Flagstar Bancorp, Inc. (FBC) CEO Alessandro DiNello On Q3 2020 Results - Quick Version Earnings Call Transcript
Flagstar Bancorp, Inc. (NYSE:FBC) Q3 2020 Results Earnings Conference Call October 21, 2020 10:50 AM ET
Company Participants
Kenneth Schellenberg - Vice President of IR
Alessandro DiNello - President and Chief Executive Officer
Jim Ciroli - Executive Vice President & Chief Financial Officer
Reggie Davis - Executive Vice President & President of Banking
Lee Smith - Executive Vice President & President-Mortgage at Flagstar Bank
Conference Call Participants
Daniel Tamayo - Raymond James
Jamie Benjamin - Piper Sandler
Henry Coffey - Wedbush
Steve Moss - B. Riley Securities
Bose George - KBW
Disclaimer: *NEW* We are providing this transcript version in a raw, machine-assisted format and it is unaudited. Please reference the audio for any questions on the content. A standard transcript will be available later on the site per our normal procedure. Please enjoy this timely version in the interim.
Operator
[00:00:06] Welcome to the Flagstar Bank, third quarter, twenty twenty earnings call, today's conference is being recorded at this time. I would now like to turn the call over to Mr. Ken Schellenberg. Please go ahead, sir.
Kenneth Schellenberg
[00:00:18] Thank you, Daryn, good morning. Welcome to the Flagstar third quarter. Twenty twenty earnings call. Before we begin, I would like to mention that our third quarter earnings release and presentation are available on our website at Flagstar dot com. I would also like to remind you that any forward looking statements made during today's call are subject to risks and uncertainties, factors that could materially change. Our current forward looking assumptions are described on slide two of today's presentation in our press release and in our 2019 form 10K and subsequent reports on file with the FTC. We are also discussing gas and non-cash financial measures, which are described in our earnings release and in the presentation we made available for this earnings call. You should refer to these documents as part of this call. With that, I'd like to now turn the call over to Alessandro DiNello, our president and chief executive officer.
Alessandro DiNello
[00:01:09] Thanks, Ken, and good morning to everyone listening in. I hope all of you and your loved ones have been able to stay safe and healthy. I'm joined this morning by Jim Ciroli, our chief financial officer, Lee Smith, president of Mortgage, and Reggie Davis, our new president of banking. As you may know, we had a bit of a change in our leadership team during the quarter. Reggie joined us on August 3rd. And I'm thrilled to bring a person of his stature in the banking industry to Flaxton. He could have gone to a lot of banks, chose to join us.
[00:01:41] Further, Christy Furcal, president of Mortgage, left Flagstar on that same day. What we hated to see Christie go. Fortunately, we had a great internal solution. The Smith has been with me from day one of Flagstaff's turnaround, was already overseeing mortgage settlements as part of his CEO responsibilities. Plus, he was also overseeing mortgage servicing, made all the sense in the world to place him in the role of president of mortgage, allowing us to have originations and servicing under one highly respected leader. Given these leadership changes, Jim will expand his remarks a bit today to cover some of these former areas, Reggie will follow with an update on the community bank and then we will handle the mortgage segment, including servicing, as usual, will then open the line for questions.
[00:02:32] A few more comments about Reggie, he's a talented, versatile, seasoned banker with a proven track record of success. As many of you are aware, diversifying our earnings has been an ongoing key strategy in growing our community bank as a pillar of that strategy. And we made a lot of progress on that strategy and therefore feels very fortunate to have Reggie on board to move us forward, not just in community banking, but in the company as a whole. Also, during the quarter, we announced that David Hollis joined our team as a new chief human resources officer, replacing Cindy Myers, who retired, well, we all hated to see Christie leave. David is doing a great job of showing her shoes. His strong background in both financial services and other industries has demonstrated results in leveraging HRR to improve organizational performance and the depth and breadth of his experience in all aspects of HRR, including diversity, equity and inclusion, will help ensure Plaxo stays in the forefront of this important field.
[00:03:33] That's where our performance for the third quarter. It was simply unprecedented, exceeding our second quarter performance, which at the time I said was the best. And Flagstaff's history. Not that long ago, I would have been thrilled to earn three dollars and 88 cents per share in an entire year, let alone in a quarter. This was an all hands on deck performance led by mortgage, followed by a phenomenal warehouse business and supported by a complementary servicing business.
[00:04:00] The fact the first nine months of this year were also unprecedented, with tangible book value per share growing by seven dollars and three cents, a stunning 25 percent. There's a story here that we don't want overshadowed in our results, and that's how successful we were at growing net interest margin X, the impact of loans with government guarantees. We were pretty much alone amongst our peers in expanding them. And I think you can put that at the feet of our unique business model and the way we've managed it. We had the foresight to protect the yields in our warehouse portfolio with flow rates, and these were yields already enhanced by significant revenue from drop. The result was an overall increase in adjusted net interest margin from two point eight percent to two point nine four percent quarter over quarter.
[00:04:49] And you'll recall that credit losses in the warehouse portfolio are de minimis, less than five million dollars over the last 12 years. The other important stories from the quarter is the aggressive way we continued to manage deposit costs with our average cost of deposits dropping again in the third quarter, the trend that has continued throughout 2020. And because we carry a large amount of wholesale funding where costs are tied to LIBOR, these costs have dropped in tandem with Fed actions. And certainly we think our margin will remain resilient and also part of the success that the retail team has achieved with respect to deposits. Average community banking deposits, which excludes custodial accounts and broker deposits, increased I have to go dollars during the quarter and to mortgage, what can I say?
[00:05:37] Three hundred and forty six million and gain on sale revenue. Eleven million dollars more than all of last year. Pretty amazing. And then clearly the servicing business just keeps chugging, supporting our mortgage business, providing efficient funding and in fee income, and even growing the number of sub service loans in the face of historically high payoffs related to the current refinancing boom. Finally, let me address credit. So far, everything is holding up. In fact, a commercial loan deferrals now total only 47 million dollars. We're encouraged by that. But cautious and staying close to borrowers, especially those who are now on tap, to start making payments again. As always, our watchwords are to be careful and conservative. That's why we increased our coverage ratio again this quarter, not because we see any weakness in our books. In fact, just the opposite. But your guess is as good as mine as to what the future holds for the economy. So we choose to be conservative.
