Executives
Dennis Oakes - VP Investor Relations
John Delaney - Chairman and CEO
Tom Fink - CFO
Analysts
Robert Napoli - Piper Jaffray
John Hecht - JMP Securities
Sameer Gokhale - KBW
Carl Drake - SunTrust Robinson Humphrey
James Shanahan - Wachovia
Scott Valentin -FBR Capital Markets
Tayo Okusanya - UBS
David Hochstim - Bear Stearns
CapitalSource Inc. (CSE) Q1 2008 Earnings Call May 6, 2008 8:30 AM ET
Operator
Good day ladies and gentlemen, and welcome to the CapitalSource First Quarter 2008 Earnings Call. My name is Karen, and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator instructions).
As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's call, Mr. Dennis Oakes, Vice President, Investor Relations. Please proceed.
Dennis Oakes
Thank you, Karen. Good morning everyone and thank you for joining us for the CapitalSource first quarter 2008 earnings conference call. Joining today are John Delaney, our Chairman and CEO; and Tom Fink, our Chief Financial Officer.
This call is being webcast live on our website, and a recording of the call will be available beginning at approximately 10:30 am Eastern Time today. Our earnings press release and website provide details on accessing the archived call.
Investors are urged to read the forward-looking statements language in our earnings release, but essentially it says statements made on this earnings call, which are not historical facts, may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.
All forward-looking statements, including statements regarding future financial operating results, dividends, transactions involving risks, uncertainties and contingencies, many of which are beyond the control of CapitalSource, and which may cause actual results to differ materially from anticipated results.
CapitalSource is under no obligation to update or alter our forward-looking statements whether as a result of new information, future events or otherwise, and we expressly disclaim any obligation to do so. More detailed information about the risk factors can be found in our press release issued this morning, and in our reports filed with the SEC.
I'll turn the call over now to John Delaney. John?
John Delaney
Thanks, Dennis, and good morning everyone. We're very pleased with the company's performance on a number of fronts this quarter. First, credit continued to be strong with non-accruals and delinquencies essentially flat from the prior quarter. We are obviously very mindful of the economic environment that we're in and the effect that it can have on credit. But thus far, we have not experienced any material reduction in credit performance. I attribute this to sound lending, good underwriting and a diversified book of business.
Second, I was actually very pleased with the adjusted earnings performance of the business at $0.51 per share for the quarter, particularly since we recognized $0.09 in quarterly adjusted earnings loss, related to the reduction of our agency portfolio by over $600 million. We have continued to reduce our agency portfolio, and today it stands at about $1.6 billion, down from its peak of about $4 billion.
The reason for this reduction is simple. We didn't need as many agencies for recompliance, and we elected to reduce the portfolio, not because we had to, but simply because we could, and it resulted in a dramatic reduction in any funding risk against this portfolio.
Third, margin improved by almost 100 basis points, reflecting both the work the portfolio team has done in passing on our higher cost of funds to our existing borrowers when we can, and the benefits of interest rate floors, which I think many of you know is a feature of our lending practices. Both of these actions increasing spreads to existing borrowers, and interest rate floors are just more examples of the benefit of a direct origination and active portfolio management model that we have here at CapitalSource.
Our proposed acquisition of certain assets in branches of Fremont Investment & Loan is on track in all material respects. In fact, we filed our regulatory applications last week. Only a few weeks ago, we spoke in some detail as to the various reasons we view this acquisition as attractive. We plan on providing you with more specific detail, as to how this acquisition will integrate with our business, and the effects it will have on the key drivers of our business model, such as originations, profitability and capital utilization.
It is our current plan to provide new guidance in August, probably with our second quarter earnings announcement that will reflect this acquisition. And the general operating environment in the credit markets has stabilized, but that is not to say that we're at a point where such stabilization is anything close to what I would consider normal.
Credit markets remain virtually closed for new issue securitizations or large loans, while deals that are very conservatively structured can likely get done, and we were gearing up for one prior to the bank deal being announced. The terms are not attractive. We've seen some stabilization in spreads and secondary loan prices, but again at levels that are far wider in the case of spreads or lower in the case of loan prices than anyone ever imagined.
As a result, the environment for new loans remains very attractive with the lack of competition existing in most of our end markets. We expect a limited number of new entrants to start filling this void, much less than some anticipate, to my mind, because the funding model for new entrants will remain, in my judgment, impaired for years to come. And I'm not sure how some of these new entrants will secure debt capitals from their business.
Let me sum up by saying we feel very good about the direction of the company. Credit and asset quality is once again strong. We have reduced our exposure dramatically to agencies. That issue should now be off the table. And the funding environment for us is improving. Regarding our dividends in the second quarter, we anticipate declaring a $0.60 dividend towards the end of this month.
