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Santander Consumer USA Holdings Inc (NYSE:SC)

Q2 2014 Earnings Conference Call

July 31, 2014 09:00 AM ET

Executives

Evan Black - IR

Thomas Dundon - Chairman and CEO

Jason Kulas - President and CFO

Jennifer Popp - CAO

Analysts

Mark DeVries - Barclays

Cheryl Pate - Morgan Stanley

Moshe Orenbuch - Credit Suisse

Rick Shane - JP Morgan

Eric Beardsley - Goldman Sachs

Charles Nabhan - Wells Fargo

Vincent Caintic - Macquarie

Ken Bruce - Bank of America Merrill Lynch

John Hecht - Jefferies

Operator

Good morning, and welcome to the Santander Consumer USA Holdings Second Quarter 2014 Earnings Conference Call. (Operator Instructions) It is now my pleasure to introduce your host, Evan Black, from the SCUSA Investor Relations team. Evan, the floor is yours.

Evan Black

Hello and thank you for joining the call this morning. On the call today we have Thomas Dundon, Chairman and Chief Executive Officer; Jason Kulas, President and Chief Financial Officer and Jennifer Popp, Chief Accounting Officer.

Before to begin, as you aware of certain statements today such as projections for SCUSA’s future performance are forward-looking statements. Actual results could be materially different from those projected. SCUSA has no obligation to update the information presenting on the call. For further information concerning factors that could cause these results to differ please refer to our public SEC filings. Also on today’s call our speakers’ will refer certain non-GAAP financial measures we believe will provide the useful information for investors. A reconciliation of those measures to GAAP is included in the earnings release issued today July 31, 2014.

For those of you who are listening to our webcast there are few user control slides to review as well as our full investor presentation on the Investor Relations website.

Now I will turn the call over to Tom Dundon. Tom?

Thomas Dundon

Thank you and good morning everyone. With me today is Jason Kulas, our President and Chief Financial Officer. Today we’ll discuss our second quarter highlights and ongoing strategic initiatives. Afterwards, I will turn the discussion over to Jason to a detailed review of the quarter’s result. We’ll then open up the call for any questions you may have.

Second quarter is also highlighted by strong net income and profitability. During the quarter, SCUSA net income of $246 million or $0.60 per diluted common share compared to net income attributable to SCUSA shareholders for the second quarter of 2013 of 182 million or $0.53 per diluted common share. This represents net income growth of 35% from the prior year, driving a return on average equity of 33% and return on average asset of 3.4%.

Inclusive of normal seasonal trend, this performance keeps us on track with our plan for the year. In second quarter total originations were 6.7 billion including 595 million in facilitated originations. This compared to total originations of 7.3 billion in the first quarter including 390 million in facilitated originations. Traditionally, the first quarter is strong origination quarter for non-prime and after producing our highest quarterly origination volume in company history in the first quarter of ‘14 originations were down moderately this quarter. Moving into the second Chrysler agreement, as we booked more originations we obtain more data enabling smarter credit decision through extensive analysis of the loans we originated.

This led to a strategic decision to tighten loan structure and less profitable FICO bands during April and May led to lower capture rate. In June after implementing some changes to better identify good loan structures and high return lower risk pockets capture rates increase leading to a strong finish for the quarter and this is continued into July. Looking ahead we have a positive long-term outlook for originations.

Our revolving underwriting models will continue to enhance our ability to price risk and we will become more precise managing deal structure as a preferred lender. One of our strategic initiatives is to continue to widen our funnel and source of applications in order strengthen our core business. As an example of this, the origination of $58 million of new vehicle loan to the continuation of our Nissan submitted flow program. In ongoing effort to execute against our plan remain focused on our unsecured lending platform. Unsecured portfolio closes the quarter at 1.2 billion up from 1 billion in the prior quarter. Total originations up 263 million or driven by installment lending volumes increasing to 193 million up from 108 million last quarter. Our revolving volumes have stabilized following the high volume on boarding last year.

Moving on to corporate governance, as we continue to revolve our government structure we’re excited to announce the appointment of two new members to the Board of Directors. We appoint the new Independent Member, William Henry to the Board of the Audit. To the Board and to the Audit committee of the Board Mr. Henry has over 30 years experience in the banking industry, and we look forward to his contribution to our Board.

