Flagstar Bancorp's CEO Discusses Q3 2012 Results - Earnings Call Transcript

Oct.24.12 | About: Flagstar Bancorp, (FBC)

Flagstar Bancorp Inc. (NYSE:FBC)

Q3 2012 Earnings Call

October 24, 2012 11:00 AM ET


Paul Borja – EVP and CFO

Joseph Campanelli – Chairman, President and CEO

Mike Tierney – President

Matt Kerin – EVP, Managing Director, Mortgage Banking and Warehouse


Paul Miller – FBR Capital Markets

Matt Kerin

Bose George – KBW

Andrew Luke – Jersey Micks

Eric Goldsmith – DSG Capital

Brad Artmonsov – Coastal Investment


Good day and welcome to the Flagstar Bank Third Quarter Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn your conference over to Mr. Paul Borja. Please go ahead, sir.

Paul Borja

Thank you. Good morning, everyone. I’d like to welcome you to our third quarter 2012 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 information 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 business.

For additional factors, we urge you to review the press release we issued last night, the Form 8-K, we also issued last night which was filled this morning with the SEC containing the press release.

Our SEC documents such as our most recent Form 10-K and Form 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 at flagstar.com.

During the call, we may also discuss non-GAAP measures regarding our financial performance. A reconciliation of these measures to like GAAP measures, is provided in a table to our press releases which was issued last night, as well as in the appendix to our earnings call slides.

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

Joseph Campanelli

Thank you, Paul, and good morning, everyone. I’d also like to welcome everyone to our third quarter 2012 earnings call. I would like to begin today with some general comments on the third quarter specifically around credit cost and asset quality.

I will then turn the call over to Mike Tierney who will discuss some of the key drivers during the quarter. After Mike finishes his remarks, Paul Borja will take us through a more detailed financial review, including our outlook for the fourth quarter. Afterwards, our executive team will be available to answer any questions you may have.

We report another strong quarter. In our second consecutive quarter profitability with third quarter net income to common shareholders of $79.7 million or 1.36, $1.36 per diluted share.

On annualized basis, third quarter return on average assets, was 2.1%, and return on average equity was 25.8%. Our quarterly net income contributed to our tier one capital ratio to 9.31% which you can see on slide 9.

Book value also increased to $17.76 per share as compared to $16.50 per share in the prior quarter, a quarter over quarter improvement of approximately 8%.

Our third quarter performance was driven primarily by record levels of residential mortgage originations and gain in loan sale revenue which we attributed largely to initiatives we have implemented over the last several years.

These initiative, combined with record low interest rates and the ongoing dislocation of mortgage market place, have a lot as to leverage our vast distribution channels in long standing customer relationships, thus prudently increasing our market share of our customer share wallet and mortgage market share.

Based on the most current industry data, Flagstar has grown its total mortgage market share, from 2%, and 9th in the country in 2011, to 3% and the 8th in the country through the first six months of 2012.

We anticipate this trend will continue as we remain focus on leveraging our core competencies as a top tier mortgage lender in a Super-Community Bank in Michigan emphasizing all three lines of business, mortgage banking, personal financial services and commercial banking.

Slides 10 through 13, highlights some of our key mortgage banking drivers including gain on loan sale revenue and margin, mortgage originations, mortgage rate locks, and revenues from our mortgage servicing rates.

As you can see, with the exception of the MSR income, we experience significant improvement in each of the key drivers.

MSR incomes was down from previous quarters due to rate volatility, however, it still remains positive.

At the same time, we continue to encourage substantial credit cost associated with our legacy portfolios in representation warranty exposure. However, turning to slide 14, you can see that the 2012 revenues from our mortgage banking business have more than fully offset credit related cost.

Slide 15, this is a breakdown of our three primary credit costs, provision for loan losses, representation of warranty reserve change in estimate, and asset resolution expense.

I want to spend some time to provide further color on each of these components. Please note that in vision [ph] for the slides I’m going to cover, we have prepared a number of slides in the appendix that related to credit quality and additional stratifications of the legacy loan portfolios which you may find helpful.

During the third quarter, we added significant reserves and strengthen the balance sheet against various legacy exposures, including residential mortgage loan and loan repurchases, primarily related to loan sold to the GSEs prior to 2009 and claims arising out of our 2005 and 2006 securitizations.

Slide 16 shows we have increased our representation warranty reserve by approximately 26% from the prior quarter to $202 million as September 30th 2012.

This increase has two major components. First, we increased reserve based on updated forecast to demands, primarily related to pre-2009 vintages. As a result of the recent change of behavior by and enhanced transparency from the GSE.

Second, we made a number of enhancements to our repurchase operations, to increase the processing capacity and to allow for the height and focus on resolving the age loan repurchase demands.

