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E*TRADE Financial (NASDAQ:ETFC)

Q3 2011 Earnings Call

October 19, 2011 5:00 pm ET

Executives

Susan Hickey - Media Relations

Steven Freiberg - Interim Chairman, Chief Executive officer and Member of Finance & Risk Oversight Committee

Michael John Curcio - Executive Vice President and President of E*TRADE Securities

Matthew J. Audette - Chief Financial Officer, Executive Vice President and Controller

Analysts

Patrick J. O'Shaughnessy - Raymond James & Associates, Inc., Research Division

Brian Bedell - ISI Group Inc., Research Division

Michael Carrier - Deutsche Bank AG, Research Division

Joel Jeffrey - Keefe, Bruyette, & Woods, Inc., Research Division

Christopher J. Allen - Evercore Partners Inc., Research Division

Daniel F. Harris - Goldman Sachs Group Inc., Research Division

Howard Chen - Crédit Suisse AG, Research Division

Richard H. Repetto - Sandler O'Neill + Partners, L.P., Research Division

Christopher Harris - Wells Fargo Securities, LLC, Research Division

Operator

Welcome to the E*TRADE Financial Third Quarter 2011 Earnings Conference Call. [Operator Instructions] It is now my pleasure to turn the floor over to Susan Hickey from E*TRADE Financial. Please go ahead.

Susan Hickey

Good afternoon, and thank you for joining us for E*TRADE Financial's Third Quarter 2011 Conference Call. Joining today are Stephen Freiberg, E*TRADE Chief Executive Officer; Matt Audette, our Chief Financial Officer; and other members of E*TRADE's management team.

Before turning the call over to Steve, I'd like to remind everyone that during this conference call, the company will be sharing with you certain projections or other forward-looking statements regarding future events or its future performance. E*TRADE Financial cautions you that certain factors including risks and uncertainties referred to in the 10-Ks, 10-Qs and other documents E*TRADE files with the Securities and Exchange Commission could cause the company's actual results to differ materially from those indicated by its projections or forward-looking statements.

This call will present information as of October 19, 2011. Please note that E*TRADE Financial disclaims any duty to update any forward-looking statements made in the presentation. During this call, E*TRADE Financial may also discuss some non-GAAP financial measures in talking about its performance, these measures will be reconciled to GAAP either during the course of this call or on the company's press release, which can be found on its website at investor.etrade.com.

This call is being recorded and a replay of this call will be available via phone and webcast beginning this evening at approximately 7 p.m. The call is being webcast live at investor.etrade.com. No other recordings or copies of this call are authorized or may be relied upon. And with that, I will turn the call over to Steve Freiberg.

Steven Freiberg

Good afternoon, and thank you for joining today's call. I will begin by covering highlights from the third quarter, and then Matt will take you through the results. I will follow with a few additional comments, after which we'll open up the call for questions.

We are pleased with our third quarter performance as we executed well during a period of extreme market volatility, driven by continued uncertainty in the global economy. We reported net income of $71 million or $0.24 per share on revenue of $507 million. Our results this quarter included a tax benefit as well as 2 specific expenses that I will summarize upfront and Matt will provide additional details later in the call.

First, we recorded an income tax benefit of approximately $62 million, or $0.21 per share, related to the taxable liquidation of the European subsidiary in conjunction with our international restructuring. On the expense side, we reserved $55 million or $0.13 per share, related to our intention to initiate and offer to purchase auction rate securities held by customers of E*TRADE Securities.

While we played a limited role in the market for these securities, we believe an offer to purchase is the appropriate thing to do for our customers and in the best interest of our stakeholders. And we will be pleased to put this matter behind us. Also on the expense side, our quarterly FDIC expenses increased $12 million from the prior quarter, including $6 million related to second quarter premiums. The FDIC made changes to its assessment methodology effective in the second quarter and with a calculation of our new FDIC assessment was finalized in the third quarter, it resulted in a $6 million increase in the second quarter estimate.

So, while we had a tax benefit and 2 expenses that were unique to the period, it was a solid quarter as we continue to execute on our strategic plan and focus on creating franchise value. The retail investor was highly engaged during this quarter and we are proud that our team and our technology supported our customers through very volatile markets, and we successfully managed periods that included record trade, call, online chat, and log in volumes.

In fact, we were recognized by SmartMoney on 2 occasions for having the fastest customer service response times, and by website monitoring for Gomez.com for being among the brokers with the fastest online trades on days of extreme volatility. On August 8 specifically, and on the heels of the U.S. debt downgrade, we processed 359,000 trades, a company record. Investors also increased their engagement via mobile devices and we saw a record mobile transactions, more than 16,000 on that same day.

During this busy quarter, we continue to execute on our strategic plan by adding sales resources, expanding our product offering, emphasizing our corporate services solutions, and managing our legacy loan portfolio. We are well on our way to increasing significantly our team of financial consultants, and have grown this group by 33% year-to-date. This team is delivering quality accounts as evidenced by year-to-date asset growth of $8 billion, and we are very pleased with our momentum in this area.

For our most sophisticated customers, we introduced Pro Elite, an exclusive program that combines no-fee access to our premier customizable trading platform E*TRADE Pro with competitive pricing and priority service and support. We supported the launch with new television, print and online advertisements and believe the program positions E*TRADE as the best choice for the active trader.

On the product front, we launched portfolio margin accounts providing sophisticated traders with more flexibility to manage risk and leverage capital. We also added a number of enhancements to E*TRADE Pro and customers can now access a number of new features including the ability to trade all option strategies, expanded CNBC content, logarithmic charts, cloud-based layouts and the E*TRADE community. Our Corporate Services group received a top rating in overall satisfaction and loyalty amongst stock plan administrators for the third year in a row, as reported by Group 5, a third-party corporate services research firm.