We’ve also added John Corston into the Board after the departure of Juan Andres Yanes. Mr. Corston also replaced Mr. Yanes as the Chief Risk Officer at Santander Holdings USA. We like to thank Mr. Yanes for service and contribution to our Board. In response to involving regulatory landscape, we continue to develop our business model remains focused on making the best use of our capital. We’re determined to allocate resources towards the greatest opportunity generating and recurring fee income via our service for others’ portfolio.

I would like to turn the call over to Jason for financial results and review. Jason?

Jason Kulas

Thank you Tom and good morning everyone. Let’s go to the second quarter results in more detail. As Tom mentioned net income for the quarter was very strong coming at 240 million a growth of 35% from last year. This was driven by net finance and other interest income growth of 32% to 1.1 billion up from 818 million during the same period last year. Interest income from retail installment contracts increased 32% to $1 billion up from $79 million during the same period last year due to significant growth on the portfolio. Interest income from purchase receivable portfolio decreased 50% year-over-year to $52 million down from $105 million. This was driven by continued run off of the portfolios and we have made no significant acquisitions since 2011 instead continuing the focus on creating organic loan opportunities.

The purchase portfolio interest income decrease was more than offset by increased interest income from our unsecured lending platform. Interest income from unsecured consumer loans grew to 84 million this quarter up from 15 million during the same period last year.

Net least vehicle income increased to $40 million this quarter up from $3 million in the second quarter of 2013 and up from $27 million last quarter. This represents an increase of 48% quarter-over-quarter as we continue to build our relationship as Chrysler-preferred lender.

Moving to originations, as Tom mentioned, we originated $6.7 billion in consumer loans and leases this quarter. We include originations facilitated for our affiliate Santander Bank NA and our originations through this quarter as it is more representative of our total originations and these originations are included in our Chrysler penetration rates. These originations figures are presented in table four of the press release distributed earlier this morning.

During the quarter, we originated more than 2.6 billion in Chrysler retail loans and more than 1.2 billion in Chrysler leases. The Chrysler penetration rate for the second quarter was 31% versus 38% in the first quarter. This decrease is driven by our strategic decision to tighten structure in the first two months of the second quarter reducing capture rates. However, June and July originations have been strong. And we expect to achieve our second year penetration rate as per the terms of the Chrysler agreement.

In the second quarter of 2014, average APR and retained and retail installment contract originations was 16% versus 16.2% last quarter and 15.6% during the same period last year. We continue to maintain pricing discipline on these new originations.

The allowance for loan losses increased to $3.1 billion this quarter from $2.9 billion last quarter. It’s important to note that because we carry approximately 17 months coverage on our vehicle loan portfolio, reserve levels are impacted by seasonality. As an example compared to 12 months coverage, the forward-looking provision model captures the seasonally worst fourth quarter loan performance twice as the second quarter ends.

This is in contrast to the forward-looking provision model as of the end of first quarter which captures the fourth quarter only once and captures the seasonally stronger second quarter twice. Although the allowance to loans ratio increased slightly to 11.6% this quarter from 11% last quarter, the increase is almost entirely due to this seasonality impact, we continue to have a stable allowance to loans ratio outlook.

The provision for loan losses increased to 589 million this quarter from 408 million in the second quarter of 2013 but decrease from 699 million last quarter. In the first quarter of this year, we had a large increase in provision year-over-year driven by growth -- mostly by growth due to additional volume with Chrysler.

This quarter, the provision variance versus the prior year was lower because the second quarter 2013 included Chrysler volume. However, the portion of provision attributable to performance and that volume is relatively flat from the first quarter evidencing stability in loss.

Looking at credit performance for the quarter, SCUSA’s net charge off ratio increased at 5.8% from 6.4% in the first quarter of 2014 and is up from 4.2% during the same quarter last year. The charge off on increase year-over-year is in line with expectations and the quarter-over-quarter decrease follows normal seasonal patterns.