[00:06:35] I don't know how I could feel much more satisfied with where we stand, we've moved in to Q4 with a stable interest margin, outstanding power to generate non-interest income and a fortress balance sheet. All things considered, we're in the best possible position as we hope for the best. We are prepared for the worst. Let me now turn it over to Jim.
Jim Ciroli
[00:06:55] Thanks, Sandra. Turning to slide six, net income this quarter was two hundred twenty two million or three dollars and eighty cents per share. This performance compared to the one hundred and sixteen million or two dollars and three cents per share last quarter. The increase of a linked quarter basis was largely due to stronger mortgage results and a nice increase in net interest income, the result of higher warehouse lending and a lower credit score. Diving deeper into this quarter's performance, a pre-tax pre provision earnings were three hundred and twenty seven million, compared to 250 million last quarter. Net interest income increased 12 million four seven percent, while average earning assets grew 2.8 billion. And the reported net interest margin decreased by 50 basis points. These were impacted by loans with government guarantees that have not been repurchased and are only the result of an accounting groza. Excluding these assets, that interest margin actually increased six basis points. This performance was primarily driven by the strength of our warehouse business that has great flaws in place to protect from margin compression and our core deposits, which benefited from higher custodial balances and also for the maturity of higher cost CDs and the expiration of promotional rates on savings accounts. We'll review these numbers in a couple of slides. Mortgage revenues for three hundred fifty eight million, an increase of 63 million compared to the very strong number we reported last quarter. During the quarter, we saw stainless steel margins increase.
[00:08:36] Asset quality remains strong, net charge offs were only five basis points in early stage, delinquencies stayed low, non-performing loans ticked up slightly as we had one commercial credit of 10 million that we put on nonaccrual status. Despite all of this, we increased the allowance for credit losses to two hundred eighty million, up from two hundred fifty million at the end of the second quarter. This reflects our views on the continued uncertainties within the economy. As a reminder, the allowances for credit losses for ECLSS includes the Reserve for unfunded loan commitments. We'll provide more details when we get to the asset quality slide and take a deeper dive into seasonal capital. Also remain solid. Total risk based capital was eleven point three percent at September 30th. Sparsity to one ratio was nine point two percent and our children leverage ratio was eight point zero percent. We allowed these capital ratios to come in at slightly lower levels than where they otherwise would be to support higher levels of warehouse loans.
[00:09:38] We don't expect any losses coming from these assets, so there is a lower need to support them with capital. We'll go into more details on our capital ratios later. Finally, we continue to demonstrate significant capital generation with growth in our tangible book value per share to thirty five dollars and sixty cents a year at quarter end up three point eighty six cents from June 30th and seven point ninety eight cents from one year ago, a twenty nine percent increase. So let's turn to Slide seven and dive deeper into the income statement. Net interest income increased 12 million, one hundred and eighty million this quarter, up seven percent from last quarter. Average earning assets grew nine percent, led by warehouse lending and a full quarters balance of loans with government guarantees that are reconsolidated due solely to forbearance. Deposit costs came down 15 basis points, while average deposit balances increase two billion. To dive deeper into net interest income and our interest rate risk position on the next slide, non-interest income increased seventy four million to four hundred and fifty two million due to higher mortgage revenues and servicing related fee revenue. Noninterest expense was three hundred and five billion, nine million for the quarter. Finally, you'll notice that the tax rate ticked up this quarter. This is a function of a higher level of pre-tax income, which is much more than the tax benefits we have in our run rate earnings with our higher level of earnings. We decided to delay certain tax planning strategies as we expect that they will provide more value should corporate tax rates be higher in the future.
[00:11:13] Considering this, it would be appropriate to use our year to date effective tax rate of twenty three percent for future periods on Slide eight beginning this quarter, we've combined our average balance sheet with details on our interest rate risk position. At the end of the quarter, average earning assets increased two billion from last quarter. This resulted from a one point nine billion increase in warehouse loans and a one point three billion increase in the loans with government guarantees that have not been repurchased. Declines in securities of zero point six billion and in mortgage loans held for investment of zero point two billion, which were due to faster prepayments and partially offset the balance sheet growth. Balances also declined by zero point four billion with the sale of the PPP loan portfolio at the end of July. We expect loans with government guarantees peaked this quarter and we will start to see balances gradually decline through the rest of twenty, twenty, twenty, twenty one, where we own an MSR for Ginnie Mae loans. We had the option to repurchase these loans after the loans have gone three months without a payment due either to delinquency or forbearance. At the end of September 30th, we had one point eight billion of such loans we had not repurchased, which is consistent with what we indicated in the second quarter call, but which the accounting rules made us reconsolidate onto the balance sheet with an offset to other liabilities.
[00:12:36] We do not believe there is significant downside to holding the loans, either by buying them or through this accounting. Grow some. If we were to repurchase the loans, we can pledge the loans to the FHL be and they are a 20 percent risk weighted asset. Further, if we do repurchase the loans, we could resell those loans at a later date, which is attractive for us, and they remain government guaranteed average deposits increase one point eight billion last quarter. Custodial deposits drove one point one billion of this increase. We also saw a growth of zero point three billion in non-interest-bearing retail deposits, a 16 percent increase from last quarter, and the zero point three billion increase in government deposits due to seasonal tax payments. We managed to pass those costs lower by 15 basis points from the impact of pricing changes we've been making since March when the Fed dropped short term rates. Additionally, as we observed last quarter, deposits continued to reprice in the new curve environment, which provided support for our net interest margin expansion was difficult to predict where rates might be in the future. We feel that our interest rate risk position is in a good place due to the actions we've taken in this lower interest rate environment. We feel that we can protect our net interest income and the net interest margin and believe that our net interest margin should be relatively flat to where it's been the last two quarters. The interest rate floors that we have, the commercial loan portfolio should protect us against further margin compression.
