Mechanics Bancorp (MCHB) Q4 2020 Earnings Call Transcript

Good day, everyone, and welcome to the HomeStreet Incorporated Year-End and Fourth Quarter 2020 Earnings Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please also note, today's event is being recorded. I'd now like to turn the conference over to Mark Mason, Chief Executive Officer of HomeStreet. Please go ahead, sir.

Hello and thank you for joining us for our fourth quarter 2020 earnings call. Before we begin, I'd like to remind you that our detailed earnings release and an accompanying investor presentation were filed with the SEC on Form 8-K yesterday and are available on our website at ir.homestreet.com under the News & Events link. In addition, a recording and a transcript of this call will be available at the same address following our call. Please note that during our call today, we may make certain predictive statements that reflect our current views and expectations about the company's performance and financial results. These are likely forward-looking statements that are made subject to the Safe Harbor statements included in yesterday's earnings release, the investor deck and the risk factors disclosed in our other public filings. Additionally, reconciliations to non-GAAP measures referred to on our call today can be found in our earnings release available on our website. Joining me today is our Chief Financial Officer, John Michel. John will briefly discuss our financial results and then I'd like to give you an update on our results of operations, credit performance and our outlook going forward. John?

Thank you, Mark. Good morning, everyone, and thank you for joining us. In the fourth quarter, our net income was $28 million, or $1.25 per share, with core income of $32 million or $1.47 per share, and pre-provision core income before income taxes of $41 million. This compares to net income, core income and pre-provision core income before taxes of $26 million, $28 million and $36 million respectively in the third quarter. Our results included unusual activities that occurred during the fourth quarter, including, as part of restructuring and consolidation of our space at our corporate headquarters in Seattle and to acknowledge the impact of the pandemic on the leasing office market, we recognized a $6.1 million charge related to the impairment of our lease and related fixed assets on space we have vacated. We estimate that this will result in occupancy expense savings of approximately $1.3 million per year through the next seven years. We paid off certain fixed rate FHLB advances and incurred a prepayment penalty of $1.5 million with the benefits expected to be realized evenly within our net interest income over the next five years. We recognized a $1.8 million reduction in our self-insured medical benefit costs, which is due to lower usage of medical services by our employees in 2020. We are not anticipating similar savings in 2021 and future years. Continued decreases in our funding costs had the result of increasing our net interest margin to 3.26%. As a result of the continuing strong performance of our loan portfolio and a stable low level of non-performing assets, no provision for credit losses was recorded in the third or fourth quarters of 2020. Our ratio of non-performing assets to total assets remained low at 31 basis points, while our ratio of loans delinquent over 30 days to total loans decreased to 68 basis points at December 31st from 76 basis points at September 30th. Loans remaining in forbearances in our commercial and CRE portfolios were $41 million at December 31st, 2020 representing 1.2% of such loans outstanding. New forbearances granted in the fourth quarter for our commercial and CRE portfolio were less than $7 million. Single-family and consumer loans remaining in forbearance excluding those guaranteed by Ginnie Mae were $76 million. In light of the recently passed Coronavirus Response and Relief Supplemental Appropriations Act, we anticipate that some single-family loans may request an additional forbearance in 2021. Our single-family loan origination and sales volumes and profit margins remained strong in the fourth quarter driven by the ongoing mortgage refinancing boom. The increase in non-interest income in the fourth quarter was due to higher sales of multi-family loans including Fannie Mae DUS multi-family loans and higher servicing income, which resulted from more favorable risk management results on mortgage servicing rights realized in the fourth quarter. The increase in non-interest expense in the fourth quarter over the third quarter was primarily due to the previously mentioned restructuring charges, higher lending commissions and management bonuses and the prepayment fee on the FHLB advances, which were partially offset by reduced medical costs. I will now turn the call over to Mark.

