The Charles Schwab Corporation CEO Reviews Interim Business Update - Conference Call Transcript

Oct.26.11 | About: The Charles (SCHW)

The Charles Schwab Corporation (NYSE:SCHW)

Interim Business Update Conference Call

October 26, 2011 11:00 AM ET

Executives

Rich Fowler – Head, IR

Walter Bettinger – President and CEO; and CEO, Charles Schwab Bank

Joseph Martinetto – EVP and CFO

Analysts

Richard Repetto – Sandler O’Neill & Partners

Howard Chen – Credit Suisse

Kenneth Worthington – JPMorgan

William Katz – Citi

Brian Bedell – ISI Group

Michael Carrier – Deutsche Bank Securities

Rich Fowler

Good morning everyone. Welcome to the Fall 2011 Schwab Business Update. This is Rich Fowler; Head of Investor Relations for Schwab and with me here today are Walt Bettinger; our Chief Executive Officer; Joe Martinetto, our Chief Financial Officer. It’s a great fall day out here in San Francisco which we can actually see this time because when our new state of the art some might even call it spicy (ph) webcast center which has the main virtue of being a converted conference room with an outside window as opposed to or even more impressive yet sadly windowless studio where we’ve done this previously. And for those of you who’re keeping track I can look out that window and see that it is indeed another top-down day.

We are doing an interim update today. So, we’ll spend just an own with Walt and Joe, sharing their perspective on life at Schwab right now. We’ll start out with some prepared comments and then, we’ll go to Q&A until it’s time to wrap up. Before Walt starts this off, let’s spend the moment on the ever popular forward-looking statement page, the main point of which is to remind everyone that outcomes can defer from expectations. So, please keep an eye on evolving disclosures and then, let’s cover how we’ll take questions.

Once again, we’ll do so via both the web console and the dial-in as well. So, for anyone who doesn’t already have it, the dial-in – excuse me, it’s 800-871-6752, the conference ID is 981 77163. So, that’s also should be available to you if you are registered through schwab.com/corporation. The number shown there, it’s also in the email confirmation that you got when you registered.

When we start the Q&A session, we’ll ask the operator to remind this how the process works. So, I think let’s see we’ve got administrative stuff out of the way. We have our speakers ready to go. I’ve got my blood pressure meds on board. So, let me turn it over to Walt to start this off.

Walter Bettinger

Thank you Joe. Good morning everyone. Thanks for joining us today. It was about a year ago I think we had this meeting and just a few blocks away the wanted black and orange of the San Francisco Giants were enjoying the World Series, although it’s a long suffering Baltimore Orioles fan I refer a different form of black and orange. But again, thanks for joining us.

Today, what we want to try to do is cover several important aspects of our company but we’re going to do so in a bit more detail than we probably typically go into during one of our semi-annual webcast presentations and more specifically Joe and I want to discuss our longer term bigger strategic and financial picture, our financial results and growth as interest rates stayed relatively flat from early 2010 into August of 2011.

We want to discuss the impact on our second half 2011 financial results of course as affected by the weakening economic environment. A bit about our plans to respond to this weakened environment as we close 2011 and move into 2012. And then, just an overall view of the opportunities that are before us and how we plan to executive on our strategies as we move forward.

Our strategy of course remains the same. It revolves around our five operating priorities. Diversified client acquisition where we look to leverage our strength and household acquisition via client referrals, advertising and independent advisors but also with the additional efforts that are intended to diversify the way that we acquire new household initiatives like our independent branch strategy as well as our index oriented 401(k) program.

Second operating priority win-win monetization and these are efforts that are grounded in the best interest of our clients that simultaneously increase the revenue that Schwab earns per dollar of client assets. Long-term retention, this is our fundamental focus on client service. The user friendly technology, great value, consistency of approach and personal relationships all designed to help ensure that clients once acquired remain long-term profitable clients of our firm.

Expense discipline, a trade at the core of our management team. Discipline and the ability and willingness to make trade authorization I think they’ve not only kept our firm focused but it’s enabled us to make some significant investments of late in strategic areas. Of course all while continuing to operate the firm at an extraordinarily low expense rate, approximately 20 basis points when you mention that against client assets.

And then fifth, certainly not least important, effective capital management and this revolves around our clear understanding that shareholders and trust, our management with our capital and the responsibilities of the company that trust that we effectively deploy their capital on ways that will yield long-term profitable growth and return, excess capital back to shareholders and ways that are considered most friendly to them.

Let’s talk a little bit about our approach and how it applies to our various constituencies. We think that the approach continues to demonstrate great results with our clients and that’s illustrated by our ongoing client growth and of course our successful win-win monetization. Our core client net assets continue to lead the investing industry and of course we continue to add large volumes of new households and accounts.

In terms of monetization, on a monthly basis somewhere between 3,000 and 5,000 of our retail investing clients choose to transition from being self-directed to one where Schwab provides ongoing portfolio advisory services and of course in return for that we get an asset base fee. And I think just as importantly because it is a win-win monetization concept the clients who choose to retain thus for these types of services typically end up with a far more diversified portfolio one that more exclusively takes into account the risk profile and tolerances. And over the long-term that’s going to lead to not only better outcomes for our clients but to a more stable and consistent client base.

We know that from a revenue standpoint, these efforts are continuously building and growing our asset management revenue stream that serves two purposes. The first one is it continues to further diminish our reliance on equity trading commissions. A revenue stream that we consider to be not only highly volatile but one that we believe is going to continue to experience significant downward pressure over the coming years and at the same time the growth on our asset management revenue stream continues to provide a ballast for us against the extraordinarily low rate environment that we all know that we are operating in today.

