Ally Financial (ALLY) Jeffrey Brown on Q2 2016 Results - Earnings Call Transcript

| About: Ally Financial (ALLY)

Ally Financial, Inc. (NYSE:ALLY)

Q2 2016 Earnings Call

July 26, 2016 9:00 am ET

Executives

Michael Brown - Executive Director, Investor Relations

Jeffrey Brown - Chief Executive Officer & Director

Christopher A. Halmy - Chief Financial Officer

Analysts

Moshe Ari Orenbuch - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Richard B. Shane - JPMorgan Securities LLC

Eric Beardsley - Goldman Sachs & Co.

Eric Wasserstrom - Guggenheim Securities LLC

Donald Fandetti - Citigroup Global Markets, Inc. (Broker)

Christopher R. Donat - Sandler O'Neill & Partners LP

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

David Ho - Deutsche Bank Securities, Inc.

John Hecht - Jefferies LLC

Kenneth Matthew Bruce - Bank of America Merrill Lynch

Operator

Good day, ladies and gentlemen, and welcome to the Ally Financial Second Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded.

I would now like to turn the conference over to Mr. Michael Brown, Executive Director, Investor Relations. Sir, you may begin.

Michael Brown - Executive Director, Investor Relations

Thanks, operator, and thank you everyone for joining us as we review Ally Financial's second quarter 2016 results. You can find the presentation we'll reference during the call on the Investor Relations section of our website, ally.com.

I'd like to direct your attention to the second slide of today's presentation regarding forward-looking statements and risk factors. The contents of our conference call will be governed by this language. I'd also like to note the third slide of today's presentation, where we have disclosed some of our key GAAP and non-GAAP or core measures. These and other core measures are used by management, and we believe, they're useful to investors in accessing the company's operating performance and capital measures that they are supplemental to and not a substitute for U.S. GAAP measures. Please refer to the supplemental slides at the end for full definitions and reconciliations.

This morning, our CEO, Jeff Brown; and our CFO, Chris Halmy, will cover the second quarter results. We'll have some time set aside for Q&A at the end.

Now, I'd like to turn the call over to Jeff Brown.

Jeffrey Brown - Chief Executive Officer & Director

Thanks, Michael. Good morning, everyone. Overall, we're very pleased with the operational performance across the entire company. And this was another high quality quarter, which demonstrates continued progress. Fundamentals are strong, the balance sheet is solid, credit trends are in line with our expectations, our auto and banking franchises has continued to strengthen and notably, we delivered on our promises of several major milestones.

Adjusted EPS was $0.54, an increase of 17% year-over-year. Keep in mind, the 17% includes the impact of unusually high weather losses in our Insurance segment, which was about $30 million worse than 2Q 2015 and cost about $0.04 of EPS. As you've likely heard from several other lenders, we also remain bullish on our auto lending and auto credit trends. The macro backdrop also doesn't give us reason to be concerned relative to the paper we are originating.

Labor market conditions remain favorable and U.S. economic growth at close to 2% is far from recessionary. Given the application flow we see, which by the way was another record quarter, we understand all of the different opportunities to book or not loans at the right economics. Our underwriting capabilities are a huge strategic advantage of Ally, particularly as we have seen plenty of credit cycles over the near 100 year history of the company.

We're also protected against any theoretical retraction in SAR, given over 40% of what we originate is pre-owned vehicle paper, which is a much larger market and arguably even more predictable collateral. So in that spirit, the Auto Finance franchise continued its focus on driving price in the marketplace and capturing high-quality returns relative to our risk appetite. Pre-tax income in the Auto Finance business was up 14% year-over-year, while the estimated risk-adjusted retail auto yield was up 44 basis points over the same period.

The lease book also performed very well and overall credit performance remain solid. Deposit growth continues at a torrid pace, with another $2.3 billion of retail deposits gathered, which is about $1 billion more growth than we posted in the comparable period last year. Momentum at the bank is pretty exceptional as consumer behaviors continue to shift towards digital and branchless banking. Our demographic trends remain powerful. More millennials keep coming, and you'll see from Chris, we've not observed any meaningful decline in the account balances.

Ally Bank has become an unbelievably strong franchise. We've got a highly respected brand and the bank is much more than a deposit gather, with even more on the horizon.

As you know, the vast majority of the additional products and services that we've announced will further expand our customer outreach and therefore earnings potential for our entire company. At today's equity price, our company is severely undervalued, given the earnings profile of our leading franchises and gives no value to the leading digital position we've established for the future.

Beyond the strong financial results, we also achieved major strategic milestones during the quarter. We received a non-objection on our 2016 capital plan, which enabled us to initiate our first common stock dividend and have the ability to repurchase our undervalued shares. We also made nice progress on our product expansion and deepening relationships with our large and growing customer base.

In June, we launched the Ally CashBack Credit Card, which is off to a great start and delivers a key product that our customers have been asking for. In addition, we completed the closing of TradeKing about a month ahead of expectations and we're working towards integrating the customer experience to bring together digital savings and investing products. This is another area where consumer preferences are in our favor and the call for digital investing platforms is expected to continue.

Slide number five contains additional details on our plan to optimize and deploy capital to shareholders. Last week, we announced our Board of Directors approved the cash dividend and share repurchase program. These actions combined total $850 million over the next 12 months and represent about 10% of Ally's current market cap. That's a sizable return of capital to shareholders.

First, the cash dividend of $0.08 per share of Ally common stock will be payable on August 15 of this year. Chris, Michael and I spend a lot of time with investors and we heard this was an important ingredient needed to attract new entrants into the stock, so we're optimistic that begins to play out.

Second, a common stock share repurchase program of up to $700 million was approved and management can effectuate the program for the third quarter of this year through the second quarter of 2017. Given that stock is trading at such a discount, this is a particularly important tool that we now have as we optimize returns and drive long-term value for our shareholders. Both of these actions we've had in our sights for quite some time and we're pleased to again deliver on our promise to investors.

