Earnings Call Transcript - FLG Q2 2021

Sal DiMartino, Director of Investor Relations

Good morning, everyone. This is Sal DiMartino, Director of Investor Relations. Thank you for joining the management team of New York Community Bancorp for today's conference call. Today's discussion of the Company's Second Quarter 2021 Results will be led by Chairman, President and CEO, Thomas Cangemi.

Thomas Cangemi, Chairman, President and CEO

Thank you, Sal. Good morning to everyone, and thank you for joining us today to discuss our second quarter 2021 performance. Joining me in our Long Island headquarters is our Chief Operating Officer, Robert Wann, and our Chief Financial Officer, John Pinto. Also joining on the line from Flagstar Bancorp are Sandro DiNello, President and CEO of Flagstar, and Lee Smith, President of Flagstar Mortgage. As you may have already seen, Flagstar reported strong second quarter results today. We also announced better-than-expected results for the second quarter of the year. This is the second consecutive quarter with better-than-expected quarterly results. I'm very happy with our strong operating performance this quarter, which is highlighted by continued expansion in our net interest margin, lower operating expenses, good loan growth, solid credit quality, and, most importantly, a substantial improvement in our earnings per share. In fact, this is the company's best quarterly operating performance in over 15 years when we reported diluted EPS of $0.35 back in the first quarter of 2005. On a non-GAAP basis, excluding mostly merger-related non-recurring items of $12 million, diluted earnings per share were $0.33, up 57% year-over-year and $0.03 or 10% ahead of consensus estimates. On a GAAP basis, diluted earnings per share were $0.30, up 43% on a year-over-year basis. As for the details of the quarter, starting with our net interest margin: our second quarter margin was 2.5%, up two basis points sequentially. Prepayment income was very strong during the second quarter, increasing 35% to $27 million compared to the first quarter of the year, and it added 20 basis points to the margin compared to 15 basis points in the previous quarter. Excluding prepayment income and the impact from holding excess liquidity during the quarter, the net margin increased five basis points to 2.3% compared to the prior quarter, ahead of our expectations.

Operator, Operator

Thank you. We will now be conducting a question-and-answer session. Our first question comes from Steve Moss with B. Riley Securities. Please proceed with your question.

Thomas Cangemi, Chairman, President and CEO

Good morning, Steve.

Steve Moss, Analyst

Hi, good morning. Maybe just starting here with margin expectations and loan pricing—good quarter here in terms of the underlying core. Just kind of color there, could you give Tom some context in terms of where you're seeing pricing have gone?

Thomas Cangemi, Chairman, President and CEO

So obviously, pricing has changed significantly over the course of the environment. We're seeing anywhere from 3% to 3-3/8% on a traditional product on multifamily. In respect to commercial, we're probably getting 30 basis points to 40 basis points above that. But as far as overall economic returns in the business, as you can see, prepayments have been relatively strong and despite the level of prepayments we still grew the book. So we're excited about growing the portfolio. We're still anticipating mid-single-digit loan growth for the company. And if you think about margin, with the fact that we have around that 3% type yield coming back onto the portfolio and holding the portfolio at a reasonable growth trajectory for the year, of course funding costs are still declining slightly, so we anticipate further decline in our cost of funds as we move into the second half of the year. So I'd say we're probably looking at between 3 to 5 basis points of potential margin expansion in Q3. The ongoing continuation of these expenses is occurring as we set ourselves up for the business combination, which will bring a lot of liquidity and, more importantly, a lot of balance sheet opportunity on the mortgage side that we're going to evaluate. We haven't been specific about what we're going to do there; it's not baked into the merger math, but we have a tremendous opportunity to look at a combined wholesale liability portfolio as we bring in excess liquidity. We'll make business decisions as we get closer to the closing of the transaction. So we're excited about ongoing margin expansion, even though we've enjoyed a unique opportunity over the past few quarters—nearly a year and a half now—of reductions in cost of funds and improvement in margins. We anticipate that to continue as we focus on consolidating the business model into 2022.

Steve Moss, Analyst

That's helpful. And then maybe one question for Sandro here. Sandro, could you give us an update on your thoughts on the mortgage banking market and kind of where you see things playing out? I do see the guidance in the deck which gives some color around that and what your underlying expectations are with the adverse market fee coming out.

Sandro DiNello, President and CEO of Flagstar

Hi Steve, nice to hear from you. Yes, we think the mortgage business continues to be very strong; the projections by the GSEs and the MBA continue to look for a very strong mortgage market. What we've been trying to do, as you know, is build a consistent mortgage revenue stream, and I think we've found our way there. It's shown not only in what we've done this quarter, but also in what we're guiding for next quarter. So we feel very good about the consistency of mortgage revenue, and I think what you see today we hope will be sort of a run rate, plus or minus 10% over the long term. I'll let Lee be a little more specific about that.