Let’s go on and talk a little bit about our strategic approach in terms of its ability to deliver long-term value for our shareholders. As I’ve indicated many times in the past, this is really management’s goal. Our focus is on this long-term earnings growth and one way that we can and do actually measure our progress on an ongoing basis against this goal particularly in difficult times like today is we look to evaluate our earnings per share power or what we call internally our EPS power. And this particular slide is one way of doing so. What we illustrate in this slide is we took Q2, 2008. That was our all-time record quarter in terms of operating earnings. It may seem a little a little bit unusual to many. Many may think it was back in the internet hay days. But, it was actually in the second quarter of 2008. We are in $0.27 operating during that period.

We took the environment that was in place in the second quarter of ‘08 and that’s in terms of interest rates, equity markets, trading volumes. Of course Q2, 2008 was not an exceptional quarter by any means. Discount rate was 2%. I think S&P ended the quarter at slightly less than 1,300. And then, we applied these identical environmental factors to the same calendar quarter so, Q2, 2011. And when we did so, our earnings per share have been just shy of $0.40 well over a $1.50 annualized. Just put that in perspective for everyone. It took almost 35 years to get to $0.27 earnings per share and just three years later, I might add three very difficult years later, we grown that earnings per share power over 40%.

This is why we are confident and this is why we remained confident in both our ability to deliver these types of results in improved environment, but also they continue to grow our EPS power despite the difficult environment that we’re in.

Let’s go on at this point and talk a little bit about some nearer-term issues with the environment and with our strategy. As we’ve discussed over the last 12 months or so, our strategy as we came into 2011 was that we were going to accelerate out of the expected curve that we anticipate it would be brought on by a stabilizing economic environment and of course the goal behind that was to advance our competitive position in a number of areas.

To put it in context in terms of numbers we’re on track increase our project spending from around $130 million in 2010 to somewhere around $190 million this year. And of course that additional investment would enable us to make significantly forward relative to competition in number of areas and that are outlined here on this slide, I won’t walk through all of them

Two of them are also up there very important near the top of the page and that is longer term initiatives our branch franchising model and our index for in 401(k). What we’ve seen is that these investments are already starting pay off in terms of growth in the client base, client assets, retention as well as monetization. I don’t want to walk through all of them, but let me just call out some prove points on a couple of these for you.

Fixed income, an area where we have greatly expanded our capabilities, our access to fixed income for our clients particularly in the muni area. We estimate that we captured about $10 billion of incremental market share with our efforts there and keep in mind that our retail investing clients who own individual bonds, they hold between 200 and $300 billion in assets outside of our firm at competitors and of course those are assets we are targeting.

In terms of advisory offers, in the past 12 months we’ve converted approximately 50,000 retail self-directed accounts, something over $15 billion. That puts us with over $100 billion in retail advisory accounts with ongoing fees. Windhaven is a part of that, just again illustration it took Windhaven about 15 years to get the $4 billion in assets and about one year later we’ve almost doubled that. From a reco or a revenue standpoint as we convert clients into fee based advisory solutions that are in their best interest, at also increases our revenue because we average in the 70 to 75 basis point range revenue for us.

Lastly I just want to mention a little bit around mobile, very interesting metrics. We introduced our mobile depositing capability about six months ago. Today, again only six months later almost 40% of all deposits made to Schwab Bank are done via a mobile device. Rather extraordinary percentage in just six months, it shows the power of putting tools in the hands of clients to give them a better experience and of course prove point on measuring that clients who are taking advantage of our mobile deposit capability have nine point higher client promoter score than those who are not.

Let’s talk a little about near-term and in terms of financial results because at the same time that we’ve been making these significant investments in our clients, I think the proof is on the page that we’ve demonstrated the clear ability to deliver improving financial results in terms of revenue and earnings and we’ve done that without rising interest rate environment, putting wind at our back. Just as an example over the period in which rates were relatively flat. So, from early 201 through the middle of 2011 we delivered 22% revenue growth, 77% earnings growth, I think if you look year-to-date through the first three quarters of 2011 compared to the first three quarter of ‘10 it was about 15% revenue growth, 27% earnings growth.

I think it should be clear from this is that we do not need interest rates to rise in order deliver solid growth and improvement in our financial performance. There is substantial growth that is going on underlying within the firm in terms of the client base, asset growth as well as the ability to monetize and when you combine this revenue growth with our scalable model, we’re able to driver higher revenue and earrings simply when interest rates remain relatively level. So I just think a very important point to make and you can see illustrated from this slide which shows both the average 10 years as well as the fed rates. We do not need interest rates to rise in order deliver meaningful improve financial results.

Now at this point I am going to and transition over to Joe I think we all recognize that one of the challenges that is over the last 60 days or so we haven’t been dealing with a stable interest rate environment, has started to decline and been under pressure. So Joe let me turn it over to you and have you pick up on some of that as well as our planned responses.

Joseph Martinetto

All right, thanks, Walt. Well, I think as you said, the first half of the year was characterized as a period of relative stability, the second half of the year has been anything but that and the third quarter we saw S&P dropped by about 14% from beginning to and that dropped the market values knocked about 200 billion after the values of our clients’ portfolios. We also saw real volatility in the rate market with a 10 year treasury dropping about 125 basis points from start to end of the third quarter.

Even with those pressures in the market, we were able to hold revenues about flat versus Q2 in the third quarter although that does include one month of options expressed results inside of our financials. Expenses ticked up a little bit as we have some cost related to closing of the transaction and we also have some continued investment to drive some of the initiatives that Walt has referred to.

