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E*TRADE Financial Corp (NASDAQ:ETFC)

Q2 2010 Earnings Call

July 22, 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

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

Brian Badell – ISI Group

Lyn Caperman – Omega Advisors

Operator

(Operator Instructions)

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 for E*TRADE Financial Second Quarter, 2010 C Conference Call. Joining me today are Steven Freiger, 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 and other forward-looking statements regarding future events or its performance.

E*TRADE Financial cautions you that certain factors including risk and uncertainties referred to in the 10Ks, 10Qs, and other documents E*TRADE files with the Securities and Exchange Commission, could cause the company’s actual results to differ materially from those indicated by its projections or fully booking statements.

This call will present information as of July 22nd, 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 this call, or in the company’s press release, which could be found on its website at investor.etrade.com.

This call is being recorded. Replay of this call will be available via phone, webcast, and podcast beginning today at approximately 7:00 p.m. Eastern Time. The call is being web cast live at investor.etrade.com. 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.

Steve Freiberg

Thank you everyone for joining us this afternoon.

To begin today’s call, I will share a number of highlights from the recent quarter. Then I will turn the call over to Bruce to take you through the quarterly results. After I add a few closing thoughts, we’ll be happy to take your questions.

The second quarter market was important milestone for E*TRADE as we recorded our first quarterly profit in three years. We report net income of $35 million on net revenue of $534 million, reflecting terrific progress from a year ago when we reported $143 million loss by net revenue up $621 million. Our results are a testament to the contributions of thousands of E*TRADE employees, and to the loyalty of millions of E*TRADE customers. And they were certainly a nice welcome for me in my first full quarter as E*TRADE CEO.

Our profitability in the quarter was driven by several items. First we had solid performance in our brokerage business, which strengthened new assets and growth in a number of key metrics, including DARTs, new accounts, and margin receivables.

Second, we benefited from the ongoing improvement in loan performance trends, resulting in a substantial decline in our loan-loss provision.

Third, we prudently managed our expenses.

Finally, effective balance sheet strategy resulted in solid net interest income in an environment of declining interest rates as well as opportunistic gains on loans and securities.

With this quarter’s results, we have now achieved three important milestones that support our returns as sustainable profitability.

First, our provisions for loan losses are now consistently below charge offs, having reached that reflection point in the third quarter of 2009.

Second, we are now generating organic bank regulatory capital continuing the trend that began in the first quarter of this year.

And third, this quarter marks our first profitable quarter since the second quarter of 2007.

I am particularly pleased with results of our warrant to reduce the balance sheet and mitigate risk. In addition to the decline related to pre-payments and scheduled principal reductions, we secured, ties, or sold $232 million in loans. And our continued effort to put back loans to sellers resulted in a $20 million legal settlement of loan claims, which contributed $15 million to the reduction in this quarter’s provision and charge offs. These actions supported by improving delinquency trends drove a meaningful reduction in balance sheet risk.

While we are proud of our results, we know there is much work ahead to insure we sustain and build on our momentum. We are gratified though that our financial progress provides us with increased flexibility to invest in the products, services, and technologies that will enhance our customer franchise to better realize growth opportunities that should drive shareholder value.

During the second quarter, I spent time with employees in a series of town-hall events and in small meetings with our management teams. I was energized by their engagement and their commitment to enhancing the customer experience through innovation and service.

We have recently demonstrated this commitment in a number of areas, including the April launched of E*TRADE mobile probe for iPad to continue our leadership in the rapidly growing mobile space. The release of open application programming interface for API allowing third party vendors and independent software developers to interface seamlessly with our investing platform.

Growth in our relationship management team to enhance the customer sales and service experience, and the elimination of our remaining account service fees to support our transparent pricing philosophy. This helped drive a 230 basis point sequential improvement in our customer attrition rate from 15% to 13% as we get closer to our objective of 10%.

When we spoke last quarter, I was just a few weeks in with E*TRADE, but already optimistic about the opportunities. Since then, my initial optimism has been reinforced. I have been very encouraged with the caliber of employees throughout E*TRADE. They have been through a challenging period, but they continue to innovate they’re engaged, and most importantly, they have focused on winning.

In addition, our financial progress, as I said, provides us with increased flexibility not only to reinvest in the business, but also develop the appropriate plans to enhance shareholder value.

I look forward to our ongoing dialogue as we build on our momentum.

With that, I will turn the call over to Bruce to take you through our results for the quarter.

Bruce Nolop

Thank you, Steve. Clearly, we are extremely pleased with our quarterly performance, which was supported by strength in our brokerage business, positive trends in our loan portfolio, and effective balance sheet management.

We reported net income of $35 million, or $0.12 per share during the second quarter, which compares with a net loss of $48 million, or $0.25 per share in the prior quarter. And a loss of $143 million, or $2.16 per share in the second quarter of 2009.

During the quarter, we generated $534 million in the net revenue, a decline of $3 million from the prior quarter, and down $87 million, or 14% from the same quarter a year ago.

Our revenue this quarter included net interest income of $302 million, which was down $18 million compared with last quarter. This 6% sequential decline reflected a $1.4 billion decline in average interest earning assets to $41 billion. And a seven basis point decline in net interest spread to 2.89%.

This reflects our strategy of maintaining a relatively consistent net interest spread despite an environment of declining interest rates.

