10-Q: Merchants Bancorp Q2 Profit Halves Amid Credit Losses

Merchants Bancorp reported a 50% drop in second-quarter net income, primarily due to a significant increase in credit loss provisions linked to multi-family property value declines and suspected mortgage fraud.

Summary

• Net income for the three months ended June 30, 2025, decreased by 50% to $38.0 million, down from $76.4 million in the prior year period.
• Diluted earnings per share fell 60% to $0.60 for the quarter, compared to $1.49 in the same period last year.
• The provision for credit losses surged by 432% to $53.0 million for the quarter, up from $10.0 million, driven by estimated declines in multi-family property values and ongoing investigations into mortgage fraud.
• Total assets increased 2% to $19.1 billion as of June 30, 2025, from $18.8 billion at December 31, 2024.
• Loans receivable, net of allowance for credit losses, grew 1% to $10.4 billion.
• Core deposits increased by 22% to $11.4 billion, now representing 90% of total deposits, while brokered deposits decreased by 50% to $1.3 billion.
• The company's efficiency ratio worsened to 43.16% for the quarter, from 31.59% in the prior year period.
• Nonperforming loans decreased to $251.5 million (2.39% of total loans) from $279.7 million (2.68%) at December 31, 2024, but loans classified as substandard increased to $417.7 million from $317.3 million.
• The Bank entered into a confidential Memorandum of Understanding (MOU) with the FDIC and DFI on June 30, 2025, agreeing to maintain capital thresholds and manage asset concentrations.

Sentiment

Score: 3

Explanation: The sentiment is negative due to a significant drop in net income and EPS, primarily driven by a massive increase in credit loss provisions and charge-offs linked to multi-family property value declines and suspected mortgage fraud. Increased operating expenses related to these issues and a worsening efficiency ratio further contribute to the negative outlook. While there are positives like strong capital, liquidity, and growth in core deposits and some loan origination volumes, the severe asset quality issues and regulatory scrutiny (MOU) are major concerns.

Positives

• Core deposits increased by $2.0 billion, or 22%, to $11.4 billion, now representing 90% of total deposits, indicating improved funding stability.
• Brokered deposits decreased by 50% to $1.3 billion, reducing reliance on higher-cost funding sources.
• Total assets grew by 2% to $19.1 billion, reflecting overall business expansion.
• Loans held for sale increased by 9% to $4.1 billion, driven by higher warehouse participations volume.
• Mortgage warehouse loan funding volume increased by 49% to $16.3 billion for the quarter, significantly outpacing the industry's 28% increase in single-family residential loan volumes.
• Multi-family loan origination and acquisition volume increased by 33% to $1.4 billion for the quarter.
• Gain on sale of loans increased by 109% to $23.3 million for the quarter, primarily from higher multi-family loan volume.
• Syndication and asset management fees surged by 200% to $9.7 million for the quarter, due to an increase in managed projects and new equity raises.
• The company maintains significant unused borrowing capacity of $5.0 billion with the FHLB and Federal Reserve discount window, enhancing liquidity.
• Approximately 95% of total loans reprice within three months, reducing interest rate risk from market rate increases.
• Tangible book value per common share increased 13% to $35.42.
• Capital ratios remain strong and exceed regulatory 'well capitalized' minimums, with the Bank's capital exceeding levels agreed to in the MOU.

Negatives

• Net income decreased by 50% for the three months ended June 30, 2025, and 41% for the six months ended June 30, 2025, compared to the prior year periods.
• Diluted earnings per share decreased by 60% for the three months and 53% for the six months ended June 30, 2025.
• Provision for credit losses increased by 432% to $53.0 million for the quarter, primarily due to estimated declines in multi-family property values and ongoing investigations into mortgage fraud or suspected fraud.
• Total loan charge-offs significantly increased to $46.1 million for the quarter and $56.6 million for the six months ended June 30, 2025, compared to $3.5 million and $4.4 million respectively in the prior year periods.
• Loans classified as substandard increased to $417.7 million at June 30, 2025, from $317.3 million at December 31, 2024.
• Noninterest expense increased by 54% for the quarter and 40% for the six months, driven by higher salaries and employee benefits (including production staff additions), and a $7.1 million rise in other expenses related to taxes, insurance, receiver expenses, and legal fees for nonperforming loans.
• The efficiency ratio worsened to 43.16% for the quarter and 42.76% for the six months, indicating higher costs relative to revenue.
• Net interest margin decreased by 16 basis points for the quarter and 21 basis points for the six months, impacted by a shift towards lower-margin loans.
• Loan servicing fees, net, decreased by 43% for the quarter and 66% for the six months, partly due to negative fair market value adjustments on servicing rights.
• Multi-family loans totaling $9.6 million with prior forbearance modifications defaulted during the three and six months ended June 30, 2025.
• Residential loans in the process of foreclosure increased to $2.6 million from $1.9 million at December 31, 2024.

Risks

• Credit risk associated with estimated declines in multi-family property values and ongoing investigations of borrowers involved in mortgage fraud or suspected fraud.
• Increased provision for credit losses and charge-offs, particularly in the multi-family portfolio, indicating potential further asset quality deterioration.
• Regulatory scrutiny and potential limitations on expansion due to the confidential Memorandum of Understanding (MOU) with the FDIC and DFI, despite current capital compliance.
• Exposure to interest rate risk, although largely mitigated by the short repricing period of loans and liabilities, still presents sensitivity to market rate changes.
• Operational risks associated with increased noninterest expenses, including legal fees and receiver expenses, tied to managing nonperforming loans.
• Dependence on the secondary mortgage market for loan sales, which can be impacted by market conditions and investor demand.
• Potential for further defaults on troubled loan modifications, as evidenced by the $9.6 million multi-family loan defaults.