Tom?
Tom Fink
Thank you, John. I concur with the assessment that our results this quarter were very good, from both the perspective of credit and our financial performance, especially, I would say, considering the state of the capital markets.
In addition to the things that John mentioned, a focus of ours during the quarter has been the renewal of our secured credit facilities on which we have made significant progress. As of this date, we have renewed two credit facilities totaling $1.2 billion of committed financing and we are working to complete the early renewal of two additional credit facilities.
The first two facilities that renewed at the end of last month had renewal dates in April of 2008, so these have been renewed in the normal course. The other two facilities, which we expect to close soon, have renewal dates coming up across the next few months, but we decided to begin the renewal process early so as to remove this uncertainty from our funding picture.
As expected, the terms of these credit facility renewals reflect market conditions, including higher pricing and lower advance rates. Also, the commitment levels have been adjusted to lower levels. The lower commitment levels make sense for us given the lower level of originations we are currently seeing and expect to see prior to the closing of the bank transaction, as well as the higher fees that the banks are now charging for unused commitments.
With respect to our Commercial Finance business, one of the things we saw this quarter was the significant and rapid drop in short-term interest entities, such as prime and LIBOR. As a result, we had both lower yield and lower cost of funds in the first quarter compared to the prior quarter. What I want to tell you is that the net of these two has been positive in terms of the credit spread that we charge to our borrowers.
As John highlighted in his remarks, during the quarter we saw an improved core lending spread relative to our 30-day LIBOR benchmark. The core yield of our portfolio, that is yield excluding any prepayment related fee income, was 10.42% this quarter. Subtracting out the 30-day LIBOR average for the quarter of 3.3%, you arrive at our core lending spread of 7.12%. This core lending spread was 99 basis points higher than our commercial finance core lending spread of the prior quarter, and we are very pleased with that performance.
On the funding side, we saw lower cost of funds in the quarter, but an increase in the borrowing spread to average LIBOR. The borrowing spread to LIBOR was 2.15% or 62 basis points higher than last quarter due to the continued volatility in the short-term funding markets. But a simple comparison of these two spread numbers shows that our net core leading spread, that is our core leading spread minus our borrowing spread, increased by 37 basis points compared to last quarter.
A final item that I would like to touch on before wrapping up is operating expenses, which has been a focus of ours. In dollar terms, total operating expenses for the quarter we're down approximately $3.6 million compared to the fourth quarter, principally due to a reduction in compensation and benefits expense offset by an increase in professional fees.
During the first quarter, we wrote-off approximately $4 million in expenses related to the TierOne acquisition, which was terminated in March, and that amount is included in the operating expense this quarter.
In terms of our percentage of assets, operating expense in our Commercial Finance segment was 2.03% in the quarter compared to 2.2% in the prior quarter. Our consolidated basis, our operating expenses, excluding depreciation on direct real estate investments, as a percentage of assets was 1.31% for the quarter down from 1.38% last quarter.
With that, I will the call back to Dennis Oakes. Dennis?
Dennis Oakes
Thank you. Karen, we're ready for the first question now. We would ask questioners just to limit themselves to one question and one follow-up, so we can get to as many callers as possible.
Question-and-Answer Session
Operator
(Operator Instructions). And your first question comes from the line of Robert Napoli with Piper Jaffray. Please proceed.
Robert Napoli - Piper Jaffray
Good morning.
John Delaney
Good morning, Bob.
Robert Napoli - Piper Jaffray
Quite nice job in a pretty tough environment. Congratulations on that.
John Delaney
Thank you.
Robert Napoli - Piper Jaffray
John, credit quality looks very good, and I just wondered what you are seeing in the economy, and what's your outlook for credit? We would expect that given what we're seeing in the economy broadly, that we would expect to see credit losses move up through this year. I was wondering if you can give us a little bit color on that, and just one follow-up then.
John Delaney
Sure. Bob, as I said in my remarks, credit, as you've highlighted, has remained very strong for us with no real deterioration in our credit metrics. However, as you're highlighting as well, we are mindful of what's going on in the real world, where there is dramatic upheaval in the credit markets and there are clear signs of reduced consumer spending, recessionary talks, whether we're tackling there or not, is all stuff that we're fairly mindful of. We're seeing some signs of that in the portfolio kind of what I'll call around the edges. That's something that's concerning us kind of in the core of the business.
