E*TRADE FINANCIAL Corporation 3Q08 (Qtr End 9/30/08) Earnings Call Transcript

E*TRADE FINANCIAL Corporation (ETFC)

Q3 2008 Earnings Call

October 21, 2008 5:00 pm ET

Executives

Donald Layton – Chairman & CEO

Bruce P. Nolop - Chief Financial Officer

Robert Burton - President of E*TRADE Bank

Analysts

Michael Vinciquerra - BMO Capital Markets

Eric Bertrand - Barclays Capital

Howard Chen - Credit Suisse

Richard Repetto - Sandler O'Neill & Partners L.P.

Matthew Snowling - Friedman, Billings, Ramsey & Co.

Prashant Bhatia - Citigroup

Mike Carrier - UBS

Brian Bedell - Merrill Lynch

Presentation

Operator

Welcome to the E*TRADE FINANCIAL Corporation third quarter 2008 business update call. (Operator Instructions)

I've been asked to begin this call with the following safe harbor statement: During this conference call, the company will be sharing with you certain projections or other forward-looking statements regarding future events or its future performance. E*TRADE FINANCIAL cautions you that certain factors, including risks and uncertainties referred to in the 10Ks, 10Qs and other reports it periodically files with the Securities and Exchange Commission, could cause the company's actual results to differ materially from those indicated by its projections or forward-looking statements.

This call will present information as of October 21, 2008. Please note that E*TRADE FINANCIAL disclaims any duty to update any forward-looking statements made in the presentation.

In this call, E*TRADE FINANCIAL may also discuss some non-GAAP financial measures in talking about its performance. These measures will be reconciled to GAAP either during the course of this call or in the company's press release, which can be found on its website at etrade.com.

This call is being recorded. Replays of this call will be available via phone, webcast and podcast beginning today at approximately 7:00 p.m. Eastern Time. The call is being webcast live at etrade.com. No other recordings or copies of this call are authorized or may be relied upon.

I'll now turn the call over to Don Layton, Chairman and Chief Executive Officer of E*TRADE FINANCIAL Corporation, who is joined by Bruce Nolop, Chief Financial Officer, Bob Burton, President of E*TRADE Bank, and other members of the E*TRADE management team.

Mr. Layton, please go ahead.

Donald Layton

Thank you and welcome to our third quarter conference call. It comes in the midst of unprecedented financial turmoil and equally unprecedented government actions to deal with that turmoil.

Our presentation today has four parts. First, I will review three things - one, a summary of how our customer operating business performed; two, the latest on credit risk and reserves; three, how we are doing on our capital plan. Second, Bruce Nolop will go over the third quarter financial results. Third, Bob Burton will discuss our credit management and risk mitigation initiatives, and I will then return to talk about some forward-looking issues, in particular, our participation in the U.S. Treasury's TARP program.

As you know, our strategic objective in 2008 was to focus on maintaining the demonstrated strength of our customer franchise, de-linking it from our balance sheet issues. Q2 showed that this de-linking was effective, and I am happy to report that the franchise has performed well and competitively in Q3 despite the market and economic stresses that appeared especially late in the quarter.

Retail segment revenue was up. Retail accounts reached a new record and have been coming in particularly quickly of late. DARTs were up, enhanced by the high volatility of the markets late in the quarter. Net new customer asset flows were also clearly positive.

I would like to point out two additional items of strategic significance. Our net new accounts continued to have a strong mix of new brokerage accounts rather than deposit accounts. This absolutely reflects a renewed focus upon our core investing customer, a trend you should expect to see more of.

Also, total customer cash and deposits, despite all the market stresses, was roughly flat with last quarter and the cost advantage component of these funds - mainly sweep deposits - actually grew slightly.

In addition, this all happened against some of the most volatile and difficult market conditions in decades. Record levels of transactions, users and other market-related activities were all successfully handled by our technology, service and operations teams. We continue to be recognized for our high performing and reliable platforms, even during such stressful times.

Lastly, our strategy to keep the core franchise strong is demonstrated by our continued level of market visibility and product innovation. This quarter we successfully launched our mobile product for the BlackBerry and made significant enhancements to our Power E*TRADE Pro platform with the launch of our Strategy Scanner and Streaming Sector tools.

Our advertising campaign featuring the E*TRADE baby continues to successfully reinforce our brand message, drive new account growth, and win industry acclaim. More evidence of this commitment and focus is that Smart Money rated us their top-rated online broker for 2008 and Barron's awarded us four stars in their survey.

