E*TRADE Financial Corporation (NASDAQ:ETFC)
Q4 2015 Earnings Conference Call
January 21, 2016 05:00 PM ET
Paul Idzik - Chief Executive Officer
Michael Pizzi - Chief Financial Officer
Rich Repetto - Sandler O'Neill
Steven Chubak - Nomura
Conor Fitzgerald - Goldman Sachs
Mike Carrier - Bank of America Merrill Lynch
Chris Harris - Wells Fargo
Ken Hill - Barclays
Devin Ryan - JMP
Andrew Del Medico - Autonomous Research
Robert Rutschow - CLSA
Good evening and thank you for joining E*TRADE's Fourth Quarter and Full Year 2015 Earnings Conference Call. Joining the call today are Chief Executive Officer, Mr. Paul Idzik, and Chief Financial Officer, Mr. Michael Pizzi.
Today's call may include forward-looking statements which reflect management's current estimates or beliefs, and are subject to risk and uncertainties that may cause actual results to differ materially. During the call, the company may also discuss non-GAAP financial measures.
For a reconciliation of such non-GAAP measures to the comparable GAAP figures, and for a discussion of additional risks and uncertainties that may affect the future results of E*TRADE Financial, please refer to our earnings release furnished with Form 8-K and our 10-Ks, 10-Qs and other documents the company has filed with the SEC. All of these documents are available at about.etrade.com.
This call will present information as of January 21, 2016. The company disclaims any duty to update forward-looking statements made during the call. This call is being recorded and a replay will be available via phone and webcast later this evening at about.etrade.com. No other recordings or copies of this call are authorized or may be relied upon.
With that, I will now turn the call over to Mr. Idzik. Please go ahead.
Thank you, Edison. Good evening and thank you for joining us. As always it is a pleasure to share my thoughts with you. Later, Mr. Pizzi will dissect the quarter. But first, I’d like to spend some time reflecting on what has been by all accounts a banner year at E*TRADE.
An adjusted net income of $340 million or $1.17 per share represents the company’s strongest financial performance in nearly a decade, and is the product of exceptional efforts by our colleagues across the organization. We’ve come so far as a company to bolster our financial and competitive positions, and in the hall of accomplishments the 2015 display case houses some of our most celebrated and hard earned trophies.
During the year, our risk profile exhibited the stuff function improvement, as the continued reduction in legacy assets was marked by two consecutive quarters of lowering reserves, while our demonstration of enhanced enterprise risk controls among other things helps solidify our regulatory standing.
We embarked upon four major capital deployment actions emblematic of our improved position and greater flexibility. And most importantly, we focused on the customer experience bringing several digital enhancements and offerings to market while further sharpening our focus to the discontinuation of noncore businesses.
To start with our financial position, based with tremendous opportunity my colleagues rose to the challenge exchanging even our own demanding expectations. To provide a highlight reel of our triumphs, we kicked off 2015 announcing regulatory approval to reduce our banks tier 1 leverage ratio by 50 basis points to a level of 9%. We reduced and refinanced our corporate debt to our target level of $1 billion at a blended average coupon of 5%, the lowest in company history.
Simplified our operating structure by extracting our broker dealer subsidiaries from the bank, which now serve as a more efficient source of capital for the parent, distributed more than $800 million of excess capital to the parent, terminated costly legacy funding sources from our balance sheet markedly improving its profile and returns while creating capacity to fuel growth with core customer deposits.
To begin the process of growing the balance sheet to a target of circa $49.5 billion. Put in place, we began executing on an $800 million share repurchase program and finally announced yet another approval to reduce our targeted bank leverage ratio in early 2016, this time by 100 basis points to 8%, a full year ahead of expectations.
Our accomplishments numbered large and were significant in scope and we ended the year in a bountifully stronger position than we began in and frankly better and stronger than the company has been in more than a decade. Notably our progress resulting position were recognized by our regulators and rating agencies across a few dimensions.
First, the MOUs at both the bank and parent were lifted early in the year, next reflective of our much improved risk profile and regulatory standing; our FDIC insurance rates were cut by more than half.
And finally, we received investment grade credit ratings for the first time in company history following seven notches of cumulative upgrades from our two covering agencies during the year with a BBB designation from S&P in August and Moody’s following suit in December.
While it is more than a pleasure to look back on these achievements, make no mistake that we are acutely focused on what is next, marked by our unwavering commitment to be faithful stewards of shareholder capital. To that end, we are currently in the midst of executing two important initiatives; first we are steadily marching towards our target balance sheet size of 49.5 billion which we expect to achieve in the second quarter.
Second, we are actively executing on our $800 million share repurchase program announced in November. Through year end we have purchased $50 million and in January to date we have put another $26 million to work.
Meanwhile we continue to evaluate other possibilities for capital deployment. Beyond making prudent investments in the business chief among these possibilities are potential acquisitions. I have mentioned that we think of these in three broad categories of which two continue to rise to the top of the list. Those are scale acquisitions in the brokerage business and opportunities to better capitalize on our customer deposits through banking.
