E*TRADE Financial Q3 2007 Earnings Call Transcript

E*TRADE Financial Corporation (ETFC)

Q3 2007 Earnings Call

October 17, 2007 5:00 pm ET

Executives

Mitchell Caplan - CEO

Jarrett Lilien - President, COO

Robert Simmons - CFO

Analysts

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

Presentation

Operator

Welcome to E*TRADE Financial Corporation’s third 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 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 periodically filed at 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 October 17, 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 found in its website at etrade.com.

This call is being recorded. Replays of this call will be available via phone, webcast and podcast beginning today at approximately 7pm Eastern time. This call is being webcast live at etrade.com. No other recordings or copies of this call are authorized or maybe 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.

Mitchell Caplan

Good afternoon, everyone and thank you for joining us for our third quarter conference call. As you are all well aware, the credit markets experienced unprecedented disruptions during the third quarter, creating an extremely challenging environment. The volatility in the credit markets, declining home prices, and the repricing of risks drove wider credit spreads. This led to increased default rates, losses and reduced liquidity across mortgage-related assets throughout the industry.

While we continued to generate strong -- and in some respects record results -- in our retail business, the success of the core franchise this quarter, was overshadowed by volatility in the credit markets. As the mortgage industry deterioration spread from the sub-prime market, and began to impact the broader financial environment, we worked quickly to analyze various scenarios based on assumptions derived from the data available to us. Based on this analysis, we made the decision to revise our annual earnings outlook on September 17th.

Along with the revised guidance announcement, we introduced a strategic plan to accelerate our balance sheet restructuring initiative and exit underperforming businesses. This plan was designed to improve earnings quality, expand companywide profitability, and increase return on equity over time.

We also outlined our expectations for potential securities related impairments and provisions for loan loss levels for the remainder of 2007 and throughout 2008. Our forecasts were set against expectations of further deterioration in the credit and residential housing markets, and that continued to be our view.

As a part of our guidance release last month, with respect to security impairments, we forecasted that we could see up to $100 million in the 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 two categories within our asset-backed security portfolio, which we identified to have the highest risk. Specifically, these were collateralized debt obligations, or CDOs, and securities collateralized by second lien mortgages.

Since the September guidance release, upon re-evaluation and refinement of our forecast, we determined that certain write downs needed to be taken in the third quarter. Additionally, we decided to accelerate the sale of the highest risk portions of these portfolios; writing down securities rated lower than AA by more than an average of $0.50 on the dollar, by changing the intent and designation to no longer hold these securities to recovery. The combined effect is that we reported an impairment charge of approximately $197 million in the third quarter.

While the fix income market continued to be incredibly challenging, we have seen some evidence of stabilization in certain pockets and the action we have taken will allow us to exit these securities as opportunities arise. The decision we have made is also consistent with our focus on reducing the securities portfolio as soon as reasonably possible as we transition the balance sheet toward retail-driven assets and liabilities. The realization of these impairments in the third quarter is to the benefit of future quarters.

While of course this does not guarantee that we won’t see any other impairments going forward, we believe that we have reduced the current risk in our two highest risk ADS categories, significantly relieving headwinds to the performance of the company in the fourth quarter and into 2008. We have provided an update to our supplemental portfolio disclosure document to reflect data as of September 30. The document will be available later this evening on the investors relation section of our website at etrade.com. On page 24 of that document, you can see the impact of the impairment.

In our whole loan portfolio, performance trends of mortgage loans, specifically within home equity loans, remains challenging but fairly consistent 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 the subset 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-performing mortgage loans are related to one to four family where, despite the delinquencies in these loans, we continue to see net losses in the range of 1 to 2 basis points. This is the result of excess collateral due to relatively low loan to value ratios and mortgage insurance coverage on loans with loan to value of greater of 80% at origination.

Consistent with our revised guidance announcement in September, the provision for loan losses was increased significantly quarter-over-quarter to $187 million. This increased our blended coverage of non-performing loans to 76%. Embedded in this ratio is coverage of excess of 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 growth trends remained robust and were particularly impressive for the summer months. We delivered continued account growth with the most significant increase occurring in our target segment, which now represents approximately 28% of our retail accounts passing the 1 million mark for the first time.

As a result of the continued improvements in the quality of our overall account base, we generated solid growth across all the key drivers of the business, including accounts, trades, assets, cash and margin borrowing.

