Mechanics Bank (MCHB) Q1 2022 Earnings Report, Transcript and Summary

Hello, and thank you for attending today's HomeStreet Q1 2022 earnings call. My name is Selena and I will be your moderator. All lines will be muted during the presentation portion of the call with an opportunity for questions and answers at the end. [Operator Instructions]. I would now like to pass the conference over to our host, Mark Mason, Chairman and CEO of HomeStreet. Please go ahead.

Thank you for joining us for our 2022 first 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 will 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 on our call today, can be found in 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, then I would 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 first quarter of 2022, our net income was $20 million or a $1.1 per share as compared to net income of $29 million or a $1.43 per share in the fourth quarter of 2021. In the first quarter of 2022, our annualized return on average, tangible equity was 12.2%. Our annualized return on average assets was 1.10%, and our efficiency ratio was 77%. Our net interest income in the first quarter of 2022 was $2.5 million lower as compared to the fourth quarter of 2021, due primarily to lower average loan balances. Interest expense related to the $100 million subordinated notes offering completed in January 2022 and reduced revenue from PPP loans. The lower average loan balances were primarily due to the sale of $244 million of Multifamily portfolio loans in November of 2021, which was partially offset by the increase in loan balances during the first quarter. Our effective tax rate for the first quarter was 19% due to excess tax benefits resulting from the vesting of stock awards in the quarter. Our quarterly effective tax rate for the remainder of 2022 is expected to be 21.5%. As a result of the continued favorable performance of our loan portfolio and the improving outlook of the impact of COVID-19 on our loan portfolio, we recorded a $9 million recovery of our allowance for credit losses in the first quarter of 2022. Our ratio of non-performing assets to total assets improved to 17 basis points. Our ratio of ACL to total loans was 66 basis points at March 31st, 2022. This is comprised of expected losses of 41 basis points and qualitative and other factors of 25 basis points. The ratio of ACL to total loans upon the adoption of CSL at the beginning of 2020 was 87 basis points, which was comprised of expected losses of 71 basis points and qualitative and other factors of 16 basis points. The decrease in expected losses is due to the continued low levels of loss experience since adoption of CSL which has the effect of reduced in the computation of projected losses and a shift in our portfolio to lower risk assets. During this period, our permanent Multifamily loans as a percentage of our loans held for investment increased from 19% at January 1st, 2020 to 47% at March 31st, 2022. As a reminder, we have never experienced the loss on a Multifamily loan. Going forward, we do not currently anticipate any significant additional recoveries of ACL as continued improvement of pandemic related credit risk is anticipated to be offset by loan portfolio growth. The $13.1 million decrease in non-interest income in the first quarter of 2022 as compared to the fourth quarter of 2021, was primarily due to a $4.4 million decrease in single-family gain on loan origination and sales activities due to a decrease in rate locked volumes and margins as a result of the effects of increasing interest rates. A $7.4 million decrease in CRE, gain on loan origination sale activities due to no sales of multi-family portfolio loans in the first quarter of 2022 as compared to $244 million of sales of multifamily portfolio loans in the fourth quarter of 2021. The $0.5 million increase in non-interest expense in the first quarter of 2022 as compared to the fourth quarter of 2021, was primarily due to a $1 million reversal in the fourth quarter of 2021 of previously accrued medical benefits related to the positive experience in our self-insured medical benefits programs in 2021. Higher occupancy costs related to higher common area maintenance charges and accelerated depreciation in the first quarter of 2022 and higher legal costs incurred in the fourth quarter of 2021, our litigation activities and other legal matters. During the fourth quarter of 2022, we issued a $100 million of subordinating notes and we utilized $75 million of the net proceeds to purchase over 7% of our outstanding common stock at an average price of $50 and 97% -- $0.97 per share. We also declared and paid a dividend of $0.35 per share. The first quarter dividend of $0.35 per share, represented an increase of 40% over the prior quarter. I will now turn the call over to Mark.

