HomeStreet, Inc.
Q2 2018 Earnings Call Transcript

Published: 24 Jul 2018

[Operator:]

Good morning. And welcome to the HomeStreet Second Quarter 2018 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [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.

[Mark Mason:]

Hello, and thank you for joining us for our second quarter 2018 earnings call. Before we begin, I would 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 and Events link. In addition, a recording and a transcript of this call 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 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 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 would 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 continued to meet the challenges 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 low interest rate first mortgages are beginning to shift to 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 non-performing 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 in 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, servicing, and 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. Retaining servicing on most of our mortgage loans we originate and sell is 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 to 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 standard loss sharing to 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 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 a $6.9 million in pre-tax restructuring charges related to these actions and we estimate an additional $1.7 million of pre-tax restructuring charges in the third quarter of this year. We expect these actions will result in annualized pre-tax 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 [ph] profit margin as our profit mix should favor lower, jumbo, and 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 named Sandra Cavanaugh as a new board member. The Board believes that Sandra’s strong background in banking and asset management will be an asset for the company as we continue to execute on our strategic plan. And now, I will it turn over to Mark who will share the details of our financial results.

[Mark Ruh:]

Thank you, Mark. Good morning everyone and thank you again for joining us. I will first talk about our consolidated results and then provide detail on our two 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 with $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 restructuring expenses net of tax. Excluding impact of these recurring 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 non-interest income, largely from higher net gain on loan originations and the sale activities in both our mortgage banking segment and our Commercial and Consumer Banking segment, somewhere offset by higher core non-interest 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 loan held for investment and loans held for sale. Our second quarter net interest margin of 3.25% remained steady from the first quarter of '18. While our retail deposit base remains relatively low, our wholesale deposit and borrowing cost have increased. During the quarter, this increase in funding cost was offset by higher yields on our interest earning assets. Non-interest expense including impact of restructuring-related expenses increased to $103.7 million in the second quarter from $101 million in the first quarter. This increase in non-interest expense was primarily from higher commission cost and 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 interest income and adjustments prior period. As Mark mentioned, the partial sale of the 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 had a 12.32% an increase of 135 basis points in terms of prior quarter. Due to the sale of the mortgage servicing rights, Tier one capital also increased in both consolidated and bank level regulatory capital ratio all realized improvement. I’ll now discuss some key points from our Commercial and Consumer Banking segment results. Commercial and Consumer Banking segment’s core net income was $11.9 million in the second quarter, increasing 17% of reporting income of $10.2 million in the first quarter. Net interest income increased $2.3 million or 5% from the first quarter of 2018 to $47.7 million primarily due to the growth in our loans held for investments. The portfolio of loans held for investment increased by $123.1 million or 3% to $4.9 billion in the second quarter. Segment non-interest income increased quarter-to-quarter to $8.4 million from $7.1 million. This increase was 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 sales as the calendar year progresses. Segment core non-interest expense was $39.3 million an increase of $940,000 from the first quarter of 2018. This increase was primarily due to continued growth of our remaining units in branch network and due to higher information systems cost and of the SE assessments 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 a $11.2 million or 16 basis points of assets at March 31. This increase was a result of a reduction in nonaccrual loans, we recorded a $1 million provision for credit losses and 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 Jun 30, an increase of $71.3 million for March 31, driven primarily by a 5% increase in business deposit accounts. Deposits in our de novo branches are those opened within the past five 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 rates lock commitments in the second quarter, and improved composite margins that resulted in an increase in core earnings from gain on loan origination and sale activities. The intensive competitive pressure on margin eased during the second quarter resulting in some recovery of our composite profit margins. Our gain on mortgage loan origination sales deposit margin increased 22 basis points over the last quarter, following the reduction of 25 basis points in the first quarter of 2018. The increase in interest rate lock commitments during the quarter was primarily due to the seasonal increase in home buying activity as refinanced mortgages decreased on an absolute basis quarter-over-quarter and represented only 18% of our total loan volumes, 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 locks being less than closing in a given quarter negatively affect Mortgage Banking segment earnings, as the majority of mortgage revenue is recognized in interest rate lock, while majority of origination costs, including commissions are recognized upon closing. The flattening yield curve also increased negative convexity in our mortgage servicing portfolio and adversely impact 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 $572,000 of pre-tax revenue, net of transaction costs and prepayment reserves resulting from the sale of the previously mentioned mortgage servicing rights. Mortgage Banking segment core non-interest expense of $54.4 million increased $1.6 million from the first quarter, primarily due to the increase in commission phase as a result of the increase in closed mortgage loan volumes. Our portfolio of single family loans serviced for others decreased to $19.1 billion of unpaid principal balances 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 two basis points compared to the prior quarter end. I will now turn it back over to Mark Mason to provide some additional insights on HomeStreet’s outlook for the future.

