U.S. Bancorp (USB) CEO Discusses Q2 2013 Results - Earnings Call Transcript

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U.S. Bancorp (NYSE:USB)

Q2 2013 Earnings Call

July 17, 2013 9:00 am ET

Executives

Judith T. Murphy - Senior Vice President, Director of Investor Relations and Analyst

Richard K. Davis - Chairman, Chief Executive Officer, President, Chairman of Executive Committee, Member of Risk Management Committee, Chairman of U.S. Bank, Chief Executive Officer of U.S. Bank and President of U.S. Bank

Andrew Cecere - Vice Chairman and Chief Financial Officer

P. W. Parker - Chief Credit Officer and Executive Vice President

Analysts

Jessica Ribner - FBR Capital Markets & Co., Research Division

Jack Micenko - Susquehanna Financial Group, LLLP, Research Division

Kenneth M. Usdin - Jefferies & Company, Inc., Research Division

Stephen Scinicariello - UBS Investment Bank, Research Division

Erika Penala - BofA Merrill Lynch, Research Division

Betsy Graseck - Morgan Stanley, Research Division

Kevin Barker - Compass Point Research & Trading, LLC, Research Division

Dan Werner - Morningstar Inc., Research Division

Jon G. Arfstrom - RBC Capital Markets, LLC, Research Division

Operator

Welcome to U.S. Bancorp's Second Quarter 2013 Earnings Conference Call. Following the review of the results by Richard Davis, Chairman, President and Chief Executive Officer; and Andy Cecere, U.S. Bancorp's Vice Chairman and Chief Financial Officer, there will be a formal question-and-answer session. [Operator Instructions] This call will be recorded and available for replay beginning today at approximately noon Eastern Daylight Time through Wednesday, July 24 at 12:00 midnight Eastern Daylight Time.

I will now turn the conference call over to Judy Murphy, Director of Investor Relations for U.S. Bancorp.

Judith T. Murphy

Thank you, Lorie, and good morning to everyone who has joined our call. Richard Davis, Andy Cecere and Bill Parker are here with me today to review U.S. Bancorp's second quarter 2013 results and to answer your questions. Richard and Andy will be referencing a slide presentation during their prepared remarks. A copy of the slide presentation, as well as our earnings release and supplemental analyst schedules, are available on our website at usbank.com.

I would like to remind you that any forward-looking statements made during today's call are subject to risk and uncertainty. Factors that could materially change our current forward-looking assumptions are described on Page 2 of today's presentation, in our press release and in our Form 10-K and subsequent reports on file with the SEC.

I will now turn the call over to Richard.

Richard K. Davis

Thank you, Judy, and good morning, everyone. Thank you for joining us today to review U.S. Bank's second quarter results. I'll begin with a view of our quarterly highlights on Page 3 of the presentation.

U.S. Bancorp reported record net income of $1.5 billion for the second quarter of 2013 or $0.76 per diluted common share. Total average loans grew year-over-year by 5.2% and 1.2% or 5% annualized on a linked quarter basis. We experienced strong loan growth in total average -- strong growth in total average deposits of 7% over the prior year and 1% or 4% annualized linked quarter. Credit quality remained strong.

Total net charge-offs decreased by 9.5% from the prior quarter, while nonperforming assets declined linked quarter by 5.4%.

We generated significant capital this quarter. Our estimated Tier 1 common ratio under Basel III rules issued in early July was 8.6% at June 30, while our Basel I Tier 1 common equity ratio was 9.2% and our Tier 1 capital ratio was 11.1%. We purchased 18 million shares of common stock during the second quarter. These buybacks, along with our dividend, which was increased by 18% in June, resulted in a 73% return of earnings to our shareholders in the second quarter.

On Slide 4, you can see that our performance metrics continue to be among the best in the industry. Return on average assets in the second quarter was 1.7%. The return on average common equity was 16.1%. Our net interest margin and efficiency ratio are shown on the graph on the right-hand slide -- side of Slide 4. This quarter's net interest margin of 3.43% was, as expected, 5 basis points lower than the prior quarter's rate of 3.48%. And Andy will discuss the margin in more detail in just a few minutes.

Our efficiency ratio for the second quarter was 51.7%. We anticipate that this ratio will remain in the low-50s going forward as we continue to manage expenses in relation to revenue trends, while continue to invest in and grow our businesses.

Turning to Slide 5. The company reported total net revenue in the second quarter of $4.9 billion, a 2.4% decrease from prior year, but a 1.5% increase over the first quarter. The decline in revenue year-over-year was largely driven by lower Mortgage Banking revenue and net interest income. While the favorable linked quarter variance reflected strong seasonal fee revenue trends led by payments, partially offset by a decrease in net interest income.

