Great. Up next we have Flagstar Financial. I'll read our disclosures. For important disclosures, please see the Morgan Stanley Research Disclosure website at morganstanley.com/researchdisclosures. The taking of photographs and the use of recording devices is not allowed. If you have any questions, please reach out to your Morgan Stanley sales representative. We are delighted to have with us today Lee Smith, Chief Financial Officer of Flagstar. Lee, thanks for joining the conference.
Thank you, Manan. It's great to be here, and good afternoon, everybody.
Lee, lots to discuss today, but let's start a little bit big picture. When you think about the strategy for the bank, how should investors think about what Flagstar is gonna look like three to five years from now? What are the key milestones that they should be watching along the way?
Yeah, thanks, Manan. That's a great question. The way we think about it, quite simply, is three to five years from now, we wanna be one of the best-performing regional banks in the country. We've put out three-year financial information, and by the time we get to 2027, if you look at all of the metrics that we're aiming for from a financial point of view, that puts us in line with our peers. We think that that is very achievable, and we're obviously making great progress. I think what else I would say is, we are striving to provide just a great customer experience. That is one of our big strategic goals, making it our point of difference across the organization and in all of the business lines that we operate. We are also looking for diversification.
I think when you look at the balance sheet in sort of three, four, five years' time, we're trying to be a third, a third, a third. So a third CNI, a third CRE, a third Consumer Lending. So you're gonna see that diversification, attention to a great customer experience, and then you're gonna see our financial metrics move back in line with our peers.
Lots to dig into there, especially the, the CNI growth story. Maybe before that, if we can spend a little bit of time on commercial real estate and credit overall. You know, paydowns have been a significant deal of win for the bank over the past few quarters, including, I think, a significant amount coming from substandard. If I remember correctly, about 60% of the paydowns were from the substandard portfolio. It looks like credit is improving quite meaningfully. Are you continuing to see that come through in the second quarter?
We are, yeah. We are continuing to see significant par pay paydowns, and a substantial amount of those par paydowns are substandard loans. I think what I would say to everybody is, as you know, in 2024, we underwrote the entire CRE book, so multifamily, and the CRE office book. We took $900 million of charge-offs, and we significantly increased our ACL reserves and coverage. If you look at what has happened since Q3 of 2024, we have started to see those payoffs, and a significant amount, as I say, of being substandard loans that continued through Q1. I think you're gonna see the same in second quarter as well. You have also seen over the last three quarters a reduction in charge-offs, and you have also seen a reduction in criticized assets. In the first quarter, we reduced criticized assets by $900 million.
and the expectation is you will continue to see those improved trends continue as we move forward here through the remainder of the year and beyond.
When you think about these payments that are coming in at par, how do you think about deciding which loans you wanna keep on the balance sheet versus what you're happy to see refi away?
Yeah, right now, we are obviously trying to reduce our exposure to CRE generally. Contractually, when a loan resets, the borrower has two options. One would be a five-year float plus 300 fixed rate, or we have a floating rate, which is prime plus 275. We are not wavering off of that. That is why I think you are seeing a significant number of payoffs because if borrowers are able to get a better deal with other financial institutions or the agencies, because obviously we are seeing people move to Fannie and Freddie on the multifamily side, they are free to do that. Our objective right now is to reduce that CRE concentration so we can build that balance sheet diversification that I spoke about earlier.
Got it. And when you think about these, these payoffs in general, is there a level of rates that might cause payoffs to slow from here?
Not necessarily. The resets are contractual, and as we look forward, over the next three years, there are $19 billion of loans that are resetting: $5 billion in 2025, $5 billion in 2026, and $9 billion in 2027. That is just going to happen in the course of time. Now, obviously, if rates were to get lower, particularly the five-year, we always look at the five-year when talking about multifamily. I think that's helpful because it might accelerate some of those payoffs. Otherwise, you know, just by being patient, we're gonna see those loans reset.
Is there an opportunity to sell commercial real estate loans in this environment?
We have. We had two pool sales in Q4 and another two in Q1. I think it's one of our strategies to further reduce the non-accrual book, and we've been successful in the sales that we've experienced. We actually booked some small gains on the sales in both Q4 and Q1. That is absolutely one of the options we have to reduce the non-accrual loans. Now, we're not necessarily looking to sell performing CRE loans because, as I say, with the contractual resets the way they are and the par payoffs that we're seeing, we're very comfortable dealing with those loans through that mechanism.
Got it. When we think about the risk on the commercial real estate side, what do you think matters the most? What are you watching the most? Is it rates? Is it inflation? Is it the overall environment? What are you most concerned about?
