E*TRADE Financial Corporation (NASDAQ:ETFC)
Q3 2007 Earnings Call
October 17, 2007 5:00 pm ET
Mitchell Caplan - CEO
Jarrett Lilien - President, COO
Robert Simmons - CFO
Rich Repetto - Sandler O’Neill
Mike Vinciquerra - BMO Capital Markets
Matt Snowling - FBR Capital Markets
Roger Freeman - Lehman Brothers
Matthew Fischer - Deutsche Bank
Howard Chen - Credit Suisse
Prashant Bhatia - Citigroup
Michael Hecht - Banc of America
William Tanona - Goldman Sachs
Mike Carrier – UBS
Welcome to E*TRADE Financial Corporation’s third quarter2007 earnings conference call. (OperatorInstructions)
I have been asked to begin this call with the following Safe Harbor statement. During this conference call, the company willbe sharing with you certain projections or forward-looking statements regardingfuture events or its future performance. E*TRADE Financial cautions you that certain factors, including risks anduncertainties, referred to in the 10-Ks, 10-Qs and other reports periodicallyfiled at the Securities and Exchange Commission could cause the company’sactual results to differ materially from those indicated by its projections orforward-looking statements.
This call will present information as of October 17, 2007. Please note that E*TRADE Financial disclaimsany duty to update any forward-looking statements made in the presentation.
In this call, E*TRADE Financial may also discuss some non-GAAPfinancial measures in talking about its performance. These measures will be reconciled to GAAPeither during the course of this call, or in the company’s press release, whichcan found in its website at etrade.com.
This call is being recorded. Replays of this call will be available via phone, webcast and podcastbeginning today at approximately 7pmEastern time. This call is being webcastlive at etrade.com. No other recordingsor copies of this call are authorized or maybe relied upon.
I will now turn the call over to Mitchell Caplan, ChiefExecutive Officer of E*TRADE Financial Corporation who is joined by JarrettLilien, President and Chief Operating Officer; and Robert Simmons, ChiefFinancial Officer.
Good afternoon, everyone and thank you for joining us forour third quarter conference call. Asyou are all well aware, the credit markets experienced unprecedenteddisruptions during the third quarter, creating an extremely challengingenvironment. The volatility in thecredit markets, declining home prices, and the repricing of risks drove widercredit spreads. This led to increaseddefault rates, losses and reduced liquidity across mortgage-related assetsthroughout the industry.
While we continued to generate strong -- and in somerespects record results -- in our retail business, the success of the corefranchise this quarter, was overshadowed by volatility in the credit markets. Asthe mortgage industry deterioration spread from the sub-prime market, and beganto impact the broader financial environment, we worked quickly to analyzevarious scenarios based on assumptions derived from the data available tous. Based on this analysis, we made thedecision to revise our annual earnings outlook on September 17th.
Along with the revised guidance announcement, we introduceda strategic plan to accelerate our balance sheet restructuring initiative andexit underperforming businesses. Thisplan was designed to improve earnings quality, expand companywideprofitability, and increase return on equity over time.
We also outlined our expectations for potential securitiesrelated impairments and provisions for loan loss levels for the remainder of2007 and throughout 2008. Our forecastswere set against expectations of further deterioration in the credit andresidential housing markets, and that continued to be our view.
As a part of our guidance release last month, with respectto security impairments, we forecasted that we could see up to $100 million inthe second half of 2007 and an additional $50 million to 100 million in 2008,for a total of up to $200 million over six quarters. These impairments were primarily related to twocategories within our asset-backed security portfolio, which we identified tohave the highest risk. Specifically,these were collateralized debt obligations, or CDOs, and securities collateralizedby second lien mortgages.
Since the September guidance release, upon re-evaluation andrefinement of our forecast, we determined that certain write downs needed to betaken in the third quarter. Additionally, we decided to accelerate the sale of the highest riskportions of these portfolios; writing down securities rated lower than AA bymore than an average of $0.50 on the dollar, by changing the intent anddesignation to no longer hold these securities to recovery. The combined effect is that we reported animpairment charge of approximately $197 million in the third quarter.
While the fix income market continued to be incrediblychallenging, we have seen some evidence of stabilization in certain pockets andthe action we have taken will allow us to exit these securities asopportunities arise. The decision wehave made is also consistent with our focus on reducing the securitiesportfolio as soon as reasonably possible as we transition the balance sheettoward retail-driven assets and liabilities. The realization of theseimpairments in the third quarter is to the benefit of future quarters.
While of course this does not guarantee that we won’t seeany other impairments going forward, we believe that we have reduced thecurrent risk in our two highest risk ADS categories, significantly relievingheadwinds to the performance of the company in the fourth quarter and into2008. We have provided an update to our supplemental portfolio disclosuredocument to reflect data as of September 30. The document will be available later this evening on the investors relationsection of our website at etrade.com. Onpage 24 of that document, you can see the impact of the impairment.
In our whole loan portfolio, performance trends of mortgageloans, specifically within home equity loans, remains challenging but fairlyconsistent with our previously revised expectations. Total delinquent mortgage loans increased to$769 million, up from $548 million in the second quarter. Non-performing mortgage loans, which is thesubset of total delinquent loans that are delinquent by 90 days or greater,increased to $266 million from $164 million in the second quarter.
