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. And 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.
So 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 going to look like 3 to 5 years from now? And what are the key milestones that they should be watching along the way?
Yes. Thanks, Manan. It's a great question. The way we think about it quite simply is 3 to 5 years from now, we want to be one of the best-performing regional banks in the country. We've put out 3-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. And so we think that, that is very achievable, and we're obviously making great progress.
I think what I also 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 with -- in all of the business lines that we operate. And so -- and then we're also looking for diversification. I think when you look at the balance sheet in sort of 3, 4, 5 years' time, we're trying to be 1/3, 1/3, 1/3. So 1/3 C&I, 1/3 CRE, 1/3 consumer lending. So you're going to see that diversification, attention to a great customer experience. And then you're going to see our financial metrics move back in line with our peers.
So lots to dig into there, especially the C&I growth story. But maybe before that, if we can spend a little bit of time on commercial real estate and credit overall. Paydowns have been a significant tailwind 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. So it looks like credit is improving quite meaningfully. Are you continuing to see that come through in the second quarter?
We are, yes. So we are continuing to see significant par 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 '24, 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 going to see the same in the second quarter as well.
And you've also seen over the last 3 quarters, a reduction in charge-offs and you've also seen a reduction in criticized assets. So in the first quarter, we reduced criticized assets by $900 million. And the expectation is you will continue to see those trends, improved trends continue as we move forward here through the remainder of the year and beyond.
So when you think about these payments that are coming in at par, how do you think about deciding which loans you want to keep on the balance sheet versus what you're happy to see refi away?
Yes. So right now, we are obviously trying to reduce our exposure to CRE generally. So contractually, when a loan resets the borrower has 2 options. One would be a 5-year flow plus 300 fixed rate or we have a floating rate, which is prime plus 275. And we're not wavering off of that. And 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, then they're free to do that. And 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 payoffs in general, is there a level of rates that might cause payoffs to slow from here?
Not necessarily. So the resets are contractual. And as we look forward, over the next 3 years, there are $19 billion of loans that are resetting $5 billion in '25, $5 billion in '26 and $9 billion in '27. And so that is just going to happen in the course of time. Now obviously, if rates were to get lower, particularly the 5-year, we always look at the 5-year when talking about multifamily. I think that's helpful because it might accelerate some of those payoffs. But otherwise, just by being patient, we're going to see those loans reset.
Is there an opportunity to sell commercial real estate loans in this environment?
We have. We had 2 pool sales in Q4 and another 2 in Q1. I think it's one of our strategies to further reduce the nonaccrual 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. So that is absolutely one of the options we have to reduce the nonaccrual 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. So 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 outweighs any of the others. What I would say, though, is we are in the process of receiving new financial information. So 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. And we're getting the financial information right now for 2024.
What I would tell you is the financial information we've received today, 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. So 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 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.
And is that mostly on the multifamily side, the cost increases?
Yes.
All right. Perfect. Maybe before moving on, there was one credit relationship that you called out that went into nonaccrual in the first quarter. Can you remind us, what that was and if there's any updates there?
Sure. Yes. So we had one borrower who had 90 loans and who had the ability to repay and decided to stop repaying early in '25. So had been paying us through the end of '24, 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 are -- 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 was some first day orders, cash collateral and secondary hearings in the bankruptcy case will be towards the end of this month. But we just feel that having the whole sort of situation under the jurisdiction of the 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 play out just following.
That's great detail. Thanks so much. So let's pivot over to C&I lending. The commercial banking, you've clearly been leaning in there, 75 new hires since last June, another 80 to 90 planned for this year. Can you give us some more color on the go-to-market strategy? What clients, the new bankers targeting and how are they incentivizing them to move their business?
Sure. So the C&I strategy is twofold. We have a national strategy around specialty lending verticals. So if you think of sports, entertainment, media, you think of oil and gas, energy, renewables, health care, technology, telecoms, those are national lending verticals. And we've also got a -- we're looking to better penetrate mid-market C&I, upper market C&I within our geographical footprint where we have brand recognition. So that would be New York, New Jersey, South Florida, the Midwest, Arizona and California.
What I would say is, Joseph obviously ran C&I lending, U.S. Bank. He built C&I lending at OneWest from nothing. We brought in Rich Raffetto to run the C&I and private client bank. He's got a lot of experience running C&I businesses. All of the bankers that we've hired are known to Joseph or Rich, and they have typically 25 to 30 years experience. So these are well tenured bankers. The expectation is, they will originate their first loan within 90 days, of being here. They'll originate 3, 4 loans in the first year and then 5 to 7 thereafter. And they are hitting their marks.
