Mechanics Bancorp (MCHB) 2018 Q2 法說會逐字稿

Good day, and welcome to the HomeStreet Second Quarter 2018 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 2018 earnings call. Before we begin, I'd 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 & Events link. In addition, a recording and a transcript 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 fact 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 the 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, may be 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 the results of operations.

Joining me today is our Chief Financial Officer, Mark Ruh. In just a moment, Mark will present our financial results. But first, I'd like to give an update on the results of operations and review our progress in executing our business strategy.

During the second quarter of 2018, we continue to meet the challenges prevented -- presented by the mortgage market, and we made substantial progress for our growth and diversification goals. Our Commercial and Consumer Banking segment continued to produce strong loan growth of 3% in the quarter. Commercial and industrial loans increased by 6% as our investments in growing our C&I lending business are bearing fruit. Additionally, home equity loans increased over 9% as borrowers with loan interest rate first mortgages are beginning to shift at home equity loan products to access our equity instead of refinancing into a new higher interest first mortgage. As mortgage rates continue to increase, we expect this trend to continue. The growth was funded by strong growth in business deposits of over 5% and growth in our de novo branches of 6% in the quarter.

Meanwhile, asset quality continued to improve with our nonperforming asset ratio decreasing to 14 basis points of total assets, representing the lowest level of problem assets since 2006. Our early warning credit indicators continue to reflect strong fundamentals in all of our markets, which is not surprising, given we do business with 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.

As part of our ongoing balance sheet and capital management, we announced the sale of approximately $4.9 billion in total unpaid principal balance of single-family mortgage loans serviced for Fannie Mae and Freddie Mac. This sale represented approximately 20% of our total single-family mortgage loan service for others as of March 31.

In conjunction with this sale, we will also transfer approximately $27.2 million of related deposit balances to the purchaser. The final transfer of the servicing unit deposits is scheduled to be completed by August 16, and we will continue to service the loans until the final transfer date.

In addition to capital relief, we expect this transaction to improve our risk management results through reduced convexity costs in the remaining mortgage servicing rights portfolio. We're taking servicing on most of our mortgage loans we originate and sell. It's an important part of our mortgage banking strategy to which we remain committed.

This strategy has historically been a competitive advantage and has provided other benefits for the company, including low-cost deposits, and these assets have generated strong returns on equity through the cycle. We also modified our loss-sharing arrangement with Fannie Mae related to our DUS multi-family servicing, moving from loss -- from standard loss sharing to a pari passu loss sharing basis. This change significantly lowered our consolidated risk-weighted assets.

Partial sale of single-family mortgage servicing and the change in our loss share arrangement on our DUS servicing increased our consolidated regulatory capital ratios. It will provide regulatory capital to support the continued growth of our Commercial and Consumer Banking business and accelerate the diversification of the company's net income.

Given the persisted shortage of new and resale housing and increased interest rates from reducing demand for both purchase and refinanced mortgages, along with a recent decrease in our composite margins, we took additional steps in the quarter to streamline our mortgage banking operations by closing, consolidating or reducing space in 20 single-family offices. These steps also include a reduction in headcount of approximately 127 full-time equivalent employees.

In the second quarter, we recorded $6.9 million in pretax restructuring charges related to these actions, and we estimate an additional $1.7 million of pretax restructuring charges in the third quarter of this year. We expect these actions will result in annualized pretax savings of $13.1 million.

The office closures and consolidations are concentrated in Arizona and coastal California and were designed to improve profitability of the segment by reducing the proportion of lower profit, jumbo, nonconforming mortgages and reducing direct origination expenses by exiting higher cost, lower market share regions.

During the quarter, the price competition amongst mortgage originators eased somewhat, resulting in an improvement in our composite profit margin. Our streamlining initiatives should also improve our composite profit margin as our profit mix should favor lower, jumbo, nonconforming loan production going forward.

We are continuously making efforts to improve the profitability of the Mortgage Banking segment, while maintaining our competitive advantage as a market-leading originator and servicer. Mortgage banking has been an important part of HomeStreet's history and success. We expect mortgage banking will continue to be a contributor to our success going forward as we work through this challenging part of the mortgage cycle.

Lastly, we took additional steps to refresh our Board of Directors, including naming Donald R. Voss as our Lead Independent Director succeeding Scott Boggs, and naming Sandra Cavanaugh as a new board member.

The board believes that Sandra's strong background in banking and asset management will be an asset to the company, as we continue to execute on our strategic plan.

And now, I'll 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'll first talk about our consolidated results and then provide detail on our 2 operating segments.

