Earnings Call Transcript - FLG Q2 2025

Operator, Operator

Ladies and gentlemen, thank you for being here. My name is Krista, and I will be your conference operator today. I would like to welcome everyone to the Flagstar Financial Second Quarter 2025 Earnings Conference Call. I will now turn the conference over to Sal DiMartino, Director of Investor Relations. Sal, you may begin.

Salvatore J. DiMartino, Director of Investor Relations

Thank you, Krista, and good morning, everyone. Welcome to Flagstar Financial's Second Quarter 2025 Earnings Call. This morning, our Chairman, President and CEO, Joseph Otting, along with the company's Senior Executive Vice President and Chief Financial Officer, Lee Smith, will discuss our second quarter results and outlook. Also joining us on this call this morning is Bao Nguyen, company's General Counsel and Chief of Staff to the CEO. Before we begin, I would like to remind everyone that during this call, we will be referring to a presentation, which provides additional detail on our quarterly results and operating performance. Both the earnings presentation and the press release can be found on the Investor Relations section of our company website, ir@flagstar.com. In addition, please note that certain comments made today by the management team of Flagstar may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements we may make are subject to the safe harbor rules. Please review the forward-looking disclaimer and safe harbor language in today's press release and presentation for more information about risks and uncertainties, which may affect us. Also, when discussing our results, we will reference certain non-GAAP measures, which exclude items from reported results. Please refer to today's earnings release for reconciliations of these non-GAAP measures. And with that, I would now like to turn the call over to Mr. Otting. Joseph, please go ahead.

Joseph M. Otting, Chairman, President and CEO

Thank you, Sal, and good morning, everybody, and welcome to our second quarter earnings call. We are very pleased with our operating results achieved during the second quarter. We continue to accomplish everything we set out to do and make progress on several fronts. We had significant momentum on our C&I growth strategy as we generated almost $1.9 billion of commitments and $1.2 billion in new loans and added additional talent during the quarter as well. And I'll remind everybody, we really started this initiative in the third quarter of last year. We further reduced operating expenses on our plan to exceed prior estimates. Our credit quality improved as both criticized and classified assets declined 9% and non-accrual loans declined by 4%. We meaningfully reduced our CRE exposure via record par payoffs, almost $1.5 billion, which was substantially over what our initial forecast was. We grew the net interest margin, and we reduced high-cost deposits and borrowings and this all resulted in our CET1 capital ratio increasing to 12.3%. Going forward, we will continue to focus on the following areas as we continue to execute on our winning strategy to transform Flagstar Bank into a top-performing regional bank. We anticipate that we'll continue to grow C&I. This will further diversify our loan portfolio and generate deposits and fee income. We'll continue to reduce operating expenses and will reduce the level of non-accrual loans and criticized and classified loans. Lee will also provide an overview of our New York rent-regulated exposure and portfolio, which we think you'll see that we've substantially taken action against that portfolio and the overall risk is much less than I think that has been reported in the market. Before jumping into our financial results for the quarter more fully, I'd like to turn to Slide 3 to discuss the news we issued yesterday after the close of the market regarding our plan to merge our holding company into the bank. Flagstar Bank, thereby eliminating the holding company. This is a similar action that one of our regional bank peers undertook in 2018 when I was the comptroller of the currency. We were supportive of this then and feel this is the right move for our company. This action is designed to primarily enhance our corporate, legal and regulatory structure. Also, as you can see, there are additional benefits, including a further reduction in our operating expenses, streamlining certain functions across the bank, eliminating redundant corporate activities such as dual board meetings, reducing redundant supervision and regulation. I will add that other than the elimination of the holding company, really nothing else changes for our company. Our Board remains the same. Our management team remains the same, and our common stock will continue to trade on the New York Stock Exchange under the ticker of FLG. On the next slide, we highlight the 4 primary management focus areas for 2025, each of which gained momentum during the second quarter. We want to improve our earnings profile through margin expansion, fee income and reducing operating expenses, continue to execute on our C&I and private bank growth initiatives, proactively manage the CRE portfolio, including reducing our concentrations, and Lee will cover that later on a slide, but we've made really spectacular strides in not only reducing the CRE portfolio, but taking corrective actions and the credit quality improvement through lower provisions and credit losses. The next few slides show the significant progress made during the second quarter in our C&I business. Beginning on Slide 5, we show some of the key highlights during the quarter. In the second quarter, we hired an additional 46 new bankers and related support staff, including credit underwriters and portfolio managers. We have added more than 100 commercial bankers since June 2024, and we intend to add an additional 50 during the second half of the year. During the quarter, we showed tremendous growth in our 2 focus areas, specialized industries lending and corporate/regional commercial banking. Overall, new commitments increased 80% compared to the prior quarter to the $1.9 billion, while originations increased almost 60% to the $1.2 billion. But I think just more importantly is our pipeline currently stands at $1.2 billion, up 40% compared to the first quarter pipeline. And I really think this is just reflective of the focuses, the industries and bringing on really talented people into the organization, most who have 25 to 35 years of experience in their specific specialties. Our expansion strategy is really twofold. Our corporate regional commercial banking business is focused on building out a relationship-based national corporate banking effort and a middle market commercial banking franchise within Flagstar's 4 main geographic areas. Our specialized industries and corporate banking business is a national model and focuses on several industry verticals, including sponsor finance, subscription finance, lender finance, health care, oil and gas, power and renewable franchise, sports, entertainment and media and communications. And each of these have been staffed and are led by significant industry specialists in their respective area. We recently announced the expansion of this business, as you will see in the next few slides; it is already driving strong origination volume.

