Flagstar Bancorp, Inc.
Q4 2014 Earnings Call Transcript

Published: 22 Jan 2015

[Operator:]

Good day and welcome to the Flagstar Bank Fourth Quarter 2014 Earnings Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Mr. David Urban, Director of Investor Relations. Please go ahead, sir.

[David Urban:]

Thank you, Brian and good morning. Welcome to the Flagstar fourth quarter 2014 earnings call. Before we begin, I would like to remind you that the presentation today may contain forward-looking statements both regarding our financial condition and our financial and operating results. These statements involve certain risks that may cause actual results in the future to be different from our current expectations. For non-exhaustible list of such factors, please see our 2013 Form 10-K and our first, second and third quarter 2014 Form 10-Qs as filed with the SEC, as well as the legal disclaimer on Slide 1 of our fourth quarter 2014 earnings call slides that we have posted today on our Investor Relations site at flagstar.com. During the call, we may also discuss non-GAAP financial measures regarding our financial performance. A non-GAAP financial measure is a metric that is not presented in accordance with U.S. GAAP. We believe that our use of these non-GAAP financial measures in addition to the GAAP results can provide investors with additional information that is useful in assessing the results of Flagstar’s operations on a run-rate basis. In today’s presentation and the press release we issued this morning and in our subsequent SEC filings, we identify these non-GAAP financial measures as adjusted measures which modify for significant items. We are providing a reconciliation of these measures to similar GAAP measures in the tables to our press release, which we issued this morning or in the appendix to our earnings call slides. With that, I’d like to now turn the call over to Sandro DiNello, our President and Chief Executive Officer.

[Alessandro DiNello:]

Thank you, Dave, and thank you everyone for joining us today. In addition to Dave, I am joined this morning by Jim Ciroli, our Chief Financial Officer; Lee Smith, our Chief Operating Officer; Steve Figliuolo, our Chief Risk Officer; and Mike Flynn, our General Counsel. I would like to take a moment to describe the order of the call. First, I am going to highlight the key items and actions we undertook during the fourth quarter. After my remarks, Jim will review the consolidated quarterly financial performance. Lee will then provide a more detailed review of our business segments and strategic initiatives. Following this, I will conclude with a view of our 2015 first quarter and then open the call for questions and answers. With that, let’s begin. During the fourth quarter of 2014, we increased core profitability with no unusual adjustments, reflecting our sustained commitment to revenue growth, solid asset quality, and continued expense discipline, all supported by stronger risk management and compliance programs. We reported net income of $11.1 million or $0.07 per diluted share as compared to adjusted net income of $7.7 million or $0.01 per diluted share in the third quarter. Importantly, net income this quarter contain no significant items. Non-interest income grew by $2.9 million or 3% on an adjusted basis to $98.4 million driven by increased net gain on loan sales and an improvement in the R&W reserve driven by lower loss experience. Non-interest expense declined. Total non-interest expense fell $1.5 million or 1% on an adjusted basis to $139.3 million led by lower legal and professional fees and other non-interest expense. Credit-related costs declined. Total credit costs, including net charge-offs from HFI loans and the R&W reserve and asset resolution expense totaled $12.3 million in Q4 versus an adjusted $23.9 million in Q3, a decline of $11.6 million. Capital increase, our Tier 1 leverage ratio rose 9 basis points to 12.6%. The balance sheet also remained very liquid with cash and agency securities representing 17% of total assets. We have also continued to add experienced leadership throughout the organization. Andy Fornarola was hired to run community banking. Andy was most recently EVP and Head of Consumer Finance at First Niagara and also brings experience from M&T and HSBC. Mark Landschulz joined our servicing team to lead performing servicing. Mark comes to us from Quicken Loans where he was their Head of Servicing. Jim Levites was hired to run specialty servicing. Jim was the veteran of the specialty servicing business and comes to Flagstar with over 30 years of experience in the business much of it with CitiMortgage. More recently, we adjusted our regional management team and the TPO mortgage business to flatten the organization, reduce operating expenses and better position us for future growth in our mortgage origination franchise. That group is now being led by Brian Vieaux who most recently was managing our retail mortgage group. Brian came to Flagstar in 2012 with over 20 years experience in the third-party mortgage origination business, primarily with CitiMortgage and IndyMac. Moving on to our results, while Jim and Lee will provide further detail and analysis in their remarks, I would like to begin by noting that I am extremely pleased that this quarter’s earnings are the result of core operations. In that regard, I would like to emphasize a few items. First, we have built a stronger risk management organization and will continue to improve our compliance infrastructure. Risk management and compliance have been and will remain a top priority for this management team. Second, we will continue to manage risk in order to maintain asset quality and the consistency of credit costs. Third, we remain committed to managing and controlling expenses to support profit growth. Fourth, we continue to pursue prudent revenue growth both in net interest income and non-interest income. And lastly, more than ever, we are confident in the future prospects of Flagstar as we continue to build the company that we believe will produce consistently improving growth in core earnings and shareholder value. As I said before we are deeply dedicated to the task at hand. With that, my colleagues will take you through a more detailed discussion of our financials and operations. So let me now turn the call over to Jim.

