Velocity Financial, Inc. Q3 FY2020 Earnings Call

Good day and welcome to the Velocity Financial Inc. Q3 2020 Earnings Call. All participants are currently in a listen-only mode. Operator instructions: After today's presentation, there will be an opportunity to ask questions. Operator instructions: Please also note today's event is being recorded. I would like now to turn the conference call over to Chris Oltmann, Chief Accounting Officer. Please go ahead.

Thank you, Matt. Hello everyone and thank you for participating in Velocity Financial's third quarter 2020 earnings call. Joining me today are Chris Farrar, Velocity's President and Chief Executive Officer; and Mark Szczepaniak, Velocity's Chief Financial Officer. Earlier this afternoon, we released our third quarter 2020 press release and the accompanying earnings presentation, which are available on our Investor Relations website. I'd remind everybody that today's call may include forward-looking statements, which are uncertain and outside of the Company's control and actual results may differ materially. For discussion of some of the risks and other factors that could affect results, please see the risk factors and other cautionary statements made in our communications with shareholders, including the risk factors disclosed in our annual and quarterly reports. Also note that the content of this conference call contains time-sensitive information that is accurate only as of today and we do not undertake any duty to update forward-looking statements. We will also refer to certain non-GAAP measures on this call. For reconciliations of these non-GAAP measures, you should refer to the press release and earnings presentation on our Investor Relations website. Finally, today's call is being recorded and will be available on the Company's website later today. I will now turn the call over to Chris Farrar for opening remarks.

Thanks, Chris. And thank you all for joining us today. We had a great quarter and I’m excited to host the call today. On our last earnings call, I outlined our plans to restart originations in the third quarter, and I'm very excited to report that we are completely operational. Our new applications have returned to pre-COVID levels and the pipeline is expanding rapidly. The silver lining of our production pause was a chance to work on the nice-to-have projects that are often tough to accomplish when a company is growing. We used the downtime to reevaluate our entire production platform and we made significant improvements to our processes as well as our technology. These improvements will make us more efficient and more customer-friendly going forward. We also restructured job functions and responsibilities, which resulted in a reduction in force at the end of September. All these decisions are never easy. Our team is convinced they were necessary and beneficial to our future growth. In terms of the portfolio, we saw a stabilization of the non-performing loans and our asset managers continued to do an excellent job of resolving delinquent loans. We continued to see strong recovery rates and the real estate markets are performing better than many had predicted. Additionally, it's important to note that we saw provision expense return to a normalized level in Q3 as the economy is performing above the adverse levels that we were assuming in our CECL model. Looking forward, our team is working hard to create new relationships on the liability side of the balance sheet to eliminate mark-to-market risk and explore other debt structures to finance our growth during the fourth quarter and well into 2021. With regard to our people, most of us continue to work remotely, but we recently allowed certain of our team members to return to work in our physical locations as long as protocols are followed. I'm happy to report that we've had minimal issues by reopening our offices. Fortunately, we're healthy, motivated, and happy to be serving our customers again. With that, we'll turn to our presentation materials. It's a relatively short and straightforward presentation today, so I'm going to just go through it top to bottom. Mark is on the call as well, and we'll both be available for Q&A. From an earnings perspective, we're very pleased: net income was up significantly as I mentioned in my opening remarks, driven largely by a return to normalized provision expense. Portfolio NIM expanded as we saw fewer NPLs and we're very pleased with the earnings result for the quarter. In terms of production, we've already highlighted that we got restarted and had tremendous response from the market. We saw near pre-COVID levels right out of the gate, and I'm very pleased to see how quickly our customers have been responding to our reopening. In terms of resolutions, again, very strong for the quarter — a 3.5% on-assets result. We expect that good performance to continue going forward and we see strong real estate markets as we continue to resolve these assets. Another important milestone in the quarter: about $335 million of loans that were in the forbearance program were actually brought current; any amounts that were past due were tacked onto the end of the loan and they sit in a non-interest-bearing account that will be recovered upon liquidation. So that was a big slug of the forbearance loans that we had done in the prior quarter coming back to current status. That was a very good improvement for us in the third quarter. From a financing and capital perspective, we're working on some new agreements right now that all have non-mark-to-market provisions. As we've indicated in the past, that's our desire and our plan going forward. We're making very good progress there and are looking forward to doing our next securitization in Q1. Turning to Page 4 from just a core earnings perspective, core earnings were a touch higher notwithstanding the workforce reduction costs and the restructuring charge that we took there. Good results and good book value growth as a result of the earnings in the quarter. On Page 5, I mentioned the good asset resolution activity; we continue to see strong performance there and good resolutions as loans are paying off and borrowers are rectifying delinquent assets. We expect that performance to continue. Turning to Page 6, in terms of the portfolio, the one significant transaction in third quarter was our transfer of about $214 million of held-for-sale loans to held-for-investment. The GAAP requirements can sometimes distort the picture a little bit. Essentially, you'll see in our loan loss provision a number of $1.6 million, so it might look at first blush that reserve provision is up for the quarter. But we had an offsetting lower-of-cost-or-market allowance on the books already for those held-for-sale loans, so this is really just a reclassification under the GAAP requirements. It actually ended up being roughly $141,000 positive to net income as a result of the reclass. That transaction took place during the third quarter as a result of our securitization of those loans, but resulted in no real meaningful change to loan loss provision. On Page 7, we talked about the production restart and the great response from our customers. Our Generate Velocity broker portal had just under 400 new brokers sign up with us and with some of the technology enhancements, we found ways for folks to interact with us more seamlessly, make the website more friendly, and continually improve that broker and borrower experience. Early returns are fantastic. We're getting much better application-level and response-level metrics than we had even forecasted or hoped for. So all those investments and enhancements are going to continue to serve us well as we expand. Turning to Page 8, net interest income: I mentioned the NIM expanded in the quarter, primarily driven by fewer new NPLs. As we go forward, we hope that we can continue to improve on this NIM as we expand and grow the portfolio. On Page 9, in terms of loan portfolio performance, you can see on the left-hand side non-accrual loans stabilized and ticked down slightly. Our projection and expectation is that we have in fact stabilized and over the next 12 to 18 months we expect that to trend down as we resolve assets as they come off the balance sheet. We're pleased with what's going on there from an NPL perspective, especially in light of the positive resolutions. From a charge-off perspective on the right-hand side, this is the only kind of negative in the quarter. Unfortunately, we had one large loan that charged off. It was not a result of COVID. It was a large loan that we made about a year ago and it was kind of a Murphy's Law loan: everything that could have gone wrong, did go wrong. We had some people internally that didn't follow procedure and we let them go. We are pursuing this borrower legally for a deficiency judgment and we're also pursuing insurance from the appraiser. I don't want to get too far into the weeds, but we can address more in Q&A if needed. The bigger point is that it was a one-off unfortunate situation. I think the last time something like this happened was five or six years ago, and more importantly, it's not an indication of a larger trend or a large number of loans that were delinquent that we had to charge off. It was just an unfortunate event on our side and we believe it to be one time and not indicative of future performance. On Page 10, just a little perspective on the CECL reserve: you can see it's running right around 29 basis points. We think we're very well preserved. I did mention that we used an adverse, highly-stressed forecast model for this CECL calculation, and so far the economy has been performing better than those assumptions. We'll see how things go in the future, but we feel very good about our CECL reserve and the level of reserve vis-à-vis the portfolio. On Page 11, talking about the future, we expect continued strong demand for our products. We think there are market dynamics and competitive dynamics at play, but we're very pleased with the response we've received so far. In terms of performance, we're hopeful that we've got our arms around the delinquency and we'll continue to work that off. We see pockets of weakness across the country, but overall real estate values are holding up very well. We remain optimistic about our ability to continue to liquidate delinquent assets. Lastly, in terms of profitability and growth, we're excited to be putting new assets on the balance sheet and believe that by Q2 next year we'll be back to pre-COVID origination levels and driving higher net interest income into profitability. An important foundation in that strategy is to continue to expand our financing capacity. We're working on that, especially on the warehouse side of the balance sheet, to eliminate mark-to-market risk. I believe we've put the pieces in place to have a great year next year and continue to expand our growth plans. As I said, that was a pretty quick, high-level presentation, and I think it's appropriate to open it up for Q&A now for both myself and Mark.

