Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  
TRANSCRIPT SPONSOR
Wall Street Breakfast

E*TRADE Financial Corporation (ETFC)

Q2 2007 Earnings Call

July 25, 2007 5:00 pm ET

Executives

Mitchell Caplan - CEO

Jarrett Lilien - President, COO

Robert Simmons - CFO

Analysts

Rich Repetto - Sandler O'Neill

Matt Snowling - FBR

William Tanona - Goldman Sachs

Prashant Bhatia - Citigroup

Michael Vinciquerra - BMO Capital Markets

Mike Carrier - UBS

Michael Hecht - Banc of America

Roger Freeman - Lehman Brothers

Howard Chen - Credit Suisse

Matthew Fischer - Deutsche Bank

Presentation

Operator

Welcome to E*TRADE Financial Corporation's second quarter 2007 earnings conference call. (Operator Instructions) I have been asked to begin this call with the following Safe Harbor statement:

During this conference call, the company will be sharing with you certain projections or other forward-looking statements regarding future events or its future performance. E*TRADE Financial cautions you that certain factors, including risks and uncertainties referred to in the 10-Ks, 10-Qs, and other reports it periodically files with the Securities and Exchange Commission, could cause the company's actual results to differ materially from those indicated by its projections or forward-looking statements.

This call will present information as of July 25, 2007. Please note that E*TRADE Financial disclaims any duty to update any forward-looking statements made in the presentation.

In this call, E*TRADE Financial may also discuss some non-GAAP financial measures in talking about its performance. These measures will be reconciled to GAAP either during the course of this call or in the company's press release, which can be found on its website at www.etrade.com.

This call is being recorded. Replays of this call will be available via phone, webcast and podcast beginning at approximately 7:00 pm Eastern time today through 11:00 pm Eastern time on Wednesday, August 8.

The call is being webcast live at www.etrade.com. No other recordings or copies of this call are authorized or may be relied upon.

I will now turn the call over to Mitchell Caplan, Chief Executive Officer of E*TRADE Financial Corporation, who is joined by Jarrett Lilien, President and Chief Operating Officer and Robert Simmons, Chief Financial Officer. Mr. Caplan.

Mitchell Caplan

Good afternoon and thank you for joining us for our second quarter conference call. A year ago this quarter we had just successfully completed two back-to-back acquisition-related conversions. We integrated three companies into one while remaining focused on broadening and enhancing our value proposition across our entire customer base.

At that time, we laid out a strategy for organic growth. At the core of that strategic plan were increased investments in marketing, service and technology to heighten product awareness and engagement, improve customer experience, and boost operational efficiency. Over the past 12 months, we have made these investments and our record financial performance and reinvigorated customer growth trends are proof points of success.

For the second quarter, we earned $0.42 per share, up from $0.39 in the prior quarter on record revenue of $664 million. The $0.42 excludes a $0.05 charge for one-time legal and regulatory items. Therefore, on a GAAP basis, we earned $0.37 per share.

The charge relates almost exclusively to a reserve we have set for an SEC inquiry of exchanges pertaining to certain institutional market-making activity, which was previously disclosed in our 10-Q and 10-K filings. The majority of this activity took place between 1999 and 2001. We are working closely with the SEC and hope to reach a prompt resolution.

Excluding the impact of this charge, the business delivered record segment income of $296 million. Pro forma operating margin also reached a record, up 300 basis points quarter over quarter to 45%. While we are, of course, pleased to deliver these record results, we are even more pleased to also deliver an increased overall quality of earnings. We achieved record revenue even as we reduced loan and security gains and increased our provision for loan losses.

The revenue in the quarter was driven by increases in net operating interest income, commission and fee revenue, all items directly related to the growth and engagement of our core retail investing customers.

Our second quarter performance speaks to the progress we have made as a company in executing against our strategic plan. We set out to drive results through investment and we are achieving them. The aim of our investment strategy is to drive organic accounts growth and particularly, growth within our target segment. In the second quarter, we opened 324,000 new accounts, including 199,000 new trading and investing accounts, the strongest in at least five years.

We also increased our base of target segment accounts at a 29% annualized rate, or by 66,000. These accounts represent tremendous current and future economic value to the business due to their attractive demographic and product engagement trends. They are valuable to our model, as the customers behind these accounts show four times the level of engagement around assets, trading, margin and cash relative to our average customer.

Our model generates exceptional value from these relationships, as we are able to leverage growth in assets and activity across our integrated technology, operations and service platforms, driving results in both our retail and institutional segments. We are also pleased that these positive engagement trends we've seen this year are continuing into the current quarter. Assets, cash, margin and DART are all up nicely so far in July and our pipeline of new unsegmented accounts remains strong.

By expanding our base of these high-quality accounts, we delivered another quarter of strong growth in total client assets, which increased 6% quarter over quarter and 18% from a year ago to a record $213 billion.

Assets balances increased in all categories with the exception of CDs, which continued to slowly decline as part of our repricing strategy. The cash component of our client assets grew by $1.9 billion to $37.9 billion. Solid results, particularly considering the seasonal tax-related outflows in the second quarter. This time last year, cash balances increased by just $300 million, so the $1.9 billion growth this quarter represents another example of the returns we are realizing on our marketing and value proposition investments.

Also as a result of our broad suite of investing and cash management products, we continued to successfully accumulate cash and deposit balances for balance sheet growth at an attractive blended cost of funds. In the quarter, our growth in retail cash balances came in at an incremental cost of 3.68%. In addition and most importantly, this growth is being fueled by broadening engagement from our new and existing customers and primarily investing base customers, who accounted for 81% of the new deposit account balances in the quarter.

On the assets side of the balance sheet, average interest earning assets grew $4.8 billion quarter over quarter to approximately $58 billion. Whole loans accounted for $3 billion of the growth and more than 100% of the growth in whole loans was in one to four family prime and super prime first lien mortgages.

HELOC and consumer loan balances declined during the quarter, ending lower as a percent of total loans and in absolute dollars. As we managed through the credit environment, we have been able to opportunistically improve loan quality in the portfolio with growth in super prime first lien mortgages while maintaining yield, partly the results of a somewhat improved yield curve. We expect to continue this mix shift towards first lien mortgages for the remainder of this year.

We also maintained our strict discipline with respect to risk mitigation, all the way down to the level of the borrower. To that end, average FICO, DTI, and CLTV metrics across the portfolio all remained unchanged quarter over quarter at a solid 735, 35, and 73% respectively. While we remain vigilant with respect to our credit risk management, in no way do we assume that will be immune to trends worsened from a macro perspective. We do, however, expect to be less affected on a relative basis, given the relative quality and mix of our assets.

With respect to our specific credit metrics in the quarter, net charge-offs increased slightly, up $1.5 million from $20.8 million in the first quarter. Net charge-offs as a percent of average loan receivables declined by 1 basis point quarter over quarter to 29 basis points. Non-performing loans increased by $50 million and we increased our quarterly provision by $9 million to $30 million. Provision exceeded charge-offs by nearly $8 million in the quarter, increasing allowance for loan losses to approximately $76 million. In addition, the percent of non-performing loans that charged off in the quarter declined to 19% from 28% in the prior quarter and 26% in the fourth quarter.

We believe that given the relatively higher FICO scores and lower DTI levels of the borrowers in our portfolio, these individuals are more likely to be refinanced and avoid foreclosure.