Part of those efforts included aggressively resolving loans aged over 180 days in the pipeline.

Slide 17 shows the positive results of those efforts with both the overall repurchase pipeline, and a percentage of demands over 180 days improving significantly from the prior quarter.

As a result, we experienced a significant increase in net charge offs in the third quarter. This increase and that charge offs produce an adverse impact on the loss rates used in our reserve model and resulted in an increase in representation [ph] and warranty reserve.

We experienced several additional encouraging repurchase trends during the third quarter as well. For example, one slide 18, you will see that audit file review request which are leading indicator of repurchase demands decreased by approximately 35% from the prior quarter.

Turning to slide 19, it shows new repurchase demands decreasing by approximately 26% from the prior quarter, again, driven by a significant declines in demands of our primary [ph] investor Fannie Mae.

On slides 20 and 21, new demands for the 2009 to 2012 vintages decreased by approximately 20% from the prior quarter, and we believe losses associated with those vintages will be relatively insignificant.

It is important to keep in mind, on an average, approximately 66% of the new demands from the 2009 to 2012 vintage are performing loans with a significant portion related to curable documentation issues. Paul will discuss further, our outlook on the repurchase division during his comments.

Please turn to slide 22 where we note that our allowance for loan losses increased to $305 million or approximately 77% of non-performing loans as September 30th 2012 as compared to 287 million or about 67% of non-performing loans at June 30 of 2012.

This increase in allowance was attributable to two components. First, our allowance associated with residential first mortgage loans increased reflecting management’s view of probably losses in the existing portfolio of interest only and adjustable rate mortgages.

Although the interest rates on a significant portion of these residential mortgage loans do not reset until 2014 and beyond.

We are currently looking into potential sales modifications refinancing programs to address these risks.

Second, on slide 23, we continue to actively serve our distress borrowers providing loan modifications to such customers which are characterized as TDR, or Troubled Debt Restructurings.

We believe it is important to help borrowers remain in their homes, and we are dedicated to supporting the stabilization of the housing market.

Although many of our TDRs continue to perform, we hold a relatively higher reserve against this portfolio which resulted in increasing allowance for loan losses from the prior quarter.

During the third quarter, we also increased reserve to reflect management’s view of probable losses within that portfolio of modified loans.

On slide 24, net charge offs decreased in total by approximately 15% from the prior quarter. Even though we continue to focus aggressively on loss mitigation strategies and working through legacy assets. Overall credit metrics improved from the prior quarter.

Slide 25 shows total delinquent loans 30 days and more past due, decreased by about 6% from the prior quarter.

This is driven primarily by consumer non-performing loans, 90 days or more past due, which improved for the third consecutive quarter with almost 6% decline from the prior quarter.

Slide 26 highlights a continued reduction in the balance of the legacy commercial real estate portfolio which we define as loans originated prior to 2010.

This portfolio has now declined by over 36% since 2011. We’ve been replacing those assets along with a substantial run off of the residential held-for-investment portfolio with new commercial loans underwritten to more rigorous standards.

I would now like to take a moment to highlight some key steps we took during the quarter to strengthen the company.

First, we increased our litigation reserves based on the assessment of overall legal exposure, some pending and threatened lawsuits by $40 million. Second, we recognized a $19.9 million tax benefit and as a result of the sale of the remainder of our $200 million plus non-agency CMO portfolio.

Third, during the quarter we participated in a HUD coordinated market auction of loans repurchased with government guarantees. And actually [ph] that transaction, we agreed to convey over $300 million of such loans in the accelerated fashion at par value.

This resulted in reduction in otherwise expected curtailment of debenture interest income, thus decreasing asset resolution expense by 7.8 million during the third quarter.

Our third quarter results also include a $15.2 million charge from what we prepaid $500 million in long term FHLB advances with a weighted average cost of 1.97%.

This not only reduces our future funding cost, but also reflects our strong growth and funding from deposits during the quarter, it provides us with room for further deposit growth as we continue to shift our funding structure towards a retail deposit emphasis.

I would now like to turn the presentation over to our President, Mike Tierney.

Mike Tierney

Thanks, Joe, and thank you for all you’ve done for Flagstar Bank, most importantly, leading us back to profitability.

Good morning, everyone. If you’d please turn your attention to slide 27. During the quarter, we experienced a decline in our net interest income and margin from the prior quarter as we experienced NIM compression from declines in our variable yields, predominantly in our adjustable rate mortgages in commercial loans.

In previous quarter, we experienced lower funding cost which helped offset decline in the interest yields. However, on slide 28, you can see that our third quarter average cost of funds was essentially unchanged from the prior quarter, although our cost to deposits continues to decline.

