HomeStreet: Likely Deal Break w/ FSUN

Unfortunately, this year I'm getting crushed in a game of Battleship, every speculative merger or in this case announced merger gets blown up (TH & BOOM being the other recent ones).  An astute commenter on my original HomeStreet (HMST) post noticed that FirstSun Capital Bancorp (FSUN) left out any mention of their pending acquisition of HomeStreet in their Q3 earnings release that came out on Monday (10/28) as an ominous sign.  After the market closed on Tuesday (10/29), the two banks jointly announced the deal as-is will be rejected by FSUN's regulators:

DENVER & SEATTLE--(BUSINESS WIRE)-- FirstSun Capital Bancorp (FSUN) (“FirstSun”) and HomeStreet, Inc. (HMST) (“HomeStreet”) announced that, based on discussions FirstSun and its subsidiary, Sunflower Bank, N.A. (“Sunflower”) have had with the Federal Reserve and the Texas Department of Banking, that regulatory approvals necessary for the mergers with HomeStreet and its subsidiary, HomeStreet Bank to proceed have not been obtained and FirstSun and Sunflower have been asked to withdraw their merger applications. FirstSun and HomeStreet are discussing the pursuit of an alternative regulatory structure for the merger. The parties are also discussing terms on which they would terminate the merger agreement if no alternative structure is feasible. There can be no assurance that an alternative regulatory structure may ultimately be feasible.

Rewinding time six months, following Q1 earnings, the two re-traded their merger agreement due to HomeStreet not adequately hedging their loan book as interest rate expectations coming into the year were for many Fed Funds rate cuts, but those expectations were scaled back significantly.  In that revised deal, FSUN also disclosed they were changing the charter structure of the primary bank subsidiary, Sunflower Bank, to a Texas state chartered bank that would be regulated by the Texas Department of Bank versus the OCC. 

Presumably the motivation behind the change was to get easier treatment after the OCC was embarrassed following the failure of New York Community Bank (NYCB) this past spring due to their significant rent-controlled NY multifamily exposure that had fallen in value (HMST has a large Class B/C multifamily loan book in Los Angeles County).

In FSUN's own words:

Neal E. Arnold FirstSun Capital Bancorp – CEO, President, COO & Director

"Let me also briefly explain the regulatory shift for us. We will remain a Fed-regulated bank holding company as previous. However, we've also decided to proceed with an application to have the pro forma bank also be primarily regulated by the Federal Reserve and the state of Texas Department of Banking.

After discussion with our respective Boards, we decided this is a better long-term path for the combined organization. We believe the Fed and the state of Texas have a firm understanding of our business and the nature of our CRE risks.

In our discussions with the OCC in Washington, it became obvious that we would not gain near-term approval given their recent experience with multifamily and CRE positions. We believe their position also resided in the fact that they were not the primary regulator for HomeStreet. The Fed is taking a very different approach, in part due to the changes we have made through the transaction. Our belief is that CRE is not the same across all categories and all geographies. And it's particularly distinguished when comparing West Coast multifamily and East Coast, New York multifamily. We've had a significant interaction with the state of Texas and the Fed, and we believe there's a pathway for this merger application to be approved."

Following this news, HomeStreet stock is down by a 1/3rd today to $9.30 per share.  To be clear, HomeStreet is still a mess, the bank is zombie that is just treading water with minimal net interest margin that is fully eaten up by their non-interest expense.  However, the loan and securities book seems to be at least credit-good, they've had minimal losses and FSUN along with their advisors have had a few different looks at it and have agreed (from the 5/1 call) :

Robert A. Cafera FirstSun Capital Bancorp – Executive VP & CFO

"So Matt, thank you for the questions. And yes, we are reaffirming the credit mark here. We actually had an outside firm assist us independent third-party review the portfolio at HomeStreet, and actually a sizable percentage of the portfolio, 75-plus percent there. And we would echo, market had made some comments on the underwriting of the HomeStreet portfolio. We would echo those comments relative to everything that we found through the process, both upfront and post announcement in terms of the strength of the underwriting on the portfolio here.

So we remain encouraged by the performance here. And as a matter of process on the underwriting side at HomeStreet practices, there is sensitivity analysis. We actually utilized our independent third-party to revalidate the sensitivity analysis side of what the credits would look like in the current rising interest rate environment. And all that led us to the same conclusion on credit mark."

