Mechanics Bank (MCHB) Q2 2021 Earnings Report, Transcript and Summary

Good day, and welcome to the HomeStreet Second Quarter 2021 Earnings Conference Call. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Mark Mason, Chief Executive Officer. Please go ahead.

Hello, and thank you for joining us for our second quarter earnings call. Before we begin, I'd like to remind you that our detailed earnings release and an accompanying investor presentation were filed with the SEC on Form 8-K yesterday and are 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 our call. Please note that during our call today, we may make certain predictive statements that reflect our current views and expectations about the company's performance and financial results. These are likely forward-looking statements that are made subject to the safe harbor statements included in yesterday's earnings release, our investor deck and the risk factors disclosed in our other public filings. Additionally, reconciliations to non-GAAP measures referred to in our call today can be found on our earnings release and investor deck available on our website. Joining me today is our Chief Financial Officer, John Michel. John will briefly discuss our financial results, and then I'd like to give an update on our results of operations and our outlook going forward. John?

Thank you, Mark. Good morning, everyone, and thank you for joining us. In the second quarter of 2021, our net income was $29 million or $1.37 per share. This compares to net income of $30 million or $1.35 per share in the first quarter of 2021. Our annualized return on tangible common equity for the second quarter was 17.2%. Our annualized return on average assets was 1.59% and our efficiency ratio was 63%. Our net interest income increased 6% in the second quarter due to a higher net interest margin and higher levels of interest-earning assets. Our net interest margin in the second quarter increased to 3.45% and as a result of lower deposit rates as our total deposit costs decreased to 18 basis points in the second quarter and $200 million of payoffs of PPP loans. The net interest income from our PPP loans caused our net interest margin to be higher by 15 basis points in the second quarter. As of June 30, 2021, the amount of remaining PPP loans was $204 million with deferred fees of $5.6 million. As a result of the continued favorable performance of our loan portfolio and improving economic conditions, we recorded a $4 million recovery of our allowance for credit losses in the second quarter of 2021. Our ratio of nonperforming assets to total assets improved to 31 basis points. Our ratio of ACL to total loans was 1.18%. The $12.2 million decrease in net gain on loan origination and sales activities in the second quarter of 2021 and as compared to the first quarter of 2021 was primarily due to lower volume and lower profit margins on our single-family mortgage origination and sales. The $1.2 million increase in loan servicing income was due primarily to unfavorable risk management results realized in the first quarter of 2021 for single-family mortgage servicing rights. The $3.8 million decrease in noninterest expense in the second quarter as compared to the first quarter was primarily due to lower payroll taxes and a $1.9 million reimbursement of legal costs received from our insurance carrier. During the second quarter of 2021, we repurchased 3% of our outstanding common stock at an average price of $44.22 per share and declared and paid a dividend of $0.25 per share. I will now turn the call over to Mark.