And I think our approach to credit is reflective of what's going on in the general world, which is we're cautious. I think it's reasonable to assume that there will be pressure on credit at all financial institutions. We've obviously seen it in residential credit dramatically, but in other aspects as well. But thus far, knock wood, we're hanging in there very well. And again, I think it's due to basic kind of sound lending, which is underwriting your loans carefully, making sure of your senior lender, given your loan to value work wells, structuring the loans appropriately and managing the credits in a tight and proactive fashion. If you do all those things even in a tough credit environment your credit outcomes shouldn't be that bad. And that's really our approach to the business.
Robert Napoli - Piper Jaffray
Okay. As far as the growth of the business I would expect also in this environment, while you could probably put on a lot of business at great rates and with the funding market the way they are, I wouldn’t expect to see much growth through the next several quarters, couple of quarters, anyway I am just wondering if you could talk about that growth and then you have some down sizing the employee basis that base is a primarily on the origination side?
John Delaney
Yeah I would say that two questions there. There hasn't really been any kind of systematic down sizing the employee base. Obviously in these kind of environments we have a very critical eye towards what parts of the company are making us money and what parts are not achieving our ROE standards, and everyone becomes more disciplined in these environment, in all aspects of the business, including operating expenses as we have been. In terms of originations, there are very good opportunities in the market.
The new lending environment has really been frozen for a while because the transaction volume is down quite a bit. There are a lot of opportunities in the secondary markets obviously. But, we think the opportunities are good. We've been very prudent about deploying new capital and we started this posture way back August of '07. If you recall, based on our view of what has been happening and where we would settling in that.
And, I still don't feel a real rush to put money to work right now because I think opportunities, even if they don't get better, I don't think that we're going to miss an opportunity in the short-term. In other words, I think the environment right now will last for some period of time. And, we're obviously very focused on our new depository, which will improve our access to all forms of capital, and we think that's going to be a terrific opportunity for us to deploy our balance sheet and grow our balance sheet in a prudent way.
So, I think we've been managing our liquidity very carefully; making sure the business is kind of flush with liquidity. We've actually delivered the business across the last six months. We think we're in a liquidity position to take advantage of what will a sustained lending opportunity and that the depository will enhance that.
Robert Napoli - Piper Jaffray
Thank you.
Operator
And your next question comes from the line of John Hecht with JMP Securities. Please proceed.
John Hecht - JMP Securities
Morning. Thanks for taking my questions. Tom, you mentioned you are addressing two facilities early, and over the next couple of months. Can you tell us beyond that what's your requirement are going to be to address your financing for the remaining part of 2008?
Tom Fink
Well, I think that well first of all those facilities have renewal or other dates that come up over the next several months. But, we are actively working on them now, to renew them early, and expect to complete that shortly.
And, I would say after that, those are the major milestones that we had to achieve with respect to our funding plan for the year, and that really clears the decks for us to focus, as John said, on the depository and closing our new bank, and acquiring the Fremont branches deposits etcetera.
John Hecht - JMP Securities
Okay. Then with respect to the net finance margin, I mean, you guys did experience, I think it was at 5-basis points of contraction this quarter, although if my data is right, it looks like that was the least amount of contraction relative to the last several quarters. So, given that you're rolling your financing and you may pick up some deposits, and it's possible that the fed is done here in terms of interest rate reductions, is it that you're bleak in the near term that we should start seeing stabilization with differential increases in net finance margins?
Tom Fink
Yeah, I think the contraction in net finance margin is driven by a number of factors, one of which is just the absolute level of rates, because we do have more assets than liabilities, and have relatively low level of leverage in the business. So lower short-term rate environment would enhance reduced the net finance margin. The things that I focused on are really our spreads relative to the short-term markets.
And, that's why I spoke in my remarks earlier about our core lending spread and net borrowing spread is well. And, the point I'm highlighting here is that the core lending spread increased, and it increased more than the borrowing spread debt, which we're very pleased about. And, John referenced actions that we're taking in the portfolio where we tend to pass on higher cost to our borrowers. Also, we have the beneficial affect of floors in the loans etcetera, contributing to that increase spread on the lending side, so that's positive.
The things have been driving the increased borrowing spread, certainly in the first quarter and the second quarter of this year. First and foremost, it's due to the volatility in the short-term funding markets. In the first quarter you saw LIBOR decrease a 160 basis point on average. And, with these credit facilities something that we have, it's just very hard for those facilities to instantly reduce their cost of funding. So, there is a bit of a lag effect.
So, as we go through 2008, particularly as you referenced with the Fed perhaps being perhaps done with their efforts, we should see that bit of noise in the cost of funding disappear that will be replaced by higher cost of funds. So, I would expect to see certainly some stability in our cost of funds, our borrowing spread relative to LIBOR, but that this increase lending spread will continue.
John Hecht - JMP Securities
Okay. Thanks very much.