Lee Matthew Smith, Senior Executive Vice President and CFO

Thank you, Joseph, and good morning, everyone. As Joseph said earlier, during the second quarter, we did exactly what we said we would do, and we're very pleased with the continued progress of our turnaround strategy. From a fundamental point of view, our CET1 capital ratio ended the quarter at 12.3%, ranking us as one of the best-capitalized regional banks and our adjusted pre-provision pretax net revenue was a positive $9 million, an improvement of plus $32 million from last quarter as we look to return the bank to profitability in the fourth quarter of this year. We continue to deleverage the balance sheet by reducing high-cost funds advances and brokered deposits. We made further progress on our expense reduction plans, reduced criticized assets by $1.3 billion, achieved significant growth in new C&I originations and saw record CRE par payoffs. In Q2, we paid down over $2 billion of brokered deposits at an average weighted cost of 4.60%. And we also let $2 billion of high-cost mortgage escrow-related deposits with a weighted average cost of 4.70% run off during the month of June. We also paid off $1 billion of funds advances right at quarter-end with a weighted average cost of 4.50%. The reduction of these high-cost funds will provide us with an ongoing margin benefit during the second half of the year, and they also provide us with an FDIC insurance expense benefit. During the quarter, approximately $4.9 billion of retail CDs matured with a weighted average cost of 4.80%. We retained approximately 85% of these CDs, and they migrated into other CD products that were anywhere from 50 to 65 basis points lower than the maturing CDs. In the third quarter, we have another $5.2 billion of retail CDs maturing at a weighted average cost of 4.50%. These deleveraging actions, CD maturities and other deposit management strategies have allowed us to reduce our cost of deposits 11 basis points quarter-over-quarter and our overall cost of funds by 10 basis points compared to the prior quarter. We continue to actively manage our deposit costs and we will look for further opportunities to reduce our cost of funds during the remainder of 2025. We also accelerated $2 billion of investment securities purchases during the quarter to optimize our net interest margin. Collectively, these actions resulted in a 7 basis point quarter-over-quarter NIM improvement to 1.81%. Our NIM for the month of June was 1.88%. Joseph already commented on the strong results in the C&I business. We are thrilled with their performance and are firmly on pace to hit our target of $1.5 billion of funded C&I loans per quarter. I should note that during the quarter, we had legacy C&I payoffs as we took deliberate derisking actions to right size outsized credits by reducing hold limits and exiting lower risk rated and less profitable credits. In terms of asset quality, criticized assets declined $1.3 billion to $12.7 billion in the quarter, a result of payoffs and upgrades. Criticized assets have been reduced $2.2 billion or 15% since the beginning of the year. The one borrower we moved to non-accrual status in the first quarter filed for bankruptcy during the second quarter. We believe this will lead to a more orderly process on about 82 of the 90 loans that are subject to bankruptcy proceedings. Of the remaining 8 loans, we've moved to appoint a receiver in the various jurisdictions and take direct control of these properties. With respect to the 30- to 89-day delinquencies, approximately $332 million were driven by one borrower who pays subsequent to month-end and has done so again, meaning that about $329 million of their delinquent loans as of June 30 are now current as of July 23. On Slide 17 of the earnings presentation, we have provided significant information around our rent-regulated multifamily portfolio. When you look at all multifamily buildings that are more than 50% rent regulated, approximately $10 billion is within New York City with an average occupancy of 97% and a current loan-to-value ratio of 69%. Of this $10 billion, $5.6 