Earnings Call Transcript - VEL Q4 2022

Operator, Operator

Good afternoon, everyone, and welcome to the Velocity Financial, Incorporated Q4 2022 Conference Call. For your information, today's conference call is being recorded. And at this time, I'd like to turn the floor over to Chris Oltmann, Treasurer and Head of Investor Relations. Please go ahead.

Chris Oltmann, Treasurer and Head of Investor Relations

Thanks, Jamie. Hello, everyone, and thank you for joining us today for the discussion of Velocity's fourth quarter and full year 2022 results. 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 fourth quarter and full year 2022 results, and our press release and the accompanying presentation are available on our Investor Relations website. I’d like to remind everyone 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 a 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. Please 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. With that, I will now turn the call over to Chris Farrar.

Chris Farrar, President and CEO

Thank you, Chris. I want to welcome everyone to our fourth quarter earnings call. Despite ongoing challenges from rising interest rates, we achieved another profitable quarter and our most profitable year ever. Our loan portfolio grew by 36% to a record $3.5 billion. We also completed six securitizations this year to support our growth. Additionally, we increased our annual core net income by over 26%, which is just under $9 million. I am very proud of these impressive results for our shareholders, especially in light of the difficulties we encountered. Regarding our portfolio, our strong credit discipline remains effective, as we had zero charge-offs in the fourth quarter and continue to resolve delinquent assets successfully. Market conditions indicate a slowdown in real estate, with fewer transactions affecting our performance in the fourth quarter, resulting in fewer payoffs and lower past due interest than in previous quarters. The positive aspect is that we will recognize this income in future periods, and payoffs have already increased in Q1, surpassing the activity from Q4 through February of this year. From a real estate valuation standpoint, some overheated markets are cooling down, while others remain strong, allowing us to continue selling REOs without issues when priced appropriately. We tightened credit in the fourth quarter and limited new production intentionally as we aimed to see improved conditions in the bond market. Thankfully, this strategy was successful, as the markets improved this year, with our first securitization in January receiving much stronger demand than our October deal. We are experiencing better execution in the new issue mortgage market and have decided to increase production levels moving forward. We anticipate that originations will bottom out in Q1 this year and grow thereafter, as we capitalize on favorable lending conditions and note that several competitors have exited the market. Our pipeline is robust and expanding, with our customers remaining loyal to our brand. Lastly, I want to highlight a significant strategic decision made last quarter to adopt fair value accounting for newly originated loans. After careful analysis, we believe this alignment will better reflect the actual economic value of our equity in our GAAP results. Over the next several years, we will gradually transition our portfolio as new FVO loans replace the currently held amortized cost loans. We believe this change serves the best interest of all shareholders and will clarify our value proposition through GAAP results. Mark will delve into more details shortly. In summary, I am extremely proud of our team's performance last year, and we are well-positioned for continued growth. We appreciate the support of all our shareholders and will now review our presentation materials. If we turn to Page 3, we have highlighted some full-year metrics. GAAP net income is up significantly, with loan production increasing 33% year-over-year. Our HFI portfolio grew over 40%, NIM decreased about 20%, and charge-offs dropped 60% on a year-over-year basis. On Slide 4, net income remained essentially flat, and core net income was slightly down from the prior year's quarter, primarily due to a lower NIM. In the fourth quarter, our earnings were impacted by about $0.10 a share due to a reduced volume of NPL resolutions compared to the third quarter. Importantly, this was not a loss or write-off; it was just income we typically recognized in prior quarters that we did not recognize this time due to slower market conditions, but we expect to recognize it in future periods. Additionally, the NPL recovery rate was 102.3%, slightly lower than 104%, indicating that while the number of transactions slowed and resolution volume decreased, we still managed to resolve assets above the contractual interest due. Regarding production and loan portfolio, we intentionally reduced originations by 44% from Q4 of '21 due to the conditions mentioned earlier in the securitization market. I’ve already addressed the portfolio size and the FVO election, so I will move to financing and capital. In financing and capital terms, we completed an October securitization of around $189 million, followed by a similarly sized deal in January, with the good news being that the January bonds were significantly oversubscribed. In terms of warehouse capacity and liquidity, we are in a strong position, with ample liquidity and warehouse capacity to continue growing our portfolio and accelerate our originations. Turning to Slide 5, from a net income perspective, we made a small adjustment on a core basis due to implementing an employee stock purchase plan last year and some equity compensation expenses impacting that adjustment. On the right side, you can see that from a book value standpoint, we have consistently grown book value by retaining earnings. On Slide 6, we’ve moved this slide up, which is our effort to indicate where we believe true value lies in the portfolio on an economic basis as opposed to a GAAP basis. As I mentioned earlier, this transition to FVO accounting should better align with the fully diluted equity value and the embedded gain in the portfolio. You can see that we had a pickup on the FVO loans, reflecting our other operating income, offset by additional costs incurred. Mark will detail those numbers shortly. On Page 7, we wanted to clarify the reasons behind our decision to elect FVO accounting. I will now turn it over to Mark to explain the rationale and the decisions supporting the FVO option.

