Mechanics Bank (MCHB) Q3 2018 Earnings Report, Transcript and Summary

Good morning and welcome to the HomeStreet Third Quarter 2018 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mark Mason, CEO. Please go ahead, sir.

Hello and thank you for joining us for our third quarter 2018 earnings call. Before we begin, I would like to remind you that our detailed earnings release was furnished yesterday to the SEC on Form 8-K and is available on our website at ir.homestreet.com under the News and Events link. In addition, a recording and a transcript of this call will be available at the same address following the call. On today’s call, we will make some forward-looking statements. Any statement that isn’t a description of historical facts is probably forward-looking and is subject to many risks and uncertainties. Our actual performance may fall short of our expectations or we may take actions different from those we currently anticipate. Those factors include conditions affecting the mortgage markets, such as changes in interest rates and housing supply that affect the demand for our mortgages and that impact our net interest margin and other aspects of our financial performance, the actions, findings, or requirements of our regulators and general economic conditions that affect our net interest margins, borrower credit performance, loan origination volumes and the value of mortgage servicing rights. Other factors that may cause actual results to differ from our expectations or that may cause us to deviate from our current plans are identified in our detailed earnings release and in our SEC filings, including our most recently filed quarterly report on Form 10-Q as well as our various other SEC filings. Additionally, information on any non-GAAP financial measures referenced in today’s call, including a reconciliation of those measures to GAAP measures maybe found in our SEC filings and in the detailed earnings release available on our website. Please refer to our detailed earnings release for more discussion of our financial condition and results of operations. Joining me today is our Chief Financial Officer, Mark Ruh. In a moment, Mark will present our financial results. But first, I would like to give an update on our results of operations and review our progress in executing our business strategy. During the third quarter of this year, we made significant progress on our long-term strategy to build a better HomeStreet. Our cost savings initiatives in 2018 and 2017 have materially reduced our non-interest expenses due to lower headcount and fewer office locations. These actions while important to improving our long-term results negatively impacted our third quarter results. In addition to some additional restructuring charges, the wind down of the closed lending offices adversely affected our results of operations during the third quarter by creating a larger imbalance of closed loan volume relative to interest rate lock volume. Our commercial and consumer banking segment achieved record net income for the quarter driven by loan growth of 3%. We were particularly pleased with 2% growth in commercial and industrial lending. During the quarter, we originated $71.9 million of new commitments and $54.5 million of new commercial and industrial loan balances. The year-over-year growth in commercial and industrial loan balances was a strong 27% reflecting the substantial investments we have made in this line of business. Overall, loan growth drove an increase in our net interest income during the quarter despite the decline in our net interest margin. The flat yield curve and increasing competition for deposits is putting pressure on our net interest margin. After several quarters of interest rate increases by the Federal Reserve, we are seeing upward pressure on deposit rates, which resulted in our cost of funds we increasing at a faster rate than our yield on assets in the quarter. Additionally, we experienced seasonal outflows of deposits by some of our larger commercial clients, which we replaced with higher cost in wholesale deposits. Notwithstanding the seasonal industry-wide competitive pressure, our de novo branches, those opened 5 years or less grew deposit balances by 4.5% during the quarter. Asset quality remained strong during the quarter with our non-performing asset ratio ending at 15 basis points of total assets. Our early warning credit indicators continue to reflect strong fundamentals in all of our markets which is not surprising given we do business in some of the strongest markets in the United States today. Job creation, unemployment, commercial and residential development activity and absorption, vacancies, cap rates and all other leading indicators of economic activity reflect strong economies in our primary markets. Given the persistent shortage of new and resale housing and increased interest rates reducing demand for both purchase and refinance mortgages, along with the decrease in composite profit margins, we took steps in the second quarter to streamline our mortgage banking operations by closing, consolidating or reducing space in 21 single-family lending offices. These steps also included a substantial reduction in headcount. These actions were completed this quarter and as a result, we realized an expected decrease in interest rate lock commitments compared to the second quarter this year. However, we did not realize a corresponding decrease in single-family closed loan volume during the quarter as we closed the pipeline originated by the production personnel no longer with us. This resulted in approximately $947,000 of additional pre-tax net costs to close this pipeline of loans. Mortgage banking industry remains at low point in the cycle. We will continue to analyze and make efficiencies, process and strategic improvements to position our mortgage banking business to be a positive contributor in the near-term and competitive in the long-term. During this low point of the mortgage industry cycle, we believe smaller, less efficient and less well capitalized companies will exit the industry whereby reducing capacity and improving profitability. Over the long-term as volumes and margins increase cyclically, we believe that our mortgage banking business will be well positioned to generate strong returns on equity given our almost 100-year history of the mortgage business, our strong market share in some of the best markets in the United States. It is important to remember that our mortgage banking business also produces and services mortgages and home equity lines of credit for our balance sheet comprising 28% and 11% respectively in our loans held for investment. These loans are a meaningful source of earnings with balance sheet diversification for our commercial and consumer banking segment. As we execute on our strategy of converting a troubled thrift into a full service regional community banking franchise, we will continue to consider new and alternative business strategies to improve efficiency and profitability in an effort to maximize shareholder value over the long run. And now, I will turn it over to Mark who will share the details of our financial results.

