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E*TRADE Financial Corporation (NASDAQ:ETFC)

Q2 2014 Earnings Conference Call

July 23, 2014 5:00 p.m. ET

Executives

Paul Idzik - CEO

Matthew Audette - CFO

Analysts

Rich Repetto - Sandler O'Neill

Alex Blostein - Goldman Sachs

Steven Chubak - Nomura Securities

Michael Carrier - Bank of America Merrill Lynch

Chris Harris - Wells Fargo

Devin Ryan - JMP Securities

Chris Allen - Evercore Partners

Christian Bolu - Credit Suisse

Dan Fannon - Jefferies

Operator

Good evening, and thank you for joining E*TRADE's Second Quarter 2014 Earnings Conference Call. Joining the call today are Chief Executive Officer, Paul Idzik; and Chief Financial Officer, Matthew Audette.

Today's call may include forward-looking statements, which reflect management's current estimates or beliefs and are subject to risks and uncertainties that may cause actual results to differ materially.

During the call, the company may also discuss non-GAAP financial measures. For a reconciliation of such non-GAAP measures to the comparable GAAP figures and for a discussion of additional risks and uncertainties that may affect the future results of E*TRADE Financial, please refer to our earnings release furnished with Form 8-K and our 10-Ks, 10-Qs and other documents the company has filed with the SEC. All of these documents are available at about.etrade.com.

This call will present information as of July 23, 2014. The company disclaims any duty to update forward-looking statements made during the call. This call is being recorded and a replay will be available via phone and webcast later this evening at about.etrade.com. No other recordings or copies of this call are authorized or may be relied upon.

With that, I'll now turn the call over to Mr. Idzik.

Paul Idzik

Thank you for joining us, and good evening. We had a good second quarter characterized by continued brokerage growth, noteworthy de-risking of the balance sheet and encouraging progress in our regulatory dialog.

In the core franchise we continued to sharpen our focus, strengthening our foundation and raising the bar internally on quality. This quarter that took the shape of launching our new brand platform, delivering a clearer message to our customers and prospects regarding the breadth of our capabilities. It also took the shape of focused investments in talent and infrastructure, positioning our company for future success.

The quarter brought continued accumulation of accounts and assets even in the midst of an industry-wide slowdown in trading activity. And with respect to our overall risk and financial position, the quarter benefited from the completion of the landmark sale of modified loans and marked improvement in the composition of our investments and funding sources. And perhaps most importantly, we made meaningful progress with our regulators, completing our first ever Dodd-Frank stress test.

Starting with that topic, since many of you have expressed more than casual interest; during the quarter we received feedback from our regulators with respect to our stress test submission. Matthew will share some of the details, but to foreshadow a bit, the dialog with our regulators on this topic has been quite healthy across both key dimensions of their assessment.

First, in terms of how our actual numbers fared, meaning capital adequacy and liquidity across various scenarios of macroeconomic and environmental stress; second, in terms of our planning process, our methodologies and stress testing capabilities.

With respect to the first, we performed well under all stress scenarios, and we feel positive about our capital position over the test period. On the second, we were encouraged by the dialog surrounding our stress testing capabilities and methodologies, our planning process, risk management and controls.

Over the past several quarters, you've heard us talk a lot about building out our enterprise risk management framework. Our stress testing capabilities are a prime example of this build out as we work to ensure our processes and procedures that met the expectations of the current regulatory environment and of our owners.

Net-net, our stress test results were as good as we could have hoped for. As you can appreciate, we view the entirety of this process to be an important step in our regulatory dialog, and importantly our continuing progress prosecuting our capital plan.

Turning to our financials, we recorded earnings of $0.24 for the quarter and net income of $69 million. Earnings benefited from an elevated net interest spread and the continuing trend of diminished credit costs. Expenses of $284 million were down sequentially, and while reflecting ongoing investments in the business, including elevated marketing spend corresponding to the launch of our new brand platform and its surrounding promotion.

Now, as we think about expenses, we remain confident that investing is the right thing to do at this time. We're also very conscious of pressures to revenues and the need to balance the bottom line impact.

Accordingly, we continually assess the appropriate level in areas of investment for the current environment. And while one quarter of muted activity does not make a trend, we're prepared to tighten our belt should revenues wane for a sustained period of time.

Further during the quarter, we exhibited continued improvement in the complexion of our balance sheet with reductions in legacy investments and funding. We completed the landmark sale of $800 million of our modified loans and rolled off $600 million high cost wholesale funding as those obligations reached their scheduled maturities.

Now, in terms of brokerage metrics, DARTs were 155,000 in the quarter, down 22% from a five-year high in the first quarter, but up 4% from the prior year. Options as a percentage of total trades were 23%, and our customers continue the increasing trend of engagement via mobile devices with a record 11% of trade executed to our award winning mobile apps. Finally, trading has held up July to-date, which has been up 3% from June.

One final point on trading; while the public discourse in this topic has calmed, our focus on delivering the best possible execution to our customers has and always will remain our top priority.

During the second quarter we were able to achieve price improvement for our customers of slightly over $20 million. That number is consistent with last quarters, but on lower volume, meaning we did an even better job of helping our customers get better pricing on the orders they placed with us.

Customer margin receivables remain relatively constant during the quarter ending the period at 7.3 billion and averaging the same throughout the quarter. These were again the highest levels we've seen in many years. We did however see some mild yield compression here as the number of accounts leveraging margin reduced, while the balances per account grew.

We added $1 billion of net new brokerage assets during the quarter. As expected, the pace of additions slowed relative to last quarter's record, reflecting seasonality in April. We added 33,000 net new accounts in the quarter, bringing our total year-to-date beyond the total for the entirety of 2013.

