Velocity Financial, Inc. Q4 FY2020 Earnings Call

Good day, and welcome to the Velocity Financial Incorporated 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 would like now to turn the conference call over to Chris Oltmann. Please go ahead, sir.

Thank you, Chuck. Hello, everyone and thank you for joining us today for Velocity Financial Fourth Quarter 2020 Earnings Call. With 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 fourth quarter 2020 press release and the accompanying earnings presentation, which are available on our Investor Relations website. I'd like to 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 filings with the Securities and Exchange Commission. 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 may also refer to certain non-GAAP measures on this call. For reconciliations of these non-GAAP measures, you should refer to the earnings materials on our Investor Relations website. And finally, today's call is being recorded and will be available on the Company's website later today. I would like to turn the call over to Chris Farrar for opening remarks.

Thanks, Chris, appreciate it. Welcome everyone to the Q4 earnings call. As you can see from our press release, we obviously had a very strong quarter to finish the year. And we're really proud of the fact that we overcame the difficult challenges we faced in 2020 so well. Despite elevated delinquency levels, our portfolio continued to provide positive income in all four quarters, and we also improved on last year's net income, which is really impressive under the extreme conditions we faced. Our people are so important to our business and I want to thank every team member at Velocity, who worked so hard to quickly adapt to the rapidly changing world that we all faced. From a macro perspective, we continue to see strong real estate values in most parts of the country. Fortunately, we have no credit exposure for the types of commercial properties that were most hard hit, i.e., hospitality, movie theatres, and standalone restaurants. On the residential side of things, we're starting to see many states roll out tenant and/or landlord relief for those impacted by the pandemic, and our special servicing team is sharing relevant information with our borrowers as it becomes available. We hope that these programs will allow folks to survive the difficulties they've encountered and get back on track. Tremendous government stimulus and a low interest rate environment have been a strong backdrop for real estate in general. And we continue to see impressive origination demand and healthy functioning real estate markets. Turning to Velocity more specifically. On the asset side, we saw increased delinquency, as well as an increased level of payoffs in secured loans. But we still see some borrowers struggling with the impacts of the epidemic, and other borrowers are catching up, or paying off entirely. Overall Q4's activity was much higher than Q3, as we see markets starting to normalize. Fortunately, we realized very strong recovery rates in the quarter and we're very pleased with the quality of new lending opportunities that we see. On the liability side, we recently completed two important financings, designed to minimize mark-to-market risk and provide us with new growth capital. We're more confident with our risk profile now as a result of these important changes and decided to put this capital to work. We're well positioned to organically grow our business with a more stable funding base. As always, we appreciate your continued support, and want all investors to know that our entire organization is focused on performing for our customers and delivering real value to all stakeholders. That concludes my prepared remarks. And now we'll turn to the presentation materials. On page three of the Q4 highlights, I'll hit the first page here and then turn the presentation over to Mark and wrap it up at the end, but, again, it’s a really great quarter for us, strong net income and EPS. The big differentiator here that's a little bit unusual for us is that we sold just under $100 million of loans in the quarter; typically we don't do that. We aggregate everything obviously for securitization. That was really driven by two factors. One, we had some very, very attractive prices. And two, we really wanted to be prudent with our liquidity and manage that well, up until a point where we got the new corporate debt done. So that was the driver for the change in the quarter. But our gain on sales really boosted the earnings over and above our normal portfolio income. Also importantly, we saw NIMs increase in the fourth quarter, again, as our special servicing team continued to drive strong recovery rates, where we saw yields that were higher, even though we had an uptick in delinquency. So, again, very strong recovery rates on delinquent assets is driving that NIM wider. In terms of production and the portfolio, a really good fourth quarter of $179 million in new originations. I mentioned that strong resolutions; we got $103.5 million in terms of recovery rates. So, again, still making money over and above the contractual interest that's due, so good results there. And then, as I mentioned in my opening remarks, non-performing loans did tick up to $332 million. Seeing the majority of that is really driven by folks that were given forbearance and then unfortunately have gone back to delinquent status. So even though we had a lot of assets resolved favorably, we are seeing some people still fall behind. And then again, just to kind of wrap up here, from the financing and capital perspective, we added a $200 million non-mark-to-market warehouse facility. So that was a great achievement for us; it really helps us minimize any risk going forward as we aggregate for securitization — we closed that in February. And then also entered into the new syndicated term loan, where we've got some great partners that are supporting us, and that transaction gave us roughly $80 million of growth capital going forward. So we've got a couple of years of capacity here as we continue to grow the portfolio and make more loans. So that's kind of a high level wrap-up on the quarter. I'll turn it over to Mark, on page four, to take you through the rest of the presentation.