Thank you, John. HomeStreet's results for the second quarter continued our outstanding start to the year. Each of our lines of business performed well, continuing to meet or exceed our expectations, and the credit quality of our loan portfolio continued its strong performance, allowing us to begin to recover pandemic-related allowances for credit losses. And given the positive outlook for the economies in our market, we may need to recover additional amounts of our allowance for credit losses going forward. As expected, our single-family mortgage loan volume and profit margins decreased from the first quarter levels due to slower refinance activity. This decrease was offset by higher net interest income, a recovery of our allowance for credit losses and lower noninterest expenses. And despite high levels of prepayments, we grew our loan portfolio in the quarter. Excluding the impact of the paydown in PPP loans, our loans held for investment increased $278 million, an annualized rate of 23%. I am particularly pleased with the level and quality of our second quarter operating results, since many of the markets in which we do business have only recently lifted business restrictions related to the pandemic. Government stimulus and normalization of economic activity should create a strong economic recovery in our markets and provide us with meaningful growth opportunities. Given our strong financial position, diversified lines of business, growth markets and disciplined risk management, I believe we continue to be well positioned to make the most of this recovery. Based upon our strong financial results and positive outlook, we repurchased $25 million of our common stock during the quarter and paid a dividend, which today equates to a yield of over 2.5% on our common stock. We plan to continue to manage our capital efficiently, retaining capital for growth while returning excess capital to our shareholders through dividends and share repurchases. In that regard and subject to our Board of Directors' review and approval and the nonobjection of our regulators, we plan on repurchasing $15 million of our outstanding shares this quarter. we expect our net interest margin to continue to benefit through the remainder of 2021 from the forgiveness of PPP loans. Looking forward, with the Federal Reserve indicating that short-term interest rates will remain low, for the foreseeable future, excluding the impact of the paydown of PPP loans, we expect our net interest margin to remain level as the benefit of our deposits continuing to reprice downward is expected to offset any decline in the rates on our loans. As previously mentioned, the increase in long-term interest rates in the first quarter of 2021 affected our single-family mortgage banking business in the second quarter, reducing the robust levels of volume and profitability that we have enjoyed since early in 2020. This impact is reflected in the change in the composition of our single-family originations between refinancings and purchases. As the percentage of refinancings decreased from 70% in the fourth quarter of 2020 to 45% in the second quarter of this year. We continue to anticipate a slight decrease in our origination and sales activities going forward as well as lower commission-based compensation expense as we return to what might be considered a more normal single-family mortgage banking environment. The pace of this normalization, however, remains difficult to forecast. Where rates move from here is anyone's guess, but we've plans for the continued normalization of single-family mortgage banking volume and profitability over the remainder of this year. While it'd expected again, slight decline in mortgage banking profitability, it's likely to result in upward pressure on our efficiency ratio in the near term. As I stated last quarter, we anticipate total noninterest expenses to decline in the second half of the year, assuming somewhat lower mortgage volume, and related lower compensation expenses to levels which we believe will result in an efficiency ratio in the low 60% range and still falling in future years. We continue to increase our commercial real estate loan originations, primarily multifamily, for both sale and for portfolio. The strong fundamentals and demand in our markets and our successful platforms support this initiative. Over time, this increase in production should support net loan growth and higher net interest income, serving to offset any decrease in noninterest income from lower mortgage banking income, which I just discussed. As a result of the increasing levels of multifamily loan originations, we are contemplating utilizing securitizations to enable us to originate to our full potential, uncapped CRE concentration levels and individual borrower lending limits and improve our capital efficiency. Additionally, securitization of our loans will enable us to retain the servicing of these loans as opposed to whole loan sales which we've used historically to manage capacity limitations and potentially provide improved execution metrics. While the final determination to proceed will be based upon various factors, including market spreads, we are anticipating completing our first securitization before the end of this year. To minimize the impact of the cost of securitization, we anticipate 2 securitizations a year on a go-forward basis in place of our prior whole loan sales, which may produce some quarter-to-quarter earnings volatility. To reiterate my comments from last quarter, the investments we have made and the improvements in our efficiency and profitability have provided us with the operating leverage that will allow us the opportunity to grow revenue and in turn earnings without meaningful additions to personnel or other operating expenses. And while quarter-to-quarter earnings may show some degree of volatility, excluding nonrecurring items such as PPP loans and expense recoveries and of course, subject to any unforeseen changes in the economy and our business, we believe we have the opportunity to continue to grow year-over-year earnings on a per share basis, both next year and going forward past the normalization of the single-family mortgage market. We would also expect our profitability metrics to continue to compare quite favorably to our peers going forward. With that, this concludes our prepared comments today. Of course, we appreciate your attention and participation today. John and I would be happy to answer any questions you have at this time.

[Operator Instructions]. The first question comes from Steve Moss with B. Riley Securities.

Maybe just starting with loan production and loan growth, just given it sounds like a little bit of a change in strategy to support higher origination levels. How do we think about this maybe translating into loan growth on a normal basis going forward here? I think as far as thinking high single digits, could we be seeing type -- double-digit type loan growth?

It is possible. I mean our expectation is high single digits. It could get into low double digits depending upon how successful we are, the utilization of securitization, as I mentioned earlier, may support higher levels. The market is very, very strong still, particularly in the markets in which we do business. And our market share is still relatively small when you consider how large these markets are even the multifamily market, which we focus on in the West Coast, of course, is very, very large. So we think that our initiative to increase production obviously is working so far. We think we have a lot of room to grow and uncapping the balance sheet, we think, is the right thing to do at this time.

