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E*TRADE Financial Corp. (NASDAQ:ETFC)

Q1 2010 Earnings Call Transcript

April 21, 2010 5:00 pm ET

Executives

Susan Hickey – Media Relations

Steven Freiberg – CEO

Bruce Nolop – EVP & CFO

Paul Brandow – EVP & Chief Risk Officer

Bob Burton – EVP & President, E*TRADE Bank

Michael Curcio – EVP & President, E*TRADE Securities

Mike Peasy [ph] – Treasurer

Analysts

William Tanona – Collins Stewart

Roger Freeman – Barclays

Rich Repetto – Sandler O'Neill

Keith Walsh – Citi

Matt Snowling – FBR Capital Markets

Michael Carrier – Deutsche Bank

Mike Vinciquerra – BMO Capital Markets

Howard Chen – Credit Suisse

Joel Jeffrey – KBW

Daniel Harris – Goldman Sachs

Faye Elliott – Banc of America/Merrill Lynch

Operator

Welcome to the E*TRADE Financial first quarter 2010 earnings conference call. At this time, all participants have been placed in a listen-only mode. Following the formal remarks, we will open the call for Q&A. (Operator instructions)

Thank you. It is now my pleasure to turn the floor over to Susan Hickey from E*TRADE Financial. Please go ahead.

Susan Hickey

Good afternoon, and thank you for joining us for E*TRADE Financial’s first quarter 2010 conference call. Joining me today are Steven Freiberg, E*TRADE’s Chief Executive Officer; Bruce Nolop, our Chief Financial Officer, and other members of E*TRADE's management team.

Before turning the call over to Steve, I'd like to remind everyone that during this conference call, the company will be sharing with you certain projections or other forward-looking statements regarding future events or 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 of forward-looking statements.

This call will present information as of April 21, 2010. 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 its Website at investor.etrade.com.

This call will be recorded. A replay 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, and no other recordings or copies of this call are authorized or may be relied upon.

And with that, I will now turn the call over to Steve Freiberg.

Steven Freiberg

Thank you everyone for joining us this afternoon. I am pleased to be participating in my first call as E*TRADE’s Chief Executive Officer. To begin today’s call, I would like to share a few thoughts and then Bruce will take you through the first quarter results. From there, I will add a few closing comments, before we take your questions.

I have had a very busy and exciting first few weeks at E*TRADE, learning more about the company, our people, and our customers. This a pivotal time for the company and I am energized by the opportunity to lead the organization to its next phase of growth and innovation. My predecessors, Bob Druskin and Don Layton, the senior management team and really the entire organization navigated the company through very challenging times, and today, with a solid brokerage business, complemented by an improving balance sheet and a strength in capital structure, E*TRADE is well positioned for growth and profitability.

I was attracted to the CEO role at E*TRADE for a number of reasons. I am a builder of businesses, and I look forward to working with the team to build on the company’s current momentum. In addition, I believe E*TRADE’s focus on expanding customer relationships, both with active traders and long-term investors aligns well with my experience in building consumer franchises through enhanced value propositions, customer segmentation, product innovation, and world-class customer service.

E*TRADE remains a respected company with a powerful financial services brand, and as I spend time with our company and our people, I am even more confident about E*TRADE’s opportunity to reach its full potential, and I look forward to engaging with you on our progress. As Bruce will describe E*TRADE’s first quarter performance, exhibit several positive trends, earnings are headed in the right direction, our retail brokerage business continues to compete effectively, balanced levels in our loan portfolio declined at a consistent rate with improving delinquency metrics, and for the first time in two years, E*TRADE Bank internally generated rather than used capital.

These trends provide us with the flexibility to make investments that will drive our continued leadership as a trading and investing platform and our ongoing expansion in the long-term investor segment.

And with that brief introduction, I will turn the call over to Bruce.

Bruce Nolop

Thank you, Steve. We are pleased with our quarterly financial performance and the progress we continue to make in building out a comprehensive product and service offering that supports the needs of a broad range of investors. Before summarizing our financial results, I will review a few highlights of the quarter.

On the product side, a number of new customer offerings or enhancements were introduced. For long-term investors, E*TRADE capital management introduced managed investment portfolios, with a competitive fee structure and an accessible entry point of only $25,000. And Power E*TRADE Pro users now have access to an expanded feature set, including streaming CNBC broadcast.

In addition, E*TRADE Mobile Pro for the new iPad was recently released, and we are proud that Apple highlighted our application on its download site and during its media briefings throughout the launch. We continue to lead the industry with tools that support today’s increasingly mobile investor.

During the quarter, we also simplified our fee structure to enhance our value proposition to customers. We eliminated the $12.99 pricing tier as well as incremental commissions that apply to certain trades. And effective in the second quarter, we are eliminating all of our account inactivity fees. We expect that these changes will reduce our revenue by approximately $50 million in 2010, but view the changes as an investment in customer satisfaction that we believe will reduce attrition rates over the long term.

