While there are a lot of positives about the proposed merger between New York Community Bancorp (NYSE:NYCB) and Astoria Financial (NYSE:AF) the deal does have some downside and it poses a few challenges.

Astoria, which is the junior partner in the deal, is not as efficient with its loans and that could cause problems for NYCB and dull its edge over the competition.

On this video segment, Motley Fool's senior banking specialist John Maxfield comments on this deal's downsides.

Listen to the full podcast by clicking here. A full transcript follows the video.

 

Gaby Lapera: There are some problems however. As you mentioned earlier, New York Community Bancorp is pretty famous in the banking world, I guess, for having an absolutely amazing efficiency ratio of 46%. Now for efficiency ratios, the lower they are the better.

Astoria Financial is coming into this deal with an efficiency ratio of 74% and a big part of that could possibly be traced to the fact that Astoria tends to outsource its mortgage origination. New York Community Bancorp is really careful about who it lends to and then that helps keep its costs down because they don't have to write off loans. And they do most of that process in-house and that means that they have a greater incentive to make sure that the loans they write are good.

Since Astoria outsources its mortgage origination, the people who write those loans maybe don't have as much of an incentive to make sure that the loans are going to be definitely fulfilled.

John Maxfield: Yeah and there are a number of negative aspects of the deal if you're a shareholder or prospective shareholder. That is definitely ... I would say that's one of the top three. But you know, if you think about it, one of the things that you mentioned is the fact that New York Community Bancorp's efficiency ratio ... and just to be clear the efficiency ratio, what this does is it takes a bank's operating expenses or its non-interest expenses and it divides those by its net revenue.

So this tells you what percentage of net revenue is being consumed by operating expenses. The corollary of this is that it tells you what percentage of net revenue is then free to pass the bottom line, or cover loan loss provisions, or pay taxes or distribute to shareholders, right? So a lower efficiency ratio is a better efficiency ratio.

Well New York Community Bancorp's has always been in the 40-50% range which is an extremely low ratio when you consider that even great banks like US Bancorp, Wells Fargo; their ratios are in the low 50% range. And I mean these are really well-run banks.

Well the problem is that with New York Community Bancorp bringing Astoria Financial and its 75% efficiency ratio, 74% efficiency ratio [...], that it's going to dilute that really large competitive advantage of New York Community Bancorp. And the other problem -- and this is the point that you're getting to with Astoria Financial outsourcing its mortgages.

So Astoria Financial, it's based in the New York area as well, which is a benefit to New York Community Bancorp in this merger. But the problem is that its balance sheet -- the majority of the assets on its balance sheet are residential mortgages. And where does it get those residential mortgages? My reading of its financial statements is that it outsources the majority of the origination of those mortgages to other banks or other mortgage brokers and then purchases those mortgages.

What we have seen throughout the years most recently in the financial crisis, and we saw it again in the 1980s with really the first too-big-to-fail Bank Continental Illinois, it did the same thing. These banks got into trouble by having other people make the credit decisions on the loans on their balance sheet. And the problem with that is that the bank that keeps that loan on its balance sheet has the most incentive to make sure that it's underwriting a really, really good loan.

It's not a guarantee that outsourcing your mortgages or your lending operations is going to be a bad thing, but it certainly increases the possibility that there's going to be a problem down the road with your loans. And that really, if you're going to look at the negative or the thorns if you will of this deal from the perspective of a New York Community Bancorp shareholder, those in my opinion are really it.

Gaby Lapera has no position in any stocks mentioned. John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short January 2016 $52 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.