Mark Szczepaniak, CFO

Thanks, Chris, and good afternoon, everybody. As Chris mentioned, we made a strategic decision starting on October 1st to elect Fair Value Options, FVO accounting for all of our originations on a going forward basis and we did apply that to all the originations in Q4. Strategically, it's just better alignment. It's actually more economic value to the shareholders. We have been presenting the economic value kind of embedded in our securitized loan portfolio through the economic equity slide that Chris just went through previously, but it's not really reflected within the financial statements because it comes in over time as you know, as net interest margin over time. So it's not reflected in our statement of equity, for example, when you're carrying it just at amortized cost. The one thing is, we now start to bring in that true fair value gain of the loans in the securitized portfolio into our equity and into our financial statements immediately as opposed to dribbling it over time. This better aligns our GAAP to tax. For IRS tax purposes, we've always had to mark the loans and our securities are at market value. So for tax, it's always the mark-to-market on both sides, where we've been doing the amortized costs on book. This aligns or converges our GAAP book and our tax bases being one the same. There are some future strategic alignments that help us out. In terms of the impact of the fair value accounting election, just to have a feel for how it's going to impact the financial statements: all new loans that we're originating are put on the books now at fair value. As we do the securitizations, we did one securitization in January, so the securitizations starting on January 1 will also go on the books at fair value as opposed to the amortized cost. But keep in mind that any costs or revenues that we use to defer for those originate loans or the securitized debt, they will no longer be deferred because there is nothing to amortize them over since they're not at amortized cost. The direct origination costs to originate a loan, direct compensation expense, commissions, etc., that used to be deferred and then amortized as a yield adjustment back up in margin. Those costs now come right into the financial statements in the income statement as operating expense. So what you're going to see as a shift to the income statement: you're going to see the gain pick up on the loans, and/or securitizations, the fair value swings in those two financial instruments will be in the other income section. Then the cost to put those instruments on the books that used to be deferred and amortized yield adjustments, those costs will run through the operating expense section. So that's what's going to look different; the other income and operating expenses are going to look bigger on both sides because of the fair value. In terms of the margin, we are still going to accrue interest income on the loans and interest expense on the securitizations in margin. The fair value adjustments we’re putting through exclude the current period interest, which is getting accrued in margin. You really won't see a big impact in the margin because you'll still have the accrued interest, both ways interest income and interest expense. If anything, that margin may start to widen out over time. Because under the amortized cost basis, besides the true interest income margin, remember, we've got those deferred costs that are being amortized up in margin, which is a reduction to margin. Now, we won’t have those deferred costs under new loans going forward, so the amount of amortization expense going up there is going to get less and less as the older amortized cost loans as of September 30 continue to pay down. So you'll probably see a widening of that margin. I know there’s a lot moving on. But that's kind of how it's going to change the financial statements. In terms of transition, on the bottom of Page 7, this is kind of what we see over a four year period. If we continue just to originate the loans, the new loans at fair value, and the existing amortized cost portfolio as of September 30 continues to pay down and pay off over around a four year timeframe, you kind of see what's happening there: the gray amortized cost portfolio becomes less and less, and you start