Thank you, Mark. Good morning everyone and thank you again for joining us. I will first talk about our consolidated results and then provide detail on our two operating segments. Regarding our operating results, net income for the third quarter of ‘18 was $11.8 million or $0.44 per diluted share compared to $7.1 million or $0.26 per diluted share for the second quarter. Included in income for the third quarter of ‘18 was a total of $418,000 of restructuring and acquisition-related expenses net of tax. Excluding the impact of these charges, core net income for the third quarter was $12.3 million or $0.45 per diluted share compared to core net income of $12.5 million or $0.46 per diluted share for the second quarter. The decrease in core net income from the prior quarter was primarily due to lower non-interest income largely from higher net gain on loan origination and sale activities in our mortgage banking segment. This was primarily due to the impact of fewer loan origination personnel as a result of our second quarter restructuring as Mark previously discussed. Net interest income increased by $641,000 to $51.6 million in the third quarter from $51 million in the second. This increase in net interest income is primarily due to the higher balances of loan held for investments. Our third quarter net interest margin of 3.20% decreased from second quarter’s net interest margin of 3.2%. While our retail deposit bases have remained relatively low, our wholesale deposit and borrowing cost have continued to increase as the Federal Reserve continued to increase short-term interest rates. During the quarter, this increase in funding costs was partially offset by higher yields on our interest-earning assets. Non-interest expense excluding impact of restructuring-related expenses decreased to $94.1 million in the third quarter of ‘18 from $104.7 million in the second quarter. This decrease in non-interest expense was primarily from lower commissioning costs on lower closed single-family mortgage loan volume. As a result of our 2017 and 2018 cost savings initiatives, total core non-interest expense declined by $29.5 million or 9% for the nine months ended September 30, 2018, compared to the nine months ended September 30, 2017. The primary driver for this reduction was lower bonus and commission expense due to lower mortgage loan volume. However, we also achieved a $9.5 million or 7.9% net decrease in base salaries due to the overall reduction in our headcount from 2,552 full-time equivalents at December 31, ‘16 to 2,053 full-time equivalents at September 30 of ‘18. Additionally, general, administrative and occupancy expenses decreased $6.1 million and $1.2 million or 12% and 4.5% respectively during the same period, due in part to reducing our total office count from 139 to 123 during the same period. These expense reductions were partially offset by increases in information services expense as we continue to invest in upgrading our technology platform to support our growth. Our effective tax rate was 17.9% for the third quarter and difference from our estimated federal and state combined statutory rate of 23.5% primarily due to the impact of higher tax-exempt interest income and adjustment to prior periods during the quarter. I’ll now discuss some key points from our Commercial and Consumer Banking segment results. Commercial and Consumer Banking segment core net income was $16.6 million in the third quarter, increasing 39% over core net income of $11.9 million in the second quarter. Net interest income increased $116,000 in the second quarter of ‘18 to $47.9 million due to the growth in our loans held for investment and despite a five basis points decrease in our net interest margin. Our portfolio of loans held for investment increased by $142.2 million or 3% to $5.1 billion in the third quarter. Growth occurred throughout the portfolio in all of our major business lines. Segment non-interest income increased quarter-to-quarter to $10.7 million from $8.4 million. This increase was primarily due to higher net gain from our sales of multi-family U.S. loans and small balance towards real estate loans during the quarter. Segment’s core non-interest expense was $37.8 million, a decrease of $1.5 million from the second quarter of ‘18. This decrease was primarily due to lower salaries and related costs from loan originations and fewer full-time equivalent employees in the corporate support functions. Non-performing assets remain relatively unchanged at $10.4 million or 15 basis points of assets at September 30, compared to 14 basis