Our annualized brokerage account attrition of 8.6% edged up a bit from the prior quarter's all time low, but was still one of the lowest quarters in the company's history.

Meeting the retirement, investing and savings needs of our customers continues be an area of intensified focus for us. To that end, we were very encouraged with the continued growth in our managed products ending the quarter at 2.9 billion, up 11% over the prior quarter and 62% over the prior year. Retirement assets also accounted for the bulk of our total net new assets in the quarter.

At the board level, we were fortunate to add Mr. Gary Stern as the Director during the quarter; significantly strengthening our skill set at the board table. Gary's background having spent 27 years as President and CEO of the Minneapolis Fed is especially relevant, given the focus of the company.

With regard to external validation, we were recognized by J.D. Power during the quarter as our overall satisfaction index showed more improvement than any other provider in the self-directed space. And importantly, we received upgrades in each of our three credit rating agencies, DBRS, Moody's and S&P; these upgrades reflecting our progress across many fronts.

So in summary, I'm pleased with what we accomplished during the quarter, and feel good about prospects for the future. We've done a lot to bolster our position in the brokerage business, including our recent brand platform launch and intensified focus on the customer.

We also remain clear-eyed and purposeful in working to strengthen the financial health of the company for the more robust balance sheet shape and the continued execution of our capital plan. We feel encouraged by the regulatory dialog around our stress testing, which has been especially rewarding, given the amount of energy my colleagues have devoted to enhancing our risk and regulatory position over the past several years.

And with that, I'll turn the call over to our assiduous CFO, Matthew Audette.

Matthew Audette

Thank you so much, Paul. I certainly echo your sentiment on the quarter in our overall position. We have great momentum internally and externally as evidenced by the strengthening of our franchise, the improving health of our balance sheet, our regulatory progress, the confidence our customers continue to place in us and our performance overall. And I'm especially pleased that our progress is starting to be recognized by our rating agencies with positive actions during the quarter from each.

So, to start with our results; we reported second quarter net income of 69 million or $0.24 per share. The decrease from net income of 97 million or $0.33 per share in Q1 and an increase from a net loss of 54 million or $0.19 loss per share in the year ago quarter, which included 142 million of goodwill impairment.

Our second quarter net revenues were 438 million, down from 475 million in the prior quarter, and 440 million in the year ago quarter. Revenues included net interest income of 270 million, a 2% sequential increase as Q2 net interest spread improved eight basis points to 255 basis points, while our average assets decreased by 700 million.

The strong spread this quarter was driven by a combination of the core business as well as some balance sheet actions. On the core business, despite an industry-wide decline in trading activity, our margin and related stock blending book were robust during the quarter with even higher average balances than in Q1.

On the balance sheet side, we had several factors impacting the spread, including the scheduled runoff of 600 million of wholesale borrowings, which reduced the overall size of the balance sheet, strong performance on non-accrual loans and the one-time benefit to loan yields related to the TDR sale. While we were quite pleased with this spread performance in Q2, the benefit to the TDR sale along with the strong performance on non-accrual loans are not likely to recur in future quarters.

In addition, prepayments on the securities book picked up towards the end of the quarter as summer moving season started to kick in, something that is likely to continue into Q3. So, factoring in the likely decline in loan securities yields and assuming margin and stock loan remain at Q2 levels, our spread would be in the mid 240s for the second half of 2014. Please keep in mind, this is not a forecast, it's more of our run rate on the spread as we exited the second quarter.

On balance sheet size, this quarter's decrease was driven by the reduction of wholesale funding along with customer activity, which included 400 million in net volume. This brought our balance sheet down to just under 46 billion. There has been some interest recently on our expectations for future balance sheet size. We've been around our current balance sheet size of 46 billion since late 2012, which is reflective of two things; first, we were focused on de-leveraging to bolster our capital ratios. And second, we deliberately remain below the 50 billion threshold, which is still our intention today. We're quite comfortable with our ability to manage the balance sheet size accordingly to leverage such as those we've utilized in the past.

Commissions, fees and service charges and other revenue in the second quarter were 161 million, down 13% from the prior quarter and up 3% from the year ago quarter. Average commission per trade of $10.72 was up $0.08 from the prior quarter and down $0.38 from the year ago period. The sequential increase was primarily related to more options trades in the mix along with more trades from our corporate services customers.

Fees and service charges revenues of 46 million included 22 million of payment for order flow, compared with 25 million in the prior quarter. This reflected a 19% decline in total trades in the first full quarter impact of the sale of G1X.

Net gains in loans and securities were 7 million this quarter, the majority of which related to the TDR sale. The prior quarter's gains of 15 million included 6 million related to the sale of our remaining non-agency CMOs.

Our operating expenses for the quarter were 284 million, down from 290 million in the prior quarter. The decrease relates primarily to the fact that G1X was included for a portion of Q1, and FDIC expense declined 5 million sequentially, largely due to the TDR sale. These declines were partially offset by increases in compensation and professional services.

As Paul mentioned, our advertising spending in Q2 was higher than normal as we launched our new brand platform type E. Our plans for full year marketing spend are unchanged at roughly 10% increase from 2013. We've just focused more of our spent in the first half of the year in 2014.

In considering our overall expenses I'd echo Paul's comment that we're mindful of the environment with thinking about our own investments under different operating conditions.