We are extremely please with the continued growth trend throughout the retail business but we are clearly disappointed with the overall company performance. For the third quarter we reported a net loss of $58 million or $0.14 per share including the $0.30 impact from the securities writedowns I already discussed. While we recognize that we cannot control the macro economic environment, we are aggressively addressing the current credit challenges we’re facing.

In accelerating the timetable to reduce our asset back securities portfolio, we are working to put the distraction of portfolio losses behind us and concentrate on the growth we continue to generate with the retail customer.

To discuss these growth trends in more detail, I’ll now turn the call over to Jarrett.

Jarrett Lilien

Thanks, Mitch. The retail business delivered strong organic growth and record results in the third quarter. Our integrated model continues to drive customer engagement across our suite of products, meeting our various customers financial services needs and we are proud of these results. Retail segment revenue was up 21% versus a year ago, while retail segment income grew 55%. This was driven primarily by continued account growth in both investing and banking accounts, which in total were up 6% year over year. Notably, this was 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, as well as deepening engagement with existing accounts to increase share of wallet. Our existing and new investing and trading customers opened 60,000 deposit accounts in the quarter. This represented approximately 64% of the new deposit accounts open in the quarter and 78% of the assets in these accounts. 80% of our investing and trading customers that opened a deposit account increased their total assets with 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 on all fronts. Our customers were net buyers in the quarter, and trading volumes increased to 194,000 DARTs. This was record activity for a summer quarter, increasing 15% sequentially and 44% year over year. Average margin debt also increased to $7.7 billion, 8% sequential increase and 16% year-over-year.

On top of putting more cash into the markets, customers also grew their overall cash balances by $1.7 billion, up 25% year over year to end the quarter at a record $39.6 billion. Cash balances increased nearly across the board, with continued growth in our lowest cost sources such as the deposit account, along with the continued success of our more competitively priced products such as the complete savings account.

These positive customer metrics including growth in accounts, assets, trades, margin and cash are particularly important this quarter given the disruption in the credit markets and the impact that this has had on the perceived stability of our business. We have worked diligently over the recent months to increase communication with our customers, and their continued engagement demonstrates their support and confidence in the company.

International retail activity was also very strong in the quarter, up 20% sequentially and 76% year over year to a record 33,000 DARTs. We are also seeing strong growth in international customer cash which exceeded $2 billion for the first time. These results are being driven by rapid growth in markets such as Denmark, Germany, Canada and the UK. As a result of this success, we have seen international revenue grow by 61% year over year, albeit off a relatively small base. Nonetheless, we are delivering solid growth from our international operations with improving scale and efficiency.

With respect to the strategic plan that we presented in September, we are making progress on all fronts. In terms of the balance sheet, average interest earning assets did increase quarter over quarter, and this was the result of prior purchase commitments in trade settlements.

By quarter end, interest-earning assets declined by $1.2 billion compared to August, consistent with the plan we introduced on September 17th. As part of this plan, we expect to hold the balance sheet at approximately current level and perhaps lower, should we not replace assets that prepay or pay down.

In terms of our announced exit of wholesale mortgage lending and the restructuring of the non-US institutional equity business, we are making progress. There has been some confusion in the market regarding our decision to exit the wholesale mortgage business and I’d like to provide some clarification. Our decision was to exit the wholesale, or broker originated portion of our mortgage operations, not mortgage entirely. The wholesale channel has historically been a source of balance sheet growth but these loans often came with little, if any, customer relationship.

We plan to continue to originate mortgages directly for our exiting and perspective retail customers. As we make this transition, we will continue to purchase mortgage loans in the secondary market, but only high quality first lien mortgages consistent with our strategic initiative to reduce credit risk. We view retail mortgage as a core product with a strong link to our customers and our overall strategy. Overall, we continue to have strong retail momentum and have reported another solid retail quarter in a very difficult and distracting macro environment.

With that, let me turn the call over to Rob to discuss some of the specifics on the financials.

Robert Simmons

Thanks, Jerry. Net revenue for the quarter totaled $321 million, down 52% sequentially and 45% year over year. This decline is the result of the fact that higher provision for loan losses and securities impairments both reduced revenue. As we look to the performance of the business outside of these balance sheet-related issues, which Mitch already discussed, commission revenue and fee-related revenue showed solid year-over-year growth trend. Commissions grew 41% while fees and service charges grew 11%. These growth rates are primarily the result of the continued success we have driven in the retail business through the growth in our target segment.