As a result to putting all that together net income dropped modestly from Q2 and Q3, but we were about flat with where we were in operating basis versus the year ago. So now let’s turn our attention to the remainder of 2011.

Clearly when you look at the scenarios that we laid out earlier in the year that year that we’ve lived through here has been much more close to the conservative scenario rather than more aggressive one. Even then, it’s hard to say that 6.5% steady market depreciation that we predicted is anywhere near where we’ve actually experienced. And as of today even with the rebound that we’ve seen in the beginning of the fourth quarter, we’re still little bit below in market valuations where we started the year.

On top of that the rate picture here, rate is deteriorated significantly from a flat rate scenario as we’ve seen rates are all across the curve continue to push down. Still, we’re on track to deliver results that are consisting with or even slightly better than which indicated in that more conservative scenario. Both revenues and expenses are likely to be a little bit higher than what are indicated in that scenario as a result of having options expressed acquisition run through our numbers here in the last fourth months of the year.

Regarding the acquisition, we had about $10 million of after tax cost related to the transaction and the third quarter results, we expect about 4 million more pretax cost here in Q4, out of that $55 million of integration cost that we disclosed that when we announced the transaction. And then we also expect options expressed on a run rate basis to add about 15 million of expense about $3 million of that is the amortization of the intangibles created in transaction.

So with three quarters already in the books and really solid the year-to-date results. We’ve been – we would have been on track to significantly outperform the scenario that we laid out from the more conservative case and not for the more recent changes in the environment. It’s not any surprise to anybody who follows the company that, we’re sensitive to declining interest rates and that the impacts of what we’ve seen here in the few months are going to weigh on the result for the fourth quarter. So let’s talk about that in some more detail.

As we look at the rate picture, I’ve talked about LIBOR in the past as being the good proxy for rate that we see at the short end of the market and LIBOR has moved up recently which will help somewhat to the extent that we do want some LIBOR based letting mortgage backed securities in the bank investment portfolio. However and it’s a big however, we’ve seen a break in the domestic cash markets and LIBOR and it’s large has been impacted by the issues that we’ve seen developed in the euro zone region Europe late and the fact of matter is due to credit concerns we’re not buying European Paper that would benefiting most from the higher LIBOR levels.

Over the course of the last quarter we continued to see pressure on cash market yields more in line with what we’ve seen in terms of responses in the treasury market overall and the declines in rates in the cash market have continued to put pressure on money fund fee waivers.

We’ve also seen a big decline across the longer end of the curve. I talked about the 125 basis points that we saw treasuries move down in the third quarter. I think everybody knows we got to a low of 172 basis points before bouncing back to today’s trading range that seems to be somewhere between 210 and 225. I just remind everybody that in the first half of the year we were solidly north of 3% on that 10 year treasury so this is still with the recovery a pretty material decline in that long-term rate. That’s going to impact us in the number of different ways. First, any new client cash that come on to the balance sheet is going to be invested at lower yields.

Second, prepayments have picked up, which means that we’ve got more money that we’ve got to put to work in today’s environment with these lower yields. And then finally, the amount of premium that we have to amortize from our bond portfolio picks up with prepayments and that puts some pressure on our near-term net interest margin. So let me get it into a little bit more detail about what that looks like for the fourth quarter as well as what we thought about 2011.

If rates stay about where they are right now, we would expect our fourth quarter net interest margin to decline to 165 basis points or so in the fourth quarter. That’s lower than we’ve indicated for the fourth quarter in the past. The biggest driver there is the increase that we’ll see in premium amortization in the fourth quarter of rate stay here.

We would expect the impact of that premium amortization to be about nine basis points on our net interest margin. So if you excluded that impact we would be back up into the mid to low 170s, which is much more consistent with the numbers that we’ve talked about in the past. The other drivers of the decline are the fact is that you would expect that are normally inherent in the portfolio. We’ve got new cash inflows, we’ve got normal portfolio cash flows, we’ve got higher prepayments all driving cash that have to get put into the markets at lower rates and all of those things put some pressure on the margin.

Our outlook is as we look to 2012 really depends on your view for long-term rates. To the extent that rates stay about here, we would expect that the pressure – the ongoing pressure on net interest margin to be relatively modest and we would see rates in the 160 or margins in the 160 area as move to the end of next year.

If rates go back down to 175 on the 10 year, that will put significantly more pressure on our net interest margin as we move through the year, as we would expect prepayments to stay high and a lot more of the portfolio that have to get invested at lower rates through the course of the year. And again you can see in that scenario, we would predict the net interest margin could fall as low as the 140 basis points. So there are a lot of things that we don’t know about next year and the rate environment at this point and we’ll back in the January or winter business update to give you some more details on how we see these all coming through. But we wanted to give you an early idea of how we’re thinking about net interest margin at this point.

Of course any growth that we’ve seen balances will help to offset some of the pressure on net interest income. So that’s something that we definitely continue to see growth in the balance sheet as clients continue to bring cash on to the – into company. And another initiative that we’re looking at is right now we’re trying to move between 4.5 and $5 billion of cash that’s sitting and brokerage cash over into the bank suite product. And the letters actually went out on these to clients about a week ago.

This spread pick up here is material and the reserve portfolio with the broker dealer, the yield write down was about 13 basis points because we’re so constrained in terms of what we’re allowed invest in there. On the bank side the average marginal rate right now is around 150 basis points. So we’re getting almost 140 basis points of incremental spread by seeing that money move from the brokerage over to the bank.