Finally, there has been a lot of discussion in the industry recently regarding consolidation. While our focus and first priority continues to be the tremendous global growth opportunity that lies ahead of us, we are always looking for opportunities that can either accelerate current growth initiatives or deliver greater scale sooner. As we have demonstrated in the past, we believe in the strategic and economic benefits of consolidation and will evaluate any transaction that we believe generates superior long-term value to shareholders.

Now to provide further details on the operational success of the quarter, I would like to turn the call over to Jarrett.

Jarrett Lilien

Thanks, Mitch. We are pleased with the performance of the company this quarter. It demonstrates that our focus and efforts are moving the needle. More importantly, the returns we are now seeing validate the investments we have made over the past five years to strengthen and transform the franchise. We invested in products, service and functionality to enhance customer experience and to continue to be a leader of innovation in the industry.

SmartMoney magazine's annual broker survey rated us number one among premium brokers for the first time ever. The difference this year? Significantly improved customer experience. While we've seen the tremendous progress we have made ourselves, we are excited to have received this external validation from SmartMoney.

Our internal measurements of customer satisfaction are at a record high and have increased in ten of the 12 past months. These improved customer experience and satisfaction levels are now translating into solid growth across our core customer metrics. Mitch already spoke about the success of our account growth and particularly the value of growth in our target segment, but our success is much broader than that. We are also seeing strong growth in our Main Street account base, which grew at a 9% annualized rate in the quarter.

Our investment in service and product is also driving success this year in migrating a greater number of our Main Street customers into the target segment, where they create the highest value. We have leveraged our marketing spend with personal contact through our call centers and branches to increase product awareness and utilization. Year to date, we have successfully migrated 30,000 Main Street accounts into our target segment, well ahead of our internal expectations for the full year.

Not only are we experiencing growth at the account level, but also at the customer level. In the quarter, we added just over 51,000 net new customers, the strongest growth in customers in over three years. As a result, we are growing customers and our engagement with them, and this is driving strong activity, margin and cash growth.

Total DART volumes held steady in the quarter, declining by just 0.5% from the seasonally strong first quarter level and increasing 2% from a year ago. That year-over-year growth is even better than it looks, considering that we had integrated two companies and were just entering the peak attrition period.

Average commission per trade rose $0.14 quarter over quarter to $12.03. Interestingly, this increase was the result of product mix rather than customer segment or geographic mix.

Options volume remains strong in the quarter and represented 15.4% of U.S. DART volume, up from 14.1% in the first quarter and 12.4% a year ago. In June, our option DART volume hit a record 16.3% of U.S. DART volume and increased 49% year over year. What is perhaps most encouraging about this growth in options volume is that it is being driven by customers who are using options to hedge rather than to speculate and by a growing portion of our account base.

Two years ago, we made investments in our options platform and value proposition, and these results are just another example of the returns we are now realizing from that investment.

Margin debt and customer cash also increased nicely quarter over quarter, driven again by the growth in our target segment accounts. Margin debt ended the quarter up 7% at $7.5 billion. On the cash side, customers increased cash product balances by $1.9 billion. The outpaced growth in assets and cash balances relative to margin debt shows that our customers continue to maintain a prudent level of leverage relative to assets.

We are also generating returns on the investments we have made in our relationship manager strategy. We now have just over 300 relationship managers, up from approximately 100 two years ago. These RMs are now assigned to 70% of our customers with $250,000 or more in assets with us. Over time, our plan is to expand our RM group to reach 100% coverage of these customers and then scale that service across an even larger subset of our customer base.

The ongoing return on our investment in RMs comes from growth in product engagement, assets per customer, and share of wallet over time. They are delivering results. In the second quarter, assets from customers connected to an RM increased by $1.7 billion. In addition, we are beginning to see real growth in client referrals from RMs to our wealth managers and lending specialists. Although still small, year-to-date referrals and closes through June exceeded the entire results for 2006.

While the customer metrics certainly tell a good story with respect to our investment returns, the true test is the economic results produced by these metrics. We are succeeding here as well. Annualized consolidated revenue per customer in the second quarter totaled $752, up from $742 in the first quarter and $716 a year ago. In addition, this revenue is growing with increased profitability, given the scale and leverage in our model. Adjusting all periods for one-time items, annualized segment income per customer grew to $336, up from $311 in the first quarter and $305 a year ago.

In conclusion, we are pleased with the success we are achieving and the impact solid organic growth is having on the model, both from bringing in new customers plus driving higher engagement with existing customers. Our investments in service and product to continue to transform the business and position the business to capitalize on the positive secular growth trends in the industry.

With that, I will turn it over to Rob for more details on the financials of the quarter.

Robert Simmons

Thanks, Jarrett. Our second quarter results demonstrate the strategic and economic success we have achieved through the investments we have made over the past several years. We delivered record results while also improving the overall quality of revenue and earnings, a result of the success we have shown in growing our mass affluent customer base.

Year over year, total net revenue grew 9%, segment income grew 14%, and operating margin improved by nearly 200 basis points. These comparisons exclude the one-time legal and regulatory items already discussed. Needless to say, we are very pleased with the continued strength and operating leverage of the business.

Now, I would like to turn to the specifics of the second quarter. Quarter over quarter, total net revenue grew 3% to a record $664 million. Within this increase, we also experienced an improvement in the overall quality mix of revenue, with net interest income, commissions, and fee-based revenue all up and a lower contribution from gain on sale of loans and securities. Net interest income after provision expense is up 4%. Loan loss provision for the quarter was $30 million, up $9 million quarter over quarter, consistent our view of the evolving credit environment.

Net interest spreads showed improved stability in the quarter, declining just 3 basis points to 271 basis points, squarely within our expected range for the year. Commissions grew 7% quarter over quarter, driven by steady retail DART activity, improved average commission rates, and stronger trading activity in our global institutional equity business. Fee-based revenue increased 10% quarter over quarter on higher asset management and mutual fund fees.

Gain on sale of loans and securities contributed just $5 million, or less than 1% of revenue in the second quarter, down from $17 million, or 3% of revenue, in the first quarter. The decline in gain-related revenues stemmed from lower gains from the sale of originated loans as part our strategic decision to portfolio more of our high-quality origination volume and reduce the amount sold for gain.

So overall, we were pleased with the top line results in the quarter, particularly given the improved quality and growth from more recurring, customer-driven components.

Turning now to expenses, we continued to realize operational efficiencies throughout the business and maintain strong expense controls. Total expenses, excluding the one-time legal items, declined 2% quarter over quarter to $367 million. Compensation expense declined approximately $5 million quarter over quarter to $119 million, or 18% of revenue. This decline was due to lower payroll-related taxes and reduced headcount.

We have been successful in maintaining a low compensation-to-revenue ratio even as we have made investment this past year in bolstering our service quality and broadening our network of relationship managers, advisors and select branch locations.

Revenue per headcount and revenue per compensation dollar continued to increase, further demonstrating the scale and value we are achieving throughout the business. Clearing and servicing expense rose 10% to $74 million. This increase was driven primarily by higher institutional trading volume and an increase in servicing costs consistent with the growth in our average loan balances.