Lee Smith, President, Flagstar Mortgage

Thanks Sandro, and thanks for the question, Steve. Giving a little more color to what Sandro said: volumes are holding up. The agencies and the MBA have 2021 at about a $3.9 trillion market, 2022 at $2.7 trillion, and 2023 at $2.4 trillion. When you look at the primary spread, it has been pretty constant over the last several weeks between 1.25% and 1.35%, as have the gain-on-sale margins. Given our diversified mortgage model, we're able to find pockets of opportunity other originators cannot. By that I mean we originate in all six sales channels. We have a balance sheet which gives us available-for-sale, held-for-investment, and MSR flexibility. We have an RMBS program which provides execution optionality. We executed four RMBS deals in Q2, with the third-largest RMBS issue of the quarter behind JPMorgan Chase and Goldman Sachs, and we're planning on five deals in Q3. As the GSEs step away from certain product classes, such as non-owner occupied, we're able to step in and take advantage given our balance sheet and RMBS program. The key, as Sandro mentioned, is consistency; we want to bring consistency to our mortgage earnings and gain-on-sale revenues. Because we have so many different levers to pull, in Q2 I guided to $150 million to $170 million of gain on sale, and in Q3 I'm guiding to $160 million to $180 million. The relevance of that is, if we're generating north of $150 million gain on sale in the quarter, Flagstar is going to generate over $2 earnings per share for the quarter, or $8 annualized. That's a lot of capital and firepower for Flagstar and, ultimately, the combined company.

Sandro DiNello, President and CEO of Flagstar

And Lee, relative to the GSE fee that was eliminated, maybe a couple quick comments on that.

Lee Smith, President, Flagstar Mortgage

Yes. It's helpful and we've seen a pickup in our pipeline from a mark-to-market point of view and from a balance sheet point of view, given that we're delaying deliveries at the same rate until that removal goes live. But if you think about it, that 50 basis points equates to about a 10 basis point higher mortgage rate for borrowers. So while its elimination is positive for prospective refinance volume, it's not going to have a material impact. More interesting recently has been the drop in tenure to around 1.25 years, and we've definitely seen an increase in refinance volumes as a result of that. Combined with the HFI removing their refi fee, that's helpful. But the removal of the fee in and of itself won't drive a ton of volume, though it has given us a bumper pickup in our pipeline. Given our diversified model, we can use our levers—delivery delays, balance sheet execution, RMBS—to take advantage. We're focused on keeping mortgage revenues consistent quarter to quarter.

Steve Moss, Analyst

Great. Thank you for all that color and great quarter on both sides.

Thomas Cangemi, Chairman, President and CEO

Thank you, Steve.

Operator, Operator

Thank you. Our next question comes from Brock Vandervliet with UBS. Please proceed with your question.

Thomas Cangemi, Chairman, President and CEO

Good morning, Brock. How are you?

Brock Vandervliet, Analyst

Hi, good morning. I'm doing well. Going back to multifamily, could you talk about activity levels there? How much of the activity you're seeing is purchase versus refinance? More generally, has the corrective phase within that asset class really shaken out at this point or where do we stand?

Thomas Cangemi, Chairman, President and CEO

Well, it's been relatively slow in the past few years, but more importantly during the pandemic there was a lack of activity. We've done pretty well with our customer base. Refinancing has always been significant—as you can see from the quarter we had significant prepayment activity—so while many of those deals traded away, we still grew the book, which we were pleased with. I'd say we're looking forward to the second half as being more of a growth opportunity for us. We still feel confident that we can grow the core multifamily book at about a 5% growth rate. The more interesting opportunities will be when we combine with Flagstar; this is going to be a growth story. I don't think anyone really anticipates the capital infusion that will go into the combined entity. We can significantly increase our exposure to many of Flagstar's strong relationships, including warehouse, commercial real estate, and construction financing. These are positions that have been well managed. When you add substantial infusions of capital on a combined basis, we've done it before—when Richmond County merged with NYCB, we were capped at $50 million per customer; now we have substantial exposure to the best borrowers. I believe that type of growth opportunity will be there for us. We are not giving projections for next year until we close the transaction, but there's no question that combining the companies will enable us to increase lending to top customers and to go after deposit opportunities throughout the branch network. We're excited about the second half. It's not going to be double-digit on a standalone basis, but we think we can achieve about 5% net loan growth. Regarding our specialty finance business, it's doing really well; we have about $2 billion undrawn out there, because of supply chain issues and customers managing their capital stacks and current capital markets conditions. But as business picks up, we expect that to draw down and see high-teens growth in that area as well. So we're excited about this combination; we think it's going to be a growth story and a catalyst for investors.