In addition, we have now successfully deployed more than 200 clients on Equity Edge online, our industry-leading equity compensation platform that launched in 2010. And with regard to our loan portfolio, we continued to decrease our credit costs and delinquency trends continued to improve, including a 5% sequential decline in at-risk delinquencies.

There is little doubt that the global economy will continue to present uncertainty. Regardless, we feel very good about our value propositions for both retail investors and institutional clients. We are pleased with the trends in our loan portfolio, and the overall strengthening financial position. We remain optimistic about the opportunity to profitably grow our franchise. I will now turn the call over to Matt to take you through the numbers.

Matthew J. Audette

Thank you, Steve. During the quarter, we recorded net income of $71 million or $0.24 per share, compared with net income of $47 million or $0.16 per share in the prior quarter, and net income of $8 million or $0.03 per share in the third quarter of 2010.

As Steve highlighted, our income tax provision this quarter included a benefit of approximately $62 million related to the taxable liquidation of a European subsidiary. The subsidiary was liquidated in connection with the company's international restructuring activities. This liquidation resulted in the taxable recognition of certain losses, including historical acquisition premiums the company incurred internationally. This tax benefit resulted in a corresponding increase to our deferred tax asset, which currently stands at $1.5 billion.

In addition, it's important to note that approximately 1/3 of its deferred tax asset is on the parent company's balance sheet, and is a potential source of corporate cash in future periods. We generated $507 million of net revenue in the third quarter. This compares to net revenue of $518 million in the second quarter, and an increase from $489 million in the same quarter of 2010.

Our third quarter revenue included net interest income of $306 million, a decline of $10 million from last quarter. This reflected a net interest spread of 2.81% on average interest earning assets of $42.7 billion, down slightly from the second quarter spread of 2.89% on $42.9 billion in assets. Previously, we have discussed that with our current balance sheet strategy, we expect to produce a net interest spread of approximately 300 basis points and a normalized interest rate environment. We still believe this to be true. However, if the current rate environment of extraordinary low interest rates persist, we would expect meaningful spread compression in future periods.

More specifically, we estimate our net interest spread could decline over time to approximately 250 basis points. I think it's important to note that this is not a forecast in anyway, but rather a sensitivity analysis of the range of spread we believe our balance sheet would experience in the current interest rate environment and a more normalized interest rate environment.

I would also highlight this assumes no change in our current balance sheet strategy, which may also change over time. Commissions, fees, and service charges, principal transactions, and other revenue in the third quarter were $181 million, up from $174 million in the second quarter, and a 20% increase over results in the same quarter of 2010.

This increase was driven by an 11% sequential and 30% year-over-year increase in DARTs. The increase was offset partially by a sequential decline in average commission per trade from $11.14 to $10.76, driven by customer mix, specifically a lower mix of trade from stock playing customers related to market performance and volatility during the quarter. Revenue this quarter also included $21 million of net gains on loans and securities, including net impairment of $3 million.

Expenses, which increased by $51 million from the prior quarter, included a seasonal decline in advertising, the reserve related to auction rate securities and an increase in FDIC premiums. As Steve mentioned, we reserved $55 million related to auction rate securities claims. This reserve relates to an agreement in principle between E*TRADE Securities and the Securities Commissioner of the State of Colorado and the North American Securities Administrators Association, to settle our outstanding auction rate securities claims.

In connection with the settlement, E*TRADE Securities has agreed to offer to purchase auction rate securities purchased through the firm by individual investors before February 11, 2008, and to pay a penalty on certain litigation investigative cost.

The amount of the reserve relates primarily to our estimate of securities current fair value relative to their par value and includes other estimated settlement cost. We believe this offer to purchase is the appropriate thing to do for our customers and is in the best interest of our customers and stakeholders.

As it relates to FDIC insurance, premiums increased $12 million from the prior quarter, including approximately $6 million related to the second quarter of 2011. As you may recall, the FDIC made changes to its assessment methodology effective in the second quarter. When our new FDIC assessment calculation was finalized in the third quarter, it was $6 million higher than our second quarter estimate. Going forward, the quarterly run rate will include this higher cost. We believe it's also important to note that the new assessment methodologies is an asset-based system with risk adjustments based on the size and quality of the balance sheet.

So as we continue to de-risk our balance sheet, decrease our credit costs and improve our regulatory capital ratios, we would expect our FDIC cost to decline over time.

Turning now to the metrics. DARTs for the third quarter were $165,000, an 11% increase over last quarter, and up 30% from year ago. During the third quarter, net new brokerage accounts were $13,000, down from $25,000 in the prior quarter and up from $7,000 in the third quarter of 2010. Year-to-date, net new brokerage accounts were $89,000 comparing quite favorably to $27,000 for the same period in 2010. Net new brokerage assets for the quarter were $2.6 billion, through the end of September, year-to-date brokerage asset inflows totaled $8 billion, compared with $5.7 billion acquired during the first 3 quarters of 2010.

We ended the quarter with $26.1 billion of brokerage-related cash, a decrease of $200 million during the quarter, and up $3.5 billion or 15% compared with the brokerage cash balance of September 30, 2010. Customers were net buyers of $2.2 billion of securities during the quarter.

Average margin receivables declined by 5% sequentially from $5.7 billion to $5.4 billion, and were up 15% over the same period in 2010. We continue to be pleased with the performance of our legacy loan portfolio and with the success of our loss mitigation activities. The portfolio contracted by approximately $700 million during the quarter. We reported a meaningful decline in net charge-offs, and delinquency trends continue to be favorable.

