The COVID-19 pandemic created a boom in mortgage banking, which in turn is creating new opportunities for many banks.
In the early days of the pandemic, the Federal Reserve cut interest rates to 0%. This reduction kicked off a refinancing wave that turned into a record year for mortgage originators. One of the banks taking advantage of the new conditions is Western Alliance (WAL 6.58%). Once known mainly as a niche lender to mortgage banks, Western Alliance recently made some major acquisitions that constitute a significant bet on the sector. Will they pay off?
Western Alliance has historically concentrated its loan portfolio on commercial and industrial (C&I) loans. Last year, C&I loans accounted for almost 53% of Western Alliance's loans held for investment. Commercial real estate accounted for about 29%, and residential mortgages represented 9% of its loan book.
In the past few months, Western Alliance bought two mortgage originators: Galton Funding and Amerihome. Amerihome focuses on more traditional mortgage products, mainly loans that are guaranteed by Fannie Mae and Freddie Mac. Galton focuses more on the non-traditional mortgages that aren't guaranteed by the U.S. government. Between Galton, Amerihome, and Western Alliance's own retail operations, the company is now one of the leading originators in the U.S.
Recent changes from the Federal Housing Finance Agency (FHFA) have opened up an opportunity for a new subset of loans that are generally compliant with Fannie Mae and Freddie Mac guidelines (hence, pretty low-risk) but aren't guaranteed by the government. Many of these loans are for second homes and investor properties. These loans are generally referred to as "non-QM" (non-qualified mortgages), and they have attractive risk-reward characteristics. Western Alliance is targeting that market, and CFO Dale Gibbons discussed it on the earnings call:
What we're also going to be getting from AmeriHome is we're going to be able to have a kind of ready deployment into mortgages that we would want to put on our balance sheet. And we prefer to have something that is low LTV but higher-yielding, which pushes you toward kind of a non-QM solution, which they're going to be rolling that product out as well.
Aside from mortgage banking, Western Alliance offers warehouse financing, a lucrative niche product that serves mortgage bankers. Warehouse loans are basically bridge loans that allow a mortgage banker to fund a loan and then sell it. Once it receives the proceeds from the loan, it pays off the warehouse bank. These loans are typically short-term (two to three weeks), they generate fees up front, and they charge an interest rate of 3% to 4%. Since the loans are secured by salable mortgage loans, the risk of credit losses is small. CEO Kenneth Vecchione considers warehouse lending a "strategic weapon" for the bank, as he put it on the recent earnings call.
Western Alliance is growing faster than its peers
While mortgage banking and ancillary services to the industry will be a larger part of Western Alliance's future, the bank is still growing at a rapid pace. In the first quarter of 2021, total assets rose 49% year over year to $43.3 billion. Revenues rose 29%, and earnings per share (EPS) more than doubled year over year to $1.90 per share. Note that the year-over-year earnings growth is somewhat exaggerated, driven by significant current expected credit losses (CECL) taken early in 2020, along with sizable provisions for COVID-19-related credit losses.
Western Alliance stock has been on a tear, outperforming the SPDR S&P Bank ETF substantially over the past year. Its stock has more than tripled since the bad early days of COVID-19.
Western Alliance grew tangible book value (TBV) per share by 25% year over year, and its five-year growth rate in TBV has been three times that of its peers. The bank trades at 14 times expected 2021 EPS, which is more or less in line with peers like US Bank. The dividend yield is on the small side compared to the big banks, but it is using its capital to fund growth.
Going forward, Western Alliance's increased focus on mortgage banking should provide additional growth opportunities. If it securitizes and sells its mortgage production, it generates fee income. At the same time, Western Alliance should be one of the first movers in the emerging market for non-government guaranteed mortgages.