Washington Mutual (NYSE:WM)
Q4 2007 Earnings Call
January 17, 2008 5:00 pm ET
Alan Magleby – Senior Vice President, Investor Relations
Kerry Killinger - Chairman and Chief Executive Officer
Stephen Rotella - President and Chief Operating Officer
Thomas Casey – Chief Financial Officer
Louise Pitt – Goldman Sachs
Thomas Mitchell – Miller Tabak
Ron Mandel – GIC
Peter (?) – Stonehill
Fred Cannon – KBW
Howard Shapiro - Fox-Pitt Kelton
Kenneth Bruce – Merrill Lynch
Bob Napoli - Piper Jaffray
Brad Ball – Citigroup
Paul Miller – FBR Capital Markets
Good afternoon and welcome to WaMu’s fourth quarter and full-year 2007 earnings conference call. All participants are in a listen-only mode. After the presentation, we will conduct a question and answer session. Today’s call is being recorded for replay purposes.
The replay will be available approximately one hour after the call has ended. The toll free number to access the replay is 800-395-7443. This call is also being webcast live and will be archived for 30 days on the company’s website.
Now I will turn the call over to Mr. Alan Magleby, Senior Vice President Investor Relations, to introduce today’s call.
Good afternoon and thank you for joining us today. I would like to welcome you to WaMu’s fourth quarter and full-year 2007 earnings conference call.
I want to remind you that our presentation today may contain forward-looking statements concerning our financial condition, results and expectations, and that there are a number of factors that may cause actual results in the future to be different from our current expectations.
These factors include among other things, changes in general business, economic and market conditions; competitive pressures in the financial services industry; economic trends that negatively impact the real estate lending environment; or legislative and regulatory changes that may impact our business.
For additional factors please see our press release and other documents filed with the SEC.
With us today are Kerry Killinger, Chairman and Chief Executive Officer; Steve Rotella, President and Chief Operating Officer; and Tom Casey, Chief Financial Officer. At this time, I will turn the call over to Kerry.
Good afternoon, everyone. Thank you for joining us today as we review the results for the fourth quarter and full year of 2007. Joining me today on the call is Tom Casey, our CFO, who will discuss our quarterly performance in more detail and update our 2008 earnings drivers. Our President, Steve Rotella, will also be available to answer questions at the end of the remarks this afternoon.
Earlier today, we announced our financial results for the fourth quarter and full-year of 2007. As you all know, the second half of 2007 has been a period of extreme stress and turmoil for the mortgage and credit markets. Our financial performance reflects that market impact, as well as proactive efforts on our part to better position the company for a difficult environment going into 2008.
For the fourth quarter, we reported a net loss of $1.9 billion or $2.19 per share. As we announced in December, the loss was due to loan loss provisioning of $1.5 billion and a $1.6 billion after-tax non-cash write down of Home Loans segment goodwill.
Due to the fourth quarter results, we also reported a net loss of $67 million or $0.12 per diluted share for the full year 2007.
Clearly, these results are disappointing, and as CEO, I take responsibility. Yes, the environment was extraordinarily difficult, but we have to do better. It is also my responsibility, along with the management team, to take the necessary actions to return the company to strong profitability - and we will.
We took the following significant steps in December to bolster the company’s capital and streamline our operations in anticipation of continued stress in the mortgage and credit markets: the issuance of convertible preferred stock, raising $2.9 billion of new capital and increasing our year-end tangible capital ratio to 6.67%, or $3.7 billion above our targeted ratio of 5.5% or more; a reduction in the quarterly cash dividend rate on the company’s common stock to $0.15 per share; a major expense reduction initiative projected to reduce 2008 non-interest expense by $500 million to $8.0 billion or less; and, a significant acceleration in the strategic focus of our Home Loans business, with increased emphasis on mortgage lending through our retail banking stores and other retail distribution channels.
The combination of these critical steps further fortifies WaMu’s strong capital and liquidity position and enables the company to continue to pursue various initiatives, particularly in our retail banking business which is at the core of our business strategy.
I want all of you to know that we are not done. We are committed to making changes, no matter how difficult, that will speed our return to profitability.
So now, let’s turn our attention to the topic of credit. Our credit performance and near-term outlook are essentially unchanged from the projections we made in our press release in December. The fourth quarter provision totaled $1.5 billion, roughly twice fourth quarter net charge-offs of $747 million, both within our December guidance.
Clearly, the current downturn in housing is acute and deeper than expected. We continue to see declining home prices, elevated inventories of unsold homes and increased foreclosure activity. As has been very well-publicized, home values are declining nationally and the downturn has been more severe in some of WaMu’s larger markets, like California, than it has been nationally.
However, I’d like to point out that we continue to support measures that could strengthen the housing market, including aggressive easing by the Fed; temporarily raising the conforming limits for GSEs; government economic stimulus actions, and continued efforts by lenders to help borrowers remain in their homes.