Turning to our segment results, we can more clearly see the success of the business separating the institutional balance sheet-related challenges from the retail performance. Total retail segment net revenue rose 4% sequentially and 21% year over year. Retail segment income grew 10% sequentially and 55% year over year, again demonstrating the earnings leverage and expense control in the model. This growth in revenue and income is the result of the success we have seen in attracting, retaining and migrating more customers into our target segment.

As we’ve said before, these customers on average demonstrate approximately 4 times the level of engagement around cash, assets trading and margin, which in turn drives approximately 10 times the revenue of an average customer as a result of the multiple points of interaction.

Institutional segment revenue and income fell sharply in the quarter, which was a direct result of the higher provision for loan losses and accelerated securities impairments already discussed.

What’s most important is that even with these losses and the impairments, the balance sheet remains well capitalized with Tier 1 capital of 5.9% and risk-based capital of 10.6%. With respect to capital management going forward, we intend to increase our tier 1 and risk-based capital ratios from current levels to provide greater cushion to the well-capitalized minimum thresholds of 5% for Tier 1 and 10% for risk-based.

As previously discussed, the strategic plan we presented in mid-September will significantly reduce the capital demands of the business going forward. Of course, our first priority is to ensure the safety and soundness of the balance sheet through the current environment, which remains somewhat volatile. When we emerge from this challenging credit cycle, we expect to be well positioned for significant share and debt repurchase, as well as investments in customer experience over time. These will all be made possible by the 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 at coverage levels by asset class, breaking them down across firstly mortgage, home equity and consumer loans. In the spirit of transparency, we have provided additional tables in our press release detailing 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 home equity loans and over 330% coverage on consumer loans. Net interest spread in the quarter dipped by 6 basis points which was a combination of a 12 basis point increase in funding costs, partially offset by a 6 basis point increase in asset yields. Given the timing of the Fed cut, the quarter only had a two-week benefit from lower rates, and we expect to see a more meaningful benefit to overall funding costs in the upcoming quarters.

With respect to our earnings guidance for the remainder of the year, we are revising our outlook primarily due to the securities impairments recorded this quarter. As a base line forecast for the business, we are projecting earnings of $0.85 to $0.90 per share. This range includes assumptions that provision expense in Q4 will be approximately $80 million with no additional securities impairments. We believe that in this environment it is extremely difficult to forecast credit-related items.

As a result, we believe it is prudent to include another $0.10 of downside to this forecast against the possibility of further credit deterioration in some combination of impairment and provision for new 2007 full year guidance of $0.75 to $0.90. This implies fourth quarter earnings of between $0.13 and $0.28 per share, given the year-to-date earnings of $0.62.

In conclusion, the third quarter was a tough and frustrating one for the company with two distinctly different story lines. On one hand, the retail segment experienced tremendous success with growth and record results throughout the business. On the other hand, the challenges we and the broader financial industry are facing as a result of the stress in the housing market completely overshadowed the success of the retail business.

As we navigate through the continued dislocation in the credit market, we will continue to make disciplined and often difficult decisions to manage through the strategic transition and focus on the true value of the franchise.

This concludes our prepared remarks. Operator, we are now ready for questions.

Question-and-Answer Session

Operator

Your first question comes from Rich Repetto - Sandler O’Neill.

Rich Repetto - Sandler O’Neill

The question has to do with the ABS portfolio and the 197 impairment. I’m just trying to understand how they were performing? I know you sold at $0.50 on the dollar. I know that wasn’t the plan. I know you want to accelerate the transition and get out of this situation as quick as you can, but I’m just trying to see, that CDOs and second liens is over $600 million from the last disclosure. I’m just trying to get more color on the background on the writedown.

Mitchell Caplan

Happy to do it. First of all, let me be clear. We did not sell, so this loss is unrealized loss. It’s an impairment running through the P&L. We did not actually sell the securities. If you remember when we last spoke and when we were on the road, we were specifically circling up as an area of concern with respect to our overall securities portfolio the ABS. We felt extremely uncomfortable obviously with our AAAs, in our agency, and so what we really looked at in particular against the entire backdrop of the $3 billion in ABS CDOs, and even in the asset-backed securities portfolio, was the CDO composition as well the second lien 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’re re-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 that we did not want to continue to hold these securities to recovery.

As a result of designating them or changing our intent as a management 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 point at market value. So what we did in working 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 market valuation.

What Rob spoke to was that across the board they were marked to less than $0.50 on the dollar, and that is across both the CDOs and the second liens. There is a specific breakdown for each of them. Rob, do you remember?