Turning to slide number six. Beyond the capital distributions, let's walk through a few points from the CCAR process that speaks to the implied performance of Ally's retail auto loan book under a severely stressed environment. We're simply showing retail auto losses as that seems to be the big focus of the market, but keep in mind there's still about $50 billion more loans on the balance sheet with essentially a 0% loss rate. So let's walk through our view of our assets, the fed's stress view of our assets and why we feel confident in the assets under a variety of economic cycles.

On the bottom left chart of slide number six, our current trailing 12 month net charge-off rate is about 1.1%. In our stress analysis, the model brings our loss rate to 1.9%. In the fed's severely adverse scenario, which is beyond what has ever been experienced even in the financial crisis, the Fed used an implied stress rate of 2.6% to 2.8%. Using the Fed's stress numbers translates to roughly an incremental $1 billion in annual losses. And as a reminder, and to put this into perspective, over the last 12 months, Ally has posted pre-tax income of about $1.7 billion and we're trading at a $4 billion discount to book value.

We don't see any rationale to explain such a deep discount. And if you don't believe us, look at what CCAR just told you. Again, the balance sheet is very clean. The business fundamentals have been consistently strong. We're implementing our stated capital plan, which will offer distributions to shareholders. We continue to demonstrate discipline and rigor in our underwriting standards.

We continue to execute on all of our strategic priorities, including gradual diversification. We have ample capital levels to support the business, even in the most severely adverse stress scenario. We're pretty neutral in any interest rate path or scenario, no exposure to Europe or Brexit. We've got an adaptable, incredible management team that believes in long-term value creation for our stockholders, and again, the franchises, the brand and the company in total are market leaders.

So with that, I'm going to turn it over to Chris for more insights on the quarterly results.

Christopher A. Halmy - Chief Financial Officer

Thanks, JB. Turning to slide seven. We delivered another great quarter underpinned by sound fundamentals and strong operating performance. Our adjusted EPS was $0.54, up 17% from the prior year, and we continue to build book value at a good pace even after adjusting for the impact of the TradeKing acquisition.

Before I get into the detailed financial results, there are a couple of items to note impacting our key financial metrics. Our Insurance business incurred about $30 million of higher weather losses over the prior year due to severe spring hailstorms in Texas and Oklahoma. Specifically, one catastrophic event in early April is the fifth largest weather event in Ally history. These weather losses trimmed EPS by about $0.04 per share. If you exclude these outsized weather losses, our adjusted EPS was up 25% year-over-year, which is pretty remarkable.

On this slide we also walk the components of adjusted tangible book value per share, which benefited from a $98 million tax reserve release and positive unrealized gains in our investment portfolio due to the flattening yield curve which benefited OCI. This was partially offset by a $0.51 impact from the TradeKing acquisition.

On slide eight, net financing revenue excluding OID was $998 million, up $71 million or 8% year-over-year, driven primarily by improved margins. Other revenue of $374 million was up year-over-year by $160 million, due primarily to the liability management transactions last year. As a reminder, the liability management charges in 2Q of 2015 were excluded from our adjusted EPS number.

On the credit side, the quarterly decrease in provision expense was driven by seasonality, where the annual increase is due to the purposeful shifts in the portfolio we've highlighted for several quarters.

Total non-interest expense was $773 million, which we break out between controllable and non-controllable items. The quarterly decrease in controllable expenses is primarily driven by seasonally higher comp-related items in the first quarter where the year-over-year increase is due mostly to slightly higher expenses in mortgage and auto servicing. Other non-interest expenses were up both quarterly and annually from the weather-related losses I just mentioned.

Tax expense was down over $90 million from the prior quarter and $38 million from the prior year. In the second quarter, as we moved towards finalizing open items on our 2013 tax return, we released a large tax reserve that we were carrying associated with the deductibility of certain expenses related to our discontinued mortgage operations. While this reserve release benefited our GAAP results by $98 million in the second quarter, we did normalize our adjusted EPS for this item. You can see the impact in our effective tax rate for the quarter, which was approximately 14%.

These results drove GAAP net income of $360 million. Looking at some other key metrics, our adjusted EPS was up $0.02 this quarter and $0.08 annually. Core ROTCE of 9.7% was up over 140 basis points year-over-year and our adjusted efficiency ratio was 44%, which is in line with our targeted range.

On slide nine, we show the detail behind our earning assets and net interest margin. Let me make a couple of overall comments about interest rates before we dive in. With respect to interest rate positioning, we remain pretty neutral. We've anticipated that rates will stay lower for longer and as a result, we've positioned the balance sheet to be somewhat neutral, as you can see in our typical disclosure in the Appendix, but importantly, we're not a bank that's totally relying on rates increasing to see expanded profitability.

Second key point is that we continue to have a nice tailwind from a deposit growth perspective. As we grow deposits, we have a great opportunity to grow assets that meet our ROE hurdle rates and also take down capital markets funding. Both of these options will continue to drive EPS growth going forward.

For this quarter, you can see NIM excluding OID was 2.72%, up 14 basis points year-over-year and up 9 basis points quarter-over-quarter. There are very few banks that have been expanding NIM in this interest rate environment, but we've been able to leverage our position in the marketplace to achieve better margins.

Our asset yields have continued to rise as we prioritize originating auto loans that offer higher risk-adjusted returns and profitability. Year-to-date, we have put on retail loans at over 5.8% average yield, which is starting to really drive up the overall retail portfolio yield. This is a key focus for us, as we manage the risk adjusted yields or yield relative to our expected charge-offs. And we've continued to sell some of the lower yielding, less profitable loans for balance sheet management purposes, which drives up that yield as well.

We also had continued strong lease performance with solid used vehicle prices, so we saw some favorability in that line item this quarter. There isn't much movement on the cost of fund side, as we didn't have any unsecured debt maturities in the second quarter. However, we see long-term opportunities for improved cost of funds as deposits replace market-based funding over time.