Operator
Your next question comes from the line of Sameer Gokhale with KBW. Please proceed.
Sameer Gokhale - KBW
Hi. Good morning. I just had a couple of quick ones. The other expense number on net was -- it showed an expense of $4.7 million this quarter compared to $4.3 million of income last quarter, and I know you have some foreign currency losses in there, but if you exclude the items that you back out to get to adjusted earnings, what would be kind of the relevant comps last quarter to this quarter? Just wanted to get a break-out of those items if possible?
Tom Fink
Well, you're right. We do have some foreign currency items. We have some foreign currency loans in a European subsidiary, which is our office in London. And, so we do get hung up with some foreign currency translation issues between euro denominated loans and our US dollar denominated balance sheet and income statement here. You know, looking at the other items that are in there that explains a big part of the swing. We have a few items that resulted in gains in other income, and we had similar amounts, I would say, in the last quarter. So, it's really that foreign currency item that explains the swing there.
Sameer Gokhale - KBW
Okay, maybe I'll follow up with some questions later on. The other thing I was wondering was, in the impaired loans, your current metrics obviously were very stable, but the one category where there was a little bit of an increase was in the impaired loans. Can you talk a little bit about the loans that went into that bucket? Were those new loans or was it just some denominator effect in the ratio that's driving that ratio up? Can you just talk about that a little bit please?
John Delaney
Yeah, sure Sameer. This is John, Delaney. One thing to remember on that category is that includes these things that are definitionally impaired.
Sameer Gokhale - KBW
Okay.
John Delaney
It's more of am accounting convention and does not really get to the heart of the matter on the loan. So I can say that the uptake in that category is entirely due to that, related to loans that we do not think are problem loans, but under the accounting definition they have to be categorized as impaired, Sameer.
Tom Fink
No I think that's exactly right John. We, that's why we in all of our conversations try to focus on the non-accruals as being the most important measure because that impaired asset number does pick up and include the fair amount the definitional impaired loans. We'll just review what that is, that maybe a loan that we consider to be credit good but is beyond its scheduled maturity, for example or otherwise not going to be paid in accordance with its contractual terms. It does not mean we're not going to ultimately get paid, and that is the big driver of the change in impaired assets this quarter.
So for all those reasons, our non accruals are really the most important metric, and just to expand on what John said about the credit metrics. We've been at the lower ends of the historical ranges here for several quarters now, so we are obviously very pleased with the credit performance of the business.
Sameer Gokhale - KBW
Okay and then just quick one last one if I may on the structured finance business, it seems like this is an environment particularly if you look at the rediscount business where there could be a lot of opportunities for you. I know you gave us some commentary on the funding side and what's happened to cost and the structures of securitizations aren't that attractive, but is the idea essentially that you renew these new warehouse facilities and then in your, rediscount business, you may have borrowers that you can lend to at very, very safe structures for you as a company and that's when you kind of ramp up, is when you just have some of these new facilities in place. Is that how you're viewing this sort of this environment from a growth standpoint, specifically if you say look at that rediscount business?
John Delaney
I think that's a very good kind of assessment or a good way of framing the whole business picture, which is that, we've taken actions across the last, really six months, to make sure the balance sheet is particularly well-positioned and then the last kind of stage of that, if you will, is the depository franchise, and it's my view that once the depository transaction close, we will have one of the lowest kind of levered balance sheet, of any depository in the country.
The company's leverage will be, at kind of almost, historic low levels in its core business, and we will have our credit facilities all renewed, we will have access to deposit based funding of a very liquid and strong balance sheet. And that we will then go in to the market prudently, but the market that we are going into is really the single best lending market I have ever seen, so whether it's the rediscount or any of other businesses, we think we will be able to earn very high returns on well-structured senior loans that are very safe.
Sameer Gokhale - KBW
Okay, thank you for that, John.
Operator
Your next question comes from the line of Carl Drake with SunTrust Robinson Humphrey. Please proceed
Carl Drake - SunTrust Robinson Humphrey
Thanks, good morning. Question is on the growth, there is a little bit of asset contraction in the core understandably with all the term loan in the first quarter, but maybe you can give us a little bit of break out on the gross originations and then the prepayments in the core and also, an outlook in the second quarter and third quarter about how growth might resume going forward. I think, that might be important in the model to get to the point at the end of '08, where you are covered adjusted earnings or the dividends by adjusted earnings?