[Jim Ciroli:]

Thanks, Sandro. Turning to Slide 5, our net income was $11.1 million or $0.07 per share in the fourth quarter as compared to an adjusted net income of $7.7 million or $0.01 per share in the third quarter. Driving the overall increase in adjusted net income was the positive operating leverage for the quarter led by 1% decline in expenses with stable revenue. Our fourth quarter net interest income fell to $61.3 million as compared to $64.4 million for the third quarter 2014. The decrease in net interest income was due to lower interest income from loans repurchased with government guarantees and from lower levels of average consumer loans. Our NIM dropped 11 basis points in the quarter to 2.80% mainly due to a lower yield on the company’s Ginnie Mae early buyout portfolio and the 21 basis point reduction of the yield on loans held for sale. The lower yield on Ginnie Mae loans resulted from a combination of lower rates and updated assumptions on the realizability of the interest income claims on these loans which while government guaranteed are subject to certain performance standards. In prior quarters the provision for expected losses on this interest income was reported in asset resolution costs. The lower yield on loans held for sale resulted from lower mortgage rates in October. Earning assets fell 1% last quarter due to the consumer loan portfolio pay downs in a late third quarter sale of jumbo mortgage loans. This slight decrease was partially offset by increases in commercial loans especially in our warehouse lending portfolio as our success in opportunistically growing our commercial book continued. Average total deposits increased 1% from the prior quarter driven by higher retail savings in government deposits, partially offset by lower retail money market accounts and CDs. We had continued success with our promotional campaign to increase retail savings accounts. The quarterly provision for loan losses fell $3.1 million to $5.0 million for the fourth quarter. During the quarter we had $9 million of net charge-offs. Excluding $3 million of net charge-offs on loans sold, net charge-offs were $6.0 million. I will provide additional details on asset quality in a couple of minutes. Non-interest income increased to $98.4 million in the fourth quarter as compared to an adjusted $95.6 million during the third quarter excluding last quarter’s $10.4 million of indemnification related charges. The improvement in non-interest income included an $8.2 million improvement in our representation of warranty activity excluding last quarter’s indemnification charges. We received $2 million in recoveries of prior rep and warranty losses and a $4 million download reserve adjustment based upon updated loss rates on Fannie Mae and Freddie Mac claims. A $1.4 million or 3% increase in gain on loan sales. We saw higher refinance volume driven by lower rates in October and early December partially offset by a seasonal decline in purchase volumes. Our gain on sale margin of 87 basis points was 4 basis points higher than the third quarter and a $300,000 improvement in the net return on mortgage servicing assets, which rose modestly to $1.6 million from $1.3 million in the prior quarter. Our gross return on the MSRs was 7.4% slightly lower than we experienced in the prior quarter as a result of higher prepayments. This gross return in Q4 was reduced by transaction costs and losses on sales totaling $3.5 million as we sold $70 million of MSRs. Additionally, third quarter results were reduced by updated model changes, which reduced the fair value of MSRs in that quarter by $3.3 million. To help you understand all of this activity better, we have added Slide 33 to the appendix. These positive developments in non-interest income were partially offset by a $3.1 million decrease in net gain on sale of assets. Gains in Q4 were $1.7 million as we sold $24 million of lower performing mortgage loans whereas Q3 gains included the sale of $48 million of performing jumbo mortgage loans and $33 million of lower performing mortgage loans. A $2.2 million decrease in other non-interest income due to lower gains on security sales and lower fair value adjustments on mortgage loans and a $1.9 million or 10% decrease in loan fees and charges primarily due to a drop in mortgage closings for the quarter. Non-interest expense fell 1% to $139.3 million in the fourth quarter as compared to an adjusted $140.8 million in the third quarter. This included a $3.2 million decrease in legal and professional fees, excluding the legal costs in Q3 related to the company’s CFPB settlement. The decrease was from lower consulting expenses. A $2.0 million decline in other non-interest expense, excluding the Q3 CFPB settlement due to lower settlement costs and other losses and a $300,000 decline in asset resolution costs, which fell slightly to $13.4 million despite a $2.0 million provision related to prior loss recoveries. The improvement in asset resolution costs was due to process improvements and lower level of problem assets. These improvements were partially offset by an increase of $5.5 million in compensation and benefits reflecting higher levels of incentive compensation and $2.6 million of severance costs. Slide 6 shows our operating metrics. We have already talked about the profitability metrics here. And I would like to focus on our operating leverage which was positive as expenses declined 1% with stable revenue. This performance was a significant improvement from the negative operating leverage in the third quarter and our capital remains strong with our Tier 1 leverage ratio improving 9 basis points. Slide 7 highlights our period end balance sheet. For the fifth consecutive quarter, we remained under $10 billion in assets at period end. While this will provide certain financial benefits such as lowering our FDIC insurance costs and relief from Durbin which is assessed based upon the bank’s asset size at December 31, we do not intend to remain under this level. For the past two quarters, our average assets have been higher than the $10 billion level and we expect to see balance sheet growth throughout 2015. Turning to Slide 8, our allowance covered 7.0% of total loans at the end of the fourth quarter as compared to 7.6% at the end of the third quarter. The total allowance coverage ratio declined even though the coverage ratios for both the consumer portfolio and the commercial portfolio remained relatively flat. This is because the commercial portfolio continues to comprise an even larger percentage of our total loan book. Taking a deeper look, the allowance coverage of consumer loans was flat as the consumer allowance coverage ratio was 11.0% at December 31 compared to 11.1% at the end of the prior quarter. The commercial loan allowance coverage ratio declined in Q4 reflecting the low level of problem loans in this portfolio and growth in higher quality loans such as warehouse loans during the quarter. Non-performing loans were $120.5 million at the end of the fourth quarter as compared to $106.9 million at the end of the third quarter. This $13.6 million increase was driven by higher non-performing TDRs. There were $9.5 million of loans that were modified in 2009 into 5-year balloon loans, which matured during the third quarter and had not yet been refinanced or modified as of December 31. Of these loans, 93% have been paying since their respective maturity. Despite this increase, non-performing assets remained relatively stable at 1.41% of total assets, as OREO levels decline due to sales. Early-stage delinquencies were down for Q3. Looking at consumer loans, 1.6% of consumer loans were over 30 days delinquent and still accruing, an improvement of 28 basis points from last quarter. There were no commercial loans at December 31 that were more than 30 days delinquent. During the quarter, we had $9 million or 91 basis points of net charge-offs, including $3.0 million of charge-offs on loan sold or 31 basis points. Excluding loans sold, net charge-offs were $6.0 million. Turning to Slide 9, we have details on our representation and warranty reserve. We have favorable experience this quarter on a few items. First, we had net recoveries this quarter. This was due to favorable results on claims, which were $2.3 million lower than in Q3 as well as recoveries, which were $2.2 million better than the Q3. Second, as we look at the $7 million reserve we established last quarter, we only had claims of $188,000, which we replenished through additional provision. Third, as a result of having more data points, to populate our vintage analyses by virtue of the passage of time and reflecting upon favorable experience, we have had recently as well as other external factors, we reduced our ending balance of the reserve by $4 million to $53 million from $57 million at the end of the last quarter. I would also point out that we add to this reserve continuously by reducing the gain on loan sales, excluding gov-guaranteed loans by 4 basis points for every loan sold. Turning to Slide 10, we continue to maintain robust regulatory capital ratios. Our Tier 1 leverage ratio was largely unchanged for the quarter at 12.6%. Our Tier 1 common ratio was 12.9% for the fourth quarter as compared to 12.7% at the end of the third quarter. Looking at the impact of a fully phased-in implementation of Basel III, our Tier 1 leverage ratio would be 10.2% and our Tier 1 common ratio would be 9.1% at the end of the quarter. This 240 basis point impact to our Tier 1 leverage ratio is mostly driven by the detrimental treatments that mortgage servicing rates receive under Basel III. Over the long-term, we plan to continue to reduce our MSR to Tier 1 ratio, taking into consideration market conditions the guide our pace of MSR reduction. Excluding our preferred stock from Tier 1 capital, our consolidated Bancorp Tier 1 leverage and Tier 1 common ratios under Basel I would be 9.2% and 11.8% respectively. As we stated last quarter, we continue to evaluate all of our options with respect to our preferred stock, including the $56 million of preferred dividends that we deferred to-date. I will now turn to Lee for more insight each of our businesses.