Average loan and deposit growth is summarized on Slide 6. Average total loans outstanding increased by over $11 billion, or 5.2% year-over-year, and 1.2% linked quarter, accelerating from the 1% linked quarter we experienced in the first quarter. Overall, and excluding covered loans, which is a run-off portfolio, average total loans grew by 7.2% year-over-year and 1.6% linked quarter.

Once again, the increase in average loans outstanding was led by strong growth in average commercial loans, which grew by 11.2% year-over-year and 2.2% over the prior quarter.

Total average Commercial Real Estate also increased over the prior quarters, with average construction loans growing by 9.9% year-over-year and 4.9% linked quarter.

Residential real estate loans also continued to show a strong growth, 19.7% over the same quarter of last year and 3.9% over the prior quarter. Within the retail loan categories, average credit card loan outstandings fell slightly as consumers paid down their balances. And average home equity lines and loans continue to decline, as paydowns more than offset new loan originations. Auto loans and leases, however, posted a very good growth year-over-year and linked quarter.

We continue to originate and renew new loans and lines for our customers. New originations, excluding mortgage, plus new and renewed commitments, totaled approximately $48 billion in the second quarter, compared with $46 billion in the second quarter of last year and $36 billion last quarter. Total average revolving corporate and commercial commitments increased year-over-year by 10.2% and 2.2% on a linked quarter basis, while utilization remained flat at approximately 25%, close to where it's been for the past 6 quarters.

Given early industry indicators, our linked quarter average loan growth of 1.2% signifies that we are continuing to gain market share. Additionally, our current expectation is that linked quarter average loan growth will accelerate again in the third quarter to the higher end of our previously stated range of 1% to 1.5%.

Total average deposits increased by $16.1 billion, or 7%, over the same quarter of last year, and by $2.4 billion on a linked quarter basis, with growth in low-cost money market and savings deposits particularly strong on both a year-over-year and linked-quarter basis.

Turning to Slide 7 and credit quality. Total net charge-offs in the second quarter decreased by $41 million or 9.5% from the first quarter of 2013. While nonperforming assets, excluding covered assets, decreased by $108 million or 5.3%. The ratio of net charge-offs to average loans outstanding in the second quarter declined to 0.70% from 0.79% in the first quarter.

During the second quarter, we released $30 million of reserves, equal to the first quarter, and $20 million less than the second quarter of 2012. Given the mix and quality of our portfolio, we expect net charge-offs and nonperforming assets to remain relatively stable in the third quarter.

Andy will now give you a few more details about our second quarter results.

Andrew Cecere

Thanks, Richard. Slide 8 gives you a view of our second quarter 2013 results versus comparable time periods. Our diluted EPS of $0.76 was 7% higher than the second quarter 2012 and 4.1% higher than the prior quarter. The key drivers of the company's second quarter earnings are summarized on Slide 9.

The $69 million or 4.9% increase in net income year-over-year was the result of a decrease in expense and lower provision for credit losses, partially offset by a decline in net revenue.

Net interest income declined year-over-year by $41 million or 1.5%, the result of a 2.7% increase in average earning assets, offset by a 15 basis point decline in net interest margin. The $8.2 billion growth in average earning assets year-over-year included increases in average total loans and the securities portfolio.

Offsetting a portion of the growth in those categories was a $3.1 billion reduction in average other earning assets, primarily due to the deconsolidation of a number of community development entities, and a $1.1 billion reduction in average loans held for sale, reflecting lower mortgage origination activity this quarter versus the same quarter of last year.

The net interest margin of 3.43% was 15 basis points lower than the second quarter of 2012, primarily due to lower-yielding investment securities and lower loan rates, partially offset by lower rates on deposits and wholesale funding, including long-term debt.

Noninterest income declined by 3.4% year-over-year, primarily due to Mortgage Banking revenue, reflecting lower origination and sales revenue, partially offset by higher servicing revenue and a favorable change in the addition to the mortgage rep and warranty repurchase reserve.

Also contributing to the decline in noninterest income year-over-year were reductions in corporate payments, the result of lower government and transportation-related transactions, and other income, which reflected fewer equity investment gains in the prior year and lower retail products revenue, primarily due to end-of-term lease valuations.

Offsetting these declines were year-over-year increases in trust and investment management fees, retail payments, merchant processing revenue, deposit service charges and investment product fees.

Noninterest expense was lower year-over-year by $44 million or 1.7%. The majority of this favorable variance is attributable to a favorable variance for professional services expense, primarily due to the reduction in third-party foreclosure settlement-related costs, as well as an accrual for a Visa-related settlement charge taken in the second quarter of last year, and lower intangible expense.