points of assets at June 30. We recorded a $750,000 provision for credit losses in the third quarter compared to $1 million in the second quarter. This decrease in provision expense was primarily due to $123,000 of net recoveries during the third quarter compared to net charge-offs of $464,000 during the second quarter. Deposit balances were $5.2 billion at September 30, an increase of $34.8 million from June 30 driven primarily by an increase in broker deposit accounts as these wholesale deposits to replace seasonal draw-downs of large commercial customers. During the quarter, we completed the consolidation of our Richland and Selah retail branches in Eastern Washington into nearby branches in Kennewick and Yakima respectively reducing our total retail branch count from 62 to 60 by the end of the third quarter. Deposits in our de novo branches or those opened in the past 5 years increased approximately 5% during the quarter. I will now share some key points from mortgage banking segment results. Mortgage banking segment’s core net loss in the third quarter was $4.3 million compared to core net income of $630,000 in the second quarter. Compared to last year, we had lower interest rate lock commitment and a lower composite margin that resulted in a decrease in core earnings from gain on loan origination and sale activities offset somewhat by increased mortgage banking servicing income. Competitive pressure on single-family mortgage pricing intensified during the third quarter resulting in a reduction of our composite profit margins. Our gain on mortgage loan origination and sales composite margin was 311 basis points, a 50 basis point reduction from the second quarter. The decrease in interest rate lock commitments during the quarter was due to generally lower industry originations and the restructuring that included closing or consolidating 21 single-family lending offices, which was previously announced in the second quarter. While the majority of loan officers affected by a reduction were no longer employed during the third quarter of ‘18, we still encourage the cost of closing of previously locked loan pipeline, including paying commission to those loan officers. This had the impact of significantly increasing closed loan volume relative to interest rate lock commitments. As previously mentioned, the net pre-tax impact of closing those loans originated by loan officers no longer with the company was $947,000 primarily in commission and fulfillment costs. When single-family interest rate locks are less than closing in a given quarter, earnings are negatively impacted as the majority of mortgage revenue is recognized in interest rate lock, while majority of originating cost including commissions are recognized upon closing. To illustrate the impact of this imbalance, if rate lock volume had been equal to closed loan volume at our reported composite margin, the estimated net income for the segment would have been $1.1 million. If closed loan volume has been the same rate lock volume during the quarter, the estimated net loss for the segment would have been $2.4 million. Single-family mortgage servicing income was $6.9 million in the third quarter, an increase from $6.1 million in the second quarter. This increase was primarily due to higher risk management results partially offset by lower servicing income. The higher risk management results were primarily driven by gains from a more stable interest rate environment and decreased negative convexity costs. The decline in servicing income is related to lower average balance of loans serviced for others due to the sale of $4.9 billion in unpaid principal balance of mortgage servicing rate in the second quarter of this year. Mortgage banking segment core non-interest expense of $56.3 million decreased $8.1 million from the second quarter of ‘18 primarily due to the decrease in commissions paid as a result of lower closed mortgage loan volumes, but also from lower base salaries to the lower headcount and lower G&A and occupancy expenses from operating fewer single-family lending office locations. Our portfolio of single-family loans serviced for others increased to $19.8 billion of unpaid principal balances at September 30 compared to $19.1 billion at June 30. The value of our mortgage servicing rights relative to the balance of loans serviced for others was 133 basis points at quarter end, an increase of 4 basis points compared to the prior quarter end. I will now turn it back over to Mark Mason to provide some additional insight at HomeStreet’s outlook for the future.

