capital markets normalize and the residential real estate market shows sign of improvement, we plan to operate at capital levels that are higher than our historic norms.
Through 2008, our business plan calls for regulatory capital to increase and exceed to 6.5% for core capital and to 12% for total risk-based capital. Our plan calls for a reduction in the balance sheet, a return to profitability and to raise capital, if necessary. To operate at our new desired capital levels, we most likely will only need two of these three events to occur.
In April 2008, we sold $770 million of security in an effort to shrink and de-leverage our balance sheet. At this time, we do not plan to pay a dividend until our regulatory capital reaches desired levels and/or are returned to normalized profit levels.
Let’s discuss our management. As we had mentioned before, we feel that one of our strengths as a company is our seasoned management team which has remained intact through this difficult period. Given the volatility in the market over the past year or so, it’s nice to have a stable management team with a long average tenure of experience, who have managed through ups and downs of industry cycles before.
With that, let me turn things over to Mark.
Mark T. Hammond
Our slide on Page 20 outlines our 2008 outlook for some of our key drivers. Starting with branch openings, we are maintaining our expectations and anticipate opening 13 branches in 2008. In the first quarter, we opened four new branches.
Asset growth, as Tom mentioned, we are planning to shrink the balance sheet to between $14 and $14.5 billion by year-end. To reflect that strategy, we have updated our guidance on asset growth to a negative 8% to 12% from our previous estimate of 0% to 2% growth.
Residential mortgage originations, we are maintaining our residential mortgage originations at $33 to $38 billion for the year. Given our heavy first quarter production, we feel that we are on pace for this target.
Loan sales, to obtain our goal to shrink the balance sheet, we plan to sell more loans. We are revising our estimate for 2008 loan sales to match our mortgage originations of $33 to $38 billion, narrowing from our previous guidance of $30 to $38 billion.
Gain on loan sale margin, we are raising our gain on loan sale margin to 73 to 83 basis points from our previous outlook of 45 to 55 basis points. While this increase may seem significant, keep in mind, the updated range is below our first quarter gain on sale margin of 89 basis points and we feel that we have the pricing power to achieve those levels.
Net interest margin, we are raising our net interest margin to 180 to 200 basis points from our previous outlook of 165 to 175 basis points. Although this is somewhat higher than we had in previous guidance, the end of the quarter was trending up from beginning of the year.
Retail deposit growth, we are maintaining our outlook for retail deposit growth of 4% to 6%. We anticipate good growth as our recently opened branches begin to season as well as from the additional nine branches we plan to open this year. Our annualized retail deposit growth for the first quarter was 9.4%. The planned shrinking of the balance sheet will focus on shrinking liabilities other than retail deposits.
Mortgage servicing sales, we are widening our estimate for both mortgage-servicing sales from $20 to $30 billion to $0 to $30 billion. With the adoption of fair value accounting for MSRs (mortgage servicing rights) we would not expect to realize gain at the time of sale. Instead our earnings in MSRs would come from loan administration income.
Allowance for held for investments and loan charge-offs, finally, we are raising our guidance on loan charges-offs from $45 to $55 million to new level of $50 million to $70 million. Additionally, we are modeling allowance for loan losses as a percentage of held for investments to between 151 and 161 basis points.
To close, although we were disappointed with our results, we are pleased that many of our key operating metrics were at or above expectations, including our net interest margin loan production and gain on sale margin.
With that, let me turn it over to CFO, Paul Borja for the questions and answer session.
Paul D. Borja
Our first set of questions comes from Kevin Flynn - Avalon Asset Management. Question one “I noticed that quarterly loan production was up 37.9% year-over-year, while the compensation benefits and commissions total grew by approximately 50%. Could you please comment on the discrepancy?”
Kevin, there are two components that we have in that line item, compensation and commissions. Our compensation was up 33% due to increases in personnel and banking and underwriting, as well as in our home lending offices. Our commission expense of the same period was up about 91% and that’s primarily due to the composition of the loan production mix.
Our loan production increased in our home lending channels and so the commissions increased based on that production. We also had loan production in our broker channels, but our brokers are paid in the form of price, so that reduces gain on sale, rather than showing up in commission.
Kevin’s second question is in which loan vintages are the non-performing loans and charge-offs centered? Is there an evolving pattern?
As we just reviewed, you can take a look at Slide 19 on our PowerPoint presentation. It sets forth the vintages for the non-performing loans, and in there, you can see that most of our non-performing loans were originated in 2006 and prior.