billion or 57% are pass rated loans. The remaining $4.3 billion or 43% are criticized or classified loans, meaning they are either special mention, substandard or on non-accrual. Of this $4.3 billion, the current LTV is 79%. Interestingly, $1.9 billion are nonaccrual and have already been charged off to 90% of appraisal value. Furthermore, of this criticized and classified population, we have recent appraisals within the last 18 months on 77% of these loans and updated financials on 93%. If you subtract the non-accrual loans from this criticized population, you are left with $2.3 billion. Of this $2.3 billion amount between charge-offs and ACL reserves, we have approximately 6% or $137 million of charge-off and reserve coverage. I should point out that of the $2.3 billion of special mention and substandard loans, 50% have already reset to a higher rate and are paying, and 40% will reprice by the end of 2026, meaning they are in the 18-month window of enhanced financial review. Suffice to say, given credit metrics, charge-offs and current ACL reserves, we feel that we are appropriately reserved against the portfolio. Also, we are currently reviewing the annual financial statements for all borrowers. And to date, we've completed the review on approximately 28%. I'm pleased to report that there have been more upgrades than downgrades, while the vast majority have stayed consistent compared to last year, implying that the overall trend is improving. Now turning to Slide 9. As we reported earlier today, our second quarter loss per share narrowed significantly compared to the previous quarter. And on an adjusted basis, it came in in line with consensus. We reported a net loss of $0.19 per diluted share, and as adjusted, we reported a net loss available to common stockholders of $0.14 per diluted share compared to $0.23 net loss in the first quarter after adjusting for the following notable items: $14 million of merger-related expenses, $2 million of severance costs related to branch closures, $7 million in accelerated lease costs also related to branch closures and $3 million in trailing costs from the sale of the mortgage servicing and third-party origination business. Importantly, however, and as I previously mentioned, our adjusted pre-provision revenue was a positive $9 million this quarter, an improvement of $32 million compared to last quarter. The following slide provides our updated 3-year forecast through 2027. Given that earning assets are lower than previously forecast due to the higher loan payoffs, we are refining our net interest income and NIM guidance by $125 million and 10 basis points in 2025, but offsetting $75 million of that with a reduction in noninterest expense, resulting in adjusted EPS being approximately $0.10 lower than previously forecast. The lower balances then roll into 2026, so we have tempered net interest income by $100 million next year, but offset that entirely with $100 million of lower noninterest expense, meaning that our adjusted EPS guidance in '26 does not change, and there is no change to our '27 guidance. Slide 11 highlights our NIM trends. And as you can see, we had margin growth during the second quarter, and we expect to see margin growth over the remainder of the year. As I mentioned earlier, the NIM for the month of June was 1.88% compared to the 1.81% average for the second quarter. Drivers to our NIM expansion include a lower cost of funds as we continue to deleverage the balance sheet and manage our cost of deposits lower, low coupon multifamily loans resetting higher or paying off at par, net growth in higher-yielding C&I loans and a reduction in non-accrual loan balances. Earlier, Joseph touched on the reduction in our noninterest expense. And on Slide 12, you can see the substantial progress we've made in reducing operating expenses. We've worked exceptionally hard to optimize the cost structure of the organization. Given actions to date, we've taken out over $700 million of costs on a year-over-year basis. Our cost reduction efforts are focused on the following 5 areas: compensation and benefits, real