[Lee Smith:]

Thanks Jim and good morning everyone. This quarter we were able to see some of the benefits from the significant efforts over the last 18 months to de-risk the balance sheet and optimize our cost structure. The objective of those efforts was to create a solid foundation that was profitable on a sustainable basis, on from which we could grow in a prudent and effective manner. As we start to focus more keenly on growth strategies across our three business line verticals, I want to start by outlining some of the key operating metrics from each segment during the quarter. Please turn to Slide 12, quarterly operating highlights for the Community Banking segment include average commercial loans increased 5% to $1.5 billion versus the prior quarter. The portfolio remains balanced among both industry type and collateral with the majority of our borrowers right here in Michigan. Where the borrower or property not in Michigan, it is typically because we have followed a strong Michigan-based customer. New C&I and CRE loan originations in the fourth quarter were $218 million. Commercial loan commitments grew 8% quarter-over-quarter to $2.9 billion. During 2014, we have grown C&I loan balances by $212 million, CRE loan balances by $211 million, and warehouse loan balances by $345 million for a net increase in new loan balances of $768 million during the year. Average consumer loans fell $125 million or 5% in Q4 driven primarily by pay-downs in consumer HFI loans and a $48 million jumbo loan sale at the end of Q3. The reduction in average consumer loans during 2014 of approximately $500 million has been the result of $560 million UPB jumbo loan sales during the year and the sale of $93 million UPB, scratch and dent, NPL and TDR loans. Average interest bearing deposits increased more than 10% during 2014 driven by higher retail and government savings deposits. It is our intention to continue to grow our commercial businesses, including warehouse lending in a controlled, safe and sound manner as we have been doing to-date. We offer warehouse lending on a nationwide basis to our own TPOs as well as TPOs who sell loans to other investors. In the C&I and CRE segments, we continue to focus on the Michigan market. And we are also looking at new products that leverage existing skill sets within the bank. As Sandro noted, during the quarter, we brought in Andy Fornarola to head up our community banking business line and we are excited by the potential of combining our own community banking platform with Andy’s experience, particularly in the consumer lending space. We will also look to opportunistically add jumbo and even conventional loans to our HFI portfolio throughout 2015 if it makes sense economically to do so. Please turn to Slide 13. Fourth quarter operating highlights for the mortgage origination business include fallout adjusted gain on sale margin, which is what we use when reporting gain on loan sale increased 4 basis points to 87 basis points in the fourth quarter as compared to 83 basis points in the third quarter. Lock volume remained relatively steady at $6.2 billion. Purchase mortgages accounted for slightly more than 53% of origination volume in the fourth quarter as compared to slightly more than 62% of origination volume in the third quarter. We took advantage from the drop in interest rates at the beginning of the quarter as the tenure bottomed out at 2.09 on October 15. And although it rallied a little for the remainder of the quarter, we have seen another steep drop for the beginning of 2015, which has been beneficial for our origination business as refinance activities picked up. We continue to remain focused on providing service excellence and monitor our quality metrics and turn times daily, while at the same time implementing strategies to eliminate excess capacity and create a more variable cost structure on the fulfillment side of the business. As I mentioned, our origination business is certainly benefiting from the lower interest rates at the beginning of this year. And we have also been working to take advantage of the recently announced FHA mid production of 50 bps. We see both of these events as having potential upside to our Q1 origination activity. We continue to look at technology as a way to further improve the top line performance and make us more efficient from an operating point of view. And we are also focused on being ready for the new RESPA/TILA disclosure requirements that go into effect later this year. Finally, we are committed to growing our retail origination business on both the retail distribution and direct to consumer sides of this business and we will keep you apprised of progress here on future calls. Moving to servicing, quarterly operating highlights for the mortgage servicing segment on Slide 14 include we executed on the sale of $6.4 billion in aggregate UPB of 72,000 loans of residential MSRs during the quarter. And we will act as the sub-servicer on 22,000 of these loans going forward. We currently service approximately 383,000 loans, of which 238,000 are sub-serviced for others. The remaining 145,000 are loans where we own the MSR or they are part of our HFI book. Approximately, 96% of our servicing book is performing loans, which means 4% or approximately 15,000 loans are 60 plus days delinquent. We are always looking at ways to reduce the number of default and delinquent loans in our portfolio given the servicing and working out delinquent loans is not part of our core growth strategy. Mortgage servicing rights fell $27.6 million or 10% to $257.8 million as a