Earnings Call Transcript - VEL Q3 2023

Operator, Operator

Good day and welcome to the Velocity Financial Q3 2023 Conference Call. All participants will be in a listen-only mode. Please note, this event is being recorded. I would now like to turn the conference over to Mr. Chris Oltmann. Please go ahead.

Chris Oltmann, Moderator

Thanks, Rachel. Hello everyone and thank you for joining us today for the discussion of Velocity's third quarter 2023 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 third quarter 2023 results and the press release and accompanying presentation are available on our Investor Relations website. I want 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 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. And with that, I will now turn the call over to Chris Farrar.

Chris Farrar, CEO

Thank you, Chris, and welcome everyone to our third quarter earnings call. Earlier today, we released our results from a strong quarter as we continue to effectively implement our growth strategy. Our core earnings increased by 29% compared to the same quarter last year, which is impressive considering the various challenges we encountered. Despite the uncertainties present, we anticipate continued market share gains and portfolio expansion. A key trend we're observing is the tightening of credit availability from traditional banks. We are seeing more high-quality borrowers who have been declined by conventional lenders turning to us. We expect this shift toward alternative credit sources to persist, and our team is well-prepared to take advantage of this situation as we have spent the past 19 years developing our platform to excel in these circumstances. Our pipeline remains strong and expanding, enabling us to be selective in extending credit and to increase our coupon rates. In terms of our portfolio, we experienced minimal charge-offs this quarter, thanks to our special servicing team. The real estate markets, particularly single-family rentals and small-cap commercial real estate, are maintaining healthy valuations and outperforming in their respective segments. We believe our strategy of focusing on small properties in neighborhoods that provide essential services will continue to yield positive results. We have been active in the capital markets as well, having completed two securitizations in the third quarter, and we recently priced our final deal of the year earlier this week. One of these securitizations marks our first transaction backed by short-term loans with a revolving structure, allowing us to replace loans that are paid off with similarly sourced new loans. During this quarter, we also consolidated our older sequential pay deals. Our strong track record in credit performance gives us the ability to access capital markets efficiently and gain support from a wide array of fixed-income investors. Another notable policy change made during the quarter was to hedge our future debt issuances backed by newly originated loans. Our timing was advantageous as we managed to offset most of the fluctuations in the underlying treasury base rates before pricing our deal this week. These hedges are cash flow hedges that will incrementally affect our income statement over time, supporting our strategy to achieve a stable and predictable net interest margin. We will continue to hedge future debt issuances prior to securitizing as a prudent risk management tactic. Despite uncertainties related to interest rates, the economy, and other unpredictable events, we are committed to growth and will seize opportunities as they arise. Our strategy is to remain flexible and utilize our extensive experience to navigate challenges. I want to commend all team members for another successful quarter. Our people are our most valuable asset, and we will persist in our hard work for all of our shareholders. That wraps up my prepared remarks, and I will now refer to the earnings materials, starting on Page 3. As previously mentioned, we achieved substantial growth in core net income, showing a stable net interest margin that increased by 10 basis points from the previous quarter. We continue to secure new production coupons that are attractive relative to our historical spreads. Additionally, I discussed our hedging strategy, which did not impact earnings for Q3; its effects will manifest in our future transactions over time as we issue them. October set a record for production, and throughout the year, we have seen growth in volumes even while increasing coupons, which is encouraging. We maintained flat non-performing loans compared to the previous quarter and continue to see positive advancements as we resolve assets, thanks to our team's excellent performance. Regarding financing and capital, we are excited about the two securitizations that will facilitate terming out loans and create a revolving structure, providing us additional capacity for future growth. In terms of warehouse and liquidity, we are well-positioned to support upcoming growth. Moving to Page 4, our book value per share saw a significant increase of $0.43 quarter-over-quarter, attributed to portfolio earnings and other income generated during the quarter. Turning to Page 5, we have included a slide that illustrates the significant embedded equity within our platform. One noticeable update since the prior quarter is that the embedded gain in the securitized portfolio has grown considerably, thanks to slower prepayment assumptions that we adopted during the quarter. This adjustment will extend the portfolio and potentially increase future earnings, reflecting the economic value of the equity we have cultivated in our platform. With that, I will hand it over to Mark to continue the presentation.

