E*TRADE FINANCIAL Corporation Q2 2009 Earnings Call Transcript

| About: E*TRADE Financial (ETFC)

E*TRADE FINANCIAL Corporation (NASDAQ:ETFC)

Q2 2009 Earnings Call

July 22, 2009 5:00 pm ET

Executives

Don Layton - Chairman and CEO

Bruce Nolop - EVP and CFO

Paul Brandow – Managing Director, Risk Management

Analysts

Howard Chen - Credit Suisse

Mike Vinciquerra - BMO Capital Markets

Rich Repetto - Sandler O'Neill

Roger Freeman - Barclays Capital

Mike Carrier – Deutsche Bank

Matt Snowling - FBR Capital Markets

Michael Hite – JMP Securities

Operator

Welcome to the E*TRADE FINANCIAL Corporation second quarter 2009 business update call. (Operator Instructions)

I've been asked to begin the 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 10-Ks, 10-Qs and other documents E*TRADE 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 July 22, 2009. Please note that E*TRADE FINANCIAL disclaims any duty to update any forward-looking statements made in the presentation. During 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 the call or in the company's press release, which can be found on website at investor.etrade.com. E*TRADE has filed a definitive proxy statement with the SEC. Shareholders are advised to read that document and related proxy materials before voting at the special shareholders meeting scheduled for August 19th.

This call is being recorded. Replays of this call will be available via phone, webcast and podcast beginning today at approximately 7:00 pm Eastern Time. The call is being webcast live at investor.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 with Bruce Nolop, Chief Financial Officer, and other members of the E*TRADE management team.

Mr. Layton, please go ahead.

Don Layton

Thank you all for joining us this afternoon. This quarter marked several important milestones for the company and we appreciate the opportunity to discuss with you the progress we have made. Bruce will take you through our financial results for the quarter, but first I want to address three topics with respect to the quarter’s strong results: Growing our core franchise, managing our credit portfolio and executing against our comprehensive capital plan. First, let me touch on our core franchise which continues to perform exceptionally well. Our online brokerage business is quite simply, thriving. We continue to take market share from traditional brokerage firms and to benefit from favorable market conditions, with increases in transactions, new customer accounts and both commission and interest income revenue.

Second quarter trading activity was robust. We set a new quarterly record, at 221,000 daily average revenue trades, or DARTs, our 2nd such trading volume record in the last 3 quarters. This represents a 14% increase over the prior quarter and a 28% increase over the same period in 2008 as we continue to benefit from our enhanced focus on the investing customer and favorable market conditions. And, as customer buying power and confidence improved with the markets, margin receivables increased 29% to $3.1 billion at the end of the quarter. We also saw significant growth in brokerage accounts this quarter, reporting a record 2.7 million accounts, a net increase of 54,000. With our emphasis on growth in brokerage accounts, we now have added more than 200,000 net new accounts during the last 12 months; far higher than historic averages. I should also point out that brokerage account attrition continues to trend lower. Attrition was just 12.6% annualized, versus 15.4% annualized for the same quarter a year ago. In addition, we averaged 1.65 brokerage accounts opened for each one closed; a 33% increase over the year ago period. The improvement in both of these metrics reflects our focus on the brokerage customer, especially in terms of improved service quality.

Total customer cash and deposits decreased $700 million. This net reduction reflected a $1 billion increase in brokerage cash, our most advantageous source of funding, offset by a decrease in non-sweep deposits of $1.7 billion. As a reminder, we are decreasing our non-sweep deposits to accommodate the reduction of our balance sheet, due to the fact that our loan portfolio is in full run-off mode. We were able to achieve the reduction in non-sweep deposits chiefly by reducing the yield on the complete savings account, or CSA, by more than 200 basis points this year. The CSA yield began the year at 301 basis points, which was reduced to 145 basis points as of march 31, and stands at 95 basis points today. Still, we added $900 million in net new customer assets this quarter, even with the impact of the planned reduction of non-sweep deposits.

Our focus on the investor franchise and our back-to-basics approach, is producing strong customer performance metrics quarter after quarter. This approach emphasizes excellence and discipline in execution, continuously improving service quality and addressing customer dissatisfiers, along with a full product development pipeline for long term investors as well as for our active trader client base. As a result, our vibrant and profitable online brokerage business is providing and excellent foundation from which to build future growth.

Let me now turn to credit. For the 2nd consecutive quarter, our loan portfolio has shown improving delinquency trends. Our delinquency numbers clearly suggest that our loan portfolio is further advanced in the credit cycle than the broader industry. In the home equity portfolio, which represents the company’s greatest exposure to loan losses, special mention delinquencies, that is 30-89 days delinquent, declined by 12% and agrious delinquencies, that is 30-179 days delinquent, declined by 19% from the end of March. These declines seem to be indicative of both the advanced seasoning in our home equity portfolio, which carried an average seasoning of 43 months at quarter-end, and our aggressive actions in 2008 to reduce open lines. Our one to four family loan portfolio has begun to show encouraging signs of reduced delinquencies this quarter. Specifically, special mention delinquencies are down 4% from March 31st and total agrious delinquencies are similarly down 3% from March 31st. Loan rates are stable overall, although there was a modest increase in severity at the 180 day charge-off point from 21% to 24%. For the total loan portfolio, the decline in special mention and agrious delinquencies resulted in another significant quarterly reduction in provision expense.

