KBRA Affirms Ratings for Silver Queen Financial Services, Inc.

KBRA affirms the senior unsecured debt rating of BBB- and the short-term debt rating of K3 for privately-owned Silver Queen Financial Services, Inc. ("SQFS", "Silver Queen", or "the company"). In addition, KBRA affirms the deposit and senior unsecured debt ratings of BBB, the subordinated debt rating of BBB-, and the short-term deposit and debt ratings of K3 for Colorado Federal Savings Bank, the main subsidiary. The Outlook for all long-term ratings is Stable.

Key Credit Considerations

The ratings recognize Silver Queen’s elevated noncore funding utilization, which is primarily attributable to the volatility of its escrow deposits sourced from Provident Funding Associates (PFA). This, combined with the higher level of CDs in the deposit mix, which are generated from its digital retail channel, results in a comparatively more expensive funding base. Additionally, there is concentration risk as a majority of the deposits are derived from PFA's servicing portfolio, though we acknowledge that these servicing and escrow deposits are relatively durable, in part, due to the common ownership of SQFS and its affiliates. The costly funding base combined with the relatively lower risk loan portfolio, including a considerable proportion of residential mortgage (68% of total loans as of 2Q24), results in a very low NIM, and, in turn, comparatively weaker profitability in recent periods (ROA of ~0.5% during 1H24). However, management anticipates NIM expansion moving forward as the Fed reduces its target rate, which was observed in 3Q24. Moreover, a continued decrease in rates could also facilitate stronger mortgage banking activity through its wholesale channel and may also support earnings. SQFS' very low expense base (~0.7% of average assets), which is due to its branchless and more simplified banking model, in part, due to leveraging the relationship with its affiliated companies, provides more flexibility compared to most banks. Given this, expenses will not necessarily rise despite the anticipated stronger revenue generation. As such, profitability has the potential to improve prospectively. However, this could be partially offset by changes in the fair value of its sizable MSR portfolio ($3.4 billion of UPB), which remains unhedged and can cause some volatility in earnings in a declining rate environment that may cause an uptick in prepayment speeds. With that said, the weighted average coupon on the servicing portfolio (WAC of ~3.4%) is significantly below current market rates and would likely have to decrease meaningfully to attract heightened payoff levels.

One of the main supporting factors of the ratings has been SQFS' pristine credit quality over the years, which is reflective of the company’s lower risk loan portfolio, including an average LTV of 37%. KBRA is mindful around the meaningful exposure to C&D lending (20% of total loans or 131% of total risk-based capital as of 2Q24), though we take comfort in management’s expertise and track record in this lending segment. Moreover, management is meticulous around project selection, which includes primarily non-agency eligible residential homes in desirable locations and affordable multifamily housing in the coastal cities. Capital remains at favorable levels (CET1 ratio of 14.4% as of 2Q24), though slightly lower than prior years due to the balance sheet growth from its hedged MBS trades, increases in RWAs from C&D and MSR growth, and a sizable special dividend paid in 4Q23. However, management intends to maintain the Tier 1 leverage ratio above 10%, which we view as adequate for its business model and risk profile. The liquidity position is managed more aggressively with respect to the loan-to-deposit ratio, which has consistently tracked above 100%, though we believe that the company has ample liquidity sources available, including a securities portfolio that reflects minimal unrealized losses and a comfortable level of contingent funding.

Rating Sensitivities

A rating upgrade is not expected, though continued diversification of the franchise, most notably on the funding side, including a higher level of core deposits, could result in positive momentum over time. A downgrade is unlikely, though further C&D growth beyond expectations, any unanticipated credit deterioration, or a more aggressive stance with capital could pressure the ratings.

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