result of the $6.4 billion in MSR sales during the quarter. And our MSR to Tier 1 capital ratio decreased from 24.9% at the end of Q3 to 21.8% at the end of Q4. It’s important to note that while the low interest rate environment and mid production provide opportunities on the origination side of the business, it will potentially lead to pressure on the valuation of the MSR asset given likely higher prepayments. As previously mentioned, during the quarter, we recruited Mark Landschulz to run performing servicing and Jim Levites to run special servicing, which includes default servicing oversight and collections. Given our desire to be a best-in-class player in the mortgage servicing space, we thought it prudent to bifurcate performing and default servicing given their critical importance. This will allow us to focus maximum attention to both areas at all times, particularly given the heightened regulatory and compliance attention around default servicing. As we have previously outlined, our focus is on growing our sub-servicing platform and we believe we can do this in three ways. Selling MSRs we create and sub-servicing those loans, on-boarding and sub-servicing loans we did not originate, working directly with the GSEs and Ginnie Mae to offer an alternative servicing platform for their book of loans. We also want to better leverage the cross-selling we are able to do across our three business line verticals in order to increase share of our mortgage customers wallet and the number of accounts per household. This initiative is in its infancy, but now that we have the right team in place, we believe there are significant opportunities for us to pursue. We continue to de-risk the balance sheet by resolving problem assets, including our IO portfolio. If you turn to Slide 15, you will see that we have $628 million of interest-only loans on our balance sheet that are yet to reset. Of these, $313 million or 50% are due to reset during 2015. The anticipated payment shock associated with these resets versus current payments is approximately 104%. Slides 15 and 16 of the earnings presentation contain a lot of key data points around this portfolio in order that you can see how we are handling and tracking the IO book. Rather than reciting the metrics from these slides verbatim, I want to focus on a few key highlights. But before that, I would just say that we continue to be extremely pleased and encouraged with the performance of this portfolio. Key takeaways include of the 1,284 IO loans that have reset through December 31, 2014, 25.6% unpaid principal balance have paid in full, 37.2% UPB or 516 loans are cash flowing resets, of which 501 have been paying for 3 months or more and 363 or 70% of this specific population have been paying for 6 months or more. 5.8% UPB or 92 loans have been charged off or foreclosed on and of this 84 defaulted prior of the reset date and only 8 defaulted post resets. For Q4, we had a right party contact rate of 100%. We are currently at 95.4% for Q1, where we have 412 IOs resetting. With respect to overall quality, Slide 15 shows that 85% of all remaining IOs have FICO scores greater than 660 and 87% of those same loans have LTVs less than 100%. The rolling 12-month average loss severity on the IO portfolio is 37%. Now, moving to our HFI loan book and de-risking efforts here. We sold approximately $24 million UPB of scratch and dent loans, NPLs and TDRs during the quarter for a gain of $1.6 million active transaction costs. We have now sold approximately $600 million in UPB of NPLs TDRs and scratch and dent loans during the last 18 months as part of a concerted effort to de-risk our balance sheet and reduce the cost associated with non-performing assets. It’s been a busy quarter as we continue to reduce risk in the balance sheet, which has been necessary in order to create the platform from which we can push on and grow in our three major business line verticals. Moving now to expenses on Slide 17, our non-interest expense during the fourth quarter was $139.3 million. This compares to $140.8 million for the third quarter after adjusting for cost associated with the CFPB settlement. And we believe our current non-interest expense quarterly run-rate is approximately $133 million to $138 million. Our Q4 non-interest expense run-rate would have been $135 million after subtracting the $2.6 million of severance costs and $2 million of provision related to prior loss recoveries that Jim mentioned earlier. During the fourth quarter, we completed a detailed cost review by business unit. This was a bottoms-up approach where we went through every cost line item for our 28 business units. We identified many cost saving opportunities that we are already working on implementing. As a result of our expense management, what you should see as we look forward is the cost base that will improve slightly from where we are today even though we are growing the three major business line verticals. This reflects the increased operating leverage and expense discipline that has been instilled within the organization. Even as we invest some of these savings into our future growth strategies, managing our cost structure aggressively will continue to remain a focus. Our goal is to reduce excess capacity and create a more variable cost structure across the organization. And we will continue to build on the work we have done today around vendor management and procurement expenses, asset resolution costs, legal and professional fees and optimizing our real estate portfolio in particular. With that, I will hand it back to Sandro.