[00:14:05] We've completed a two billion dollar program to lock in these low rates on our funding costs for the long term, using a combination of interest rate swaps and fixed cost purchase money, laddering that out for three to seven years. While this will make us more asset sensitive in our banking business, our mortgage origination business is liability sensitive. So we believe this program will set us up for future success regardless of where rates are. We continue to have a strong liquidity position driven by the strength of our deposit base and access to multiple sources of liquidity, both on balance sheet with our high quality securities portfolio and off balance sheet with our undrawn FHL facilities. At September 30th, we had ready liquidity of five point six billion, not including the ample access we have to borrow at the Fed discount window. Let's now turn to slide nine, which details are non-interest income and non-interest expenses. Non-interest income rose seventy four million for the prior quarter on the strength of mortgage revenue for wholesale revenue of three hundred and forty six million represented an increase of forty three million. Followed adjusted WLOX increase nine percent to 15 billion and the gain on sale margin was two hundred thirty one basis points. But channel margins did come down slightly from last quarter. The overall margin expanded slightly due to do largely to the game we booked. But our NBA transaction this quarter and other execution improvements.
[00:15:36] We also recognized. But a return of 12 million or MSRA, the current quarter represented more normalized run rate as last quarter we made certain model changes that we believe are congruent with the economic forecast we use for seasonal and for higher prepayments. These results were achieved even with the average value of the MSR following two basis points. Eighty five basis points of view. At the end of the third quarter, we would observe that the MSR market continues to show signs of improvement. As demonstrated with the small MSR sales we executed in August. Loan and income improved five million due to a decline in the liberal based credit that we provide our sub servicing customers for the custodial deposits that they control and from a higher level of fees for loans and forbearance. Noninterest expense increased to three hundred and five million for the third quarter, compared to two hundred ninety six million last quarter, reflecting a 10 million increase in non mortgage related expenses. This increase was primarily due to the capitalization of origination costs in the second quarter for the loans and the accelerated vesting. Certain components of executive compensation. Resulted from the recent secondary share offering. Despite increased volume, mortgage expenses were flat quarter over quarter as the ratio of mortgage non-interest expense to closings from mortgage expense ratio actually declined. This improvement was due to certain expenses in the second quarter that did not recur this quarter and are not expected to recur in the future, including certain performance related incentives related to our office and business division.
[00:17:17] So let's turn to asset quality on Slide 10. Credit quality in the loan portfolio remains strong. Early stage delinquencies continued to be relatively low. Only 14 million of total loans were over 30 days delinquent, still accruing as September 30th, relatively flat from 15 million on June 30th.
[00:17:36] Non-performing loans ticked up slightly as we had one commercial credit of 10 million that we put on nonaccrual status. The O.S.S. completed its review of shared national credits recently, which resulted in no rating changes for our loans or allowances for credit losses, covered one point seven percent of total HFA loans, excluding warehouse loans from the denominator. Given their relatively clean credit loss histories and considering that substantially all of these loans are collateralized with agency or government backed loans. Our coverage ratio would stand at a very strong three point one percent. Proselyte 11, we can see that we ended the quarter with 280 million of ACL consisting of two hundred fifty five million allowance for loan losses and twenty five million in the reserve funded loan commitments. In total, our ACL at quarter in increased by 12 percent over what we reported at the end of the second quarter. This quarter, we continued to use three different Moody's forecasts for the next two years to guide our allowance level. S one growth forecast 20 to 30 percent, a baseline forecast weighted at 40 percent in an S3 adverse forecast weighted at 30 percent. All forecasts used in September released. The resulting composite forecast for the third quarter was roughly equivalent to the scenario we used in the second quarter.
[00:19:00] Unemployment in the year 10 percent and recovers only slightly in 2021. GDP recovers only slightly by the end of the year from current levels. It does not return to near record levels until 2024. HPI drops about two percent from mid twenty twenty through twenty twenty one. Well, there are signs that point to a possible reshape recovery. We're going to be cautious in our confidence about the recovery until we see more success on the medical side of combating this pandemic. Accordingly, we have qualitative reserves of 63 million, primarily in our series and Seni portfolios, guided by the seasonal model output. Using Moodies adverse scenarios to provide coverage for industries and customers that we believe could be more exposed to the stressful conditions in our forecast, we provided a portfolio by portfolio breakdown of resulting ECL coverage ratios in our appendix. On Slide 12, we've updated our exposure to those industries we believe are more likely to be most impacted. In total, we have a billion of outstanding loans in this category, representing five point seven percent of our total loan portfolio. It's interesting to note we have almost no loans and deferral in these portfolios today, down even from September 30th.
[00:20:19] In our commercial and industrial loan portfolio, the covid impacted loans total zero point three billion. You can see that the exposure here is relatively low, especially as deferrals in these portfolios total only two million. We have no oil and gas exposure and our commercial real estate portfolio, we have zero point seven billion outstanding in the areas most likely to be impacted by covid, including commercial real estate loans, secure hotels, retail properties and senior housing loans. In this category, our average unrecovered LTV was 55 percent and our average recovered debt service coverage ratio was one point six times. We still don't have any loans in these portfolios that we believe will default in our hotel portfolio. We're seeing occupancy levels of 53 percent.
[00:21:05] Now, this is not quite to the point covering debt service, but at this level of occupancy, their cash burn slows considerably. Well, we believe that we will have losses, we continue to see strong voter support across the portfolio. We feel good about our credit risk in this portfolio as we're starting just starting from a position of strength, from our carefulness about who we lend to, to the disciplined underwriting of those credits and the precognitive LTVs debt service coverage ratios in the commercial real estate portfolio.
[00:21:36] Turning to slide 13, our capital ratios remain solid and nicely above our stress buffers, total risk based capital with eleven point three percent in September 30th and our two to one ratio was nine point two percent, both relatively unchanged from the prior quarter, despite two billion of asset growth. As expected, our tier one leverage ratio of eight point zero percent increased twenty eight basis points this quarter. If we just waited our warehouse close to 50 percent but waited at a higher percentage of current risk based copper rules, you'd see that our capital ratios compare favorably to most other mid-sized banks. Now this makes sense. The loans are fully collateralized by 50 percent risk weighted assets and those assets remain under our custody while the loans are on our lines. Further, there is even an outstanding proposal to make this distinction in the risk based capital. That was the proposal that we wholeheartedly support. So adjusting the risk weighting on the warehouse loans to 50 percent higher total risk based capital would be thirteen point four percent, over 200 basis points higher, which would put that ratio above the average for all mid-sized banks are to one ratio would be ten point nine percent. As we pointed out, with our warehouse loan portfolio loans held for sale and loans with government guarantees, we have more than half our balance sheet and nine hundred and sixty two basis points of total risk based capital dedicated to asset categories that have very little risk contract loans held for sale turnover every one to two months. And this portfolio was carried at fair value. The portfolio of loans with government guarantees has no real downside and perhaps the modest upside. When you take all of this into consideration, we believe that we are operating at strong capital levels, given our low risk balance sheet composition and now turn it over to REGGI to cover community banking.