It’s important to note that 43% of our non-performingmortgage loans are related to one to four family where, despite thedelinquencies in these loans, we continue to see net losses in the range of 1to 2 basis points. This is the result ofexcess collateral due to relatively low loan to value ratios and mortgageinsurance coverage on loans with loan to value of greater of 80% atorigination.
Consistent with our revised guidance announcement inSeptember, the provision for loan losses was increased significantlyquarter-over-quarter to $187 million. This increased our blended coverage of non-performing loans to 76%. Embedded in this ratio is coverage of excessof 100% of non-performing loans in the categories of highest expected losses;specifically, home equity and consumer.
In our core retail franchise, customer engagement and growthtrends remained robust and were particularly impressive for the summermonths. We delivered continued accountgrowth with the most significant increase occurring in our target segment,which now represents approximately 28% of our retail accounts passing the 1million mark for the first time.
As a result of the continued improvements in the quality ofour overall account base, we generated solid growth across all the key driversof the business, including accounts, trades, assets, cash and marginborrowing.
We are extremely please with the continued growth trendthroughout the retail business but we are clearly disappointed with the overallcompany performance. For the third quarter we reported a net loss of $58million or $0.14 per share including the $0.30 impact from the securitieswritedowns I already discussed. While werecognize that we cannot control the macro economic environment, we areaggressively addressing the current credit challenges we’re facing.
In accelerating the timetable to reduce our asset backsecurities portfolio, we are working to put the distraction of portfolio lossesbehind us and concentrate on the growth we continue to generate with the retailcustomer.
To discuss these growth trends in more detail, I’ll now turnthe call over to Jarrett.
Thanks, Mitch. Theretail business delivered strong organic growth and record results in the thirdquarter. Our integrated model continuesto drive customer engagement across our suite of products, meeting our variouscustomers financial services needs and we are proud of these results. Retailsegment revenue was up 21% versus a year ago, while retail segment income grew55%. This was driven primarily bycontinued account growth in both investing and banking accounts, which in totalwere up 6% year over year. Notably, thiswas led by year-over-year growth of 24% in our target segment accounts,including 16% annualized growth in the seasonally slower third quarter.
We continue to see success in attracting new accounts, aswell as deepening engagement with existing accounts to increase share ofwallet. Our existing and new investingand trading customers opened 60,000 deposit accounts in the quarter. This represented approximately 64% of the newdeposit accounts open in the quarter and 78% of the assets in theseaccounts. 80% of our investing andtrading customers that opened a deposit account increased their total assetswith us, showing broader engagement trends. Assets per customer in the quarter increased to a record $61,000.
In the third quarter, we saw positive customer activity onall fronts. Our customers were netbuyers in the quarter, and trading volumes increased to 194,000 DARTs. This was record activity for a summerquarter, increasing 15% sequentially and 44% year over year. Average margin debt also increased to $7.7billion, 8% sequential increase and 16% year-over-year.
On top of putting more cash into the markets, customers alsogrew their overall cash balances by $1.7 billion, up 25% year over year to endthe quarter at a record $39.6 billion. Cash balances increased nearly acrossthe board, with continued growth in our lowest cost sources such as the depositaccount, along with the continued success of our more competitively pricedproducts such as the complete savings account.
These positive customer metrics including growth inaccounts, assets, trades, margin and cash are particularly important thisquarter given the disruption in the credit markets and the impact that this hashad on the perceived stability of our business. We have worked diligently over the recent months to increasecommunication with our customers, and their continued engagement demonstrates theirsupport and confidence in the company.
International retail activity was also very strong in thequarter, up 20% sequentially and 76% year over year to a record 33,000DARTs. We are also seeing strong growthin international customer cash which exceeded $2 billion for the firsttime. These results are being driven byrapid growth in markets such as Denmark,Germany, Canadaand the UK. As a result of this success, we have seeninternational revenue grow by 61% year over year, albeit off a relatively smallbase. Nonetheless, we are deliveringsolid growth from our international operations with improving scale andefficiency.
With respect to the strategic plan that we presented inSeptember, we are making progress on all fronts. In terms of the balance sheet, averageinterest earning assets did increase quarter over quarter, and this was theresult of prior purchase commitments in trade settlements.
By quarter end, interest-earning assets declined by $1.2billion compared to August, consistent with the plan we introduced on September17th. As part of this plan, we expect tohold the balance sheet at approximately current level and perhaps lower, shouldwe not replace assets that prepay or pay down.
In terms of our announced exit of wholesale mortgage lendingand the restructuring of the non-US institutional equity business, we aremaking progress. There has been some confusion in the market regarding ourdecision to exit the wholesale mortgage business and I’d like to provide someclarification. Our decision was to exitthe wholesale, or broker originated portion of our mortgage operations, notmortgage entirely. The wholesale channelhas historically been a source of balance sheet growth but these loans oftencame with little, if any, customer relationship.
