Apr 26, 2016
Executives
David Urban - Director of Investor Relations Alessandro DiNello - President and Chief Executive Officer James Ciroli - Executive Vice President and Chief Financial Officer Lee Smith - Executive Vice President and Chief Operating Officer Leonard Israel - President, Mortgage Banking
Analysts
Paul Miller - FBR Capital Markets Scott Cyphers - Sandler O’Neill and Partners Kevin Barker - Piper Jaffray Henry Coffey - Sterne Agee CRT Jesus Bueno - Compass Point
Operator
Good day and welcome to the Flagstar Bank’s First Quarter 2016 Earnings Conference Call. Today’s conference is being recorded.
At this time, I’d like to turn the conference over to David Urban, Director of Investor Relations. Please go ahead.
David Urban
Thank you, Chris, and good morning, everyone. Welcome to the Flagstar first quarter 2016 earnings call.
Before we begin, I would like to mention that our first quarter earnings release and presentation are available on our website at flagstar.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 2 of today’s presentation in our Press Release and in our 2015 Form 10-K and subsequent reports on file with the SEC. With that, I’d like to now turn the call over to Sandro DiNello, our President and Chief Executive Officer.
Alessandro DiNello
Thank you, Dave, and thank you, everyone, for joining us today. In addition to Dave, I’m joined this morning by Jim Ciroli, our Chief Financial Officer; Lee Smith, our Chief Operating Officer; Steve Figliuolo, our Chief Risk Officer; and Len Israel, our President of Mortgage Banking.
I’m going to start the call by providing a high level view of our performance for the quarter, then I’ll turn the call over to Jim for a deep dive into our financial results. And Lee will follow with a more detailed review of our business segments and strategic initiatives, and I’ll conclude with guidance for the second quarter before opening up the lines for questions.
We had another successful quarter further validating our business plans and marking our fifth straight quarter of putting strong consistent earnings on the quarter. Earnings grew 18%, producing a 1.2% return on assets, while capital, liquidity, and credit quality all remains strong with a great start to the year.
We took advantage of market opportunities, overcame seasonality, and had a strong rebound in mortgage originations booking $6.9 billion of fallout-adjusted locks for the quarter, and closings increased 9% significantly outpacing the market. On our last call, we talked about our desire to increase our distributed retail and direct-to-consumer originations, and we saw the first signs of traction from that initiative.
Fallout-adjusted locks were up $152 million, or 62% for the quarter from these channels. At last count, we had 26 retail mortgage locations in 19 states.
These retail channels report us not only the opportunity for more stable purchase originations, but also for better margins. Another growth initiative we announced on our last call with builder finance.
I’m happy to report that we closed our first loan at the end of March and we are building a very impressive pipeline. This business provides another revenue stream and important diversification for our Community Bank.
We are also seeing strong synergies develop between our builder finance clients and our mortgage origination theme. The rest of our commercial loan business also perform well during the quarter.
Average outstandings were up $135 million, or 6%, and we’re seeing a stronger pipeline of high-quality loans. We said last quarter that we had completed the de-risking of the balance sheet, and that future loan sales would be opportunistic.
Thus in the first quarter when we saw the opportunity to execute the sale of lower spread residential mortgage loans at attractive pricing, we see there adding $9 million to gain on sale. We’ll invest the proceeds into higher spread assets, such as commercial loans, providing a boost to our net interest margin without using liquidity or capital.
This section highlights one of the significant strength for Flagstar. Our ability to generate assets quickly, we can rotate assets efficiently when the opportunity presents itself without fear of becoming too liquid.
As part of our activity growth and the future, we are refreshing Flagstar’s brand. Yesterday, after seven months of intense market research and development, we watched an advertising campaign highlighting the way Flagstar craft solutions with a financial success of our customers in mind.
We believe each customer is unique, and each solution is custom fit, that’s the Flagstar difference. Our new brand positioning, which is designed to capture this uniqueness and leverage it to build market share will be executed throughout all of our businesses.
Finally, we are inching closer to a TARP refinance subject to market conditions, regulatory approval, and other conditions, we believe that we will be able to complete the transaction within the next 90 days. I want to be clear that we cannot be certain on the timing of this important transaction, but we are confident that we are making positive progress toward its execution.
I
I think what we have done best during our tenure is to build an organization who is most important and valuable asset is that people. We have built a great team of people and put them in the right spot.
They really care about what they do each and every day. That’s the primary reason we have enjoyed some success and what sets us apart from average organization.
Looking ahead, while we’re very pleased with the progress we’re making, we are actively looking for strategic opportunities to expand our banking relationships, strengthen our mortgage origination capabilities across all channels, and grow our subservicing business. With that, my colleagues will take you through a more detailed discussion of our financials and operations.
First up is, Jim.
James Ciroli
Thanks, Sandro. Turning to Slide 6, our net income was $39 million, $0.54 per share this quarter.
This compared to net income of $33 million, $0.44 per share last quarter. Our earnings this quarter were led by higher net interest income, increased noninterest income, and strong credit metrics.