John Delaney
Yeah, and one thing, that I think you should know Carl, is that but for the sale of the agencies, this quarter, which was, the strategic decision that we made, we didn't have to, we decided to do it. We would have covered the dividend on adjusted earnings. I think it is worth making that point. But one of the things I mentioned in my comment is, it probably around the time of our second quarter, our earnings announcement, we plan on providing a whole array of kind of new guidance around the business, all the key drivers of the business. Because we think that will be the time when the depository is closed, we will have work through the process that we're working through now in terms of our planning around the depository, our integration of the depository approval being in-hand and will understand that better.
And that's what we think is really the best time to provide more specific answers to questions we are getting. I'm not trying to defer the question, but I think that we will be able to provide such a full set of answers then, that it address the reality of the business of that time with the depository closed. I would rather differ providing some more specifics on that until after that. Because in reality it's really such a game changer on some of these metrics.
Carl Drake - SunTrust Robinson Humphrey
Okay and then…
John Delaney
I do not mean to be punting on your question here, but I just think that in a pretty short period of time we will be able to address some of those things with specific detail and a lot of clarity.
Carl Drake - SunTrust Robinson Humphrey
Okay, I understand, one follow-up on the prepaid fee income was down I think 14 basis point contribution but the other fee income was still pretty healthy. Maybe you or Tom could talk about the components of fee income. I assume a lot of that is transaction fee related, and still relatively healthy, given what I think were lower volumes?
Tom Fink
Right, I mean the prepayment fee income is just lumpy right.
Carl Drake - SunTrust Robinson Humphrey
Yes.
Tom Fink
That's been our explanation for that literally every single quarter end and it's true. And then the rest of the fee income is just the normal amortization of deferred fees plus additional fees that we can charge for various things along the way with borrowers.
Carl Drake - SunTrust Robinson Humphrey
So, that little fee income seems to be relatively consistent from a yield contribution other than the lumpy prepaid part?
Tom Fink
That’s right.
Carl Drake - SunTrust Robinson Humphrey
Okay.
John Delaney
Yeah, the prepaid fee moves around. It was low this quarter, and it was higher in the fourth quarter. It was low in the third quarter and there was some speculation that maybe this is a new trend based on the credit markets, then was high in the fourth quarter again and now, well again.
So again, these results to some extent were negatively affected by two things. One, lower prepayment fees and also we had some one-time expenses which Tom mentioned associated with our Q1 deal being terminated. So, in future of course we expect either both those expenses not to be there and some of these prepayments numbers to stabilize more along the lines of historic levels.
Carl Drake - SunTrust Robinson Humphrey
Is there any visibility on this coming quarter on prepay fee income?
Tom Fink
Yes, I mean, we're one month into it so.
Carl Drake - SunTrust Robinson Humphrey
Okay, alright. Thank you.
Operator
Your next question comes from the line of James Shanahan with Wachovia.
Please proceed.
James Shanahan - Wachovia
Thank you very much. At the investor day in early March, I recall some discussion about the company's interest in pursuing a private CLO, in fact, I think that management even commented there had been some meetings that had occurred or some progress had been made. And what is the status of that or any similar financing? Does management still have any interest in anything like that?
John Delaney
Yeah, we were geared up to do one of those transactions as we indicated, but in light of the bank acquisition, we made a decision to move loans into the bank at closing, rather than do that. And if we were to execute one of those private CLOs, we would be permanently kind of financing those assets, which would make it difficult to move them into the depository and would not provide as much benefit immediately as the depository could if we were to kind of reserve those assets to be placed in the bank.
So, we made the decision based on that transaction being announced, and as you know from our Investor Day, that transaction wasn't on the table the way it is now. And so moving down the path of the private CLO, once the transaction was announced we said, hey a better option is to move these loans into the bank, they are high quality loans, they are performing really well, they are very attractive bank assets, and it allows the depository to start with a little more heft.
So we made the decision to reserve those loans for placement in the bank. That's really the only thing that happened, but we were moving down the path to getting one of those deals done.
James Shanahan - Wachovia
Okay. Thank you. And a brief follow up if I may, back in form 10-K the company disclosed about $5.6 billion in committed capacity under credit facilities. I believe the number announce today was $4.6 billion. I can't quite get to tie those numbers together. There were a couple of very small maturities and during the March quarter, February and March, and then it looks like the one facility that was $1.4 billion was downsized to $1 billion. But I still don't quite get to a $4 billion reduction in capacity. What might I be missing here?
Tom Fink
Yeah. Well, you are right, and as I addressed in my remarks, we have brought down some of the commitment levels in some of the facilities because it's our expectations in what we utilize versus the significantly higher cost to have that unused commitments sitting around. And then earlier in the year, there were some small facilities that we weren't really utilizing that we've -- bodes well.
James Shanahan - Wachovia
When you just, when you talk about facilities that you're looking at renewing early, are you referring to the $1.5 billion facility due in August of '08 and the liquidity renewal for the $700 million facility that's actually due in '09, is that correct?
