Mechanics Bank Q3 FY2023 earnings call

• Impact of interest rates: Continuing adverse impact of significant interest rate increases on the business, with net interest margin affected by higher costs of interest-bearing liabilities.
• Allowance for credit losses: $1.1 million recovery in Q3 due to reduced higher-risk land and development loans, expecting allowance ratio to remain stable.
• Deposits and funding: Pursuing promotional CDs and money market accounts to retain deposits, using borrowings as lower cost funding alternative.
• Loan origination: Focus on variable rate products like commercial, residential construction, and home equity loans; low multifamily loan originations except Fannie Mae DUS loans.
• Asset quality: Strong asset quality with nonperforming assets decreasing, loan delinquencies at low levels, net charge-offs at $500,000 in Q3.
• Dividend: Board approved $0.10 per share dividend payable on November 22, 2023.
• Fannie Mae DUS business: Evaluated unsolicited proposal to purchase DUS business, determined price inadequate.

In the third quarter of 2023, HomeStreet Bank's net income was $2.3 million or $0.12 per share, compared to $3.2 million or $0.17 per share in the second quarter. Net interest income decreased by $4.6 million due to a net interest margin drop from 1.93% to 1.74%. The allowance for credit losses recovery was $1.1 million in Q3 vs $0.4 million in Q2. Non-interest income was consistent with Q2. Non-interest expenses decreased by $41.7 million mainly because of the Q2 goodwill impairment charge. Common equity Tier 1 and total risk-based capital ratios were 9.55% and 12.7% respectively as of September 30, 2023.

• Net interest margin expected to stabilize near term, not expected to increase materially until rates stabilize.
• Anticipate higher DUS-related loan sales but still below normalized production levels as Fannie Mae's total production is lower than expectations.
• Expect stable loans held for investment, deposits, net interest margin, noninterest income, and stable noninterest expenses except seasonal compensation benefits in first quarter.
• Confident in remaining profitable through the cycle excluding unforeseen events or economic changes.

• Interest rate competition for deposits from banks, money market funds, and treasury bonds, leading to some deposit outflows.
• Historically low originations in interest rate-sensitive residential and commercial mortgage banking businesses impacting earnings.
• Potential impact of unforeseen economic changes on the company's ability to remain profitable.

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

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

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

A: About $600 million as we disclosed in our Q matures next March. Basically, it's a bank term funding program. Based on rates at that time, we anticipate that we probably will extend it for another year because basically there's no prepayment penalty for paying that off early. Secondly, the other ones had a three to five year maturity over the time split up pretty evenly over those periods a little bit more in the shorter term. So that was put on approximately a year ago, it's going to be two to four years.

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

A: Yeah. In terms of looking at the expenses what they're going through, the biggest change has been in the compensation benefits. We continue to reduced headcount where possible, part of it by layoffs, part of it by just not filling open positions. So we've been able to accomplish that. Obviously, our commissions and bonuses are lower because of the performance this year. But you can see the headcount going down and we continue to expect the headcount in the fourth quarter to be lower than it is in the third quarter. Across the Board, we've just taken steps where we can to defer or eliminate expenses where possible. For example, in marketing expenses, we've deferred or eliminated programs that we do there. Other expenses that are items that we can eliminate we do, do that going forward and we continue to look for that. We think there is -- we'll continue to evaluate. And if we see additional opportunities we think we can still have some benefit going forward.

Q: Great. Thank you. Good morning, gentlemen. Mark or John do you have the substandard loan balance as of September 30?

A: We don't. We can try to look at that real quick but we -- it would have been filed with our call... Yes I don't have the call report in front of me. But I will tell you it is not changed materially. I think it actually -- hopefully. I'm correct declined slightly I think.

Q: Okay. And then sticking on credit is there any updated color on the non-accrual from 2Q? I think it was the $27 million relationship?

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

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

A: Well I can give you a little color. I wish it was going better I believe that we have restructured about $100 million of multifamily loans. And when you look at our loan origination numbers Tim and you look at multifamily I think there's $40-some million this quarter. Look at the other day. The details in the... It is in the release that we are looking up on talking. That represents restructured loans not new loans. We actually write a new loan as opposed to modifying the existing one. So it will show up as a loan origination. Yes, $44 million this quarter. Last quarter you see $65 million quarter before $18 million. Those are the restructuring numbers to date right? About $100 million or a little more. And why isn't that number larger? In our multifamily portfolio as you know these are hybrid loans with initial fixed rate periods. And given when the loans were originated and the fixed rate periods of the loans these loans were mostly five-year but five- and seven-year fixed rate periods. Well a lot of these loans are originated in 2021 and 2022. So they're not up for repricing or moving from fixed to variable rate interest rates for a few years still. And because that date is further out we have a harder time getting borrowers to be concerned about that change in debt service. There's a widespread belief that rates will be down by then and circumstances will be better. And so this is activity that is at a low level today. But as you can imagine, over the next year or two years that activity will pick up. But what also will improve is our view of the risk of that activity and we will probably be less interested in restructuring some of these loans, given their loan, loan to values and good cash flow. So we'll see.

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

A: I think the fourth quarter would be a similar change. As Mark mentioned, there is some reductions in personnel that we'll be realizing the full benefit in the fourth quarter. And just as a reminder in the first quarter and why we comment on it always is we do have those compensation benefit costs that come in to hit hard in the first quarter, which is basically employer taxes and 401(k) maths.. And merit increases. They hit the second quarter really. So the first quarter is primarily – it's literally projecting out. It's literally $1 million more in the first quarter compared to the fourth quarter. And then it kind of comes down again and goes through the cycle. So – but that's – so the first quarter that's the only reference we have to slightly increasing that's because of those. But we think there's offsetting costs in the compensation that Mark talked about in the fourth quarter that will carry forward to the first quarter. So other than that one item, we see a general trend continuing.