The next question comes from [Mark Agga - MLP]. “Backing out the MSR accounting change and residual swap losses, it looks like non-interest income came in a bit over $17 million. Can you please provide a little detail on what is in the other income line? Are there non-recurring items that we need to adjust for on a go-forward basis?”
The other income contains a number of items. One of the items that is in there is a positive change in our secondary market reserve year-over-year of about $4 million. As our secondary market reserve increases and decreases you will see the effect there for loans that we’ve originated in prior years and there is also the effect there of our insurance income from our captive-RE. But as you might imagine, these tend to go back and forth so we would expect that the amount that we are currently showing approximates a reasonable run rate.
The next question from Mark ”Is there any residual?” We presume lingering, he means, “effect of the MSR accounting change? That is, could we see a small carryover effect or was the Q1 implementation a one-time issue?”
First, is there any lingering effect of our overall adoption? The answer is no. But, by the nature of adopting fair value and having a hedging strategy in place, we do have the ongoing effect of the hedge and so there is a potential gain or loss recognition going forward based on the effectiveness of the hedge strategy and potential losses associated with prepayments fees. So you will see effects going forward.
And the next question is from Annett Franke - Friedman Billings. “Please explain how you are getting this gain on sale margin. What is the collateral that you sold into the secondary market and do you think it’s sustainable?”
Our gain on sale is based upon our gross gains from loan sales less the related expenses and those include our hedging costs and secondary market reserves. This is a good time to point out that relative to our peers, we report our gain on sales on a net basis, where others might be reporting them or seem to be reporting them on a gross basis either without reducing for all expenses or by including some other tangential income.
We do not include any of that tangential income, such as interest income on our pipeline or on other types of income related to the loans. So the gain on sale margin is coming from the gross gains minus the expenses related to the sales.
What kind of collateral are we selling into the secondary market? It is primarily Fannie, Freddie, Ginnie loans, and to a smaller extent, loans to the Federal Home Loan Bank of Indianapolis.
Do you think this is sustainable? And to that, we would refer you to our guidance on drivers, which shows that we expect 73 bps to 83 bps going forward.
The next set of questions from Annett Franke says, “The compensation and benefits jumped in the quarter, please explain why and is that a run-rate for the year?”
We talked about that briefly in an earlier question and we don’t expect that what you are seeing in the current quarter would necessarily be a run-rate. What we have included within the current quarter is we have FICA taxes resuming on some of our higher income earners in Q1 versus Q4 of last year.
We also have new raises taking effect as we talked about in the speech. And we have also increased staff as compared to prior years for loan servicing and collection, as we talked about, for personnel for our bank conversion work, as well as increases for our FHA credit personnel.
Next Gary Gordon has a couple of questions. His first is how did you generate the large gain on sales spread? Was it easier competition, was it hedging, was it something else?
And for this, I will turn the question to Mark.
Mark T. Hammond
No, no it’s not predominately through hedging. The increased gain on sales spread came through a combination of a number of factors. First, decreased competition, second, over the last year we’ve upgraded our sales force in our home lending as well as our third party channels and we’re seeing that the quality sales people are bringing on quality customers, allowing for margin improvement.
Three, we think our technological platform has driven business to us, as well as our historic high level of customer service. We continue to be thought of and rated well by independent surveys on customer service relative to servicing, particularly our mortgage brokers and correspondents.
And we also believe there is a view from third parties that we are a most likely survivor in the residential mortgage business and we feel that there has been a number of customers wanting to align themselves with us and that historically not being as price sensitive as they’ve historically been, being more focused on relationships.
And then lastly, I’d like to point out that the overall markets move more to an agency type market, which has historically been a core competency for us.
Paul D. Borja
The next question from Gary Gordon would also be for Mark Hammond. “Your equity asset ratio is down to 4.5%. Doesn’t that argue for asset shrinkage?”
Mark T. Hammond
We focus more on regulatory capital and we are, as we mentioned, operating at levels of regulatory capital that we’ve historically operated at. But given the uncertainty of the economic environment, we are looking to increase our regulatory capital, which will result in an increase in the equity ratio. And as we have mentioned, we are looking to increase that through not only a shrinkage of assets, but also hopefully resumption of earnings and potential of raising additional capital.
Paul D. Borja
The last question from Gary Gordon is also for Mark Hammond. “In the past you have successfully traded mortgage servicing rights. Is this a good time to hold or sell? Has the credit crunch changed demand for servicing?”
Mark T. Hammond
There is a market, but bids have not been as aggressive as we’ve seen in past years. You’d probably expect this, given the preservation of capital at a lot of banks, as well as the opportunities to buy heavily discounted assets at distressed sales have created an environment where the capital that is to be invested is looking for those discounted distress sale opportunities, as opposed to buying the size assets that we’ve historically sold.