Foreseeing a difficult credit environment in 2008, we issued guidance in December significantly increasing our first quarter provisioning to a range of $1.8 to $2.0 billion and Tom will go into much more detail about our credit profile and outlook in his remarks.
Reflecting the strength of our franchise, the company generated revenues of $3.4 billion in the fourth quarter, a combination of strong net interest income and growth in depositor and other retail banking fee income. We achieved those revenues despite the continued illiquidity in the capital markets during the quarter, which resulted in net losses on the company’s trading and available-for-sale securities portfolios of $528 million.
Without those net valuation losses, our quarterly revenue would have increased to $3.9 billion. We expect the revenue strength of our businesses, together with a capital cushion of $3.7 billion above our target tangible capital ratio of 5.5% at year end, to enable us to manage through a severe credit period and return to our targeted levels of financial performance thereafter.
The Retail Bank continued to perform well in 2007, delivering a year-over-year 12% increase in non-interest income which far exceeded the 5% increase in non-interest expense. The modest increase in non-interest expense was driven by a rise in staffing levels as we opened new retail stores throughout the year, along with the continuing emphasis on growing the company’s small business activities.
The quarter’s decline in net income to $278 million from $456 million in the third quarter reflected the increase in the provision for loan losses in the segment’s home loan and home equity loan portfolios, which were pressured by the deteriorating housing market.
Pretax income from our Retail Banking network, excluding the loan loss provision totaled $3.3 billion in 2007, up 14% from $2.9 billion in 2006.
We continued our strong customer growth trends in 2007. We added 1.1 million net new checking accounts during the year, exceeding our goal of adding more than 1 million net new checking accounts for the second consecutive year. Reflecting the growth in new accounts, the average balance in non-interest checking accounts was up by 7% year-over-year.
And the continued attractiveness of our Free Checking product led to a 7% increase in retail banking households to end the year with just under 10 million households. The pace of increase in net new checking accounts slowed somewhat in the fourth quarter due to normal seasonality and the closure of inactive accounts.
Checking account sales both in our stores and online continued to be solid during the fourth quarter and we expect net new checking to show a nice increase in the first quarter of 2008.
As we look forward, we expect the Retail Bank to continue its strong growth trend and continue to target more than 1 million net new checking accounts this year and expect to open between 100 and 150 new financial stores in our existing markets in 2008.
Net income of $92 million in the fourth quarter for our Card Services group was up from $66 million for the third quarter. Earnings were reduced, however, by valuation losses of $159 million on retained interests, reflecting continued illiquidity in the capital markets which drove higher discount rates.
The quarter also included a charge of $50 million arising from the VISA related litigation liabilities. Visa has filed documents with the SEC in preparation for an initial public offering. In connection with our ownership interest in Visa, we expect to recognize a benefit from their planned IPO.
Managed receivables at year end increased 16% over the past twelve months. However, with a slowing of the economy and modestly higher rates of unemployment, we are cutting back on direct marketing and focusing our efforts to grow new accounts from WaMu’s retail customer base.
We opened 653,000 new credit card accounts in the fourth quarter. While overall account growth was down 31% on a linked quarter basis, the percentage of new customers from our retail channel has increased to 37% of the quarter’s production, compared with 28% a year ago.
As we have said in the past, the primary external variable impacting Card’s credit quality is the level of unemployment. In line with our expectations, we saw net credit losses increase to 6.9% of average managed receivables from 6.37% in the prior quarter. At the same time, the period end 30+ day managed delinquency rate increased to 6.47% from 5.73% in the third quarter.
We expect further softening in the economy during 2008 and therefore are expecting the double digit managed receivables growth of the past two years to decline to mid-single digits as we adjust our management of the portfolio to that environment.
In the past we have stated that normal loss rates for our credit card portfolio should be in the range of 7 to 8%, however, given the economic softening projected for 2008 we anticipate that range of loss to be somewhat higher in the range of 8.5 to 9.5%.
We are coming off a period of cyclical lows for credit card losses, but as we have stated before, we expect that the impact on our risk adjusted margins will be partially mitigated through our risk based pricing and fee strategies.
The Commercial Group continued to deliver solid operating results in the fourth quarter reporting net income of $94 million, up 62% from $58 million in the third quarter. Non-interest income improved somewhat from the third quarter but continued to be negatively impacted by the lack of liquidity in the capital markets in the fourth quarter.
Commercial Group loan volume totaled $4.8 billion for the fourth quarter, up 18% from the prior quarter, driven by an increase in commercial real estate lending. At the end of the year, the portfolio increased to $40.1 billion, consisting of $30.5 billion in multi-family loans and $9 billion of commercial real estate loans.
Credit quality continues to be very strong with net charge-offs for the quarter at less than 1 basis points. Despite the ongoing strong credit quality of our Commercial Group, as with our credit cards, we are tightening our underwriting and planning for less growth of this portfolio in 2008.
As we look at our Home Loans business, it’s clear that the weakness in both the housing and credit markets have led to a fundamental shift within the mortgage industry. The lack of liquidity for loans that are not backed by a mortgage agency guarantee has shifted most lenders toward primarily originating conforming products. At this time, it is only banks with balance sheet capacity that are making nonconforming loans.