Commissions, fees, and service charges, principal transactions, and other revenue in the second quarter were $195 million. And this was essentially flat compared with the prior quarter as an increase in DARTs was offset by a $0.33 decline in average commission per trade, from $11.38 to $11.05. This decline reflected the pricing changes that we implemented earlier this year as well as customer mix.

We again experience increased principal transactions in our market making business, which we see as a continued growth opportunity. This business generated $29 million in revenue, which represents an increase of 10% from the prior quarter, and 26% from the prior year.

Our revenue this quarter also included $37 million of net gains on loans and securities, including a net impairment of $12 million as we managed our investment portfolio to limit our risks and realized gains due to favorable market conditions.

Our total operating expense for the second quarter declined 7%, or $20 million from the prior quarter to $276 million. This included lower compensation, advertising, and restructuring costs. Our operating expense also declined by 16% from the second quarter of 2009, and by 10% if we exclude the one time FDIC assessment of $22 million in last year’s expenses. We are pleased with this performance, which reflects our ongoing focus on expense management.

DARTs for our U.S. operations were 170,000 during the second quarter, up 10% from the prior quarter, but down 16% compared with the second quarter of 2009, which was a period of significant market volatility.

Net new brokerage accounts were 18,000, representing a marked improvement from last quarter’s results when added 2,000 accounts. Moreover, brokerage accounts were up by 21,000 if not for the reduction of 3,000 cross-border accounts in connection with our European restructuring.

Net new asset flows into our U.S. brokerage business were a positive $2.1 billion during the quarter, and now total $4.3 billion year to date.

Brokerage customer cash declined by $1.1 billion to $20.7 billion while customers were net buyers of $3.4 billion in securities.

Bank customer cash declined by $1.2 billion.

Customer margin receivables in the U.S. grew by 26% during the quarter and ended at $4.8 billion. This represented a 60% increase from a year ago.

As Steve highlighted earlier, we are pleased with the performance in our loan portfolio. The portfolio contracted by $1.2 billion during the quarter, including $232 million in loan securitizations or sales, and $746 million related to loan pre-payments were scheduled principal reductions.

Our loan loss provision declined from $268 million in the first quarter to $166 million in the second quarter. This is the seventh consecutive quarterly decline in the provision, which is now 68% below its peak of $518 million in the third quarter of 2008.

Equally important, loan charge offs declined from $288 million in the first quarter to $225 million in the second quarter. This is the fourth consecutive quarterly decline, and charge offs are now 42% below their peak of $386 million in the second quarter of 2009.

The decline in the loan-loss provision in charge-offs this quarter included the benefit of a legal settlement on loan claims as we continued to look for opportunities to put back loans to sellers. The $20 million settlement contributed $15 million to the declines during the second quarter. And we expect the remaining $5 million to reduce our provision and charge-offs in the third and fourth quarters. The allowance for loan losses ended the quarter at $1.1 billion, down $59 million from the prior quarter, and remains at 6% of gross loans receivable.

The improvement in our loan loss provision and loan charge-offs was driven primarily by our improving delinquency trends. Total special mentioned delinquencies declined by 14%, with a decline in the in the 1-4 family portfolio of 17%, and a decline in the home equity portfolio of 8%. Total special mentioned delinquencies are now down 36% from their peak in the fourth quarter of 2008.

Overall, we were extremely pleased with the improved credit performance and expect the credit cost will continue to decline, however because the timing and magnitude of the improvement is affected by many factors. We anticipate variability in any one quarter while continued to see a downward trend over the long term.

We are pleased that the bank generated capital again this quarter. The bank generated $61 million in regulatory risk based capital during the quarter, bringing the year to date total to $108 million. Our bank capital ratios continue to be substantially in excess of regulatory well-capitalized thresholds. As of June 30, the Tier 1 capital ratio was 7.27% to total adjusted assets, and 13.39% to risk weighted assets.

We ended the quarter with $1 billion of risk based total capital in excess of the level that our regulators define as well capitalized.

We also are very pleased to report that we generated substantial capital on a consolidated basis during the quarter. We increased consolidated Tier 1 capital from 1.1 to 1.5 billion. And we increased our tangible common equity from $1.7 to $2.1 billion.

We ended the quarter with $181 million in corporate cash. This is an increase of approximately $63 million from the prior quarter, and included $100 million refund on the tax loss carry-back legislation, a $25 million dividend from the bank, and a $58 million cash payment of the May coupon on our Spring and Lee notes.

To summarize, we were very pleased with our performance in the quarter, and look forward to building on our momentum.

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.

First, I would like to comment on the Financial Regulatory Reform Legislation that was signed into law yesterday. While this legislation is generally considered to be comprehensive for the financial service industry as a whole, we believe the majority of the changes will have no material impact on our business.

The implementation of Holding Company Capital Requirements, however, is relevant to us as the parent company is not currently subject to capital requirements.

With that said, we fully expect that our holding company capital ratios will exceed the well capitalized minimums well in advance of the requirement.

Our confidence in our ability to meet these requirements is reinforced by a few items. First, our trajectory towards sustainable profitability as demonstrated in our second quarter results.

Second, anticipated additional conversions of our convertible debt, and third, the utilization of our deferred tax asset as we deliver profitable results.

Therefore, I want to emphasize that at this time, we are quite comfortable in our ability to meet these future holding company capital requirements. And we have no plans to raise additional capital as a result of the financial regulatory reform.