These favorable variances were partially offset by higher compensation and benefits expense and increases in marketing and technology expense.

Net income was higher on a linked quarter basis by $56 million or 3.9%, as a result of a 1.5% increase in revenue and lower provision for credit losses, partially offset by a 3.5% increase in expense.

On a linked quarter basis, net interest income was lower, as average earning assets declined by $2.1 billion and net interest margin declined by 5 basis points. The decrease in average earning assets was a result of the reduction in other earning assets and loans held for sale, while the expected 5 basis point decline in net interest margin was primarily due to lower loans on rates and securities.

Given the current interest rate environment, we expect net interest margin to be relatively stable in the third quarter, which, combined with our expectation for a linked quarter loan growth, should lead to a modest increase in net interest income in the third quarter.

On a linked quarter basis, noninterest income was higher by $111 million or 5.1%. This favorable variance reflected seasonally higher payments and growth in all fee categories with the exception of Mortgage Banking revenue. In June, we had expected Mortgage Banking revenue to be higher in the second quarter than the first quarter, primarily due to very strong application volumes earlier in the quarter. However, since the time we made that statement to the end of the quarter, rates moved up by about 60 basis points and refinance activity slowed significantly. As a result, Mortgage Banking revenue actually came in slightly lower this quarter than last.

The $5 million decline in revenue reflected an increase in origination and sales revenue, including a favorable change in the reps and warranty reserve, offset by a lower gain on hedging activity than the prior quarter. Although applications were higher in the second quarter than the first quarter, the increase in volume was offset by a reduction in gain on sale margin. We calculate gain on sale margin based on applications expected to close.

On a linked quarter basis, noninterest expense was higher by $87 million or 3.5%, mainly due to other expense, which include higher insurance and regulatory expense relative to the first quarter. In addition, marketing and business development expense and professional service expenses were higher in the current quarter versus the prior quarter due to the timing of business line projects and initiatives.

Turning to Slide 10. Our capital position remains strong and continues to grow. Based on our assessment of the final rules for the Basel III standardized approach released earlier this month, we estimate that our Basel III Tier 1 common equity ratio at June 30 was 8.6%, compared with 8.3% calculated under the previously proposed rules. At 8.6%, we are well above the 7% Basel III minimum requirement and above our targeted ratio of 8%.

Turning to Slide 11. In June, the Board of Directors declared an 18% increase in our common stock dividend. As a result, in the second quarter, we returned 73% of our earnings to shareholders. Dividends accounted for 30% of the return to shareholders and the 18 million shares of stock we repurchased in the second quarter accounted for the remaining 43%.

Of note, our tangible book value per share rose to $13.48 in the second quarter, which represented an 11% increase over the same quarter last year and a 1.6% increase over the prior quarter.

Finally, Slide 12 provides updated detail on the company's mortgage, repurchase-related expense and the reserve for expected losses on repurchases and make-whole payments. Rep and warranty's repurchase reserve was reduced this quarter by $43 million and the outstanding repurchase and make-whole request balance at June 30 was $64 million, compared with $66 million at March 31.

I'll now turn the call back to Richard.

Richard K. Davis

Thanks, Andy. Last Friday, Andy and I had the honor of commemorating the 150th anniversary of the signing of our national bank charter, by ringing the closing bell at the New York Stock Exchange. We were joined on the stage by 10 U.S. Bank employees who proudly represented and celebrated the rich heritage that they and their coworkers, along with many who came before them, have helped to create and build over the past 150 years.

Importantly, as we took that moment to observe and reflect on our past, we also celebrate the present and the strong foundation upon which we are building our company's future. U.S. Bancorp posted record earnings for the second quarter, while once again achieving industry-leading profitability metrics.

We continue to build our future as we have in the past by investing in our well-diversified mix of businesses, by maintaining prudent risk management, by focusing on operating integrity and compliance, by sustaining strong capital and liquidity and by providing superior returns for our shareholders. As always, we remain focused on producing consistent, predictable and repeatable results for the benefit of our customers, our employees, our communities and our shareholders.

That concludes our formal remarks. Andy, Bill and I would now be happy to answer questions from our audience.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Paul Miller of FBR.

Jessica Ribner - FBR Capital Markets & Co., Research Division

This is Jessica Ribner for Paul. Just a question, I guess, on your Mortgage Banking expectations going forward. Are you looking for higher purchase volumes? Or do you see the same level of refis? I mean, we're part of the way through the third quarter, what's your outlook?

Andrew Cecere

So Jessica, let me tell you, first, from the perspective of what occurred in the second quarter. From a production standpoint, repurchase activity went from about 71% of the book in the first quarter to about 59% in the second quarter. And applications were also down about 10 points in terms of refinancing. I would expect that trend to continue. We do expect, again it's early in the quarter, but given the current rates there, I expect mortgage revenue will be down a bit, given the rates are today and we'll continue to update throughout the quarter.