Turning to slide 29, we increased total deposits by over 500 million from the prior quarter replacing more than what we prepaid in FHLB advances. This is consistent with our strategy to grow branch deposits to fund our growth.

On slide 30, our core deposits declined slightly from the prior quarter, as clients move to higher yielding CDs in reacted to a prolong low interest rate environment.

Please turn to slide 31.

Recognizing the importance of strong brand recognition in active community involvement, during the third quarter, we entered into a three-year agreement with the University of Michigan to become an official sponsor of the university’s athletic program.

This partnership meshes perfectly with our marketing message that as the largest bank headquartered in Michigan, Flagstar’s Michigan based, and Michigan focused.

It also pairs us with one of the top academic and athletic collegiate brands in the nation. We expect that this agreement will increase our brand awareness with 540,000 U of M alumni thus helping to generate additional core deposits in Michigan.

Please turn to slide 32, slide 32 and 33. Over the last year, we’ve been successful in raising deposits in Michigan and reducing our overall cost of funds.

Based on the FDIC’s latest deposits statistics for the 12 month ended June 30th 2012, Flagstar was the fasters growing bank in Michigan, among banks with at least five branches.

And the fastest growing bank in the United States among all banks with at least 30 branches, and our average branch size has increased by 20 million which is a 33% increase.

As of June 30th 2012, the latest available data, we are the sixth largest deposit share in Michigan moving up one spot from last year.

Over that period, we had deposit growth of approximately 30% as compared to an average of about 6% for all of Michigan.

The power ratio as a measure of the company’s fair share by its deposits related to the number of branches it has.

For example, a power ratio of 100% means that you’re taking your fair share of the amount of deposits in your market, relative to the number of branches you have. If you’re over 100%, you’re doing well. If you’re under 100%, not so good.

In Michigan, Flagstar’s current power ration is 145%, and unlike some of our leading competitors, we’ve never done an in-market consolidation which leads to a higher power ratio.

We remain dedicated to our Super-Community banking strategy in Michigan, and believe that the unparalleled customer service, strong rates and everyday convenience of our Michigan branch franchise allows us to continue to fund new mortgage and commercial loan growth going forward.

As we grow our bank presence, we also continue to emphasize prudent growth in our commercial loan portfolio which is illustrated on slide 34 and 35.

And now, I’d like to turn the presentation back over to Joe.

Joseph Campanelli

Thanks, Mike. I’m sure most of you are already aware that I’ll be stepping down as CEO and Chairman, effective November 1st 2012. Before I turn the presentation over to Paul, I’d like to thank all of our employees for their extraordinary efforts to help turn Flagstar around.

I deeply appreciate all of your hard work and long hours during my tenure to make Flagstar a success. It wasn’t always easy, but we accomplished a great deal. And I’m confident Mike Tierney is the right man to lead Flagstar going forward.

With that, I will turn the presentation over to Paul.

Paul Borja

Thank you, Joe. Good morning again, everyone. And as mentioned, our net income for the third quarter was $79.7 million or $1.36 per share on a fully diluted basis. This follows our profitable second quarter in which we earned $86 million or $1.47 per share fully diluted.

Our third quarter earnings were due in large part to the increase in our gain on sales, offset by the increases we made to our loan loss reserves and our representation warranty reserves reflecting our cautious view about the near term outlook.

We have in prior calls focused on three key areas of our operating results, revenue generation, expense management, and credit costs. From a revenue generation perspective, our third quarter results rose from mortgage banking revenue including the highest level of gain on loan sales in a single quarter in the bank’s history, and a continued strong levels of net interest income before the provision for loan losses.

With respect to net interest income, it declined slightly to $73.1 million from $75.5 million in the second quarter. At the same time, the bank’s net interest margin declined 2.21% from 2.37%.

On a company-wide basis, the yield on our interest earning assets declined by 26 basis points due to lower yields on our mortgage loans held for sale which are short term assets and thus more sensitive to interest rate movement, on our loan repurchase with government guarantees, the portfolio of which had a 12 month to 10 month life and earns varying yields based on debenture rates outstanding at the time of delinquency.

Due to lower yields on our residential mortgage loans as higher rate loans have refinanced, and in our commercial real estate loans as our legacy loans have paid off or refinanced away from us.

The cost of our liabilities during the third quarter was relatively flat and so the spread earned on our assets declined 1.81% from 2.10% during the second quarter.

The overall decline in yields reflects the continuing low interest rate environment during the third quarter, and its effect on our shorter term and medium term assets is also reflective of the inter period volatility of these rates.

During the third quarter for instance, the 10-year US Treasury rate remained at historic lows beginning and ending the quarter at a rate of 1.65%.