We were gratified that Barrons recognized our comprehensive customer experience in its 2010 annual online brokerage survey. Barrons awarded E*TRADE Securities four out of five stars, described this as a one-stop shopping destination, highlighted our mobile trading technology, and listed us among the best firms for long-term investing.

Turning to our financial results, the company had a net loss of $48 million, or $0.02 per share during the quarter, which compares with a net loss of $67 million or $0.04 per share in the prior quarter, and a loss of $233 million, or $0.41 per share in the first quarter of 2009. During the quarter, we generated $537 million of net revenue, which is an increase of $13 million from the prior quarter, and an increase of $39 million or 8% from the same quarter a year ago.

Our revenue this quarter included net interest income of $320 million, which was essentially flat compared with last quarter. This reflected a net interest spread of 2.96% on average interest-earning assets of $42.4 billion. Therefore, while average interest-earning assets declined by $1.4 billion, a 10 basis points expansion in the interest income spread allowed us to maintain a consistent level of net interest income.

Commissions, fees and service charges, principal transactions, and other revenue in the first quarter were $196 million. This was a 5% sequential decline compared with the fourth quarter, which reflected lower retail trading activity as well as a $0.10 decline in the average commission per trade. The decline in the average commission included the impact of our recent pricing changes, which was partially offset by a more favorable customer mix this quarter. We enjoyed increased principal transactions this quarter in our market making business. They were up $3 million from the prior quarter and $9 million from the prior year.

Our revenue this quarter also included $29 million of net gains on loans and securities. This net gain was greater than $9 million of impairments during the quarter. Our total operating expense for the first quarter declined from the prior quarter by $23 million to $295 million. This included lower compensation, real estate-owned bad debt and restructuring expenses, which more than offset higher seasonal spending for advertising and market development. Our operating expense declined 4% compared with the first quarter of 2009, if we exclude FDIC insurance premiums and restructuring activities during both periods.

We are well on the way toward completing our previously announced plan to restructure our international operations. We are exiting local market trading operations, but will continue to offer customers residing outside of the US the ability to trade in US securities. We completed the sale of our German operation at the end of last year, and in April, we consummated the sales of our local Nordic and UK businesses.

During the quarter, we recorded $3.4 million in international restructuring charges. Over the next two quarters, we expect to record approximately $1 million in restructuring charges, including a $3 million credit during the second quarter and a $4 million charge during the third quarter. The restructuring charges are lower than previously expected, due to a gain on the sale of the UK business and lower-than-anticipated costs. With our restructuring largely completed, we will focus on US metrics going forward, as the international local activity will be phasing out over the next few quarters.

DARTs for our US operations were 155,000 during the first quarter, which is down 2% from the prior quarter, and 11% compared with the first quarter of 2009, a period of significant market volatility. Brokerage accounts were up 2,000 and we ended the quarter with 2.6 million accounts. Net new asset flows into our US brokerage business were a positive $2.2 billion during the quarter. Therefore while the total number of brokerage accounts remained relatively constant, we believe the generation of net new assets indicates higher quality customer accounts.

Customer assets in the US were $159 billion at quarter-end. Net new assets were a positive $400 million during the quarter, with the increase in brokerage assets more than offsetting the planned decline in customer bank assets. Brokerage customer cash increased by $1.4 billion to $21.8 billion, while bank customer cash declined by $1.8 billion, including the sale of approximately $1 billion of savings accounts to Discover. Customer margin receivables in the US grew by 5% during the quarter and ended at $3.8 billion. This represented a 67% increase from a year ago.

Turning to the balance sheet, we made continued progress in the run-off of our loan portfolio, with total loans declining by $1 billion during the quarter. Our loan loss provision declined for the sixth consecutive quarter, from $292 million in the prior quarter to $268 million this quarter. Net charge-offs were $288 million, which was a $36 million decrease from the prior quarter. Because our provision was less than our charge-offs this quarter, our loan loss allowance declined by $20 million. Our loan loss reserve continues to be approximately $1.2 billion, which is equal to 6% of total loans.

Delinquency trends continued to improve, with quarter-over-quarter total special mention delinquencies declining by 4% and total at-risk delinquencies declining by 8%. We continued to be pleased with the impact that our loan modification program is having on our credit exposure and comfortable with our provision. As Steve highlighted earlier, we were extremely pleased that the Bank generated $48 million in regulatory risk-based capital during the quarter. And while we may not generate capital in every quarter, we do expect that the Bank will generate capital for the full year 2010, marking a key milestone in our return to financial strength.

Our bank capital ratios continue to be substantially in excess of regulatory well-capitalized thresholds. As of March 31, the Tier 1 capital ratio was 6.83% to total adjusted assets and 13.08% to risk-weighted assets. Our sale of the savings accounts in particular allowed us to free up approximately $50 million in Tier 1 capital. We also ended the quarter with $947 million of risk-based total capital in excess of the level that our regulators define as well capitalized.