Our loan loss provision was $98 million, down 5% from $103 million in the second quarter, and down 35% from $152 million in the third quarter of 2010. We expect favorable trends to continue over the long-term although they are subject to volatility in any given quarter. Loan charge-off declined by approximately $21 million in the third quarter to $157 million, and were down from the $222 million we reported in the third quarter of 2010.

The allowance for loan losses at quarter end was approximately $800 million. The performance of our legacy loan portfolio continues to benefit from aggressive loss mitigation strategies, including the use of servicers that specialize in troubled assets.

As we discussed in our second quarter conference call, we transferred $1.4 billion in loans to such servicers in the month of July. These special servicers focus on loan modifications, often pursuing trial modifications for loans that are more than 180 days delinquent. The large transfer of loans during the quarter, combined with this focus on late stage delinquencies, resulted in an increase in TDR delinquencies for loans of 180 days or more past due during the quarter.

After the successful completion of the trial period, typically 90 days, the loan will become current. There's no impact on the allowance for these modified loans as they had already been written down to the expected recovery value when they became 180 days past due. Overall, we continue to be pleased with the performance of our modified loan portfolio. Specifically, we saw an improvement in the average re-delinquency rate, 12 months after modification for both 1-4 Family loans, which was down to 28% versus 31% in the second quarter, and Home Equity loans, which was down to 42% versus 43% in the prior quarter.

Moving now to capital. The bank generated $147 million of regulatory risk-based capital and $76 million of Tier 1 Capital in the third quarter. As of September 30, E*TRADE Bank's Tier 1 Capital ratio was 8.1%, and it's risk-based capital ratio was 17.2%. With respect to our parent capital ratios, all of our acquired ratios were above the well-capitalized minimums.

In addition, our consolidated Tier 1 common ratio was 9.3%. We also continue to track our consolidated ratios under Basel III requirements. We believe that Basel III at its current form will increase this ratio by approximately 20 basis points to 9.5%, meaning we estimate we are above the 2019 fully phased in requirements today. The main reason for the increase in the Tier 1 common ratio under Basel III is the difference in capital treatment of unrealized gains and losses on available for sale securities.

Turning now to dividends of excess capital out of our bank. Since late 2009, the company has requested and received the approval of our primary regulator to send quarterly dividends from our bank to our parent. The dividend had been equal to E*TRADE Securities, our introducing broker dealer, profits from the previous quarter. We believe our former regulator, the OTS, viewed these dividend requests as distinct from a more comprehensive request to release a portion of the bank's excess capital.

During the quarter, we transitioned regulators from the OTS to the OCC in the Fed. We believe our new regulators would view all dividend requests with an equal level of scrutiny. Therefore, rather than pursue a request solely for E*TRADE Securities profits during the quarter, we believe the best path for our shareholders is to work on a comprehensive dividend plan that could efficiently distribute capital amongst our regulated entities and parent company.

We have begun this process and our expectation is that it could take several quarters to conduct. And we cannot predict the likelihood or timing of regulatory approval for any such dividends.

Moving now to corporate cash, we ended the quarter with $438 million, compared with $424 million at the end of the second quarter. To summarize, we are pleased with our quarterly and year-to-date performance. And although we are most certainly not immune to the challenges of the macro environment, we are confident that our strategy, supported by declining credit costs, and an increasingly strong financial position provides us the flexibility to execute through uncertain times. With that, I will turn the call back to Steve for closing remarks.

Steven Freiberg

Thank you, Matt. Before taking questions, I would like to share a few additional comments. We are very pleased with the quarterly and year-to-date performance as we continue to execute on the plan we've laid out 1 year ago on this same call. Customer metrics are strong and our corporate businesses continue to gain momentum, while our credit outlook and capital position continue to improve each quarter.

We have shown meaningful progress this year at a number of key measures, including new accounts, asset flows, and earnings. Comparing year-to-date results with the same period in 2010, we have added more than 3x the number of net new brokerage accounts, brokerage inflows are up 40%, and we have generated $163 million in net income compared with a $4 million loss in the third quarter of 2010.

Looking ahead, as evidenced by the increased activity in August, it is not possible to predict the markets or how the retail investors might engage in the short-term. As it relates to October, month-to-date DARTs are flat compared with September. Regardless of short-term volatility though, we are optimistic that E*TRADE is well-positioned to meet the needs of both traders and investors today and over the long-term.

We continue to focus on initiatives that support our mission to deliver the best investing experience and plan over the next few quarters to introduce a number of enhancements to the customer and prospect experience. Later this month, we will introduce enhancements for options traders, including advanced screener, analyzer, and optimizer tools followed by other new products for traders early next year.

We continue to add customers to the beta version of E*TRADE 360, our new, personalized, investing experience that allows customers to access all accounts and their favorite features on a single page. It will be differentiated in that the platform will be available to all customers, from the beginner investor, to the most sophisticated traders. We expect to make E*TRADE 360 available to all customers in mid-December, and launch officially with additional features in early 2012.

Also in December, we plan to launch a new prospect website introducing an enhanced visual and navigational experience that we believe will increase prospect engagement and conversion. We should transition to this new site entirely by the end of January. We will continue to add sales resources in both our retail and corporate sales teams, as we build on our momentum and focus on asset and high-quality account growth.

Finally, during the quarter we engaged Goldman Sachs to conduct a strategic review of our business to ensure we are maximizing value for all shareholders. While the committee and the board are making good progress, at this point, there is no additional information to share so I’ll not have have anything more to add this evening. Again, we are pleased with our third quarter performance and look forward to building on our progress as we close out the year and move into 2012.

With that operator, we're ready to take questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Daniel Harris of Goldman Sachs.