estate optimization, vendor costs, outsourcing, offshoring non-strategic back-office functions and processes, and FDIC expenses. Quarter-over-quarter, expenses decreased $24 million, and we are significantly ahead of our full year 2025 noninterest expense guidance. Our cost savings are net of growth in other areas such as the build-out of our C&I business, together with investments in our risk compliance and technology infrastructure. Turning now to Slide 13, which shows the growth and strength of our capital position. At 12.3%, our CET1 capital ratio is top quartile among our peer group. Our priority continues to be to redeploy this capital into growing our C&I business as we further diversify our balance sheet. The next slide is our deposit overview. As I mentioned earlier, the decrease in our deposits was due to the payoff of $2.2 billion of high-cost brokered deposits and approximately $2 billion of mortgage escrow-related deposits. The next slide shows our CRE par payoffs. We had a record quarter of par payoffs of approximately $1.5 billion, almost double the amount for the first quarter. Of this amount, 45% or $680 million were rated as substandard. Approximately $500 million of this quarter's par payoffs or 33% were New York City greater than 50% rent-regulated buildings. This quarter's record number of CRE par payoffs provides an indication of the robustness of the market for these loans. And while this acceleration of par payoffs impacts short-term earnings, it also accelerates our strategy to diversify our balance sheet to 1/3 CRE, 1/3 C&I and 1/3 consumer. These par payoffs are also driving the significant reduction in CRE balances and in the CRE concentration ratio. Since year-end 2023, CRE balances have declined $8 billion or 16% to $39.7 billion while the CRE concentration ratio is down 80 percentage points to 421% compared to 501% at year-end 2023. Slide 16 provides an overview of the multifamily portfolio. This portfolio has declined nearly $4 billion or 12% year-over-year. We maintain a strong reserve coverage on this portfolio of 1.68%, the highest relative to other multifamily-focused banks in the Northeast. Furthermore, the reserve coverage on multifamily loans where more than 50% of the units are rent-regulated is 2.88%. Earlier, I stated that one driver to our margin expansion is the resetting of our multifamily loans. We have about $16 billion of multifamily loans either resetting or maturing between now and the end of 2027, with a weighted average coupon of less than 3.7%. If these loans pay off, we will reinvest the proceeds and capital into C&I growth or pay down wholesale borrowings. If they reset, the contractual reset is at least 7.5%, which gives us an immediate NIM benefit. Going back to January 1, 2024, approximately $4.9 billion of CRE loans have reset. Of that amount, $2.3 billion has paid off at par and $1.9 billion have reset and are current, meaning 85% of CRE loans that have reset are either paid off at par or current. Skipping to Slide 18. This slide details our ACL by loan category. Our ACL reserve decreased $53 million quarter-over-quarter, a result of lower held for investment balances and lower criticized assets. These positives were offset by a weaker Moody's economic forecast, which added over $60 million to the reserve. Our coverage ratio, including unfunded commitments, was 1.81%, in line with last quarter of 1.82%. On Slide 19, we provide additional details around our credit quality trends. Criticized and classified loans declined $1.3 billion or 9% on a quarter-over-quarter basis to $12.7 billion, while they are down $2.2 billion or 15% since the beginning of the year. Net charge-offs of $117 million were relatively unchanged compared to the prior quarter at $115 million. We believe we further derisked and positioned the balance sheet for growth and profitability. Fundamentally, we have strong capital that we can invest into loan growth, strong liquidity and funding, strong credit reserves, and we've executed on optimizing the cost structure of the organization. I will now turn the call back to Joseph.