to converge or transition to almost a full fair value. Now, this is for illustrative purposes. The fair value option is an election. So we're talking about all of our originations going forward. We have also said that we'd like to grow the company organically as well. I mean, if we decide to acquire loans from other institutions, we'll look at that on a case-by-case decision. And we want to take acquired loans and apply fair value, or maybe already amortized, we leave and amortize. So there are some things that could cause this transition to look a little bit different. But for the most part, you're going to start seeing the amortized portfolio coming down, and the fair value side of the portfolio going up into this transition. On the next slide, let’s pick up our loan production. As Chris mentioned, we strategically decided to reduce and put the brakes a little bit, tightening up the credit on our loan production in Q4, because of the volatility that we saw in the securitization market, and we wanted to wait until the first of the year to see if that securitization market came back, which again, we did a securitization in January, and the execution of that security was better than the one we had done in October. Those were very smart decisions to kind of pull back on that production. At the same time, though, we continue to raise the interest rates on our loans in response to what the Fed did on interest rates. We continue to raise them. Our overall WAC on our Q4 production was at 9.7%, which is up 78 basis points from the prior quarter's production. You can see from our fourth quarter of '21 production is up 339 basis points. We continue to raise that WAC. Even though interest rates have gone up, we still have a very healthy pipeline in our portfolio, and we expect to grow those originations coming out of the first quarter moving forward. On Page 9, our loan portfolio growth continues to grow even as the weighted average coupon goes up. We were, as Chris mentioned, up 36% year-over-year and our pro forma growth is $3.5 billion compared to $2.6 billion total portfolio. You can see the table below, which shows that growth. So very strong growth, and still very strong appetite and demand from our borrower base for our product, all while still keeping that loan-to-value ratio right around 67% to 68%. The average loan balance is again still around $400,000 or sub $40,000 on average per loan. On Page 10, Q4 asset resolution active and our NPLs, Chris alluded to this. Q4, the volume of NPL resolutions was just low. Q4 was pretty much a market phenomenon where the securitization market kind of went away, and the borrowers weren't prepaying; it just felt like everybody took a Q4 holiday. So the Q4 resolutions were low; we resolved $25 million in total, both long-term and short-term loans on our UPB compared to, say, the fourth quarter of $44 million, to give you an idea of the lower volume. If you took the first three quarters of '22, Q1, Q2, and Q3 on average, they were all around $44 million. So Q4 was $25 million in resolutions. The key point, though, is even on that $25 million, you could see a 2.3% gain, meaning the gain over and above collecting the contractual principal and interest on those loans. We are still making the same percentage gains on the NPL resolutions. That's more of a temporary situation. Those resolutions will occur, and those NPL loans will cure. We expect to make that gain going forward. It's more of a timing thing. We've already seen in January and February of this year that NPL interest we received from the defaulters for two months has already exceeded what it was all in Q4. Slide 11, on the net interest margin. We expect our portfolio of NIM to stabilize. Chris mentioned the lower NPL resolutions in Q4 had an impact of 61 basis points on the NIM. We expect to recover that in future periods, and we're already seeing that start to come back now in Q1. The portfolio WAC has increased, so our portfolio WAC quarter-over-quarter increased by 25 basis points. So again, the fact that Q4 saw low NPL resolutions, we're seeing it come back. Everyone is seeing NPL dollars returning. On top of that, we have a weighted average coupon on the portfolio that we expect to maintain. So we do expect that NIM to stabilize moving forward.

