U.S. Bancorp. (USB) — Q3 2016 Earnings Call Transcript

Thank you, Melissa and good morning to everyone who has joined our call. Richard Davis, Terry Dolan, Andy Cecere, and Bill Parker are here with me today to review U.S. Bancorp's third quarter results and to answer your questions. Richard and Terry will be referencing a slide presentation during their prepared remarks. A copy of the slide presentation as well as our earnings release and supplemental analyst schedules are available on our website at USBank.com. I'd like to remind you that any forward-looking statements made during today's call are subject to risk and uncertainty. Factors that could materially change our current forward-looking assumptions are described on page 2 of today's presentation and our press release and in our Form 10-K and subsequent reports on file with the SEC. I'll now turn the call over to Richard.

Thanks, Jen. Good morning, everybody and thanks for joining our call. I'd like to begin our review of U.S. Bank's results with a summary of the quarter's highlights on page 3 of the presentation. U.S. Bancorp reported net income of $1.5 billion for the third quarter of 2016 or a record $0.84 per diluted common share. I'm very pleased with the third quarter results. Industry-leading profitability was supported by solid loan and deposit growth and broad-based core revenue growth. As a reminder, our prior quarter results included notable items including a Visa gain of $180 million in noninterest income and $150 million related to litigation accruals and a charitable contribution in noninterest expense. There were no notable items to report in the third quarter. So for the remainder of this call, we will discuss the results on a core basis excluding the notable second quarter items I just described, as this is how we believe the investment community looks at our results. Slide 4 provides you with a five-quarter history of our profitability metrics which continue to be among the best in the industry. In the third quarter, our return on average common equity was 13.5% and our efficiency ratio was 54.5%. Turning to slide 5, the Company reported total net revenue of $5.4 billion in the third quarter. Excluding notable items in the second quarter of 2016, this represents an increase of 2.3% on a linked quarter basis. Our revenue growth was primarily driven by loan growth of 1.1% and strength in a number of our fee-based businesses, including mortgage banking and Payment Services. The industry continues to face headwinds from the low rate environment and a flatter yield curve. This quarter, our net interest margin was also impacted by higher levels of cash balances due to the strong deposit inflows. However, despite our lower net interest margin, which declined by 4 basis points to 2.98%, in line with expectations, we reported net interest income growth both sequentially and on a year-over-year basis. Credit quality was stable in the third quarter as expected. Both nonperforming assets and net charge-offs decreased modestly compared with the prior linked quarter. Before turning to Terry, I'll provide you with an outlook for the fourth quarter. Currently, we expect average loans to continue to grow in the range of 1% to 1.5% sequentially. While mortgage loan growth is expected to slow in line with industrywide tapering of refinancing activity and due to seasonality, we look for a rebound in commercial loan growth in the fourth quarter and expect strength in consumer loans to continue. Given the current shape of the yield curve, we expect that the net interest margin will decline a couple of basis points. However, we expect net interest income will increase on a linked quarter basis, principally driven by growth in earning assets. We look for somewhat lower mortgage revenue in the fourth quarter, in line with an expectation of lower refinancing activity. We expect expenses to grow 2.5% on a linked quarter basis, primarily driven by seasonally higher expenses, including tax credit amortization costs related to our community development business. And finally, given the underlying mix and quality of the overall portfolio, we expect credit quality to remain relatively stable and we expect the provision to increase in line with loan growth. Terry will now provide you with more details about our third quarter results.