Thank you, John. HomeStreet reported strong results in the fourth quarter, concluding a year in which notwithstanding the challenges presented by the global pandemic, we benefited from our diversified business model, our conservatively underwritten loan portfolio and the steadfast commitment of our employees. We'd like to take a moment to recognize and thank all of our frontline employees as well as those working from home for quickly adapting to the pandemic last year and serving our customers and communities, but also each other and thereby helping the company to achieve these stellar results. During the just completed quarter, our net interest margin once again increased as a result of improvement in our funding costs. We continue to benefit from high loan volume and profitability in our single-family mortgage banking business and we had record origination volumes of commercial real estate loans and higher volumes of commercial real estate loan sales. These increased revenues along with the benefits of our efficiency and profitability improvement project initiated in 2019 resulted in meaningful improvement in our profitability and our efficiency. I'm very proud of what we achieved last year. For the full year 2020, our core results from continuing operations resulted in a return on average assets of 1.23%, a return on average tangible common equity of 13.4% and our efficiency ratio of 61.4%. And for the fourth quarter, our core results from continuing operations resulted in a return on average assets of 1.73%, a return on average tangible common equity of 19% and an efficiency ratio of just 56.1%. These fourth quarter and full year results all meaningfully exceed the targets we established in 2019 for profitability and efficiency improvement following the restructuring of our single-family mortgage business and we accomplished these results despite the challenges of the pandemic and the significant additional loan loss provisions we recorded in the first half of the year. We also returned $73 million of excess capital to our shareholders during 2020 via dividends totaling $0.60 per share, and the repurchase of 2.2 million shares or 9.2% of total shares outstanding at an average price per share of $26.31 substantially below our tangible book value at the time. Additionally as a result of our repurchases and earnings for the year, our tangible book value per share increased 16% last year. We're quite pleased that the combination of our strong operating results and our active capital management during the course of the year resulted in our shares outperforming other regional banks by a meaningful margin, returning 1.4% compared to the negative 8.7% total shareholder return of the KBW Regional Bank Index. Looking forward, with the Federal Reserve indicating that interest rates will remain low for the foreseeable future, we expect our net interest margin to modestly expand as deposits continue to reprice downward and as we receive payoffs from the initial Paycheck Protection Program. Single-family mortgage volumes should remain robust for the foreseeable future as the low interest rate environment has not completely been priced into mortgage interest rates due to the industry's inability to absorb the massive amount of volume spurred by these historically low interest rates. As capacity normalizes in the industry, mortgage interest rates should decrease in line with our historical spread over long-term treasury rates. We expect that this transition will reduce the very strong gain on sale margins we are currently enjoying, but maintain strong volumes for an extended period of time. The transfer of our Fannie Mae U.S. multifamily lending business to HomeStreet Bank from a holding company subsidiary announced last quarter has already resulted in higher levels of loan origination volume and should result in higher sales volumes going forward. Despite the higher than expected mortgage loan volumes, we have continued to maintain discipline on the expense side, generally using overtime and temporary personnel to aid in processing the additional volume. We are also instituting more scalable technology solutions, which we believe will result in greater efficiencies when loan volumes return to more normalized levels. In the fourth quarter, we finalized and executed an amendment to our core systems contract effective this month. As a result, we will begin to see the results of lower information systems expenses this quarter. Beginning last week we have been granted access by the SBA to begin submitting