Daniel F. Harris - Goldman Sachs Group Inc., Research Division

I appreciate the color you guys gave around the NIM and where you expected that could go to. I was just wondering if you could put just a little more timing around that, if things stayed the same, and you do get to that 250 basis points, is that over 4, 6 quarters? How long would you think that would take? And what are your assumptions built into that for margin load deterioration if at all?

Matthew J. Audette

Dan, this is Matt. As far as the balance sheet strategy that would ultimately lead to 250 in this interest rate environment, it's the strategy we're executing now. So it's focusing on a balance sheet funded by customer deposits. Our expectation is that, that customer base grows, that margin loan grows along with that. And the legacy loan portfolio continues to run off. And the investment strategy is in little to no interest rate in credit risk assets. Specific on when we would hit that 250, there's no particular timeframe on that, other than if this current interest rate environment persists, that is our expectation where it could go down to. It's not years and it's not tomorrow. So it's probably the best way I could put it for you.

Daniel F. Harris - Goldman Sachs Group Inc., Research Division

In staying on the balance sheet, looks like for the -- pretty much for the last year, we've been right around $42 billion, edging up to $43 billion on the balance sheet. And I think that's where Steve you had said that, that's position you feel as comfortable. Any update on that? Do you anticipate, with the amount of deposits that are out there that would like to find a home that, that could grow or you're comfortable at that $41 billion, $42 billion mark?

Steven Freiberg

I think in several conversations on the topic, we really did indicate that we don't have a precise number that we target. That the balance sheet ultimately will be driven -- meaning its size, by the quality and size of the deposit base that’s generated by our E*TRADE customers. So we would expect it to grow with the passage of time, but in line with the needs of our customer base. It's been relatively stable for a while. Basically some volatility as customers have held more or less cash, depending upon the environment. So I think sort of a normal view would be if we grow our customer base 5%, 6% a year, that the balance sheet probably grows in line with that. Although I would say there's opportunity with the passage of time to diminish the use, because there's still a sizable amount of wholesale funding that's on the balance sheet that's both high cost and nonstrategic. There's limits on how low it can go. But that said, I think again the balance sheet will be driven by the franchise size and the franchise needs.

Daniel F. Harris - Goldman Sachs Group Inc., Research Division

Just last for me, on a different topic here, on the market making side, I was a little surprised to see the equity shares traded dropped by close to 40% yet your revenue capture was up by almost double. What are you seeing there that drove that change, and what shall we expect going forward?

Michael John Curcio

It's Mike Curcio. Basically it's a mix issue. So we saw much more trading in NMS issues, which are more profitable and less trading in the bulletin boards. And we're seeing on the retail side a lot of traders are seeing better opportunities in NMS these days. So that's what attributed that mix change.

Steven Freiberg

It wasn't a strategic shift, essentially. It was basically the markets really selecting where they wanted to focus or concentrate. So that's going to move around. But clearly to Mike's point, basically the revenue per share is clearly more compelling in the mix, even though the actual volumes have come down substantially, although we can't predict because that could shift around in any given month.

Operator

Next question comes from Patrick O'Shaughnessy of Raymond James.

Patrick J. O'Shaughnessy - Raymond James & Associates, Inc., Research Division

First question I wanted to ask you touching on the interest spread again. What is it structurally about your balance sheet that might protect it maybe more so than some other online brokers out there? And by that I mean, if you look at some of the other online brokers that have interest margins below 2% -- you guys obviously kind of see yourself normalized at 3% in this environment, maybe down at 2.5%. What is structurally that maybe keeps your net interest spread, maybe a little bit higher than some of the other online brokers out there?

Matthew J. Audette

Patrick, it's Matt. I think just talking specifically to our customer base, when you think about a balance sheet funded almost entirely by your own customer deposits and non-maturity deposits, the spread that you can achieve on that is as unique to the firm as it is your customer base. Meaning it's driven by the stickiness and the customer behavior of that cash. So focusing specifically on us, we think the suite deposits are not a rate product. They're product of convenience and they're extremely sticky, and we think that is one of the biggest drivers that ultimately leads to 300 basis points, but every firm is different so our customer base we think -- and the cash associated with it, is a big driver of that.

Steven Freiberg

I think you've seen the shift over the last, probably 12 to 18 months more and more of our customer cash is in our suite product, to Matt's point, less is in savings oriented product where the customer specifically was oriented towards rate, and that shift has been quite substantial. So with low rate sensitivity deposits, that tend to have longer duration, we probably have a better opportunity take advantage of the curve. That said, and we've emphasized this, and we know that it's systemic, our preference is to have a steep curve and one that is elevated in absolute terms from where it is. But in the absence of that, and to Matt's point, we think the range that we've laid out is a reasonable view, although it could go higher and or lower than that range. But we would say that range captures the vast majority of the scenarios that we think are likely, although clearly it's not definitive by it's very nature.

Patrick J. O'Shaughnessy - Raymond James & Associates, Inc., Research Division

And then as a follow-up question, when we look at the deposits in the bank this past quarter, it's actually down slightly quarter-over-quarter, was that just kind of a function of your customers were not buyers during the period and then move some money from cash into securities or...

Steven Freiberg

Actually, you picked up exactly, our customers surprisingly were very strong net buyers during the quarter. I recall the number being approximately 2.6, $2 billion net -- $2.2 billion. And if you think about it, I believe our deposits were down approximately $200 million.

Matthew J. Audette

Patrick, If you look at the brokerage-related cash is down from 26.3 to 26.1.

Steven Freiberg

So the brokerage cash was down minimally, yet our customers were substantial buyers of securities during the period. So net net, they absorb a small piece of the cash they held with us, but really brought new resources to the firm in order to execute their transactions.