Reflecting this environment, our Home Loans volume declined 28% on a linked quarter basis and we saw an increase in the percentage of conforming loan originations. On the positive side we are seeing high quality in the nonconforming loans we are originating but we are limiting our balance sheet growth to preserve our capital.
In this environment we estimate the overall mortgage origination market in 2008 will be approximately $1.5 trillion, 40% lower than 2007 originations.
In December we announced the plan to substantially adjust and resize our Home Loans business to reflect a smaller overall market, by discontinuing all remaining lending through our subprime mortgage channel; closing approximately 190 of 336 home loan centers and sales offices; closing nine Home Loans processing and call centers; eliminating approximately 2,600 Home Loans positions, or about 22% of the staff; eliminating approximately 550 corporate and other support positions; and closing WaMu Capital Corp, our institutional broker-dealer business, as well as our mortgage banker finance warehouse lending operation.
These steps significantly accelerate our focus on mortgage lending through our retail banking stores and other retail distribution channels.
I’ll now turn it over to Tom.
Thank you, Kerry.
The second half of 2007 was a period of unprecedented challenges in the mortgage and credit markets. The environment has been difficult for all financial institutions, and for Washington Mutual in particular, but I’m pleased with the steps we have taken to strengthen our capital and liquidity position during this period of uncertainty.
My comments today will focus on four key areas: first, in the past six months we have significantly reduced our exposure to market valuation changes. We have reduced the combination of our trading assets and loans held for sale by nearly 70% from $25 billion at the end of June to $8 billion at year end. Approximately 40% of the $8 billion was conforming loans held for sale to the agencies and are hedged by TBAs.
Second, we are proactively managing our way through the housing correction and are focused on managing exposure to those loans most at risk.
Third, solid operating revenues and a substantial capital cushion above our targeted tangible capital ratio of 5.5% and disciplined expense management across all of our businesses are expected to provide us the financial flexibility to manage though this period of expected elevated credit costs.
Fourth, we have sufficient liquidity to fund our business operations.
I’ll review each of these issues and our outlook on earnings drivers for 2008 in my remarks this afternoon.
Before I go into detail regarding the impact of the housing correction on our loan portfolio, I want to address the ongoing deterioration of the capital markets during the fourth quarter.
For the quarter we recognized $528 million of net losses in trading assets and available-for-sale securities. These losses were primarily in three areas: remaining trading assets of our institutional broker-dealer operations, credit card retained interests and adjustments in the valuation of available-for-sale securities.
While the capital markets remain volatile, we have been proactive in reducing our market valuation exposure as you will see from the details I’m about to review.
Of the $528 million of losses, $267 million related to the mark-to-market on trading assets in the fourth quarter. The $267 million is primarily comprised of two items. The first was a $159 million adjustment related to higher discount rates used in valuing our $1.8 billion in credit card retained interests.
The second relates to $83 million in trading losses by our broker-dealer, WaMu Capital Corp., which is in the process of being closed due to our change in strategy for our Home Loans operations. At year-end, 42% of the $507 million of these securities were rated AAA. The book value of those securities rated AA or below, was 69% of the securities’ par value.
The other area we experienced write downs of assets was on our AFS portfolio, where in the fourth quarter we recognized net losses of $261 million. At year-end, 93% of the $19 billion in AFS mortgage backed securities were rated AAA and less than 1% was below investment grade.
All the other than temporary impairment losses recognized in the quarter were on securities rated AA and below. We have included a schedule of our remaining AFS portfolio and you can see that the securities below AAA have been marked down between 20 and 73%, depending upon their underlying collateral and rating. In total the book value of those securities was approximately 70% of the securities’ par value.
Now lets move on to credit quality and provision for loan losses. As Kerry mentioned, the fourth quarter’s net charge-offs and provision for loan losses were consistent with the guidance we provided in December. The provision of $1.5 billion was up from $967 million in the third quarter and net charge-offs grew to $747 million in the fourth quarter from $421 million in the prior quarter.
At quarter end, our nonperforming assets ratio totaled 2.17%, up from 1.65% at the end of the third quarter. Although we are not seeing significant changes in early stage delinquencies, once a borrower is delinquent it is difficult for them to cure their loan because home prices in many areas of the country are not only deteriorating, but homes are also taking longer to sell.
In addition, liquidity for consumers has decreased with far fewer refinancing opportunities, especially for nonconforming loans. We don’t expect to see an end or reversal of this trend until the level of home inventories peaks and starts to decline.
Another driver of the increase is loan modifications for troubled borrowers and rising real estate owned balances. We have been very proactive in modifying loans to keep our borrowers’ in their homes when possible. As a result we have seen a dramatic increase in troubled debt restructurings reported as part of our nonperforming assets.
Approximately 56% of the $633 million in non-accrual TDRs were current with revised loan terms at year-end. We expect the level of modifications to continue to rise in 2008 as we continue our proactive practice of modifying loans.