Joseph M. Otting, Chairman, President and CEO

Thank you, Lee. On Slide 20, we highlight the significant embedded price appreciation potential in the stock price at current price levels. We closed yesterday at $12.05, reflecting 70% of second quarter tangible book value per share compared to 160% for our peers. As we continue to improve our credit quality profile, successfully execute on our strategic plan and return to profitability, we believe the valuation gap between Flagstar and our peers will narrow and ultimately go away. If we trade at only 1x our year-end 2027 tangible book value per share adjusted for warrants, our stock could trade at $17.64, representing potential upside of 46% from current levels. If we trade in line with the peer multiple, our stock price could trade at $28.23 representing potential upside of 134% from current levels. We have made significant strides during the first 6 months of the year as a team effort, and together, we will transform Flagstar into one of the best-performing regional banks in the country. Now operator, I would like to turn it over and open it up for questions. Thank you.

Operator, Operator

Your first question comes from Jared Shaw with Barclays.

Jared David Wesley Shaw, Analyst

I guess on margin, can you give a little bit of detail on the securities purchase that happened? And then as we look out going forward with that 1.88%, I guess, ending margin, does that take into account the FHLB payoff and sort of expectations around interest recapture in that?

Lee Matthew Smith, Senior Executive Vice President and CFO

Yes, it does. So thanks for the question, Jared. We pulled forward $2 billion. If you go back last quarter, that was what we forecast to buy between the end of Q1 and the end of the year. Given our excess cash position, we accelerated those securities purchases into Q2 because it maximizes NIM. We were basically buying agency CMOs with a weighted average coupon of about 5.25%. And so we just felt that was another action we could take to optimize our NIM position. And the FHLB purchase or what we bought back was right at the end of June. So you don't see any benefit of that in the Q2 results, but it is included in the NIM forecast for the remainder of the year.

Mark Thomas Fitzgibbon, Analyst

Joseph, I remember you mentioned earlier that stock repurchases could start in mid-'26. Is that still the expected time frame for buybacks, or has it been moved up at all due to your strong capital position?

Lee Matthew Smith, Senior Executive Vice President and CFO

Yes, this is Lee. As both Joseph and I have mentioned, our current focus is on investing excess capital to grow Commercial & Industrial (C&I) and other asset classes. This is where we want to allocate our resources within the franchise. We believe that the significant progress we've made in the C&I sector will continue in the same positive direction. Regarding stock buybacks, we are not considering them at this time. However, as I previously stated, if by the middle of 2026 we return to profitability and are performing well across the board, and if we are still trading at a discount to our book value as we are now, that might be something we need to reconsider.

Joseph M. Otting, Chairman, President and CEO

Yes. I think, Mark, what Lee said was kind of what we've communicated clearly, we need to get through '25 well into '26. And if we start being accretive to capital, then I think the Board will have some dialogue on what to do with that excess capital.

Christopher Edward McGratty, Analyst

Last quarter, you talked about the trajectory of the asset base over the next couple of years. I guess my question is, with this quarter's payoffs, albeit at par, I guess, what's the degree of confidence that the payoff acceleration will continue and the asset base will be smaller?

Lee Matthew Smith, Senior Executive Vice President and CFO

Yes, that's a valid point, Chris, and it's part of why we've adjusted our interest income forecasts. Currently, we anticipate our balance sheet will reach approximately $93.3 billion by the end of 2025, which is about $2.7 billion less than our previous estimate from last quarter. This change is primarily due to a few factors: the payoffs from commercial real estate have nearly doubled compared to the first quarter, and we expect Q3 to demonstrate another strong quarter for these payoffs. Additionally, we noted that the commercial and industrial loans experienced a slight net decline as we seek to reduce risk in some legacy portfolios that did not meet our profitability criteria. However, we expect to see a net positive outcome from commercial and industrial lending in Q3. Despite the smaller balance sheet, as mentioned in my earlier comments, this trend will carry into 2026, followed by a recovery in 2027. By the end of 2026, our projected balance sheet will stand at about $98.5 billion, down from around $102 million, and by 2027, we expect it to be $109.6 billion compared to $111.4 billion. Furthermore, I want to highlight that due to the significant strides made in our expense optimization plan, we can completely offset the reduction in net interest income guidance with those cost savings in 2026.