Got it. And then maybe just in terms of the expansion in loan growth. So I guess maybe 2 parts. One, is the level of originations you think sustainable at the current quarter level? And are you guys hiring additional people just kind of curious as to how to think your expense is there, too? Compensation-wise?

We'll probably add a small number of producers, but we are still realizing efficiencies from the restructuring work that we did. So we are still not expecting a material addition to personnel for the foreseeable future.

Okay. And is the kind of $900 million type level we saw for originations, perhaps a sustainable level? Or just kind of curious on that.

We think so.

Yes.

We hope to improve on that number. But yes.

And that's including the originations of loans held for sale. That's just for the held for investment. So we do have additional originations beyond that.

Okay. Okay. That's helpful. And then just maybe on the potential for a $15 million buyback and the step down here. Just kind of curious capital levels, call it, relatively steady. Is this just reflective of your expectations for higher growth? Or just kind of how do we think about this going forward?

We're leaving a little capital for growth, right? The -- if you think about what we're making per quarter, we are paying a dividend that's a little in excess of $5 million a quarter. This quarter, it's a little higher because net income is a little higher because of the reversal of ACL, right? So if you back that out with a $15 million repurchase, plus $5 million of dividends leaving a little capital for growth, it should kind of make sense.

Okay. Okay. That's helpful. And then just in terms of -- one last question for me, just in terms of loan pricing. Just kind of curious as to what you guys are seeing for rate these days?

It is not much different than last quarter, frankly. The note rates on new production, construction is still in the mid- to high 4% range. Single-family is in the low 3s, multifamily low 3s. C&I is 4% to 4.5%. Those are major numbers on note rates.

The next question comes from Jeff Rulis with D.A. Davidson.

Question on the really, the -- I wanted to circle back to the loan growth a little bit. I think you guys had kind of talked about targeting larger relationships, and particularly in multifamily. I wanted to kind of follow-up and say, was that a factor in this quarter's growth? And part 2 of that is any purchase loans in what you characterized as growth in the quarter?

Second question first, no purchase loans. The closest we get to purchase loans are some syndications or participations on the C&I book, but it's quite small. This is all our originations. Large borrowers didn't really impact this quarter. We did a few loans for larger borrowers, but I wouldn't say it was beyond the average per quarter. The decision to consider securitizing going forward, a portion of the loans has some benefit to larger borrowers. And I think I mentioned in my comments that we have borrowing relationships that we would very much like to do more with, but we have house limits on loans to one borrower, plus we have legal limits as well, right? And securitization is a way to go beyond those limits.

And one other thing, Jeff, as I think when you heard in the past, I was talking about larger loans, we were specifically referring to the DUS program because we changed our structure. So we're allowed to do bigger loans, but those are loans held for sale.

Okay. Fair enough. And I guess, John, while I have you on the margin, I may have missed it at the beginning there, kind of rattling through the PPP impact. Do you have the key contribution to margin in the first quarter versus the second quarter? And/or maybe just had a core margin with that stripped out would...

Actually, if I strip out the PPP loans, their total impact, both the balances and the revenues that we had in the first quarter, it actually had a negative impact of about 2 basis points in the second quarter, it had a positive impact of about 15 basis points. So when you look at the steady state, if you exclude PPP loans, we kind of are expecting a flat rate if you exclude their impact.

Flat margin.

Flat margin, excuse me, sorry.

Okay. And John, that 2 basis points respectively, that was to the margin, not earning asset yields, correct?

Yes. To the net interest margin, that's correct. So if you pulled out the balances in the income. And the reason the first quarter was negative is because we put on a lot of balances that we're earning 1%.

Checking around people.

Yes, yes. And Mark, sorry, one more. On the -- so if we're talking about high single-digit or low double-digit loan growth stable credit. Your comment that may continue to have a reverse provision here. Is there -- maybe just bigger picture, kind of comfort, maybe that's through the end of the year and then you stabilize on the reserves, if you could kind of ballpark kind of where that base level is where that kind of settles in?