We're looking at all of those factors. There isn't sort of one that, you know, outweighs any of the others. What I would say, though, is we are in the process of receiving new financial information. On an annual basis, we get new financial information on all of our commercial real estate credits. We obviously did that in 2024 where we fully underwrote, or re-underwrote, the entire book. We're getting the financial information right now for 2024. What I would tell you is the financial information we've received to date, we feel very positive about. We're not seeing anything really change from what we had already looked at last year. We've seen a handful of upgrades even and de minimis downgrades. The rest have stayed on par with where they were. We're obviously looking at the financial information.
That's a big driver. As I said, if interest rates were to come down, that's helpful, but it's not the be-all and end-all because you have the contractual resets. And then in terms of inflation, I mean, that is, it's obviously come down from where it was a couple of years ago. And so I think that's helping owners. They're not sort of seeing those cost increases, so that's a good thing as well.
Is that mostly on the multifamily side, the cost increases?
Yeah.
All right. Perfect. And maybe before moving on, there was one credit relationship that you called out that went into non-accrual in the first quarter.
Yep.
Can you remind us what that was and if there's any updates there?
Sure. Yeah. We had one borrower who had 90% loans and who had the ability to repay and decided to stop repaying early in 2025. Had been paying us through the end of 2024. Very idiosyncratic, unique situation. We decided to seek all contractual and legal remedies, including appointing a receiver. That was approved in the Manhattan Court, and then the borrower subsequently filed for bankruptcy, or 82% of the 90% properties filed for bankruptcy. We feel good about that. We feel that it will obviously lead to a much more orderly process as we move forward. That just happened a couple of weeks ago. There were some first-day orders, cash collateral, and second-day hearings in the bankruptcy case will be towards the end of this month.
We just feel that having the whole sort of situation under the jurisdiction of a bankruptcy court will lead to a much more orderly process. We feel very good about our secured, senior position, and we think that it will, it'll play out just fine.
That's great detail. Thanks so much. Let's pivot over to CNI lending. You know, the commercial banking, you've clearly been leaning in there. Seventy-five new hires since last June, another 80-90% planned for this year. Can you give us some more color on the go-to-market strategy? You know, what clients are the new bankers targeting and how are they incentivizing them to move their business?
Sure. The CNI strategy is twofold. We have a national strategy around specialty lending verticals. If you think of sports, entertainment, media, oil and gas, energy, renewables, healthcare, technology, telecoms, those are national lending verticals. We have also got a, we are looking to better penetrate mid-market CNI, upper-market CNI within our geographical footprint where we have brand recognition. That would be New York, New Jersey, South Florida, the Midwest, Arizona, and California. What I would say is, Joseph obviously ran CNI lending at U.S. Bank. He built CNI lending at OneWest Bank from nothing. We brought in Rich Raffetto to run the CNI and private client bank. He has got a lot of experience running CNI businesses. All of the bankers that we have hired are known to Joseph or Rich, and they have typically 25-30 years' experience.
These are, well-tenured, bankers. The expectation is that they will originate their first loan within 90 days of being here. They'll originate three or four loans in the first year and then five to seven thereafter. They are hitting their marks. In Q1, we originated over $1 billion of commitments. These would be new CNI loans, $750 million of which was funded. We're on track to do the same in the second quarter. As you mentioned, we still continue to hire those bankers. Our sweet spot is typically $50 million-$75 million in terms of loan value. We're not taking outsized positions in any one name. We're diversified again, between the different CNI strategies, so specialty lending and then better penetrating the markets that we're in from a middle market and upper-market CNI point of view.
Yeah, we feel very good with how that is progressing.
It sounds like you're on track for that $1 billion increase in CNI outstandings that you were focused on for the second quarter.
$1 billion of new originations.
New originations.
because we do still have runoff of our legacy portfolio.
Legacy.
Specialty and some of the other legacy portfolios we've been right-sizing. There's the, you have that in the second quarter. We're getting towards the end of that and getting very close to where you'll start to see net growth from a CNI point of view. In terms of new originations, yes, we will be above the billion mark.
Are there any specific verticals that are getting you the most growth in the second quarter?
It's the specialty lending verticals, particularly, are doing very well. It's across the board, and we're seeing good traction in the various specialty businesses as well as the middle market, CNI as well.
Part of what you've spoken about there in the past is that these relationships are adding on the lending side, but how many of these relationships are also generating fee income for the bank as well?