Operator

Your next question comes from the line of Jack Micenko of SIG.

Jack Micenko - Susquehanna Financial Group, LLLP, Research Division

Looking at the sort of the slowdown in deposit -- average deposits growth, I'm wondering on your perspective, and maybe this is a broader question, around the whole loan demand question. But do you think that the banks generally are exhausting really what's out there from a deposit take? Or are we starting to maybe see -- maybe a little bit of cash being deployed on the deposit side into investment and business activities that could maybe possibly lead to an expansion of loan growth in the back half of the year? Just curious of your observations there.

Richard K. Davis

Jack, it's Richard. I think it's what you are predicting and it's what we've been saying for a long time, the first good movement we'll see on bank balance sheets is customers using their own deposits. And I'm happy to report, our deposits, while they were up, the number of customers with deposits was up as well. But the customers who already have deposits that are using some of those to, we think, employ them in some form of growth. After that, we would hope to see our lines of credit, especially in the wholesale side move from a utilization of 25% to anything -- 26% would be great. We used to be at like in the mid to high-30% utilization level. So there's a significant amount of pent-up opportunity and customers are paying for those lines to have them available and to keep them current. And then finally, there may be new lines and loans that will occur, particularly on the large end, when some transactions start to belie underlying growth. I will say, we do read it like you do. I think it's a positive that it's not growing anymore than that, as long as the number of customers are growing. And to follow our prior comments, I do think we're starting to see some of these green shoots that we mentioned 90 days ago, as being real and sustainable, and more green shoots. It's not a rush to a huge recovery, but it's absolutely and positively no longer a concern of going backwards. We're just seeing customers being thoughtful, careful. But one at a time, they're starting to get more comfortable about their future and they're starting to invest, starting with their deposits, sometimes getting lines of credit with the intent to use, and in many cases, starting to make decisions that have long-term outcomes for the long view of the economy.

Jack Micenko - Susquehanna Financial Group, LLLP, Research Division

Great. And then just the ratio of NCOs on the card book look like it walked up a little bit. I know in the Appendix you talked about lower recoveries, obviously, dollar amount down and the trend is good. Can you talk about what that means on the recovery side and what you meant by lower recoveries and how you're thinking about that going forward?

P. W. Parker

Yes, this is Bill. Part of that is really a timing thing as we brought more of the collection activities in-house on the recovery side. Not all of the recovery collection activities, but some of them. But as we do that, that delays the recognition of the recovery. But I don't expect it to have a material long-term impact, so it's really more of a timing issue.

Operator

Your next question comes from the line of Ken Usdin of Jefferies.

Kenneth M. Usdin - Jefferies & Company, Inc., Research Division

I just wanted -- on the fee side, I just wanted to ask you about just the payments businesses and specifically, in the corporates payments business is still having a bit of a tough revenue trajectory. Just wondering if you could specifically talk about that one, but also talk about just your outlook for the 3 payments businesses as we look ahead?

Richard K. Davis

The whole payments business is, 59% is our issuing business. And the 29% falls in -- 39% falls in the Elavon or merchant acquiring, and 10% falls in the corporate payment side in terms of revenue. And to start with your question, the corporate payments is about 1/3 of that is government and that continues to be down 20% year-over-year, particularly based on government spending, probably some of the trickle effect of the sequester and certainly just the budget increase or decreases that have been evident on the federal side. But the rest of it continues to actually start showing some support again. The PCAR growth is up 13% over last year. We're starting to see a flattening and a stabilization of T&E for the first time, year-to-date. So on the corporate side, while it's 10% of the total, the government piece, which is 1/3 of that, is still under some form of stress, but the rest is starting to show some positive trajectories. As it relates to the Elavon, which is our merchant acquiring, which also has a nice diversification of geographies, it's a global business, we're continuing to see growth in same-store sales that would reflect what you've seen in the statistics that both the federal government and some of the European government has said. So there's a nice second quarter lift there. We'll have pretty stable margins in terms of how we get paid. And we're actually quite encouraged by what we see on the Elavon side, both domestically and globally. And then finally, on the bigger part of it, the 59%, which is led by our issuing side, we're also seeing nice support there. As you know, the average net receivables or the outstandings were slightly down year-over-year, and that's particularly because people are just starting to have a higher payment activity and the payment rates were probably 1.5% higher than they were last quarters or last year, so people are starting to pay them off. But they're using the card. And so credit's been -- was up almost 3% year-over-year, following another 3% in quarter 1's growth. So we're seeing active accounts growing nicely. They're using their card more often. They have -- they're right now, they're paying them back more prudently. And at the end of the day, that will slow and they'll start to let that outstanding roll over and that will be another benefit. The credit card sales for us is 9% year-over-year absent the portfolio that we sold. And I couldn't be more optimistic about the payments business, as you see a nice trend in quarter 2, we should continue to see that growth.