Regarding our consolidated results. Net income for the second quarter of '18 was $7.1 million or $0.26 per diluted share compared to $5.9 million or $0.22 per diluted share for the first quarter. Included in net income for the second quarter of '18 was a total of $5.4 million of restructuring expenses net of tax.

Excluding impact of these restructuring charges, core net income for the second quarter was $12.5 million or $0.46 per diluted share compared to core net income of $5.6 million or $0.21 per diluted share for the first quarter.

The increase in core net income from the prior quarter was primarily due to higher noninterest income, largely from higher net gain on loan origination and sale activities in both our Mortgage Banking segment and our Commercial and Consumer Banking segments, somewhat offset by higher core noninterest expenses.

Net interest income increased by $2.5 million to $51 million in the second quarter from $48.5 million in the first. This increase in net interest income is primarily due to the higher balances of loans held for investment and loans held for sale.

Our second quarter net interest margin of 3.25% remains steady from the first quarter of '18. While our retail deposit betas have remained relatively low, our wholesale deposit and borrowing costs have increased. During the quarter, this increase in funding costs was offset by higher yields on our interest-earning assets.

Noninterest expense, excluding the impact of restructuring-related expenses, increased to $103.7 million in the second quarter from $101 million in the first quarter. This increase in noninterest expense was primarily from higher commissioning costs on higher closed single-family mortgage loan volume.

Our effective tax rate was 19.6% for the second quarter and differs from our expected 21% to 22% tax range, primarily due to the impact of higher tax-exempt interest income and adjustments to prior periods.

As Mark previously mentioned, the partial sale of mortgage servicing rights and the changes in our loss sharing agreement related to our Fannie Mae DUS servicing had a positive impact on our regulatory capital ratios. Specifically, our consolidated risk-based capital ratios realized significant increases, with our consolidated total risk-based ratio ending the quarter at 12.32%, an increase of 130-odd basis points from the prior quarter.

Due to the sale of mortgage servicing rights, Tier 1 capital also increased and both consolidated and bank level regulatory capital ratio all realized improvement.

I'll now discuss the key points from our Commercial and Consumer Banking segment results. Commercial and Consumer Banking segment core net income was $11.9 million in the second quarter, increasing 17% of reported income of $10.2 million in the first quarter.

Net interest income increased $2.3 million or 5% from the first quarter of '18 to $47.7 million, primarily due to the growth in our loans held for investment. The portfolio of loans held for investment increased by $123.1 million or 3% to $4.9 billion in the second quarter.

Segment noninterest income increased quarter-to-quarter to $8.4 million from $7.1 million. This increase is primarily due to higher net gains from our sales of multi-family commercial real estate loans during the second quarter.

Secondary market demand for our multi-family commercial real estate loans is typically seasonal, and we expect to see increased sale as the calendar year progresses. Segment core noninterest expense was $39.3 million, an increase of $940,000 from the first quarter of '18. This increase was primarily due to the continued growth of our lending unit and branch network and due to higher information systems cost and FDIC assessment as a result of our deposit growth.

Nonperforming assets declined to $10.4 million or 14 basis points of assets at June 30 compared to nonperforming assets of $11.2 million or 16 basis points of assets at March 31. This decrease was a result of a reduction in nonaccrual loans.

We recorded a $1 million provision for credit losses in the second quarter compared to $750,000 in the first quarter. This increase in provision expense was primarily due to $464,000 of net charge-offs during the second quarter compared to a net recovery of $580,000 during the first quarter.

Deposit balances were $5.1 billion at June 30, an increase of $71.3 million from March 31, driven primarily by a 5% increase in business deposit accounts.

Deposits in our de novo branches, or those opened within the past 5 years, increased 6% during the quarter.

I'll now share some key points from Mortgage Banking segment results. Mortgage Banking segment's core net income in the second quarter was $630,000 compared to a core net loss of $4.6 million in the first quarter. We had increased interest rate lock commitment in the second quarter and improved deposit margin that resulted in an increase incorporating from gain on loan origination and sale activities.

The intense competitive pressure on pricing eased during the second quarter, resulting in some recovery of our composite profit margins. Our gains on mortgage loan origination and sale deposit margin increased 22 basis points over that quarter following the reduction of 25 basis points in the first quarter of '18.

The increase in interest rate lock commitment during the quarter was primarily due to the seasonal increase in home buying activity as refinance mortgages decreased on an absolute basis quarter-over-quarter and represented only 18% of our total loan volume, down from 27% during the first quarter.

