Please standby, we're about to begin. Ladies and gentlemen, thank you for standing by. Good day, and welcome to the Flagstar Bank Second Quarter 2019 Earnings Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Ken Schellenberg. Please go ahead, sir.

Thank you, Paula, and good morning. Welcome to the Flagstar second quarter 2019 earnings call. Before we begin, I'd like to mention that our second quarter earnings release and presentation are available on our website at flagstar.com. I would also like to remind you that any forward-looking statements made during today's call are subject to risks and uncertainty. Factors that could materially change our current forward-looking assumptions are described on Slide 2 of today's presentation, in our press release, and in our 2018 Form 10-K and subsequent reports on file with the SEC. We are also discussing GAAP and non-GAAP financial measures, which are described in our earnings release and in the presentation we made available for this earnings call. You should refer to these documents as part of this call. And with that, I'd like to now turn the call over to Sandro DiNello, our President and Chief Executive Officer.

Thank you, Ken. Good morning to everyone listening in. I appreciate you taking the time to join us today. In addition to Ken, I'm joined this morning by Jim Ciroli, our Chief Financial Officer; Lee Smith, our Chief Operating Officer; Kristy Fercho, our President of Mortgage; Drew Ottaway, our President of Banking; and Steve Figliuolo, our Chief Risk Officer. As usual, I'm going to start the call by providing a high-level view of our performance for the quarter. Then I'll turn the call over to Jim for details on our financial results. Lee will follow with a review of our business segments and strategic initiatives, and I'll conclude with the guidance for the second quarter before opening up the line for questions. Overall, I was pleased with our results for the second quarter with top-line revenue growth and effective expense management combining to produce positive operating leverage. Our adjusted net income of $41 million or $0.71 per diluted share exceeded the $37 million or $0.64 per diluted share we achieved in the previous quarter, but was down 18% from the same quarter last year driven by the write-down of our commercial loans in Live Well Financial a mortgage loan originator which we disclosed as a concern in our first quarter 10-Q. I will touch on this matter more later. It's important to note that the increase in non-interest expenses is mostly attributable to a nice bump in mortgage originations during the quarter especially in our growing retail channel where commission expenses are directly tied to originations. We've also in the quarter demonstrated once again how a unique business model works. In this case, an unexpected drop in interest rates that put the pressure on interest margins presented us an opportunity to significantly increase mortgage revenues which helped produce solid profitable…

Thanks, Sandro. Turning to Slide 6, our adjusted net income this quarter was $41 million or $0.71 per diluted share even with a $30 million charge-off. This performance compared to the $37 million or $0.64 per diluted share of adjusted net income last quarter. This quarter was highlighted by revenue growth of 20% leading to strong operating leverage of 8%. Our results for the quarter were led by strong growth in net interest income and a higher level of mortgage revenue. We will discuss earnings in more detail when we get to Slide 7. Asset quality negatively impacted this quarter by the $30 million Live Well loan charge-offs discussed earlier. As a result, our non-performing loan ratio increased 30 basis points. Additionally, we reduced our reserves by $17 million mostly driven by the full payoff of three substandard loans and also due to the continued low levels of charge-offs in the rest of our loan portfolio. Our allowance coverage of the loan portfolio decreased to 0.9% reflecting the charge-off activity for the quarter, the reserve reduction, and strong growth in period end warehouse loan balances. I will provide more details when we get to asset quality. Expenses also scaled nicely this quarter showing only 12% growth and reacted with 20% increase in revenues. Mortgage origination volumes drove $20 million of the increase. On the basis of $1 billion attributed in loan warehouse loan growth, our capital ratios were lower this quarter, while our total risk based capital was 11.6% at June 30. This capital ratio would have been relatively flat to last quarter without that warehouse loan growth. And we believe those warehouse loans have little to no credit risk. Capital simplification will improve this ratio by 38 basis points and will take us through a more extensive analysis of…