[Alessandro DiNello:]

Thank you Lee, I am now going to close our prepared remarks with some guidance for the first quarter of 2015 and then open the call for questions and answers. On Slide 19 are those itemized guidance parameters. We expect net interest income to increase slightly led by modest earning asset growth. The net interest margin is expected to be relatively stable, but it could narrow a bit. Given the current level of interest rate and volatility, mortgage locks are expected to be at least 5% above Q4 levels. We expect a modest improvement in gain on loan sale margin. We expect loan administration income to be flat to up while the net return on the mortgage servicing asset will continue to be challenged by volatility in interest rates and transaction costs on any sales we might execute. The ratio of our MSR to Tier 1 capital may rise from year end levels as we properly react to market conditions. We expect our provision expense to be at or possibly slightly above Q4 and asset resolution expenses to decline with no significant change in R&W reserve levels. And as Lee noted, we expect non-interest expenses to be between $133 million and $138 million. This concludes our prepared remarks and we will now open the call to questions from our listeners. Brian?

[Operator:]

Thank you. [Operator Instructions] And we will now take our first question from Scott Siefers with Sandler O'Neill Partners.

[Alessandro DiNello:]

Hi, Scott.

[Scott Siefers-Sandler O'Neill Partners:]

Good morning, guys. Good morning. Obviously, Lee, I was hoping you could clarify or I just want to make sure I understand your comments on the expense base correctly? So, it sounded like you suggested we could see a little relief even from here despite growth in all the business lines. Should we think that to mean that if like refis are totaling in originations come in better than you might expect throughout the year, the cost base is going to be pretty firm still in this kind of sub $140 million level sort of regardless of the origination volume?

[Alessandro DiNello:]

Let me – I will let Lee answer that more specifically, Scott, but I will just start by saying that at this point the guidance we are giving is limited to Q1 and that is $133 million to $138 million range, but certainly what you are suggesting is what we would like to see to happen. Let me – let Lee to elaborate on that.

[Lee Smith:]

Yes. I think what I would say Scott, it obviously depends on the level of refinance activity. Obviously, at some point, you are going to see some increase, but I think what I would say and as I mentioned in my prepared remarks, we believe we will be between $133 million and $138 million for Q1. And during the fourth quarter, we completed a detailed bottoms-up cost review by business where we did identify many cost saving opportunities that we are currently working on implementing. But as you mentioned the key here is we are going to invest some of these savings in growing all three of our major business line verticals. So, as we move forward, you should see a cost base that will be more efficient from an operating leverage point of view. So, I think what you asked is, you will see – you should see what you alluded to, but again it just depends on what sort of volumes we would see because at some point, you will sort of see a greater increase.

[Scott Siefers-Sandler O'Neill Partners:]

Okay. That’s helpful. Thank you. And then switching gears a little, Sandro are you guys able to kind of update or provide any additional clarity on what you might be able to do with the former TARP preferreds and for timing and some flexibility or relief there?