customer applications for the next round of PPP loans. We are working with both first-time applicants and existing PPP customers that are applying for Second Draw Loans. For those commercial customers we granted forbearance in early 2020, nearly all have completed their forbearance period and resumed making regular payments. Our remaining forbearances outstanding consist of a small amount of forbearances granted in the fourth quarter and customers granted a second forbearance. We are confident in the credit quality of our loan portfolio as it is primarily secured by high quality real estate and some of the strongest and previously fastest growing economies in the nation, and these loans were underwritten at distress levels generally more severe than the current conditions in our markets. As a result, our loan portfolio is performing well despite the challenges of the pandemic. Of course, there still exists some degree of uncertainty as to the ultimate impact of the pandemic on our loan portfolio. However, given our strong credit performance to date and the pandemic and unless things materially take a turn for the worst, we do not currently foresee a need to make additional provisions for loan losses at this time. Conversely, should our loan portfolio continue to perform well and the economy recover more rapidly or to a greater extent than currently expected, it is possible we may need to release some portion of the additions made last year relating to the pandemic to the allowance for credit losses. Our investor deck filed with the SEC yesterday contains detailed data on our underwriting standards and portfolio composition. We have again included a few slides further disaggregating the information and providing additional detail on the parts of our portfolio most at risk today. As we look forward into 2021 and beyond, we plan on maintaining and building on the cost efficiency gains we have achieved over the last two years. Our focus will be on profitable growth and maintaining our strong infrastructure and risk management. These activities will include an evaluation of our real estate space needs in a post-COVID operating environment with a more dispersed workforce and implementation of initiatives that will allow us to serve our customers better and work more efficiently. Most of our primary business units have rebuilt their pipelines and are reporting pre-pandemic levels or greater levels of business and our retail deposit branch network is located in large densely populated markets that can support this growth with the growth in core deposits. This gives us great optimism for the future. Finally, we plan to continue to actively and prudently manage capital to support growth and return excess capital to our shareholders through dividends as well as potential share repurchases. As I close my remarks today, I admit it's difficult for me to overstate the achievements we have made in the midst of this unprecedented global pandemic. It gives us great pleasure to have guided the company to what appears to be a higher and more consistent level of profitability. This of course is the result of the hard work of many and strategic actions initiated far before the start of 2020. As we contemplate our next steps, we anticipate that the successful implementation of our strategic and efficiency improvement initiatives, our ongoing efforts to improve the composition and deposit costs and our ongoing efficient capital management will have an enduring impact on our profitability and efficiency through the economic cycle. Specifically, we believe we have the opportunity to continue to grow earnings per share through the normalization of the single-family mortgage market. And finally, 2021 marks HomeStreet's centennial as a company. We were incorporated on August 18, 1921. At that time corporations were either delivered by horseback, steamer, wheeler, or train. Of the nearly 2,900 incorporations filed in Washington that year only 33 exist today. Things have changed much during the past century. But HomeStreet has always served its communities with the highest standards in care, surviving the Great Depression, wars, the thrift crisis, the Great Recession and the current pandemic. We don't know what challenges will face us in the future. But with our culture, employees and loyal customers we feel confident we will continue to thrive despite the challenges. With that, that concludes our prepared comments today. We appreciate your attention. John and I would be happy to answer any questions you have at this time.