Thanks, Richard. I'll start on slide 6 which highlights our loan and deposit growth. Average total loans outstanding grew 1.1% on a linked quarter basis and increased 7.6% compared with the third quarter of 2015. Excluding the retail card portfolio acquisitions completed in the second half of last year and student loans that were reclassified to held-for-investment in the third quarter of 2015, loans grew by 6.4% compared to the prior year. In the third quarter, the year-over-year increase in average loans outstanding was led by strong growth in average total commercial loans of 9.0% and strong growth in average total residential mortgage loans of 8.6%. Consumer loan growth was broad-based, led by credit card loans and other retail loans. Specifically, credit card loans grew 5.9%, excluding the retail card acquisition; and other retail loans grew 5.2%, excluding the student loans. Home equity loans grew 2.4% on a year-over-year basis, with growth primarily sourced from our branch network. On a linked quarter basis, our average loan growth was 1.1%, in line with our expectations. Credit card loans grew 2.4%; residential mortgage loans grew 1.4%; home equity loans were up 0.5%; and other retail loans were up 2.7%. Total average deposits increased by more than $28 billion or 10% compared with the third quarter of 2015 and were up 3.6% on a linked quarter basis. On a year-over-year basis, the trend reflected strong growth of 11.9% in our low-cost deposits, which includes our non-interest-bearing deposits and our interest-bearing savings deposits. This strong core deposit growth more than offset the runoff in higher-cost time deposits. Turning to slide 7, credit quality remained relatively stable in the third quarter. Third quarter net charge-offs increased by $23 million or 7.9% compared with the prior year, but decreased by $2 million compared with the second quarter of 2016. Net charge-offs as a percentage of average loans were 46 basis points in the third quarter, unchanged from the prior year and down from the 48 basis points reported in the linked quarter. Compared with a year ago, nonperforming assets increased $97 million or 6.2%, mostly due to downgrades that occurred in the prior quarters related to energy credit. Linked quarter, nonperforming assets decreased by $8 million or less than 1%, primarily driven mainly from improvements in residential mortgages and other real estate. We continued to add to the allowance for loan losses in the third quarter, in line with loan growth. Slide 8 provides highlights of third quarter results versus comparable periods. Third quarter net income increased by $13 million or 0.9% on a year-over-year basis, net revenue growth was partially offset by higher noninterest expense. As Richard mentioned, results in the prior quarter were impacted by notable items, including a $180 million Visa gain in noninterest income and $150 million in noninterest expenses related to litigation accruals and a charitable contribution. Excluding notable items from the second quarter, net income increased by $2 million or 0.1%, reflecting total net revenue growth of 2.3%, offset by noninterest expense growth of 3.1%. Our efficiency ratio of 54.5% was in line with our guidance of 54% to 54.9%. Turning to slide 9, net interest income on a taxable-equivalent basis increased by $122 million or 4.3% compared with the prior year. Strong average earning asset growth was offset somewhat by the impact of a 6 basis point decline in the net interest margin to 2.98%. The year-over-year decline in the net interest margin primarily reflected increased funding cost, higher average cash balances, and lower rates on securities purchases partially offset by higher rates on new loans. Compared with the second quarter of 2016, taxable-equivalent net interest income increased by $47 million or 1.6%. Growth in average total loans was offset by a 4 basis point decrease in the net interest margin. The linked quarter decline in the margin primarily reflects the impact of higher cash balances which represented 3 out of the 4 basis point decline, as well as lower average rates on securities purchased, offset somewhat by the benefit of higher LIBOR rates on loans during the quarter. Slide 10 highlights trends in noninterest income which increased $119 million or 5.1% year-over-year. The increase was primarily due to growth in mortgage banking revenue, trust and investment management fees, credit and debit card revenue, and merchant processing revenue. Mortgage banking revenue increased $90 million or 40.2%, supported by core growth and strong industrywide refinancing activity which drove originations and sales volume. Trust and investment management fees increased $33 million or 10%, reflecting lower money market fee waivers, growth in assets under management, and improved equity markets. A $30 million or 11.2% increase in credit and debit card revenue was driven by higher transaction volumes, including the acquired portfolios. Merchant processing revenue increased $12 million or 3%. Excluding the impact of changes in foreign exchange rates, merchant processing revenue increased 5.3% from the prior year. On a linked quarter basis, noninterest income increased $73 million or 3.1%. The increase was principally due to stronger mortgage banking revenue and growth in payment services revenue. Mortgage banking revenue increased $76 million or 31.9%, which slightly exceeded our previous guidance range of 20% to 30%. Growth in mortgage banking revenue was driven by higher production volumes, reflecting stronger refinancing activity. Mortgage banking revenue was also supported by a favorable change in the valuation of mortgage servicing rights net of hedging activities. Corporate payment products revenue increased by $9 million or 5.0%. And as a reminder, corporate payment products revenue is seasonally stronger in the third quarter of each year. Merchant processing revenue increased $9 million or 2.2% due to seasonally higher transaction volumes. Excluding the impact of foreign currency changes, merchant processing revenue would have increased by 3.5% sequentially. Commercial product revenue decreased by $19 million or 8.0%, primarily due to higher capital markets volume in the second quarter which in turn reflected market volatility during that quarter. Turning to slide 11, noninterest expense increased $156 million or 5.6% on a year-over-year basis. Compensation expense grew versus the prior year, primarily due to hiring decisions to support business growth and compliance programs, as well as the impact of merit increases and variable compensation tied to production. Professional services increased $12 million or 10.4%, also reflecting costs associated with compliance programs. Technology and communication expense increased $21 million or 9.5%, including the impact of capital investments and costs related to the acquired credit card portfolios. We continue our investment in our brand which is reflected in slightly higher marketing costs from a year ago. On a linked quarter basis, noninterest expense increased $89 million or 3.1%. Compensation expense increased $52 million or 4.1%, due to the impact of one additional day in the quarter and increased staffing. The $23 million increase or 5.1%, in other noninterest expense primarily reflected seasonally higher costs related to investments in tax-advantaged projects and the impact of the FDIC surcharge which began in the third quarter of 2016. Marketing and business development costs decreased $7 million or 6.4% due to the timing of various marketing programs. As Richard mentioned, we expect expenses to grow in the fourth quarter, however at a slower pace than the 3.1% growth that we recorded in the third quarter. Our current expectation is for linked quarter expenses to grow by 2.5% in the fourth quarter. This is primarily due to seasonal expenses, including tax credit amortization costs which we expect will increase on a linked quarter basis approximately $60 million during the fourth quarter. As a reminder, we realize the benefit of these tax credits in our tax rate.