Thanks Chris. Hi, everybody. On page four, it's kind of an overview of the earnings for Q4 and from a pretax standpoint as Chris mentioned a very strong quarter for Velocity Financial, $11.7 million in total pretax income for the quarter, $7 million of that is generated by the in-place portfolio. We talked about the in-place portfolio and the fixed spread that we generate on that portfolio. So, again, nice earnings in that portfolio of $7 million for the quarter. A lot of that — some of that also being the default interest and prepayment fees; we'll show that in a couple of slides. The resolutions that we have on the NPL loans as Chris mentioned on these non-performing loans, we still have strong resolutions and again, we collect all contractual principal and interest as well as default interest and sometimes prepayment fees as well, so we'll show that in a couple of slides again. $0.7 million of the $11.7 million was gain on sale loans; as Chris mentioned there was very strong demand for our product in Q4. So, because of the strong demand for the product as well as wanting to make sure we have plenty of liquidity for the origination pipeline volume that we saw coming through while we were working on this corporate debt deal, as Chris mentioned this $175 million debt deal that came through in February. So, we wanted to really strengthen our liquidity position and have strong prudent liquidity. So, we did sell out $96 million worth of UPB in Q4 generating a $4.7 million gain. We sold a little bit more in January, again — just again this market was strong with a lot of short-term liquidity and this debt deal came through in February. Our goal now is to get back to our basics of originating loans and holding loans on our portfolio, and then putting them into long-term securitizations and locking in that fixed rate spread. So, we'll opportunistically look maybe to sell loans once in a while, but the main goal is to follow the business model that we've always had in terms of holding these loans for securitization purposes. The book value per share on the same page to the right increased from $10.44 a share at the end of Q3 to $10.93. On page five, Chris mentioned the volume picking up again in Q4. So, you can see in Q1, we had about $248 million in volume. Then you see the second and third quarter was basically the suspension of loan originations during the pandemic, and then starting with our origination platform again we had full quarter originations in Q4 as Chris mentioned $179 million. Originations in Q4 were all of our 30-year product; there was no short-term product in those originations. We’re currently not offering the short-term products. We're just kind of watching the market and looking at the appropriate re-entry points to start offering that short-term product, but as of now we're still offering the 30-year product. On page six, showing our held-for-investment loan portfolio. To the left, you see the loan portfolio composition, basically all held-for-investment loans as you can see. You can see the loan portfolio at the end of Q4 came down slightly from Q3 and from end of year 2019, and as was mentioned, that's mainly because of six months of no originations, just starting up again in Q4. So, for 2020, the principal prepayments and some of those sales in Q4 were greater than the amount of new loans put on. So, we had a little bit of run-off that portfolio, but now we're back to full origination again. We expect to be adding to that in-place portfolio on a fixed-rate spread on a go-forward basis. And then the right side of that is just kind of showing the waterfall on the loan portfolio from Q3 to Q4 and you’ll see I'm talking about the principal prepayments and loan sales kind of exceeded the loan production for the quarter. Page seven is our non-performing loan resolution activity. And as Chris had mentioned, very strong resolution activity. You see in Q3, we resolved $12.5 million of total UPB non-performing loans; almost 2.5 times that for Q4, $30 million of resolution, and $1.1 million gain for the quarter from those resolutions. So you can see even for Q3 and Q4, bringing in about a 3.5 point gain on our NPL resolutions. So we're kind of really following our historical resolutions on non-performing loans. We've said that over 90% of our non-performing loans either pay off or pay current. And when they do that, we collect not only 100% of the contractual principal and interest, but also default interest, and in many cases, depending on when the loans pay off, prepayment fees on top of that. So that's what's generating that 3.5% gain for Q3 and Q4. You'll see in the 10-K that we had a 3.5% average non-performing resolution gain for the entire year of 2020. So we did average 3.5% the whole year, so it's very steady and consistent. And as Chris mentioned, the uptick in non-performing loans because of the pandemic hasn't been that troubling to us, because historically we've always made money on these non-performing loans and we continued to do that through all of 2020. Page eight just shows the net interest margin. Over on the left side, for Q4, our net interest margin was 4.07%, an improvement over Q3 of 3.77%. And again, we just saw the resolution activities in Q4, strong resolutions of $30 million, bringing 3.5% gain, default interest and prepayment fees, so that helps the net interest margin and all this was due to the margin, so part of the reason for the uptick there. To the right, you can see the components of net interest margin. So, the top line is the loan yield. The loan yield went from 8.21 to 8.40 from Q3 to Q4. But also the debt costs overall; average debt cost improved as well, so widening of the margin, which is really a good sign for us going forward. On page nine, loan portfolio performance. Chris mentioned the uptick in the non-performing. So you'd see at the end of Q4, just a little over 17% compared to the 15.8% for Q3. And the main reason for that, as Chris mentioned, was loans that came out of our COVID forbearance program, but then missed their next three months payments coming out and then were put on non-performing. So even though the forbearance program ran through April through June, where we gave them a 90-day forbearance, if they missed the three months after that, that's going to end up in Q4, and that's one of the main reasons for the uptick. Going into January and February, that is pretty much leveled off. We don’t see more uptick right now, and we expect to start working through that, as you saw $30 million in Q4. We're working on resolving those NPL loans. Our overall charge-offs remain very, very consistent. You can see from 36 basis points for Q4 2019, 33 basis points Q3 of 2020 and 37 basis points Q4 2020. So we've been very consistent and around 35 basis points on charge-offs; that’s been consistent with historical trends. So very consistent over time on our charge-offs, very little charge-offs. On page 10, in terms of the loan loss reserve, we implemented our CECL reserve on January 1 of 2020 under FASB GAAP. And because of the COVID pandemic, we felt that it was prudent to increase that reserve in light of the pandemic and the increase in non-performing loans. It was prudent to increase that reserve during Q1 to Q2, and you can see we did that; it went from $2.3 million starting out the year to $5.2 million at the end of Q2, which is 28 basis points. And we felt that that was probably a very good level of reserve to have and we've kind of maintained that level over the second half of 2020. So, for Q3 and Q4 it went up one or two basis points. We ended the year at 30 basis points, $5.8 million in reserve. And again, based on the low charge-off level and still the 3.5% gain we see on resolving the NPL loans, we feel that we're very comfortable with that reserve where it's at right now. Chris, I'll turn it back to you to talk a little bit about Velocity's outlook for 2021.