During the fourth quarter, we continued to see net charge-offs of subprime and home equity loans dominate net charge offs, accounting for approximately 70% of the total charge-offs on residential loans. These loans also continue to drive the majority of the increase in our provision.
At year-end, our reserve for loan losses was up 36% to $2.6 billion from the end of the third quarter reflecting the effects of increases in NPAs and charge-offs in the second half of the year. The allowance for loan losses is up 65% from mid-year 2007.
In order to give you some perspective to evaluate the credit risk of our loan portfolio we have grouped loans that are driving the majority of charge-offs by type, LTV and FICO. We expect the following three groups of high-risk loans to drive the majority of the credit losses going forward: $18.6 billion in subprime loans; $15.1 billion in home equity seconds, with combined loan-to-values greater than 80% that were originated in 2005 through 2007; and $2.1 billion of prime Option ARMs with loan-to-values greater than 80% that were originated in 2005 through 2007.
The subprime portfolio is comprised of $16.1 billion in home loans and $2.5 billion of home equity loans. You will note that this portfolio comprises 44% of our total residential loan net chargeoffs but only represents 8% of our total real estate loan portfolio. The subprime portfolio is the group of loans that is responsible for the largest increase in our allowance for loan losses in 2007.
However, this portfolio is in runoff mode and shrank 7% in 2007. As it was the first portfolio to experience problems, we anticipate it will be the first to see delinquencies and losses peak.
There has been significant press regarding potential stress to the subprime borrower as a result of their rates adjusting upward. We have been very proactive in working with our subprime customers to modify their loans to minimize that risk.
The second group of loans comes from our home equity portfolio. At year end only 30% or $17.8 billion of our home equity loans were second lien and had original CLTVs greater than 80%. Of that amount $15.1 billion of those loans were originated between 2005 and 2007 when home values were near their peak. So we have broken these out and identified them as being a high risk group.
In the fourth quarter that group of loans comprised 26% of our total net residential loan charge-offs but only 8% of our total real estate loan portfolio. Over the past two quarters we have seen the number of losses from this portfolio as well as the severity of losses increase as home values have decreased.
One additional important fact is that only 6% of our home equity loans were originated through our wholesale channel as the majority were originated through our retail channels.
The last category is Option ARM loans. Option ARM loans with original LTVs above 80% totaled $3.4 billion, or 6% of the total Option ARM portfolio. Approximately two thirds or $2.1 billion of these loans were originated between 2005 and 2007. As you can see we don’t originate many loans at LTVs above 80%.
However, one of the key credit events in the life of an Option ARM is when the loan recasts and minimum payments can increase dramatically. You can see on the chart that we have approximately $4.8 billion or only 8% of the portfolio that will be impacted by recasts in 2008.
As a result of recent declines in CMT rates, the MTA index used for most of our Option ARM portfolio has declined which is also taking pressure off these borrowers.
The average LTV at origination of our Option ARM portfolio was 72% and the current average FICO of 694. As a result, as has been the case historically, many of these borrowers may refinance their loans before the loan is recast. The $2.1 billion of high-risk loans had an average LTV at origination of 90% which is why we have broken them out for you.
During the fourth quarter, these high risk loans collectively accounted for approximately 70% of our total real estate loan net charge-offs, but represented only 19% of our total real estate loan portfolio at year end.
When you exclude this group of loans, the remaining first lien loans have a weighted average LTV at origination of 66% and a current average FICO of 718, and the second lien loans have an average combined LTV at origination of 66% and current average FICO of 740. So the remaining portfolio has a solid customer profile with equity cushion to withstand declines in home values.
In contrast to our home loans portfolio, our credit card, multi-family and commercial real estate portfolios continue to perform well. The most significant external factor affecting the performance of our card portfolio is the level of unemployment, which increased during the quarter.
A linked quarter increase of 30-plus day managed delinquencies to 6.47% from 5.73% and managed net credit losses to 6.9% from 6.37%, were in line with our expectations. We continue to proactively manage the credit quality of this portfolio.
As Kerry commented, we are coming off cyclical low levels of losses for credit cards and we expect losses to increase in 2008 and be in the range of 8.5 to 9.5%.
I’ll provide my overall guidance for credit provisioning in a moment along with the other 2008 earnings drivers.
As we evaluate our performance for 2007 and deploy our business plans for 2008, we have good momentum in most of our core operations despite the ongoing disruption in the capital and credit markets.
Net interest income was up slightly in 2007 as an increase in net interest margin to 2.85% from 2.6% in 2006 more than offset an 8% decline in average interest-earning assets as we deemphasized balance sheet growth.
Most of this decline was due to our decision to sell most of our home loans production in much of 2006 and the first half of 2007 which resulted in a reduction in average home loan balances of 18% year-over-year.
We expect net interest income to grow in 2008 primarily due to reductions we are seeing in the short term rates, specifically 3 month LIBOR.