Yeah. That ultimately is the goal. I talked about the relationship strategy. Ultimately, we'll leverage those CNI loans to do a couple of things. One would be to bring in deposits, but also to bring in fee income business, treasury management, and other fee income opportunities. We've hired someone to build out that treasury management part of the business, which the legacy banks were not really focused on. Building those deep relationships with these CNI customers is a big part of the overall strategy.
When you think about those fee businesses, right, there's treasury management, as you mentioned, but there's also payments, capital markets, 401(k) advisory. What areas are you expecting to drive the most growth over the next few quarters?
Again, I think it will be across the board. It's the categories you've mentioned. We've just started subscription lending. We feel that can drive additional fee income as well. There was an example that I gave on the first quarter earnings call. We were lead left on a deal for a reputable fund where we were able to bring in structuring fees, agent fees, and other fees. As we build out the CNI business, having those lead left positions is another way we can build fee income. We can also generate fee income from the mortgage business. We feel that we'll generate more volume through the private client bankers from a mortgage point of view, as well as commission income from the wealth business that we have, and deposit fees.
The fee income is sort of coming across multiple categories. We're not just necessarily relying on one.
The other piece is the expense side. You know, that's been a big focus for the bank overall, reducing expenses and over the next three years, you know, while still investing in the business. You've talked about investing around $40 million in risk governance infrastructure. Can you give us some more color on what those investments are and when they'll be done?
Yeah. So, we have said that we are taking out $600 million of NIE year over year. That number is net of investments we're making in risk and compliance, as you just mentioned, but also the CNI growth that we've talked about. So the $600 million is net. We've been focused on five areas: compensation and benefits, real estate optimization, vendor costs, outsourcing and offshoring, non-core back office functions, and the FDIC expense as well. We have effectively accomplished that $600 million. To give you some examples, if you look back about a year ago, 15 months, the Flagstar organization had 9,000 employees. We're about 5,700 today as a result of some of the business sales that we've done.
We were also able to get synergies out of the three banks coming together that we had not previously done, and so we were able to sort of get cost savings there. We have obviously been working on reducing vendor costs. I think the legacy organizations had similar vendors doing the same things, and we have been able to consolidate some of our vendor costs as a result of that. The FDIC expenses are somewhat complex because the way they are calculated, there are multiple sort of variables including your liquidity profile, wholesale borrowings, profitability, asset quality, regulatory ratings. We have done a nice job as we have delivered the balance sheet and paid down broker deposits and FHLB advances of reducing those FDIC expenses. We have optimized our real estate portfolio.
We've talked about, and we took a one-time charge in Q4 of 2024, of consolidating 60 bank branches that are in close proximity to other bank branches. There was about 17 private client facilities, again, very close to others where we can consolidate, and two operating centers that we will be exiting as well. We've outsourced or offshored those non-core back office functions. As an example, we had six data centers, one of which was in Manhattan. We're going down to two, and ultimately, we'll get to fewer than that. There are other back office functions that Anu, CIO, has been able to offshore or outsource. All of those actions that have either happened or are scheduled to happen have got us to that $600 million that we've talked about.
That is net of the investments we are making in risk compliance and growing, the CNI and other parts of the organization as well.
I know you're leading this effort on the expense side. It sounds like most of the work has already been done or at least been laid out. Is that fair?
It has for the savings that we were looking to achieve in 2025. What I would tell you though, with costs is you're never done. It's probably my restructuring background and my optic about the expenses. We will continue to drive expenses out of the organization and get as efficient as we can. Obviously, I think we've done a lot of the heavy lifting, and certainly what I would describe as the low hanging fruit has been achieved. I think there's opportunities to drive further savings in some of the categories that we just went through. Our aim is to continue to drive our efficiency ratio down and in line with our peers.
I wanna pivot over to deposits. In addition to the expense side, you've made a lot of progress in improving the funding profile of the company as well. I think you've been paying down wholesale funding, but also you've been growing core deposits. Can you talk a little bit about what you've done on the deposit side and what trends you're seeing more recently in the second quarter?
Sure. As you mentioned, we've paid down a lot of wholesale borrowings, certainly multiple billions in 2024 of FHLB advances, broker deposits. That continued in the first quarter. We paid down more, about $2 billion of broker deposits. That trend will continue in the second quarter. You'll continue to see us bring down broker deposits. The intention is to pay $1 billion of FHLB advances off between now and the end of the year as well. We continue to reduce wholesale deposits. At the same time, we're working as hard as we can to reduce the cost of our retail and other deposits that we have on the balance sheet. We've done a nice job. I mean, you saw a significant reduction in the first quarter over Q4.