We will now begin the question-and-answer session. Operator instructions: Our first question comes from Stephen Laws with Raymond James. Please go ahead.

Chris, I guess first, let me talk about I think $53 million of production in October. Is that kind of a good run rate as we think about November and December or is there seasonality or how do you think about that ramping? And kind of coupled with that, it seems like the focus recently has been exclusively one- to four-family rental; is that likely to continue for the foreseeable future? How do you think about the mix of the new loan production?

Sure. So I think it takes some time for applications to build and for your pipeline to build. So I don't think the $63 million is the run rate; we do expect that to increase over the quarter. There's a little bit of seasonality in Q1, kind of January-February, so it could maybe level off or pull back a little in that Q1. But we think by the time we get to Q2 we'll be back to more normalized levels that we were pre-COVID. In terms of the second part of your question, we tightened up on some of our small commercial guidelines and intentionally wanted to have a little bit less exposure there just in light of everything going on in the economy. So yes, on a go-forward basis we would expect a higher level of one-to-four production than small commercial. The mix is likely to be weighted a little more toward one-to-four.

Great, appreciate the color on that. And kind of a follow up: given the trends we're seeing coming out of COVID with migration shifts and about half the portfolio in New York and California, have you seen a change in demand as to where the loan applications are coming from? Have you seen anything interesting that shifts the geographic concentration of the loan demand?

Not yet. It's probably too new to read, still in the large MSAs. As you know, we'd like to stay in the more liquid markets, so I would expect our originations to continue there. A lot of what we do is in the suburbs and has always been there, so we're seeing a lot of demand there, but I don't think there's anything material yet to highlight.