The volume of interest rate lock and forward sale commitments at $1.7 billion was lower than closed loans designated for sale by 3% this quarter. Note that single-family interest rate lock being less than closing in a given quarter negatively affects Mortgage Banking segment earnings, as the majority of mortgage revenue is recognized at interest rate lock while the majority of origination costs, including commissions, are recognized upon closing.

The flattening yield curve also increased negative convexity in our mortgage servicing portfolio, increasing the adversity of the portfolio and yet it adversely impacts risk management results. Single-family mortgage servicing was $6.1 million in the second quarter, a decrease from $6.7 million in the first quarter. This decrease was primarily due to lower net servicing fees, offset somewhat by improved risk management results. Included in the single-family mortgage servicing income was $573,000 of pre-tax revenue, net of transaction cost and prepayment reserves, resulting from the sale of the previously mentioned mortgage servicing rights.

Mortgage Banking segment core noninterest expense of $64.4 million increased $1.6 million from the first quarter, primarily due to the increasing commissions paid as a result of the increasing closed mortgage loan volume. Our portfolio of single-family loan serviced for others decreased to $19.1 billion of unpaid principal balance at June 30 compared to $23.2 billion at March 31, reflecting the $4.9 billion of unpaid principal balance sales completed during the quarter.

The value of our mortgage servicing rights relative to the balance of loans serviced for others was 129 basis points at quarter-end, an increase of 2 basis points compared to the prior quarter-end.

I'll now turn it back over to Mark Mason to provide some additional insights on HomeStreet's outlook for the future.

Thank you, Mark. Looking forward to the next 2 quarters in our Mortgage Banking segment, we currently anticipate single-family mortgage loan lock and forward sale commitment volume of $1.4 billion and $1.3 billion in the third and fourth quarters of this year, respectively.

We anticipate mortgage held for sale closing volumes of $1.6 billion and $1.3 billion for the same periods. The unusually lower volume of interest rate lock commitments relative to closed loan volume forecast for the third quarter is due to the closing of home loan centers previously discussed.

Lock volume was immediately impacted, while we remain responsible for closing the pipeline of mortgages originated by these closed offices. For the full year of 2018, we now anticipate single-family mortgage loan lock and forward sale commitments to total $6 billion and held for sale closing volume to also total $6 billion.

Additionally, we expect our mortgage composite profit margin to remain in the range of between 315 and 325 basis points during the remainder of the year. In our Commercial and Consumer Banking segment, we continue to expect our 2018 quarterly loan portfolio growth to average between 2% and 4% for the remainder of the year. Reflecting the yield curve as of the end of the second quarter, and asset changes in market rates and loan prepayment speeds, we expect our consolidated net interest margin to increase in the third quarter to a range of 325 basis points to 335 basis points and remain in that range for the fourth quarter of 2018.

During the third and fourth quarters, we expect our total core noninterest expense to decrease an average of 3% to 5% per quarter, given seasonally lower closed single-family mortgage loan expectations and the impact of our streamlining. Changes in our total core noninterest 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.

Core noninterest expenses in our Commercial and Consumer Banking segment are expected to increase between 2% and 3% per quarter for the third and fourth quarters of this year. Notwithstanding the increase in core noninterest expense in the Commercial and Consumer Banking segment, we expect segment revenues to grow at more than twice the rate of this expense growth during these periods.

This concludes our prepared comments. Thank you for your attention today. Mark and I would be happy to answer any questions you have at this time.

(Operator Instructions) The first question comes from Jeff Rulis of D.A. Davidson.

On the -- just on the staffing, the 127-employee headcount reduction, was that all completed as of the end of 2Q?

Actually, no. They were all noticed and the branches that were closed were vacated, but some of those individuals have termination dates in the third quarter as they're part of the group that is closing out the remaining pipeline.

You have a percent of -- just a rough number of that -- those individuals that are still around? Is it just a rounding -- I mean, how many are...

I'd say roughly 1/3 continue into the quarter, third quarter.

And then as of now, just on the expense side, it's just the remaining $1.7 million in 3Q, no other restructuring costs anticipated and a pretty clean 4Q?

That's correct.

Okay. Got it. Another question on the sale of the MSR and that loss share change with Fannie Mae, does that impact or reduce the servicing income outlook?