John Delaney
That's correct.
James Shanahan - Wachovia
Alright. Thanks very much for clarifying. I appreciate it.
Tom Fink
Yeah. That one that's due in '09 has a renewal date and I think June of '08. So those are the exactly the two I was talking about.
James Shanahan - Wachovia
Excellent, thank you.
Operator
Your next question comes from the line of Scott Valentin with FBR Capital Markets. Please proceed.
Scott Valentin -FBR Capital Markets
Good morning. Thanks for taking my question. Just a question on corporate structure, assuming the bank here, the Freemont deposits are acquired, I think it's a great opportunity for growth given the lack of competition and attractive returns. Is there any thought about the restructure maybe that limits the ability to grow given their requirements of payout a substantial percentage of earnings. Would there any acceleration or deceleration in the structure?
John Delaney
Yes, we had this question before and I think at this point we are there is no plan to change our corporate structure. One of the things that we want to make sure that we highlight with investors, is that we are actually not required to payout nearly as much of our earnings as most REITs are, because at this point the majority of our earnings are actually coming from non-real estate activities, which is why our tax rate is so much higher than most REITs, slower than C-Corp or a commercial finance company, but it's higher than most REITs. And it's one of the benefits of our structure if you will, which also means we pay more tax is that we really don't have to payout nearly the percentage of earnings as most REITs do. And so that flexibility exists in our structure.
So should we look at that decision you're framing which the Management and the Board look everything all the time. We frame it around a number of issues, not just the ability to retain more earnings, because we actually have the ability to retain substantially more than we do currently, without being running or follow the Repos.
Scott Valentin -FBR Capital Markets
Okay, that's helpful, and just a follow-up question. Your credit quality remains exceptionally strong. I am just curious, your reserve- to-loan was about flat during the quarter. What's the policy or your philosophy going forward, if you're seeing kind of a weakness on the fringes, is there any thought about building reserves in front of that?
John Delaney
Yeah, I mean, if our portfolio informs us or tells us through its various kinds of statistics and devices or metrics that we use to track the portfolio, the reserve should be higher with the reserves up. There are only two components of our reserves that result in the total reserve, there is a specific reserve and there are the policy reserves. One is designed for known problems, and one is designed to cover loans that are inherent in the portfolio, loan losses that are the inherent in the portfolio. But those situations haven't necessarily surfaced.
And so, each quarter we evaluate those specifics and policy. Specifics generally tend to be more of a loan-by-loan analysis of problem loans. Policy tends to be looking at historical performance. It's got factoring in current charge-off data that occurs in that quarter and how that kind of informs are changes historical performance and then also looking at other rivers or metrics in the portfolio. And all those things come together that lead to our reserve levels.
And so, should things calculate on the negative side within the portfolio, that would affect a policy and to expect they didn't get to this specific reserve level that would affect our policy reserves.
Scott Valentin -FBR Capital Markets
Okay. And just one last follow-up quarter. You've done a good job also on the expense side maintaining efficiencies. Is there a goal there in terms of percentage of receivables or is it better way to look at it, maybe percentage of originations?
Tom Fink
Well, we tend to look it the average expenses as a percentage of assets, that's really been the metric we have tracked, and that's what we're focused on. But also to elaborate a little bit further on your last question which John answered. One of the things that affect our allowances as a percentage of our assets is the mix of loans, your cash loan versus asset based, versus real estate. Correcting for the mix or the change in the mix of the loans, these reserve factors that we use have really been in the same range for several years here, and were developed at a time when the company had much higher levels of non-accruals. And we have been, for several quarters now here, at the lower ends of our historical ranges.
So I think we would feel very good about the level of reserves in the business, and if we weren't looking at the economy the way we are, you could almost make the argument on a statistical basis, a quantitative basis, to actually reduce the level of reserves. So I think maintaining our reserves at these levels is a very healthy sign for how well reserved we are in the portfolio.
Scott Valentin -FBR Capital Markets
Thank you very much.
Operator
Your next question comes from the line of Tayo Okusanya with UBS. Please proceed.
Tayo Okusanya - UBS
Hi. Good morning. Two quick questions, the first one, with the renewed lines, could you talk a little bit about what's the cost of funding is on those lines versus what the lines cost you in the past?
Tom Fink
Sure, Tayo. They have gone up as we expected they would. They are all based on a spread to a cost of funds, and it's generally gone from a number that was between 75 and a 100 basis points to a number that's between 200 and 250.
Tayo Okusanya - UBS
That's gone up about a 125 to a 150 basis points.