And in HomeStreet's most recent earnings release:

"In the third quarter our ratio of nonaccrual assets to total assets and our total loan delinquencies remained low at 0.47% and 0.69%, respectively. Our credit quality remains strong and we have not identified any potentially significant credit issues in our loan portfolio.”

And previously in the merger break press release:

“We are disappointed that the regulators are unwilling to grant the regulatory approvals necessary for the merger to proceed,” stated Mark Mason, Chairman, President and Chief Executive Officer of HomeStreet. “Importantly, HomeStreet has been advised by its regulators that there were no regulatory concerns specifically related to HomeStreet that would have prevented approval of the merger.”

So while the rate environment hasn't been kind to these loans, it doesn't appear on the face they're in any real trouble of permanent losses as long as HomeStreet is able to hold.  The multifamily loans have an approximate 2.5 year duration, some are reaching their pricing date, its not a super long duration portfolio that will leave them stuck for years.  In a slide deck, HMST provided the below update:

They've got a plan to sell some MF loans, hopefully prove out the marks, and the last bullet makes it fairly clear they'd be open to another M&A transaction.  I still think it makes an attractive acquisition target as they're in attractive retail/deposit markets and an acquirer could buy HMST at a significant discount to tangible book and enjoy that accretion over time as loans mature.

Other thoughts:

• HMST puts out an "estimated tangible fair value per share" metric that attempts to fair value the loans and their debt (I might exclude the debt) to give a more mark-to-market look at book, it was $18.52 at 9/30, or about 2x the current share price.  GAAP tangible book value is $28.13 per share.
• Mark Mason is still in charge, he's a controversial banking figure for good reason, so that adds some hair to situation, his capital allocation skills are bluntly terrible.  In reading the deal proxy, it also appears that an ongoing role for him was an important consideration.
• Presumably, activist Blue Lion Capital (1.3% owner) is still around, they've been vocal about the deal, especially around change of control payments to Mark Mason.
• FSUN did raise capital already to make the deal work, points to their commitment to make the deal work, I wouldn't fully count out another recut transaction that would be at a nice premium to today's share price.
• In the original strategic alternatives process, HomeStreet did receive two other legitimate offers that made to the final round of bidding, one for $15.19 per share in cash and the other for $13.50 per share in cash.  Again, validating the idea that others have due diligenced this portfolio and that there should be buyers for HomeStreet if the deal with FSUN expires in mid-January without a newly structured deal.

While HomeStreet is certainly a far lower quality bank than First Horizon (FHN), the situation rhymes a bit in that regulators are blocking the deal for reasons largely outside of the target's control, as a result, the stock is forced sold by arbitragers possibly creating an opportunity to pick up shares on the cheap.  I bought a few more shares today.  But full warning, this is much riskier than FHN.

Disclosure: I own shares of HMST (also short some Nov $15 calls I wrote a few months back)

HomeStreet: BANC/PACW Style Merger with FirstSun, Cheap Proforma

This morning, FirstSun Capital Bancorp (FSUN) (~$850MM market cap) announced they were acquiring HomeStreet (HMST) (~$200MM market cap) in an all-stock transaction that includes a PIPE investment, lead by Wellington (being done at $32.50 per FSUN, or $14.12 per HMST), that neutralizes the mark-to-market impact of HomeStreet's balance sheet.  FirstSun is an insider controlled (69% insider ownership) C&I loan heavy bank that trades OTC with geographic concentration in Kansas, Texas, Colorado, New Mexico and Arizona.  FSUN will be the surviving entity, with FSUN management in charge (HMST's Mark Mason given a semi-ceremonial position as Vice Chair of the board) and be listed on the NASDAQ post "mid-2024" close, increasing the liquidity of their shares.

The credit quality of HomeStreet's assets has never really been in question, by re-marking them at current values, along with cost synergies, FirstSun will be able to enjoy outsized earnings in the early years of the deal.

HomeStreet shareholders will be receiving 0.4345 shares of FSUN for every share of HMST.  As I write this, there's actually a negative spread, likely because FSUN is OTC and illiquid, but the proforma entity is trading at approximately 5.9x next years estimated earnings, well below peer banks.