Bernard Von Gizycki, Analyst

Just questions. I know you're trying to reduce your multifamily concentration and utilize proceeds into growing C&I. So the $16 billion in the regulated portfolio, are you contemplating any sales here? Or will reductions here going forward be from any maturing or charge-offs?

Lee Matthew Smith, Senior Executive Vice President and CFO

Yes. So I think as you can see, we're doing a very nice job of receiving par payoffs, and a substantial amount of those par payoffs are substandard. And as you correctly point out, between now and the end of '27, we've got another $16 billion resetting. So as it relates to the performing part of the portfolio, we feel very comfortable that what we're executing on right now is paying dividends. I think the sale option applies more to the non-accrual loans. That's just one of the options along with dispositions, workouts. That's just one of the strategies in terms of dealing with the non-accrual loans. And so that's how I sort of think of the sales strategy.

Joseph M. Otting, Chairman, President and CEO

Yes. And the other thing I would add there is, obviously, we're trying to work with borrowers where we can enhance the credit either through maturities paydowns or then offering up additional collateral with cash flow to support the loan. So it is a multitude of buckets. And quite frankly, what you've heard from us for multiple quarters is our real desire to get the criticized loans paid down as a concerted effort, and we saw significant results this quarter from that effort.

Casey Haire, Analyst

So I guess, just following up on that last question. I was wondering if you could provide an outlook for the net charge-offs. I know you guys kept your provision guide intact, but I was wondering if we could see some leverage from net charge-offs, which held flat this quarter.

Lee Matthew Smith, Senior Executive Vice President and CFO

I'm sorry, Casey. We expect charge-offs to decrease as we progress into Q3 and Q4. We're confident in the guidance we've provided regarding the provision for the rest of the year. I'd like to emphasize that there has been a reduction in the HFI portfolio mainly due to multifamily par payoffs, and we've also seen a significant reduction in criticized assets, down 15% or $2.2 billion since the start of the year. Right now, we anticipate these trends to continue.

Joseph M. Otting, Chairman, President and CEO

Yes, I think there are a couple of areas to consider regarding the payoffs. Approximately 20% comes from the agencies, and in many cases, those credits meet a higher standard to clear the agency hurdle. About 20% of the payoffs come from JPMorgan, so together, these two sources account for roughly 40% of the total payoffs. The remainder is distributed across other channels. According to our rollover documentation, we are 75 to 100 basis points over market rates, which serves as a motivating factor for borrowers in our discussions about reducing our exposure. We have consistently communicated this intent. As a result, borrowers are incentivized to address the substandard credits, which represent about 50% of the payoffs, by offering credit enhancements to remove them from our books. As mentioned earlier, these enhancements can include paydowns or additional collateral, and borrowers are making these moves to secure lower interest rates in the market.

Operator, Operator

We have no further questions in our queue at this time. I will now turn the call back over to Joseph Otting for closing comments.

Joseph M. Otting, Chairman, President and CEO

Okay. Thank you very much for joining us this morning and allowing us to give you kind of an update. The executive management team of the bank is very excited about our progress and the direction that we're heading. We laid out an ambitious plan when we first arrived shortly after March of 2024. For the most part, we've stuck with that plan and actually outperformed in certain areas of the plan, including expenses. I think at the time, people were questioning perhaps our sanity that we could take that much expense out, but not only are we going to take that out, we're going to exceed that. And also, the C&I business is coming along. We couldn't be more pleased with the talent and the growth in the C&I business. And that's a real driver for us to reshape what Flagstar Bank will look like in the future. So we do think we're well on track for all the parameters that we laid out and goals and objectives, and the team is really focused on building this into a really top-performing regional bank. So again, I'd like to thank you for taking the time to join us this morning and for your interest in Flagstar Bank.

Operator, Operator

This concludes today's conference call. Thank you for your participation, and you may now disconnect.