Sure. It's hard to comment on what the actual pace will be. I mean we've added $20.5 million to the ACL in the first and second quarters of last year, specifically for the pandemic. We -- since that time, our portfolio has continued to perform well even better. So there was going to be pressure on the ACL without the pandemic. If you look at our loan coverage from the ACL pre-pandemic, I think we were around 87 basis points, I believe. And given improved performance and a greater composition of multifamily loans in the portfolio, our steady-state ACL, fully passed any pandemic recoveries, is likely to be 87 basis points or lower, if that helps. Now how quickly we get there is a little unclear though at this juncture, I would still expect to recover based upon all the trends more this year.

Okay. So pace of maybe drift down is up to some review, but that falling at some point, sub-1% of loans is not a figure that you think is out of the question?

No. And for lack of a better yardstick, it's so hard to know. If you just recovered it evenly through the end of '23 -- I'm sorry, '22. That might not be a bad estimate, but I can't assure that, that's going to be the pace. But I mean, we have to plan somehow also, I mean we have the same internal problem. And for lack of a better yardstick, that might be a good way to consider recovery.

Yes. Jeff, we're still, as everybody else is learning the CECL modeling and the processing, the implications of it and how it works. And it's a very involved process, and you don't have a ton of history with it. So as Mark said, that's a reasonable assumption going forward. But when it actually happens, we'll kind of go through each quarter and have to evaluate whether it makes sense.

Right. I mean we could recover it faster than that, potentially. If there are any indications of an elongation of risk, it could be slower. We surely don't anticipate that today. So I don't know if that's helpful or not.

That is, I get the gymnastics of the process here. I just -- was part of the question is your loan growth. And you talk about lowering reserves just kind of growing into it. And if you keep this pace, it's -- you're kind of doing at it from both sides. So helpful otherwise, I appreciate the comments.

The next question comes from Matthew Clark with Piper Sandler.

Maybe just first on the share repurchase, another $15 million in the upcoming quarter here. What are your thoughts beyond 3Q in terms of share repurchase? Do you get to a point where given all you bought back that the float starts to become a concern or an issue? Or do you feel like you can continue the buyback beyond this quarter?

I feel like that would be a high-class problem. Let me start with that, right? I mean if we are so successful in managing our capital that we're able to return enough capital that, that becomes a float issue, we would split the stock first from a share -- because I would assume the stock price would be going up commensurately, right? We would probably split the stock. I would also assume our multiple would go up as well because that would mean an ever improving return on equity and EPS. I haven't really considered that potential problem yet. But I guess if we got there, that would be a good problem to deal with.

Okay. So it's fair to assume that buybacks will likely continue beyond this quarter?

Yes, that's our working assumption. On one perspective, and you'll understand it's biased. If the market is not going to appropriately value our shares, one of the best investments we can make is buying it back to the benefit of our remaining shareholders. And if we have enough capital that we're generating on top of that return of capital to shareholders to satisfy our growth needs, absolutely the best thing for us to do.

Okay. Got it. And then just on expenses, I think you've talked in the past about a run rate. You've given some guidance for the next 2 to 3 quarters, which is obviously helpful. But you've also talked about the normalization of mortgage kind of gain on sale with some offsets. So do you feel like that run rate of $54 million, $55 million can come down next year? Or do you feel like even with maybe gain on sale revenue declining, that run rate might be able to come down?

I think that's a good run rate. There could be some volatility within quarters, particularly because of the seasonality of the normalized mortgage business. There -- when you get further out, let's say, to late '22, '23, inflation will impact you somewhat, right? I mean just think about annual merit increases that for our industry have averaged about 3% a year. There will -- even with a steady-state FTE count, there is some inflation in expenses. And so there might be some small increase in that number as you get out, let's say, to 2023.

But I think the important thing to remember here is just the operating leverage. So as we're going through this and keeping our expenses pretty relatively flat, we have the potential with our growth in our loan portfolio to really start getting increased revenues to get better operating efficiencies.

Right. So regardless of whatever inflation might do to expenses, we're expecting revenue increases of a multiple of whatever that is.

Understood. Okay. And then just on the for-sale originations coming down a little bit from where they were this quarter. Do you feel like -- I think you did $2.16 billion of SFR loans sold last year and about $713 million on the CRE side. I guess how do you feel about both of those buckets? Do you feel like you can come close to matching that type of for-sale production on the SFR side? And what are your thoughts on the commercial side as well?

