The banking industry experienced one of its first big deals of the year when the Phoenix, Arizona-based company Western Alliance Bancorp (NYSE: WAL) announced its intention to acquire AmeriHome, a national leader in the acquisition and management of business-to-business mortgages. Western Alliance will pay $ 1 billion in cash to AmeriHome, valuing the company at 140% of its tangible book value. Western Alliance will fund the acquisition with on-balance sheet cash and a future capital increase of $ 275 million.

It’s a bit of an interesting time to buy a non-bank mortgage service. But the agreement on paper and the rationale behind it seem to make sense.

How AmeriHome fits

The $ 36.5 billion Western Alliance Bancorp is a large commercial lender with very few residential loans. The bank also derives most of its income from net interest income through loans on its balance sheet. AmeriHome, which had been plans to go public before the acquisition, will help to diversify the bank’s income and possibly the composition of its loans.

AmeriHome’s core business is providing mortgages to consumers and purchasing mortgages from corresponding sellers, such as independent mortgage bankers, community and regional banks, and credit unions. But instead of keeping these loans on balance sheet and trying to earn net interest income from them, AmeriHome bundles these loans and sells them on the secondary market.

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However, AmeriHome retains the mortgage servicing rights for the bulk of these loans, which involves collecting mortgage payments on the loans and passing them on to investors. By selling the loans it purchases and initiating them in the secondary market as well as managing mortgage loans, AmeriHome generates fee income, which constitutes almost all of its income.

The acquisition of AmeriHome will change the composition of Western Alliance revenue from 95% net interest income and 5% fee income to 70% net interest income and 30% fee income. This will likely help the business to generate more consistent profits throughout the interest rate cycle, as commercial loans tend to be more profitable in a rising rate environment, while the mortgage industry enjoys a declining interest rate environment.

The Western Alliance management team also said on a recent conference call that AmeriHome’s more than 700 correspondent loan 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 short term, to deploy some of its excess liquidity.

Attractive financial data

The financial data for the deal certainly looks very attractive. Western Alliance expects the acquisition to increase profits by 30% in 2022, which means the bank’s post-acquisition profits will be 30% higher than the bank’s stand-alone profits would have been. in 2022. The deal will dilute the tangible benefits of Western Alliance. book value, but only minimally, and the bank expects to recover the dilution within a year.

Western Alliance also plans to increase its return on average tangible equity (ROTCE) by 5% in 2022 as a result of the deal. That’s a significant number, especially given that Western Alliance generated 17.8% ROTCE in 2020 and 19.6% in 2019, both solid returns.

The great thing that makes AmeriHome a much better operation within a bank than itself is that it can take advantage of the bank’s cheap deposits to fund its operations. As a non-bank entity, AmeriHome currently has to finance its loans and operations with higher cost borrowing.

Is there a risk ?

Hearing that Western Alliance had bought a mortgage services company from the get-go probably didn’t wow investors right off the bat. After all, Western Alliance has grown into a highly successful banking stock through its commercial lending activities. Why stray?

Additionally, while the transaction dramatically increases commission income, which investors normally view in a positive light, commission income from mortgage business can be volatile. When rates drop like they did in 2020, the business can be great as falling rates create a refinancing boom. But when rates go up, no one refinances. And buying mortgages is getting more expensive, although this is somewhat offset by the rising value of mortgage management rights in a rising rate environment. And who can say that mortgage activity hasn’t already peaked in 2020.

However, AmeriHome appears to have a strong model and a good technology platform in its direct-to-consumer business. The company grants mortgages to consumers and then sells those mortgages in the secondary market, while retaining the rights to administer the mortgages. AmeriHome then leverages real-time data to determine which of its customers would benefit from refinancing their mortgages and target those customers, which the company says is more effective 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 equity of nearly 18% over the past six years. This period also includes a fairly large fluctuation in rates.

A smart move from Western Alliance

I can certainly understand how some investors may not like Western Alliance getting into the mortgage business when commercial loans have always been the bread and butter of the bank. And there may be questions about AmeriHome’s performance if rates increase significantly. But the company has proven over the past six years that it can deliver solid earnings in a rising rate environment. In addition, the Federal Reserve’s fed funds rate has not exceeded 2.42% since 2008.

AmeriHome will make Western Alliance more profitable in a declining rate environment, and become more profitable as a unit as it can take advantage of Western Alliance’s cheap deposits to fund its operations. The increase in profits and the growth of ROTCE that Western Alliance expects to achieve through the deal are hard to dispute.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

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