[Mark Mason:]

Thank you, Mark. Looking forward to the next two quarters at 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 four 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 close loan volume forecast for the third quarter is due to the closing of home loans that was previously discussed. Locked volume was immediately impacted while we remain responsible for closing the pipeline of mortgages originated by these closed offices. For the full-year 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 basis points 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 of 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 to 335 basis points and remain in that range for the fourth quarter of 2018. During the third quarter and fourth quarters, we expect our total core non-interest 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 streamline. Changes in our total core non-interest expenses or very similar quarter-over-quarter driven by seasonality and cyclicality in both our single family and commercial real estate closed mortgage loan volume. Core non-interest expenses in our Commercial and Consumer Banking segment are expected to increase between 2% and 3% over the quarter for the third quarter and fourth quarters of this year. Notwithstanding, the increase in core non-interest 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:]

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Jeff Rulis of D.A. Davidson. Please go ahead.

[Jeff Rulis:]

Good morning.

[Mark Mason:]

Good morning, Jeff.

[Jeff Rulis:]

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

[Mark Mason:]

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.

[Jeff Rulis:]

Do you have a percent of – just a rough number of that – those individuals are still around, is it just around it – I mean, how many are ?

[Mark Mason:]

Yeah. I say roughly, roughly a third continued into the quarter, third quarter.

[Jeff Rulis:]

Okay. 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.

[Mark Mason:]

That's correct.

[Jeff Rulis:]

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

[Mark Mason:]

No, it doesn't. It's a part of the structure of the Fannie Mae’s program. You can choose between two 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 at this point was one that included exposure to the first 5% of losses in what was essentially deductible, but capped losses at 20% of original principal balance roughly. We moved to what’s called a pari passu loss sharing arrangement where you share equally from dollar one, but up to 33% of that original principal balance, which you know it sounds like greater exposure, but in reality it isn't because of the 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 thought 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, they 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.

[Jeff Rulis:]

Okay. So there – 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?

[Mark Mason:]

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 very strong credit quality.

[Jeff Rulis:]

Got it. And maybe one last one, just on the credit side, kind of you’ve flipped it to modest net charge-offs from a long string of recoveries. Any – do you read anything into that or is it just sort of a lumpy quarter, any comment on the net charge off trend?

[Mark Mason:]

This is more a story of recoveries and not charge offs, right. Our charge offs come from consumer loans primarily. Once in a while, we will have a small business charge off, but recoveries have been the story for a 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 are starting to see that.

[Jeff Rulis:]

Yeah. Okay. Thank you.

[Operator:]

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

[Steve Moss:]

Good morning. On the…

[Mark Mason:]

Good morning, Steve.

[Steve Moss:]

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

[Mark Mason:]

I think it's all the markets. What we did see, and it is 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 garner 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 periods and Oh, my gosh, we’ve gone too far, right. And this is what typically happens in this business when you have a – an extraordinary change in rates and something like what we are currently experiencing in this 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 we fall on the MBA statistics on a point. No one essentially made money out of 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.

[Steve Moss:]

Okay. And then I guess on the mortgage servicing side with the sale here just a little color as to what you're expecting around 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 update or thoughts around how quickly you can rebuild the servicing portfolio?

[Mark Mason:]

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 most risk management resource. And you see in the quarter that we’re 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 risk management results today is the yield curve. And the fact that we made money and servicing historically out of positively slow yield curve, because of the amount of our hedge comprises swaps and that 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, seven-year, 10-year, 15-year tenures. And those are pretty flat cancellations today. And so we're going to get some help on convexity costs from the sale, but the thing is really going to turn around our servicing results for the risk management standpoint is going to be getting succeed this in the yield curve.

