CapitalSource Management Discusses Q2 2012 Results - Earnings Call Transcript

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 |  About: CapitalSource, Inc. (CSE)
by: SA Transcripts

CapitalSource (NYSE:CSE)

Q2 2012 Earnings Call

July 30, 2012 5:30 pm ET

Executives

Dennis Oakes - Senior Vice President of Investor Relations

James J. Pieczynski - Chief Executive Officer, Director, Member of Asset, Liability & Credit Policy Committee and President of Capitalsource Bank

Douglas H. Lowrey - Chief Executive Officer of CapitalSource Bank, President of CapitalSource Bank and Director of CapitalSource Bank

John A. Bogler - Chief Financial Officer, Chief Financial Officer - Capitalsource Bank and Executive Vice President - Capitalsource Bank

Analysts

Mark C. DeVries - Barclays Capital, Research Division

Aaron James Deer - Sandler O'Neill + Partners, L.P., Research Division

Steven A. Alexopoulos - JP Morgan Chase & Co, Research Division

Jennifer H. Demba - SunTrust Robinson Humphrey, Inc., Research Division

Moshe Orenbuch - Crédit Suisse AG, Research Division

Sameer Gokhale - Janney Montgomery Scott LLC, Research Division

Henry J. Coffey - Sterne Agee & Leach Inc., Research Division

Scott Valentin - FBR Capital Markets & Co., Research Division

Daniel Furtado - Jefferies & Company, Inc., Research Division

Operator

Good afternoon, and welcome to the CapitalSource Second Quarter 2012 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Dennis Oakes. Please go ahead.

Dennis Oakes

Thank you, Amy. Good afternoon, everyone, and thank you for joining the CapitalSource Second Quarter 2012 Earnings Call. With me today are CapitalSource CEO, Jim Pieczynski; CapitalSource Bank Chairman and CEO, Tad Lowrey; and John Bogler, our Chief Financial Officer.

This call is being webcast live on the company website and a recording will be available later this evening. Our earnings press release and website provide details on accessing the archived call. We have also posted a presentation on our website. It provides additional detail on certain topics, which will be covered during our prepared remarks, though we will not be making specific references to the presentation. Investors are urged to carefully read the forward-looking statements' language in our earnings release and investor presentation; but essentially, they say the following: Statements made on this 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, involve 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. And finally, more detailed information about risk factors can be found in our reports filed with the SEC.

Jim will now begin the prepared portion of our call. Jim?

James J. Pieczynski

Thank you, Dennis, and good afternoon, everyone. For us, clearly, the earlier than expected reversal of $347 million of our deferred tax asset valuation allowance was a very positive development for us in the second quarter. It substantially increased our tangible book value and moves us one step closer to applying for bank holding company status. Additionally, our loan portfolio grew very nicely with growth of 5% since March 31 and growth of 30% based on where we were at a year ago level. As we said earlier, our expectation for this year is to have 15% to 20% loan growth and we are still on track for that. This growth is still being done at attractive rates, which is resulting in our net interest margin for the second quarter of 4.95%, which is at the high end of our projected range for the year of 4.75% to 5%.

Finally, we repurchased 12 million shares during the quarter, which pushes the total repurchases to over 102 million shares since our buyback initiative began in December of 2010. This has resulted in roughly a 30% reduction in our shares outstanding.

From an overall earnings perspective, excluding the tax benefit resulting from the valuation allowance reversal, our net income for the quarter was $0.17 per share. As Tad will describe, some of the bank metrics showed modest declines from the first quarter levels, but that is generally explained by onetime items and an unusually low net loan loss provision in the prior quarter.

For the first 6 months of the year, however, we are on plan or slightly ahead of plan on key financial performance metrics relating to growth, profitability and credit performance.

After the quarter closed, as expected, we retired the remaining $23 million of our 7 1/4% convertible debentures that were outstanding. Our recourse debt at the Parent has now been reduced by 2/3 over the past 12 months and the only remaining recourse debt we have at the Parent is our long-dated trust preferred securities, which do not begin to mature until 2034.

Recognizing that reversal of the valuation allowance happened 6 months earlier than projected, I wanted to spend a moment explaining the process which led us to conclude that doing so was appropriate this quarter. As part of our normal quarterly review of the valuation allowance with our auditors, we mutually concluded that there was sufficient positive evidence to release the majority of the valuation allowance as of June 30. That evidence included 8 quarters of sustained profitability, meaningful improvement in the reliability of earnings, a significant reduction in impaired loans, and a dramatic decline in the size of the Parent loan portfolio, which gave rise to most of the historical credit losses. The reversal resulted in a tax benefit of $1.49 per share and positively impacted the company's tangible book value, which increased to $7.15 at the end of the quarter. We have previously indicated that once this initial reversal takes place, we would not expect any material reversal of the remaining valuation allowance, which is now $166 million as of June 30. Based on detailed analysis of the valuation allowance, which was undertaken prior to the action taken this quarter, we are not forecasting any additional tax benefit from the remaining allowance.