From where we stand today, we still believe that make sense to invest, so we will continue to do so. As I think about the metrics that we used to gauge the appropriateness in us, we had solid momentum across a number of this. Spread has increased in the lows, partially due to healthy margin loan balances, an indicator of customer engagement. Credit has improved relating to lower provision and FDIC expense. And our corporate interest expense has come down with a possibility of further declines. So all trading activity has come down has over the past three months. That isn't the only indicator of our ability to invest.

Now, given our frontloading of marketing spend and the seasonality of the second half of the year particularly Q3, we expect overall operating expenses come down slightly from this quarter's level during the remainder of 2014.

Moving on to the loan portfolio, we had ended the quarter at 7.1 billion, a reduction of 325 million from the prior quarter driven by 310 million of payments. For the next few quarters we expect runoff in the range of approximately 300 million per quarter.

This quarter's provision for loan losses was 12 million at the low end of our expected range. This is down slightly from Q1 which would have been 15 million excluding a third-party settlement. Our allowance ended the quarter at 401 million essentially flat with the prior quarter.

Charge offs for the quarter are 14 million were predominantly in the home equity portfolio as one- to four-family charge-off was zero, which is consistent with last quarter adjusting for unique guidance.

As we think about provision expense going forward, we are mindful that the majority of our HELOC portfolio converts to amortizing over the next few years. To take a step back we think about our home equity portfolio in three separate categories when it comes to reserves. The first is balloon loans of 210 million, for which we are already reserved for the full life of loan.

The second is, home equity installment loans that's 600 million, which have always been amortizing. And the third is home equity lines of credit of 2.3 billion, the majority of which are not amortizing. It's this third category where we generally reserve for the next 12 months loss expectation and where conversions are scheduled to pick that materially in 2015 which could cause provision expense to increase in the quarters surrounding conversion.

And additional point on provision expense is that we've had essentially no charge-offs in the one to four portfolio over the last couple of quarters, which has caused our reserves for that category come down to keep overall provisions low.

With the current allowance for this book now relatively small at 44 million, there is not much more room for this trend to continue. So we expect provision expense for the rest of 2014 to be predominantly driven by the conversion of HELOCs and to continue to be within the range of 10 million to 30 million per quarter. Actual results within that range will be driven by the performance of conversions relative to our expectations.

One final point on the loan portfolio, home prices improved approximately 5% during the quarter leading to continued improvement in our LTVs. The average CLTV for the home equity book improved to 94%, while the average LTV for the one to four book improved to 81%.

Moving on to the regulatory front, as Paul mentioned, we received feedback from the OCC on our stress test which were submitted at the end of the first quarter as part of the first wave of Dodd-Frank Act stress test for banks of our size.

The submission was based on September data and included our operating forecast through 2016 under varying scenarios. The most constraining being severely adverse which contemplated inputs such as the 40% drop in the equity markets, and the 25% drop in home prices.

Since the results for banks in the 10 billion to 50 billion range are not public for this first official test. I can't discuss much in a way at specific results. But as Paul mentioned the two key takeaways are; first, we remained meaningfully about the regulatory low capitalized levels for all capital ratios across all scenarios. And second, we were quite satisfied with the feedback around our stress testing process and our approach in methodologies.

In all, we feel incredibly good about what we've accomplished here; our considerable efforts to de-risk and de-leverage are proving their worth with our strong capital performance across all scenarios. When coupled with our company-wide focus on building out our stress testing capabilities and controls over the past couple of years, achieving results like these is quite gratifying.

One final point in our submissions, keep in mind that they were based on September 30th, 2013 data. Since then our risk profile has improved. Through solid earnings the continued runoff of legacy assets and funding the sale and elimination of remaining non-agency CMOs and most important our sale of 800 million of modified loans reducing a disproportionate level of tail list.

Turning now to what this means for our capital and dividend plans going forward? The stress testing process for banks of our size differs in the CCAR process. So while the completion in response to these stress test is great progress, includes an important hurdle. It is not of length in approval of our capital plan. Each dividend request will continue to require a formal approval on a quarterly basis.

As we focus on our longer term capital plan while this stress testing process and its results are a key milestone equally as not more important will be demonstrating sustainability in the processes we had built, specifically in enterprise risk management, meaning, it's a great progress that build out our ERM framework that it will be even better when we can demonstrate a sustained operating track record.

So while our longer term plans continue to include managing the bank to a lower Tier 1 leverage ratio of 8% ultimately, our near-term plans are to continue requesting quarterly dividends of consistent amounts. In light of our regulatory dialog including the feedback on our stress test, my hopes are unchanged in wanting to be in a position to have more clarity on our path to our longer term plans by the end of the year. I think the accomplishments of the past couple of quarters only bring us closer to this objective.

Turning now to the use of dividends; we've been spending a significant amount of time thinking through what is the best use of capital. After much thought and analysis we believe the best use of capital today is to reduce our parent company debt. This is consistent with our commentary over several quarters now and is reflective of plenty of recent work on the topic. However, keep in mind that while this is our thinking today, this can, and likely will evolve over time as we get more clarity around our dividend levels and the returns in other uses of capital improve.

I'd like to add a little more color on current thinking around debt reduction. While we believe reducing debt is the best of capital today, we are also mindful that paying off our debt entirely, all 1.8 billion of it would likely result in a costly and inefficient capital structure. The key question therefore becomes how much reduction should we target. After much work in reviewing a host of different measures including earnings capacity, competitive measures, regulatory capital guidelines in credit rating agency data, to name a few. We believe the right level of debt for us over the long-term is approximately $1 billion.