Mark Szczepaniak, CFO

Thanks, Chris. Hi everyone. Thanks for joining our third quarter earnings call. On Page 6, loan production continues to improve during the year even with the current high-interest rate environment. As you can see, Q3 production was almost $291 million in UPB, which is a 12.3% increase over Q2 and almost a 34% increase from our Q1 production. The strong production growth during 2023 has occurred with the weighted average coupons on new originations for all three quarters remaining constant at about 11%, while the strong 2023 production growth at the higher weighted average coupons (WACs) continues to demonstrate borrower demand for our products. As a result of the strong growth in production, Page 7 shows a similar growth in our overall loan portfolio. Our total loan portfolio as of September 30th was almost $3.9 billion, which is a 4.2% increase from Q2, almost a 13% increase on a year-over-year basis. The weighted average coupon on our total portfolio as of September 30th was 8.63%, that's 23 basis points higher than at the end of Q2 and 92 basis points higher year-over-year compared to the third quarter of last year. While our loan portfolio is growing, our loan-to-value (LTV) ratio remains consistent on the overall portfolio at 68%, and for 2023 production, the LTV has actually averaged a little lower at 66%. On Page 8, our third quarter NIM increased 10 basis points over Q2. Our portfolio yield increased quarter-over-quarter by 14 basis points, while our cost of funds only increased by about 5%. So, not only are we seeing growth in production, but we're also seeing an increase in our NIM. On Page 9, our non-performing loan rate for Q3 was flat at 10% compared to Q2. The ongoing strong collection efforts by our special servicing department, as Chris mentioned, have continued to result in resolutions of our NPL loans at favorable gains. If you look at Page 10, it highlights the continued success of our NPL resolution efforts. In Q3, we resolved $65.7 million worth of UPB of NPL loans for a net gain of $1.2 million. Although not on this slide, if you take a look at all of 2023, through September 30th, we resolved over $154 million of UPB of NPL loans for a total gain of $4 million. Page 11 presents our CECL loan loss reserve and loan charge-offs. The CECL reserves on September 30th was $4.7 million or 16 basis points of our outstanding loans held for investment and amortized cost balance. Our CECL reserve has been very consistent at 15 to 16 basis points over the last five to six quarters. Keep in mind, the CECL loan loss reserve does not include our loans being carried at fair value. That's the loans at amortized costs. Q3 charge-offs are also shown in the right corner on Page 11. For the third quarter, they were only $95,000, and our charge-offs have continued to be minimal over the last five to six quarters. Page 12 shows our durable funding and liquidity position at the end of Q3. Total liquidity as of September 30th was $60.3 million, comprised of about $29 million in cash and cash equivalents and another $31 million in available liquidity on our unfinanced collateral. As Chris mentioned, we did issue two securitizations in Q3. In July, we issued the 2023 RTL1 security with about $81.6 million of securities being issued. Chris mentioned this is a noteworthy security for us because it was the first security ever issued by Velocity that's collateralized by our short-term loan product. It is a fixed-rate security with the reinvestment period, where our newly originated short-term loans can be added to the security as existing loans pay off. This new type of financing for us demonstrates further diversification in financing options for Velocity and is another type of cost-effective non-mark-to-market financing. In August of the quarter, we issued the 2023-3 security, collateralized by our long-term loan product, with almost $235 million in securities issued. And as Chris mentioned, in tandem with this long-term security, we collapsed one of our older securities, 2016-1, that was an older, higher-cost debt. The 2016-1 security is one of the older sequential waterfall securities, where the higher-rated low-cost tranches paid off first. As those pay down, they became more expensive. Remember, in 2017, we started doing the pro-rata, where the tranches all pay off kind of evenly. So, it's nice to have collapsed one of those securities that got more expensive over time and take that freed-up loan collateral and bring it into the 2023-3 securitization at a lower cost. Finally, available warehouse line capacity as of September 30th was almost $595 million on total maximum line capacity of $810 million. So, with that, I'll turn it back over to Chris to go over the economic outlook.

