Earnings Call Transcript - VEL Q1 2023

Operator, Operator

Good afternoon and welcome to the Velocity Financial First Quarter 2023 Earnings Conference Call. Please note this event is being recorded. I’d now like to turn the conference over to Chris Oltmann, Treasurer and Director of Investor Relations. Please go ahead.

Chris Oltmann, Treasurer and Director of Investor Relations

Thanks, everyone, and thank you for joining us today for the discussion of Velocity's first 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 first quarter 2023 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. 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, President and CEO

Thanks, Chris. I would like to welcome everyone to our first quarter earnings call. Earlier today, as Chris mentioned, we reported another strong quarter as we continue to grow in a disciplined and profitable way. Our successful matched funding strategy of locking in fixed rate spreads has held up very well considering the rapid rise in rates. As you're all keenly aware, there's been a tremendous amount of volatility in the regional banks, many of whom were essentially borrowing short and lending long. We continue to see these competitors tighten credit or step away entirely from the market, which has led to an increase in lending opportunities for us. We believe the same will continue to play out for the remainder of the year, and we're seeing better borrowers and higher quality assets as a result of this banking stress. In terms of our portfolio, we continue to see expected levels of performance and first quarter resolutions rebounded to a more typical rate, which contributed to a 49 basis point portfolio yield increase from Q4 2022. Perhaps more importantly, we've constructed our portfolio in such a way as to avoid the most problematic commercial real estate assets. Over 15% of our loans are secured by single-family rental properties, and 75% of the portfolio has a residential component. On the small commercial segment of our business, the properties backing our loans tend to be small neighborhood-serving assets that are usually in very high demand. We do not have exposure to large office buildings where other lenders are starting to see significant realized losses. As we look forward, we believe we're well positioned to succeed in a variety of potential outcomes as we experience a slowing economy. With respect to growth, we were very conservative with new originations in the first part of the year, but have recently started to increase our volumes. Although real estate market transactions have slowed, we continue to see plenty of borrower demand. As an example, we received over $3 billion in new loan requests in the first quarter of 2023 and originated just over $200 million in new loans. This healthy demand, disciplined credit process, and our stable in-place portfolio income allows us to be very selective in adding new assets. On the capital market side of our business, we're pleased to see continued support for our platform as we just priced our second regular way deal of the year with strong investor demand. In April, we completed our most significant transaction of the year by resecuritizing a portion of our retained bonds at attractive rates on a non-mark-to-market basis. This new structure frees up capital to fuel further growth and provides us with a more stable alternative to short-term repo financing. Looking forward, we expect continued earnings and portfolio growth, positive asset resolutions, and another successful year. Very proud of how well our team has prepared our company to navigate these shifting times and want to thank all our stakeholders for their continued support. That concludes my remarks, and I'll pop over to the earnings presentation on Page 3. From an earnings perspective, a very clean, simple, straightforward quarter, nice core earnings slightly below where they were the prior quarter from last year, and I think that speaks to the strength of our business model to be able to absorb all the change that we've seen in the last 12 months and almost do the same type of number. In terms of recovery rates, again, another strong quarter of positive earnings from NPL recoveries. So we were very pleased with those results. And as I mentioned, we're continuing to see our yield increases not only from higher whacks on new originations, but that bounce back in resolutions on NPLs. In terms of the portfolio, things are pretty healthy; they are performing as expected. We did reduce volumes intentionally. We could have done more production, but we really wanted to see how capital markets were going to behave and the rest of the markets in general. And as I said, because we're getting good demand on the securitization side, we're going to increase that production going forward. In terms of financing and capital, I did mention that the second securitization that we just priced went off very well. And as I mentioned, the transaction was a really important one for us, generating just under $65 million of new capital that we put into the business, paid off $15 million of repo that was against those bonds, and opened up what we think will be a new avenue as we continue to retain assets in the future. We certainly have the ability to remake those as well. So, we're very pleased with the support that we got in the capital markets there. On Page 4, looking at book value, another strong quarter of book value growth as we executed on our strategy to retain earnings and grow book value; you can see we did well there. And on a core basis, there's a little bit of an add-back here from some of the equity components. On Page 5, even though we've got healthy book value growth and on Slide 4 we showed you GAAP book value, we think the economic book value is much higher. We believe the embedded gain in our portfolio is not accurately reflected in GAAP book value, and that economic value is still quite healthy and in excess of where we report GAAP book value. So, with those comments, I'll turn it over to Mark on Slide 6 to take us forward.

