Michael Brown - Ally Financial, Inc. Jeffrey Brown - Ally Financial, Inc. Christopher A. Halmy - Ally Financial, Inc. David Shevsky - Ally Financial, Inc. Timothy Russi - Ally Financial, Inc..

Eric Beardsley - Goldman Sachs & Co. Eric Wasserstrom - Guggenheim Securities LLC Moshe Ari Orenbuch - Credit Suisse Securities (USA) LLC (Broker) Christopher Roy Donat - Sandler O'Neill & Partners LP Richard B. Shane - JPMorgan Securities LLC David Ho - Deutsche Bank Securities, Inc. John Hecht - Jefferies LLC.

Good day, ladies and gentlemen, and welcome to the Ally Financial Third Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time. As a reminder, today's conference is being recorded.

I'd now like to introduce your host for today's conference, Mr. Michael Brown, Executive Director, Investor Relations. Sir, please go ahead..

Thanks, operator, and thank you, everyone, for joining us as we review Ally Financial's third quarter 2016 results. You can find the presentation we'll reference during the call on the Investor Relations section of our website, ally.com.

I'd like to direct your attention to the second slide of today's presentation regarding forward-looking statements and risk factors. The contents of our conference call will be governed by this language. I'd also like to note the third slide of today's presentation where we have disclosed some of our key GAAP and non-GAAP or core measures.

These and other core measures are used by management and we believe they're useful to investors in assessing the company's operating performance and capital measures, but they are supplemental to, and not a substitute for, U.S. GAAP measures. Please refer to the supplemental slides at the end for full definitions and reconciliations.

This morning, our CEO, Jeff Brown, and our CFO, Chris Halmy, will cover the third quarter results. We'll have some time set aside for Q&A at the end. Tim Russi, President of Auto Finance, and Dave Shevsky, Chief Risk Officer, are also here to assist with your questions. Now, I'd like to turn the call over to Jeff Brown..

Thanks, Michael. Good morning, and thank you for joining our call. Operating performance in the third quarter was again solid across the board. We continue to make consistent and steady gains over prior periods.

And almost every key operating metric, including core net income available to common, adjusted EPS, core ROTCE, and tangible book value per share increased on a year-over-year and linked-quarter basis. Adjusted EPS of $0.56 is up 11% year-over-year and our strongest since becoming publicly traded in 2014.

We'd rather just be direct and acknowledge this is a miss from analysts' expectations, and we'll certainly talk about the drivers during this call, but I also want to be clear that nothing we observed in the quarter meaningfully impacts our long-term plans for guidance we previously provided.

We're also in the midst of our annual and longer term planning processes inside the company and feel even more bullish about the upside potential that exists given our relentless focus on the customer and new product development.

There will always be ebbs and flows in the quarter-to-quarter progression, but we are still fully committed to a longer term, which I define as the next three- to four- years target of 12% core ROTCE and delivering in the range of a 15% adjusted EPS CAGR.

That will take steady and deliberate execution to deliver, but that's what our shareholders expect from us and that's entirely reasonable. Strong deposit growth and retention continues to be a key part of our plan to improve profitability.

And in the third quarter, retail deposits were up 19% year-over-year and put Ally on pace to surpass $12 billion of total deposit growth this year. Deposit growth enables us to drive more efficiency in our funding profile such as bringing down the unsecured debt load as well as altering our public and private secured borrowing programs.

We had another steady quarter of auto originations, with risk-adjusted yields up 53 basis points year-over-year. As we've been discussing, we're generating higher yields in the portfolio that are more than offsetting higher charge-offs and the increase in loan-loss provision. This is, again, a deliberate shift in our portfolio mix.

Let me provide a few contextual points on the higher provision. Flows we are seeing across the balance sheet remain entirely in our comfort zone. We believe the U.S. consumer is healthy, but overall pretty cautious and still focused on keeping debt loads in check.

We're getting the returns to cover the higher provisions even if we stress the book much harder than expectations. The newer retail originations we are booking position us well for even better profitability going forward.

And we aren't seeing issues with skips, up-ticks and first-payment defaults, or roll downs in delinquencies that might drive us to reconsider our underwriting strategies. Now, Chris will comment on a couple areas we are watching, but overall we feel good and believe we are booking good assets and generating quality returns.

As we've said before, we remain committed to being good stewards of capital and expect to keep our Auto Finance balance sheet fairly flat in the current environment as we continue to move from leases to loans. Our aim is to optimize capital deployment and prioritize risk adjusted returns over growth in Auto Finance.