We’re not going to require any additional capital to make this move because the money is already sitting on our balance sheet it’s just moving from one entity to another and not putting any additional pressure on the overall size of the balance sheet. So when the money moves the leverage ratio and consolidation will stay unchanged. We will have to put some additional money into the bank to top it up to 7.5% leverage ratio target, but we’ve got more than enough cash on hand to make that infusion and hold the bank to that capital level. So, we’re not going to need to raise any additional funding or any additional capital to support this move.

I mentioned in the press release that we saw on money fund fee waivers from the declining cash rates. And you can see here in Q3 that we saw the money fund fee waivers move up to $160 million from 128 in Q2. If rates stay where they are today, we’d expect that fee waivers could pick up to about $165 million in Q4 and then would stay at about that level as we moved into 2012.

I just remind people that money funds continue to be a really important part of our overall client offering as well as an important of that longer term earnings power that Walt referred to. Even in this market where money funds are facing real challenges from a competitive yield standpoint, we continue to see the overall earrings contribution power of funds grow over time is represented by the overall size of the bars here in the chart.

As we put all of this together and start to put together our outlook from next year. We believe in environment where rates stay about flat, we’ll be able to offset the incremental pressure that’s been created from the recent decline in rates with the growth that we’ll experience in the core client franchise as well as the impact from the book transfer that I referenced earlier.

In an environment where revenues will be roughly flat, we’ve look to keep our core Schwab expenses also roughly flat. And that comment on revenues excludes any impacts from the options expressed acquisition. To achieve flat expenses, we’re going to have to do a little bit of fine tuning in our expense space here, but it’s pretty modest as we look to get some of our assets in places where they are going to most needed.

We would expect that we’ll probably see restructuring charges in the range of $5 to $10 million here in the fourth quarter as we go through that exercise, but it’s going to be substantially smaller amount of restructuring impact than what we saw in the early part of 2009 and the last time we did some cost reduction efforts.

From a trajectory standpoint, this environment looks a fair amount like what we experienced in the late part of 2008 when we had a really rapid decline in interest rates and then it took some period of time for us to absorb that impact in our financials. So we may see something similar in terms of earnings projection from here where we go through a period of bottoming out before we see a return to growth and profitability later in the year. And again we’ll be able to provide some more information about that as we get to the business update in the winter period.

Moving on quickly to some of the more normal pages that people would expect me to cover on capital and liquidity here. The balance sheet did top of $100 billion in the third quarter, some of that driven by organic growth, some of that driven by the acquisition of options expressed. You can also see the impact of the options expressed acquisition in the capital line where the share issuance from the transactions reflected there.

Parent cash still sits around $1.2 billion, so again gives us plenty of room to be able to top up the bank capital ratios and still have a substantial cash balance at the parent company. And then finally on this slide, all of our capital ratios remain just about in line with they’ve been the offshore for several quarters.

And last but not least on the credit front, we’ll take a quick run through this. Our money front holdings of European Paper are on the low end for the competitive set and we’re concentrated in holdings and safe names in geographies. We’re out of all the places you’d expect us to be out of given how long this cycle has taken to develop. On the lending side, there is not a lot that I think we need to spend time on here as the metrics are virtually unchanged from where they were in the last quarter.

And now I’ll hand it back to Walt for some concluding remarks.

Walter Bettinger

Thanks, Joe. Let me just wrap up our prepared comments with the quick summary and a recap of what we spoke about our strategies working for clients and it’s clear that even in a stable interest rate environment, we’ve demonstrated the ability to deliver revenue and earnings growth. Again we don’t need interest rates to go up in order to deliver growth.

As a result we’re going to stay committed to our long-term strategies. Both as they relate to serving clients and also as they relate to our confidence and our ability to deliver earnings per share growth for our stockholders. At the same time we want to be realistic, we recognized the deteriorating environment brought on by the European crisis and additional actions taken by the fed is put a bump in the road for us so we’re going to respond, we’ll respond appropriately. Our response is not going to be one that risks derailing our long-term strategy. We’re not going to risk derailing the quality of our clients experience with us.

We’re going to remain focused on producing results in the near-term, but really we strive to manage the company for a long-term shareholder value through the cycle. We’re going to continue invest in our competitive position and of course we will continue to build our earnings per share power, the ultimate way that we’ll deliver results for our shareholders. So, maybe with that Rich, why don’t we go ahead and let’s transition to the Q&A part of our meeting.

Rich Fowler

Okay. As we start that off. Operator, can I ask you to remind us how the process will work to ask a question over the phone.

Question-and-Answer Session

Operator

Yes, sit. (Operator Instructions). Your first question comes from the line of Rich Repetto.

Walter Bettinger

Okay.

Richard Repetto – Sandler O’Neill & Partners

Hello, Rich and Walt.

Rich Fowler

Hi, there.

Richard Repetto – Sandler O’Neill & Partners

This is Rich Repetto.

Rich Fowler

Hi, Rich.

Richard Repetto – Sandler O’Neill & Partners

I guess Walt and Joe. I guess the question is on this ultra-transfer that you outlined, we actually wrote about that today. But the – how do you determine you picked I think you said 5 billion or somewhere around there. What was the cut off, you have 27 billion or somewhere around there of the cash. So what determine that you cut it off at 5 billion and then can you give us the timing and you just incorporate in the NIM guidance that you gave Joe, the 140, 160 guidance?