We ended the quarter with $418 million in corporate cash, an increase of approximately $25 million from the prior quarter. We expect to receive during the second and third quarter a tax refund of approximately $100 million related to the legislation in 2009 that extended net operating loss carry-backs to five years. We expect that the parent company will retain $95 million of this cash, with the remaining $5 million going to the bank. Given our improving financial position, we plan to pay cash for the May coupon on our springing lien notes, although we will consider this decision more specifically as we approach the interest payment date.

Finally, I would like to highlight a change that we are making in our financial reporting this quarter. In addition to the trading and investing and the balance sheet management segments, we are now providing increased visibility into our corporate expenses with the introduction of a new corporate segment. This new corporate segment includes unallocated expenses for finance, legal, human resource and risk management functions as well as corporate interest expense.

In summary, we believe that our first quarter results demonstrate the strength in our core retail franchise and continued improvement in our overall financial condition. We welcome Steve to the organization and look forward to his leadership as we focus on growth and profitability.

And with that, I will turn the call back to Steve for closing remarks.

Steven Freiberg

Thank you, Bruce. Before opening the call for questions, let me share a few additional comments. Clearly, we are on the right track in both our brokerage business and in our legacy loan portfolio, and I am committed to continuing this positive trend. As we generate capital and move towards profitability, our challenges to invest in and grow our core brokerage business, manage legacy risk and identify and prioritize opportunities for enhancing growth. I welcome this challenge and I am certain that the rest of our management team does too.

And although it is still early days for me, I have several thoughts about E*TRADE’s future. These include that we build on our heritage and strength as a technology leader to develop and/or embrace the next set of disruptive innovations; further leverage rapidly evolving research segmentation and decision science tools to drive more effective customer acquisition and retention and to expand customer relationships, particularly in the long-term investor segment; enhance our product suite and customer interaction models to better serve our active trader and long-term investor segments; and continue to support our brand and extend it more fully.

Not surprisingly, these themes support our strategy to extend our leadership in the active trader segment, while continuing to expand our relationships with long-term investors. I look forward to the coming weeks and months as we develop and execute plans for E*TRADE’s next stage of growth. And as I said earlier, I look forward to engaging with you on our progress.

With that, operator, we are ready to take questions.

Question-and-Answer Session

Operator

(Operator instructions) Thank you. Our first question comes from William Tanona of Collins Stewart.

William Tanona – Collins Stewart

Good morning Steve, good morning Bruce, or I should say good evening. Question on delinquencies, particularly the one-to-four, I was surprised to see that the early-staged delinquencies have actually stayed flat here, for it looks like the last two to three quarters, and I was also I guess surprised to see the later-staged delinquencies increase here, just seems like it’s a trend that is not necessarily consistent with some of the other financial services companies that we have seen report as of late.

Bruce Nolop

This is Bruce, and one thing to remind everyone is that for first lien delinquencies, we have a month lag, and so it’s really – the statistics for us is through February and some of the ones you may be comparing maybe through March. Overall, we are very happy with the stabilization we are seeing in delinquencies, and we expect the trends to continue and any additional information we have since the February time period would reinforce that belief.

William Tanona – Collins Stewart

Okay. And then in terms of the $1 billion, in terms of loan reductions there, you mentioned that $700 million was principle reductions as well as prepayment, can you kind of quantify the difference between prepayments and principle reductions and specifically how much of that is modifications?

Steven Freiberg

In terms of prepayments, it’s the lion’s share of reduction, $700 million [ph] very small amount of actual maturities.

William Tanona – Collins Stewart

Okay. And in terms of the $47 million of risk-based capital that was created as a result of changes that took place on the risk-weighted assets, can you help me understand exactly what changes took place to free up that capital?

Steven Freiberg

The primary change would be as the loan portfolio pays down, so that’s reduced. The money is reinvested in agency securities, so it’s that difference in the risk weighing, which is a major part of it. In addition, we are able to use more of our deferred tax assets this quarter. And then just the relationship of the profitability of the bank versus the loan loss provision is more favorable than it had been.

William Tanona – Collins Stewart

Okay. Thanks.

Operator

Your next question comes from Roger Freeman of Barclays.

Roger Freeman – Barclays

Hi, thanks. I guess first, your comment on dropping those fees for inactive accounts, can you just help us think about that a little bit more, I understand you want to or I guess you are looking those as possible sources of the re-engagement at later point, but as you think about sort of your balance sheet, you know, shrinkage objectives and the cash that’s in those accounts (inaudible), is that countered at all in your near-term priorities?

Steven Freiberg

No, the inactivity fee, we found was just one of the primary customer dissatisfiers, and it was an irritant, and we wanted to make sure that we are doing everything we can to retain our accounts and not have anything that would be a dissatisfier to them. And that will be the lion’s share or not the lion’s share, but the majority of the $50 million will actually be that inactivity fees, and so, you will see that coming in starting in the second quarter. But it’s part of our overall strategy to focus on our online brokerage business and to grow our customer accounts and the quality accounts.

Roger Freeman – Barclays

I mean, what is the profit earlier of an inactive client that doesn’t use any of your services, doesn’t try it, and will there be a specific action to re-engagement?