For the quarter, we posted an annualized return on assets of 1.2% and returns on equity – common equity of 10.1% and 12.2%, respectively, it was a very good start to the year. Let’s turn to Slide 7.
Our first quarter net interest income increased 4% from last quarter to $79 million. This result was led by a 6% increase in earning assets, partially offset by a slight drop in the net interest margin.
Our NIM fell 3 basis points in the quarter to 2.66%, driven mainly by lower relative spreads of the earning asset growth we had at the end of last quarter. Average earning assets increased $631 million, or 6% this quarter, led by a $425 million, or 17% increase in loans held-for-sale due to higher mortgage originations.
Average loads held-for-investment were largely unchanged from the prior quarter, as relationship-based commercial loans increased 6%, while consumer loans declined 3%, largely due to the sale of $787 million of performing mortgage loans during the quarter. As interest rates dropped, we elected to sell these loans at a $9 million gain to be to able to redeploy those funds in the higher spread opportunities, such as commercial loans, where our relationship focus continues to deliver good results.
We also sold $96 million of high-risk loans during the quarter. Average total deposits were largely unchanged last quarter, as the drop in company controlled and government deposits was largely offset by higher retail deposits.
The company experienced a provision benefit this quarter of $13 million. This largely resulted from the release of reserves associated with the two sets of loan sales during the quarter.
Asset quality continued to be strong, and I’ll provide additional detail on that in a couple of slides. Noninterest income increased $8 million, or 8% to $105 million this quarter, led by higher net gain on loan sales, partially offset by a drop in the net return on the mortgage servicing asset, and reduced R&W benefit.
So let’s dive deeper into each of these items. First quarter net gain on loan sales increased $29 million, or 63%.
The increase from the prior quarter reflected higher fallout-adjusted locks and improved gain on the sale margin, and also included the $9 million gain from the sale of $787 million of mortgage loans. Excluding the sale, net gain on loan sales increased $20 million, or 43%.
We saw our fallout-adjusted locks increased 37%, led by higher refinance activity, due to lower interest rates, and stronger correspondent in retail production. The net gain on loan sale margin was 109 basis points this quarter.
Excluding the HFI loan sale, the adjusted margin was 96 basis points, an improvement of 4 basis points over the last quarter. The net return on the mortgage servicing asset was a net loss of $6 million this quarter, as compared to income of $9 million last quarter, largely due to an increase in prepayments, as well as the smaller benefit from the collection of performance incentives on prior period’s MSR sales, and the R&W benefit declined $4 million this quarter, as the R&W reserve remained unchanged at $40 million.
Moving now to expenses, noninterest expense increased 6% to $137 million this quarter, as compared to $129 million last quarter, led by higher compensation and benefits expense and commissions, partially offset by lower other noninterest expense. Compensation and benefits increased $9 million, primarily due to seasonality caused by higher payroll taxes and anticipated increase attributable to our growth initiatives and a full quarter’s expense related to the ExLTIP plan.
Commissions rose $2 million, mainly due to higher mortgage loan closings and other noninterest expense fell $3 million, led by lower warrant expense resulting from a decrease in our share price and a decline in the FDIC assessment expense. On the tax front, the company’s effective tax rate this quarter was 34%, as compared to 25% last quarter.
Last quarter’s 25% effective rate resulted primarily from state income tax benefits. The effective tax rate this quarter is reflective of our long-term rate.
Slide 8 highlights our average balance sheet. Average earning assets increased $631 million, or 6%, led by a 17% rise in loans held-for-sale, the result of higher mortgage originations.
HFI loans were flat and reflected a 3% decline in average consumer loans and a 6% increase in average commercial loans. The consumer loan decline was the result of HFI sales.
Despite these sales, our ending balance of HFI loans was roughly equal to the average balance this quarter, and Lee will provide more details on our commercial loan growth. Average retail deposits were flat, and the cost of these funds declined slightly despite the increase in the Fed funds rate near the end of the quarter.
Average long-term FHLB borrowings increased $341 million, as we lengthened our funding and support of earning asset growth that occurred late last quarter. At March 31, 2016, our common equity-to-asset ratio remained strong at 9.4% and our book value per share rose an annualized 12% to $22.82.
Let’s now turn to asset quality on Slide 9. Asset quality remains strong, no matter how you look at it.
Nonperforming loans fell $13 million to $53 million at the end of the quarter, while the nonperforming loan ratio fell below 1%. Early stage delinquencies remained at a low level.
Looking at consumer loans, only $11 million, or 37 basis points were over 30 days delinquent and still accruing, down $3 million in the prior quarter. There were no commercial loans at March 31, 2016.
There were more than 30 days to delinquent. Net charge-offs were $12 million this quarter, including $6 million of net charge-offs associated with the sale of high-risk loans.
Excluding loan sales, net charge-offs were $6 million, or 40 basis points below this quarter, compared to $7 million, or 51 basis points last quarter. In March 31, 2016, our allowance coverage was 2.9% of total loans, down only slightly from the end of last quarter.