Finally, we had a very productive quarter on all fronts. With organic capital generation, improving trends in the loan portfolio, and now return to profitability, we are on the right track to enhance shareholder value. And I am fully committed to this most important objective.

I look forward to the coming months as we develop and execute plans for E*TRADE’s next stage of growth. And I look forward to engaging with you on our progress as respect to the company’s strategy for delivering shareholder value.

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

Question-and-Answer Session

Operator

At this time, I would like to remind everyone, in order to ask a question, please press star one on your telephone keypad.

Your first question comes from Roger Freeman of Barclays Capital.

Roger Freeman – Barclays Capital

Hi, good evening. I guess the first question is, Steve, now that you’ve on the job for a quarter, as you think about sort of longer-term for the organization. What role do you think a bank has within the E*TRADE sort of product set, you know, the value to customers, you know, products that you want to bank to fill?

Steven Freiberg

Yeah, that’s a relevant question. First and foremost, the role the bank, you know, has played in the institution has been important. As I know you’re more than familiar, we have approximately $30 billion of customer deposits. And those deposits are both fully important to our customers being an FDIC insured institution. But as important, those are largely in today and probably 70% of those deposits do in fact come from our brokerage customers. They are very low cost, very stable, and very profitable deposits for E*TRADE. And so that alone really is a compelling reason to have the financial institution to bank. And I would expect that that would continue over the long-term.

You know, in addition to that, it would clearly looking at, you know, the bank options and opportunities, but it’s a bit premature to go anything that is specific. But again, just to emphasize, very large deposit base, very stable, largely coming from our brokerage clients, very profitable, very important.

Roger Freeman – Barclays Capital

Okay, that’s helpful. Then, two other questions.

One, Macro around the mortgage portfolio and one are a little more granular. I guess, you know, looking at this quarter again and prior quarters, you’ve been, you know, selling off bits and pieces of the portfolio as opportunities arise. I mean, I guess looking at the portfolio as a whole at this point, how wide of a gap do you think there is? I imagine you look at this fairly regularly between what you think the value on a mark-to-market basis would be versus what you’ve accrued to. I mean I would assume that gap continues to shrink.

Steven Freiberg

I do think you answered the question directionally. The differential between, you know, book and market is in fact improving. That said, I don’t really have, you know, a specific valuation or number. As you’re probably aware, the portfolio really is I think designated as a portfolio that we will hold, a hold for maturity portfolio so that our flexibility around the portfolio is, relatively speaking, extremely limited. But all in all, it’s a portfolio that we continue to be aggressive in the management dove. I think you’ve seen in the results this quarter in particular, we shrunk the portfolio by $1.2 billion, combination of kind of our normal processes, plus the ability to secure ties and sell possibly $230 million of assets. And just to make a point, we sold it actually at a profit, so it went out at above par, which we thought was actually a terrific thing to occur, particularly in this environment.

So, you know, we’ll continue to manage the portfolio, particularly the Legacy book, down. But at the same time, I think it would be unrealistic to make any assumption that there would be, you know, one large solution to the challenge portfolio.

Roger Freeman – Barclays Capital

By the way, on that point, if given that you’re selling loans above par, which I assume is just a function of the low rate environment, the longer rates stay low that those opportunities are more prevalent for you, right?

Steven Freiberg

You know, I would say that if the rate environment is important, but again emphasizing that the portfolio is largely held for procurement portfolio. In addition to that, the risk is probably, or the perceived of real risk probably the most important element to year even more so than the rate environment.

Roger Freeman – Barclays Capital

Okay, and then just one sort of granular question here. Looking at your, the stature you’re giving on the modifications, the TDRs, when you do that, where typically in the sort of delinquency cycle is that? Like could I roughly assume that, you know, those are balances that are coming in from the 180-day plus, or is it kind of spread out over all. And I’m assuming when you do that, right, it does come out of your portfolio, your loan portfolio delinquency statistics, right, and then becomes a current loan then again.

Bob Burton

Yeah, this is Bob Burton. The loans do come out of generally the range between 90 and 180 days for the most part. Generally, the first mortgage loans are modified a little bit later in the process. But we’ve found that we’ve had good success modifying product even if it’s up to the 180 day level. In some cases, even modified loans beyond 180 days.

The performance of that portfolio, the modified portfolio has been very good. We think we’re getting good economic lift. We’re going to continue to work that as hard as we can.

Roger Freeman – Barclays Capital

And if you do a scheduled principal reduction as part of a modification, then do you take a gain on that to the extent that the reduction is less than what you had basically accrued the loan for on a loss basis?

Bob Burton

I’m not sure I understand your question, Roger. Can you rephrase?

Roger Freeman – Barclays Capital

If you cut someone’s principal when you modify in a loan mod, do you typically take a gain on that as a result because you’ve already taken charges against that loan that are in excess of what you’re agreeing to lower the principal to.

Bob Burton

First of all, we do very few principal reductions, but if we did that, it would actually create a loss on the transaction since we’d write that principal reduction down.

Roger Freeman – Barclays Capital

Okay, all right. Thanks.

Operator

The next question comes from Rich Repetto of Sandler O’Neill.

Rich Repetto – Sandler O’Neill

Good evening guys. Hello.

Steven Freiberg

Hi, Rich.

Rich Repetto – Sandler O’Neill

Yeah, I guess the first question, Steve, is on the call, on expenses, you know, the expenses came down nicely. You know, you demonstrated good expense discipline. I understand the advertising. Can you talk a little bit about the comp coming down when revenues were, you know, just down slightly quarter to quarter?