Steven Freiberg

Sure. And the tendency is that often an account goes inactive for a period and they can be reactivated in terms of their level of engagement with us. And it affects not only the inactive ones, it’s just a perception that we found that even some of our very best customers had a perception that, that we had something that was not consistent with the other competitors in the online industry. And so, just from a customer perception standpoint, that has a benefit as well.

Roger Freeman – Barclays

Got it. Okay. And then on the provision for loan loss, you might have said this and I might have missed it, why did it pick up in the HELOC portfolio so much in the quarter?

Steven Freiberg

Right. The way it works is that the provisioning is based on your actual experience and then you forecast on that basis. And it so happens that this quarter, the loan modification program was more skewed toward home equity than toward our first lien – I am sorry – I would say more for first lien and less home equity. And the home equity went down as we were putting in some operational changes and that had the effect of reducing that activity during the quarter. And first lien is an area that have been gradually increasing. So, that aspect creates a disproportion compared to what had been the experience and that flows through your loan provision.

Since that time, we have returned to more normalized mix of loan modifications including an increase in home equity modifications, and therefore going forward, we fully expect starting with the second quarter to be back to a normalized provisioning and you will see home equity and first lien return to their more normal trends. And overall, we expect that the provisioning for the year will not differ from where we began with our expectations.

Roger Freeman – Barclays

Okay. But then I guess does that mean the last few quarters, the decline in provisioning has really been more just a function of modifying loans and some pushing out the –?

Steven Freiberg

No, it’s really the function of the change, and we – in our analysis, although you have some differences in the absolute amounts of provisioning, in terms of the trends that it doesn’t have an impact on provisioning or on the delinquencies.

Roger Freeman – Barclays

Okay. Last question quickly, customer mix, you made a comment, it was more favorable this quarter, what was that in reference to?

Steven Freiberg

Yes, the primary one was that we had more transactions in our corporate services group, which is in the stock plant administration and it’s more exercises of restricted stock that they sell the stock into the market, and that’s a higher profitable trade.

Roger Freeman – Barclays

Interesting. Do you think standard being a seasonal thing, particularly with more restricted stock being –?

Steven Freiberg

Yes, that’s probably, it is something that more and more we will take into account that there does seem to be more restricted stock that’s best in the first quarter, and people are tending to sell the stock when it’s best. The other one in the mix I would mention is we had an uptick in auctions as well, which is another favorable pattern.

Roger Freeman – Barclays

Yes, okay. Great. Thanks.

Steven Freiberg

Yes.

Operator

Your next question comes from Rich Repetto of Sandler O'Neill.

Rich Repetto – Sandler O'Neill

Yes, good evening and welcome Steve. Hopefully you come in at an upswing here for sure.

Steven Freiberg

Thanks, Rich.

Rich Repetto – Sandler O'Neill

I guess to follow-up on the question that Roger asked on the provisioning, to be blunt, I don’t fully understand, because I see you over-provided, even though the charge-offs in home equity have sort of continued down on a trend downward. So, I guess would you expect charge-offs later on because these modifications to increase –?

Steven Freiberg

Rich, what I will suggest is, I have Paul Brandow, our Chief Risk Officer elaborate further and just see what color he can add.

Paul Brandow

I will give you an explanation now and then maybe if you have some questions later on, we can handle them there, but this is really the fact that the interplay between the two different reserves that are involved with loans, the FAS 5 reserve and the one that’s specific to TDRs. The way we do a forecast, right, we need to make an assessment of the amount of modifications that are going to be done, which would in turn then create the FAS, both the FAS 5 and the TDR and the FAS 114 reserve, because modifications for home equity were lower end of first quarter and since our forecasting is based on our most recent experience, that tended to leave more of our loans to the non-modified state, which would be showing up in higher FAS 5 reserves.

Since we now have returned to a much more normal level of home equity of loans, we expect that to affect, in effect to dissolve over the next quarter or two. And so, by the end of the year, assuming again that the modification activities stays at what is now the returned higher pace, it should return to what we expect at the beginning of the year.

Rich Repetto – Sandler O'Neill

Okay. We fairly can spend some time offline going through that. But moving on, the expenses, nice reduction quarterly, sequentially in expenses, and Bruce, the other line came down dramatically from I think 38 million to 21 million, can you give us a color what was going in that line and why it came down?

Bruce Nolop

Yes, there are a couple of things. One is you had lower REO expense that occurred, and that’s because of stabilization of home prices at a favorable impact on that expense line, and then bad debt that the fourth quarter of 2009, it was an abnormally high amount of charges that went through that line, and we are back to normal bad debt levels.

Rich Repetto – Sandler O'Neill

Got, you. Okay. And a very last question, you know, the focus on the core brokerage and everybody knows that, that has been the strength here with the company through the downswing, the economic downswing. I guess the question is, there was sort of an uptick in attrition with the net loss of accounts in March. I was just trying to see and I am also looking back at the prior quarter, and it looks like the accounts are different than in the last press release. So, is there some accounting thing going on with the brokerage accounts and what do you attribute the attrition in March, too?