No, it doesn't. It's a part of the structure of the Fannie Mae program. You can choose between 2 options on total potential losses and the increments by which you may be exposed to them. The loss sharing arrangement we were under and had been under for, I guess, 30 years to this point was the one that included exposure to the first 5% of losses in what was essentially a detectable, but cap losses at 20% of original principal balance roughly. We moved to a what's called a pari passu loss-sharing arrangement, where you share equally from dollar 1, but up to 33% of that original principal balance, which sounds like greater exposure, but in reality it isn't because of this first loss piece, the deductible piece. The losses in Fannie Mae's program, overall, have been very minimal. In our case, in 30 years, we've never experienced a loss. We've never actually had a 30-day delinquency in this line of business. And we thought it was a good change for us to move to a pari passu arrangement. It reduces the exposure to first losses. And since we feel very strongly about our performance in underwriting, we felt that, that was going to be a good risk management change. The regulators also agree with that. And so the way you account for or determine the level of risk-based assets that have to come back on balance sheet from this recourse portfolio, servicing portfolio, is lower and that's what gave us the risk-based capital relief.

Okay. So it's strictly a loss-share change, not a -- you don't have to give back some sort of profit or income from the arrangement.

No, no. Fannie Mae is sort of ambivalent as to which one you choose. They perceive, from their standpoint, their risk management standpoint, them to be equivalent. We don't because of our strong credit quality.

Maybe one last one, just on the credit side. I know you flipped to modest net charge-offs from a long string of recoveries. And do you read anything into that? Or is it just sort of a lumpy quarter? Any comment on the net charge-off trend.

This is more a story of recoveries and not charge-offs, right. Our charge-offs come from consumer loans, primarily. Most of all will have a small business charge-off, but recoveries have been the story for couple of years now. And what we -- as we said, I think, at the end of last year, we can't expect recoveries to continue to completely cover charge-offs and now you're starting to see that.

The next question comes from Steve Moss of B. Riley FBR.

On the gain on sale margin here, you mentioned improvement in your markets, end markets helping improve the gain on sale quarter-over-quarter. I was wondering, does that refer to changes in the Puget Sound market? If you give some more color on that.

You know, I think, it is all of the markets. What we did see and it's a volume-related question, right. In the fourth quarter, and really, as the year progressed last year, you saw a seasonally lower volume than expected. And then when you got to the very low volume portion of the season, fourth quarter and first quarter, the volume -- the industry volume dropped even lower than expected and you had the impact of excess capacity pushing people to stretch their pricing even further to counter more of the remaining volume, and people typically go too far, right. They give too many price exceptions, and then they close the books at the end of the period and say, oh my gosh, we have gone too far, right. And this is what typically happens in this business when you have an extraordinary change in rates, and something like what we are currently experiencing is availability problem in housing that we have a substantial overcapacity condition and the first thing people will do is try to grab more of what's left. And then they realize, well, that's not good for business because we're going to lose a lot of money. The industry did, if you're following the MBA statistics on the point, no one essentially made money on originations in the first quarter. And so the appropriate business reaction to that is, okay, we have to increase our profit margins again, and I think that's generally what you're seeing.

Okay. And then, I guess, on the mortgage servicing side, with the sale here, just a little color as to what you're expecting on revenues? It sounds like you may have, obviously, some moving pieces, but you may have some benefits from hedging going forward that you haven't had in the last couple of quarters. And also, just any updated thoughts around how quickly you can rebuild the servicing portfolio?

Sure. Well, first, consider collected fees, they should go down around 20%, right, offset by new growth in the portfolio. That's the easy calculation. The tougher one is risk management results. And you see in the quarter that we are still experiencing negative risk management results through the end of the quarter. We're expecting those to improve somewhat as convexity was reduced a little bit. But the biggest challenge with the risk management results today is the yield curve, and the fact that we made money in servicing historically out of positively slow yield curve because of the amount of our hedged comprised of swaps and which is a substantial part of the hedge today. I mean, I think, it's roughly 80% today of our hedge is swaps from 30 days to a couple of tenures, 7, 10, 15-year tenures and those are pretty flat calculations today. And so we're going to get some help on convexity costs from the sale. But the thing that's really going to turn around our servicing results from a risk management standpoint is going to give you some seedness in the yield curve.

Okay. And then in terms of just on the -- do you think you will grow this -- the MSR book back over the next 12 to 24 months? How should we think about that and...

Well, obviously, it's going to grow again, right. The pace of growth is going to be slower than it used to be because origination volume is lower, right; lower, industry wise; lower, because we have reduced the capacity of the system, right, recently with the loan center closings. I would expect that it will take until third quarter of next year, sometime second to third quarter, to rebuild to the same presale $23 billion level.