Operator

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

Richard H. Repetto - Sandler O'Neill + Partners, L.P., Research Division

I guess the first question is, Matt, you explain sort of the TDI, in the 180-day delinquencies. I'm sorry, but I wasn't able to catch the full explanation there. But the rationale or the driver behind the uptick in the delinquencies on the TDI is the 180 days?

Matthew J. Audette

Historically, our modification programs have been focused on delinquent loans. In connection with the servicing transfer this quarter, we started to focus on trial modifications, and the trial modifications are focused almost entirely on loans that are 180 days delinquent. So your typical modification, you agree to terms of the borrower, they make a payment, you make them current, and they go along their way. On the trial modifications, typically loans are in the process of foreclosure, so we typically require that they make 3 payments in a row. Because if we officially agree to modification, you would stop the foreclosure process, and if they missed their second payment, you're going to start it up again. So it's very costly to do that. So we wait for 3 payments to occur and then make it current. What you're seeing in that 180 days delinquent bucket is that during that trial period, we continue to report them in that 180 days. But once they make that third payment, we'll move it current. The other thing probably important to highlight Rich are these are loans that are in the process of foreclosure so they've already been written down to their estimated recovery value. We think anything that we do here, there's only upside. Worse case it doesn't work and the costs are just the same as we previously thought they were.

Richard H. Repetto - Sandler O'Neill + Partners, L.P., Research Division

And next just on the revenue side, just a couple of small line items here. But the gain on sale securities sort of went down sequentially, $6 million to $7 million, as well as fees and services. And I know you’ve given guidance that it would go down, but is this the sort of more appropriate run rate for going forward for both these lines, or any color you can give us?

Matthew J. Audette

The short answer to the question is yes. On the gain on sales side, I think going back to 2009 and '10, on an annualized basis, those bounced around the $150 million range. Back when rates were a lot more volatile than they've been this year, although the past couple of months, they're a little bit volatile but our expectations is that gain on sales line when compared to $150 million range per year is certainly going to come down. Specific to fees and service charges, we had a little bit of lumpiness last quarter with some corporate actions, specifically the Citi reverse stock split that created some lumpiness in the fees, so we saw that come down to a more normalized level this quarter.

Richard H. Repetto - Sandler O'Neill + Partners, L.P., Research Division

And then lastly Steve, I respect the guidance that you put in the prepared remarks about the strategic review. But I will ask a question, when it does come to conclusion, or when you get to the findings that they ultimately come to, will there be -- I'm just trying to find is there a conclusion to this? Is there going to be -- will you discuss this on a conference call later or how do we expect to end this?

Steven Freiberg

That's a good question. Clearly, there will be a conclusion for obvious reasons. How we would convey that externally, I don't have a definitive view yet to provide you. Although expectations, since we publicly said we've engaged and initiated, we will need a process to bring it to closure both internally and externally. So when we're ready, I'm sure you will be on the invited list as someone who has tracked the firm and been important to the firm over its years. But at this point in time, it's just something I can't give you precision on. Although as you might expect, as much as you want to hear the conclusion, we would like to bring the process to closure and just move forward. So stay tuned, but I just can't give you a precise answer yet. Although, since it is a public process so to speak, at least as initiated, we will bring it to a level of closure.

Operator

Next question comes from Howard Chen of Crédit Suisse.

Howard Chen - Crédit Suisse AG, Research Division

Back on the investment side, just curious what type of securities you're investing in today, what duration those are, and maybe what types of yields you're getting?

Matthew J. Audette

There's been no change in strategy there. So it's low interest rate risk, low credit risk assets, which essentially means agency securities. And our philosophy is really to match the duration of deposit. So it's typically been in the 2.5 to 3 year range, and that continues to be the focus on the asset side.

Steven Freiberg

Again the duration runs in that 2.5 to 3, but the instruments will cover a very broad part of the curve.

Howard Chen - Crédit Suisse AG, Research Division

And then on your commentary of the increase in DTA of the parent company, just under what conditions would lead to a release of that or something that you can use to invest in the business or deploy, et cetera?

Matthew J. Audette

It's pretty simple, it's income. So over time, as we earn income, we won't have to pay taxes on that income, and that will release the DTA. So of that $1.5 billion, $1 billion is essentially in the bank structure, and $0.5 billion is at the parent. So ultimately that will turn into cash through the avoidance of paying taxes.

Howard Chen - Crédit Suisse AG, Research Division

And then finally for me, just on your commentary in the comprehensive plan, I know we have a few quarters here, but you could you just help frame the parameters of the discussion of how you think about the excess capital and deploying that in this new context of a broader, more comprehensive plan?

Matthew J. Audette

Sure. So if you look at the bank, we have broadly $3.5 billion of capital, and if you look at all the different measures, anywhere from $1.3 billion of that to $1.5 billion of that is considered excess, at least on the official guidelines. So from our perspective, given we have a $1.5 billion of debt at the parent, we would like to have the flexibility to officially manage that for the best interest of our shareholders. So you can expect that as the type of dialogue we would have. From a regulatory perspective, you can expect that they have certain others perspectives as well. So we're going to work through that. So we expect it to take several quarters to do so. So I would highlight that we're fairly comfortable going through that time period given the level of corporate cash we have, which is slightly in excess of $430 million. And given that we just refinanced our nearest maturity over the summer, so our nearest maturity in now not until 2015. So we have well in excess of 2 years of debt service coverage, which is about $175 million a year. So we feel like we've got a decent run rate here to work through this comprehensive plan.