Reggie Davis
[00:23:27] Thank you, Jim, and good morning. And this is my first opportunity to be in front of many of you. I'd like to comment on the potential I see in the community banking business. And Flagstar, what excited me about coming to Flagstar was the tremendous potential of this franchise, looking at this company from the outside. I've been impressed with the way the company has been able to grow its loan book and a well diversified manner with a focus on building advisory relationships with our clients. Now, having been inside for nearly 90 days, I'm even more impressed with the energy and commitment of the Flagstar team. This team is on a very deliberate journey to build a best in class, client focused organization. The two deposit acquisitions meaningfully transform the retail deposit base to where we can focus more on full relationships. This will continue to be our focus as we build out an omni channel experience for our retail clients. In the near term, we want to focus on sustaining the strong performance we've seen from the warehouse lending team and take this opportunity to improve our productivity across all businesses and community banking.
[00:24:32] Please turn to slide 15. Quarterly operating highlights for the community banking segment include average warehouse lending balances increased one point nine billion, or 51 percent, to seven point six billion in the quarter due to the low interest rate environment driving strong refinance volume. Our relationship based approach and speed of execution also enabled us to add new clients, as well as increase lines for existing customers during the quarter. We continue to maintain our disciplined underwriting in this business. Average commercial and industrial and commercial real estate loans decreased 450 million or nine percent, with the decrease being driven predominantly by the sale of cheap loans that we closed in July. We continue to be thoughtful in terms of new facilities and believe our strong credit policies and diversified portfolio will be a strength. As the fallout from the pandemic becomes becomes more apparent to average, consumer loans held for investment decreased 219 million or five percent, a result of increased payoffs in our FirstLine mortgage portfolio, cautiously offset by growth in other consumer loans, which is predominantly our indirect more in RV loan portfolio, which is performed rather nicely in this environment. I'm also proud of the success that the retail team has achieved. Average community banking deposits, which include custodial accounts and broker deposits, increased half a billion dollars or five percent over the last quarter to ten point three billion.
[00:26:04] We saw a nice growth in balances and governmental deposits due to seasonal tax collections, non-interest-bearing DDA and low cost savings accounts. We also saw Cindy balances contract point three billion, the overall cost of these deposits declined by 22 basis points to forty two basis points from sixty four basis points last quarter. The retail team did a great job in retaining CDs with them where they're maturing and redeploying these deposits in D-Day and savings accounts. Turning to commercial lending on the next slide, we continue to manage our well diversified commercial loan book and the warehouse lending book, we've been using our Cordin balance sheet to accommodate the needs of our customers. Despite this having a direct impact on our period end capital ratios through October 19th. We've averaged seven point four billion. Demonstrating these efforts to sustain the business growth are succeeding in commercial real estate. We're in a conflict and we're in constant contact with our customer base. The Home Builder book is performed beyond our expectations, the result of strong management teams and the close working relationship that those teams have with our lenders. Here at Flagstar, the Seni book remains well diversified and we're starting to see our customers get their business back on track.
[00:27:21] We're taking steps now to build our relationships in markets so that we can be in a position to fully serve these customers when the opportunities present itself. I'll now turn things over to Lee.
Lee Smith
[00:27:33] Thanks, Reggie, and good morning, everyone. We couldn't be more pleased with how our mortgage and servicing businesses are performing right now, providing significant and valuable non-interest income in this low interest rate environment. The 346 million of gain on sale revenue generated during the third quarter was a record of Flagstar as mortgage banking revenues increased an incredible 63 million or 21 percent quarter over quarter as we continue to take advantage of the strong refinance market. Furthermore, we ended the quarter servicing or sub servicing just over one point one million loans, an increase of six percent from the previous quarter. So we added over 100000 non Flagstar originated loans to our best in class servicing platform. A unique one stop shop mortgage business model allows us to originate mortgages across multiple PPO and retail channels, provides optionality in how we sell or distribute the loans, and also enables us to sell the mortgage servicing rights, creating and retain the sub servicing on those loans. This is complemented by a warehouse, a mortgage lending capabilities and the custodial and escrow deposits generated by the servicing business. Also, help us fund our balance sheet. This model allows us to build these partnerships, remain nimble and flexible and maximize earnings throughout the mortgage lifecycle.
[00:29:07] I will now outline additional key operating metrics from our mortgage and servicing segments during the third quarter. Please turn to Slide 19. Quarterly operating highlights for the mortgage origination business include full out adjusted volume increase eight percent to 15 billion quarter over quarter, while the net gain on loan sale margin increased 12 basis points to 231 basis points. As a result, gain on sale revenues increase a significant 43 million to 346 million in the quarter. The majority of our volume growth was seen in a high margin retail broker, a non delegated correspondent channels refinance activity accounted for 67 percent of our volume during the quarter and retail accounted for 31 percent of lost volume. We continue to use margin as a lever to keep volume in check with capacity and ensure continued exceptional service for our customers. Mortgage closings with fourteen point four billion in the third quarter, a 19 percent increase from the previous quarter as we continue to add underwriting and fulfillment capacity given the increased production volume as a result of the low interest rate environment.
[00:30:28] Our mortgage operations team continues to operate effectively in this work from home environment. We haven't seen any degradation in productivity during the pandemic and we continue to hire and train new fulfillments staff, therefore building capacity throughout. We also maintained that disciplined approach to the types of products being originated as effectuated at the outset of the pandemic, where we move to stop originating High-Risk products and tighten the credit box in certain areas to protect our position and minimize any future write downs or losses a period end. We have approximately 2.5 billion in Ginnie Mae. Early buyouts on our balance sheet of approximately one point eight billion were a result of borrowers opting to forbearance as a result of the pandemic. The accounting consequence of owning the MSR is to show them as early buyouts, whether you buy them out or not, and therefore the biggest impact of Flagstar is against capital.
