Ready Capital Corporation (RC) Q2 2019 Earnings Call Transcript

Ready Capital Corporation (RC -0.46%)
Q2 2019 Earnings Call
Aug 08, 2019, 8:30 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Thank you for standing by. This is the conference operator. Welcome to the Ready Capital Corporation second-quarter 2019 earnings conference call. [Operator instructions] And the conference is being recorded.

[Operator instructions]. I would now like to turn the conference over to Andrew Ahlborn, chief financial officer. Please go ahead, sir.

Andrew Ahlborn -- Chief Financial Officer

Thank you, operator, and good morning. And thanks to those of you on the call for joining us this morning. Some of our comments today will be forward-looking statements within the meaning of the federal securities laws. Such statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect.

Therefore you should exercise caution in interpreting and relying on them. We refer you to our SEC filings for a more detailed discussion of the risks that could impact our future operating results and financial condition. During the call, we will discuss our non-GAAP measures, which we believe can be useful in evaluating the company's operating performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP.

A reconciliation of these measures to the most directly comparable GAAP measure is available in our second-quarter 2019 earnings release and our supplemental information. By now everyone should have access to our second-quarter 2019 earnings release and the supplemental information. Both can be found in the Investors section of the Ready Capital website. I will now turn it over to Tom Capasse, our CEO.

Tom Capasse -- Chief Executive Officer

Good morning, and thank you for joining our second-quarter earnings call. During the quarter, we began to see the benefits of the incremental purchasing power added with the Owens merger. We had record combined origination and acquisition activity and made significant progress, increasing earnings contribution from steady net interest margin. Additionally, the growth in core levered yields in the operating segments brought the company a step closer to our stated goal of a steady 10% ROE.

In the quarter, originations and acquisitions of small balance commercial loans totaled $835 million, increasing portfolio loans or those producing stabilized net interest margin by 20% to $3.1 billion. Acquisition activity included a $320 million legacy loan portfolio purchased opportunistically from a bank. Unlike the highly competitive large balance commercial real estate debt market, our growth was achieved without sacrificing spreads or credit quality. Average spreads in our fixed and transitional products were 310 and 390 basis points, respectively, and average credit metrics of loans secured by stabilized properties included loan to values of 64%, debt service coverage ratios of 1.4x and debt yields of 10%.

As part of our strategy to increase net interest margin and allocate capital to the highest yielding segments, our trading team acquired $42 million of loans from collapsing legacy, Small Balance Commercial, MBS, in addition to the $320 million legacy loan bank purchase for a total -- a record total for the quarter of $362 million. These purchases our primarily low loan-to-value, performing legacy loans from banks, with weighted average coupon slightly higher than our originated fixed product. The majority of the quarter's acquisitions were securitized in the quarter, providing a stable low- to mid-teens ROE. As a supplement to stabilize revenue from net interest margin, our gain on sale businesses also performed well.

SBA 7(a) originations increased 22% to $54 million, and Freddie Mac multi-family originations increased 16% to $73 million. Loan sales generated revenue of $4 million and our average sales premium on SBA 7(a) loans rose 130 basis points to 10.9%. Significant headway was made turning over the Owens portfolio. The combination of asset runoff and leverage on the Owens loan portfolio provided $107 million in investable proceeds.

Returns on allocated equity for the Owens segment were 500 basis points below the 11% companywide average, resulting in a 125 basis point drag to consolidated ROE. We remain focused on keeping operating expenses rightsized in the business. In the quarter, increased scale resulted in a 230 basis point reduction in our operating expense ratios. Operating leverage resulted in revenue growth of $5.5 million, while fixed costs in the small balance commercial segments experienced only marginal increases.

While we expect fixed cost to remain materially consistent in the upcoming quarters, variable costs, particularly in the loan underwriting processes, will fluctuate with volume. We remain committed to implementing strategies to run the business efficiently and cost effectively. As discussed in the first quarter, we introduced three new loan products, including a larger peri passive SBA loan, a fixed rate 7(a) loan, and a fixed rate small balanced commercial transitional loan, with slightly higher rates with increased prepayment flexibility. These new products represent a small fraction of the quarterly volume, but we expect them to contribute on the margin in upcoming quarters.

Additionally, we continue to evaluate expansion beyond our existing platform. On the agency side, we're actively pursuing growth beyond our Freddie Mac small balance loan license into other products, either by directly owning a diversified portfolio of licenses or through joint ventures. We also expect to expand both our origination and acquisition businesses in Europe. We will be -- we will have more concrete news to share in the upcoming quarters.

