Waterstone Financial, Inc. — Q2 2020 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2020; interim financial statements are unaudited. Dollar figures below are in millions unless otherwise stated. Waterstone operates community banking in Wisconsin and mortgage banking through Waterstone Mortgage, which originates residential loans primarily for sale.
Financial performance and position
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Net interest income | $13.2 | $13.0 | $25.8 | $25.9 |
| Provision (credit) for loan losses | $4.5 | $0.03 | $5.3 | $(0.7) |
| Noninterest income | $66.9 | $35.2 | $98.4 | $59.4 |
| Noninterest expense | $47.7 | $35.4 | $82.9 | $64.7 |
| Net income | $20.9 | $9.6 | $27.0 | $16.2 |
| Diluted earnings per share | $0.85 | $0.37 | $1.08 | $0.61 |
| Reported net interest margin | 2.62% | 2.82% | 2.65% | 2.88% |
Q2 annualized return on average assets was 3.87% and return on average equity was 22.39%, versus 1.95% and 9.96% a year earlier. For the first half, the respective returns were 2.59% and 14.03%, versus 1.67% and 8.28%.
- Mortgage banking drove the earnings increase: Q2 mortgage banking income was $63.8 million, up from $34.1 million; mortgage segment net income rose to $16.8 million from $3.9 million. Segment originations were $1.14 billion, up 44.1%, supported by refinance demand and higher gross margins. For the first half, mortgage segment net income was $18.7 million versus $4.6 million.
- Community banking earnings weakened: Q2 segment net income was $4.1 million versus $5.8 million, principally reflecting higher loan-loss provisioning. First-half community banking net income was $8.2 million versus $11.6 million.
- Balance sheet at June 30: Assets were $2.22 billion, up 11.1% from year-end 2019. Loans held for sale were $383.4 million, up $163.3 million, while loans held for investment totaled $1.43 billion, up $45.8 million net. Cash and cash equivalents were $76.9 million; available-for-sale securities were $164.1 million.
- Credit: Allowance for loan losses increased to $17.7 million, or 1.24% of loans, from $12.4 million, or 0.92%, at year-end. Nonaccrual loans declined to $5.5 million (0.39% of loans) from $7.0 million (0.51%); there were no loans 90 days or more past due and still accruing.
- Funding and capital: Deposits were $1.16 billion, up $89.9 million from year-end; borrowings were $599.1 million, up $115.5 million. WaterStone Bank was reported well-capitalized, with total risk-based capital of 22.68%, CET1 of 21.64%, and Tier 1 leverage of 17.04%.
- Cash flow, first half: Operating activities used $134.2 million, investing activities used $34.7 million, and financing activities provided $171.5 million; cash increased $2.6 million to $76.9 million. Operating cash use largely reflects the high-volume mortgage origination-and-sale cycle.
Material changes versus comparable periods
- Net income rose 117% in Q2 and 67% for the first half, largely on sharply higher mortgage banking income amid falling rates and refinance demand.
- Credit provisioning increased substantially: $4.5 million in Q2 versus $30,000, and $5.3 million for the first half versus a $650,000 provision credit. Management cited pandemic-related economic uncertainty and higher unemployment assumptions.
- Net interest margin narrowed year over year. First-half net interest income was nearly flat, as higher loan balances and lower time-deposit costs were offset by lower asset yields and higher borrowing expense.
- Mortgage compensation and other operating costs increased with production volumes; professional fees also rose, including litigation costs. Shareholders’ equity declined $8.1 million from year-end, primarily due to dividends and share repurchases.
Outlook, risks, contingencies and unusual items
- COVID-19 exposure: The filing states that the pandemic could impair borrowers, reduce fee and interest income, increase credit losses, and adversely affect margins, mortgage activity, and financial results. Management could not quantify the future impact or provide a clear earnings outlook.
- Borrower relief and PPP: At June 30, $121.8 million of loans, or 8.49% of loans receivable, were subject to COVID-related payment deferrals; these modifications were not treated as troubled debt restructurings under the CARES Act. The company had also funded 264 PPP loans totaling $29.8 million. One modified loan with a $55,000 balance had missed its contractual interest-only payment by quarter-end.
- CECL: The company elected under the CARES Act to defer adoption of the expected-credit-loss standard and continued using the incurred-loss model. Management expected the initial CECL allowance increase, including unfunded-commitment reserves, not to exceed 130% of the December 31, 2019 allowance; the estimate remained subject to model validation and change.
- Liquidity and refinancing: $727.9 million of time deposits were scheduled to mature within one year. The $104 million of short-term FHLB advances had maturities in July and August 2020 and May 2021. Management said funding markets remained open but noted rate volatility and potential reliance on more costly funding if deposit outflows increase.
- Legal matters: The company recorded an approximately $1.1 million reserve for an individual arbitration award, including fees and costs; it is seeking to vacate the award. Approximately 100 related individual arbitrations were pending; management said a loss was reasonably possible but not probable and could not estimate a range.
- Capital returns: The company repurchased $20.4 million of stock in the first half and completed its repurchase program in Q2. Equity records show dividends declared of $0.74 per share for the first half, including $0.12 per share for Q2.
- Interest-rate sensitivity: Management’s one-year simulation estimated net interest income would increase 1.90% with an immediate 100-basis-point rate increase and decrease 3.76% with a 100-basis-point decline; actual outcomes depend on repricing and prepayment behavior.
Important facts for investors to verify
- Whether elevated refinance volumes and mortgage margins persist, and how production mix, capacity, and loan-sale execution affect earnings.
- Performance and delinquency trends in deferred loans and PPP exposures, especially after deferrals expire; whether pandemic conditions require further provisions or charge-offs.
- CECL model validation and the eventual allowance adjustment, including reserves for unfunded commitments.
- Developments in the individual arbitration and related proceedings, including any change to the reserve or potential exposure.
- Deposit retention and funding costs as large time-deposit maturities and short-term FHLB advances come due; available liquidity and capital after distributions.