Steven Freiberg

Yeah, I mean from the standpoint of compensation, it really had several drivers, Rich.

One that really, you know, in many cases preceded my arrival here on the comp side. A fair amount of restructuring on the, particularly on the local international businesses as well as restructuring, you know, domestic business. And what we’re seeing is the benefit of that now flowing through the P&L.

So A, it’s sustainable. In fact, the comp lines from the standpoint of looking out over time should continue to basically follow I think a reasonably good trend. And that’s just again a testament to getting partization into the business as well as for the hard work that E*TRADE employees have accomplished.

It really had three dimensions to it. One is confidence as you pointed out. The second is on a sequential basis, the marketing costs have come down as well. But if you look at a year-on-year basis, we continue to reinvest at a higher rate in the franchise meaning marketing costs are actually higher by about 15% on year on year basis.

And then finally, particularly on a sequential basis, the restructuring costs in the second quarter were better than what we basically had in the first quarter. That really makes up, I think, the combination.

I guess to reemphasize, you know, part of my role is to continue to put a fair amount of pressure on the expense line. But at the same time, not only take expenses where appropriate lower, but we direct them open to marketing and sales as well as product and technology. We can grow the franchise.

Rich Repetto – Sandler O’Neill

Very helpful. Next question is on the credit and reserve. I know, Bruce, you talked a little bit, I thought you made mention of, you know, credit. You expected a longer term trending down, but, you know, quarter to quarter, you know, some variance. I’m looking at the reserves and how you build, for example, on 1-4 family, the provision equaled the charge-offs. And you’re carrying allowances that’s well above what you would take as the annual run rate there. You know, if you just take $70 million, it would be %280. So I guess the question, and on home equity, you know, it looks like you play a little catch up with the modification and release reserves. So my question is, you know, are you expecting 1-4 family to carry it a bit? Is that why you carry such a big allowance going forward? And what type of expectation? Are we caught up on the modification for home equity?

Bob Burton

Yeah, I would say that the factors that go into the provision are really quite a few. But just directionally, the first lien portfolio is further behind in the mortgage, or the home equity portfolio in terms of advantages, and seasoning, and modification. So in a sense, it’s still at the point where it hasn’t fully crossed the inflection where provision will start being lower than the charge-offs. But we expect that to occur in the future.

And with respect to home equity, it has achieved that inflection point. And modifications are being helpful.

Paul Brandow

Just one other point. This is Paul Brandow. I just wanted to remind you, Rich, that if you’re looking at the total allowance, recall that that’s both the general allowance plus the allowance for the TDRs. And the TDR allowance is not an expectation of losses over the 12-month period. It’s an expectation of loss over the life of the loan. So the total allowance is not – you can’t translate that into a 12-month forward-looking loss estimate.

Rich Repetto – Sandler O’Neill

Got it. Okay, last question. Looking at the bank average, the interest earning, the average balance sheet at the bank, you know, a couple of the asset classes went up margin loan. That’s great. That’s a high margin. But you had a little bit of help in maturity securities. One of the few categories that actually went up as the overall balance sheet went down, Schwabb did the same thing at the same yield, the 370-plus yield. So I guess the question, are there opportunities at a certain duration. And the only other follow-up is on the 232 that you did sell of loans, you know, what type of loans were they?

Bruce Nolop

Sure, this is Bruce, and just we established the health and maturity portfolio for the first time this quarter. So it was something that we instituted. And we added about $800 million of securities in the portfolio this quarter. We expect to grow it at the roughly $2 to $3 billion over the next few quarters. And that’s where it will hold. And we did that strategically because we thought it would be a good match with the customer deposit base that’s funding them.

So that’s the strategy, and we can talk about the individual securities that go in there. But in general, they are agency securities similar of risk characteristics as the rest of the portfolio.

With respect to the securitization of, and sales of securities for $232 million, those were conforming securities that we were able to sell and securitize with the Fannie Mae agency. So that was almost a one off type set of transactions.

Rich Repetto – Sandler O’Neill

Okay, congrats guys. Nice job this quarter.

Steven Freiberg

Thanks.

Operator

Your next question comes from Daniel Harris of Goldman Sachs.

Daniel Harris – Goldman Sachs

Hi, good evening guys. I was wondering if you could comment a little bit on the rate portrayed. Obviously, you guys made the change in pricing earlier this year. It came down a little bit this quarter. Is this, you know, essentially a good rate, or did you see, you know, higher level of certain type of asset trading driven by the volitility in the quarter?

Bruce Burton

This is Bruce again. In terms of the impact of the pricing change, the overall impact was about $0.50 to the average commission per trade for the quarter. And sequentially, that was a $0.14 change from the first quarter to the second quarter. So the remaining $0.19 of decline was due to customer mix. And the main factor there was you had a smaller percentage of so called main-street investors would pay a higher commission.

But we also had, just to comment, some offsetting positive mix. For example, options were a good mix this quarter.

Steven Freiberg

Let me stop, Steve. I’ll just finish up on the commentary that what we talked about, you know, for the first quarter when pricing was kind of implemented, meaning the cost of the business is actually coming in almost precisely on our expectations. So it’s also in line with what we expected when we went through the process of both developing, both the analytics as well as the strategy products execution. So it’s actually executing two expectations.

