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Here’s the entire text of the Q&A from E*Trade’s (ticker: ET) Q3 2005 conference call. The prepared remarks are here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.

Q&A

[Operator]: [OPERATOR INSTRUCTIONS]. We'll pause for just a moment to compile the Q-and-A roster.

Mike Vinciquerra with Raymond James

[Q - Mike Vinciquerra]: Hi, good afternoon, guys.

[A - Mitchell Caplan]: Hi Mike.

[Q - Mike Vinciquerra]: A couple of questions mostly on kind of the modeling side, looking forward to a lot of things kind of changing here over the next twelve months. But first of all, the big jump in bank our interest earning assets, about 4% sequentially. Should we assume that that is a pace that you guys want to maintain for the foreseeable future? Is that kind of an extraordinary boost for the one quarter?

[A - Mitchell Caplan]: There are a couple things that are happening. One is, one of the things you'll note is that quarter-over-quarter we had about a 50%, little bit more than a 50% origination increase in originations from our retail customer base. And we increased what we kept on balance sheet by about 170%, quarter over quarter. So it was a strong quarter in which we were able to grow the balance sheet around mortgage loans, HELOCs, you can see it as we continued to connect with these retail customer through complete and otherwise. One of the things I think we've talked about in the past, to answer your question specifically, is that the earnings alone at the "Bank legal entity" can generate 10% annualized growth without contributing any capital down from the parent. So without saying any more, I think what we'll do is as we give guidance in December for next year it will be much more specific about the obviously the top line guidance and where it's coming from and the implied growth in the balance sheet as a result of that.

But clearly we are in a place where our goal is to try to grow the loans as a percentage of your total assets, as we said here, to 59. We'd like to see that between 70% to 80%. So a lot of that would be the result of just declining your securities portfolio.

[Q - Mike Vinciquerra]: Okay, great. Thank you. And then two other things, maybe for Rob. The FAS123 impact for 2006, have you guys put together an estimate of what that will be? I guess we had 8 million in the quarter?

[A - Robert Simmons]: No, we'll talk about 2006 in December when we come out with our regular guidance, Mike. But this quarter, the component that was purely options-related was about $7.1 million this quarter. So that's, you know, kind of a reasonable run rate for now.

[Q - Mike Vinciquerra]: Okay. And then just finally, just to clarify on the marketing, Rob, I guess we had 21 million this quarter. You said you expect it to be up 6 to 8 million for Q4, implies something in the high 20s, which is still pretty much in line with where you were Q2. Is that, am I looking at that the right way? And then next year we're talking about something similar in terms of your annual marketing budget?

[A - Mitchell Caplan]: A couple of things, Mike. Yes, you're absolutely looking at it right in terms of Q4. With respect to next quarter or the quarter that we're currently in, we do intend to spend more. It does look a little bit more like Q2 when you're out of the, What traditionally had been a seasonably slow summer. And so there will be a penny of additional increased marketing expenses in Q4. Again, with respect to 2006, we'll deal with all of that when we give guidance in December for next year, including the details around marketing.

[Q - Mike Vinciquerra]: Thank you very much.

[A - Mitchell Caplan]: Absolutely.

[Operator]: Richard Herr with KBW.

[Q - Richard Herr]: Hi, guys. How are you?

[A - Mitchell Caplan]: Hi, Rich.

[Q - Richard Herr]:
Just a quick question on the start of with gain on sale. Obviously a minor detail. But a lot of what we've been hearing from other banks is gain on sale margins haven't been very good, and it looks like yours held up, your gain on sales revenues held up pretty well this quarter. Could you maybe just discuss and give a little color on how that was and if you expect that to continue?

[A - Mitchell Caplan]: Absolutely. Happy to do it. So I think if you remember last quarter, you actually saw a gain on sale pretty consistent on the originated gain on sale as a result of the originated loans. What you saw last quarter down was gain on sale of securities and otherwise, really the institutional part of the gain on sale business. And I think what we said was we expected to see gain on sale associated with the mortgage volume being pretty consistent going forward. Again, you have to remember it's down probably 60% from its high. So we were in a position where close to a year ago we made the decision that regardless of where interest rates were going, we wanted to reposition the mortgage company from being an originator and reseller to try to originate and move in the direction of putting stuff on balance sheet. So as a result, overall origination volumes would be down, and ultimately what we packaged and sold into the secondary market would be down. So that's why I think you're seeing us be much more consistent versus other people who are being much more impacted right now by the declines in the marketplace.