Our plan to file bank holding company application in the first quarter of next year is unchanged by the earlier than expected reversal of the valuation allowance. Converting the bank to a commercial charter and operating as a commercial bank remains a long-term strategy, but there is no short-term urgency for the conversion. We are very comfortable with our existing business model, which relies on the California Industrial Bank Charter, particularly in the current very low interest rate environment, which the Fed had suggested will persist at least through the end of 2014.

The prospect of filing our bank holding company application within the next 6 months or so influences our thinking about liquidity management and capital deployment strategies, as a key consideration for the bank holding company review will be the regulatory capital levels and the related consolidated credit metrics. The recent reversal of the valuation allowance, though helpful, does not have a dollar-for-dollar benefit on regulatory capital. The amount of the unreserved DTA, which we included in our consolidated Tier 1 capital, is currently estimated to be in the range of $80 million to $90 million.

Our bias over the next 18 months -- over the past 18 months, which is unchanged, has been to return capital to shareholders via share repurchase, since we have had ample liquidity and our shares have generally traded below our adjusted tangible book value.

Since inception of the buyback program, we have purchased $654 million of our shares at an average price of $6.37 and remain committed to returning the balance of the excess Parent capital to shareholders over a reasonable period of time. As we approach the filing of our bank holding company application, we will balance the opportunity to buy back shares against the need to maintain regulatory capital and consolidated credit ratios at the levels we anticipate will be needed for our application. We do not see this as a barrier, however, to achieving our return of capital objectives.

Before concluding, I want to mention that we recently added a new lending group, Premium Finance, which made its first loans in the second quarter. We established the group by hiring 2 very experienced individuals to lead a small team with many years of experience in commercial lending and life insurance premium financing. Our new loan product provides funding alternatives to clients seeking to utilize permanent life insurance for estate planning, executive compensation and other business purposes. This traditional premium finance business will add to our existing specialty product groups, further diversify our national lending franchise and make our overall portfolio more granular, as these fully secured premium finance loans are smaller than our overall average.

Tad is up next and he will provide an overview of the second quarter performance at CapitalSource Bank. Tad?

Douglas H. Lowrey

Thank you, Jim. Good afternoon. We're very pleased with the overall financial performance at the bank through the first 6 months of the year. The second quarter financial results were mixed, due principally to an increase in the quarterly loan loss provision and several onetime items in the first quarter, which make some of the linked-quarter comparisons unfavorable. However, we do not see any concerning trends in the current quarter credit quality numbers and expect the second half of 2012 to be strong.

Turning to the specifics. Loan growth in the second quarter was $250 million, representing a 5% increase over the prior quarter and consistent with our full year projection of growth of 15% to 20%. All of our lending groups contributed to second quarter production, with significant growth in Commercial Real Estate, technology cash flow, lender finance and equipment finance accounted for nearly 60% of the total. As Jim pointed out, we're very excited about the addition of Premium Finance lending to our specialty product lineup and look forward to reporting their growth in future quarters. We are seeing some pricing pressure across our lending groups, but so far it is more case-specific than broad-based. All-in yields for new funded loan production year-to-date have continued to hold up nicely with the exception of multifamily in California, where we continue to see more intense price competition.

We successfully redeployed cash and investments into higher-yielding loans again this quarter, so deposits only increased by $33 million. We expect to be more aggressive in raising deposits to fund projected loan growth during the second half of the year with our current expectations in the $250 million to $300 million range.

Our cost of interest-bearing liabilities, which is both deposits and Federal Home Loan Bank borrowings, declined again and now is at 1.05%, down 6 basis points from the prior period. And our new deposits added in this quarter averaged below 90 basis points. Despite these very low interest rates, our retention of existing customers who rolled over their certificates of deposit at maturity remained above 90% this quarter. Based on our current interest rate forecast, we expect our cost of funds will be at or below current levels for the balance of 2012.

As Jim also mentioned, our net interest margin at 4.95%, down from 5.12% last quarter, was at the high end of our projected range for the year of 4.75% to 5%. As we talked about last quarter, certain onetime items, including a change in prepayment assumptions on our mortgage-backed securities in our investment portfolio based on prepayment expectations and interest rate movements and the recapture of interest on a nonaccrual loan, which paid off at par, added 13 basis points in the first quarter net interest margin.

