Velocity Financial - Q2 2023

Transcript

Operator (participant)

Good afternoon, welcome to the Velocity Financial second quarter 2023 conference call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, then one on your touch-tone phone. To withdraw from the question queue, please press star, then two. Please note, this event is being recorded. I would now like to turn the conference over to Chris Oltmann, Treasurer. Please go ahead.

Chris Oltmann (Treasurer and Director of Investor Relations)

Thanks, Danielle. Hello, everyone, and thank you for joining us today for the discussion of Velocity's second quarter 2023 results. Joining me today are Chris Farrar, Velocity's President and Chief Executive Officer, and Mark Szczepaniak, Velocity's Chief Financial Officer. Earlier this afternoon, we released our second quarter 2023 results, and the press release and accompanying presentation are available on our Investor Relations website. I'd like to remind everyone that today's call may include forward-looking statements which are uncertain and outside of the company's control, and actual results may differ materially. For a discussion of some of the risks and other factors that could affect results, please see the risk factors and other cautionary statements made in our communications with shareholders, including the risk factors disclosed in our SEC filings.

Please also note that the content of this conference call contains time-sensitive information that is accurate only as of today. We do not undertake any duty to update forward-looking statements. We may also refer to certain non-GAAP measures on this call. For reconciliations of these non-GAAP measures, you should refer to the earnings materials on our investor relations website. Finally, today's call is being recorded and will be available on the company's website later today. With that, I will now turn the call over to Chris Farrar.

Chris Farrar (President and CEO)

Thank you, Chris. We appreciate everyone joining the call today. We're pleased to report another excellent quarter and thank all of our team members who work so hard to support our mission. Our continued growth in earnings and book value are a result of a sound strategy and attention to detail from everyone at the firm. Our origination pipeline is very healthy, and we continue to be choosy with credit as we've seen increased demand with banks tightening their lending activities. This pullback has allowed us to create attractive risk-adjusted deals for new portfolio loans. We recognized a 19% increase in originations versus the prior quarter while holding expenses flat, which obviously improves our operating margins. With respect to credit performance, we continue to profitably resolve delinquent loans and recognize overall gains from recognizing default interest.

Our delinquency rates increased this quarter. We expect the net resolutions of these assets to continue to drive future gains similar to our long-term history, as the real estate market remains stable in terms of valuation. Our special servicing team continues to sell REOs at a healthy pace, and the markets are liquid when priced reasonably. CRE has come off some of the overheated markets as Fed policies cooled the rapid price appreciation we were experiencing, which we view as a long-term positive for our business. Capital markets are improving as we see spreads starting to tighten and better investor participation in the new issue market due to limited supply and the potential of a terminal rate from the Fed. Our financing relationships and capital sources are strong as we continue to grow in earnings per share. Great quarter for us.

I mentioned the net revenue growth earlier, up 6.8% quarter-over-quarter with flat operating expenses. That's, you know, a testament to our operating team in doing a great job of growing volume and controlling costs to improve margins. Overall portfolio yield increased up 24 basis points year-over-year, which is a result of putting on these new loans at much higher coupons. Obviously, we've got a large fixed-rate component there, so to move that coupon up that much speaks to the volume that we've been doing at these much higher levels. In terms of production, I mentioned $258 million up for the quarter, up from the previous quarter, down significantly from last year.

As you can see from the earnings, you know, earnings are not driven by current month or current quarter production. We're very comfortable with the levels that we're at right now, and we're more focused on allocating capital with attractive risk-adjusted returns as opposed to just doing volume. Portfolio is growing nicely from the net growth of the originations. In terms of credit performance, the NPLs for the quarter moved up to 10% from 8.2% in the previous quarter. There are really three things going on there. One, the portfolio seasoning. You know, just as a reminder, last year, we did $1.7 billion in originations, and delinquency tends to peak 24-36 months after originating a new loan.

As the portfolio seasons, we'll see some of that delinquency come on. Two, we're quick to put borrowers in foreclosure. Many lenders will work with a borrower when they're delinquent or, or delayed in, in making payments. If, if borrowers will communicate with us, we're often open to doing that, and if they work them out. If not, we're very quick to put someone into foreclosure, especially if they're not communicating with us, just to make sure we get a resolution, and we protect the equity that we have ahead of our loan. Thirdly, the NPLs come on a lot faster than they come off. You know, if, if we move quickly to pop them into foreclosure, it might take several months for something to resolve, so there's kind of a lag effect there.