Now let me turn to credit. I want to address three credit issues - the nature of the special review we did, a summary of the results, and our forward-looking expectations.

As announced in September, we performed a special review of our credit allowances. This review was designed to [update and] improve what we had previously been doing in two ways  one, take advantage of more data from this credit cycle rather than historic cycles in a variety of ways as this cycle's data is now becoming substantive enough to employ considerably more than previously. And two, updating various underlying assumptions given the unprecedented uncertainties that exist today. One example of such is an increase in the assumed severity for the first lien mortgages.

The result was that we now have an expected forward-looking path of charge offs in our home equity and the first lien portfolios which is somewhat higher than previously envisioned. Thus, our Q3 provision reflects not only charge offs in the quarter, it reflects the need to build up our allowance to include four quarters of higher expected charge offs.

To illustrate this, actual charge offs in the quarter were only up $30 million over Q2 as compared to the provision expense, which was up $199 million. The new assumption is for charge offs to be up by therefore approximately $40 million per quarter over the next four quarters relative to our prior assumptions.

At this point let me make some forward-looking comments about credit.

First, delinquencies: We have previously stated home equity delinquencies - and I will focus on the 30 to 179 day at-risk buckets - were in low growth to flat mode. We are maintaining that status at this time. There was considerable noise in home equity delinquencies during the quarter, and we simply do not know if we might have already transitioned to a no-growth or flat mode, that is, the peak.

However, we are maintaining our view that at-risk delinquency levels will improve in the near future. First lien mortgage delinquencies continued to perform better than previously expected and remain in this low-growth mode. We expect delinquencies for this portfolio - that is, the first liens - to peak some time in mid-2009.

Second provision. We strongly believe Q3 to be the peak quarter for loan provision, although we obviously cannot guarantee it. This quarter's provision included the cumulative effect of higher expected charge offs over the next four quarters. I would also remind everyone that our portfolio of home equity loans has a limited 2007 vintage but is dominated by the older 2006 vintage. As a result, we expect to peak sooner than with most credit-challenged institutions. We expect provision expense to decline substantially over the next few quarters.

Third is charge offs. For home equity loans, we view quarterly charge offs similar to delinquencies, that is, they are at or near their peak with improvement expected during the next few quarters.

At this point I would like to address our three-year home equity charge off guidance, which covers the years 2008 through 2010. We previously announced that we would be somewhat above the high end of the $1 billion to $1.5 billion range. As of now we believe it to be about 20% above the high end of the range, subject to all the uncertainties of any such forecast, especially in these volatile times.

I want to note that, given our three quarters of actual charge offs this year and the allowance as of September 30 for home equity loans, we have already provided for approximately three-quarters of the full three-year charge off forecast.

For our first lien portfolio, please note that while our expected charge offs over three years have increased, they will generate only a fraction of home equity losses in a size that is important to our earnings but not to our capital.

Next I want to address our balance sheet plan. Our five-pillar capital plan, which I have described in fair detail in prior talks, continues to be aggressively implemented. Q3, in fact, demonstrates how we are navigating the very stormy oceans of today's financial markets despite our credit issues because we have been ahead of the curve in many ways. I will now go over this in some detail.

Total gross loans declined this quarter by $1.2 billion or 4%, and we reduced our exposure to undrawn home equity lines by another $700 million to $3 billion. This lowers risk and frees up capital.

Non-core assets sales have generated high levels of capital and cash at very shareholder friendly terms. By deciding early - that is, in Q1 - to sell various valuable properties then, we were able to close on approximately $660 million of such deals in the third quarter. With the sale of our Canadian brokerage and our equity stake in Investsmart of India, Canada provided a pretax gain of $428 million and Investsmart generated a gain of $22 million. The gain from these sales was over the top end of our estimated range and the foregone earnings from sales of the two properties were only about 4% per annum based upon the sale prices.

Such sales were a key ingredient in developing a capital cushion to deal with uncertain times. In Q3 these gains offset almost the entire loan provision, even at the much enhanced level taken. With the asset sales and our other capital plan activities, we have built up a substantial cushion to absorb our expected peak losses, but also to deal with potential additional credit costs, clearly prudent in this year's environment.

This quarter we downstreamed $250 million to E*TRADE Bank via a redeemable preferred investment. This still left us with $665 million of cash at the parent at the end of the quarter.