This facilitated continuation of the current refinancing environment and higher yielding residential mortgage loans that we held for investment, refinanced to lower rate for paid off. In both cases, reducing the yield we earn on those asset classes.

At the same time, during the quarter, the 10-year Treasury rate fluctuated from a low of 1.40% to a high of 1.87%.

Reducing the overall yield, we were able to earn on our residential mortgage loans that we hold for sale for periods of 25 to 45 days.

The overall average balance of our interest earning assets increase slightly during the third quarter, but only partially offsetting the effect of these lower yields on net interest income.

These increase was primarily in mortgage loans available for sale, reflecting the higher level of closings during the quarter, and warehouse loans which tend to increase as our originations of loans held for sale increase.

We also had an increase in our average balance of cash levels reflecting the increase in mortgage loan sales during the third quarter, and also our focus on managing liquidity to levels consistent with our funding needs.

However, such balances only earned at a 25 basis point level, thereby reducing the overall yield of our interest earning asset base.

At the same time, these increases were partially offset by the decline in the average balance of mortgage loans held for investment, as loans refinanced and the average balance of our commercial real estate portfolio.

With these, and other changes in average balances and yields, the bank’s interest income for the third quarter declined slightly to 119.7 million from $123 million during the second quarter.

During the third quarter, we were able to reduce our funding cost, although not to the same extent as in the prior quarter, as we saw less elasticity with deposit rates than in the past.

However, we see opportunities for potential reductions as we continue to execute on our strategy for a liability structure comprised substantially with our retail deposit products.

For the third quarter, the average cost of our retail deposits declined to 92 basis points from 98 basis points in the second quarter.

We continue to see declines in the cost of our certificates of deposit. With a lower rate structure of our retail certificates of deposits, continuing to replace maturing higher cost retail certificates of deposit, and wholesale CDs and our funding structures.

At the same time, our repayment during the third quarter of $500 million in FHLB advances with an average cost of 1.67%, allows for replacement funding with lower cost deposits. Because the advances we paid off with a lower cost in tranche of outstanding FHLB advances on our books, however, their payoff actually increased the average funding cost of the remaining FHLB advances.

As such, during the third quarter, our overall funding expense declined 46.7 million from 47.4 million in the second quarter.

However, the cost to such funding increased slightly to 1.73% from 1.72% during the second quarter.

For the fourth quarter of 2012, we would expect our net interest income to be slightly higher than the level of the third quarter, with net interest rates approximately equal to that of the third quarter, but with a slight increase in average interest earning assets.

As with the third quarter, we expect such net interest income increase to rise from the continued growth in mortgage reduction during the quarter, thereby increasing the average levels of the portfolios of available-for-sale residential mortgage loans, and warehouse loans.

We would also expect the replacements of the FHLB prepaid advances with lower cost in deposits, to offset in part, the lower yield experience during the third quarter.

With higher net interest income, and a higher average base of interest earning asset expected in the fourth quarter, we would expect this to result in a lower net interest margin for the fourth quarter.

Our ability to meet this estimate of net interest income for the fourth quarter 2012, depends upon a number of factors including the continuing ability to generate and maintain higher average balances of available-for-sale mortgage loans, our ability to invest the excess funds and assets of similar yields, the absence of a sudden insignificant increase in the general interest rate environment during the quarter, that could significantly curtail our production of available-for-sale residential mortgage loans, and no substantial increases on non-performing, or non-accrual loans.

Turning to gain on loan sales, the bank’s mortgage business during the third quarter generated $334 million in gain on loan sales, as compared to $213 million during the second quarter.

To put that in perspective, the third quarter gain on loan sales, was higher than such gain in loan sales for all of 2011. And the combined gain on loan sales for the second quarter and the third quarter, is higher than the bank’s previous record for gain on loan sales for the entire year, 2009.

During the third quarter, the bank continue to originate loans through refinancing of residential mortgage loans, including participation in the HARP 2 program and origination of FHA and VA loans.

The gain on loan sales for the third quarter 2012 reflects a strong growth in overall loan loss volume arising from both overall industry volume increases as well as the increase in market share.

During the third quarter, we again experienced growth in both our loan loss and our sales, with a combination of competitors exiting certain channels of the mortgage business and our increase in market share as discussed earlier.

We believe we remain well position to participate meaningfully in the current mortgage market and we expect to continue our efforts in building market share.

For the fourth quarter 2012, we expect that our loan loss and our loan sales will be higher than those levels experience during the second quarter, but not as high as we experienced in the third quarter.

Our view is based upon the continued strength we see in the refinancing demand, tempered [ph] in part by our expectation of seasonal decline, generally experienced in the year-end holiday season.