Coverage was 4.5% of consumer loans, up 24 basis points from last quarter and 1.3% of commercial loans, reflecting the strong asset quality, and continued lack of the delinquent loans in this portfolio, our allowance covered NPLs over three times. Turning now to Slide 10, we continue to maintain robust regular capital ratios.
On a Basel III, partially phase-in basis at March 31, 2016, our Tier 1 leverage ratio was 11.0% as compared to a 11.5% at December 31, 2015. Our Tier 1 common ratio was 14.0% at March 31, 2016.
The decrease in the Tier 1 leverage ratio resulted mostly from the 40 basis points negative impact of the higher phase-in requirement in 2016 under Basel III, as earnings retention roughly supported earning asset growth during the quarter. This slide also presents an analysis of our Tier 1 leverage ratio, which is our constraining capital ratio, reflecting the pro forma impact of redeeming our TARP preferred shares.
The pro forma impact also contemplates a reduction in equity from the payment of deferred preferred dividends, which at March 31, 2016 totaled $94 million. As you can see on a pro forma basis, we still have an 8.2% Tier 1 leverage ratio at March 31, 2016, a healthy trust bumper over the minimum level needed to be considered well-capitalized, particularly considering the composition of our balance sheet now has less risk.
We anticipate that our internal regulatory capital generation rate will continue to be strong for the next few years. Keep in mind, our Tier 1 capital at March 31, 2016 has already been reduced by $212 million, 161 basis points for our NOL-related DTAs, which should be earned back on the next few years, and further reduced by $133 million, 101 basis points for MSRs in excess of amount allowable under Basel III.
As we continue to reduce our levels of MSR and grow our Tier 1 capital through earnings retention, these deductions from Tier 1 capital should also shrink significantly, resulting in, at least, over the next few years, a higher level of regulatory capital growth. I’ll now turn to Lee for more insight in each of our businesses.
Lee Smith
Thanks, Jim, and good morning, everyone. We’re obviously very pleased with that performance in Q1.
But even more satisfied with this represents the fifth consecutive quarter of consistently strong profitability, both validating the business model we put in place and strategies we’re deploying to optimize results. For the 12 months ended March 31, 2016, we generated $165 million of after tax net income, on average total assets of $12.6 billion, which represents a return on assets of 1.3%.
We’ve also started to invest in new business initiative, such as to build the finance team and expand existing business lines, such as our distributed retail and direct-to-consumer mortgage origination businesses. As a result, we believe we’re well-positioned in the long run to build on the consistent results you’ve seen over the last 15 months.
I will now outline some of the key operating metrics from each of our major business segments during the quarter. Please turn to Slide 12.
Quarterly operating highlights for the Community Banking segment include average commercial loans increased $135 million, or 6%, $2.4 billion during the quarter, led by C&I lending, which increased $99 million, or 21%, and further bolstered with CRE lending, which increased $44 million, or 6% quarter-over-quarter. During the last 12 months, we’ve grown total average commercial loans by nearly $700 million, led by $345 million, or 56% increase in warehouse lending, largely due to our strategy change 18 months ago of providing warehouse financing to correspondents who sold to investors other than Flagstar.
This is a business line we see opportunities to grow further in the future and it has positive synergies with our mortgage origination business. CRE lending has grown $188 million over the last 12 months and C&I lending $142 million over the same time period, as we successfully executed on our relationship-based approach with borrowers in many different industries.
Under the leadership of Drew Ottaway and the introduction of new business lines, such as MSR lending, equipment finance, and build the finance, where we’ve already approved $200 million in new facilities this year, the first of which just funded. We believe, we will continue to see solid consistent growth, as we move forward, and are excited about the potential of unknown mortgage lending businesses.
Average consumer loans decreased $109 million, or 3% in the quarter, as we sold $787 million of performing residential mortgage held-for-investment loans. So realized significant gains on our existing portfolio in response to market conditions.
We also sold $96 million UPB of MPLs, TDRs and legacy scratch and dent loans, as we took advantage of the business opportunity to sell some higher risk assets and further de-risk the balance sheet.
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Average total deposits were largely unchanged last quarter, as a drop in escrow deposits from pure MSR subservice accounts was largely offset by increased retail demand deposits. Over the last 12 months, average retail deposits have grown 6% to $5.8 billion.
Government deposits have increased 13% to $1.1 billion, and company-controlled deposits have risen 22% to $1.2 billion. Finally, on the technology front, we completed the project to replace all of our ATMs with state-of-the-art terminals during the quarter.
Overall, we are very encouraged by the sustained growth in the community bank our positioning and potential for the future. Please turn to Slide 13.
First quarter operating highlights for the mortgage origination business include fallout-adjusted lock volume increased 37% to $6.9 billion, led by increased refinance volume. Mortgage closings increased 9% to $6.4 billion quarter-over-quarter, as our underwriting and fulfillment teams adjusted to the higher lock volume, but also maintained consistent turn times and excellent service levels.
We talked about the impact of trade last quarter, particularly in our brokerage channel 90 days on, and we can say trade was a speed bump that were moving on from. And while our broker business isn’t quite back to pre-trade levels, it has been more than offset by growth in our correspondent and retail channels.