Thanks, Jim, and good morning everyone. We're very pleased with how quickly we pivoted during the quarter to maximize revenue and earnings from our mortgage business given the lower 10-year treasury note rate as we saw healthy increases in both flat adjusted loss and gain on sale margin quarter-over-quarter. Average earning assets increased a commendable 9% or almost $1.5 billion as we experienced positive growth in all consumer and commercial lending channels. The warehouse lending business we acquired a little over a year ago is paying dividends as we increase average warehouse balances an impressive 70% or $822 million quarter-over-quarter. Average deposits increased $1.3 billion or 10% and we now serve a single sub-servicing almost 1 million loans and are the fifth largest sub-servicer in the country which provides us with another source of stable earnings. We're obviously disappointed with the Live Well commercial loan partial charge-off of $30 million during the quarter after they abruptly and unexpectedly ceased operations. We are confident that this situation is not reflective of a deterioration in our remaining commercial portfolio and the underlying collateral for this loan was unique and not something we have elsewhere in that book. We ended the quarter with almost $20 billion in average assets and have once again demonstrated the flexibility of our business model where the different businesses act as a natural hedge meaning we can generate strong earnings in any interest rate environment. I will now outline some of the key operating metrics from each of our major business segments during the second quarter. Please turn to Slide 12. Operating highlights for the Community Banking segment include average commercial and industrial and commercial real estate loans increased $294 million or 8% in the quarter and the growth was evenly found between the two portfolios. Average consumer…

Thank you, Lee. I'm going to close our prepared remarks with some guidance for Q3 and then open the call for questions and answers. Please turn to Slide 17. We expect net interest income to improve approximately 5% while net interest margin will be flat or decline slightly. The anticipated gain on loan sale income will increase 15% to 20%. We expect the return on the MSR to decline slightly. All other non-interest income is expected to decline 5% to 10%. As Lee noted, we anticipate non-interest expenses to be between $220 million and $225 million and we expect the effective tax rate to be 18%. This concludes our prepared remarks. We will now open the call for questions from our listeners. So I will turn the call over to Paula.

Thank you. [Operator Instructions]. We'll take our first question from Scott Siefers with Sandler O'Neill.

Good morning, Scott.

Hey, thanks for taking my question. I guess the first question is just on the gain on sales margins. I mean really, really strong improvement this quarter and appreciate the context you put it in about regarding the improved mix basically but just curious if you could talk a little about how much is left. Could you continue to enrich the mix of originations and then just on sort of a steady state in other words if you had not improved the mix of originations, what kinds of trends are you seeing by channel on gain on sale margins?

I will give Kristy a second to think about that but my reaction Scott is I think we've seen improvement in our margin in all areas, some more than others. And I think that is because as we said in our prepared comments that we have really focused on optimizing the production as opposed to just optimizing volume. And I think that has proven to work very well for us. As I've said we increased our mortgage revenue by 45% quarter-over-quarter. I think that compares pretty favorably to other large mortgage originators.

Yes, Scott. What I would add is the big story in the mix really came in bulk. And so the way you saw the volume coming in bulk, we were seeing easily one pipe for billion a day and we just maintained the discipline there where the margins were in terms of that both channel choosing to do more in the retail originations as we said in our prepared remarks. So the volume certainly is there. It was the discipline around where we wanted to maximize that and take margin and not just take volume for volume sake.

And Scott, I'll just add. If you actually just look at Q1 over Q2, I mean just going back to Sandro's point, the volume growth we saw in multiple channels particularly correspondent, non-del, broker, and retail and that's where we saw the margin expansion. I mean because those are the higher margin channels and we focused on getting the business from those channels which is why the margin increased so much quarter-over-quarter.

But the real important point really more than volume or margin is revenue that's what we were focused on and the revenue growth is what I was most pleased with.

Yes, that's perfect. Thank you guys for the color. Let me switch gears to the Live Well situation maybe just a comment or two about what's left and I guess what gives you comfort that it's well secured, I know there was some question on the collateral valuation at the beginning. So just maybe a little more color on if what's left, if there's any question or additional risk to it or if you feel like this was a good very conservative whack at the apple, so to speak?

Yes, we feel extremely comfortable with where we've valued the collateral. And so, you can't say anything for sure of course but we're confident that the ultimate resolution will be similar to where we've marked the asset. And then as we go through the legal process perhaps there's other opportunities for recovery.

Moving on, we'll go to Bose George from KBW.

Hi, Bose.

Hi, good morning. Just a follow-up on the gain on sale, is the guidance for next quarter for the increase driven by volumes or margins or both?