Looking at deposits on slide 10. We continue to see phenomenal growth with retail balances up $2.3 billion quarter-over-quarter and $9.5 billion year-over-year. We now have over $72 billion in total deposits, which makes up around 52% of our funding. Deposit growth is a big strategic advantage for us as it will continue to lower cost of funds, provide stable funding for all economic cycles and generate more customers for us to sell our expanded products.

We've continued to grow new customers at a very good pace of over 40,000 this quarter. Millennials continue to make up our largest segment of growth from a demographic perspective. Many people associate millennials with lower balance accounts, but we've actually stayed pretty efficient from that perspective with average customer balances of $50,000 to $55,000. All of this points to annual deposit growth of over $10 billion, which is a big tailwind for us in continuing to deliver strong EPS growth in 2017 and beyond.

On slide 11, our fully phased-in Common Equity Tier 1 ratio increased this quarter to 9.3%, as we booked consistent earnings and further utilized our DTA. Our DTA continues to decline as we post strong earnings, although the tax reserve release I mentioned earlier did slow that decline this quarter.

In the second quarter, we redeemed our Series A preferred stock, so we will no longer have any preferred dividends, which will also benefit our EPS going forward.

Moving to slide 12 on asset quality. Before I go through the numbers, we know there's a lot of interest in asset quality across the industry. Therefore, we'll be following up with an additional call for analysts and investors next week to talk more about this topic on credit with our leadership team in auto and risk. We want to make sure there's no misperceptions about auto lending or how we manage credit risk. Stay tuned for a press release later today with details about the call.

Back to the slide. Consolidated annualized charge-offs for the quarter were 54 basis points, down 10 basis points quarter-over-quarter and up 15 basis points year-over-year. Overall credit continues to perform well across the portfolio. On the commercial side, our dealers are strong and we continue to see a pretty healthy U.S. consumer. Focusing on the retail auto loan portfolio in the bottom right, total charge-offs for the quarter were 94 basis points.

As we've been saying for some time, you should continue to expect modest year-over-year increases, given the mix optimization that has been underway for a while now. We added the dash line this quarter, since our asset sales have the effect of lowering the denominator of our book as we generally sell lower yielding but lower loss loans. These loan sales have contributed to raising the charge-off rate on auto loans by about 6 basis points this quarter.

In the bottom left, our 30 plus day delinquency rate of 2.6% increased from the seasonal low point in 1Q. Overall, the fundamentals of the business continue to be very solid on the risk side. We prudently manage the risk in our portfolio. It's a competitive market, but we see large players acting mostly rational and we feel good about the loans we were able to buy, given all the applications that we're sourcing.

We've modestly shifted the profile of the loan portfolio and we're getting more than compensated for the modest increase in the risk through additional yield capture.

Looking briefly on slide 13, which drills down more into the drivers of the overall portfolio loss rates. In general, a very clean low loss balance sheet. If you look across these four main buckets of assets, they are all largely prime, short duration loans. I will also remind you that these loans are all secured by collateral, which provides greater incentives for borrowers to honor their obligations and reduces loss volatility in the downturn.

Obviously, retail auto gets most attention, but we have $35 billion of commercial auto loans that rarely lose any money. Our mortgage loans are predominantly high FICO, low LTV prime jumbo loans and the Corporate Finance loans are senior secured loans that have actually had net recoveries for most of the quarter shown here.

And then, you have retail auto loans, which make up about $63 billion of the $113 billion loan portfolio and $158 billion balance sheet. We spent a lot of time at our Investor Day talking about risk management on that portfolio and can spend more time on our call next week, but we feel very good about the dynamics of that portfolio and maintaining solid profitability through cycles.

Now, let's turn to slide 14 to go through the segments. Auto Finance had an excellent quarter, as we reported $426 million of pre-tax income in 2Q. Total net revenue is up 11% year-over-year, which drove a 14% increase in pre-tax earnings, despite no increase in the balance sheet.

As we've mentioned previously, we're focused on improving the returns in the auto business and optimizing the capital. As you can see, with the increased profitability this quarter, our strategy is working. Quarterly originations were solid at $9.4 billion supported by record application volume and the strength of the franchise in the marketplace.

Looking at the chart in the bottom right, we've broken out our origination mix by FICO band. You can see, we've been doing a bit less non-prime in 2016, but obviously FICO is just one aspect of credit risk. And you also have to consider things like term and other structure attributes with a tremendous focus on layered risk, that all gets reflected in our pricing loss assumptions, or our NAALR, which we disclose in the table in the far bottom right.

Our NAALR is up 12 basis points year-over-year, but that compares with 55 basis point increase in yield driven in part by some of the pricing initiatives we've made in the marketplace this year. So that is really the blocking and tackling of the business and our core competency, be the best financing provider for dealers, while continuing to optimize loan pricing relative to the risk and also relative to the volume being put on the books. Overall, we feel great about what the business has delivered.

On slide 15, you could see our origination channels in the top left, where the mix is starting to stabilize, given the shift away from the subvented business. And in the top right, you can see the mix by segment is also starting to stabilize with used car lending over 40% again.

The bottom two charts summarize the balance sheet. On the consumer side, we continue to see lease decline at a good pace, being replaced by loans on balance sheet as well as auto loan service for others. And on the commercial side, we continue to see strong balances as dealer inventory has recently been more skewed towards higher-priced trucks and SUVs on their lots, yet days of inventory remains very healthy.

On slide 16, Insurance reported a pre-tax loss of $18 million, again, the main driver of the variance both year-over-year and quarter-over-quarter was a significant increase in weather related losses we experienced. The level of damage from hail, particularly in April, was unusual, but can happen from time-to-time. Aside from weather, the business continues to deliver steady results and is obviously a key component of our overall offering to dealer customers.

On slide 17, we show results for the Mortgage Finance segment. As a reminder, we split out our ongoing mortgage business this year and moved the legacy portfolio, which includes loans originated prior to 2009 to the Corporate and Other segment. While this segment continues to be relatively small, it was a more meaningful contributor to earnings with $9 million of pre-tax earnings. We bought about $1 billion of prime jumbo loans this quarter as the asset base continues to grow modestly. We would expect to see more meaningful growth in earnings from this segment when we get some limited direct originations up and running towards the end of the year.