Mark Szczepaniak, CFO

Thanks, Chris. And hi, everybody. Slide 6 looks at our loan production. As we had mentioned, we have strategically decided to pull back a little bit on loan production towards the end of Q4 and also at the beginning of the first quarter of this year as a result of some of the volatility that we saw in the markets at that time. We've since then begun to pick up our originations, and we will continue to do that going forward this year. For Q1, we had low production, with $217 million in UPV. I think a key takeaway there is that $217 million in new originations, the weighted average coupon in most new originations was 11.1%. So we had continuously during the second half of last year and as the first quarter this year continued raising our note rates on our loans in response to all the Fed rates last year and the recent ones this year. Thus, we’ve continued to raise the interest rates on the loans, as Chris mentioned, and still have very good strong demand and application pipeline activity from our borrowers. And again, the 11% weighted average whack for first quarter originations this year shows a significant improvement. If you compare that to the first quarter of last year, those originations had a whack of 6.3%, which gives you an idea of the strong increase in the coupon that we've put out on our portfolio. On Page 7, the overall portfolio at the end of Q1 ended up at about $3.6 billion in UPV, representing a 25% year-over-year growth from the end of Q1 of 2022. That growth was driven pretty evenly by strong demand for one to four-family and multifamily properties. The weighted average coupon of the entire portfolio at the end of Q1 was 8.15% compared to 7.95% at the end of the year and 7.50% at the end of the first quarter last year. Therefore, there was a year-over-year total portfolio weighted average coupon growth of about 65 basis points, reflecting the strong increases we implemented during the second half of 2022 and the first quarter of 2023 on our note rates. We mentioned last quarter that beginning October 1 of 2022, we elected to use the fair value option accounting for our new loan originations, meaning we put those originations on our books now at fair value. Our Q4 originations went out at fair value, as well as our Q1 2023 originations. So at the end of Q1, we now have about $437 million in UPV of loans in our health investment portfolio that are loans recorded at fair value. On Page 8, our first quarter non-performing loan asset resolution activity was strong. Again, we mentioned during Q4 the NPL resolution activity was down a little, not the rate of resolution; we were still at about a 3% gain, but just the total UPV of resolutions was down. We thought we would see that pick up again in Q1, and we have. We take a look at our first quarter of 2023 NPL resolutions where we achieved almost $39 million in NPL resolutions for a $1.3 million gain or a 3.5% gain. Comparing this to Q4 where we resolved $25 million in NPLs, we can see that the first quarter of this year returned to our historical trends in terms of UPV resolved and the types of gains we're used to seeing. This is very good news. As for our net interest margin on Page 9, as Chris mentioned, our portfolio yield increased by 49 basis points from the end of the year to the end of the first quarter; the 41 basis point increase reflects the increase in note rates as well as those NPL resolution gains coming in stronger in Q1, contributing to the overall yield. The cost of funds yield increased by 10 basis points, but we see the portfolio yield well outpacing the cost of funds, leading to a widening out of that margin. We ended the quarter with a yield net interest margin of 3.23%. On Page 10, for our investment portfolio performance, we ended Q1 with our non-performing rate at 8.7%, which is consistent with the year-end result of 8.3%, and down a full 100 basis points from where it was at the end of Q1 2022, which was at 9.8%. Again, we're seeing that non-performing loan rates stay fairly consistent, and as the previous slide showed, we are still on our historical average of three points or more of gain on those NPL resolutions. Our CECL loan loss reserve for the quarter of $5 million is basically flat to where it was at the end of the year for 2022 at $4.9 million, holding steady at 16 basis points. We have been maintaining this level constant at 15-16 basis points for the past five to six quarters, and we don't see that changing too much right now. Regarding the CECL reserve, keep in mind that this debt is on the portfolio that is at amortized cost; therefore, the newer loans that we put on in Q4 last year and in Q1 this year, which are the fair value option loans, are not subject to CECL losses because they're always carried at fair value. The reserved amount is for the older portfolio on an amortized cost basis. As we continue to put on more and more loans at fair value and the amortized cost loans pay down, we would expect to see that CECL reserve in terms of dollars hopefully start to come down as that portfolio gets smaller. In terms of the charge-offs in the bottom right of the page on Section Page 11, we had $44 thousand in charge-offs in Q1 compared to zero in Q2. Charge-offs have remained very low, averaging about 29 basis points over the last five quarters. It’s important to note that charge-offs occur when a loan is converted to an REO, at which point we charge off the loan. When we have that REO, we usually fix and work on the property before selling it for resolution. In accounting, we show that as a gain on REO, which is separately reflected in the resolution table. On Page 12, regarding our durable funding and liquidity strategy, our cash reserves at the end of the first quarter and financing collateral are very strong at $45 million, with $39 million of that being actual cash and cash equivalents, and the remaining $6 million being on finance collateral. Our total maximum capacity on our warehouse lines is $832 million, and at the end of Q1, we still had about $533 million of available capacity, providing ample liquidity. Chris already mentioned that we completed our first securitization of 2023 in January and observed improved execution compared to the one we did in Q4 in October, showing that the markets are recovering. The indicative pricing we see now for securitization indicates even better pricing. As Chris mentioned, we completed the REMIC where we received about $65 million in financing, taking retained certificates from older securitizations that we had held back from issuance. We retained them at the time, and we re-leveraged those in the new securities, resulting in almost $65 million in financing. We could have put those into a repo at any time, but as Chris mentioned, that would be subject to margin calls—this new financing is a non-mark-to-market facility using older retained tranches. I think this shows the adaptability we have in a non-mark-to-market world. With that, Chris, I'll turn it back to you to give an outlook on Velocity's 2023 key business drivers.