Thank you, Mark. Looking forward to the next two quarters in our mortgage banking segment, we currently anticipate single-family mortgage loan lock and forward sale commitment volume of $1.1 billion and $1.3 billion in the fourth quarter of this year and first quarter of next year respectively. We anticipate mortgage loan held-for-sale closing volumes of $1.2 billion and $1.1 billion for the same periods. For the full year of 2019, we anticipate single-family mortgage loan lock and forward sale commitments to total $5.7 billion and loan closing volume to total $5.8 billion. These volumes will be highly dependent on inventory levels of the housing markets in which we do business, local economic conditions affecting employment growth wages as well as prevailing interest rates. Reflecting the competitive pressures on gain-on-sale margins, we expect our mortgage composite profit margin to remain in the range of between 310 basis points and 320 basis points during the next two quarters as well as for the full year of 2019. In our commercial and consumer banking segment, we expect our quarterly loan portfolio growth to average between 2% and 4% for the fourth quarter this year and through 2019. Reflecting the yield curve as of the end of the third quarter and asset changes in market rates of loan prepayment speeds, we expect our consolidated net interest margin to remain in the range of 310 basis points to 320 basis points over the next two quarters and remaining within that range throughout 2019. During the fourth quarter, we expect our total core non-interest expense to decrease between 3% and 5% given seasonally lower closed single-family mortgage loan expectations and the ongoing impact of our streamline. Following that decrease, we expect non-interest expenses to increase as seasonal lending volume increases during the middle of 2019. For the full year of 2019, we expect total core non-interest expenses to decline by approximately 1% compared to 2018 reflecting the cost saving initiatives we have implemented during 2017 and 2018, which were primarily concentrated on mortgage banking segment. These savings will be somewhat offset by increased non-interest expenses in our commercial and consumer banking segment as we continue to invest in our growth. Total core non-interest expenses will vary somewhat quarter-over-quarter driven by seasonality and cyclicality in both our single-family and commercial real estate closed mortgage loan volume. The FDIC’s fall 2018 regulatory agenda released last week signaled that the final rule addressing the change to the capital treatment of mortgage servicing rights will be released to this month. As a reminder, in September of 2017, the regulators proposed a rule easing the capital burden for smaller banks by raising the cap on the amount of net MSRs allowable in Tier 1 capital from 10% to 25% and increasing the risk weighting exposure for the amount of MSR above the threshold from 100% to 250%. The pro forma impact on us, if the rule will apply to our preliminary third quarter 2018 capital ratios, will be to increase our consolidated Tier 1 ratio from 9.12% to approximately 10.1% and our total risk-based ratio of 12.6% to approximately 12.5%. This concludes our prepared comments. Thank you for your attention today. Mark and I will be happy to answer any questions you have at this time.