Kenneth M. Usdin - Jefferies & Company, Inc., Research Division

Okay, great. And then on the second question, just an expense question, an operating leverage question. On a -- at least, on an as-reported basis, we're looking at a little bit of a year-over-year decline in revenues, but a little bit of a year-over-year step up in cost, and you did call out the regulatory costs this quarter. So I just wanted to try to understand the balance between revenues, expenses and how do help us understand that regulatory cost, if it's now run rated or was that kind of a onetime catch-up?

Richard K. Davis

Good question. And I own that, good question because I tell you, we shoot for positive operating leverage every year. I think we are still very much in the game to be able to create positive operating leverage, even in the next couple of quarters, but it will be more challenging. And here's my real clear direction for you. As much as mortgages will probably be down, mortgage revenue, in the next couple of quarters, just based on the elements, and you know we're a heavy purchase shop, so our decrease might not be as significant as some of you reported. But I'm not going to take an expense reduction into important investments in the next quarter or two just to accommodate lower mortgage revenue until which time the middle of the curve starts to bend up. And if it does and the market starts to get stronger, then I think we'll be fine. So I'm not going to do any near-term adjustments just to appeal to a finally [ph] negative operating leverage if that's what it has to be, but we are going to continue to watch our expenses. The cost of compliance, as you recall, about a year ago, but in particular, the consent order, was almost $50 million a quarter, and that is trimmed down now to a substantially less, call it, $5 million to $10 million a quarter, as we wind down some of those mortgage-related activities. But I will tell you that we've continued to add compliance personnel and compliance protocols across the company to accommodate this higher requirement that we achieve near perfection on all of our operating activities. And so not all of that 50 is going to be given back. Most of it, however, though, Ken, is burned into the current run rate and you'll see it stabilize. I'm just a little concerned that mortgage might drop off more than I can accommodate in expense reduction dollar-per-dollar and we're not going to overachieve on that because I don't want to suffocate the future.

Operator

Your next question comes from the line of Steve Scinicariello of UBS.

Stephen Scinicariello - UBS Investment Bank, Research Division

Just a couple of quick ones for you. Just curious to hear your take given the new -- the final capital rules that we got out there, and really my question to you is a little bit more big picture. I mean, do you feel that you guys kind of have a real competitive advantage versus some of your larger kind of brethren, given what we're seeing out of those rules?

Andrew Cecere

Well, the new rule effectively increased our cap ratio about 30%. Our binding constraints Tier 1 common under the standard -- 30 basis points, Tier 1 common under the Basel III standard. So last quarter, we were at 8.2%, using the same calculation, we would have been at 8.3% this quarter and the new calculation allowed us to get to 8.6%. 8.6% is about where -- above where we think we need to be. Our internal guideline is about 8%. And that is based on an assumed SIFI buffer of 50 basis points and an additional internal buffer of 50 basis points. So I think from a capital standpoint, we're in very good shape. We're not in a situation where we're trying to build capital to a level nor are we in a situation that we're overcapitalized and have no use for the capital. So when we're in a situation like we are today, where we're returning about 70% and reinvesting 30%, it allows us to reinvest at a level to accommodate the loan growth and earning asset growth that you're seeing. So we're in a really good spot. It allows us to make the investments we need to make, at the same time, allow for the growth that we are seeing right now.

Richard K. Davis

Yes, and just to put an exclamation point, Steve, we really like our position. We like our size, we like our simplicity, we like our diversification. As it relates to capital leverage and liquidity, we think we're substantially where we need to be before any fine-tuning that needs to occur. And I think all the rules that come out continue to remind us that being not a G-SIB is a positive outcome, but being big enough to matter. And being able to manage a very significant portfolio of a simple balance sheet allows us to be in a pretty good shape and we like the future we have.

Stephen Scinicariello - UBS Investment Bank, Research Division

Definitely, it looks you're in a real sweet spot going forward. And then the second question I had for you was just kind of in the same vein of kind of those investments for the future and you kind of touched on a little bit, talking about some of the expense initiatives going forward. Just kind of curious if there was any, maybe that you wanted to kind of flag for us just so we're aware, some of the things that you've got going on, some of the things you're investing in and maybe some of the timing of those things, how they might affect the expense line going forward?