Okay, that's helpful. And then in terms of -- just on the earning asset side, you sold some jumbo mortgages here from the loan portfolio and the securities book, you shortened the duration, just kind of wondering what to look for on the yields?

On portfolio yields, in general or individual?

Yes, in general.

In general. Well, they're rising, right, not just as a consequence of the Fed, but about 1/3 of our portfolio adjusts monthly, about another 1/3 or so adjusts on a schedule, right. And so those loans are still adjusting up from prior changes in rates, right, as we -- as they hit their adjustment day. And so we see or expect yields to rise. Can you guys give me a chart quickly, and I'll give you more current the answer. Meaningfully, by year-end, right, something in the range of 20 plus basis points and more the following year, right. Again, that's without any other changes. A combination of change in mix and schedule expected increases in rates on periodically adjusted loans.

The next question comes from Jackie Bohlen of KBW.

Mark, I just wanted to look into headcount a little bit more, and understanding that you still have about 1/3 left of the individuals, who were part of the restructuring, how are you thinking about headcount in both the divisions heading into the latter half of the year and into 2019?

Total headcount in the banking division is going to rise somewhat going forward as a consequence of, one, continuing to open branches. We still have a pipeline of branches over the horizon to open. We have some open positions also. And what we forecast, we never accomplish because we never seem to hire all the currently open positions. But headcount in the bank could rise 40 or 50 FTE by year-end, if we were to accomplish all that we're hoping to. In the mortgage bank, now, of course, headcount is falling, right, and headcount typically falls seasonally toward the year-end, right, as we allow attrition to help reduce our capacity in the fourth quarter. And so I would expect headcount in the mortgage bank to fall 5% to 10% potentially through attrition by year-end and sort of hang around that number going forward.

Okay. And I would assume that growth in the commercial consumer bank in terms of headcount in 2019 is likely to be higher than any potential additions in the mortgage bank? And would you think there would be any additions in the mortgage bank in 2019? I know it's a...

Currently, we're expecting it to be flat in the mortgage bank next year. Understand, we continue to analyze ways to improve the results at this point -- low part of the cycle. So I can only be so definitive, right. In the commercial bank, again, we would expect a growth in deposits at branches. We expect to see some continued growth, but not meaningful, not meaningful. And remember, of course, that any growth in expenses, will it be headcount or nonpersonal expenses, we're expecting revenue to grow multiple in those numbers, right. I mean, these are additions related to revenue generation.

Okay. Definitely understood. And given the capital benefits from the MSR sale and then from the change in the loss method that you used with Fannie Mae, does that accelerate any of your growth goals for the commercial consumer segment?

I wouldn't say that it accelerates them. It ensures we don't need outside capital that will be dilutive potentially. It may accelerate them based upon the results. We feel comfortable now with our plan going forward on the near-term horizon that we can accomplish it without the need for additional capital or anything outside of our control. And so I'd say, it helps the probability of achieving it.

The next question comes from Tim O'Brien of Sandler O'Neill.

A question for you. $31.6 million in commercial business loan growth this quarter, can you talk a little bit about the underwriting there? And are they prime-based loans? That's what I'm assuming. Can you give some color?

Sure. You know, we've been making pretty meaningful investments in trying to grow our C&I business, particularly in California, and those investments are beginning to show returns. The lending is both prime-based and LIBOR-based. It depends on the market and it depends on the size of the customer, frankly. The larger the customer, the more likely the index is going to be LIBOR. The size of lending relationships is growing somewhat, though we continue to be a community bank with SBA business and other smaller lending. Our focus for C&I has been larger relationships on both the deposit and the lending side. And what you would see is a variety of industries and really solid underwriting. We have a pretty conservative credit culture here. And even in the C&I business, we are trying to grow without taking extraordinary credit risk. And so that's what you would see if you were to look at the details of that lending. We're comfortable with it. We're comfortable with the credit quality. We're comfortable with the customers, and finally seeing some results and we're expecting that to accelerate.

So of the $319 million in commercial business loans you guys had at the end of June, what percentage of those loans are prime-based versus LIBOR-based versus something else,[CMT General]?

I don't have that answer at my fingertips. I would say that prime is more pervasive than LIBOR today, but that relationship is slowly changing.

And the primary source of repayment is cash flows, I'm assuming.

Well, we are primarily a collateral-based lender. We do have some cash flow-based loans in service industries, primarily, right, where you don't have hard assets. But in cash flow lending, we look for very solid histories of repeatable cash flows, strong margins and just very strong management. And so cash flow lending is a small minority of loans we make. We need underwriting cash flow, but we typically have collateral.