Chris Farrar, President and CEO

Great, thank you, Mark. In terms of the market, we're certainly seeing the pressures from higher rates and lower transactions, as I mentioned, but we are still seeing functioning markets, and we're able to liquidate assets when we end up with REOs, so that seems stable. Obviously, there's a lot of cross currents in the market, and we'll see how things unfold. From a credit perspective, we're being more cautious and selective with our lending, which I believe is paying off. We'll continue to monitor that on a market-by-market basis, as some markets are seeing prices come down while others are still gaining. Regarding our capital, I mentioned the successful transactions that create strong liquidity for us moving forward. In terms of earnings, we're going to stick to our core competencies and originate assets with good healthy spreads, which will contribute to earnings growth in the future. That wraps up our prepared remarks and presentation. We can open it up for questions.

Operator, Operator

We will now begin the question and answer session. The first question comes from Steve Delaney from JMP Securities. Please go ahead.

Stephen Laws, Analyst

Hi, good afternoon, Chris and Mark. First, let's start with very solid numbers; I really want to applaud you guys. The UPV recoveries or non-accrual rates, things are really holding in there in a volatile environment where we're not seeing many do that about their portfolios. Looking at that, and the action you're going to take to free up the liquidity with a REMIC, how do you think about opportunities today? I know the whack was 11.1%—can that be increased additionally in this environment when banks and others have pulled back? How do you think about returns on new money you're putting to work today?

Mark Szczepaniak, CFO

Sure, good questions. Yes, I think we feel like we're where we want to be in terms of spread; could we go higher? Probably. But if there is an upper limit, we would start to get into private money funds that would begin to compete with us. If you look at the current spread and where we're executing, on our last two securitizations, we’re seeing ROEs well north of 25%. We think that's a very healthy level, and NIMs are 4% or more—we think that’s where we want to be, and that hits our target. I don't think we'll likely raise it much more from here; we will need to monitor the Treasury market as we go.