Our adjusted net gain on loan sale margin increased 4 basis points quarter-over-quarter to 96 basis points adjusted by HFI loan sales. The high gain on sale margin was primarily attributable to an increased mix of retail production.
The steps we took during the first quarter toward expanding our distributed and direct-to-consumer retail businesses are beginning to yield positive results. With retail originations increasing from 5% to 6% of fallout-adjusted locks, as we call it or having the recruitment pipeline approximately 100 loan officers and sales assistants.
In highly regulated environment and given our comprehensive risk and compliance infrastructure and that cost of funds, we believe, we have the compelling business offering, which leverages all parts of our business model, including lending and servicing and are committed to growing the retail origination business. Finally, we’re seeing positive results from our consumer portal, which we launched in December.
If you recall this portal also acts as a document aggregator, which drives incremental operational efficiencies and we’re pleased with the early returns. We’re also continuing to invest in ways that will further enhance the capabilities of this portal in the future.
Moving to servicing, quarterly operating highlights for the Mortgage Servicing segment on Slide 14 include, we were recently notified by Fannie Mae that we have been named a Fannie Mae Servicer Total Achievement and Rewards or STAR performer for 2015 in the general servicing category, in recognition of our outstanding performance and best practices. This recognition by Fannie Mae, we discuss them at the loan sales reflects the extraordinary efforts by Flagstar servicing team to deliver operational excellence and enhance our position as an elite mortgage servicer.
We added another component default servicer during the quarter, as we continue to build out our best-in-class servicing platform, giving us more optionality when loans become seriously delinquent. Including concurrent flow and bulk sales, we executed on the sale of $5.1 billion in aggregate UPB, or more than 23,000 loans of residential MSRs during the quarter, where we will be the subservicer on over 10,000 of those loans.
We currently service approximately 340,000 loans of which 192,000 of subservice brokers making us the seventh largest subservicer in the nation. The remaining 148,000 ofloans where we own the MSR were that part of our LHFI book.
Approximately 98% of our service in book is performing loans and 2%, or approximately 8,000 loans, a 60-plus-day delinquent. Longer-term, we remain focused on three areas, growing our fee income generating subservicing business, which has the capacity to service up to 1 million loans.
Leveraging this platform to cross-selling across our three business line verticals and executing on an MSR reduction strategy, given the requirements of Basel III. Our goal is to reach to fully phase-in MSR limit by the end of Q1 2018, through efficient bulk and flow sale transactions, and we’re on track in implementing the early phases of this plan.
Given our capabilities as an originator and the subservicer, our ability to lend against service in advances and now directly against the MSR asset and pay interest to MSR owners on custodial and escrow deposits, given we’re a bank, we believe we have a compelling business model and proposition implies that mortgage servicing rights. Moving onto expenses on Slide 15, our noninterest expense increased $8 million to $137 million in the first quarter.
The increase was largely due to higher compensation and benefit expense and commissions, partially offset by lower FDIC premiums another noninterest expense. Noninterest expense slightly exceeded the high end of our guidance from last quarter, because mortgage volumes came in higher than we expected in Q1.
The higher compensation and benefits quarter-over-quarter was predominantly driven by two things. One, planned increases in head count, the growth initiatives, which accounted for $3 million, and two, highest seasonal payroll taxes, which accounted for $4 million of the quarter-over-quarter increase.
Commissions increased by $2 million quarter-over-quarter, as a result of higher mortgage closings. These increases were offset by a reduction of $3 million in another noninterest expense, due to the warrant expense decreased given the reduction in stock price, and $2 million reduction in FDIC premiums, as a result of our balance sheet de-risking program.
Our efficiency ratio improved slightly in the quarter to 74.5% compared to 75.2% in the prior quarter. Our stronger mortgage revenue was offset by highest seasonal expenses and our investment in growth initiatives.
We previously stated that our targeted long-term efficiency ratio is in the mid-60s. And our immediate focus in achieving that goal is on growing revenues across all three major business lines, while continuing to build on the cost discipline and management moving still throughout the organization.
As always, we remained focused on optimizing that cost infrastructure and we’ll continue to look for ways to drive further efficiencies throughout the organization. We estimate noninterest expense will be between $140 million and $145 million during the second quarter 2016, due to the costs associated with higher mortgage originations and our investment in growth initiatives, including the 100 distributed retail loan officers and sales assistants we have hired or having the recruitment pipeline.
Furthermore, we believe our efficiency ratio will remain in the low to mid-70s, given the investment period that is needed to ramp up new business opportunities. However, and as previously mentioned, we’re very confident of these initiatives together with the growth we anticipate in existing channels combined with that cost and expense discipline will ultimately see us achieve our long-term goal of the mid-60s efficiency ratio target.
In summary, we are executing against our strategic plan and are well-positioned to build on the consistently strong results you’ve seen over the last 15 months. We are pleased with our progress and are committed to delivering strong returns for our shareholders.
With that, I’ll hand it back to Sandro.