Tom Fink
Yeah, that's right.
Tayo Okusanya - UBS
Okay. Good, that's helpful.
John Delaney
Now interestingly, you know, we had wider spreads this quarter. So directionally, we've been able to take those increased cost of funds and really pass it on to our portfolio largely.
Tayo Okusanya - UBS
Right. Okay, that's helpful. Then, the agency portfolio, two quick questions, the sales that you did in the first quarter of '08, I'm just curious why the firm decided not to wait a little bit to try to see RMBS pricing improve versus the traders you covered in the quarter at a loss, and then how do we think about the further sales post 1Q '08 on what the implications would be for 2Q '08 adjusted EPS on this?
John Delaney
We, well, first of all we're not agency security traders by nature, at least senior management the company is, we've got a very high quality and experienced team to manage this portfolio, but my nature and Tom's nature is that we're not agency traders. So when we make decisions for this company on capital we're not necessarily making bets about how agencies will trade. We did see a recovery of agencies in the second quarter and we did execute a lot of our sales in the second quarter.
So the first quarter is clearly a very tough quarter for agencies, spreads really peak kind of around the end of the first week to the beginning of the second week on agencies. Really historic widening of spread on agencies occurred in the first quarter. And we did sell some agencies in the first quarter.
But our business, we really look at the agency portfolio and because we had a view that we were kind of over allocated if you will towards re-compliance assets, so that the prudent thing to do was to take some of the funding risk out of the business, take some of the GAAP earnings volatility out the business and reduce the size of that portfolio.
Tayo Okusanya - UBS
So without the sale of $1.5 billion in the second quarter, could you talk a little bit about what gain or loss you're expecting from that sale?
Tom Fink
Sure, first of all for GAAP obviously no, no impact in the sense that all the stuff has been on the agencies securities has been mark-to-market
Tayo Okusanya - UBS
Right.
Tom Fink
The way you can measure this Tayo is, if you look at the income statement, you see there is an item in other income that we record for the residential mortgage portfolio, and then there is another item that we record in the adjusted earnings reconciliation. And those two numbers are typically within a few million dollars of each other, and the difference being related to the interest accruals on the swaps and for example, in the hedge portfolio. And it's down there in other income geographically, because that's where it's required to be.
So there's typically a few million dollar difference between those numbers related to, basically, interest income or interest expense, you can think of it, on the portfolio. This quarter, there is now, there is a bigger loss to the tune of about $20 million, $21 million, a greater difference, and that is the component that is the realized loss for adjusted earnings purpose is related to sale. And that equates to this approximately $0.09, $0.095 that John mentioned in his remarks.
Tayo Okusanya - UBS
Okay.
Tom Fink
Okay?
Tayo Okusanya - UBS
Great that's helpful. Just one more question, the core lending spread, this is a macro-economic question. Core lending spread improved almost a 100 basis point, but the net finance margin declined by about five basis points. Could you just walk me through the reconciling items between, or the core lending spread versus the net finance margin and what's the difference between those two numbers?
Tom Fink
Well, the core lending spread as we defined it, on the call here and in the press release is very simply, our yield minus our prepayment related fees. Prepayment related fees are this lumpy item, and it moves around from quarter to quarter, so you subtract that prepayment related fee, and you get to our core yield, and since we are a floating rate lender, we will subtract the floating metric LIBOR from this core yield, and get to that core lending spread. So, core lending spread is basically the credit spread we charge on the coupon that's embedded in the coupon on our loans, plus the normal core fee income that we earn.
And net finance margin is a different metric. That our net investment income, which is our interest income and fee income, minus our interest expense plus our operating lease income on our direct real estate investments, divided by the average income earning assets. So, you are talking about two different components.
Tayo Okusanya - UBS
Right, okay. So the core lending spread is just on the commercial portfolio?
Tom Fink
You are right, which is obviously big part of the --our business and our earnings.
Tayo Okusanya - UBS
Okay.
Tom Fink
But the fact is, it's a little bit confusing is that the net finance margin is down a few basis point. There was quarter about this earlier, that's due to the fact that we are a floating rate lender, and we've got LIBOR as a component of our yield on $10 billion plus of average interest earning assets, and with lower LIBOR you are going to see lower interest income.
Tayo Okusanya - UBS
Okay. Great that's a lot.
John Delaney
Right thanks.
Operator
Your next question come from the line of David Hochstim with Bear Stearns. Please proceed.
David Hochstim - Bear Stearns
Thanks. John you mention the competitive environment in few times, I wonder if you could provide some color, and kind of relate what you are seeing in the way of spreads on new business to what's happening with your funding cost, and how much benefit there is on the new business your seeing currently?