Secondly, with respect to the institutional gains, last quarter it was pretty flat. I think you've seen it as high as 20 million. And I think we guided last quarter and said we would expect to see it anywhere in the range of 5 to 10 on a quarterly basis. And I'd say we're pretty comfortable with that range now and going forward.

[Q - Richard Herr]: Okay, that's helpful. And just looking at the corporate interest expense, I'm assuming that the jump there really had to do with the carry of, for Harris?

[A - Mitchell Caplan]:
You got it. $450 million carried for three weeks.

[Q - Richard Herr]: For three weeks. Okay. So I guess looking at a full-quarter number, maybe it's a 3 million or a 4 million additional expense there?

[A - Mitchell Caplan]: At 8 million bucks a quarter.

[Q - Richard Herr]: Just lastly, one last question. On the average rate per trade, I apologize if you covered it in the prepared remarks. But, you know, it continues to stay strong at $10.89. I know you're guiding forward at $10. I think the original guidance we had gotten as late as June was $9.50 to $9.70. Any reason there for the strength?

[A - Mitchell Caplan]: Yes, two reasons. One is, there's good news and bad news with Professional being down so significantly. So I think if you saw, our DARTs were up nicely quarter-over-quarter and, certainly, year-over-year. It was driven much more by retail, which was up 16%. In fact, Professional was down 8%. So when you think of the mix between Retail and Professional, Retail has a significantly higher average commission than Professional. Then commensurate with looking at the retail commission, when you look at the mix between products that are higher yielding in terms of average commission, things like options and otherwise, international, as well as the kinds of customers, meaning more Main Street, less active trader, you end up shifting toward a higher average commission from that, as well. So the answer to your question is mix shift, and it's mix shift, both in terms of Retail and Professional, and also within Retail. Again, we've guided down for Q4 to $10, assuming that you see a more traditional return to the mixes that we have always seen historically, to the extent that's not the case, there's upside. But right now, clearly, our view is that we would presume that Q4 may look more like the norm.

[Q - Richard Herr]: Okay, thanks a lots.

[A - Mitchell Caplan]: Absolutely.

[Operator]: Rich Repetto with Sandler ONeill.

[Q - Rich Repetto]: Hi, guys, how you doing?

[A - Mitchell Caplan]: Hey, Rich.

[Q - Rich Repetto]: I was just going to zone in a little bit. I had some peculiar numbers here on the Institutional segment, in the segment earnings.

[A - Mitchell Caplan]: Absolutely.

[Q - Rich Repetto]: It looks like, for whatever reason, the net interest is going down, quarter to quarter. I was wondering, in the back, on the bank net interest, that's up. So what have I missed? There's a number in here that I'm not getting.

[A - Mitchell Caplan]: Yes. You're absolutely missing the most important connection, and that is if you look at the number on the P&L, it ultimately gets reduced or eliminated through consolidation. That is a payment that gets made from Institutional to Retail for the origination of both Retail deposits and Retail credit products. So it is possible for the Institutional spread to look like it's going down simply because it's losing earnings as a result of paying more to the Retail business. This is exactly what you want to see. You want to see more and more growth on the balance sheet coming from the Retail business and the Retail business getting paid for it by Institutional. So you'll see, as I was talking about holistically when you think about enterprise spread, you'll see the overall spread of the Company going up, you'll see the spread of the bank going up, you'll see the whole Company spread going up, but Institutional is just acting now in the capacity not as an originator as much, but more as a manager of the balance sheet around credit risk and interest rate risk.

[Q - Rich Repetto]: I think I got it. It's more of an intercompany like you say, elimination.

[A - Mitchell Caplan]: It is. It is simply the payment in dollars from Institutional to Retail for their ability to generate deposits and also borrowings. And the reason that's the case is that, as you know, retail deposits are our lowest form of, in terms of cost of liability. So you want to reward retail for generating it as opposed to having to go out and do wholesale borrowings. Similarly, the same thing is true. The yield on direct originated products, mortgages, HELOCs, a margin, whatever it is, is going to be higher than what you would be buying in the secondary market.

[Q - Rich Repetto]: Okay, Mitch. And just sticking on this Institutional focus here a bit. It looked like the brunt or the good increase, big increase in comp was absorbed in Institutional. I'm just taking a look it went from 30, up $14 million. And you had a $17 million or so, increase. Just trying to figure out, you know, why.