Bruce Nolop

Sure, in March, you have the inactivity fee comes in. So, you typically would find that, that would have an impact in the last month of the quarter. And as we discussed a little earlier, in some ways, this is getting rid of the less valuable accounts and some more and more what we look at is the overall quality of accounts and that’s for our point of view, the best metric is the 2.2 billion of net new assets that came in. And so, while we want to grow the number of accounts, we are probably even more focused on the net new assets and because of things like inactivity fees and other factors, you will have changes that we should help going forward.

Rich Repetto – Sandler O'Neill

And just on the accounting, I am looking at the last press release, you said 2.7 million brokerage accounts, was there a change –?

Bruce Nolop

Yes, the change was that in, as I mentioned, we were going to focus on US metrics going forward, and so, we are excluding the international local accounts. And so, we are trying to be apples-to-apples. And going forward, it should get a little less confusing, but for a while, we are going to transition.

Rich Repetto – Sandler O'Neill

Understood. Thanks guys.

Operator

Your next question comes from Keith Walsh of Citi.

Keith Walsh – Citi

Hi good morning everybody or good evening. Sorry, getting a little confused here. First for Bruce, just opportunity for more loan sales and specifically what’s the gap you are seeing these days around the market value versus what you have marked these loans to? And I have got a couple of follow-ups.

Bruce Nolop

Yes, rather than quote specific prices, I would say that we continue to monitor the market, and what we see are the prices in the secondary market are still below the intrinsic value. And so, we do not see the potential to do anything material in terms of additional loan sales.

Keith Walsh – Citi

I mean, what’s the trend on that gap though would we have been seeing over the last six to eight months?

Bruce Nolop

With that, I think some additional color, I will call on Bob Burton who is the President of the E*TRADE Bank to comment.

Bob Burton

We are seeing some narrowing of that difference between what we believe the intrinsic value is in the market, and we are looking for example to take advantage of opportunities to potentially securitize some of the loans in the portfolio, but we still think there are ways to go before that gap narrows to the point where we would even contemplate additional sales.

Keith Walsh – Citi

Okay, and then second question for Bruce, maybe if you could just remind us, upward movement on short-term rates, why your two larger competitors has positive EPS leverage, and for you guys, it’s actually slightly negative?

Bruce Nolop

Yes, I can’t comment on the balance sheet of the competitors, but for us, we manage the balance sheet to be neutral in terms of the impact of interest rate movement, and even since last quarter, we have become more neutral. So, with a change in short-term rates, at this point, we don’t see any effect on our interest income, and that’s a combination of just the way that the mix of assets and liabilities are constructed as well as hedging activities, which the people in our bank treasury department manage.

Keith Walsh – Citi

Okay, and then the third question just for Steve and just around strategy here, what attracted you to this job specifically, and what do you view as your immediate priorities as we move throughout 2010? Thanks.

Steven Freiberg

Keith, just to frame it, one that the industry at large which essentially is the brokerage and financial services has always been an interest of mine. I have spent 10 out of my 30 years on that side of the house, and I have always basically enjoyed it and enjoyed basically building franchises within the category. Secondarily, E*TRADE in particular as I said earlier is at a pivotal point, and I spent also a good part of my career in turnarounds, and I am very optimistic at this point about the opportunity that E*TRADE specifically presents. I also enjoy consumer-oriented franchises. We have got a terrific brand, a very strong core business. We have potential to expand that core business into other segments that I think hold significant potential. And we have to work through as it’s clearly evident, some of the challenges of the past, which is in fact the legacy asset book and so we can’t move sight or we can’t basically let up the vigilance around that.

So, that and itself and again just to remind the group, it’s been of about three weeks, so that beginning to get a better understanding of both the opportunity of the issues and risks associated with the franchise that are on balance. So, I couldn’t think for a better company at a better time to join.

Keith Walsh – Citi

Great, thank you.

Operator

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

Matt Snowling – FBR Capital Markets

Hi, good evening. Just maybe a question on the net interest margin, it came in a little higher than we were looking for, is that just simply the effect of redeploying the cash on the balance sheet in higher rates, higher rate securities?

Steven Freiberg

Sure, there’s really three reasons. One is as you mentioned that we were able to put more cash into securities. Secondly, we have a higher margin balance, which is very much lucrative balance, and third is the mix of our deposits. It became more skewed towards brokerage cash rather than bank cash and that in turn lowers our cost of funding, which gets translated into higher margins.

Matt Snowling – FBR Capital Markets

Okay. And maybe going back to your interest rate sensitivity, you mentioned you were neutral right now?

Steven Freiberg

Yes.

Matt Snowling – FBR Capital Markets

To rates, but is the model itself still asset-sensitive, in that you have just hedged out some of that sensitivity in the near term?

Steven Freiberg

I would say, again I think this is when I will call on Bob Burton who is the President of the Bank to explain further about how we manage that.

Bob Burton

Yes, in general, although we certainly engage in hedging activities to customize our position, the balance sheet is generally moving closer and closer to neutral as the loan portfolio pays off. And so, we have the risk generated by the loan portfolio and by our securities portfolio offset by the value creation as interest rates move from our large internal deposit base. So, as a rule, it leans toward being basically neutral.