Brock Vandervliet, Analyst

And just following up on multifamily: what's the latest on the threat to 1031 exchanges—has discussion moved on at this point?

Thomas Cangemi, Chairman, President and CEO

That's an interesting question. If I had a definitive answer it would surprise everyone. Clearly it's on people's minds. I ask my top customers all the time whether it's positive, and opinions vary. It is a tax strategy that may or may not go away, but right now it seems like momentum to remove it is losing steam. It's a big issue for commercial real estate. If 1031 exchanges were eliminated, assets might stay on the market longer, but the jury is still out. It would have implications for transactions and therefore for municipal budgets, especially in New York City, which benefits economically from those transactions. 1031 is always an issue for long-term investors—they will find other ways to access liquidity, such as cash-out refinances. They might take less cash out, but they will adapt by using other tax strategies that are available, though none are as meaningful as a 1031. So removing 1031 would be negative for owner sentiment, but for our portfolio and customers, they will adapt.

Brock Vandervliet, Analyst

Okay. Thanks for the color, Tom.

Thomas Cangemi, Chairman, President and CEO

Sure.

Operator, Operator

Thank you. Our next question comes from Dave Rochester with Compass Point. Please proceed with your question.

Thomas Cangemi, Chairman, President and CEO

Good morning, Dave.

Dave Rochester, Analyst

Hey, good morning guys. Nice quarter. Since it's been a few months since the announcement of the deal and you mentioned you've done additional work and discovery on opportunities to enhance the combined performance, can you frame that more quantitatively to any extent? For example, some of the opportunities you expect on the loan or deposit growth side or the fee income side? I know you mentioned the strong deposit opportunity previously—going after deposits at Flagstar's current warehouse customers sounds like a great shot on goal. Can you quantify how large that pool is you're seeing and what you think the chances are you can capture some of that?

Thomas Cangemi, Chairman, President and CEO

We see many opportunities as our two management teams work together to get to the finish line. What's most important is that in the announced transaction, many of the upside attributes were not included in the deal math. We have a double-digit EPS accretive transaction with tangible value creation. We're not forecasting the benefit of a wholesale shift from wholesale to retail deposits in our initial math, which will be a significant benefit as we decide how to position our liability structure. There'll be tremendous opportunity to look at the combined entity. We're liability-sensitive and Flagstar is asset-sensitive; combined, we can choose our positioning as the Fed makes rate decisions later in the year—this is a significant catalyst for us. Regarding warehouse lending, they have very strong relationships and are number two in warehouse nationally. We believe we can hold and grow that business nicely and expand into larger relationships that were previously too big for them alone. Also, many existing customers will be reignited by a capital infusion. We've done this before—for example, after Richmond County merged with NYCB we significantly increased CAGRs on loan growth. On a pro forma basis we're now just under $90 billion and that creates a lot of liquidity and opportunity. We also see deposit opportunities where Flagstar has liabilities funded at other banks that we can bring back onto our balance sheet. Banking as a Service is another initiative: we allocated resources to build out a digital platform and Banking as a Service; we had our first win in Q1, another one last week, and I believe we got another anticipated win last night, so we expect two more programs coming on in Q3—one fee-generated and one deposit-generated with zero cost to deposits. We're diversifying our funding base and moving away from dependency on wholesale finance toward a traditional bank funding model over time. We picked up about $400 million from our customers from January 1 through June 30—getting our fair share of deposits is a cultural change. When we make loans, we expect deposit relationships as part of the business. We're focused on efficiencies and technology initiatives, and we believe we'll achieve estimated cost savings on the transaction and potentially more via automation, robotics, and AI. Collectively, there's a lot of cross-selling opportunity on C&I that we've historically underplayed, and there is substantial upside as we become a fuller-service commercial bank. We won't provide specific guidance until closer to closing, but over time investors will view this as a growth story with strong credit attributes on both sides.

Dave Rochester, Analyst

Okay, appreciate that. Maybe switching gears and drilling into the warehouse lines this quarter: the balance held up fairly well given industry trends. How do you see that book trending from here given mortgage activity forecasts? I know you talked about delivery delays and the cash window cap that could actually help drive more warehouse volume in the market. Can you comment on how you see that book trending?

Thomas Cangemi, Chairman, President and CEO

They (Flagstar) are excited about the business. I'll defer to Sandro and Lee since they run that business currently; we're going to support it and make significant investments because we believe it's a tremendous opportunity.

