All that's standing between Flagstar Bancorp Inc.'s past as a troubled mortgage lender and a potential future as a full-service community bank is $1.1 billion of problem loans.

So, the Troy, Mich., company is bringing in another $370 million of capital to bridge the gap.

The $13.8 billion-asset Flagstar announced Thursday that it expects to raise the capital in a deal that would batter its shareholders by increasing the number of shares outstanding by 40%. The deal of common and convertible preferred stock is expected to close early next week.

The capital would allow Flagstar to unload pools of its nonperforming assets. Although its stock tumbled 45.7% Thursday on the news, the strategy was viewed favorably by analysts who said this is a good way for Flagstar to get out from under the bad loans.

"This is another heavily dilutive capital raise for them that will essentially just plug a gap," said Eliot Stark, a managing director with Capital Insight Partners in Chicago. "But it could put them on the road to execute on their growth strategy and begin to put their past behind them."

While Flagstar has pervasive credit problems, they started to abate in the third quarter, dropping 8% from the previous quarter, according to data released Wednesday.

Yet Joseph Campanelli, who joined Flagstar last October as chief executive, has been aggressively trying to reshape the company by diversifying into more commercial businesses, so a faster disposition of problem assets makes sense.

"Our management believes that the proceeds of this offering and the concurrent common stock offering will provide us with sufficient additional capital to permit an acceleration of our loss mitigation strategies through efforts to aggressively reduce nonperforming assets," Flagstar said in the registration statement for the convertible preferred component of the offering filed Thursday.

Flagstar would not comment further, citing a quiet period.

Jon Winick, the president of Clark Street Capital, a bank advisory and loan sale firm, said loan sales are picking up as bank companies demonstrate skepticism about an economic rebound that would return problem assets to performing status. The bid-ask spread that has gridlocked loan sales is narrowing for those with enough capital to take the hit.

"Our advice is if you can materially reduce your nonperforming loans and still be well capitalized, you should do it," said Winick, who is marketing performing and nonperforming pools.

Helping Flagstar's capital-raising efforts is the fact that at least one buyer is interested in snapping up some of the problem loans. Flagstar said in the filing that it has received "a firm offer' for $473 million of nonperforming residential mortgages, with the buyer offering 44 cents on the dollar for that portfolio.

The pricing is indicative of the current distressed asset market.

The new capital would be used to cover the difference between the price at which Flagstar is currently carrying the assets and the price at which they would be sold.

Terry McEvoy, an analyst with Oppenheimer & Co., said selling the $473 million pool would not only reduce problem assets, it would eliminate other costs associated with carrying problem assets.

Flagstar has lost $1.01 billion since 2007, as it has been besieged by a flood of problem mortgages and loans made in recession-weary Michigan. On Wednesday it reported a loss of $22.6 million for the third quarter, narrowing its loss by 92% from a year earlier and 77% from the second quarter.

Its loan-loss provision totaled $51 million, down 60% from a year earlier. The loss of 15 cents a share beat McEvoy's prediction for a loss of 20 cents a share.

The third-quarter results, however, included an $11.9 million charge for extinguishing the debt. The new capital and potential reduction in nonperforming assets, McEvoy said, could send the tangible common equity ratio from a thin 5.7% as of Sept. 30 to about 9% in the fourth quarter.

Yet longtime shareholders have been stung, watching their stakes grow smaller as $1.2 billion of capital has flowed into Flagstar since January 2009. MatlinPatterson Global Advisors LLC, a New York private-equity firm, has made several investments, including a $250 million infusion that came alongside $266.6 million from the Treasury Department's Troubled Asset Relief Program. The firm invested another $100 million in capital throughout 2009.

Earlier this year, MatlinPatterson invested $300 million in what was supposed to be Flagstar's $500 million rights offering. Existing shareholders were largely unmoved, though, investing just $600,000. MatlinPatterson has said that it supports Flagstar and would continue to maintain its majority ownership stake.

Stark said investors that paid $5 a share in March are likely feeling some pain with the $1 price of this offering. "The fresh money always gets the best prices," he said.

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