We will now begin the question-and-answer session. [Operator Instructions] And our first question will come from Jeff Rulis of D.A. Davidson.

Good morning.

Good morning, Jeff.

I guess, Mark Mason, the question on your assumptions on the non-interest expense, what does that – what are the underlying assumptions on headcount in 2019?

The headcount will increase slightly not in the mortgage banking area. That headcount is expected to be flat currently, but in the commercial and consumer banking area, we would be opening some additional branches and hiring some additional commercial lenders and those activities will result in some slight increase in headcount in the commercial and consumer banking.

Thank you. And then just what were you looking at, well first question, restructuring costs those – are those now completed at least for this round that you have announced?

Yes.

Okay. And then is there something in your fiscal calendar or kind of a planning or budgeting period where additional restructuring would be analyzed if needed or is that more of an ongoing process?

We do not have any planned restructuring currently. We continue to analyze opportunities to improve efficiency in all aspects of our business whether it be technology improvements, workflow improvements, real state occupancy and capacity improvements and we expect to have some improvements in many of those areas next year. We also look at strategy and are there ways to improve our strategy, which would improve our results not only over the long-term, but the short term. And so, I would never really say we finished and particularly given the challenging part of mortgage cycle is important that we continuously look to ways to improve those results.

And maybe one quick one for Mark Ruh just on the tax rate, any thoughts on that’s kind of been bumping around in ‘18 but kind of what you expect for Q4 and then into ‘19?

I expect Q4 similar to what we have for Q3 based upon basically changes in our provisioning expenses. For 2019, I think, I discussed in the last call, it’s approximately 21% and I believe that, that’s going to be accurate or a good estimate for 2019 again 21% for 2019.

Okay, thank you.

The next question will come from Tim O’Brien of Sandler O’Neill. Tim O’Brien: Good morning. Just one question on efficiency in the mortgage banking segment, obviously that ratio is pretty elevated, do you anticipate any improvement in that looking out into 2019. Is it possible that could come down below 100% or is it just reflective of the nature and challenges of the market right now and it’s going to take some market changes to improve that?

We currently expect the mortgage banking segment to be profitable next year. I think that we made a lot of changes and it has several quarters in this year in the cost structure. And absent another meaningful decline in industry loan volume or a meaningful decline in our composite profit margin being the biggest factors. We expect this segment to be profitable. We don’t expect it to return to higher levels of profitability that we have experienced in more recent years though given the lower composite margin and lower volume we expect that profitability to – not nearly as significant, but we do expect it to be profitable. Tim O’Brien: Good. That’s good to hear. That’s I guess the product of all the work that you guys have gone through. Just shifting gears quickly to deposit betas, the margin kind of guidance that you gave for next year, does that include any assumptions of rate increases in the forward yield curve, some perspective in the forward yield curve?

It does. We are not sure what the yield curve is going to look like and so making assumption solely based upon Federal Reserve increases without a commensurate assumption on the yield curve is kind of throwing dice. And so when we forecast, we are forecasting static changes or micro changes and so obviously depend upon which direction the yield curve changes could have a positive or negative impact on the margin. Tim O’Brien: Alright. Those are my questions. Thanks, guys.

Thanks Tim.

And next we have a question from Jackie Bohlen of KBW.

Sorry, I was muted. Good afternoon, everyone.

Hi, Jackie.

Hi. Just a couple of questions on deposits kind of digging into some of the more micro trends there. Are you seeing any variance in terms of repricing betas, I know you mentioned that they've been holding the line from the retail segment, but just across geographies?

You know we're not really seeing different experience. Our geographies are generally larger metropolitan areas along the West Coast, very competitive deposit markets accordingly. And I don't know that we're seeing differences in geographic regions and then that includes the Hawaiian Islands, which is a strong savings region. It’s just become more competitive, so our betas grew up a little this year. Fortunately, it’s still below our loan beta and so we're able to do at least on the retail side maintain our spread. Where we’ve been hurt is wholesale borrowings.

No, I understood. And what about deposits from commercial customers?

Yes. That's hard to generalize, right, when you think of all the different businesses. As we noted in the third quarter some of our larger commercial clients and think about title companies and alike drew down their deposits with decline in real estate activity, some of our other commercial clients had true seasonality in their cash flow patterns and so we had a headwind there in the quarter. But I think that basically we see strong cash flow at our commercial customers, some of which they leave with us and some of which they invest, but they are not borrowing as actively as we might have thought.

Okay. And then just one last one on, obviously, credit remains very, very clean. Are there any categories or any areas that you look at that perhaps you're starting to watch a little bit more closely as rates have risen?