Before I move on from credit, I wish to mention that our increasingly successful loan modification program is contributing to the meaningful improvement in the quality of the loan portfolio. We have completed over $250 million in loan modifications, primarily via permanent or temporary interest rate reductions and we are pleased with the performance of this program and its success in allowing more Americans to stay in their homes.

Finally, let me turn to the very significant progress we recently have made in executing our capital plan to strengthen our financial health and position the company for long term growth and profitability.

During the quarter, we raised gross proceeds of more than $600 million of cash common equity, materially strengthening our balance sheet. Our capital raise shares, which Bruce will take you through in detail, are now clearly stronger than they were at the beginning of the year, and will help to ensure that we remain significantly above the well-capitalized threshold as defined by our regulators, even under weaker economic conditions than are expected. Equally important, assuming completion, our pending debt exchange for $1.7 billion, which was more heavily subscribed than anticipated, will cut our cash interest payments at the parent company by more than half. We will hold a special shareholders meeting on August 19th to seek approval of the exchange of the irrevocably tendered bonds. Assuming we receive shareholder and regulatory approval, we expect to close the debt transactions by the end of the third quarter.

Needless to say, we are thrilled with the results of our recapitalization to date. The success of the equity and debt transactions, we believe, demonstrate that investors see the strong franchise value and growth potential of our online brokerage business, that they see credit issues declining and becoming manageable and that they see that our recapitalization gives our bank, our balance sheet strong enough to carry it nicely through the rest of this credit cycle.

With that, I’ll turn the call over to Bruce for more on the quarter’s financials.

Bruce Nolop

Thank you, Don.

During the quarter, we generated a net loss of $143 million or $0.22 per share on net revenue of $621 million. The loss was due primarily to the loan loss provision of $405 million. While the provision remains high, we are pleased that it has decreased for the third straight quarter. It is more than $100 million off its peak and is nearly converging with quarterly charge-offs.

Our 2nd quarter revenue included net interest income of $340 million, a 22% increase over the first quarter, which resulted from a 57 basis point expansion in the interest income spread to 291 basis points. The largest contributor to this significant spread expansion was the 50 basis point reduction in the annual percentage yield on our complete savings account from 145 basis points to 95 basis points. We do expect to see a continuation of favorable interest rate spreads, but on a gradually declining balance sheet.

Commissions, fees and service charges, principal transactions and other revenue were up 18% over last quarter, which reflected higher commission revenue from the record trading volume in the quarter and an increase in the average commission per trade by $0.46 to $11.05, which was due to a more favorable mix.

We continue to practice disciplined expense management, keeping down the costs that are within our control. However, operating expenses increased $35 million sequentially due to FDIC fees being higher by $29 million, which included a one-time $22 million special assessment and $10 million in increased reserves for legal matters. Therefore, the additional volume-related costs were more than offset by our ongoing expense productivity programs.

Our loan loss provision of $405 million was slightly above the $386 million of net charge-offs during the quarter. The total allowance for loan loss as thus, was essentially flat at $1.2 billion, as of June 30th. This allowance was equal to 5.3% of gross loans receivable, which compares with 2.3% a year ago.

Total special mention delinquencies were down 8% from March 31st and total at-risk delinquencies were down 9%. The movement during the quarter included for the home equity portfolio, at-risk delinquencies were down 19%; for the 1 to 4 family portfolio, at-risk delinquencies were down 3%; and for the consumer and other portfolio, at-risk delinquencies were down 10%. The allowance for loan losses as a percentage of non-performing loans or the coverage ratio, ended the quarter at 83%, which was down from 92% last quarter. However, excluding the non-performing loans, at least 180 days past-due as they have been written down to their expected recovery value, the coverage ratio was 169%, which was up from 149% last quarter.

To summarize, at-risk delinquencies declined across the portfolio, reflecting a consistent decline in special mention delinquencies that began at the beginning of the year for home equity loans and more recently for the remainder of the portfolio. We increased the 1 to 4 family reserve, but reduced the reserves for home equity and consumer and other loans.

In terms of liquidity, we had $527 million of corporate cash at quarter end. The bank had $4.5 billion of cash and we had unused federal home loan bank credit lines of $6.7 billion. I should note that the decrease in unused lines this quarter reflects the Atlanta Home Loan Bank’s revised rules that increased the haircuts on pledged collateral.

Finally, I want to provide more insight concerning our comprehensive capital plan to bolster the bank’s capital cushion and strengthen the company’s capital structure.

We successfully raised $586 million of net cash equity in the 2nd quarter. In total, we injected $500 million as equity into the bank during the quarter. The $500 million in new capital was much greater than our net usage of $28 million of risk-weighted capital during the quarter. We generated $333 million of organic capital during the quarter. Through $232 million of bank earnings before taxes and credit losses and $101 million of freed up capital through a reduction in the loan portfolio. Other sources and uses were a net contributor of $44 million. These positive amounts were then offset by the credit provision of $405 million, resulting in the net usage number of $28 million. Thus, we realized a $472 million increase in the bank’s capital cushion during the quarter, ending with $916 million in excess risk-based capital, over the well-capitalized threshold.