We think in the single-family for-sale production bucket, if you will, that this year will be similar to last year. They just -- it's just going to come in different quarters. The Fannie Mae DUS business, we think, will be higher this year. Our multifamily loan sales, if we do end up securitizing this year, whole loan sales, of course, will be down. Sales through securitization will be up. The total may not be much different this year than last year. It kind of depends on the volume of securitization. If we don't securitize, we will likely do whole loan sales sometimes by the end of the year. It's just a little unclear right now.

The next question comes from Jackie Bohlen with KBW.

I wanted to chat about deposits, just really nice growth in the noninterest-bearing accounts this quarter. I just wanted to see what some of the internal trends may have been there?

A lot of business deposit growth in the quarter. And sort of across all markets, we are adding relationships and more deposit-only relationships. We have a specialty deposit group that we've been building over the last couple of years, that's starting to get some traction. That's helped a great deal. The existing customers we're banking have retained somewhat more cash as well. I think that's true across the industry right now. We wish they are borrowing more, but they are retaining more cash. And I think the trends you see with our peers are also true here. But we saw an acceleration this quarter, very happy with it.

Okay. And is that -- I noticed that you also had CD decline, which those in combination, obviously, did great things for the mix in the quarter. Is that more a factor of repricing to intentionally run people out or you -- not run people out, but reduce CDs? Or is it more people as their CDs are maturing, putting them into other accounts?

Well, I think it has more to do with the runoff of much, much higher priced money and because we have reduced our rates farther than we would have historically. We're trying to retrain our customers somewhat. We were always not just a premium rate payer. But at times, we've led our markets when we were growing at 20% a year, and we needed to grow deposits at a much higher rate. Well, since we changed our growth expectations, we have also lowered our rates to be a lot closer to our peers. And for some deposit -- CD deposit customers who are only shopping at absolute highest rates. There are better rates available, whether it's online or otherwise. And so I think that, that is -- has helped us lower our CD balances in an effective way for what we really consider core customers.

Yes. And one other aspect, Jackie, is we do have some wholesale CD deposits that we utilized from time to time in the past, it's been a larger proportion of our balances. So some of the decrease has been in the wholesale side.

Brokered CDs.

Yes, brokered CDs.

That's true, too.

Okay. So setting aside -- sorry, go ahead.

Just adding on to that, since they are substantially borrowings as our deposits grow, we reduce the need for overall borrowings.

Okay. And setting aside kind of the unknown about customer liquidity behavior and how that's going to fluctuate in the coming quarters. Would you expect kind of the core trends of having great shoppers shift out while business customers and lower cost deposits shift in, would that continue?

That's our plan. Everything we're doing is trying to grow the number of relationships, grow the proportion of the relationships that we have. Look, we have been working for, gosh, I guess I can say now, many years to convert what once was a very traditional thrift to a full-service commercial bank. And this ongoing change in composition of deposits is a primary part of that ongoing initiative.

And also, I think on the consumer side, I think we are developing a really strong core base of customers that are less price sensitive than may have been historically in the past for this bank. So I think that's another positive benefit on the consumer side. It's more stable customers that won't be leaving you for a couple of basis points.

Okay. Okay. Great. That's very helpful. And then one last one for me, and I apologize if this is a moot question. But just wondering if you could provide an update on kind of where you stand with any subleasing plans that you might have? I know there's obviously a number of factors that influence that if you're still looking to do any of that activity. But I just wanted an update there.

Well, thank you for asking that question. You may remember in the fourth quarter of last year, we took a pretty substantial charge, about $6 million to accelerate our subleasing efforts, there were still a hangover from our downsizing of the mortgage business. That was very successful. We have led the market, I guess you can use that term as the lowest price Class A footage available in Seattle since that time. And I'm happy to report that we have substantially completed that subleasing effort. Having said that, we are in the process of restructuring expectations of how much time our people spend in the office versus working remotely and moving some number of people to nonpermanent workspace, hoteling workspace. And we are expecting that, that process will ultimately create some more excess space that we'll have to sublease. Please don't ask me the metrics of that yet. It's still unclear, but we may have a little more to do going forward.

Okay. Okay. That's a good update. And I mean, I would assume that when you think about the run rates that we discussed earlier in the call that all of this was taken into consideration for that barring the endos of kind of future subleasing.