On the brokerage side we have superior platforms and systems in place and utilizing the scale inherent they are in is attractive. On banking we see value in optimizing our low cost stable deposits through a more traditional approach. While an abundance of small and medium sized opportunities exist in these areas, we are staying highly objective with an eye on delivering compelling returns on capital ensuring our customers will be well served and remaining closed towards digital ethos [ph].
As we examine specific opportunities, management and our board pass each through a robust filter ensuring our heightened standards for risks, our demonstrated commitment to creating value for shareholders and our regulatory standing are the forefront of any decisions. Irrespective of acquisitions, as we think about both growth and capital deployment, we have started the work on sizing the implications exceeding $50 billion in assets. While I remain hopeful that logic wears its noble head and that certain regulations might change we take a more pragmatic approach to managing our business.
Accordingly, I talked to Mr. Pizzi and team with understanding all elements of crossing this threshold from systems, to reporting, to personnel and most relevant for your purposes cost. While there is still a lot of analysis to do and the numbers will be refined, initial estimates suggest about $50 million over two years related to getting in shape with an additional recurring component of approximately $15 million annually. Keep in mind that not all of these costs specifically those related to the initial build out would have immediate P&L impact. Mr. Pizzi will cover more on that later.
These costs are certainly not insignificant and as we note in our numerous occasions kept tolling over the 50 billion lines won’t benefit our owners particularly in the current rate environment. However with cost and benefits will clearly define we will be able to make an informed decision considering rates, growth and return on capital, so we are spending a healthy amount of time working through this exercise for the avoidance of any doubt our intent for the foreseeable future is to manage our balance sheet to our stated target and not cross into the nifty land of 50.
While on the top of expenses the team has completed the budgeting work for 2016 and I like to give some color on how we are thinking about spend going forward. We have made a lot of important investments in the business over the past few years in particular fortifying the company’s risk and control framework in line with our enhanced expectations, bolstering our foundations through improvements to systems and infrastructure and finally upgrading talent.
With much of the foundation of work complete we have really just begun to shift our dollars to chip away into the ring enhancements truly geared towards improving our competitive position. Today, with this more rational expense structure we are transitioning the way we think and talk about overall spending to be more directly in line with the revenue environment meaning operating margin. And this measure for 2016 we expect it to be 39%. There is substantial upside in a more normalized rate environment where our target should move to the mid 40s range. While Mr. Pizzi will share additional thoughts and expenses in the coming quarter, I wanted to accentuate a revamped approach on the matter.
Turning to our business metrics, customer activity rates slowed in its global and macro economic uncertainty during the year with DARTs of 155,000 down 8% from 2014. Q4 continued the trend of moderation as DARTs of 147,000 were down 6% from the third quarter. Options during the quarter were stable at 24% of total DARTs consistent with our full year mix.
In January to date, we have seen uptick in training activity amidst volatile markets and in line with seasonal patterns. Through yesterday DARTs are tracking up 26% from December. Despite uncertainty in the markets our customers showed confidence when they acted as there were net buyers of $6.8 billion to securities during the year and maintained relatively healthy margin balances throughout and in the year at $7.4 billion.
For the quarter, margin balances averaged $7.5 billion down from $8 billion last quarter. Recently, we have seen a decline to about $7 billion. Despite the macroeconomic were [Indiscernible] our core franchise also continued its steady growth adding 13,000 net new brokerage accounts during the fourth quarter bringing the full year total to 96,000 after we adjust for unique items.
Our adjusted attrition rate for the quarter of 8.2% improved from 9.3% in the prior quarter and brings our full year adjusted attrition rate to 8.9% in line with 2014 in a range that we think is healthy given our business model.
We brought in $2.8 billion of net new brokerage assets during the quarter which was up from $2.1 billion in the third quarter and brings our full year total to $9.3 billion representing a 3.8% growth rate. Importantly, approximately one third of those net new assets were closed into retirement accounts.
Retirement investing and savings continue to represent a key component of our future growth. Both are challenge and our opportunity is to better engage with customers to broaden their awareness and showcase our capabilities as a provider of investment solutions for both the near and long term focus.
We ended the year with $48 billion of retirement assets with our 880,000 retirement accounts, both of which increased modestly during the year. We also earned $3.2 billion of assets and managed accounts which we think compliments this component of our business quite nicely.
Another tremendous area of opportunity for us is our stock plan administration business. We continue to invest in this business during the year and completed the transition of clients onto our award winning Equity Edge Online platform. During the year, we added 144,000 net new accounts in this business and ended the year with 1.4 million planned participants.
Turning to the enhancements we’ve made to our digital store front and co-platforms leading with etrade.com, we launched a new welcome page for perspective customers to better deliver a value proposition the moment a window shopper steps into the store. While it is in early days we have seen an improvement in the funding rate for new accounts directed to this page. It is up over 2.5 percentage points compared to our prior experience.