Thank you, sir. We'll now begin the question-and-answer session. Today's first question comes from Steve Moss at B. Riley Securities. Please go ahead.

Good quarter, guys.

Hey, Steve.

Good morning, Steve.

Good quarter. Maybe start off with the margin here. I'm curious as to where you're seeing new money loan origination yields and what the impact of PPP was on the margin for the quarter?

Why don't we start with the latter? John, what was the impact last quarter from PPP?

It was less than one basis point. It was about $0.5 million in terms of income. So we still have most of it to be recognized in 2021.

Okay. That's helpful. And loan yields in production?

New originations, Steve, are down about 16 basis points in yield in the fourth quarter. Not happy, but that's the reality. Fortunately, deposit costs are down more.

Right. So in terms of the business mix you guys are seeing coming up—obviously good growth in multifamily and that probably continues going forward—how is commercial business doing relative to CRE?

Well, loan growth in the general C&I area is slow. People are generally focused on maintaining or reestablishing business volume and are generally not making new investments in their business. People are also generally not switching banks. Having said that, we had a reasonable origination quarter in our commercial business area. The reality for us though is for the foreseeable future that line of business will continue to be smaller than our single-family mortgage and commercial real estate businesses. The bulk of the balance sheet growth going forward, at least in the next year or so, is expected to be in multifamily loans. Multifamily originations we expect to grow meaningfully this year and beyond. That is a focus for us. That is an asset class that has through the economic cycle performed extremely well and during the pandemic still performed extremely well. I think it's important to remember that where we and our borrowers' properties are located pre-pandemic were the strongest markets in the country. If you're looking at national numbers of multifamily performance, you might get the wrong idea about performance, particularly looking at areas like the Northeast which is really struggling with delinquencies that are often twice what you see in our markets. Also, some might wrongly assume that lower quality properties would perform worse. We do lend on some B and C quality properties, often in large population areas. Their performance on delinquencies is often better than A quality properties in some markets, because these tenants are typically multi-income households or multigenerational families in the same unit, and they've been able to weather the storm from a rental delinquency standpoint much better.

Okay. That's very helpful. And then on capital here, the Board meeting's two days out. You were very profitable this past quarter. It probably carries over to this quarter for mortgage banking. How big could the potential buyback be and what are you thinking about capital levels here?

I have to be careful not to front-run the Board or our corporate governance process. Before the Board will make this decision, we'll review with the Board the status of our loan portfolio and credit, our current forecast for results of operations, and our recently completed annual capital stress test to aid them in making the decision. Having said that, we have been fairly consistent in the size of the authorizations that we have proposed over the last year, and I think you can expect the same going forward.

All right, great. Thank you very much.

Thanks, Steve.

Our next question comes from Jeff Rulis with D.A. Davidson. Please go ahead.

Yeah. Good morning.

Hey, Jeff.

Good morning.

I wanted to ask about the expense front. A lot of the low-hanging fruit from the restructure has been realized. The systems renegotiation was one of the last visible pieces. Is the strategy now more efficiency through growth, or are there more structural cost trims to come?

I think we are coming to the end of significant structural changes. We have a few smaller trims this quarter that aren't super material. Going forward, what you will see is operating leverage — an expectation that revenues will grow but non-interest expense will not grow at the same pace. We have established levels of productivity and we believe we have capacity to grow revenues without commensurate growth in non-interest expense. We continue to look at our occupancy costs and space needs in light of a changing landscape for space and there is potential to further reduce those costs, although I can't predict the magnitude yet. Some costs will increase due to inflation and necessary technology spending to stay current on customer functionality. But overall, we expect operating leverage and statistical efficiency gains primarily.

Is the systems renegotiation more of the operating leverage or will we see another structural expense savings following this conversion in the first quarter?

It's not a system conversion. It's a renegotiation of the base core systems contract, not a change in systems.

I apologize. Will the savings from that renegotiation be meaningful in 1Q?

It is about $2.5 million a year, but there are some offsetting increases and added functionalities, so you won't see the entire $2.5 million as a straight reduction.

The prior guidance we've provided is roughly savings of 3% to 4% compared to this year in terms of IT costs, which contemplates the items Mark mentioned.

On the margin: did we capture the full impact of the FHLB prepayment? And what's the margin outlook for the balance of the year excluding PPP?

The FHLB repayment penalty was actually incurred at the end of the quarter, so it's not reflected in the quarter's margin. That will be a benefit going forward and it is being spread out over five years.

You can calculate the benefit.

Yes. You can calculate the benefit from that. That is the main point.

But the core outlook, excluding the PPP benefit, with the puts and takes on new loan yields and deposit costs, is the outlook flat to up?

Right. Flat to moderately up.

Yes.

Okay. I'll sit back. Thank you.

Thanks, Jeff.

Our next question comes from Matthew Clark at Piper Sandler. Please go ahead.

Hey, good morning.

Good morning, Matt.

Maybe we can circle back on the non-interest expense run rate. Coming into the quarter the expectation longer term was $53 million to $54 million with the normalization of mortgage and the reinvestments you need to make on the tech side and inflation. Is that still the thought or has there been a change?

