Mechanics Bancorp (MCHB) Q2 2021 Earnings Call Transcript

Good day, and welcome to the HomeStreet Second Quarter 2021 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Mark Mason, Chief Executive Officer. Please go ahead.

Hello, and thank you for joining us for our second quarter 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 and 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 forward-looking statements that are made subject to the safe harbor statements included in yesterday's earnings release, our investor deck and the risk factors disclosed in our other public filings. Additionally, reconciliations to non-GAAP measures referred to in our call today can be found on our earnings release and investor deck 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 an update on our results of operations and our outlook going forward. John?

Thank you, Mark. Good morning, everyone, and thank you for joining us. In the second quarter of 2021, our net income was $29 million, or $1.37 per share. This compares to net income of $30 million, or $1.35 per share in the first quarter of 2021. Our annualized return on tangible common equity for the second quarter was 17.2%. Our annualized return on average assets was 1.59% and our efficiency ratio was 63%. Our net interest income increased 6% in the second quarter due to a higher net interest margin and higher levels of interest-earning assets. Our net interest margin in the second quarter increased to 3.45% as a result of lower deposit rates; our total deposit cost decreased to 18 basis points in the second quarter and $200 million of payoffs of PPP loans. The net interest income from our PPP loans caused our net interest margin to be higher by 15 basis points in the second quarter. As of June 30, 2021, the amount of remaining PPP loans was $204 million with deferred fees of $5.6 million. As a result of the continued favorable performance of our loan portfolio and improving economic conditions, we recorded a $4 million recovery of our allowance for credit losses in the second quarter of 2021. Our ratio of nonperforming assets to total assets improved to 31 basis points. Our ratio of ACL to total loans was 1.18%. The $12.2 million decrease in net gain on loan origination and sales activities in the second quarter of 2021 as compared to the first quarter of 2021 was primarily due to lower volume and lower profit margins on our single-family mortgage origination and sales. The $1.2 million increase in loan servicing income was due primarily to unfavorable risk management results realized in the first quarter of 2021 for single-family mortgage servicing rights. The $3.8 million decrease in noninterest expense in the second quarter as compared to the first quarter was primarily due to lower payroll taxes and a $1.9 million reimbursement of legal costs received from our insurance carrier. During the second quarter of 2021, we repurchased 3% of our outstanding common stock at an average price of $44.22 per share and declared and paid a dividend of $0.25 per share. I will now turn the call over to Mark.