Once in the door, all customers were met with several overhaul sections of our site including a revamped account overview page, our new retirement center which provides a simpler interface and a writing content to help customers engage, take charge and keep their goals on track. Our new tax center, which brings more efficiency and ease to a process that is notoriously stressful and convoluted.
And finally, this morning we announced the introduction of tip ranks to our platform. And listening to the customers we heard a strong need to help navigating the scores of public content across social and financial channels. The two which represents analyst sentiment on individual stocks and then ultra clear way takes a unique algorithm based approach to analyzing and aggregating recommendations for more than 3,700 sell side analysts and 4,500 financial buyers.
Turning to our active trader platform E*TRADE Pro, we made a number of upgrades to further equip retail investors with professional grade tools. The big ticket items include a new options analyzer which simplifies very complex strategies. In addition to a new streamline design, the revamped tool enables traders to build multiple options strategies, run through various strike and date scenarios, customize graphing features and more seamlessly submit any strategy for trading.
And our new margin analyzer which provides greater clarity by way of a new detailed overview of buying power, displaying real time requirements for each position in a customer’s portfolio.
Lastly is Mobile, which continues to become a more prevalent component of our offering as Mobile DARTs were a record 14% of total DARTs in 2015 and 15% in Q4. Customers seek an experience that rivals the desktop in terms of power and depth, and this year we delivered robust enhancements to further empower customers on the go.
Some of the more noteworthy features we added this year include, conditional orders to help customers more nimbly seize opportunities based on different market conditions, multi leg options to execute complex strategies, a Bespoke [ph] mutual fund trading experience and mould that embraces the unique form factor and several new technologies available on Apple products including home screen support and iOS, Apple Pay and of course our Apple Watch app we were the only broker among our peers to offer account level data.
When it comes to the progress of our digital offering where we see significant third party recognition this year including running four out of five stars overall and variance 2015 broker review, three first place awards along with five best in class ratings in stockbrokerage.com 2015 review. And for the fourth year running Equity Edge Online was rated number one for client satisfaction and loyalty by Group 5.
So in summary, 2015 was a great year for E*TRADE. We are very proud of the accomplishments we made but recognize there is more to do to drive growth in the metrics and I know we can do better. So as we turn the page to a new year, I’m enthusiastic about the many initiatives we have underway to enhance our offering and grow our franchise, all while keeping focused on continuing to deliver value for shareholders. I am eager to share our progress along the way and I am confident 2016 will be another great year for E*TRADE.
And with that, I will turn it over to impavid CFO, Mr. Pizzi.
Thank you, Mr. Idzik. I’ll start with our results. For the quarter we reported earnings of $89 million or $0.30 per share. That compares to $98 million or $0.33 per share in the prior quarter after excluding the impact of the wholesale funding transaction. It also compares to adjusted net income of $78 million or $0.26 per share in the year ago quarter after excluding extinguishment of corporate debt.
The quarter also included an elevated tax rate of 43% largely related to the impact of our wholesale funding transaction on the full years pretax income and the associated impact on non-deductible items. We expected to return to a more normalized 38% to 40% range in 2016.
Revenues were $454 million, up from an adjusted $443 million in the prior quarter attributable to higher net interest spread but down from $461 million in the year-ago quarter as a result of lower customer activity.
Net interest income of $285 million improved $22 million from the prior quarter, driven by a healthy 30 basis point improvement in spread, primarily related to the elimination of expensive wholesale funding, partially offset by a $1 billion lower average balance sheet, again the result of the wholesale elimination.
Spread for the quarter was 288 basis points above the high 270s range we discussed on the last call as a result of better margin loan yields coupled with meaningfully slower prepayments fees within our securities portfolio.
As for 2016 spread, holding the fed funds rate constant and doing the same for our most erratic variables relative to where they ended the year, margin, stock lending and prepayment fees we expect our spread for the year to be in the 270 basis to 275 basis point range with Q1 in the high 270s. I would note that with margin relative to where it ended the year there is some downside.
Commissions, fees and service charges and other revenue were $160 million, down 10 million from the prior quarter and down $16 million versus the year-ago quarter, largely attributable to a decline in trading activity related to both periods. Average commission per trade of $10.66 declined $0.21 from the prior quarter and $0.18 from the year ago quarter. The sequential decrease was driven by a higher mix of active traders and fewer contracts for option trade. The year-over-year decline was also driven by higher mix of active traders.
Securities gains were $9 million compared with an adjusted $10 million in the prior quarter. For the full year we expect gains to be in the $30 million to $40 million though any given quarter could vary.
Expenses for the quarter were $305 million, up $12 million from the prior quarter; it goes by a couple of unique items. First, we have $6 million of executive severance within the restructuring line, second we had an $8 million onetime third party contract charge in the communications line. Excluding those two items, expenses were $291 million.
Looking ahead we are truly shifting our framework to be more aligned with the revenue environment and that is evident in the investments we are making going forward. The new investments are ones that will have a more direct impact on the growth in our business. As for the more significant drivers of the current year’s expense guidance which is predicated on an operating margin of 39% they are the following: first, the impact of adding talent. We grew headcount in 2015 and will have the full year run rate of those additions as well as continued hiring throughout 2016. In 2015, many of the hirers we made related to foundational enhancements and improvements to project management.