Thanks, Terry. I'm very proud of our record third quarter results. We maintained our industry-leading performance measures and we reported an 18.1% return on tangible common equity in the quarter. Our industry continues to face challenges from the low-interest rate environment. However, we remain confident that we can continue to grow revenue even as we prudently manage expenses and strategically invest in our businesses to create value for both our customers and for our shareholders. That concludes our formal remarks. Andy, Terry, Bill, and I would be happy to answer any of your questions.

This is Ricky Dodds from Matt's team. I've got a quick question on C&I loan growth. It's a little weaker than we expected and I was wondering if you could provide us any color on what's driving the slowdown at USB?

Yes. I'll go first, Ricky, and I'll turn it over to Andy. As we’ve said, I think, at our Investor Day five weeks ago, we think quarter 3 represents a pause in C&I lending, meaning that it was strong in quarter 2 and we expect it to recover in quarter 4, in part based on what we believe is the vagaries of quarter 3 where we had some of the Brexit activities move things up into quarter 2, and perhaps some of the uncertainty around the election and other things moving things into quarter 4, but we see that returning nevertheless. You'll see that we had a particularly across-the-board performance in most of the corporate space as the slowdown reflected things like higher paydowns, reductions in deal activity. And a healthy capital market condition allowed some borrowers to use the debt markets, although we also captured some of that in our capital markets activity. The rest of the lending, though, on the consumer side, remained strong and in fact got stronger as the year progresses, and we continue to see that progressing into quarter 4 as well. But for a little color around commercial and CRE, maybe we'll have Andy give you that.

So another factor was a little lower utilization rate. We were down maybe 75 basis points from 26 to 25.25 this quarter, and this is reflective of some of the things Richard talked about. Again, I think the very strong debt capital markets issuance that we saw in the second quarter and early in the third quarter impacted bank outstandings, as we talked about. And finally, M&A activity which was a driver of strong growth in prior quarters took a little bit of a pause here in the third quarter, either delayed or deferred to future quarters. So those factors all come into play and that's why we think it was more of a pause and that will come back a little bit as we see growth certainly over quarter 3. It's how strong it gets in the next couple of weeks; we'll be able to reflect at the next conference.

I wanted to ask about expenses and efficiency, Richard. Where are you on the ongoing effort to kind of improve productivity and expenses but also keep investing? Is it a goal to try to self-fund your expenses and investments with savings elsewhere? Or is it more about an efficiency ratio mindset?

Yes, so you know, John, we don't measure efficiency ratio. It becomes the result of the fraction of revenues-to-expenses. So the best way to keep it low is to do more revenue which is our number-one goal. Expense-wise, I think we've telegraphed to you all that we appreciate that the higher cost of compliance and actually some of the capital expenditures we've been making in innovation technology continued to bear down on expenses. So I will continue to let expenses grow only to the level that revenue is allowing it under the circumstances that we set forth at the Investor Day, which is that we think there will be a couple of nominal rate increases in 2017. With those rate increases, we made a commitment to you all, based on what we can see today, to provide slightly positive operating leverage in this environment. We also said, however, if those rates don't materialize, it will be much harder for us to do that. To give you a sense of it, without the rates, a couple of rate increases in the next year, that for us is hundreds of millions of dollars in expenses that we would need to reduce further and I think would probably cut into some of the muscle of the Company's long-term objectives for growth and innovation. So we're not going to make that commitment at this stage, but we'll watch every nickel and dime. I always find a need to pause and remind you guys, to be in the 54%s isn't, like, easy. We don't sit there and watch every nickel and dime and we have efficiency programs all over the Company. One of the ways we've kept it low is that we continue to get better every day. We take innovation and we let technology make it more efficient for our Company and for our people and therefore better service, but it's not easy. So we do have expense programs all the time, every day, and forever. Some of the companies I know that announced efficiency programs, they put names around them, they give you dollar amounts; we don't do that because it's not our style. We also don't need to. But we do watch it every single day. So we will let revenue dictate in most cases to how well that efficiency ratio performs. Our goal is to have it continue to be in the mid-50%s for a while. At that point, we'll measure against a future that I think won't be starved for investment. At the same token, the minute things get better and we have every opportunity to save a dollar, we will do that very thing and give you a better return.

Just on the topic of rates, I was hoping to ask Terry if he could flesh out a little bit of the outlook on the NIM that you gave for next quarter. What are some of the puts and takes, the good guys and bad guys affecting the NIM outlook for next quarter? And if you could include there, what's your guess as to the effect that one Fed rate hike would have on your NIM in the quarter afterwards? Thanks.

