Description

Long NYCB Series A 6.375% Pfd

A long position in the NYCB A $25 par preferred is both a cheeky play on lower interest rates and an attempt at free-riding on the recent $1bn common equity capital injection. The thesis is that in 12 months time the bank should be profitable on a quarterly basis, normalizing the debt component of the capital structure. As tail risk recedes due to increased profitability, the bank’s credit stack should re-rate first before anyone needs to believe in sustainably high RoEs for the common equity. The investment is ‘free-riding’ in the sense that preferred holders should reap the benefit of the increased common equity capital beneath them and higher loan loss reserves without incurring principal haircuts, as the cost of the recapitalization was overwhelmingly borne by the preexisting common shareholders.  Key points are that peak uncertainty has passed, management & Board have been replaced, institutional private equity with nonpublic information have underwritten the loan book, and all that remains is for the turnaround plan to take hold. The relevant statistics on the preferred issue at hand: 6.375% coupon through 3/17/27; floating coupon thereafter at 3m+3.821%. $515mm issue size.

New York Community Bank (NYCB) was a sleepy Queens, NY thrift for the last hundred and fifty years or so. Their primary niche was lending to NYC area rent-regulated apartments funded by local deposits, often sourced from the same Queens/Brooklyn families that owned the apartment buildings. In March 2023 they gained nationwide attention for purchasing $38bn of assets from Signature Bank when Signature failed during the mini banking crisis of the same year. This transaction set NYCB on the fateful journey above $100bn in total assets and into Category IV regulatory status. The following article contains a good deal of the colourful regulatory history at NYCB, but suffice it to say that all the long-standing regulatory chickens came home to roost at once at year-end 2023 when NYCB underwent its first full year review as a $100bn+ asset bank. (https://www.reuters.com/markets/us/us-regulators-greenlit-nycbs-rapid-growth-even-with-red-flags-2024-03-07/)

As any reader of the financial press knows, NYCB got into trouble immediately thereafter in January 2024. By trouble, we mean an out-of-court recapitalization process and miniature run on the bank. After a headline roller coaster ride during the first two months of the year, in March a veritable Who’s-Who of financial sector private equity investors stepped in to provide $1bn in fresh equity and revamp the organization, replacing management and the Board. The financial backers include Liberty Strategic, Hudson Bay, Reverence Capital, and Citadel. Importantly, they installed a management team and board full of heavyweight players in bank regulatory circles - specifically former secretary of the US Treasury Steve Mnuchin and former Comptroller of the Currency Joseph Otting. Between their investments in common equity, convertible preferred stock, and warrant coverage, the investor group has for all intents and purposes taken control of the bank.

As of early August, off-the-cuff we would peg the turnaround as being 25% done. The majority of the relevant loan loss reserves have been booked (on office CRE lending in particular) but several quarters of SME/commercial loan origination and deposit repricing are needed to restore the income statement to profitability. Fed rate cuts greatly assist this process. The preferred stock should appreciate towards par as soon as it’s evident to most that further equity capital will not be required. We would expect that the income statement will reach breakeven or small profits in the vicinity of 3Q’25, although decreasing losses in the interim should help give the market confidence on the trajectory.

The turnaround thesis:

• Deposit costs fall: Base rate cuts by the Fed, most likely starting in September, will help reduce NYCB’s cost of deposits. Given the mini bank run in early 2024, NYCB is a high rate payor with their 5-5-5 product. Essentially they needed to backfill the lost deposits by paying at the very top of the rate table for insured deposits. As market rates fall they should see significant benefit given their high cycle-to-date deposit beta (e.g. the highest cost deposit products which approximate the Federal Funds rates should fall 1:1 with FF as opposed to lower rate checking / savings accounts paying a small fraction of FF)

• Asset yields increase: Reinvestment of cash balances into SME/commercial lending will increase NIM. The business plan has a large amount of asset repricing built into it given back book / front book repricing dynamics on loan portfolio, as well as mix shift within loan types (e.g. from CRE into C&I). Specifically treasury assets and multifamily lending from 2019 and earlier will be reinvested at significantly higher rates going forward. Finally the C&I loan origination efforts will also bring operating deposits from the commercial lending relationships.