Howard Chen - Crédit Suisse AG, Research Division

Maybe as a follow-up to that, Matt -- just to confirm in very simple terms for me, if you think you have $1 billion to $1.5 billion that you could upstream in the bank, you think you would like to use that to delever at the parent. And so you kind of view the size of delevering with the excess capital that you have in bank as kind of one-for-one?

Matthew J. Audette

We'd certainly like to upstream it to the parent. I think the $1.3 billion to $1.5 billion is the excess above the regulatory minimums. So I think everybody could expect, in this environment for quite sometime, the regulators wouldn't allow you to dividend all of that up. But that's just to frame the discussion, where we would be focused is on that excess capital.

Steven Freiberg

I think just to add, Howard, I think the flexibility will be available to us with the passage of time although we can't predict with any certainty time. What really happens, which is the continuation of the trend that we've been on for a while, which is improve the risk profile of the company, improve the earnings and the quality of the earnings of the company, and improve the capital position of both the bank and the parent. And as long as we continue down that path, I think it will return to us many more degrees of freedom, and that's what we basically aim to work towards. And from your question how we deploy it, I think again, in part it's obvious that we are carrying a very heavy burden of the past -- sort of a tax from the credit crisis. The loan was basically -- the debt service, one of the burdens that we'd like to correct for and I think Matt summed it up well. But there are other areas that we would invest with the passage of time, but probably not prepared today to go in any detail. That one's the most direct and most obvious.

Operator

Your next question comes from Michael Carrier at Deutsche Bank.

Michael Carrier - Deutsche Bank AG, Research Division

Just one more question on the capital side. It seems -- if you give the Basel III Tier 1 common, if you're above 9% at this point, I think that would be the only firm out there. So it seems like, from a capital standpoint, you'd be fine. But even -- when you think about going forward, because whether it's the capital that you have today or the capital that you're going to generate over the next 6 to 18 months, we can calculate that, but where do you think you would be comfortable, in terms of keeping that ratio, and then based on what your conversations are with the regulators?

Matthew J. Audette

The 9.3%, Michael, that's the parent. So I think we're focused on the bank. So the Tier 1 leverage ratio at the parent is at 8.1%, and the risk-based capital ratio is at 17.2%, so depending on where the regulators focus, those will be the 2 ratios that would be most relevant to how much we could upstream, and the dollars in excess of those 2, that's that $1.3 billion, $1.5 billion I referenced. So it's an area to have the dialogue. What they would ultimately be comfortable with us upstreaming, versus what we would desire, I think that will play out over time. I think our objective though is just to have the most efficient distribution of capital between the bank and the parent in the future.

Steven Freiberg

And again, I think it's just worth emphasizing, that if the regulators would speak, and this is obvious, it's not unique to our firm. Just what I said earlier, this is not a binary item. It's essentially -- it will change with the passage of time. Again on what is the risk profile of the company, what is the capital position, which is the point you've made of the company. And what is essentially the earnings of the company, which clearly is future capital. So I think as we look at it, it's dynamic, it basically will change with the passage of time. And we also know the environment will change with the passage of time, maybe better, maybe not so much better as the regulators assess what they believe is necessary for the safety and soundness of any institution, including our own. And we're not trying to be -- avoid anything direct, just to say that we know what we need to do with the passage of time to put ourselves in a better position so we can gain more flexibility. But it is a moving target, it is dynamic, but it is important because that flexibility over time is important for us to have, essentially, a world-class franchise.

Michael Carrier - Deutsche Bank AG, Research Division

Just one follow-up, on the expenses I guess, just 2 questions on that, anything unusual obviously, x the reserve, got that -- any of the line items, and I guess the only one that kind of stands out is the clearing and servicing. So not sure if the transfer of some of those loans had an impact typically, seasonally this quarter you would expect that to be a little weaker, but given the volumes in the industry, you might think that it would be a little bit higher, so just anything unusual in that line item or overall in the expense side?

Matthew J. Audette

So the 2 main items are the auction rate securities reserve and the increased updates in insurance premium on clearing and servicing. So that line does include a lot of the cost associated with the risk mitigation activities. So that can be pretty lumpy. You saw a little bit of an uptick in that in the second quarter and saw that come back down -- call it more normalized levels this quarter. So it's just the lumpiness associated with that activity.

Operator

Your next question comes from Chris Allen of Evercore.

Christopher J. Allen - Evercore Partners Inc., Research Division

Just going back to kind of Dan's questions, I think you guys have done a good job in terms of explaining the balance sheet strategy, but if you could walk through just some of the mechanics in terms of how the NIM, the spread would decline, is it more a function of variable rate loans repricing, new assets coming on at lower spreads in the securities portfolio? If you could just give us some clarity around that, that would be helpful.

Matthew J. Audette

Sure Chris, this is Matt. So exactly what you just highlighted. So on the asset side, as the legacy loans pay down at higher rates, you've got the reinvestment at much lower rates today. We also, as Steve commented earlier, we do have a wholesale book that we raised back in '07 and '08, which are at much higher cost. Over time, that will run off, which actually improve it. So I think the gating factor here is the interest rate environment. So a company that funds itself with customer deposits in an interest rate environment of extraordinarily low rate. Just the amount of spread you are on those deposits is just much lower. So that's going to manifest itself in a lower spread over time.

Christopher J. Allen - Evercore Partners Inc., Research Division

And just how much of the securities book is rolling over on a quarterly basis at this point?

Steven Freiberg

Legacy assets, I think...

Matthew J. Audette

So the loan portfolio came down $700 million during the quarter. The securities portfolio is not a run-off portfolio. So there's a lot of buying and selling as well as pay down activity in there. So there's not a clean metric to give you there, but on the loan portfolio it's about $700 million for the quarter.