Daniel Harris – Goldman Sachs

Okay, thanks, that’s helpful. Shifting over to the market making side, this is an area that, you know, is continued to show some really nice growth year over year. And you know, Knight Capital also noticed some pretty positive trends. How should we be thinking about the strength there in the quarter, you know, around the flash crash and the volatility there which probably throws some higher-margin trading versus, you know, what we should expect going forward. It certainly seems like volumes were elevated in the quarter. But was the revenue capture of the margin methods also elevated?

Steven Freiberg

You’re talking about the market making, the principle transactions? That was not really a function of the flash crash. In fact, it can be attributed very much to the success in bringing in more external customers. And we think that’s one of the benefits by the strengthening capital structure and financial condition of E*TRADE. It’s makes us a much more viable and strong competitor in that market. So we see continued growth in that. And again, not related to any of the flash-crash issues.

Daniel Harris – Goldman Sachs

Okay, and then lastly for me. You know, we’re also seeing margin deck that continues to move higher year over year across most of the brokers. You guys obviously are benefiting from that too. Any sensitivity the clients have to a higher margin rate, or how are you thinking about the margin rate here, you know, now that the assets are moving nicely higher over the last 12 months?

Bruce Burton

This is Bruce. I would just say that clearly, margin is extremely important to our business. We were very pleased that the average margin balance for us grew by 15% this quarter, which is really helpful to our results.

And in terms of the sensitivity of the rate, that is something that we monitor very carefully. And we want to make sure that we’re always competitive. And it’s something that we discuss with particularly our major customers to make sure that we’re giving them a good value proposition.

Steven Freiberg

Let me just add more of the commentary. I think it’s important, even though we grew the margin balances sequentially approximately 25%, essentially our margin spreads actually, well, yield and spread, actually improved throughout the period. So I think it just adds kind of a factual element to, you know, to the outcome. So not only do we have growth, but we did not compromise the price of spread in order to grow.

Daniel Harris – Goldman Sachs

Great. Thanks a lot guys.

Operator

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

Matt Snowling – FBR Capital Markets

Yeah, good evening. I guess my question as far as the billion dollars of excess capital at the bank, I guess it seems that, you know, credit has clearly turned the corner. The bank is generating organic capital. So at what point do the regulators allow you to upstream more of that capital to the holding company to perhaps pay down debt?

Bruce Burton

That’s something we just can’t comment on. It’s Bruce, and but I think it is fair to say that now that the bank is generating capital and as you noted, we already have excess. That’s clearly a topic that we will be discussing with the regulators as we go forward.

Matt Snowling – FBR Capital Markets

All right, fair enough. Follow up question on funding. You know, you still have a, you know, about $9 billion of repo and home loan bank funding. If I recall, a lot of that was hedged so that you couldn’t necessarily let that roll off. But now that you’re, you know, potentially taking gains, can you take those gains and break those hedges?

Steven Freiberg

The answer is we could, but theoretically, also loss on the hedges would be so specific, and from our analysis that it would not make sense to do at this point. It perhaps will make sense in the future, but not now.

Matt Snowling – FBR Capital Markets

Okay. And how long is that funding? What’s the duration of that funding?

Steven Freiberg

The home-loan bank loans are three to seven years they’ll be rolling off. And in terms of the repo and the hedge accounting related to them, they roll off every ten years.

Matt Snowling – FBR Capital Markets

Ten, okay. Thanks.

Operator

Your next question comes from Mike Vinciquerra of BMO Capital Markets

Mike Vinciquerra – BMO Capital Markets

Thanks. Just to follow up on Dan’s question on the commission rate. I had a note from last quarter that you guys, the commission rate actually had stayed stronger because there was more stock plan administration selling. You get a higher commission rate there. And this quarter, it actually held up pretty well. Did you continue to see more than typical activity out of that particular segment?

Steven Freiberg

We saw good activity, but sequentially, it would be down. And that’s because you tend to have more exercises of particularly your strict stock in the first quarter and as well as options. So it’s seasonality in that business. But overall, that business is performing very well for us. And it’s a real strong point for the company.

Mike Vinciquerra – BMO Capital Markets

Okay, so at this point, no reason to expect any major changes on the – I know you get a mixed shift, but in the commission rate, nothing to really flow through another third quarter you know about?

Steven Freiberg

No.

Mike Vinciquerra – BMO Capital Markets

Okay. I want to ask on the loan securitization just to make sure that I understand the accounting there. You said you sold agency securities. Is there any sort of residual on that, or is the residual already with your clearing partner anyway who takes care of the servicing for you? I’m sorry, your servicing partner who takes care of that for you.

Bruce Nolog

No, there’s no residual involved in that.

Mike Vinciquerra – BMO Capital Markets

So you sold $232 million in loans, and you actually got a small gain. So that was a cash transaction essentially to you guys/

Bruce Nolog

Yeah.

Mike Vinciquerra – BMO Capital Markets

Okay.

Steven Freiberg

Right, and just to tell you the gain, it was $6 million gain.

Mike Vinciquerra – BMO Capital Markets

Okay, and I just want to – go ahead, I’m sorry.

Bruce Nolog

Just to be clear, we took back the security.

Mike Vinciquerra – BMO Capital Markets

I see, got you. Okay. Then just two more items. FDIC insurance premiums and servicing costs, I would expect those over time to be declining as the portfolio comes down and as your deposits run off at the bank. Is that fair, Bruce? Is there something specific to this quarter why we haven’t seen any real improvement in those particular line items?