• Loan loss provisions decline from 2024 levels. We’d suggest that although losses on NYC office lending are likely to be as bad as feared, the large quantum of reserves already built should cover most of the upcoming chargeoffs on loan maturities. Office lending is one of the asset classes where the new private equity sponsors were able to do property-level loss analysis based on rent rolls, maturities and current market conditions (as opposed to conditions at loan origination), and NYCB holds one of the largest office reserves in the country.  Losses on NYC rent regulated apartments are likely to be a good bit less than is commonly assumed by the buyside (“these buildings are zeroes”).  Given the maturity schedule of both the office and apartment loans, the bank has significant time to work out the problem assets.

• Having just put in $1bn of equity, the private equity sponsors are unlikely to walk away quickly in the event of moderate credit deterioration from here. In fact, they underwrote significant credit deterioration as part of the investment case and reserving.

• Management has laid out the timing and quantity components of their restructuring plan (e.g. how much they will make and when they will make it) reproduced below. If one believes these forecasts are at least halfway right, the Series A preferred is a buy.

• In our opinion the dominant variable in the forecast, and the one with the widest range of outcomes in the eyes of market participants, is loan losses: specifically expected losses on rent regulated apartments. 

  • Unlike every other real estate asset class, the concept of vacancy is not the primary risk in rent regulated apartments (because rents are all well below market rate, ensuring demand). The primary issue is inflation driving expenses above the allowable increase in rents. Falling inflation in the next few years would be a massive boon to NOI as rents increase. As of June 2024 allowable rent increases are 2.75% on one-year stabilized leases and 5.25% increases on two year leases. (https://therealdeal.com/new-york/2024/06/17/nyc-rent-guidelines-board-approves-2-75-rent-hike/)

  • Fed rate cuts and lower inflation / lower term premia should bring down longer term rates that form the basis of cap rates and building valuation. Falling cap rates rebuild borrower equity in the properties and lower funding costs. 

  • Given the ~40% drop in property values on average since 2019, tax assessments based on property value should also fall considerably. Taxes are the largest component of building operating expenses, so decreases in taxes significantly increase property level NOI.

  • Borrowers generally have considerable financial assets that can support the properties; during the last 40 years of falling interest rates, property values rose considerably in NYC. Every 5 years or so for the last few decades property owners would refinance their buildings with a new loan at the same LTV (generally 60%) but take considerable cash out of the building given the increasing property value.  Many years of wealth extraction has given the owners the means to keep the loans current should they want to. Avoidance of tax bills given very low historical basis in the properties, land value optionality, and expectations regarding falling interest rates (higher values and lower lending rates) and tax abatement (higher NOI) in the future are the reasons property owners give when asked why they continue to pay down debt balances. 

  •  Because of the above points, we believe that losses on rent regulated apartments are likely to be very manageable for NYCB, allowing the bank to work out its exposure to the asset class over time.

NYCB management forecast:

NYCB rent regulated apartment exposure:

In conclusion we think the NYCB A pfd is an interesting investment that stands to benefit nicely over the next 12 months as the new management team undertakes their restructuring plan. That plan should disproportionately benefit from falling interest rates, and we would expect the bank to reach income statement breakeven during 2025. The main risk is credit losses on rent regulated apartments, but that risk is contained to buildings with 100% rent-regulated mix and then spaced out over time, allowing the bank to use pre-provision profitability to work through any issues. 