Alessandro DiNello
Thank you, Lee. I’m now going to close our prepared remarks with some guidance for Q2, and then open the call for questions and answers.
Please turn to Slide 17. We expect earning assets and the net interest margin to be relatively stable.
We anticipate mortgage locks will increase approximately 15% to 20%, as the spring buying season kicks in. We expect a slightly stronger gain on loan sale margin from our adjusted Q1 number fueled by a greater share of retail originations.
We anticipate a slight improvement in the net return on the mortgage servicing asset as prepayment speeds subside. We expect the balance of our MSRs will decline slightly.
We anticipate our provision expense will match net charge-offs, which we believe will be consistent with the net charge-off ratio on Q1 adjusted for loan sales and loans with government guarantees. As Lee noted, non-interest expenses will probably be between $140 million and $145 million due to seasonality and investment in growth initiatives.
This concludes our prepared remarks and we’ll now open the call to questions from our listeners. So I’ll turn it over to Chris to open up the lines.
Operator
Thank you. [Operator Instructions] And we’ll take our first question from Paul Miller, FBR & Company.
James Ciroli
Hi, Paul
Paul Miller
Yes, how you guys doing?
James Ciroli
Good.
Paul Miller
On the $400 million TARP repayment, can you talk about the mechanics of that like would you have to refinance that completely through debt or can you refinance only a portion of that? Can you also talk about what do you think you can get the deals done at on interest rate basis?
James Ciroli
So unfortunately Paul, not going to be able to give you much color on any of that, we are still pulling all of the information together that will need in order to be able to be certain of the structure of the transaction and of course interest rates are all depends on when you go-to-market and what all the market conditions are at that time. So it’s really hard for me to predict that.
Paul Miller
Okay, then on the adjusted book value basis, how much is in the – how much of the TARP accrued – the TARP accrued interest rate payments are in the book value, how much we have to back out?
James Ciroli
$94 million, Paul. This is Jim, right.
Paul Miller
Hey, Jim, how you’re doing? Thank you.
James Ciroli
Yes.
Paul Miller
And then lastly, the builder business is relatively new to you. Can you add some more color around that or exactly with the stuff are be sold, where you put on your balance sheet, is it put on your balance and sold once that houses are complete?
James Ciroli
Yes, so these are typically lines of credit. That supporting the development of land and/or the construction of homes in relatively large developments and so the – either typically large developers that are that are the borrowers and so we’re financing the development and construction during that period of time.
We’re not talk about the BMO, now we do believe that our synergies as I noted in my comments that will allow us to obtain the fair portion of BMOs. But the actual build finance loans are not for long-term financing.
Paul Miller
What type of yields that you get on the lines of credit?
James Ciroli
We didn’t get a spread of somewhere between 300 and 400 basis points Paul, depending upon the interest rate and the fees that we expect to collect from the draw perspective.
Paul Miller
Okay, hey guys, thank you very much, great quarter.
James Ciroli
Thank you.
Lee Smith
Thank you, Paul.
Operator
And we’ll take our next question from Scott Cyphers of Sandler O’Neill and Partners.
James Ciroli
Good morning Scott.
Scott Cyphers
Good morning guys. How you’re doing?
James Ciroli
Good.
Lee Smith
Good.
Scott Cyphers
First question, Jim to the extent that there is visibility, when you talk about the net servicing revenue line continue to be pressure by prepayments, I mean obviously lot of that is going to be new rate base. But I wondered just kind of what you mean by pressure in that, it’s been a positive number as long to a negative this quarter.
When you talk about pressure, which is still expected to revert to positive number, and then as we look beyond the second quarter, is there any sense for kind of how that line item may trend, can I realize as a rate base, but just given with such a kind of meaningful doubt, just curious that your thought?
Lee Smith
So let me take a shot with that then Jim can add some color to it. First of all, relative to providing with some guidance going forward, at the next quarter, I’m not going to go there that’s all our function, one might happen in the markets and interest rates in such and your guess as good as mine.
I think over the next quarter, we would see the return been a little bit better, but I wouldn’t go so far as to show you that is going to be positive. We didn’t suggest that in our guidance and that is a lot of uncertainty there.
I do think if you look at the long term, we’ve always been able to perform pretty well with the return of our MSR asset over the long-terms and you have these situations that occur in the market that provide that cost some negative impact. But I’m confident that over the long term will always have a pretty good overall success.
Jim, anything you would like to add on that?
James Ciroli
Yes, adding to that was said we’re always positioning our MSR to make sure that our net position between our origination business and our MSR, the fund balance sheet will yield a positive, so while we saw prepayment accelerate this quarter because of the low level of mortgage rates, we more than made up for the mortgage origination side. The only other thing that I would encourage you to think about as well in my prepared remarks we talk about that negative impact of the MSR balances have on capital and that by the first quarter of 28 teen as Basel III is fully phased in will have to bring that balance down to the were not in a position where were deducting, the MSR balance from capital.
So that is going to necessitate a certain term a glide path of sale that need to take place in the future and as you think about future performance you’ll have to factor in the cost of those transaction, the sale transaction.