Bruce Burton

Two things are, first on the servicing, that will decline over time. But there are few expenses related to REO that go through that as well. And so it’s not just a straight calculation. But directionally, you’re correct that it should go down proportionally with the decline in the portfolio being serviced.

With respect to FDIC Insurance, there is a mix issue. You have higher fees on brokerage cash than on bank cash for the deposit. But again, directionally, they should be relatively constant with the deposit base.

But again, we don’t see a big change going forward in the deposit base. Most of the decline in the bank has already occurred.

Mike Vinciquerra – BMO Capital Markets

Perfect, okay, thank you very much.

Operator

The next question comes from Howard Chen of Credit Suisse.

Howard Chen – Credit Suisse

Hi, good afternoon. Congratulations on the return to profitability. The first question, I had, a follow-up on the non-advertising operating expense step down. What’s the timing of those restructuring programs you mentioned Steve? I guess I’m just trying to gauge how much of an incremental step down we should anticipate in the next quarter all those being equal.

Steven Freiberg

Yeah, we don’t provide, we don’t specifically on that front. So I’ll turn to Bruce. Yeah. So I really can’t give you a precise answer on that other than to say that now through the remaining two quarters in the year, those numbers basically should be really fully reflective of that past restructuring.

Bruce Nolog

Okay, thanks. And then switching topics, if I thought about just, this is a starting point, it’s a standing and growing profitability for the company from here. One key in our minds is what’s the ultimate size and mix of the balance sheet. Steven, I’m hoping to get any thoughts you have on that.

Steven Freiberg

Just as you would expect, it’s a bit premature on that front to give you a specific number, you know, where this will become optimal. So I would say over the next, probably over the next several quarters, we’ll have a much better sense of really the size of the balance sheet and where we find the right balance between what we deploy as the balance sheet income and returns. But that’s what we’re working on as we speak.

What I can say though, is particularly is what you’ve seen in the past that we’re continuing basically, to manage as we have been managing to reduce as substantial as we can, as quickly as we can.

Bruce Nolog

Okay. Thanks. And then just, you’re freeing up regulatory capital. It doesn’t sound like you’re that concerned about Reg Reform. Just remind us of any target bank and parent company capital ratios that you’re sort of inspiring to.

Steven Freiberg

I can tell you at the parent level, from the standpoint of target on a regulatory basis, total capital to risk weighted would be for 10% Tier 1 Capital total adjusted 5, Tier 1 Capital to risk weighted would be 6. And those would be considered bioregulators to be a well-capitalized institution.

And so those are sort of the thresholds that we have in mind at the holding company. And from the standpoint of the bank, actually we’re, as we said, we’re well ahead of the statutory requirements.

Bruce Nolop

And we haven’t, at this point, established any targets for the parent above what’s been published as the official threshold. But for the bank, what we said is that even thought the well-capitalized threshold is 5% on Tier 1 Capital to total assets, that we’re targeting 6%. And with respect to risk-based capital we’ve said we wanted to be in excess of the 10% threshold by at least 500 million.

So if you think about it, we have a billion dollars of excess capital now, and of that 500 is above what we target internally.

Bruce Nolog

Okay, thanks. That’s helpful, Bruce. And just a quick number’s clean up, what was the end-of-period share count?

Steven Freiberg

In terms of the actual shares outstanding, it would be 210 million. And in terms of the fully diluted, it would be 290 approximately. We’re seeing if we can get any more specifics. 220.4 is the actual outstanding at end of period.

Bruce Nolop

I’m sorry, 220.

Steven Freiberg

Great. Thanks so much. And congrats, again.

Bruce Nolop

Thank you.

Operator

The next question comes from Michael Carrier of Deutsche Bank.

Michael Carrier – Deutsche Bank

Thanks, guys. First question, just on the balance sheet, the movement in this segregated cash, I just wanted to figure out what that was. And then just the comment that you had of increasing the balance of the [inaudible] Maturity, just based on that shift what you’re seeing. Just any comments on sensitivity to interest rates or NIM outlook.

Bruce Nolop

Sure. First of all, on the segregated cash, this is actually a good story. It’s got two components. First is the growth in our margin balances, that that set of receivables is financed out of the segregated cash. So the fact that we grew our margin book by about $1 billion during the quarter, that reduced your segregated cash.

And secondly, we were able to move $1 billion from segregated cash into our sweep deposits. And what that does is give us much more flexibility as to how we can invest it of the amount that’s in excess of margin receivables.

So that’s why you saw the decline in both cases. From our standpoint, a really positive movement.

And in term so the net interest, just to comment overall rather than on the health of the maturity portfolio, we think that we’re going to be able to maintain the spread approximately where it is now, and are targeting around the 300 basis point spread for the next few quarters.

Michael Carrier – Deutsche Bank

Yeah. I just wanted absolute context to it.

Steven Freiberg

Yeah, we reported in the quarter, 289 basis points, down seven from the prior quarter as we held more cash through the quarter on average. But invested basically above those averages by the end of the quarter. And to Bruce’s point, our expectation is that we can target and maintain over the coming quarters. That must have made us about a 300 basis point spread. So a little bit better than were we were in the second quarter as we deploy, basically, or utilize the cash balance in the enterprise.