And what's the largest loan that you have in that portfolio or relationship do you have in that portfolio? Or largest couple? The largest three, I guess.

The largest relationship is 30 -- $63 million.

I'm sorry, Mark. Did you say 53?

$63 million, 6-3. It is to a multistate hospitality company, hotel and restaurant operator. The credit facilities range from several significant commercial real estate loans to operating lines and equipment lines.

And next largest?

I was playing with the time. Well, I'm trying to think. Give me a second.

No. That's okay.

It drops really quickly. I guess, it's really why I should be saying is, that's our largest part. We have a largest relationship. Big part of that is a commercial real estate relationship on our operating lines. It falls pretty quickly down into the $20 million range, right. So the portfolio remains pretty granular.

Do you have any shared credits or SNCs embedded in that portfolio?

We do. We have about $120 million of loans. They're not all officially shared national credits. Most of them are what we call club deals, right, where we're not the lead lender, but several of them shared national credits and they're all performing well. We're trying to stay with regional credits, that we know the businesses. That -- they have to be larger than we would leave. Especially right now, we are first club credit like that.

Great. Well, it was heck of a quarter. Good progress on that front. Was any of the production this quarter attributable to participations or club deals? Or was it all...

It was -- and I have to get back you to make sure this comment is correct. I think we've funded a $10 million participation in a deal, but I'd have to get back to you to confirm that.

And do you require operating accounts, C&I, I mean, non-interest-bearing checking accounts of any fully funded in-house produced deal that you guys make for C&I?

We require the full banking relationship on all C&I deals, except sometimes some SBA deals we can't get when you have multiple SBA loans, and you have multiple lenders, right. But typically, we require a relationship.

And just looking out, I don't know, 2 years or 5 years or something, Mark, how -- obviously, you talked about this being a focus of investment particularly now, but I think you've kind of stayed in the game and focused on growing this part of your business as a part of your long-term strategy. How much of your business of your book of loans would you envision and see in commercial business lines accounting for -- I don't know, it's a meaningful period looking out. How do you want to judge long-term success of HomeStreet as far as this strategy that your -- that you've set course on?

We would love to...

Either dollar amount or percentage.

We would love to have 1/3 of our loan balances in C&I, Tim. I mean, it's, obviously, below that now. It's in, what, the low-teens, mid-teens somewhere like that. We'd like to double the current concentration. And I think that's a reasonable target for someone in our situation who has had to build that business almost from scratch, right. With a balance sheet that's still growing, I think that may be a pretty lofty goal. But I think that's a reasonable target when you look at the competition, what's available in the marketplace and overlay that with our pretty conservative credit culture that if we were able to get to 1/3 of the loan portfolio, I think that, that would be pretty strong performance for us. And to answer your prior question, we had an $8 million closing on a participation in the quarter.

Great. And then last question on the deposit side, non-interest-bearing checking account -- non-interest-bearing accounts checking and savings, $626 million, 12.3% of total deposits, how much of that is tied to your commercial and consumer segment? How much is part of that business do you attribute to that business?

Bear with me for a second. We believe we should be.

Even ballpark it, Mark, like, is it the majority of it? Is it -- you know what I mean. I guess, my question is, one of the reasons commercial banks are successful is because they effectively lock in a stickier, low-cost funding base to support growth in their commercial lending business in real estate, even beyond C&I lending, and I'm assuming that's a critical part of your strategy here as well. So how much would you like to see non-interest-bearing grow over time, over some extended period of time, and for HomeStreet's success, for strategy to prove successful?

Okay. So that's a bunch of questions in that.

I guess, how much would you like that deposit base, non-interest-bearing checking and savings associated or attributed to commercial and consumer, I guess, to grow and account for as a percentage to your deposit base? It's 12.3% at the end of June and...

Let me answer the first question, which was composition to date, Tim. How about that?

Okay.

Of the non-interest-bearing deposits at quarter-end, which were approximately...

(inaudible)

Right. So it's about $1 billion, right, between servicing deposits and nonservicing. Of the amounts of deposits, of the $627 million, $432 million were business. Now that's a business that both comes from the C&I business, which is a majority, but also small business that walks into the branches, right. So the majority of that, about 80% roughly is commercial. And that number, Tim, when I got here was almost 0.

Yes. And then growth envisioned down the road?

That's going to be dependent upon our success in growing both large and small business. I mean, the question I can't answer, as we sit here, is how much of that is large business versus small? And the small business component I expect to be larger than you might imagine. So it's important for us to be good on the street with small business. And so our lending activities and general cash management activities are going to be larger business. We love for that to dominate the company's deposits. We are both a consumer and a commercial bank, but the largest growth upcoming will continue to be in the commercial area, and I still expect it to dominate.