Correct.

The next question comes from Tim Coffey with Janney.

Mark, if I can just kind of get a little more color on this potential securitization. The one before year-end, what's the probability that happens?

Today, I would say it's very good. But I am not a predictor of interest rates nor spreads. And interest rate spreads can be volatile, and they can change quickly. So I'd say it looks good right now. Our folks are doing a lot of work on it. Of course, the first securitization takes a great deal more work in establishing structures, relationships and all that, but remains to be seen. So we are hoping to get this accomplished. We think that it's an important structural maturity in our business and gives us a lot more flexibility. At times, gain on sale, they might recognize in securitization is larger than the whole loan market. At times it's not, right? And so that's a significant consideration.

But the retaining the servicing is a very, very positive aspect of the securitization.

It's very important. The ability to retain our customers, the ability to sort of uncapped CRE concentration concerns or the loan borrower concerns to be able to do as much business as possible with the large borrowers that you feel most comfortable doing business with. It's a great opportunity.

No, there's a ton of benefits to the program. You also mentioned potential earnings volatility in the quarter, most of the securitizations are completed. What's the magnitude of that volatility?

Well, you can think of it this way. If you look at last year's home loan sales, we did them in each quarter, not exactly the same amount. But we did some in each quarter. If you took that total, let's say, and only put it in the, let's say, second and fourth quarters, right, you would have volatility between the first and third and second and fourth.

Okay. And just kind of how you're thinking about when you would secure -- you would do a securitization? Would it be something like, say, the first and fourth quarters when the residential mortgage market is seasonally weak?

I think we're thinking more second and fourth quarters, but that may not turn out that way. If we -- let's say we were to close a securitization by the end of this quarter. It's more likely we would securitize in the first quarter of next year and then 6 months later.

Okay. Okay. I was just trying to get a handle on the timing of that.

Yes, to be more precise, but ...

We'll figure it out as you start doing them. And then, John, just looking at the investment portfolio, I mean it's been coming down on average balances, period imbalances for the last 3 quarters. It's at a relative range where it's historically been. Is there anything that you see in the investment market that I mean, you don't like that potentially you could see a buildup in cash? Or is it just really dependent on the normal things like increase in deposits and loan growth?

Yes. I think it's more dependent on the latter. In terms of our investment portfolio, we utilized that almost exclusively as a liquidity portfolio to meet liquidity requirements. However, we have -- do a very good job of, on a relative basis, generating earnings out of it. But I think going forward, you're going to see a relatively stable percentage of balance sheet in our investment portfolio. So as we grow, I would expect that to grow slightly, consistent with the growth in the balance sheet just to maintain our liquidity requirements. And go ahead.

Just a footnote to that, though, inside of that portfolio is essentially a collateral portfolio, right? Because we do -- we have a fairly large derivatives book because of our level of hedging, many of our agreements, of course, require collateral. And so inside of that book is a sub portfolio, if you will, that is collateral qualifying under these various agreements. But in terms of total, John's right, we were generally targeting as a percent of assets. But sometimes, we grow it a little. We've been lucky to grow it before -- while rates were a little higher, which has been nice. But I don't think you're going to see us focus on growing that as a percent of assets.

And we have a follow-up from Jeff Rulis with D.A. Davidson.

Just a housekeeping. The PPP loans outstanding as of 6/30. And if you could -- John, if you want to comment on the pace of forgiveness through year-end?

Well, I can tell you, I just closed a little bit. We have about 200 -- a little bit over $200 million worth of loans and about a little over $5 million worth of deferred fees. Our expectations, and we haven't always been right because we're not sure what the SBA does all the time. Our expectations is that a majority of those will be forgiven by the end of the year. And so that's kind of our working model. But that depends on 2 things: The SBA processing, which seems to have picked up; and also our customers filing the forgiveness, which sometimes they tend to wait until the last second and going through that process. So our expectation is that most of it will be gone by the end of the year. And that's -- does that answer? I think that's the best answer we got right now.

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

Thank you again for attending our call and for the great questions, and we look forward to speaking to you next quarter.

The conference has now concluded. Thank you for attending today's presentation, you may now disconnect.