Matt Snowling – FBR Capital Markets

Does that assume that you re-price your deposits in line with rising rates?

Bob Burton

Well, it certainly makes – there are certainly a series of assumptions we have to make about how sensitive our deposits are to move in. And we just use historical numbers to look at that.

Matt Snowling – FBR Capital Markets

Okay, thanks.

Operator

Your next question comes from Michael Carrier of Deutsche Bank.

Michael Carrier – Deutsche Bank

Thanks. Just a question on the net new brokerage accounts, you had this quarter a little less than 2000 [ph], last quarter was negative. Just trying to figure it out because in the industry, when you will get some of your peers, they are showing two-year highs in terms of net new brokerage accounts in organic growth. I know when I look at your spending on the marketing, it’s a little bit lower, but just trying to understand if there is anything else going on there in terms of the new growth?

Bruce Nolop

Two comments I would make. One is that if you recall in January, we had some (inaudible) and so 6,000 accounts were eliminated through that process. And that was not something that was in prior quarters if you compare. And secondly is that we find that new accounts are very largely correlated with volatility. And so, this was a period of lower volatility, and I just would comment that already when you have seen some increase in the market volatility that we can see the impact from that immediately. And so, that’s something that probably is a more telling factor in the slower growth.

Michael Carrier – Deutsche Bank

Okay. And then secondly, just on the outlook for the commissions in after fees, if I look at the $50 million that you are protecting for the year, just trying to understand how much of that was in the first quarter versus long term [ph]?

Bruce Nolop

Sure, yes. The first quarter, the impact was about $4 million and for the next three quarters, it will be $15 million per quarter, which gets you up to the $50 million.

Michael Carrier – Deutsche Bank

Okay. Thanks a lot.

Bruce Nolop

Okay.

Operator

Your next question comes from Mike Vinciquerra of BMO Capital Markets.

Mike Vinciquerra – BMO Capital Markets

Thank you. Just following up on Mike’s question there on the commission rate, you did say that the majority of the loss $50 million is going to come from the inactivity fees, right. So, there’s not going to be much of an impact on the commission rate itself.

Bruce Nolop

Yes, I would give you a feel for that. For the quarter, we estimate that it was about a $0.33 impact, and again that was offset to a large degree by mix. And going forward, that would be more in the range of about $0.50.

Mike Vinciquerra – BMO Capital Markets

Okay, great. And then the corporate service side, I mean the stock prices have written certainly more people have incentives to sell restricted stock if it does it. So, is that help to support potentially more activity from that segment?

Bruce Nolop

Sure, yes. I am going to have Mike Curcio who is the Head of our Brokerage Operations also corporate services reports to him. So, maybe he can add some color.

Michael Curcio

Yes, absolutely. As markets have come up and individual stocks have come up, there has become more and more value in auctions than we see a list in DARTs through the corporate service channel, because more auctions are exercised, more restricted stock is sold, and that’s a positive advantage on our commission because the commissions are much higher than the rack rate.

Mike Vinciquerra – BMO Capital Markets

Great. Thank you, Mike. And just other thing, Bruce, on the net interest margins that you didn’t mention as far as the lift in the quarter. I noticed your repo rates fell pretty substantially, is this reflective of tighter credit spreads in the marketplace or how do that kind of come about as pretty significant quarter-over-quarter?

Bruce Nolop

Again, this is one I will refer to Bob Burton.

Bob Burton

Certainly, some of it is related to the market, but in addition, early last year, we locked in a lot of longer-term repo arrangements that are expiring, and as they expire, we have been able to reduce our costs of repo.

Mike Vinciquerra – BMO Capital Markets

Great. So, that sounds like it’s a sustainable level analysis in the low 2s [ph] now?

Bob Burton

That’s what we would expect.

Mike Vinciquerra – BMO Capital Markets

Great. Thanks guys.

Operator

Your next question comes from Howard Chen of Credit Suisse.

Howard Chen – Credit Suisse

Hi good afternoon everyone. Steve, your commentary was pretty constructive on the outlook for the organic growth of the franchise, I am just curious, as the new CEO, thoughts on the feasibility and appetite of a strategic sale to franchise?

Steven Freiberg

We expected that question would come up. Let me just emphasize, Howard, and I do appreciate the question, that we have a driving online brokerage business, we have strengthened our financial position, and I believe we have the opportunity to grow and prosper as a standalone company. And I think that sums it up.

Howard Chen – Credit Suisse

Okay. Thanks. Just wanted to hear it from you. And then second, any latest thoughts on what the appropriate size to balance sheet and balance sheet composition is for the longer term franchise?

Steven Freiberg

Again, just to reiterate, it’s been all of three weeks. I think the trend that the business has followed to this point is correct, which essentially is a combination of reducing the legacy at-risk assets, derisking of the company on a whole hosted front, and as we develop a broader longer-term strategic plan for the company, which is part of one of my year-end priorities, I think that will be a derivative of the plan overall. So, to be a combination of relative size, diversification of the franchise, level of risk that we are willing to take on with an expectation of kind of earnings and returns, so it’s very early to give you an absolute outside the context of broader set of strategies, but that is a high priority for all of us that we could frame essentially the future of this company.