[00:31:30] These loans were all performing before the pandemic, and we believe a significant number will go back to making payments and get reinstated after the forbearance period expires, either on their own or through the partial claims process. Once the loan is reinstated, it's no longer categorized as an early buyout. We believe a small number will get modified outright or modified in conjunction with a partial claim, at which point we will buy them out and securitize the loan, realizing the gain on sale benefit of doing so. Given the increase in home prices over the last few years, an equity most owners have in their homes, we don't anticipate many borrowers going into foreclosure following the end of the forbearance period. The overall impact of Flagstar of this asset class is somewhat neutral. It does create an operational need to work through these loans. And as I mentioned, it impacts capital. Given the accounting rules and recognition, loans will only be bought out if we can modify the loan and securitize, therefore realizing the gain on sale benefit that would be generated. Finally, we expect volume and margin to decline in the fourth quarter because of the usual seasonality impacting the number of business days and the winter months, affecting the purchase market in particular, and for cash gain on sale revenues to be approximately 200 million in Q4.
[00:32:57] We're very pleased with the performance of our record setting mortgage business in the third quarter and believe it will continue to be a meaningful contributor to the banks earnings in future periods. Moving to servicing quarterly operating highlights for the mortgage servicing segment on Slide 20 include we ended the quarter service, you know, sub servicing approximately one point one million loans, of which almost eight hundred ninety four thousand or eighty one percent a sub-surface further MSR owners of the one point one million loans we ServiceSource Sub-surface. Ninety three percent of that by Fannie Mae, Freddie Mac or Ginnie Mae. The number of loans serviced or Sub-surface increased slightly in the quarter as we added in excess of 100000 non Flagstar originated loans. And despite the high levels of refinance activity, we're able to replace runoff with new loans from our mortgage origination business. Another advantage of our business model.
[00:33:54] Today we have the capacity to service subserve two million loans, as well as provide ancillary offerings such as reCAPTCHA services and financing solutions to MSR owners. If you look at slide 38, you will see that we are generating five to seven million of operating profit before tax for every 100000 loans we add to the platform. This is an increase from our previously reported 46 million as we continue to achieve economies of scale benefits in this business. As it relates to forbearance through September 30, 112 427 borrowers representing ten point six percent of the FirstLine mortgage portfolio that we need to service for, Sub-surface have requested forbearance relief because of covid-19. We've seen a significant decrease in new forbearance requests since the peak weeks at the outset of the Kobe pandemic. Interestingly, 28 percent of those borrowers who requested forbearance have continued to make their monthly payments through September 30 and have not taken advantage of forbearance option. This effectively means that right now seven point six percent of the loan. But we Servicio Sub-surface are actually using forbearance as part of the forbearance period. We're also waiving certain fees and there will be no negative reporting to the credit bureaus. The peak number of loans in forbearance was 129 1332 and as of September 30, that number has declined by approximately 17000 or 13 percent of borrowers who had initially opted out have opted out, paid off their loan, reached out to say that hardship has been resolved and that loan is current or had their loan modified during the third quarter. We have unboarded approximately 10000 non Flagstar originated loans that were in forbearance. So comparing period over period forbearance activity isn't as meaningful. During the quarter we sold 800 million inflow MSR deals. The market source is certainly coming back after it dried up at the outset of the pandemic and our MSR to see to one ratio is currently 16 percent significantly below the 25 percent threshold before it becomes Cassol. Punitive only custodial deposits average seven point three billion in the third quarter, an 18 percent increase compared to the prior quarter. Again, this is just another benefit we get from our sub servicing business as it provides liquidity that helps fund our balance sheet. As servicing business continues to flourish and be successful when combined with our mortgage origination capabilities. We believe the scale and quality of both operations give us one of the most valuable mortgage business models in the industry.
[00:36:49] This concludes our prepared remarks, and we will now open the call to questions from our listeners.
Question-and-Answer Session
Operator
[00:36:54] Thank you. If you would like to ask a question, please signal by pressing star one on your telephone keypad, you on a speakerphone. Please make sure that your mute function is turned off to allow your signal to reach our equipment. Again, that is star one to ask an audio question will pause for just a moment to allow everyone the opportunity to signal. Our first question comes Daniel Tamayo from Raymond James.
Alessandro DiNello
[00:37:20] Hey, Danny.
Daniel Tamayo
[00:37:22] Hey, good morning, guys. Congratulations on a great quarter. I just wanted to Cassola talk a little bit about, first, the you know, the sustainability I asked this last quarter, but clearly holding up the sustainability of the warehouse yields if you're still able or, you know, given kind of the competition there. But if you're still able to charge these higher rates for your clients using that period in balance sheet or if there's some other factor going on there and if and if if you envision that changing at all going forward.
Alessandro DiNello
[00:37:55] I do not envision a change, we we have not had to at all on any of our annuity rates that we are charging. As you probably know, Dani, most, if not all of these warehouse lines are at their flaws. So I think the sustainability of the yield is the likelihood of that is pretty high in terms of the balance. As Reggie noted through the to yesterday or so, we're at seven point four dollars billion average balance thus far in October. So that's hanging in there as well. So I think, you know, I mean, we do have a disciplined concentration policy. And so, you know, growth So, will be measured against capital growth. But I think I think the opportunity there going forward is pretty strong. Let me see if he has anything you want to address.
Reggie Davis
[00:38:48] No, nothing to add. I mean, we've got a fairly disciplined approach. We like that business. We think we can get paid for it. And we're seeing more and more opportunities as our competitors struggle to execute.
Daniel Tamayo
[00:39:03] All right, and then maybe just stepping back a little bit, you know, as far as the potential for a sequel, you're steeper yield curve comes into play here. You know, you could talk about what levers you have to pull, you know, kind of overall in order to mitigate that, how that might impact the business overall. And then, you know, you've talked a lot about capacity being, you know, outstripping demand on the on the volume side, on mortgage for your the last several quarters. How much that, you know, maybe your Delta there is there that if you do see we do see a steep yield curve and lower demand before you would see a significant reduction in kind of volumes on the market. Thanks.