We decided to increase the investment in E*TRADE Bank because it had two extra credit costs. One, we had the previously disclosed $154 million loss net of hedges on our Fannie and Freddie preferred stock. Please remember we did not hold these through the full collapse of the agencies, but sold out early and through the quarter so that we only lost a bit less than half of the $330 million value we had as of June 30. Second, in the reexamination of our credit reserves, we have had an extra large loan loss provision in this quarter of $518 million, up [$199] million over Q2, substantially more than originally expected.

Given these two events, we decided to inject $250 million into the bank. The result was a well-balanced cushion with approximately half a billion dollars of capital in excess of the well-capitalized level at the bank and about two-thirds of a billion dollars of cash at the parent. I think you will agree that the depth of our capital plan and the quality of its execution is very well demonstrated in that we can absorb these two charges and still have such substantial cushions remaining.

I will also take this opportunity to mention some other factors in our capital plan. We continue to generate on a routine quarterly basis significant capital directly to E*TRADE Bank to absorb risk. Earnings at the bank before credit costs were $188 million during the third quarter. This generates capital to partially offset credit losses and is in the previously predicted range of $180 million to $200 million per quarter.

Regulatory capital requirements are reduced by $50 to $100 million for ever $1 billion of loan reduction. Our outstanding loan balances declined by approximately $1.2 billion in the third quarter. Thus, in the modeling of our capital strength at the bank, earnings generation and loan prepayments provide a very nice wind to our back each and every three months of a ballpark figure of about one-quarter billion dollars.

And I note that bank liquidity remains strong, as we have increased cash held on the balance sheet to over $2.3 billion and available borrowing capacity at the Federal Home Loan Bank which is over $10 billion.

Our balance sheet repair initiatives also apply to the parent company. We have a multifaceted plan to reduce the debt at the parent and thus reduce our interest burden on our earnings and our liquidity. We have reduced our parent debt by over $150 million so far this year. We however did no - I repeat, no - 3(a)(9) debt for equity exchanges in the third quarter as the relative prices of our equity and bonds made it unattractive to do so. We are very conscious of the cost of capital and shareholder dilution issues. We will opportunistically reduce debt further this year, carefully weighing the cost of doing so.

We have $450 million in mandatory convertible notes that will become common next month. The $600 million combination of the year-to-date debt reduction and the conversion of the mandatory notes next month would represent around $38 million in annualized interest that we won't have to pay in 2009. We will continue to examine our debt reduction alternatives in the fourth quarter opportunistically. And as I mentioned previously, we have almost twothirds of a billion in cash at the parent.

Let me repeat - this balance sheet plan was designed to start with decent cushions at the bank and the parent, then generate large amounts of capital from internally generated pre-credit earnings at the bank, and build parent cash via non-core asset sales. We built cushion into the plan to absorb uncertainties and also to absorb the inevitable peak in loan provision. So far, in our opinion, it seems to be working well.

And with that, I will turn the time over to our new CFO, Bruce Nolop, to take you through the numbers. Bruce, the former CFO of Pitney Bowes, joined us recently and I know he's looking forward to working with all of you.

Bruce P. Nolop

Thanks, Don. During the third quarter, we generated a net loss of $50.5 million on net revenue of $378 million. Earnings per share reflected a loss of $0.09, and the loss from continuing operations was $0.60.

However, I want to reiterate that our results this quarter were impacted by three significant items.

First, our revenue was reduced by $160 million for a loss in our securities portfolio chiefly related to the sale of our Fannie and Freddie preferred stock.

Second, we took a loan loss provision of $518 million this quarter.

Third, we realized $450 million of pre-tax gains from the divestiture of our brokerage business in Canada and the sale of our equity stake in Investsmart.

If we net these three items, they had a negative impact of $228 million, which is the reason we are showing a loss for the quarter. And their relative magnitude can cause us to lose sight of the strength of our underlying retail franchise.

The ongoing earnings power of the franchise can be seen in our Retail segment results. Retail segment revenue of $406 million and Retail segment income of $171 million were both up slightly from last quarter, and the segment's operating margin held steady at 42%.

Our commission revenue this quarter increased 6% from the prior quarter and our average commission per trade was up modestly over last quarter. We also saw a 12% increase in revenue from principal transactions, which tracked higher market volume.

DARTs were up 7% from last quarter based on a very strong September and were roughly in line with the third quarter of the 2007 levels.

Net new asset flows into the company continued, a solid $800 million this quarter. However, the volatility of this market has led to our customers deleveraging and reducing their risk exposures. Margin calls are also up, therefore we experienced a decline in margin debt, down by 21% at the end of this quarter.