Slide 18 gives the results from Corporate Finance, which reported pre-tax income of $14 million. We continue to see positive net financing revenue trends driven by a growing asset base, which was up almost $900 million year-over-year. Provision was down slightly quarter-over-quarter and year-over-year.

As we've mentioned, Corporate Finance is a great profitable business that we expect to continue to grow. As we mentioned TradeKing briefly, the integration is well underway and we're excited to bring over their seasoned management team to run the business. We closed TradeKing in June, so we had one month of financial results that were essentially breakeven and are included in our Corporate and Other segment for the time being. We expect to ramp up that business after we get the rebranding and marketing going early next year.

So, overall, we're very pleased with the fundamental results in our businesses and delivered another solid quarterly performance.

And with that, I'll turn it back to JB to wrap up.

Jeffrey Brown - Chief Executive Officer & Director

Thanks, Chris. Let me wrap up very quickly on slide number 19. Our plan to grow EPS is well underway, and as you heard, a 17% improvement in adjusted EPS in the second quarter. And I just encourage you to look at the 17% relative to the year-over-year comps across banking. Frankly, we feel like we're a unique story in banking given some of the self-help opportunities we have on our side, such as having now eliminated all preferred dividends, pursuing a long runway for deposit growth to replace capital markets and expense of funding, achieving the ability to conduct share repurchases, which is incredibly accretive given where the stock is trading, and implementing a product expansion philosophy that is thoughtful and prudent in its use of capital while also planting the seeds for future profits and revenue diversification.

Our Auto Finance business is competitively advantaged, well-balanced between new and pre-owned loans, and a respected leader in the marketplace. The strengths of our model have been demonstrated time and time again and this positions us for stable and resilient returns through market cycles. And lastly, our digitally-driven banking approach is sound, successful, more cost-effective and well-positioned for the future.

So, with that, let's turn it back to Michael for your Q&A.

Michael Brown - Executive Director, Investor Relations

Thanks, JB. As we do move into the Q&A session, we request that you please limit yourself to one question, plus a single follow-up. If you have additional questions after the Q&A session, the IR team will be available after the call.

Operator, if you could please start the Q&A?

Question-and-Answer Session

Operator

Thank you. Our first question is from Moshe Orenbuch with Credit Suisse. Your may begin.

Moshe Ari Orenbuch - Credit Suisse Securities (USA) LLC (Broker)

Great. Thanks. I was intrigued by the commentary about kind of the asset sales and the impact on the yield and indirectly on the credit loss. Can you just talk about that strategy and how you see that affecting returns? I mean, I guess you're 9.7%, if the $700 million were bought back, you returns would be over 10%. How do you see that evolving, given those two strategies of buyback and (28:21)

Christopher A. Halmy - Chief Financial Officer

Moshe, I wouldn't necessarily say it that way. When we sell the loans, we're obviously looking at selling loans that are low return on equity loans that basically have low margins on it and therefore low losses. So, one of the main strategies that we've really laid out this year for the auto business is really trying to optimize the ROE of that business. And part of the way we're doing that is, while we originate across the spectrum, we're looking at a lot of the super prime loans, where we don't see the real profitability and looking to sell those loans. While we do that, we do keep servicing. So, we do get some servicing income from that. But – so, overall, it helps the yields of the portfolio, because they're low yields, but it obviously affects the charge-offs as well.

Moshe Ari Orenbuch - Credit Suisse Securities (USA) LLC (Broker)

Sure. But when you think about the ROEs, I mean, how do you see that progression, given that you're now buying back stock as well? Like how could (29:24)

Christopher A. Halmy - Chief Financial Officer

Yeah. So – you want to go ahead?

Jeffrey Brown - Chief Executive Officer & Director

No, go head.

Christopher A. Halmy - Chief Financial Officer

So when I think about the ROEs of the overall company to the extent that the auto business stays somewhat flat, we improved the returns in the auto business and therefore, we returned that capital to shareholders through future buybacks or dividends.

Jeffrey Brown - Chief Executive Officer & Director

But, Moshe, I think consistent with that we put out to the Street fully on target for double-digit return on equity exiting this year and our sights are on some even bigger and broader than that. I think long-term targets closer to that 12% range. And that's driven by a variety of factors that we talked about, One being capital normalization optimization, which now comes through being able to buy back shares, but also that big funding component that we've talked about for quite some time. As you get more deposits into the house, you can fund more assets into the bank. Normalized there, that's a huge long-term opportunity for us to recognize as well.

The only other thing I'd just point out on the loan sales, which sometimes we get a chuckle when we think about the sizable discount to book, is because the loan sales that came off during the quarter all were at a gain. So we're moving assets at a gain I think should send a signal about the overall quality of the book.

Moshe Ari Orenbuch - Credit Suisse Securities (USA) LLC (Broker)

Great. Thanks very much.

Jeffrey Brown - Chief Executive Officer & Director

Thanks, Moshe.

Operator

Thank you. Our next question is from Rich Shane with JPMorgan. You may begin.

Richard B. Shane - JPMorgan Securities LLC

Thanks guys for taking my questions. So, I'd love to – I'm really intrigued by slide 14 where you show the originations and the NAALR, and I think this ties a little bit into Moshe's question as well.

When we look at the year-over-year change in FICO mix, it doesn't seem from an origination perspective like there's a big change. Is the difference in the higher NAALR a function of what you're selling off, because this only shows originations and doesn't show what's retained, or is there also an impact of collateral in your expectations on collateral? And related to that, are you changing your LTV requirements on loans?