Please refer to slide number 8 in the webcast presentation for more details. The second quarter delinquency ratio increased to 3.8% from 3.1% last quarter and is up from 3.5% during the same quarter last year. The portfolio growth rate has stabilized versus the growth rate at the beginning of the Chrysler agreement. Generally new originated loans do not have delinquency immediately so the ratio is driven lower when our portfolio is growing more rapidly.

Moving on to the expenses, during the second quarter, our operating expenses increased 23% to $211 million from $171 million during second quarter in 2013 due to strong asset growth over the previous year. Our efficiency ratio improved to 17.4% from 19.6% during the same period last year as we continue to demonstrate industry leading efficiency. This is further evidenced by our revenue versus expense growth for the six months ended 2014 versus 2013.

On a GAAP basis, revenue growth lagged expense growth due to one-time IPO cost; however, excluding these costs, revenue growth outpaced expense growth. Looking ahead, we expect moderately higher expenses for the remainder of the year but from an efficiency ratio perspective still in line with 2013 levels.

Regarding incremental compliance expenses consistent with the 8-K we filed in the June, we estimate the need to add approximately 100 full time employees related directly and indirectly to regulatory compliance including CCAR. Thus far 20 positions have been identified as being specific to CCAR and we’ve hired the majority of these people and we will continue to evaluate the remaining staffing needs.

Turning now to liquidity, our capital markets and treasury teams have been very busy this quarter, demonstrating SCUSA’s strong access to liquidity by the execution of two public securitizations totaling $2.6 billion from our core non-prime securitization platform SDOT,

Over 2 billion of additional liquidities from private term amortizing facilities and a series of six subordinate bond transactions totaling 409 million.

Both SDOT transactions were very well received and oversubscribed alone for each transaction to be upsized. It also achieved price improvement versus the prior deal and some of the tranches were executed with the tightest spread and program history showing continued strong inventory demand for our program.

Also as most of you are aware, this quarter we corrected a waterfall distribution error for one of our 2013 ADS transactions SDOT 2013-5. After consulting with rating agencies and counsel, we selected an investor focus solutions to resolve this issue, depositing $71 million into the trust and increasing over-collateralization accordingly. The $71 million does not affect due to its consolidated balance sheet but only result in a time issue to the company’s cash flow. We believe this solution demonstrate both our ability and willingness to quickly correct the issue and further evidences SCUSA’s strengthen as a servicer. Additionally, we’ve implemented a number of enhanced internal controls and we continually evaluate our ABS systems infrastructure to improve our processes.

During the quarter, we execute an agreement with Citizens Bank of Pennsylvania adding to our forward-flow relationships. Citizens have committed the purchase of 600 million per quarter in Chrysler Capital prime assets for the next three years representing a total commitment up to 7.2 billion.

Aggregate loan sales for the quarter totaled 1.8 billion in our composed of 1.4 billion through month sale programs to BofA and Citizens and also a bulk lease sale of 369 million to our affiliate Santander Bank, NA. These loans sales exhibits SCUSA’s continued focus on balance sheet management and growth in our service for other portfolio. The portfolio of loans and leases service for others totaled 8 billion at quarter end up from 6.2 billion at the end of the first quarter and up from 4.5 billion at the end of 2013. Loan sales for the quarter produced gains on sale of totaling 22 million down from 36 million in the first quarter, as the first quarter include the sale residuals from our Chrysler Capital prime retail platform CCAR.

Servicing fee income totaled $22 million for the quarter up from $10 million in the first quarter as the service for other portfolio grew 28% from the prior quarter. The portfolio has also grown 76% since December 2013 as we continue to focus on this capital higher ROE strategy.

Before we begin Q&A I would like to turn the call back over to Tom. Tom?

Tom Dundon

So in summary, look at back over the second quarter we’re able to produce strong income and profitability and we gave up a margin volume early in the quarter, margins increased as we made a strategic decision to avoid less profitable loans like tightening structures. Our custom scores and retains originations increased, evidencing enhanced credit and after indentifying the entire return lower risk pocket our volume outlook remain very positive. We continue to focus on our efficient core, non-prime portfolio; we are excited about the opportunity to head with Chrysler, our service portfolio for others and our unsecured lending platform. Total finance and other interest income increase net leased vehicle income is up, unsecured lending volume is up and service for others platform continues to drive a strong fee income stream.

