Velocity Financial, Inc. quarterly report, Q2 FY2020

Velocity Financial, Inc. — Q2 2020 Form 10-Q

Reporting period: Three and six months ended June 30, 2020. Velocity originates and manages investor real estate loans secured by residential rental and small commercial properties. The quarter was heavily affected by COVID-19: loan originations and purchases were suspended in late March and remained suspended through June 30.

Financial performance and position

Metric	Q2 2020	Q2 2019	Six months 2020	Six months 2019
Interest income	$39.8 million	$36.9 million	$84.4 million	$73.0 million
Net interest income	$16.7 million	$13.2 million	$32.1 million	$26.9 million
Provision for loan losses	$1.8 million	$0.2 million	$3.1 million	$0.6 million
Income before taxes	$2.6 million	$5.0 million	$6.4 million	$11.6 million
Net income	$2.1 million	$3.5 million	$4.7 million	$8.2 million

Q2 interest income rose about 8% year over year, as average loans increased to $2.10 billion from $1.69 billion. The portfolio yield fell to 7.59% from 8.71%, primarily because more loans were nonperforming.
Portfolio-related net interest margin was 3.54%, down from 3.91% a year earlier and 4.18% in Q1 2020. Lower funding costs were offset by weaker loan performance and portfolio seasoning.
Q2 operating expenses increased to $10.9 million from $8.3 million; management cited origination-related costs that could no longer be deferred after production was suspended, as well as public-company expenses.
Common shareholders’ reported loss was $46.8 million for Q2, or $2.33 per share, despite $2.1 million of net income. The difference reflects a $49.0 million deemed dividend from marking Series A preferred stock to its maximum redemption value. Six-month common loss was $44.2 million, or $2.20 per share.
At June 30, total assets were $2.19 billion; cash and cash equivalents were $9.8 million and restricted cash was $6.7 million. Total liabilities were $1.89 billion, including $1.60 billion of securitizations, $160.8 million of warehouse facilities and $74.6 million of secured corporate financing, all net of issuance costs.
For the first half, operating cash flow was $23.7 million, investing cash flow was $2.7 million and financing cash flow was negative $37.5 million. Cash, cash equivalents and restricted cash decreased by $11.0 million to $16.5 million.

Changes, capital and asset quality

Nonperforming loans held for investment increased to $268.8 million, or 14.6% of that portfolio, from $151.1 million (7.9%) at March 31, 2020 and $100.5 million (6.0%) a year earlier. Management attributed the deterioration primarily to COVID-19. Separately, the company’s broader portfolio statistics report nonperforming loans of $329.1 million, or 16.0% of total loans, including $13.3 million of COVID-19 forbearance loans 90 days or more past due.
The allowance for credit losses was $5.2 million, up from $2.1 million at June 30, 2019. The company recorded $3.1 million of first-half provision; management attributed $2.4 million of the increase to COVID-related macroeconomic forecasts. The reported annualized Q2 charge-off rate was 0.10% of average nonperforming loans.
Loans in the COVID-19 forbearance program totaled $293.7 million held for investment and $41.0 million held for sale at June 30. The program generally allowed payment deferrals of up to 90 days; interest continued to accrue on qualifying loans.
The company completed its IPO in January, receiving approximately $100.7 million in net proceeds and using $75.0 million to repay corporate debt. In April, it issued $45.0 million of Series A preferred stock and warrants to affiliates of two major shareholders, generating $43.2 million net proceeds.
Preferred stock is senior to common stock and carries a liquidation preference initially set at $2,000 per share, with holder repurchase rights beginning in 2022 subject to debt restrictions. Warrants cover approximately 3.0 million common shares. These instruments create potential dilution and material future redemption obligations.
CECL was adopted January 1, 2020, increasing the opening allowance by $137,000 and reducing retained earnings by $96,000 net of tax. The June estimate used a COVID-19 stress scenario with a five-quarter forecast and four-quarter reversion period.

Outlook, risks and unusual items

No specific earnings or operating guidance was provided. Management said originations remained suspended as of June 30 and that it was exploring financing alternatives before resuming lending.
In July, the company completed a $276.0 million loan securitization, issuing $179.4 million of notes and certificates. It used securitization proceeds to pay off warehouse lines; management reported that all loans had long-term securitization financing as of July 31.
The Barclays repurchase agreement matured and terminated August 3, 2020; the Citibank agreement was extended to September 30, 2020. The company reported covenant compliance at June 30. Warehouse amendments imposed a minimum unrestricted cash requirement of $7.5 million and scheduled paydowns through August 3.
A securities class action filed July 9 alleges misstatements and omissions in the January IPO offering materials and seeks unspecified damages. The company stated it intends to defend the case; its outcome cannot be predicted.
A previously identified material weakness in income-tax accounting controls remained in place at June 30 pending further testing. Management nevertheless concluded disclosure controls were effective at a reasonable-assurance level and that the financial statements fairly presented the company’s position and results.
Other key risks include the duration and economic effects of COVID-19, further deterioration in borrower payment performance and collateral values, the ability to restart originations, securitization-market access, and the availability and cost of financing.

Important facts for investors to verify

Whether originations resumed, and the pace and economics of new lending and loan purchases.
Subsequent delinquency, nonperforming-loan, forbearance, charge-off and allowance trends, including how COVID-related deferrals are classified and accrued.
Liquidity and funding after the warehouse facilities’ repayment, including securitization capacity, covenants and the September 2020 Citibank facility maturity.
The preferred stock’s conversion, redemption and liquidation terms; potential warrant dilution; and the effect of deemed dividends on common shareholders.
Developments in the IPO securities litigation and remediation and testing of the tax-accounting material weakness.