With respect to advertising, total ad spend declined approximately $10 million quarter over quarter, consistent with our marketing plan for 2007. You'll recall that we plan to front load the marketing spend in Q1 to drive growth in our target segment accounts early in the year, and this is exactly what happened. As Jarrett discussed earlier, we experienced the strongest organic growth ever in target accounts this quarter, the result of marketing investment made in Q1. Despite the marketing spend being down quarter over quarter, we still spent roughly $6 million more than last year at this time, consistent with our continued investment plan.

Operating expenses such as communications and occupancy and equipment, declined slightly quarter over quarter, a result of continued efficiency realization and prudent expense control throughout the business.

We also had a $1.5 million credit to restructuring and other exit charges this quarter, which was simply a favorable true-up to sublease assumptions built into our earlier restructuring of facilities in California.

Other expense increased by about $38 million quarter over quarter, but increased just $3 million adjusting for the legal items. This $3 million increase was predominantly related to higher FDIC insurance premiums as a result of our growing base of customer deposits.

Our reported tax rate for the quarter came in at 34%, hitting the low end of our forecasted range. For the remainder of the year, we expect the tax rate to remain closer to the low end of our 34% to 37% guidance range partially as a result of the continuing strong contribution from our international operations.

Turning now to liquidity, the business continues to generate strong cash flow, providing significant opportunities to reinvest in the business as well as repurchase stock to create further shareholder value. In the second quarter, we did both. We made investments in marketing, service and technology to continue to drive growth and efficiency. We redeployed approximately $100 million in additional regulatory capital and used $73 million to repurchase 3.1 million shares of stock.

Since our buyback activity began in Q2 of 2001, we have used $764 million to repurchase over 80 million shares at an average price of $9.50, generating close to $900 million of value. As of June 30, we have $211 million available for further share repurchase under our current board authorization.

With respect to our 2007 guidance, we have narrowed our range by $0.06 by increasing the low end by $0.03 and reducing the high end by $0.03. Our new range is $1.58 to $1.72 per share, leaving the midpoint unchanged at $1.65. As a result of the strong customer growth and engagement trends we continue to see, we are comfortable maintaining the midpoint of our range, even as we expect to provision at or above current levels in the third and fourth quarters.

For consistency purposes, this range is based on pro forma earnings that exclude the $0.05 of legal items from this quarter. In addition, we have now realized the full $0.05 in below the line investment gains that we expected for the year through the sale of E*TRADE Australia and E*TRADE Korea. As a result, there are no additional below the line gains embedded in our new guidance range for the back half of the year.

The record results generated in the second quarter represent the return on investments made over the past several years. Through these investments, we are positioned to leverage our account growth, particularly the growth we are seeing within our target segment. We can do so cost effectively to generate strong financial performance and increase value to shareholders.

With that, we would like to open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Rich Repetto - Sandler O'Neill.

Rich Repetto - Sandler O'Neill

Good afternoon, guys. Congrats on an excellent quarter. The target segment growth is pretty interesting. You brought on 66,000 --and Rob went through that marketing spend went down, but you even brought on more, 43,000 in the first quarter. Mitch, you said about 30,000 came from existing accounts through the pipeline, so that would say less than 30% are migration and the rest are brand-new people bringing them in. Are my numbers correct, is the question?

Mitchell Caplan

Yes, as long as you recognize that the 30,000 is for the first two quarters, for the first half of the year. So that shows you of the total that we have brought in 66,000 in this quarter plus what we brought in the first quarter in target segments, if you add those two, about 30,000 or so came for migration and the rest were coming from new accounts or marketing spend. So it is a great way to think about it, Rich.

Rich Repetto - Sandler O'Neill

Okay, it is 110 in the first half you brought through?

Mitchell Caplan

That's right, so of the 110,000 about 30,000 or 32,000 or whatever came from migration, which is a little bit ahead of what we had originally planned when we built the budget. The rest came from just the marketing dollars and new account growth of the right kind of customers.

Again one of the things I was also saying is and I think you know this, as we add customers in the quarter, we put them into that unsegmented bucket for the next quarter and we are again going into this quarter, into Q3, with a very strong bucket of unsegmented, which we would hope would continue to fall out into the target segment the way we have seen and would expect the way we have seen in Q1 and Q2.

Rich Repetto - Sandler O'Neill

So I guess the follow-up question, then, is if 70% or more are coming right out off the street, you mentioned in the prepared remarks that they are 4X on more or less asset metrics. I think you mentioned 10x before on the revenue generation.

Mitchell Caplan

Yes, absolutely. So when you look at them, the percentage of target segment customers that we have still represent about 75% of our revenue on an annualized basis. So yes, you are right. They are much stronger with respect to all the other metrics in terms of assets, cash, all the stuff we talked about and then you see it flow through in terms of the actual revenue line items and you also can see it when you look at, as Rob was saying and Jarrett was saying, when you look at revenue per customer, or revenue per account, profit per account, they are all up significantly quarter over quarter and year over year. That is across all the accounts. It is obviously a lot of that led by what is happening in the target segment growth.

So again, I think I was saying that in the prepared remarks that in July, we're very, very pleased with what we have seen so far. We are really almost through the month, the first month of the quarter. In terms of what we have seen, our customers have absolutely been net buyers so far in the month and even notwithstanding the strong net buys that we're seeing, we've seen some very strong growth in cash, continued growth in margin, and growth in daily average revenue trades that seem stronger than what we have seen from the industry at large.

Rich Repetto - Sandler O'Neill

My one last question, I got to get one in on consolidation here. There has been a lot of activity spurred on by the buy side in some cases, but I guess the question is as you look out on the landscape, what are your priorities? What best fits with E*TRADE as you look at the M&A sort of landscape?

Mitchell Caplan

First of all, our first priority is as I was saying, we have got to continue to keep our head down and focused on execution. I think it is the first time in a while as we have got into this year that we have really see a reinvigoration of account growth and where we have seen the economics coming through in terms of top line revenue, controlled expenses, and bottom-line income. So we're going to stay focused on that.

That being said, when you think about where the opportunities are for organic growth domestically and international, Jarrett is working on it and he has got it covered. Part of my job is to look at the broader industry and recognize that we have been proponents in the past of consolidation. We recognized that with the right strategy and the right discipline and execution, you can create value. We have certainly done it over the years with a number of acquisitions, culminating with Harris and Brown and to the extent that the opportunity presents itself, it is something that we would take advantage of, whether it is directly in our space -- which is certainly the opportunity you are talking about, given all of the discussions in the marketplace -- or even in the broader financial services marketplace.

Operator

Your next question comes from Matt Snowling - FBR.

Matt Snowling - FBR

Given the recent events, Mitch, can you give us a little bit more detail on what your HELOC portfolio looks like in terms of maybe size, delinquencies, how much may be in the 2006 vintage?

Mitchell Caplan

Yes, virtually nothing from the 2006 vintage, which is good news. When you look at the size it is it is down, and you can see it; we will give you the specifics. I cannot remember the specific numbers. I know that it is down.

Robert Simmons

It is down $400 million.

Mitchell Caplan

About $400 million, so in other words, what happened is we allowed all the prepayments to just move through and, again as we have said, literally I think when we were giving guidance back in December, one of the things that we said was that we would expect to see maybe a 60% or 65% mix of first lien and about 30% or 35%, 40% coming from HELOCs.

Then as we saw and moved through Q1, we said, no, I think we're going to move more in the direction of about 75%, 80%, 85% of the growth coming in first liens both in Q1 and in Q2. In fact, we have been closer to 100%. So that is basically where we are. If you look at the size the portfolio, in HELOCs, it's about $12 billion or so. It is down about $400 million quarter over quarter.