We also reported bank Tier 1 capital on total adjusted assets of 6.79% and Tier 1 capital on risk-weighted assets of 12.65%. At the same time, we are well on our way to materially reducing the parent company’s debt service burden. Assuming we receive shareholder and regulatory approval, we will exchange approximately $1.7 billion of non-interest bearing, convertible debentures for an equal principal amount of our existing high yield debt. Bond holder response to the exchange offering exceeded our expectations, with Citadel tendering the maximum amount of $1.23 billion and with virtually all other holders participating at their maximum levels, as well. Assuming completion, this exchange will reduce the parent company’s annual cash interest payments by approximately $200 million, to an annual total of approximately $160 million.

Our $527 million of corporate cash is up $121 million from the end of the prior quarter. Assuming the debt exchange is approved by shareholders and regulators, this should be sufficient to meet the parent company’s cash debt servicing requirements through 2011.

And I will now turn the call back over to Don for his closing comments.

Don Layton

Let me wrap up with some forward looking comments in the same order as my introductory ones; the customer franchise, credit exposure and our capital position.

First, the customer franchise. The business is firing on all cylinders and we are extremely happy about how well the franchise is performing. We continue to get our fair share of volumes and revenue versus our online competitors and are clearly gaining share against traditional brokerages. Our focus on the investor customer and the basics of the online brokerage business are really paying off. Nevertheless, despite the high volumes in the first half of the year and the records DARTs this quarter, we will continue to manage the business to a conservative outlook for the 2nd half of the year, just as we did for the 1st half.

We will continue to manage expenses closely and as we did for the first half, we will be positioning the company to more likely be surprised on the upside and to produce strong operating income.

Second – credit exposure. Loan delinquencies, which are the precursor to losses, are declining nicely with special mention delinquencies down 17% from the end of 2008. As a result we believe we are likely to have a material reduction in quarterly charge-offs during the remainder of the year. We believe that this past quarter marked the cyclical peak for charge-offs and that likely we will soon reach the stage where the loan loss provision is less than the charge-offs during the quarter. We expect that this crossover probably will occur sometime later this year, which will mark a significant watershed event in our eventual return to profitability.

And last, our capital position. We have strengthened the bank’s capital position considerably and we are continuing to generate bank capital organically, both through consistent pre-credit provision, profitability and with our deliberate efforts to reduce the size and risk of the bank’s balance sheet. We estimate that the break-even credit loss provision for the quarter is about $250-$300 million. Therefore, with the expected decline in the loan loss provision, we anticipate that the bank will be a net generator of regulatory capital in the foreseeable future, possibly even later this year.

Assuming the debt exchange receives shareholder and regulatory approval, which we fully expect to occur, we also will have enhanced the parent company’s liquidity and reduced its debt service burden, especially through the end of 2011. As a result, we’ll be in a position to be flexible and opportunistic in response to market conditions with regard to our capital planning actions such as further debt for equity exchanges, additional open market equity offerings or sales of any non-core assets.

In summary, we believe are now much better positioned, both to cope with any unforeseen problems and also to seize the opportunities that we see for our online brokerage franchise. With that operator, you may open the line for questions.

Question-and-Answer Session

Operator

(Operator instruction). Your first question comes from Rich Repetto with Sandler O’Neill.

Rich Repetto – Sandler O’Neill

Good evening Don and Bruce.

Don Layton and Bruce Nolop

Hi.

Rich Repetto – Sandler O’Neill

I guess the first question is, you had a significant expansion in the bank net interest margin and you explained how the complete savings account and you can see it in the earnings release that the costs went down by almost half, I guess the question is - $1.7 billion in deposits in CSA went away but the average balances went up quarter to quarter; does that mean we’ve still got a nice decline coming going forward?

Bruce Nolop

When you say the average balances, what do you mean? The average balances of what item?

Rich Repetto – Sandler O’Neill

Of the retail deposits. They went from $26.4 billion to $27.1 billion, even though you had a $1.7 billion you said, sort of draw down on the CSA.

Bruce Nolop

Yeah, simplifying some but not a lot, we have 2 major components to our retail deposits; one is the sweep deposits. They are our most advantageous source of funding; they are inexpensive and they are part of our customer franchise. We like them. They have gone up well, that’s a positive thing in most ways. Second part would be our direct to the bank savings deposits, CSA being the largest one. That’s the one where we’re reducing the rate to show it will start coming down, because in aggregate, we just do not need all the liabilities we have. I want to highlight that for a minute. Through 2008, due to the market conditions and our particular situation, we were very concerned about liquidity at the bank level and we had liability costs competing with other firms that wanted to make sure they had good support from their depositors. We’ve gone from that liability position where we had to pay high rates on deposits, to a position where we’re actually ultra-liquid at the bank and we are literally looking to have reduction in deposits to accommodate our shrinking asset side balance sheet as the loan portfolios and total runoff. So we think there’s more room to shrink the balance sheet. We will be doing that consistently as loans runoff, as well. We had a large amount of cash at the bank balance sheet at quarter end; larger than we’d like. We’ll be looking to reduce that over time. We would however, be consistent with treating our customers reasonably and doing it in a relatively smooth manner consistent with our business franchise.