This means, based on our thinking today, we would ultimately pay off 800 million of debt. The timing of and our ability to reduce debt by this magnitude will depend on several factors. Most importantly the level of dividends from the bank to the parent in cost associated with paying down our existing notes. I don't have precision around our plans today, but I hope to be in a position to provide more clarity on actions later in the year. As a reminder on year's callable debt is the 2017 notes which are callable in November of this year. Our nearest maturity is May of 2016 when 435 million comes due.

Overall, we feel strongly that reducing our corporate debt will put us in a much stronger financial position and will drive shareholder value. But again please be mindful that changes in the environment could shape and change our views and there are multiple constituencies involved in these decisions including our board and regulators. We are focused on executing our capital plan in getting into a position to reduce debt.

In closing, it was a solid quarter for us. We meaningfully improved our risk profile in our recognition our efforts with upgrades from all three credit rating agencies. We made good progress with the regulators on our dialog around the stress test and the receipt of our fourth consecutive quarterly dividend. And I feel good to be talking with more specificity on our plans for use of capital. I look forward to continuing and evolving that dialog in the second half of the year.

And with that, operator, we will open the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) The first question comes from the line of Rich Repetto. Your line is open, please proceed.

Rich Repetto – Sandler O'Neill

Yes, good evening. First question is for the assiduous CFO here. Matt, I didn't quite -- when you talked about the balance sheet size, you said it was deliberate to keep it at 46 billion, but what I didn't get or maybe I just didn't hear you. But does that include going forward that you're going to do everything to stay below a [specific] (ph) type situation at the bank? Or how do you balance that with growing the balance sheet and producing more net interest income, but you're having more expense side if you hit that 50 billion mark?

Matthew Audette

Yes. So Rich, so in speaking to our views today, it's been a big focus of ours to get the balance sheet size down, to get the capital ratios up, specifically the leverage ratio. And a secondary focus of staying below 50, I think over the long-term things of course could change; the returns on those deposits could change. Our wholesale funding, we still have 4.6 billion of that that's scheduled to roll off over time which creates a bunch of capacity to bring deposits back on balance sheet, so really speaking to our views today knowing that over time they can certainly evolve.

Rich Repetto – Sandler O'Neill

Okay. I know that they could evolve, I guess, quite well. If you do want to get to, say, 300 basis points spread in a different environment, it just appears like the balance sheet would need to be bigger. Anyway, I'll ask one more like a follow-up question. Thank you for the discussion on the debt and the ideas and thoughts on capital usage.

I guess the question is when you say if the environment change like what else, what type of environment would you not want to take down the debt level or where that target would change and that would not become 800 million of debt reduction not be the priority where you might do some other capital return whether it be dividend, buyback or etcetera?

Matthew Audette

Yes. So hopefully the message is debt reduction is absolutely our focus. I think the key thing to always keep in mind is we're going to be focused on what is the best use of capital for shareholders. Those things could change. I think just using the topics that we were just discussing, the return on deposits, especially there is deposits of balance sheet in this interest rate environment with the level of FDIC costs that we had in running the bank at 10.2% leverage ratio, the returns on that could be dramatically different with higher levels of interest rates with 8% leverage ratio, and FDIC rates is cut in half. So things could evolve over time. But I want to be very clear that our focus today in the best use of dividends is to reduce debt of the parent.

Rich Repetto – Sandler O'Neill

Okay. Thanks and congrats on a good quarter.

Matthew Audette

Thanks, Rich.

Operator

The next question comes from the line of Alex Blostein. Your line is open, please proceed.

Alex Blostein - Goldman Sachs

Thanks, guys. Good afternoon. Thanks for a lot of color and a lot of details I've seen there on the call. But let's -- I wanted to go back to the capital question.

I guess on the one hand you guys still have significant amount of excess capital at the bank today. So by our math it's about 300 million. And it looks like there is also a significant amount of excess cash at Holdco today, which should enable you to pay down the debt that's callable this year. So I guess what I am trying to get to is it feels like there is flexibility in the interim to deploy some of the excess capital at the bank without necessarily funneling it to the Holdco. So can you discuss, I guess, that opportunity and what really goes into that decision, because there is a couple of things you guys could do obviously both on the deposit front or breaking down the wholesale funding front?

Matthew Audette

Sure, Alex. So I think on the near-term focus on capital levels and use of capital, we are really focused on continuing to generate capital earnings at the bank and dividend being in a position to continue to dividend those specific amounts. When we get to the longer term plans that are being able to start to run at a lower leverage ratio that's going to involve reviewing a host of different things, I hope to be in a position by the end of the year to get more specificity and details on that.

I think the core of your question is because we're above 9.50% is there some flexibility to do something with every dollar above 9.50%. It's not as black and white with that. We are focused on having healthy capital ratios at the bank continuing those consistent dividends and getting to a place where you can achieve the long-term. So that's where we are focused.

Alex Blostein - Goldman Sachs

Got it. Thank you for that. And then the second question I have for you guys is the discussion around provision guidance. In the $10 million to $30 million, I guess, the view is -- that's your expectations for the next couple of quarters assuming unamortizing loan book and the losses there perform as expected. Can you give us a sense of what that 'as expected' is? I don't know what sort of loss number that you are assuming or something else that we can use as to gauge the performance of that book relative to your expectations?

Matthew Audette

The short answer is no, Alex. I think the longer answer though is that the range of 10 to 30 is of course informed by our views. I think if you look at just the last couple of quarters on home equity, the provision for the home equity component or book itself has been around 20 million which is coincidentally right in the midpoint in the range. So we'll obviously see it over time, but in the 10 to 30 is the best I can give you.

Alex Blostein - Goldman Sachs

Got it. And just one more from me, on spread income real quick; if you look at securities lending that's been, I'd say, surprise for the last couple of quarters. How sustainable you guys think that incremental revenue you have seen within NII and securities loan for you?