[Alessandro DiNello:]

Well, I can tell you this, we are certainly aware of the situation and we are investigating all the opportunities that might be out there for us. So Jim, anything do you want to add to that?

[Jim Ciroli:]

We have – Scott, I appreciate the question, but we don’t have an update at this time.

[Scott Siefers-Sandler O'Neill Partners:]

Okay, alright. And then maybe final question, so you guys kind of bounce around the $10 billion asset level and Jim you have suggested we would probably won’t stay there – stay below $10 billion for very long, which I guess brings sort of Durbin and FDIC more into the – into focus. So, as you look at potentially those kinds of dynamics impacting your numbers or pressuring your numbers once you go above and sustain over $10 billion. What are the plans to counter some of those pressures and are they enough to overwhelm any of the pressures that would come or how are you thinking about that dynamic?

[Jim Ciroli:]

So, I think that what I would say as we got near the end of the quarter, what we saw was that we were in measurable distance of still staying under $10 billion, so we decided to limbo under $10 million. The Durbin pickup alone was about $3 million. And what I would point out is that because we have been under the $10 billion mark all year long, throughout ‘15, we are going to be under small bank pricing on FDIC. And then Durbin, the Durbin benefit should persist throughout ‘15 and into the first half of ‘16 as well.

[Scott Siefers-Sandler O'Neill Partners:]

So the concern that you expressed relative to what happens on the cost side or how it negatively impacts our operating leverage is that more of a 2016 event?

[Jim Ciroli:]

Well, no. Now I would answer the cost question, Scott is – Scott, we have already made the investment. There is – I really don’t see much in the way of incremental costs from being over $10 billion. We already have the...

[Scott Siefers-Sandler O'Neill Partners:]

FDIC costs.

[Jim Ciroli:]

Yes, as early as ‘16.

[Scott Siefers-Sandler O'Neill Partners:]

Okay. Yes. And I guess that’s where the thrust of my question was, like at some point, there is going to be a revenue hit from going and staying about $10 billion, and is that the kind of thing you think you can absorb or will you have to have additional costs cuts or sort of other pricing changes to counteract any of those in the eventuality of it?

[Jim Ciroli:]

No, at that point in time we will be able to absorb that.

[Scott Siefers-Sandler O'Neill Partners:]

Okay. Alright, it sounds good. Thank you.

[Alessandro DiNello:]

Thanks, Scott.

[Operator:]

And we will now take our next question from Paul Miller with FBR Investment Bank.

[Alessandro DiNello:]

Hi, Paul.

[Paul Miller-FBR Investment Bank:]

Yes. Hi guys. Thank you very much. Just taking a step back a little bit because I am not sure if I picked everything up, but on Slide 15, Lee you went through this slide, which I think is very good, but I just want to make sure I understand it completely. You had total resolutions right at 1,171 with total resolutions out of – were they all the loans that reset in 2014 that were in the IO book?

[Lee Smith:]

Yes. So the way to look at this Paul is from January 1, 2013 through December 31, 2014 we have had 1,284 IOs reset. And the table on the right hand side shows you exactly what happened to all 1,284 of those loans.

[Paul Miller-FBR Investment Bank:]

So of the 1,284 loans, 300 basically paid in full and then the cash flow resets, what exactly is that can you explain that to me?

[Lee Smith:]

Sure, yes. So there is couple of things. One, just to say Paul we had about 440 loans reset in Q4, so with that 1,294 about a third of that actually did reset in Q4. The cash flow in reset to loans where you would keep the reset date, the payment shock has occurred and these borrowers continued to pay the higher monthly mortgage payment rate. And then the chart on the left hand side it actually we are tracking how long after the reset date where you have these cash flow resets of the borrowers continued to pay. And as you can see from the chart a significant amount of these borrowers are being continuing to pay for more than six months following the reset. So this is an important metric for us to track because with the recent reset and they are paying the higher monthly rate we want to make sure that they are comfortable and able to make that payment. As soon as we see any change in payment behavior we are back on the phone to these doors.

[Paul Miller-FBR Investment Bank:]

And so if I add Jim that’s very clear, so I didn’t quite understand that, now if I add charge-off foreclosures roughly a 6% rate and then default servicing these are loans that they have not made the payment after the reset, so is that accurate about 9% are running into trouble?

[Jim Ciroli:]

Yes. So here is what I would say though, the loans that are with full servicing we can still rehabilitate those loans and we are actively trying to rehabilitate those borrowers where we can and those will be rehabilitated through a modification. So you should look at the ones that are in default servicing and say some portion of those will be modified. And we are actively working on those. And then you have got the 92 that have charged off to-date. And as I mentioned in my prepared remarks what’s interesting is 84 of those defaulted prior to the reset. So the reset wasn’t the trigger for them to default, only 8 of the 92 have defaulted post reset.

[Paul Miller-FBR Investment Bank:]

Yes. That’s what I wanted to get a clarification on that. And so I don’t know if you are willing to make this comment, but you guys I think believe in the April – first quarter April earnings release put a very big provision out there that kind of surprised people. And I think one of the explanation was that you were concerned about these resets and how these loans will perform, looking on our side it looks like these loans are performing better than expected, is this in line with your expectations with that big provision or better than expected?