John Delaney
I would say that new business on a pure spread basis, depending upon the product, we've got a variety of senior lending products and some have been more effective than others. I would say that new senior loans -- just focused on spread for a minute, are anywhere from 2 basis points to 500 basis points wider on a spread basis literally. Some of the products with such a lack of liquidity have new spreads close to 4 basis points to 500 basis points. Some of the things that are a little tighter or more liquid with the banks are still playing is probably closer to 200.
But there are other components as well, that you are able to obtain in this market that is immediately evident, if you will, in terms of the spread and the loan the day you book it, but becomes quite valuable kind of downstream. And those include things like prepayment fees, lockouts on transactions. So that there is prepayment not allowed for several years, and if prepayment were to occur there is a yield maintenance feature and so there are whole bells and whistles, if you will, of additional features, interest rates floors, which we are getting the benefit of now on some of the transactions that we are able to do across for last, now several years.
So there is a package of features, if you will, to loans that we are able to kind of garner if you will, because of the current environment that you can't get normally, but if you are talking about your spread, you're probably talking 2 basis points to 500 basis points.
David Hochstim - Bear Stearns
And then relating that your increase cost of funds, is that the 100, 125.or greater
John Delaney
Well, Tom indicated our credit facility spreads are going up 125 basis points, 150 basis points, pretty significant increases. Now, obviously, based on the numbers I just described, we can pass that on to the borrowers that I'm not worried about. But, the other nice thing that’s happening is with the depository from a horizon, our cost of funds are actually going to go down.
David Hochstim - Bear Stearns
Yes.
John Delaney
So, we'll have this dynamic where the lending opportunities -- and what I didn’t mention is, the other benefit of lending money right now, is the structures are really tight and the leverage levels are lowers. So in addition to wider spreads, we're getting much better credit packages if you will. So at a risk adjusted return it's dramatically better. But some of the dynamic we'll have is , we'll have that going on the left side of the balance sheet, if you will. Then as we prudently and carefully integrate the depository into our business and move our business into depository, you'll have a situation where our net interest margin should widen quite substantially, I think.
David Hochstim - Bear Stearns
Okay. Thanks.
Operator
And your final question comes from the line of Robert Napoli with Piper Jaffray. Please proceed.
Robert Napoli - Piper Jaffray
Thank you. Just a quick follow up on the warehouse lines and what terms Tom are they one year or you moving them out two years or until they renew? Are you extending renewals?
Tom Fink
Yeah. It's a good question Bob, the billion dollar facility that renewed for one year of pricing, and then it's got an additional year beyond that in terms of an amortization period if needed. So from the way I look at things, that's effectively a two year life on it.
And then with respect to these facilities that we are talking about renewing in the near future that's a being a key element of our discussions as well.
Robert Napoli - Piper Jaffray
So you're looking at -- you are hoping for similar structures?
Tom Fink
Yeah.
Robert Napoli - Piper Jaffray
And when do you hope announce something this in the month of May in those facilities?
Tom Fink
Yes, certainly, this last summer.
Robert Napoli - Piper Jaffray
Great.
John Delaney
So that is shaping up well Bob but what I wanted also focus on one more time, is we're really focused on the acquisition of the branches and the deposits of Freemont Investment & Loans because we think from a future funding platform our business should integrate into the depository. And really be funded in the depository. And that's even with the great work that Tom and his team has done on the treasury side in terms of renewing our facilities and extending them etcetera, have directionally where we are headed is towards the depository.
Robert Napoli - Piper Jaffray
I mean, that's a great point and just, in that regard what's the next signpost that we can look forward that tells us the regulators that things are moving along and can you narrow in on the closing date at all?
John Delaney
We can't really narrow it. We have a contractual deadline, if you will, the end of July. We thought our applications is as I indicated. And the application is a very substantial document. And in the application we not only separate our business plan but a variety of things that are required as part of the application assessment done and that's been submitted. We put together a terrific; really a world-class board for this depository, which we are very pleased with and think it will be a real asset for the institution.
So I think at this point as I said in my comments, it's on track in all material respects. We've done everything we need to do at this point, we have submitted our application. We continue to work closely with the company which has been a terrific and very constructive relationship and we are moving forward as hard as we can and we are doing whatever we need to do, both with the seller and with the regulators to meet the expectations that each of them have.
So, there is no real milestone that I can kind of point out to you at this point, other than to say that we are operating under a relatively short-time horizon.
Robert Napoli - Piper Jaffray
Thank you.
Dennis Oakes
Thank you everybody. That concludes our call. Bye, bye.
Operator
Thank you for your participation in today's conference. This concludes your presentation and you may now disconnect. Good day.
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