Robert Simmons

Specifically the ABS portfolio and the second lien were marked through the A tranche, in the case of CDOs, to about $0.53 and about $0.28 for the second lien.

Mitchell Caplan

Fundamentally, Rich as a result of recognizing the fluidity of the market, recognizing that we weren’t going to be in a place where we were going to see these charge-offs starting to come through and that we did have the flexibility as a management team to make the decision to no longer hold these to recovery, it allowed us to move the impairment forward, effectively, to the benefit of future quarters.

Operator

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

Mike Vinciquerra - BMO Capital Markets

Just to clarify that, Mitch, I just wanted to make sure: so you haven’t sold them but you intend to sell them? Or have you sold them since the end of the quarter? I’m not quite clear on it.

Mitchell Caplan

Okay, perfect question. We have not yet sold them. I think one of the things we have talked about very clearly over and over again is the success that we are experiencing in the retail franchise, the engagement we are seeing with our customer, the important of showing our business model whether it’s through the engagement of the customer, our capital ratios, our excess liquidity protection as well as where we are in terms of overall capital.

So recognizing that, we understood that one of the things that was imperative and we talked about in the last call was this transformation from the balance sheet as it currently stands, to one that is really almost exclusively driven by retail; getting to an 80% or 85% retail balance sheet both on the asset and liability side.

There a number of ways to do that. Obviously one is to delever so as you have prepayments just to allow the balance sheet to shrink, particularly with your securities. Another would be to sell them.

Given what we were seeing in the market place, our view was that we no longer wanted to hold these securities in the ABS portfolio around CDO and second lien to maturity, given that there would clearly be writedowns. We believed that the best thing to do was to change our intent to hold them to recovery, designate them as no longer held fro recovery. The accounting impact of that is an immediate impairment. We talked about the impairment and that is how they are currently marked.

We will take advantage as the market firms of selling them and if we could sell them in the ranges that they’re marked at it is certainly an opportunity that we would take advantage of to help speed up this transformation.

One of the things that we as a management team realize is that the incredible success we are seeing in retail is being overshadowed by this very volatile and uncertain credit market, and the faster that we can make that transformation the more important it is for us.

Mike Vinciquerra - BMO Capital Markets

Following up a little bit, when you guys were on the road recently, you were talking about if you had to mark your entire ABS portfolio to market, I think you were saying $400 million to $450 million seemed like a reasonable market if you went ahead and sold everything today. Can you update us as to where that might have stood at September 30 when you did your analysis?

Mitchell Caplan

I’m happy to do it. So the current mark on the entire ABS portfolio today, negative mark, would be $268 million. Of that $268 million, $137 million relates to below AA and a $131 million relates to AA and AAA, as well as the fact the $268 million is in fact a pre-tax rather than an after-tax number. So when you think about the breakdown, I guess the risk is really in our minds going forward around the $137 million that relates to anything below AA in the ABS portfolio on a pre-tax basis.

Rob anything you want to add?

Robert Simmons

No, other than obviously there still is the risk that other rating agency downgrades could move other AA bonds into a category that they would become at risk. But again, it’s very 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 place this quarter.

Operator

Your next question comes from Matt Snowling - FBR Capital Markets.

Matt Snowling - FBR Capital Markets

Can you give us a little bit explanation as to what happened to the OCI accounts?

Mitchell Caplan

To the OCI? Absolutely.

Matt Snowling - FBR Capital Markets

Yes, there’s a $144 million drop somewhere?

Robert Simmons

OCI this quarter was about $483 million as you can see on the balance sheet there. Just to give you a quick sense of the composition of that, obviously that’s on an after-tax basis so all these numbers that I’ll talk about will be comparable on an after-tax basis. The MBS component of the agency, the AAA component of the $483 million is about $315 million of that. So, roughly 62% of the OCI balance you see relates to our MBS portfolio; the $268 million that relates to the ABS portfolio that Mitch just went through, on an after-tax basis that would represent about $169 million of that $483 million balance.

So again, half of that would relate to securities that are AA and above. So you can see the vast majority of the mark in OCI relates to a combination of MBS agency paper and ABS that’s AA or higher rated.

Matt Snowling - FBR Capital Markets

And $315 million from the MBS portfolio, I would have thought that would have gone the other way given where rates are coming down, or is that just spreads widening?

Mitchell Caplan

Spreads widening, my friend.

Operator

Your next question comes from Roger Freeman - Lehman Brothers.