Joseph Martinetto

Timing wise this is going to happen late Q4, early Q1 so, around the end of the year. Yes, it was incorporated into the guidance but it’s not going to help Q4 any because it’s going to be very late in the quarter. On the sizing, I think you’ve seen this move through a series of these kinds of moves over the years and there are a lot of factors that we consider as we think about these things. We started moving money fund balance first because quite frankly they have the biggest impact in terms of long-term value creation because the differences in what we were going to pay versus what we were going to earn was the most incremental revenue driver if you looked in a normalized rate environment in a little long run. So, we started there and largely completed the money fund moves with the move over a year ago now.

So, we’ve not started looking to other places where we might be able to incremental benefit from these kinds of moves. This really ends up being constrained a bit by capital and cash levels. This isn’t capital intensive as I referenced but it is going to take $350 million or so parent company cash to support this. It’s marginal from a revenue perspective to the extent that the cash is on hand. But, it’s not quite the same math you think about having to go out and raise money to be able to make the whole transaction work. So, it’s gated a bit by the amount of cash we’ve got on hand, what our target cash-in capital levels are and how all of that comes together to create a potential opportunity.

Richard Repetto – Sandler O’Neill & Partners

Okay. Joe, just one follow-up on that then. If you build cash then over the next couple of quarters as you will. Would you – is there more opportunities, so there is no customer constrain. Again, you have 27, 26 billion of this in your suite pipe. So, there is potential to sweep more if you compare from the capital standpoint.

Joseph Martinetto

Rich, I think we would consider additional, what we want to recognize the dynamics are different based on the source of the cash that’s on the – in the broker whether it be retail cash or cash from clients of registered investment advisor. So, it’s not necessarily that all 27 billion is something that we would consider. But, there may be additional incremental opportunity that cash and capital ratios permitting that we would pursue.

Richard Repetto – Sandler O’Neill & Partners

Okay. Thank you very much.

Operator

So, your next question comes from the line of Howard.

Howard Chen – Credit Suisse

Hi, good morning everyone.

Walter Bettinger

Hey, Howard.

Joseph Martinetto

Good morning, Howard.

Howard Chen – Credit Suisse

Walt, in terms of the net new asset growth for the franchise. I know it’s a difficult environment out there. But, is it still your thought that growth will remain somewhat depressed in this your interest rate environment or are there any other factors whether they be environmental or competitively that you all are kind of keeping an eye on.

Walter Bettinger

I think the biggest impact on our net new assets has occurred in two area of the firm. One in the 401(k) side where we made a conscious decision over the last couple of years to slow down our rate of growth there because we wanted to be investing and building our capabilities for the introduction of our index oriented 401(k). So, that doesn’t get a lot of headline but it’s had a fairly significant impact in terms of net new assets.

In of course, the second one is on the retail side where as many people we’ve talked about in the past that the upside down relationship between money fund yield and typical bank deposit yield has really hurt our net new assets. It doesn’t really affect the advisor business as much because investors, affluent investors working with advisors don’t tend to put their cash to be invested with the advisor. So, we have much lower cash waiting period. But, on the retail side, we tend to get more of the client’s wallet. So, we do have the cash and clients make a rational decision. When they come into wealth, whether it be the sale of a home or a bonus from their employment or sale of a business, they make a rational decision on where to put the cash and when money funds were yielding 1 basis point and bank deposit yields are measurably higher, we tend not to attract that cash. So, I think the environmental factors are far and away the largest impact in terms of net new assets.

The one other factor that is at least worth acknowledging is that we have taken a much more stringent look in the last couple of years on the quality of net new assets. Net new assets are not all created equal both in terms of the revenue they generate as well as the potential risks that they create for the firm and we have tried with diligence to ensure that we are actually bringing on revenue producing new assets as well as assets that don’t sit in vehicles that had incremental risks to our company.

Howard Chen – Credit Suisse

Great. Thanks, Walt. That’s very helpful. And then, if I add your commentary and Joe together the flexibility point in the model in this tough environment seems to be the firm’s ability that can contain expenses. But, I’m curious on revenues do you see any ability to tweak value propositions in a way that doesn’t disrupt the client value proposition or experiences you see it and second Joe, just how would you gauge kind of the timeline to more concrete capital and leverage guidance so maybe you’ll be able to kind of move or shift that 7.5% target over time. Thanks.

Walter Bettinger

I’ll take the first one and let Joe take the second one. Howard, we look very carefully at the client value proposition and the potential benefits that we could derive from an earnings standpoint in the near-term with the changes. But, changes in our pricing model or for that matter you referenced on the revenue side. But, reduction and expenses it will impact client experience. I think our view is that with the long-term perspective those types of changes are not ones that we would put on the table today.

Our value proposition is strong. I think it’s yielding the quality organic growth. I think again, you see it reflected in our numbers. When rates just stay level, we’re able to drive significant growth as illustrated. So, to make near-term decisions to try to cut off a little bit of the trough that occurs when you have this punishing decline that we’ve had in the last few months. To make decision, to cut off a little bit of that trough which have a long-term implication are not things that we are likely to be going to consider.

Joe, I’m going to turn to you on the capital side.

Joseph Martinetto

Okay, thanks Walt. On the capital side, I don’t have a whole lot of new to add at this point. I think we’ve been talking for a quarter or so about going through stress test exercise meaning the capital plan to the set using that is the background for the dialogue and I think we’re still on track for that exercise. So, that will get turned in early in January and then we’ll use that as the vehicle to open the conversation with the various regulators.

We’re in kind of gray periods as we’ve talked about being a truthful company where our regulators gone but our chargers not, we are not captured in all of this specific regulations that wrap up a lot of the banks of similar kinds of size or balance sheet. It’s probably the safest way to put that. But, that said, this is a long-term game for us while we are not necessarily constrained in our ability to do certain things. We want to make that we are fostering the right kind of relationship with regulators that we’re going to have to work with for a long time. So, we’re going to – we’ll move it this at an appropriate pace. We’re going to make sure that we’ve got appropriate support for our arguments. We’re going to try to build that long-term relationship in a way that lets us get to the place that we think is appropriate around capital management and when we get there we will have more that we’ll be able to say about that.