We plan to continue to originate mortgages directly for ourexiting and perspective retail customers. As we make this transition, we will continue to purchase mortgage loansin the secondary market, but only high quality first lien mortgages consistentwith our strategic initiative to reduce credit risk. We view retail mortgage as a core productwith a strong link to our customers and our overall strategy. Overall, wecontinue to have strong retail momentum and have reported another solid retailquarter in a very difficult and distracting macro environment.
With that, let me turn the call over to Rob to discuss someof the specifics on the financials.
Thanks, Jerry. Netrevenue for the quarter totaled $321 million, down 52% sequentially and 45%year over year. This decline is theresult of the fact that higher provision for loan losses and securitiesimpairments both reduced revenue. As welook to the performance of the business outside of these balance sheet-relatedissues, which Mitch already discussed, commission revenue and fee-relatedrevenue showed solid year-over-year growth trend. Commissions grew 41% while fees and servicecharges grew 11%. These growth rates areprimarily the result of the continued success we have driven in the retailbusiness through the growth in our target segment.
Turning to our segment results, we can more clearly see thesuccess of the business separating the institutional balance sheet-relatedchallenges from the retail performance. Total retail segment net revenue rose 4% sequentially and 21% year over year. Retail segment income grew 10% sequentiallyand 55% year over year, again demonstrating the earnings leverage and expensecontrol in the model. This growth in revenue and income is the result of thesuccess we have seen in attracting, retaining and migrating more customers intoour target segment.
As we’ve said before, these customers on average demonstrateapproximately 4 times the level of engagement around cash, assets trading andmargin, which in turn drives approximately 10 times the revenue of an averagecustomer as a result of the multiple points of interaction.
Institutional segment revenue and income fell sharply in thequarter, which was a direct result of the higher provision for loan losses andaccelerated securities impairments already discussed.
What’s most important is that even with these losses and theimpairments, the balance sheet remains well capitalized with Tier 1 capital of5.9% and risk-based capital of 10.6%. With respect to capital management going forward, we intend to increaseour tier 1 and risk-based capital ratios from current levels to provide greatercushion to the well-capitalized minimum thresholds of 5% for Tier 1 and 10% forrisk-based.
As previously discussed, the strategic plan we presented inmid-September will significantly reduce the capital demands of the businessgoing forward. Of course, our firstpriority is to ensure the safety and soundness of the balance sheet through thecurrent environment, which remains somewhat volatile. When we emerge from thischallenging credit cycle, we expect to be well positioned for significant shareand debt repurchase, as well as investments in customer experience overtime. These will all be made possible bythe continued strong cash flow generation of the core business.
With the additional provision in the quarter net of charge-offs,allowance for loan losses increased to $209 million, representing a 76% coverage of total non-performing loans. To put this number into context, we look atcoverage levels by asset class, breaking them down across firstly mortgage,home equity and consumer loans. In thespirit of transparency, we have provided additional tables in our press releasedetailing loan balances, performance metrics and credit ratios by asset class.
Our ending allowance to non-performing loan ratio of 76%includes 8% coverage on first-lien non-performing loans, 116% coverage on homeequity loans and over 330% coverage on consumer loans. Net interest spread in the quarter dipped by 6basis points which was a combination of a 12 basis point increase in fundingcosts, partially offset by a 6 basis point increase in asset yields. Given the timing of the Fed cut, the quarteronly had a two-week benefit from lower rates, and we expect to see a moremeaningful benefit to overall funding costs in the upcoming quarters.
With respect to our earnings guidance for the remainder ofthe year, we are revising our outlook primarily due to the securitiesimpairments recorded this quarter. As abase line forecast for the business, we are projecting earnings of $0.85 to $0.90per share. This range includesassumptions that provision expense in Q4 will be approximately $80 million withno additional securities impairments. Webelieve that in this environment it is extremely difficult to forecastcredit-related items.
As a result, we believe it is prudent to include another $0.10of downside to this forecast against the possibility of further credit deteriorationin some combination of impairment and provision for new 2007 full year guidanceof $0.75 to $0.90. This implies fourthquarter earnings of between $0.13 and $0.28 per share, given the year-to-dateearnings of $0.62.
In conclusion, the third quarter was a tough and frustratingone for the company with two distinctly different story lines. On one hand, the retail segment experiencedtremendous success with growth and record results throughout the business. On the other hand, the challenges we and thebroader financial industry are facing as a result of the stress in the housingmarket completely overshadowed the success of the retail business.
As we navigate through the continued dislocation in thecredit market, we will continue to make disciplined and often difficultdecisions to manage through the strategic transition and focus on the truevalue of the franchise.
This concludes our prepared remarks. Operator, we are now ready for questions.
Your first question comes from Rich Repetto - SandlerO’Neill.
Rich Repetto -Sandler O’Neill
The question has to do with the ABS portfolio and the 197impairment. I’m just trying tounderstand how they were performing? Iknow you sold at $0.50 on the dollar. Iknow that wasn’t the plan. I know youwant to accelerate the transition and get out of this situation as quick as youcan, but I’m just trying to see, that CDOs and second liens is over $600million from the last disclosure. I’mjust trying to get more color on the background on the writedown.