Now in terms of funding the business. Our capital markets' execution remain strong. First, we completed our third transitional loan -- collateralized loan obligation, pricing a $320 million deal at a weighted average cost of LIBOR plus 133. Second, we securitized the $320 million legacy loan pool, completing a $300 million deal with senior bonds, pricing at a fixed rate of 2.9%.

Third, we continue to improve pricing on our warehouse facilities. In the quarter, we renegotiated terms on certain facilities, reducing pricing 30 basis points and increasing advance rates 5%. And lastly, subsequent to quarter end, we priced a $57.5 million seven-year unsecured note at 6.2%, our best execution in the public markets to date. On the heels of a corporate ratings' upgrade to BBB, we were able to extend term and reduced pricing from previous issuances.

Proceeds are expected to fund our pipeline for the remainder of the year. Depending on future volume, we anticipate completing additional fixed rate SBA and floating rate transitional CLO securitizations in the second half of the year. Headed into the second half of the year, acquisition and origination pipelines remain strong, approaching $1 billion. In our SBC portfolio lending segments, the close in money-up pipeline equals $305 million.

In our gain on sales segments, the total closed in money-up pipeline equals $335 million. Additionally, the acquisition pipeline remains healthy at $323 million. Now a few comments on the market. First, the recent unexpected rally in the 10-year treasury will likely improve the competitiveness of the Freddie Mac SBL program versus banks, while reducing fixed rate small balanced commercial volume as the floor on the AAA-rated small balance commercial, ABS, renders the small balance commercial rate less competitive with banks.

This underscores the ability of Ready Capital's product diversity to absorb rate volatility. Second, a paradox in this economic cycle is the impact of extremely tight labor markets on demand for small balance commercial space that is under 50,000 square feet. Net small balance commercial absorption was flat in the first quarter, hitting a 34 quarter low as small businesses cannot hire to expand -- higher labor to expand. In a March NFIB Small balanced business poll, 90% of small businesses looking to hire reported few to no qualified workers to fill open positions.

This contributed to a healthy 4.5% year-over-year growth in SBC property rents in the first quarter. SBC originations also remained strong with 2018 marking the sixth consecutive year of $200 billion plus volume. Now on the flip side, reduced building purchase demand from the tight labor market, along with the flattening yield curve, rendering bank fixed rate business loans less competitive with prime-based SBA loans, reduced SBA volume 9% year over year for this SBA 6-month ending June. However, Ready Cap's SBA volume is up 1% over the same period.

I'll now hand off to Andrew to discuss our financial results.

Andrew Ahlborn -- Chief Financial Officer

Thanks, Tom. Before talking through highlights on some of the slides included in the supplemental information deck, I'd like to discuss a few of the financial statement items this quarter. On a GAAP basis, earnings for the quarter were $0.25 per share. Core earnings for the quarter were $0.37 per share, the biggest difference being a $0.14 per share decline in the fair value of our residential mortgage servicing rights portfolio.

The growth in core earnings is attributable to a $8.3 million increase in net interest margin, a 39% growth in residential mortgage banking income and continued contribution from our joint venture investments. Return on average stockholders' equity grew 80 basis points sequentially to 8.8%, marking continued progress toward a long-term stabilized 10% ROE. Keep in mind, as Tom pointed out, the Owens portfolio represents headwinds of about 125 basis points on ROE, and we expect those assets to wind down over the next 12 to 18 months. Currently, 26% of the original $131 million loan portfolio has paid down with the remaining loan portfolio, generating a 10% levered return in the quarter.

Additionally, we have sold or are in contract to sell $24 million of the original $77 million REO value acquired. As of June 30, $112 million of net legacy Owens assets remain on the balance sheet, representing 15% of the outstanding equity. As Tom highlighted, investment activity in the quarter was significant, with quarterly originations and acquisitions of $835 million, portfolio loans are those expected to produce stabilized net interest margin, grew 20% to $3.1 billion. Other key balance sheet items include the securitization of over $620 million of SBC loans, new investments in joint venture opportunities and the purchase of mortgage-backed securities from a recently launched flow program.