Alessandro DiNello
[00:39:53] Yeah, well, you know, it's hard to your look out that that far into the future, Danny, but I guess I'd say this. I think our view is that we've got some runway in the mortgage business and we're going to continue to take advantage of that as long as we can. You know, should we see rates start going the other way than the yield curve? I think there's other pieces of the business, that chicken at that point that might mitigate that could and probably would mitigate any reduction we see in the mortgage business momentously or anybody else wants to add anything to that.
Jim Ciroli
[00:40:22] I agree with those comments, Danny. You know, you really have to look at the balanced model we have. And so while that could crimp the mortgage business a little bit to think about how well the servicing business would do in that kind of an arrangement and think about how the community banking business is going to perform in that scenario. And so, you know, we're not really able to predict where rates are going to be, obviously, but we've positioned the company to do well, regardless of where they're going to be.
Lee Smith
[00:40:52] Yeah. And Danny, usually I sort of emphasize that the diversified model, we've always said we can be successful, whatever happens to interest rates. So I won't repeat anything Sandrock and Jim have said on the mortgage side, and we've said this before, you know, 70 to 75 percent of our expenses are variable to CIMMYT variable. And so as the volume goes down, you're going to have some natural flex in your expense base as well.
Daniel Tamayo
[00:41:21] That's terrific. I appreciate all the color. I missed the last one on so, that on the expenses, as you mentioned, you know, lower than so, than what they've been running in the quarter related to mortgage. You mentioned the office adviser's incentives have come out. Is that just the driver there? And you think that that percentage is going to be lower than kind of what we've seen prior to this quarter going forward?
Alessandro DiNello
[00:41:46] Yeah, the main driver for that, Danny being, is the focus on coming to an end and so that's come out, you won't see going forward, I think, in terms of where you're seeing the run rate on mortgages. And we've got a chart, I think it's slide 42. I think that's the zip code. Give a take on where you can expect the expenses to be as a percentage of closings.
Daniel Tamayo
[00:42:14] Terrific. Thank you, sir. Also, thank you.
Operator
[00:42:20] Our next question will be from Scott cyphers from Piper Sandler.
Jamie Benjamin
[00:42:24] Morning, Sky. Good morning. Good morning. This is actually Jamie Benjamin on for Scott. Thanks for taking my questions. First, against the NSA on margins, held up very well with some benefit from the securitization transaction quarter. I was wondering if you could clarify what that benefit was this quarter, how much the benefit was from the R&D?
Jim Ciroli
[00:42:46] Yeah, we have yes. DISCLOSE that now.
Alessandro DiNello
[00:42:49] But it was it was rather it was sizable, but it was only maybe half of that half of that benefit. The other half was really just what I call other execution improvements to be made on the spending side. I'll just jump in. And Jim's half of it is, yes, we got better execution around the hedge and we did see an increase in our normal correspondent channel quarter over quarter from a margin point of view. That's our biggest channel volume. So those were the three drawing's.
Jamie Benjamin
[00:43:24] Perfect. Thank you. And then one follow up. Appreciate the clarity around the decrease in deposit costs is worrying more. Moreover, could you tell us a little bit about what additional levers you could flex on the net interest margin, whether it's balance sheet movements, more deposit costs, deposit cost, leverage, et cetera? Thanks.
Alessandro DiNello
[00:43:47] Well, so I think we're pretty we feel pretty confident that the yields are going to hold because of the influence of the warehouse side and on the deposit. There's still some runoff from higher rates, CDs that are going to come into play. And follows just kind of let me let you comment on that.
Reggie Davis
[00:44:06] Yeah, I think one of the things we've been pleased with this year is, as we've said before, this happened with the CD portfolio. We've been able to move that into lower cost products. We know because of the maturity schedule, we've got additional opportunities for the balance of the year. So we would expect that trend to continue.
Jamie Benjamin
[00:44:28] Thank you very much. You're welcome.
Operator
[00:44:32] Our next question will be from Henry Coffey from Wedbush. Yes.
Henry Coffey
[00:44:38] Good morning, everyone, and thanks for taking my questions to specific areas. Once you know, you talked a little bit about the Ginnie Mae opportunity. Exactly how does that work, especially with the servicing you may own over the servicing you may be sub servicing. So what I mean, I know it's a capital impact, et cetera, but I'm thinking about it more as an opportunity. And what is the governor behind converting that one point eight dollars billion of loans and in forbearance into Ebow and then Ebow into securitization gains?
Alessandro DiNello
[00:45:17] Ok, so let me take this, Henry, and then Jim will probably want to point in terms of the So, 2.5 billion Jenie EBOs we referenced and the one point eight that are on the balance sheet because the borrowers are in forbearance, that is all Flagstar around GenY, MSR, so that Flagstar around EBOs, the accounting consequences I mentioned in the prepared remarks.
Henry Coffey
[00:45:44] Do you own them or are you just putting them on your balance sheet?
Alessandro DiNello
[00:45:48] We're putting them on the balance sheet. We have not bought them out. And this is where this is what I'll explain. The accounting consequence of owning the MSR is to show them as an early buy out whether you buy them out or not. And so the biggest impact for us is against capital. These loans were all performing prior to the pandemic and we think a big portion will go back to making payments and get reinstated after the forbearance period expires, either on their own or through the partial clearing process. Once they're reinstated, they're no longer categorized as any, but a small number will get modified outright or they'll get modified in conjunction with a partial plan. If that's the case, we will then buy them out unrealized the gain on sale benefit of re securitizing the modified loans.
Jamie Benjamin
[00:46:43] What is the size of that number or. We don't know yet.
Alessandro DiNello
[00:46:48] We don't know yet. We're working. You've got to remember the first six month period per the case act. The forbearance is expiring now and so borrowers have the option to extend for a second six months or they can opt out because they just continue to pay and they don't need forbearance. You know, all was sort of working through those loans that don't want to extend. And we can either correct through a partial client process or a modification on a partial claim. So we're working through that. But we cannot say right now X marks the spot because there's so many moving parts.
