NYCB: The Bear Case Is Dead – New York Community Bancorp Inc. (NYSE:NYCB)

For shareholders of New York Community Bank (NYCB) who have stuck with the company for the past three years, the pressures on their bank have been exhausting. The liability-sensitive balance sheet, the inability to grow due to the SIFI threshold, a dividend cut, and the failed merger with Astoria Financial have all combined to give shareholders three years of terrible underperformance since late 2015. Even when banking regulators moved to lift the SIFI threshold to $250 billion from $50 billion last year, critics continued trashing the company due to the impact that rising short-term interest rates were having on net interest margins. Investors and commentators criticized NYCB management relentlessly, and New York Community Bank shares closed out on Christmas Eve 2018 at $8.78 per share, trading with a 7.75% dividend yield and at a massive discount to book value.

Congratulations to anyone who was able to stomach the pessimism and buy, because I have little doubt that last Christmas was the bottom for NYCB shares. The number one factor that was weighing on the share price – the assumption that interest rates would continue to rise rapidly – is now off the table. Fed funds futures are no longer pricing in any rate hikes, and multiple members of the Federal Reserve have indicated that they are now planning to pause and allow data to guide them as to what to do next.

With the shift in Fed funds futures taking rate hikes off the table, all of the other positives can now shine through for New York Community Bank. Even after a 40% rally off the lows, it’s not too late to get in.

ChartData by YCharts

Fed funds futures indicate minimal chance of rate hikes this year.

With the most recent Federal Reserve meeting that took place last week, the Central Bank left rates unchanged, as expected. Fed Chief Jerome Powell made clear that he wanted more data before considering further rate hikes, and this left Fed funds futures showing just a 10% possibility of interest rates rising for the remainder of 2019. As most market followers know, the Federal Reserve never likes to surprise the market. If it were even slightly leaning towards raising rates, it would be out making comments and giving speeches to prepare the market and to guide the Fed funds futures higher. So, with rate hikes off the table for now, how does that impact NYCB?

New York Community Bank’s net interest margins have declined from 2.93% in 2016 to 2.25% last year. This 68 basis point shift may not sound like much, but when it is calculated on a portfolio of $40 billion of interest earning assets, it equates to hundreds of millions of dollars of lost profit. The bank had been doing an incredible job of cutting expenses to offset this margin pressure and lost profit, but in spite of management actions, Wall Street traders only seemed to focus on net interest margins. This is typical of Wall Street. It’s almost as if there is an unwritten rule amongst fund managers that a liability-sensitive bank is not ownable if interest rates are rising, regardless of fundamentals.

But the fundamentals that were ignored for much of 2018, such as NYCB trading at a wild discount to book value, earnings per share being stable in the face of margin headwinds, and the stock trading with a giant dividend yield, are all completely relevant today. Only today, they are finally attracting investors because the threat of more interest rate increases is now off the table.

What would happen if interest rates actually were reduced in the future?

As we know, New York Community Bank’s net interest margins declined from 2.96% to 2.25% over the past few years. Margins could decline a little more this quarter, as current deposit costs are higher than some of the earlier time deposits that are now coming up for renewal. But once these last tranches of deposits renew at current rates, that’s it. All deposits should be priced at market levels, and funding costs will stop rising.

Meanwhile, new loans are pricing well above the ones that are rolling off, and NYCB has over $14 billion of loans approaching contractual maturity over the next three years that are priced more than 100 basis points below current rates. On top of this, we have balance sheet growth for the first time in five years. The result of all of this will first be margin stabilization, and that will occur this year. But assuming that interest rates actually decline going forward, all of the headwinds NYCB had been facing turn into tailwinds.

Typically, when the Federal Reserve lowers interest rates, they do it with much greater speed than when they increase rates. This is because they are usually cutting rates in response to a contracting economy. The math for calculating bank margins is the same in this situation, we just simply project falling deposit costs, which translate into higher earnings and higher net interest margins for New York Community Bank.