Great. Thanks Mark. Appreciate it. Just to finish up the presentation here. From an economic perspective, obviously, we are hopeful that we'll start to see things reopen and the economy start to get back on track and we expect to see good growth as we go forward. We think we'll be able to take advantage of that and build on that by originating more loans. We're seeing really good lending opportunities there, so we're encouraged by that. From a portfolio perspective, hoping to see that begin to normalize and start to trend down in terms of delinquency. I think we've been very conservative with our loan loss reserves in case things don't go the way that we hope, but I think, as we've been talking to our special servicing team, we're seeing good resolutions and expect to start working off that backlog of loans. Lastly, obviously, we have the capital in place to fuel our growth and so we're very bullish there and excited to be going on offense here growing the business. From a risk perspective, getting everything over to non-mark-to-market really allows us to sleep well at night that we won't have to deal with any surprises there. So, we've really strengthened the balance sheet and the business to grow going forward. So, that wraps up all of our prepared remarks and presentation. With that, we'll open it up for questions.

We will now begin the question-and-answer session. The first question will come from Arren Cyganovich with Citi. Please go ahead.

Thanks. Maybe just touching on the new production. It looks like you're on pace to do around $190 million in the first two months as a gauge. That would be a bit of a decrease from year-over-year, but it's a modest increase from the prior quarter. You don't have the short-term product, which is the primary impact there. What's your expectation for new production for the year? Will it be around this pace? Are there any seasonal pickups you would expect in 2Q and 3Q? Just give us some thoughts on that.

Sure. Hi Arren. I think our guidance has been we expect to do $1 billion for the year. Q1 is usually seasonally a little light—January and February are a little bit light. I think March will be at a stronger level than we saw in January and February. So, I think we do expect the quarterly production numbers to grow from this level, and we think $1 billion is very doable for the year. As Mark mentioned, we'll probably reintroduce the short-term product soon, and that'll be another help in terms of the overall growth. So excluding that product and looking at the levels where we're at, we feel really good about how much capacity and demand there is out there for this product. So, yeah, we think this is probably the low quarter of the year.