With that I’d like to open up for question. Operator?

Question-and-Answer Session

Operator

Hello and we will now open the call for questions. Please limit yourself to one question and one follow-up question. Thank you. And our first question comes from Mark DeVries with Barclays.

Mark DeVries - Barclays

Yes. Good morning, thanks. Appreciate the new disclosures that you provided around your reserving methodology. I get the seasonal effect that you've laid out. I just want to make sure I understand the implications as we roll that forward. If you assumed a stable credit environment after accounting for the seasonality, while 2Q you're clearly getting hit with the peak charge-off quarter is the fourth quarter, twice. As you get to the back of the year, of the fourth quarter, and you're only picking that up once, is it right to assume that you would actually see your reserve ratio decline a little bit at that point?

Tom Dundon

Yes. That's a great assumption. In fact, as we look forward, that's exactly what we see. So, it trends back toward where it was in the first quarter.

Mark DeVries - Barclays

Okay, so in a stable credit environment the ratio goes up in the front half of the year and it goes down in the back half of the year?

Tom Dundon

Yes.

Mark DeVries - Barclays

Okay. Great. Great. And the next question, I just wanted to make sure I understand the earnings implications of the move, I think in the back half of the year, to retain less loans. Is -- I think you guys lay out in slide 20, you imply that while retaining less loans is a little bit dilutive over the long term, in the near term it's actually accretive to earnings because you're not having to reserve up front for 17 months of charge-offs. Is that accurate, and if so, does not retaining as much loans actually raise the earnings expectations in the near term?

Tom Dundon

You know, I think what it does given some of the other changes we've talked about, is give us more confidence than we might have had a quarter ago in our ability to hit the earnings targets we've laid out for this year. So, we've talked about growth going forward, and the downside case, and those kinds of things. But as we look at 2014, I think this strategy makes us even more confident that we can hit that 10% EPS growth we've talked about for this year.

Mark DeVries - Barclays

Okay, got it. Thank you.

Tom Dundon

Sure.

Operator

Your next question comes from Cheryl Pate with Morgan Stanley.

Cheryl Pate - Morgan Stanley

Hi, good morning. Just a couple follow-ups actually, to Mark's question. In terms of the 50 basis points expected on loans sold to third parties and serviced by SCUSA, is that a net of expense number? And then, maybe could you share with us some color as to how that might be different in the prime versus non-prime buckets?

Tom Dundon

Yes. So, on the first question, it is a net of expenses number, so that's kind of how we think of the net return on that business. Going forward, as maybe the mix of sold assets changes slightly, a couple of the dynamics change. The gain on sale dynamics could change, although we don't project significant changes in that because we don't count on big gain on sale. But, the servicing economics do change. So, what we expect going forward is that that 50 basis points maybe goes slightly higher than 50 basis points, because the mix continues to shift slightly as you sell more of the near-prime assets. But, the way to think about that 50, which is really the number we're focused on now, is that the bulk of that 50 is made up of what we make servicing the assets, and less than 10 basis points or so of the 50 is gain on sale.

Cheryl Pate - Morgan Stanley

And then just secondly on the reserving methodology, I appreciate the color on slide 22 of the deck. Just when we think about I think you’ve laid out in your 8-K back in June, thinking about going from a 17 month to 15 months overtime. Can you just provide a little bit more color around sort of how you would expect that to play out over the next several quarters or when should we expect that this 17 months moves down a little bit.

Jason Kulas

We think of that move from 17 to 15 is probably a longer term move. One of the things that we watch very closely is as we go through our very structured provisioning process in the various levels of approvals and committees and governments we have around that is this concept of a loss of margins periods, the time that lapses between the first time of default and the actual charge off. Our expectation is that, that period of time continues to shrink which justifies a lower of month’s coverage. Clearly, we have to see that play out in order to get there but that’s what we expect and we also expect it based on what we’ve seen historically. So I would say we don’t expect that move down in the near term, but as you look several years out, we would expect that move.

Operator

Your next question comes from Moshe Orenbuch at Credit Suisse. Moshe, your line is open.