The increase in accumulated other comprehensive losses relates to the hedging of our fixed rate portfolio. Amounts attributable to closed hedges will amortized into interest expense over the duration of paired securitized debt. The $8.3 million quarter-over-quarter growth in net interest margin was due to a $6.1 million increase in interest income from portfolio loans, a $1.7 million contribution from the Owens loan portfolio and marginally higher loan payoffs. The $800,000 increase in provision for loan losses relates to specific reserves on two SBC properties as well as increases to the general reserve due to a change in portfolio allocation.

Other revenue sources also experienced significant growth in the quarter. Net residential banking revenue increased 39% due to a $176 million in additional volume quarter over quarter. Other income was up due to an increase in origination fees correlated to volume growth and the addition of net operating income from the Owens REO portfolio. Turning to the earnings deck.

Slide 3 sets forth key items and metrics for the quarter. Of note is the continued strength in investment activity. The benefits of having a diversified origination and acquisition platform are evident as volume contributions were significant from each channel. Slide 4 shows the composition of the company's return on equity and an 80 basis point increase in core ROE to 8.8%.

As indicated in Q1, we increased equity allocation to the acquisition segment from 18% to 29% as more capital is deployed into accretive acquisition opportunities. Improvements quarter over quarter include 110 basis point increase in core levered ROE, and a 230 basis point reduction in operating expenses. As we have said, headwinds from the legacy Owens portfolio are estimated to be 125 basis points. Slide 5 summarizes our SBC investment activity over the previous five quarters, with further details on the current quarter -- quarter's activity provided on Slide 6, each of which includes acquisition activity.

Each product line experienced sequential quarterly growth, with total investment activity growth of 80% and a $500 million increase in portfolio loans. Slide 7 summarizes our SBC origination segments. Portfolio growth totaled 15%, and we remain optimistic by the stabilized leverage yields and low delinquencies. The Q3 pipeline is robust, with $113 million closed through July 31 and another $385 million money up.

Slide 8 covers the activities of our SBA segment. Increases in gross leverage yields were driven by optimizing leverage on the loan portfolio and increased returns on loan sales due to a 130 basis point increase in sale premiums. Slide 9 shows summary information for the acquired portfolio. This segment continues to provide stable double-digit levered yields, further supported by variable gains from our joint venture investments.

In the quarter, we purchased over $360 million of loans, securitizing the majority before quarter end. Slight declines in weighted average coupon were accompanied with an increase in weighted average maturity and a rebalancing of the portfolio favoring floating rate notes. Slide 10 highlights the activities of our residential mortgage business. Mortgage banking activities, supported by an attractive rate environment, experienced significant growth quarter over quarter.

Quarterly volume increased 50% and margins increased by approximately 70 and 30 basis points in our third-party and retail channels, respectively. A 41 basis point decline in the 10-year resulted in a $6.3 million writedown of the MSR, as model prepayment speeds increased 50 basis points. We expect considerable volume in Q3 with $218 million closed in July, breaking previous monthly highs. Slide 11 summarizes the credit performance of our securitizations across each of our product lines.

Performance across all originated products remain strong with minimal delinquencies. The next few slides are similar to those presented in previous quarters and reflect the diversity of our loan pools, the composition of our capital structure and various liquidity sources. Now I'll turn it over to Tom for some final thoughts before we take questions.

Tom Capasse -- Chief Executive Officer

Thanks, Andrew. We believe the quarterly results to be reflective of ready capital's ability to deploy capital across our five lending products as well as source investment opportunities in the secondary markets. We have positive momentum heading into the second half of the year and remain optimistic about redeploying the remaining Owens equity into levered returns consistent with the company's other operating segments. The increased scale of the business, along with a substantial pipeline, will bring the company closer to our long-term target, 10% return on equity.

Thank you for your time and continued support. We remain confident in Ready Capital's ability to provide a competitive risk-adjusted return for our investors with its differentiated approach and business model. Operator, we'll now open it up for questions.

Questions & Answers:

Operator

Thank you, sir. [Operator instructions]. Our first question comes from Jade Rahmani with KBW. Please go ahead.

Jade Rahmani -- KBW -- Analyst

Thanks very much. It sounds like pipelines are extremely strong on -- across all of your businesses. The 10% stabilized ROE, over what time frame do you expect to achieve that? Is it contingent upon the Owens portfolio, legacy assets being sold over the next 18 to 24 months?

Andrew Ahlborn -- Chief Financial Officer

Jay, this is Andrew. Yes, I think that's one component of it. Through Q2, we had liquidated or were in contract to sell roughly 30% to 35% of the REO portfolio. We're actively marketing the other sort of 50%.