In 2016, many of the hires we make will be related to business growth. In conjunction with this, we expect consultant headcount to decline, which is captured in professional services. Second, we plan to increase our marketing spend in the high single digit percentage range during the year. We maintain flexibility here and will be mindful of what the market conditions warrant.
And last, the impact of our reduced FDIC insurance premiums. We had a drop in our assessment rate in mid 2015 and will recognize the full benefit of that in 2016. We expect the expense to this expense to be approximately $6 million per quarter for the $49.5 billion balance sheet. So those were the pieces that will impact the full year. More specifically for Q1,we expect operating expenses to be around $310 million which includes a sequential uptick in marketing spend that combined with a smaller balance sheet will have in Q1 relative to the rest of the year will cause our up margin for the quarter to be below our full year guidance.
And to be clear on our operating margin guidance, the metric is aligned with that which we report in our key performance metrics and is the percentage we make on revenue after provision and operating expenses, meaning an exclusive corporate interest expense and other below the line items. We view this metric as an important measure of how we are managing the business.
Moving onto the loan portfolio, it ended the year at $5 billion, down 6% during the quarter and down 22% for the full year. The allowance reduced yet again as we continued to see positive performance relative to our expectations ending the quarter at $353 million, a $23 million decline from the prior quarter, this translated into a benefit to provision for loan losses of $23 million as net charge offs were zero.
With respect to HELOCs, we began 2015 with $600 million of HELOCs scheduled to convert to amortizing payments or mature during the year. We managed with the first significant volume of conversions and maturities and we now have a sizeable sample of converted loan performance to measure against our original expectations. We enter 2016 armed with even more data to forecast the performance of the future convergence and maturities.
This year we have about $800 million of our total $2.1 billion of home equity loans of which $1.7 billion are HELOCs scheduled to do so. So here’s what I would emphasize on the topic. In the month that HELOC converts from an interest only to an amortizing repayment, we observe a significant increase in the rate of new 30-day delinquencies would ultimately result in a default rate approximately twice that of the non-converting population.
Translating that into actual loss terms the 24 month benchmark default rate on non converting loans has been about 6%, while those that have converted are closer to 12%. Furthermore, the charge-off occurs approximately 6 months to 9 months after the conversion event when the loan reaches 180 days past due consistent with our standard accounting process for Mortgage loan charge-offs.
And finally, our loss estimates incorporate our assumption on loans converting in 2016 are generally of poor credit quality than the average converted loans to date as national housing values peaked in 2006 when most of them were originated translating to higher CLTVs and less equity in the properties today. These conversions and their performance are the single largest factor impacting our loss modeling and while we expect charge offs to increase in 2016 we are confident with our current level of reserves and continue it to expect provision expense for the year to be near zero.
Moving onto capital, we announced four major capital deployment actions in 2015 and we are in the midst of executing on two of them, balance sheet growth and share repurchases. On balance sheet growth we expect to reach our targeted balance sheet size in Q2, at that point on a pro forma basis we would be left be about 7 billion of off balance sheet deposits. Before assuming any level of growth in the business, 2 billion of these deposits could be brought on the balance sheet at our direction. So taking this into account and again before assuming any level of customer cash growth we have the ability to cross $50 billion organically.
To expand on Paul’s comment regarding the work underway to size the impact of expenses of crossing $50 billion in assets, first we would have the upfront non recurring expenses to implement the quality of the requirements associated with crossing the threshold.
More specifically, those are tied to requirements scripted under Dodd-Frank, mainly CCAR, the liquidity coverage ratio and resolution planning. Within the rough initial estimate of $50 million we are still -- we are doing much work to determine what the final number will be and what portion of that would actually flow through the P&L versus how much will be capitalized. That does not include any additional FDIC costs which will be incurred at a rate relatively in line with our cost today.
With respect to the $15 million estimate of recurring annual expenses that would be predominantly associated with additional headcount in various legal compliance and financial roles. But while we work through these calculations it is important to note that we will only cross the $50 billion threshold if doing so presents compelling returns.
Lastly, with respect to corporate cash we ended the quarter with $447 million up $15 million from the prior quarter as a $50 million dividend from E*TRADE Securities was offset by the usage of $50 million to repurchase shares. As a reminder, we intend to resume quarterly dividends from the bank and the parent in Q1 and in light of our reduced tier 1 leverage threshold to 8% to the bank this quarter we intend to request dividend in excess of it’s $97 million of Q4 net income.
And with that, operator, we will open the call for questions.
Thank you. [Operator Instructions] And our first question comes from the line of Rich Repetto from Sandler O'Neill. Please proceed.