Rich Repetto – Sandler O’Neill

Got it. Okay. Next question is, you had pretty sizeable pre-provision, pre-tax earnings of $232 million. Now there is the agreement with Citadel on the market making side – I’m just trying to see is there any kind of – and I know trading activity was out of whack and high, as you mentioned but – any sort of guidance on how the change of the market make – I know it’s low margin business but, what guidance on that pre-provision, pre-tax earnings, going forward?

Don Layton

Yeah, Rich, the Citadel transaction is still subject to approval by the OTS, it’s not been implemented. But I would comment that first you do see our principal transactions which is the market making business, that had a good quarter. Secondly, one of the things that contributed to our net interest income this quarter in the bank was in the stock borrow transactions, that was up considerably during the quarter and quite helpful. Then finally, the order flow transactions that we currently do with Citadel and with other, with our own in-house activity, those order flow incomes were higher as well. So, the gist of your question is correct that the increase in trading activity was one of the contributors to the higher organic capital generation and income at the bank this quarter.

Rich Repetto – Sandler O’Neill

Got you. And all those things seem consistent with your peers as far as security lending and payment (inaudible). I guess last question, Don, is you know if seems like you’ve executed - barring drastic change in the credit environemnt, you’ve executed on a plan – I guess the last risk seems like with all companies these days, regulatory risk. Could you go through just any updated view on what the regulators have said after the capital raise? Is there any interest in TARP at this point?

Don Layton

Okay. Well obviously when we did the capital raise we indicated to everybody that we developed our plans including with close consultation with our regulators. We’re not going – you can appreciate that we would never comment upon the details of the conversations we have with regulators. But it’s sort of obvious that they’ll be happy with extra capital and reduced parent debt burden. But beyond that, they’re not going to make any comment and I wouldn’t comment on their comments to us, if you will.

But, just some common sense – looking at the numbers – I’ll point out some numbers that as a regulator you would be interested in here. One of course is the provision decline, another is - we focus on the bank excess risk weighted, risk-assets, up to $916 million; that is an extremely high level versus where we have been. That’s obviously a positive with any kind of regulatory regime. And, I want to emphasize one of the items Bruce went through, is what we call our capital walk. Between the shrinkage and the risk-weighted assets and the bank, between the high pre-credit operating earnings and other misleading items, we only used $28 million of the $500 million of capital. That’s a very low number and as a regulator, you’re going to be looking for that number to turn positive, because then you have a situation where the bank organically generates more and more capital. It’s going to bounce around some and we’ll make no promises, but we think that when it turns positive is not that far off in the future; so that’s obviously a good thing for anyone who thinks from a regulatory perspective. In terms of TARP, we didn’t mention it in the press release because honestly there’s nothing new that’s happened. We have - our application remains active. We indicated when we did the equity raise we were going to leave it active and not withdraw it at that time. Obviously, we represent a different financial picture to the treasury, who is the decision-maker here. But we only represent right now a partial different company; we do have our common equity. But, we won’t represent the fully recapitalized E*TRADE until the debt exchange closes, which again we’ve said will be sometime later this quarter.

Rich Repetto – Sandler O’Neill

Understood. That’s all I have and hopefully this has been a pivotal quarter for you.

Don Layton

Yeah, I mean, let me summarize. The operating business was great, credit continued to moderate and lot of people told us that you need six months to really prove your case; we now have six months. Including capital we think we hit a home run in our capital planning.

Bruce Nolop

Thank you.

Rich Repetto – Sandler O’Neill

Thanks.

Operator

Our next question comes from Roger Freeman with Barclays.

Roger Freeman - Barclays Capital

Oh hi, good evening. Within the 1 to 4 family bucket, as you point out the dollar amount of delinquent loans is coming down, which is certainly encouraging. How do you look at that sort of on a percentage basis? It did tick up, although it looks like most of it was in June. So I’m wondering is there anything in June, or if there’s been other months where there’s been a timing mismatch between when mortgages are due and when once a month paychecks come through, that kind of thing that cures themselves pretty quickly? Is there anything there? Because, this trend is a little different than what some of your peers have been showing us in improvement.

Don Layton

I want to remind you that we are not a direct servicer of any of our mortgage loans.

Roger Freeman - Barclays Capital

Right.

Don Layton

Because of the way the timing works, in home equity we are able to report the same month. So, when we say June, it was the month of June. For first mortgages, because we have so many servicers, it’s on a one month lag. So the number you’re seeing for June as reported is actual May. May, as best we can tell is a seasonal slow point in mortgage payments, first and seconds, as a generalization in history and as much as we can tell. We don’t think there’s anything else going on other than that. And don’t ask me why May is slow – it just seems to be that way.

Roger Freeman - Barclays Capital

Got it. Okay. Now I think in your Q last quarter I read you were removing the broker underneath the bank. Has that occurred from a legal perspective? And can you just talk about sort of what – was that something the regulators wanted you to do in order to be able to guarantee that your upstream capital to the broker? And, does it make it any more difficult to sell up just the brokerage business or for that to come up?