Customer cash was relatively steady this quarter, but the mix shifted slightly toward low-cost sweep deposits and away from higher-cost certificates of deposit.

We believe that our deposit flows will be helped by the new FDIC insurance guarantees. We estimate uninsured deposits, including the effective of the FDIC [break in audio].

This reflects net charge offs of $279 million during the quarter which compares with $249 million last quarter.

Our significant build of reserves this quarter took our allowance as a percentage of total gross loans receivable to 3.3%, which is up from 2.3% last quarter and 0.6% last year. And this includes an increase in each of our loan categories.

Total delinquencies for the quarter were up 12% from last quarter and 30 to 179 day delinquencies - which is what we characterize as the at-risk portion - were up 8%. We exclude over 180 day delinquencies from our at-risk focus because these loans have already been written down to their recovery value and thus won't consume our loan loss allowance.

And we can breakdown the loss provision by loan category as follows:

Our one to four-family mortgage at-risk delinquencies were up 10%, however the at-risk delinquencies as a percent of the loss reserve for this category was down dramatically.

The at-risk delinquencies in our home equity portfolio were up 5% to $561 million, but the atrisk delinquencies as a percent of the loss reserve declined to 81% from 97% last quarter.

The at-risk consumer and other delinquencies were up 27%, but this represents only an $8 million increase. This category of loans also saw a decline in at-risk delinquencies as a percent of the loss reserve.

Finally, I want to highlight that when we look at our total loan portfolio, our at-risk delinquencies as a percent of our allowance has decreased to 139% from 176% last quarter.

Now I will turn it over to Bob Burton to discuss risk mitigation.

Robert Burton

Thanks, Bruce. Our management of the loan portfolio looked at three key elements that continued to reduce our portfolio risk. First, this is a runoff portfolio, with minimal additions since early 2007. Therefore, we continue to benefit from prepayments that have reduced our gross loans 19% from a year ago. Across all our portfolios, we saw a $1.2 billion or 4% reduction in unpaid balances in the third quarter. We expect our existing portfolio to have runoff of approximately $4 billion over the next 12 months.

Second, we expect to see continued benefits driven by the favorable vintage composition of the portfolio. Our 2006 vintage is the main driver of loss in the portfolio. Now over 27 months old, only 49% of the original purchase lines remain as outstanding balances.

As we've discussed previously with respect to the home equity portfolio, the 2007 vintage represents only 12% of the total and, because we've tightened up our credit criteria earlier than many others, the 2007 vintage has actually performed better than 2006, very different than what we see in the rest of the industry.

Finally, our loss mitigation efforts continue to accelerate. We've taken our exposure to undrawn home equity lines from over $7 billion a year ago to $3 billion at the end of Q3, down $700 million from last quarter and better than expectations.

Most importantly, the remaining $3 billion exposure is low risk, with virtually no delinquency and strong housing and credit characteristics. For example, this $3 billion in open lines has an updated CLTV of only 69%.

Our efforts to put back loans to sellers has resulted in approximately $118 million in repurchases since our effort began, $25 million of that in Q3.

In addition, we significantly increased the intensity of our collections and loss mitigation efforts working with our third-party servicers, both through using new collections partners and through more dedicated and intense collection efforts. So as the portfolio ages and our mitigation efforts continue, we expect that our delinquencies, charge offs, and provisions will peak earlier than many of our bank competitors.

With that, I'll turn it back to Don.

Donald Layton

Thanks, Bob. Let me wrap up with a couple of key points of a forward-looking nature.

First, the U.S. Treasury's TARP program. This is a fast-moving series of events and exactly how it all works is being developed in real time. In addition to the increase in deposit insurance we talked about earlier, the government's capital purchase program is of interest to us. We believe we qualify for the program and are submitting our application to it. The program has the potential to significantly improve the balance sheet strength of E*TRADE at both the bank and parent levels. We will update you as we learn more and as appropriate.

Second, the unprecedented economic and financial market events which began in September continued into October. Thus, October month-to-date DARTs are quite high and we are opening up new accounts at a considerably higher than normal pace. Also similar to September, margin loans continue to decline as investors have had margin calls and are deleveraging their personal finances. It is unclear how far into the fourth quarter these circumstances will continue.

In September we said that our return to quarterly profitability later this year could be at risk given the state of the housing market, which continues to set historic records in how bad it is. Thus, we are not predicting quarterly profits in the fourth quarter.