Our second quarter NIM does not contain any of these similar onetime benefits. Our capital levels remain extremely strong with a total risk-based capital at 16.2% and a Tier 1 leverage ratio of 12.7%. Although the full implementation of Basel III is several years off and its final structure is still unknown, we believe the application of the methodology to our current capital calculations would have a minimal impact on our capital ratios, which are well in excess of the proposed Basel standards.

Total assets for the bank at quarter end rose to $7.1 billion, an increase of almost $700 million or 11% over the last 12 months. Loans held in the bank now stand at 87% of total consolidated loans at June 30, as the bank continues to grow and the Parent loan portfolio continues to run off.

As I mentioned earlier, certain credit metrics in the quarter showed an uptick compared to the prior period. Our net loan loss provision was $13 million due principally to $9 million of new specific reserves combined with general provisions for new loan growth. This compares to an unsustainably low $2 million in the first quarter, which arose because a $4.5 million reduction in general reserves due to loan payoffs largely offset increases required for new loan originations, which resulted in no net change in general reserves. In addition, specific reserves were unusually low last quarter.

Our nonaccrual loans also increased in the second quarter, up $19 million to $102 million, but we increased the total loan loss reserve by $5 million, which still results in 100% coverage for the total of all nonaccrual loans in the bank. 80% of those loans remain current today.

We do not see any concerning trends in the second quarter credit charges and we view our credit metrics, specifically nonperforming assets which stand at 1.53% of total assets, to be in line with our peer banks. John is up next. John?

John A. Bogler

Thank you, Tad, and good afternoon to all those listening to our conference call today. Excluding the valuation allowance reversal, consolidated earnings in the quarter were $40 million or $0.17 per share. That amount included 2 onetime items, a benefit of $8 million on debt extinguishment as a result of redeeming $25 million face value of our trust preferred securities in the quarter, which was partially offset by $4 million in charges related to the abandonment of a lease for excess space in our Chevy Chase office. Focusing for a moment on the tax impact to the valuation allowance reversal in this quarter and future quarters, it is important to remember 3 things. First, the reversal results in a tax benefit which resides on the Parent company balance sheet that will be used in future quarters to offset consolidated federal and state tax payment obligations. Secondly, the consolidated entity will reflect GAAP tax expense at approximately a 41% effective tax rate going forward. And finally, the bank income statement and balance sheet are unaffected by this reversal. The bank is also an approximate 41% taxpayer, but makes its tax payments to the Parent under a tax-sharing agreement.

Turning now to some of the income statement items in the quarter. There were small decreases on a consolidated basis in interest income and noninterest income, reflecting the declines at the bank, which Tad spoke about. The timing of loan sales, loan repayments and new originations in the quarter also negatively impacted interest income within the bank, as higher-yielding loans rolled off early in the quarter and a large percentage of the new loans were added late in the quarter. Combined with our expectations for strong production in July and lower loan repayments, interest income should show an upswing in the third quarter. Consolidated credit improved in the quarter with nonperforming assets down by 18%, including a 44% drop in the REO balance to $19 million. As we continue to proactively move REO and other troubled loans off of our balance sheet, we incurred somewhat higher professional fees this quarter for workout-related expenses. The quarterly loan loss provision on a consolidated basis was down slightly at $10.5 million compared to $11.1 million in the prior period. That net provisioning includes a $12.6 million release of general reserves in the Parent other commercial finance segment, due principally to pay off at par of certain substandard loans.

Total operating expenses for the first half of the were $98 million, which is consistent with our projected full year total of $190 million to $200 million, representing a 5% to 10% decline from total 2011 operating expenses. As we realize more of the benefits from efficiencies gained due to the elimination of duplicate functions, following the move of approximately 200 Parent employees into the bank on January 1, we expect quarterly operating expenses to decline from the second quarter level.

Parent company cash at June 30 pro forma for the $23 million repurchase of the remaining 7 1/4% convertible debentures earlier this month was $168 million, an increase of $61 million from the prior quarter. Second quarter loan sales and payouts were higher than expected and more than offset $78 million of share repurchases. Due to repayments in the first half of the year totaling approximately $125 million, we are now projecting incremental payoffs in the non-securitized portfolio of just $40 million to $50 million for the balance of the year.

One more quarterly tax payment from the bank to the Parent will occur in September, which we estimate will be in the $20 million range, bringing total incremental unrestricted cash generated at the Parent $60 million to $70 million between now and the end of the year. In short, there was a bit of noise around certain of our interest income and expense items on both the bank only and consolidated basis in the second quarter. We have made good progress harboring all majors of profitability, credit and capital deployment through the first 6 months of 2012 and feel very good about how we are positioned going into the second half of the year.

Jim will now add some brief concluding remarks before we take questions. Jim?