Future Outlook

Management does not expect the actions called for by the regulatory Memorandum of Understanding (MOU) to have a material adverse impact on financial performance or day-to-day operations, although they may limit or delay the Company's or the Bank's ability or plans to expand. The addition of production staff is expected to continue to elevate production, gain on sale, and expenses in future quarters.

Management Comments

• The $38.4 million decrease in net income compared to the three months ended June 30, 2024, reflected an increase in provision for credit losses of $43.1 million. The increase in provision for credit losses was primarily associated with estimated declines on multi-family property values, after receiving new appraisals, and the ongoing investigation of borrowers involved in mortgage fraud or suspected fraud.
• The increases in provision expenses and charge-offs were also attributable to certain types of subordinated loans that the Company no longer offers to borrowers. These subordinated loans have been largely identified and evaluated for potential losses that have either been included in the provision for credit losses as specific reserves or charged off.
• The declines in Special Mention loans reinforce the view that the frequency of migration to criticized status has subsided.
• The Company believes that its loan portfolio remains well collateralized.
• The $16.9 million in total expenses associated with credit default swap premiums, the collateral preservation of nonperforming loans, and the addition of production staff had a negative 941 basis point impact on the efficiency ratio for the three months ended June 30, 2025.
• The lower interest expense reflects a shift towards borrowings that has become a more cost-effective option than utilizing brokered certificates of deposit, in addition to growth in lower-cost, interest-bearing checking accounts.
• Management expects that a substantial portion of the maturing core certificates of deposit will be renewed. However, if a substantial portion of these deposits is not retained, we may decide to utilize FHLB advances, the Federal Reserve discount window, brokered deposits, or raise interest rates on deposits to attract new accounts, which may result in higher levels of interest expense.

Industry Context

The company's mortgage warehouse loan funding volume increased by 49% for the quarter, significantly outpacing the 28% industry increase in single-family residential loan volumes, suggesting strong market share gains or favorable positioning within the mortgage sector. The focus on government-backed or secondary market-eligible loans aligns with a strategy to mitigate risk in a fluctuating interest rate environment. The increase in credit loss provisions and charge-offs, particularly in multi-family properties, indicates specific asset quality challenges that may or may not be widespread across the broader banking industry, but could reflect localized market conditions or unique portfolio exposures.

Comparison to Industry Standards

• The company's mortgage warehouse loan funding volume growth of 49% for the three months ended June 30, 2025, significantly exceeded the Mortgage Bankers Association's estimated industry increase of 28% for single-family residential loan volumes in the same period, indicating strong performance relative to the broader market.
• The company's capital ratios (e.g., Total capital ratio of 13.4% for the Company and 13.1% for Merchants Bank) remain well above the regulatory 'well capitalized' minimums (10.0% for Merchants Bank), demonstrating a strong capital position compared to regulatory benchmarks for financial institutions.
• The decline in commercial real estate loans as a percentage of Tier I risk-based capital from 348% to 328% suggests a move towards better alignment with regulatory guidance, which often flags concentrations exceeding 300% as a concern, although it remains high.

Corporate Governance

Legal Proceedings

• Ongoing investigation of borrowers involved in mortgage fraud or suspected fraud, which contributed to increased provision for credit losses and charge-offs.
• Legal fees tied to preserving collateral for nonperforming loans contributed to a significant rise in other expenses.

Related Party Transactions

• On June 27, 2025, the Company completed a $312.1 million sale of All-in-One first-lien home equity lines of credit through a sale to a related third party, with the Company retained as the mortgage sub-servicer.

Stakeholder Impact

• Shareholders: Significant decrease in net income and diluted EPS, along with a decrease in total shareholders' equity, negatively impacts shareholder returns. However, tangible book value per common share increased, and capital ratios remain strong.
• Employees: Addition of production staff indicates growth in certain areas, but increased expenses may impact overall profitability.
• Customers: The company continues to offer a wide range of financial products and services, including an insured cash sweep program for deposits, which benefits customers with large balances.
• Creditors: Strong capital ratios and significant unused borrowing capacity provide comfort regarding the company's ability to meet its obligations, despite increased credit losses.
• Regulators: The MOU indicates increased scrutiny and requirements for capital maintenance and risk management, reflecting regulatory concerns over asset quality and concentrations.

Next Steps

• Continue to manage asset concentrations and implement plans regarding Bank operations and strategy to mitigate risk, as per the MOU with FDIC and DFI.
• Monitor the effectiveness of modifications to loans for borrowers experiencing financial difficulty.
• Evaluate the impact of new accounting standards updates (ASU 2023-09 and ASU 2024-03) on financial statements.
• Potentially issue up to $500 million in registered securities under the effective shelf registration statement to finance growth objectives.
• Continue efforts to reduce credit risk through loan sale and securitization activities, and credit protection arrangements.

Key Dates

Recommendation

While Merchants Bancorp reported a substantial decline in net income and EPS, primarily due to a significant increase in credit loss provisions and charge-offs related to multi-family property value declines and suspected mortgage fraud, the company maintains strong capital ratios and ample liquidity. Core deposits are growing, and loan origination volumes in key segments are robust. The regulatory Memorandum of Understanding (MOU) signals heightened scrutiny but also a commitment to address identified issues. A 'Hold' recommendation is warranted for investors who believe the current asset quality issues are specific and manageable, and that the company's underlying business model and strong capital base will allow for a recovery once these challenges are addressed. However, continued monitoring of asset quality trends and the impact of the MOU is crucial.

Keywords

Banking, Mortgage, Financial Services, SEC Filing, 10-Q, Credit Losses, Multi-family Housing, Mortgage Fraud, SEC Filings, Financial Results, Bank Holding Company, Loan Portfolio, Deposits, Capital Adequacy