[Steve Moss:]

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

[Mark Mason:]

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 loan center closings. I would expect that it will take until third quarter of next year sometime second or third quarter to rebuild the same presale $23 billion level.

[Steve Moss:]

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

[Mark Mason:]

On portfolio yields in general or individual?

[Steve Moss:]

Yes in general.

[Mark Mason:]

In general.

[Mark Ruh:]

Well, they are rising, right. Not just as a consequence of the fed, but about a third of our portfolio adjust monthly about a – another third or so adjust on a schedule, right. And so, those loans are still adjusting up from prior changes in rigs, right as we – as they hit their adjustment date. And so, we see or expect yields to rise if you guys give me a chart quickly now, giving more form to answer. Meaningfully, by year-end, right something in the range of 20-plus basis points and more and then more following year, right. Again, that's without any other changes. Combinational change in mix and scheduled expected increases in rates on periodically adjusted months.

[Steve Moss:]

All right. Thank you very much.

[Operator:]

The next question comes from Jackie Bohlen of KBW. Please go ahead.

[Jackie Bohlen:]

Hi, guys. Good morning.

[Mark Mason:]

Hi, Jackie.

[Jackie Bohlen:]

Mark, I just wanted to look into headcount a little bit more and understanding that you still have about a third left to the individuals who are 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?

[Mark Mason:]

Total headcount, in the bank division is going to rise somewhat going forward as a consequence of one, continuing to open branches, where we still have a pipeline of branches over the horizon to open, we have some open positions, also and in what we forecast, we never accomplish because we never seem the 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 of them we’re hoping to. In the mortgage bank, now of course headcount is falling, right. And the headcount typically falls seasonally towards the year-end, right as we allow attrition that help reduce our capacity in the fourth quarter. And so I’d expect headcount in the mortgage bank to fall 5% to 10%, potentially through attrition in by year-end and sort of hang around at that number, going forward.

[Jackie Bohlen:]

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 potentially additions in the mortgage banks and would you think there 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?

[Mark Mason:]

Yeah, I mean currently we are expecting it to be flat in the mortgage bank next year. Understand you know we continue to analyze ways to improve the results at this part -- both part of the cycle. So I can only be so definitive, right. In the commercial bank again with expected growth in deposits branches we expect to see some continued growth, but not meaningful. And remember of course that any growth and expenses whether it’d headcount or non-personal expenses we're expecting revenue to grow multiple in those numbers, right, I mean these are conditions related to revenue generation.

[Jackie Bohlen:]

Okay. And I 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?

[Mark Mason:]

I wouldn't say that it accelerates them, it ensures we don't need outside capital that would be to dilutive potentially. It may accelerate based upon results. We feel comfortable now with our plan going forward from 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 achievement.

[Jackie Bohlen:]

Okay. Great. Thank you.

[Mark Mason:]

Thank you.

[Operator:]

The next question comes from Tim O'Brien of Sandler O’Neill. Please go ahead.

[Tim O'Brien:]

Good morning. Thanks for taking my call. 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 us some color?

[Mark Mason:]

Sure. We've been making pretty meaningful investment in trying to grow our CNI business particularly in California. And those investments are beginning to show returns. And the lending is both prime based and LIBOR based. It depends on the market and 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 the lending relationships is growing somewhat though we continue to be a community bank with SBA business and other smaller lending, our focus for CNI has been larger relationships on multi-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 CNI business we are trying to grow without taking extraordinary credit risk, and so that’s what you would see, if you would 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, some results, and we’re expecting that to accelerate.

[Tim O'Brien:]

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, I don’t know?

[Mark Mason:]

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

[Tim O'Brien:]

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

[Mark Mason:]

Well, we are primarily a collateral based lender, we do have some cash flow based loans in service industries primarily right, we don’t have wide assets. But in cash flow lending, we look for a very solid histories of repeatable cash flows, strong margins and just very strong managements. And so, cash flow lending is a small minority of the loans we make. We mean underlying cash low but we typically have collateral.

[Tim O'Brien:]

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

[Mark Ruh:]

The largest relationship is $63 million.

[Tim O'Brien:]

I’m sorry Mark, did you say, $53 million?

[Mark Ruh:]

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

[Tim O'Brien:]

And next largest?