Sandro DiNello, President and CEO of Flagstar

Hi Dave, nice to hear from you again. From Flagstar's point of view, the warehouse business we take as much as we can get. When the mortgage market is strong, our warehouse balances are higher; when it's weaker, they are lower. With the upcoming combination, we are looking at every opportunity to expand lines with existing customers and talk to customers who were previously too big for us. I think we can mitigate some natural reductions in balances that we might see in a smaller mortgage market because of the combination. Don't focus too much on any one line of business; if warehouse goes down, something else usually goes up. That's the beauty of our diversified commercial model. Our net interest income is consistent over time—we manage the total. In the past quarter our net interest income was about $180 million plus or minus 5% to 10% each quarter. If you believe that's a run rate for Flagstar, then don't get focused on any one line because in any given quarter builder finance may be lower or higher and warehouse may be lower or higher, but we manage the total and the margin. We've shown a very stable net interest margin through multiple economic scenarios—our NIM went up 8 basis points this past quarter. Combined with consistent mortgage business guidance that Lee gave, the combination of our commercial banking and mortgage business shows strong earnings potential. On a converted basis, based on the exchange ratio, the contribution from Flagstar can be meaningful to NYCB's total.

Thomas Cangemi, Chairman, President and CEO

If I could add, being a big originator, we buy loans from certain warehouse customers and offer ancillary lending services—MSR financing, servicing advances—that can be helpful to larger warehouse customers. We're a one-stop shop in that regard, and that's part of the service equation Sandro mentioned.

Sandro DiNello, President and CEO of Flagstar

People come and go in the business, but Flagstar has been providing warehouse lending in this country for 30 years, and that longevity, combined with service, is what has helped us gain market share.

Dave Rochester, Analyst

Yes, I agree. Thanks for all the detail. Maybe one last one on expenses: Tom, those were better than expected this quarter. What's your view on the trajectory going into the end of the year?

Thomas Cangemi, Chairman, President and CEO

We've been working hard to keep the expense line at a conservative level. We budgeted approximately $130 million in operating expenses and delivered about $129 million this quarter.

John Pinto, Chief Financial Officer

129.

Thomas Cangemi, Chairman, President and CEO

129-ish. I think it's going to be relatively flat—Q3 around $130 million. I'll give you some guidance for the year, but we need to be careful given the merger timing. We're doing a little better than budget. Q1 versus Q2 differences are partially driven by payroll tax timing—Q2 is higher. We're focused on efficiencies and will have opportunities as we combine in the longer run. We're focusing on automation and technology; we are investing to catch up and be more efficient, including the Fiserv core conversion and related tech initiatives. We expect to achieve our estimated cost savings on the transaction and believe there will be additional opportunities via robotics, AI, and other tech initiatives that will improve efficiency.

Dave Rochester, Analyst

All right, great. Thanks, guys. Appreciate it.

Thomas Cangemi, Chairman, President and CEO

Thank you, Dave.

Operator, Operator

Thank you. Our next question comes from Steven Alexopoulos with JPMorgan. Please proceed with your question.

Thomas Cangemi, Chairman, President and CEO

Good morning.

Steven Alexopoulos, Analyst

Good morning. Tom, regarding the deposits that came in from the relationship with Fiserv: can you give more color on the nature of those deposits and what drove such wide fluctuations during the quarter?

Thomas Cangemi, Chairman, President and CEO

Yes, I'll defer to John to walk through some of the program specifics. This is one of many initiatives we're working on as part of Banking as a Service.

John Pinto, Chief Financial Officer

With that program, Steven, it's related to the economic impact payments—stimulus payments—from rounds 1, 2, and 3. A large portion of it came from the third program. When debit cards tied to those payments are sent to consumers, they start using them and deposit balances ramp up quickly and then decline over a month or two, which is what we saw in Q2. As Tom mentioned in his opening comments, we peaked over $3 billion and then came down to $1.1 billion as of June 30. After a couple of months that decline slows as people use part of the funds and leave the rest on the card for a while. We expect it to roll down more slowly in the second half of the year and to have some duration. This was our first Banking as a Service relationship and we carved it out in the quarter because of the uncertainty of duration. We expect more such opportunities from technology partners.

Thomas Cangemi, Chairman, President and CEO

Yes. To add, we anticipate two more programs coming on in this quarter. I believe last night we received notification of another anticipated win, and we had another win about a week ago, so for Q3 we expect two additional programs—one fee-generated and one deposit-generated with zero cost of deposits. We're diversifying our funding base and moving away from dependency on wholesale finance. We picked up about $400 million in deposits from our own customers from January 1 through June 30—getting our fair share of what's ours. This initiative is a cultural shift: when we do loans we want the deposit relationship also. Our lending team and retail strategies are working together; handoffs from lending to retail to private banking are being executed, and it's starting to show results. We're focused on funding the balance sheet more like a traditional bank over time, which will reduce our dependence on wholesale funding. The combined benefit of Flagstar and NYCB will provide lots of optionality as we figure out rate movements and funding strategies.