Probably a little bit of both. But I think more so margin than on volume. But you never know, Bose, right, it's hard to know what's going to happen tomorrow let alone over the next three months. I think what I'd like to emphasize is we'll adjust to where the opportunity is. And so if there's more opportunity for volume at a narrow margin but we think that brings us more net revenue that's what we'll do. And I think we've been able to show quarter-over-quarter as we can make good and swift decisions on where the best opportunity is.

Okay great. Thanks. And then switching to the guidance on the net interest margin, can you just talk about the drivers there and are you incorporating the rate -- two rate cuts or how does that work?

Well, let's look at yields and then cost, right? On the yield side as we noted in our prepared comments we're definitely seeing pressure on the yield side on the commercial book. And so we're concerned about how that's going to react not only from the press from competition but then of course if you get a 25 basis point decline in the Fed funds rate next week then you're going to see all of the adjustable loans adjust pretty quickly and you'd never know for sure just how quickly you can adjust the deposit cost to match up with that decline. So we're little cautious on that. And so I think that's how I would answer your question. Jim, you want to add to that?

Yes. The guidance we've given for the quarter reflects what you see in the curve right now which is almost certainty as Congress said at the rate cut next week, a small chance of 50 basis point cut but we just go with what the market tells us. When you focus then on the short-term, the short end of the curve we are slightly asset sensitive. And I think Sandro said it well that that slight asset sensitivity defines what our goal is in terms of managing our deposit costs. So we'll get out and we'll manage those deposit costs in a very thoughtful and deliberate way and we know what we have to do to maintain that flat to down guide on NIM.

I'd say add Bose that I was very pleased that we only saw one basis point narrowing of our margin this past quarter given all the pressures that were in the business and the way the interest rate, interest rates reacted over the last three months. So I'm pretty confident that we can manage the margin reasonably well.

Okay. Thanks. And okay just one more just on the servicing fee, your average servicing fee has gone up quite a bit over the last year. Just curious are you getting better execution, just holding more excess servicing or mix shift or is there anything else going on there?

Yes, on the MSR we're definitely holding more G&A and that's having a positive impact on the carry and then we're holding a bigger asset, that's what we see.

Yes, Bose, Jim did a good job in his comments talking about how well our team managed that investment. As you know we do a lot of warehouse lending. So we see a lot of other companies. And of course the non-bank mortgage companies don't hedge their MSR. And in this environment, we're out in the last month to see only a $1 million deterioration and the value of our MSR is pretty remarkable. And I think that shows how strong our team is managing that MSR on a day-to-day basis but we've been able to keep it pretty much unchanged despite increasing or decreasing interest rates.

I'd add to that that track record goes back to the team goes back to 2016.

Up next we have Steve Moss with B. Riley FBR.

Good morning, Steve.

Good morning. I guess just following up on the Live Well asset here, just wondering what are your thoughts with regard to whether you retain the asset or liquidate it?

Well I can't, I don't know I can't speculate. It depends on what the market opportunity is. We don't have a desire to own the collateral long-term necessarily but if that is the best that's the most efficient way to go that's what we'll do. But as I said to the earlier question, I'm not too concerned about where we have it marked. I think we're in a good place with it. And I think that we're going to be able to work through it reasonably well. Jim, anything you want to add to that?

Yes, what I'd add to that is we did bring some consultants in to help us evaluate the collateral; evaluate what our strategy and pricing was of collateral. So I'd say that that Sandro's comments were really informed by what that consultant was able to inform us about with respect to collateral and the pricing.

Okay. And then I guess just perhaps digging a little further on funding costs and in particular deposit costs here, if we do see 50 basis points this quarter, what do you we expect for your deposit pricing?

Well as you may know Steve, I've been managing or I did manage the deposit base here for many, many years. And my philosophy has always been that on the way down, you don't wait for others to move, you move in. So we will be aggressive in our adjustment of deposit rate that's in our history. Now we've got to balance that against our need for funding. So I can tell you that we lose deposit rates by 25 basis points, if the Fed drops 25 but we're not going to be overly cautious about it either. I think managing the deposit cost going to be important, really important managing the margin. And as Jim said, we're a touch asset sensitive and so the way to deal with that is by being more aggressive on the deposit side, we're not going to be afraid to do that.