Don Layton

You asked a lot of question about I guess one topic. First of all, yes it has legally been completed; it was completed during the month of June. Second item was that it was done at the request of the regulators. But, you get into the issue of would it now be more difficult to sell off the broker rather than the bank. The answer was I try as much as possible to let people know that the concept of selling off the broker, whether it was before the move under the subsidiary, of the bank, or now, is not in fact practical from a wide variety of perspectives. The business flows between the brokerage firm, the clearing subsidiary and the bank are intermixed from our customers and it’s really a single business with different legal entities booking.

Roger Freeman - Barclays Capital

Understood. Actually to that point then. Now that we can sort of have a longer term discussion about how your business is going to evolve, to the point of the bank, how do you perceive the bank existing in the future of E*TRADE. To some extent you’re sort of taking down emphasis on the non-transaction sort of deposit accounts. Are you going to be a business that some day makes mortgage loans again? Is there going to be a bank tied to E*TRADE or is this really going to be more of a brokerage business?

Don Layton

We stated I think probably most clearly in the annual reports that I’ve written, our focus lies on the investor business. And that means, in terms of legal entities and product lines, a broker operation and clearings off of brokerage and all sorts of investment products and it actually means a bank, a bank is necessary to extract full value from the sweep deposits and as well it will be emphasizing offering investment products to compliment other alternative investments, in this case savings products, to compliment other investments to our clients. And it is to be a vehicle to offer money transfer, money movement products, which investors like as well. So, for the reasonable future, while we work through our problems, the bank is limited to that. The loan portfolio is in full run-off mode. And that’s where we’re aiming at this point. Not to be a bank for a bank, but a bank as an adjunct to an investor business.

Roger Freeman - Barclays Capital

Got it. And just lastly, the increase in the stock borrow revenues this quarter; how much of that was from the trading of Citigroup? You haven’t had difficulty to borrow that stock?

Don Layton

We don’t comment on Citi stock other than to say that we were benefitted by the fact that there was good demand for certain stocks in the market. And you are as currently up on those names as anyone.

Roger Freeman - Barclays Capital

Okay.

Don Layton

But we can’t comment otherwise.

Roger Freeman - Barclays Capital

Okay. Thanks.

Operator

Your next question comes from Matt Snowling with FBR Capital Markets.

Matt Snowling – FBR Capital Markets

Good evening. Don I just wanted to follow up on some of your earlier comments on the nemesis margin. I understand what you’re doing in terms of taking down your funding costs for your deposits. But, when shrinking the balance sheet, why would you not first look at repo funding, which is coming in at a higher rate?

Don Layton

Yeah. We would look at it first. We have two wholesale types of funding on the bank balance sheet on the liability side. One is that repo book you mentioned and the other, actually, is home loan bank borrowing. Most of which are at fixed rates, so given the way rates have gone or rates that are now perceived as high. Unfortunately to reduce either of those beyond what we have done would have significant earnings impact. In terms of the home loan bank, we would have to pay what is basically economic make whole clause and lock up against today’s low rates a loss, which we don’t think is desirable when we’re very aimed at having good capital ratios for the bank. The same thing is true on the repo book. The repos, while floating rate instruments in terms of interest rate sensitivity, were established several years ago. Against them on the asset side were fixed rate, longer assets and hedges were put in place. Given the way the rates have gone, those hedges are now at significant negatives and if we took the repos down we would have to recognize the mark to market on those hedges and that would be a significant negative. So we wish to rather run both of those types of liabilities out and avoid having the undue accounting loss, which would hurt our capital ratios.

Matt Snowling – FBR Capital Markets

Okay. That makes sense. Can you tell us the duration of those – repo and home loan bank funding?

Don Layton

The answer is: Mike?

Mike Peevus

The duration of home loan bank funding loans is 5 years. The duration of the repos, they extend out approximately 10 years, but they ladder down over that period.

Don Layton

That was Mike Peevus, treasurer of the bank.

Matt Snowling – FBR Capital Markets

Another question in terms of the $5 billion of cash that you’re sitting on, earning 30 basis points, you said you were going to look to take that down going forward. Can you help us understand what you’re going to look at?

Don Layton

Our preferred method of reducing it is by having the liability side of the balance sheet shrink, not redeploying it into other assets.

Matt Snowling – FBR Capital Markets

Okay. That makes sense. And one more question on the Citadel payment for order flow. I think you’re expecting a $100 million gain; does that fall in the next quarter?

Bruce Nolop

First of all, it would not be a gain, it would just be cash paid forward to it. That would be in the 3rd quarter. But again, that’s still subject to approvals. So we don’t want to imply that it is a done deal.

Matt Snowling – FBR Capital Markets

Okay. Thanks a lot.

Operator

Your next question comes from Mike Carrier with Deutsche Bank

Mike Carrier – Deutsche Bank

Thanks. The first question is just on the core brokerage business. If I look during the quarter at advertising expense, you know got taken it down fairly significantly. I think if you pair that with the lower rate on the savings account, it looks like obviously you had the net new assets decline from the $3.5 billion run rate over the past few quarters to less than $1 billion. Then your net new brokerage account gross turned negative in June. Then clearly now, we’re facing the seasonal headwinds with DARTs being down. How are you guys balancing – you know you want to invest in the business so you don’t turn away clients versus managing the costs and managing the balances on the liability side of the balance sheet?