Unfortunately, these events provide a very subdued backdrop to our view of volumes and market conditions in 2009. As you will recall, we announced back in April that we were going to cut expenses then to reflect the then-consensus view that the U.S. was entering recession and we did so to the tune of $50 million per annum in compensation expenses, fully completed by midyear. This will now stand us in good stead as that recession is, we believe, fully upon us.

We will update you more on our views of 2009 along with our announcement of the fourth quarter earnings, but we expect to have a continuing emphasis on productivity and overhead reduction as we budget for the new year.

As to returning to quarterly profitability in 2009, the substantial decline in credit costs that we are forecasting gives us a good start on this. But we want to see how business conditions, highly uncertain at this point in time, are evolving before being more specific as to the timing. In the meantime, our customer business continues to perform well and we will focus on developing that franchise, which provides the true value for E*TRADE stockholders in the future.

With that, we are happy to take your questions. Operator, over to you.

Questions-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Vinciquerra - BMO Capital Markets.

Michael Vinciquerra - BMO Capital Markets

The main question is really just to look at where you stand in terms of your capital. Obviously, you've padded the balance sheet pretty significantly, but when you look out - and you've done all this new analysis on your balance sheet - do you feel comfortable that the progression you're going to have in terms of earnings generated from the brokerage business, along with the capital you have on the balance sheet, is going to be more than substantial to handle the losses that your current analysis is projecting?

Donald Layton

The answer is yes. Given the forecast we have and given the cushions we have on the balance sheet, we think we can handle the losses and losses higher than we forecast to a pretty strong degree. Obviously, the future isn't knowable. But if you do the numbers over the kind of timeframes we're talking about, we seem to have lots of cushion to deal with the credit issues.

In addition, even ignoring the government's TARP program, we have access to additional sources of capital which we could undertake if we wished to do so, and so we feel pretty confident that we can make it through our credit issues and be a thriving brokerage company in the future.

Michael Vinciquerra - BMO Capital Markets

And then just a follow up on one thing you said in your remarks, maybe you can clarify. You talked about one of the portfolios, it sounded like, being at peak delinquencies and another not. Could you just clarify where you see home equity and first lien, just so I'm clear on that.

Donald Layton

Yes. Home equity is the one where we may be very close to the peak of delinquencies and we think it will happen soon, a lot of our reason being not just behavior of delinquencies but the vintage analysis we've talked about. For first lien mortgages, we see the peak of delinquencies not until later, say some time mid-ish 2009.

Operator

Your next question comes from Eric Bertrand - Barclays Capital.

Eric Bertrand - Barclays Capital

On the TARP purchase plan, can you let us know how much you're going to be applying for and would you consider using this fairly low-cost financing to swap out some of the other debt or do you think you're going to use it as additional cushion?

Donald Layton

As you know, the program is set up to offer, as much as we can figure out, 1% to 3% of risk weighted assets. For us, the 3% number is modestly over $800 million, so our discussions with our regulator is for, if you will, roughly the full amount, rounding off to $800 million.

As you state, it seems to be attractive capital in terms of its terms. What will we do with it? The answer is some portion of it would be placed in the bank where the credit loss and customer confidence issues would reside, but other components of it, at least as far as we know now, could be retained at the parent, enhancing that two-thirds of a billion of parent cash I mentioned.

Would we use some of it to swap out and pay down other debt, which is trading at quite a bit of a discount? The answer is that is possible. That's a realistic alternative. I will let you know, though, that the timing of that would probably not be immediate. We would be looking to see that the provisions really did come down over several quarters to be sure that that cash, which provides a cushion for us, would not be needed for credit and therefore could be used for other purposes, including debt repayment.

Eric Bertrand - Barclays Capital

And on the actual TARP itself or the actual purchases of troubled assets, do you think it's potential for you to actually sell some of the HELOC assets into that, should you find a price or would you expect to actually run off the portfolio as previously discussed?

Donald Layton

Our planning assumption is that this is a runoff portfolio. We do not know enough about how the actual asset purchase would work in so many ways. We just have no evidence to come off our basic notion, our planning assumption that we will hold it to maturity.

Operator

Your next question comes from Howard Chen - Credit Suisse.

Howard Chen - Credit Suisse

Don, during the quarter you downstreamed $250 million of preferred equity to the bank. You mentioned the $665 million in cash at the parent at quarter end, but can you provide a more specific sense of how much flexibility you have to continue downstreaming if see further deterioration in the macro environment?

