Mechanics Bancorp (MCHB) 2023 Q3 法說會逐字稿

Hello, and thank you for joining us for our third-quarter 2023 analyst 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, the expectations, and uncertainties about the company's performance and our 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.

Joining me today is our Chief Financial Officer, John Michel. John will briefly discuss our financial results. Then I'd like to give an update on our results of operations and our outlook going forward. We will then respond to questions from our analysts. John?

Thank you, Mark. Good morning, everyone, and thank you for joining us. In the third quarter of 2023, our net income was $2.3 million or $0.12 per share as compared to core net income of $3.2 million or $0.17 per share in the second quarter of 2023. These results reflect the continuing adverse impact of significant increase in interest rates has had on our business.

Our net interest income in the third quarter of 2023 was $4.6 million lower than the second quarter of 2023 due to a decrease in our net interest margin from 1.93% to 1.74%. The decrease in our net interest margin was due to a 25-basis-point increase in the cost of interest bearing liabilities caused in large part by an increase in the proportion of higher-cost borrowings to the total balance of interest-bearing liabilities.

During the third quarter, the cost of deposits increased 4 basis points, the cost of long-term debt increased 15 basis points, and the cost of borrowings increased 19 basis points. The increases in the rates paid on interest-bearing liabilities were due to the increases in market interest rates during 2023. The income tax benefit realized in the third quarter of 2023 was due to the recognition of return to accrual differences related to tax-exempt income. Our effective tax rate for future periods is expected to be substantially lower than our statutory rate due to the benefits from tax-exempt investments and loans.

A $1.1 million recovery of our allowance for credit losses was recognized during the third quarter compared to a $0.4 million recovery of our allowance for credit losses in the second quarter. The recovery for the third quarter was primarily due to reduced levels of higher-risk land and development loans, which resulted in lower expected losses. Going forward, we expect the ratio of our allowance for credit losses to our held-for-investment loan portfolio to remain relatively stable and provisioning in future periods to generally reflect changes in the balance of our loans held for investment assuming our history of minimal charge-offs continues.

Our ratio of non-performing assets to total assets decreased from 45 -- 44 basis points at June 30 to 42 basis points at September 30, 2023. Non-interest income in the third quarter was consistent with the second quarter of 2023 as we continue to experience low levels of single-family and commercial mortgage banking originations.

The $41.7 million decrease in non-interest expenses in the third quarter of 2023 as compared to the second quarter of 2023 was due to the $39.9 million goodwill impairment charge in the second quarter of 2023. Our other non-interest expense declined slightly during the third quarter as we continue to take steps to defer or eliminate the expenses where possible.

Our common equity Tier 1 and total risk-based capital ratios have improved significantly during the current year. As of September 30, 2023, the company's common equity Tier 1 and total risk-based capital ratios were 9.55% and 12.67% respectively, while the bank's common equity Tier 1 and total risk-based capital ratios were 13.32% and 14.03%, respectively. These ratios have increased this year, primarily a result of seasoning of multifamily loans originated in 2022, which after a year, performance qualified for 50% risk weighting.

I will now turn the call over to Mark.

Thank you, John. As John stated earlier, our operating results for the quarter reflect the continuing adverse impact. This is historically record velocity and magnitude of increases in short-term interest rates. Our earnings were $2.3 million and our net interest margin decreased in the third quarter to 1.74% due to decreases in balances of lower cost transaction and savings deposits and overall, higher funding costs.

To mitigate the impact of a lower net interest margin, we have reduced controllable expenses where possible, reduced staff to the minimum levels to transact current business volume in a safe and sound manner, raised new deposits through promotional products and focus on new loan origination activity, primarily on floating rate products such as commercial loans, residential construction loans, and home equity loans.

We've been mindful to maintain strong risk management and to sustain and protect our high-quality lending lines of business, preserving our ability to grow once the interest rate environment stabilizes and loan pricing and volumes normalize. The deposit outflows we experienced in the third quarter were primarily due to depositors seeking higher yields. We have not to date experienced any material identifiable deposit loss related due to concerns about deposit security.

With non-interest-bearing and low-cost deposits seeking higher yields, we have pursued a strategy to attract new deposits and retain existing deposits through promotional certificates of deposit and promotional money market accounts. This strategy affords us the opportunity to retain deposits without immediately repricing all of our existing low-cost core deposits. This strategy has over time contributed to rising deposit rates as customers choose to move money to these promotional accounts to achieve higher returns. Our level of uninsured deposits remains very low at 8% of total deposits. This competitive rate environment has resulted in reductions in our net interest margin.

While we expect our net interest margin to stabilize in the near term, we do not expect increases in our net interest margin materially until rates stabilize. We utilize both brokered deposits and borrowings to meet our wholesale funding needs. Our choice of funding is primarily based on the lowest cost alternative.