Moshe Orenbuch - Credit Suisse

Sorry can you hear me.

Jason Kulas

Yes.

Moshe Orenbuch - Credit Suisse

Okay, I am just wondering if you could kind of give us some sense as to given the fact that you talked about some slower results in the first couple of months in this quarter. How do you think about volume growth and then maybe just a little bit about the retention levels of that and how do you think about that from a balance sheet management standpoint?

Jason Kulas

We do expect volume to continue to grow especially as the Chrysler relationship continues to mature. And we would expect that a significant portion of that volume is because of the nature of it is up market, super prime and prime type volume. It will be sold to third parties, either through structuring vehicles we do or directly in hold on form. So we do expect that shift towards service for others and selling assets to third parties to continue to grow. I think one of the things that we talked about before was this concept of guiding to lower growth. And I think the key thing there is we still view that as a downside case. If the current trends play out, we continue to be able to originate assets at the pace we’re originating them, have both -- good performance trends on the assets that are in the back book as well as this growth in the service for other’s business and the change in the mix of the income. We think that it’s possible that we could exceed that range but where we are not is still feeling positive where things stand today and consciously optimistic about the future.

Moshe Orenbuch - Credit Suisse

Thanks, and just to follow up for a second. Obviously, a lot of this is contingent upon the ability to sell those loans at attractive pricing. I'm assuming that given the current environment both for credit and interest rates, that that remains good. Could you just talk a little bit about your thoughts as to how that is likely to go over the balance of the year?

Tom Dundon

I think the key to that, we think the key to that is that we have to keep originating assets with the right structures and the right prices. And we think if we continue to do that, the rest of it kind of takes care of itself. A big component of this is a third party's confidence in us as a servicer. I think the track record we've established with third parties, and having major consumer institutions sign up to have us service assets for them, is one that will continue to be able to leverage. So, even as maybe interest ebbs and flows at certain price levels, we think that our ability to originate assets that make sense for the environment that we're in will continue, and that the demand will continue there. That's our expectation at this point.

Operator

Your next question comes from Rick Shane at JP Morgan.

Rick Shane - JP Morgan

Good morning, guys. Two questions, one's just sort of a bookkeeping or housekeeping issue. What was the mix on Chrysler during the quarter between prime, and non-prime?

Thomas Dundon

So if you look at -- let me just add up the numbers here.

Rick Shane - JP Morgan

Hey Jason, while you're sort of thinking about that maybe I'll ask the other sort of bigger-picture question, and we can circle back on the Chrysler stuff at the end of the question. Just curious, given what you're seeing from a competitive environment and also the constraints that you're facing now and the changes to your business model, how do you feel about your ability to take advantage of opportunities in the marketplace? What's out there, and how do you think you guys can respond?

Tom Dundon

This is Tom. So, we still hold -- auto loans amortize, and fairly quickly. We have quite a bit of balance sheet capacity, and we try to be smart about what we're going to use our balance sheet for. And so, within that size, $1 billion or so dollars a month, we feel pretty confident that we can make the best decision based on the environment. And you know, in terms of what we're able to sell or how we're able to price, what we find is to the extent that the market is efficient and the pricing is tight like it is now, selling assets is actually fairly easy. So, you get the benefit of, it's easy to sell, but sort of the detriment of tight margins. And as the market has less liquidity and less capacity, we have the ability to take price, and that's historically how we've handled the fluctuations. So, it feels like we're in a pretty good position and we've demonstrated that in the past to handle some of the changes in liquidity in the market.

Rick Shane - JP Morgan

And are you seeing any softening of that at this point as the opportunity improving as move through the year or is it sort of, is intensely competitive has been late ‘13 and the 2014?

Tom Dundon

It’s intensely competitive but what we’ve seen is that the deterioration of margin that started 18 months ago let say with lots of competition and our competitors end up building our models of a time where there is a very low competition and the margins will probably higher than what a sustainable in the competitive environment capital is attractive to high margin. The margins we think are now at a place where additional capital should not be attracted and you need to have expertise and efficiency to compete. And so I think I don’t believe the less efficient player is going to be very successful in the environment today we’re, last few years they can compete.