Chris Farrar, CEO

Thanks, Mark. On Page 13, just a high-level overview of where we're headed. As I mentioned at the beginning, the market continues to be strong in terms of valuation and when we price REOs and assets, if they're priced right, they move quickly, and we expect to continue to see positive gains from the portfolio there. The economic outlook remains murky with lots of differing predictions and expectations, but we feel like we're well positioned regardless of which way things break based on our prior years' experience and our low LTVs. I did mention that we're starting to see prepay speeds slow, which could potentially lead to an uptick in our future income and assist us in expanding the portfolio on a larger scale. In terms of capital, I mentioned that we already priced the last deal of the year and believe we have good access to capital markets, expecting that to continue. Lastly, from an earnings perspective, I really think that this theme of tight credit is going to help us and be a tailwind as we grow going forward. So that concludes our prepared presentation, and we'd now like to open it up for questions, if there are any.

Operator, Operator

Thank you. We'll now begin the question-and-answer session. Your first question comes from Stephen Laws with Raymond James. Please go ahead.

Stephen Laws, Analyst

Hi, good afternoon. Another nice quarter, so congratulations on that. Chris, I wanted to get an idea about your pipeline. October has been the strongest month in the year, and Q3 volumes have also been the highest in about four quarters. Can you discuss the production outlook? Do you see the pace in October as the new normal? How do you think that will play out? Also, is there any seasonality in the production numbers as we approach year-end?

Chris Farrar, CEO

Yes, sure. I think the fourth quarter will be our strongest quarter of the year. November is always a little light due to the Thanksgiving holidays. However, December is always a good month for us as people try to close everything by the end of the year. So, I expect it to be our strongest quarter. Moving forward, next year, I believe we're on pace for significantly higher volumes than what we did this year. The first quarter typically starts off a little slow, but builds through the months. So, we think the run rate in October is probably a touch high if you wanted to use that for a forward run rate for every month, but not too far away from that.

Stephen Laws, Analyst

Great to see strong volumes look like they'll continue. Can you talk about terms on these new originations? I don't think you're pushing coupon as much as you could, given less competition. But can you talk about some other places where you focus to really high-quality production on the underwriting side?

Chris Farrar, CEO

Yes, sure. One of the things we're seeing is that borrowers are approaching us with larger loan sizes. We're seeing applicants with $3 million to $5 million loans who would have historically gone to banks, and now we’re getting a chance to serve them. These borrowers tend to have higher credit scores and somewhat stronger balance sheets. We've been able to capitalize on that at the end of the third and start of the fourth quarter. We anticipate that trend will continue moving forward.

Stephen Laws, Analyst

Great. Mark, you touched on the new securitization with the replenishment feature, the reinvestment period, which sounds fantastic. Congrats on completing the last sequential pay deal. Can we discuss the reinvestment period, the benefits with new production? What's the expected life on loans? How does this impact deal expenses when we amortize over a longer timeframe, given a longer expected life? Thank you.

Mark Szczepaniak, CFO

Yes. On the short-term loans, those loans generally have terms ranging from 18 to 24 months, with an average life typically between 12 to 15 months. The reinvestment period is 18 months, allowing us to replace paid-off loans with new loans as they originate. This mechanism significantly reduces the need for issuing new securities and incurring associated costs again just to add new loans. Additionally, regarding deal costs, all loans being issued now are subject to fair value accounting, hence all origination costs and any associated deal costs are recognized upfront.

Stephen Laws, Analyst

Great, appreciate you highlighting that. Thank you for your comments this afternoon.

Chris Farrar, CEO

Thanks, Stephen.

Operator, Operator

The next question comes from Sarah Barcomb with BTIG. Please go ahead.

Sarah Barcomb, Analyst

Hey everyone. Congrats on the quarter and thanks for taking the question. You had another quarter of strong gains on those NPL resolutions. I was hoping you could give a little more context on your outlook for NPLs and resolutions on the NPLs. If we assume that we could see another rate hike and we remain in a higher-for-longer QT cycle, how do you see that evolving?