Donald Layton

The $665 million strategically serves a few purposes. One, it's there to finance the cash needs of the parent itself. Number two, it's available for downstreaming. And number three, as mentioned just in the last question, possibly at some point using it on a cash basis to repurchase debt. Other than that, it is our judgment whether to downstream it or not. There are no particular covenants or issues restraining us other than common sense and judgment, although I do note, of course, we would be talking to our regulators on that. On the other hand, I don't know many bank regulators who would object to you putting more capital into a bank.

Howard Chen - Credit Suisse

Asked another way, how much capital do you think you need right now to fund the parent co?

Donald Layton

You mean its own cash needs?

Howard Chen - Credit Suisse

Correct.

Donald Layton

That's actually a variable question because the biggest cash need in the parent is for debt interest expense, and the biggest cash interest expense is the interest on the Citadel debt. And, as was disclosed long ago, the first four coupons on the Citadel debt can be paid not in cash but payment in kind. So we could use that money or we could use some of the cash to pay it or not at our discretion, and that's basically the scenario.

Other than that, the parent would not need - net, the parent doesn't need much cash other than paying the Citadel interest coupon.

Howard Chen - Credit Suisse

And then Bruce, my follow up, you touched on the work force reductions during the quarter. Does the 3Q expense run rate include most of the benefit of those reductions and can you speak about the potential for further expense reductions? Is the heavy lifting done or do you see more, a lot more opportunity to for further operational leverage here?

Bruce P. Nolop

The run rate would continue into the fourth quarter. So in other words, the full benefit of the headcount reduction has not passed through as of yet.

In terms of additional cost cutting, I'm not sure if it's heavy lifting but I will say that we are in a mode of continuous improvement and, as we look at the budget for 2009 and particularly the uncertainty of the market, we'll be looking at areas that we can trim and also areas that can be considered from a contingency point of view.

But the one thing I would say is that what we don't want to do is in any way compromise the ability of the company to really strengthen its competitive position. As we're seeing the light at the end of the tunnel of the loan losses, we want to make sure that we really can thrive and prosper coming out. So as the CFO, my job is to make sure we keep the right balance between reducing costs but also preserving flexibility and the ability to grow into the future.

Operator

Your next question comes from Richard Repetto - Sandler O'Neill & Partners L.P.

Richard Repetto - Sandler O'Neill & Partners L.P.

I guess the first question is, could you walk through going from the $600 of excess capital to the $516, because I'm just a little - I'm trying to see how much wind at your back or the capital efficiencies. I was confused by Footnote 1 a little bit. And then you also said by year end last quarter that you'd be at $700 to $800. Does that go away with sort of this reviewing on the loan portfolio?

Donald Layton

Yes, okay, let me take those in reverse order.

Our December 31 guidance for the excess risk capital at the bank is changed and is variable at this point. It should not particularly increase if we do not do anything related to new capital and particularly the government program. So we're talking about a $500, $600 level by the end of the year if the government program does not come in. If the government program comes in and we receive money, a significant amount of that would be downstreamed and as a result we would probably have much in excess of that level.

So there's quite a variable answer there, so that's as much as we can tell you. It will vary - we don't really want to see anything under a half a billion, quite honestly.

Number two, kind of the walk, it would get a little complicated, but you basically have the roughly quarter billion dollar increase in capital from the earnings pre-credit costs and the shrinkage in the loan portfolio. You then have the $250 - that's $500 coming in. On the outside you would have the loan provision of the, call it $500. And you would have the outflow of the Fannie and Freddie loss of $150. So you have a - that's $650. So you figure those out and the result is you're down about $150, which is what happened.

Richard Repetto - Sandler O'Neill & Partners L.P.

And my one follow up here, on the investment securities portfolio it shows that, on the CMO side, 101 moved into the below investment grade relative to, I believe, the prior quarter. Could you talk about that and what the expectation on that 101 million of CMO is?

Donald Layton

Yes. We started talking much earlier this year about concerns about the CMO portfolio, which at that point was initially rated almost all AAA.

And we announced - I believe it was at the end of  I remember, it was the end of first quarter; I think it was the end of first quarter - that we were starting to do impairment testing on individual securities in the portfolio. Not waiting for the official downgrade by the rating agencies but, where we thought that we had concerns about the securities or it was on credit watch or some forward-looking indicator, we indicated at the time we were trying to get a little bit ahead of the issue by doing that rather than waiting for the downgrades.