Most importantly, you know, we, we continue to see the positive gains over and above contractual principal and interest, and we continually monitor our portfolio and look at delinquent assets. Based on everything we've seen and reviewed, we, we don't expect our, our results to be any different than what we've historically seen. In terms of financing capital, had a really nice transaction earlier in the quarter, where we did a re-REMIC of several of our retained interests from previous deals. This was a great transaction for us because it continues to down the theme of non-mark-to-market financing, where virtually almost all of our financing now in the book is non-mark-to-market. Investment banks offer us repo facilities on those securities, but, they come with mark-to-market risk.

We think this is a, a more elegant solution to control risk, and it was a great transaction for us. I guess I would just say, in terms of liquidity, $72 million, so we're in real good shape there with, with all of our financing counterparties and have plenty of capital to grow. Turning to page four, very straightforward and simple. Nice earnings growth, adding to book value, as we've kind of always said is our strategy. You can see, we ticked up to, to $12.57 on a GAAP basis. Continuing to just focus on growing earnings and growing book value. On page five, we think that we've created a lot more value than, than what the GAAP book value would indicate.

This is a, a buildup of the, not only the inherent value, in the platform but also what we think is created in the future value of the, of the business and, and a potential premium if, if someone were to, you know, be interested in acquiring the business. Suffice it to say, we think, the economic value of the company is much higher than, than the book value, on a GAAP basis. With that, I'll turn it over to Mark, on page six.

Mark Szczepaniak (CFO)

Thanks, Chris. Hi, everybody. Continuing with the financial results on page six, we can see the improved loan production as interest rate increases has slowed down. Q2 production was just under $259 million in UPB. As Chris mentioned, a 19.2% increase from the $217 million in Q1. The weighted average coupon for both Q1 and Q2 production, year to date in 2023, was 11%. That's about a 3.25% year-over-year increase over Q2 of 2022 in our weighted average coupon. The strong production increase in Q2 at the 11% WAC demonstrates the continued borrower demand for our product. Moving to page seven, shows the strong portfolio growth attributable to the improved loan production. Our total loan portfolio as of June 30th, was $3.7 billion.

That's a 3.4% increase from Q1. It's a 20% increase from Q4 of last year. The weighted average coupon on our overall portfolio as of June 30th, was 8.40%. That's a 25 basis point increase from the portfolio at Q1, and an 87 basis point increase year-over-year from Q2 2022. We've increased our coupon. Our production is, is growing, and all this with the LTV ratio still remaining consistent quarter-over-quarter at 68%. On the next page, our Q2 net interest margin remained consistent with Q1 at about 3.25%. Looking at the components of net interest margin, our cost of funds increased 25 basis points quarter-over-quarter, driven by higher utilizations of our warehouse line and cost in the warehouse line.

Our portfolio yield on the loan side increased consistent, the same, increased 25 bips quarter-over-quarter, driven mainly by the 11% overall weighted average coupon on our year-to-date 2023 production. Net result in Q2 NIM is consistent with Q1. On page nine, our non-performing loan rate for Q2, as Chris mentioned, increased to 10%, driven by a combination of portfolio seasoning. As Chris mentioned, we did $1.7 billion last year. We did $1 billion of that really in the first six months of last year. As that portfolio starts to season, we're going to see a little bit more delinquencies and also the strong collection efforts by our special servicing department. During the first six months of 2022, we funded that $1 billion.

Our special servicing department is being more aggressive in collecting the, the, the efforts on the NPL loans. Of that 10% non-performing, as Chris mentioned, we're quick to put borrowers into foreclosure because that's where we get their attention, that's where we get the payoffs and the paid current that we see on the resolution table. That's where we get the gains. That 10%, over 7.5% of that was foreclosure. Page 10 illustrates the continued success of our NPL resolution efforts. In Q2, we resolved over $50 million in non-performing UPB for a net gain of $1.5 million over and above, collecting all the contractual principal and interest, and again, maintaining that 3% or three-point gain on our NPL resolutions.

Moving to page 11, presents our CECL loan loss reserve. The CECL reserves of June 30th was $4.6 million, or 15 bips of our outstanding loans held for investment at amortized cost balance. Our CECL reserve has been very consistent between 15 and 16 bips over the last five quarters. Kind of just as a reminder, the loans carried at fair value that we started doing in 4th quarter of last year are not subject to a CECL reserve. Q2 charge-offs are shown on page 11 as $717,000 for the quarter, 2nd quarter.

However, subsequent to closing the books for the quarter, during our post-close internal review process, we discovered that our, one of our servicers had received funds from a borrower in the amount of $393,000 that had not been applied to the outstanding loan balance. Taking this borrower payment into consideration, the actual Q2 charge-offs for Q2 were $324,000, not the 717 or 39 basis points of non-performing loans, not the 87, which is actually a decrease from Q1. Management determined that the adjustment was immaterial to the overall results of the quarter. As opposed to reopening all the books, we will record this $393,000 recovery in Q3. Finally, page 12 shows our durable funding and liquidity position at the end of Q2.