Scott Cyphers
Okay, great. That’s helpful thank you.
And then if we can jump over to expenses, I guess prior to this quarter, you got a really good consistency in sort of the $130 million, $40 million per quarter range, and the guidance for 2-Q is very understandably a little higher given origination anticipation, just curious as you look out sort of over the pole, are we sort of setting up for a higher baseline of expenses going forward or to be ramp back down into that level as we get into sort of seasonally strong to origination in the second half of the year?
James Ciroli
Yes, so start couple of things on it. So the noninterest expensive, we did slowly exceed the high end of our guidance last quarter because the mortgage volumes aiming high than we expect it Q1 and as you heard we’re guiding towards a $144 million $145 million, at an NIE run rate expense in Q2.
As you criticized this reflects the continued investment, we expect some making growth businesses such as the distributed retail mortgage on builder finance businesses and growth in mortgage production volume from our core business, so more view is that growth will ultimately leads the higher revenues as we look forward. So I think base probably have shifted up slightly but it should be more than offset in the longer-term revenue growth, and that’s why you heard him to prepared remarks, up to confident, but over the long run will achieve that mid-sixties efficiency ratio target.
Scott Cyphers
Okay, that’s perfect. Thank you very much.
James Ciroli
Thanks Scott.
Operator
We’ll take our next question from Kevin Barker of Piper Jaffray.
James Ciroli
Hi Kevin.
Kevin Barker
How you’re doing? Thanks.
Just for the discuss some of the sales of the MSR, so you’re talking about end up to 2018 to reach your productions to Basel III. Could you – do you expect any of the changes in the MSR sales to take?
I mean do you expect MSR sales to perform, and what you’re right now or the increased amount of counterparties or potentially change the way your sewing of assets?
James Ciroli
The only thing that I would say, Lee might want to add something to this is – to the extent, we can increase the flow agreements. We want to do that and include sub servicing arrangements with us.
So Lee and team are working hard to that end, but otherwise you got to see where the market is and where the best opportunity to execute in the market is and that’s what we’ve always done and that’s what we will continue to do. Lee, do you want anything…?
Lee Smith
Yes, I mean I think we proven that we can execute the bulk sales or concurrent both sale and as we mentioned we sold $12.1 billion of MSRs in the first quarter. I think what’s interesting Kevin is we feel very good about the quality of our originations, and we can provide additional services, the bulks of MSRs, the transaction such as sub servicing, recapture, paying interest on the custodial and escrow deposits and financing solutions around either the MSR asset will servicing advances.
So we believe we have a comprehensive offering, the few of the sellers can provide combined with the quality originations underlying the MSR has been sold. In terms of the market, I think it’s a pretty common theme.
This often new funds that are coming into the market, and we continue to see that. I think there’s still a lot of people that see the MSR asset, as a high yielding good asset and they’re looking to partner with people that can provide them with a very comprehensive operational management around that asset.
And as I just described, we can do that.
Kevin Barker
So you’re saying it’s going to be purely flow sales at that point? And you mentioned that it was $5.1 billion of sales this quarter and you disclosed on Slide 14, it was $2.6 billion.
So I’m assuming the delta there is primarily the extreme bulk and flow?
James Ciroli
Yes.
Lee Smith
Yes, correct. The $2.6 billion is the bulk and the delta is the flow.
But we would like to, I mean, we would like to be executing the majority of the sales on a flow basis, because they’re much more predictable. But we can complement the flow sales with bulk sales, as necessary as we’ve done historically.
Kevin Barker
Okay. And just to clarify some of the comments you made around TARP.
Is there a sort of premium or discount on top of the melt outstanding cost of deferred dividends. Could you just expand upon a little bit?
Alessandro DiNello
Yes, I don’t think you should assume that.
James Ciroli
Yes, right. Now, if you look at the terms, there is not.
Kevin Barker
Okay. So it’s straight just principal plus the deferred dividends, that’s the way we should think about?
Alessandro DiNello
Yes.
James Ciroli
Yes.
Kevin Barker
Okay. And then in regards to your deposit days and as we had a significant increase in noninterest-bearing deposits.
Was there any specific driver of that this quarter and do you think that to continue?
Alessandro DiNello
Well, we have a specific driver. This particular quarter was the deposits from our custodial arrangements on our servicing book.
So Q1 typically has increases relative to income tax payments, and then of course, because of the large refinance activity in Q1, that builds up the custodial deposits as well. So that’s the primary driver of the big increase in Q1.
James Ciroli
Yes, Kevin, I think, you’re looking at the quarter in-balance there, which is impacted by the P&I payments from the revised machine.
Kevin Barker
Okay. And then you would expect that to be seasonally higher in the second quarter.
So you have a little bit more liquidity?
James Ciroli
I wouldn’t necessarily say that it would be seasonally higher in the second quarter. Actually, I think it might go the other way.
I think, it might – they could drop more, because there’s a prepayment slowdown, and as tax payments get made. So, yes, I don’t see any huge change, I guess, I haven’t met.
Kevin Barker
That’s fine. I appreciate taking my questions.