Thank you, John. During the quarter, we achieved a number of our goals, including growing our loan portfolio, completing our $100 million subordinate notes offering, and returning excess capital to our shareholders, while improving our overall cost of capital. We grew our held for investment loan portfolio at an annualized rate of 24%. The growth was achieved through the origination of $747 million of loans, absence of Multifamily portfolio loan sales, and a slowdown in prepayments. Historically, we have sold a portion of our permanent Multifamily loan production. As a part of our growth strategy, we decided to forego the current revenue from these loan sales this year, and instead, establish a foundation for future earnings growth. We currently anticipate against selling a portion of our portfolio of Multifamily loan production in future years. As a result of strong loan originations, a focus on loan retention, and portfolio growth along with slower prepayments, our net interest income is expected to grow meaningfully growing forward, and be a larger and more consistent component of our revenues. While we expect growth in our portfolio coming from all our business units, our commercial real estate loan originations, primarily Multifamily, are expected to be the primary driver of our near-term growth. With the completion of our $100 million subordinated notes offering last quarter, we accessed inexpensive capital to continue our stock repurchase program and support our future growth in earnings per share. The credit quality of our loan portfolio continued its strong performance in the first quarter. As John mentioned earlier, greater clarity on the impact of COVID on our portfolio allowed us to recover $9 million of our ACL. This recovery reflects ongoing reduction pandemic related credit risk, our conservative credit culture, as well as our focus on originating lower risk Multifamily loans. As expected in the face of increasing interest rates, our single-family mortgage banking revenues decreased during the first quarter and were less than 10% of total revenues. Additionally, our first quarter Fannie Mae DUS Multifamily loan origination and sale activity was substantially lower than we anticipated. Despite higher lending caps, the Fannie Mae DUS program was often not competitive in the quarter. In fact, first quarter Fannie Mae DUS national loan production declined 23%, quarter-over-quarter and 8% from last year's quarterly average. We now expect Fannie Mae to be more competitive over the remainder of the year and recently announced changes in underwriting and pricing support these expectations. As such, we anticipate significant improvement in our DUS production on loan sales over the remainder of this year. Due to lower revenues, our efficiency ratio in the first quarter increased to 77% and we anticipate the second quarter efficiency ratio while improved from first-quarter results, will remain elevated for the same reasons. However, as a result of loan portfolio growth and related increases in net interest income, and our ability to leverage our existing operating expense infrastructure, we believe we will improve our efficiency ratio to 60% or below for the second half of this year. And we believe we can reduce our efficiency ratio to the mid-50% range in 2023. These levels include the impact of our single-family mortgage banking operations, which historically have added three to five basis points to our overall efficiency ratio. These anticipated improvements on our efficiency ratio are the result of our profitability improvement initiatives we completed two years ago. Let me state it simply, our decision to retain all of our portfolio permanent Multifamily loans in the more challenging environment for single-family mortgage production have reduced current earnings. However, we believe that our strong loan portfolio growth and associated net interest income growth combined with our ability to deliver our existing non-interest expense base and our continued efficient capital management should provide for meaningful earnings-per-share growth starting in the second half of this year and for 2023 and beyond. As much as I'd like to fast forward to the second half of the year, when our results should better reflect the new level of earnings power that we have been creating, the foundations for that earnings power are actually visible today. Our annualized loan portfolio growth was 24% in the first quarter and much of that was originated near the end of the quarter. Just consider what mid-teens loan growth, a stable net interest margin, strong credit quality, significant operating expense leverage, and continued efficient capital management provides as one looks to future earnings potential. We believe that our earnings growth will not be incremental, but rather more of a step function upwards. In that regard, in the second half of this year, we are targeting a return on average assets in excess of 1.25%, any mid-teens or better average return on tangible equity -- I'm sorry, return on average tangible equity. In 2023 and beyond, we are targeting a return on average assets in excess of 1.35% and a high teens or better return on average, tangible equity. Of course, these targets imply that the potential of meaningful increases in earnings per share are possible. Before going, target returns assume a generally stable economic environment, current consensus views on rise in interest rates and the yield curve, and an absence of changes in law or regulations or other events or factors which could negatively impact the success of our business strategy. I hope our current shareholders, as well as the analyst community, will give appropriate weight to my comments today. We have substantially reduced the contribution of single-family mortgage banking to our earnings, and we are significantly growing our [Indiscernible] for investment loan portfolio with high quality, lower credit risk loans, which together should provide for much more durable and reliable earnings going forward. We have made meaningful efficiency improvements to our operations and processes, giving us significant operating leverage to support our expected future revenue growth. We have used our capital wisely, providing for our balance sheet growth while returning excess capital to shareholders through dividends and sizable share repurchases. These actions should result in much higher and consistently growing levels of profitability when compared to our history. Our combined efforts over the recent years have already produced superior returns for our investors. For example, our one-year, three-year, and five-year total shareholder returns as of the end of the first quarter were, 10%, 89%, and 78% respectively, versus the benchmark KRX, which were 3%, 38%, and 32%. And despite having consistently outperformed the KRX, our valuation remains well below level of consistent, of the quality, and profitability prospects of our bank in relation to our peers. We remain confident, however, in our ability to execute our business strategy and achieve our goals, including the appropriate valuation. With that, this concludes our prepared comments today. Thank you for joining us and for your attention. John and I will be happy to answer any questions you have at this time.