Matthew Audette

It's tough to predict. I mean it's margin and securities lending go pretty much hand in hand. So I think it's in the same bucket of how well could we predict whether the Q1 DARTS we're going to hold steady as well, right? So it's very hard to predict. We're obviously very happy with it. But it would just be hard to predict.

Alex Blostein - Goldman Sachs

Got it. Thanks so much.

Operator

The next question comes from the line of Steven Chubak. Your line is open, please proceed.

Steven Chubak – Nomura Securities

Hi, good afternoon.

Matthew Audette

Hi, Steve.

Steven Chubak – Nomura Securities

I was hoping to spend a little bit of time dissecting your logic or rationale as to why you are reluctant to grow the balance sheet above 50 billion. And I recognize that there is a risk of incurring incremental SIFI-related expenses. But just taking a step back and looking at the progress you've made on the risk management front, you have all of the capital and liquidity stress test systems in place including the regulators are pleased with your progress. I'm simply just talking to identify what are the potential sources of incremental expense that would compel you to limit your growth to the bank beyond 50 billion, because based on all of the cost benefit analysis that we do, that's the opportunity that's most accretive.

Matthew Audette

Steve, I think we've been incredibly clear about our primary objective which is to get the leverage ratio at the bank (indiscernible). So in order to do that we have reduced the size of the balance sheet, a secondary objective there has been to stay under 50 billion. Our objectives remain the same of continuing to maintain that leverage ratio at the bank till we get to a place where everyone involved is comfortable that's migrating to that longer term capital plan.

I think another thing that's very important for us, the amount of time and energy and effort that we spend on enterprise risk management, highlighting the stress test build out as we have today, but another key thing for us is demonstrating sustainability in the things that we've done. So it's not just important to build something out. It's important to build it out and show that we can do it over time. There is lots of things to do, but I think we have shows over the past couple of years, we've laid out a very long-term plan, in each quarter that goes by, feel like we are continuing to make progress on it.

Steven Chubak – Nomura Securities

Okay. So presumably if there is sustained progress that's made and you demonstrate that to regulators, is there any reason that you will then still be reluctant to grow the balance sheet beyond 50 billion? I'm just trying to identify whether is an individual source or area of incremental cost that you simply haven't incurred as of yet that makes you reluctant to consider that alternative?

Paul Idzik

Steven, I think there is certainly a bit of incremental cost you would expect to see in legal compliance risk and some in IT. We are talking about theoretic right now. We are pretty clear there have been underscoring today that our intent is to stay consistent with our capital plan and to really work on that and to stay below 50 billion. I am encouraged by the fact that in Washington and around the country there is recognition that a bank that's 50 billion or 55 billion doesn't have the complexity of $250 billion bank. There is some healthy discussion which I think has been well balanced about how do we think about that level and how might that change, and as well as all banks of X billion dollars are not of the same complexity.

So we are very happy to keep driving value for our owners by prosecuting our capital plan and to maintain a watchful eye on our opportunities, but also maintain a watchful eye on the regulatory and political environment. We are pretty happy with that current stated course of action.

Steven Chubak – Nomura Securities

All right. That's certainly fair. I do appreciate that color. Then just one more from me on the detail relating to your -- to managing your corporate data, and, Matt, I do appreciate the additional color you provided there. I just wanted to get a sense as to how the trust preferred is actually fit into that whole plan, and whether an improvement in your credit rating would actually prompt you to reduce the level of targeted debt.

Matthew Audette

So the tougher parts are rest that are in the bank but in their current regulatory environment. They are still included in good Tier 1 capital up at the parent. Obviously that is being phased out starting in 2015. I think what we've said today trust preferred are considered capital, so they are not on our focus.

I think whereas to your second question on where our ratings go? Is that going to change our thoughts and level? Yes, I think the –- our in the level of debt is after reviewing a host of different measures and is our view on the right level of debt over the long-term. I think if you just look at the financial results and the balance sheet that we've been producing and extrapolate that out. The credit rating associated with that over the long-term I think would be quite good. So we thought that through and thinking through the right level of debt at $1 billion.

Steven Chubak – Nomura Securities

Okay. And actually just to -- relating to the first question on the troughs, I know that you do have one trench that's actually quite expensive, which if you are going to maintain that level of billion dollars of debt outstanding, presumably you would want to take out at least some of those higher cost trenches, I just want to know how that would fit into the overall strategy?

Matthew Audette

I put that in the bucket of tactics, Steven. I don't have any comments on that. I mean we are well aware of course of the trust preferred. We are well aware that one of them has got a 10% coupon on it. It's a very small amount. I'll put that in a bucket of tactics that we will deal with at a later time.

Steven Chubak – Nomura Securities

All right. Fair enough. Thank you for taking my questions.

Matthew Audette

Sure.

Operator

And the next question comes from the line of Michael Carrier. Your line is open, please proceed with your question.

Michael Carrier – Bank of America Merrill Lynch

Thanks, guys. Hey, Matt, first on expenses, I think you mentioned just on the 284 level just going forward that kind of pull back some -- in that range of 275 to 280, I want to get some color. And then if the environment does remain muted in terms of the levers that you have to pull back it because most of the advertising -- are there other line items that you guys have invested some -- that you could pull back if this lasts for a couple of quarters?

Matthew Audette

On where expenses are heading, I mean if the trend is down slightly and really highlighting the seasonality of marketing where we are focused on spending roughly 120 million for the year but we spend 70 million of it in the first half of the year. And then of course typical Q3 slowdown in volumes, you'd likely see some sort of movement in that direction as well meeting down on the clearing cost. So I think that those are things to look at. If we were to conclude we needed to pullback. I think marketing is always the most obvious one, but I think when you look at the areas that we are investing in is largely associated with people.