Richard K. Davis

Yes, good question, Steve. A couple of things. One is we're going to continue to build our Wealth Management businesses. As you know, we started this trip 3 years ago. It was the one piece of the puzzle I didn't think U.S. Bank had sufficiently demonstrated leadership, and not only in our Wealth Management, but in our ultra-high net worth, under a brand called Ascent. We'll continue to open those offices. We're continuing to provide technology to our teams to create a unique experience and you'll see our continued expense initiatives in Wealth Management. Secondarily, you all know that we've just recently bought a company called FSV earlier this year in Florida, which is a prepaid card provider and processor. We continue to extend our position there. We now have no third-party partners in any part of prepaid because we have cradle-to-grave capability and a significant leadership position. I want to continue to add to that investment and build a stronger and a unique position of strength for prepaid as it adds to our card provision. And then finally, Corporate Trust, which you know we recently took across the pond and continue to see opportunities even outside of America to grow our Corporate Trust business. We've recently become more of a provider on hedge fund servicing and other areas by some recent acquisitions. There will be more where that came from. It could be both in the form of M&A or in the form of organic growth, but I'd say those 3 areas which are the 3 areas that continue to make us unique: payments, Corporate Trust and Special Wealth Management growth. I think those are areas you'd want us to invest in. They've got great trajectory now and I want continue that momentum so that when the world is better and ready to roll, we'll already be there.

Operator

Your next question comes from the line of Erika Penala of Bank of America.

Erika Penala - BofA Merrill Lynch, Research Division

I just had a few follow-up questions and the first is on the dollar cost trajectory for the remaining of the year. Should we take out the $66 million in quarter-over-quarter increase in regulatory expense when we're thinking about the run rate for the third quarter? Or will some of that stay?

Andrew Cecere

What I would say, Erika, is the first quarter is seasonally low and then we had a little bit of a positive insurance recoveries and other expense. And I think the second quarter is more reflective of our run rate of expense with normal increases. So I would use second quarter as more of the basis for expense.

Erika Penala - BofA Merrill Lynch, Research Division

Got it. And the second follow-up question is you mentioned that mortgage revenues would be down just a bit. But we heard another large bank mention that they think if rates stay -- loan rates stay here, that the mortgage market is going to be down 30% to 40%. Is the message from U.S. Bank that you will outperform the market? And if that 30% to 40% decline is correct, where are you in terms of your outperformance relative to that number, just in proportion?

Andrew Cecere

Right. So first, Erika, as you know, mortgage application, or gain-on-sale revenue is one component of mortgage revenue. There are other puts and takes, including servicing revenue, the net hedge and so forth. So my expectation is not have our mortgage revenue decline to the level you just described. It's going to be less than that, but I do think it will go down. Application volume is a component of that, but there are a lot of gives and takes. And again, we'll update as we see more throughout the quarter, but I do expect mortgage revenue to be down a little bit, principally due to the gain on sale, principally due to applications, but there are some offsets.

Richard K. Davis

And Erika, it's Richard. It will be down unless rates were to turn. This thing turns so fast. We'd be crazy to try to predict the next 10 weeks when we can't see it that far. But we also have a -- always had a focus on purchase. So it's coming our way as a real base to what we're being good at and what we're focusing our market reputation on. And as you'll also remember, we never were as big on a HARP kind of a product, which is probably more likely to be one of the victims of increasing rates. And we didn't rely on that a lot because we didn't have a portfolio that allowed us to have much to refi. So in some cases, we probably should do better than average, but it will definitely be down and we're projecting the second half of the year to be less than the first half.

Erika Penala - BofA Merrill Lynch, Research Division

Got it. And just one more follow-up, Richard, it was loud and clear as you answered Ken's question on taking out expenses near term to accommodate some of the swings in mortgage revenue. I guess, no matter what, we should just look to your consolidated guidance of 50% on the efficiency side as we think about the puts and takes of --

Richard K. Davis

Yes, that's a really good way to think of it because we never set that target, it's always a result. But I can tell you that low-50s and where we have been forever. And especially in the last few years, by quarter, that should not change materially. That we will protect that. And I can tell you, I know we can because mortgage isn't the only thing that's growing around here and it will just be one of the components we'll keep an eye on. So I'm glad you heard me, because I don't want to be dollar-for-dollar and be shortsighted. We've been working for 5 years to grow a substantial amount of momentum and become a revenue company, not an expense company, and I'd hate to slow that down this last stage and we're going to be very protective of it.

Operator

Your next question comes from the line of Betsy Graseck of Morgan Stanley.

Betsy Graseck - Morgan Stanley, Research Division

I just wanted to drill into a couple of business lines. One is the merchant acquiring business that you have, and I know that you've invested globally there. We had some news the other night from the FT that suggested that the European Commission is proposing some changes on interchange in Europe, which I know many people have been thinking about. One of the elements they are supposed to be considering supposedly is separating out payments issuers from processors. And I'm wondering what that does to your merchant acquiring business in Europe, is it something that would be an opportunity for you?