Rick Shane - JP Morgan

Got it. Great, thank you.

Jason Kulas

And Rick on the question on mix. We had about 2.6 billion of the volume would be categorized as prime and it’s the prime retail installment contracts and at least which is also prime and about 1.2 billion or so in Chrysler non-prime. That’s from first quarter would be the prime and lease were about the same and Chrysler non-prime in the first quarter were substantially higher.

Rick Shane - JP Morgan

Great. Thank you very much.

Thomas Dundon

Sure.

Operator

The next question comes from Eric Beardsley with Goldman Sachs.

Eric Beardsley - Goldman Sachs

Thank you. Just on originations, could you just help us quantify what they were in June and how they're tracking in July?

Tom Dundon

Yes, so if you look at total originations in June, they were just under $2 billion. What we're tracking in July is a little bit about 10% higher than that.

Eric Beardsley - Goldman Sachs

Okay. And in terms of your ability to balance sheet growth moving forward I guess has anything changing your view, are you able to actually bring loan balances higher or would be looking to sell any production that would have balances grow?

Thomas Dundon

Yes, I think we’ll look to continue to sell and also retain a marginal at, so I think continued marginal growth in the balance sheet for the remainder of the year, but you will see significant growth in the sales of the third parties. We want to maintain a healthy next year and we expect to continue to do that.

Eric Beardsley - Goldman Sachs

Great. And then, just on the servicing for others, it looks like the fee was somewhere roughly around 120 basis points or so of the average service balances. Where does that migrate to, as the mix of servicing prime and non-prime changes?

Tom Dundon

We don't expect that to migrate considerably. We do have a little bit of fluctuation in some of the contracts we have with our affiliate, where we have some adjustments based on performance. And so, you've seen as the numbers have been small, you've seen that impact the quarter-to-quarter numbers. As time goes on, that's going to have much less of an impact, both because those balances that are impacted in that way are amortizing, and because the overall book away from that is growing at such a fast pace. So, we don't expect a significant change there going forward.

Eric Beardsley - Goldman Sachs

Okay, great. Thank you.

Operator

And your next question comes from Charles Nabhan with Wells Fargo.

Charles Nabhan - Wells Fargo

Hi, good morning. In terms of strategic initiatives, could we expect more along the lines of the citizens flow agreement, or are you looking at more new OEM agreements? And in addition to that, if you could provide us with an update on some of your initiatives in the unsecured lending space?

Tom Dundon

Sure. On the bank flow side, I think we're as we -- I think we mentioned, we're putting a pretty intense focus on our capital markets group, and we feel like the opportunity to sell assets and residuals is, the returns are more attractive leveraging our capital markets infrastructure. So, I would expect that would be the majority of our focus. What was the other question?

Jason Kulas

Unsecured lending updates.

Thomas Dundon

Yes. So unsecured lending is actually going pretty well. We have a number of initiatives that we have been working on for a while that are more subject to our ability to get the technology and the governance in place to grow the existing channels. So we won’t be entering any new businesses, but we will add flow through what we currently do. So we have the infrastructure in place but we are sort of cautious with how we increased the funnel there, increased the flow. But we are on track with most of the plans and the returns seem to be about what we expected. So it’s going pretty well.

Charles Nabhan - Wells Fargo

Okay thank you, and as a follow-up, with regard to your comment about tightening standards earlier in the quarter, could you give us a sense for what FICO band you were referring to? Is that more below the 640 range, or the 650 to 750?

Tom Dundon

Yes, I think primarily it's going to be on the non-prime to sub-prime space. The prime, we're actually going the other way on super prime. Where there's some areas that it took us -- we needed the data and experience to understand which loans should have remained in the super prime and prime pricing, so when we receive an application, there are some areas that are tricky. And we initially would mis-cast some portion of those applications as sub-prime, until we had enough information to properly price these loans. So, I think you'll see -- I think a lot of what we're going to gain in the future will be super prime and prime share, and then on the sub-prime and non-prime, a lot of what we gave up was a result of increased competition, changing the expected performance from where we -- what our models would traditionally tell us, and that gets back to what I said earlier, that the models were using information from a time where there was no competition. We have some pretty quick, early indicators that show us that what we were originating wasn't giving us the proper cash flows, and so we tightened some of those areas. We also made some operational changes and so we probably tightened more than we should have, but it's just kind of what we do. So, we tightened a little more than we should've, we're giving some of that back as we speak, where we realized that we went a little too far. There was some good return pockets that we should've kept. But then, there were clearly some areas that we needed to give up. They're not sustainable, they don't make money, and I don't know if those loans are getting picked up in the market or if other people realize it too.