Happy to do it. First of all, let me be clear. We did not sell, so this loss is unrealizedloss. It’s an impairment running throughthe P&L. We did not actually sell the securities. If you remember when we last spoke and whenwe were on the road, we were specifically circling up as an area of concernwith respect to our overall securities portfolio the ABS. We felt extremely uncomfortable obviouslywith our AAAs, in our agency, and so what we really looked at in particularagainst the entire backdrop of the $3 billion in ABS CDOs, and even in theasset-backed securities portfolio, was the CDO composition as well the secondlien composition.
What we had done is, as you know, the market is fluid. It’s challenging; it keeps moving. We’re constantly in a position where we’rere-evaluating and refining the forecast. When you looked at that and we came back, we made the determination,that we needed obviously to have certain writedowns, but more importantly thatwe did not want to continue to hold these securities to recovery.
As a result of designating them or changing our intent as amanagement team given all these other facts and circumstances I just described,it doesn’t matter whether the securities are cash flowing. What happens is you impair them at that pointat market value. So what we did inworking with our team internally is if there’s a mark that’s readily available,you use it. If there’s not a mark that’s readily available, you use marketvaluation.
What Rob spoke to was that across the board they were markedto less than $0.50 on the dollar, andthat is across both the CDOs and the second liens. There is a specific breakdown for each ofthem. Rob, do you remember?
Specifically the ABS portfolio and the second lien weremarked through the A tranche, in the case of CDOs, to about $0.53 and about$0.28 for the second lien.
Fundamentally, Rich as a result of recognizing the fluidityof the market, recognizing that we weren’t going to be in a place where we weregoing to see these charge-offs starting to come through and that we did havethe flexibility as a management team to make the decision to no longer holdthese to recovery, it allowed us to move the impairment forward, effectively,to the benefit of future quarters.
Your next question comes from Mike Vinciquerra - BMO CapitalMarkets.
Mike Vinciquerra -BMO Capital Markets
Just to clarify that, Mitch, I just wanted to make sure: soyou haven’t sold them but you intend to sell them? Or have you sold them sincethe end of the quarter? I’m not quiteclear on it.
Okay, perfect question. We have not yet sold them. Ithink one of the things we have talked about very clearly over and over againis the success that we are experiencing in the retail franchise, the engagementwe are seeing with our customer, the important of showing our business modelwhether it’s through the engagement of the customer, our capital ratios, ourexcess liquidity protection as well as where we are in terms of overallcapital.
So recognizing that, we understood that one of the thingsthat was imperative and we talked about in the last call was thistransformation from the balance sheet as it currently stands, to one that isreally almost exclusively driven by retail; getting to an 80% or 85% retailbalance sheet both on the asset and liability side.
There a number of ways to do that. Obviously one is to delever so as you haveprepayments just to allow the balance sheet to shrink, particularly with yoursecurities. Another would be to sellthem.
Given what we were seeing in the market place, our view wasthat we no longer wanted to hold these securities in the ABS portfolio aroundCDO and second lien to maturity, given that there would clearly bewritedowns. We believed that the bestthing to do was to change our intent to hold them to recovery, designate themas no longer held fro recovery. Theaccounting impact of that is an immediate impairment. We talked about the impairment and that ishow they are currently marked.
We will take advantage as the market firms of selling themand if we could sell them in the ranges that they’re marked at it is certainlyan opportunity that we would take advantage of to help speed up thistransformation.
One of the things that we as a management team realize isthat the incredible success we are seeing in retail is being overshadowed bythis very volatile and uncertain credit market, and the faster that we can makethat transformation the more important it is for us.
Mike Vinciquerra -BMO Capital Markets
Following up a little bit, when you guys were on the roadrecently, you were talking about if you had to mark your entire ABS portfolioto market, I think you were saying $400 million to $450 million seemed like areasonable market if you went ahead and sold everything today. Can you update us as to where that might havestood at September 30 when you did your analysis?
I’m happy to do it. So the current mark on the entire ABS portfolio today, negative mark,would be $268 million. Of that $268million, $137 million relates to below AA and a $131 million relates to AA andAAA, as well as the fact the $268 million is in fact a pre-tax rather than anafter-tax number. So when you thinkabout the breakdown, I guess the risk is really in our minds going forwardaround the $137 million that relates to anything below AA in the ABS portfolioon a pre-tax basis.
Rob anything you want to add?
No, other than obviously there still is the risk that otherrating agency downgrades could move other AA bonds into a category that theywould become at risk. But again, it’svery difficult to forecast this market. As we look at the current mark of the ABS book as Mitch mentioned, that$268 million was roughly half of that being AA or higher. We feel like we’re in a reasonably good placethis quarter.
Your next question comes from Matt Snowling - FBR Capital Markets.
Matt Snowling - FBRCapital Markets
Can you give us a little bit explanation as to what happenedto the OCI accounts?
To the OCI? Absolutely.
Matt Snowling - FBRCapital Markets
Yes, there’s a $144 million drop somewhere?