I think when you look at our balance sheet, Steve; you'll see all of that. It's easy to see the assets that are going to reprice down the commercial loan portfolio. If you look at the FHLB, you look at the interest we pay where we're at the sub-servicer on custodial deposits. You look at the trust preferred, there's a whole host of liabilities were also priced down to liability, the asset liability sensitivity and that short end of the curve is really something that we feel within our ability to manage to whatever degree we have to manage it, certainly what we see in terms of rate cutting back.

Jim, on those custodial deposits is actually my next question. The interest there is paid is an offset to loan administration income. Just kind of thinking, how do we think about that line item? How indexed are those deposits if you will. And perhaps how that translate into fee income for you guys?

We've given you a page, a new page to the deck, it’s actually Slide 37 in the Appendix that will I think give you a lot more information, we've ever given before and I'll turn it over to Lee to elaborate.

Yes, I think you're exactly right, Steve. The loan -- it includes servicing and sub-servicing fees less the amounts paid to MSR owners for the interest on those escrow deposit so remember with sub-servicing 84% of the overall portfolio, the benefit Flagstar receives from most parties is shown in interest income. So it isn't matched up on the GAAP rules which is why to Jim's point, if you look at Page 37 of the deck which is a new slide we've included this non-GAAP servicing profitability slide where we do match interest income and interest expense from escrow deposits. And as you can see from that, just from servicing profitability point of view, we are achieving $4 million to $6 million of operating profit pre-tax for every 100,000 loans we have.

But Steve, I think if you look at that page, it's interesting to look how the interest expense has grown quarter-over-quarter related to the custodial deposits. And as was noted in the prepared comments, custodial deposits improved $1 billion from the last quarter. So there's a lot of and freshly in large part because of the prepayment of loans because a number of loans that we serviced really didn't change much quarter-over-quarter. So that billion of deposit, that's all tied to LIBOR. It ranges from LIBOR plus little LIBOR minus, so something but it's all tied to LIBOR. But the important point is so as the LIBOR declines, the cost of those deposits decline immediately and that is completely viewing efficient for funding.

Moving on, we will go to Kevin Barker with Piper Jaffray.

Hi, Kevin.

Good morning. Just going back to some of the comments Jim made on capital and the share buybacks, it looks like you paused or bought back very little in the second quarter and then how the priorities look going forward given where your capital ratio stands today and the amount of growth that you put on the balance sheet especially in the second quarter?

Well, let's just come back to the share buyback. If you recall buyback, we executed beginning of February and January was an accelerated share repurchase. And we have all said that we work with another -- we work with an investment bank and we execute immediate buyback. And then there is a settle-up transaction later which happens for us kind of mid-second quarter. So really the way we think about it from a share buyback, we've done in February with a small settle-up that we have that's what you're seeing come through Q2. So we used our total $50 million of authorization. But I go back to my prepared remarks, when we look at the capital ratios at the end of the quarter and you think about meeting capital, the risk of possible loss. I just don't -- so when you look at the $1 billion worth of balance sheet inflation that we have which will also come down through the second half of the year from that warehouse loan increase, it is not something that that bothers us, concerns us, and as the balance sheet deflates, you'll see the capital ratios come back up because of that and also because of the -- just earnings accumulation we will experience over the next couple of quarters.

And not to mention capital implications payment next year. But to your point Kevin we’re managing the capital very closely and making sure that the assets we put on the books bring us the return that makes sense given the use of the capital. And that's why you heard a couple of us stating in our prepared remarks that we passed on quite a few opportunities that we were comfortable that from a credit point of view but we couldn't get to the hurdle from earnings point of view.

Okay. And then obviously warehouse picked up quite a bit and your loans held-for-investment picked up quite a bit during the second quarter and you gave your guidance for the third quarter but as you look into the slower seasonal months in the fourth and first quarter, what do you expect as far as in average balance or do you feel like you could sustain your current loan balances as we move through those quarters given the seasonality of the balance sheet at this point?

Well only speaking to the third quarter, right. And we look at our guidance and we sit and think that net interest income was going to grow about 5%. So that would suggest that there isn't going to be significant growth in the balance sheet projected over the next quarter. So while we might see some growth here, we might see some decline there and we got to pass that and we’re not going to comment.