The next question comes from Tim Coffey of FIG Partners.

Mark, if I'm reading the tea leaves right, it looks like payoffs have average write above $300 million a quarter. Am I getting that right on the commercial bank, of course?

Bear with me one second, I'll get you a real answer. Payoffs continue to be high, right. That's for sure. In the quarter, payoffs, pay downs and sales, right, were up about 50%, right. In the first quarter, that was about $400 million. It was over $600 million in the second quarter. Part of that was sales. Now remember, we grew the loan portfolio in the commercial real estate area more in the first quarter, we have less sales. Second quarter, we had more sales and that attributed to some of that effect. Actual prepayments fees, I don't have that information in front of me. I can tell you, they haven't slowed down. I think I can say it's safe.

Yes. And that's kind of what I was looking at as well. And so then my question would be, do you anticipate doing more loan sales out of the DUS product or the SBA or even like you did this quarter, the CRE non-DUS and family stuff. Do you offset some of those elevated payoffs?

No. Our strategy on that type of loan mortgage banking or SBA banking is what it is, right. I mean, we originate SBA loan sales to sell the insured portion. That's the most effective use of capital, right. The return on capital invested in those loans is best by creating servicing and originating more. So we sell them as we originate them. Same with the Fannie Mae DUS loans. They originated for sale or actually promised or contractually sold are committed by Fannie Mae at the date of origination. So we don't really have an ability to hold those loans. That activity will rise and fall with activity in the marketplace and our ability to execute on it. Now runoff, let me give you a quick answer, though, annualized runoff this quarter in the entire portfolio was about 27.5%. That was up from 21.5% in the first quarter. So you're right. You are seeing higher runoff, but fourth quarter last of year was even higher, 35%. I think that includes sales, right. So that additional activity will make that number jump around.

Okay. With your comments about growing about commercial bank revenues and expense growth going forward, what do you think is an achievable efficiency ratio in that segment, say a year from now?

Well, I hate to be overly optimistic because I've missed my own targets in the past, but we do make steady progress, right. If you're watching this number, you have seen seeing it continue to decline. It is seasonal during the year, right. Because of the seasonality of Fannie Mae DUS and SBA loan origination sale, the efficiency is worse in the first 2 quarters of the year and better in the second 2 quarters. If you look at last year, the same pattern, the average is about 70% efficiency last year. We've averaged lower that in the first half of this year. In the second half of the year, we should average in the low 60% range, 63% to 65%, somewhere in there, and that should give us something in the mid-60s for the year this year. Next year, we think that number will be lower by 2 or 3 basis points, maybe 4 basis -- 2% or 3% or maybe 4% or 5% next year, as we continue to work the number down. We think that number can go meaningfully lower. We are trying to do not the impossible, but something very challenging, investing growth and improve efficiency. Now the efficiency improvements, we're getting through operating leverage, right. That's a production of our growth. We could simply stop and improve the efficiency ratio by stopping investing in growth and trying to optimize the ratio. Because we have this growth -- goal of diversification, we have to try to do both. And so we are slower to accomplish our goals and efficiency as a consequence of feeling the need to grow and diversify.

Okay. Understood. And then what was kind of the weighted average yield on the new loan production this quarter? I apologize, if I missed this from earlier.

I'm sure we stated it, but I will tell you, 4.92%, but that's overall, right. If you look at -- well, there is a whole lot of categories, right. I mean, in fixed lending, mortgages, construction was 5.5%, business banking 5.9%, consumer banking 6.22%. When you go into mortgage, single-family fixed is about 5.5%, fixed CRE 5.11%, the composite 4.92%. The range probably 4.3% to 6.2%, roughly.

Okay. What was the lower yield except for the HELOC?

The lowest yield in lending we're doing today is in the variable adjustable commercial real estate, short-term bridge, construction, monthly adjusting, right, low rate risk.

Okay. All right. Maybe you took care of my follow-up question on that one. And then, in the -- the expenses this quarter was a nice surprise. Did that include some of the expenses from the proxy contest?

Clearly, we had some, right. But we had a full quarter of investment. We opened 3 branches right at the end of the second quarter, if you are paying attention.

One at the end of the first quarter.

I'm sorry, end of the first quarter. Thank you for reminding me. And so we had a full quarter of those expenses, right.

Yes, okay. But the proxy -- the expenses really of the proxy were not really material?

Not really material.