OCI this quarter was about $483 million as you can see onthe balance sheet there. Just to giveyou a quick sense of the composition of that, obviously that’s on an after-taxbasis so all these numbers that I’ll talk about will be comparable on anafter-tax basis. The MBS component ofthe agency, the AAA component of the $483 million is about $315 million ofthat. So, roughly 62% of the OCI balanceyou see relates to our MBS portfolio; the $268 million that relates to the ABSportfolio that Mitch just went through, on an after-tax basis that wouldrepresent about $169 million of that$483 million balance.
So again, half of that would relate to securities that areAA and above. So you can see the vastmajority of the mark in OCI relates to a combination of MBS agency paper and ABS that’s AA or higherrated.
Matt Snowling - FBRCapital Markets
And $315 million from the MBS portfolio, I would havethought that would have gone the other way given where rates are coming down,or is that just spreads widening?
Spreads widening, my friend.
Your next question comes from Roger Freeman - LehmanBrothers.
Roger Freeman -Lehman Brothers
The thing that struck me is just looking at the supplementaldisclosures, it looks like there was another 15% deterioration in thedelinquencies in the HELOC portfolio from August to September. It went from 349 to 404, and it looks likethe 80% to 90% CLTV tranche there actually were the highest increase. , Mitch, can you talk a little bit to thatand just put that in the context of the 25% incremental deterioration you wereexpecting this year and plus another 25% next year, the trend line doesn’t lookencouraging.
Happy to do it. Asyou see the increase there, remember that we were on the road we were talkingabout two things affecting the overall value. One would be a 25% increase in August by the end of this year and anadditional 25% next year. The otherthing we talked about is seeing the recovery value drop from our model, 80 to 70 by the end of the year although we arecurrently running at 85.
If you look at the increase in September, the increase isthe largest, as you pointed out, in the HELOC in the 80 to 90 and 90 to 100, sothe areas that while we were on the road and the last time that we did the callthat we circled up.
I think we are still comfortable by and large with the rangeof about 25% growth rate given that we are continuing to see recovery ratespretty consistent at about 85%. So itmay be a little higher on one and a little lower on the other. As you go into next year, and we’re still ofthe belief there will be another drop from 70 to 60 and another increase of25%.
I think the most important takeaway, however, is that if younoticed in the guidance that Rob just gave, he talked about the bank businessand what he thought it would earn, and then he said in an effort to be prudent,considering another $0.10 of possiblecredit securitization which could come from either securities impairments orsome of these trend lines that you have seen; notwithstanding the fact thatwhat we’re currently seeing, I think we’re reasonably comfortable with what wehave set. But again, it’s a market influx, and that was the identification of the additional $-.10 or $65 million. All of that by the way is pre-tax.
Roger Freeman -Lehman Brothers
My follow-up is then on the CDOs. Again, it looks like you marked down the ABSCDOs, according to the supplemental disclosures, just about $100 million. As you point out, it’s all in the below AAcategory. But then Mitch, you also saidthat the mark on that would be $137 million. Can you reconcile that difference? It looks like it is not fully marked to where you could sell the stuffat. Is that a fair assessment?
Let me clarify. Whenyou’re talking about the mark on the ABS portfolio of $268 million, about halfof that relates to AA or above; so about half of that obviously is in that A orbelow category. The marks that we took,specifically to the ABS CDO book and the second lien book, were the marks wetalked about earlier. We marked them notto zero, but we marked for instance the ABS CDO book to about $0.53 on thedollar and the second lien book to about $0.28 on the dollar.
Your next question comes from Matthew Fischer - DeutscheBank.
Matthew Fischer -Deutsche Bank
First off, the capital, again you mentioned it dipped below6% but you I guess want to improve that, keep that up above 6%. So what’s the comfort level here? How will this impact your buybacks?
It’s a great question. We ended tier 1 at 5.88%. As Robsaid, we ended risk-based at 10.5 bips. Assuming that directionally we’re goingto move up 6%, 11%, whatever. First ofall, one clear possibility is in Q4 if we allowed the prepayments to rollthrough and the balance sheet to delever, that would move you directionallywhere you want it to go and we certainly mentioned that as a possibility as wework through Q4.
At the same time, I think it’s important to note that wehave on a pre-tax basis corporate cash that we could downstream in excessive ofabout $258 million that is totally available to be downstreamed if that’s whatwe wanted to do. As well, we have anundrawn line of credit on a pre-tax basis that is about $396 million.
Let me just clarify, there is about $160 million of cash atcorporate with again, as Mitch mentioned, $250 million on a completely undrawnrevolver. Now those are obviously, theywould be available effectively on an after-tax basis to cover higher pre-taxlosses if necessary.
Right that is exactly correct. So as we look at that, we see theopportunities for us to be able to increase our capital ratios. I think as Rob said, the most important thingfor us is to solidify our capital position given the uncertainty in the market.Once we get beyond that, as Rob I think also said in his comments, it puts usin a position given our strong cash flow, to begin a share and debt repurchaseprogram.
Matthew Fischer -Deutsche Bank
Home equity loans roughly flat from Q2. How quickly and how will you go about theplanned mix shift towards first lien?
It’s a great question. So there are two possible ways. The first is obviously you are going to have continued prepayments inyour loans, both in your first and second. As the prepayments come through, we certainly will not be replacingthem. So that will be one way that you’dbegin the mix shift. The other would be to the extent that we made a decision over time to either sellthem or securitize and sell them, which would also expedite the mix shift.