[Alessandro DiNello:]

We will have Jim to take that one.

[Jim Ciroli:]

So, I appreciate the question, but the way we look at this is very cautiously and over time as Lee pointed out we have got a significant amount of resets yet to come. So it’s I think it’s still too early to tell – to be able to answer that question.

[Paul Miller-FBR Investment Bank:]

Okay. And then is it – correct me if I am wrong with the resets what is the reset range, was it something like in the 70% range on average or is it lower than that now?

[Lee Smith:]

Yes. So the reset, the payment shock for to – every loan that’s resetting in 2015 and there is approximately $313 million UPB the payment shock is 104%. So it’s effectively doubling your monthly mortgage payments. If you look back at what reset in 2014, it was – it was pretty similar, a little less probably about 98% payment shock. So it’s fairly comparable, 2015 is fairly comparable with what we saw in ‘14.

[Alessandro DiNello:]

And the payments shock is against with our current...

[Lee Smith:]

Current monthly mortgage.

[Alessandro DiNello:]

If you look at the slide on the Page 15, it shows you that for those that are resetting in 2015 the payment shock is only 14% against their original payment what they were qualified for I should say.

[Paul Miller-FBR Investment Bank:]

Okay, qualified, I was confused by that chart. Okay. And then on the mortgage bank I know the first question that you baked out in this a little bit, the refi index has been up I think 60%, 70% in the first two weeks of the year. And if rates stay at this low level, it sure looks like that 5% increase in locks could be somewhat conservative. I would think that you are seeing greater than a 50% daily application rate at this point versus December?

[Alessandro DiNello:]

Yes. So, Paul what we have seen is that the refinance activity clearly has picked up. And I think our experience is reasonably consistent with what the MBA has been talking about relative to application increases. So, we have seen the volume pickup in all of our production channels, but hey, it’s only three weeks into the year here. So, it doesn’t make a trend, but we are on top of it. We are adjusting our capacity on an ongoing basis. We are trying to keep our cost as variable as possible, but we are ultimately going to make sure that we maximize the revenue opportunity as long as it’s there. And as Lee mentioned in his prepared remarks, there is also the FHA MIP reduction that’s starting any day now, I think within the next couple of days. And we have already seen activity related to that. So, that’s another thing that we are all over and we are going to maximize those opportunities as long as they are there. But it’s really early here to get too excited about it. So, we are trying to be measured, but at the same time very aggressive in our activities to take advantage of the opportunity that have presented itself.

[Jim Ciroli:]

Yes, let me add to that. Rates dropped sharply coming into the year and we just don’t know that they could rise sharply as well.

[Paul Miller-FBR Investment Bank:]

Okay. Hey, guys thank you very much.

[Jim Ciroli:]

Thank you.

[Alessandro DiNello:]

Thanks, Paul.

[Operator:]

And we will now take our next question from Kevin Barker with Compass Point Research.

[Alessandro DiNello:]

Good morning, Kevin.

[Kevin Barker-Compass Point Research:]

Good morning. Could you just talk about what might be the major impediment to repaying TARP or potentially looking at bringing your dividends current given that they are deferred right now?

[Jim Ciroli:]

Right. So, this is Jim. When you go to repay TARP, you again have to demonstrate your ability to live without that Tier 1 capital. And that is entirely dependent upon the level of risk and how well you manage that risk within your balance sheets. You have got to go through that regulatory exercise. So, that’s one impediment. The other impediment is this is holding company level capital. So, we would have to do something at the holding company level or be able to dividend up from the bank level in order to have the cash funding to be able to either bring those preferreds current or to begin to retire them.

[Kevin Barker-Compass Point Research:]

So, what is the major impediment to dividend that money between the bank and the holding company, because you had close to 20% Tier 1 common equity ratio for Basel III at the bank, correct me if I am wrong?

[Jim Ciroli:]

No, I think you are right about that. As you look at just the rules and regulations, banks are subject to a 2-year plus a step period limitation on the dividends that they can upstream to the parent. So, you look at the past 2 years of net income and that’s your dividend paying capacity without getting regulatory approval.

[Kevin Barker-Compass Point Research:]

Okay. And then when I think about the Tier 1 leverage ratio where it is and some of the stress tests you are going through right now, you are close to 10% on Tier 1 leverage. You have $4 billion core loan portfolio, but your total balance sheet is $9.8 billion which is constraining you. I mean, is there any options there to shrink the overall balance sheet in order to deleverage and put yourselves in it and de-risk the overall company in order to put yourself in a better position to repay TARP? Is that an option you are looking at or is this something where you say it’s probably best to earn and increase your retained earnings in order to increase your capital base and be able to repay it a year or two down the road? I am just trying to see how you are thinking about that and how you are positioning the balance sheet?

[Jim Ciroli:]

Right, Kevin. So, I understand all of the logic that you expressed. What I would say is that in order to be the size of mortgage player that we are both in the origination and the servicing side, we made the investment in the risk management and infrastructure systems that we need to really be subject to the over $10 million rules from a regulatory standpoint. So, we think it’s going to be significantly better for us to be over that $10 billion and growing than under the $10 billion and reduce our assets and therefore our earnings capacity just simply to retire what admittedly is very high cost capital.