[A - Mitchell Caplan]: Happy to walk you through it. So I think as you know, Rich, a couple years ago when our esteemed CFO took over, he became incredibly focused on deployment of capital. And as we think about allocating expenses throughout our business, including comp and benefits, the expenses get allocated based on the capital that's required. So if you look at the total capital on our Company, a very significant percentage of it is allocated over to the balance sheet management group in Institutional. As a result of that, they take a very significant proportion of overall expenses, which were to be allocated including comp and benefits. So when you see, as Rob walked you through in expenses this quarter, being up $20 million or $21 million, and 18 of it being up in comp and benefits, and then you're allocating that based on overall capital deployment, they end up getting hit with a significant piece of that capital, of that allocation of expenses.

[Q - Rich Repetto]: I get you. I thought, I wanted to be an Institutional guy because I thought you'd given them the bigger bonuses.

[A - Mitchell Caplan]: No, and what happens is, Dennis is cringing your question because he's so focused on margins and profitability. And, no, those numbers in the end will get trued up when you pay out the final bonuses.

[Q - Rich Repetto]: Okay. And very last question, don't want to go on here. Jarrett, when we, early September, we talked about, we thought we'd hit 1 billion in net new client cash and deposits. So I I assume, I think we're on the run rate of probably, I would assume, 800 or so through the two months. And then for the three months we ended up increasing 800 overall. So I was just wondering, did we see something in September with client cash that, where the rate, the acceleration slowed a bit in September?

[A - Jarrett Lilien]: No, really what you saw is the continuation of it. And that's what made it so impressive is that the market was strong. So you saw a lot of that money moving into the market. If you look at security holdings, they were up $5 billion in the quarter. And basically if you looked at it overall, total assets were up 10%. So really, cash came in, and it just went to use with other products, some of it, and some stayed in the cash products. So it was exactly as the model's supposed to work.

[Q - Mitchell Caplan]: Hey, Rich, let me also add a little something to that and bridge you through some of the numbers. So, a good way to think about that is the most significant investment by our customers in equity did happen in the third month of the quarter. Not surprising when you see the performance of the marketplace. So one thing to Jarrett's point is that when you look at asset growth being up 10% quarter-over-quarter, it was also up about 9% or 10% with respect to the securities holdings. You know, the market was up on a blended basis about 4%. So you know that there was net in-flow, significant net in-flow into equities from our customers. So basically what you saw happen over the course of the quarter was $700 million moved from what would be defined as free credit on the bank on the brokerage balance sheet over to the bank. In addition to that, you had in the neighborhood of $300 million of organic growth in cash that was moved from within the system onto the bank's balance sheet. You had about $200 million in transaction accounts, and you had about another $200 million in certificates of deposit. Now what's interesting is both the CDs and the transaction accounts are about in the high 90's as a percentage being originated from our core investing customers as opposed to the marketplace at large. So when you add those up, you get about the 300 and the 400 is about 700 million of net growth in the system. Okay? So and total enterprise cash was up about 800. Then specifically what happened is you actually saw growth in either free credit or sweep in excess of that by about $600 million. That $600 million ultimately flowed out between the time that it came in and the end of the quarter as people invested in the equities marketplace. So net/net we ended up in a place where we got about $1.4 billion onto the balance sheet from a bank perspective, which optimizes the spread. We got net/net 800 million of enterprise catch up, and we saw at least $600 million of our current customers' cash move into equity and equity holdings. So as Jarrett said, one of the things that we've always wanted to test is what happens to the marketplace when you have a stronger equities market? Can you still grow cash? And this is evidence of being able to grow $800 million in enterprise cash while also growing assets, and particularly, securities holdings.

[Q - Rich Repetto]: Understood. I guess the moral of the story is you need to look at it more holistically.

[A - Mitchell Caplan]:
That's exactly right. And that's why one of things I hinted at is, you'll see us in short order start looking across the board at enterprise numbers. So we, last quarter we introduced this concept of enterprise cash. Soon you'll see the concept of enterprise yield on credit. That will ultimately lead to enterprise spread within the Company. So the great news is that Dennis and the team did an awesome job in a very difficult market of widening the spread by a basis point. At the same time, totally independent of that, our margin balances grew. You saw the growth in margin of both quarter-over-quarter and year-over-year, and this quarter, margin spread widened by over 60 basis points. So if you looked holistically at the whole enterprise, you would have seen an even greater widening of credit spread.