[Operator Instructions]. As a reminder, if you're using a speakerphone, please remember to pick up your handset before asking your question. We will pause here briefly as questions are registered. The first question comes from Jeff Rulis with D.A. Davidson. Please proceed.

Thanks. Good morning, Mark and John.

Good morning, Jeff.

Hey, Jeff.

On the loan growth side, with the -- well, two questions. Were there any loan purchases in that growth this quarter and where geographically did you see pockets of the greatest strength?

First, we don't purchase loans from others. All of our loan origination has been organic and will remain so. In terms of strength, I think you can look to where our loans have historically been originated. We have good data in our investor deck, particularly in commercial real estate, about where we have concentrations. We have a concentration in Southern California, that's probably our largest concentration. Los Angeles County and greater Southern California. The next concentration would be in the [Indiscernible] area. Western Washington. And then there are other areas, generally coastal areas, that we serve. So no real changes here. Our business is concentrated in the big markets in the West, the coastal west. And those markets performed well during the pandemic. They continue to perform well. Real estate inflation is among the most significant in the West, and that's helping fill the activity.

And Mark, your loan growth outlook is with 20% plus this quarter annualized. Is that sustainable? Is that -- I'm looking at your sort of guidance slide and up, up is basically the guidance but just wanted to get a relative sense for pace.

Sure. Obviously, we're off to a hot start given our guidance. I think that on the last call we said we are expecting to be at the higher end of our guidance. I think that's still true. I might add or better, at this juncture given the start.

What is that guide, Mark, 100%?

The guidance is --

10% to 15%.

It's 10% to 15% growth this year, particularly given the start. I think we feel good about the upper end of that and potentially better.

Got it. Thanks. And Mark, also just checking in on the buyback and obviously with the sub-debt and use of that, but just the -- your appetite going forward, given where prices have moved. Just checking back in on buyback appetite.

While we didn't use all of the proceeds as you've noted. We are still interested in continuing to buy our stock back. We had an authorization of $75 million for our board in the first quarter. We are going to be discussing when we may reenter the repurchase market with our board. We didn't expect prices to come down this far, right? Obviously, if any of this did, we'd be making a lot of money on short-time, I guess. So they're pretty attractive, right? When you consider the returns, particularly in our cases, we think about the confidence we have in our growth and earnings growth and what the reasonable valuation of that gross should be. These are pretty attractive levels by stock. And so we're going to be discussing when we expand our program.

Thank you.

The next question comes from Matthew Clark with Piper Sandler. Please proceed.

Hi, good morning.

Morning.

First on the commercial real estate, just CRE in general, including Multifamily. I was wondering how high are you willing to let that commercial real estate concentration go? Do you have an internal limit relative to capital? Just trying to get some color there.

Sure. We are willing to let that concentration go to 600% of 22 capitals. We feel very confident in our credit culture and particularly in our growth. Our growth is primarily going to come in permanent multi-family loans. I wouldn't expect to see meaningful growth in some of the other categories of commercial real estate, though we'll see some consistent with inflation at least. Multi -- permanent multi-family loans are among the lowest risk assets in banking. And if you're paying attention to what is happening with housing availability and the related impact on rental rate increases, we feel very, very good about the collateral. We start with very conservative loan-to-values and debt coverage ratios. And we have seen shock in increases in rental rates, which of course, simply make these loans safer, just to give you an idea of recent increases over the last year, fourth quarter '21 to fourth-quarter '20, we have seen rental rate increases ranging from 13% in Spokane to 33% in Scottsdale, Arizona. Seattle and Bellevue were 19% and 20% over that year. And these are not unusual numbers. There is still an absence of sufficient housing in the big western markets where we lend and we feel very, very good about the collateral we're landed against. Our regulators additionally, give us continued high marks for our risk management program. They say it's best-in-class and best practices and they feel very comfortable with our policy limit for CRE.

And then on CRE loan sales in terms of volume, I think last quarter, we discussed maybe being down 50% year-over-year. This quarter, year-over-year down more than that, linked-quarter, obviously, also down more just without whole loan sale. Any updated thoughts on how much CRE loan sales in terms of volume might be down? I think you did $773 million last quarter, including the whole loan sale.