Henry Coffey
[00:47:31] And you look at the one on the one point eight billion in foreclosure and Ginnie may still be single parents. I'm sorry. I'm sorry. I misread know it's OK. If you look at the one point eight billion in forbearance in Ginnie Mae land, those are counted as delinquent. Right. And so if they go one hundred and eighty or longer delinquent, isn't there an opportunity to buy the loan out or. Yeah, I'm thinking about it from an opportunity point of view, not from a capital constraint point of view, that one point eight dollars billion of loans that.
[00:48:10] Are surely healthy that that are that are theoretically in delinquency status, when forbearance is over, then they have to don't they have to all go through some kind of modification to get current and. Restatement of principle and all those sorts of things that we see in with Fannie and Freddie loans or?
Alessandro DiNello
[00:48:34] No, not all of them, some of them, some of them have continued to pay, and so they remain current and they will just opt out. Some of them will get corrected through a partial clearing process only. And then those that need to be corrected through a partial time and a modification or just some modification, then, yes, we will buy those out. But there's a clear waterfall that you have to follow.
Jim Ciroli
[00:49:02] But we don't know how much each one of those books, correct? Right.
Henry Coffey
[00:49:06] No, no, no. This is how far I'm just I'm thinking of it more as an opportunity than as a problem because you have lots of liquidity and you have lots of capital notable know his comment that, you know, could it could have some upside.
Alessandro DiNello
[00:49:20] We just don't know what it is at this point. Right.
Jim Ciroli
[00:49:22] And we haven't quantified that yet. But also keep in mind that a lot of our sub-surface and clients, you know, have a good relationship with us. And whatever that opportunity is, I'm sure we'll be able to partner with them to develop the opportunity as well with within their own loans.
Henry Coffey
[00:49:39] No, no, I agree. I'm just trying to figure out what the benefit ultimately could be. Gain on sale for the fourth quarter. The number was the revenue number you quoted. Could you give that to me again, Lee?
Lee Smith
[00:49:50] At 200 two zero zero 200 million.
Henry Coffey
[00:49:54] So that's that's that's obviously down from what we saw in the last two quarters. And is there going to be sort of a disconnect with so, locks being down because of the seasonality of the business, but originations, you know, actual closing still being fairly high and then you get some cost compression in there. How do you think that plays out?
Lee Smith
[00:50:17] No doubt about that. I think you'll find the closings will remain strong because originations will fall out of just the locks were high in Q2, Q3. So we're going to continue to push those closings through into the fourth quarter, fall out of just the locks that there is going to be a reduction in volume and margin because of the seasonality that we usually see in Q4. Few of these stays and the winter months affecting the purchase market in particular. And if you look at the agency and my forecasts, they they've got volume coming down in Q4 as well, consistent with what I've just said.
Henry Coffey
[00:50:57] No, no. How So, are all these IPOs affecting the competitive landscape for you? All right, now? I think we're at number you call if you include the specs were at six since August, so.
Lee Smith
[00:51:10] Yeah, it's not it's not it's not impacting us at all from a business point of view. What I would say, though, is I'm obviously thrilled to see a number of new investors looking at more favorably. And I would hope and think that that could bring more new investors into the Flagstaff's stock.
Henry Coffey
[00:51:29] I can I can only agree with all of that, so thank you, thanks for the comments. This is very helpful and congrats on a great quarter.
Alessandro DiNello
[00:51:39] Thank you.
Operator
[00:51:40] Thank you. Our next question from Steve Moss with B. Riley Securities.
Steve Moss
[00:51:45] I say good morning. Most of my questions have been asked here, but just on credit here is kind of curious with regard to where our criticizing classified loans these days.
Alessandro DiNello
[00:52:00] Yeah, we're wondering the same thing, we really don't see them in our portfolio. Honestly, I'm not trying to be facetious. I'm being honest with you. So we said this last quarter on a precautionary basis when loans were in deferral. You know, we took a stance unless proven, unless it is proven that those loans should be passed. Watch still pass that they're not they're not criticized. But at this point in time, we're not seeing a significant amount of criticized loans in our own portfolio.
Jim Ciroli
[00:52:42] Yeah, you know, if you don't want to get overconfident about that, and that's why my comments are cautious around what might happen going forward, and that's why we've So, taken the liberty to push our ACL as high as we think we can, given the economic scenarios that that our model uses and the qualitative adjustments that we're permitted to make. I mean, we're pushing it as much as we can because we're just going to be careful here. So we're with you. You know, we wonder, like, why we're surprised, really and pleased that it is holding up as strong as it is. And, you know, I guess we'll wait and see as we get through the pandemic how it all shakes out. I mean, right now, I don't believe that we're going to use this reserve.
[00:53:30] I think our sponsors are of high integrity and quality and they're going to work through these difficult times and we're going to be OK. But if we're not, as I said, you know, hope for the best. But we're we wonder we're prepared for the worst. Should have to happen. And go back to my comments in my prepared remarks about what our view on the economy is, both in terms of Cecil and we're not yet convinced that we've got to be shaped recovery.
[00:53:58] And remember, you know, go look at the balance sheet and identify what really are commercial loans in this organization, if you take away our loans, our residential loans that are available for sale and you take away the warehouse loans where we've had only five million dollars of losses over the last 12 years, including through the Great Recession, the we wonder part of that portfolio that's really exposed to we wonder losses is small compared to the size of the company and compared to the typical mid-sized bank with twenty nine dollars billion in assets.
Steve Moss
[00:54:34] Ok, that's helpful. And then on the return on the mortgage servicing, I said just kind of wondering, you know, how sustainable the low income is here. What would the downside potentially be if, let's say, mortgage rates come down another 25 or 50 basis points?
Alessandro DiNello
[00:54:53] Let me read the comment and Jim, I want to add here, look, historically we've been pretty satisfied if we can get a four to six percent return on our MSR asset and we've consistently been able to do that or better at times because of a particular market circumstances. But we haven't achieved that in a particular quarter. But what you saw this past quarter was particularly phenomenal. And to think that that can happen quarter over quarter I think is unlikely. But I think in your model, you're looking at four or five, six percent return on the MSR asset. I think you're going to be in a pretty good place.