Chris Farrar, President and CEO

On Page 12, the loan investment portfolio performance. In the second quarter of last year, we pretty much returned to our normal range of non-performing. Our sweet spot is 7% to 9%. That range doesn't make us nervous at all. Overall, over 95% of our non-performing loans resolve in a gain position for us, we make money on those. You can see since June, we have been around 8%, 7.4%, 8.3%; we are kind of hovering in there. Keep in mind that the 8.3% increase in Q4 reflects some lower resolutions in that quarter. We also put the brakes on production, so there wasn’t a normal new production inflow to help offset. We expect that number to stabilize in the 8% to 7% range going forward. Slide 13, the CECL loan loss reserve. The CECL loan loss reserve at the end of the year was $4.9 million compared to $5.3 million at the end of Q3, still at 15 basis points. We feel that's an accurate reserve rate on HFI, UPB. Remember, on the loan loss reserve, we had a slight tick down because we had less loans and a smaller portfolio at the end of the year that were subject to CECL, due to the fair value option loans put in place in Q4. That explained the decrease, but we are still at the same rate of 15 basis points. The real positive takeaway is that there were no charge offs for Q4. Looking at total charge-offs for the year were only $520,000 on a $3 billion portfolio. On Slide 14, our funding and liquidity is still very durable. We have plenty of warehouse capacity available. We did six securitizations in 2022, as Chris alluded to. We have a substantial amount of reserves and warehouse capacity, ending the year with total liquidity of about $64 million including cash, cash equivalents as well as unfinanced loans, so we have about $64 million in available liquidity. Our maximum capacity on the warehouse line is $810 million. At the end of the year, we had $500 million available capacity. Thus, we have plenty of capacity in terms of cash, liquidity, and warehouse capacity to grow the business and increase originations as Chris mentioned moving out of Q1 into the rest of 2023. Chris, with that, I'll turn it over to you for kind of our key business drivers and outlook. Great. Thank you, Mark. Just wrapping up, where we are headed and how we see things in terms of the market, there are certainly a lot of cross currents going on. We are seeing a softening in the real estate markets in terms of price and volume; however, it has been modest so far. We have been able to, as I said, execute on our REOs comfortably, and we see markets generally holding up fairly well. In terms of credit, again, the same story, a lot of cross-currents there. We have tightened our credit box recently and fortunately, with our business model and our portfolio earnings, we can manage volumes as we see fit and modulate risk appropriately. On the capital front sector, we expect to do a securitization next quarter. Again, we're continuing to see good trends there and expect that to go well. We are also looking for other opportunities to continue to grow our capital base accretively and in a way that is helpful to all shareholders. Lastly, on the earnings front, as Mark expressed, we do think yields will improve going forward, and so will our volumes as we start to step on the gas pedal here. We are still open and looking for strategic opportunities and haven't found anything compelling yet, but if we do, we'll certainly execute on that. So that wraps up our presentation, and I think we should open it up for any questions.

Operator, Operator

Our first question today comes from Stephen Laws at Raymond James.

Stephen Laws, Analyst

Chris, let's begin with volumes. You noted in your prepared remarks that the first quarter will be the lowest point. What are your expectations for volumes ramping back up on a monthly or quarterly basis in the second half of the year, and where do you anticipate them leveling off?

Chris Farrar, President and CEO

Yes. Hi, Stephen. Good question. I think we're projecting somewhere in the 200 million to 250 million range, which would probably be what we expect on a quarterly basis. I think for the year, we believe it will be in excess of 900 million. So Q1 will be the low point, but it will start to grow from there.

Stephen Laws, Analyst

Thanks for that, Chris. Mark, I wanted to touch base on the NPL resolutions year-to-date. You mentioned more versus Q4. Is that more in volume or more in the margin on the recovery, or is it more referring to both?

Mark Szczepaniak, CFO

Hi, Stephen, how are you doing? In terms of the first two months of this year, we've seen more actual gain coming through than we did in all of Q4. So that's the actual resolution gain dollars.

Stephen Laws, Analyst

Thanks for that clarification. I wanted to make sure I was clear on that. On the WAC, there was a big increase on your 4Q production, 9.7, I believe. Here we are in mid-March. Can you talk about where that is today? Have you increased it further since year-end, or is it kind of settled in at that level?

Chris Farrar, President and CEO

So we've continued to follow the bond market and our benchmarks concerning current production. Right now, we're just a tad under 11%. So we've raised the coupon significantly to align with the market. We feel like we're at the right level from a margin and NIM perspective to execute on the securitization.