Given that, we would say yes, at this time, to hold and not sell in this current environment. And then since adoption of fair value, if we were to sell, we would not be selling for income recognition reasons, but we’d be selling for interest rate sensitivity or capital relief reasons.
Paul D. Borja
The next question is from Randy Sternke from Merrill Lynch. “Please explain the change in accounting for the MSR and what the specific accounting implications were for the quarter and for future periods?”
The change in accounting for MSR was our election to use the fair value method under FASB 156 in accounting for our MSRs. This is in contrast to our method last year in which we used the book amortization method, booking the MSRs at fair value and then writing them off over a specified period of time.
So, going forward, starting with Q1 of ‘08, we will assess the fair value of the MSRs, compare it to our then current book value and adjust up and down with the adjustment reflected in our income statement. At the same time, we will be assessing the value of our specific hedges, and netting that amount against the MSR movement up and down.
So, going forward, you’re going to continue to see loan administration income, but you will also see a little bit of amortization expense, but a line item that shows MSR marked to market. And that will be the net of the value in the hedge.
The next question from Randy Sternke is, “Are there specific products or geographies driving the rise in non-performing loans and charge-offs? Is there further evidence that borrowers are walking away from properties due to negative equity or reduced equity value?”
For that answer, I’ll turn over to Mark Hammond.
Mark T. Hammond
Yes, like we mentioned previously in the speech, the two asset categories that have been the most troubling for us have been our commercial real estate residential development loans as well as our high loan to value home equity loans and second mortgages. Those have been the most troubled portfolios.
And then geographically, as we mentioned, Michigan, Florida and California, in that order, have been the hardest hit geographic locations, but the problem is a broad one. It’s not just a local one, but it’s been more concentrated in those three states.
To the second question, is there evidence borrowers are walking away from properties? The answer is yes. We are seeing the migration of borrowers go from current to 30 days down, 60, 90 and foreclosure at the fastest migration speeds that we’ve ever witnessed in certain circumstances where there is declines in equity and negative value.
And that continues to be a problem for us, as it is for the industry. I will say, though, that we have not seen a large pick-up in the severity of loss nor in charge-offs at our first mortgage portfolio. And I think that has been because a lot of our portfolio has credit enhancement on it, has mortgage insurance on it, and has in a relatively good original LTV and equity cushion to begin with.
If you turn to Page 12, which also shows our credit metrics, I think it’s important to note that the rate of decline or the increase of the negative credit metrics has been slowing.
Paul D. Borja
Our next question is a follow-up from Randy Sternke which is also for Mark Hammond. “Is Flagstar witnessing further deterioration in commercial real estate? Please provide details on the level of specific versus general reserves.”
Mark T. Hammond
Yes, we are seeing our rate of deterioration seems to be slowing and looks to be nearing its peak. Clearly, if we were to see further economic deterioration or more severe recession, that could continue to increase, but like we mentioned before, we are seeing a flattening off of the credit metrics. And then, once again, I would refer you back in the speech to the number of slide that we provide on commercial real estate to get further color.
Paul D. Borja
The next question from Randy Sternke asks, “What underlying variables are driving the strength in the gain on sale margin?”
I believe this is a topic we just discussed earlier.
And lastly from Randy, “What is Flagstar’s provisioning methodology?”
I presume that’s for our allowance per loan losses, and our allowance for loan loss methodology has two components. There is a general reserve and a specific reserve. We first look at loans within the general pool that may be impaired and we pull them out of the general pool, we assess their collectibility based upon terms and to the extent that we believe that there is a collectibility issue, we assess a specific reserve.
The remaining loans we take a look at and we layer, we put them on top of a systematic formula that we’ve developed, which incorporates historical losses, delinquencies, loan performance and ratings. So with respect to the allowance for loan losses, we combine those two, so it’s a very structured systematic method involving a number of folks who look at the loans in good detail.
I think it’s good to point out at this time that we always look at the trends, the delinquencies, the actual losses that are out there, but we also want to reiterate the point that if the ongoing economic conditions, if the recession is severe, there always could be more provisioning.
Or if the commercial or residential real estate values decline at an even more significant rate than we’re seeing, then we could also see some more provisioning.
Paul D. Borja
The next questions are from Bose George of KBW. The first question is for Mark Hammond, “Can you discuss why the hedging costs related to your gain on sale took such a strong positive turn in Q1 of ‘08? Do you think the Q1 gain on sale margin is sustainable?”