Don Layton

You’ve put together a lot of different data points and I think you’re getting yourself headed in the wrong direction from our point of view. Let me just hit a few items. Number one, our advertising has always been seasonal and the first quarter is our high point anyway. So, advertising works somewhat with a lag, therefore the first quarter is very important. Second, you’re kind of facing the summer low so you don’t do as much; so that’s traditional. Number 2, you pointed at June in particular going negative. We have a tradition here of – although we’re changing it – where we have a quarterly fee to people who have inactive or small accounts. The fee hits in March, the end of March, June, September, December. So if you look back, you will find we always have a pattern of account closures in the third month of the quarter. It’s not anything strategic; it’s just a normal seasonality. I’ll mention as an aside that we’re reducing the impact of that fee and we’ll be getting rid of it over time.

The AUM going down is again, that is mainly due to the fact that the customer non-sweep deposits that we’re pushing out, went down. We are specifically trying to manage that down for a balance sheet. If you adjust for that, you will find it was quite a reasonable level. Lastly, when I believe we did the first quarter call, Bruce had indicated that in our budgeting we made a conscious decision about expense levels in advertising that reflected our desire to keep advertising out there, like its normal business, but number one as everybody knows reading the newspapers – especially the newspapers – advertising rates are down. So, you get the same bang for the buck. I’ll mention secondly that a lot of our advertising historically was aimed at deposits when we worried about raising a lot of deposits, whether as part of the business strategy or for liquidity. We clearly don’t need to do that anymore. The third item is, we did make a decision to shift somewhat at the margin dollars and budgeting towards product development and a little bit out of advertising is where we felt we got more customer bang for the buck. So we don’t think we’ve got anything here that indicates anything other than a full blooded approach to developing the business. The rest is just kind of noise and tactics.

Mike Carrier – Deutsche Bank

Okay. All fair. The only other question is, when you’re managing the balance sheet, I guess the focus is on the investment products longer term. But I guess in the near term, in terms of your models, how accurate are you guys in terms of taking that savings rate down by 50 BPs? What are your expectations in terms of the client balances leaving? Are you fairly sure that the 50 basis points is enough or do you run the risk that too many assets leave the bank before the run-off on the loans?

Don Layton

You asked two questions. One is what’s happening and the other is predicting. Given the way rates are ultra-low, we’ve never quite been in this environment, the ability to predict exactly what’s going to happen to non-sweep deposits or rate changes, we have modest ability to do so, but I wouldn’t’ overemphasize it. Obviously, our non-sweep deposits will reflect our rate, what the competition is doing, what other business customers are doing with us and such. What we do know is we would like to definitely run down the percentage of our non-sweep deposits, which comes from people, bank depositors who are not brokerage customers. We have been running down that percentage and continue to work on doing that, that it would be no more in the parlance of internet hot money or whatever phrase you like. We’re trying very much to make sure our brokerage customers stay here. We have marketing people who watch the impact on the brokerage customers, and so far we haven’t found any material hit to our brokerage customers and I’d say that the 2nd quarter’s DARTs and most of the other aggregate numbers, net new brokerage accounts, trend and indicate that we’re able to handle that trade off quite well.

Mike Carrier – Deutsche Bank

Okay. Thanks a lot.

Operator

Our next question comes from Howard Chen of Credit Suisse.

Howard Chen – Credit Suisse

Good afternoon Don and Bruce.

Howard Chen – Credit Suisse

Good afternoon.

Don Layton

Hi Howard.

Howard Chen – Credit Suisse

Thanks for taking my questions. I hear your constructive commentary on overall credit quality. But the company is still seeing new early delinquency and MPA formation and that environment still seems uncertain. So I guess I’m just not entirely clear on how you get to a point where you’re bleeding loan loss reserves later this year. Could you just detail and refresh some of the thinking on just your overall macro assumptions? What happens with home prices and what you see in terms of the new formation as we look out the next few quarters?

Bruce Nolop

This is Bruce. I’ll tell you, I think we haven’t really changed the way we have done it all along, which is to do modeling. In terms of home price assumptions, it’s using Case-Schiller data. So that has an assumption of 4.5% decline over the next 12 months. So that’s imbedded in there. But I think what gives us the most confidence about loan loss provision coming down is just the nature of the accounting, where you are always going out at least 12 months, predicting what your charge-offs will be. So therefore, if delinquencies have been coming down and you expect that you will be having lower charge-offs as a result, that has a compounded effect on the loan loss provision, which is why we think it has to – at some point – start initially going at least equal to charge-offs. But then, it will go lower than charge-offs. The way the accounting works, you will actually see positive capital generation before you’ve seen the total decline in charge-offs. Loan provision is more like a leading indicator and charge-offs are more lagging. That’s what gives us the confidence about it.

Howard Chen – Credit Suisse

Okay. I understand the accounting. I was just more curious about the timing and expectation for the back half of the year.

Bruce Nolop

I just turned to Paul Brandow who is our Chief Risk Officer. Maybe you can just elaborate a little bit further.

Paul Brandow

The only thing I might add, if I listened to your question correctly, is the reason we get some confidence is we have actually not seen an increase in entry-level delinquencies and non-performing assets. Quite the opposite. Entry-level delinquency is consistent, in the special mention category in particular, with (inaudible) it translates sort of mathematically because lower rates translate into lower charge offs which in turn as Bruce mentioned, into the lower accounting number provision.