Roger Freeman - Lehman Brothers

The thing that struck me is just looking at the supplemental disclosures, it looks like there was another 15% deterioration in the delinquencies in the HELOC portfolio from August to September. It went from 349 to 404, and it looks like the 80% to 90% CLTV tranche there actually were the highest increase. , Mitch, can you talk a little bit to that and just put that in the context of the 25% incremental deterioration you were expecting this year and plus another 25% next year, the trend line doesn’t look encouraging.

Mitchell Caplan

Happy to do it. As you see the increase there, remember that we were on the road we were talking about two things affecting the overall value. One would be a 25% increase in August by the end of this year and an additional 25% next year. The other thing we talked about is seeing the recovery value drop from our model, 80 to 70 by the end of the year although we are currently running at 85.

If you look at the increase in September, the increase is the largest, as you pointed out, in the HELOC in the 80 to 90 and 90 to 100, so the areas that while we were on the road and the last time that we did the call that we circled up.

I think we are still comfortable by and large with the range of about 25% growth rate given that we are continuing to see recovery rates pretty consistent at about 85%. So it may be a little higher on one and a little lower on the other. As you go into next year, and we’re still of the belief there will be another drop from 70 to 60 and another increase of 25%.

I think the most important takeaway, however, is that if you noticed in the guidance that Rob just gave, he talked about the bank business and what he thought it would earn, and then he said in an effort to be prudent, considering another $0.10 of possible credit securitization which could come from either securities impairments or some of these trend lines that you have seen; notwithstanding the fact that what we’re currently seeing, I think we’re reasonably comfortable with what we have set. But again, it’s a market in flux, 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 ABS CDOs, according to the supplemental disclosures, just about $100 million. As you point out, it’s all in the below AA category. But then Mitch, you also said that 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 stuff at. Is that a fair assessment?

Robert Simmons

Let me clarify. When you’re talking about the mark on the ABS portfolio of $268 million, about half of that relates to AA or above; so about half of that obviously is in that A or below category. The marks that we took, specifically to the ABS CDO book and the second lien book, were the marks we talked about earlier. We marked them not to zero, but we marked for instance the ABS CDO book to about $0.53 on the dollar and the second lien book to about $0.28 on the dollar.

Operator

Your next question comes from Matthew Fischer - Deutsche Bank.

Matthew Fischer - Deutsche Bank

First off, the capital, again you mentioned it dipped below 6% 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?

Mitchell Caplan

It’s a great question. We ended tier 1 at 5.88%. As Rob said, we ended risk-based at 10.5 bips. Assuming that directionally we’re going to move up 6%, 11%, whatever. First of all, one clear possibility is in Q4 if we allowed the prepayments to roll through and the balance sheet to delever, that would move you directionally where you want it to go and we certainly mentioned that as a possibility as we work through Q4.

At the same time, I think it’s important to note that we have on a pre-tax basis corporate cash that we could downstream in excessive of about $258 million that is totally available to be downstreamed if that’s what we wanted to do. As well, we have an undrawn line of credit on a pre-tax basis that is about $396 million.

Robert Simmons

Let me just clarify, there is about $160 million of cash at corporate with again, as Mitch mentioned, $250 million on a completely undrawn revolver. Now those are obviously, they would be available effectively on an after-tax basis to cover higher pre-tax losses if necessary.

Mitchell Caplan

Right that is exactly correct. So as we look at that, we see the opportunities for us to be able to increase our capital ratios. I think as Rob said, the most important thing for 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 us in a position given our strong cash flow, to begin a share and debt repurchase program.

Matthew Fischer - Deutsche Bank

Home equity loans roughly flat from Q2. How quickly and how will you go about the planned mix shift towards first lien?

Mitchell Caplan

It’s a great question. So there are two possible ways. The first is obviously you are going to have continued prepayments in your loans, both in your first and second. As the prepayments come through, we certainly will not be replacing them. So that will be one way that you’d begin the mix shift. The other would be to the extent that we made a decision over time to either sell them or securitize and sell them, which would also expedite the mix shift.

Operator

Our next question is coming from Howard Chen - Credit Suisse.

Howard Chen - Credit Suisse

First question, I guess is a bigger one. It’s been a month since you announced that strategic realignment. You as the management team have had time to assess the situation, to discuss the numbers and see your shareholders and incremental owners. Realizing that he changing environment, I am just curious what lessons do you and the management team take away from the past few months? What in management’s control doesn’t happen again going forward?