Okay. Thanks. And then the portfolio yield ticked up a little quarter-over-quarter; I believe that was referenced as being related to increased collections of non-performing loans and default interest. Is that viewed as an elevated level, or do you expect this to stay at this level as you're continuing to work through some of these loans?

Yeah, that's a really good question. It's very tough for us to forecast, because it is so lumpy. It just depends on when assets resolve, so whether they'll fall in the first quarter or the second quarter is tricky for us to forecast. But I think we like to build our model and our projections kind of in the low 8s, so you'll see it bouncing around in there from 8.0 to 8.5 depending on the timing of when some of these loans resolve. Sometimes we have a loan that's been delinquent for two years and you'll obviously have a big catch-up on a loan like that. Other times you'll have a loan that's only been delinquent for 120 days and it's not as impactful.

And Arren, this is Mark. This was a trade-off there as well, because when the loans are going non-performing, we don't accrue interest. That's why we call them non-performing, right? So we're not accruing interest in the financials, but then as Chris mentioned, our special servicing department is working with the borrowers and getting them to pay current, and then we receive that cash. As we get the cash interest and the default interest, we're then booking that actual cash proceeds to the financials. So you're right, as they start catching up, there may not be as much lumpy cash coming in, but then if they catch up because they're paying current, once they go to current, there's not as much lumpy cash coming in, but then we're back to accruing the interest, so that accruing interest is hitting the financial statements once again. There's a trade-off there.

Yeah, fair point. Okay. And then, on the cost of funds, maybe discuss the new financing that you've added. The non-mark-to-market facility is obviously a big positive. How is that going to impact your expectation for cost of funds as you roll through 2021?

Yeah. So we're definitely going to have a higher cost of funds on the corporate debt side, because we upsize there. So that will be a drag on this year's results, but we thought it was the most attractive capital to grow the business, so we don't have to do an equity raise or anything like that at the levels where we're trading. So it will be an earnings drag this year, but as you've seen when you build the model, production that's put on this year fully scales into the following year, so it will be a bit of a headwind for this year but we'll see stronger growth thereafter.

Okay. All right. Thank you.

The next question will come from Stephen Laws with Raymond James. Please go ahead.

Hi, good afternoon. Nice end to the year, especially the opportunistic loan sales. Wanted to touch base really following Arren's question on the financing costs, but more on the portfolio side. The older sequential-pay deals look like they are below 20% for a couple of them. Are there opportunities to call them or resecuritize them at lower costs, or do you have expectations for how those will pay down and change the mix of funding costs in 2021?

Yes. So we absolutely do have that opportunity. It's a little bit tricky to predict exactly, but we will definitely in the next 12 months pay off a couple of deals. That will be a good opportunity for us to swap out some funding cost. It tends to be smaller balances, so it's probably not a huge impact to our overall costs. To give you historical context, when we first started out, our call rates on these securitizations were maybe 5% or 10% of the original deal. As we progressed and got a better track record, those stepped up to 20%, then 25% and 30%. So I don't think there'll be a meaningful swap out to overall costs immediately, but as the business matures, there will be some more significant savings, probably in 2022 to 2023.

Okay. That's great to know given the cost of those first three deals and where we stand there. I see your point about the small balances, but it does move it a little bit, given the…

Little bit. Yes.

And then to follow up on a comment in the press release, I think it was the shorter-term deal, the 2020-2-MC1, paying down a little faster than others. Is that expected to continue? It looks like it's $138 million; how quickly do you think that pays down as we think about this blended mix?

Yes. So the majority of the collateral on that deal are short-term loans that were kind of 12 to 24 months duration. So we do expect that to be a much faster speed relative to the other deals. So yes, we expect that to continue throughout the year.

Great. And then on the loan sales, do you expect to do any of that this year now that the corporate facility is closed and the corporate term loan is in place? You've got the preferred to retain and the securitizations to execute on; is selling loans something we should expect to see on a recurring basis or not?

Yes. I don't think you should expect it on a recurring basis. We did sell probably $50 million or so in the first quarter; we'll be opportunistic. We have to allocate capital smartly. So if we see a really great price or the right opportunity, we'll take advantage of it. But in terms of the way we model the business and the way we're forecasting, we're not counting on something like that as a regular activity.

Yes — $50 million in January, close to 5.5 points.