Total liquidity as of June 30th, $72 million, comprised of $34 million in cash and cash equivalents, and another $38 million in available liquidity on our unfinance, financed loan collateral. As mentioned, we issued two securitizations in Q2. In April, we issued the 2023-1R security. That security is a re-REMIC, where we financed retained tranches from previous securitizations. We re-leveraged securitization tranches that we've kept from previous securitizations. This new type of financing demonstrates the diversification and financing options for our company and is another type of very cost-effective, non-mark-to-market financing for us. This re-REMIC generated about $48 million in cash proceeds to us. Then in May, we issued the second securitization, 2023-2, which is one of our long-term normal securitizations. We issued about $202 million of securities.

Finally, our available warehouse, unused capacity as of June 30th, was $573 million. Still plenty of capacity to continue pursuing growth in our production. That wraps up the financials. Now I'd like to turn the presentation back to Chris for a discussion of Velocity's economic outlook. Chris?

Chris Farrar (President and CEO)

Thanks, Mark. Looking forward, you know, we think the, the market is, is doing very well, especially in light of all of the, the Fed action. Continue to see very strong real estate market. I think some of the areas that were overheated have cooled down, which is good. In terms of credit performance, we, keeping a close eye on it, but we think that we're, we're going to do very well and continue to see good positive resolutions. A good shape from a capital position. You know, we think we continue to grow earnings and, still see strong demand for our, our products. We expect to, to grow the portfolio and, and grow earnings. We think, we think all in all, everything looks really good. With that, we'll open it up for questions.

Operator (participant)

We will now begin the question and answer session. To ask a question, you may press star, then one on your touch-tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. The first question comes from Steve DeLaney of JMP Securities. Please go ahead.

Steve DeLaney (Managing Director and Senior Equity Research Analyst)

Good afternoon, everyone. Can you hear me?

Chris Farrar (President and CEO)

Yes.

Steve DeLaney (Managing Director and Senior Equity Research Analyst)

Great! Well, I'm, had to be on my cell, but, so I apologize for that. Nice quarter, again. I think we say that every quarter. Knock on wood.

Mark Szczepaniak (CFO)

Never gets old, Steve.

Steve DeLaney (Managing Director and Senior Equity Research Analyst)

Yeah, for sure. Could you speak a little bit about 2023-2 and just how that execution went, compared to 2023-1?

Chris Farrar (President and CEO)

Sure. I think I would say it was pretty similar, not quite as strong demand, as we saw in, in 2023-1, because it was kind of pre the banking crisis. I think things were really starting to tighten up at the beginning of the year, and then that, that obviously put a damper on things. We were oversubscribed and able to get very good execution. You know, we're, we're, we're out in the market actually right now with our, our next deal for Q3 and...

Steve DeLaney (Managing Director and Senior Equity Research Analyst)

Wow! Okay.

Chris Farrar (President and CEO)

We're getting good response there. I think, I think we're seeing good activity from, from bond investors.

Steve DeLaney (Managing Director and Senior Equity Research Analyst)

Does the absolute rate, you know, you're getting 11% coupons, and a lot of that obviously passes to the, to the bond buyers. Is that factor, you know, are people looking at that as a positive, or are they scared that that's going to lead to credit, poor credit performance with that much carry?

Chris Farrar (President and CEO)

Yeah. I, I would say it, it's probably the former, not the latter. I mean, if you look historically over the last 18 years, that coupon is, is not outside of the band of where we've been. I, I mean, everybody always asks, why is that the case? You know, et cetera. I haven't heard anyone say it's a concern or a, or a predictor of bad things to come.

Steve DeLaney (Managing Director and Senior Equity Research Analyst)

One for Mark, if I may, and then that'll be it for me. Nice book value growth in the quarter. We had a couple of residential credit mortgage REITs in the last 24 hours report, and they used securitizations, and there were, there were declines in book values, and obviously they mark both sides of their securitizations. I'm sure there were some credit spread impacts in this, but we saw the book value declines that were in the, you know, 4%-5% range quarter-over-quarter. I was just curious, Mark, if you can comment on, you know, I know you have your HFI portfolio and then, held for investment, and then you have your fair value portfolio.

Mark Szczepaniak (CFO)

Correct.

Steve DeLaney (Managing Director and Senior Equity Research Analyst)

I guess I'm really asking about the fair value portfolio and, and how that worked out, in the second quarter, given the increase we've seen in the 10-year.