[Mark Ruh:]

I was playing for time, well, I’m trying to think of –

[Tim O'Brien:]

No, yeah, that’s okay.

[Mark Ruh:]

Yes. If Rob’s really quickly, I guess, it’s really what I should be seeing is, that's our largest, where our 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.

[Tim O'Brien:]

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

[Mark Ruh:]

We do -- we have about $120 million of loans, they’re not all officially shared national credits, most of them are what I call club deals, right.

[Tim O'Brien:]

Yeah.

[Mark Ruh:]

But, we’re not the lead lender, but some of them are shared national credits and they’re all performing, they’re all performing well. We try to stay with regional credits, but we know the businesses that they have to be larger than we would lead.

[Tim O'Brien:]

And then…

[Mark Mason:]

It actually right now of leaving our first club credit like that.

[Tim O'Brien:]

Great. Well it was a 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?

[Mark Mason:]

It was and I have to get back 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.

[Tim O'Brien:]

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?

[Mark Mason:]

We require a full banking relationship on all of 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 relationship.

[Tim O'Brien:]

And just looking out I don’t know two years or five 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 seeing 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 the strategy that you're that you've set course on?

[Mark Mason:]

We would love to…

[Tim O'Brien:]

Either a dollar amount or percentage?

[Mark Mason:]

We would love to have a third of our loan balances of C&I Tim. I mean it's obviously below that now, it’s in 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 somebody in our situation who has had to build that business almost from scratch right with the balance sheet with 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 a third of the loan portfolio, I think that that would be pretty strong performance for us. Hey I didn’t answer your prior question, we had an $8 million closing on a participation in the quarter.

[Tim O'Brien:]

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

[Mark Mason:]

Bear with me for a second…

[Tim O'Brien:]

Even ballpark at Mark, like is it the majority of it. Is it you know what I mean. I guess my question is you know what one of the reasons commercial banks are successful is because they effectively lock in a stick to your low cost funding base to support growth in the 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 in over time over some extended period of time, and for HomeStreet success for strategy to prove successful?

[Mark Mason:]

Okay. So that’s a bunch of questions in that…

[Tim O'Brien:]

I guess how much would you like that deposit base non-interest bearing checking and savings associated attributed to commercial and consumer, I guess to grow and account for as a percentage of your deposit base?

[Mark Mason:]

Well…

[Tim O'Brien:]

You know it's 12.3% at the end of June and…

[Mark Mason:]

Let me answer the first question which was composition today Tim, how about that?

[Tim O'Brien:]

Okay.

[Mark Ruh:]

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

[Mark Mason:]

Right, so it’s about a $1 billion, right, between servicing deposits and non-servicing.

[Tim O'Brien:]

Yeah.

[Mark Ruh:]

Of the non-servicing deposits so the $627 million, $432 million were business, now that’s business that both comes from the C&I business which is the majority but also small business that walks into the branches, right. So the majority…

[Tim O'Brien:]

Did that…

[Mark Ruh:]

Of that about 80% roughly is commercial. And that number Tim when I got here was almost zero.

[Tim O'Brien:]

Yes. And then growth in vision down the road…

[Mark Mason:]

That’s going to be dependent upon our success in growing both large and small business, 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 convert is 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 through our living activities in general cash management activities grew larger. We love for that to dominate the company’s deposit. 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.

[Tim O'Brien:]

Thanks for answering my questions. It took up too much of your time, but I appreciate it.

[Mark Mason:]

Thanks, Jim.

[Operator:]

The next question comes from Tim Coffey of FIG Partners. Please go ahead.

[Tim Coffey:]

Great. Thanks, good morning, gentlemen.

[Mark Mason:]

Good morning, Timothy.

[Tim Coffey:]

Hi, Mark. If I’m reading the tea leaves right, it looks like payoffs have average right above $300 million a quarter, I’m getting that right on the commercial bank for us?

[Mark Mason:]

Bear with me one second, I will give it to a real answer. Payoffs continue to be high, right.

[Tim Coffey:]

Yeah.

