The banking sector saw one of its first big deals of the year when the Phoenix, Arizona-based Western Alliance Bancorp (WAL 1.80%) announced its plans to acquire AmeriHome, a leading national business-to-business mortgage acquirer and servicer. Western Alliance will pay $1 billion in cash for AmeriHome, valuing the company at 140% tangible book value. Western Alliance will finance the acquisition with balance sheet liquidity and a future capital raise of $275 million.
It's a bit of an interesting time to be purchasing a non-bank mortgage servicer. But the deal on paper as well as the rationale behind it seem to make sense.
How AmeriHome fits in
The $36.5 billion Western Alliance Bancorp is a heavy commercial lender with very few residential loans. The bank also makes the bulk of its revenue from net interest income through loans held on its balance sheet. AmeriHome, which had been planning to go public before the acquisition, will help diversify the bank's revenue and potentially its loan composition as well.
AmeriHome's main business is originating mortgage loans to consumers and purchasing mortgage loans from correspondent sellers, such as independent mortgage bankers, community and regional banks, and credit unions. But instead of keeping those loans on the balance sheet and trying to make net interest income on them, AmeriHome pools these loans together and sells them into the secondary market.
However, AmeriHome retains the mortgage servicing rights to the bulk of these loans, which involves collecting the mortgage payments on the loans and passing them on to the investors. By selling the loans it buys and originates into the secondary market as well as servicing the mortgages, AmeriHome generates fee income, which makes up almost all of its revenue.
The acquisition of AmeriHome will change Western Alliance's revenue mix from 95% net interest income and 5% fee income to 70% net interest income and 30% fee income. This will likely help the company generate more consistent earnings throughout the entire interest rate cycle because commercial loans tend to be more profitable in a rising rate environment, while the mortgage business benefits from a falling rate environment.
Western Alliance's management team also said on a recent conference call that AmeriHome's more than 700 correspondent lending partner relationships will likely help the bank generate more residential mortgages to hold on its balance sheet. AmeriHome will help the bank, especially in the near term, deploy some of its excess liquidity.
The financials of the deal certainly look very attractive. Western Alliance expects the acquisition to be accretive to earnings by 30% in 2022, meaning that the bank's earnings after the acquisition will be 30% higher than what the bank's stand-alone earnings would have been in 2022. The deal will dilute Western Alliance's tangible book value, but only minimally, and the bank expects to earn back the dilution within one year.
Western Alliance also expects to grow its return on average tangible common equity (ROTCE) by 5% in 2022 as a result of the deal. That's a big number, especially considering Western Alliance generated a ROTCE of 17.8% in 2020 and 19.6% in 2019, both strong returns.
The big thing that makes AmeriHome a much better operation within a bank opposed to on its own is that it can take advantage of the bank's cheap deposits to fund its operations. As a non-bank, AmeriHome currently must fund its loans and operations with higher-cost borrowings.
Is there risk?
Right off the bat, hearing that Western Alliance bought a mortgage servicing business probably did not excite investors. After all, Western Alliance has become an extremely high-performing bank stock through its commercial lending business. Why deviate?
Additionally, while the transaction does significantly increase fee income, which investors normally view positively, fee income from the mortgage business can be volatile. When rates fall like they did in 2020, the business can be great because falling rates create a refinancing boom. But when rates rise, no one is refinancing. And purchasing mortgages become more expensive, although this is somewhat offset by the increasing value of mortgage servicing rights in a rising rate environment. And who's to say that mortgage activity didn't already peak in 2020.
However, AmeriHome appears to have a strong model and a good technology platform in its direct-to-consumer business. The company originates mortgages to consumers and then sells those mortgages into the secondary market, while retaining the mortgage servicing rights. AmeriHome then leverages real-time data to figure out which of its customers would benefit from refinancing their mortgages, and targets those customers, which the company believes is more efficient than trying to acquire new customers.
The strategy seems to have paid off. AmeriHome has generated positive net income every month since February 2015 and has produced an average return on average equity of nearly 18% over the last six years. This time period includes a pretty big fluctuation of rates, too.
A smart move from Western Alliance
I can certainly understand how some investors may not like Western Alliance jumping into the mortgage business when commercial lending has historically been the bank's bread and butter. And there may be some questions about how AmeriHome will perform if rates rise significantly. But the company has proven over the last six years that it can generate strong earnings in a rising rate environment. Also, the Federal Reserve's federal funds rate hasn't surpassed 2.42% since 2008.
AmeriHome will make Western Alliance more profitable in a falling rate environment, and will become more profitable as a unit because it can take advantage of Western Alliance's cheap deposits to fund its operations. The earnings accretion and ROTCE growth that Western Alliance expects to achieve from the deal are hard to argue with.