We also expect that during the fourth quarter, we will continue to sell substantially all of our loan originations, residential mortgage loan originations.

Based upon our experience in the interplay of margin and volume levels, to manage our capacity, and depending upon the types of loans that we lock and originate, we believe that our margin levels could be slightly below that of our third quarter margin.

Accordingly and based on preliminary October results, it will be reasonable to expect that our gain on loan sale income for the fourth quarter 2012, could be approximately 20% to 25% below that experienced during the third quarter of 2012.

Note that even with such reduction, we would expect our gain on loan sale income for the fourth quarter, to still be well above that of the second quarter 2012. Our estimate of the fourth quarter gain on loan sale income 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, that the operating environment for mortgage banking activity does not significantly change, with the bank’s ongoing relationship with its investor, primarily the GSEs, remains consistent with past practices involving loan sales, escrow accounts and loan servicing.

That the expected trend in mortgage originations, industry wide for the fourth quarter, does not decline beyond current industry projections, and if there are no regulatory or other legal impediments to our full participation of the mortgage bank industry.

Another driver of mortgage banking revenue, is our net servicing revenue which is a combination of income we earn from servicing loans, and the net effect of the hedges on the mortgage servicing rights on our balance sheet.

During the third quarter, we continued to earn income from our mortgage servicing rights during a quarter in which as we discussed earlier, there was significant interest rate volatility in the market place.

In total, our net servicing revenue was $11 million for the third quarter of 2012, a decrease of $29 million in the second quarter of 2012.

This reflects the refinancing experienced during the third quarter, as well as the hedging challenges experienced during that time with the volatile interest rate environment given the Federal Reserve QE3 announcement, and the European market place impact on the US Treasury market.

Our mortgage servicing asset increased during the third quarter 2012 to $687 million from $639 million at the end of the second quarter due in large part to our continued high levels of loan production during the third quarter.

As September 30, 2012, the asset reflected approximately $82 billion of loans we are servicing for others primarily to GSEs.

For the fourth quarter 2012, we expect that net servicing revenue will be at or slightly above the amount earned during the second quarter which was $25 million.

Our estimate assumes that there remains a close and positive correlation between rate movements of the 10-year treasury, and residential mortgage rates, as well as the absence of significant volatility in mortgage rates and interest rate curves specially such volatility as was experienced in the third quarter.

Non-interest expense, excluding asset resolution, was $221 million in the third quarter 2012, as compared to $149 million in the second quarter of 2012.

For the third quarter, non-interest expense also included a $15 million loss for pre-paying the FHLB advances, and a $40 million litigation reserve expense.

Excluding those items as well, and asset resolution for comparability to the second quarter, the third quarter 2012 non-interest expense would have been $166 million.

This reflected slightly higher compensation expense and higher commission expense due to the higher levels of loan originations during the quarter, as well as higher general and administrative expense associated with our use of professional and consulting firms.

For the fourth quarter 2012, we expect that our non-interest expense would be approximately equal to that of the third quarter, without the effect of the FHLB pre-payment expense, or the litigation reserve expense.

This assumes that the FDIC assessment rate remains unchanged, then mortgage volumes are at levels consistent with that reflected in our earlier discussion of gain on loan sale income.

And upcoming regulations or governmental directives do not require changes in service levels or business operations, and there are legal consulting and professional expenses remain constant with that of the third quarter.

Turning to our credit cost, loan loss provision expense declined to $53 million for the third quarter as compared to $58 million for the second quarter.

At the same time, we continue to build our reserves, increasing it to $305 million as of September 30, 2012, from $287 million at June 30, 2012, for the reasons discussed earlier.

Going forward, we expect to continue to engage in modification of residential mortgage loans, which then become trouble debt restructurings or TDRs as part of our loss mitigation efforts.

Also, we work this past year improving our loan servicing process so that we may efficiently assist our loan customers.

We believe our diligent efforts in this area has contributed to the improvements we’re experiencing in two of our credit quality metrics.

The ratio of non-performing loans, to total loans, and the ratio of non-performing assets to total assets.

At the same time, we note that our loan balances in the 30-day and 90-day past due categories for loans have declined with the 60-day category substantially flat.

We believe that our loss mitigation effort should further reduce over time, our over 90-day delinquent residential mortgages.

At this time, we anticipate that the provision for loan loss is for the fourth quarter 2012, should be approximately equal to that of the amount in the third quarter.

This estimate assumes among other things that current trends of unemployment and housing prices remain unchanged, and the growth rate of TDRs and short sales remain flat.

It also assumes that the loss rates we apply against our different portfolios do not change significantly based on our experience with our own portfolio, different segmentation or due to effect of various macroeconomic, or other factors.