Mark Szczepaniak (CFO)

Yeah, you're exactly right. I mean, the one thing, remember, what we did, we started marking our loans, our loan originations, to fair value, beginning with Q4 last year, October first of last year.

Steve DeLaney (Managing Director and Senior Equity Research Analyst)

Right.

Mark Szczepaniak (CFO)

Then starting this year, on the first of 2023, we also elected to mark our securitizations at fair value. You're right, there, there was some, you know, decline in the fair valuation of the loans quarter over quarter. Then on a, on the converse side, because remember, our securitizations are fixed rate securitizations that-

Steve DeLaney (Managing Director and Senior Equity Research Analyst)

Yeah

Mark Szczepaniak (CFO)

exactly equal, pretty much hedge. It's a natural hedge on the loans. when you have-

Steve DeLaney (Managing Director and Senior Equity Research Analyst)

Sure

Mark Szczepaniak (CFO)

The fair value loss on the loans, our, our natural hedge is kind of kicking in, and we picked up... You'll see fair value gains on the securitizations. Look at the financials we put out the Q, you're going to see good-sized fair value gains quarter-over-quarter on the securitization. That kind of what maintains that growth and book value, is that natural hedge of that securitized portfolio.

Steve DeLaney (Managing Director and Senior Equity Research Analyst)

Okay. All right. Well, I will leave it there and, give someone else a chance to ask questions. Thanks for your comments.

Mark Szczepaniak (CFO)

Thanks, Steve.

Operator (participant)

As a reminder, if you have a question, please press star one. The next question comes from Stephen Laws of Raymond James. Please go ahead.

Stephen Laws (Head of Real Estate Finance and Fixed Income Capital Markets)

Hi, good afternoon. As Steve mentioned before me, nice quarter again. It seems pretty recurring here, and I know you guys see some tailwinds in the business. Mark, I really want to start with that. Can you talk about the, you know, competitive landscape or lack thereof from the banks? I know three months ago we talked on the call, and you talked about being able to improve kind of your underwriting credit standards on new production and maybe getting some stuff that, you know, possibly would have gone to banks previously. You know, have banks pulled back even more? Have they reentered at all? Can you maybe give us an update on those comments versus last quarter?

Chris Farrar (President and CEO)

Sure. That was directed to Mark, or?

Mark Szczepaniak (CFO)

I think it was to Chris.

Stephen Laws (Head of Real Estate Finance and Fixed Income Capital Markets)

Oh, no, I'm sorry, Chris, that's for you.

Chris Farrar (President and CEO)

Okay.

Stephen Laws (Head of Real Estate Finance and Fixed Income Capital Markets)

Yeah.

Chris Farrar (President and CEO)

Got it. Okay. I thought you said Mark. Okay.

Stephen Laws (Head of Real Estate Finance and Fixed Income Capital Markets)

Sorry, Mark, you chipped in, but sorry, that's for you, Chris.

Chris Farrar (President and CEO)

No problem. Yeah, I would say, I would say, the, the environment feels pretty similar to where it was in Q1. I don't think it's gotten worse or better, but definitely seeing the banks be cautious. We're hearing from borrowers who come to us and say, "I can't believe, you know, the bank wouldn't do this for me. Can you guys help me out?" I would say the opportunity set seems to be about the same.

Stephen Laws (Head of Real Estate Finance and Fixed Income Capital Markets)

Great. As far as your origination volumes, as you look out, and apologies if it was covered in the first couple of minutes, I was a touch late, but, you know, it seems like picked up a little in Q2. I know early in Q1, you guys had sort of become cautious, got more active later in the quarter. Do you think you're kind of at your normal run rate here for the second half? Do you think things, more likely to maybe pick up, go down? Kind of how do you, you know, frame volume as we move through the back half of the year and into 2024?

Chris Farrar (President and CEO)

Yeah, I, I think this is a good run rate. I think, you know, we're projecting this out for the rest of the year. I think, you know, we, we, we think that we'll, we'll end the year, you know, right around $1 billion. I think, I think this feels right.

Stephen Laws (Head of Real Estate Finance and Fixed Income Capital Markets)

Great. Well, again, nice quarter, and appreciate the comments this afternoon.

Chris Farrar (President and CEO)

Thanks, Stephen.

Operator (participant)

This concludes our question and answer session. I would like to turn the conference back over to Chris Farrar for closing remarks.

Chris Farrar (President and CEO)

Thanks, everybody, for joining. We appreciate all your support and look forward to talking to you again next quarter.

Operator (participant)

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