Christopher A. Halmy - Chief Financial Officer

Yeah. We're not – we haven't changed our underwriting requirements on loans. So, we haven't had a shift there. When we look at our originations, because we play across the spectrum, we look where we can get the best risk-adjusted returns. And that could change on a quarterly basis. And one of the reasons we laid out both for FICOs as well as our NAALR here is to really show that you can't just look at FICO when you're trying to determine what the expected loss is going to be. There's a lots of other attributes; term, LTV, PTI, DTI. So, there's a lot of terms where the underwriting is much more sophisticated than looking at a FICO.

It's important, and one of the reasons we like to lay this out is to show that overall from a loss perspective, you should see our book migrate towards that NAALR. And when we do asset sales and we've done about $4 billion of asset sales in the first half of the year, and I would say that's higher than normal, which is one of the reasons we showed a little bit of a dotted line in the effect on charge-offs, but when you do those loan sales, it obviously has the effect of moving up the overall loss rate for the company.

Having said that, when we look at the pricing expectation of those loans and the loss expectation when we price them, we are in line; we feel very comfortable with that. The other thing I just want to mention is, we watch the U.S. consumer very closely, we watch early warning indicators very closely, and right now, we see a very healthy U.S. consumer. We're not seeing real concerns about early warnings of the U.S. consumer headed down.

Richard B. Shane - JPMorgan Securities LLC

Hey, Chris, thank you for unpacking all the different questions here. I'm just going to ask one last follow-up. Is that estimated NAALR based on the originations or is that based on what's retained?

Christopher A. Halmy - Chief Financial Officer

No, just the originations.

Richard B. Shane - JPMorgan Securities LLC

Okay, great. So, the actual NAALR for what is retained, given the mix shift that you're describing should be tad higher than this?

Christopher A. Halmy - Chief Financial Officer

Just a tad higher. That's exactly.

Richard B. Shane - JPMorgan Securities LLC

Great. Okay. We look forward to hearing about this next week. Thank you.

Christopher A. Halmy - Chief Financial Officer

Thanks, Rick.

Operator

Thank you. Our next question is from Eric Beardsley with Goldman Sachs. You may begin.

Eric Beardsley - Goldman Sachs & Co.

Hi. Thank you. Just on the charge-off trend again. I guess relative to the guidance back from the Investor Day in the fourth quarter earnings call for that 10 basis point to 15 basis point year-over-year increase in charge-offs, I guess how should we think about that with this quarter? I mean, are we going to see you revert to that trend or is this quarter sort of an outlier?

Christopher A. Halmy - Chief Financial Officer

No, I don't think the quarter is an outlier. I think on a quarterly basis, we obviously go when we originate the loans where we think we're going to get the best risk-adjusted spread. So, based on the guidance that we give you today is that the charge-offs in the book and the overall charge-offs will start migrating towards that NAALR. We'll continue to be transparent with that. So, to the extent that the dynamics in the industry change and we can get good risk-adjusted spreads up or down from there, we'll do that.

But based on previous guidance I've given, what I would say is the loan sales have affected that a bit, because we've been much more aggressive in loan sales in the first half of the year than we originally anticipated. And given where we've seen the opportunity in the book and what we've started originating in the first half of the year, that's also going to affect that previous guidance.

Eric Beardsley - Goldman Sachs & Co.

Got it. So, the plus 23 basis points, if we strip out the loan sales from this quarter, maybe it's not 10 basis points to 15 basis points, but perhaps somewhere in between that level and where we are now, based on what you're originating today?

Christopher A. Halmy - Chief Financial Officer

Yes. If I look at the average NAALR of what we've put on the books for the last year, it's somewhere between 1.15% and 1.20%. So I would say, it's going to be in that range adjusting for loan sales.

Eric Beardsley - Goldman Sachs & Co.

Terrific. Thanks. And then I guess as we think about what you're putting on today, then is there any expectation that you're going to continue to take price and we should see those yields step-up, or do you feel like we're in a stable environment here from an underwriting perspective?

Christopher A. Halmy - Chief Financial Officer

I feel like we're in a stable environment at the moment. We've really taken price throughout the first half of the year. We're holding it as we've come into July here. I wouldn't say that the competition has gotten more aggressive or less aggressive. So I think based in this environment, we think pricing will stay steady.

Eric Beardsley - Goldman Sachs & Co.

Okay, great. Thank you.

Jeffrey Brown - Chief Executive Officer & Director

Thanks, Eric.

Operator

Thank you. Our next question is from Eric Wasserstrom with Guggenheim. You may begin.

Eric Wasserstrom - Guggenheim Securities LLC

Thanks very much. Chris, can you talk a little bit about at this point what your intent is in terms of the funding mix for the back half and maybe on a – however long you have visibility if it's a three quarter, four quarter outlook, particularly with respect to the term debt that's coming through, whether it's your intent to refi that or pay it off using deposit funding, or how you're thinking about the liability structure?

Christopher A. Halmy - Chief Financial Officer

Yeah. We have about $1.5 billion, a little – slightly less than that of unsecured debt maturities in the second half of 2016. A lot of that honestly is lower cost debt that we put on around three years ago. So, it's not some of the high cost debt. So it shouldn't have a big effect on cost of funds, but we do not expect to refinance that with other unsecured debt. We expect to refinance that with really deposits and the growth in the deposit base. The bigger leg down really and from a cost of funds perspective will be in 2017, where we have about $4.5 billion of unsecured debt maturities, which once again we don't expect to use additional unsecured debt. We expect continued growth in the deposit base and that growth in the deposit base will be couple with migration of more assets into the bank, which will really replace that unsecured debt.

As deposits grow, and we're growing them around $10 billion a year, not only will the unsecured debt come down, we'll also replace some of the secured debt that we either do through some of our private facilities or through the ABS market. So, it really is a nice tailwind for us from a cost of funds perspective. You think about the average deposit rate of 1.11% today and when you think about the securitizations being somewhere in the 1.5% to 2% range and obviously unsecured debt being in a 4.5% range, we have a pretty good tailwind going forward on cost of funds.

Eric Wasserstrom - Guggenheim Securities LLC

And the average coupon on that 2007 maturity debt, what is it currently?