Addendum on rent regulated apartments:

The core issue with rent regulated apartments is a 2019 NY law that mandated rent increases at rates lower than inflation, in the process squeezing NOI because expenses rose faster than income. The same law also removed many of the pathways for owners to transition rent regulated units to market rent units over time, removing one of the usual escape valves for adverse rent increases. Historically banks considered these buildings among the safest of all commercial real estate exposures because the regulated rent level was so far below market rates - vacancy was literally never an issue, so the cash flow projections had close to zero volatility through economic cycles. After the enormous economic and monetary stimulus of 2020 boosted US inflation, property expenses in these buildings increased at rates much higher than rent. Compounding this issue, interest rates rose significantly, causing fully amortizing debt service coverage ratios to drop below 1.0 when the fixed rate period ended after 5 years. Consequently the popular conception of these assets has swung dramatically from “zero loss content” to “all rent regulated buildings are zeroes” in the last few years. The reality is much more nuanced - many rent regulated buildings contain a mix of market rate apartments and rent regulated apartments. Given the large jump in market rate apartment rents, increases on the market units are typically sufficient to carry the profitability of the overall building. Hence this addendum focuses on 100% rent regulated buildings, where the problems reside. 

Loan structure: The overwhelming majority of loans in NYCB’s rent regulated portfolio are 10 year term with a 30 year amortization schedule. According to the company the interest rate on a typical loan was generally fixed at treasuries + 250bps on average for the first 5 years at the time of origination. At the end of the 5 year initial rate term, the borrower has the option to either 1) refix the loan to a new fixed rate based on the 5 year rate at the time (+250bps), or 2) let the loan revert to a floating rate (3m SOFR +250bps). The loans on the back book carry an average coupon of ~3.9% given historical treasury rates. Recent 5yr fixed rates have been around 6.5% and floating rates are ~8% so the repricing jump is significant. We’d suggest that the borrowers paying the higher floating rates are the ones in a position to cover principal amortization out of pocket for a while, and are choosing floating rates on the expectation of Fed rate cuts. We’d note that NYCB is also repricing loans at treasuries+350bps where possible (e.g. on maturity of the original 10 year term or in exchange for concessions granted to borrowers). 

Market wide property values: 4.1% was a typical cap rate at the time of loan origination, and high 5s to 6% are current cap rates. Recent transaction data suggests 40% declines in property values on average. 

Market wide costs: the largest cost by far for rent regulated apartments is property tax. Rent regulated buildings command the highest tax rates among NY property types, and as values have fallen significantly in the last 4 years many borrowers are pursuing tax abatement at the current market values. 

Source: New York City Rent guidelines board price index of operation costs

Stylized / Hypothetical rent controlled building numbers: although NYCB is seeing borrower NOI increase by an average of 3-5% on refix, we are showing a reasonably bad case loan outcome below for 100% rent controlled properties (e.g toughest cases). 

Source: Piper Sandler and industry conversations, tax assessment decreased in line with property values

So what is actually happening as the 2019 vintage loans come up for refixing? 

May conference call: “In the bullets, you'll note that we expect about $2.6 billion of our multi-family book to reprice in 2024. I mentioned an expectation of about $4 billion in total. We've had very good success with repricing of our existing portfolio over the last 15 months. We had $2.1 billion of loans that have repriced. About 1/4 of those have actually paid off at the repricing date and the other 3/4 have repriced up to current market rates, and we've seen almost no delinquencies to date. In other words, the borrowers have been able to cover that service in spite of the elevated level of interest rates.”

July conference call: “Over the past 18 months, we had $2.9 billion, almost $3 billion of our multi-family rent- regulated loans that have hit their reprice dates and as I mentioned, strong payoffs there. Almost a fourth of those loans have paid off. 69% have repriced and this is an important statistic. When they reprice, they reprice to an average of 8.19%. That's up from 3.85%. That trend will continue and that'll have a significant upside into our net interest margin on a go-forward basis”.