Look, the expenses, we are not happy about incurring, but in relation to total expenses, they're not really material.

(Operator Instructions) The next question comes from Henry Coffey of Wedbush.

I hope you -- I apologize, if you've addressed this before, I got on the call late. But I know there had been a lot of resistance in the past to selling servicing because in a true sale you inevitably give up too much control. Can you talk about what changed in your thinking? And was it sort of a geographic decision saying, well, we don't have offices in those states anymore, you might as well sell the servicing? Or was it something different?

It was a number of things. One, an interest in ensuring that the company will be able to continue its business strategy in light of its low stock price, right. I mean, instead of considering going to the market at this time for more capital late later this year or beyond, we wanted to make sure that we have the capital. The prices are very, very good right now, right. So in terms of market timing, again, this was the highest sale of the year, right. If you look at all servicing sales, absolutely the highest value paid. That drove part of it. And there is no free lunch though, right. It is a very negative activity here on a lot of fronts. One, we're losing revenue, right. 20% of our monthly servicing revenue just got sold. All you're doing is accelerating revenue when you sell it, right. We recognized a small gain, but that in and of itself would not be worth the activity. The business has enjoyed a competitive advantage on The Street by retaining servicing. I mean, this -- the mortgage banking part of this business is almost 100 years old. And it is important to our customers, our retail customers, that we will retain that relationship post sale. So when we don't do that, we hear about it. And we are still hearing about it, right. But we have to offset that with the capital benefits. So what did we do to choose which loans we're going to sell and how much? We didn't want to sell clearly more than we thought was needed for our general business strategy. Two, the loans we chose were the lowest rate, highest value loans in the portfolio. Two, they were the least likely refinancing, accordingly. So it had the least negative impact on future operations. Three, we tried to select loans that were outside of our retail banking footprint and/or loans originated by loan offices no longer with the company, right. So on all of the most negative aspects, potential aspects of the transaction, we tried to be sensitive to reduce that impact to the greatest extent possible. And even doing that, we end up, of course, selling some loans from some current originators and end market customers because they have very low rates and they're not happy with us, but we'll maintain those relationships and get through it.

Does there exist a universe in which you could sell MSRs, so to speak, retain the servicing relationship and through -- as a sub-servicer and still satisfy future capital release requirements? Or is that just an impossibility?

Well, again, no free lunch, right. You can do that. The last time we sold servicing in 2014, we had it did both ways with or without retaining sub-servicing. And the discount to execution was so significant at that time, we chose to sell the full servicing without sub-servicing. This time, having checked with dealers, we expected the same discount. And so we only had a bid as a full sales servicing. Very hard to accomplish everything by the measure you're looking for. We would have had to sell more servicing to accomplish the same capital relief.

So since the capital relief is not an issue going forward, can you think about it as a business strategy because there is -- on the outside chance that the yield curve does continue to flatten, et cetera because the commodity trends never compete -- never -- they seem to never smile on us. So is there a scenario in which you could begin to change the servicing business model, sell more servicing, retain the sub-servicing, obviously, book a smaller gain, but that's okay because you don't need the MSR profitability and then be able to grow the business more aggressively? Or is the current thought, well, we sold a bunch of servicing, we'll originate more in-market servicing and regrow the MSR?

It's a tough question, right. If you knew the future, you could make those decisions well. The thing that we know is the returns on equity for us historically in servicing have been very, very high, but not particularly good right now, right, because of the flat yield curve. But when the curve steepens, the returns get really, really attractive, and it is a cyclical business. The yield curve is a cyclical animal, and it will steepen again. It's a very tough set of questions as to, are you making decisions based upon short-term outcomes or long-term outcomes? And these are things we wrestle with every day. So I wouldn't say we would never pursue that strategy, but it's not our strategy today.

And then just a final question around the closing of the mortgage origination branches. Since I didn't see any technology charge, is that mainly sort of an in-house product that you're using? Or are you using a third party to facilitate your originations and with the closing down, is there going to be a cost disadvantage associated with any residual contract?

Yes and yes. So we did have some technology charge-offs that are related to undepreciated equipment, right, that is -- and network systems and things that were being amortized, that is embedded in the numbers you've seen. We do have a little bit of a disadvantage currently on our primary technology contract because of the minimums. That would be our loan origination system. We will work that out over time, but that's a little bit of a disadvantage currently, not certainly material.

Everybody complains about that aspect of that contract with that vendor.

That's an insightful question. I'll just let that go.

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 all for your patience and attention today and the very insightful questions. We look forward to talking to you next quarter.

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