When you look at across the median across really the average median, mode, all that stuff, what you see are, again, the same consistent high FICO scores, 730, 740, something like that. You see DTIs and LTVs that again, are conservative and are probably significantly better than what you have seen in maybe the general risk industry at large or in others.

So my recognition is I think our LTV's are in the mid to high 70s, so again, because of that, what we are seeing, one of the reasons I think that notwithstanding we saw a reasonable increase in non-performing from Q4 into Q1, what you saw read out in actual charge-offs this quarter was down, was down from the 26% to 19% because we're seeing that a lot of these are getting refinanced out and we're getting paydowns on them, and that is fine. So we're not seeing them read all the way through into charge-offs.

Matt Snowling - FBR

What do the delinquencies look like?

Mitchell Caplan

When we do the follow-up calls, I'll give you the exact number, but I think it is about certainly 1.5%, 2%, sort of in that range. I think probably definitely below what you are seeing in the industry.

Matt Snowling - FBR

One quick question on the AOCIs, it looked like that dropped $130 million. I am just wondering what may be behind that.

Robert Simmons

The movement in AOCI quarter to quarter was primarily a function of the securities portfolio being mark-to-market, a reflection of the rate movement in the quarter and the mark on the securities portfolio. There is some offset from hedges and some offset on FX, but that is it; that is the predominant mover there.

Matt Snowling - FBR

Rob, is this a portfolio you intend to hold maturity or is this for trading?

Robert Simmons

We have talked a lot about our longer-term objective being to be toward a more retail-oriented balance sheet, so that will definitely continue to be the trend at this point. If you look in the quarter, if you look at the asset mix, we had about 67% of our interest-earning assets in the form of whole loans and roughly 33% in the form of securities. So we would expect that mix to continue to shift toward a retail mix and away from a wholesale.

Mitchell Caplan

The other thing, Matt, I just wanted to follow-up with you, is for the home equity, as of this quarter, I think we're in like $95 million, $96 million, $98 million, something like that in MPL and, again, we're experiencing sub-2%

Operator

Your next question comes from William Tanona - Goldman Sachs.

William Tanona - Goldman Sachs

The net new assets obviously down on a sequential basis, how much of that was due to tax disbursements in April?

Mitchell Caplan

You have got it. So if you looked at it on a monthly basis, I think last we were at basically the months of April, May, and June, May and June were as strong or stronger than we had seen in the prior quarter and April was basically flat to slightly down as a result of the outflows that you saw from tax payments.

So it is what resulted in the decline quarter over quarter in the net asset inflows. The same thing happens, it is really actually pretty interesting. When you look as cash for the quarter, as we came into the last 12 days or something or 14 days of the quarter, part of the way that we obviously grow our balance sheet on the asset side is we are now trying to match it to the growth of retail customer cash.

What you will see is that notwithstanding that we grew the asset side of the balance sheet by whatever it was, $4 billion, $4.5 billion on average, the ending to ending point was a little over $3 billion because we actually moved out of securities as we finished up the quarter and our actual growth in securities quarter over quarter was only about $400 million and was really driven, if I remember correctly, by both our munis on a tax-advantaged basis and our FHLB stock.

So when you look at where we were in the cash, literally, with ten or 12 days to go to the end of the quarter, we were at $2.7 billion and we ended at $1.9 billion because we saw our customers be net buyers of in excess of $1 billion in literally the last ten days of the second quarter. Obviously, as I said earlier, that has continued in Q3 to the tune of another $300 million, $400 million.

William Tanona - Goldman Sachs

Great, that's helpful. On the nonperforming loans, again, can you help us understand exactly where you are seeing those nonperforming loans tick up there in terms of whether it's demographic or what type of loans or what geographies and segments such that we understand it a little bit better?

Mitchell Caplan

Yes, we continue to see low charge-offs in our first liens, basically 1 basis point, what we have totally traditionally seen. The consumer loans are showing charge-offs that are pretty much equal to what they have traditionally shown. It is just your seeing, obviously, you're coming down the back end of it so you're not replacing any of the consumer loans. So to the extent that we are seeing charge-offs, which were, as I said, only up about $1.5 million, the incremental delta is going to be coming through in the form of the HELOCs.

When we look at it, we're not seeing it in terms of any specific geography. Again, as I said, it is sub-2% in terms of what we're seeing with total NPLs now in the HELOC portfolio of $98 million.

William Tanona - Goldman Sachs

So there are no specifics between geographies or adjustable rates or anything like that? You're just seeing a broad deterioration, if you will?

Mitchell Caplan

Yes, and I'm not even sure I would call it a significant deterioration. I think that what we saw was the pickup between Q4 and Q1, which we talked to. In Q1 to Q2, we're actually seeing less deterioration in the sense that although your NPLs are growing, we saw a definite decrease in the read through, so if you looked at the NPL in Q4 as the pipeline for Q1, we saw, again, about 26% of those read through. In Q2 what we saw was about 19% read through, so we actually saw a bit of an improvement, which were pleased about.

As we have been working with the sub-servicers, what we're hearing is because of the underlying credit characteristics, whether it is FICO or DTI or LTV, of the borrower, they are being taken out in the marketplace by other lenders.

Operator

Your next question comes from Prashant Bhatia - Citigroup.

Prashant Bhatia - Citigroup

Just on the mortgage portfolio, I think roughly $32 billion, can you tell us how much of that you originated versus how much you bought from third parties?

Mitchell Caplan

I don't even think I can break it out. We have originated, I think, last quarter we had said a relatively small part. Most of it has been bought in the industry. I think some of our big providers are Nat, Citi and others, but we have been originating more each quarter than we have in the prior quarter, I guess, for the past maybe four or five quarters and we are continuing to keep more on balance sheet. So we are in a place where I think this past quarter, we probably originated about what, $1 billion?

Jarrett Lilien

Yes, a little bit more. We kept the highest percentage on balance sheet this quarter that we have in a long time.

Prashant Bhatia - Citigroup

Okay, so most of the 32 is through third parties it sounds like?

Mitchell Caplan

Yes, absolutely.

Prashant Bhatia - Citigroup

A lot of talk in the industry, some of the firms are saying looking at FICOs, looking at LTVs, and so on, based on past experience really is not proving all that relevant right now. I do not know if you are seeing that as well, but how you get comfortable being that you did not originate these loans, with the real quality of them? How do you know that you will not have to see charge-offs and provisioning rise going forward?

Mitchell Caplan

Let me address that if I can in two separate answers. The first is that by and large, when we buy, we often buy with anywhere from six to 12 months of seasoning. So we rarely buy new originations. We're buying stuff that we have seen with some seasoning issues, so we can see how the borrower is performing. We also buy with a look-forward put back for another six to 12 months, so that if we see something that we're uncomfortable with, we put the loan back.

Given that, historically I think when you look at how we have performed compared to the industry, we have been significantly better. So one of the things that we talked about that we obviously hoped to see when we did see the increase in charge-offs and we increased our provisions in Q1 of this year was we're waiting for the report that would come out on the industry and we did maintain our relative out performance.