Operator

And your next question comes from Vincent Caintic with Macquarie.

Vincent Caintic - Macquarie

Hi, good morning. Two questions. First, you mentioned your Nissan subvention program. I was wondering if you could size that opportunity and any target penetration rates there, and then second, a question on the extension of the reserve coverage to 17 months. What's driving the lengthening of loss emergence period? And what would drive that down over time? Thanks.

Tom Dundon

Sure. On Nissan, we've been -- it's a partnership where Nissan refers applications, and we have the benefit of the relationship with the captive finance company and so there's some bonus cash that is to the benefit of either NMAC or us through this partnership. We've taken a few months to roll it out, and now we're going through optimizing. So, I don't want to get too detailed as far as volume opportunity and size, because a lot of that is the execution and the teamwork between Nissan and us. But, we think we're at the early stage of the relationship and we expect to see pretty significant growth from where we are today, as we learn the channel better and work together to optimize and help them sell more cars. And then I'll let Jason handle the provisions.

Jason Kulas

Now as we look at that loss emergency period, I think it’s important just to think about just the nature of prime versus non-prime. So on the prime side, that loss emergency period tends to be shorter, whereas on the prime side in general it tends to be longer. And as we look forward and we are in a higher loss environment, we see that loss emergent period shortening. So it’s both kind of mix driven as well as loss environment changing. So that’s as we look forward and expect it can go down from 17, those are some of the changes we expect to see but again we’ll have to see that play out as it goes.

Operator

And your next question comes from Ken Bruce of Bank of America Merrill Lynch.

Ken Bruce - Bank of America Merrill Lynch

Thank you, good morning. I apologize if this question has already been addressed, I've been bouncing between a couple calls, but the change in terms of the credit that you were willing to take over the course of the quarter, was that motivated by something you saw within the context of the loan pools themselves, just in terms of deterioration in the actual credit profile of those potential borrowers? Or, was this something that you were doing as a proactive step to essentially slow the non-prime piece of originations because of the other issues related to CCAR and other things that you're obviously planning for?

Tom Dundon

Yes, that's a good question. So no, it's -- we want every loan, so we want every loan that's priced properly. And as long as we believe we have the proper channels to either sell the loan and retain the servicing, or retain the loan on our balance sheet, so there hasn't been any capital constraints that come in our decision making. It's simply been as we look at the early indicators on segments of the sub-prime book, we thought there were areas that were mispriced and competition was over-valuing certain segments. And on top of that, we felt like we had to make some changes to deal with the environment as it sits today, versus historically. And so, the combinations of some enhancements we made and how we underwrite along with our realization that the market was underpricing some portion of the mix. So once again, we gave up more than maybe we should've, but we wanted to see some better early indicators, and where the early indicators improved we took back some of that margin. We're taking back some of that volume, and then a lot of it we've left behind and we don't think it's profitable even with some of the advantages that we have around expenses, modeling and collections. The margins just don't work.

Ken Bruce - Bank of America Merrill Lynch

Okay. And I guess are you’re looking at the 17 months in terms of the way you’re thinking about the loss reserves in the like, would that be something that you would ultimately maybe rethink as you approach the first if you will follow CCAR stress test I mean I don’t know how much benefit or credit you would get for your elevator reserve levels which might be associated with just keeping that longer kind of time horizon, but is there any way to think about maybe buffering the balance sheet to help to get through this whole capital planning process?

Thomas Dundon

Sure. CCAR was a qualitative problem, not quantitative and so what you’re saying it doesn’t have a big influence on it I think the way provision work here there is a technical side where the model drive coverage. And then there is sort of the judgment side or the managerial side and what we’ve historically done when losses are at a historically high level score-for-score, then you’ll see a need for less coverage because in our opinion things are getting better as competition decreases.