Thank you, John. HomeStreet's results for the second quarter continued our outstanding start to the year. Each of our lines of business performed well, continuing to meet or exceed our expectations, and the credit quality of our loan portfolio continued its strong performance, allowing us to begin to recover pandemic-related allowances for credit losses. Given the positive outlook for the economies in our market, we may need to recover additional amounts of our allowance for credit losses going forward. As expected, our single-family mortgage loan volume and profit margins decreased from the first quarter levels due to slower refinance activity. This decrease was offset by higher net interest income, a recovery of our allowance for credit losses and lower noninterest expenses. Despite high levels of prepayments, we grew our loan portfolio in the quarter. Excluding the impact of the paydown in PPP loans, our loans held for investment increased $278 million, an annualized rate of 23%. I am particularly pleased with the level and quality of our second quarter operating results, since many of the markets in which we do business have only recently lifted business restrictions related to the pandemic. Government stimulus and normalization of economic activity should create a strong economic recovery in our markets and provide us with meaningful growth opportunities. Given our strong financial position, diversified lines of business, growth markets and disciplined risk management, I believe we continue to be well positioned to make the most of this recovery. Based upon our strong financial results and positive outlook, we repurchased $25 million of our common stock during the quarter and paid a dividend, which today equates to a yield of over 2.5% on our common stock. We plan to continue to manage our capital efficiently, retaining capital for growth while returning excess capital to our shareholders through dividends and share repurchases. In that regard, and subject to our Board of Directors' review and approval and the nonobjection of our regulators, we plan on repurchasing $15 million of our outstanding shares this quarter. We expect our net interest margin to continue to benefit through the remainder of 2021 from the forgiveness of PPP loans. Looking forward, with the Federal Reserve indicating that short-term interest rates will remain low for the foreseeable future, excluding the impact of the paydown of PPP loans, we expect our net interest margin to remain level as the benefit of our deposits continuing to reprice downward is expected to offset any decline in the rates on our loans. As previously mentioned, the increase in long-term interest rates in the first quarter of 2021 affected our single-family mortgage banking business in the second quarter, reducing the robust levels of volume and profitability that we have enjoyed since early in 2020. This impact is reflected in the change in the composition of our single-family originations between refinancings and purchases, as the percentage of refinancings decreased from 70% in the fourth quarter of 2020 to 45% in the second quarter of this year. We continue to anticipate a slight decrease in our origination and sales activities going forward as well as lower commission-based compensation expense as we return to what might be considered a more normal single-family mortgage banking environment. The pace of this normalization, however, remains difficult to forecast. Where rates move from here is uncertain, but we've plans for the continued normalization of single-family mortgage banking volume and profitability over the remainder of this year. While we expect a slight decline in mortgage banking profitability, it's likely to result in upward pressure on our efficiency ratio in the near term. As I stated last quarter, we anticipate total noninterest expenses to decline in the second half of the year, assuming somewhat lower mortgage volume, and related lower compensation expenses to levels which we believe will result in an efficiency ratio in the low 60% range and still falling in future years. We continue to increase our commercial real estate loan originations, primarily multifamily, for both sale and for portfolio. The strong fundamentals and demand in our markets and our successful platforms support this initiative. Over time, this increase in production should support net loan growth and higher net interest income, serving to offset any decrease in noninterest income from lower mortgage banking income, which I just discussed. As a result of the increasing levels of multifamily loan originations, we are contemplating utilizing securitizations to enable us to originate to our full potential, uncapped CRE concentration levels and individual borrower lending limits and improve our capital efficiency. Additionally, securitization of our loans will enable us to retain the servicing of these loans as opposed to whole loan sales which we've used historically to manage capacity limitations and potentially provide improved execution metrics. While the final determination to proceed will be based upon various factors, including market spreads, we are anticipating completing our first securitization before the end of this year. To minimize the impact of the cost of securitization, we anticipate two securitizations a year on a go-forward basis in place of our prior whole loan sales, which may produce some quarter-to-quarter earnings volatility. To reiterate my comments from last quarter, the investments we have made and the improvements in our efficiency and profitability have provided us with the operating leverage that will allow us the opportunity to grow revenue and in turn earnings without meaningful additions to personnel or other operating expenses. While quarter-to-quarter earnings may show some degree of volatility, excluding nonrecurring items such as PPP loans and expense recoveries and, of course, subject to any unforeseen changes in the economy and our business, we believe we have the opportunity to continue to grow year-over-year earnings on a per share basis, both next year and going forward past the normalization of the single-family mortgage market. We would also expect our profitability metrics to continue to compare quite favorably to our peers going forward. With that, this concludes our prepared comments today. Of course, we appreciate your attention and participation today. John and I would be happy to answer any questions you have at this time.

The first question comes from Steve Moss with B. Riley Securities.

Maybe just starting with loan production and loan growth. Given it sounds like a change in strategy to support higher origination levels, how do we think about this translating into loan growth on a normal basis going forward? As far as thinking high single digits, could we be seeing double-digit loan growth?

It is possible. Our expectation is high single digits. It could get into low double digits depending upon how successful we are. The utilization of securitization, as I mentioned earlier, may support higher levels. The market is very strong, particularly in the markets in which we do business. Our market share is still relatively small when you consider how large these markets are, even the multifamily market, which we focus on in the West Coast, of course, is very large. We think that our initiative to increase production is working so far. We have a lot of room to grow, and uncapping the balance sheet seems the right thing to do at this time.

Got it. In terms of the expansion in loan growth, I have two parts. One, is the level of originations you think sustainable at the current quarter level? And are you hiring additional people? I'm curious how to think about expense and compensation.

We'll probably add a small number of producers, but we are still realizing efficiencies from the restructuring work that we did. We are not expecting a material addition to personnel for the foreseeable future.

Yes.

We think so.

And that's including the originations of loans held for sale. That's just for the held-for-investment number. We do have additional originations beyond that.

Okay. That's helpful. And then on the potential for a $15 million buyback and the step down here, just curious about capital levels being relatively steady. Is this reflective of expectations for higher growth? How should we think about this going forward?

We're leaving a little capital for growth. If you think about what we're making per quarter, we are paying a dividend that's a little in excess of $5 million a quarter. This quarter it's a little higher because net income is a little higher because of the reversal of ACL. If you back that out, with a $15 million repurchase, plus $5 million of dividends, leaving a little capital for growth, it should make sense.

Okay. That's helpful. One last question for me on loan pricing: what are you seeing for rates these days?

It is not much different than last quarter. The note rates on new production: construction is still in the mid- to high-4% range. Single-family is in the low 3s, multifamily low 3s. C&I is 4% to 4.5%. Those are the major numbers on note rates.

The next question comes from Jeff Rulis with D.A. Davidson.

I wanted to circle back to loan growth. You had talked about targeting larger relationships, particularly in multifamily. Was that a factor in this quarter's growth? And part two, were any purchase loans included in the growth?