Yes good evening Paul, good evening Mike. Just my first question is a follow up to the SIFI [ph] sort of research that you’ve done on the cost, and when you talk about a compelling return, I just wanted to get a little bit more color of what you’d sort of categorize as a compelling return. And then it looks like you would still have $2 billion in sweep or off balance sheet deposits you could add so that would give you some growth. But where could you see growth coming from on the deposit side that actually get that compelling return on the SIFI cost?
A couple of things I would point out there Rich. One, that the $2 billion doesn’t assume any growth in cash that’s really where we what the calculations would be if we ran them as of 12/31. Continuing to -- if you look at our customer cash balances overtime and a trend you will see that overtime that they have been growing. So we would expect that number to grow with our business as we grow accounts and grow customers.
The $2 billion that we have there to think about what we give as our reinvestment grade of essentially 175 basis points or so you can use that to estimate the revenue that’s available on that $2 billion. When we think of returns we are not really just talking about the dollar return or margin but we have to put equity against that balance sheet. So what we are really talking about is a compelling ROE to grow the balance sheet through 50 taking into account those costs.
Okay, that’s helpful. And I guess I’m sure that you are still working through a lot of the cost here. But I guess my follow up question would be and this may not be as relevant today, but interest rate sensitivity and it seems like the other e-brokers get specific in regards to how they would be impacted by rate hikes whether they happen, whether it is likely now as before. But with the wholesale funding clean up are you able to give us a better idea of the interest rate sensitivity for E*TRADE?
Yes, in the past with the various movements on the balance sheet, one here you could see the wholesale funding but even the changes in the composition in cost of corporate debt, the pay downs in the loan portfolio, the deleveraging project to bring our balance sheet down to get to a target capital ratio and then there is sort of releveraging or bringing the balance sheet back up in size that we are doing now. We have shied away from giving that guidance.
We are at a point now where we are completing some works and I would say stay tuned, because we are going to be coming, we’ll be coming with a more fulsome disclosures around our interest rate sensitivity.
And maybe I will sneak one in for Paul if I could. On the M&A, Paul we hear a lot that is -- there was an article about a broker, private broker up for sale. Any of the properties out there as far as scale properties, do you find particularly interesting?
Rich, it’s always good to hear from you, I find lots of things interesting, but you can’t possibly expect me to answer that question.
I’ll pass then. Thank you.
The next question comes from the line of Steven Chubak with Nomura. Please proceed.
Hi, good evening.
Good evening, Steven
Appreciate all the detail you guys provided on the incremental expense associated with crossing I guess what you call that nifty land at 50 threshold, so just sticking with actually the classification but if we were to take that 175 basis point spread on a newly deployed client cash, I’m just trying to get a sense as to how long it would take, it actually crossed the threshold organically where the economic benefits put into would make sense
Well Steven, we -- as Michael has said we’ve been doing a lot of analysis and furring our brows a bit about whatsoever we had to talk about this, but as Mike said we could go over there organically. Mike, I don’t know if you want to add anything that because it’s difficult to forecast the way exactly Steven is describing it particularly given the impact, there was a potential rate raiser, potential new introduction.
And I think you’re thinking about in a correct way. As rates move higher the spread earned on that balance sheet will be larger, so we will need less balance to earn that compelling return. At a lower rate environment we’re going to need more balance. Looking sort of those relative earnings on that, relative to a reasonable equity cost and therefore return on equity that you want to achieve as a target and I think you can back into a number.
Okay. That’s helpful. And maybe just switching over back to the NIM discussion, I just wanted to get a sense as to given the guidance where you indicated a rebasing presumably in the asset yield side, if you can give some additional detail in terms of what assumptions are being made in certain items particularly those are in more volatile like stock lending but also in terms of security yields and the pro forma return?
Yes. The guidance we gave holds some of those components constant, so we’re holding the margin balance constant at a rate at this level there. We are holding stock loan contribution constant throughout that calculation and then essentially running a constant balance sheet of 49.5 to give that spread guidance in the 270 to 275 basis point range. It also assumes no additional movements in federal funds.
Okay. And this one follow-on from me, but the FDIC expense guidance update that you provided, does that contemplate to step up in fees that expected later in the year?
The run rate expense guidance does not include any step up in fees. The step up in fees is out there as an issue. We expected to have to get closer sometime in 2016. We’ve incorporated it into a planning and therefore it is incorporated into the operating margin guidance that we’re given you, but the run rate as we don’t know the form that charge is going to take. It could be a one-time charge. It could be ongoing assessment. It could actually be an element of both. Because of that we have not factored it into the dollar guidance, but we have taken it into consideration the calculation of the operating margin.
That’s it from me. Thanks for taking my questions.
The next question comes from the line of Conor Fitzgerald with Goldman Sachs. Please proceed.
Good evening, Conor.
Just you guys have been pretty aggressive for the share repurchase early. I just want to understand kind of your appetite for maybe using a chunk of your authorization sooner or rather than later just given what’s happen with markets and kind of your stock specifically year to-date?
Well Conor as you can well expect and Mr. Pizzi will talk more of this in a bit. We’re in the same quiet period requirements as a corporation as we would as an individual. And so that has some issues with regard to what we can or can do accelerating or decelerating during this period of time, but Mike do you want to.