So I think the coverage for us is more a model and management judgment and less about the balance sheet. The balance sheet would be a separate conversation, the amount of capital we need to hold, the amount of assets we need to hold will have a huge impact or have almost no impact in how we think about how much coverage we need for losses.

Ken Bruce - Bank of America Merrill Lynch

Okay thanks, and lastly, I recognize your unsecured consumer loan portfolio is relatively small, but there was a significant pickup in terms of the charge-off ratio there. Is it -- can you maybe put some context behind what's driving that, if that's within the performance metric that you kind of laid out when you enter into this business? If you'd just explain that, it would be helpful.

Tom Dundon

Sure. It's going to look a little funny because we boarded so much paper to start, and those loans were seasoned, and now you're seeing new originations which obviously in non-prime unsecured, you get a quick charge-off. You get a quick pop in charge-offs on all new originations. But it's performing within our expectations, and I think you'll find that it's going to be easier to understand or more predictable after this little period where we just boarded a bunch of seasoned loans.

Operator

Yes, and our last question comes from John Hecht at Jefferies

John Hecht - Jefferies

Good morning, thanks for taking my questions. I wonder if we could just drill a little bit more into the competitive environment. I mean, if you look at the yields on the retained paper, they're up year-over-year and they're relatively consistent with Q1. Wondering if you could talk about where the bands of pricing competition's occurring, and then what other factors you would cite in terms of the competition, maybe in terms of loan-to-value and duration and so forth?

Tom Dundon

Sure. So, in the second quarter, we were able to get on the sub-prime book, our internal score is higher. Our margin, our expected margin, is higher than in the first quarter but that came with a reduction in volume. And it's impossible for that not to happen, in our opinion, meaning anytime you want to raise margin you're going to give up volume. And although we try to be strategic, and we try to be smart about how we do it, the markets efficient and anytime you increase margin you will decrease volume. And we believe that the margin we had to take is the minimum margin you would need to want to book these loans. So, we think the market is inefficient right now, or has not realized the coming severity and the coming frequency, primarily in the sub-prime space around a little higher LTVs. And so, we think that the nuance around deal structure and how important that is in terms of loan performance in a very competitive environment is maybe something that the market has to learn the hard way, maybe. So, it's not really, really bad. It's just on the margin, if you have a minimum return hurdle and we're not getting it, we'll give those loans up. And we see that mostly on the higher loan to values where we think the market is a little too tight.

John Hecht - Jefferies

Okay. And then if you could comment on recovery rates, I think they've held up a little better than expected thus far this year. What your expectations are, maybe for the second half of the year, and what factors you're looking at to drive that?

Tom Dundon

Yes, they've gone down as expected for the seasonal, and they've gone down a little more than expected based on seasonality. So, a very hard thing to predict. We predict that they're going down. In our models, we predict lower recoveries than we're currently getting. As a philosophy, recovery rates -- or another way to say the price of used cars -- isn't a huge driver of how we feel emotionally about the business, because when the recovery rates go down, used cars are cheaper. When used cars are cheaper, our customers can afford them more easily so we're able to take more volume and get better performance. What we do get from lower recovery rates is a little higher losses in the current book, but that's more than offset by the increased yield in volume we get from cheaper prices. So, although we think they're going down, it's not -- it doesn't help or hurt us going up or down. So, we -- I think the market tends to think high used car prices or high recover rates are a good thing, and that's probably not true for our business. It's probably better that things just don't move really quickly, right? As long as they move up and down, sort of in a measured manner, then we can do a really good job of taking the benefit off of one side or the other of the trade.

Operator

There are no further questions at this time. I would now turn the call over to Tom Dundon for final comments.

Tom Dundon

All right, thanks for joining the call today, for your interest in SCUSA. Our investor relations team will be available for follow-up questions and we look forward to speaking with you again next quarter. Thanks a lot.

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Source: Santander Consumer USA Holdings' (SC) CEO Thomas Dundon Q2 2014 Results - Earnings Call Transcript
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