Right. Well, our current plan is not to do any Multifamily permanent portfolio quality loan sales this year. We do expect our Fannie Mae DUS loan origination sale activity to pick up meaningfully over the remainder of the year if you look back on my earlier prepared comments. We're very disappointed with Fannie's program in the first quarter. It was amazing how much less they did nationally and that reflects our experience. But also what was a little shocking, if you look at Freddie Mac's Multifamily production versus Fannie Mae's in the first quarter, Fannie Mae DUS originations were 1/2 of Freddie Mac's in the first quarter. So all that points to hopefully a much better remainder of the year for them to catch up. Going forward in 2023 and beyond, we are expecting or at least currently planning to sell about what we've averaged the last couple of years. That number could be roughly $600 million, but we'll have to get -- wait till we get to next year to see how we feel about it. But as we plan -- in our planning, we're expecting to return to some amount of permanent Multifamily portfolio loan sales next year.

Okay. And then shifting to the buyback, it sounds like you're going to be discussing that here shortly, but is there a lower TC ratio impact that decision to some degree? I guess, is there any floor you want to manage to you as it relates to TC? I know regulators care, obviously, about regulatory capital more than anything, but any commentary around the level of the TC ratio relative to the buyback?

Well, that's a fair question. We watch all the ratios, not just the regulatory ones, but tangible capital ratios as well. I think that it's important to remember one thing. Our capital ratios at the bank level were impacted by the subordinate data offering. They were somewhat impacted from a tangible level by increasing OCI levels. But all of our stocks activity in the funding of it in the first quarter occurred at the holding company, right? So there's a meaningful difference between bank level capital ratios, particularly tangible and holding company. We have different risk appetites internally for capital ratios at the bank level versus the holding company as well, and I think that's true for most of our peers. As a direct answer though, that does enter into our considerations, how low we would be comfortable letting our tangible capital level or common equity capital level in relation to assets at the holding company. And so we're going to watch that. We're very comfortable today. It's roughly, what? 8%, I think. Just under 8%. Many of our peers are well below that level. Some people in the 5% range, which is a little surprising. So it's a consideration, we're very comfortable we're that today. So as we continue to make profits, that continues to give us lots of room to consider repurchases.

Okay. Thank you.

You bet. Good question.

Thank you. The next question comes from Woody Lay with KBW. Please proceed.

Hey, morning, guys.

Good morning, Woody.

Hey, Woody.

I wanted to touch on the single-family mortgage outlook. As we've seen industry-wide, revenues have been under pressure. For you all, just as we look to the quarters ahead, do you think we could see a slight redundancy in mortgage revenue or is 1Q '22 AS solid base from here?

Well, remember, there's always seasonality, right? And the larger volume periods are in the second and third quarters, volume start slowing down. After the third quarter, as you draw down the pipeline, typically first quarter, you begin rebuilding the pipeline, but generally not until March. Now, overlaying that is the current changes in interest rates, mortgage rates in particular. That has a depressive effect on volume, as you would expect. And so our first-quarter was especially low because of both factors. We do have some concern for the prospect of rising volume in the traditional home buying season in the middle of the year, just by available inventory. The levels of resale and new home inventory, well, they've been low for years, but they are at critically low levels today. And so we're being at least internally, somewhat conservative about our expectations for volume this year in total, we do expect to see some improvements in volume in the middle of the year. How much, remains to be seen, it's going to rely on large part on I think changes in the resale market.

Right. Okay. That's helpful color there. And then I wanted to turn to the [Indiscernible]. I think on your guidance slide calls for a stable [Indiscernible]. I was just wondering what rate assumptions that assumed in the guidance?

The rate assumptions that we've assumed in the guidance is pretty consistent with what the consensus is in terms of rate increases here. We are being a little conservative from that perspective. Our interest rate modeling is showing that we will benefit from a rising interest rate environment as with everybody else, somewhere in the 1% to 3% range, for 100 basis points and higher than that for 200 basis points. We're evaluating that on a constant basis. Obviously, the Fed's meeting next month to go through that in terms of process. So the guidance we provided was stable as a little bit conservative from a rising interest rate environment impact on us.

Right, so we believe we have opportunity beyond stable. And to the extent that the Fed has larger increases, that probably makes for a little larger opportunity initially, and then we'll have to see how deposit betas go.

All right. All right. And then my last question, obviously, loan growth has been really strong the past couple of quarters. How should we think about deposit growth throughout this year? Do you think it can continue in it's high-single-digit range as it did in 1Q, or how are you-all thinking about it?