Sure. Incorporated into our guidance, we're assuming that the rate hike does occur in the December timeframe; and that in and of itself would have a positive impact with respect to margin, probably maybe by a basis point or so. But one of the things that we anticipate, John, is that the cash balances that we saw an increase in, in the third quarter, we think are tied to money market reform. And that is going to have an impact in terms of net interest margin at least probably through the fourth quarter. We anticipate that it's going to be transitory and that those cash balances will start to dissipate as people get more comfortable with money market reform, but when we guide that the net interest margin is going to be down a couple of basis points, the cash balances are going to have an impact on that.

And Terry, just to clarify, the one basis point net interest margin help, is that for the quarter that if it happened in December you would get that help this quarter? And would there be a carrythrough to the next quarter that's a little bigger than that?

Yes.

Yes and yes.

Back to the loan growth topic, thanks for the color that you've given in terms of near-term trends; and I hear you in terms of some of the inconsistencies around borrower demand amid the uncertainty right now. How does that play into your expectation for how you're looking at 2017? I know you don't yet have guidance and therefore, loan growth. But I want to get an idea if you continue to expect improvement coming out of the fourth quarter through 2017 and generally expect a higher level of loan growth. Thanks.

The answer is yes. We've maintained a range of 1% to 1.5% for quite some time. Each quarter presents its own challenges, yet we've managed to stay consistent, and I believe this trend will continue into the future. While revenue growth may be strong in retail, it can be challenging in commercial; however, our model is well-balanced. We have a positive outlook for both commercial and consumer segments, and we anticipate a stronger performance in 2017 compared to 2016 due to gradual improvements in the economy and our ability to capture market share. I haven't mentioned market share recently, but we have seen significant deposit growth and consistent 10% year-over-year growth in commercial loans, which indicates we are making strides in this area. Additionally, this market share momentum is likely to persist and strengthen. In a competitive environment, when other banks face challenges, we benefit from customers seeking alternatives. Our goal is to be the preferred choice for customers looking to switch from their current banks, which bodes well for our business growth. For next year, we expect solid performance across all categories. Our home equity line continues to grow through traditional means, relying on superior products and services delivered by our branch teams, which sets us apart from many competitors. Therefore, I believe the fourth quarter will remain within our established range, and we may see a slight positive bias into next year.

Then separately, I guess this would be a question for you as well, would be around the regulatory side. Since we've been talking about the regulatory expenses that you've been putting in the work, can you give us a related update on the BSA/AML progress and if there's any way to help us with expectations of when that could be resolved? Thanks.

Yes, sure, John. We're deep in the middle of it, so I not only don't have a projection of when we'll leave, if I had it I wouldn't tell you because of the regulators. I haven't made any agreements. So that will take a while; it will definitely be well into next year that we'll get a line of sight on when we can look for an exit of that. In the meantime, it's taken us to a compliance cost level that I had hoped to recover when we got out of the mortgage consent order which we're now long out of. But as it turns out, when the AML Consent Order came in, it's virtually replaced those same costs. So with our growth expectation of reducing expenses, we're unable to do that at this point. But it's also finding its way now into the run rate of the Company. It's also made us a better bank. I don't like Consent Orders and we only have the one and it's frustrating to me. But the fact of the matter is it's a proxy for the expectations of zero tolerance for errors and we've aligned that proxy with everything we do. It takes a little bit of time to adjust to it. It takes a little bit more money to get your first, second, and third lines to do amazing levels of oversight and quality assurance. But once and when you've done that and you've put it into your run rate, both in costs and the way you do business, we'll be a better bank for it. So I would like you to think that the AML project has extended itself through the whole Company to improve our compliance capability and therefore fend off any other future areas of shortcomings. And I would say next year we'll be able to give you a better line of sight; but at this stage, we're deep in the middle of it, doing our very best job to satisfy the regulators and to overperform even to our own expectations. And at this point, I'd be hesitant to give you any kind of an exit timetable.

I had a question on the fee side of things. Terry, you mentioned that mortgage would be down in the fourth; and you talked about into the quarter how it would have a nice leap. I'm just wondering. It looked like the gain on sale margin was quite high. I'm calculating 150. Can you walk us through the mix of refi versus purchase and what you're expecting in general for mortgage to do in the fourth quarter?

If you compare the third quarter to the second quarter regarding the mix of refinancings, in the second quarter, approximately 65% to 70% of the mix was related to purchases, while around 35% was refinances. In the third quarter, this shifted closer to 45% for refinancings, and we anticipate that the refinancing mix will decrease to about 40% in the fourth quarter. It's decreasing based on our observations. The refinancing activity is mainly coming from high-quality products, predominantly sourced through our retail banking system. As for the gain on sale margin, we're experiencing a better margin in the third quarter than we did previously. The growth in the third quarter can be attributed to both increased production and higher margins. You are correct in your assessment.