Howard Chen – Credit Suisse

Okay, great. Thanks. And then final question, loan portfolio seems to be running off credit behaving as you expected better-than-expected, I guess as the environment becomes more normal, just any broad thoughts on when that inflection point in franchise profitability happens?

Steven Freiberg

You know, at this point, one we are not predicting it. Paul again also just emphasized that the trends have been positive and we expect as you have described it those broad backward trends to continue and within that frame, we believe that we can continue to produce deposit of results, deposit of trends. But predicting precisely when we will cross the profitability, it is something we would not really provide at this point.

Howard Chen – Credit Suisse

Okay, great. Thanks so much for taking my questions.

Operator

Your next question comes from Joel Jeffrey of KBW.

Joel Jeffrey – KBW

Just a quick question, I think you said earlier that most of the run-down in the loan portfolio was due to prepayments. Now, if we get into a higher rate environment, do you continue to see that trend as being sustainable?

Bruce Nolop

You want to comment on that Bob Burton?

Bob Burton

Yes. Sure. You know, certainly we continue to expect that, that will continue to see prepayment. Obviously we are on move with the industry and to the extent that prepayments slow, we expect to see that. However, remember that our portfolio is older, and to think there’s a constant benefit across a number of factors in that age is going to help us.

Joel Jeffrey – KBW

Okay, great. And then, it looked like advertising was up quarter-on-quarter, and typically seasonably up in the first quarter of the year. But given your sort of heavy focus on the brokerage side of the business, is this an elevated trend we could continue to see or you think it will sort of resort back to more traditional seasonal levels.

Bruce Nolop

What we said at the beginning of the year is we expect it to be overall spending on advertising and market development to be roughly equal to modestly above 2009 and that continues to be what we expect, but we are having a more broadening space throughout the year than we did last year.

Joel Jeffrey – KBW

Okay, great. And then just lastly, in terms of your working capital needs, how much sort of working capital do you guys need to run the business on an annual basis?

Bruce Nolop

Well, in terms of the brokerage company, it’s in connection with the bank as well, and maybe I can answer it that way, that we look at $1 billion to $2 billion of cash that we would maintain in the bank. And that would be to level and whereas slightly above that amount right now.

Joel Jeffrey – KBW

Okay, great. Thanks.

Operator

Your next question comes from Daniel Harris of Goldman Sachs.

Daniel Harris – Goldman Sachs

Hi good evening guys. One of the things I wanted to touch on was the market making business, it looks like the shares that you are trading are going way up and obviously it’s a difficult market for market making in the quarter with volatility declining. But how do you see that part of your business moving or going forward?

Bruce Nolop

Yes, this is a really good story. As I mentioned the transactions are up, and so, with that, I am going to let Mike Curcio who supervises this businesses well, maybe elaborate on what is a road jump for us right now.

Michael Curcio

Sure, Bruce. We are seeing some really good trends, now that we are past our crisis, and we invested in our business making it more automation and all the NMS talks where we are getting a lot more external customers. So, that’s really where you see in the growth, especially in both imports, but we have also seen a nice list within the NMS businesses well, and we feel that trend will continue as long as market conditions are the way they are, and they could even increase if we get more volatility. So, we are very excited about that business.

Daniel Harris – Goldman Sachs

Okay. And sort of on a similar vein, can you sort of remind us what are the obligations and opportunities you guys have to increase payment for order flow as we move further away from some of the things that have occurred over the last few years?

Bruce Nolop

As you know, the agreement that we have expires at the end of the year, and we will be looking at alternatives for the order flow, and we will be comparing different alternatives and obviously need to make a decision before then, but at this point, don’t have anything to report.

Daniel Harris – Goldman Sachs

Okay. And then just lastly, I know that there was some moving parts in the first mortgage in the HELOC book on the provision rates, but in terms of the first mortgage portfolio, we are starting to see some stabilization in the charge-offs. I don’t know where obviously the number goes next quarter, but we were trending that you were building the reserves prior to this quarter. I mean, you said that, that price flipped off [ph] next quarter. At what point do you think you start releasing reserves in that first lien portfolio, and are you seeing any signs of what actually lead to the things that sooner rather than later?

Bruce Nolop

Again, I will ask Paul Brandow, our Chief Risk Officer respond.

Paul Brandow

I think you actually almost answered my questions for me. We do agree the trends in the home equity portfolio, been favorable in the first lien, but first lien also has declined quite consistently over the past 12 months at a slower pace than home equity, because as we have mentioned before, it’s a less seasoned portfolio, and furthermore we have first mortgages with relatively low LTVs and it’s taken a longer time for some of those to become delinquent. Having said that, we would expect that the possible trend to continue perhaps at this more moderate pace that we have seen over the past few months. But to the point it was mentioned before, in the quarter, sort of the special-mentioned delinquencies were more or less flat, but there were improvements in the roll rates in the categories, and actually we did see more significant declines in the later-stage buckets. So, again, we won’t predict when exactly that means that we would flip, but we are pretty confident that’s coming not too far away.