So if you look at where our expenses have grown, it's in a combination of comp and professional services. And there is a very specific -- many specific thought processes is by and one of them is to have enough in professional services that if it does make sense to pull back. We've got the type of spend that we can pull back as opposed to doing it all through -- pull some employees. Well, that's a little bit more difficult, a little bit more costly to pull back. So I think we've got that right balance for many reasons, but one of them is so we can be a little bit tactical if necessary.

Michael Carrier – Bank of America Merrill Lynch

Okay. That's helpful. Paul, I may have just a follow-up. I think over the next few years, two years, you got outside on the provision side, the capital deployment once you get approval. When we think about on the top line in some of these investments that you are making, if I look out over the next two, three years where do you see the most maybe a reward for that investment? Is it on the net new asset side and some of the fee-based products? Is it on more accounts on the trading side or is it on the retirement side? I was just trying to get a sense of where you kind of see that top line going?

Paul Idzik

We are in the yes/and category there. First of all, we think we can do a better job, and as we reposition the brand, do a better job of capturing more over existing customers assets particularly retirement assets and longer term investing assets.

Secondly, I think you've seen the numbers. We are doing a better job already attracting net new accounts and that's obviously a combination of bringing in new accounts and retaining, keeping our attrition low. So we are thinking about working both sides of that P&L if you will, both side is what comes in on the revenue side.

Let me just give you an example of where the investment spending is very tangible, very oriented towards the doing a better job as a digital company, being a bit smart about how we go about things. The team has gone through and redone in a very sophisticated way in terms of doing customer testing etcetera or online application. And we've increased the hit rate, if you will the funding rate on that online application from 50%, so half of the people who started in actually funding their accounts to 58%. That's quite a terrific increase, and we are looking for further opportunities to make it easier for people to do business with us and therefore bring us more business.

In addition, we think there is some real opportunities to improve the octane mix, if you will of the average customer by continuing to add financial consultants prove to excellent dialog with customers in helping them identify their needs are growing the portfolios that we help those customers with and helping those customers organically grow their portfolios and make better informed and smarter decisions about their financial health. So we are not looking for just one line as we improve our relationships through our customers. We are looking for progress across a multiple number of revenue lines.

Michael Carrier – Bank of America Merrill Lynch

Okay. Thanks a lot.

Operator

And the next question comes from the line of Chris Harris. Your line is open, please proceed.

Chris Harris – Wells Fargo

Thanks. Hi, guys. The whole topic around you guys need to demonstrate sustainability in your risk management processes, I'm wondering if you could maybe give us a little bit more guidance around that. How long do you guys have to demonstrate that sustainability before you can do a little bit more with your capital?

Paul Idzik

Well, I'd say the sustainability issue is not a single point in time issue. As our regulators get a better understanding of what we do and a more fulsome understanding of what they want to accomplish across the industry. Those expectations change. We are very gratified for example that the skills and talent we built around stress testing have resulted in our regulators providing us feedback that indicates they are comfortable that we have a sustainable process with which to do the stress testing. That's very important as I said earlier, not only to our regulators, but certainly to our owners. I don't think there is any easy answer to what constitutes sustainability, because our regulators expect us to be improving what we do on the risk management compliance front, logically expect us to improving that everyday.

We certainly are seeing indications from the regulators that they are taking this very seriously and even the largest institutions are discovering you can't take your eye off the ball in this.

Chris Harris – Wells Fargo

Is it fair to say that that process could take multiple years?

Paul Idzik

It's not a multiple year issue in terms of our build out. I feel very good with the build out we've done. But as I said, the sustainability issue is not one that just stops today. New regulations come in the force, we add new product lines, we add new products the regulators are going to want to see us build compliance and control around that and demonstrate sustainability over time. It doesn't just stop at a certain point in time.

Chris Harris – Wells Fargo

Okay.

Paul Idzik

There is no time clock on our intent and our great desire to improve our relations and are standing with our regulators and there is no time clock and them having a very logical desire to continue improving the safety and soundness to the financial institutions around this country.

Chris Harris – Wells Fargo

Okay. Then as it relates to the dividends how do the bank – bank's net income has been over $100 million for the last two quarters and the dividends still remains at 75. I'm just wondering why there is that slight difference. Why you guys can't -- at least dividend and the net income up? Then related to that why can't you at least dividend and capital to get you back down to the 9.50% ratio like why the regulators want to see this now 10% plus Tier 1 leverage at the bank?

Matthew Audette

Chris, a couple of things, first, it's only -- it hasn't been too long since we didn't have any dividends at all, right? So this is the fourth quarter where we already have dividends, and we are in incredibly good position to have that. I think our view on dividends and what we have expected over the short-term, that has been very clear in a consistent range. Our view in dividends over the longer term, I think we've been very clear in where we want to go. And our getting between those two points, we're working on and we hope to be in a position to have more clarity by the end of the year. I think having a bunch of different steps and why we're not doing exactly this amount of dividends or that amount of dividends is not something I'd comment on. I think our near-term plans are clear, our long-term plans are clear. I think we have a great track record of executing well, and that's where we are focused on.

Chris Harris – Wells Fargo

Okay. Just one quick point of clarification for me regarding the flexibility on paying down the debt; just so I'm clear, the amount that's available today, I assume that's just all in the corporate cash bucket, 570 million or could you potentially source cash from other places?