Steven Alexopoulos, Analyst

If we stay at $4 billion of deposits from loan customers, how do you size that potential and what are you doing to get that kind of growth? Are you bundling pricing with new loans?

Thomas Cangemi, Chairman, President and CEO

To be simplistic, our lending relationships are relatively short on average—perhaps two and a half to three years—so we have repeated opportunities to win deposit relationships. Historically many transactions were handled without us getting the deposit account. I've made it a priority: if you want the lending relationship, we want the deposit and operating accounts. It's part of our cultural change. We're working to get our fair share of customer deposits, leveraging technology partners and Banking as a Service relationships to capture deposits and fees. We are also working on lines of credit for our best customers where deposit relationships are part of the arrangement. We're ramping up, and while we won't give firm numbers today, we expect to grow this line of business into next year as we hire and deploy people in the field to capture local market relationships.

Steven Alexopoulos, Analyst

Got you. Thanks. Just finally on prepayment income—you had $27 million in total this quarter. What portion of the loans prepaying are staying with you? Given where rates have moved, are you seeing more moves to take advantage of government options and go into longer-term government funding?

Thomas Cangemi, Chairman, President and CEO

Good question. Of the $27 million in prepayment income, about $5 million was from our best portfolio. We have about a $600 million securitized multifamily portfolio that we don't control and will prepay from time to time. In the business overall, when you exclude a couple of large one-offs, perhaps around 50% to 60% of prepays stay with us, but I'd like to see that percentage higher. Government programs have been attractive and have taken some loans away, particularly larger trades. When we combine with Flagstar, we'll be able to offer customers alternatives to government programs—capital markets solutions that can be competitive and help retain business. We may decide to package and sell loans, use derivatives, or embed financial structures to retain customers. The government is a big player, but we've grown the book despite prepayments. Going into the second half we're focused on getting more of the bread-and-butter business and mining the portfolio to retain customers where possible. I remain confident we can grow the book mid-single-digits on a standalone basis, not counting Fiserv-related deposits.

Steven Alexopoulos, Analyst

That's very helpful color, Tom. Thanks for taking my questions.

Thomas Cangemi, Chairman, President and CEO

Thank you, Steve.

Operator, Operator

Thank you. Our next question comes from Christopher Marinac with Janney Montgomery Scott. Please proceed with your question.

Thomas Cangemi, Chairman, President and CEO

Good morning, Chris.

Christopher Marinac, Analyst

Thanks. Hey, how are you? Tom, I want to ask about the share buyback timing. How much time has to pass after the merger closes before you can deploy the additional earnings? Is that something on the near-term horizon?

Thomas Cangemi, Chairman, President and CEO

I think it's fair to say buybacks are on the near-term horizon. We're in proxy solicitation on both sides now. Flagstar has an opportunity to generate significant capital; those numbers are better than expected on a combined basis. On a very conservative assumption we anticipate about $0.5 billion of additional capital outside of our current run rate that could support capital alternatives. Once the transaction closes, we'll evaluate all capital opportunities, including continuing our strong dividend and potential buybacks depending on market conditions. Our priority is to grow the business; reinvesting in the company is a high priority. But subject to market conditions, buybacks will be on the table alongside dividends and growth investments. That $0.5 billion in excess capital is after estimating the fully embedded cost saves and includes us continuing to pay our current dividend, so it's a meaningful amount of capital.

Christopher Marinac, Analyst

Right. So payout ratios should improve and the absolute distribution could rise as you discussed.

Thomas Cangemi, Chairman, President and CEO

Yes, absolutely. We'll look at all alternatives, but we believe growth is the priority. Sandro and I have spent a lot of time modeling customer opportunities; they have great relationships and will have significant runway with combined capital. We can go after current customer opportunities, warehouse relationships, and larger customers that were previously out of scope. The priority is growing the business and reinvesting in the platform, while keeping capital return alternatives available depending on conditions.

Christopher Marinac, Analyst

Great. Last question: on the systems side, how much integration will get done by year-end 2021 versus pushed into the first half of 2022?

Thomas Cangemi, Chairman, President and CEO

This is our largest transaction. The Fiserv DNA platform is an excellent core solution—both companies are Fiserv customers which helps tremendously. Teams are working together and we anticipate converting the core systems in early-to-mid 2022. If we close in early Q4, we should be able to have the systems converted by mid-2022. A lot of work has been done already; we've set the leadership structure publicly—13 direct reports to me, six from Flagstar and seven from NYCB. This is not a traditional merger; it's an alliance. Culturally integrating the two franchises is critical—we must be one company, not an us-versus-them. We'll have dual headquarters with blended leadership and unique verticals, and we'll build on that. We're looking forward to blending cultures and leveraging both teams. Sandro may want to add a few comments because he's been deeply involved.