Steven Freiberg

In broad stroke, if the average duration, let's say, a little less than 3 years, you can probably do your own back of the envelope math as to what that would imply from the standpoint of what rolls and has to be reinvested in any given period.

Christopher J. Allen - Evercore Partners Inc., Research Division

Just one other question, any commentary in the decline in advertising spending? Obviously, you expect to kind of come in from a seasonal perspective but...

Steven Freiberg

You hit it on the head, it's exactly that. Summer months basically reflect seasonality, and you would expect the fourth quarter to rebound to its normal seasonality, which tends to be, typically, one of the better quarters all-in-all from the standpoint of being in the marketing business, and that probably cascades right back into the first quarter.

Christopher J. Allen - Evercore Partners Inc., Research Division

Any change in the thinking on spending in advertising given the environment right now?

Steven Freiberg

I would say that other than on the margin, where we basically ebb and flow, I think broadly our strategy is intact.

Operator

Your next question comes from Brian Bedell of ISI group.

Brian Bedell - ISI Group Inc., Research Division

Just a couple of follow-ups. Just going back to the dividend strategy, dividending the cash up from the bank, if you get to a point, let's say, at the end of next year when you have that first potential hit at the springing lien notes, and you haven't been approved to dividend cash up, is there enough -- would there potentially be enough cash with some of the DTA being able to be deployed, and the corporate cash you have in the balance sheet plus what you're earning, to still potentially retire the springing lien notes, even without dividending the extra cash up from the bank?

Matthew J. Audette

So Brian, so the December 2012 call out is certainly our focus. I think there's a lot of different things that impact corporate cash. I think the key thing to focus on here is the current level of cash, it's just over $430 million. No maturities of debt until 2015. And yes, that DTA at the parent, that 500 million ultimately would become cash at the parent. That all depends on earnings over that same period of time. So it certainly could be volatile, but it is a potential -- certainly a potential source.

Brian Bedell - ISI Group Inc., Research Division

But do you actually need the dividend from the bank to actually try to retire the springing lien notes. I guess is it dependent upon your success with the comprehensive dividend plan?

Matthew J. Audette

Sure. I think the math ends up being pretty simple. There's 1 billion of those notes, they'd be called 112 so you're talking over $1 billion and the current corporate cash is $400 million. So there definitely need to be a source if you're going to call those in their entirety.

Brian Bedell - ISI Group Inc., Research Division

At least some of it, okay. And then I calculate your effective tax rate at about 40%, is that correct, and is that a good ongoing run rate for normalized tax rate?

Matthew J. Audette

Yes, Brian, it's going to bounce around in the low 40s, the key distinction there making it above the actual federal rate of 35%; as well as some state noise, is about a third of that interest in the springing lien notes is not tax-deductible. So at some point in the future, when those aren't around, it would actually improve it. But in the short-term, the low-40s is a good assumption.

Steven Freiberg

Just a point. Just want to remind folks that because of the DTA and the like, even though the rate's high, just remember we're not paying cash taxes.

Brian Bedell - ISI Group Inc., Research Division

And just on the net interest margin, just on one area -- the wholesale borrowing cost, in your assumption of a static rate environment, do those wholesale borrowing costs that you have right now changed significantly over the next several quarters or couple of years? In terms of the actual rate you're paying on them?

Matthew J. Audette

The wholesale borrowing book is going to take a long time to run off. Those were brought on board in '07 and '08 when liquidity was at a premium. So we've locked those up for a long period of time.

Steven Freiberg

Unfortunately, it's not a lot we can do at this point. And this is sort of, if you put it in perspective, at least the way I view it, sort of the legacy cost that we're still incurring, that's one of them, and you could do the math as to what wholesale is versus if we replaced that with customer. You also, you made a point on the high cost of our debt. We I think made a point during the prepared remarks that our FDIC insurance premiums now are high, relative to what we expect -- this is a relative comment, but it also translates to absolutes, that if the profile of the company improves, those costs will come down. And finally, with the passage of time, we're still carrying a very heavy burden on provisioning that we expect will, over the course of time, also come down. So all those -- all of those items sort of vector in the right direction, but they all require time.

Brian Bedell - ISI Group Inc., Research Division

And then just on the actual rate on that wholesale borrowing, the yield that you're paying, in your scenario Matt, did you expect that rate to stay roughly around the same where it is in the third quarter? In that 250 scenario?

Matthew J. Audette

The wholesale borrowing book is locked up both in balance and roughly in rate for that long period in time. Neither would really move much.

Operator

Your next question comes from Chris Harris of Wells Fargo.

Christopher Harris - Wells Fargo Securities, LLC, Research Division

I want to come back to the net interest here. Assuming there is some degradation heading into next year, I'm just curious, what kind of flexibility do you guys have on the expense side and maybe offset some of that decline in revenue, if any?

Steven Freiberg

Expense is certainly going to be a focus, especially the more challenging the environment gets, I think any company, ourselves included, would certainly focus on expenses. But I think the gating factor on net interest spread in the ultimately that going into the bottom line is going to be interest rate environment. So there's certainly some things you can do on the expense side, but the spread in this environment would continue to be challenging.

Christopher Harris - Wells Fargo Securities, LLC, Research Division

And then, with respect to your attrition, I know you guys have made a lot of improvements here. Attrition rates really come down a lot from kind of at peak levels, but you're still running at kind of double digit percentages and kind of above your peers. I'm just kind of curious as to what's really driving the accounts moving out and what kind of initiatives can you guys put in place to try and drive that down further?