But, it’s going to take us a little bit of time to work through that and get to a point where we’ve got a real comfort level around our ability to deliver on capital management for the long run here.

Howard Chen – Credit Suisse

Great, thanks. That will make sense. And then, finally Joe, quick one on the numbers, that 1.2 billion that you referenced about parent. Where would you be comfortable taking that to I guess if we – if the ball transfer took up 400 million and in generating more than the 800 million is that kind of a level of comfort on the bottom that you’re willing to kind of take that buffer too. Thanks.

Joseph Martinetto

That’s the reasonable number for now. Historically, we use to talk about keeping 12 months of our fixed obligation in cash of the parent company. At 800 million it’s almost twice what that number would be. So, that’s still a pretty healthy buffer to any kind of cash liquidity means if the holding company. So, I think we’re getting more comfortable with our ability to work that number down. We’re probably not ready to go all the way down to that long-term target at this point. So, there is a little bit more flexibility, but, we’re going to have to watch out the environment develops before we’re willing to get all the way back down to that kind of a number.

Howard Chen – Credit Suisse

*

Perfect. Thanks for taking the questions.

Joseph Martinetto

Okay, before we go to another call question. One of the web console questions came in maybe we just need to keep on the regulatory thing for a second. We’ve had a query about what we think is going on the money market fund regulatory side and any risks et cetera or opportunity we might see on that front. So, Walt will cover that.

Walter Bettinger

I can’t respond to any question on money fund without registering once again the fascination I have with additional regulatory reform after the changes in 2a-7. When you think about I believe reserve portfolio eventually paid out I believe $0.99 or there about. There has been far more money lost in banks depositories over the years with amounts in excess of FDIC coverage than I believe is likely been lost in money funds. But, the fascination continues with additional money fund and regulatory change.

We could have many debates has to why that is. But, in any even there is of course a series of proposals around money fund that all are designed to play some incremental responsibility on a party whether it be the investor, be it some form of holdback as to their ability to sell, whether it be the sponsored of some form of capital requirement or whether it be some form of subordinated type of investor who would agree to be last one out and take some form of higher yield in a different share class.

There is a whole variety of different proposals. I think fundamentally for us and within our business model, we think that money funds are in the way we manage them and I can’t speak for others. But, the way we manage them we feel very comfortable with the current environment. The 2a-7 changes have certainly brought down potential risk. If in fact, we were to get something that was fairly dramatic in terms of one of those three regulatory changes, we have been serving and evaluation work with our client base. And our client base would like be a very comfortable with prime funds, maybe no longer being offered and clients would move into (inaudible) treasury fund if in fact they were subject to less risk of either have variable or some of these other burdensome changes.

So, again I think we feel fairly comfortable depending on how this unfolds. Although, as you can tell by my comments we have a degree of frustration around the ongoing initiatives that are likely to have an impact on money funds. But, I think no matter how it goes we have alternatives to us that will be favorable to our clients as well as favorable to our shareholder.

Rich Fowler

Okay, well we go back to the phones.

Operator

Okay. Our next question comes from the line of Ken.

Kenneth Worthington – JPMorgan

Hi, good morning. Ken Worthington from JPMorgan. In terms of the bank, how competitive is Schwab right now in terms of making additional loans. The Schwab being the more competitive in the loan side, less personally you see in NIM. And then, when investing on the bank side, where you’re finding the best value. Are yields kind of most attractive to you securities going out three to five years or your buy belling more or less than you have had in the past try to go out kind of longer maturities and shorter maturities or any color on how you’re investing will be great.

Walter Bettinger

Again, I’ll maybe take the first part of that Ken and then, transfer over to Joe for the capital discussion. I think I rated the bank are actually quite competitive and our loan growth rate and this is the double edge sword of course. It’s likely constrained to some extent by the strategies that we undertake which largely result in our lending are being done within people who are existing clients at Schwab. Now, that said, we do have a number of initiatives underway to expand the breadth of our lending offer. For example, pledge asset loan program and the number of other initiatives that are along those lines. But, I think our rates overall are fairly competitive and not a barrier to the rate of growth of our lending book within primarily out client base.

Joe, I’m going to turn over for you question on investing.

Joseph Martinetto

Sure. We are witnessing an interesting times here when it comes to trying to figure out exactly where your portfolio sets in and what is characteristics are. The biggest challenge here as this ultralow level of interest rates, the prepayments model are not performing well. Now, that’s probably euphuism for some of them look to be feeling somewhat severely here. So, trying to understand exactly what we think we own in terms of duration at this point and keeping ourselves invested appropriately. It’s little bit more arts and science I think in the market right now.

As we are looking at the portfolio in response to the most recent changes. We’ve seen our portfolio shorten a little bit here. So, we are looking to reinvest marginal cash flows, no longer out the curve probably in a greater proportion of fixed rate versus floating rate asset in the moment. With nothing changed about our strategy or philosophies but we’re having to change tactics a bit to drive our portfolio back out to that two-year duration point which is what we’ve targeted for a mark period of time. So, we’re being relatively aggressive in terms of our acquisition of fixed rates assets at this point trying to get ourselves back out to that two-year kind of duration.

So, that 45, 55 marginal fixed floating investment is tilted up a little bit higher on the fixed side. But, it doesn’t imply that we’re trying to add duration to the portfolio as much as we’re just trying to get back to the target duration.