You will see a reduction in the second quarter over Q1, despite there not being any Fed decreases. We meet and we are myopic on looking at our deposit costs and what we can do to further optimize those overall costs. What I would also say is in the second quarter, we have $4.9 billion of retail CDs maturing at a weighted average cost of 4.8%. We will get a natural benefit from those maturing and resetting lower. Typically, we have been retaining 80-85% of CDs that have been maturing and then replacing that small runoff with new CDs. We have been very active in managing the cost of our deposits down.
I think when we do get a Fed rate decrease later in the year, looking at the forward curve, you know, we'll target a 55-60% beta.
It sounds like even if we don't get rate cuts, you actually have a line of sight, at least deposit costs going down through the third quarter.
We have the ability to reduce.
To keep bringing it down.
Costs. Yeah.
All right. Perfect. In terms of growing those core deposits, what has your go-to-market strategy been there? Like, you know, how much of these new deposits are coming in because of the new products that you're putting on?
Yeah. We're obviously leveraging the new lending relationships to bring in deposits. That takes time. It doesn't happen immediately. We'll sort of leg into that over time, but that's definitely part of the core strategy, and the relationship banking and having deep relationships with our customers, not just it being one way where we're effectively giving our balance sheet away. That is definitely a core part of the strategy. I mean, the consumer team has done a really nice job from a deposit point of view as it relates to DDAs and savings deposits and the CDs. We're leveraging the private client groups as well to bring in deposits, and they're using some of their products, whether that be the mortgages as an example. That's a lever to bring in more deposits as well. Then just other industry relationships we have.
Obviously, the mortgage relationships have allowed us to raise deposits from mortgage companies that we lend to from an MSR lending point of view. That's how we've sort of been able to keep up the deposit story.
Got it. And how do you think about the loan-to-deposit ratio for the company overall over time?
Yeah. Again, if you look at the three-year projections that we've put out there, by the time we get to the end of 2027, it's about an 80% loan-to-deposit ratio, which is in line with peers. We're probably, you know, around high 80% to 90 % today. As I mentioned at the beginning, our aim is to have all of our metrics looking like other regional peers by the end of 2027.
Great. The other topic is NIM, and NIM has been starting to stabilize over the past couple of quarters. Your guide is for some nice improvement over the next three years.
Sure.
What is the optimal rate environment for you?
The NIM strategy, again, there's sort of several tactics which I'll get into shortly. In terms of the way we think about our balance sheet today, from an interest rate risk point of view, we're neutral. I think we're in a good position. Obviously, if rates were to decrease, I think it would accelerate multifamily payoffs. The mortgage business would benefit, and you would see both more fee income, and obviously you'd see us add more mortgages to the balance sheet. In terms of our NIM strategy going forward, it's sort of really around a few factors. The multifamily loans that are resetting over the next three years, so there's $19 billion, they have a weighted average coupon of less than 3.8%. When they reset, they're resetting at either five-year flub plus 300 or prime plus 275.
At a minimum, they're going to 7.5%. You get a big lift just from those loans resetting. Obviously, if they pay off, then we can invest that into the CNI growth. Typically, the CNI loans, you're looking at a spread to SOFR of anywhere from 175-250 basis points. That's obviously a big improvement on those multifamily loans today that are sitting at sub 3.8%. As we talked about, we're continuing to be laser-focused on managing the cost of the liability side. Our own deposits, as well as paying down those wholesale borrowings, and deposits as well. We've got over $3 billion of non-accrual loans. We've been very punitive on ourselves in the way we risk-rated assets last year.
As we reduce those non-accrual loans, we'll get the NIM benefit as a result of those moving off of non-accrual and either reinvesting the proceeds or they become performing and accruing loans. There are many levers that we're looking at that obviously help us improve our NIM over that three-year horizon.
When a loan moves from non-performing into performing, do you have a catch-up benefit for the NIS as well?
We do. Yeah. In many instances, if it goes from non-accrual back to accrual, you will have a catch-up NIM benefit. That's exactly right.
Got it. As we think about the right NIM for the bank, I think you've mentioned 2.8-2.9% by 2027.
Mm-hmm.
Can it increase above that? What do you think the normalized NIM for the portfolio you have is?
Yeah. Right now, the 28-29 is by the time we get to 2027. I do think it can get better. Reason being, that three-year horizon has $19 billion of the multifamily loans resetting. That still leaves another $14 billion or $15 billion beyond 2027. Again, those are low coupon. There is definitely room for us to further improve the NIM once we get beyond 2027, just given that we will still have some of those legacy multifamily loans on the balance sheet that will eventually move off or reset. We will continue to manage the liability side of the balance sheet as tightly as we can. I do think there is room beyond that 28-29 that you are quoting at the end of 2027 for us to get better.