In the third quarter, we initiated the $0.08 per share cash dividend for the first time. In addition, we were able to buy back 8.3 million shares at attractive levels. Progress on our strategic plan, which is designed to get more value out of our leading franchises, remains on track with some notable progress in the third quarter.

The new Ally branded credit card offering has been well received and is adding to the suite of consumer banking products we can offer our customers. The wealth management and online brokerage efforts are on track, and we are working towards an integrated customer launch in the first quarter of next year.

Next on deck to launch is a consumer mortgage product, which is on target for the fourth quarter.

And despite a flat capital allocation, we also took steps to expand our offerings in the Auto Finance business including establishing a commercial financing team to target transportation and equipment financing opportunities with businesses and municipalities.

This business will provide incremental diversification within our auto book, while aligning to our core strengths and point-of-sale vehicle financing and secured lending. We also strengthened our capabilities on the digital side in auto financing through the small acquisition of a California-based online auto lender exchange called BlueYield.

The transaction offer the technology and expertise that will advance our progress in building a direct-to-consumer option as well as ultimately driving to an end-to-end digital platform.

The auto space, just like the rest of financial services, is going more and more digital, and this acquisition will support us, delivering a digital auto financing process to serve both dealers and consumers.

We fully believe dealers will continue to play a central role in the purchasing and financing process, but obviously it's important for us to establish new partnerships and technologies to ensure we play a leading role. As you've hopefully seen, we launched our first integrated brand campaign in September.

This is significant, as it's the first time we're going to market with a campaign that talks about the breadth and depth of our product offerings and speaks to the unified Ally vision we've been working towards for the past 20-plus months.

This is a key part of our mission – transforming the references of a pure-play auto lender to becoming a leader in the broader market of digital financial services. Overall, we are encouraged by the progress and our momentum.

We're planting seeds for the future through low-risk, low-capital efforts that along with our self-help drivers will meaningfully contribute to improved financial performance and hopefully multiple expansion in the coming years. And, with that, let me turn it to Chris for a more detailed account of the results..

Thanks, JB. On Slide 5, net financing revenue crossed over $1 billion for the quarter. Year over year, net interest margin expansion continues, despite the painfully flat yield curve.

While we could see a dip in the fourth quarter due to seasonality, we continue to see significant runway to grow net financing revenue over time; and, frankly, migrating from around $4 billion annually today up to a run rate of around $5 billion is in our sights over the next few years.

Provision was up quarter over quarter due to seasonality and up year over year due to our deliberate mix shift and increase in our coverage ratio, as we built our allowance in the retail loan book. As we've said, we've been taking on more credit risk, but we are getting paid for it and believe we still have substantial coverage for higher losses.

Also, keep in mind, lease residual exposure is running off about $1 billion per quarter at a time when used values are softening. And we'll cover more detail on these dynamics in a minute.

Non-interest expense was up year-over-year, due primarily to the acquisition of TradeKing as well as increased FDIC deposit fees and some modest investments related to product expansion.

While expenses are up, as we get into the second half of 2017 we expect increases in revenue to outpace expense growth, providing positive operating leverage and driving our adjusted efficiency ratio steadily down to the low 40%s over the next few years.

In Discontinued Operations, we accrued $52 million for a potential settlement in connection with our discontinued mortgage business. And after adjusting for Disc Ops and OID, we had adjusted EPS of $0.56 this quarter, with core ROTCE of 9.8%.

We view this as another solid quarter, and nothing we saw alters the long-term guidance we've been providing to the Street. We had some increases in expenses as we position for the future, and we booked up some additional provision given the repositioning of the retail loan book.

But we were able to deliver 11% year-over-year EPS growth and core ROTCE in the range of our 10% near-term target. And as JB mentioned, the current auto originations and strong deposit growth position us very well for the future from a financial results perspective. On Slide 6, NIM was up five basis points year-over-year.

A lot of the same themes you've previously heard from us continue this quarter. Retail auto yields are up 34 basis points year-over-year, which offset the declining lease portfolio. We expect to see some seasonal pressure in 4Q on lease revenue, so NIM will be down next quarter, but should bounce back nicely in the first half of 2017.

We haven't had a lot of expensive unsecured debt maturities, so cost of funds was pretty flat as well. With respect to interest rate sensitivity, we became asset-sensitive this quarter given the relative decline in floating-rate liabilities. We are not holding our breath for The Fed to raise rates in November or December.

And maybe, more importantly, we think it will be quite some time before we have a rate curve that helps anyone in banking. So this is where the self-help factors really support our long-term path. Let's look at Slide 7 and discus the dynamics on the right side of the balance sheet.

