Mechanics Bancorp (MCHB) Q3 2023 Earnings Call Transcript

Good afternoon, and thank you for attending today’s Third Quarter 2023 Analyst Earnings Call for HomeStreet Bank. Joining us on this call is Mark Mason, CEO, President, and Chairman of the Board. I would now like to pass the conference over to our host, Mark Mason. Please go ahead.

Hello and thank you for joining us for our third quarter 2023 analyst 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 will make certain predictive statements that reflect our current views, the expectations and uncertainties about the company’s performance and the financial results. These are likely 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 on our call today can be found in our earnings release and investor deck available. 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 and our outlook going forward. We will then respond to questions from our analysts. John?

Thank you, Mark. Good morning everyone and thank you for joining us. In the third quarter of 2023, our net income was $2.3 million or $0.12 per share, as compared to core net income of $3.2 million or $0.17 per share in the second quarter of 2023. These results reflect the continuing adverse impact of the significant increase in interest rates on our business. Our net interest income in the third quarter of 2023 was $4.6 million lower than the second quarter of 2023, due to a decrease in our net interest margin from 1.93% to 1.74%. The decrease in our net interest margin was due to a 25-basis-point increase in the cost of interest-bearing liabilities, caused in large part by an increase in the proportion of higher-cost borrowings to the total balance of interest-bearing liabilities. During the third quarter, the cost of deposits increased four basis points, the cost of long-term debt increased 15 basis points and the cost of borrowings increased 19 basis points. The increases in the rates paid on interest-bearing liabilities were due to the increases in market interest rates during 2023. The income tax benefit realized in the third quarter of 2023 was due to the recognition of return to accrual differences related to tax exempt income. Our effective tax rate for future periods is expected to be substantially lower than our statutory rate due to the benefits from tax-exempt investments and loans. A $1.1 million recovery of our allowance for credit losses was recognized during the third quarter, compared to a $0.4 million recovery of our allowance for credit losses in the second quarter. The recovery for the third quarter was primarily due to reduced levels of higher-risk land and development loans, which resulted in lower expected losses. Going forward, we expect the ratio of our allowance for credit losses to our held-for-investment loan portfolio to remain relatively stable and provisioning in future periods to generally reflect changes in the balance of our loans held for investment, assuming our history of minimal charge-offs continues. Our ratio of nonperforming assets to total assets decreased from 44 basis points at June 30 to 42 basis points at September 30, 2023. Non-interest income in the third quarter was consistent with the second quarter of 2023 as we continue to experience low levels of single-family and commercial mortgage banking originations. The $41.7 million decrease in non-interest expenses in the third quarter of 2023 as compared to the second quarter of 2023 was due to the $39.9 million goodwill impairment charge in the second quarter of 2023. Our other non-interest expense declined slightly during the third quarter as we continue to take steps to defer or eliminate expenses where possible. Our common equity Tier 1 and total risk-based capital ratios have improved significantly during the current year. As of September 30, 2023, the company's common equity Tier 1 and total risk-based capital ratios were 9.55% and 12.7% respectively, while the bank's common equity Tier 1 and total risk-based capital ratios were 13.32% and 14.03% respectively. These ratios have increased this year primarily as a result of seasoning of multifamily loans originated in 2022 which, after a year of performance, qualified for 50% risk weighting. I will now turn the call over to Mark.