In conversations with the company, they note that property level NOI is not actually down 10% on average in their portfolio (as is commonly asserted), but on average has increased 3-5% from 2019. The surprise has been the degree to which landlords / equity owners have been able to clamp down on operating costs. (Insert joke here about 40 year old stovetops).  As the loans approach refixing, typically the loan officers will approach the building owners ahead of time to ask them to contribute more cash / equity to pay down the debt balance to restore the LTVs and DSCRs. Given that many of the buildings have low income tenants, a number of the properties qualify for refinancing with the various affordable housing programs at the GSEs. Hence borrowers are choosing to refinance away from NYCB at lower rates in government programs. Most of the owners are families that have owned the properties for decades if not generations and manage them full time, and they have no desire to sell the properties as they would incur a significant tax bill given low basis. Also, many of these owners received a significant amount of Covid stimulus payments in addition to their other financial assets, and so choose to either pay down the loan - either in lump sum form or an as-you-go basis to cover that year’s shortfall to fully amortizing DSCR (e.g. that year’s scheduled principal payment). Given the relatively modest shortfall of NOI to full DSCR ($20k per year in the example) compared to the long term optionality on land values, interest rates, property tax abatement, and rent reform, the borrowers are incentivized to keep the properties current. Many of the buildings also have street-facing retail units whose rental income is sufficient to cover the debt payments, which is not included in many stylized models on loan refinancing including the one above.  As a result both NYCB and other area banks have seen close to zero foreclosure proceedings on these assets. 

NPLs: A reasonable objection to our characterization of rent-controlled credit quality above is the second quarter jump in multifamily NPLs from 339mm to 794m. The explanation is that NYCB has taken a very forward looking approach to credit quality: for loans refixing over the next 18 months they ordered updated appraisals for all buildings with a DSCR <1.0 at current market loan rates. If the updated LTVs on those loans was in excess of 100%, they declared the loans non-performing even if the borrower remains current on (pre-refixing) payments. NYCB also preemptively undertook partial charge offs on loans with updated LTVs in excess of 100% to reduce the loan balance to the appraisal value less transaction costs to sell. The amount of net charge off required as a result of this exercise was relatively low compared to the balance of the loans (76mm of NCO vs 794mm loans classified as NPL) - indicating that low initial LTVs on multifamily properties are providing decent protection for the lender even on problem assets in sharp contrast to office lending where management undertook the same exercise. This forward looking exercise has pulled the majority of 2025 expected losses into the present period.

As a side note: Regarding the increase in multifamily loan delinquencies from 103mm to 893mm in 2Q, 700mm of that amount was related to a short-term delay at quarter end from a few borrowers and the loans subsequently cured 3 weeks later in July. 

Addendum on NYC office loans:  NYCB started the year with 3400mm in office loan exposure or 3.8% of total loans. 3.8% is at the high end of US regional banks, who have office CRE at 2.0% of loans on average. However as of 2Q, NYCB has already taken forward-looking net charge offs and reserves of 16.5% against this exposure which puts them at the high end of peers’ loss allowance coverage. We’d note that the private equity consortium had time to review/diligence 80%+ of the total office loan portfolio given its obvious risks and the granular nature of the loan book. Of course, it can always be worse. Using the very high end of expected office default probabilities from KC Fed research (30% PD) and a 60% loss-given default, one could argue that the loan loss reserve should be 18% which would approximate some of the worst loan loss rates realized during the GFC for an overall asset class. The incremental 150bps of allowance would require ~50mm in incremental provisions realized over the next ~7-8 years given the loan maturity schedule. Given the starting 61% LTV on the office portfolio, 60% LGD implies ~75% effective price decrease versus original underwriting values. To be clear, their office lending book (54% of which are in Manhattan) is definitely not good. However it’s simply unlikely to be a big enough problem vis a vis the existing reserve coverage to change the outcome for the preferred stock. 

Chart 3: Expected default rates on office properties increased with property size

https://www.kansascityfed.org/research/economic-bulletin/banks-commercial-real-estate-risks-are-uneven/

NYCB office CRE maturities as of 12/31/23

Catalyst

breakeven in 2025