Challenging in this market to find a whole lot of places that we think are offering great value that every place that we’ve pursued and we’ve been pretty aggressive over the course of last two years. We’ve jumping in as we’ve seen assets begin to trade again to try to take advantage of spreads that we thought were superior in the market. Other have done the same thing and we’ve seen most of the goods spreads keep pushed out of the market. The couple of places where we’ve been more aggressive in the last couple of quarters than maybe we’ve been in the past. Multifamily agency has been a good place for us to put some money to work. one in terms of the spreads, two in terms of because of little bit inflation from prepayment risk because those assets work more like soft bullets than amortizing portfolios.

And then also, CMBS. We’ve been buyer of certain components of CMBS as we’ve seen that market comeback to life. But again, there we’ve been very conservative on the credit front. We’ve got some pretty rigid parameters. We’ve some more deals than we buy. But, we’re still seeing an opportunity to pull a little bit money to work there at some pretty attractive deals.

Kenneth Worthington – JPMorgan

Great. That was very helpful. Thank you.

Rich Fowler

Okay. We’ll do one more from the web. This one covers any comments on the initial response to the new 401(k) offering and how we see that shaping up.

Walter Bettinger

Thanks, Rich. Actually a question about growth, something that we’re excited about. The early response and of course we’ve been doing it soft launch to-date just speaking primarily with existing clients as well as we’ve had a fair number of sponsors who have become aware of our offering from communications with the investment community who have reached out to us and the response has been very, very favorable. We actually already have a number of plans that we’ll be converting in the next few months although we won’t formally announce the program for a little bit further out into the future. But, I think the timing is perfect. You’ve got the disclosure issue.

You got increasing awareness of the fiduciary implications. I think there is a general understanding and recognition among most people that giving individualized professional advice to 401(k) investors is the right thing to do and programs like target funds are fairly a blunt instrument. They try to bundle people together into large groups and give them all the same advice. So, the response has been quite favorable.

Again, I expect it to be a real winning program unfolding over the next handful of years for Schwab and at the same time as with all things we try to do at Schwab also something that’s going to give better outcomes to the end client.

Joseph Martinetto

Okay. Why don’t we go back to the phone?

Rich Fowler

Okay. Next question comes from the line Bill.

William Katz – Citi

Yes, hi. Bill Katz from Citi. Thanks for taking my question, I appreciate it. Just coming back to the money market discussion for a moment, two-part question. The first part, just given some of the changes that going on even before considering the more on those changes. Do you still feel you have the same kind of earnings leverage recovery as rates rise and then secondarily if the more honest outcome were to past and the business would to tilt more towards the government and munis relative to the prime what might that mean in terms of the incremental earnings recovery.

Joseph Martinetto

I think we feel fairly confident in the earnings recovery from the current model. We would – and by that I’m not referring to any form of recapture of late fees at this point. I’m just referring to the capture of ongoing fees that would otherwise have been waved. I think at a 50 basis point growth investment, we recovered the vast majority and certainly as you get to the next quarter on top of that, you’re recovering all of what we are waiving today. I think we feel fairly confident in that.

If you get some of the more draconian changes, it just depends on how they unfold. So very, very low and modest capital levels are things that might be workable but when you get up much above 1% capital. Certainly, as you get up in the two, three, four range. It’s not a model that is likely to be successful on an ongoing basis and if we ended up in environment where money fund – prime money funds for retail investors were no longer viable. Again, as I indicated I think that we would see a conversion for business model like ours to (inaudible) treasury type funds.

The potential implication that if you play it all the way out is that you’re – you have the opportunity for your yield spread advantage in a more normalized rate environment to not be as wide relative to bank deposit rates. But, of course there are big assumptions in that. One of them is how aggressive will banks be on deposit rates as they look to rebuilt their capital basis and cover a lost revenue stream elsewhere in new business model are there in fact going to see that potential decline in yields for retail investor as a further opportunity for them to maybe have their deposit rates a little bit lower. So, there is an awful lot of dynamics we would have to unfold in a projection of the competitive implication of prime funds disagreeing for retail investors. Good question.

William Katz – Citi

If I may, I just have one more question. Just sitting back for a moment based on your guidance it seems like you’re facing the most likely scenario flatter earnings growth for yet another year for lot of that is because you can’t control but that’s the reality. Given at that job, where are you in terms of the acquisition appetite you so let off strategically in terms of things you’ve done and you said in the past you don’t want to do some sort of hurry deals. But, as that shifted it all in any way that may improve the trajectory of the growth either from a scalable transaction or diversification of business transaction?

Joseph Martinetto

We look very diligently at every opportunity that comes along and just try to evaluate it in terms of the best interest of our shareholder over the long-term and that’s going to take into account whether it would be a scale transaction or any form of acquisition that would fill in a whole in our client offering if we that one existed.

I will say that we are not anxious to take on balance sheet challenges that would – that run the risk of derailing the long-term opportunity for us to deliver to shareholder. Again, I reference back to the slide I showed on taking the Q2 ‘08 environment and applying it just simply three years later and what we’ve done to our EPS power. We want to deliver that and plan to deliver that for our shareholders. We wouldn’t want to take again actions that appeared inappropriate and derail that simply by chasing some form of acquisition.

So, we’re going to very careful. We look at everything I guess in summary. But, I can’t imagine as considering seriously something that would put that earnings growth at risk down the line.

William Katz – Citi

Okay. It’s very helpful. Thanks for your answers.

Joseph Martinetto

Any other question on the phone.