Sandro DiNello, President and CEO of Flagstar

The integration is moving along at a good pace. Teams are working well together and the shared Fiserv relationship is a big plus. Getting the basic core system converted should not be particularly difficult. The Flagstar mortgage business will largely remain where it is—no conversion there. There are over 400 different systems to address, so it's an undertaking, but I'm very comfortable with the progress and I don't expect integration issues that will negatively impact operations at legal day one or during full conversion.

Christopher Marinac, Analyst

We appreciate it.

Operator, Operator

Thank you. Our next question comes from Peter Winter with Wedbush Securities. Please proceed with your question.

Thomas Cangemi, Chairman, President and CEO

Good morning, Peter.

Peter Winter, Analyst

Good morning. Tom, with the new potential lending opportunities from combining with Flagstar, how are you thinking about office space? From a credit perspective the portfolio is doing great, but it seems work-from-home trends may be permanent and could affect office building values longer term.

Thomas Cangemi, Chairman, President and CEO

Great question. We'll have to see how it pans out in New York City. We've lent to very strong borrowers and our collateral tends to be lower leverage. Regarding criticized assets, we believe we peaked in February and we're seeing declines as cash flows are re-evaluated and assets move back to higher ratings, which is encouraging. Loans that were interest-only are moving back to full payment and that trend will continue. We deal directly with our larger office customers; I believe we have about $500 million in classified loans in this category with an average LTV around 56%, just under 60%. There's enough equity that we don't expect losses to the bank. Our borrowers have ample liquidity and capacity to pay. Yes, work-from-home will have effects, but we underwrite conservatively and have strong sponsorship in our portfolio. I don't envision losses for the portfolio we hold.

Peter Winter, Analyst

Do you think that portfolio will decline over time given the changing dynamics?

Thomas Cangemi, Chairman, President and CEO

It could decline a bit, but commercial lending is commercial. We'll be active in banking the best customers in our markets and will expand into Sandro's markets. We will be on the ground in new markets—Florida, Arizona, Michigan—and there will be opportunities for future growth. We're focusing on conservative underwriting and the right leadership to grow verticals and lines of business thoughtfully.

Peter Winter, Analyst

Excellent. Can you clarify again the core margin outlook—what you're looking for in the third quarter and the drivers for the margin?

Thomas Cangemi, Chairman, President and CEO

The drivers are consistent with prior quarters. We guided earlier that we see roughly 2 to 5 basis points of margin potential expansion; we came in up 5 basis points in Q2. That range is reasonable for Q3—let's say 3 to 5 basis points. Looking ahead, as we bring on Banking as a Service initiatives that have zero-cost deposits, that helps. We are holding reasonable yields on multifamily while funding costs decline. Additionally, when we combine with Flagstar we can eliminate some macro hedges—about $2 billion of derivatives—and that yields a pre-tax benefit of around $40 million, or roughly 200 basis points on that notional—not included in our merger math today. So we expect ongoing margin expansion from 2021 into 2022 as we consolidate the business model.

Peter Winter, Analyst

Okay, thanks Tom.

Operator, Operator

Thank you. Our next question comes from Steven Duong with RBC Capital Markets. Please proceed with your question.

Thomas Cangemi, Chairman, President and CEO

Good morning, Steven.

Steven Duong, Analyst

Good morning, guys. Tom, we have about $2 billion of swaps rolling off in February. Can you remind us how much of a boost that gives to net interest income, and should we see that benefit in the first half of next year?

Thomas Cangemi, Chairman, President and CEO

I mentioned earlier that combining with Flagstar makes the company more asset-sensitive, which reduces the need for those derivatives. Removing those swaps will provide benefit. We estimate roughly $40 million of pre-tax earnings benefit from the elimination of approximately $2 billion of derivatives that come off in February. That translates to about 200 basis points on that notional. We expect that benefit in Q1/Q2 of 2022 depending on the timing, and it's one of many benefits from the combination that wasn't included in our initial merger math.

John Pinto, Chief Financial Officer

Yes, February.

Steven Duong, Analyst

That's great to hear—nice to have another tailwind in the first half of next year. On Banking as a Service, is that mainly a focus on growing deposits, or is there a credit component as well?