How do you think about the asset sensitivity of the balance sheet? Because I know some of these CNI loans come on at variable rates. The new CRE you are putting on is also at a variable rate. How do you think about the asset sensitivity there?
Yeah. We're neutral. I mean, we were slightly, ever so slightly liability sensitive as we pulled forward some securities purchases. And we've sort of hedged that to get back to neutral. You know, we feel pretty good about our sort of balance sheet sensitivity. And as I mentioned, you know, just we have what I describe as a natural business model hedge. If rates were to come down, you would, it would obviously help us with that multifamily portfolio and the mortgage business. That's sort of just an embedded business model hedge that we have.
Got it. Perfect. I think we might have covered this in your responses, but any other quarter-to-date updates that you wanna give?
No, I think we're doing exactly what we said we would do. We're executing on the plan. We've obviously covered a lot of areas, but we're continuing to see healthy payoffs and paydowns of that multifamily book. We're seeing good traction in terms of new CNI origination activity. We are managing the liability side of the balance sheet in terms of the cost of deposits. We're paying down wholesale deposits as we said we would. We said we would accelerate securities purchases. We're doing that. We feel very good about where our cost run rate is, and as I say, we feel that we've done what we need to do, or it's on the schedule to happen in terms of achieving the $600 million year-over-year cost savings. We're executing and doing everything that we said we were going to do.
All right. Perfect. I'll end on capital management and regulation overall. You've been pretty clear that you wanna deploy the excess capital on the CNI side because that's your key growth area. Over the medium term, what is the right payout structure for the bank between buybacks and dividends?
Right now, as you correctly said, our focus is on investing in the franchise and growing franchise value. We believe investing in the CNI growth and growing the balance sheet will obviously help us do that. We're obviously focused on returning to profitability. We've said publicly that we expect to do that in the fourth quarter, and so, you know, that is a big milestone for the organization, and that is our sort of near-term focus.
I do believe that, you know, if we get to, sometime in Q2 2026, and we're profitable, we're firing on all cylinders, we're executing on our strategy, you know, obviously if the stock is still trading at the discount to book that it is today, and we're sitting at over 12% CT1 capital like we are today, you know, then I think that will be a conversation that we will have. It's, you know, we're sort of 9-12 months away from that. Right now, we're focused on investing in the franchise, growing the franchise, and realizing the shareholder value that we feel would come if we execute on our strategic plan.
Because if I think about the capital you need to grow the franchise, there is also the offset from the commercial real estate book that you're running off, right?
There is.
So the net capital you need is, is a little bit lesser than what you're putting into new CNI loans. Is that fair?
That's right. At some point here, you will, so we will be in a net growth mode.
Yeah.
And you, you're exactly right to think about it, but our expectation is at some point here, you will see us in a net growth mode where, as a result, we are using that capital.
Got it. The last topic I wanted to touch on was on regulation. We have a new Vice-Chief of Supervision. We've had new regulators at the FDIC and the OCC in their seats for some time. How are you thinking about potential changes to bank regulation, maybe any changes to the category thresholds for CAT - 4 banks? Can you talk a little bit about where you see regulation going and what impact that might have on your strategy?
Sure. Yeah. I, I, Joseph would be great at this question. I think we feel good about the changes and the people that are in the seats. I listened and heard Michelle's comments the other day. I thought they were very positive. I think it will lead to a much more pragmatic approach. I do think that there will be greater unity across the agencies as well as a result of the new leaders. I think that will drive more efficiencies and help all banks. I do not necessarily think there will be as punitive from a capital point of view, which will allow banks to lend more to various businesses and industries. I do think one of the outcomes will be a moving of the cap.
I don't know exactly what could happen to the $100 billion cap. I do believe it'll go higher, whether it's inflationary or an arbitrary number that is chosen. I don't know, but I do believe that it will move higher. One thing I would just say, the $100 billion cap, I know we're slightly below it. We're not managing to that. We've obviously invested in our risk compliance internal audit infrastructure because we are a CAT4 bank, and we believe that gives us competitive advantages. We will keep that infrastructure in place because we think it's helpful. I do think this new regulatory environment will be helpful to all banks, not just Flagstar, but to all banks.
All right. Perfect. But then we're out of time. Lee, thanks so much for joining us.
Thank you, Manan. Appreciate you having me. Thank you.
Thank you.