James J. Pieczynski

Thanks, John. Before closing the prepared portion of our call this afternoon, I want to touch on 2 remaining items. First, I want to congratulate all CapitalSource Bank employees who just celebrated their fourth anniversary of the founding of the bank on July 25, 2008. I particularly want to single out Tad Lowrey for his leadership as CEO of the bank since its inception, which was also recognized recently by the Board of CapitalSource Bank as it elevated Tad to the Chairman's role of the bank.

Secondly, I wanted to touch briefly on the competitive environment in which we are making new loans. There's been a quite a bit written in recent weeks about a modest rebound in C&I lending, which, of course, is the heart and soul of our national direct origination platform. We remain confident in our ability to achieve projected loan growth this year of 15% to 20% and have seen very modest signs of economic improvement in some of our markets and among some of our borrowers over the first half of this year.

We've also seen global economic and political events together with domestic uncertainty, particularly over the last 6 to 8 weeks, putting a damper on economic activity. Our niche businesses and the ability to add them on occasion as we did this quarter with Premium Finance continue, however, to position CapitalSource for a strong and profitable growth. Additionally, our specialty lending areas have only selectively been subject to the type of price competition which is occurring with some frequency in more commodity-like businesses such as general cash flow for multifamily lending. As a result, we continue to fill comfortable with our growth projections and the ability to maintain lending spreads and our net interest margins at enviable levels compared to banks of comparable size. Operator, we are now ready for the first question.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Mark DeVries at Barclays.

Mark C. DeVries - Barclays Capital, Research Division

First question will be for Tad. Tad, I'm trying to understand what's embedded in the NIM guidance. And what I'm struggling with is why, I guess, it implies kind of flattish to down NIM here when you've got pretty robust asset growth, which is enabling you to switch from -- maybe some of your proceeds from cash and securities into much higher yielding assets that you would think would provide some upward boost to your NIM. Is there some type of offset there where loans were also repaying, running off at high yields and coming out in much lower yields that's kind of offsetting the benefit you would think you'd get from that?

Douglas H. Lowrey

You just hit the nail on the head, Mark. There are 2 strong benefits and that is the cost of funds should stay the same or lessen slightly. The investment mix -- the loan mix versus investment should continue to improve. And those are small upticks, but we have a substantial -- every new loan that we book, even though we haven't seen the price competition we expect yet, we are modeling that to occur and we continue to run off loans at 8% and 9% and 7% and record new loans in the 5% to 6% range. So that's the primary driver.

John A. Bogler

The other piece that I would add to that, during the first quarter, as well as the second quarter, within the loan portfolio, we recorded 65 basis points of benefit from the FAS 91 and discount amortization that was being accreted through. And a portion of that is related to loans that have prepaid. So there's been some acceleration of that benefit. In our forecast, we assume that the level of repayments and prepayments declines back down to more of a sustainable level than we think for the long term. So we would lose some of that accelerated amortization benefit.

Mark C. DeVries - Barclays Capital, Research Division

Okay, that's helpful. And then next question for Jim. Just trying to get some thoughts on how you're thinking about buying back stock here? I think you've talked about, as you transition towards thinking about your bank holding company status acquisition and applying for that again next year, when I look at kind of the excess equity, it seems to be implied at the holding company where you've got almost $575 million between kind of your non-securitized loans and your securitization equity. But you only have about $131 million remaining in your existing repurchase authorization. Would you look to ask for more if you went through that? Are you going to want to retain a healthy amount of that equity?

James J. Pieczynski

Well, right now, as you pointed out, we do have $131 million of remaining buyback authorization through the end of the year and our forecast is that we will still be able to do that. So in terms of increasing the level of buyback activity over and above that, quite frankly, that is going to be dictated a lot by the regulatory guidance we get because we are going to want to file our bank holding company application with a strong regulatory capital level, and we've got to take that regulatory capital and kind of balance that against the credit metrics that we have at the Parent as well. So there's a lot of things that are moving on relative to that. At this point, as I said, we're comfortable with completing the $130 million before the end of the year and then we have to evaluate whether or not we can increase the authorization beyond that level, based on where we are relative to regulatory capital and our credit metrics.

Operator

Our next question comes from Aaron Deer at Sandler O'Neill.

Aaron James Deer - Sandler O'Neill + Partners, L.P., Research Division

Looks like most portfolios increased in the quarter, but the health care asset baseline was down. I'm just wondering if maybe you had creditor 2 that had priced away in the quarter or if the loan pricing that you're able to get is unsatisfactory. What's going on there? And maybe, just kind of what the aggregates loan pipeline looks like currently relative to a few months ago?