Mitchell Caplan

I think we have come away with a couple realizations, most of which I think -- I hope, I believe very strongly -- that I knew going into it. One, and that is the customer is at the center and the most important at everything we do. As we think about the decisions we make in running our business, it is all about continuing to ensure for that customer both a great value proposition, with respect to product and services and also making it clear to that customer what a solid, stable and growing franchise we have by discussing things like excess liquidity. I think it’s up to now $14.4 billion from the FHLB has actually increased; continuing to deleverage the balance sheet, strengthening our capital ratios and obviously the sources that are available for us for additional capital. So, I think that is the first thing we learned.

The second thing that we learned in the process is it is absolutely imperative to have a phenomenal management team. I will tell you I think I am incredibly blessed. The team has been extraordinary in working together in what has been a very, very difficult time. Without a doubt on the retail side, the whole team stayed focused and delivered results that I think are incredibly impressive, summer or otherwise. With respect to looking at what’s happening in the marketplace from the instability and the fluidity and the challenging environment, we are dealing with exactly the same thing that everybody else is dealing with. So at the result of that it’s all about having a strong team that can evaluate and make decisions that are appropriate, I think promptly and then execute as quickly as possible.

Howard Chen - Credit Suisse

A quick follow up on the numbers. Rob, you mentioned in your prepared remarks you expect to see some benefit from the recent Fed cut in upcoming quarters but earlier this week I saw that you cut the max savings yield by 25 bips to 470 following a 50 rate cut. Can you discuss what impact that may have on the spread going forward and what helps alleviate that spread compression?

I know management in the past has spoken to not wanting to have a top three yielding savings product but at 470 I think you’re kind of there so has there been a change in deposit pricing philosophy?

Robert Simmons

Let me talk a little bit about spread and then I’ll let Jarrett talk about pricing because I think it is a very important part of our strategy. With respect to spread, obviously one of the things that we have been talking about for the last month is strategically moving towards a place where in a balance sheet that is much more retail centric has less wholesales funding in an environment where we continue to grow cash that we think that overtime that will have a positive impact on spread.

Again, we were very pleased to see even in a seasonal quarter with obviously the summer months but also the volatility that we saw this quarter in the market, that we were still able to grow our cash by $1.6 billion, $1.7 billion I think was a real accomplishment and I think that as part of our strategy going forward is to continue to accelerate that balance sheet transition that we’ve been talking about; reduce the wholesale components of it which overtime will have the effect of widening spreads.

Jarrett Lilien

I think Howard where you’re right as well is there are forces there that will help increase spreads such as growing customer cash and replacing wholesale borrowings. But on the other hand there are other forces that are contracting on spreads. As rates come down on some of our lower rate products, there’s only so far that you can go down and so you won’t be able to pass every Fed rate cut through the market.

With our highest grade products, one of the things that we have to be very conscious of is really stability with the customer and fulfilling the promises we make to the customer and so we are looking at being able to manage any rate changes in a measured way. If you look at the markets I think what there’s something like 70% probability of another 50 basis point cut in 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 looked like the right place to be for now. If there is further Fed action -- or even if 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 savings product.

Mitchell Caplan

A couple points I’d add is that one of the things I look at is that not only were we successful I think at bringing in $1.7 billion but we brought it in flat to the prior quarter on an incremental cost I think 3.9. So our incremental cost declined was 3.9% again in the quarter. Given that as we’ve always said, the vast majority of what we are bringing in is coming from an investing customer, they are traditionally opening both a free credit or sweep account and at the same time this other account.

I don’t believe we have changed our philosophy of wanting to be one of the top rate providers;, I don’t think we will ever. I think we we’ve basically been comfortable with being within the top 20 or 25 and so what we are working through now as Jarrett said is, what’s the long-term strategy as the Fed continues to act?

The other thing I would say is when you think about spread again. absolutely it is a balancing act but the good news is you will replace wholesale funds which are clearly more extensive that cash under any circumstances, particularly when you think about the cost of that into hedge to extend out the duration and so there is a value in that, and certainly one we can continue to bring in at a 3.9% incremental cost of funds, I am pleased there.

When you move over and you look at the asset side without a doubt you will have compression as a result of things that are generating a higher yield like your second lien coming off and being replaced with first liens. But at the same time, you will have a benefit of securities coming off, which typically has the load appeal. So net net, I believe over time you will be spread widening as a result of the balancing of all of these different acts.

Operator

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 your models, where is that peak?

Mitchell Caplan

Where is that peak now?

Robert Simmons

In Q1 of next year we expect it to increase through by about 25% from current levels.