Non-interest income in 2007 was down 5% from 2006 primarily due to approximately $1 billion in trading and AFS losses related to the disruption in the capital markets. Excluding the market valuation losses, non-interest income would have reflected solid improvement, especially by our Retail Bank.
During 2007 the Retail Bank added 1.1 million net new checking accounts and generated a 13% year-over-year increase in depositor and other retail banking fees. We expect this strong trend in retail banking growth to continue in 2008.
We continued to have tight controls on our operating expenses throughout 2007. Non-interest expense, excluding the write down of goodwill, was essentially flat with 2006 despite including $143 million of expenses incurred in the fourth quarter tied to expense reduction efforts targeted to lower 2008 non-interest expense by approximately $500 million.
It’s the solid business plans in our Retail Bank, Card Services and Commercial Group along with the significant strategic shift of our Home Loans business toward the strength of our retail distribution capabilities that will provide significant revenues in 2008 to help offset the expected increase in credit losses.
We continue to maintain a strong liquidly position in addition to a strong tangible capital ratio of 6.67%. At year-end we had $3.7 billion of capital in excess of our target tangible equity to tangible asset capital ratio of 5.5%.
In addition, we exceeded all the well-capitalized banking ratios by a meaningful margin. Our funding comes in large part from retail deposits generated in our stores from our core customers. We have $144 billion in retail deposits which account for 49% of our total funding. The remaining wholesale funding is diversified with a staggered maturity profile.
At year end we had approximately $29 billion in available excess liquidity. This amount includes FHLB borrowing capacity, other secured borrowing sources and cash/cash equivalents.
Now lets move on to our earnings drivers. Given the uncertainty of the economy and capital markets, 2008 performance is difficult to predict. However, the following update is our best estimate of earnings drivers for 2008.
We ended the year with total assets of $328 billion which was down slightly from the end of the third quarter. Average total assets for all of 2007 were $323 billion. In December we gave a range of 0 to 5% growth. As we look at the current environment of a weaker economy and elevated provision levels we are still looking to be in that range but at this point I expect us to be on the low end or just about flat year-over-year.
We also anticipate it to be an ongoing period of elevated credit provisioning. Given that environment, we will be closely managing our capital levels and therefore are expecting very little in the way of asset growth and our guidance is for average assets to be flat to up 5%.
The net interest margin of 2.85% for the fourth quarter was essentially flat from the third quarter despite an additional 50 basis points decline in Fed Funds during the quarter, as illiquidity in the capital markets has limited the 3 month LIBOR rate from falling as much as Fed Funds rates.
In addition, deposit pricing pressures have reduced the positive impact from the lower fed funds rate. Since year end 3 month LIBOR has declined approximately 75 basis points due to improved liquidity and the anticipation of further rate cuts by the Fed. This will likely push our NIM to the high-end of our current guidance range of 2.9 to 3.05%.
Our credit provision guidance is unchanged from what we stated in early December. We expect net charge-offs in the first quarter to be up 20 to 30% and the provision to be in the range of $1.8 to $2.0 billion. While difficult to predict, we expect the quarterly loan loss provisions for each of the remaining quarters of 2008 to be at a similar level. If actual charge-offs differ from this expectation then the provision will also be impacted.
An additional caveat I need to make to that guidance relates to the management of our credit card portfolio where the timing of securitizations is difficult to predict. Given the uncertainty of the capital market it’s possible our forecast for the timing and amount of card securitizations will change during 2008. If we retain more credit card receivables on our balance sheet we will need to increase the provision. I will keep you updated each quarter.
As in 2007, we are expecting to add more than 1 million net new checking accounts in 2008. Given that expectation, our guidance for depositor and other retail banking fees is an increase of 12 to 15% in 2008.
Non-interest income in the fourth quarter of $1.4 billion equates to an annualized run rate of $5.5 billion. However, the fourth quarter included about $500 million of market valuation adjustments and as I’ve reviewed with you earlier we expect we will have less exposure in that area in 2008.
We are also expecting the market for nonconforming residential loans to remain illiquid so have modest projections for gain on sale in 2008. Given these assumptions, our current guidance for non-interest income in 2008 is to be at or above 2007 results of $6 billion.
Non-interest expense for 2007 totaled $10.6 billion but included a $1.8 billion charge for goodwill and $143 million for our expense reduction steps. Again, as we said in December we are targeting a reduction in non-interest expense to $8 billion or less in 2008.
In conclusion, although we see good revenue growth and disciplined expense management, the increased credit costs will make 2008 a challenging year. However, we begin the year with a very strong capital position. We have approximately $3.7 billion in capital above our target capital ratio of 5.5%. This excess equates to a capital cushion of $5.9 billion on a pretax basis.
With that, I’ll now turn it back over to Kerry for his closing comments.
There's no question that elevated provisioning will impact earnings in 2008. But it is also inevitable that provisioning will decrease with time. The key is to separate the cyclical effects from the secular earnings power of the company. Until 2007, this company had a 10-year average return on average assets of 1.09%, which is consistent with our long term target of earning high teens return on common equity.