So as we move through that, we'll be able to deploy that capital back into levered returns similar to our other operating segments. And that 125 basis point drive that we mentioned will continue to decline. The other thing I'll point out is a lot of the investment activity in the quarter was back ended. The large acquisition happened in the end of May and origination volumes really ramped up toward the end of the quarter.

So we should see additional net interest margin flowing from those investments. So absent any other onetime items that we're not aware of, I would say we're getting closer to that 10% ROE, quicker than we may have otherwise expected. So I guess, those are my thoughts on that.

Jade Rahmani -- KBW -- Analyst

And in terms of the earnings trajectory for the rest of this year, do you anticipate earnings exceeding the dividend in the back half?

Andrew Ahlborn -- Chief Financial Officer

I think we're focused on covering the dividend over the third and fourth quarter.

Jade Rahmani -- KBW -- Analyst

Can you also comment on two other items? One, credit performance in the quarter and perhaps give some color on historical collateral recovery values in the small balance series space because, I think, it's -- in this space, many folks are not that familiar with. And secondly, just the impact from lower rates, how that would affect the business?

Andrew Ahlborn -- Chief Financial Officer

Sure. Maybe I'll start off with specific credit performance in our portfolio and then turn it to Tom. We had a few specific loans go liquid in the quarter, two in our SBC fixed rate business, one in a regional mall in Oklahoma. That note is since in contract to be sold at minimal losses.

The other is an office building in Greenwich, Connecticut, where their main tenant vacated the building upon expiration of the lease. That borrower is currently working to repurpose the property into a multi-family or even an apartment building. So we're working with him through that. Expected losses on that property have already run through the reserve.

We also experienced a handful of SBA loans acquired in the CIT acquisition, where the business closed, and we've writtn those loans down to expected recovery. Absent that, we've seen credit performance remained stable quarter over quarter.

Tom Capasse -- Chief Executive Officer

Yes. Just to kind of, Jade, the market backdrop to that, in terms of where we are with small balance commercial loans in the credit cycle, this asset class, remember $5 million large, look at it, we define it as on average of $5 million appraised value for the property and less than 50,000 square feet, that market is much more correlated with housing. In fact, the correlation of the box would mean small balance commercial index to the -- Case-Shiller is 0.8. So we're about three to four years behind the large balance market in terms of the credit cycle.

And I'll throw out two metrics. One is the cap rate for large balance properties is currently around 6.25. With respect to SBC, it's more like 7% and some -- seven and some change, about 100 basis points higher. And the other aspect is the Case Shiller, which are the larger bounce Moody's increased index is about 100 -- it's about 50% to 70% coming, depends on which asset class you look at over the 2007 peak, a small balance index -- price index is just in the last few quarters and following housing attained the '07 peak.

So from that standpoint, if -- that's where we see. Small balance commercial credit is going to be a good place to hide when the recession comes. The last question you had is rates. The rally in the 10-year treasury is definitely going to impact our Freddie business in a positive fashion because it makes -- from the multi-family and small balance perspective, it makes the GSE execution much superior to banks flooding off of deposits, 5-to 7-year type of loans.

The flip side, it will affect the fixed rate program because that -- or fixed rate conventional program, because that's funded in the ABS market. And there you have a dynamic where the senior debt is kind of floored at, call it, 2.5%. So that would make it less attractive. So well, that's one of our reasons we like our platform, because it's hedged, if you will, against some of the volatile rate movements we see in the treasury market.

Jade Rahmani -- KBW -- Analyst

And have you quantified what a 50 to 100 basis point decline in LIBOR would impact earnings by?

Tom Capasse -- Chief Executive Officer

Yes. Absent volume in our fixed rate business, we're going to see declining cost in our warehouse period. Spreads or margins in our transitional products remain flat. So we think we're positively correlated with a decline in rates.

As Tom said, it's going to affect different volumes and different product lines differently.

Jade Rahmani -- KBW -- Analyst

OK. I think your 10-Q last I checked showed, I think, about a $1.4 billion to $1.8 million decline in NIM for 50 to 100 basis point decline in rates, which is quite manageable. It's about one -- about 2% of earnings or so and volumes could possibly make up for that. Thanks for taking the questions.

Operator

Our next question is from Tim Hayes with B. Riley FBR. Please go ahead.