Turning to our representation in warranty expense, that expense increased for the third quarter significantly as compared to the second quarter.

For the third quarter, we increased our reserves from $161 million at June 30, 2012, to $202 million to reflect among other things the increases in our losses, that we would expect could arise from increases in forecast of demands by the GSEs.

In particular, we experienced increases in GSE demands in the 2005 and 2006 loan vintages well after we had assumed such vintages would not be as actively reviewed.

We also experienced GSE demands in the 2007 and 2008 vintages at a level beyond that normally expected for loans seasoned to that degree.

Our reserve level also reflects the higher charge off levels during the quarter, as we remediated loans in our pipeline, causing the pipeline to decline meaningfully.

For the fourth quarter 2012, we would expect that our provision expense in this area would be approximately half that, of the expense in the third quarter, this would be above that of the second quarter, and at a level that we believe would allow us to prudently address further changes in GSE demand during the fourth quarter.

Our estimate assumes that there are no significant changes in the current practices or patterns of the GSEs, and at the levels of loan file request, loss severity rate and recovery rate remain unchanged.

Turning to asset resolution expense, it declined to $12 million from $21 million in the second quarter.

This decline reflected the $7.8 million benefit we realized from the HUD coordinated market auction of our loans during the third quarter as we discussed earlier.

For the fourth quarter 2012, we anticipate that the asset resolution expense will be approximately 20% to 30% higher than the second quarter, but still well below the level of the first quarter as we continue to engage in loss mitigation activities, and also continue our processing of the balance of repurchase government insured loans.

With that, I’ll turn it back to Jo Campanelli for the question and answer session.

Question-and-Answer Session

Joseph Campanelli

Thank you, Paul. I’d like to ask [ph] our operator to open the lines up for questions and answers.


(Operator instructions). Our first question will come from Paul Miller with FBR. Your line is open, please go ahead.

Paul Miller – FBR Capital Markets

Yes, thank you very much. Hey, Paul, can you back up a little bit on your credit cost guidance for your reps and warrants, I’m not sure I head you cleanly or correctly. Are you expecting to start the slow down the reserve billed [ph] or to continue to go the reserve billed at the current level?

Paul Borja

We expect – this is Paul Borja, we expect that, first of all, we believe that we’re properly reserved at the end of Q3, but that we expect that during the course of Q4, that we would have additional provision expenses which may be charge offs, or reserve billed.

Paul Miller – FBR Capital Markets

Did you say, would it be at the same level as the third quarter or be lower, or you’re not giving that guidance?

Paul Borja

Our provision expense for the fourth quarter, we believe would be lower than that of the third quarter.

Paul Miller – FBR Capital Markets

Okay. And then the litigation expense of $40 million, I mean everybody knows, I think, out there, that you’re right now current in a court case, and we’re not going to make an assessment of what that’s going to be, but I guess, they’re suing for $110 million.

Can you tell me what you reserved against that, or is that something that you don’t release?

Paul Borja

As a general matter, as you know, we provide disclosure based on our overall litigation exposure, and so we don’t provide individual amounts, and we also don’t comment on any litigation.

Paul Miller – FBR Capital Markets

Okay. Okay, and then your guidance for your charge offs, I just want to make sure I have this all right, charge off is relative to on portfolio, not off portfolio including TDRs, you’re saying those trying still [ph] remain in a favorable manner and that the charge offs, tell me if I’m wrong, and the charge offs are going to go down in the fourth quarter most likely?

Paul Borja

With respect to our loans and our books?

Paul Miller – FBR Capital Markets


Paul Borja

With respect to our loans and our books, the charge offs are going to impact the provisions which is the expense to the extent that we see that there are additional reserves necessary.

At this point, we expect that the provision expense to be at or slightly higher than what we had in Q3, but we expect there – continue to be charge off. I don’t believe that we provide the charge off amount on a separate basis because that really feeds into our provision expense which is what’s going to affect our overall bottom line.

Paul Miller – FBR Capital Markets

Now you gain on sale, not you gain on sale really, really jumped. You know we got increased production, but you gain on sale from 1-6 to 2-4, and you highlighted in some of your discussion is that, some of that was due to change of processes.

Can you elaborate on that a little bit?

Paul Borja

Why don’t I turn it to Matt Kerin who heads the mortgage banking group.

Matt Kerin

Hello, how are you.

Paul Miller – FBR Capital Markets

How are you doing?

Matt Kerin

Good, thank you. I mean we, amongst the management team, made a commitment to the business going back a year and a half, and we’ve continued to invest in people, modification of processes, there’s been dislocation in the market, we’ve obviously been managing to our capacities as we’ve continued to extend our capacity to produce which has certainly had an impact on the increase in the margin.