Yes. We are being substantially more careful about commercial construction, who we lend to, what types of projects, where they're located, in particular, multi-family construction, new lending has slowed at least for our part materially over the last couple of quarters as we’ve sought to restrict that business to very, very strong sponsors, who are end-users, not merchant builders, who have strong portfolio cash flow and liquidity should cost over-run or timelines to build construction and absorption lease extend, and both of those are true, right. I mean, we’ve seen many projects this year have construction cost over-runs and more elongated absorption periods. Fortunately, our underwriting and customer selection has been very strong. And those concerns which we knit into our underwriting have supported those additional timelines and costs and so we are being even more selective go not out of the market.

Okay. Thank you. That's great color. I'll step back.

The next question will come from Tim Coffey of FIG Partners.

Great. Thank you. Good morning, Mark.

Good morning, Tim.

You just – can you maybe provide a little bit more color on the seasonal outflows and deposits you saw this quarter, and maybe kind of – can you provide a little more detail on what made those seasonal?

Sure. As I just mentioned in my answer to Jackie, part that was real estate-related. We do have several significant regional title companies, who are consistent with lower mortgage volume, lower home sales volume, they have lower transactional volume, right. So those temporary funds, right, closing real estate transactions have declined and pretty significantly, I mean, in the tens of millions of dollars each. We have other large commercial customers, who have seasonal cash flow and that unfortunately happens every year, it’s a little more acute this year.

Okay, right. And if we look at your loan-to-deposit ratio using just loans held for investment, that's up near 100%. Is that a level you're comfortable with given the current rate environment or do you see that coming down?

We have been running about 90% on that calculation for a long time. And I think our prior discussion about the deposits has had an impact this quarter, right. We have had to supplement retail deposit growth or lack thereof this quarter with wholesale deposits despite an increase in the loan portfolio of 3% and that’s what’s really driving that, but we expect that to normalize back to around 90%.

Okay, okay. And then I don’t know if it was in the text of the prepared remarks, but you discussed the expectation of an eventual shake-out in the mortgage lending business, the industry that you compete in and the markets that you compete rather. Are you seeing any signs of that starting to happen or are your competitors still competing on by cutting fees?

To this point, it’s anecdotal right. And we hear a lot of anecdotal stories of individual loan officers lead the industry, of course, some of that are our loan officers who are not performing that we are reducing headcount with. Also smaller mortgage brokers and mortgage bankers we think this quarter you will see more substantial reductions in capacity in that regard and through next quarter. This is the low part of the reason right and many who have been able to hang on through the summer and the fall will not be able to do so and we expect to see more movement here over the next 6 months.

Okay. And then with I think you – as Mark mentioned now 60 retail branches is that the right number for you or could you see that number going down?

Retail deposit branches.

Yes, I am sorry, yes, retail deposit branches.

We see that number increasing over time. We consolidated a couple of smaller branches in Eastern Washington that we have acquired or transitioned branches over the last couple of years. We have other branches that are de novo branches that both have been opened in the last several years that are on their expected growth path. And so while we may not yet have the level of deposits that we would like to see the mature branch, they are still on their expected slope of growth. This has been our strategy for the last 6 years and we expect that – we expect to continue that. Supplementing that is higher C&I related deposit growth. And so we think that our strategy has been a good one. It has resulted in an average deposit growth of 20% a year, the last 6 years. Some of that has been through M&A transactions, but the preponderance of it has been organic growth, which resulted in lower deposit betas in the industry and consistent growth and we think we are on the right track.

Okay, great. Well, thank you. Those are all my questions.

Thanks Tim.

And the next question comes from Brian Rohman of Boston Partners.

Well, I had a question, but they have already been asked, so I won’t ask any. I will say it was a good serviceable quarter moving in the right direction guys.

Thank you, Brian.

[Operator Instructions] And this will conclude our question-and-answer session. I would like to turn the conference back over to Mark Mason for any closing remarks.

Thank you all for your patience and attention and attendance today on our third quarter call. We look forward to speaking with you again next January.

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