Tim Hayes -- B. Riley FBR -- Analyst

Hey. Good morning, guys. Thanks for taking my questions. My first question, your New York concentration in the SBC portfolio increased by a good amount this quarter. Just wondering what types of assets are backing the loans there and of the amount that is multi-family, if you anticipate being impacted at all by recent rent regulation legislation or were able to maybe take advantage of some cap rate widening in light of that?

Tom Capasse -- Chief Executive Officer

Yes, Tim, the -- basically, we're obviously focused on small balance multi-family in a maximum of -- I think it's 50 units. So as some of it may be workforce housing. But generally speaking, the whole issue with rent stabilization and the New York law that was passed, which some experts are saying affect large balanced properties by a decline of up to 15% in valuation, that does not at all affect our market because ours are basically small properties that don't utilize these -- don't rely on rent stabilization as a significant factor in the in the NOI generation. I think, Andrew, what was the total ...

Andrew Ahlborn -- Chief Financial Officer

Yes, so Tim, if we look to the portfolio and our balance sheet loan exposure is $10 million. There's two properties that are subject to rent stabilization, very low LTVs. We think the effect of the law on those properties are pretty minimal. We also have about $10 million of exposure in our Freddie bonds.

So overall, on the total portfolio, it's really the de minimis.

Tim Hayes -- B. Riley FBR -- Analyst

OK. Appreciate the update there. And then also, appreciate the update on the resi mortgage banking volumes you gave in your prepared remarks. Just wondering how gain on the sales have been tracking so far in Q3 relative to the second quarter?

Tom Capasse -- Chief Executive Officer

Yes. Sorry, Tim, specific to the resi business or other?

Tim Hayes -- B. Riley FBR -- Analyst

Yes. Specific to Resi.

Tom Capasse -- Chief Executive Officer

Yes. I think we're going to see increases in the quarter. Our margins, I believe, are up about 15 in July compared to June. So given increases in margin, increases in volume, we expect Q3 to be strong in terms of that.

In terms of our other products, Freddie sales were actually down in Q2 and not due to volume, but due to just timing of sales and timing of origination. So we would expect that Q3 sales of our Freddie products be stronger than Q2. And SBA volume is tracking higher than it was in Q2 as well. So overall, I would expect that revenue from gain on sales to increase quarter over quarter.

Tim Hayes -- B. Riley FBR -- Analyst

OK. Glad I asked that. Got a little bit more color than I was bargaining for, so appreciate that. And then income from the JV, maybe a little lighter than it's been tracking on average on a quarterly basis.

I know it can be volatile. But just curious if that's a reflection of lighter repayment activity and if there's any sensitivity to interest rates that could drive earnings there in the near term?

Tom Capasse -- Chief Executive Officer

Yes. The JV investment is really supported by a portfolio of nonperforming loans. So the volatility there is more due to take outs of those loans rather than performance affected by interest rates. So as loans are liquidated or paid off, we'll see incremental gains.

That's really the driver there.

Tim Hayes -- B. Riley FBR -- Analyst

OK. Got it. And then just one more for me. I'm just curious how pricing competition currently looks between Freddie and Fanny small balance programs and if you anticipate any headwinds there in the near term? And then I know you mentioned that being one of your strategic initiatives, trying to expand kind of your agency exposure there, but whether it's JVs or I know you've talked about acquiring a Fannie license in the past or -- and/or team, just curious if you can give an update to that initiative and how any conversations that are going on?

Tom Capasse -- Chief Executive Officer

Yes. Just on two counts. On the first count in terms of the Fanny versus Freddie pricing in the small balance space. I'll point out that the way the GSEs operate they are subject to caps by the FHFA, roughly $35 billion, I think.

And however, these are not subject to the cap, and they've been running on a large balance subject to the cap, they've been running ahead of the -- where they were year over year, I think it's up about 20%. So there is a bit of some volatility in terms of market share, pricing between the two on the non cap products like the small balance. So what happened in the first quarter, Fannie dropped the rates very, very significantly, causing the -- what we've -- as discussed in first quarter, the drop-off in Freddie volume. But then, I think, was maybe a month ago, they kind of whipsawed -- Fanny kind of whipsawed it, and raised rates again.

So that in turn triggered a -- an increase in our Freddie pipeline and volumes. So you'll continue to see -- well, we don't think you'll see that much of volatility going forward. I think there's a little bit more rationalization between the two in terms of secondary market pricing. And then as far as the -- looking at expanding the agency platform, we continue to engage with a number of counterparties, and we'll have more concrete developments there, I think, over the next quarter or two.