Thank you John. As John stated earlier, our operating results for the quarter reflect the continuing adverse impact of the historically record velocity and magnitude of increases in short-term interest rates. Our earnings were $2.3 million and our net interest margin decreased in the third quarter to 1.74% due to decreases in balances of lower-cost transaction and savings deposits and overall higher funding costs. To mitigate the impact of a lower net interest margin, we have reduced controllable expenses where possible, reduced staff to the minimum levels to transact current business volume in a safe and sound manner, raised new deposits through promotional products and focused our new loan origination activity primarily on floating-rate products such as commercial loans, residential construction loans and home equity loans. We've been mindful to maintain strong risk management and to sustain and protect our high-quality lending lines of business, preserving our ability to grow once the interest rate environment stabilizes and loan pricing and volumes normalize. The deposit outflows we experienced in the third quarter were primarily due to depositors seeking higher yields. We have not to date experienced any material identifiable deposit loss related to concerns about deposit security. With non-interest-bearing and low-cost deposits seeking higher yields we have pursued a strategy to attract new deposits and retain existing deposits through promotional certificates of deposit and promotional money market accounts. This strategy affords us the opportunity to retain deposits without immediately repricing all of our existing low-cost core deposits. This strategy has, over time, contributed to rising deposit rates as customers choose to move money to these promotional accounts to achieve higher returns. Our level of uninsured deposits remains very low at 8% of total deposits. This competitive rate environment has resulted in reductions in our net interest margin. While we expect our net interest margin to stabilize in the near term, we do not expect increases in our net interest margin materially until rates stabilize. We utilized both brokered deposits and borrowings to meet our wholesale funding needs. Our choice of funding is primarily based on the lowest cost alternative. Historically, the lowest cost alternative between brokered deposits and borrowings has varied based on market rates and conditions. Since the beginning of this year, FHLB and the Federal Reserve Bank term funding program interest rates have generally been lower than broker deposits. As a result, our borrowing balances have been increasing and our broker deposit balances have generally been decreasing. While this may affect some metrics, such as our loan-to-deposit ratio, we believe that this is the best choice today, as it minimizes our funding costs and we continue to have substantial borrowing availability beyond our needs and usage today. We continue to experience the cyclical downturn in single-family and commercial mortgage loan volume as higher rates and spreads dampened the demand for new loans. Volumes in the third quarter were consistent with the second quarter, and we do not expect seasonal volumes to increase until rates and spreads stabilize and then start decreasing. In our residential construction business, our builders have continued to increase their land acquisition and new project development and our commitments and loan balances have begun to increase again. At quarter end, our cash and securities balances of $1.5 billion were 16% of total assets and our contingent funding availability was $5.1 billion, equal to 76% of total deposits. Our loan portfolio remains well diversified, with our highest concentration in Western States multifamily loans — historically, one of the lowest-risk loan types. Asset quality remained strong in the third quarter, as total past due and nonaccrual loans and nonperforming assets all decreased in the quarter. Our loan delinquencies remain at historically low levels, and our net charge-offs during the third quarter were only $500,000. Our portfolio has been conservatively underwritten, with a very low expected loss potential. As a result, credit quality remains solid and we currently do not see any meaningful credit challenges on the horizon. We are continuing to limit loan originations, focusing on floating-rate products such as commercial loans, residential construction and home equity loans. We are generally not making any new multifamily loans today, with the exception of Fannie Mae DUS loans, which we sell. We are focused today on working with our existing borrowers, to create prepayments or modify existing loans to advance more proceeds where appropriate or extend fixed-rate periods in exchange for increasing the interest rate on the loans. Despite our significantly reduced loan origination volume, our loan portfolio has not declined materially as a result of prepayment speeds, which continue at historically low levels, particularly for multifamily loans. At September 30, 2023, our accumulated other comprehensive income balance, which is a component of our shareholders' equity, was a negative $127 million. While this represents a $6.76 reduction to our tangible book value per share, we know it is not a permanent impairment of the value of our equity and has no impact on our regulatory capital levels. Given the available liquidity, earnings and cash flow of our bank, we don't anticipate a need to sell any of these securities to meet our cash needs, so we don't anticipate realizing these temporary write-downs. During the third quarter, the company evaluated an unsolicited nonbinding written proposal to purchase our Fannie Mae multifamily DUS business for $57 million. We analyzed this proposal and determined that the price proposed was inadequate in relation to the resulting benefit and value of the DUS business to our company, which includes our related loan servicing asset of $31 million as of September 30, 2023. Our Board of Directors determined that a sale of the DUS business at this price was not in the best interest of the company. Both prior to and since the receipt of this offer, we have received and responded to other parties interested in buying our DUS business. We have not to date received any other formal offers. Last week, the Board of Directors approved a $0.10 per share dividend payable on November 22, 2023. This dividend amount was unchanged from the prior quarter. In the near term, we anticipate stable levels of loans held for investment and deposits, stable net interest margin, increasing noninterest income and stable noninterest expenses except for seasonal increases in compensation benefit costs expected to occur in the first quarter. Additionally, with our strong capital levels and low level of credit risk, and excluding unforeseen events or economic changes, we do not foresee circumstances that would impact our ability to get through this cycle while remaining profitable. The current interest rate environment has created significant challenges for our company. In particular, the rate competition for deposits from banks, money market funds and Treasury bonds is significant and some of our customers have moved some of their funds. Additionally, our interest rate-sensitive residential and commercial mortgage banking businesses are experiencing historically low originations, further challenging our earnings. However, these conditions will change when interest rates stabilize and ultimately decline. Historically, an environment of stable rates has provided significantly better financial performance for our bank. We believe that we are doing all the things appropriate at this time to endure this period and preserve the value of our business, so that we can take advantage of the upcoming beneficial rate cycle. In summary, our challenge and our opportunity is time. The simple passage of time will provide the opportunity for our net interest margin to normalize and loan origination volume and revenue in our residential and commercial mortgage banking businesses will improve significantly. Our ability to negotiate this period is supported by our strong credit, sufficient capital and loyal customers. With that, this concludes our prepared comments today. We appreciate your attention. John and I would be happy to answer questions from our analysts at this time. Investors are welcome to reach out to John or me after the call, if they have questions that are not covered during this question-and-answer session. Operator?