Chris Farrar, CEO

Yes, sure. Sarah, thanks for joining. We feel very good about the outlook for NPL resolutions. There's a lot of capital on the sidelines for these assets. When we sell them at foreclosure steps or market them, we see good activity with a lot of cash buyers. Our view is that the rate hikes won't have a huge impact on the value of the recoveries we’re getting, and we expect that trend to continue. However, if the economy starts to tank and unemployment rises significantly, that could change my outlook. As long as we continue to see strong economic activity, we believe we will have favorable outcomes there.

Sarah Barcomb, Analyst

Great, okay. I was hoping you could talk a little more about the value and earnings outlook for fee-based income coming out of the Century portfolio and the value of the HUD license. Just highlight that for investors.

Chris Farrar, CEO

Sure. We're very excited about that segment. We spent this year building out the team and developing expertise, and our pipeline is very robust now. We didn't do a lot of loans this year, but we anticipate that next year will be quite strong, resulting in significant gain-on-sale income, which we find favorable as it has high returns on equity (ROE). We're very optimistic about the opportunities next year as we leverage this pipeline.

Sarah Barcomb, Analyst

Great. Thanks so much for the answers and congrats again.

Chris Farrar, CEO

Thanks, Sarah. Appreciate it.

Operator, Operator

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

Steve Delaney, Analyst

Thanks and good afternoon, everyone. Chris, Mark, and Chris. I'm curious about bridge lending, and it's great that you have that new product working for you. Do you detect any rate play strategy from borrowers who have projects underway? Are they trying to buy time to refinance into another floater hoping the long end rates come down in the next couple of years before locking in for the long haul? Curious about your thoughts.

Chris Farrar, CEO

Yes, sure. It's a good question. We see a lot of the former that you mentioned. However, we typically pass on those cases because they seem to suggest that a borrower is distressed, which isn't a good risk for us. The borrowers we successfully work with are seasoned flippers who understand their markets. There's still a significant amount of aged housing needing refurbishment, and we feel confident backing those borrowers.

Steve Delaney, Analyst

Okay. It’s nice to hear that activity continues to be strong for you. I noticed on Page 11, charge-offs were down significantly. Could you provide some insight into why that might be the case when comparing Q3 to the first two quarters of the year?

Chris Farrar, CEO

Yes. Mark, do you want to handle that one?

Mark Szczepaniak, CFO

Yes. If you recall, during our second quarter earnings call, we had $716,000 in charge-offs, including $393,000 that should have been lower due to a borrower payment we received after the quarter closed. Since we did not get that information in time, we recorded it as a charge-off, which should have been recognized in Q4. So, normalizing for that, there wasn’t a significant trend with the charge-offs decreasing as it appears.

Steve Delaney, Analyst

Got it. Thanks for clarifying that anomaly. That makes sense. I would have been surprised if it was decreasing that much anyway. Lastly, Chris, regarding NPLs year-over-year, what do you see as the main cause or causes? The cost of carry is more expensive, definitely, to be a borrower these days, but are there other contributing factors affecting the terminal fair market value of properties or executions from borrowers?

Chris Farrar, CEO

Yes. Good question, Steve. There isn't a single dynamic causing the uptick in NPLs. I agree with you that cost burdens on borrowers are substantial. We've helped mitigate that somewhat due to our fixed-rate loans. However, when someone gets behind and starts to dig a hole, it can be challenging to recover. Anecdotally, I believe we're seeing a large number of speculators getting flushed out, particularly with 1-to-4 family homes. Many borrowers who thought flipping homes was easy are discovering the challenges it entails. In the small commercial asset sector, delinquency rates are lower, and they're holding up well due to their neighborhood-serving characteristics that remain in high demand.

Steve Delaney, Analyst

That makes sense. Thank you for your insights, and congratulations on another strong quarter in an extremely challenging market.

Chris Farrar, CEO

Thanks, Steve. I appreciate it.

Mark Szczepaniak, CFO

Thanks, Steve. Appreciate it.

Operator, Operator

This concludes our question-and-answer session. I'll now hand back for any closing remarks.

Chris Farrar, CEO

Nothing further. Thank you all for joining, and we'll talk to you next quarter.

Mark Szczepaniak, CFO

Thank you, everybody. Appreciate your time.

Operator, Operator

The conference call is now concluded. Thank you for attending. You may now disconnect.