Would you expect to be able to sustain that NII going into the fourth and first quarter especially given the shape of the yield curve at this point?

Well again I don't want to speculate on anything further out. If you look historically at our net interest income performance, you can come to your own conclusions as to how we're able to perform in the fourth and first quarter. But I can't comment on that.

And Henry Coffey with Wedbush has our next question.

Good morning.

Yes, good morning everyone. Good morning. Thank you for taking my question. It's interesting to see how quickly you can kind of turn on the mortgage machine to take advantage of the rate decline. When we look at the -- when we look at the collateral behind your mortgage warehouse loan that you're having issues with the press says --

Henry, let me correct you just one second.

Yes.

That is not a warehouse loan; we did have a warehouse loan. Let me just explain. We have two loans at Live Well, one was a warehouse loan, the warehouse loan is completely paid off without any loss or charge-offs. The other loan which was secured by marketable securities is where the issue lies.

Okay, got. Now thanks for clarifying that. When you look at Live Well, the press says that the problem was that you had Ginnie Mae IO collateral that you and others that were exposed to that credit were counting on Ginnie Mae IO collateral which obviously is a pretty volatile item. I'm going to assume that's correct. I would take from some -- I would take it from some of the remarks you made on the call that you don't have other loans so collateralized; is that accurate or --?

Yes, it’s accurate. But I also want to -- I want to say one other thing. Maybe just a clarification from what something you just said. We do not believe that the collateral issue is related to market conditions. I want to be very clear about that. There's a different problem that we're researching, so I’ve made reference to the law enforcement and the SEC investigation. We don't have all the answers to that. I can't really comment on it any further. But I just want to be clear that we do not believe that the collateral issue that we experience and the charge-off associated with that had anything, anything to do with market conditions.

So there's no -- you're not looking at your overall approach to the business is saying we oh, oh, we need a better telescope here, you're happy with your telescope so to speak?

Yes, given the uniqueness of this particular credit, credit absolutely. Now that doesn’t mean we don’t inform ourselves and look deep into our operations to make sure that it couldn't be something similar but we've done that and I'm comfortable answering your question today than I did.

Great. Thank you. The other thing kind of from a broader look a couple of banks have been talking about issues in their A, C and D acquisition and development portion of their portfolio which obviously includes both commercial and residential activity. You have a pretty broad scope on that -- view on that market. Are you seeing weakness in the A, C, D business, strengths in the A, C, D business because of where the mortgage market is. What are your thoughts on the overall tone of that sub-portion of the lending market?

I will let Drew comment, I'll just say to begin that we haven't seen any weakness whatsoever from a credit perspective. So we don't have delinquencies at any level in the A, C and D but Drew I know you'd probably want to chime in that.

I'm happy to add on. I mean we are really happy with the way we've grown that book of business. It's very well diversified. We banked seven of the top 10; we banked 51 of the top 100. We really take concentration policies around what we take as collateral, that mix of that collateral and how we monitor that collateral. So as Sandro said, we haven't any concerns today with that book of business. I think affordability is still an issue out there but I think price appreciation is slowing. So we think there's ample room for us to continue to grow that book of business.

The opportunities have come in, almost every week and our loan committee were seeing new opportunities in the space.

Are the builders at the very low end of the spectrum maybe that's not even the top 100, the five trucks and 20 homes a year; is that builder having access to credit or is that builder in your view credit starved?

I do think the market overall is still constrained by available credit. We don't happen to bank builders like that. We only bank large regional builders that do significantly more than 20 houses and five trucks.

Next we will go to Chris Gamaitoni with Compass Point.

Hi, Chris.

Hi everyone. I wanted to clarify one of the guidance points on the all other non-interest income down 5% to 10%. Is that inclusive or exclusive of the DOJ fair value change?

Yes, the DOJ completely excluded from many comments that we've made.

Okay, that's helpful. And then thinking about the HFI growth of 5% to 10% quarter-over-quarter. Is there any thoughts on kind of the composition of that, is that strength in core commercials, is it homebuilder loans, is it greater warehouse balances. Just wondering to kind of get a better understanding of what's going on in the business to drive that?

In the past quarter you’re speaking Q2 --

Future guidance.

No, the future guidance.