Looking forward over the next several years, we have some attractive uses for our deposit growth. And the biggest bang for our buck will be addressing the unsecured debt maturities. Over the next four years, we have $12 billion of unsecured maturities that carry an average coupon of 4.7%.

We expect to refinance little to none of that debt with additional term unsecured issuance. The only caveat is simply the timing of when the Bank will be able to dividend cash up to the parent and balancing the slug of unsecureds that come off in the first part of next year.

But over the fairly immediate future, as maturities roll off, it will accrete right to the bottom line. And there will be more room to run after that. In the outer years, we have over $9 billion of expensive debt maturing in 2021 and later.

It's also possible, over time, we could bring some of those maturities forward through liability management, as we did in 2014 and 2015. So, again, building towards a path of $5 billion NII from the balance sheet. For a broader perspective on the value of deposit growth, let's look at Slide 8.

This is just an illustrative example of the potential earnings power of that deposit growth.

We expect over the next three years to four years, our deposit base will grow over $40 billion as we look at retail growth from both new and existing customers, the sweep deposit growth from the wealth management platform, and opportunistic growth in the broker deposit book.

And unlike some banks that may struggle to put deposits to work in value-added ways, we continue to have attractive uses. We just talked about the biggest opportunity with unsecured debt. Beyond that, we can optimize between asset growth, if we see the right returns, or reducing secured debt, which is still pretty high.

Following the illustration, you combine those opportunities and you are in the ballpark of around a 2% contribution margin on average. Simple math, $40 billion times the 2%, and you have $800 million of incremental annual revenue in a few years.

So the deposit growth has been strong, and we expect that to continue and drive a material increase in profitability. This is a big part of our story and why we are so focused strategically on continuing to strengthen the brand, the franchise and our customer base. Deposits are the entry point.

We're growing tens of thousands of new customers every quarter, which is important for deposit growth and our customer product expansion initiatives. On Slide 9, you can see retail deposit growth has been outstanding with balances up $2.6 billion quarter-over-quarter and up $10.4 billion year-over-year.

Even with a 4-basis-point average retail deposit rate decrease year-over-year, we expect total deposit growth to surpass $12 billion for the year. We're getting growth from both new and existing customers.

26% of the deposit growth came from our existing customer base, which is a higher contribution relative to prior years, while average customer balances also increased slightly this year. We've got great momentum behind the franchise and, as we've discussed, deposit and customer growth is financially and strategically important.

On Slide 10, our fully phased-in common equity Tier 1 ratio was flat this quarter at 9.3%. Our DTA continues to decline at a solid clip as we post strong earnings, and the disallowed DTA is down around $300 million from the prior year.

We returned nearly $200 million of capital to shareholders this quarter through an $0.08 per share cash dividend and share repurchases. We were able to buy back $8.3 million, or roughly 1.7% of our outstanding shares. And given where our stock trades, we continue to see this as an attractive option to deploy capital.

As a reminder, we have $700 million of repurchases approved through CCAR, so we have around $540 million to put to work over the next three quarters. Let's look at asset quality on Slide 11. Losses were up seasonally this quarter to 75 basis points for the entire portfolio.

As we have discussed for a few years, you should expect seasonal impacts on a quarter-by-quarter basis and increases on a year-over-year basis due to the deliberate shift in the retail order loan book. You can see the retail loan book performance on the bottom of the page with net charge-offs of 1.37% this quarter.

We have a few dynamics impacting that number. Our newer vintages are seasoning into their higher loss periods. As we've discussed previously, these vintages purposely have a higher loss content that's compensated by a higher yield on the portfolio.

So we're getting paid for the risk, but we expect to see higher losses and provision for the next year or so until the retail auto portfolio fully seasons. We also saw an increase in loss severity during the quarter, particularly with lower recovery values on our repossessions.

We have had some higher year-over-year increases in our recent loss rates as 2015 and 2016 replaced the 2012 to 2014 vintages. But we expect to see those increases moderate over the course of 2017.

From my view, and building on what we shared with you on the credit call in August, losses continue within our range of expectations for the portfolio as a whole. However, even if losses deviate somewhat from expectations, we've achieved pricing levels that more than cover us for that risk.

Looking at provision in the top right, a significant driver this quarter was the increase in our retail auto coverage ratio, which was up 5 basis points to 1.41% this quarter. This drove an incremental $30 million or so of provision expense in 3Q.

We always want to be sure that we're appropriately and prudently reserved on this portfolio, and we built our allowance of balance again this quarter. So, in general, we continue to watch the portfolio very closely and granularly. We are feeding the latest information back into our credit strategies and models.