Prashant Bhatia - Citigroup

Is that expected to be the peak in Q1?

Mitchell Caplan

It is in our current model Q1, and I think we expected to then 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 been so far?

Mitchell Caplan

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 still didn’t sell the assets; and I guess, why not?

Mitchell Caplan

Because we made the decision to impair the securities quite recently. Once we made the decision as a management team given all the facts I talked about with the fluidity and the changing marketplace and the markdowns as well as the decision to no longer hold them to recovery to be in a position that once we got there we took the impairment and we are, as you can well imagine, working on it.

Operator

Our next question is coming from Michael Hecht - Banc of America.

Michael Hecht - Banc of America

I just wanted to come back on that interest spread. It sounds like over time there’s going to be a lot of moving parts. Near term, can you talk a little about where net interest spread ended the quarter versus the 265 average for the period?

Mitchell Caplan

I’m not sure where we ended the quarter versus the average to be honest.

Michael Hecht - Banc of 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 levels either in dollars or percent of revenues going forward here? Do you guys have any flexibility in the model to offset what looks like some pretty significant negative operating leverage.

Robert Simmons

First of all, comp expense quarter-over-quarter was actually down 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 of revenue, it’s going to be apples and oranges because the provision and the impairments obviously as you know, run through the revenue line item, and so they make a quarter-over-quarter comparison as a percentage of revenue not meaningful. But the quarter-over-quarter comp expense is actually down.

Operator

Our next question is coming from William Tanona - Goldman Sachs.

William Tanona - Goldman Sachs

Just a quick one here on the net new asset flows, obviously third quarter was a record on the retail side of the equation. You guys brought in $1.1 billion versus $1.6 billion in the prior quarter. Schwab is the only one who’s actually reported their statistics yet. They are off about 40% where you guys are down about 30%. So I’m wondering what type of ramifications, if any, all the negative news or headlines is having in terms of the retail investors’ willingness to put money with you guys?

Mitchell Caplan

Well, actually we’re not really seeing any real impact there. I guess big picture, I think in August there was some impact. I mean, we had 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 spent a lot of time communicating with our customers.

What we’ve seen I think were some very encouraging things with our customer behavior. First of all was seeing that they are actually net buyers in the quarter. So they were putting more money into the market and they were also out there putting more cash into their accounts. Again, there were numerous rumors out there in August, and even in spite of all of that, you had net buying; you had increases in cash; and basically a very positive customer experience, starting really with account growth, which we also saw has been something that’s been very positive and where it counts, in the target segment.

William Tanona - Goldman Sachs

If you think about that from a monthly standpoint, did you see a difference in the trends throughout the quarter? And if so, how has that continued into the early part of October here?

Mitchell Caplan

We really don’t comment so much past September 30th. But one thing I will say about the health of the customer is that they were very strong net buyers in August which obviously with 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, obviously margin was up but margin as a percentage of investing assets quarter on quarter was actually down. So less leverage, buying appropriately, selling appropriately, bringing in more cash.

Also in terms of what they were trading, we actually saw bulletin board volume down quarter on quarter, which given that volumes were up so much that’s pretty interesting. So where we saw our customers transacting was less in penny stocks and more in NASDAQ and New York listed stocks. Again, we saw options as a percentage of total DARTs up to record levels, which is again a positive indication as they’re using those hedge and yield enhance.

So a very positive quarter for the customers showing that they’re healthy, which gives me confidence. A healthy customer means that they’ll be back again and that gives me some confidence that this can continue for a while.

Robert Simmons

The only thing I think I would add to that is there is no doubt that there was an impact. The good news is that at the end of the day the TOAs in were significantly greater than the TOAs out and we were able to see all of the metrics you’re seeing. But if you look at year-over-year comparison we were growing at about 24% in our segment. It’s slowed to 16%. I think some of that is the seasonality and I think some of it is the attrition that we did see pick up in the month of August around all of the rumors.

To answer your question specifically I think we saw August be much lower and September begin to resume to more normal levels with respect to asset inflows.

Operator

Our next question is coming from Mike Carrier - UBS.

Mike Carrier – UBS

Just a follow up on account growth; it looks like your overall account growth is decent in the quarter and then target growth was good. But it seems like almost all the growth was in the banking area, quarter over quarter, and year over year. I’m just curious kind of what’s going on under the covers with the brokerage account growth?