On the second question first, no purchase loans. The closest we get to purchase loans are some syndications or participations on the C&I book, but it's quite small. This is all our originations. Large borrowers didn't really impact this quarter. We did a few loans for larger borrowers, but I wouldn't say it was beyond the average per quarter. The decision to consider securitizing going forward, a portion of the loans, has some benefit to larger borrowers. We have borrowing relationships that we would like to do more with, but we have house limits on loans to one borrower, plus legal limits as well. Securitization is a way to go beyond those limits.

One other thing, Jeff: when we talked in the past about larger loans, we were specifically referring to the DUS program because we changed our structure. So we're allowed to do bigger loans, but those are loans held for sale.

Okay. Fair enough. John, circling back on PPP impact — do you have the key contribution to margin in the first quarter versus the second quarter? If you had core margin with PPP stripped out, what would that look like?

If I strip out the PPP loans, their total impact — both the balances and the revenues that we had — in the first quarter it actually had a negative impact of about 2 basis points. In the second quarter, it had a positive impact of about 15 basis points. So when you look at the steady state, if you exclude PPP loans, we are expecting a flat marginal rate excluding their impact.

Flat margin.

Okay. And that two basis points respectively was to the margin, not to earning asset yields, correct?

Yes. To the net interest margin, that's correct. So if you pulled out the balances and the income. The reason the first quarter was negative is because we put on a lot of balances that were earning 1%.

And Mark, one more: on loan growth and the potential for continued reverse provision, what's your comfort level on where reserves might settle once pandemic-related allowances are recovered? Could it be sub-1% of loans?

We added $20.5 million to the ACL in the first and second quarters of last year specifically for the pandemic. Since that time, our portfolio has continued to perform well. If you look at our loan coverage from the ACL pre-pandemic, I believe we were around 87 basis points. Given improved performance and a greater composition of multifamily loans in the portfolio, our steady-state ACL, fully past any pandemic recoveries, is likely to be around 87 basis points or lower. How quickly we get there is unclear; I would still expect to recover more this year based on current trends.

So the pace of drift down is subject to review, but sub-1% isn't out of the question?

No. For lack of a better yardstick, if you recovered it evenly through the end of 2022, that might not be a bad estimate, but I can't assure that's the pace. We have to evaluate each quarter.

Yes. We're still learning the CECL modeling and its implications. It's a very involved process and we don't have a ton of history with it. As Mark said, that's a reasonable assumption going forward, but when it actually happens, we'll evaluate each quarter.

We could recover it faster than that. If there are any indications of an elongation of risk, it could be slower. We don't anticipate that today.

The next question comes from Matthew Clark with Piper Sandler.

On the share repurchase, another $15 million in the upcoming quarter: what are your thoughts beyond 3Q? Do you reach a point where the float becomes a concern, or can buybacks continue beyond this quarter?

That would be a high-class problem. If we become so successful that returning capital makes float an issue, we would consider a stock split. If the stock price increases commensurately with improved return on equity and EPS, a split could be considered. It's our working assumption that buybacks will likely continue beyond this quarter. If the market undervalues our shares, buying back stock is one of the best investments we can make for our shareholders, provided we retain capital for growth.

On expenses, you've talked about a run rate and given guidance for the next two to three quarters. Do you feel that a run rate of $54 million to $55 million can come down next year, even with gain-on-sale revenue declining?

I think that's a good run rate, though there could be quarter-to-quarter volatility due to seasonality in the mortgage business. Looking further out to late 2022 or 2023, inflation will have an impact — annual merit increases average around 3% a year in our industry. There might be some small increase in expenses as you get to 2023.

The important thing is operating leverage. With relatively flat expenses, growth in our loan portfolio has the potential to increase revenues and improve operating efficiency.

Regardless of modest inflationary pressure on expenses, we're expecting revenue increases that should be a multiple of that pressure.

On for-sale originations coming down a bit this quarter: you did $2.16 billion of single-family retail loans sold last year and about $713 million on the CRE side. Do you feel you can match that type of for-sale production on the single-family side? Thoughts on the commercial side?

We think single-family for-sale production this year will be similar to last year, but it may come in different quarters. The Fannie Mae DUS business should be higher this year. If we securitize this year, our multifamily whole loan sales will decline but securitization-related sales will increase. Total sales may not differ much from last year; it depends on securitization volume. If we don't securitize, we will likely do whole loan sales by the end of the year. It's unclear right now.

The next question comes from Jackie Bohlen with KBW.

I wanted to discuss deposits, particularly the nice growth in noninterest-bearing accounts this quarter. What internal trends drove that?

A lot of business deposit growth this quarter across our markets; we are adding relationships and more deposit-only relationships. We have a specialty deposit group that we've been building over the last couple of years that's starting to gain traction. Existing customers are also retaining more cash, a trend we're seeing across the industry. We saw an acceleration this quarter and are very happy with it.