Steven Freiberg

Just for perspective for the rest of the group, if you went back two years, the attrition rate at E*TRADE is approximately 15%, and the company, through a number of actions, has effectively brought it down to just about 10% to 10.5%, so we've made a lot of progress over that point of time, which is important. Part of differential is that we believe a stricter definition of what's an open active account for us versus maybe industry norm. So we basically -- when accounts have a few assets within, and I think we're using less than $25, we effectively -- account is closed and we count it as an attrited account. We don't believe, in fact, we know for a fact, the industry doesn't use that standard. So what we've experienced, particularly this year, when we had the market prior to the last 2 months take a substantial decrease in value, a number of accounts fell into that. So what you could argue, because we track this as you would expect, not only the aggregate, which is important, but by segment -- on where our income is really derived from, and what I will tell you is, the customers that really drive this franchise, the attrition rates are in the 2%, 3% range, and they are extraordinarily good and strong. It's on that margin, where you're really trading off, not only the definition but the quality of the account, and on what's the incremental cost to keep someone versus the incremental benefit. We don't have -- I don't have -- I can't tell you that we're going to drive the 10% to 8%, even though we would like to. What we will say is that we'll spend what we need to spend in order to drive the attrition rate to a level that makes economic sense for the franchise. And I don't know if that helps you, but it probably gives you some color, we manage it by segment, we report in the aggregate, but we also have a definition that we think is a bit more firm than others that basically we compete with within the industry. So we feel good about the progress we made, we feel good about the segments. Would I like it to be lower? The answer is yes. It doesn't make economic sense for us to drive it lower. I can't tell you because it would have to be done from the bottoms up not the top down.

Christopher Harris - Wells Fargo Securities, LLC, Research Division

Last question here for me real quick, it sounds like you've had some improvement in your re-default rates after the last 12 months, now that you guys got some higher quality servicers in there for a large portion of your portfolio, what are you expecting there? Are you expecting a continued decline in the re-default rate? Maybe you can kind of quantify that for us, if possible.

Matthew J. Audette

You're referring to the modified 12 months re-default rate?

Christopher Harris - Wells Fargo Securities, LLC, Research Division

Correct.

Matthew J. Audette

I think the servicers are definitely going to have an impact, and you're going to see that impact over time. I wouldn't get too precise on the number, other than to reiterate that on the 28% re-delinquency rate on the 1-4s and the 42% on the home equity, we feel really good about those. And certainly they could go down from there, but I think at those levels, we feel good now. So we think the program has done well, and we're going to continue to focus on that.

Steven Freiberg

It really is more -- I think it's a good story not only for E*TRADE, but for the customers that have gone through the modification program. We think there's economic benefit to the firm that's real, and it's measurable. And at the same time, the individual gets to stay within their home and has the capacity to actually, or the liquidity or the cash flow to actually make payments, and we were pleasantly surprised not only with the absolute number, but the trend. And when we look at external data, and there's not a lot around, we think it basically benchmarks extraordinarily well, and so we also learned over time how to, I think, be better selective and provide a more tailored solution to the needs of our particular -- that particular customer. But again, to Matt's point, we can't predict the 28, or the 29, or the 26, but directionally we've gotten better just about every vintage. And in addition to that, I think the absolute number or the range that it's in now, is quite compelling.

Operator

Your next question comes from Joel Jeffrey of KBW.

Joel Jeffrey - Keefe, Bruyette, & Woods, Inc., Research Division

I just had a quick question. On the timing of the ARS charge, was that any way related to the switch in regulators, and their interest in having us behind you guys before they start to allow you to return capital to shareholders?

Steven Freiberg

The answer is no. It's been an issue that's been out there for quite a while. I would say the quarter in which we made the decision to move down this path was completely independent. It's just basically coincidental to a change in regulators. I just feel good as the CEO of the company, that it's been an issue that's been out there for a while. And that we've had an opportunity now to start the process, to put it behind us. And that's important. Again, a lot of the legacy of the current crisis, the more of that we could put behind us, the more we could focus on our competition and the franchise, and that's really where we should put our energy. It was just purely coincidental that it happened within the same quarter.

Joel Jeffrey - Keefe, Bruyette, & Woods, Inc., Research Division

What was the maximum client exposure?

Steven Freiberg

At its peak, the clients had just north of $800 million of ARS within their accounts. You've got to go back probably 3, 3.5 years, and the number basically in the last reporting period was approximately 125, that would have been at the end of the second quarter. Clearly it's lower today than it was then, but as you would expect, that residual -- meaning what's left, is by definition, less liquid and more challenged. And therefore the reserve is reflective of that.

Joel Jeffrey - Keefe, Bruyette, & Woods, Inc., Research Division

And then just lastly, with the sort of the new Volcker Rule proposal's coming out. Just wondering what your thoughts are on how that could impact your market-making business. Would it just be heightened compliance cost, or anything along those lines?

Steven Freiberg

There would be some incremental cost on both management compliance and other related, but not substantial. And we have a very small prop desk -- so to call. But you wouldn't see it, if you look for it at the standpoint in our revenues or our income. In fact, the last data point I can recall, which is 2010, I think we generated about $300,000 of revenue off that activity, and that was off a $2.1 billion, $2.2 billion revenue base. So it's really not a consequence from the business model standpoint on prop trading, but on market making, we continue to basically support - I'm very proud of the business and whatever the incremental costs are, it will not change our business model.

Operator

At this time, there are no further questions. I will now turn the floor back over to Mr. Steven Freiberg for any closing remarks.

Steven Freiberg

Thank you again for joining us tonight. And we look forward to speaking with you again next quarter. And good evening to everyone.

Operator

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

.

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Source: E*TRADE Financial Management Discusses Q3 2011 Results - Earnings Call Transcript

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