Christopher A. Halmy - Chief Financial Officer

In 2017?

Eric Wasserstrom - Guggenheim Securities LLC

Yeah.

Christopher A. Halmy - Chief Financial Officer

I don't know off the top of my head, but I would expect it would be somewhere in the 4.5% range.

Eric Wasserstrom - Guggenheim Securities LLC

4.5%. Okay. And then, lastly just on your operating expense, ex-Insurance, I think was somewhere around $480 million in the quarter. How do we think about that level going forward? Is there a still downside opportunity or is that sort of a run rate level and we should really think about operating leverage?

Christopher A. Halmy - Chief Financial Officer

Yeah. I'd guide you to look at the operating leverage. We are really committed to keeping the efficiency ratio in the mid-40% range, so – because we were around 44% this quarter. We think 44%, 45%, somewhere in that range should really hold. We're obviously continuing to make investments in the business, particularly on the technology side and really the rollout of some of our digital products. So, we're not in cost cutting mode, but we will be very conscious around cost and make sure that we keep the efficiency ratio in the right spot.

Eric Wasserstrom - Guggenheim Securities LLC

Great. Thanks very much.

Michael Brown - Executive Director, Investor Relations

Eric, it's Michael. If you look at the Investor Day presentation, we do have all the coupons on the last slide of that presentation, but we can also get that over to you as well. It's on our website.

Eric Wasserstrom - Guggenheim Securities LLC

Great. Thanks, Michael.

Operator

Thank you. Our next question is from Donald Fandetti with Citigroup. You may begin.

Donald Fandetti - Citigroup Global Markets, Inc. (Broker)

Yes. Jeff, I was wondering if you can talk a little bit about on the strategic front what your plans are for diversification and how that might play into acquisitions?

Jeffrey Brown - Chief Executive Officer & Director

Yeah. Thanks, Don. I mean, I think obviously the TradeKing acquisition is kind of well underway integrating. And as Chris mentioned, we would think back half of this year, probably even more first quarter of 2017, as when that really gets to look and feel and be branded like Ally. And so, for now, I think the near-term focus is very successful integration and preparing for the customer rollout there.

Simultaneous that also that Chris mentioned, we are working on our direct mortgage origination capability, which we expect to be online fourth quarter of this year. So, that will give us some opportunity to go out and originate mortgages with our Ally family of customers, mortgages and another requested product. And as you know and as you've heard, we've been pretty active in buying jumbos for quite some time, but it'll be nice to have a modest origination capability.

We will not retain any MSR and we will have very, very, very modest rep and warranty risk. So, it's a very different model than maybe GMAC of the past, but we think mortgage is another natural credit product to extend there.

The credit card rolled out this past quarter. It's off to a great start. I think also as you know, that's an affinity relationship. So, it is not a balance sheet product, but I think our focus would be several years down the road, if we're comfortable with the performance of the book and that really is resonating with the Ally family of customers, that would be another product that we would look to bring on balance sheet.

On top of that, within our Corporate Finance business, which, again, U.S. secured middle market lending, very clean collateral ROEs in the upper teens, that's another business that we seek to expand. And then within auto, you continue to try to find opportunities to optimize the book. So, you hear a lot of what we're doing on the origination front, but there's also small verticals that are sitting inside of auto that are more focused on small business, our commercial services group, some of the transportation finance opportunities there that we continue to explore.

So, within auto, I think, strategically, we think the footprint is probably about as big as it gets. We're comfortable originating in this $36 billion to $40 billion type of range on an annual basis, but I don't think, absent something strategic, you'd expect something much broader than that on the auto side. So, most of the focus comes back on the development of all these consumer banking products outside of Ally Bank.

On the acquisition front, again, I think near term, we're focused on executing priorities at hand, returning capital to shareholders though the dividend and through buybacks. And given where the stock trades today, it would be very hard to think about doing any type of sizeable deal, and through time that could change and we'll reprioritize at that point in time. But right now, it's more closing and consistent execution, Don.

Donald Fandetti - Citigroup Global Markets, Inc. (Broker)

Got it. Thank you.

Jeffrey Brown - Chief Executive Officer & Director

Thanks, Don.

Operator

Thank you. Our next question is from Chris Donat with Sandler O'Neill. You may begin.

Christopher R. Donat - Sandler O'Neill & Partners LP

Hey, good morning. Thanks for taking my questions. For Chris, I want to ask on a modeling side, should we be thinking about some upward pressure on the net interest margin as you've got – assuming originations stays sort of the same mix you have and then the mix that rolls off your back book, does that put upward pressure on?

Christopher A. Halmy - Chief Financial Officer

The net interest margin in the third quarter actually expanded greater than I had even given previous guidance to -

Jeffrey Brown - Chief Executive Officer & Director

Second quarter.

Christopher A. Halmy - Chief Financial Officer

... to second quarter. Sorry. So, as I look to the third quarter, I expect that at least on a year-over-year basis we'll still have pretty good expansion in the net interest margin. Because the seasonality in the fourth quarter, because commercial balances are usually higher in the fourth quarter, our NIM comes down, but I think overall from a year-over-year basis, I do see an expanding NIM. As we continue to put on these loans at the 5.8% type yields in the auto space, I do expect that the overall yields will continue to migrate up. I don't see a lot of cost of funds opportunities for the second half of this year, but I do see those cost of funds opportunities longer-term. So, I still think we're in a stable to expanding net interest margin environment.

Christopher R. Donat - Sandler O'Neill & Partners LP

Okay. And then just wanted to ask a different question about the stress scenario you laid out or mentioned on slide six, the 1.9%. Because I agree with your point that I think there's a bit of a disconnect between what the market expects, as far as where auto credit is going and what's a stress scenario. So, can you give us maybe a little color around what else would be going on for a 1.9% net charge-off ratio? Are there other like parts of that including GDP or used-car prices or something you can share with us?