Matthew Audette

No, that's the total amount. And keep in mind; we wouldn't bring that down to zero, right? We wanted -- historically, and our view is to keep at least two years of debt service coverage up at the parent, which would be around $220 million at our current debt level. So we wouldn't take it down out to zero. But that is the primary source of cash with that reduction.

Chris Harris – Wells Fargo

Okay, helpful. Thank you.

Matthew Audette

Yes.

Operator

And the next question comes from the line of Devin Ryan. Your line is open. Please proceed.

Devin Ryan – JMP Securities

Yes, thanks. Good afternoon. Most of my questions have been asked; maybe just one on the brokerage and it looks like another pretty solid account add quarter, and you obviously had a really robust first quarter. With respect to all the changes that have occurred here with marketing strategy and I believe there are some streamlining to the account opening process. I mean, are we actually starting to maybe see some traction tied to that yet, or has the recent momentum just been more related to the environment unless some of these things that have actually changed internally at the company?

Paul Idzik

I think that's an insightful question, thank you for that. Just like we had a discussion earlier on similar topic, we want to see several more quarters of this type trend before we're happy with believing that some of the changes we made are sustainable. But certainly having net new accounts pass the mark we had in all of 13 already this year is a good sign. We're seeing positive progress in our customer satisfaction and feedback from customers.

And further I think we stack up pretty well on many of the metrics against our competition. So we're feeling better about what's happening. We have a lot of work to do. No one is putting down tools here. So I'd say stay-tuned, but I think we're on the right path.

Devin Ryan – JMP Securities

Okay, great. And with respect to just the headcount growth, obviously 4% is still a pretty robust number, and you guys did alluded to this with the investment spending, but can you just give a little more detail around where that is specifically located? Are these revenue driving seats versus maybe some catch-up on the support side, and is there still more hiring to come or do you guys already gotten there now that you have headcount up, I'd call it 10% year-on-year?

Paul Idzik

Well, first of all, as we add new accounts etcetera in that we need to maintain customer service levels and as we're engaging more richer dialog with our customers and trying to provide greater level support as they entrust us with higher asset levels, we need to add financial consultants. So, there is definitely some additions in the customer-facing side. We've continued to add staff on the compliance, risk and legal sides as the environment continues to change as we've needed to do more in both the advertising space. We've talked about wanting to be more analytical and smarter about what we're doing and shifting the focus of what we do in marketing to be more focused on our customers, less advertising focused and more customizing around our customers and prospects. That requires not only marketing people, but technology people.

So, those are the areas we're doing hiring in. And as a company that tries to support and does successfully support its customers not only with online channels, but with a dedicated high quality team of professionals, the definition around E-Trade of what's customer-facing and what's not customer-facing is a little blurred. I mean I think I'm really proud of working at a company where a great majority of my colleagues believe they're getting up everyday to make the customer's lives better and they will attract more customers.

Devin Ryan – JMP Securities

Okay, great. And then just with respect to the capital -- I apologize to beat the dead horse here, but I just want to make sure that I'm clear, so the regulators, are they necessarily waiting to monitor your risk management processes further here, before they potentially allow you to move forward? Is that what we're waiting for or we're just still having that dialog and it could happen at some point in the near future, but we just don't know the exact date? And I guess following on that, are you interacting with the same group at the OCC that review the stress test on this front as well?

Matthew Audette

So, I think on the path from here. I mean I think the new information this quarter is our comment on the stress test. We said last quarter I hope to be in a position by the end of the year to give comments on our view on when and how we'd head to the longer term capital plan. That's the same comment this quarter. So really nothing has changed other than we've gotten to the stress test.

So, I think the fact that our capital ratios increased through the wholesale reduction, wholesale funding reduction and customers were net buyers of the balance sheet didn't actually grow during the quarter has pushed the leverage ratio up about 10%. And I think the focus on what do we need to do to be able to use that incremental piece of -- interim piece of capital I think is missing a broader picture, right? We're heading towards the longer term capital plan; we've been headed to that capital plan for quite some time.

So that's what I'd take away from this. As far as who we interact with, we have -- I feel like we have great relationships at the OCC and the Fed, we interact constantly and have very good dialog.

Devin Ryan – JMP Securities

Okay, great. Thank you.

Operator

And the next question comes from the line of Chris Allen. Your line is open. Please proceed.

Chris Allen - Evercore Partners

Good evening, guys. I just wonder if you could tell us what the one-time benefit in the loan book that's showed up in the loan yield this quarter was.

Matthew Audette

Yes. So, there is a couple of things, and you may have noticed in the delinquency tables, we had delinquent loans maturing at a much faster pace in the second quarter. So, to the extent those are non-accrual, you can add some periods where you get more than one interest payment in a period.

And then second on the TDRs, we had a subset of those that were on non-accrual as well. When we sold those, we were able to get paid for the total amount of accrued interest. So, creating a little bit of a boost in the yields during the quarter, but if you look at the trends going back to in Q1 were it's just below 4% and it popped up during the second quarter, everything else being equal I'd suspect it would go back down in Q3 to the levels we saw in Q1.

Chris Allen - Evercore Partners

Got it, okay. And then, in the past you've given us some metrics around the HELOC book in terms of voluntary prepayments. I'm wondering if anything has changed in that front, is it still close to the same levels we've heard in the prior quarters, and the credit quality as people trying to amortize, does that remain steady or is there any change in that front either?

Matthew Audette

Yes. The short answer is nothing new. On the home equities the metrics have been -- approximately 40% have made voluntary payments of around $500 more in the last year, about half of those, 2500 or more. So nothing has changed on the performance of those that have gone through the end of draw. The comments there are the same. It's just such a small population that extrapolating anything from that to the larger population that is going to become amortizing, 15 and 16 is something that we think makes sense to do.