Mark T. Hammond
This is a very complex question with a complex answer that I’ll try to summarize as best as I can. But now that we’ve adopted MSRs, we’ve combined the hedging-related cost or income along with the pipeline-related cost or income. On the pipeline, in this environment, there are inherent gains on our mortgage pipeline, on selling our agency loans. Those can be expressed in the form of either hedge gains and/or through booking of asset sales.
And a lot has to do with the timing of when we report and where interest rates are on the last day of the quarter. So to the extent that there are inherent gains in both, there is also though, just the nature of hedging, if one goes up the other is going to go down. So for the portion that’s related to hedging, you’re going to see the line item associated hedging often offset with the actual gain that’s booked on the asset sale.
Similarly, the servicing asset, there’s not necessarily, when you’re in fair value, inherent gains in the asset, because that’s being realized on the value. But there is a direct correlation between what you realize or lose in the hedged position is offset by the portfolio evaluation.
So a lot has to do with the time of the month and where the hedge position is relative to where the period ends to which side of the income effect are you going to see it on, the hedging side or the portfolio valuation side, when you are valuing the asset to seek it could rise or fall, the asset. So to try to predict our run rate on the hedging side is really difficult.
And once again, just to summarize, when you net the hedging effect on the pipeline there’s pretty significant inherent gains in that pipeline. When you net the hedge effect out of the servicing portfolio, if we’re effectively hurt servicing, that those should be approximately a wash.
I think probably we’ve got to go back because there is another question on that, that I didn’t finish on, do you think the gain on sale margin is sustainable. And as we mentioned in the call, we don’t think 89 basis points is sustainable, our guidance is for somewhat lower than in that.
We got to remember that’s an annualized guidance for the year and it’s already got a good quarter in it. So we’re anticipating the second, third, and fourth quarter will be below where the first quarter was, but still higher than traditional environments.
Paul D. Borja
The next question for Mark Hammond from Bose George is, ”Did you have to adopt fair value accounting for your servicing asset? If not, what drove your decision? Also, now that you have adopted fair value accounting, will there be no gains from the sale of servicing going forward?”
Mark T. Hammond
No, we did not have to adopt fair value accounting. There is, we thought it was the most appropriate accounting methodologies, most of our larger peers have already adopted fair value accounting on their MSR asset. And we did it to minimize the potential of volatilities on earnings recognition from period-to-period.
As far as gains going forward on the sale of assets, as we mentioned, the sale of servicing probably will not be driven by income realization considerations. It will probably be driven by either capital or interest rate sensitivity considerations, but if we were to book a gain or a loss, that would be associated with whether the sale price exceeded and/or fell below our internal modeling of how we’re evaluating that asset, and assuming that we’re modeling it appropriately, there wouldn’t be any anticipated gains or losses.
Paul D. Borja
The next question is “Can you discuss the loss severities you’re seeing on both residential and commercial loans?”
Mark T. Hammond
Yes. I think, if we can refer you back to Slide 13, and if you study that, summarizes the loss severities that we’ve seen. I just want to point out that relative to a lot of our peers, our severities at a lot lower levels. On the other hand, if property continues to significantly depreciate and/or the potential recession or slowing of the economy that we’re in becomes severe, then we’d anticipate that those severity levels will increase and that’s something that we’re continuing to monitor.
Paul D. Borja
Our last question from Bose George is also for Mark Hammond. “Can you discuss the motivation for potentially raising new capital? Your capital levels have been stable for the last couple of quarters, so does the decision to raise additional capital reflect concerns about increasing losses and has there been any regulatory pressure to preemptively raise capital?”
Mark T. Hammond
We’re currently operating at capital levels that have been around our historic norms, if you look back over the last 10 years or so, and once again we have managed predominantly to regulatory capital levels. The reason to increase or move to operate at a higher regulatory capital level is for insurance and cushion due to the uncertain times. And clearly, we need to balance any potential way to increase that capital with other concerns.
The way we look to do this, as we mentioned, is to shrink the balance sheet, hopefully have a resumption of earnings and then also potentially raise additional capital. If we were to raise additional capital, we have to balance that with the concern of shareholder dilution.
And as far as being told by our regulators to raise capital, we have not been told, by our regulators that you must raise capital, but clearly they would like it, and prefer that, I think that’s understandable in this environment. It would certainly be their preference if we did.
Paul D. Borja
And that concludes our questions for today. With that, I’ll turn it back to Mark Hammond.
Mark T. Hammond
I want to thank you all and hope everyone has a great day. And overall, once again, we are pretty optimistic going into 2008, but also realistic of the concerns and challenges that we’re going to have manage through. Thank you.