As you can see, we’ve increased our market share gradually, but I would say, prudently, or in a controlled manner and that we would look at that to continue.

We’ve obviously been blessed by the FRBs, accommodative monitoring policy and we’re probably looking at historically low mortgage rate certainly in my lifetime and probably dating back to the pre-world war 11. So I think that we are continuing to look at the unprecedented margin levels today, associated with many companies, our included that are managing our margins to stay and sink with our capacity while we continue to increase capacity.

So it’s really a multi-functional dynamic here that’s gone on to generate these margins that we’ve had.

Paul Miller – FBR Capital Markets

We know that low interest rates, and we know that this is probably one of the most profitable time periods for mortgage banking, but nobody else out there has really seen this type of jump in the gain on sales. So that’s what we’re trying to say, what did Flagstar did differently than everybody else?

Matt Kerin

I would say there’s a couple of things. One, if you look at our product mix, about 12% of our production is on the HARP space, the HARP 2.0, and that has commanded premiums in the execution market place, but investors use on the pre-payment potential for those loans, versus what’s going on with some of the heavier pre-payments feeds in the industry today from the balance [ph] perspective, but I think the biggest thing is we’ve become more efficient in terms of processes, we have committed to more resources and to leverage potential from a resource, expense to dollar of revenue is fairly dramatic in the business.

So I think it’s a combination of us increasing share of wallet which it doesn’t necessarily have an intently higher cost of doing business because customers are already doing business with us today, it’s the fact that we have improved our processes and workflows to make us more efficient in getting our loans out, it’s the rate environment, and it’s also just us increasing our share of the overall market.

Paul Miller – FBR Capital Markets

Okay. Thank you very much, gentlemen.

Paul Borja

Thank you, Paul.

Joseph Campanelli

Thanks, Paul.


Well take our next question from Bose George with KBW. Your line is open.

Bose George – KBW

Hey, good morning guys. I just wanted to follow up on the gain on sale [ph], did the HARP percentage change quarter over quarter?

Joseph Campanelli

Modestly, I mean not anything relevant, it’s been fairly consistent.

Bose George – KBW

Okay, so that really wasn’t the driver. And then secondly, just in terms of the dynamics of the decline that you guys are forecasting for next quarter, the 25%, can you just walk through that again? Was there anything sort of one time in this quarter that’s going away to the next quarter or just any way to think about what’s happening there?

Matt Kerin

No, I think – this is Matt Kerin again, and Paul can certainly jump in, but I think it’s largely driven by the fact that we look at the margins and we look at the demand that was made.

If you think about the last quarter, rates went as low as 131, at the same year, and that drove an unprecedented refinance boom. We also had a fairly strong focus on the purchase market with many of our customers, so we’re looking, as we look at that.

So I think we’re just kind of taking a conservative and appropriately so, approach to, as others build up their capacity margin, we will certainly have some compression. And that’s really kind of the large driver there, I would guess.

Bose George – KBW

Okay, great, that makes sense. And then switching to the litigation issue, I know you can’t say anything about the existing litigation, but I was curious, are there other bonds that you guys have done with bond insurance where there might be risks that we should think about?

Paul Borja

This is Paul. We did, back in the mid 2000s when folks were doing two to three or four securitizations. We did four securitizations over the course of two years, and we’ve disclosed them in the footnotes to the financials. Those are the only ones we’ve done, two HE lock [ph], two home equity securitizations and two second mortgage securitizations.

Bose George – KBW

Okay, great. And actually, one last one, in terms of your DTA valuation allowance, when do you – conversations occur about potentially reversing that?

Paul Borja

Our DTA right now, as of September 30, is $309 million against which was 100% valuation allowance in discussions that we’ve had with our auditors and with our accounting consultants.

We view that as a reversal point between four to 12 quarters, after four to 12 quarters of profitability. And also based upon our ability to reasonably forecast profits going forward and being able to track that.

So at this point, after two quarters of profitability, it’s a bit premature to have those discussions. We’re aware of institutions that have reversed as soon as five quarters, and institutions that have reversed as late as 12 quarters.

Bose George – KBW

Okay, great. Thanks a lot.

Paul Borja

You’re welcome.


Our next question will come from Andrew Luke [ph] with Jersey Micks [ph]. Your line is open.

Andrew Luke – Jersey Micks

Good morning. I was just wondering if results of some of the banks outside of Michigan were possibly one of the good reasons for the mortgage restructuring and turnaround of the bank in general.

Mike Tierney

I’m not quite sure I understand this. What do you mean by some of?

Andrew Luke – Jersey Micks

Well there was – banks were sold off, I thought Michigan like in Georgia.