And then Mark, can you give us what goes into the other income line, $1.3 million for the quarter? Nice pickup; it's been a little bit up and down this year. Can you give us an idea of what is in that line item and how we should think about it as we model forward?

Yes, Steve, what's in the other income line for Q3: as we discussed, we moved about $214 million of UPB from held-for-sale loans to held-for-investment because those loans were pledged in the securitization we completed in July. When loans are classified as held-for-sale, GAAP requires lower-of-cost-or-market valuation accounting, and over time we had built up a valuation allowance for those held-for-sale loans which reduced other income by roughly $1.3 million. When we reclassified those loans to held-for-investment, we were required to reverse that held-for-sale valuation allowance, which resulted in about a $1.3 million positive to other income. At the same time, as held-for-investment loans, they carry a loan loss allowance under the loan loss methodology, which is reflected in provision expense — roughly $1.06 million of provision expense in the quarter. So the net effect is largely a reclassification: the reversal of the held-for-sale valuation allowance shows up as a one-time positive in other income of about $1.3 million, and there is a related provision expense on the loans now classified as held-for-investment. It's essentially a one-time, non-recurring accounting reclassification and that is the primary driver of the $1.3 million in other income for the quarter.

All right, appreciate the color there.

And one other thing I'll point out: Slide 16 in the presentation has a breakout that walks you through that whole entry so that delineates it.

So there it is. I paused on 15 on my geographic question, so I haven't suffered — he points out. Lastly, and I'll drop off, can you talk about financing costs? They went up due to where the markets were in June and July. It's good to get those deals done. Can you talk — I know it's early for your target in a Q1 securitization — but where do you see the market today? What type of margin are you thinking about or how do you answer toward outlook for financing costs? How does the securitization market look today versus what you were able to execute in June or July?

In talking to our investment bankers, we think the market is significantly improved from that timeframe. We've got some pretty good data points to show that. In terms of where our spreads will be, we think they will be at least where they were pre-COVID. By spread I mean our interest-earning spread — the difference between the loan yield and our debt cost. We believe, as a result of the Fed's interventions and improving markets, we'll be able to get back to pre-COVID levels on a margin basis.

Our next question comes from Don Fandetti with Wells Fargo. Please go ahead.

Yes. Can you talk a little bit about where yields are on new originations versus pre-COVID? And also, can you reconcile the share count of diluted shares, in terms of the press and warrants in there — are they all in there? I went through all the numbers in detail and want to confirm.

Sure. On the first part, we're seeing coupons about 75 basis points lower than where we were pre-COVID. But we think on the debt side it's probably lower than that, so from a spread perspective we think we'll be at least at our normal spreads, if not wider, going forward.

Hi, Don. On the share count: on a fully diluted basis, there were a little over 20 million common shares outstanding for Q3 on a basic basis. On a fully diluted basis, that goes up to a little over 32 million shares because you have to take the average stock price for the quarter; the average price was about $4.40. That causes the convertible preferred to be dilutive: the convertible preferred converts to about 11.7 million shares at a $3.85 strike price, which is below the $4.40 average, so those shares are included in the diluted share count. Also, the warrants were issued in two tiers with two different strike prices: $2.96 and $4.94. The $2.96 strike price is dilutive because it's below the $4.40 average price, so that tier is included in diluted shares. The $4.94 strike price would not be dilutive because it is above the $4.40 average. So the additional dilution you see is driven by assuming the preferred converts and the lower-strike warrants are exercised. That explains the increase to a little over 32 million fully diluted shares.

Our next question comes from Steve Delaney with JMP Securities. Please go ahead.

Thanks. Hello, everyone. A couple of mine have been taken. Chris, I was wondering if you could provide after the September reduction in force, your current full-time headcount today versus where you stood pre-COVID?

Yes, we reduced by 60 full-time employees. I think we're roughly 180 to 182 people now.

Okay. And then following up on Don's question on the coupons — I was going to ask the same thing. If you're down 75 basis points, I'm looking at my rate sheet and the 10-year is probably down about 100. Credit spreads can be anywhere, but it sounds like maybe you're able to get a slightly higher coupon relative to the 10-year today than maybe you did late last year, early this year. Does that make sense? I know you think about MBS credit spread but the 10-year is an easy reference. Also, what are you generally quoting on LTV today? What are you trying to come in at?

You're thinking about it the right way. Another point is that we've reduced loan-to-values across the board, effectively getting a higher coupon for a lower LTV loan. So when you put those two together, we're effectively getting at least the same spread, and probably a little bit wider than where we were pre-COVID. In general, we've reduced our commercial LTVs by about 5%. Given that one-to-four production is a larger percentage of production now, the overall weighted-average LTV won't drop as much because those assets tend to have different LTV profiles, but we have taken a reduction in commercial LTVs as a risk-management action.

Got it. Thank you for the comments.

This concludes our question-and-answer session. I would like to turn the conference back over to Chris Farrar, CEO, for any closing remarks.

I just want to say thanks to everybody for joining the call. We appreciate your support and interest, and we're available if you have further follow-up. Thank you.

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