Historically, the lowest cost alternative between broker deposits and borrowings is varied based on market rates and conditions. Since the beginning of this year, FHLB and the Federal Reserve Bank Term Funding Program, interest rates have generally been lower than broker deposits. And as a result, our borrowing balances have been increasing and our brokered deposit balances have generally been decreasing. While this may affect some metrics such as our loan-to-deposit ratio, we believe that this is the best choice today as it minimizes our funding costs, and we continue to have substantial borrowing availability beyond our needs and usage today.

We continue to experience the cyclical downturn in single-family and commercial mortgage loan volume as higher rates and spreads dampened the demand for new loans. Volumes in the third quarter were consistent with the second quarter, and we do not expect seasonal volumes to increase until rates and spreads stabilize and then start decrease.

In our residential construction business, our builders have continued to increase their land acquisition and new project development and our commitments and loan balances have begun to increase again.

At quarter end, our cash and securities balances of $1.5 billion were 16% of total assets and our contingent funding availability was $5.1 billion, equal to 76% of total deposits. Our loan portfolio remains well diversified with our highest concentration in western states multifamily loans. Historically, one of the lowest risk loan types.

Asset quality remained strong in the third quarter. The total past due and nonaccrual loans and nonperforming assets all decreased in the quarter. Our loan delinquencies remain at historically low levels, and our net charge-offs during the third quarter were only $500,000.

Our portfolio has been conservatively underwritten with a very low expected loss potential. As a result, credit quality remains solid and we currently do not see any meaningful credit challenges on the horizon. We are continuing to limit loan originations, focusing on floating rate products such as commercial loans, residential construction, and home equity loans.

We are generally not making any new multifamily loans today with the exception of Fannie Mae DUS loans, which we sell. We are focused today on working with our existing borrowers to create prepayments or modify existing loans to advance more proceeds where appropriate or extend fixed rate period in exchange for increasing the interest rate on the loan.

Despite our significantly reduced loan origination volume, our loan portfolio has not declined materially as a result of prepayment speeds, which continue at historically low levels, particularly for multifamily loans. At September 30, 2023, our accumulated other comprehensive income balance, which is a component of our shareholders' equity, was a negative $127 million. While this represents a $6.76 reduction to our tangible book value per share, we know it is not a permanent impairment of the value of our equity and has no impact on our regulatory capital levels.

Given the available liquidity, earnings, and cash flow of our bank, we don't anticipate a need to sell any of these securities to meet our cash needs. So we don't anticipate realizing these temporary write-downs.

During the third quarter, the company evaluated an unsolicited nonbinding written proposal to purchase our Fannie Mae multifamily DUS business for $57 million. We analyzed this proposal and determined that the price proposed was inadequate in relation to the resulting benefit and value of the DUS business to our company, which includes our related loan servicing asset of $31 million as of September 30, 2023.

Our Board of Directors determined that a sale of the DUS business at this price was not in the best interest of the company. Both prior to and since the receipt of this offer, we have received and responded to other parties interested in buying our DUS Business. We have not to date received any other formal offer.

Last week, the Board of Directors approved a $0.10 per share dividend payable on December 22, 2023. This dividend amount was unchanged from the prior quarter. In the near term, we anticipate stable levels of loans held for investment and deposits, stable net interest margin, increasing non-interest income, and stable noninterest expenses, except for seasonal increases in compensation and benefit costs expected to occur in the first quarter.

Additionally, with our strong capital levels and low level of credit risk, and excluding unforeseen events or economic changes, we do not foresee circumstances that would impact our ability to get through this cycle remaining profitable. The current interest rate environment has created significant challenges for our company. In particular, the rate competition for deposits from banks, money market funds, and treasury bonds is significant, and some of our customers have moved some of their funds.

Additionally, our interest rate sensitive residential and commercial mortgage banking businesses are experiencing historically low originations, further challenging our earnings. However, these conditions will change when interest rates stabilize and ultimately decline. Historically, an environment of stable rates has provided significantly better financial performance for our bank. We believe that we are doing all the things appropriate at this time to endure this period and preserve the value of our business so that we can take advantage of the upcoming beneficial rate cycle.

In summary, our challenge and our opportunity this time, the simple passage of time will provide the opportunity for our net interest margin to normalize and loan origination volume and revenue in our residential and commercial mortgage banking businesses while improved significantly. Our ability to negotiate this period is supported by our strong credit, sufficient capital, and loyal customers.

With that, this concludes our prepared comments today. We appreciate your attention. John and I would be happy to answer questions from our analysts at this time. Investors are welcome to reach out to John or I after the call if they have questions that are not covered during this question-and-answer session. Operator?