[Q - Rich Repetto]:
I get it. Three more Fed hikes, too, so it should widen farther. Thanks, guys.

[A - Mitchell Caplan]: Absolutely.

[Operator]: Campbell Chaney with Sanders Morris Harris.

[Q - Campbell Chaney]:
Good afternoon, everybody.

[A - Mitchell Caplan]: Hi, Campbell.

[Q – Campbell Chaney]: Looking at some of the asset liability management, the numbers on your rate volume table in the back, I noticed you've switched about $1 billion out of the reverse repos into FHLB advances. Can you walk us through that? Could you just try and go out the duration curve a little bit on that, lock in some rates?

[A - Mitchell Caplan]:
Yes. Well, actually, no. There's virtually no difference in duration between FHLB and reverse repo. There are FHLB products that you can buy with embedded options in them that have a longer duration protection. But when you look at our current borrowings from FHLB, they're virtually overnight, and so is reverse repos. So there's very little impact. The benefit is that traditionally, the cost of borrowing at the federal home loan bank is less expensive than it is for reverse repurchase agreement, particularly with collateral like loans, whole loans. So as we continue to increase our whole loans and our overall loans as a percentage of assets, it's much more cost effective to use that as collateral at the FHLB and borrow it from them.

[Q - Campbell Chaney]: So, it would be safe to say we're going to continue to see this overnight repos come down and FHLBs go up?

[A - Mitchell Caplan]: Yes, I think that would not be surprising at all.

[Q - Campbell Chaney]: Okay. And can you give us an idea of how Harris Direct is going to fit into this table? Maybe give us some color on impact on the margin now that you've had Harris for a little bit of time.

[A - Mitchell Caplan]: You mean in terms

[Q - Campbell Chaney]: The net interest margin. Any impact, any

[A - Mitchell Caplan]: Yes. Again, I think what we said on the call was that we expected a neutral Q1 for Harris Direct, which is this current quarter. So we assume that whatever the benefits were as a result of the revenue, they would be offset by the expenses and so the real benefits for Harris Direct would come in '06, now a full quarter ahead. So there's nothing that you should see that's going to be meaningfully different as we report in Q4, and then with respect to next year, it will make a big difference and we'll talk about that when we do guidance in December.

[Q - Campbell Chaney]: And you're talking about the net interest margin.

[A - Mitchell Caplan]:
Yes.

[Q - Campbell Chaney]:
Okay. Great. Thanks a lot.

[A - Mitchell Caplan]: gain, because, as you know with Harris Direct, we get about $3 billion of cash, which is helpful, and we get a little bit over $1 billion in margin. So the idea with both Harris Direct and BrownCo was not only to connect with those customers around the trading, but also part of what we were purchasing was the relationship with those customers which included cash and credit in the form of margin.

[Q - Campbell Chaney]: So as things look, there's going to be additive to the margin?

[A - Mitchell Caplan]: Absolutely. It will be additive to the margin, and then the issue is just on a macro level what else is happening. Again, I think Dennis did an extraordinary job this quarter. What you basically saw happen was, overall, both our assets and our liabilities repriced. Our liabilities reprised about 5 basis points lower than our assets did. And then there was about a 4-basis point compression as a result of the flattening of the yield curve, resulting in a net/net 1-basis point increase in spread.

[Q - Campbell Chaney]: Well, I think you guys do a terrific job keeping the margin up.

[A - Mitchell Caplan]: Thanks.

[Operator]: Rich Repetto from Sandler O'Neill.

[Q - Rich Repetto]: Just one last quick question, Mitch. The 6 to 8 million increase, now is that just pouring it on from the last campaign, or is this a campaign designed to sort of handle any potential attrition with the acquisitions?

[A - Mitchell Caplan]: I don't know what that is really, I think it's focused globally on all of our customers, both current and prospective. Best way I can answer it for you.

[Q - Rich Repetto]: Okay, thanks.

[A - Mitchell Caplan]: Absolutely.

[Operator]: Ladies and gentlemen, we have reached the end of the allotted time for questions and answers. I would now like to turn the conference back over to management for any closing remarks.

[Mitchell Caplan, Chief Executive Officer]:
Thanks very much, everybody, for joining us, and we will speak to you in December when we give the guidance call.

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