Okay. And then lastly, you still have a return in the short-term business. You mentioned you continue to watch that market. Can you provide a little color on what metrics you're looking at? What would you like to see before you start offering that product again?

Yes. So it's more driven on the financing side. We're looking at the securitization and capital markets to make sure that we've got a rock-solid exit in place and that's really what we're working on right now. We've made a lot of good progress there, so I think you'll see us get back in a quarter or two.

Great. Well thanks. Appreciate the comments this afternoon.

Thank you, Stephen.

The next question will come from Steve DeLaney with JMP Securities. Please go ahead.

Thanks. Hello, everybody and congratulations on your reopening and back to more normal times. Great quarter.

Thanks.

My very capable compatriots in the research field have checked off about six of my seven or eight questions. So they did a great job on their Q&A. I've got a couple things. Following up on Stephen’s question about the bridge loans: in the past when that was more active two or three years ago, what would you say your average quarterly volume in that short-term product was? And if you could give us a range of expected gain on sale margin? Thanks.

Sure. I'll take the second one first. We probably won't do gain on sale there. We'll probably aggregate and securitize. We did sell through the business historically up through 2019, and then at the beginning of 2020 we stopped selling it and started aggregating for our first securitization. So we paused that strategy and prefer to securitize the product rather than sell it. In terms of volume, it was roughly running about 30% of our business. So it was significant; it could be meaningful volume when we turn it back on.

So 70 to 80, $70 million to $80 million a month.

Yes. It was significant. So we'll see how things go as we turn it back on, but it can be meaningful volume.

Okay, great. And thanks for the color on the new financings. Obviously getting a term-loan facility is quasi-capital for you in the non-mark-to-market structure. Thanks for the guidance on the higher cost of funds. I'm curious on the warehouse facility: now with that $200 million, what is your total warehouse funding capacity at this time?

We are at $350 million today. We'll probably put another facility or two in place to expand that, probably getting to $500 million to $600 million on a go-forward basis. We have two other facilities in place at $100 million and $50 million, which is how we get to the $350 million right now.

Got it. Okay, well listen, thanks for the comments. Amazing to see the stock up 70%-plus since September 30, clients are happy and keep it rolling in 2021. Thank you.

Thanks, Steve. We appreciate your support.

Thanks, Steve.

The next question will come from Don Fandetti with Wells Fargo. Please go ahead.

Hey, Chris. Just wondering if you could provide your thoughts on the housing market given that mortgage rates have moved up here, and then also the competitive environment for your lending business?

Sure. Hi, Don. In general, the markets are very active. I would say refinancing is probably going to cool off if rates continue rising, but we still see strong purchase activity and strong demand. When we have to sell a one-to-four or if we see properties that are facing foreclosure, they're able to sell very quickly. So I think there's still more demand than supply from our perspective. We expect that market to stay pretty strong even with rising rates. In terms of competition, we're fortunate in that we don't have a lot of direct pressure to drop rates to match someone else. There are other lenders getting share and that's great — there's plenty of market for everyone. But we haven't felt competitive pressure to reprice our product. Some non-QM lenders are offering products that are similar on the one-to-four and small commercial side, but volume there is less than pre-COVID and we've intentionally been cautious. So we're not seeing tremendous pricing pressure right now.

Our next question will come from Mark Cooper, Investor. Please go ahead.

Hi, good afternoon. Thanks for taking the call. I was just wondering, the warehouse facility that you have in place, how difficult was it to expand your facility to get more loans on? Thank you.

Yeah, sure. Thanks for the question. It's relatively straightforward. Our lenders are very supportive and helpful and as we reach capacity they're more than willing to upsize — they can do it in chunks. We have plenty of capacity right now. As I mentioned earlier, we're going to add another one or two credit facilities, which will give us another couple of hundred million of capacity. The lenders have said they're willing to upsize for us, so there's plenty of capacity if we need it.

Okay. And also for further growth, you operate through brokers. Is there another method to get to borrowers other than brokers that you're looking at? Thank you.

No, we exclusively work with brokers. We're built for that model. There are other ways to reach borrowers but they can be pretty expensive, and it's not something we intend to do. There's plenty of growth ahead of us with the current broker model.

Okay. Appreciate it. Thank you very much.

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

Thank you. Again, appreciate everybody taking the time out of your day to listen to the call and thanks for your support. We're going to continue to work hard to grow our business and execute on the plan. So thank you all for joining the call.

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