Tim Hayes -- B. Riley FBR -- Analyst

OK. Great. Thanks for the color there and thanks for taking my questions.

Operator

Our next question comes from Scott Valentin with Compass Point Research. Please go ahead.

Scott Valentin -- Compass Point Research -- Analyst

Thanks for taking my question. Just a question around leverage. I'm looking at Page 14 on the presentation, it looks like total leverage is, kind of, climbs up a little bit, almost four times. I'm just wondering how you're thinking about leverage going forward, maybe what your upper limits are for leverage?

Tom Capasse -- Chief Executive Officer

Yes. So the number that we really focused on is the recourse number. We're trying to keep the business at or below two times. So the $1.8 million is creeping up toward that limit.

What I'll say is, in inventory right now, we have substantial amounts of acquired fixed and transitional loans that we expect to securitize by the end of the year. So as we do that, that ratio should decline. The total leverage, which is made up mainly by the consolidation of our securitized portfolio, is going to creep up as we produce more of them in any given year. But we're really focused on keeping that recourse leverage ratio below two.

Andrew Ahlborn -- Chief Financial Officer

The other thing I would add to that is that with respect to the gross leverage ratio, which is 3.9 times, our portfolio of $3 billion is very granular. It's more like an asset-backed securities portfolio, in a sense that, I think, the average balance is roughly -- it's under $1 million, especially with the recent acquisitions of some of the legacy loan pools, which have average balances in the $400,000 range, for example, that $320 million pool that we acquired. So -- and given the -- the credit metrics and the fact that from a credit in terms of where we are in the cycle and this product specifically, the punch line is we can bear a lot more gross leverage than let's say, a large balance commercial REIT that's financing $150 million, $500 million transitional loans, and where the top 10 loans are multiples of their net equity. So just one broad comment in terms of the amount of leverage, how we think about leverage from a gross leverage perspective.

Scott Valentin -- Compass Point Research -- Analyst

OK. That's helpful. And then just kind of, I guess, a housekeeping question. On tax, how should we think about tax rate going forward? I know you had some benefits the last couple of quarters.

Just wondering, I think, 6% was kind of a number we were using, I don't know if that's still relevant going forward?

Tom Capasse -- Chief Executive Officer

Yes. The biggest difference between I think tax is going to be the decline in the residential mortgage bank, the resi servicing rights. As rates continue to move lower, I would expect unrealized losses to increase there. So to the extent we have those losses, you're going to see a positive provision such where -- I think that's the story this year in terms of tax.

Scott Valentin -- Compass Point Research -- Analyst

OK. Thanks. And then just in terms of mortgage banking, I know you mentioned gain on sale margins look pretty healthy and volumes are healthy. How should we think about on the expense side, is there kind of a ratio you guys look for when you think about revenue to variable expense for the mortgage bank?

Tom Capasse -- Chief Executive Officer

Well, yes, -- we -- the GMFs is extreme. The management team there is very experienced at managing the ratio of variable versus fixed costs in the context of the inherent volatility in mortgage originations. And so for example, I think, last year, they reduced expenses I think...

Andrew Ahlborn -- Chief Financial Officer

10%.

Tom Capasse -- Chief Executive Officer

Yes, exactly, 10%. So they're very good at using outsourced underwriting and closing to manage the volatility and originations. And beyond that, I point out that they -- given the size of their servicing book, which is now...

Andrew Ahlborn -- Chief Financial Officer

Almost $8 billion.

Tom Capasse -- Chief Executive Officer

Yes, $8 billion. They have a really good match between the change in the value of the MSRs in relation to the gain on sale from production, as you see it with the recent volatility in the 10-year.

Andrew Ahlborn -- Chief Financial Officer

Yes. I would point out the ratios, you can calculate off of the income statement in Q2 are probably going to remain consistent. I think there's a slight increase in margins in July. But by looking at the residential mortgage banking activities over the variable expenses and the noninterest expense, I think it should give you a pretty good idea where we're going.

Scott Valentin -- Compass Point Research -- Analyst

OK. That's helpful. Thanks for taking my questions.

Operator

Our next question comes from Stephen Laws with Raymond James. Please go ahead.

Stephen Laws -- Raymond James -- Analyst

Hi. Good morning. A couple of follow-up questions on the resi banking and maybe if we can start more of a macro level. Rates have come down a good bit. I'm surprised to see that the purchase refi split, frankly, hasn't changed that much year over year.