So we've consistently during the year each quarter taken impairment on testing on securities in advance of their downgrades. This quarter a lot of the downgrades caught up and you're seeing the result, but it's not - from our perspective there was no big change due to the downgrade. That was a lagging indicator of the impairment, which we had already been testing for. And the impairment this quarter was only $18 million, I believe, flat with the prior quarter.

Operator

Your next question comes from Matthew Snowling - Friedman, Billings, Ramsey & Co.

Matthew Snowling - Friedman, Billings, Ramsey & Co.

Can you discuss how you're positioned for further rate cuts in terms of your balance sheet.

Donald Layton

In terms of our official asset and liability position, we are slightly positive if rates are cut, but we want to give a caveat. Normally when you talk about rate cuts you think of the whole yield curve moving up and down. In this particular case, while rate cuts from the Fed might be official, we do note, as has been well covered in the media, that other rates like LIBOR and such have been very erratic due to credit issues and liquidity issues between banks.

So we just regard the whole possibility as being a relatively minor impact of various rate moves, because so far LIBOR is not particularly following in a lockstep way the fed funds rate.

Matthew Snowling - Friedman, Billings, Ramsey & Co.

What did you end the quarter in terms of your [inaudible] spread?

Donald Layton

I didn't catch the - can you repeat that?

Matthew Snowling - Friedman, Billings, Ramsey & Co.

At the end of the quarter, what was the net interest spread?

Donald Layton

At the end of the third quarter?

Matthew Snowling - Friedman, Billings, Ramsey & Co.

Right. [Inaudible] the average, but how did you exit the quarter.

Bruce P. Nolop

The spread was slightly lower in September than August, if that's your question. But I just want to reiterate that we would be a beneficiary from a rate decline, and so don't read into that that's a strength.

Operator

Your next question comes from Prashant Bhatia - Citigroup.

Prashant Bhatia - Citigroup

The charge offs, I guess, continue to be higher than your originally expected. The profits are lower. The early delinquencies continue to rise, really in all categories if you look at the loans. And the reserves that you have don't really cover the annualized charge offs on the home equity side, and bank capital's declining. So what is it that you would need to see to make you determine you need more capital? Is there a specific number that you're looking at or what's going to drive you to raise capital?

Donald Layton

Okay, there's two issues there. Number one, the current allowance is our estimate of the next four quarters of charge offs for home equity and firsts, as per our accounting policy. It does not equal four quarters of the most recent charge off because, as stated, we believe we are near the peak in delinquencies and charge offs and, of course, the provision we're calling the peak the third quarter. Given the very low growth of these delinquencies of late, in the home equity we think it's justifiable to think that the peak is pretty close. That's number one.

Number two, capital at this point, in this environment every financial institution is interested in capital, and so we are as well. We, with the government program or without the government program, would be looking to increase our capital cushions. We have a wide variety and Bruce, as the new CFO, is studying them of alternatives which we think are shareholder friendly and, if necessary, we would embark upon them, although I note that the size and attractiveness of the government program, it kind of overwhelms our other alternatives in terms of being the preferred one.

Prashant Bhatia - Citigroup

Asked another way, what kind of - you think you're at peak, but I think you had thought that prior as well. What's the margin of safety? How comfortable are you going without capital because, as we've seen, at times when you truly need it, if you wait too long it might be too late.

Donald Layton

First of all, we've never called the peak of provisions yet. This is the first time we're doing that. In fact, I think we specifically didn't do it in the past.

Second, we do have some scenarios run of trying to - what if things are much worse. And we do that internally and we believe our current capital cushions - again, half a billion at the bank and the twothirds of a billion at the parent - are sufficient to cover those kind of reasonable downside scenarios.

Out of an abundance of caution, again, given the overall environment, we're interested in other capital, not only as a defensive measure but, quite honestly, as we come out of, as Bruce said, the light at the end of the tunnel, and if we really do peak earlier than others, we think there might be opportunities to deploy that capital as we're healthier when other firms are not yet necessarily healthy.

Prashant Bhatia - Citigroup

And then just in terms of, you talked about the quarterly profitability. You weren't sure about the past there. In 2009, do you think you'll be profitable on a full year basis in 2009?

Donald Layton

As we said, we'll talk to you more at the end of Q4. The business environment is variable enough. It's hard to make predictions like that much ahead of time.

Operator

Your next question comes from comes from the line of Mike Carrier - UBS.