Rich Fowler

Your next question comes from the line of Brian.

Brian Bedell – ISI Group

Hi, this is Brian Bedell, ISI Group. Hello, can you hear me?

Joseph Martinetto

Yes.

Brian Bedell – ISI Group

Just a quick question. One on the capital actions. If client deposits increase as a percent of your client, maybe you can remind as where they stand right now as a percentage of client assets. I think it was last time you spoke about around 15, little over 15%. What level if we did get into a tough bear market would you be concerned from a capital perspective and what kind of defenses other than dividend capital from the parent down to the bank could you deploy in that situation.

Walter Bettinger

I think client cash has picked up just a little bit, maybe in the 16ish percent range. But nowhere near the level in late ‘08 where I believe we got up as high as 25%. We don’t see anything on the horizon taking us close to that number. Although of course we all aware and modeling of what that could mean if it did.

In terms of if we were to trend significantly up, that cash tends to go a lot of different places. It doesn’t just necessarily cumulate on the balance sheet. Still going to money funds, client by CDs from our third party platform. There are a lot of places that the cash goes. It’s not just simply racing to the balance sheet.

Brian Bedell – ISI Group

And so is rate sort of a ratio that you are like to really maximum ratio that you’re comfortable with before taking other defensive action?

Joseph Martinetto

First of all, ratio on the client side than it is what that leverage ratio and number gets to be at the holding company. So, it was about 6.5% leverage ratio in action versus 6% internal target. We’ve got about 50 basis points of room. So, we’ve got pretty good size buffer for balances that entries before we have begun to think about alternative capital movements. We also have some actions that we could take. There are still some rate sensitive balances on the balance sheet. So, we could look to modify some pricing to see if we can mitigate some of the flows on to the balance sheet. So, there are number of things that we could do before we ever get to capital and we’ve got a pretty good size capital buffer still inherited in the way we’re running the company.

Brian Bedell – ISI Group

Okay, great. And then, just one follow-up maybe more towards the growth angle. Here recent apartment ruling about widening access to employers sponsored plans for investment advice obviously plays well into your business model. Can you talk also a little about your timing of how quickly you think the indexing an ETS 401(k) plan will gain traction in terms of converting new plans over to that format that something we’ll see very significant traction over the next couple of years. But, do you still think this is a longer-term trend that’s going to gain traction more slowly.

Walter Bettinger

In terms of the Department of Labor publication that sort of an endorsement of the way mostly we’ve been operating for a period of time and it’s an endorsement of the way that we’ve designed this program, which uses a third-party advice engine so that we don’t have an input or impact in what the advice engine splits out. So, we’re just simply delivering that advice. So, the announcement was in line with how we’ve designed the program.

My anticipation is that this is going to gain traction fairly quickly. Now, in terms of its impact within our financial results given the size of our company, that’s going to take a few years I think before you’re likely to say, that’s a financial driven impact from this program. It might show up earlier within metrics, yes, you could see it affecting NAA. Bear in mind, we’ve largely not pursued new retirement plan business for a couple of years. So, as we just simply begin to be out there a bit more aggressive in the market, you like to see a uptick in metric. But, flowing through to the P&L, it’s likely to build over a period of time. Although, I’d like to say I would welcome the opportunity, you’ll be pleasantly surprised and have it have a bigger impact even sooner.

Brian Bedell – ISI Group

And do you think it could you close to the 8% organic growth rate say in the next 12 months or be it four months from now.

Joseph Martinetto

I think that’ll be tall task to expect a one new program to do that. But, I do think it could start to make some progress towards that number.

Brian Bedell – ISI Group

Great. Thanks so much.

Joseph Martinetto

Another phone question.

Rich Fowler

Yes, there is an online question from the line of Michael.

Michael Carrier – Deutsche Bank Securities

Thanks guys. Mike Carrier, Deutsche Bank, Just – well, maybe on the transition that you’ve been seeing mainly like the advisory services. I guess when you look at your client base, maybe the asset balances but at what portion other business do you think can transition over to the advisory type of product that service in overtime.

Walter Bettinger

The retail business today I believe is between 600 and $700 billion assets. We are up over 700 billion. Of course, prior to the client that you’ve referenced where we’ve lost about 200 billion of market cap or I’m sorry of client to market values. And right now, we’ve little over 100 billion of that. Although, we haven’t really want to put out percentages around it, I think our view is that there is a significant amount of that 600 some hard billion today that can eventually move over into the advisory based solution. And so, it continues to be a big, big opportunity.

I wouldn’t put it in the category Mike, we’ve just scratched the surface but I also wouldn’t put it in the category that we are anywhere near sort of at the limit as to what the opportunity is. Every day as you saw by the numbers we are having 100s of conversations and every month 3,000 to 5,000 more investors decide that they’ll be better served having us managed that money and I don’t see anything to get away of that trend line. I do think that we’ll continue to build out our capabilities there as we have for example with the acquisition of Windhaven and the better solution we have for clients, we expect even we’ll be able to accelerate that trend.

Michael Carrier – Deutsche Bank Securities

Okay, thanks a lot.

Walter Bettinger

Okay. Well, we’re at the top of hour. We promised we’ll keep folks on time. So, we’re going to stop there. I know we didn’t get to everybody. But, we’ll be speaking with many of you in coming days and weeks. So, we’ll work through questions as we can overtime and then, we’ll look forward to getting the whole group together in the winter update end up January, early February. So again, thanks everyone for spending the time with us and we’ll talk to you soon.

Joseph Martinetto

Thank you.

Operator

This concludes today’s conference. You may now disconnect.

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