It's going from about 80-20 to 75-25. Can you maybe talk about why that's the case? Is it the footprint from the old GMFS that's largely in the southeast with lower home prices? Or can you maybe talk about why we haven't seen a bigger pickup in refi volume, even though we've seen a big pickup overall in volumes. I think it's the largest quarter since Q2 of '17. So...

Tom Capasse -- Chief Executive Officer

Yes. We think it's really the market, to us, we were surprised that the refis haven't increased as well. We think it's due to the size of the properties, the concentration of the market. Well, also, I would add to that, GMFs has a -- they use a lot of radio and direct consumer focus on the purchase market, the realtors, the homebuilders, and that's been one of their strong suits for years.

So there has been a pickup in -- on a macro basis in housing starts in their footprint, Louisiana, Alabama, Mississippi, so that -- that accounts for the somewhat divergence with the national average. And again, we view that as a positive because they're less dependent on the movements on the 10-year treasury to feed -- to generate gains on sale.

Stephen Laws -- Raymond James -- Analyst

Great. And that leads me right to my next question, which is the rate. We've seen the 10-year rally quite a bit, but mortgage rates last week seemed to have frozen. So it seems, kind of, a basis widening there.

But do you think mortgage rates continue to drop, given where the 10-year is? Was the drop in the 10-year simply so sudden that mortgage rates haven't had time to react? Or have we reached the glass floor, where that's just where people are lending, and it's just kind of not going below that? And how do you see that shifting from here?

Tom Capasse -- Chief Executive Officer

I'm sorry, are you referring to residential mortgage rates or to commercial?

Stephen Laws -- Raymond James -- Analyst

Residential. Just -- I mean, for simple 30-year fixed-rate mortgage rates by -- just seem to not have moved last week, even though the 10-year drops have been 30 or 40 basis points in the last couple of weeks.

Tom Capasse -- Chief Executive Officer

Yes. I mean, since the credit crisis, the dynamics of the movements in 10-year treasury is such that it tends to immediately be reflected into the market, that, let's say, it dropped 50 basis points, the first 25 will be immediately reflected, and then it have a somewhat lagged effect for the next 25 basis point move. So I think we don't expect the basis point for basis point correlation at this point in terms of where the absolute treasury yields are and in relation to the mortgage rates.

Stephen Laws -- Raymond James -- Analyst

Great. And then a little longer term, some news a couple of weeks ago about the QM patch expiration in 2021, Calabria's comments seem to be that he's committed to letting that occur, although given the size of the market, it's likely some phase outs of that QM patch. But when you think about that, how much, if any, of your volume do you think is being done under that? Are you -- would you look to add some other product offerings where maybe you're doing non QM loans and looking to the private market instead of the GSEs for that? Or kind of how do you think about transitioning the business over the next 18 months ahead of the QM patch expiration?

Tom Capasse -- Chief Executive Officer

Yes, it -- the QM patch, which -- our view is we recently were at actually meeting senior executives at Fannie and Freddie, our view is that it's going to be extended for -- they already set six months beyond the 2021 date and because of transition and others, as we think it's really a 2022 proposition. But that being said, it doesn't really have a material impact on our company because GMFS is only, as of this quarter, was 8% of net equity. So that -- we -- so given that, with that one caveat, we are looking at with our external manager, Waterfall Asset Management, we have a -- they have a number of products they're rolling out on the non-agency side, that we're looking to plug into GMFS as well. And they have experience prior to the credit crisis as a non-agency all-day lender.

So right now, they're extremely profitable in their core GD-Fannie-Freddie footprint. But they do -- they do have some differentiated products, like new FDA and VA But -- so that's a long in way of saying that we will look at non-agency products going forward. But again, it is only 8% of the net equity of the firm.

Stephen Laws -- Raymond James -- Analyst

Yes. Thanks for the color there and the clarification. I realized it was under 10%, but I certainly think there's an opportunity there for private mortgage investors and good to see you guys are ahead of the curve there, working with Waterfall, your managers. So that's it for now.

I'll save some housekeeping stuff for later, but I appreciate you taking my questions.

Operator

Our next question is from Christopher Nolan with Ladenburg Thalmann. Please go ahead.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Hey, guys. On the 10% ROE target, how much of that is from reinvesting the ORM? How much is from higher leverage? How much is from lower operating expenses?