Thomas Cangemi, Chairman, President and CEO

Right now the focus is on deposits and fees. We haven't rolled out a credit component yet. In the short term, it's about fee income and deposit generation. Over time, we are considering credit offerings tied to the platform, but we won't discuss specifics until nearer-term. We intend to build out the digital platform; we added a Head of Digital and will hire into that area. We expect three or four wins this year if the pipeline materializes and will build more capabilities over time. We're also evaluating other digital opportunities, including potential uses of blockchain, but it's early and we are studying how it could create efficiencies and customer opportunities.

Steven Duong, Analyst

If I could squeeze one more for Sandro on the warehouse business: over the long haul how do you differentiate and grow market share in warehouse lending?

Sandro DiNello, President and CEO of Flagstar

The answer is consistent across Flagstar: it's about providing the best service in the marketplace. We've been in the warehouse business for 30 years and we know how to serve customers well. Customers like our service and they come back even if we're not always the cheapest. Our commitment to be there through cycles, including during the pandemic when many lenders stepped back, allowed us to pick up relationships. We keep enough dry powder to be there when customers need a lender and that service equation has worked to grow our share. We'll continue to be one of the top warehouse lenders nationally.

Thomas Cangemi, Chairman, President and CEO

And being a large originator, we can also buy loans from warehouse customers and offer combined services which strengthens the relationship. That complements what Sandro described.

Sandro DiNello, President and CEO of Flagstar

Exactly—Flagstar's longevity and service model are critical to our position.

Steven Duong, Analyst

Great color, gentlemen. I appreciate it.

Operator, Operator

Thank you. Our next question comes from Ebrahim Poonawala with Bank of America. Please proceed with your question.

Thomas Cangemi, Chairman, President and CEO

Good morning, Ebrahim.

Ebrahim Poonawala, Analyst

Good morning. I'm sorry if I missed this, but Sandro, you talked about earnings power of the combined company. When I look at your PPNR—call it about $150 million this quarter—we've seen a big reset in gain-on-sale. Do you still see room for PPNR to decline relative to Q2? Can you talk to that because that's been a big uncertainty in modeling Flagstar's PPNR into 2022 and beyond?

Sandro DiNello, President and CEO of Flagstar

If you look at our track record, we've leveraged capital well. We've taken advantage of our capital base to maximize returns from the business. From 2015 through 2020 Flagstar's total shareholder return was strong—162%—which demonstrates that focus. We concentrate on the end number and invest capital where it makes sense to drive margins and consistency. Historically we haven't guided very far out beyond the next quarter; we've given guidance in our release for the next three months and I won't go further today. Look at our history and that should give you comfort on our ability to execute.

Ebrahim Poonawala, Analyst

Understood. Separate question for Tom: you talked about bringing on teams under Reggie Davis—should we expect onboarding of commercial lenders prior to the deal close or is that a 2022 event? Are you already talking to folks to bring them on early next year?

Thomas Cangemi, Chairman, President and CEO

We're extremely active. Reggie Davis and I have been working on opportunities in our markets; we're hiring and organizing leadership roles now. The consolidation is to our advantage, and talent is showing interest because of the larger combined platform. We're looking to expand retail, commercial, mortgage, and other verticals. We're doing a lot on leadership and in-field roles—market managers and branch-level leaders—to bring in business we historically left on the table. It's ongoing and you'll see more activity as we approach closing and into next year. Starting from zero gives us a blank canvas to paint with the right people, and we're focused on building out the teams to capture market share.

Ebrahim Poonawala, Analyst

Sounds good. Thanks for taking my questions.

Thomas Cangemi, Chairman, President and CEO

Thank you, Ebrahim.

Operator, Operator

Thank you. Our next question comes from Matthew Breese with Stephens. Please proceed with your question.

Matthew Breese, Analyst

Good morning. Tom, could you give a sense for how much of the combined loan portfolio will be floating rate and able to reprice with Fed hikes? I appreciate the difference with and without floors if you have that.

Thomas Cangemi, Chairman, President and CEO

Excellent question. I don't have the exact number in front of me, but Flagstar has historically been a floating-rate franchise—many of their deals are tied to floating indices—while NYCB has been more fixed-rate. Combined, we'll have capital markets tools and derivative capabilities to manage pricing on a loan-by-loan basis if needed. The combined portfolio will be a blend of fixed and floating across different verticals. Multifamily tends to be more fixed-rate historically, but with the combined capabilities we'll be able to offer customers alternatives and derivatives to manage rates. The overall balance should be healthy and well diversified; exact percentages will depend on which lines grow faster, and we will provide more specifics as we move closer to integration.

Matthew Breese, Analyst

Okay. Turning to your core margin guidance of 3 to 5 basis points, is that adjusted for liquidity like this quarter? Also, can you define 'excess liquidity'—you had about $2.1 billion cash this quarter versus $2.7 billion last quarter—what's your adjustment methodology?

