New York Community Bancorp (NYCB -0.67%) kept the wave of regional bank consolidation going with its recent announcement that it plans to acquire the Michigan-based Flagstar Bancorp (FBC). The deal will create an $87-billion-asset institution with a presence mainly in the Northeast and Midwest. It also makes meaningful progress toward NYCB CEO Thomas Cangemi's main goal of transitioning the bank from its current thrift model into the more typical commercial banking model that has become popular today.

Breaking down the deal 

NYCB is a nearly $58-billion-asset bank that operates largely in New York, but also has a presence in New Jersey, Ohio, Florida, and Arizona. Nearly three-quarters of its loan book is in multifamily lending. The bank has long operated on a thrift model, meaning much of its loan portfolio is composed of fixed-rate loans, while much of its funding comes from higher-cost deposits and borrowings.

The thrift model, which has really fallen out of favor with investors, has made NYCB liability-sensitive. That means that unlike most banks today, the bank actually performs better in an environment of falling interest rates, where the cost of its funding reprices downward along with the benchmark federal funds rate, while many of its fixed-rate loans maintain their yield. 

Flagstar Bancorp is a nearly $30-billion-asset bank that operates in Michigan, Indiana, Wisconsin, and Ohio, and has a small presence in California. It runs a big mortgage operation that flourished last year in the falling-rate environment that drove record profits in the mortgage industry. Flagstar last year generated a 29% return on average tangible common equity, which is just superb.

People standing together in a board room.

Image source: Getty Images.

NYCB plans to purchase Flagstar in an all-stock deal that values the bank at $2.6 billion, or 115% tangible book value (equity minus intangible assets and goodwill). If you're a Flagstar shareholder, that probably seems like a very low premium right now with many bank valuations at all-time highs and with Flagstar coming off a strong year. But keep in mind that Flagstar, because of its incredible mortgage earnings, grew tangible book value more than 41% between the end of the first quarter of 2020 and the end of this most recent quarter. That is a ton of growth. Additionally, mortgage banking income is not valued as highly as other sources of income, because it's cyclical.

NYCB shareholders are probably pretty happy with this price tag because the acquisition didn't dilute their equity, but rather grows equity right away upon closing of the deal by 3.5%. It also is 16% accretive to its earnings in 2022, meaning that after the acquisition is complete, NYCB's earnings are expected to be 16% higher in 2022 than they would on a stand-alone basis. Additionally, NYCB will be able to maintain its high $0.68 per common share dividend, giving the bank a dividend yield of 5.4% at its recent price of $12.53 per share, which is also a huge increase for Flagstar shareholders.

Becoming a commercial bank

Remember, part of Cangemi's grand plan is to really change the bank's loan and funding mix, and this acquisition does take meaningful steps in that direction.

On the lending side, the acquisition brings down NYCB's reliance on multifamily lending from 75% of its total loan portfolio to only 56%. It also adds Flagstar's mortgage warehouse lending business and makes the combined bank asset sensitive, meaning the bank will see more net interest income when the Fed raises rates.

Loan Portfolio of combined bank.

Image source: NYCB and Flagstar investor presentation.

On the funding side, Flagstar gives NYCB roughly $10.8 billion in sticky, zero-cost non-interest-bearing deposits, which are the best kind of deposits a bank can have. It also lowers NYCB's heavy reliance on borrowings from the Federal Home Loan Bank and higher-cost certificates of deposits. Overall, the acquisition reduces Flagstar's total cost of funds by 17 basis points (0.17%).

NYCB cost of funding.

Image source: NYCB and Flagstar investor presentation.

Now, even after the Flagstar acquisition, I still wouldn't call NYCB's funding base good. Its cost of funds is still quite high in this zero-rate environment, and more than 40% of its funding is still from FHLB borrowings and certificates of deposits. Additionally, commercial and industrial (C&I) loans -- those to businesses, which usually bring in high-quality deposits -- will still only make up less than 10% of total loans at the new bank.

A good start, but work to do

The acquisition of Flagstar is a big move for NYCB, but still just one step in the larger process. To get that 40% of higher-cost funding down, the combined bank will need to bring in better deposits. The good news is all banks have a lot of liquidity right now, so hopefully NYCB can start by running off more than $3 billion of its FHLB borrowings that will mature this year. Watching how quickly NYCB can run down these wholesale deposits will be important.

Then the combined bank will need to increase its C&I operations to attract more relationship lending. Cangemi certainly seems committed to this, and NYCB has already been focused on turning more of its existing banking relationships into deposit relationships or fee income opportunities. But the fact is that every bank wants C&I loans, and these could be harder to get than the bank realizes. The good news is the bank will soon be $87 billion in assets, giving it a large presence and a lot of the resources it needs to hopefully expand into more holistic commercial relationships.

While there is undoubtedly a lot of work to do, the acquisition is certainly a very meaningful step in the right direction. NYCB, which is not trading at a high premium, managed to score a big acquisition that makes progress on its goals without diluting its tangible common equity, or having to reduce its attractive dividend yield. Furthermore, the bank is starting to create a very clear story for investors to follow on how it can finally turn itself around. And all of this certainly deserves some recognition.