The recent earnings call for Axos Financial, Inc. painted a picture of a company firing on all cylinders, boasting double-digit growth in earnings per share, book value per share, and loan balances. But beneath the surface of this financial juggernaut lies a hidden truth, one that could have profound implications for Axos's future profitability: a vast portfolio of hybrid adjustable-rate mortgages (ARMs) poised to reprice just as interest rates begin to decline.

While many analysts focused on the immediate impact of the FDIC loan purchase on Axos's net interest margin (NIM), a closer look at the transcript reveals a significant vulnerability that has gone largely unnoticed. Axos holds $5.2 billion, a whopping 28% of its total loans, in hybrid ARMs. These loans, primarily comprised of 3-year to 5-year fixed rate multifamily and 5-year hybrid single-family loans, have been ticking time bombs, offering artificially inflated yields in the current high-interest rate environment.

But here's the catch: a substantial portion of these hybrid ARMs are set to reprice in the next few years.

This concentrated repricing schedule coincides with the widespread expectation of falling interest rates in the coming years. As the Federal Reserve pivots from its aggressive rate hike campaign, these hybrid ARMs will reprice downwards, dragging Axos's overall loan yields and NIM with them.

Potential Impact of Falling Interest Rates on Hybrid ARM Portfolio

To understand the potential magnitude of this impact, let's consider a hypothetical scenario. Assume that interest rates fall by 200 basis points over the next three years, a conservative estimate given the historical volatility of interest rates. Assuming no prepayments, the hybrid ARM portfolio alone could see a yield reduction of approximately 100 basis points.

This would translate to a $22 million decrease in annual interest income from multifamily loans and a $30 million decrease from single-family loans, a combined loss of $52 million per year. While Axos's asset sensitivity will provide some offset, the impact on NIM and earnings per share could be significant.

Axos's management has downplayed this risk, pointing to the repricing of hybrid loans as a potential offset to reduced index rates on other floating-rate loans. They also highlight the ability to lower deposit rates as a buffer against NIM compression.

However, the effectiveness of these mitigating factors is questionable. The hybrid ARM portfolio is heavily concentrated in the near term, creating a significant headwind as rates decline. Lowering deposit rates will likely prove challenging in a competitive deposit market, particularly as other banks grapple with the same hybrid ARM repricing issue.

The hidden risk of the hybrid ARM portfolio raises serious questions about Axos's long-term profitability. While the FDIC loan purchase provides a temporary boost to NIM and earnings, the looming repricing of hybrid ARMs could create a drag on profitability just as the benefits of the acquisition begin to wane.

Investors should closely monitor the performance of Axos's hybrid ARM portfolio in the coming quarters, paying particular attention to prepayment rates and the repricing of loans in a falling rate environment. The true test of Axos's management prowess will lie in their ability to navigate this hidden risk and maintain their impressive track record of profitability.

Hypothesis

Axos's heavy concentration in hybrid ARMs, set to reprice in a falling rate environment, presents a significant risk to the company's long-term profitability, potentially overshadowing the short-term gains from the FDIC loan purchase.

Key Numbers

$5.2 billion (28% of total loans) in hybrid ARMs 58% of hybrid ARMs repricing in the next three years Potential yield reduction of 100 basis points on hybrid ARMs assuming a 200 basis point decline in interest rates Estimated $52 million annual decrease in interest income from hybrid ARMs in this scenario

"Fun Fact: Axos Financial originally started as Bank of Internet USA, reflecting its innovative approach to banking. It later changed its name to Axos, derived from the Greek word "axios," meaning "worthy" or "deserving." However, the question remains whether its heavy reliance on hybrid ARMs will prove worthy of its name in the years to come."