Stephen Laws, Analyst

And last one, if you don't mind. I know NPLs picked up a touch. I needed to normalize that; so I think due to pulling back a little in Q4, that probably takes out about 150 million or 200 million of performing loans from the denominator. So maybe the number over-reflects the uptick there. But I noticed in the back of the supplement, your 60-day to 90-day, I think went from about 120 million to 185 million. Can you just touch on what you're seeing inside the portfolio year-to-date from a credit migration standpoint given the backdrop? Some additional color there would be fantastic, and I appreciate your comments this afternoon.

Chris Farrar, President and CEO

Yes, sure. Absolutely. We definitely saw the uptick there. Our read is that clearly some borrowers are feeling stressed and are seeing the impacts of the Fed's actions. That shows up in delinquency. There tends to be a lot of noise in that 30-day bucket; we don't really sweat that one too much, as people bounce around quite a bit there. But when you get into 60 and 90 days, that's when you're going to need to get involved. We've seen the non-performing loans that our special asset team works on increasing in the fourth quarter. Clearly, borrowers are feeling the pressure from the Fed's actions. If we handle it properly and get the value right, we’re confident we’ll be fine. In a paradoxical way, those delinquencies can actually end up being profitable for us unless we misjudged the value. So I would say we're monitoring the situation closely, but we aren't overly concerned or seeing anything that raises red flags at this point.

Operator, Operator

Our next question comes from Steve Delaney from JMP Securities.

Steve Delaney, Analyst

To start, I’d like to applaud your FVO decision. I think probably a lot of the people on this call know that both Redwood Trust and MSA use the fair value method on their securitized portfolios. I really do think it will help you get across your book value and your economic value, making it definitely more transparent. So congratulations. I think that's good progress, and will be well received. Well, back to the current quarter, 4Q. So got a little fuzzy. Understood. Okay, core was only down $0.02 and I understand the resolution impacts that accounted for $0.10. I’m getting fuzzy in my old brain; what was the key factor or factors offsetting the lower resolution income that netted out to an $0.08 improvement somewhere? I know you had some higher coupons, but could you comment on that and help connect the dots for me?

Mark Szczepaniak, CFO

Sure, Steve. One of the things you are seeing that offsets the lower resolutions and the earnings per share, is again the FVO election for Q4. With the fair value election, instead of recognizing the embedded value of our loan portfolio slowly over time, you bring that value in on day one when you fund the loans. We likely brought in somewhere in the neighborhood of maybe $5 million to $6 million on a pretax basis in the quarter based on the $270 million worth of UPB that we funded and applied FVO to in Q4.

Steve Delaney, Analyst

Got it. Yes, I kind of overlooked that. Despite my compliment on the FVO option, I didn’t apply it to Q4. So, regarding the market today, we have your WACs and everything related to the fourth quarter originations. Chris, could you comment on your loan products today? I think I know what you are focused on. What products are you specifically targeting? And what kind of coupon and fees can you achieve in today's market on the loan side?

Chris Farrar, President and CEO

Sure. Yes. Throughout the year, it was certainly an adjustment as borrowers had to react to ever-increasing rates. There is kind of a give and take occurring. People would walk away and come back later and say, oh my god, it's 100 basis points higher, okay I'll take it. So there is definitely an adjustment period happening there. We stay focused on the core areas where we've always excelled. We see good demand in the investor one to four; we also see strong demand in short-term loans, like fix and flip, bridge lending, and that area remains robust. We have been very selective with office space, as we're not bullish on that segment. Other than that change, I would say we see strong demand across those products, with rates ranging from the low side of 10% to 11.5%, depending on the property type.

Steve Delaney, Analyst

And that's on the coupon, right?

Chris Farrar, President and CEO

Yes, that's the coupon.

Steve Delaney, Analyst

So fees are additional, right?

Chris Farrar, President and CEO

That's right. Fees are additional.

Steve Delaney, Analyst

Well, thank you for the clarification. I do want to point out that while office space is a concern, dental and medical offices are still showing strength. So if you’re focusing on those, you're in a good position.

Chris Farrar, President and CEO

I think that's a fair point. Additionally, neighborhood-serving office buildings have also been performing well, so we are mainly avoiding Class A downtown centers. Many of those community-serving small office spaces have been holding up well.