Mike Tierney

I think that it’s fair to say that the most efficient return on capital is right here in Michigan, you can see the great job Mike and his team has done in increasing our power ratio and placing deposit growth. So I think it’s a better allocation capital and hence, better returns accommodation with the focus on building a strong mortgage origination platforms, series of platforms. Those things all come together for the last couple of years.

Andrew Luke – Jersey Micks

Great. So they weren’t doing necessarily poorly, but we just think they’re going to do better in Michigan. Is that part of the reason they’re sold off or more just...

Mike Tierney

If you look back it strategically, our discussion when we announced this out, it was a much more efficient reinvestment in Michigan market.

Andrew Luke – Jersey Micks

Okay. I was curious. Is there any future target price for the next several months, or 24 months or anything like that?

Joseph Campanelli

We have not, normally don’t provide target prices. What we normally do is we’ll provide, we believe sufficient drivers for models, to the analysts. Investors tend to have different types of models, so it’s difficult for us to do apples to apples comparison.

So we believe we have provided the most meaningful drivers within our existing operational structure. And hopefully provided enough background as to why we think that’s an appropriate estimate.

Andrew Luke – Jersey Micks

Okay, I understand. All right. Thank you, appreciate it.


Our next question comes from Eric Goldsmith with DSG Capital. Your line is open.

Eric Goldsmith – DSG Capital

Hi guys, terrific quarter. Are there current restrictions on the declaring that dividends and if that’s the case, when do you think you guys can start?

Mike Tierney

Yes, the fact that we saw HARP [ph] standing and it is in the regulatory for close and paying dividend currently.

Paul Borja

We’ve also, if I could, also we’ve differed trust preferred and we differed HARP and other terms of the trust differ to the HARP, we need to resume those dividend payment before we can resume dividend payments elsewhere.

Eric Goldsmith – DSG Capital

Okay, thanks very much.

Paul Borja

You’re welcome.


I’m showing no further questions. We have a question from Brad Artmonsov [ph] with Coastal Investment. Your line is open.

Brad Artmonsov – Coastal Investment

Hey guys, great quarter. Question for you, regarding the new consent order that’s been signed, can you walk us through how in effect, you particularly, your – got a large mortgage – platform?

Mike Tierney

With respect to the consent order we recently entered into with the OCC, as we recall back in January of 2010, we had a similar order surprisingly on the OTS, and with OTS has been – that obviously transitions over, there are a variety of issues that outlined in the agreement.

The vast majority was we have actions and initiatives underway to modify, correct and enhance the underlying processes to work through.

I’m not sure – there’s a second part of your question?

Brad Artmonsov – Coastal Investment

I don’t know if there’s been discussions or – that I’m understandings of how your business practices will be changed or the sizes of your sort of mortgage origination or in other kinds of lending is going to be modified given a new regime?

Paul Borja

If I could, I believe in the press release that we issued separately last evening, regarding the consent order, I believe we indicated that we do not think that our current business operations will be impacted adversely by the consent order.

It requires us to address fundamental issues, certain issues that all bankers address in a regular basis, liquidity, capital planning, asset management.

And so we expect to do so in due course in partnership with our regulators.

Brad Artmonsov – Coastal Investment

Got it. And the second question is on the new rules that are coming in effect early next year. Can you talk about how it’s going to affect your business, sort of on balance, I know there are a lot of regulations coming down the pipe.

Paul Borja

Are you referring to Basel III? The capital regulations? Or some other regulations?

Brad Artmonsov – Coastal Investment

More with regards to mortgages.

Matt Kerin

This is Matt Kerin. I’m assuming you’re asking about the QRM and qualified mortgages. I mean obviously, we’re very actively engaged with the MBA and in conversations with the appropriate parties in Washington.

And we believe that we’re going to be largely dated [ph] from much of these because it’s a predominantly a GSE seller for now and into the foreseeable future. That is our selling point of our company. So we don’t really think that barring any adverse changes, we’re mindful of what’s going on in the industry from a regulatory perspective, compliance is right up there with production and production is second to making sure that we have good quality control of our products so that we’re going to in compliance with the regulatory standards as they evolve.

So I think we’re well positioned now, we don’t see that as an obstacle to our doing business going forward.

Brad Artmonsov – Coastal Investment

Great. It’s a fantastic quarter. Good luck guys. And hopefully, one off expenses and deductions won’t abate [ph] at some point.

Mike Tierney

Thank you.

Paul Borja


Brad Artmonsov – Coastal Investment



And I’m showing no further questions in queue at this time.

Mike Tierney

Well thank you all for participating this quarter’s conference call. Thank you.

Paul Borja

Thank you very much guys.


And this concludes today’s teleconference, you may now disconnect.

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