James Ciroli
Thanks.
Alessandro DiNello
Thanks, Kevin.
Operator
And from Sterne Agee, we go next to Henry Coffey.
Alessandro DiNello
Hi, Henry.
Henry Coffey
Good morning, and thank you for taking my question. Just for the record, it’s Serne Agee CRT, the last one.
The – when we look at your MSRs as a standalone asset, and we look at what the investors are buying in the bulk business. What kind of certain net return do you think they’re targeting or realizing, so net of subservicing and amortization and together all the silly fair value stuff.
What – when you talk to them, what kind of net return they’re realizing from your MSRs?
Alessandro DiNello
I don’t know the answer to that and I wouldn’t speculate on that. I mean, we’re not buying MSR.
So that’s how we look at it. We we’re a seller of MSR, so I don’t know Lee or Len anybody have any color on that?
Lee Smith
I mean, yes, we don’t know what others expected returns are. I mean that’s up to them and their models.
I mean, we stated before on calls going back over the last couple of years, the way we look at the MSR asset. We target a 6% to 8% ROA.
But you’ve got to remember, we hedge that net of hedging costs, and we have a very comprehensive operational infrastructure around that asset through the servicing business as well. So that’s how we think about it, but how we’ll just think about it and their expected returns to their business.
Henry Coffey
And if you look at your own servicing business, excluding any kind of fair value more than your MSR, is this – was that profitable and what did it look like?
Alessandro DiNello
Yes, I think it is profitable. And I think that, as we go forward the – because it’s an economy of scale, kind of business, as we have said many times, because we have the infrastructure in place, as we as we grow the portfolio.
I think the numbers $5 million to $7 million per 100,000 loans is added to the pre-tax profitability of the company. So we’re now at a position where we feel like we can take the next steps to grow if we’ve got the operation you heard about the award that the team received.
So we’ve got the quality, we’ve got the infrastructure I think we’re going there.
James Ciroli
And we have the capacity I mean with servicing loans 40,000 loans and as I mentioned we have the capacity to service a 1 million so we have the capacity and Sandro is right every 100,000 loans is incremental $5 million to $7 million of operating profit pretax.
Henry Coffey
Okay, so what’s the governor to getting to a 1 million. what’s restrain then?
Alessandro DiNello
There’s three ways that we that we have loans and as we go through the detail, but the thing that we have to do different from what we’ve done thus far because thus far loans have primarily come from Flagstar originations as we have to obtain third-party contracts to the service loans originated by others and MSR is owned by others. So the way it take it from there.
James Ciroli
Yes I mean there’s basically three ways we can grow the lot the number of loans that we have subservicing so we can sell the MSRs that we have originated. And subservice those loans back and not what we’ve been doing successfully over the last two or three years.
We can onboard loans that we have been or we originated. And you can imagine being an MSR seller, we talk to a lot of buyers of MSRs who were buying MSRs not just from us but others.
And we can work directly with the agencies and G&A, if they ever wanted to direct close the loans to a servicing platform that I felt good about. And so that’s another way that we can grow our loan service book.
Henry Coffey
Great, thank you for taking my questions.
Alessandro DiNello
Thanks, Henry.
James Ciroli
Thanks, Henry.
Operator
We go next to Bose George of KBW
James Ciroli
Good morning.
Unidentified Analyst
Hi, good morning. This is actually [indiscernible] for Bose.
I want to ask first on your capital position, obviously your capital ratios are fairly robust with the TARP redemption hopefully coming up and maybe lifting of the OCC consent order at some point. How you think about kind of how you want you use that capital?
Do you want to utilize it to continue to grow the balance sheet and grow your asset base or the more opportunistic ways you are looking to use it?
James Ciroli
Well those are all things that we’re considering, so we’re certainly considering the growth of the balance sheet. We’re certainly considering strategic opportunities across all of our lines of businesses.
So I’m not ready to be specific about that, but those are all things that are coming to play here as we get this transaction done get the consent order lift and then move forward.
Lee Smith
First thing is first and we mentioned that two most important hurdles.
Unidentified Analyst
Got it and should we think is there read through from the TARP redemption to the lifting of the SEC consent or to those kind of have to have tandem or – are they not latest?
James Ciroli
No, they don’t. They’re independent situations that were working on separately.
Unidentified Analyst
Okay, and then I just want to ask one on your mortgage loans, while look I mean was that quarter-over-quarter when most of their mortgage participants were down I just wanted to see if that was something that’s kind of more of a country guy is taking market share of it’s just I saw opportunity in the correspondent market this quarter?
James Ciroli
Yes, let Lee – Len give you some color on that. My quick response is we saw some increase in our retail production both in our distributed retail as well as our direct-to-consumer and we did a good job of taking advantage of lower rates in the refinance market.
Len, anything you want to answer that?
Leonard Israel
Yes, I would like to add to that that during the fourth quarter we took more of an impact adversely needed to trade as a result of our higher GTO concentrations, we talked about that on the last call. So really our rebound is a reflection of the traction in our retail rebound from in our correspondent platform and return to what we would consider to be a new normal if you will.