Richard K. Davis

Yes. It's definitely not a concern based on what we've read, like you have. We're entirely an acquirer, not an issuer, and a processor. So the issuers are where that is, the gun sights are pointed in that topic. And as you said, there is an opportunity for us, particularly given our close-loop capability in our own proprietary product, that we believe this could be a net positive for us as a leading acquirer and processor. So we don't see it as a negative. We're trying to understand whether it's a positive, but we're not worried about it.

Betsy Graseck - Morgan Stanley, Research Division

Okay. And then separately in auto, could you give us a sense as to what exactly happened in auto? And what kind of reinvestment in the business you're doing now? And then a little bit on opportunity for share gain from here and what would drive that?

P. W. Parker

Betsy, this is Bill. Yes, we had a strong auto quarter, both loans and leases. And we anticipate that to be a strong third quarter, too. We obviously can monitor the new car sales. So we get a good sense of what our market share is, and in the second quarter, we definitely grew market share. It's a competitive space, but we've made the right investments to be successful there. We've been in the business a long time and we're very good at it.

Betsy Graseck - Morgan Stanley, Research Division

Right. And there's been some discussion around how the CFPB has come into the mix here, requiring the dealer rebates be done in a potentially a different way. And I know you've updated The Street on how you're thinking about it, but has your thoughts changed at all since your last update?

P. W. Parker

No. When that came out, we took action immediately, and narrowed the amount of dealer reserve discretion. We had no negative consequences to that. I think our dealers all understood it. We worked with them and we've seen increase in volume since then.

Betsy Graseck - Morgan Stanley, Research Division

Okay. So no competitive reaction against what you did?

P. W. Parker

A couple of other banks followed us, yes.

Richard K. Davis

A couple of banks followed us, but it didn't hurt our volume and we're actually feeling that we've green fenced [ph] a little bit of the risk. The real issue here, Betsy, as you know, is going to be, if the banks as an entity can compete effectively with the captives who are not part of the CFPB's oversight, and that's a long time to be determined. And as it relates to our position against both of those entities, we're growing market share and we like the business, so we're going to continue to find ways to expand, not only in geographies, but also in product types that are start to emerge as rates start to go up.

Operator

Your next question comes from the line of Kevin Barker of Compass Point.

Kevin Barker - Compass Point Research & Trading, LLC, Research Division

I just would like to discuss some of the increase in Commercial Real Estate loans this quarter compared to what's happened over the last year. You definitely saw a pickup from the first quarter and we're starting to see just broad growth across from the Fed data. Is there any particular sectors where you're seeing Commercial Real Estate pick up or any particular regions where you're seeing that?

P. W. Parker

Yes, I can speak to that. This is Bill. We've seen -- for several quarters now, we've seen multifamily being kind of the lead property class for demand. And for us, we've seen good new construction activity in Seattle, both Bay Area and Southern California, and then Houston. Those have been the primary areas for us. In other areas, we have seen some hotel/motel lodging demand that's picked up a little bit. That's strong pretty much in all the coastal cities. So those are the primary areas that we've seen Commercial Real Estate growth.

Kevin Barker - Compass Point Research & Trading, LLC, Research Division

Okay. And then concerning residential real estate, given that the 30-year has moved up so much and you're seeing a decline in application volume for conforming 30-year fixed mortgages, are you seeing any application shift towards 5/1 ARMs or 15-year fixed, given the move-in [ph] rates? Or is that -- you're also seeing a similar decline as you are for 30-year fixed?

Andrew Cecere

This is Andy. There's a bit of a shift to more of a shorter duration, as you described, and a little bit perhaps more on the variable rate. I will also tell you that, which we're putting on balance sheet, our Smart Refinance product has always been shorter in terms of the term there, closer to the 15-year. So the 30-year is not impacting that as much, and the decline is coming on the mortgage production in the 30-year, but there is some shift to shorter terms.

Richard K. Davis

I'd say here, as it turns out, I was surprised, but I thought there might be a bit of a tsunami effect or a cash-for-clunkers effect where we get a pent-up demand and anybody who still hadn't refi would come into the game now. And it doesn't seemed to have happened. I mean, it seems that people are still moving at kind of a snail's pace. So if they still see a deal that's better than the one they have, they'll come in. But we're not seeing that kind of onetime surprise that I thought we might have. That relates to mortgage. But until short-term interest rates start to move, we won't expect to see a great deal of effect on the commercial and wholesale side, although I do still predict there will be a bit of a rush to the gates when that starts to become a real thing. And we haven't seen that triggered yet and I think that will be an upper for wholesale lending at that moment in time, which could be a few quarters out.