I noticed a decline in CDs as well, which with noninterest-bearing growth helped mix. Is that repricing to intentionally reduce CDs, or are customers letting CDs mature into other accounts?

The CD decline has more to do with runoff of much higher-priced money and because we have reduced our rates farther than we would have historically. We're retraining our customers somewhat. Historically, when we were growing quickly, we led the market on rates to acquire deposits. Now that growth expectations have changed, we have lowered rates to be closer to peers. Some CD customers who shop solely for the absolute highest rates might move elsewhere, but this has helped lower our CD balances in an effective way for what we consider our core customers.

One other aspect: we have used wholesale CD deposits from time to time in the past, and some of the decrease has been on the wholesale side.

Just to add, those were brokered CDs. As our core deposits grow, we reduce the need for overall borrowings.

Setting aside unknown customer liquidity behavior, would you expect the core trend of business customers and lower-cost deposits shifting in — while rate-sensitive shoppers shift out — to continue?

Yes. We're focused on growing the number of relationships and the proportion of core relationships. We've worked for years to convert from a traditional thrift to a full-service commercial bank. This shift in deposit composition is a primary part of that initiative.

On the consumer side, we are developing a strong core base of customers who are less price sensitive than in the past. That provides a more stable deposit base that won't leave for a couple of basis points.

One last question: can you provide an update on subleasing plans? I know many factors influence that, but any update would be helpful.

In the fourth quarter of last year, we took a substantial charge — about $6 million — to accelerate subleasing efforts related to downsizing the mortgage business. That was very successful. We've offered very competitively priced Class A space in Seattle since then, and I'm happy to report we have substantially completed that subleasing effort. We are now restructuring expectations on how much time our people spend in the office versus working remotely and moving some people to hoteling workspaces. That process may create some more excess space that we'll have to sublease. The metrics are still unclear, so we may have a little more to do going forward.

Okay. I assume your discussed run rates earlier took this into consideration, barring future subleasing needs.

Correct.

The next question comes from Tim Coffey with Janney.

If I can get more color on the potential securitization: what's the probability that you complete one before year-end?

Today, I would say it's very good. The first securitization takes a great deal of work to establish structures and relationships, but our team is doing a lot of work on it. Spreads can be volatile, and that is a significant consideration, but we think it's an important structural maturity for our business and provides much more flexibility. At times, gain-on-sale recognized in securitization is larger than the whole loan market; at other times it's not. We're hopeful to complete one before year-end, but we remain contingent on market conditions.

Retaining the servicing is a very positive aspect of securitization.

You mentioned potential earnings volatility when securitizations are completed. What's the magnitude of that volatility?

Think of last year's home loan sales: they came in different quarters. If you consolidated sales into fewer quarters due to securitization timing, you'd see quarter-to-quarter earnings swings. It would be similar to shifting gain-on-sale recognition across quarters.

Are you thinking of doing securitizations in particular quarters, such as first and fourth, or maybe second and fourth?

We're thinking more second and fourth quarters, but that could change. If we close a securitization by the end of this quarter, it's more likely we'd securitize in the first quarter of next year and then six months later.

Understood. And John, on the investment portfolio: average balances have been coming down for the last three quarters and are in a relative historical range. Do you see anything in the investment market that would cause you to rebuild the portfolio, or is it dependent on deposits and loan growth?

It's more dependent on the latter — deposits and loan growth. Our investment portfolio is primarily a liquidity portfolio to meet requirements, though we do a good job generating earnings from it. Going forward, you'll see a relatively stable percentage of the balance sheet in our investment portfolio. As we grow, I would expect it to grow slightly to maintain liquidity requirements.

A footnote: inside that portfolio is essentially a collateral portfolio, because we have a derivatives book and many agreements require collateral. So inside that book is a sub-portfolio that is collateral-qualifying under various agreements. But in terms of total percentage of assets, we're generally targeting consistency and not focusing on growing it as a percent of assets.

We have a follow-up from Jeff Rulis with D.A. Davidson.

Housekeeping question: PPP loans outstanding as of June 30, and can you comment on the pace of forgiveness through year-end?

We have a little over $200 million of PPP loans outstanding and a little over $5 million of deferred fees. Our expectation, though not guaranteed, is that a majority of those will be forgiven by the end of the year. That depends on SBA processing, which seems to have picked up, and on customers filing forgiveness applications — sometimes they wait until the last second. So our working model is that most will be gone by year-end.

This concludes our question-and-answer session. I would like to turn the conference back over to Mark Mason for any closing remarks.

Thank you again for attending our call and for the great questions. We look forward to speaking to you next quarter.

The conference has now concluded. Thank you for attending today's presentation; you may now disconnect.