James J. Pieczynski

Yes, I would say in the health care ABL space, we actually have one large loan that was a $50 million loan that did pay off this quarter that actually was a cash secured loan. So as a result, we had a deposit that flowed out in connection with that transaction as well. So that really accounts for the reduction in that balance. In terms of the pipeline, I think the pipeline looks very good in the health care ABL space. I think it was a little more challenged at the end of last year, but I feel that it's picked up a lot and we've got a lot of good deals that we are working on in that space. So I would expect to see growth happening in the space going forward.

Aaron James Deer - Sandler O'Neill + Partners, L.P., Research Division

How about the pipeline in aggregate overall?

James J. Pieczynski

In aggregate, overall, I feel good. As I said, our target for this year has been to do our $2.2 billion of originations. We're on track to be doing that based on what we did in the first quarter and the second quarter. And the third quarter is starting off good. I think, in terms of deals being brought to credit committees. There's certainly a lot of volume and a lot of activity that's coming through. So there's nothing at all that I'm seeing to indicate we won't be doing a similar pace going forward. So I still feel comfortable about our total origination target for the year.

Aaron James Deer - Sandler O'Neill + Partners, L.P., Research Division

That's great. And then just as a follow-up, you've mentioned, having done some analysis on Basel III and didn't seem too concerned about the impact that might have, which I guess is not surprising given your heavy level of equity capital. But did it all change how you think about the business lines that you're serving and how you price for that given what could be at the higher risk ratings on some of those? And then it doesn't sound like that has affected at all your thoughts on timing for the bank holding company application. Is that correct?

James J. Pieczynski

No impact on the latter, no impact on the bank holding company. It's too early to think about changes in products. It's made us more appreciative that we don't have consumer business. Made us more appreciative, we don't have a single-family residential business, because the proposal clearly is somewhat punitive on that. We have always risk weighted most of our loans or capital weighted most of our loans at the full amount of regulatory capital. So really not much impact there that we see and what we do, except for Commercial Real Estate and the details there are in the fine print, the type of Commercial Real Estate that we've been doing for the last 4 years seems to be outside of the boundaries of the Basel add-ons. But it's still too early to see what the final would be. So if they were to screw -- tighten screws on that, we would have to look at the pricing there.

Operator

Your next question comes from Steven Alexopoulos at JPMorgan.

Steven A. Alexopoulos - JP Morgan Chase & Co, Research Division

I wanted to start -- looking at the loan yields, if you're getting, I think, you said 5% to 6% on new loans, and I think the current yield was 7.09%, should we just continue to expect this to bleed down? I don't know if it'll be at 15 basis point rate or so per quarter. And what's the timeline that it should get to this 5% to 6% range?

James J. Pieczynski

Well, I guess, there's 2 components of it. As John mentioned, when we're looking at yields part of that includes -- when we're talking about the deals we're doing right now, typically, the rates are in kind of that 5% to 6.5% type zone. But we also have some of this associated with prepayment penalties and the like. That are also increasing our yields somewhat. So I think the answer is, you're probably going to start to see that declining and it will be lower from where it is right now. But I think in terms of how low does it ultimately go, it's probably going to be in that 6.5%-ish type zone, something like that.

John A. Bogler

Right. So there's an element of that, that obviously takes into consideration what your expectations are for the forward interest rate curve. If we just assume that interest rate remained flat from here until whenever, if you just kind of think of our portfolio is having kind of a 4-year life, you'd expect over the next probably 2, 2.5 years that we would see the remainder of the higher-yielding loans that would repay or refinance down to the current interest rates that we're originating at.

Steven A. Alexopoulos - JP Morgan Chase & Co, Research Division

Got you. And then on the other side of the balance sheet. Your cost of deposits were $95 million and looking at that one slide there, I think, they were at $80 million to $85 million range is where you added new retail funds this quarter. Is that where we should think about your cost of deposits moving down to, because you did give some commentary that it might be flattish. I'm not sure if the rate went up a little bit on acquisition of new CDs.

James J. Pieczynski

No, the rate didn't go up. The reason we say that, a, is to be conservative; and b, we're finally getting to the point where some of the CDs that we're all over are at lower rates. You get spoiled by rolling over 2.5% to 3% CDs and financing those at 1.05% to 0.95%, but there are a few maturity buckets where we actually have lower than that. When you crunch it all together, there's no anticipated change in the market in our pricing and we think it should continue to come down. We are going to be more aggressive in the second half than we were in the first half, though, because we still see a lot of loan growth and we want to finance that with deposits.

Steven A. Alexopoulos - JP Morgan Chase & Co, Research Division

Okay. Actually as a follow-up on that, with the loan growth. Can you give us some color on what drove the increase in the general real estate lines, I don't know if there's a few larger transaction, I think it was just over 40% of the quarter is loan growth.