Our next question is coming from Howard Chen - CreditSuisse.
Howard Chen - CreditSuisse
First question, I guess is a bigger one. It’s been a month since you announced thatstrategic realignment. You as themanagement team have had time to assess the situation, to discuss the numbersand see your shareholders and incremental owners. Realizing that he changing environment, I amjust curious what lessons do you and the management team take away from thepast few months? What in management’scontrol doesn’t happen again going forward?
I think we have come away with a couple realizations, mostof which I think -- I hope, I believe very strongly -- that I knew going intoit. One, and that is the customer is atthe center and the most important at everything we do. As we think about the decisions we make inrunning our business, it is all about continuing to ensure for that customerboth a great value proposition, with respect to product and services and alsomaking it clear to that customer what a solid, stable and growing franchise wehave by discussing things like excess liquidity. I think it’s up to now $14.4 billion from theFHLB has actually increased; continuing to deleverage the balance sheet,strengthening our capital ratios and obviously the sources that are availablefor us for additional capital. So, Ithink that is the first thing we learned.
The second thing that we learned in the process is it isabsolutely imperative to have a phenomenal management team. I will tell you I think I am incrediblyblessed. The team has been extraordinaryin working together in what has been a very, very difficult time. Without a doubt on the retail side, the wholeteam stayed focused and delivered results that I think are incrediblyimpressive, summer or otherwise. Withrespect to looking at what’s happening in the marketplace from the instabilityand the fluidity and the challenging environment, we are dealing with exactlythe same thing that everybody else is dealing with. So at the result of that it’s all abouthaving a strong team that can evaluate and make decisions that are appropriate,I think promptly and then execute as quickly as possible.
Howard Chen - CreditSuisse
A quick follow up on the numbers. Rob, you mentioned in your prepared remarksyou expect to see some benefit from the recent Fed cut in upcoming quartersbut earlier this week I saw that you cutthe max savings yield by 25 bips to 470 following a 50 rate cut. Can you discuss what impact thatmay have on the spread going forward and what helps alleviate that spreadcompression?
I know management in the past has spoken to not wanting tohave a top three yielding savings product but at 470 I think you’re kind ofthere so has there been a change in deposit pricing philosophy?
Let me talk a little bit about spread and then I’ll letJarrett talk about pricing because I think it is a very important part of ourstrategy. With respect to spread,obviously one of the things that we have been talking about for the last monthis strategically moving towards a place where in a balance sheet that is muchmore retail centric has less wholesales funding in an environment where wecontinue to grow cash that we think that overtime that will have a positiveimpact on spread.
Again, we were very pleased to see even in a seasonalquarter with obviously the summer months but also the volatility that we sawthis quarter in the market, that we were still able to grow our cash by $1.6billion, $1.7 billion I think was a real accomplishment and I think that aspart of our strategy going forward is to continue to accelerate that balancesheet transition that we’ve been talking about; reduce the wholesale componentsof it which overtime will have the effect of widening spreads.
I think Howard where you’re right as well is there areforces there that will help increase spreads such as growing customer cash andreplacing wholesale borrowings. But on the other hand there are other forcesthat are contracting on spreads. As rates come down on some of our lower rateproducts, there’s only so far that you can go down and so you won’t be able topass every Fed rate cut through the market.
With our highest grade products, one of the things that wehave to be very conscious of is really stability with the customer andfulfilling the promises we make to the customer and so we are looking at beingable to manage any rate changes in a measured way. If you look at the markets Ithink what there’s something like 70% probability of another 50 basis point cutin the market, something like that right now. We’ve got a weigh our rate cuts and not be all over the board.
So we’re taking those in a measured approach, 470 lookedlike the right place to be for now. If there is further Fed action -- or evenif there isn’t -- we may bring our rates down but some of it is Fed-related,some of it is the competitive environment. We don’t want to be tops but we want to have an attractive savingsproduct.
A couple points I’d add is that one of the things I look atis that not only were we successful I think at bringing in $1.7 billion but we brought it in flat to theprior quarter on an incremental cost I think 3.9. So our incremental costdeclined was 3.9% again in the quarter. Given that as we’ve always said, the vast majority of what we arebringing in is coming from an investing customer, they are traditionallyopening both a free credit or sweep account and at the same time this otheraccount.
I don’t believe we have changed our philosophy of wanting tobe one of the top rate providers;, I don’t think we will ever. I think we we’vebasically been comfortable with being within the top 20 or 25 and so what weare working through now as Jarrett said is, what’s the long-term strategy asthe Fed continues to act?
The other thing I would say is when you think about spreadagain. absolutely it is a balancing act but the good news is you will replacewholesale funds which are clearly more extensive that cash under anycircumstances, particularly when you think about the cost of that into hedge toextend out the duration and so there is a value in that, and certainly one wecan continue to bring in at a 3.9% incremental cost of funds, I am pleasedthere.
When you move over and you look at the asset side without adoubt you will have compression as a result of things that are generating ahigher yield like your second lien coming off and being replaced with firstliens. But at the same time, you willhave a benefit of securities coming off, which typically has the loadappeal. So net net, I believe over timeyou will be spread widening as a result of the balancing of all of thesedifferent acts.