That being that, we're encouraged by what we see in that population that once you hit the end of draw period, that there is not some dramatic credit shoe to drop. But again it's a small population.

Chris Allen - Evercore Partners

Thanks a lot guys.

Operator

And the next question comes from the line of Christian Bolu. Your line is open. Please proceed.

Christian Bolu - Credit Suisse

Good evening, Paul. Good evening, Matt. Thanks for taking my questions. Just a couple of questions on some of your longer term initiatives, would it be helpful to get a progress report on some of those initiatives, I'm particularly interested in your initiatives to deepen customer wallet share, any metrics around progress that would be helpful?

And then secondly, how should we think about the longer term cost implications of your push towards mobile fee-based platform? Should we expect some pressure on operating margins as you invest to grow or can you preserve core margins, how wide you transform the platform?

Matthew Audette

So, I think a couple of things I'll address there, Christian, on deepening the customer wallet. I think a good tactical example is our managed products. We continue to grow those at a much faster pace than growing our overall assets. We're up to 2.9 billion in those accounts in the second quarter versus 2.6 billion last year. And those are the types of things where you think about the classic assets and customer that we'd get long ago. They would likely have that type of money, buy they would keep it elsewhere. They're starting to bring that type of money to us. I think that's the type of thing you'd see on deepening the customer wallet.

From a fee-based platform, there is no dramatic or broad cost implications of that. I think there are lot of things on -- lot of the areas that we've investing that Paul touched on earlier, whether it's customer-facing, technology or people, they're working on trading type assets as well as a fee-based type assets. I don't think there is a broad cost-based implication to the extent that we're successful in that.

Christian Bolu - Credit Suisse

Okay. You don't think you (indiscernible) transform increasing number of financial consultants, etcetera, I guess is my question.

Paul Idzik

We feel very positive about the pay back period related to the specifically the addition of the financial consultants, and I just want to remind you that one of the things that we found frustrating a little while ago was the fact we weren't doing a stellar job of explaining to existing customers the breadth of our offerings. And I'm encouraged based upon some customer focus groups that I've personally attended as well as some of the data that the customers are starting and process the starting to understand the breadth of E*TRADE's capabilities much better than they ever had before. And I think as you see the net new assets coming in both from brand new customers and from existing customers, that message is starting to resonate.

Christian Bolu - Credit Suisse

Great, that's helpful. I guess my second question on payment for order flow, just given some of the focus around non-marketable equity limit orders and the rebates they have gotten from exchanges would just be helpful to get your views and how you get comfort around your practices here?

Paul Idzik

We have extraordinarily thorough practices in our order routing that have been reviewed at the highest levels of the firm and include independent experts who take a look at that. We feel very, very comfortable with what's happening there. And we believe in all likelihood in many cases we're operating at or near best practices across what we do.

Christian Bolu - Credit Suisse

Okay. Thank you very much.

Operator

And the next question comes from the line of Dan Fannon. (Operator Instructions) Mr. Fannon, your line is open. Please proceed with your question.

Dan Fannon - Jefferies

Great, just one from me on longer term expense trends. Clearly you've highlighted the investments that you're making today and ongoing, but in an environment where -- the revenue environment is still okay and volumes are tracking at levels now, do you think 2015 still represents an area for which they'll still be spending in areas like professional fees and hiring or does that where we start to see a bit more of the leverage in the model?

Paul Idzik

Well, first of all, welcome to your first call.

Dan Fannon - Jefferies

Thank you.

Paul Idzik

Thank you for joining. We're already starting to see some of the benefits of our investment. Certainly as we continue to grow accounts, you'll see us have to add professionals to support those customers. A significant amount of our build outs have been in many areas, but much of that depends upon our continued analysis of what we need to build out as well as what we can afford. We're certainly not spending money simply because we've had a good couple of quarters. We're spending money with the intent to be able to support the brand as we're now portraying it to our customers and to shift the way we serve those customers, both online and over the phone and in-person.

So, it's not a linear relation between just a couple of variables, it's an attempt, and successful attempt to-date. It's starting to change the P&L dynamics of our company. So I think you have to stay with us for several calls, and you'll see what will start to happen.

Dan Fannon - Jefferies

Great. And I guess one more follow-up just on the FDIC expense, it seems like the benefit this quarter you highlighted was from the sale, and should we just assume the trend in that associated with the runoff in the portfolio, or are there other variables that could result in step functions or changes in that trajectory?

Matthew Audette

So, over the longer term, we'd expect it to come down by half. I think in the shorter term if there are any tactical things like the TDR -- sale of TDR portfolio; they're impacted in a meaningful way. I think the short answer to that is no. I mean when you go through the details of the account, the higher risk assets where there is a surcharge for those, the TDRs were disproportionately high when you look at the rest of our portfolio.

So, I would view the current rate which was $19 million and also roughly 19 basis points on assets is about where I'd see it in the near-term, keeping in mind if we continue to do the things that we've been doing, the bias on that is going to be a lower rate, not a higher one.

Dan Fannon - Jefferies

Great. Thanks for answering my questions.

Operator

And we have no more questions at this time.

Paul Idzik

We'd like to thank everyone for joining this evening, and hope you have a pleasant evening. Bye-bye.

Operator

Ladies and gentlemen, that does conclude that conference call for today. We thank you for your participation and ask that you please disconnect your lines.

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Source: E*TRADE's (ETFC) CEO Paul Idzik on Q2 2014 Results - Earnings Call Transcript

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