James J. Pieczynski

Yes, there were -- I mean, there were -- we did one industrial transaction which I think was helpful in the quarter, and then there were several other deals that we had done. So I wouldn't say there was kind of a general theme of where it was all coming from. I think it's been pretty wide spread across the spectrum between the industrial side, the commercial side and to a lesser extent, the hospitality side.

Steven A. Alexopoulos - JP Morgan Chase & Co, Research Division

Okay. And I know you touched on this. Some banks were also saying that some of their borrowers are getting more cautious, given what's in the headlines, regarding fiscal cliff, et cetera. Can you talk about what you're maybe seeing or hearing from your customers, what segments we should think of as being a little more sensitive to that?

James J. Pieczynski

I would say, probably in terms of our customers, the area where I think you may have the most sensitivity maybe in terms of the equipment area where you're seeing people talk about cutting back a little bit on capital expenditures and the like. So I would say that's -- from what's driven more by the economy, I think that business may be more impacted by the economy where you're seeing a little bit of a pull back there. But we haven't really seen it in the other areas, to be totally honest.

Operator

The next question comes from Jennifer Demba at SunTrust.

Jennifer H. Demba - SunTrust Robinson Humphrey, Inc., Research Division

Steve just actually asked most of my questions. But back to his question on the granularity of the loan growth. Can you just give some more color on maybe some of your larger transaction sizes, from the first quarter to the second quarter?

James J. Pieczynski

I don't have that detailed kind of -- in terms of the detail between the first quarter and the second quarter. That's something that's probably we can get back -- we can get with you off-line on that to kind of show the level of average loan size in the first quarter versus the second quarter. I don't have that with me now. But largely, the hold sizes are small and we have purposely been migrating down in that area. I don't have that detail in front of me, so we'll have to get back with you on that.

Operator

The next question comes from Moshe Orenbuch at Credit Suisse.

Moshe Orenbuch - Crédit Suisse AG, Research Division

You had -- I guess you still had to had decent paydowns coming in the securitized loans. Any kind of update as to whether you'd expect to see cash coming out of that at some point in 2013?

John A. Bogler

No, we don't expect anything to really come out of that portfolio in 2013. We think that they will all -- the debt and like that will be fully repaid in 2014 on each of the 3 securitizations.

Moshe Orenbuch - Crédit Suisse AG, Research Division

Okay. And as it relates to kind of the bank holding company comments. Is that a process that's kind of underway now and can't be changed? Or would you -- as you -- if you looked at it, could you kind of push it out a period of time?

James J. Pieczynski

We could -- it might be easier to accelerate it than push it out because we have begun discussions with our regulators. Certainly nothing official and we've tipped our hat a little bit there. So it might be easier to accelerate than push it out. We're still thinking early next year, but it depends on 2 of the big factors -- there were 3 big factors. One is the reversal of this tax asset, but we also need to continue to improve the credit metrics, and we gained a lot of ground in the second quarter. We expect further improvement in the third and fourth and then the other is the annual bank regulatory exam needs to be complete before we file as well.

Moshe Orenbuch - Crédit Suisse AG, Research Division

The timing of that exam is...?

James J. Pieczynski

It's typically in the fall. Early fourth quarter is when it typically begins.

Moshe Orenbuch - Crédit Suisse AG, Research Division

Got you. Okay, just last thing, just kind of the Premium Finance business. Could you give us some kind of sense as to what kind of size you might be targeting over the next year or 2?

James J. Pieczynski

I think in terms of what that business can grow to, we're kind of targeting to have roughly $50 million of originations in the first year. The nice part about this business is that you typically have a deal that ultimately can have a 5- to 7-year life so we'll do an origination in year 1. And assuming everything is going the way it's supposed to, we will do a similar -- a loan amount for a similar level in the second year, in the third year, in the fourth year and on. So while I expect our first year originations to be in the $50 million range, I would expect that this is a portfolio that could grow to $300 million to $500 million over kind of that next 3 years or so.

Operator

Our next question comes from Sameer Gokhale at Janney Capital Markets.

Sameer Gokhale - Janney Montgomery Scott LLC, Research Division

My first question was for Jim. Jim, I think you had talked about this, the DTA allowance and I believe if I heard you correctly, you suggested that you're unlikely to be reversing any more of the allowance beyond what you've taken this quarter, which looks like it was roughly, I think, 67% or so of the overall valuation allowance. So I just wanted to get a little bit of color because my understanding was that initially, the idea was that you'd reverse 60% of it and then the rest of it wasn't a guaranteed reversal because you had state-by-state allowances and so the function of how much you earned on a state-by-state basis plus there were securities and you had to realize income related to the securities in order use DTA. If they were in loss positions, you wouldn't be able to use them. So has anything changed there related to what you were thinking about before with respect to the DTA or is it just the case of you taking, say, 67% of the allowance back and so the rest of it, you just basically said, it's just highly unlikely that will ever get back. So has anything changed there?