Thank you. Our first question today comes from Matthew Clark of Piper Sandler. Your line is open. Please go ahead.

Good morning, guys.

Good morning, Matthew.

Good morning, Matthew.

First one around the margin. Can you give us a sense for what assumptions you're making behind your guidance to keep the margin stable here in the near term? It looks like the spot rate on total deposits kind of reaccelerated here at the end of September after kind of keeping them at bay in 3Q?

Yes. In terms of projecting forward, what our activity is — we're anticipating that the Fed will raise rates one more time in the fourth quarter and then keep them stable pretty much through the end of 2024. We believe when they say 'higher for longer' that they're going to do that. So based on that, looking at our mixes and our funding and our future activity, we feel that the margin has stabilized at the current time. And we expect that — if interest rates stabilize, we'll start seeing some benefits as our loans reprice.

We are anticipating that we may see some additional loss in money market funds over the next year. But beyond that, we believe our deposits should be relatively stable.

Okay. And then do you have the average margin in the month of September?

We don't report monthly margins, Matt — sorry.

Okay. And then the $1.6 billion of borrowings that you hedged, can you give us the terms on that?

About $600 million, as we disclosed, matures next March. Basically it's a bank term funding program. Based on rates at that time, we anticipate that we probably will extend it for another year because basically there's no prepayment penalty for paying that off early. Secondly, the other ones had three- to five-year maturities and were split up pretty evenly over those periods — a little bit more in the shorter term. So that was put on approximately a year ago, so it's going to be two to four years.

Yeah. Probably just a little over three years on average.

Great. And then it looks like in your guidance you're expecting higher levels of DUS-related loan sales. Can you give us a sense for your outlook for DUS-related production in 4Q and 2024?

We think it's going to be a little higher than it's been, but DUS production as a whole — if you look at Fannie Mae's total production — is only running at about two-thirds of their expectations. So we expect that while our production is going to be better, it's not going to be anywhere near what normalized production would be.

Okay. Fair enough. Thanks.

Thanks, Matt.

Our next question today comes from Woody Lay of KBW. Your line is open. Please go ahead.

Hey, guys. Thanks for taking my question. Wanted to start on expenses and was just hoping you could give some color on what drove that decrease quarter-over-quarter. And it sounds like any cost savings — any cost-save initiatives — have been largely completed at this time?

Yeah. In terms of looking at the expenses what they're going through, the biggest change has been in compensation and benefits. We continue to reduce headcount where possible, part of it by layoffs, part of it by just not filling open positions. So we've been able to accomplish that. Obviously, our commissions and bonuses are lower because of the performance this year. You can see the headcount going down and we continue to expect the headcount in the fourth quarter to be lower than it is in the third quarter. Across the board, we've just taken steps where we can to defer or eliminate expenses where possible. For example, in marketing expenses, we've deferred or eliminated programs. Other expenses that are items that we can eliminate we do that going forward and we continue to look for that. We think there is — we'll continue to evaluate. And if we see additional opportunities we think we can still have some benefit going forward.

So on the headcount question, I believe, John, we quote FTE, correct?

Yes.

So that's an average of full-time equivalent employees but the absolute headcount at the end of the quarter is below that number as John said. So all else being equal you should see an FTE reduction in the fourth quarter.

Got it. Maybe moving over to the loan-to-deposit ratio. Are you comfortable running the ratio at 110% over the near term, or would you ideally like to get that down?

Look, over the long term if you look at our history, we've run roughly a 95% loan-to-deposit ratio. We've always run a somewhat higher loan-to-deposit ratio than our peers because we've never struggled to originate loans. We would rather be operating back at around 95%. But we're working with what we have at this juncture. Why are we struggling with that ratio? Primarily prepayment speeds. We've lowered our loan originations substantially but not eliminated originations, because it's beneficial to originate variable-rate loans today, particularly high quality. We have not had anywhere near normal levels of prepayment speeds because of the loan extension you experience in a very low rate period like this. So we've accepted the reality that we're going to run a loan-to-deposit ratio higher than what we would consider a normalized level for us. We don't think it represents an excess risk today given our strong on-balance sheet liquidity, strong borrowing capacity and so on. But if you ask what's our preference it would be to be back around 95%. I just don't think that's going to be possible in the foreseeable near term.