Christopher A. Halmy - Chief Financial Officer

Sure. I mean, in this scenario, you need unemployment well over 10% and you need GDP basically crashing to a recession. In that CCAR scenario, things were worse than the 2008 recession. So, you see a pretty dramatic downturn in the U.S. economy for something to get as bad as getting our losses up to the 1.9%. So, I don't want to give anybody the impression that that's what we expect in a normal recession, it's not. That's what we expect it to be in a pretty severe recession. In that used car prices also fall dramatically. So, this is in our estimation some of the worst of the worst.

Christopher R. Donat - Sandler O'Neill & Partners LP

Okay, got it. Thanks very much, Chris.

Operator

Thank you. Our next question is from Sanjay Sakhrani with KBW. You may begin.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

Thanks. Good morning. A quick clarification on the yield. When I look at the auto lease yield, that was up a fair amount. Is that a sustainable level there?

Christopher A. Halmy - Chief Financial Officer

The auto leases are obviously coming down. So, they're just above $11 billion today. Balances on the yield has been helped by some of the used car prices staying better than we would have expected. We're still seeing gains on off-lease vehicles over $1,000 per vehicle. So, a lot of that goes into that yield and that yield is once again higher than I expected.

I previously had given guidance that we expect our lease yield to be between 6% and 7%, somewhere in that range. So, we're well above that today. As the lease book comes down and used car prices continue to normalize, I do expect those yields to really come down in the lease book, but we've been surprised to the upside. So, we'll see. But it's becoming a smaller and smaller portion of the book is an important point.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

Okay. And you guys kind of hit on the competitive environment. It seems like, generally speaking, your fundamentals have been quite resilient and arguably slightly better in terms of originations maybe even relative to the past. Could you just talk about it a little bit? I mean, why are you able to see such good quality paper?

Christopher A. Halmy - Chief Financial Officer

A lot of this goes back to the relationship we have with our dealers. And we see lots of application flow and we're often the first look on these applications. And when you think about over 18,000 dealers that we have relationships with, we have the ability to really pick our spots and approve loans that we think come with the best risk-adjusted returns, and those relationships go a long way. We've been saying for the last couple of years, this is not a commodity business, and that's important. We know how to underwrite these loans, we have a core competency in really understanding risk and where we expect losses to go and how to price for that.

So, a lot of this has to do with our expertise and our dominance in this market and our relationships with dealers. And it's working extremely well for us.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

Okay, great. One last question on the DTA, how should we think about the utilization of the capital that's created with that over the course of the year, now that we've gotten see CCAR past us? Thanks.

Christopher A. Halmy - Chief Financial Officer

What you should think about is the DTA will obviously continue to just come down with earnings, but we have the disallowed DTA piece, which is a little over $750 million. So, we expect to really start burning through that as well. The guidance that we give, and I think I previously gave, it's probably somewhere at $300 million to $400 million on an annualized basis, a decrease. So – and that goes into capital over time. (49:53) Excuse me?

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

Can you utilize that in any way?

Christopher A. Halmy - Chief Financial Officer

Sure, you can, but my view has always been we need to earn through that capital prior to asking through the CCAR process the ability to use it. So, do I think that over time this is real capital that gets utilized either through growth in the balance sheet or through incremental distributions? The answer is yes.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

Okay, great. Thank you.

Jeffrey Brown - Chief Executive Officer & Director

Thanks, Sanjay.

Operator

Thank you. Our next question comes from David Ho with Deutsche Bank. You may begin.

Jeffrey Brown - Chief Executive Officer & Director

Hey, David?

David Ho - Deutsche Bank Securities, Inc.

Hey, good morning. Can you update us on how much of your below 620 FICO loans are being funded at the bank and kind of the progress on getting eventually 100% funded at the bank?

Jeffrey Brown - Chief Executive Officer & Director

Yeah. So, David, it's JB, I'd say we keep working and having active discussions with our regulators on trying to normalize the funding regime and what we can book at Ally. I still believe in my heart, the regulators do seek to treat us consistently with every other institution. So we've made progress. I think roughly 85%-ish of loans that we're booking today are getting funded at Ally Bank. So, a year ago, that was closer to 70%, 75%, but obviously I think our end state is trying to get basically 100% there.

We still are not able to fund the 620s at the bank today. We would hope that would be something that we would cross over next year at some point in time. And part of this is steps you lay out to sort of normalize the level of capital that's required at the bank, and then step two, being able to book a more reasonable or total funding mix. So we continue with those discussions and long-term, I think that presents pretty good opportunity for us.

David Ho - Deutsche Bank Securities, Inc.

Great, right. And that's obviously not baked into your NIM expectations near-term...

Jeffrey Brown - Chief Executive Officer & Director

Correct.

David Ho - Deutsche Bank Securities, Inc.

... or longer-term? And then, circling back on the credit cost overall, fully appreciate the comments on the NAALR and the loss rates, but taking a look at reserve increases, it seemed a little lighter this quarter despite the migrating higher NAALR. Is that just really just growth slowing down a little bit based on your origination forecast and just a little bit of the mix? How do we think about the reserve methodology?

Christopher A. Halmy - Chief Financial Officer

On a year-over-year basis, we did grow in the retail portfolio. So some of the provision we have is due to growth, but it is slower than we've seen in some of the prior quarters. We're also carrying a coverage rate of 1.36%. So, if you think about the guidance that I just gave, somewhere between that 1.15% to 1.20% normalized for loan sales, we're still keeping a pretty robust coverage rate on the provision. So – and then to the extent that the NAALR or the expected losses in our future originations stay in that range, I would expect that our overall coverage rate would be somewhere in that range as well.

David Ho - Deutsche Bank Securities, Inc.

Okay, great. Thanks.

Operator

Thank you. Our next question is from John Hecht with Jefferies. You may begin.

John Hecht - Jefferies LLC

Thanks very much. And most of my questions have been asked, but one, Chris, it sounds like you insinuated it's become a relatively stable competitive environment where you're not seeing much fluctuation in either pricing or terms. I'm wondering is there any channel or maybe loan type where you are seeing the ability to improve either term or price as some of the lenders begin to pull back in certain categories?