Can you help us triangulate that to what kind of delta? You helped us understand the 20% to 30% up in the third; does that roll back off in the fourth or is it somewhere in the middle?

Yes, I would say that it's probably somewhere in the middle, again, simply because of where the production is going to come from. When you have higher levels of production you're able to get better margins and pricing with respect to the product and therefore better margins as a result. But when we end up looking at the fourth quarter, we do expect the margin on production to be starting to taper a little bit, as well as production levels.

A second follow-up, just, Richard, you've made the point about the kind of set-your-clock-to-it seasonality. I was just wondering on the rest of fees generally, do you see just the same type of growth patterns happening as far as the ones that grow and the ones that typically don't? And just your general sense of the ex-mortgage, just fee businesses, any improvements underneath the surface there?

Yes, I'll let Andy answer that, but I want to tell you, Ken, we're a seasonally strong fourth/third quarter Company on revenue, also higher expenses in third and fourth quarter because of the CDC. But that's one of the reasons this can look like a consistent predictable outcome, but it's slightly different each time. Quarter 4 we like a lot for fees and I'll have Andy give you some color around that.

Right. The quarter 3 is the strongest quarter for corporate payments and then it tapers off a little bit. If you look at merchant and credit card issuing, I would expect a continued level of growth that you saw this quarter, same-store sales in that 2%-plus, total revenue in that 3% to 5% like you saw this quarter. So I would see that same expectation, other than corporate payments which does tend to go down in the fourth quarter because third quarter is the strongest given the government activity. Trust fees will be a bit of a function of what the market is doing. We had a strong quarter this quarter with both strong market activity as well as good core growth. I would expect that to continue. And then Terry made reference to money market reform. We did see quite a shift in our balances also. Our primary funds went down in the neighborhood of $6 billion given money market reform; but our government bonds went up almost $9 billion. So how that settles out will also be impacted with fees here in the fourth quarter.

Just a follow-up question on John's line of questioning, if I look at the 6% year-over-year increase in expenses in both 2Q and 3Q, Richard, could you help us break it down in terms of how much of that could be attributed to higher compliance costs and risk management costs and how much of that could be attributed to costs to invest for innovation?

Yes, the increase in expenses is due to both factors. To start, with the company growing at this size, merit increases are approximately 3%, which accounts for around 1.5% of our total expenses since half of those expenses are compensation. Additionally, we are investing significantly more in capital expenditures for innovation and technology. Five years ago, our annual investment in capital expenditures was between $400 million to $500 million, but this year it is projected to be between $800 million and $1 billion, with a run rate closer to $750 million to $800 million. This is a positive development as we have evolved into more of a technology-focused company. Given our leadership in payments, these investments are crucial and will generate value in the future. What remains of the expense increase can be attributed to compensation costs and improving overall operations by spending more on areas we previously overlooked, such as quality assurance, which is not solely related to compliance but ensures we do our job better. It’s essential that our employees are fairly compensated, and the way we treat them and the strength of our company culture matter greatly. Sometimes, we must invest in protecting our brand, ensuring employee safety, and maintaining a positive work environment, which we are prioritizing. While compliance costs are a factor, having a 6% increase is not sustainable long-term; I aim for that to decrease to 3% to 5% over time, although current compliance costs contribute to that excess increase. Eventually, once we achieve stability in these areas, we will benefit from those investments.

And just a follow-up question, in terms of Governor Tarullo's speech, it sounds like given that your binding constraint will be the capital conservation buffer. That shouldn't make any difference in terms of how you think about capital planning at your size or the need to scale up to your asset base in order to deal with a higher capital requirement. Am I thinking about that correctly?

Yes, so let me take a stab at it and then Andy can add to it. When you end up looking at Tarullo's comments and then the impact to U.S. Bank, we don't really see that it's going to have a significant impact on either our capital distribution plan or the requirements that we have with respect to the minimum requirement. That is because of the fact when you end up looking at the capital depletion that occurs during the stress-testing process that capital depletion for U.S. Bank, given our risk profile, is lower than the 2.5% buffer that is already incorporated into it. So we think that our minimum requirement from a regulatory perspective is going to continue to be at that 7%. We don't see that technology changing a lot. Impact to peers? Probably the smaller peers, simply because of the fact that they don't have to deal with some of the qualitative aspects I think will be net positive to them. But we don't see a big change to it. So, Andy?

And because of that, Terry, our current binding constraint is the standardized ratio under the base case and it will continue to be up.

You talked a little bit about the shift that was coming in because of the money market change. But deposit growth just continues to outpace loan growth. 10% over the last year for you all is just incredible at this part of the cycle. So why is this? The deposits keep flooding back into the bank balance sheets. Where is the primary source of all that coming from, because it's across-the-board for most banks?