Stephen Laws, Analyst

Sure, I do agree with your point though: the less competitive environment will allow us to be more selective on the credit side. From a growth outlook or maybe origination perspective, you mentioned you maneuvered a bit more cautiously in Q1—how should we view a monthly or quarterly run rate as we move forward?

Mark Szczepaniak, CFO

Yes, I think 250 is a good number going forward. I think we'll see a slow steady climb this year, barring any craziness. So, I think 250 is a good number for you to use as we project going forward.

Stephen Laws, Analyst

Lastly, regarding the financing, if I understand it correctly, the RE remix was a security issue where you were able to retain those into a new deal. Can you discuss any legacy transactions that may amortize down sequentially and could potentially become more expensive? Are there any opportunities to call or securitize those?

Mark Szczepaniak, CFO

Yes, absolutely. We've transitioned almost all of our deals over to the sequential pay structure, and there are still two more deals left where we could do that. One is a 2016 deal that is sequential, but has a very small balance—under $30 million. Then we also have a mixed collateral deal, which financed a bunch of non-performing assets. We have a significant amount of capital tied there, which will be freed up once it pays off, likely in the next 12 to 18 months. Those notes are not callable, so we need to see a full pay down before we can access that capital.

Stephen Laws, Analyst

Got it. Great. I appreciate the insights this evening.

Mark Szczepaniak, CFO

Thank you, Steven.

Operator, Operator

The next question comes from Steve Delaney of JMP Securities.

Steve Delaney, Analyst

Hello, everyone. I apologize for disconnecting myself. I don't know whether it's this market or just old age kicking in, but I managed to find my way back. You're stuck with me. I thought you got thrown off your horse? That could have been, but it's hard to take a call with a cell phone on a horse. I've managed to do that before. Seriously, great presentation to kick this off. I was intrigued by your comment about former bank customers. It's unfortunate what we're going through. It's hard to believe that in this day and time we have major financial institutions facing asset liability management failures, but that's the crazy world we live in. The borrowers you're talking to—does it extend beyond the three brand-name companies that have failed at this point? Are you seeing this happening broadly across the country?

Mark Szczepaniak, CFO

Yes. Yes, the short answer there is yes. We're definitely seeing most banks, if not all, pulling in their horns and becoming more cautious for sure.

Steve Delaney, Analyst

And specifically on real estate, do you think?

Mark Szczepaniak, CFO

Yes, and we're seeing a higher quality of borrower than we used to see. Quite frankly, six to nine months ago, many of them would have probably ended up at the banks.

Steve Delaney, Analyst

We certainly don't wish for any instability in the financial system. I recognize that eventually we all pay the price. It seems that the little guy will have some better opportunities moving forward; it certainly appears that demand remains high. It's interesting we're seeing similar patterns on the bridge lender calls this week—lots of demand and not much competition among banks. So it will be fascinating to watch this going forward. Considering your 11.1% whack on new originations, if the Fed is indicating they might be done, and we experience lower rates in 2024, that could potentially raise your opportunity set. What do you feel about the growth aspects of where you currently sit as a company?

Mark Szczepaniak, CFO

Yes, that's right, Steve. We appreciate it. We've been operating for 19 years and have seen various market conditions. We took our medicine last year when rates surged so fast, while many banks lagged in facing the realities of the situation. We feel that we’re in a strong position to grow selectively and thoughtfully from here, and we are definitely noticing increasing demand and inquiries for financing. If rates were to decline, that would further enhance our opportunities.

Steve Delaney, Analyst

Well, congratulations on a great start to 2023. We look forward to doing this again in a few months.

Chris Farrar, President and CEO

Great. Thank you, Stephen.

Steve Delaney, Analyst

Nice job. Thank you.

Operator, Operator

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

Chris Farrar, President and CEO

No further remarks. Thank you all for joining, and we'll be in touch next quarter. Thank you.

Mark Szczepaniak, CFO

Thank you, everybody.

Operator, Operator

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