So if you looked at what our charge-offs were, they are typically somewhere around 40% to 45% better than the industry, usually 20 to 30 basis points better. We saw exactly that same relationship maintain in Q1 and I think that particularly given what we've seen in charge-offs in Q2 and the lower read through, I feel pretty good about what we have seen so far. That is the first thing.

The second thing is in response to your questions, we did. We obviously took a reserve this quarter of $30 million in excess of the charge-offs, that $22.3 million, so we took a reserve in excess of what the charge-offs were and I think as Rob said in his prepared remarks, we would expect to take those kinds of similar reserves, or theoretically, even a little more, again, expecting that the charge-offs will be less than the reserves as the move through the second half of the year in Q3 and Q4.

But given the shape of the yield curve, given what we are seeing in terms of customer engagement around cash, around DARTs, around margin, given what we're seeing in terms of controlled expenses, as an offset, we believed that we were comfortable with the range continuing at the midpoint of $1.65 and then tightening the range $0.03 in either direction.

Prashant Bhatia - Citigroup

In terms of the non-performing loans as well as the special mention loans that you classify, how big is that right now?

Mitchell Caplan

The non-performing loans were up, as I said, I think $50 million quarter over quarter. Actually, let me look at the numbers and when we follow up with you this afternoon, we will give you the exact numbers so we can be specific and it will clearly, obviously, be filed in the Q in a couple weeks, but we will follow up with you in advance.

Operator

Your next question comes from Michael Vinciquerra - BMO Capital Markets.

Michael Vinciquerra - BMO Capital Markets

Good afternoon. Thank you for the additional detail in your metrics. It is certainly very helpful and gives us some more material to ask some hopefully intelligent questions.

I want to ask you on the growth rate in your revenue per customer, when I look at what you're talking about, you are seeing a better customer mix with more targeted accounts. You are seeing options growing as a percentage of the total and your assets per customer are up about 14% year over year, yet your revenue per customer is only up 5%. Are we building to something that is going to see an acceleration in revenue per customer? Give me some idea about what we can expect there.

Mitchell Caplan

A couple of things. One is provision is up and gains are down significantly. So there has been a huge mix when you think about the quality. One of the things I think we always got hit for and there was a discussion about was the gain on sale of securities above the line. So when you think about it, the quality of earnings has changed dramatically and given the credit environment, our provisions are up.

I think the metrics are reading through when you look at each individual line item, like around assets and fee-based revenue, when you look at cash and credit and you look at net interest income, when you look at commission revenue, it absolutely is reading through in all of those and it really is just the continued, and I hope that will continue to see the transformation around the quality of recurring revenue.

Michael Vinciquerra - BMO Capital Markets

With gains now being only $5 million for the quarter, does that tell us that maybe we should see some acceleration because you will not have that headwind going forward, at least on this particular metric, revenue per customer?

Mitchell Caplan

Yes, agreed.

Michael Vinciquerra - BMO Capital Markets

The funding mix at the bank, big growth this quarter, 9% sequential growth in the average balance sheet. When I look at your three main funding categories, retail deposits rose 8.4%. Repos and other was up 12%, and FHLB up 23%, the last two of those being your highest cost sources. Is there any thought process to not growing those types of categories and then just letting the retail deposits drive it, even it means slower balance sheet growth?

Mitchell Caplan

Yes, 100% and you will hear more from us about that. But let me set context. First of all, what you're looking at is average balances as opposed to ending balances, so when you look at ending balances, it is smaller because again, as I said, we were out of some of the securities that we bought in the beginning of the quarter in preparation for adding the loans based on the growth in cash balances. So again, we had originally modeled and what we have seen was going to a place where although we ended at $1.9 billion in cash, up from whatever it was, $300 million a year ago, we had really seen it closer to the $2.5 billion, $2.7 billion, moving toward $3 billion before the net buy.

So as we really were planning for the quarter in many respects, if you look at the growth, ending balance to ending balance it was up probably a little over $3 billion and we would have presumed that a significant portion of that would have been done close to $2.5 billion or $2.7 billion around cash, but for the net volume that we saw.

So strategically, what you're describing is exactly the direction that we are going in as we think through both the remainder of this year and certainly I think you'll hear more from us as they go through '08. We would expect to see retail being the driver for the balance sheet, freeing up capital and as a result of freeing up capital, continuing to use it for things like fairly significant share buybacks.

Michael Vinciquerra - BMO Capital Markets

Your NIM held up great very well in the quarter and I noticed your transaction accounts were up very, very nicely. Can you give us a sense for mix between max rate checking versus money market?

Mitchell Caplan

Absolutely, love it. Great question. Again, as I said to you, I think the incremental cost of funds in all of retail deposits was about 3.68%. So at 3.68%, obviously it is not all at the CSA of 5.05 or 5.10. So what you saw was you saw growth in free credit, you saw growth in [inaudible] and you so growth in transactions. Within transaction, you saw a nice mix between things like max rate checking and money market, which have a lower cost of funds, in addition to your CSA account, which has a higher cost of funds, which resulted in a blended bases across all retail deposits of this 3.68 incremental.

So again to your point, yields remained flat quarter over quarter. You might have otherwise expected them on the asset side to be up a bit given the shape of the yield curve. I think one of the things that we said if I remember correctly, I will go slowly on this, in December of last year, we said that if the yield curve between Fed funds to ten years, for every 10 basis points of steepening you would see about $0.015 on an annual basis of value to the bottom line.

So although period end to period end Fed funds to ten years between Q1 and Q2 was up 25 basis points, most of that occurred in the last month of the quarter. So clearly we would be benefiting from that shape of the yield curve going forward.

Some of that benefit was offset by making the economic decision to literally reduce your consumer portfolio, reduce your HELOC portfolio within your mortgages and move, as I said, exclusively to 100% acquisition of single-family first lien mortgages. So net net, your asset yields stayed flat quarter over quarter and your cost of funds, if I remember correctly, was up three basis points, keeping our spread pretty stable and squarely within what we guided to in December of last year; I think at 265 to 275.

Operator

Your next question comes from Mike Carrier - UBS.

Mike Carrier - UBS

Just had another question on the credit side. Clearly there is not much differentiation in the market just in terms of the different portfolios. I'm just trying to get a sense, when you say next quarter and actually the second half of the year that provision will continue to be a little bit higher than we are at now and the net charge-offs will continue to grow higher, I'm just trying to balance. The last quarter was the $25 million level. Now we're up to $30 million.

Just making sure, if your expectations of the next 12 months, where they are given the portfolio, so every quarter we're not going…?

Mitchell Caplan

Great question. So I think a great way to think about this is that if consensus was $1.65 or $1.64 or whatever for the year, which was where we were in terms of the midpoint of our guidance, clearly in delivering $0.42, given that consensus was about $0.40 for the quarter, we exceeded that by about $0.02. We could clearly have let that read through in upping our guidance for the remainder of the year, moving the consensus up by $0.02.

In addition I think we're seeing, as I said, some of the benefits now from things like customer engagement, the shape of the yield curve, relatively controlled expenses. In our minds, what we are saying is that we think given the macro environment, not withstanding that again, what we are only seeing is 2% or under in terms of the kinds of loss or loss mitigation around the HELOC portfolio, which again is in NPLs only at about $96 million or $98 million, that we think that the prudent thing to do is continue, given the strength of the earnings, to continue to build our reserve.