Tom Capasse -- Chief Executive Officer

Yes. We expect operating expenses to stay relatively flat quarter over quarter. The 125 basis point drag from Owens we expect to decline as we liquidate that portfolio over the next 12 to 18 months. And then the remainder, as I said before, the majority of what we bought in Q2 was on -- was back-ended.

So I would expect that the net interest margin contribution from those purchases to be incrementally higher in Q3 than they were in Q2. And given where our pipelines are, particularly in the acquisition and transitional loan product, I would expect sequential growth in net interest margin from those products as well. So the majority of it is probably going to come from increase in NIM, followed by the liquidation of the Owen's portfolio, reducing that 125 basis point drag.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

So Tom, given that the core ROE is 8.8 and Owens puts a 125 basis point drag on it, that gets you to 10%. And then if you get higher leverage, that should increase it a little bit above that. So is it fair to think that 10% ROE is sort of a floor target can go above that?

Tom Capasse -- Chief Executive Officer

We say that, that's our -- we think that's achievable based on the current cost structure of the business and the target leverage ratios and the investment pipeline and capacity that we currently have.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

OK. Thank you.

Operator

Our next question is from Crispin Love with Sandler O'Neill. Please go ahead.

Crispin Love -- Sandler O'Neill + Partners, L.P. -- Analyst

Hi, guys. Thanks for taking my questions. You've talked about having a focus on growing Ready's net interest income businesses and growing net interest income, which was definitely evident during the quarter. Do you have a target net interest income you'd like to get to for 2019? And do you also think that the second-quarter run rate for NII is a good starting point as we look to the back half of the year? Or is there any reason why it should soften at all?

Tom Capasse -- Chief Executive Officer

Yes. In terms of the first question, we're trying to migrate toward maybe 70%, 80% of our revenue coming from stabilized income, so some combination of net interest margin and servicing income. So that's really where we'd like to move toward. And do you remind -- mind repeating the second part of your question?

Crispin Love -- Sandler O'Neill + Partners, L.P. -- Analyst

Do you think that the net interest income that we saw in the second quarter, is that a good run rate going forward? Or is there any reason why you think that would come down? I think it was -- if you look at NII before the provision, around $21.3 million in the quarter, it was definitely a big pickup from last quarter.

Tom Capasse -- Chief Executive Officer

Yes, I think that's a good run rate. Marginal increases came from larger payoffs in Q2. So there's going to be a little volatility in those payoffs as we get to accrete the discount. But given that we purchased the majority of -- and originated the majority of the loans in -- on the back half of the quarter, I would expect incremental growth from that activity as well.

So I think that the 21 -- 22 is a good run rate.

Crispin Love -- Sandler O'Neill + Partners, L.P. -- Analyst

OK. And then on the SBA gain on sale, it seemed as if it was pretty high during the quarter and higher than what we've seen for the last few quarters. I think it was around 10.9% or so. Can you comment on what you think drove that? And then also what you've been seeing on SBA gain on sales during the third quarter.

Tom Capasse -- Chief Executive Officer

So yes, the -- there is some level of volatility in the secondary market -- new -- sorry, the pooling market for SBA government-guaranteed securities. They typically run from nine to as much as 14 points. The average is around where it is today, 11. It declined more recently in the third and fourth quarter of last year and to some extent, first quarter of this year, due to higher-than-expected prepayments from bank competition that emerged in that -- some of these -- late in the cycle, these banks have become deposit rich and they're looking for avenues to grow loans.

So we see some of them being aggressive versus the SBA product. So that seems to have kind of petered out in terms of SBA prepayments on the 7 (a) loans, and that was reflected in turning in better execution this quarter. But again, it is -- at 10.9% or 11%, that's roughly what the average is over the last three to five years.

Crispin Love -- Sandler O'Neill + Partners, L.P. -- Analyst

Guys, thanks for taking my questions.

Operator

This concludes the question-and-answer session. I would like to turn the conference now over to Thomas Capasse for any closing remarks.

Tom Capasse -- Chief Executive Officer

Thank you, and we appreciate everybody's support and look forward to talking again in the third quarter.

Operator

[Operator signoff]

Duration: 52 minutes

Call participants:

Andrew Ahlborn -- Chief Financial Officer

Tom Capasse -- Chief Executive Officer

Jade Rahmani -- KBW -- Analyst

Tim Hayes -- B. Riley FBR -- Analyst

Scott Valentin -- Compass Point Research -- Analyst

Stephen Laws -- Raymond James -- Analyst

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Crispin Love -- Sandler O'Neill + Partners, L.P. -- Analyst

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