Your next question comes from Prashant Bhatia -Citigroup.
Prashant Bhatia -Citigroup
Just on the home equity the 146 basis points of charge offs. Where is that now and according to yourmodels, where is that peak?
Where is that peak now?
In Q1 of next year we expect it to increase through by about25% from current levels.
Prashant Bhatia -Citigroup
Is that expected to be the peak in Q1?
It is in our current model Q1, and I think we expected tothen be flat in Q2 and Q3 so peak and not decline, if I remember correctly,until the end of next year.
Prashant Bhatia -Citigroup
Just based on that model, how accurate has that model beenso far?
It’s been basically right in the range.
Prashant Bhatia -Citigroup
In terms of the markdowns that you’ve taken to $0.53 and $0.28 on the dollar, you said you stilldidn’t sell the assets; and I guess, why not?
Because we made the decision to impair the securities quiterecently. Once we made the decision as a management team given all the facts Italked about with the fluidity and the changing marketplace and the markdownsas well as the decision to no longer hold them to recovery to be in a positionthat once we got there we took the impairment and we are, as you can wellimagine, working on it.
Our next question is coming from Michael Hecht - Banc of America.
Michael Hecht - Bancof America
I just wanted to come back on that interest spread. It sounds like over time there’s going to bea lot of moving parts. Near term, canyou talk a little about where net interest spread ended the quarter versus the 265average for the period?
I’m not sure where we ended the quarter versus the averageto be honest.
Michael Hecht - Bancof America
Maybe we can shift a little over to the expense side then,which seemed a bit high particularly on comp expense. How should we think about comp expense levelseither in dollars or percent of revenues going forward here? Do you guys have any flexibility in the modelto offset what looks like some pretty significant negative operating leverage.
First of all, comp expense quarter-over-quarter was actuallydown by about $1.5 million. So, I mean,salaries are down, commissions are down, et cetera. If you’re looking at it as a percentage ofrevenue, it’s going to be apples and oranges because the provision and theimpairments obviously as you know, run through the revenue line item, and sothey make a quarter-over-quarter comparison as a percentage of revenue notmeaningful. But the quarter-over-quartercomp expense is actually down.
Our next question is coming from William Tanona - GoldmanSachs.
William Tanona -Goldman Sachs
Just a quick one here on the net new asset flows, obviouslythird quarter was a record on the retail side of the equation. You guys brought in $1.1 billion versus $1.6billion in the prior quarter. Schwab isthe only one who’s actually reported their statistics yet. They are off about 40% where you guys aredown about 30%. So I’m wondering whattype of ramifications, if any, all the negative news or headlines is having interms of the retail investors’ willingness to put money with you guys?
Well, actually we’re not really seeing any real impactthere. I guess big picture, I think inAugust there was some impact. I mean, wehad customers that were calling, that were concerned. They were wondering about capital levels,security of assets, and that’s why I said in the prepared remarks that we spenta lot of time communicating with our customers.
What we’ve seen I think were some very encouraging thingswith our customer behavior. First of allwas seeing that they are actually net buyers in the quarter. So they were putting more money into themarket and they were also out there putting more cash into their accounts. Again, there were numerous rumors out therein August, and even in spite of all of that, you had net buying; you hadincreases in cash; and basically a very positive customer experience, startingreally with account growth, which we also saw has been something that’s beenvery positive and where it counts, in the target segment.
William Tanona -Goldman Sachs
If you think about that from a monthly standpoint, did yousee a difference in the trends throughout the quarter? And if so, how has that continued into theearly part of October here?
We really don’t comment so much past September 30th. But one thing I will say about the health ofthe customer is that they were very strong net buyers in August which obviouslywith hindsight, proved to be a smart thing. They were pretty good net sellers in September so they made money. If you look at leverage ratios, obviouslymargin was up but margin as a percentage of investing assets quarter on quarterwas actually down. So less leverage,buying appropriately, selling appropriately, bringing in more cash.
Also in terms of what they were trading, we actually sawbulletin board volume down quarter on quarter, which given that volumes were upso much that’s pretty interesting. Sowhere we saw our customers transacting was less in penny stocks and more inNASDAQ and New York listedstocks. Again, we saw options as apercentage of total DARTs up to record levels, which is again a positiveindication as they’re using those hedge and yield enhance.
So a very positive quarter for the customers showing thatthey’re healthy, which gives me confidence. A healthy customer means that they’ll be back again and that gives mesome confidence that this can continue for a while.
The only thing I think I would add to that is there is nodoubt that there was an impact. The goodnews is that at the end of the day the TOAs in were significantly greater thanthe TOAs out and we were able to see all of the metrics you’re seeing. But if you look at year-over-year comparisonwe were growing at about 24% in our segment. It’s slowed to 16%. I think someof that is the seasonality and I think some of it is the attrition that we didsee pick up in the month of August around all of the rumors.
To answer your question specifically I think we saw Augustbe much lower and September begin to resume to more normal levels with respectto asset inflows.