At 8x, still below peers but accounting for some of the overearning related to the marks, HMST would be worth $21/share.

I'm going to hang onto my shares, stick this in the same mental bucket as Banc of California (BANC) where a stronger bank takes over a weak one, extracts a lot of synergies and as we get closer to 2025, the market will start to recognize the new earnings profile of the combined bank.  I continue to like regional banks in today's market, for a few reasons:

1. With short terms rates likely coming down in 2024, banks will attempt to quickly reduce their deposit costs (100% beta) to protect their NIMs;
2. Commercial real estate exposure is generally overstated by the media/market, it will take a long time to play out giving bank's time to reserve and workout loans;
3. We'll continue to see a lot of mergers, banks need more diversified deposit platforms to extend deposit duration.

Any other banks out there ripe for a similar transaction structure?

Disclosure: I own shares of HMST

HomeStreet: Stressed West Coast Small-Regional Bank, Pursuing a Sale

HomeStreet (HMST) ($180MM market cap) is a small regional lender based in Seattle that flew a bit too close to the sun in 2021-2022 and is now facing increased borrowing costs as they rely heavily on wholesale funding (loan-to-deposit ratio above 110%).  Their net-interest margin has been squeezed, as a result, they're a barely profitable enterprise despite minimal credit issues (ROE currently ~3%, versus 11.5% in 2022).  I first came across HomeStreet after it was briefly mentioned on the Value After Hours podcast by the team at Seawolf Capital.  Last night it moved up my watchlist because Bloomberg reported that HomeStreet is pursuing a sale, but also open to an asset sale or capital raise.  The speed of these troubled bank tie-ups seems to be increasing and regulators appear more open to mergers (BANC/PACW is guiding to a quick 6-month close).  I would expect this process will have an expedited timeline.  The simple/quick thesis that would make HomeStreet attractive to a buyer capable of fixing their funding problem:

1. HMST trades for 1/3rd book value (~$9/share versus tangible book value at $27.50/share), despite having virtually no held-to-maturity portfolio and thus far, minimal issues in their loan book.  The tangible book number does include -$5.37/share of unrealized losses in the available-for-sale portfolio that will eventually burn off too.
2. HMST has an attractive footprint across Seattle, southern California, Portland and a few branches in Hawaii where the deposit market is dominated by local players.  A larger regional bank could come in and realize significant synergies, especially in the current environment where regulators/politicians are once again more worried about shoring up the financial system than saving jobs or blocking branch closings.
3. HMST is one of ~20 banks that has a license to originate and service multi-family loans under Fannie Mae's Delegated Underwriting and Servicing ("DUS") program.  This is an attractive franchise as Fannie Mae bears 2/3rds of the credit risk on a pro-rata basis while the lender maintains the relationship and associated servicing fees.

Other thoughts/risks:

• 36% of their loan portfolio is multi-family lending in California.  Multi-family has held up reasonably well, we're starting to see some cracks in transitional bridge loans that mREITs fund, but too early to tell if troubles will work their way up to the MF CRE bank debt.  Typically, a transitional bridge loan is taken out with long-term financing by a bank when a property is stabilized.
• Uninsured deposits were down to 7% of total deposits on 6/30, from 14% on 3/31, making a bank run here less worrisome (no venture or start up deposits), this is more a zombie bank that can't turn a profit or originate new loans.  HomeStreet is currently limiting lending to more niche floating rate products like construction loan and HELOCs.
• Capital allocation has been exceptionally poor, HomeStreet has been a big buyer of their own shares in recent years, typically at prices well above book value. In 2022 alone, HomeStreet bought back 7.3% of their shares at an average price of $50.97/share.
• HMST was recently kicked out of the S&P 600 small cap index which could have caused some forced selling pressure on the shares.  They also slashed the dividend significantly in April.

When a stock trades this cheap on a tangible book basis, the buyer can swoop it up for a huge discount, let's say 50% of book and still would be a 50% gain for the HMST equity.  I'm guessing this will be a stock-for-stock deal, so the realized premium might not be that big.  I bought some shares this morning.  Any other banks that need to make a deal?

Disclosure: I own shares of HMST