Yes, I think it's going to be very similar to what we saw in Q2 and honestly that's what you see just about every quarter for Flagstar is that doesn't typically come in any one area. Now Q2 was unique in that we had such a big increase in the warehouse business and there's a lot of reasons for that and we touched it finally on our prepared comments, number one Drew and his team did a really good job of maximizing utilization rates. So jumping on top of the opportunities that presented itself once the rates produced a little bit of boom in the refinance area reacting quickly to overlying requests and things of that nature that allowed us to grow that that business that is really good from the return perspective quickly. But otherwise it's very balanced against CRE and inside of CRE with finance, and then with C&I. And then also the continual growth of our consumer loan book and non-auto indirect performed really well here this year. So I wouldn't expect it to be much different. Drew, do you have any other?

No, I think that's exactly right. I mean I think we have a really good mix of commercial and consumer and warehouse and I think we've been able to take advantage or the advantages presented themselves. In this quarter, we had an outsized advantage with warehouse that we jumped on and we have a great book even within warehouse over 300 customers. So it's not like a type or concentrated in any one name and frankly the acquisition that we had last year has helped bolster those results. But the C&I is very well diversified in terms of local core businesses and national platforms that we service, CRE very, very much the same thing. And then you can see the continued diversification in the consumer book of business including the non-auto indirect.

Our next question will come from Daniel Tamayo with Raymond James.

So this is kind of a longer-term question on the asset growth. You've obviously had very strong asset growth and deposit growth in the last several years even excluding the Well's branches. I think you've talked in the past about kind of a $3 billion to $5 billion number over two to three years on an organic basis? Is that still something you think is achievable going forward here or how do you think -- how are you thinking about kind of long-term balance sheet growth now?

Well, growing the company is important than growing earnings per share. But I think that we're at today given capital levels and the growth that we have achieved, we've got to be careful that the growth that we have going forward is meeting higher return levels. And so we're very, very focused on that and the opportunities are going to be there because we have lots of good people that have come to work at Flagstar and have great relationships not only here in Southeast Michigan but across the country. And so we know that we're going to get the opportunity. What we don't know is whether the opportunities will produce a return that will be satisfactory to support the use of our capital. So we're probably going to be a little bit more cautious about that going forward but only because of capital levels. But as we've done in the past, we will take advantage of the opportunities that present themselves to us and we'll execute on them in a positive way.

And then how does the kind of help for investment loan to deposit ratio which has crept over 80% here factor into that or is capital still the kind of defining threshold for how you're thinking about loan growth?

Well, yes I think capital is defining threshold not to say that HFI or the ratio that you approved to is not considered but clearly I think capital. Jim, would you agree.

Yes, and I think Sandro said it well, it's not that we ignore those modified loan in deposit ratio where we cognizant of what our runway is from a liquidity standpoint but as we look at it right now, we've invested the capital that we have and improving the outlook and stability of the company now has the ability to buy back stock. We initiated a dividend earlier this year. So we have the capital management tools that enable us if we don't like the returns that we're seeing what's presented to us, we can always sit back on the capital and maybe even buy some of it back if we think that's the right thing to do. So we've got more tools available to us to manage that return on equity mix as we go-forward.

And we do have a follow-up from Kevin Barker with Piper Jaffray.

My question has been answered, thank you.

Thanks, Kevin.

Thank you. And now I'll turn it back to Mr. Sandro DiNello for any additional or closing comments.

Thanks, Paula. All said it was a good quarter with solid contributions across the board from retail banking, commercial, and mortgage including servicing, they all came through with strong results. And this quarter in particular, we completed payoff of our acquisitions Wells Fargo and DCB and the deposits that efficiently funded our loan growth, focus on a strong performance of our retail mortgage channel, and Santander and the huge upswing in warehouse lending plus the new businesses we started such as our indirect non-auto lending are emerging as important contributors. And you put it all together, you get the profile of a unique bank with many diverse pieces that work together and complement each other to deliver consistent earnings and long-term growth and shareholder value. In closing thanks again to the Flagstar family for your outstanding performance. Thanks to our shareholders for your support. And thank you again for taking the time to listen in today. I look forward to reporting third quarter results in October.

And that does conclude today's conference. We'd like to thank everyone for their participation. You may now disconnect.