Yes. I think as you probably understand we are operating under plan and that’s regard as throughout the amount that we’ve done far this year as we entered the quiet period late in December. With that, that’s been a consistent amount of purchases. With the movement in the prices and the volatility of the market it’s an item of active discussion between Paul and I as to what the appropriate – what the appropriate set of actions to be when we can exit this period in a couple of days.
That’s helpful. And then I think you were one of the first to raise margin lending rate after the Fed hike. I’m just wondering if you can give a little color on what you’re seeing in the early inning in terms of your success and passing through that higher rate. Just trying to give us – to get a sense as given competition been relatively strong on margin lending balances?
From what I understand most of our major competitors have now passed through that increase, some delayed a little bit and we are not really seeing much in the way of any movement really, but it’s been largely pass-through.
Helpful. And if I could sneak in, sorry. And then if I can sneak in one last more with that. That 175 number you quoted, that’s net of the money market fee revenue you lost? And then just one more if you could. What do you kind of think your cost of capital is on a low risk? What was the revenue stream like this that would be helpful? Thanks.
The 175 is the marginal rate of reinvestment. So in terms of where we are effectively buying duration match securities in today’s market. Please keep in mind; yields have been exceptionally volatile as have spread, so that number is bouncing around. We could think it is range of about 175 to 2% right now. We haven’t historically disclosed our cost of equity but it’s actually fairly straightforward calculation from the cap end [ph] model, so in terms of where we’re coming out, but I think from that you’re going to get around to 10 percentage type range cost.
Okay. And sorry, so the 175 is the spread revenue, but you do lose money market fee revenue in the other revenue line?
Yes. So, if you move deposits back on balance sheet and you’re buying in the 175 to 2% range you are giving up the fees that you are earning on the off balance sheet portion.
I’m sorry, what’s that in today’s rate environment?
It’s about 23 basis points.
All right. Thank you very much.
The next question comes from the line of Mike Carrier with Bank of America Merrill Lynch. Please proceed.
Thanks, guys. Mike, just on the expense outlook, so I know you just mentioned on the first quarter the 310, it seems like that’s a pretty decent bump up even with advertising from like the adjusted number that I think it’s around 290 in this quarter. So just wanted to see what’s driving that? I know you mentioned advertising and seasonal comp, but if there’s anything else that gets the lift in the first quarter?
Yes. If you go back and look, you’ll see the comp is always the higher in the first quarter that is really related to all the tax items and resets that go on, so that will be occurring as well, as well as the ramp up in marketing. And then some of the full year headcount really continuing, but that’s really more about for the full year and not just for the first quarter.
Okay. And then, just in terms of going over the $50 billion, you guys gave the cost and I’m just curious when you think about like getting positioned for that transition if you determine that make sense, like what’s like the timeline in terms of getting prepared – any additional hiring, any additional system cost maybe because it’s something that you guys have been planning as you been kind of revamping the infrastructure that it wouldn’t take that long or are you still thinking it will take few quarters to be building that out?
Look, I think that one, I’d say, there is no decision to cross at this point. We are working on a plan, but a plan is not a decision point. I think at some point, yes, with the growth in cash it will become more and more likely decision, but at what point that is a little bit off in the future. How the rules work? Some of the CCAR rules you have five quarters to come into compliance with, so that gives an operating window of time, but obviously you want to have a very detail and well thought out plan put place before you start down that road, you have a fixed window to get it in place.
Other rules actually kick in, this is heightened expectation rules. They kick in day one when you cross 50. So, that work has to be done almost immediately, but some of that’s a bit more structural and a bit easier to put in place. So, as we step back from it, you don’t have -- its not going to take a full two years in terms of the expense period to go over 50, but there is going to be a period ramp up time as you’re building up the plan and as you’re beginning on the execution of the first phases of the plan particularly personnel to get some of this work done.
Okay. Thanks a lot.
The next question comes from the line of Chris Harris with Wells Fargo. Please proceed.
Thanks guys. Another clearly really strong quarter in credit, and I appreciate your comments about expectations on the default rates and the HELOC book. But I’m just trying to square that with what you guys are actually reporting. This is a third consecutive quarter of no charge offs in the HELOC portfolio. So it seems like you guys are running way-way better than that. So, help us maybe bridge the loss experiences you’re kind of reporting that versus what you think they potentially might be going?
I can provide you a little bit of color on that. And I think the gross charge offs for the period were $21 million, that will be coming out in our 10-K when we file it. And we are seeing an elevated level of recoveries that are driving the net charge off number of zero. We expect that recovery stream to continue somewhat, but it has been exceptionally strong and we are coming up on increase conversion balances. So that really square us to have we get to the loss modeling that of course the 353 allowance.
Okay. All right. That makes sense. And then the commentary around acquisitions, would you guys consider acquiring a bank that had credit risk, is that part of the potential candidates that’s you’re considering?