Thomas Cangemi, Chairman, President and CEO

I'll defer to John on the mechanics. The margin guidance I gave is our expectation for ongoing margin expansion and depends on how we deploy liquidity and execute on Banking as a Service initiatives. John?

John Pinto, Chief Financial Officer

From a deposit perspective, it's about average balances, not ending balances. In Q1 our average non-interest-bearing deposits were about $3.2 billion and then averaged roughly $5.5 billion in Q2; that change was driven primarily by our first technology partner relationship. We carved that out when we looked at margin because we did not know the duration—those balances peaked quickly and then rolled down quickly within the quarter, which is why you see a change in average balances. We do expect another sizeable deposit flow coming from another partnership that should have zero cost, which would be attractive as an alternative to wholesale markets. We also have a potential fee-income opportunity from Banking as a Service, and a very large opportunity is in the pipeline. We're excited about these alternatives—working with technology partners to bring deposits and potentially lending opportunities over time. We'll update the market as things close.

Matthew Breese, Analyst

Okay. You mentioned expanding financial services into blockchain—what capabilities are you envisioning adding or what markets do you plan to attack with that?

Thomas Cangemi, Chairman, President and CEO

I'm being careful on specifics. We're actively looking at how blockchain can benefit financial services operations and customer opportunities. It could create efficiencies and new business, and we are studying multiple use cases to see where it creates the most value for a combined company. We have large businesses that could benefit from blockchain-based efficiencies and customer propositions, but I won't get into specifics until we have clearer plans. Stay tuned.

Matthew Breese, Analyst

Last one: tax rates stepped up a bit this quarter—what is a good run rate going forward and will the combined tax rate change materially?

John Pinto, Chief Financial Officer

We're still evaluating the combined tax rate and don't expect it to move dramatically. There may be a slight benefit on state apportionment when combined. In Q2 the effective tax rate was higher for two reasons: many merger-related expenses are primarily non-deductible based on their nature, and New York State increased its tax rate from 6.5% to 7.25%, which required a one-time revaluation of deferred taxes. On a standalone run-rate basis, just under 26% is a reasonable estimate. We'll do more work on the combined basis, but we don't expect significant deviation from that level.

Matthew Breese, Analyst

Okay, that's all I had—thank you.

John Pinto, Chief Financial Officer

Thank you, Matt.

Operator, Operator

Thank you. Our next question comes from Andrew Leshner with KBW. Please proceed with your question.

Unidentified Analyst (Andrew Leshner), Analyst

Hey, how's it going? It's Andrew on for Chris McGratty. You had a very clean quarter in terms of credit and you were able to bring deferrals down further. I was wondering what your deferral outlook from here looks like and your overall outlook on New York City and any potential problem areas you foresee going forward? Thanks.

Thomas Cangemi, Chairman, President and CEO

Great question. In our prepared remarks we discussed the drop in loans that were interest-only: it's down to about $1 billion from $2.5 billion at the beginning of the pandemic. You'll see that continue to decline. As we get closer to the end of CARES Act protections at the end of this year, we believe most customers will be out of relief programs. We have zero clients on full deferral, which is great. We've been proactive working with customers to transition them, and we're seeing benefits—Manhattan reopening has been favorable for the boroughs and was the last to reopen. For loans that were classified, about 85% are related to Manhattan exposure; we think classified assets peaked in February and are declining as portfolios recover, which is encouraging. That will also have favorable effects on expenses and FDIC assessments as assets return to performing status. Sandro also reported zero loans on deferral at Flagstar. Overall credit trends are strong and the city is moving in the right direction, with vaccinations and reopening helping demand and rental activity. We remain cautiously optimistic and continue to monitor potential problem areas, but we are comfortable with our underwriting and the credit quality of our portfolio.

Unidentified Analyst (Andrew Leshner), Analyst

Great. Thank you for the color. One more: was there any reason you moved PPP loans back out of held-for-sale into held-for-investment?

John Pinto, Chief Financial Officer

Our PPP loans were down to about $95 million and given where the market and our liquidity posture were, we were comfortable holding those loans long term, so we moved them back into held-for-investment.

Unidentified Analyst (Andrew Leshner), Analyst

Okay, thank you.

Operator, Operator

Thank you. There are no further questions at this time. I'd like to turn the floor back over to management.

Thomas Cangemi, Chairman, President and CEO

Thank you again for taking the time to join us this morning and for your interest in NYCB and Flagstar. We look forward to chatting with you again at the end of October, when we will discuss our performance for the three and nine months ended September 30, 2021, and provide further updates on the planned merger. Thank you.

Operator, Operator

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation. Have a wonderful day.