Michael Carrier – Deutsche Bank

Okay. And then so just a followup. I think a lot of banks, you know, you’re obviously seeing the benefit from either reserve releases or improving credit. And I think what you try to get your arms around is if you look at like the top-line growth, in an environment where darts were up, margin balances were up, you still had pretty much like flat revenues next to the provision. So I guess as the balance sheet shrinks, and I’m trying to just – I know you can’t gage exactly where that’s going, but if you look at brokerage cash, or brokerage – or cash held by brokerage customers, it’s $20 billion. That would be like the online brokerage business. So maybe it’s $20 to $30 billion. I’m just trying to understand, you know like what’s the offset? Meaning, where are there areas to grow the business? So as you’re constantly shrinking the balance sheet, you know there’s still opportunities go grow the earnings.

Steven Freiberg

Yeah. Let me put some perspective to it. If you think about E*TRADE or the industry, first and foremost the trading business, I think you made a point on DARTS, it has it’s on inherent volitility. Although, if you look over long trends, you know, we expect that business, broadly as an industry, it may not be specific to E*TRADE, probably grows at 5%-7% a year. Obviously, with a lot of volitility in between.

I think secondarily, particularly for E*TRADE, we have a longer-term opportunity to basically to better serve and therefore better translate into what economic benefit for E*TRADE. The investor population, which is somewhat distinct from the trading population, we have a large and better base of those folks. And we’ve begun, over the last year, to provide, build, develop more product service that would provide the relevant level of value prop to those folks. But we still have a lot of opportunity ahead of us there. So it’s an area of opportunity.

It think thirdly, I think to your point, the bank which has been a source of both economic profit on the deposit side, and the downside of that is a lot of that historically was invested in assets that never did turn out to perform the way we had expect. But overtime, you know, as that normalizes, you know, the bank, whether it invests basically in securities or any other, or any other asset, should be a very profitable enterprise for this entity.

And then finally, I think Bruce, yeah, Bruce covered it in the piece. We have some terrific so terrific secondary – not second tier businesses, but secondary businesses particularly in larger banking, particularly in corporate services, we provide both options and restrictive stock plans to a number of company with are important to us with the new customers coming through there.

We have plenty of options to grow. We just have to basically get our house fully in order, which is really what we’ve been accomplishing over the last several years. But we have, I think, many options, many leverages to grow the firm.

In my first 100 days or so here, what I basically tried to do is to understand the industry, understand E*TRADE and then begin to start to put these into what the right set of priorities would be so that we can actually grow the top five, as well as benefit from what you’ve seen on the bottom line.

The goal is to basically have the concert play all the instruments, top and bottom, so we kind of play it out.

Michael Carrier – Deutsche Bank

Okay. That’s helpful. Thanks a lot.

Operator

Next question comes from Brian Badell with The ISI Group.

Brian Badell – ISI Group

Hi. Good evening. Can you hear me? Okay, great. I guess just following real quick on the balance sheet. Just for example, if you are reducing the asset loan say by about 4 ¼ billion, and let’s say over the next eight quarters, get it down by say 8 billion or so. Is it your intention to really reinvest that into securities or to reduce the funding costs out of the balance sheet if you had to sort of choose one way or the other?

Bruce Nolop

Yeah. I think it’s a good challenge for us. And I’m not sure the answer is binary either. And we’ll look at basically the trade offs, and the tradeoffs typically are many. One would be from the standpoint of bringing up capital. How best to deploy it back into the firm so it gives us more degrees of freedom.

Second is basically grow through profitability. And finally, from a broader-based strategic standpoint, what are the best options for this particular company. But the trend has been, from a factual standpoint, as we’ve freed up essentially cash or freed up basically the liabilities from the asset as $1 billion over the quarter has rolled off. We have fundamentally reinvested in largely, agency securities. That has been the strategy up through now. That doesn’t mean that we’ll sustain it in its absolute form, but I would say that that will still be a very important part of what we do.

Brian Badell – ISI Group

Okay. So it’s sort of like quarter by quarter you think about how the strategy plays out?

Bruce Nolop

Well, I think that we’re going to have a more comprehensive view. But I’m just saying, if you look at basically recent history, that’s what the strategy has dictated and what the company is executing against.

Brian Badell – ISI Group

Right. Okay. And then this question may be a little premature, but as you return to more sustained profitability and the provisions eventually will come down pretty significantly, how do you think about the cost structure of the company, let’s say 12, 24 months from now in terms of what kinds of things you’d like to spend money on that you haven’t been able to spend on in the past. Maybe if you can just touch on maybe four buckets of that. Number one, incentive compensation; number two, advertising; number three, investments in the franchise; and then number four, in terms of the FDIC assessments coming from a ReReg, are you impacted by any kind of assessment, assessment calculation change in that regard?

Bruce Nolop

How many questions?

Brian Badell – ISI Group

I’m sorry. I guess if you just touched on – I guess I’m looking for incentive comp, and obviously advertising. As you become much more profitable and to what degree do you feel you have freedom to really invest much more in the franchise.

Steven Freiberg

Let me think. Let me take a shot at it. One, on many fronts, the overall profitability helped the company continue to improve. As we said, I think our earnings release and our commentary gives us many more degrees of freedom to pursue the opportunities that we think are best suited for the company. And it probably will fall into lots of separate categories.

We would like to intelligently enhance our marketing spend, you know, where it makes sense. And there’s a whole host of ways to do it. Some actually cost money, some basically cost in resources versus money. So I’ll just give you some examples.