Until the environment improves, our senior leaders will be primarily focused on credit, capital management, liquidity and expense reduction. In addition, I hope it's clear that we will be uncompromising in our commitment to turn this company around. Performance is paramount.
And to this end, I will not accept a cash bonus for 2007, and bonuses for the management team have been greatly reduced commensurate with our results. We all understand that we have to do better – and we will.
We're now focused on 2008, which we know will be a challenging year. However, we will not lose sight of the fact that we have a powerful banking franchise that is at the center of our business strategy.
Our retail and small business banking efforts are paying off. Our card services and commercial groups are vital and continue to do well. Our brand is valuable and strong. Our core businesses continue to perform, and we’re determined to leverage them to return WaMu to the level of profitability our shareholders expect and deserve.
With that, Tom, Steve and I would be happy to take your questions.
In consideration of the number of people who have joined us on the call today, we will accommodate one question per caller. We will get to as many questions as time permits.
Our first question comes from Paul Miller – FBR Capital Markets.
Paul Miller – FBR Capital Markets
I know you are going to get a ton of questions on credit, I want to start it off here on the Pay Option ARMs. You talk about the Pay Option ARMs resets, the bulk of them are in the 2010 to 2012 time period, but you do have – correct me if I am wrong – 10% loan caps on these loans.
I was wondering if you can talk about how many loans have a neg-am balance and so some of these will probably hit their loan cap balances in 2008, probably in the latter half of 2008. Have we seen any of the defaults coming from that, and can you just address that issue?
We really have not seen that issue become a problem. As I mentioned in my comments, the fact that treasuries are coming down so fast is actually reducing the amount of neg-am and those reset dates may actually get extended. We will have to continue to watch that but that is what we are seeing already, as the index comes down, those payments become less.
Our next question comes from Brad Ball – Citigroup.
Brad Ball – Citigroup
I wonder if you could describe in more detail your revised guidance for credit card net chargeoffs - 8.5% to 9.5% seems a bit extreme. What kind of economic scenario underlies that and could you talk about the composition of your card portfolio; I know you said 37% of new account came through retail in the quarter, what is it for the entire book?
And, just to clarify Tom, you said the provision may have to go higher, depending on securitizations. Does that mean the $1.8 to $2 billion guidance per quarter is not inclusive of credit card provisioning or increased credit card provisioning as per the new guidance?
I’ll try to take you through all of those. The first one, we saw a very good performance of receivable growth in the quarter, up about 37% of total origination. That is probably running at about a third, we’ve been talking about for quite some time, so we just indicated that we are seeing more penetration as we are deemphasizing some of the national brand.
But overall that portfolio is growing as a total percentage; probably at this point it has to be ranging about 20% of the total managed receivables.
With regard to the level of net credit losses, we did give an indication last quarter that we were seeing NCLs go up; we were obviously surprised by the unemployment report as I am sure many of you were - a rather significant increase to 5%. What we are trying to do is capture the outlook on unemployment in that range.
Obviously we are not predicting the unemployment rate in our drivers, but we are trying to be cautious that if the unemployment rate was to continue that we would expect to see higher NCLs.
Lastly on your point about 1.8 to 2, we have been running at about a 65% securitization of total managed receivables, and I was trying to indicate there that there is timing and levels of securitization depending on pricing and liquidity that could move that number around from quarter to quarter, and I was trying to capture that.
If the total credit card securitization percentage was to decline, that would put some upward pressure on the provision, but that is not in our outlook right now that’s included in our range for now, but if it was to change significantly I just wanted to make sure everybody understood the sensitivity around the accounting for securitization of credit cards.
Our next question comes from Bob Napoli - Piper Jaffray.
Bob Napoli - Piper Jaffray
Just wondering if you could give a little more color on your commercial portfolio and outlook for credit in that business?
We are really not seeing much activity in that area on the commercial side at all, the whole portfolio. Net chargeoffs were about $30 million for the whole portfolio. Non-accrual loans were only at $24 million; it’s a pretty high-quality portfolio and we have not seen any issues there at all. That portfolio has been tightly managed and we are not seeing any deterioration to speak of.
I just want to jump in on that. Remember that over $30 billion of that $40 billion portfolio multi-family loans and we have actually seen some positive trends around rentals around the country. I would tell you that proactively since we have seen this credit issue roll through different asset classes, we are expecting to take our new origination volume down in 2008, with some particular emphasis around the piece of our business – smaller piece nonetheless – where we are lending on commercial real estate.
Our next question comes from Kenneth Bruce – Merrill Lynch.
Kenneth Bruce – Merrill Lynch
Hoping you would shed some light within your Pay Option ARM portfolio it looks like your average current over 80% LTV is about 25%. Can you give us some sense as to how much second liens may be behind these first liens? Do you have any sense of that? And, if you do, are you seeing any different performance out of those with seconds versus those that don’t?