Without knowing the future, it’s impossible to predict the speed at which interest rates will decline in the next recession, but just to drive home the point, if we were to simply bring full-year net interest margins back to where they were in 2016, that extra margin on a $40 billion loan book translates to about $350 million of incremental pre-tax profit. And don’t forget that the loan portfolio is growing again, so a rising NIM will be even more beneficial than ever.

About that growing loan portfolio

Most investors are aware, but it still needs to be mentioned that up until 2018, New York Community Bank was purposefully not growing its asset base due to the $50 billion SIFI threshold. What many are not aware of is that the company had been selling around $1 billion of quality multi-family loans each year for the past five years in order to remain below this threshold. Now that the $50 billion SIFI threshold has become $250 billion, the bank has decades of growth ahead. Just in the months since the regulations were changed, NYCB added over $2 billion of assets. A quick look at the cash flow statement from last quarter shows the year-over-year decline in loans sold, which fell from $1.93 billion last year to just $35 million this year.

But in addition to the loans that are no longer being sold, the Specialty Finance division which operates up in Foxborough, Massachusetts, has been growing its loan book by double digits for years. This team of bankers, which NYCB brought on last decade, has been – to put into baseball terminology – batting 1.000. In the 25 years that they have been working, including the time before they were working for NYCB, they have had zero loan losses. It’s no wonder that New York Community Bank wanted to bring them under their umbrella, as one of the the hallmarks of the bank is its pristine loan quality and an obsession with not losing money or charging capital.

(Source: NYCB)

The interesting thing about this network of bankers working in the specialty finance division is that they typically reject about 95% of the loans that come across the table. Management has never commented about this, but I can’t help but wonder if the pace of loan growth could be significantly faster if, instead of accepting just 5% of loans, they were to accept 10-15%. I am not sure what the threshold is that would bring about the first loan losses, but there has to exist the possibility of conservatively accelerating loan growth within this division.

If we were to assume that New York Community Bank’s core multi-family loan portfolio grows by $2 billion per year, thanks to a combination of natural growth as well as no longer selling $1 billion of loans, and the specialty finance division continues growing at 20% per year, we could easily have $60 billion of assets within a few years.

Is an acquisition or a merger of equals on the table?

Up until the most recent conference call, the possibility of NYCB enacting a merger was completely off the table. After all, with most bank mergers, the currency used is newly printed shares from the acquiring bank. But with the share price trading at half of what it was trading for in 2015, and with NYCB shares trading at a massive discount to book value, management and the board attempting a merger would definitely raise some eyebrows.

Over the past six weeks, however, we have seen NYCB shares rocket back towards their $12.99 book value. We have also seen two Midwest banks, Chemical Bank and TCF Financial (TCF), as well as two very large banks, BB&T Corp. (BBT) and SunTrust (STI), agree to mergers of equals with minimal premium paid. These mergers, which are projected to bring double-digit EPS accretion to all, have sparked discussion about the possibility of New York Community Bank getting back into the market for another acquisition.

For anyone unaware, mergers are a huge part of the bank’s past success, as we can see in the slide below.

(Source: NYCB)

Typically, New York Community Bank will identify an acquisition target. In order to limit the potential for loan losses, it will also arrange to sell or dispose of most of the target bank’s assets, while keeping its low-cost deposits to repay more expensive wholesale borrowings. While I would prefer to see NYCB complete its buyback and show some traction on earnings to get its own currency even higher before targeting a bank, CEO Joe Ficalora commented on the most recent conference call that there are potential targets out there that would be happy to agree to a no-premium, all-stock merger because they view NYCB shares as significantly undervalued.

Critics of management won’t agree with me, but I am certain that company management will not destroy shareholder value in any transaction. After all, CEO Joe Ficalora and CFO Tom Cangemi are two of the largest shareholders, together owning over 8 million shares of stock. This brings me to my next point.