Chris, we’re considering a number of things across three dimensions, right, which we’ve talk on a couple of calls now. But let’s remember the reason we brought this up is because we were in period of repair at the time and couldn’t entertain these at all. So as the music has changed here, we wanted to make sure that were very clear with the street, with the sell-side, with our investors that we’re now in a different spot and we can entertain this things. As we said today two of those three categories have emerged this, having more potential attractive opportunities and I say potential. One is certainly trying to find ways to add scale on the brokerage business because the operating leverage is so attractive.
The second is in banking, finding way to monetize the value of our customer deposits to a greater degree than we do today, and that would imply acquiring an institution that has strong capabilities and traditional intermediary activities.
Okay. Helpful. Thank you.
The next question comes from the line of Ken Hill with Barclays. Please proceed.
Hey, good evening guys.
So, I know you’ve talked a lot about acquisitions here, but during the quarter I think you guys announced an expansion of your relationship with Jefferies giving clients access to Munis and you had a relationship in place on IPOs for with the year now, so are there any other in-demand products that could maybe satisfied through more of a kind of partnership than anything else?
That’s a good question, Ken. We look at partnerships all the time. We’ve recently got involved in a partnership and their back office that we think not only provides customers a better service level, but provides us better economics, so we look at those all the time particularly as people produce new products. And if you think about the introduction of TipRanks today that’s very much of partnership and that’s providing some additional valued, educational and investing knowledge to our customers through a partnerships, so we think about those all the time.
Okay. And then just modeling question here for the commission, I know you guys, it drops quite a bit and one of the peers kind of stabilized on a little bit higher. I know you mentioned some of the higher percentage of active traders this quarter. Is there anything different that you are seeing from the customer base? You guys targeting a higher group of active traders and making it earlier to them to trade out at this kind of rate that might be kind of driving that lower over time and should we expect that to stabilize some?
Ken, we’re clearly continue to invest in, for example, E*TRADE Pro which unquestionably signals the fact that we are absolutely committed to serving the needs of those valued customers and much of what you’re introducing on the mobile devices is also aimed at serving that valuable client base, because they like to stay and touch and like to be able take when they want to take action.
So, our dedication to that area is very important. Our modeling on that metric which you just describer is influence by a number of factors and including the impact of corporate services businesses and a change in buying behavior somewhat in the fourth quarter people repositioned and few more mutual fund type purchases as opposed to just straight darts, straight equity trade. So there’s a number of moving factors, Ken.
Okay. Thanks for taking my questions.
I could just make one correction to an earlier comment to Conor’s question. I gave the gross revenue number on the off balance sheet, the off balance sheets we’ve deposits. There are fees paid in that arrangement. So when I gave the number of 23 basis points we’re actually in the 10 to 15 basis point range because we have to pay the administrator fees, so it’s not quite as high as that. We also expect that to go up with the full quarter now of the post the Federal Reserve increases into the 25 to 30 basis point range.
The next question comes from the line of Devin Ryan with JMP. Please proceed.
Thanks. Good afternoon. Just a questions here on excess liquidity. If this market volatility persist, does that change your view at all round the two times debt service cushion, are you r well above that now. But just trying to think about what’s truly excess? And also you’re now being at the 8% Tier 1 leverage capital plan objective, that’s great. Should we think about that is an ending point or is there still a goal to maybe move that lower over time?
I’ll take the second first. Devin, we just got permission to take it down to 8, so you’ll forgive us for one to catch our breath a bit. And I appreciate your patience, but we’re going to catch our breath a bit.
We do think as a loan portfolio continues to cure, that there is some more opportunity to take down to a level that towards the seven handle, but that something that we want to carefully work through with our regulators and make sure that all the right people are comfortable before we even start entertaining that idea. The dust is just begun to settle on the trophy of getting that done, so we’re going to be patience in approaching the same careful way we did in getting down to eight. And then Mike is going to take the other question.
Yes. On the two times debt service, please keep in mind the two times debt service is actually a covenant in our revolver at this point in time, so we will not go below the 100 million number. We view corporate cash as sort of ultimate pre-source of liquidity if we need to use it between our legal entities and it also source of capital, so therefore we are not going to operate at a thinner margin in that two times level.
Okay, great. Helpful. And then just with respect to Sec lending, the balances bounce around quite bit, revenues is tend to be less volatile there. So just within the NIM guidance with that line specifically, should we just think about a revenue level being relatively constant with where it’s been or just how should we think about that dynamic.
Well, in the NIM guidance we are keeping at constant. Now constant does mean the constant yield there. I mean the content overall contribution. Keep in mind, that the hard to borrow component that is essentially the rebate earned on the stock lending is put to the borrowing line and the borrowing balance is driven by customer activity. So there’s going to be a lot of volatility in the yield that’s posted there. But from a dollar perspective we expect to be relatively flat.
Okay, great. And then just finally to be clear here, the operating margin expectation 39% that includes provisioning I’m assuming I know, there is not much expected this year but want to make sure that that objective includes provision?
That includes provision and our guidance on provision for the year is zero.
Okay, great. Thank you.
