'Scale Matters': Expanding in Mortgages as Others Pull Back

Michael Daly is still enamored of the mortgage business.

Daly, chief executive of Berkshire Hills Bancorp in Pittsfield, Mass., was excited about his companys chance to enter Philadelphia by buying First Choice Bank in Lawrenceville, NJ, in a low-premium transaction. The fact that First Choice has a national mortgage platform simply increased his enthusiasm for the deal.

Weve been committed to home finance and have been making the necessary investments to continue to grow it, Daly said during a conference call to discuss the acquisition. Its a sizable investment to do rightso scale matters.

The $7.8 billion-asset Berkshires interest in bulking up in mortgages comes at a time when other banks are taking a step back.

BankUnited in Miami Lakes, Fla., disclosed in January that it had stopped originating mortgages after concluding that the margins were too thin to generate a meaningful return. Christopher Whalen, senior managing director at Kroll Bond Rating Agency, predicted a month later that the nations four biggest commercial banks could follow BankUniteds lead.

Daly, meanwhile, has witnessed firsthand the cyclicality of mortgage lending.

Berkshire, which jumped into the business with its 2012 purchase of Greenpark Mortgage, began a major cost-cutting effort just a year later after a spike in interest rates stymied refinance activity.

So why make a new push now?

Daly said during the conference call that Berkshire is determined to achieve a 1% return on assets without aggressively pursuing commercial real estate loans, which have been drawing significant regulatory scrutiny, or relying on the Federal Reserve to raise interest rates. Berkshires ROA was 0.82% at March 31.

That is where First Choice comes in. Its mortgage unit, First Choice Loan Services, originated $2.5 billion in mortgages last year, generating $68 million in revenue. The unit sells all of its originations, and Daly said the resulting fees should push Berkshires noninterest income beyond 30% of total revenue, a key milestone on the way to achieving a 1% ROA. (The ratio stood at 21% at the end of the first quarter.)

More than half of the mortgage units loans were made in Arizona, Texas and California. At the same time, a large percentage of the originations are tied to the units exclusive status as a mortgage lender to Costco customers.

Their platform provides diversification of geography and risk and it comes with a compliance culture and management team that complements, and in some cases, upgrades our own, Daly said.

Berkshires in-house mortgage unit generated just $4.1 million in mortgage revenue last year.

Still, the move has some people scratching their heads, including analyst Richard Parsons, who recently applauded BankUniteds decision to get out of the mortgage business. What isnt clear to me is that First Choice has a competitive advantage in the one- to four-family business, Parsons said.

At the same time, Parsons expressed concern about the elevated level of nonaccrual credits on First Choices balance sheet. About 2.8% of the banks $222 million portfolio of one- to four-family loans were in nonaccrual status at March 31, according to a regulatory filing.

Daly, for his part, said his team is scaling up with eyes wide open.

This is not a new business to us, Daly said. Weve learned a lot of lessons along the way. Not all of them have been easy. We understand the volatility in the markets and we monitor that closely.

Beyond mortgages, Daly touted Berkshires entry into Philadelphia, which should help with the expansion of 44 Business Capital, a Small Business Administration lender the company recently bought. The expectation is that 44 Business Capital, which has historically focused on loans of $1 million or more, can use First Choices branches to finally make smaller loans that can qualify for credit under the Community Reinvestment Act.

We like the economics of smaller transactions, Sean Grey, Berkshires chief operating officer, said during the call. Theyre typically very deposit heavy [and] are typically very relationship-oriented and loyal to the financial institution.

Philadelphia, along with the rest of Pennsylvania, has been an MA hotbed in recent years. Such activity has proved a double-edged sword for community banks that arent selling, said Kevin Tylus, president and chief executive at Royal Bank America in Bala Cynwyd, Pa.

On the plus side, the $800 million-asset Royal and other small banks have been able to hire scores of bankers displaced by other deals. Weve had several strong people come to us as a result of MA, Tylus said.

But the personnel gains are accompanied by a far more competitive landscape.

Berkshire Hills is a sizable bank with more leverage, Tylus added. I think Berkshire is nine times larger than Royal Bank. Were going to need to be more efficient.

It is unclear whether Daly, who has a penchant for identifying targets before insisting on one-on-one negotiations, will pursue more deals to bulk up around Philadelphia. He seemed content, for now, with the agreement he hammered out with First Choice.

This is a really good transaction for us both strategically and financially, Daly said. It provides us with a foothold into great markets and complements the specialty lending investments weve already made in those areas.