Operator, Operator

Our next question comes from Arren Cyganovich from Citi. Please go ahead with your question.

Arren Cyganovich, Analyst

Thanks. I was wondering if you could talk about what the cost of the January securitization was?

Chris Farrar, President and CEO

Sure. Hi, Arren. That was at a very low 7% coupon.

Arren Cyganovich, Analyst

Got it. And then maybe you could help walk through an example of the FVO accounting, if you were to say or they originated a $100,000 loan. I know you typically do closer to $400,000 but just for my simplistic brain using $100,000 for illustration.

Chris Farrar, President and CEO

Yes, sure. Just the way I think about it is we put a $100,000 loan on the books for 3 points. That would mean about a $3,000 unrealized gain in your example. We would also book some additional income that we collect from the origination process. We provide a breakdown of those costs to demonstrate how much that is, but there’s value there for sure. On the expense side, instead of deferring some of our overhead and costs to originate that loan as required under the GAAP method, we would simply expense that entire dollar amount. I can tell you that for $270 million in total, we booked about $6 million worth of income.

Arren Cyganovich, Analyst

Pre-tax basis? Yes.

Chris Farrar, President and CEO

Yes, pre-tax, right.

Arren Cyganovich, Analyst

And in terms of the decision to mark the loans at a premium including the gain upfront, how do you determine that 3% in your example? Would that fluctuate over time depending on market conditions? Regarding the existing book, would you then be marking that down over time if rates or conditions changed? What are the key dynamics that impact the fair value marks on the existing portfolio?

Chris Farrar, President and CEO

Yes, absolutely. Our capital markets team uses a discounted cash flow model to project what a willing buyer would pay for those assets. That’s how we start with our baseline and derive the fair value of an asset. Those assets will absolutely fluctuate over time, depending on the discount rate, interest rates, prepay speeds, and various factors affecting the market. It is crucial to point out that we will mark the corresponding debt associated with those assets as well, so we believe there will be limited volatility going forward since we expect movements on both the asset and liability sides to align with each other. Recently, we sold $20 million worth of loans in the first quarter just to validate our estimates. They sold right around that price, so we believe we have adequately determined fair market value. We might not sell assets every quarter going forward, but we remain closely aligned with capital markets and understand market trends. We will be careful to mark those assets as fairly and conservatively as possible. That valuation is based on estimations of what buyers are willing to pay, not necessarily what we would sell them for. Ultimately, we expect to recognize more income than those estimation levels over time through NIM rather than through fair value marks.

Arren Cyganovich, Analyst

Just last one for me; when you have loans that go into nonperforming status, would you then mark those lower by some certain level? Since you've had the benefit of resolving nonperforming loans at or above 100%, if there were a situation where house prices or commercial properties declined and you begin to experience resolutions below 100%, would that then compel you to remark the entire portfolio, or would it be portfolio-specific?

Chris Farrar, President and CEO

Right. Yes, so on the NPLs, we will indeed mark those down as they transition to delinquency. The GAAP standard states we evaluate what a willing buyer would pay. So, yes, we will definitely mark them down. In terms of the overall strategy, we still implement the policy where, when a loan goes nonperforming, we will start looking at the underlying collateral's value.

Mark Szczepaniak, CFO

Arren, this is Mark. As I said, when dealing with NPL loans, we will continue our established policy where we consider the value of the underlying collateral. There is a distinction between valuing a loan, which is a financial instrument with future cash flows, and a real property valuation, which has its dynamics. Our approach will still involve assessing the collateral's value when the loan shifts to nonperforming status.

Operator, Operator

Ladies and gentlemen, at this time, I'm showing no additional questions. I'd like to turn the floor back over to the management team for any closing remarks.

Chris Farrar, President and CEO

Thanks, everybody for joining the call. We look forward to getting back together soon. I appreciate everybody taking the time to hear our story. Take care.

Mark Szczepaniak, CFO

Thanks, everybody.

Operator, Operator

And ladies and gentlemen, with that, we will conclude today's conference call and presentation. We thank you for joining. You may now disconnect your lines.