James J. Pieczynski

No, I would say nothing has changed at all. Before, what we had kind of said was that our expectation was that we'd be able to reverse 60% by the end of the year. And as you pointed out, we reversed 67% this quarter. The remaining valuation allowance there, which is the $166 million that I talked about, is really a valuation allowance that we don't have any expectation of reversing. A lot of that is due to, as we said, state NOLs as well as capital losses that we do not currently foresee a way that we would be able to utilize those benefits. So as a result, those stay fully reserved and it's our expectation that they will continue to be fully reserved.

Sameer Gokhale - Janney Montgomery Scott LLC, Research Division

Okay, that's helpful. And then, the other question was on the use of your cash at the Parent. And I know you suggested that you might want to wait, the bank holdco process is underway. So you want to see how that plays out before you maybe use the incremental cash beyond the authorization for buybacks and the like. But you also bought back some trust preferreds. It looks like you bought those back for about $0.68 on the dollar. Buying those back at discounts, obviously, would add to capital. You seem to have a lot of capital already, but you're just waiting for the bank holdco application to be approved. So is it safe to say that, let's say, you get the bank holdco approval, you're going to be less inclined to buy back any of these trust preferreds and you will really use the cash more for buybacks, that would be your preference because you won't really need the capital?

James J. Pieczynski

Right. I think the way we look at it is we look at kind of our capital and we look at our liquidity. We clearly have a significant level of liquidity now and we clearly have a lot of capital. And I think, we're quite frankly, looking between both of those levers. We think, as we said, we've got the ability to retire stock and continue to return capital to our shareholders that way. However, at times to the extent we can buy debt and buy debt at a discount, which lowers, obviously, the debt that we have outstanding, but also does increase our level of capital, we view that as something that clearly is attractive from a regulatory perspective as well. So the answer is yes. We will look at reducing our debt and we will look at retiring our stock. So we will consider all of that.

Sameer Gokhale - Janney Montgomery Scott LLC, Research Division

Okay. And then in terms of the mix shift of the assets and the yields coming down on some of the older loans. I know at one point you used to have loans that had significant prepayment penalties -- or fees, I should call them, as those loans paid down. So would your expectation be that as those loans pay down, they've been offsetting prepayment fee income element to it that you would also be recognizing over time and helping offset some of the margin loss that you would have?

James J. Pieczynski

Yes, I think we would have that. One of the things we try to do when we're doing deals right now is we try to get lockouts, prepayment penalties and the like to the extent we can. So yes, we'll have some benefit associated with that and John Bogler had alluded to some of that benefit earlier. The reality is that in some markets, it's difficult to get prepayment penalties, just for example when you're doing deals right now because it is a competitive market out there. So the answer is yes. We do try to get lockouts, we do try to get prepayment penalties, but we can't do that at the same level that we were able to do that years ago.

Sameer Gokhale - Janney Montgomery Scott LLC, Research Division

Okay. And then just my last question, the $4 million of charges that related to some sort of abandonment of the lease. I mean, this is something that was at the corporate level, so it isn't anything that went through any provisioning item, correct? If you look at the other commercial finance segment, there was, I think, draw down of -- or a negative provision, but there were 2 components and there were some specific provisioning of $10 million or so. So this doesn't relate to that, right? This is just something separate at the corporate level where you had charges of $4 million?

John A. Bogler

That's correct. We've had some excess base as part of some staff reductions last year and so we're in position and we had planned to do this during this year, just occurred, of course, and had anticipated. But the $4 million just relates to abandoning some space.

Operator

Next question comes from Henry Coffey at Sterne Agee.

Henry J. Coffey - Sterne Agee & Leach Inc., Research Division

From a very simplistic point of view, now that you've recaptured the DTA, you've switched to being a GAAP taxpayer. As we look at the existing run rate of earnings and try to project forward, you've given us a pretty good insight into the various components of the bank. But now we're dealing with something like a 35% or 40% tax burden. Are there some obvious counterbalances to that, that we should be thinking in? $60 million buybacks, yes. But I'm just wondering as you walk through the whole per share earnings equation, what else should we be thinking about?

John A. Bogler

There's nothing unique to be thinking about it. We would look as our effective tax rate of being 41%, which would be a combination of our federal and state income tax. So I think it's straightforward and simplistic as that.

Henry J. Coffey - Sterne Agee & Leach Inc., Research Division

So, in theory, we're estimating $0.10, we should just reduce it by $0.40 going forward?