Don Layton

We have a more general comment. A lot of people come to us and go, what are you macro economic assumptions in doing your loan provision or allowance creation? In fact, for a specific portfolio it is so difficult. There is no ability to correlate, if you will, macro GDP assumptions or unemployment assumptions. The thing we use most is just the pattern of delinquencies coming in and rolling through the pipeline to the charge off point. It’s by far the most dominant. And because allowance is based on four quarters going forward for most of the portfolio, leaving out modified loans, and we have the first six months virtually kind of known because the delinquency is already in and it runs off to 180 point, we get a fair amount of confidence about where we’re going.

Howard Chen – Credit Suisse

Thanks. As a follow up on a separate topic, could you just provide some color on the OTTI charges and gains on sale this quarter?

Don Layton

First of all, the OTTI was a net charge of $30 million. There was a larger number in the income statement, but that was simply due to a change in the accounting rule. So it has a large number of about $200 million. That is nothing new. That is simply reflecting what has already been taken through other comprehensive income. So $30 million was the impairment this quarter. And, the other question is about the gain. We have benefitted from the agency security portfolio essentially being up in value. When we looked at the opportunity to lock in those gains from what we thought the value was, compared to what the market was, we though this was a great time to do so. So that was the gains that we took this quarter.

Howard Chen – Credit Suisse

Okay thanks. And then a final one for me. Just a follow up on the downsizing of the balance sheet. I hear all your commentary on the retail versus wholesale funding to clients and why you can’t do one or the other. But, it seems like a lot of firms have always had the opposite problem that you’ve had and they’re asset rich and liability poor. Do you think there’s any opportunity to garner any value in those deposits, rather than maybe just letting them go?

Don Layton

First of all, you’re absolutely correct. We find ourselves in the very odd position of being a company that has been – at least up until our capital raise – capital-challenged but at the same time so liquidity rich. It reflects who we are that our underlying customer base is investors. People with cash, not borrowers, such as a credit card or an auto loan company or something would have. We think about the issue of the value of those deposits strategically, where we can’t use them and that there are opportunities possibly in the marketplace to do it. We’re aware of that, we think about it, but I wouldn’t say anything more specific than that until someday we might announce something.

Howard Chen – Credit Suisse

Okay. Thanks, Don.

Operator

Our next question comes from Michael Hite with JMP securities.

Michael Hite – JMP Securities

Hey guys, good afternoon.

Don Layton

Hi.

Michael Hite – JMP Securities

I just wanted to come back to the overall strategy of the balance sheet. You talk about I guess the strategy of shrinking the balance sheet at the bank, but I think over the last 2 or 3 quarters, the average interest earning assets have expanded and I know a lot of that is just cash and cash equivalents. But, also I’m somewhat surprised to see MBS available for sale. So I have a two part question. What are you buying and kind of what’s the intermediate term plan for the size of the balance sheet?

Don Layton

We are looking to shrink the balance sheet. We are behind in where we’d like to shrink it for the very normally great reason that our sweep deposits have been growing, not shrinking. And, that despite the major reduction in our CSA rate, instead of the money dramatically declining, it has proven to be rather sticky and only started to decline really late first quarter, early 2nd quarter when we had the rate reduction. Normally in the financial business, these are considered unalloyed, joyful things to have – you have good liquidity and loyal customers. So we’re behind which is why our cash isn’t building up on the bank balance sheet, some of which has been channeled into growth into typical agency MBS. The agency MBS we use, as a broad generalization will be relatively short duration and by definition, virtually no credit risk items. Other than that, the people on the desk, Mike Peezu you heard from earlier, will choose exactly what types to go into at the time, based on market views that they have.

Michael Hite – JMP Securities

Okay. And then just to follow up on the question earlier on the net interest spread. The 291 basis points versus 230 for the last quarter. It seems like there are some moving parts here. Obviously the CSA declining, which is higher costs coming in, that maybe sticks and there maybe some benefit going forward if that continues to come down, but the stock lending stuff may be not as permanent. Can you just help us think about the direction and the sustainability of the net interest spread at 291 basis points?

Bruce Nolop

I think you put it quite well that the stock loan business definitely helped this quarter and we’re not counting on it being at this high level going forward. But the other potential are twofold. What Don said before, I’ll summarize. You have two positive trends. One is a mixed trend in that our cost of funding is declining as the ratio of sweep deposits goes up, relative to non-sweep deposits. It’s just lower-cost funding. Secondly, as Don also mentioned, you have the potential for further reduction in the CSA rate and that is something. Then the other thing I would point out is you’ve got much more cash right now than we’d like. We have $4.7 billion, compared to our goal of more like $2 billion. That’s money that’s not really earning its full potential. So either through a reduction in the amount that we pay for funds or in reinvesting that cash in something better for earnings, that also gives you the upside. So bottom line as I said in my prepared remarks, we think that the spread should be relatively constant. The issue is more of the declining balance sheet.

Michael Hite – JMP Securities

Just one specific follow up. The yield on margin receivables picked up a nice amount quarter over quarter and just any more color on that?

Bruce Nolop

Right. That is simply due to the international – essentially it was higher this quarter. If you look at what we do in our base business in the US, it was relatively constant. Nothing there. It’s just an anomaly for the quarter.