Daniel Harris – Goldman Sachs

So, the big provision bill that you or the big reserve bill that you had in the fourth quarter, that probably shouldn’t expect anything much more than that, given the trends we are seeing and maybe getting better. That’s as far as I understand what you are saying. So, thanks very much.

Paul Brandow

You are welcome.

Operator

Your next question comes from Faye Elliott of Banc of America/Merrill Lynch.

Faye Elliott – Banc of America/Merrill Lynch

Hi, thank you. Good afternoon. I think I might be repeating the previous question, but I just wanted to make sure for modeling that I understand I guess your philosophy on your provision, on your reserves, and it looks like your reserves to EOP loans and your reserve to LPAs was growing up across categories and actually as a whole, and I guess I am still not clear whether you are saying that you are ready to lower that provision such that these numbers can start coming down, these ratios can start coming down a little bit.

Bruce Nolop

Yes. This is Bruce. The one thing I would say at the outset is our philosophy really isn’t the governing factor that we apply consistent procedures and a very rigorous modeling. And so, I just don’t want you to think that this is a subjective process. And with that, I will let Paul respond to it.

Paul Brandow

The only thing I would manage what Bruce said was keep in mind that we have a steadily declining portfolio, so other things being equal with larger [ph] ratios up.

Faye Elliott – Banc of America/Merrill Lynch

Right. And I expected that would be the reason, but if you have a continuing declining portfolio, then would you provision less to drive those rate to allow those ratios to start coming down given the trends that we are seeing?

Steven Freiberg

I think the effect would be that or the results would be that, but as Bruce alluded to you before, our process for providing for loans and reserving for loans is based on a consistent procedure, which starts with an estimation of losses going forward based on a number of factors and including the loan level performance of our own portfolio. So, yes, what you say is going to happen overtime, but we get at it with a different set of analysis.

Faye Elliott – Banc of America/Merrill Lynch

Okay, thank you.

Operator

(Operator instructions) Your next question comes from Roger Freeman of Barclays.

Roger Freeman – Barclays

Hi, yes, just a couple of quick follow-ups. With respect to the wholesale funding, I think there was a question earlier about where you are putting sort of maturing loans and you are buying MDI [ph] securities, what about further reduction of say, FHLB loans, since it has a higher cost to it?

Steven Freiberg

Yes, I think we have communicated before and I will just make sure everyone understands that. The wholesale funding we have a couple of constraints that limit our ability to reduce that amount of funding. First, on the home loan bank loans, any reduction there was required of prepayment penalty, so essentially pulls interest fast-forward, and that has a negative impact on capital. So, it’s something we do when we can, but it’s not something we can do regularly. And then with respect to the repo financing, the constraint there is there are hedging arrangements that are associated and that would be a pretty significant financial impact if we try to produce.

Roger Freeman – Barclays

Just on that one, I know you have talked about that in the past, what is the – like what’s the average duration of those swop hedges on the repo portfolio, because at some point, do those sort of run-off?

Steven Freiberg

Eventually, but it’s a long duration. My memory is bit more like four or five years in the maturities, but then –

Roger Freeman – Barclays

Okay. Got it. I just wondering on repos, I think the balance actually went – sorry, FHLB actually went up in the quarter? 2.761 versus 2.749.

Steven Freiberg

(inaudible)

Roger Freeman – Barclays

Yes, I mean, it wasn’t much.

Steven Freiberg

Yes.

Roger Freeman – Barclays

I was just wondering why have you all –

Steven Freiberg

Our Bank Treasurer, any comment on that, Mike Peasy [ph]?

Mike Peasy

Home loan bank line has a certain amount, but it’s just overnight, it’s a very small amount.

Roger Freeman – Barclays

Okay.

Mike Peasy

Not any fluctuations there between the cash side of the balance sheet, on the asset side and the funding side. And so, you will see some small amount of variability. You shouldn’t expect to see any large growth.

Roger Freeman – Barclays

Okay. All right.

Steven Freiberg

Definitely no change in strategy.

Roger Freeman – Barclays

Got it, okay. Makes sense. All right. Just on a lighter note, would you say you have got more advertising benefit out of this frivolous loan and losses and any expenses?

Bruce Nolop

Well, we wouldn’t comment on that, but I would just say overall that we have got a lot of free media from the whole Super Bowl campaign that made that very worthwhile. As a CFO, I appreciate that we are certainly on investments.

Roger Freeman – Barclays

Got it, okay. Thanks.

Operator

This concludes the question-and-answer portion of today’s call. I will now turn the conference back over to Mr. Steven Freiberg for any closing remarks.

Steven Freiberg

Thank you for joining us tonight. We feel very good about the progress we made in the first quarter, and we look forward to speaking with you again next quarter. Good evening.

Operator

Thank you. This concludes your conference. You may now disconnect.

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