Mike Carrier - UBS

First a question on just the credit and capital. Your allowance is around 3.3, lower than your net charge off ratio and kind of in between the delinquencies, depending on what you're looking at. I realize the difference in your portfolio in terms of the vintage '06 weighting, but the entire industry isn't all weighted to '07 either. And so your outlook is fairly different than some of the companies, the management teams that we've heard on the bank side.

So just in terms of the changes that you made in the modeling assumptions, what are some of those assumptions and, in particular, I guess, what are you expecting on kind of the unemployment rate going forward?

Donald Layton

We were asked last quarter how does the unemployment rate directly impact our modeling of loan loss provision and charge offs, and the answer is it doesn't. There is no reasonable quantifiable linkage from unemployment directly to an estimate of charge offs going to the future.

Instead, the notion that you're got of unemployment is built into things that are more directly linked, such as roll rates staying high, which we have assumed more than in the past; during the period, which entry level delinquencies continue to be high, and things like that. So that's how they work in.

And this process, you have to work in this process other than to have just an arbitrary number that kind of comes out of thin air, so that's how we reflect the economy. And realizing that any kind of forecast for four quarters, much less all three years, has, as I've said, the usual uncertainties associated with it, that's why we're keeping a substantial additional set of cushions at the bank and the parent to deal with those uncertainties.

Mike Carrier - UBS

In the balance sheet, just curious why the segregated cash would decline by over 50% in the quarter.

Bruce P. Nolop

You got me in that detail. Excuse me. I'm being told that was the sale of Canada coming out of the books.

Operator

Your last question comes from Brian Bedell - Merrill Lynch.

Brian Bedell - Merrill Lynch

Just on the home equity assumptions, does the home price depreciation factor into that analysis and, if so, what would be your forecast of peak to trough home price depreciation on an aggregate basis throughout the portfolio?

Donald Layton

The answer is home price depreciation is in there. In particular it impacts the first lien portfolio assumption; if you actually go into foreclosure what you would get. Rather than have our own estimate we use the Case-Shiller futures, and it's calling for a further 10% decline in the next 12 months in house prices. That's a national average. We do use the numbers by the various metropolitan regions that they carry.

Brian Bedell - Merrill Lynch

And does that factor into the home equity portfolio as well?

Donald Layton

The answer is yes.

Brian Bedell - Merrill Lynch

And then just on the TARP, I guess two things there. Number one, are you considering selling investment securities into the TARP rather than the home equity portfolio? And I guess the reason I would say that is on anything that's a significantly troubled asset, wouldn't you have to take a significant markdown? That would hit your capital immediately and therefore wouldn't it be better to leave an accrual portfolio to sort of bleed over time where you could protect against it over a slower provision?

Donald Layton

Yes. You have made a statement that has a lot of true parts to it, but I'll repeat our basic comment. The actual asset sale program is so unspecified at this point, how it's going to work with respect to securities, how it will work with respect to home loans. We don't know enough to have an intelligent opinion, therefore our working assumption, everything considered, is we will continue to own all these - to hold loans until maturity.

Operator

That concludes the question-and-answer portion of today's call. I will now turn the call back to Don Layton for some closing comments.

Donald Layton

Okay, I want to thank everyone for participating. There are three themes that I think everyone should keep in mind for this quarter, dominating the results.

Number one, the actual underlying customer business is doing fine, participating competitively. It is not particularly impacted by our balance sheet issues. That was a great concern back 9 months, 12 months ago. It is not anymore.

Number two, we took our larger credit positions. We've explained to you the nature of the review. I want to note the comment that, if our three-year forecast is accurate - it will have the uncertainties of any forecast - we have put the bulk of the problem behind us with the approximately three-quarters of the three-year loss already charged off or provided for.

And the third comment is that our capital plan is working well. We have built up much more substantial cushions than I believe people thought was possible on more shareholder friendly terms during this year so that we could absorb those extra charge offs and still have the very substantial cushions.

And other than that, I think it's a wrap. Thank you very much for listening.

Operator

We thank you for your participation in today's E*TRADE FINANCIAL Corporation third quarter 2008 business update conference call and ask that you please disconnect your phone lines as well as your webcast browsers. Thank you.

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Comments

[sheep:]

the problem is prevailing...and under 2 $ a flock of sheep is just in panic because of Citadel-rumors (so who cares really about the facts - I read all the 10 pages of the conference - and where is the trust after all?)

2008 Oct 29 09:14 AM