Michael Hite – JMP Securities

Then a question on – I think this was mentioned in an earlier question – the pre-tax, pre-provision, the bank earnings of $32 million that ticked up from $181 million. I just want to understand the definition of that. When I deduct that from the overall pre-tax, pre-earnings fro the entire company, it kind of implies negative earnings for the retail business. I’m just trying to figure out where my math is wrong there.

Bruce Nolop

As Don said, we really run the company as a single business and much of the profit of the broker is in the bank. In fact, at this point, we moved securities under there; the clearing operation is under there. So virtually all of the profit is going to be reflected in the legal entity. So you’re at the point where it’s really hard to distinguish between the two in most cases and that’s the key.

Don Layton

When it’s the bank pre-credit earnings it will reflect part, most of the retail business and it will reflect all of the balance sheet management segment, you can’t from outside pick apart which was which. You can’t cross-reference the segments, it’s too complicated.

Bruce Nolop

So you might ask, so why do we even pay attention to legal entity? It’s simply that that is where regulatory capital gets defined; that’s why we emphasize that.

Michael Hite – JMP Securities

That’s fair. We should just think about that more as a consolidated type of number. It’s not clean but it’s getting more and more…

Bruce Nolop

That’s what I’d recommend.

Michael Hite – JMP Securities

That’s fair. Then just on the June trades down 18%, any color on whether it was more rated toward ETFs or options trading kind of slowing down? And then Ameritrade has kind of noted that July is tracking down another 15-16% or so, so far. Is there any reason to think you guys have seen anything different?

Bruce Nolop

No, the traditional, seasonal summer slowdown seems to have started about mid-June and continues. It is my understanding of the history of the business that you’ll get it unless there is some macro event that causes volatility to go up and therefore trading to be more normal.

Michael Hite – JMP Securities

Okay. Is there anything that’s driving the slowdown more so than anything else?

Bruce Nolop

It’s mainly we believe, the seasonal slowdown. There is some second tier impact on some of the – there’s been some articles about the leveraged ETF kind of stuff. We regard that as very secondary.

Michael Hite – JMP Securities

Okay. Then just a last housekeeping thing for me. Post the swap, what’s Citadel’s expected pro forma ownership in E*TRADE?

Bruce Nolop

On a fully-diluted basis it would be 49%

Michael Hite – JMP Securities

Great. Thanks a lot guys.

Don Layton

Voting, common would only be 16%.

Bruce Nolop

That’s right. Don makes a good point to emphasize. Because of the regulatory restraint, Citadel will not be able to convert the bonds into common stock without going through processes and it will not be able to vote the shares. So from a pure controlled voting point of view, it’s a 16% ownership.

Operator

Thank you. Our final question comes from Mike Vinciquerra with BMO Capital Markets.

Bruce Nolop

Hi Mike.

Mike Vinciquerra - BMO Capital Markets

Sorry about that guys. I had my mute on. I just wanted – one thing on the securities portfolio. We didn’t talk much about that except to say that we had a $30 million write down for the quarter on the credit side. Bruce, can you give us a little more detail on that? It’s an $11 billion portfolio, and give us any sense for trends in the payments there an if you’re seeing any indication of weakness.

Bruce Nolop

It’s really a TMO portfolio. It’s not the full amount because that would include all the agencies, which there’s no issues. There’s really nothing that I can point to that’s unusual. It’s really pretty consistent with what we’ve been doing on a quarterly basis. There’s no new trend that I would be able to discern or describe.

Mike Vinciquerra - BMO Capital Markets

So no more concerns in that portfolio at this point?

Bruce Nolop

No, no.

Mike Vinciquerra - BMO Capital Markets

And just to clean up – a couple of your peers have talked about their auction rate securities exposure. You just mentioned for us that we have full disclosure on your clients’ exposure and if there are any issues to be concerned about there?

Don Layton

There is nothing to announce on our side. In terms of how much we have, it’s about $200 million outstanding now.

Mike Vinciquerra - BMO Capital Markets

So at this point, no news. Are you being approached by anybody in terms of New York State or anyone to do something about buying those back?

Don Layton

You know I won’t comment on those kinds of regulatory legal things.

Mike Vinciquerra - BMO Capital Markets

Fair enough. Okay. Thank you guys.

Operator

That was our final question and I’ll turn it back to Don Layton for final remarks.

Don Layton

I think after a few tough, after a tough year and a half, E*TRADE this quarter, when we look back, it will be regarded as the major turnaround quarter for the company in the three key areas: the underlying business clearly showing that it knows what its doing, it’s got its franchise back, not just generally but to produce revenue and good bottom line profits, that credit – we’ve hit the six month point of showing trends in delinquencies to feel relatively comfortable that the numbers are heading down to much more manageable levels, and of course a capital raise and a debt exchange that far exceeded anyone’s expectations of what we might be able to do, based upon our franchise value. So, we think this has been an excellent quarter for us in terms of building E*TRADE back to a position of strength. We look forward to having those times when the first one is we start to be a capital generator in the bank, that quarter hopefully in the near future, and ultimately when we start to have profits in the bottom line again. We think it’s visible and we look forward to working with you as we get to that point. Thank you.

Operator

Thank you for participating today’s conference call. You may now disconnect.

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