We're expecting it too. We believe we're going to be able to generally fund our growth with deposit growth. We have very low levels of borrowings today. The pandemic was great for us and allowing us to grow deposits and extinguish a lot of borrowings. But we're currently planning to generally fund our growth with deposit growth.

All right. Thanks for taking my questions, guys.

Thanks, Wood.

Thank you. Our next question comes from Steve Moss with B. Riley Securities. Please proceed.

Good morning.

Good morning, Steve.

Good morning. Just following upon on rate tier, just in terms of pretty big move in the five-year here towards last couple of weeks in the quarter. Kind of curious where you were seeing loan pricing these days here as we move forward.

It depends on the product. In the commercial world, most of our lending is prime-based so every time it moves up. Spreads are staying the same generally so those yields are rising in lockstep with a rising short end rates. On the longer end, loan yields are starting to rise but competition is still fierce and rates have not moved -- competitive rates have not moved with changes in the yield curve completely. Now, I expect that to catch up. There is a tremendous amount of activity in the permanent commercial real estate area. A lot of borrowers wanting to refinance or a complete purchase transaction before additional changes in rates and originators like us obviously, had great quarters in satisfying that appetite. We're not sure where the yields currency is going to go though. Is it actually going to have a healthy curve or is it going to invert? We've seen component inversions or partial inversions already to your point about the five-year -- three to five-year area. That's going to keep longer rates more attractive and we're still actively lending based upon a five and seven-year rates, mostly in commercial real estate. So very competitive. Rates have not risen as much as maybe they should or could. But if you want to be an active originator, which obviously you are, you got to be competitive.

Okay. That's helpful. And then in terms of just thinking about credit costs and the reserve here going forward, step down to 65 basis points, probably a bit more than I was thinking. Just curious is this like the bottom as you guys think about the reserve ratio and just yield -- it's -- were there any overlays maybe I should ask in terms of economic assumptions, as we think about this?

Yeah, there were. If you noticed, I broke out in my comments, the difference between what the expected losses are and what the overlays were. And while there -- our expected losses went down was one of the bigger drivers, we actually increased our overlays compared to when we adopt the CSL.

Instead of overlays let's use the phrase qualitative factors.

That would be better. The qualitative factors because it's a combination of items. And so those have actually increased as a percentage of portfolio on absolute dollars even more because our portfolio is bigger. So I think from that perspective, we look at this is that we have room to absorb continued loan growth this year, and we expect to probably start provisioning on a regular basis beginning next year. But we did have the larger recovery in the first quarter just because trying to support it through CSL didn't allow us to defer any of it.

Any longer.

Any longer.

Okay. And then maybe just a little follow-up on mortgage. Apologize. I missed it. Just on gain on sale margin here coming in just kind of curious as to Mark, you mentioned a lack of inventory here, obviously there's a number of mortgage originators out there you have crosswind at higher rates. How are you feeling about gain on sale margins?

Well, look, it's very volume dependent right now. We have had some compression in profit margins, which is totally expected when volumes fall like this. So our -- look, our expectations are modest. We're going to have some modest growth. And then we will get to the end of this year, you're going to see compression again, right? I think what's more important on this line item is to remember that this also includes our origination sale activities of Fannie Mae DUS multifamily loans and to a lesser extent, SBA loans. And consistent with my earlier comments, we're expecting meaningful increases in Fannie Mae DUS activity over the remainder of this year. And so for modeling purposes, don't think you're just relying on single-family volume activity for this line item. We expect it to improve meaningfully this -- over the course of this year.

Right. Okay. I appreciate all the color. Thank you very much.

Thanks, Steve.

Thank you. Matthew Clark, you may now proceed.

Actually, I think my question was answered. No, I know there was some, sorry. Lost my train of thought. The borrowings that you added in the quarter can you just give us a sense for the rate. At what rate it was at the time?

Are you talking about the wholesale borrowings? Not, not the debt I'm assuming.

Yes, not the debt.

Yes. Okay. Yes. The wholesale borrowings are coming in per rates are roughly in the 30 basis points overnight rate, and that's what we've been adding on since it's a pretty low level. And so we expect to continue to fund those at current rates going forward with our borrowings, and as Mark said, we don't expect any significant increase in the level of borrowings over the next couple of years.

Okay. Thank you.

Thank you. There are no additional questions waiting at this time. So I'll pass the conference back to Mark Mason for closing remarks.

Thank you all for joining us today. Thank you to our analyst community for the great questions. looking forward to speaking with you again next quarter.

That concludes today's HomeStreet Q1 2022 Earnings Call. Thank you for your participation. You may now disconnect your line.