Our next question is coming from Mike Carrier - UBS.
Mike Carrier – UBS
Just a follow up on account growth; it looks like youroverall account growth is decent in the quarter and then target growth wasgood. But it seems like almost all thegrowth was in the banking area, quarter over quarter, and year over year. I’m just curious kind of what’s going onunder the covers with the brokerage account growth?
I think the most important thing, let me turn it over toJarrett, but again I think I have stated every quarter and I’m not sure thatpeople really recognize it – it is the same customer. So when you see an account grow you’reactually seeing a customer grow. It maynot be necessarily one for one, because some of it is, as you know the plan isaround acquisition, migration and retention. The vast majority of our balances and the vast majority of our accountswhen you look at banking and lending are in fact coming from your investing andtrading customers.
In terms of overall accounts it was actually a strongquarter any way you slice it. I mean interms of brokerage or bank, still better on a gross account basis than anyquarter of all of last year. And thenyou look at it a couple of ways, I mean marketing spend was down 26% quarter onquarter but gross accounts were down 13% quarter on quarter.
I’d rather look at it the other way which is summer tosummer; so a year ago to this year we actually spent 11% more on marketing andsaw gross account growth of 13% more. Soany way you really want to come at this thing, this was a great summer for newaccounts in both brokerage and bank, and Mitch’s point is right on target. The people that are opening bank accounts arethe brokerage customers.
This is a trend that has been going on for several quarterswhere, if you look at the significant cash that we’ve been generating as afirm, we’ve been generating cash primarily to brokerage customers. Either a customer who is a new brokeragecustomer in the quarter that also is opening some sort of a deposit account oran existing retail brokerage customer that’s adding to an existing account oropening another account. We’ve beenrunning upwards of 70% to 80% of our cash increase that we’ve been seeing overthe last several quarters has actually been cash from brokerage customers.
Mike Carrier – UBS
That makes sense. Ithink I am just looking at it more on the economics, meaning if you have a lotof the accounts on the banking side the deposit rate is going up and the lossis, on the other side going down, except we saw more growth on the brokerageside.
No, it’s actually a great question because to my earlierpoint, you actually are not seeing cost to fund go up there. It’s staying pretty flat at about 3.9%. That’s the first point.
The second is, and I think we mentioned this in the call,but we should probably continue to point out more and more so people understandit, when you look at a customer who opens a cash account, they also increasetheir assets with us. They also increasetheir trading behavior. They alsoincrease their margin balances. Sogenerally, cash is a leading indicator of a deeper engagement. It’s usually the first thing that comes afterthe brokerage account is opened, and then you begin to see increased balancesacross margin trading and cash and assets in a way in which it all drives tothe bottom line.
Our next question is coming from Rich Repetto - SandlerO’Neill.
Rich Repetto -Sandler O’Neill
I wasn’t clear on the buyback whether that was being delayedor can you start buying back shares with free cash or whether you were going toconcentrate on the capital ratios?
I think the first thing we’re going to do is concentrate onthe capital ratios and make sure that, from our perspective as a managementteam, everything is absolutely as sound as we want it to be. Remember, the customer matters first andforemost. Once we are at a comfortablelevel, whether it’s downstreaming from corporate, whether it is additionalretained earnings, whether it’s deleverage, whether it’s drawing on line,whatever it may be, and we feel comfortable, then we will begin the process ofrepurchase of shares.
Rich Repetto -Sandler O’Neill
So it’s probably an ‘08 event now?
I would say so.
Our final question is coming from Mike Vinciquerra - BMOCapital Markets.
Mike Vinciquerra -BMO Capital Markets
If I could ask a couple questions, just on the tradingside. The institutional business in youroriginal release with the credit side of things, you mentioned that you wererestructuring that and I was under the impression that it was going to shrinkin terms of its commission generation going forward. Can you talk about the timing there and if Iread that correctly?
I guess you did read that correctly, but what we’ll berestructuring are some of the non-U.S. institutional pieces and we’re makingprogress but that’ll be finalized towards the end of the year so the realimpact that you’re going to see is into 2008.
Mike Vinciquerra -BMO Capital Markets
So the $46 million in institutional commissions thisquarter, is that expected to drop? Notwithstanding the nice uptick in volume we saw this quarter, but isthat expected to be off noticeably as you restructure that business?
Into 2008, we’ll talk about that when we give guidance butthere will be pieces of that business that will no longer be with us.
That’s correct. Theonly thing I would say is if you break it up right now I think the U.S.is a much more significant percentage of what is driven than internationallyand so there will be an impact but it should de minimus when you think about itwithin the context of the overall P&L.
I mean if you think about it, we’re restructuring the partsthat weren’t that profitable.
I’ll now turn the call over to Mr. Caplan for any closingremarks.
I thank you all for joining us on today’s call. Clearly, I think as everybody knows, it’sbeen a pretty tough period macro economically and for the company, given allthese credit challenges but we’re very pleased with the success that we’reseeing in our core retail business. Weobviously will continue to execute on our strategic plan in order to managethrough this very volatile credit situation and focus the company on theopportunity and the strength of the franchise that we’re building.
Thanks again, and everyone have a great evening.
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