(Operator Instructions)

Matthew Clark, Piper Sandler.

Good morning. The first one around the margin. Can you give us a sense for what assumptions you're making behind your guidance to keeping the margin stable here in the near term? It looks like the spot rate on total deposits reaccelerated here at the end of September after keeping them at bay in 3Q?

Yeah, in terms of projecting forward, what our activity is, we're anticipating that the Fed will raise rates one more time in the fourth quarter and then keep them stable pretty much through the end of 2024. We believe when they say higher longer that they're going to do that. So based on that, looking at our mixes and our funding, and our future activity; we feel that the margin has stabilized at the current time, and we expect that if interest rates stabilize, we'll start seeing some benefits as our loans reprice.

We are anticipating that we may see some additional loss in money market funds over the next year. But beyond that, we believe our deposits should be relatively stable.

Okay. And then do you have the average margin in the month of September?

We don't report monthly margins. I'm sorry.

Okay. And then the $1.6 billion of borrowings that you hedged, can you give us the terms on that?

That's $600 million as we disclosed in our Q -- matures next March. Basically, it's a bank term funding program. Based on rates at that time, we anticipate that we probably will extend it for another year because basically, there's no prepayment penalty for paying that off early.

Secondly, the other ones at a three- to five-year maturity over the time split pretty evenly over those periods, a little bit more in the shorter term. So since that was put on approximately a year ago, it's going to be two to four years.

Probably just a little over three years in average.

Great. And then it looks like in your guidance, you're expecting higher levels of DUS-related loan sales, can you give us a sense for your outlook for DUS-related production in 4Q and 2024?

We think it's going to be a little higher than it's been, but the DUS production as a whole, if you look at Fannie Mae's total production is only running at about two-thirds of their expectations. So we expect while the production's going to be better, it's not going to be anywhere near what normalized production would be.

Okay. Fair enough. Thanks

Woody Lay, KBW.

Hey, guys. Thanks for taking my questions. Wanted to start on expenses, and was just hoping you could give some color on what drove that decrease quarter over quarter? And it sounds like any cost savings -- any cost-save initiatives that have been largely completed at this time.

Yeah. In terms of looking at the expenses, what they're going through, the biggest change has been in the compensation benefits. We continue to do reduce headcount where possible, part of it by layoffs, part of it by just not filling open positions, so we've been able to accomplish that. Obviously, our commissions and bonuses are lower because of the performance this year. But you can see the headcount going down. We continue to expect the headcount in the fourth quarter to be lower than it is in the third quarter.

Across the Board, we've just taken steps where we can to defer or eliminate expenses where possible. For example, in marketing expenses, we've deferred or eliminated programs that we do there. Other expenses that are items that we can put off or we can eliminate, we do do that going forward and we continue to look for that. We think there is -- we'll continue to evaluate and if we see additional opportunities, we think we can still have some benefit going forward.

So on the headcount question, I believe, John, we quote FTE, correct?

Yeah.

So that's an average of full-time equivalent employees. But the absolute headcount at the end of the quarter is below that number, as John said. So all else being equal, you should see an FTE reduction in the fourth quarter.

Got it. Maybe moving over to the loan-to-deposit ratio. Are you comfortable running the ratio at 110% for the -- over the near term or would you ideally like to get that down?

Look, over the long term, if you look at our history, we've run roughly 95% loan to deposits. And so we've always run somewhat higher loan-to-deposit ratio than our peers because we've never struggled to originate loans, right? We would rather be operating back at around 95%. But we're working with what we have at this juncture.

And why are we struggling with that ratio? Primarily prepayment speeds, right? We've lowered our loan originations substantially, but not eliminated originations because it's beneficial to originate variable-rate loans today, particularly high-quality. We have not had the anywhere near-normal levels of prepayment speeds because of the loan extension you experienced in a very low rate period like this.

So we've accepted the reality that we're going to run a loan-to-deposit ratio higher than what we would consider a normalized level for us. We don't think it represents an excess risk today given our strong on balance sheet liquidity, strong borrowing capacity, and so on. But if you ask what's our preference, it would be to be back around 95%. I just don't think that's going to be possible in the foreseeable near term.

Right. That's good color. Lastly, I just wanted to touch on profitability and you touched on it in your opening remarks. But I know there can be some seasonal impact over the next couple quarters just with mortgage and payroll increases. But as you look out over the near term, is the expectation that you will remain profitable over the near term?

Yes. Now having said that, our profitability is going to remain low, right, given our net interest margin and the circumstances of funding cost today, but we believe that we will remain profitable or we would have made the statement, and that's the same statement we've been making each quarter, right?