The next question comes from the line Brian Bedell. Please proceed.
Hi, good evening folks, maybe just to add on to that question on the 39% op margin with the provision, should the provision varied greatly in either direction, do you view that as something that would change that operating margin or would you use that as sort of contributing to that 39% target either way?
Well, as you’d expect we have to react to that when it occurs, if provisions come in above what we anticipate, we’ll have to look, we may be able to reduce other cost, those numbers come in big and chunky those, so our ability to move the other numbers is not quite the flexibility you might have otherwise. And if it comes in better, we’ll again take a look and see. We’ve often times on these calls said we like to flex our marketing budget and when times are good invest in driving future customer growth and one times are bad being as responsible as we can, so that’s a bit something we have handle day-to-day as we see what happens.
Okay. Now that’s great, that’s great color. And then maybe just for you Paul, in the acquisition spectrum I think actually question both to you and Mike. Mike, you can talk a little bit about financial metrics or huddles for deals that you might be following in terms of either accretion timeline or ROE? And then maybe Paul how do you feel about the RIA business, it’s one o big area that you are not in and not see that scaling your capabilities? Thanks.
Why don’t you take the metrics one first?
Sure. Anything we are looking at is going to have to –have to have an extremely compelling return in terms of the investment that we are making, in terms of either ROE or return on invested capital. We would also expect accretion commensurate to the
deal size and the risk in the deal, so we would expect higher metrics for deals that are going to be -- that have higher complexity or higher risk to them in terms of what we can achieve. I guess the only sort of thing I would talk about that is probably anything that’s around capability or product, we haven’t talk much about that, they would be on the smaller side, but any larger amount of use of capital is going to have an extremely compelling return profile on accretion.
On ROE we been pretty consistent in our thinking on this switch, not really all that intrigue by that opportunity right now for two main reasons. One, we really want to see how the department of labor regulations that are muted [ph] might turn out. That could have quite a significant impact on that business. And secondly, if you’re going to go in that business I believe you need to enter that business with scale and so that would also make us think twice about that. And so for right own that’s not quite in – quite at the top of our mind.
Okay. That’s great color. Thank you.
I think we’ll take – we have two more – two more calls please, Edison.
The next question comes from the line Andrew Del Medico with Autonomous Research. Please proceed.
Andrew Del Medico
Hey, guys. Just a follow-up on the potential bank M&A, you’ve done job of de-risking the balance over the past several years. What’s change in your thinking that will make you one of kind of get back in and add more credit risks now?
Well, let me just repeat that. We’ve talked about potential acquisitions thinking about, not even thinking about potential acquisitions across three fronts. And I think considering the type of credit risk that we have been managing over the past several years and how it came on the books is not exactly what I would consider traditional banking business.
Andrew Del Medico
Okay. I guess what when you evaluate a potential bank acquisition, I guess what is loan channels and some assets would you really be looking at best?
I think you want to look at when we think about think, we think about things that are kind of complement our existing business, our business model, how we go about things, the type of customers we have, will it have any residents even with the E*TRADE corporate services business. And so those are the type of applications of our thinking and the direction we’re taking.
Andrew Del Medico
Okay. Great. Thank you.
Our last question comes from the line of Robert Rutschow with CLSA. Please proceed.
Hi. Good evening. Thanks for taking my questions. First question on expenses, it looks like your headcount was up by about a 100 little over 100 this quarter, so does the guidance for 2016 for the 39% pretax assume that you’re going to see a ramp up in headcount expenses and does that means you would see some offsets elsewhere in the extend categories?
The guidance includes our projected headcount, but it’s not – the headcount projection is not – continued growth, the rate is going to slow from what it has been. So, you don’t necessarily – you not necessarily going to see offsets. The hiring in the fourth quarter is very much around staffing up for the tax season or financial season that we enter this time of the year.
Okay. And one more question on that possibly going about $50 billion. In terms of the deposits that you would want to bring on, are there any impediments that you have to change any customer agreements to bring those on balance sheet? And what would you anticipate the earning asset level to be if you were to bring on additional $2 billion in deposit?
Well, we’re working through that, I mean right now in terms of the actual conversions that are underway, you will notice that assets that are in -- of balance sheet team down as we brought some on our balance sheet. We have additional conversions that are going to occur in this quarter, I mean that’s going to be a lot of process bringing us to our target level of 49.5 by sometime in the second quarter.
The additional $2 billion amount is really part o the same process if we wanted to bring it on, we could. The remaining amount for various reasons it’s either in money funds that the customer has chosen to be in a tax exempt product. It is money above the FDIC insurance threshold, so be insured it has to be held by the different bank, therefore cannot be brought back onto our balance sheet. So of that seven, five of it cannot be brought back, two can be brought back that’s what we gave in the prepared remarks. And then as we grow accounts and grow our business overtime we expect that too to grow.
Great. Thank you.
Thank you. And I just like to thank all of you again for spending this last hour with us. We appreciate your interest and hope you’ll have a really great evening. Good bye.
Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line.
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