So again, if you think about each of those $0.02 or $7 million going to Q2 and Q3 and Q4 off of our guidance, it would tell you that you could see off of the original thing that was going to be 25 in Q1, that you could be at $32 million, $33 million in each of the two quarters; one maybe a little bit less, one maybe a little bit more, but that is probably the general direction. Does that help?

Mike Carrier - UBS

That was helpful. Then just on the equity side, just on the AOCL, similar concept, meaning, what is in that portfolio? How can we get our arms around what is related to rates versus what is related to credit mark-to-market?

Mitchell Caplan

In what, I'm sorry?

Mike Carrier - UBS

On the balance sheet, in the equity side of the AOCL.

Mitchell Caplan

Yes, that is not loans.

Robert Simmons

The movement in AOCI in the quarter is purely related to the securities mark that goes through OCI.

Mitchell Caplan

There is nothing in the loans in there and when you look at our securities portfolio, I think as we have said, 98% of them are AA and AAA.

Mike Carrier - UBS

I understand that. I'm just saying like when you think of AA, AAA, that has been a big issue in the market, meaning what is really AAA versus what we have been told is AAA.

Mitchell Caplan

Again, we test for impairment and we do all that kind of stuff and if there were any issues on impairment, it would be moving through our P&L. So when you look at our portfolio, it really is mostly agency paper, Fanny, Freddie, and that is really the gist of it.

Mike Carrier - UBS

Finally on the international trading, I know back at the analyst day you mentioned the FX segment of that. I'm just hearing internally from our guys on the FX floor that the amount of revenues or the amount of volume on the retail side is just phenomenal. I am just wondering when you start having international, can you strategically have an FX operation to compete with some of the online brokers that just focus on FX?

Jarrett Lilien

What we want to be careful about, actually, and let me take a big step back. In some of our international locations where customers are more accustomed to trading currencies, we actually have FX trading product. In the U.S., that is not really the case. In the U.S., when you look at the online players that let people play FX, it is really a model of revolving door, get a customer in, let them trade, blow up, and get a new customer.

What we are looking to do with our U.S. model in FX is have it be a product extension that enables people to play the foreign markets, to invest in the foreign markets. Last week, we launched our global trading product to all of our customers here in the U.S., letting them trade in six non-U.S. markets, five non-U.S. currencies.

FX is a nice piece of it and so far we have had good results for the first week, but it is interesting. The FX piece of it, even when we're not encouraging people, they are using the FX facility to transfer money, for instance, from dollars to yen so they can buy stocks in Japan. Still, it is a nice business with a nicer margin and actually generating about two times the margins than we're seeing on the equity commission.

So it is a different approach, but it is one that is sustainable because it is one that enables our clients to be more successful rather than just a new trading product that entices them to blow themselves up.

Operator

Your next question comes from Michael Hecht - Banc of America.

Michael Hecht - Banc of America

I was hoping to get little more color on the strength in the service charges and fees you talked about this quarter. How much is coming from account service fees or maintenance fees for an activity that you guys still charge, but a lot of your competitors have eliminated versus just core growth in fee-based assets?

Mitchell Caplan

Great question. Account service fees for us in terms of earnings are down quarter over quarter. The growth that your seeing in the revenue is coming from the mutual funds and the related assets products.

Michael Hecht - Banc of America

On the flows and I know you've been beefing up that disclosure, so thanks, that's helpful, but the $1.6 billion of flows you saw in the second quarter, I'm just try to get a sense; I mean, if we think about it, you guys are doing about as much inflow in a quarter as Schwab probably does in about a week. Can you help us understand why you guys are lagging Schwab so much?

Mitchell Caplan

We're about ten years younger.

Michael Hecht - Banc of America

Well, you would think with a smaller base, you'd actually have a higher organic growth rate, but it's actually lower. If you think about the increase you had in cash balances, it's more like $1.9 billion than $1.6 billion overall, how do we think about what types of products your investors are actually pulling money out?

Mitchell Caplan

You can’t do it because it is apples and oranges, right? The idea is one of them is net asset inflow and the other one in terms of the cash balances are absolute growth in cash. It is a different form of calculation and I am sure that afterwards I am happy to or Adam is happy to walk you through the difference between those two calculations.

So when you look at the 1.6 and you look at what we've brought in Q1 versus Q2, I think we were down the exact same percentage that Schwab was down between their Q1 and their Q2, given probably the seasonal outflows that you see with taxes. Again, we're starting to see growth. We're $213 billion in assets, it's a record for us and the highest we have ever been. I think we are finally starting to make headway.

We're just in a place where as I look at our model, it was only as we got through Q1 of this year now into Q2 as we're going into Q3 that I think we're really seeing the returns for the investment and the growth in the target segment and you would hope to accelerate the growth in assets.

Michael Hecht - Banc of America

On that point of tax season, any more color on deposit growth towards the end of the quarter? I think you saw about a $57 million increase in June and about $0.5 billion increase in April, which I thought would have been the heavy tax outflow month. Anything going on there?

Mitchell Caplan

I think what you are probably looking at is the balance sheet, which is the bank balance sheet as opposed to the whole integrated customer cash.

Michael Hecht - Banc of America

That is everything; that is all the cash balances added together.

Mitchell Caplan

I don't think so.

Robert Simmons

The cash number that you get on a monthly basis is just the deposit piece of it. As you know, there is another piece that is the brokerage or unswept or money market fund piece. You get that data on a quarterly the basis. So when you add those two together, you're going to see the total change in customer cash. On a month-to-month basis, you're getting half the equation.

Mitchell Caplan

Right, you are only getting what runs through the bank's balance sheet.

Michael Hecht - Banc of America

All right. Just one other metric I wanted to follow-up on, despite this growth you're talking about in targeted customers, the cross-sell rates you disclose, the number of products per customer, it has been static at 2.1 for awhile here. What is going on there? What do you think it is going to take to start seeing some increase in that?

Robert Simmons

This is a number that takes our total customer base and as you know, we have now gone through a process of giving a lot more visibility to the segmentation around that both on analysts day and in fact in this earnings release that you see. So when you look at the account segmentation detail, you can see that we have about 1 million corporate services account that by definition will only have one product associated with those for the time that they are waiting for their options to vest.

So when you calculate it excluding some of the other accounts like corporate services, if you look at it on a target segment account, it would give you the ability to do that for the most part, the story gets a lot better. You get closer to 2.5 or closer to 3.

So we're very pleased with the engagement. The mechanics of that particular metric is one that we are actually looking at and we might revise that next year.

Mitchell Caplan

So if you look at it, my recollection is it has grown in target segment from like 2 to 2.7 or something like that, so you have seen significant growth on a year over year.

Michael Hecht - Banc of America

A last question, just to help me think about comp expense for the year, it is down nicely quarter over quarter, year over year as a percent of revenues. Despite the investment you are making, I think you have talked about improving service levels, how sustainable do you think that level is?

Mitchell Caplan

I think we have always guided starting in December and we have not changed anything, to 18 to 19%, so fundamentally what we're doing is we're continuing, as we said, to grow headcount in the areas of service and headcount is decreasing in other areas through continued use of technology and efficiencies.

So we continue to be more efficient in the core areas of operations and processing, increasing our incremental op margins and at the same time, we're making the investment in the headcount around service.

Again, we have done that now. I think we started literally a year ago by telling you we were going to make that $40 million investment. We made it. We continue to have the headcount. We continue to grow it, and yet you're seeing comp and benefits come down as a percentage of revenue. I suspect you will again see it stay in that 18% to 19% and I think you will also see growth in the area of service.