James J. Pieczynski

That's correct. You reduce it by $0.04.

Henry J. Coffey - Sterne Agee & Leach Inc., Research Division

We keep talking to you about buying back stock, you keep putting out cautious messages and then you go out and buy back more than we thought, which is wonderful. But the additional buybacks that you did during this quarter, really there's 2 questions. The additional buybacks that you did this quarter were funded from unexpected sources or was that just part of the plan? And should we be thinking about you potentially buying back more than $60 million of stock between now and year end?

James J. Pieczynski

No, that was part of our plan, as I said. Whenever we are buying back stock, we're looking at our capital ratios and we're looking at our liquidity and we have the ability to be able to do that. So going forward, that's what we're going to continue to look at is, what are our credit metrics looking like and what's our capital level.

Henry J. Coffey - Sterne Agee & Leach Inc., Research Division

But you've got said a $60 million of targeted cash flow coming to the holding company.

James J. Pieczynski

That's correct. That's what we expect -- that's the inflows that we have coming in between now and the end of the year. But we also have a significant level of cash at the Parent still -- even pro forma for the paydown of the debt, where we had a $168 million of cash at the Parent right now. And we'll add to our cash to that level over the rest of this year.

Henry J. Coffey - Sterne Agee & Leach Inc., Research Division

But if we read you correctly, becoming a bank holding company is very important, but of greater importance is to continue return on capital measures. If that meant delaying the bank holding company process for 6 months, would that be an issue or...?

James J. Pieczynski

Yes. We are now officially pregnant, and we're close enough after the reversal of this and close enough with our credit metrics.

Henry J. Coffey - Sterne Agee & Leach Inc., Research Division

That it's time to move forward?

James J. Pieczynski

It's time to move forward. We feel like we're very close to the finish line. We don't see any change in the financial metrics. So there's no rush to do it from that perspective. It's just that we've been talking about it for 4 years and we're close enough that we don't want to do anything that would jeopardize that.

Operator

Our next question comes from Scott Valentin at FBR Capital Markets.

Scott Valentin - FBR Capital Markets & Co., Research Division

I just wanted to get a little more color on the credit side. I know you guys mentioned that non-accruals increased in the bank, but there was no real, I guess, trends that were -- giving you concern. I'm just curious, maybe if you can disclose, maybe the watch list if that's increased at all or what you're seeing in delinquency buckets? And on the past, you had some lumpy credits come through, some legacy credits from the holding company that were sold to the bank. I'm just wondering if that's the case this time as well or if it's more just a group of credits?

James J. Pieczynski

It's not the case. Our credits still are little bit lumpier than our Parent group, but much less than they used to be. We think that the nonperforming -- let me stop and start over. You call it the watch list. We call them classified assets. We had a very significant reduction in classified assets in the second quarter, but we also had some things going in both directions. So it's the new downgrades that caused the increase in the non-accruals. But we did -- again, we don't see anything from a geographic perspective, from a product line perspective, from a size perspective, from a bank versus legacy perspective. We just think that's part of the normal noise in originating and carrying a $5 billion loan portfolio. So I think we'll be happy if our nonperforming assets, if we can manage that in the 1.5% level where it is today, these kind of margins.

Scott Valentin - FBR Capital Markets & Co., Research Division

Okay, fair enough. And then on the asset sales, any material differences between the book value and the sale price? I think you sold some REO this quarter.

James J. Pieczynski

We had included in our numbers for this quarter was -- we did have some numbers in there for REO costs. They weren't significant this quarter. I think they were in the $2 million range. So it wasn't significant. We've actually kind of gotten our REO balance down and down significantly and our goal is to continue to reduce that level.

Scott Valentin - FBR Capital Markets & Co., Research Division

I mean, in terms of you're not seeing any pressure on write down value versus sales value, it's coming in line?

James J. Pieczynski

No.

Operator

Our last question comes from Daniel Furtado at Jefferies.

Daniel Furtado - Jefferies & Company, Inc., Research Division

I just had a real quick one. And that is, I heard you on the 41% GAAP tax. Do we think the same from a cash tax perspective for '13 and or how should we be thinking of that from a cash perspective?

John A. Bogler

No, the cash tax is dependent upon a number of factors and how they would unwind from a book-to-tax difference. It's very difficult for me to give you kind of the percentages as to what that means. But I do believe in 2013, it will be less than 41% on a cash basis. But I really can't give you any better indication than that.

James J. Pieczynski

And there was just one follow-up question. The REO loss that we had in the second quarter was $3.8 million, I had mentioned $2 million, $3.8 million was the level.

Douglas H. Lowrey

And that's a combination of expenses on holding these and the write-downs to get them sold.

Dennis Oakes

All right, everybody, thanks very much for your time.

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