Right, right. Got it. Thanks for taking my question, guys.

Thank you.

Timothy Coffey, Janney Montgomery Scott.

Great. Thank you. Good morning, gentlemen.

Good morning, Tim.

Mark or John, do you have a substandard loan balance as of September 30?

We don't -- we can try to look it up real quick, but we -- it would have been filed with our call report.

I don't have the call report in front of me, but I will tell you it has not changed materially. I think it actually, hopefully I'm correct, declined slightly I think, (multiple speakers) we can look it up while we talk.

Okay, I'll look it up.

(multiple speakers) No material change is what I --.

Okay. And then sticking on credit, is there any updated color on the nonaccrual from 2Q? I think it was a $27 million relationship.

Oh. No update other than, at the time that we downgraded those loans, we restructured the loans with requirements for funded interest reserves of 1 year to 18 months and where necessary, additional collateral or cross-collateralization. And so, we still feel fine about the credit loss potential on the loans. But there's no update to the circumstances, but we think that the restructured loans are on the place they need to be given the circumstances.

Okay. Great. And then on the efforts to create more prepayments in your loan portfolio, you've been doing that most of this year or at least you've been talking about most of this year, I should say, maybe doing it longer. Do you have any kind of details on how that's going?

Well, I can give you a little color. I wish it was going better. I believe that we have restructured about $100 million of multi-family loans. And when you look at our loan origination numbers, Tim, and you look at multifamily, I think there's $40 million-some this quarter. I looked at it the other day. The details are in that. It is in the release and we are looking up while I'm talking. That represents restructured loans, not new loans. We actually write a new loan as opposed to modifying the existing one, so it will show up as a loan origination -- yeah, $44 million this quarter.

Last quarter, you see $65 million; quarter before $18 million . Those are the restructuring numbers to date, right, about $100 million or a little more. And why isn't that number larger? Our multifamily portfolio, as you know, these are hybrid loans with initial fixed rate period. And given when the loans are originated and the fixed rate periods of the loans. These loans were mostly five-year, but five- and seven-year fixed rate periods.

Well, a lot of these loans are originated in '21 and '22. So they're not up for repricing or moving from fixed to variable rate interest rates for a few years still. And because that date is farther out, we have a harder time getting borrowers to be concerned about that change in debt service. There's a widespread belief that rates will be down by then and circumstances will be better.

And so this is activity that is at a low level today. But as you can imagine, over the next year or two years, that activity will pick up. But what also will improve is our view of the risk of that activity, and we will probably be less interested in restructuring some of these loans given their loan, loan to values, and good cash flow. So we'll see. Does that help?

And just to add to Mark's comment is so what we are seeing now is some of the loans are actually repricing, which normally they've paid off in the past. So we're seeing a couple of loans repricing. And when they reprice, it's good for us because they reprice to the 6.5%, 7% level. So we pick up interest income on that, right.

But underlying that and maybe further to John's point, we may not see the level of prepayments, we would normally see at or around the repricing dates. If the new variable rate is not materially higher than the refinancing rate, many of these borrowers may choose to pay that higher rate and wait for rates to decline if indeed, that's the view of the time.

So it's kind of curious, we value these loans and the market values these loans generally like a yield to call on a bond, right, assuming they prepay on or around this rate transition date or repricing date. We may not actually see that to the extent that we have historically, so it remains to be seen.

Okay. And then just one final question for me on expenses. Well, if we look at, we strip out the goodwill write-down from the second quarter, expenses have been coming down call it $1 million-ish per quarter this year. Is that a trend you're looking to accelerate? Or would you expect -- should we be expecting 4Q expenses to be at that same cadence?

I think the fourth quarter would be a similar change. So as Mark mentioned, there is some reductions in personnel that will be realizing the full benefit in the fourth quarter. And just as a reminder in the first quarter and why we comment on it always is we do have those compensation benefit costs that come in and hit hard in the first quarter, which is basically employer taxes and some 401(k) match --

And merit increases.

They hit the second quarter really (multiple speakers) so the first quarter has primarily -- it's literally projecting out, it's literally $1 million more in the first quarter compared to the fourth quarter. And then it comes down again and goes through the cycle.

So but that's -- so the first quarter, that's the only reference we have slightly increasing. That's because of those. But we think there's offsetting costs in the compensation that Mark talked about in the fourth quarter that will carry forward to the first quarter. So other than that, one item we see general trend continuing.

Okay. Great. That's great color. Thank you. Those are my questions. Appreciate your time.

Thanks, Tim.

We have no further questions in the queue, so I'll turn the call back over to Mark Mason for closing remarks.

Again, we appreciate your attendance today and your patience for our prepared remarks and your questions. Look forward to speaking with you next quarter. Thank you.