Marty, one of the main reasons, as both Terry and I mentioned, is money market reform. We experienced approximately a $6 billion decline, with some of that going to governments. The industry as a whole saw around $0.5 trillion move away from prime obligations or prime funds. Some of this has transitioned into bank balance sheets, and I believe some will return once investment policies are revised to accommodate floating NAV. This is a significant factor. Another factor is the shifting of deposits among banks. Due to ratings and some ongoing stresses, we are receiving a lot of deposits from non-U.S. banks, which has also been beneficial.

The other thing, when you look at the mortgage servicing, this was an interesting quarter for mortgage because you had the production go up with refis, but you also had rates trickle up at the back end of the quarter. So your valuation on servicing was actually positive as well. That happens occasionally but not typical. When you look at the about $25 million that you had positive in valuation, but you also had prepayments that were coming through, so your actual cash flow increased the other adjustments of servicing value, how do you look at the net of those two things going forward in the impact to the mortgage banking fees in the fourth quarter and then into next year?

Yes, Marty, I think when we look at the fourth quarter, it’s a bit challenging to predict beyond that. However, as we consider the MSR hedge, we expect it to decrease a little. This would be another reason for anticipating a decline in mortgage banking revenue during the quarter.

But the other changes would also taper down, so that big negative you had there would be less negative as you moved into the next quarter as well.

That's fair.

First, a follow-up from Investor Day, I wasn't sure about your appetite for bank acquisitions after that day. In other words, once you get the regulatory side resolved, are you willing to look a little bit more or not?

Yes, absolutely. You can refer to any of the 40 earnings calls I’ve participated in, where we have consistently expressed our preference to invest further in the 25 retail markets we currently operate in, rather than entering new markets that may offer weaker pricing power and diminished brand strength. For instance, consider the deal we made in Chicago a couple of years ago, where we strengthened our presence there. Similarly, our move into New Mexico positioned us as the third-largest bank overnight. Such opportunities will remain appealing to us. The prospect of entering a new market where we currently lack a foothold would need to be exceptionally promising and must hold a strong market position to capture our interest. The positive aspect is that even though we are currently unable to pursue this, there’s nothing out there that we wish we could have had, and the timing is quite favorable. However, when the opportunity arises again, you can count on us to seek significant in-market deals that would be worthwhile enough to disrupt our current momentum, but only in the markets where we are already established.

Then a separate question. Your last comment at Investor Day, maybe I can call it the Richard Davis soliloquy.

Well, I don't know. Now what? Me and the 10-year bond? What is it now?

Banking has a unique and noble opportunity to change the world; there isn't another industry like it. While we don't provide food, transportation, or medicine, we support people's aspirations. However, there's a stark contrast between this perspective of banking's noble role and the negative reputation the industry has today, stemming from issues related to cross-selling.

Sure.

I'm just looking for some additional perspective from you. What are you doing to ensure this doesn't happen at U.S. Bancorp? And, more generally, when you do make a mistake and you say there's a guarantee, what do you do to fulfill that guarantee?

I want to begin by noting that we've examined this topic both as an industry and as individual banks. Years ago, during a financial services roundtable, we sought to contemplate a nationwide brand reputation and the process of rebuilding after the downturn, but we quickly realized that the American public wasn't ready for that. Unfortunately, the banking industry still lacks a unified voice. However, we agreed that each bank could improve its efforts in satisfying customers and developing its own brand, and collectively, that would help in the rebuilding process. While we may not be where we want to be, this approach is essential. Each bank must stand firm on its own and prioritize what's best for its customers. If one bank falters, it doesn't reflect on the entire industry. We need to communicate that narrative more effectively. In our company, the starting point is crucial regarding our sales culture, but it's important to emphasize that it's all about culture. Sales practices and customer interactions are integral to that culture. To answer your last question, the commitment is to always uphold what you promise, rectify mistakes if they occur, and learn from those experiences for future actions. I've often discussed how bankers should evolve from baggage handlers to pilots within the same organization. In fact, as of this morning, the news suggests that baggage handlers need to adopt a more pilot-like approach. We believe this applies to our industry as well. We need to handle each transaction uniquely, honestly, and genuinely. When mistakes happen, it's vital to correct them and apply those lessons moving forward. You know me well, Mike; I've been with you for a long time, and we've never used the term 'cross-sell.' To be honest, I’m not even sure what cross-selling means at this bank. I would estimate our metrics are quite low because a customer typically needs only a few services from a bank at any point. We don't focus on measuring that or setting quotas. Instead, we encourage our employees to ensure customers are aware of what we offer so they can reach out when their needs change. This means our customers choose our products; we don’t push them. As long as we have what they want and it comes with fair services and fees, we’re happy to provide it. I want to clarify that, in this industry, selling is not inherently negative. It's acceptable as long as it aligns with people's needs and clearly communicates the benefits at the right time. It’s challenging for the industry, but fundamentally, people trust their bankers and appreciate their banks because of their choices. They don't have the same affection for the industry as a whole, and it will take time to improve that perception. Yet if every bank and banker commits to better practices, we can potentially revitalize the industry despite occasional setbacks. I must say, all of this is happening amidst a challenging economic climate. Banks had more opportunities to thrive years ago, as better economic conditions led to healthier consumers and quicker growth. In favorable times, customers require us more, and we can respond with affirmative actions, making us more effective. Conversely, during difficult times, we shift to a defensive stance, helping protect customers from potential dangers, but that doesn't create as appealing a narrative. Ultimately, it does matter how we navigate these challenges. I genuinely believe banking is a noble profession, and I'm proud of the work we do and the individuals involved in it across the nation. It plays a crucial role in America, showcasing our uniqueness. Importantly, it's the only sector capable of providing leverage; a dollar in deposits at a reputable bank translates to seven dollars in loans, which significantly contributes to economic growth. I'm optimistic that one day we will reach our goals, but it requires a focus on improving one bank at a time, and we are dedicated to making that happen.