Right. That's good color. Lastly, I just wanted to touch on profitability and you kind of touched on it in your opening remarks, but I know there can be some seasonal impact over the next couple of quarters just with mortgage and payroll increases. But as you look out over the near term is the expectation that you will remain profitable over the near term?

Yes. Now having said that, our profitability is going to remain low given our net interest margin and the circumstances of funding costs today. But we believe that we will remain profitable or we wouldn't have made the statement. And that's the same statement we've been making each quarter.

Right. All right. Got it. Thanks for taking my question, guys.

Thank you.

The next question comes from Timothy Coffey of Janney Montgomery Scott. Your line is open.

Great. Thank you. Good morning, gentlemen.

Hey, Tim.

Good morning, Tim.

Mark or John, do you have the substandard loan balance as of September 30?

We don't. We can try to look at that real quick but we — it would have been filed with our call report.

Yes, I don't have the call report in front of me. But I will tell you it has not changed materially. I think it actually declined slightly, I believe.

Yes, I will report.

Okay. And then sticking on credit, is there any updated color on the non-accrual from 2Q? I think it was the $27 million relationship?

No update other than at the time that we downgraded those loans we restructured the loans with requirements for funded interest reserves of a year to 18 months and, where necessary, additional collateral or cross-collateralization. We still feel fine about the credit loss potential on the loans, but there's no update to the circumstances. We think that the restructured loans are in the place they need to be given the circumstances.

Okay. And then on the efforts to create more prepayments in your loan portfolio — you've been doing that most of this year — do you have any kind of details on how that's going?

Well I can give you a little color. I wish it was going better. I believe that we have restructured about $100 million of multifamily loans. When you look at our loan origination numbers, and you look at multifamily, I think there's $44 million this quarter; last quarter you saw $65 million; the quarter before $18 million. Those are the restructuring numbers to date — about $100 million or a little more. Why isn't that number larger? In our multifamily portfolio these are hybrid loans with initial fixed-rate periods. Given when the loans were originated and the fixed-rate periods of the loans — these loans were mostly five-year, but five- and seven-year fixed-rate periods — a lot were originated in 2021 and 2022. So they're not up for repricing or moving from fixed to variable rates for a few years still. Because that date is further out we have a harder time getting borrowers to be concerned about that change in debt service. There's a widespread belief that rates will be down by then and circumstances will be better. This activity is at a low level today. Over the next year or two that activity will pick up. But what also will improve is our view of the risk of that activity and we will probably be less interested in restructuring some of these loans, given their loan-to-values and good cash flow. So we'll see.

And just to add to Mark's comment, what we're seeing now is some of the loans are actually repricing, which normally they'd pay off in the past. So we're seeing a couple of loans reprice. When they reprice, it's good for us because they reprice to the 6.5%–7% level, so we pick up interest income on that.

Right. But underlying that, and maybe further to John's point, we may not see the level of prepayments we would normally see at or around the repricing dates. If the new variable rate is not materially higher than the refinancing rate, many borrowers may choose to pay that higher rate and wait for rates to decline. We value these loans and the market values these loans generally like a yield-to-call on a bond, assuming they prepay on or around this repricing date. We may not actually see that to the extent that we have historically. So it remains to be seen.

Okay. And then just one final question for me on expenses. If we strip out the goodwill write-down from the second quarter, expenses have been coming down, call it $1 million-ish per quarter this year. Is that a trend you're looking to accelerate, or should we expect fourth quarter expenses to be at that same cadence?

I think the fourth quarter would be a similar change. As Mark mentioned, there are reductions in personnel that we'll be realizing the full benefit in the fourth quarter. Just as a reminder, and why we comment on it always, is we do have those compensation benefit costs that hit hard in the first quarter, which is primarily employer taxes and 401(k) match and merit increases that generally get recognized. So the first quarter is typically about $1 million more compared to the fourth quarter. We think there's offsetting costs in the compensation that Mark talked about in the fourth quarter that will carry forward to the first quarter. Other than that one item, we see a general trend continuing.

Okay. Great. That's great, John. Thank you. I appreciate your time.

Thanks, Tim.

We have no further questions in the queue. I'll turn the call back over to Mark Mason for closing remarks.

Again, we appreciate your attendance today and your patience for our prepared remarks and your questions. Look forward to speaking with you next quarter. Thank you.

This concludes today's call. Thank you for joining. You may now disconnect your lines.