In Q1, we originated over $1 billion of commitments. These would be new C&I loans, $750 million of which was funded, and we're on track to do the same in the second quarter. And as you mentioned, we still continue to hire those bankers. Our sweet spot is typically $50 million to $75 million in terms of loan value. So we're not taking outsized positions in any one name. And we're diversified again between the different C&I strategies, so specialty lending and then better penetrating the markets that we're in from a middle market and upper market C&I point of view. And so yes, we feel very good with how that is progressing.
So it sounds like you're on track for that $1 billion increase in C&I outstandings that you were focused on for the second quarter?
So $1 billion of new originations because we do still have runoff of our legacy portfolio. So specialty and some of the other legacy portfolios, we've been rightsizing. And so 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 C&I point of view. But in terms of new originations, yes, we will be above the $1 billion mark.
And 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. But it's across the board, and we're seeing good traction in the various specialty businesses as well as the middle market C&I as well.
And 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?
Yes. So that ultimately is the goal. So I talked about the relationship strategy. And so ultimately, we'll leverage those C&I loans to do a couple of things. One would be to bring in deposits, but also to bring in fee income business. So treasury management and other fee income opportunities. And we've hired someone to build out that treasury management part of the business, which the legacy banks weren't really focused on. And so building those deep relationships with these C&I customers is a big part of the overall strategy.
So 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. So 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. So as we build out the C&I business, having those lead left positions is another way we can build fee income.
But we can also generate fee income from the mortgage business and we feel that we'll generate more volume through the private client bankers from a mortgage point of view as well, as well as commission income from the wealth business that we have and deposit fees. So the fee income is sort of coming across multiple categories. We're not just necessarily relying on one.
And then the other piece is the expense side. That's been a big focus on -- for the bank overall, reducing expenses and over the next 3 years while still investing in the business. So 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?
Yes. 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 C&I growth that we've talked about. So the $600 million is net. We've been focused on 5 areas. So compensation and benefits, real estate optimization, vendor costs, outsourcing and offshoring noncore back office functions and the FDIC expense as well. So -- and we have effectively accomplished that $600 million. So -- and to give you sort of 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. But also we were able to get synergies out of the 3 banks coming together that we hadn't previously done. And so we were able to sort of get cost savings there. We've obviously been working on reducing vendor costs. I think the legacy organizations had similar vendors doing the same things, and we've been able to consolidate some of our vendor costs as a result of that.
The FDIC expense are somewhat complex because the way they're calculated there's multiple sort of variables, including your liquidity profile, wholesale borrowings, profitability, asset quality, regulatory ratings. But we've done a nice job as we've delevered the balance sheet and paid down brokered deposits and flub advances of reducing those FDIC expenses. We've optimized our real estate portfolio. We've talked about and we took a onetime charge in Q4 of '24 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 2 operating centers that we will be exiting as well.
And then we've outsourced or offshored those noncore back-office functions as an example. We have 6 data centers, one of which was in Manhattan. And so we're going down to 2. And ultimately, we'll get to fewer than that. But there's other back-office functions that our new CIO has been able to offshore or outsource. And so 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. And as I say, that's net of the investments we're making in risk compliance and growing the C&I and other parts of the organization as well.
And 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 '25. What I would tell you though with cost is you're never done. And it's probably my restructuring background, myopic about the expenses. And so 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. But I think there's opportunities to drive further savings in some of the categories that we just went through. And our aim is to continue to drive our efficiency ratio down and in line with our peers.
So I want to 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. So we -- as you mentioned, we've paid down a lot of wholesale borrowings, certainly multiple billions in '24 of FHLB advances, brokered deposits. That continued in the first quarter. We paid down more -- about $2 billion of brokered deposits. And that trend will continue in the second quarter. You'll continue to see us bring down brokered deposits and the intention is to pay $1 billion of flub advances off between now and the end of the year as well. So 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. And we've done a nice job. I mean you saw a significant reduction in the first quarter over Q4. And you will see a reduction in the second quarter over Q1 despite there not being any Fed decreases. So 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've got $4.9 billion of retail CDs maturing at a weighted average cost of 4.8%. So we will get a natural benefit from those maturing and resetting lower. And typically, we've been retaining 80% to 85% of CDs that have been maturing and then replacing that small runoff with new CDs. So we've been very active in managing the cost of our deposits down. And I think when we do get a Fed rate decrease later in the year, looking at the forward curve, we'll target a 55% to 60% beta.
So it sounds like even if we don't get rate cuts, you actually have a line of sight at these deposit costs going down through the...
We have the ability to reduce cost...
Keeping it down...
Yes.
All right. Perfect. And in terms of growing those core deposits, what has your go-to-market strategy been there? Like how much of these new deposits are coming in because of the new products that you're putting on?
Yes. So 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. So that is definitely a core part of the strategy. But 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.
And 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. So 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?