I just wanted to follow-up on some of the comments you made about mortgage banking. In particular, you're mentioning the increase in refi activity. I would assume that the refi activity would tend to be more retail originations versus correspondent. So you probably had a positive mix shift this quarter. Was that a dramatic impact on the number and the gain on sale margin? And going forward, do you expect that mix shift to change as well?

It was a little bit more retail. And just generally speaking, the gain on sale margins on refinancings are higher than purchases, so that was also a factor. As Terry mentioned, we would expect the refinancing component to go down in the fourth quarter as well as the overall volume. If you look at just the last few years, historically in a normal environment, fourth quarter activity is down 10% to 15% because it's just fourth quarter; and new purchases particularly are down. So I would expect that same trend. And we will update you at further conferences during the quarter to give you an update about what we're seeing because it's also very dependent upon rates, particularly at that level of the yield curve which is quite an impact on activity for the fourth quarter.

We're also seeing in the servicing market the market for MSRs softening and so the yields on those assets are going up. Are you seeing an opportunity to get better margins in the correspondent market and that support your overall gain on sale margin? And are you potentially participating in the purchase of MSRs?

We're not going to participate in the purchase of MSRs. We're in the correspondent market. It depends on the geography and the type of loan. I would say some of it is very competitive in terms of pricing and some of it a little less competitive. So it depends on the mix.

Maybe on the auto business, I realize it's not a huge part of your loan book; between the loans and leases maybe 9% or so of the book. But it's been a source of growth. You outlined a couple of years ago some ambitions for market share improvement which you seem to have achieved. I wonder if you could just talk about further appetite for growth both in loans and leases. And then in terms of the credit quality, you had the comment in the release about lower residual gains. The appendix does show delinquencies rising, albeit from pristine levels. Is the performance you're seeing in line with what you had penciled out when you wanted to grow this book? Or is there a deterioration happening? Or how should we think about that?

Brian, this is Andy. I'll answer those questions. First of all, the volume continues to be strong. It's a function of our dealer partnerships and the technology investments that we've made in the business. It's a good mix of lease as well as purchase. I would expect us to continue to have partnerships expand and continue to see strong growth. I'd also mention that we do not do any subprime activity in this business and we in fact have very conservative credit standards both in terms of term as well as the credit quality underneath it. So it is a high-quality portfolio and I'm very comfortable with the credit. One phenomenon that is occurring in the marketplace is residual values are coming down a bit. That's a function of dealer incentives going up which makes the comparison of new versus used favor the new. That means that the gain on sale is still positive but might have been somewhere in the $1,000 range; it's closer to $600 or $700. You'll see that phenomenon occur through our fee income category. Again I want to highlight it's still positive; it's just less positive.

Maybe one follow-up, and just to get the spirit of the question right; it's not to pin down basis points and the efficiency ratio, but just to make sure it's the right base. For 2016, it sounds like efficiency will be a little higher; the ratio will be a little higher in 4Q. And then I'm assuming we're using the adjusted 2Q number. So as we think about slightly positive operating leverage with a couple rate hikes, or maybe flat without, is the base 55%? Basically 55%?

This year, we expect it to remain in the mid-54%s. If we achieve slight positive operating leverage, it will stay there. If we don't, it could rise to 55%, but it won’t exceed the mid-50%s or drop to 51%. The momentum will depend on the interest rate trajectory, particularly a steeper yield curve, or a stronger economy. What we see in expenses this year will largely mirror what we see next year, with little variation. Our goal is to continue to generate revenue and keep growing as we have each year. We achieved record EPS this year not just due to a decent buyback, but also because of strong loan quality, good underwriting, and solid revenue. We aim to maintain this consistency moving forward.