That guidance is roughly true except for the impact of single-family mortgage. When we're talking about those numbers, that's the core expenses subject to higher levels of mortgage volumes, which we are expecting to extend through this year and our view of that expansion since the last discussion has elongated. For this year, we expect our non-interest expense inclusive of the impact of mortgage to be a little above that number.

With commensurate revenue increase.

And with commensurate revenue, of course.

On gain on sale margins this quarter, up in single-family and down in commercial, what are your thoughts? Single-family should normalize lower; how should we think about gain on sale margin for commercial? Was there something unusual that caused it to come down?

It is dependent upon mix. What is the mix of Fannie Mae DUS sales versus portfolio loan sales? Fannie Mae DUS sales typically have higher gain on sale margins, somewhere in the 3.5% plus range. Portfolio loan sales typically have profit margins around 1% to 1.5%, depending on the transaction. Selling into a declining market can give you a bit more margin. Going forward, we expect multifamily margins to get back to more normalized levels around 1% to 1.5% profit, and mix will jump around during the year due to seasonality, particularly in the DUS business. The second half of the year tends to be more active for whatever reasons.

About 101 and 102 and between those two depending on what you have.

Right, meaning 1% to 1.5% profit.

In terms of the volume of commercial loans sold this quarter — $407 million — how should we think about volume going forward, given it was more than double last quarter?

We indicated at the end of the third quarter to expect the fourth quarter to be higher, and it was higher than we expected, which was great. I would expect that volume to be lower this quarter. How much lower is unclear, but I think our volume will be at least half and might be meaningfully better than half of last quarter.

That sounds reasonable. It was driven more by DUS loans and we did have a large non-DUS sale in the fourth quarter that we expect not to reoccur at that size.

Not in that size. Typically, first quarter is one of the lowest quarters.

On the 130 reserve, how do you think about that ratio post-CECL? Coming into the year when you adopted it, you stepped it up from the 80s up to 115 or so. If the economy continues to improve modestly, how low would you be willing to let that ratio go?

That's a great question with many variables. One variable post-pandemic is the expected loss rate, which continues to fall. Over the past several years we've had very few charge-offs, reflective of changes in portfolio composition and our credit culture. Our expected loss component continues to fall, meaning the preponderance of our allowance is expected to become qualitative factors again. Pre-pandemic, two-thirds of the allowance was qualitative. We're expecting to return to that profile, but perhaps with a lower expected loss component and with our portfolio composition being heavier on multifamily, which has a zero expected loss factor. Our post-pandemic coverage could fall below the 87 or 89 basis points it was pre-pandemic. How far down is tough to project now, but post-pandemic coverage down to the 87-89 basis point range is plausible.

That is fair. We think we probably won't reach that level until late 2022 or 2023. The next year and a half is likely to remain uncertain.

And so we intend to hold reserves.

Can you remind us how much you have in net PPP fees left to be realized?

My guess is probably about $6 million to $7 million on the old program, not counting the new loans that's going out now.

I thought I heard occupancy savings coming through net interest income — is that correct?

No. The occupancy savings go through non-interest expense. The FHLB prepayment benefit would go through net interest income. The occupancy savings will be about $1.3 million a year on a go-forward basis.

That $9.5 million in G&A — is that where the higher healthcare costs are? I'm trying to isolate that number.

That was in the compensation and benefits line; the $1.8 million save in medical costs happened in the fourth quarter, but we do not expect that to be recurring.

On the G&A side, is the $9.5 million anything unusual?

The G&A line includes the $1.5 million prepayment fee. Other than that, I don't think there are unusual items.

Okay. Thank you.

Our next question comes from Jackie Bohlen with KBW. Please go ahead.

Hi, good morning.

Good morning, Jackie.

Mark, can you provide an update on your thoughts for the on-balance-sheet single-family portfolio given expectations for volumes to remain high? What are your expectations for balances in the portfolio?