Operator

Your next question comes from Roger Freeman - Lehman Brothers.

Roger Freeman - Lehman Brothers

A couple follow-up questions on the lending side. What percentage of your HELOC loan balance is to customers who you also hold the first lien with?

Mitchell Caplan

Virtually 100%.

Roger Freeman - Lehman Brothers

Okay, so that puts you in some control in any foreclosure process. Then the other question I have is when loans do default; or actually, what percentage of your loans are to customers that also have brokerage accounts with you at this point?

Mitchell Caplan

Originated loans, originated loans to brokerage customers? We don't break it out.

Roger Freeman - Lehman Brothers

The question I wanted to ask is when a customer defaults on a mortgage and they have a brokerage account if you, do you have the ability to seize assets in the brokerage account as collateral, or does it not work that way?

Mitchell Caplan

No, you do not. You do in their bank account, so if they have a bank account with you, you have the ability to seize it. You do not have the ability in a brokerage account.

Roger Freeman - Lehman Brothers

Okay, do you do that?

Mitchell Caplan

We do.

Roger Freeman - Lehman Brothers

Third question, the decision to keep more of your whole loans on balance sheet, what is driving that? Is it the prices that you can get in the secondary market have gone down, with more risk being priced in? Is that part of what we're seeing, that the gains on sales are decreasing as a function of the decrease in pricing in the market?

Mitchell Caplan

I think is more that strategically, if you go back and you historically look at our business in terms of originating loans to customers in the mortgage world, four or five years ago it really was around refinancing. As we moved out of the refinancing boom, we realized that the amount of loans that we were originating dramatically decreased to literally the hundreds of millions in a quarter.

Ultimately we repositioned the whole business and said the goal in originating mortgages is to originate them to our customers and put them on balance sheet and hold them on balance sheet. So that is each quarter, we have directionally tried to originate and hold a bigger and bigger percentage of what gets originated on balance sheet.

So as a result of that, when you look at this particular quarter, what you actually see is, if I remember correctly, I think it is 5 million. The breakdown when you look between retail and institutional is like a positive 7 million and negative 2 million in institutional. The reason that is the case is that when you actually get the Q, I think what you will see is that institutional made about $3 million and retail made about $2 million from selling into the secondary market. The reason that institutional reads out as a negative $2 million is that they are paying a positive $5 million to retail to originate a mortgage which can be put on balance sheet where the economic return will read out and spread over time as a gain on sale.

So the decision is always made at that moment in time when you look at the origination are you better off putting it on balance sheet because of the economics and have it read out over time and spread or are you better off in selling? So as we have been originating more of the kind of assets that we want to hold on balance sheet, which will read out into better spread, there has been less sale into the secondary market, therefore less gains,

Roger Freeman - Lehman Brothers

Okay, that is helpful. In the investment portfolio, I think you have something in the neighborhood of $2 billion in asset-backed securities aside for your MBS holding. What percentage of that is in ABS CDOs and what percentage of that is AAA rated?

Mitchell Caplan

The vast majority of it is AAA rated, but let me get back to you with the specifics when I look at it.

Roger Freeman - Lehman Brothers

That's fine. We can follow-up on that later.

Mitchell Caplan

About 20% of the asset-backed are in CDOs and, again, they are all AAA rated, yes. That's right.

Roger Freeman - Lehman Brothers

Some of the other categories would be what? CLOs, or what would the other 80% be?

Mitchell Caplan

No, it would be traditional AAA-rated ABS portfolio. What I'll do is when we follow-up on the call with you, I'll give you some more specifics.

Roger Freeman - Lehman Brothers

That's helpful. Last question, quickly. You made an interesting comment on the increased use of options as a hedging strategy. I'm curious, Mitch, do you see that more as a function of the cost to hedge has come down because of increased liquidity in the options market? Or is it a more defensive measure on the part of your customer base, given volatility in the markets? Or maybe both?

Robert Simmons

It is more of just a more sophisticated customer. I mean, if you really do go back five years ago when it was only about 5% of DARTs, then it was really used as a speculative tool and most customers were actually a little bit afraid of options. What you've got today with a lot of option education is it is not only hedging, it is also yield enhancement and what's really nice about it, as we mentioned in the remarks, is it is being used by more and more of the customers, so I do not think it is really anything that is happening in the market and the liquidity or the cost as much as it is education and a broader segment of retail understanding how they can use options to their benefit.

Operator

Your next question comes from Howard Chen - Credit Suisse.

Howard Chen - Credit Suisse

Given the environment, I just wanted to make sure I am clear on management's message on asset quality. I guess first, if I back into the nonperforming loan figure, it looks like the end of the quarter was $168 million of NPLs, which I guess is roughly $50 million, $52 million up from the first quarter levels. Is that roughly right?

Mitchell Caplan

I think it is up about $49 million, as we said. Yes.

Howard Chen - Credit Suisse

Mitch, given your fairly constructive thoughts on the credit outlook versus what we're hearing in the industry, I am just trying to get a better feel on credit management. A $7 million reserve build seems to make sense in the environment, but if NCAs were up $50 million, $49 million in the same period, I guess that would imply that the reserve coverage fell to something in the 45% range.

What gives you the confidence that this is the appropriate reserve? I hear you with regard to just being flexible with regard to adjusting that going forward, but I just want to get your feel right now.

Mitchell Caplan

Okay, so as you look at where we are right now and we look forward in terms of 12 months of losses, or four quarters worth of losses, there are probably two significant things that get us extremely comfortable with where we are.

The first one is that when you look at what actually is reading through, as I said, there was a reasonably strong improvement in Q2, given that when you think about the pipeline from Q1, what read through was down from 26% to 19%. Again, I think we're seeing that because some of the customers who had been moving into the NPL pipeline before they are actually get into charge-offs are actually getting refinanced and taken out; not by us, but I guess by others.

So given that, we feel that we are pretty comfortable with seeing the 19% range. That is the first thing. The second thing is we're fundamentally changing the mix. So in other words, we are continuing to allow consumer to bleed off as we always have, we are continuing to let HELOC and others reduce. We're doing, literally, as I said, 100% of the buying in first lien position mortgages, which traditionally have had about a basis point charge-offs.

So when you think about those two things, we believe that the current quality of our portfolio is better and then the average there and you see it when you look at us compared to the industry at large, and you see other metrics from the industry or otherwise. We also believe that we're going to make some significant changes.

That said, I think what we're clearly saying is we do not believe that we are immune, so if you look at this quarter, given what we saw in terms of charge-offs only going up 1.5, we increased reserves by $9 million and we went to $30 million. Even in the context of reaffirming the guidance in the range, we have said that we do believe that we will likely take, within that guidance context, likely take reserves up in Q3 and in Q4, notwithstanding the fact that charge-offs may in fact be less than those reserve levels.

Howard Chen - Credit Suisse

That's helpful. Thanks for reviewing that. I guess it is still early in the third quarter, Mitch, but with regards to that first point, that 26% to 19%, do those trends still hold true in the early parts of July?

Mitchell Caplan

I guess from what we can see so far. Again, it is hard to know because we do calls with them and we have actually people on-site managing it, so [inaudible] to change that view.