It's actually Jason Harbes on Matt's team. Most of my questions have been asked and answered, but maybe I'll just ask a question on the card business. You've seen really nice momentum there this year. It looks like a lot of that is on the back of a Fidelity portfolio acquisition late last year. One thing that caught my eye was the net charge-off ratio was unusually low both sequentially and year-over-year. Is that primarily a function of the higher quality of that Fidelity book? Because I'm looking at the reported level compared to your normalized through-the-cycle target of 4.65% and it's quite a bit below. So just any comments around how your credit card business is going would be much appreciated.

This is Andy again. Yes, that is the key difference; the Fidelity portfolio is slightly higher quality. Our card portfolio is very high quality, but the downturn that you see in that charge-off level of delinquencies is a function of the higher-quality Fidelity portfolio.

Maybe just a bigger-picture question on the expense outlook for next year, this year it looks like you're going to come in a bit above the 3% to 5% target. A lot of that seems like it's related to some of the remediation activities that you are undertaking. But as we think about 2017, would it be realistic to think you might actually come in more towards the low end, as those costs or issues are resolved?

Yes, Jason, we've discussed the compliance programs, which are related to the topics Richard mentioned regarding AML and BSA. We will likely continue working on that into next year. Last quarter, we mentioned that compliance costs peaked in the second quarter, but we also noted that we don’t expect them to decrease significantly, at least not through 2017. I would view this more as a plateau where costs will remain at that level for some time until we address some of these compliance issues. So when considering the 2017 timeframe, that's how I would approach it.

Good morning, Richard. How are you?

I'm good. I was wondering where you were.

Still here in Georgia.

Well, you were on the Morgan Stanley call; I know you love them more.

Yes, you mentioned the election and Brexit, and I'm interested in your perspective on the current regulatory landscape. It appears that everyone's focused on recent speeches from Tarullo or comments from Fed governors, which might be causing us to overlook the bigger picture. Could you share your thoughts on the overall regulatory environment? Do you foresee any significant changes based on the election results?

First of all, I believe that if we consider this a nine-inning game, we're likely in the eighth inning. We have a good understanding of most conditions at play, including the environment, the regulators, the public sentiment, the economic climate, and the dynamics of the market. There isn't much that is new. While there may be some adjustments related to the election, it's important to note that many regulatory positions aren't directly tied to the election outcome or to the President's term. These roles have different timelines, such as the FDIC and the OCC, for example. As such, the philosophies and overall expectations regarding bank regulation are fairly established. Most rules are understood, and now we are focusing on the nuances, trying to interpret certain statements to see if there have been any significant changes. I don't foresee major shifts ahead. I also believe that when a new President is elected, there will be slight variations in approach. I won't comment on which might be more favorable, but one option might create some uncertainty that causes us to take a step back to observe how things develop, while the other likely maintains the status quo and is something we can manage since we are familiar with it. Regardless, I don't anticipate any scenarios in which bank regulation becomes less stringent. I also don’t see any significant areas where it might become tougher. However, I do believe we need to address the current focus on corporate culture and ethical practices, which I support welcoming oversight on. If banks are able to demonstrate, over time, that they are predominantly operating correctly and ethically, that could serve as a positive indicator for the public. They would recognize that we are stronger and safer. If we can show our commitment to good practices in the coming years, particularly in light of a potentially improving economy, I think we will be in a strong position. For our bank, we don’t spend a lot of effort worrying about future predictions. We maintain strong relationships with both local and national regulators, which we trust. For us, this is just part of running the business, and we view it as a normal aspect of operating the bank. We're not overly concerned about it or trying to make forecasts on what might happen next.

On the topic of culture, how do you see that becoming more prominent? Will it be incorporated into the DFAST? What are your thoughts on how that will unfold?

Yes, that's a good question. It's too early to know. The OCC is conducting a horizontal review, initially focusing on unauthorized new accounts. I’m not sure how extensive this review will be, but it will likely expand to include areas like incentive practices and eventually culture. We have always considered culture a priority from the start. I anticipate that the OCC will lead this under their oversight of the banks, while the Fed will approach it in their own way. I don’t expect this to enter the CCAR stress test framework at this early stage. Instead, I see it impacting the CAMEL ratings and the assessment of management and board oversight. This adds another layer to our understanding, akin to a spotlight on a stage that illuminates certain aspects while missing others. The focus will shift, revealing cultural elements. We will need to articulate our actions better and demonstrate the sustainability of our good practices, which means we'll need to increase record-keeping, auditing, and quality assurance. Overall, this is a positive development as many banks already excel in these areas. We will likely discover that this represents a strength we have not fully acknowledged until now. While it often takes issues to highlight these areas, I believe that the American public will be quite satisfied with what they learn.

Thank you for listening to this review of our third-quarter results. Please contact us if you have any follow-up questions.

Thanks, everybody.