Critics of NYCB management are not thinking clearly

For the past few years, I have watched an ever-larger number of New York Community Bank observers make excessively harsh comments about management. They often suggest that management is clueless, that they should sell the bank, that they should retire, that the board should fire them, and so on. Amazingly, none of these critics seem capable of bringing facts to the table (other than a share price that has been declining) to support their argument. Rarely do critics acknowledge the constraints that the SIFI threshold put on management. Rarely do these critics acknowledge the truly unique set of circumstances that New York Community Bank was operating in until last year, with margin pressures from rising rates and no ability to grow to offset the declining interest income. And rarely do these critics recognize the absolutely fantastic job NYCB management did navigating this nightmare operating environment.

If we look at things such as efficiency ratios and non-interest expenses, we can better see what I’m referring to. Most banks operate with an efficiency ratio significantly higher than New York Community Bank’s ratio, which historically is in the mid-40%’s range. We can also look at non-interest expenses over the past couple of years. Remember, without the ability to grow assets, management could not offset declining interest income. But non-interest expenses are very controllable. In the past year, non-interest expenses declined from an annualized run rate of around $660 million to the low-$500 million range. The impact of these cost savings to the bottom line is the equivalent of adding about $7 billion of income earning assets at a 2.25% NIM. Earnings per share have remained stable, yet critics are not impressed.

Management also worked with the board and implemented a cash flow-positive, debt-funded buyback. With $300 million of newly issued debt costing 5.9% before taxes and shares yielding 7.5%, NYCB was very aggressive in buying in its shares while they traded below $10. Critics should note that this buyback was not just another typical buyback to deploy excess cash. It was a perfectly timed, aggressively implemented buyback that absolutely nailed the bottom.

With every share that was repurchased, cash flow is retained for the company. Assuming New York Community Bank enacts a merger later this year using their stock as currency, this buyback will very likely be proof of management buying low and selling high – something that everyone claims they want to do, yet so many fail at.

By controlling expenses, management was able to offset the earnings decline from net interest margins and maintain earnings per share well above the dividend payout. By taking complete advantage of the insane discount NYCB shares were trading at very recently, management was able to lower the bank’s total dividend payout, making the payout per share even more sustainable. They did this while critics shouted that dividends would have to be cut. They did this while people trashed them and their conservative management style. It’s a shame more banks don’t act like New York Community Bank.

It’s not too late to get in

With NYCB shares rallying nearly 40% since Christmas Eve, many might be wondering if it’s too late to buy. I would argue emphatically that it is not. These types of impressive rallies are indicative of shorts covering and smart money piling in. These early buyers are very aware that this is the trade to make now that interest rates are on pause. They just weren’t going to be first ones to jump in.

With assets now likely to double, or even triple, over the next decade through both organic growth and banking mergers, New York Community Bank is now once again a growth company. With the stock price improving, it is highly likely that NYCB will, at some point, use its shares as currency to take over another bank’s deposit base. It will most likely dispose of the target bank’s assets and redeploy the funds into NYCB’s conservative, bread-and-butter multi-family loans as well as its specialty finance loans.

At some point, interest rates will fall, likely as a result of a weakening economy. Falling interest rates mean margin expansion for the first time in years. A weakening economy means more opportunity for New York Community Bank to take over failing banks, such as the FDIC-brokered AmTrust transaction back in 2009. For the first time in recent history, the stars have aligned and New York Community Bank has a very bright future. I would use any dip as a buying opportunity if I weren’t already overloaded with NYCB shares. As readers may know, I used the late-2018 selloff to massively increase my position in New York Community Bank. The trade was simply too easy. It didn’t require a leap of faith at all. This is perhaps the safest bank in the banking universe. The stock has already rallied 40% from its lows, and it is not even to book value yet. I look forward to a decade of prosperity and growth.

Disclosure: I am/we are long NYCB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short NYCB Puts.

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