Howard Chen - Credit Suisse

Earlier in July, Moody's downgraded the rating of E*TRADE CDO1. I know you took a write-down for this one in the third quarter of last year, but can you just update us on any remaining exposure you may have to that manufactured housing CDO and then your view on the outlook for the remaining CDOs that you have and what you're actually doing there?

Mitchell Caplan

Yes, so a good way to think about this is that the CDOs that we have originated I think are through CDO1 through 6. We held a residual in CDO1, which we wrote down to zero. We did that last year. When you look at the rest of the CDOs, we are holding all of them right now at book value. The total book value for 100% of CDO1 to 6 is $11 million.

Howard Chen - Credit Suisse

That book value, would that have changed from, let's say a quarter ago?

Mitchell Caplan

No.

Howard Chen - Credit Suisse

Finally, Mitch, just switching gears, we're now a few quarters into the launch of the loan optimizer. It seems like your margin loan balances are tracking higher. From what you can see, is at all of function of your customers shifting their leverage away from HELOCs or credit cards to margin loans or is that simply just a function of overall equity market appreciation? Put another way, are you happy with the way that the loan optimizing is progressing?

Mitchell Caplan

Yes, but again it is early days and so we would hope to continue to see, has the loan optimizer been as successful as the cash optimizer? No. But again, it is early days and we expected it to take longer. When you think about the growth that we experienced in margin in this past quarter and, again, I think what we have seen so far in Q3, we think that most of that is driven, whether it is the loan optimizer or otherwise, by continued engagement within the target segment.

Jarrett Lilien

The thing is, the loan optimizer is a good awareness tool right now and it is doing its part, but just reiterating what Mitch said, the real growth is additional accounts. It is the growth in the target segment that drives 76% of our revenues. It grew 29% in the quarter. That is what is driving assets, cash, DARTs, and margin.

Robert Simmons

Let me clarify one other point that was made earlier by Mitch. It was a question around the vintages and stuff. I think if you look at our total book as of the end of this quarter, you can see that the growth in our loan book came exclusively in one to fours and margin, which are our highest quality loan categories.

If you look at our consumer and our HELOC book, they were both down. So the question with respect to vintages, we do not have zero in '06 vintages in our book. We will give you some more details when we file our Q. But I just wanted to clarify that the reduction of $400 million related to our HELOC book this quarter and we would expect that sort of trend to continue.

Mitchell Caplan

I was responding to what Matt was talking about, which is within the '06 vintage, we have zero in sub prime. So I think that was the issue that I was responding to and I guess the sheet of paper that I have been seeing. So again, our sub prime quarter-over-quarter continued to stay flat and declined a bit. Then what could be thought of as sub prime, I guess, in the '06 vintage is zero at this point.

Operator

Your final question comes from Matthew Fischer - Deutsche Bank.

Matthew Fischer - Deutsche Bank

The Global Trading Platform, you fully launched it last week. Does any of the second half guidance include any contribution from that?

Mitchell Caplan

No.

Matthew Fischer - Deutsche Bank

At what point do you start to see some activity and some of the usage rates increase? Are you already seeing some of the beta people start to be become more active users?

Robert Simmons

There is some Global Trading activity built into the second half. It is just that we are not betting right now on an avalanche. If we start to get a huge pickup, which I believe one day we will get and actually, part of me believes that it will come in an avalanche at some point, just the way the online trading was adopted or adapted in the U.S., people overnight all of a sudden wanted to trade online in the U.S.

We have built a measured to increase in Global Trading into the second half budget, no incredible upside. I think what you're going to have more likely is that what we will build into our numbers is a nice, gradual increase. We're seeing that early days so far. The beta customers picked up activity. A lot of new customers came in.

Another interesting thing that we saw in the marketing that we have done around it is that some of the increase in new accounts, in general, has been driven by Global Trading Platform advertising. It is one of the more newsworthy things and when we advertise behind it and do promotions behind it, people are clicking through there and oftentimes starting up by just opening up a U.S. account.

So a lot of the results are very positive, but are showing up in other places right now. I would add one other place where the positives are yet to turn up, which is what it does for us on the infrastructure side. In time, what we would like to do and we have talked about this before, is have our non U.S. platforms replaced by our Global Platform. That will help us increase efficiency and reduce costs.

An example, for instance, would be in Hong Kong today we have a platform. We have customers in Hong Kong, but our U.S. platform trades the U.S., it trades Hong Kong. Why can't our Hong Kong customers trade through essentially the U.S. platform or the Global Platform for Hong Kong, for the U.S., allow us to eliminate the Hong Kong platform completely; again, increase efficiency, reduce costs, and really gain scale advantage.

So there are advantages of this platform left and right. They will show up throughout the business. So far we are extremely pleased with the results.

Matthew Fischer - Deutsche Bank

Okay, then the other piece is the UK bank charter.

Mitchell Caplan

Yes, happy to do it. The answer is we're in great shape. One of the things we learned about in the process of actually filing for the UK bank charter was that we did not need an independent bank charter, but instead in working with the FSA, we could simply apply for an extension of our current license to not only be a brokerage and bank, we have cleared all the hurdles and we have already started taking cash deposits. In fact, if I remember correctly, cash deposits internationally were up 15% or 16% quarter over quarter.

Matthew Fischer - Deutsche Bank

You're already up and running? When do you start to really market some of the bank products abroad?

Mitchell Caplan

Again, that will be the next step. The goal here is rather than to necessarily spend the marketing dollars directly for a bank product in the UK and all the related EU countries is to market it as part of an overall investing offer exactly as we do in the United States.

So right now, we're doing it mostly through service and calls. We have done a little bit of advertising in some of our international locations, but as we continue to move forward with the international strategy and marketing, you will see an offer that will include a host of things, one of which will be cash, just as we do in the United States.

Matthew Fischer - Deutsche Bank

When you say down the road, are we talking an '08 or are we talking second half of this year to start really taking advantage of this now fully-integrated international platform?

Mitchell Caplan

Well, I think it just depends, again, on how we allocate the marketing spend between the U.S. and international, but to the extent that we see the kind of growth, then we will allocate the dollars internationally. I think that is exactly what we're thinking about trying to do and we are seeing a pickup in cash growth internationally.

Robert Simmons

You know, you have your long-term vision, which for us is global financial services and global financial services includes investing and trading, cash management, and lending. So that is your long-term vision. You need to build a brand in that direction.

Then you've got your short-term opportunities, and I would say that we are more efficient and effective with our marketing dollars than almost anybody, which means being opportunistic, looking at what is going on in the market and then marketing to what the market demands at that time. That is what is going to drive short-term marketing dollars. Long term branding and marketing dollars are going to be around global financial services.

Matthew Fischer - Deutsche Bank

You have to develop different marketing products for each region?

Mitchell Caplan

The products actually can be pretty similar because you're using the charter that you have through the FSA and extending it, so then it goes to the issue of the currency and because we have FX because of trading, it is not complicated. It is not that complicated for us to do. Really, it is building, as Jarrett was saying, the brand outside of the U.S. just as we have done inside the U.S. to go after this investing customer. As you are going after the investing customer, building the total relationship with them, including cash.

Operator

I will now turn the call over to Mitchell Caplan for any closing remarks.

Mitchell Caplan

Great, thanks everybody for joining us on the call. We look forward to following up with you after our Q3.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: E*TRADE Financial Q2 2007 Earnings Call Transcript
This Transcript
All Transcripts