Yes. Again, if you look at the 3-year projections that we've put out there, by the time we get to the end of '27, it's about an 80% loan-to-deposit ratio, which is in line with peers. We're probably around high 80s to 90% today. But as I mentioned at the beginning, our aim is to have all of our metrics looking like other regional peers by the end of '27.
Great. The other topic is NIM, and NIM has been starting to stabilize over the past couple of quarters, and your guide is for some nice improvement over the next 3 years. Sure. What is the optimal rate environment for you?
So 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. So 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.
But 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 3 years, so there's $19 billion, they have a weighted average coupon of less than 3.8%. So when they reset, they're resetting at either 5-year [ flub ] plus 300 or prime plus 275. So at a minimum, they're going to 7.5%. So you get a big lift just from those loans resetting. And obviously, if they pay off, then we can invest that into the C&I growth. And typically, the C&I loans, you're looking at a spread to SOFR of anywhere from 175 to 250. And so 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. So our own deposits as well as paying down those wholesale borrowings and deposits as well. And then we've got over $3 billion of nonaccrual loans. We've been very punitive on ourselves in the way we risk weighted assets last year. And as those -- as we reduce those nonaccrual loans, we'll get the NIM benefit as a result of those moving off of nonaccrual and either reinvesting the proceeds or they become performing and accruing loans. And so there's many levers that we're looking at that obviously help us improve our NIM over that 3-year horizon.
And when a loan moves from nonperforming into performing, do you have a catch-up benefit NII?
We do. Yes. So in many instances, if it goes from nonaccrual back to accrual, you will have a catch-up NIM benefit. That's exactly right.
Got it. So as we think about the right NIM for the bank, I think you mentioned 2.8% to 2.9% by 2027. Can it increase above that? What do you think the normalized NIM for the portfolio you have is?
Yes. So right now, the 2.8%, 2.9% is by the time we get to '27. I do think it can get better, reason being -- that 3-year horizon has $19 billion of the multifamily loans resetting. That still leaves another $14 billion or $15 billion beyond '27. And again, those are low coupon. And so there's definitely room for us to further improve the NIM once we get beyond '27, just given that we'll still have some of those legacy multifamily loans on the balance sheet that will eventually move off or reset. And we will continue to manage the liability side of the balance sheet as tightly as we can. So I do think there's room beyond that 2.8%, 2.9% that you're quoting at the end of '27 for us to get better.
And how do you think about the asset sensitivity of the balance sheet? Because I know some of the C&I loans come on at variable rates. The new CRE you're putting on is also at a variable rate. So how do you think about the asset sensitivity?
Yes, we're neutral. I mean we were slightly -- ever slightly liability sensitive as we pulled forward some securities purchases. And we've sort of hedged that to get back to neutral. So we feel pretty good about our sort of balance sheet sensitivity. And as I mentioned, just we have what I'd 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. So that's sort of just an embedded business model hedge that we have.
Got it. Perfect. And I think we might have covered this in your responses, but any other quarter-to-date updates that you want to 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 C&I 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. And 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. So we're executing and doing everything that we said we were going to do.
All right. Perfect. So I'll end on capital management and regulation overall. You've been pretty clear that you want to deploy the excess capital on the C&I side because that's your key growth area. But over the medium term, what is the right payout structure for the bank between buybacks and dividends?
So right now, as you correctly said, our focus is on investing in the franchise and growing franchise value. And we believe investing in the C&I growth and growing the balance sheet will help -- 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 that is a big milestone for the organization. And that is our sort of near-term focus.
I do believe that if we get to sometime in Q2 '26, and we're profitable, we're firing on all cylinders. We're executing on our strategy. Obviously, if the stock is still trading at the discount to book that it is today, and we're sitting at over 12% CET1 capital like we are today, then I think that will be a conversation that we will have. But it's -- we're sort of 9 to 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.
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? So the net capital you need is a little bit lesser than what you're putting into new C&I loans. Is that fair?
That's right. But at some point here, you will -- we will be in a net growth mode. And so 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. And we have a new Vice Chair of Supervision. We've had new regulators with 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-IV banks? Can you talk a little bit about where you see regulation going and what impact that might have on your strategy?
Sure. Yes. Joseph would be great at this question. But 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. And I think that will drive more efficiencies and help all banks.
I don't necessarily think there'll be punitive from a capital point of view, which will allow banks to lend more to various businesses and industries. And I do think one of the outcomes will be a moving of the cap. So I don't know exactly what could happen to the $100 billion cap. I do believe it will 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 CAT-IV bank. And we believe that, that gives us competitive advantages. So we will keep that infrastructure in place because we think it's helpful. But I do think this new regulatory environment will be helpful to all banks, not just Flagstar but to all banks.
All right. Perfect. With that, we're out of time. Lee, thanks so much for joining us.
Thank you, Manan. Appreciate you having me.