Operator

Your next question comes from the line of Dan Werner of Morningstar.

Dan Werner - Morningstar Inc., Research Division

Could you give us an update on the bank M&A environment in terms of what you're seeing. Are you still seeing the big gaps between sellers and buyers at this point, given that we've seen a lot of M&A activity amongst the smaller banks?

Richard K. Davis

Dan, we haven't seen any activity. I mean, I could pick it up, I wouldn't. But, I mean, I can make it sound interesting, but we haven't. We've had no approaches of any significance. We're not approaching anyone. Like you, I read about the small banks continuing to cobble together to find some critical mass, which makes total sense to me. Because the cost of compliance and just regulatory costs are easier by a larger base. But really, none. I mean, it couldn't be more dormant. And our interest couldn't be lower either. So I think as to an opportunity, we're not playing that indeed right now.

Operator

Your next question comes from the line of Jon Arfstrom with RBC Capital Markets.

Jon G. Arfstrom - RBC Capital Markets, LLC, Research Division

Just a follow-up on that. How about the payments business and the processing business, are you seeing more opportunities there?

Richard K. Davis

Yes, that actually, that feels a little more heated. Because, first of all, we're known to be an acquirer -- an active acquirer. We're known to -- we'll talk to anybody. I've said this before, but a few folks that created the great idea in a garage that's got payments unique that's attached to it, we'll talk to them. And some of the deals we look at are typically privately-held businesses. They're smaller than you would probably ever read about, but these are groups of people that either don't want to go out and raise the second round, the third round of capital and they want to be part of something bigger. In many cases, we can bring them in to be part of the company as well or sometimes they just sell and move on. But I would say, we have a very active list of M&A opportunities. Fewer as a percentage would come to the end, but it's not for a lack of having looked and seeing interest. And people know us, so they're coming at us.

Jon G. Arfstrom - RBC Capital Markets, LLC, Research Division

Okay, good. And then Andy, maybe a question for you. On your margin guidance, you talked about flattish for Q3. Is that something that's Q3-specific? Or is this more of a longer-term trend where maybe we're seeing we're near the end of the margin pressure for the company?

Andrew Cecere

Yes, Jon. So we talked about the fact that I expected the margin pressure to be worse in the first quarter, 5% in the second quarter and start to dissipate as we got in the second half of the year. So it's not a unique third quarter event. It's just a function of our reinvestment rates coming closer to our rates currently on the books, and currently rolling off. So we talked about that happening. It is happening, and we do expect the relative stability.

Richard K. Davis

Let me add one last -- we didn't get a question on it, so I'm going to create my own. Richard, what do you think about the growth of loan volume? We went from 1% linked quarter in quarter 1 to actually 1.25% in quarter 2. We have enough of a view to see that, that will go up in quarter 3. I don't know exactly how far because things -- we still have 10 weeks to go. But we are seeing -- here's how I would characterize it. Our flight-to-quality, which we've talked about for many quarters, many couple of years now, has become the real deal and it's certainly brought us a lot of good market share in the years going into this downturn. It's now becoming into a kind of phase 2 where we, we're invited into a lot of transactions and a lot of customers, at the depths of the recession, when they wanted a strong -- you know our highest ratings held [ph]. And now, they're rolling these over and we're getting invited back in at higher positions. We're invited in, in some cases, to lead transactions. And of course, the other business that comes with it is amazing. So for us to try to articulate why in a basically flat loan growth market we are growing now, and why we still think that can continue and in fact grow. I do think the secret sauce in U.S. Bank's business line is that we've got this flight-to-quality that's now turning into a -- we auditioned, we performed well, and now we're getting the lead part. And that's a really a good thing to see at this point and stage. And then as these commitments, we never talk enough about our commitments have continued to grow faster than our loans outstanding. And as you all, as analysts, know, the minute and if those actually get used, whoever has the line of credit has established themselves as the first among few to be the one to draw on, that's going to be the next round of loan growth, notwithstanding new customers. So we love our positioning there, we're actually fairly opportunistic and we're going to tell you that in an optimistic way to give you a sense that we see sustainability there.

Judith T. Murphy

I think that's it, Lorie. Are there any more questions?

Operator

Thank you. That concludes the Q&A portion of today's call. I will now turn the floor over to Judy Murphy for any additional or closing remarks.

Judith T. Murphy

Great. I want to thank everyone for listening to our call. As always, if you have questions, please feel free to give Sean O'Connor or myself a call later today. Thank you.

Richard K. Davis

Thanks, everyone.

Operator

Thank you for participating in U.S. Bancorp's Second Quarter 2013 Earnings Conference Call. You may now disconnect.

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