First on the increase in loans greater than 80%: keep in mind that we have seen home price appreciation down across the industry; obviously a lot of these loans were done at 80% so they obviously go above once there is some decline in housing. That is driving most of that. We feel pretty good, as I mentioned, very, very small percentage of Option ARMs are throwing off loss this year.
With regard to second liens on Option ARMs, it is very difficult for us to know which customers have second liens on an individual loan so it is quite difficult for me to give you a perspective on that.
Our next question comes from Howard Shapiro - Fox-Pitt Kelton.
Howard Shapiro - Fox-Pitt Kelton
I am going to join the list of people asking credit related questions. I am wondering if you could tell us on the loans that are charging off in your first lien and home equity portfolios, what is the loss severity that you are experiencing and how is that changed versus a year ago?
And on your credit card portfolio, can you tell us what percentage of your portfolio is newer vintages and what percentage is California? I am sure you know that all the other large issuers are saying that the former high-hump appreciation states are seeing elevated loss rates.
And let me just squeeze one more question on credit in if I could. I noticed that there was a fairly dramatic pay down in your subprime portfolio – about 26% annualized – given the lack of refinancing alternatives I was a little surprised by that. Just wondering if you could just tell us what’s going on there.
I missed the last question, I apologize – 26% annualized decline in?
Howard Shapiro - Fox-Pitt Kelton
In your subprime portfolio – you went from 19 – something like that.
Let me get that one first. First off, we have stopped doing any subprime lending; that portfolio is in runoff mode and that is obviously going to drive down that portfolio as that portfolio runs down.
With regard to severities that we are seeing on prime and home equity, clearly severity rates are clearly up year-over-year; we weren’t even talking about severity rates a year ago. Given home price declines in key states like California and Florida, the severity rates for home equity can approach 100% for example.
In the prime space, those are more like 25 to 30% type range, and that obviously depends on the underlying collateral, how much equity is in the home, and how the individual area has performed in the environment.
With regard to your questions about Card, just to give you some perspective, at the end of year, about 19% of our total outstandings are in California. We haven’t seen any differentiation as far as chargeoffs as a percent of our (?) portfolio, it’s pretty consistent based on the weighting in California.
Our next question comes from Fred Cannon – KBW.
Fred Cannon – KBW
Kerry, just a bit broader question perhaps. If I look back, you haven’t really achieved an ROE above 15% since 2003; your stock is down 70%. You seem to have some plans in place to move forward, but I am just thinking, you also have scaled back a lot of your origination capacity and obviously the company is going to struggle through 2008.
Could you give us some feel for security that you do have a plan in place that as we emerge we can get back to reasonable levels of profitability?
Fred, certainly the top priority for myself and the entire management team, and certainly with the support of the Board of Directors is to get the company back to an earnings power that we believe it is capable of achieving.
We think there are a number of parts of our business that are operating very well and right in line with the long-term targets we have and that’s why we keep harking back to the growth that is going on in our retail bank, the key income growth, the expense management, the growth in the managed receivables in the card business, the growth in our commercial business.
Certainly the most challenging thing we’ve had to deal with here is the unprecedented conditions in the housing markets, which have both impacted the ongoing business activities of our Home Loans group and has required us to retool that business in a fairly significant way.
And the second factor, which is certainly quite meaningful, is the impact that that environment has had on the credit costs of the company. Our credit costs are significantly elevated from what we think would be normal.
What we are working very hard to do is first be sure we have the appropriate level of capital in place, and then be sure we have the right amount of liquidity to work our way through very diligently the plans that we have in place and to work through the credit challenges as methodically and as aggressively frankly as we possibly can.
Again, it’s a very difficult market condition, but we are just taking it head on, we’re rolling up our sleeves, working around the clock and a very determined team to get us back to a satisfactory level of profitability as soon as we possibly can.
I think one of the messages to investors is to keep an eye on the profitability from our continuing operations before credit costs and see how that is progressing over time and then these credit costs which are at a highly elevated level right now, we are going to work as diligently as we can to get those down as quickly as we can.
The Board of Directors has been highly engaged in the processes; we are certainly in constant dialogue with the plans that we have in place to get this turnaround completed and they are certainly supportive of the initiatives that we are executing right now.
Our next question comes from Peter (?) – Stonehill.
Peter (?) – Stonehill
I was actually hoping you could help me in two areas. One is, you talk about a lot of growth in the retail banking area, but I see the deposits have declined significantly in the last two quarters; I think it’s about 13 or 14%. I was wondering, given that you have CD rates high in the competitive scale, why that is, and also, how are you continuing to grow fees given that.
Also, I was wondering in the credit card portfolio, both your managed receivables and your delinquency rates in credit losses have grown significantly in the past year, but your quarterly provisioning for loan losses has stayed flat. I was wondering if you could help me with that as well.
Clearly, in the retail bank deposits have obviously become more competitive but we have not seen the reduction that you said. From June of this year, we’ve been just slightly down, about $2 billion in retail deposits as the balance sheet has come down, and consumers have been reaching for higher cost deposits.