If we look though on a year-over-year basis, we’re pretty much mirroring what we’ve seen other participants in the market report in terms of year-over-year changes in their production.
Unidentified Analyst
Okay, that makes sense. Thanks guys.
James Ciroli
Sure.
Operator
We take our next question from Jesus Bueno of Compass Point.
James Ciroli
Hi.
Jesus Bueno
Hi, how is it going? Thanks for taking my questions.
Just a follow-up on the servicing, what was the servicing that you sold and retained sub-servicing what was the retention rate for this past quarter?
Alessandro DiNello
Yes. So we sold approximately $5.1 billion, it’s about 23,000 loans we’ve retained the servicing on 10,000 of those loans.
Jesus Bueno
Great. Thank you.
And obviously the – you had the benefit of the margin expansion during the quarter. It looked, I guess, and part to the actually muted a bit by the heavier shift the correspondent running.
So, I guess, as you’re guiding to modestly higher margin next quarter, I know you noted that the – that retail would be up. But, I guess, are there any reads how are you see margins kind of unfold so far this quarter?
Are they on a core basis are they directionally higher than they were many saw in the first quarter?
Alessandro DiNello
Yes. I think, in our case, just speaking for Flagstar, then given the fact that we see our mixed changing a bit towards the retail, that’s really what’s driving the increase.
I think otherwise we don’t see margins changing substantially in the next three months.
Jesus Bueno
That’s great. And so in terms of volumes as well, are there any trends developing the second quarter?
I know, you noted that you had refi strength in the first quarter, but I guess, between purchase and refinance, are you seeing kind of strength in one versus the other?
Alessandro DiNello
Well, I think, I’ll let Len give some color on this in a second. I think that we’re seeing purchase activities strengthen.
But you would normally expect to see that, as you get into the second quarter of the year. So, I don’t think there’s anything particularly unusual about that.
We’re guiding to another 15% to 20% increase in locks. And we’re pretty confident that we’re going to be able to achieve that.
Len, anything you want to add?
Leonard Israel
Yes, just maybe add to it that we are seeing applications for purchase many transactions increasing. And, again, as we are seeing a traction in our retail, we expect to see more of that business coming through.
And we’re doing a good job with our TPO customers as well, as we continue to expand in that area. So we’re opportunistic there.
Jesus Bueno
Okay. Thank you.
I hope in terms of one last one. Just on loan growth, obviously you saw balances drop with the sale there just into mortgage loans.
And you’ve noted deploying – redeploying capital into commercial loans at, jut given what were the originations? I guess, how should we think about the loan growth going forward?
And in terms of your own originations capabilities also you did just about $80 million in commercial loans last quarter. I guess, how do you plan on kind of filling our Board, the loans that you sold?
Alessandro DiNello
Well, so first of all, relative to the growth of earnings assets, we’re guiding to relatively flat balance sheet over the next three months. Relative to the cash that we would invest to replace the age of buy loans that we sold, our first choice is always going to be relationship-based lending, whether that’s in the commercial, real estate, or C&I, consumer lending or wherever that might be, we’re going to first go for those relationship-based situations.
To the extent that we can’t go the whole quick enough then we will go to retaining some of the high-quality production to our mortgage origination platform. And as I noted in my prepared comments, that’s really one of the great advantages that Flagstar has is our ability to generate assets, good quality and good yielding assets pretty quickly.
And we can choose the durations that we need in order to keep the interest rate risk in the right place. And so, exactly what’s going to happen, I can’t tell you, because we just don’t know.
But we do know that that we will not have difficulty filling the asset bucket.
Jesus Bueno
That’s great.
Alessandro DiNello
And anything to add, Lee?
Lee Smith
Yes, and I would just build up a franchise comment, we did mention in the prepared remarks, but we talked about the asset sales. We did that $210 million of loans that we originated ourselves in the first quarter to our balance sheet.
Jesus Bueno
That’s great, helpful.
Lee Smith
Outside of the commercial growth that we refer to.
Jesus Bueno
Okay. Well, thank you very much for taking my questions.
Congrats on a quarter.
Alessandro DiNello
Thank you. You’re welcome.
Operator
And with no further questions in the queue, I’d like to turn the conference back over to Mr. Alessandro DiNello for additional or closing remarks.
Alessandro DiNello
Thanks, Chris, and thanks to everybody for your interest in Flagstar. We feel very good about our prospects for continuing to post strong and consistent earnings going forward.
We’re working hard at building a less volatile income stream in our results over the last 18 months, showed great progress in that regard. We have built a strong bank that is uniquely supported by a powerful national loan origination platform.
We road ahead, holds many opportunities for Flagstar. And I’m more confident than ever that we will be able to take full advantage of those opportunities and produce return for our shareholders that they will be very pleased with.
Thanks also to my Flagstar colleagues for all the contributions they make to our success and very proud to work with all of you. And finally, thanks to, everyone, for your time this morning.
I look forward to reporting Q2 results in July.
Operator
And this concludes today’s presentation. Thank you all for your participation.