[Kevin Barker-Compass Point Research:]

Is there any consideration to catch up dividends rather than repay or you consider doing that instead?

[Jim Ciroli:]

I have been looking at all options at this point in time.

[Kevin Barker-Compass Point Research:]

Okay. And then quick question on the IO arm portfolio from some of the Paul’s questions, I know you had a 15% decline in your IO arm portfolio quarter-over-quarter, but reserves went up by my estimates roughly $3 million. Do you have further opportunities to make material declines in the IO arm portfolio in the next couple of quarters?

[Jim Ciroli:]

Yes, I will let Lee handle that more. But what I would tell you Kevin is as we look forward into ‘15, half the portfolio resets over the next year. So, if anything as we look at the IO portfolio at least from a finance perspective and I will let Lee answer from a business perspective with the long loss development periods that, that product really has, we are going to be very cautious about taking that reserve down. We are going to take that reserve down when we know that the risk is gone.

[Lee Smith:]

Yes. And I think what I would add from a business perspective, Kevin is as I said in my prepared remarks, when we look at this IO portfolio and how it’s performing, we are pleased and encouraged with what we are seeing to-date, but obviously we want to sort of see a few more quarters say before we start getting some real trends, but everything we have seen today is encouraging. If there are opportunities to refinance these loans and the borrower wants to go down that path, then we will obviously look to do that. If the borrowers are experiencing financial hardship, we need to move them to a modification then we will look to do that. And then as you know based on sales of NPLs and TDRs and jumbos that we have executed on previously, yes, if there are sale opportunities that make economic sense then we would look to explore such sales. But I think net-net overall, we are encouraged with what we are seeing from this portfolio.

[Kevin Barker-Compass Point Research:]

Okay. Thank you for taking my questions.

[Alessandro DiNello:]

Thank you, Kevin.

[Operator:]

And we will now take our last question from Bose George with Keefe, Bruyette & Woods.

[Alessandro DiNello:]

Good morning, Bose.

[Bose George-Keefe:]

Good morning. Actually just one follow-up on that IO portfolio up to 1,284 loans what was the number of loans that were delinquent when it went into the reset?

[Lee Smith:]

So, yes, Bose, we charged off 92 of the 1,284. And of that 92, 84 defaulted prior to the reset, so only 8 of the 92 have defaulted post reset.

[Bose George-Keefe:]

Okay, great. And then just one another one just on expenses, longer term, if revenues don’t really grow in line with what you guys would expect? Is there room for you to take down expenses a little further or is there kind of a targeted expense ratio that you think of in a more normalized basis?

[Alessandro DiNello:]

Certainly. Bose, if we are not able to achieve the revenue targets that we are shooting for internally then we will take the action that we need to take on the expense side make no mistake about that. But what we would rather do is continue to find ways to operate more efficiently, support the growth in the businesses going forward without increasing our overall cost of operation. So, that’s really what we are striving to do and I am confident we are going to be able to do that. But no question about it, we will take the action we need to take if the revenues aren’t where they have to be.

[Lee Smith:]

And I would just add, Sandro and I think history has proven that we can do that. I mean, as you know, Bose, we have taken $200 million of cost out of the business over the last 18 months. So to Sandro’s point, we will do whatever is necessary.

[Bose George-Keefe:]

And just in terms of normalized expense ratios, is there anyway to think about that at the moment?

[Jim Ciroli:]

This is Jim. So, as Lee mentioned, we are continuing to invest in our businesses for growth and we could always pullback that investment and just harvest, but we don’t think that’s the best thing to do. And as long as we are in that growth mode, I think our efficiency ratios are going to be a little bit elevated over where you see them trending long-term, but to answer your question specifically is going to be hard to do until we really understand what the full potential of each of those three businesses are. I could probably answer it for a community banking business or an origination business, but as you blend the three businesses together, they all have different expense loads to them and it’s really hard to understand where the potential for those businesses is going to be at any point in the future.

[Bose George-Keefe:]

Okay, that’s fair. Thanks.

[Jim Ciroli:]

Thank you, Bose.

[Operator:]

And it appears there are no further questions at this time. And I would like to turn the call back over to Mr. Sandro DiNello for any additional or closing remarks.

[Alessandro DiNello:]

Thank you, Brian and thank you to all of you for your interest in Flagstar. We have been through a tough, but necessary journey these last 2 years. And as you are aware, each quarter had significant events outside of core operations. Some of those events were positive, some were not, but Q4 did not produce any such non-core events. Instead, we saw solid core earnings growth and that solid core earnings growth was based on the strong foundation, which this active and positive management team has been committed to building at Flagstar. We will continue on that path while remaining mindful that all of our work is based on our commitment to building this company in a safe and sound manner. Thank you for your time this morning. I look forward to reporting on Q1 results in April. Have a great day.

[Operator:]

And ladies and gentlemen, that concludes today’s conference call. We thank you for your participation.