Most of the deposit reductions have been in the wholesale area - institutional CDs and commercial deposits. We had one large customer pull their deposits as a result of an acquisition – A.G. Edwards and Wachovia – so that was some impact.
And we are also being quite disciplined in our pricing of our platinum checking. All of those things we feel very good about our deposit profile in the retail bank and I think the team has done a very good job.
With regard to the fee income, we are seeing yet another year of double digit growth and projecting one for next year. That is again on the back of generating new checking accounts; 1.1 million new checking accounts this year and that is obviously the key driver of our fee income.
Then finally, on the managed credit losses, as we probably indicated all year, net credit losses were at historical lows; they were even further reduced because of some of the bankruptcy law changes going back into previous quarters, and we’re expecting credit losses to continue to increase as unemployment starts to increase.
That is the view that we have and I will continue to keep you up to speed on it but no unique story in any of those real line items.
Our next question comes from Ron Mandel – GIC.
Ron Mandel – GIC
Kerry, I was wondering beyond a cash bonus if you are taking any bonus this year. And then, more broadly, if you could elaborate a little bit about cash and non-cash bonuses at the most senior level other than you and what level you will be paying for any type of bonus.
Ron, for the pay programs this year, again the primary bonus we have is a cash bonus and again I asked the Board not to consider me, so I refused any kind of a bonus there. I would say that for our executives, compared to last year, the reductions were probably in the neighborhood of two thirds to 75%.
Our next question comes from Thomas Mitchell – Miller Tabak.
Thomas Mitchell – Miller Tabak
Recognizing that setting an appropriate level of loss reserve is more of an art than a science, I can’t help but note that your reserves at the end of 2006 were 59% of your non-performing assets and that despite growing your reserves aggressively during 2007, you ended the year with reserves at 36% of non-performing assets.
I could understand if the mix of business had change or the mix of non-performing assets had changed, that the expected ultimate losses on the change in mix might arrive at a lower level for setting reserves, but it’s a little difficult for an outsider to understand in a period where apparently the severity of losses being taken and the frequency is rising – the severity is rising rapidly – why it would be appropriate to reduce the relationship of reserves to non-performing assets.
So I am just wondering if you could explain to me the thought process you used in deciding to reduce your reserve relative to your non-performers?
Tom, thanks, obviously loan loss provisioning is a challenge for anyone. Let me give you some perspective on it. First, we are taking into account all the non-performing assets and losses and chargeoffs that we are seeing in our calculations so please be aware of that. That is an incurred loss type of construct under GAAP.
Couple perspectives that may help you understand it a little bit. I mentioned in my prepared remarks the significant increase in real estate owned and also (?) that we have done, and so keep in mind that on the real estate owned side, as that portfolio grows, that gets put into the NPA number but there is no ALLL associated with it because we’ve already written that down to net realizable value. So that is one thing that you have to factor in.
The other thing is with regard to the loans that we transferred into the held-for-investment portfolio you may recall our comments back in the third quarter and the fourth quarter where we transferred loans that we were previously going to be selling, we brought them back in the portfolio, those were all brought in at market value.
As a result of that, we have approximately $500 million of additional discounts if you will. So some of the normal relationships that you may be trying to trend are impacted by those types of dynamics and it makes it difficult.
What I would point you to is that when we look at our allowance for loans held in the portfolio, it’s actually grown quite a bit from a year ago. December of 2006, our allowance as a percent of loans held in the portfolio was about 72 basis points and that number now is at 1.05.
So you can see that the ALLL is growing as the risk profile is increasing, although you do have some of these unique set of circumstances that really weren’t in place last year, particularly the REO that sits in the NPA.
Our last question comes from Louise Pitt – Goldman Sachs.
Louise Pitt – Goldman Sachs
I just have a very quick question for you. With respect to credit ratings, clearly (?) your rating from the other agencies already in the triple-B category, I just wondered if you had any comments about the fact that your competitive position vis-à-vis your large U.S. domestic peers in retail and commercial banking is clearly becoming a disadvantage in terms of rating. Can you comment a little further on that?
Clearly the credit rating is an important part of our business, although a lot of our funding is at the bank level, and that is profoundly focused on retail deposits; as I mentioned, about 50% of our funding comes from retail deposits and then we have a very large capability with the Federal Home Loan Banks so our need to go to the public market is quite limited and in fact, in my prepared comments, we don’t see any need to go to the public markets for our holding company as well.
So, while the credit ratings are down, we don’t really depend on the secondary markets for funding purposes in any large extent. We really positioned ourselves from a liquidity standpoint at the holding company; we’ve got cash available there through 2010. The cash position of the bank is predominately retail deposits. We don’t rely on any kind of asset backed CP programs or the issuance of CP in any way. So our dependency on the secondary market is quite limited.
With that, I think we’ll draw it to a close. Thank you all for joining us today. If you have any follow-up questions, be sure to contact Investor Relations. Thank you all very much.
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