Jim Ciroli
[00:55:28] Yeah, I completely agree with that comment. Look, I mean, this quarter was just, you know, things bounce the right direction for us. But part of it also is, you know, we've been very cautious in how we value that asset. We've made some remarks last quarter that we took we took a very conservative spin to the fair value on that asset in second quarter. And taking that conservative pen is just going to set you up to be at the high end of the range that the Sandercoe, you know, outlined there.
Alessandro DiNello
[00:56:01] And I might add, you've got to have really good people and we have some really, really good people that manage that asset.
Steve Moss
[00:56:08] That's helpful. And then one last question, just in terms of expenses dedicated to the bank of 10 million quarter over quarter, kind of curious, is that the new level run rate? Just think about that going forward.
Alessandro DiNello
[00:56:23] Yes. So I said in my prepared remarks, Steve, there was a comment that some of it was a credit that was in last quarter. It isn't going to recur. And that's having to do with the capitalized origination costs and the people. We sold those in July. The other there was some there was some costs related to the in the secondary that happened last quarter that triggered some So, payments under some executive compensation arrangements. Those are not going to recur. So there's just some So, nonrecurring things that are inflating the level of two, three expenses right now and deflated to expenses.
Lee Smith
[00:57:04] So to answer your question, it's not a new.
Steve Moss
[00:57:10] That's helpful. Thank you very much, I appreciate that.
Alessandro DiNello
[00:57:14] Thank you.
Operator
[00:57:15] Our next question from Bose George from KBW.
Bose George
[00:57:20] Hi, guys, good afternoon. Yes, actually, most of mine have been asked as well that a couple of little things. You already spoke about the name a little bit, but can you just talk about, you know, how it looks next year if rates remain the same, but as mortgage banking is close at some point and what that does with the, you know, the warehouse business and loans held for sale, just how that impacts the margin the next year?
Jim Ciroli
[00:57:46] Look, I think I think the if rates remain the same, I think that we're in a pretty good position to sustain our net interest margin. It's hard for me to look further out than a quarter. And, you know, Jim, I think both Jim and I suggested for the next quarter we feel pretty good. So going out farther than that, man, I'm going out on a limb here. But, you know, I feel pretty good about what our position is there. I think even if the mortgage business declines in the numbers that the NBA, Fannie Mae, Freddie Mac, I think next year, I think that the warehouse balances can stay pretty strong because we're gaining market share and that area and we could do more than we're doing right now. We're being pretty selective about who we're doing it with and so, we're being pretty firm on our pricing. So, you know, I think that the prospects for warehouse being strong, even so, in a weaker mortgage market, are pretty good. But, hey, you know how things change from quarter to quarter. So it's pretty hard to go out and talk about next year.
Alessandro DiNello
[00:58:47] And I also we could add to that. If you look a couple of quarters ago, warehouse balances were lower, even in the second quarter, they were lower. And we're still delivering, you know, pretty, pretty consistent levels of net interest margin, excluding those loans with government guarantees we talked about. So I think there's room to have the warehouse balances rotate down. Not that we think that's going to happen to the Sandra said, but I think there's room to have those rotate a little bit lower. And still be able to sustain that in net interest margin at the levels we've been reporting the last couple of quarters.
Bose George
[00:59:27] Okay, great, that's helpful. Thanks. And actually, just one more on the So, Ginnie Mae buyouts. You know, some of your peer banks have purchased quite a bit of this ahead of, you know, sort of curing. There's some I'm just curious what your thoughts are there. Is it are they sort of institutions with this liquidity to somewhere just, you know, thought why there's been a fair amount of buyouts already.
Alessandro DiNello
[00:59:51] Yeah, I mean, those you know, we don't comment on other institutions and what they're doing, I can only comment on our approach and, you know, I think I've been over that. We will buy them out where we can modify either outright or is part of the partial plan and re securitize.
Jim Ciroli
[01:00:09] Yes. There's no benefit to buying them out quickly. But that we see they're buying them out is also permanent. So you can't undo that. And so when we buy them out, we was talking through with Henries earlier question, we're going to be sure that that we want to buy out the loans that that we're buying out.
Bose George
[01:00:32] Ok, yep, makes sense. Thanks, guys.
Operator
[01:00:35] Thank you. I'm showing no further questions at this time. I'd like to turn the call back over to our speakers for closing remarks.
Alessandro DiNello
[01:00:44] Thanks, Carrie. And my closing for the second quarter, I talked about how the calls for social justice in the world around us had inspired a cultural change at Flagstar. How in the past we had not communicated much with our employees about what was going on in the world, how we set out to change that, and how we're not turning back in the third quarter. We continue to engage employees on issues that are important to them and continued with our diversity, equity and inclusion initiatives. This is not a passing fad for us. It's the real deal, a fundamental cultural change. We are changing the composition of our leadership team and we will change the composition of our board of directors to achieve more diversity. We're putting money behind support for minority small businesses and nonprofits that support the NRA. We're taking a hard look at our hiring practices and we're taking cues from our employees about how we can do better. And I'm doing my best to put the arm on fellow bankers and business leaders through organizations I belong to, to support the and I and their own companies. Why? Well, first, because it's the right thing to do. And second, because I firmly believe it makes for a better company.
[01:01:51] These past two quarters also happen to be the best of US history. Is it a coincidence or is there a connection with our cultural change? In my mind, there's no question about that. The seeds of the success that is playing out today were planted when we recruited top notch executives to run our businesses, when we built affordable risk management structure, when we carefully diversified into commercial lending, when we developed our fee and deposit generated some servicing businesses. And when we leverage relationships we had nurtured for years to make warehouse lending a profitable, low risk operation now one of the top five warehouse businesses in the country. But I have to think that what we're doing on the DNA front is not just underpinning, but it is accelerating our success. We're a much better company today for it and expect to be even better in the future because of that. Last but not least, thank you to our employees who own this success. I'm in awe of what you have accomplished and circumstances beyond the imagination. And thanks to everyone who has taken the time this morning to hear the story of a most successful quarter. Talk to you in January. Please stay safe and healthy.
Operator
[01:03:03] Thank you. Ladies and gentlemen, this concludes today's teleconference. You may now disconnect.