[Mark Ruh:]

And that’s for sure, in the quarter payoffs, pay downs and sales right were up about 50%, right. The first quarter has about $400 million is over $600 million in the second quarter. Part of that was sales though remember we grew the loan portfolio of the commercial real estate area more in the first quarter we have less sales in the second quarter we had more sales and that attributed to some of that affect. 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 you safe.

[Tim Coffey:]

Yeah. 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 to offset some of those elevated payoffs?

[Mark Ruh:]

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 based 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, were actually promised or contractually sold or committed by Fannie Mae at the date of origination. So, we don't really have the ability to hold those loans. That activity will rise and fall with activity in marketplace and our ability to execute on it. Now, run-off, let me give you a quick answer though, annualized run-off 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 run-off, the fourth quarter of last year was even higher 35%, and I think that includes sales, right. So…

[Tim Coffey:]

Right.

[Mark Mason:]

That additional activity will make that number jump around.

[Tim Coffey:]

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

[Mark Ruh:]

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've seen it continue to decline. It is seasonal during the year, right. Because of the seasonality of Fannie Mae DUS, and SBA loan origination and sale, the efficiency is worsening our first two quarters of the year, and better in the second two quarters. If you look at last year, the same pattern, and in the average about 70% efficiency, last year. We’ve averaged a little over that in the first half of this year. 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 basis points or 3 basis points, maybe 4 basis points – 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. It’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 role of – goal of diversification we have to try to do both. And so we’re – we are slower to accomplish our goals and efficiency as a consequence of P&L to need to grow and diversified.

[Tim Coffey:]

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?

[Mark Ruh:]

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

[Tim Coffey:]

Okay. What was the lower yield expect I got the [indiscernible]?

[Mark Mason:]

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.

[Tim Coffey:]

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

[Mark Mason:]

Clearly, we had some, right. But we have a full quarter of investment. We opened three branches right at the end of the second quarter, if you’re paying attention, one is in the first quarter -- into the first quarter. Thank you and so, we had a full quarter of those expenses, right.

[Tim Coffey:]

Yeah. Okay. But, the proxy – the expense related to proxy were not really material?

[Mark Mason:]

Not really material – look the expenses, we are not happy about incurring, but in relation to total expenses, but not really material.

[Tim Coffey:]

Okay. All right. Well, all my other questions have been answered. Thank you.

[Mark Mason:]

Thanks, Tim.

[Operator:]

[Operator Instructions] The next question comes from Henry Coffey of Wedbush. Please go ahead.

[Henry Coffey:]

Two of a kind. I hope you – I apologize if you 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 say, 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?

[Mark Mason:]

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. Instead of considering going to the market at this time for more at this time for more capital later this year or beyond. We wanted to make sure that we have the capital. The prices are very, very good right now, right.

[Henry Coffey:]

Right, right.

[Mark Mason:]

So in terms of market timing, again this was the highest sale of the year, right. If you look at all sourcing sales, absolutely the highest value paid. That drove part of it. And there's 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 the mortgage banking part of this business is almost a 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 ones 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 a least negative impact on future operations. Three, we try to select loans that were outside of our retail banking footprint and/or loans originated by loan officers no longer with the company, right. So on all of the most negative aspects – potential aspects of the transaction we try 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 as we go through it.

[Henry Coffey:]

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

[Mark Mason:]

Well, again, no free lunch, right. You can do that. The last time we sold servicing in 2014, we had it bid both ways with or without retained 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 it 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 job relief.

[Henry Coffey:]

So, since the capital relief is not a issue going forward. Can you think about it as a business strategy because there’s -- on the outside chance of 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 – or is the current thought, well, we sold a bunch of servicing will originate more in-market servicing and regrow the MSR?

[Mark Mason:]

That’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. They're 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 – that strategy but it's not our strategy today.

[Henry Coffey:]

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 in 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 it going to be a cost disadvantage associated with any residual contract?

[Mark Mason:]

Yes and yes, so we did have some technology charge offs that related to underappreciated equipment, right, that is, and network systems and things that were being amortized, that has 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 out over time, but that's a little bit of disadvantage currently, not too material.

[Henry Coffey:]

Everybody complains about that aspect of that contract with that vendor. So thank you very much.

[Mark Mason:]

That's insightful question. I would just let that go.

[Henry Coffey:]

Right. Thank you.

[Operator:]

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

[Mark Mason:]

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

[Operator:]

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