Christopher A. Halmy - Chief Financial Officer

Yeah. I mean, let me make a comment about the competitive environment. When you think about the top 20 lenders in this business, they are the same guys who've been around for 10 years and they have been around a long time doing this business beyond 10 years. So, it's a pretty rational group of players. Now, in any given quarter, there are players who will take more risk or take less risk, and they'll do that either through underwriting policy or through pricing and you see that. And you've heard some of that on calls in the last couple of weeks where people have either dialed up originations in a certain segment or have dialed down originations in a certain segment.

For the first half of this year, we've really focused on what we consider the belly of the credit curve. Somewhere in that 600 FICO to 650 FICO, you've seen our used cars really increase – our used cars penetration increase. And that's where we're seeing some of the best profitability. I wouldn't say that really changed this quarter, and it's been pretty steady for us, but to the extent that the competitive dynamics change in any one of these segments, we're prepared to either pull back or go in. And this is some of the dynamics and ongoing dynamics of how this really auto lending environment works. So – so, right now, things are on the margin, but we feel pretty good about where we're playing in the credit space.

John Hecht - Jefferies LLC

All right. And my follow-up has been asked. So, thanks very much.

Christopher A. Halmy - Chief Financial Officer

Thanks.

Jeffrey Brown - Chief Executive Officer & Director

Thanks, John.

Operator

Thank you. Our next question is from Ken Bruce with Bank of America Merrill Lynch. You may begin.

Kenneth Matthew Bruce - Bank of America Merrill Lynch

Thank you. Good morning. I guess my questions, some relate to some of the earlier questions and comments. Looking back at this past quarter, you sold about 17% of originations. It looks like it's about that same amount for the last year. Is that really a targeted level of sales that we should be modeling just for purposes of trying to size up what the balance sheet looks like?

Christopher A. Halmy - Chief Financial Officer

No. I mean, previously, we sold around – of the $41 billion of originations last year, we're aiming to sell around $3 billion. We've sold $4 billion already in the – over $4 billion in the first half of this year. So, we've ramped that up a bit. I think that's expected to slow in the second half of the year. I do expect to sell some incremental pools of loans, but not necessarily at that same rate.

Some of this really has to do with where our origination volume is. And if you think about our overall book, if we originate somewhere between call it $35 billion to $40 billion, we amortized this book about $35 billion a year. So, in order to keep the book somewhat what I would call steady from a size perspective, we'll use loan sales. So, depending on where that overall origination volume is will depend on how much we sell from a loan sale. Also depends on where the market is. We see the market for loan sales today being very robust in the first half of the year, that obviously changes. So we're not – I want to be careful to say this. We're not in the originate and distribute business, okay? We originate loans that we're happy to keep on balance sheet. However, while shell (57:25) loans for, what I would call, balance sheet management purposes when we see the ability to improve returns in the overall balance sheet. So, that's an important differential here. So, I would guide you to say, look at our overall retail loan portfolio, both retail and lease, and we expect that to stay somewhat steady from a balance perspective going forward.

Kenneth Matthew Bruce - Bank of America Merrill Lynch

Okay. No, that's helpful. And I guess, we shouldn't really read into it from the perspective that you've pointed out that you can sell loans at gains and ultimately buy back stock at a pretty significant discount, that could lead one to believe that you might be looking to shrink the balance sheet and actually accelerate buybacks. Obviously, CCAR is done for this year, but in the future. So we really shouldn't expect something of that nature.

Christopher A. Halmy - Chief Financial Officer

No at this point.

Kenneth Matthew Bruce - Bank of America Merrill Lynch

Okay. And maybe if I can just get one last question. And I guess you point out that the lease remarketing gains have been – they're really strong in the quarter, certainly more than we had expected, and we've heard comments from some others that some of the prices received at auction don't necessarily match up with what the Manheim is. Is there any kind of difference in terms of the mix of business that you all are getting back from a lease rollover point of view that's leading to that better performance? And then separately, lease volume itself has ticked up significantly in terms of new car sales. And I don't know if you kind of view that any differently today than you have in the last year and how you talk about it, but any thoughts around the pickup in lease activity just on the new car sales side would be helpful as well?

Christopher A. Halmy - Chief Financial Officer

Yeah. The advantage we really have on the off-lease vehicles is our SmartAuction platform, which allows dealers across the U.S. to buy these cars at wholesale prices. And when we distribute cars through our SmartAuction platform, we're able to realize a higher value than the physical auctions and we're able to distribute the cars much quicker. Okay? So, it's not like we have to wait around until the next physical auction and it takes 30 days or 40 days to do that and we don't have to transport vehicles around the country.

So, from a cost perspective, it's cheaper and we realize a better value. So, that is one of the reasons we've always been very comfortable with lease. It's one of our core competencies and one of the reasons that you can't just look at Manheim. I think Manheim is directional if you want to understand what's happening in the used car prices, but obviously it doesn't necessarily directly correlate to the gains or losses we get in our book.

When it comes to the overall lease penetration or lease volume in sales, it's obviously something that we watch pretty closely. And the biggest concern you obviously have is cars that are getting leased today in three years or four years are coming off and they become used cars at that point. It could put pressure on – continue to put pressure really on the used car prices as supply goes up. Where we've been surprised over the last year or two years really is that demand for used cars has really kept pace with that supply, but obviously that could wane in the future. So, you have to be careful of that.

On the opportunity side, however, because Ally is such a large used car lender today, we look at those off-lease vehicles as great opportunities for us to put back into loans and really drive our originations going forward. So, that's a couple of things for you.

Kenneth Matthew Bruce - Bank of America Merrill Lynch

Great. Thank you very much. Appreciate it.

Michael Brown - Executive Director, Investor Relations

Okay, great. That's all the time we have this morning. If you do have any additional questions, please feel free to contact Investor Relations. Thanks for joining us this morning. Thank you, operator.

Operator

You're welcome. Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day.

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