Mitchell Caplan

I think the most important thing, let me turn it over to Jarrett, but again I think I have stated every quarter and I’m not sure that people really recognize it – it is the same customer. So when you see an account grow you’re actually seeing a customer grow. It may not be necessarily one for one, because some of it is, as you know the plan is around acquisition, migration and retention. The vast majority of our balances and the vast majority of our accounts when you look at banking and lending are in fact coming from your investing and trading customers.

Jarrett Lilien

In terms of overall accounts it was actually a strong quarter any way you slice it. I mean in terms of brokerage or bank, still better on a gross account basis than any quarter of all of last year. And then you look at it a couple of ways, I mean marketing spend was down 26% quarter on quarter but gross accounts were down 13% quarter on quarter.

I’d rather look at it the other way which is summer to summer; so a year ago to this year we actually spent 11% more on marketing and saw gross account growth of 13% more. So any way you really want to come at this thing, this was a great summer for new accounts in both brokerage and bank, and Mitch’s point is right on target. The people that are opening bank accounts are the brokerage customers.

Robert Simmons

This is a trend that has been going on for several quarters where, if you look at the significant cash that we’ve been generating as a firm, we’ve been generating cash primarily to brokerage customers. Either a customer who is a new brokerage customer in the quarter that also is opening some sort of a deposit account or an existing retail brokerage customer that’s adding to an existing account or opening another account. We’ve been running upwards of 70% to 80% of our cash increase that we’ve been seeing over the last several quarters has actually been cash from brokerage customers.

Mike Carrier – UBS

That makes sense. I think I am just looking at it more on the economics, meaning if you have a lot of the accounts on the banking side the deposit rate is going up and the loss is, on the other side going down, except we saw more growth on the brokerage side.

Mitchell Caplan

No, it’s actually a great question because to my earlier point, 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 understand it, when you look at a customer who opens a cash account, they also increase their assets with us. They also increase their trading behavior. They also increase their margin balances. So generally, cash is a leading indicator of a deeper engagement. It’s usually the first thing that comes after the brokerage account is opened, and then you begin to see increased balances across margin trading and cash and assets in a way in which it all drives to the bottom line.

Operator

Our next question is coming from Rich Repetto - Sandler O’Neill.

Rich Repetto - Sandler O’Neill

I wasn’t clear on the buyback whether that was being delayed or can you start buying back shares with free cash or whether you were going to concentrate on the capital ratios?

Mitchell Caplan

I think the first thing we’re going to do is concentrate on the capital ratios and make sure that, from our perspective as a management team, everything is absolutely as sound as we want it to be. Remember, the customer matters first and foremost. Once we are at a comfortable level, whether it’s downstreaming from corporate, whether it is additional retained 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 of repurchase of shares.

Rich Repetto - Sandler O’Neill

So it’s probably an ‘08 event now?

Mitchell Caplan

I would say so.

Operator

Our final question is coming from Mike Vinciquerra - BMO Capital Markets.

Mike Vinciquerra - BMO Capital Markets

If I could ask a couple questions, just on the trading side. The institutional business in your original release with the credit side of things, you mentioned that you were restructuring that and I was under the impression that it was going to shrink in terms of its commission generation going forward. Can you talk about the timing there and if I read that correctly?

Robert Simmons

I guess you did read that correctly, but what we’ll be restructuring are some of the non-U.S. institutional pieces and we’re making progress but that’ll be finalized towards the end of the year so the real impact that you’re going to see is into 2008.

Mike Vinciquerra - BMO Capital Markets

So the $46 million in institutional commissions this quarter, is that expected to drop? Notwithstanding the nice uptick in volume we saw this quarter, but is that expected to be off noticeably as you restructure that business?

Robert Simmons

Into 2008, we’ll talk about that when we give guidance but there will be pieces of that business that will no longer be with us.

Mitchell Caplan

That’s correct. The only 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 internationally and so there will be an impact but it should de minimus when you think about it within the context of the overall P&L.

Robert Simmons

I mean if you think about it, we’re restructuring the parts that weren’t that profitable.

Operator

I’ll now turn the call over to Mr. Caplan for any closing remarks.

Mitchell Caplan

I thank you all for joining us on today’s call. Clearly, I think as everybody knows, it’s been a pretty tough period macro economically and for the company, given all these credit challenges but we’re very pleased with the success that we’re seeing in our core retail business. We obviously will continue to execute on our strategic plan in order to manage through this very volatile credit situation and focus the company on the opportunity and the strength of the franchise that we’re building.

Thanks again, and everyone have a great evening.

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