As we speak, we’re working on basically kind of new prospect home pages. We’re working on basically reorienting our advertising. You’ll probably see more of that coming into the late third and into the fourth quarter, more aggressively actually. And actually, importantly, it’s not so much spend, but more of segmentation analytic, a lot of testing and learning that we have approximately 15 million prospects that come to our website annually.

We have recently reach the conversion rate measured by industry standards, but there’s an immense opportunity, we believe to do better. And in addition to that, we have a large number of customers who come to us who opened accounts, but never fund. We think we have a large opportunity to do better and that’s through being smarter about the touch points and the through puts, and basically how we can bring them from, I would say hollow accounts to more productive accounts.

In addition to that, which really was started in the later part of 2009, we started converting more relational service and relational sales people into the company. And again, our costs are coming down as we’re basically putting on a higher caliber personal interface with our customer base, and we’ll continue to invest in that because the [inaudible] model looks reasonably good.

In addition to that, and a bit more tactical, working on things like portfolio margining, three-and-four-legged spreads. Working on basically leveraging what I would say are more common aspects in any online segment today, like communities. We can go on, and on, and on, and on.

So there’s a lot of opportunity ahead of us. The question is prioritization and then how we fund it without bloating the cost base. So in a perfect world, we’ll be smarter and we’ll be leaner, and more productive. And this is a bit premature, but that’s sort of the direction we’re taking the company.

Brian Badell – ISI Group

Yeah. That’s fantastic color. And so I guess you’ll sort of balance the cost of that verses sort of the operating margins that you’re showing?

Steven Freiberg

That’s correct. That’s correct, and each one basically will be measured where it’s appropriate as kind of an independent event and has to basically stand on its own viability from this standpoint of not only the P&L, but the return that this company will realize.

Brian Badell – ISI Group

Right. And then on a full-year basis, does the incentive comp structure change dramatically if you show say profitability on a full-year basis?

Bruce Nolog

I would say there’s a correlation, but it’s not the traditional wire house or investment bank. And so the correlation is going to be relatively mild.

Brian Badell – ISI Group

Right, right. Okay. And then just lastly on the share count, we’re at Q90, is that a good run rate for the third quarter? And then if you convert – I think the conversion is already in the share count, is that correct?

Steven Frieberg

That’s correct, 290 is a good number, and it’s a fully-converted number.

Bruce Nolog

Right. And the reason why that’s appropriate is when we shift it from a loss to a gain, you move from the basic shares to the fully diluted. So 290 is the assumption assuming that we continue to be profitable. And if it were still a loss that you assume, then you would use the lower 220 number.

Operator

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

Faye Elliott – Banc of America/Merrill Lynch

Hi. Thanks for taking my call. It says here in the guidance that some of the operating trends moved more positive toward the end of the quarter, and maybe could be reflected next quarter and stronger sustainable operating numbers. And I guess to ask, are you thinking higher pre-pay given the rate environment towards the end of the quarter? And has your outlook loan runoffs shifted based on that?

Paul Brandow

It’s Paul Brandow. We really haven’t seen much of a change in the pre-payment rates recently. And the current levels are what we reflect in our current provision and in our allowance.

Faye Elliott – Banc of America/Merrill Lynch

Okay. And you don’t expect that to increase at all? You don’t expect run off to increase just based on the rate levels currently?

Paul Brandow

We haven’t seen it, and unless we see a change in behavior, we are not planning on it.

Faye Elliott – Banc of America/Merrill Lynch

Okay. Thanks a lot.

Operator

The next question comes from Joel Jeffry of KBW.

Joel Jeffrey – KBW

Thanks guys. Most of my questions have been asked and answered. But just a couple of housekeeping question. I know you had said that DARTS buyins were pretty good in the quarter. Can you give us a percentage of what the options were in that category?

Bruce Nolog

They were up 16% at call, yeah, 16%.

Joel Jeffrey – KBW

Okay, great. And then in terms of the margin balances, you know, some of your competitors have said that there tends to be a lag effect. And I know with the equities markets being up in the past few quarters and then declining recently, is there a chance that we see the balances come back down in future quarters?

Steve Freiberg

There’s certainly a chance, but I think that in general, margin balances would tend to grow if the market is viewed as an attractive place for them to buy more securities. So I think it’s going to be a function of where the market goes to some degree.

Joel Jeffrey – KBW

Okay. Great. And then just lastly, in terms of deposits, I know you guys had a sale of deposits in the past quarter. Are you guys still actively looking to sell deposits?

Steven Freiberg

No. We’re not.

Joel Jeffrey – KBW

Okay. Thanks so much.

Steven Freiberg

You’re welcome?

Operator

Your next question comes from Lyn Caperman of Omega Advisors.

Lyn Caperman – Omega Advisors

Actually, my question was asked, although I’ll let you hear my question. Going through the penny saved is a penny earned, we have a big negative spread on our outstanding debt versus earning our cash, generating cash. We’re building cash at the holding company. I know it requires regulator approval, but I would encourage you to look for that regulator approval to take out some of this debt to improve our net interest margins so to speak.

Steven Freiberg

It’s currently on our radar.

Lyn Caperman of Omega Advisors

Thank you. Great job, by the way. Thank you. Good call, good responses. Thank you.

Operator

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

Steven Freiberg

Thank you, Operator. And thanks for joining us tonight. This was an important quarter for E*TRADE as we continue to make substantial progress towards sustainable growth and profitability. 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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Source: E*TRADE Financial Corp. Q2 2010 Earnings Call Transcript
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