I think they're going to stabilize.

I think that we're nearing stabilization. John, what would you say in terms of timing of stabilization?

I think it's in the first half of this year. We expect prepayments to start slowing in the second half of the year, so our portfolio should start growing because we'd have fewer prepayments. Origination volumes for loans held for investment have been pretty consistent and going forward we'll start to see stabilization and growth as prepayment levels decrease slightly.

On Slide 19 you referenced anticipated increases in CRE and gave great color on multifamily. Does that encompass the CRE comment or are there other CRE balances you plan to grow this year?

Multifamily is the primary growth area. We do finance other property types but on some property types we're just out of the market. As a general matter we are not actively lending on retail or many office properties. We're watching self-storage closely and in some markets it's overbuilt. We do originate owner-occupied C&I financing and we will do some amount across property types, but we are selective and focused on high-quality sponsors and low loan-to-value deals.

How has demand for construction loans been?

Demand has been surprisingly stronger than I would have expected. We are only financing multifamily construction today. Some of those projects have a small mixed-use retail component, but those are the only projects we are actively considering.

Outside of residential homebuilding.

We do have a homebuilding lending unit that had slightly lower volume last year. Homebuilding is active, but many builders are running out of land. Our portfolio will dip at the beginning of the year and then grow through the end of the year. It's a robust and profitable market for single-family residential construction.

Okay, great. Thank you for the added details.

Thanks, Jackie.

Our next question comes from David Chiaverini with Wedbush Securities. Please go ahead.

Hi, thanks. A couple of questions. On mortgage volume: in 2020 you did $2.1 billion of originations for mortgage banking. If 2021 stays elevated but declines from 2020, what do you think a normalized mortgage banking volume looks like further out into 2022?

Had you asked me a year ago I would have said about $1.0 to $1.1 billion, which was the volume we had built our mortgage unit to produce in a stable rate environment. However, the unit we built is performing far better than expected: loans per loan officer are greater and our operational efficiency is higher. We now believe stabilized volume for that unit may be in the $1.5 billion to $1.6 billion range depending on competition. Importantly, we are restricting growth in personnel, so that higher volume is essentially with the same FTE or only a few additional operations staff, which means the efficiency of that operation is significantly higher than planned.

On expenses and EPS outlook: could there be levers to bring the expense pace lower as mortgage volumes pull back? Could non-interest expense move down into the low $50 millions in 2022?

I don't think so. We expect to realize additional efficiencies, but the greater improvements come from operating leverage — growing revenues without commensurate growth in operating expenses. We plan to grow the balance sheet and originations without materially growing operating expenses, which is how we expect to continue to improve efficiency.

So given that, it wouldn't be unreasonable to see EPS continue to grow even if mortgage banking slows?

Yes. We believe we have the opportunity to continue to grow earnings per share through those periods as a consequence of balance sheet growth, share repurchases and greater efficiencies where revenue grows faster than expenses. That's why I made that comment in prepared remarks.

Last housekeeping question: you mentioned PPP Round 2. How much are you expecting to process? Roughly half of Round 1?

The count is likely to be half or a little better. To date we have some $85 million in about 617 loans. We're just in the first week of taking applications. The average loan size is lower — about $130,000 — and demand has been stronger than we expected.

About $130,000 average loan size.

We are actually surprised at the level of demand. We were not expecting demand to be this high and we'll see where it settles out.

Great. Thanks very much.

You're welcome. Thank you.

This concludes the question-and-answer session. I'd like to turn the conference back over to Mr. Mason and the management team for any final remarks.

We don't have anything further to say. We really appreciate your attention particularly to our views on our future profitability. We believe that we have made a substantial change in our durable core profitability, and we're enjoying obviously a great period in mortgage loan refinancing, but we think the real story here is how we exit that period. We appreciate your time today. Thank you.

This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.