We're getting paid for the mix shift in our book. We're not chasing volumes, and we continue to be comfortable with the risk-reward trade-off of the portfolio. And we'll dive deeper on that in a minute. Let's look at Slide 12. We just talked a lot about our retail loan book.

But we'd like to pull back the lens and look at our overall balance sheet for context. Retail loans represent about half of our total balance sheet risk exposures. We have $36 billion of commercial auto that typically loses no money.

Our mortgage portfolio had net recoveries during the quarter, our Corporate Finance business had no losses and our lease portfolio at $13 billion is where you have to pay attention to residual value risk. That risk is declining every day at Ally as our portfolio shrinks. So, overall, we have a prime secure balance sheet.

We're increasing the risk allocation to loans as we're decreasing the risk allocation to lease. Net-net, we believe the overall balance sheet risk and susceptibility to volatility is declining. On Slide 13, Auto Finance reported $319 million of pre-tax income this quarter.

Total net revenue was up 8% year-over-year despite relatively flat earning assets due to the portfolio mix and retail auto pricing actions offsetting lease revenue declines. We covered some of the dynamics on provisions, so let me touch on used car values.

During the quarter, used car prices for our lease book declined around 5% to 6% on a year-over-year basis, driven primarily by underperformance in certain GM cars. As we have discussed previously, Ally had expected a 5% decline in used vehicle prices in 2016 and 2017.

And while we had some favorability in the first half of the year, we're now seeing used vehicle prices decline in line with our expectations. As the lease book is down over $6 billion in the past 18 months, our financial exposure has been significantly reduced.

It's important to keep in mind, public used vehicle indices such as Manheim or Odessa have a different vehicle mix than Ally, and may calculate changes in proceeds differently. Lower used car values will continue reducing our lease revenue as we move forward, but that headwind should subside after 2017, when our lease book reaches a steady state.

Looking at originations, a solid $9.3 billion supported by another quarter of record application volume and deliberate focus on risk-adjusted returns over volume.

Also, we continue to see good risk-adjusted returns in the retail auto business, which were up 53 basis points year-over-year, which is the difference between the originated yield and our loss expectation or NAALR. Non-prime retail order originations made up just over 11% of 3Q originations.

As a reminder, we show the NAALR since we don't want to give the impression that we're taking less risk. We have also decreased the amount of super-prime business as well. So, net-net, we've originated a fairly consistent risk mix over the last year or so. So, overall, the fundamentals of the Auto business are solid and we feel good about the result.

What's critical for you to know is that the auto business should hit an inflection point in another year or so as the business transitions through lease declines, while yields increase and provision builds as the retail portfolio normalizes. This should all drive expanded profitability in auto. Now, let's dive a little deeper on this transition.

On Slide 14, we've provided some additional detail around improving risk-adjusted margin specifically in the retail auto portfolio. There's two key messages on this slide. Number one, we had increased risk in the auto loan book as residual risk declines from lease exposure. But, again, we're getting compensated nicely for it.

The table in the middle of the slide shows the last 12 months ended 3Q, 2016 versus the comparable last 12 months from a year ago. Retail auto net financing revenue is up $354 million, while provision expense is up $195 million.

And the second key message is we're successfully offsetting the decline in the lease portfolio with higher net financing revenue on the loan portfolio. Net-net, our quarterly net financing revenue was up $60 million from the run rate a year ago despite significantly lower lease income.

And we should continue to see a nice increase in the retail loan net financing revenue as the overall portfolio yield migrates closer to the average originated yield we're putting on the books.

There were a lot of concerns in the market at the beginning of 2015 when GM took the leasing in-house, and we feel like we've successfully demonstrated that the business is adaptable, more diversified and can continue to thrive outside of any OEM contractual arrangements On Slide 15, our origination mix is relatively steady and the growth channel makes up over a third of our originations.

The mix by segment is also starting to stabilize, with used car lending representing 40% of the quarter's originations, which is up nicely year-over-year. The bottom two charts summarize the balance sheet. On the consumer side, lease declined at a good pace, being replaced by retail loans.

And on the commercial side, dealer inventory balances are up given a shift to higher-balance SUVs and trucks. On Slide 16, Insurance reported pre-tax income of $56 million. This was favorable to 2Q, where we experienced seasonally higher weather-related losses.

On a year-over-year basis, weather losses were also up, but 2015 was low relative to the seven-year average for this time of the year. Written premiums were $252 million, up quarter-over-quarter, but down slightly year-over-year.

While we had some adverse weather in the first half of the year, the business continues to deliver steady results and remains an important part of our value proposition to dealer customers. On Slide 17, we have results for the Mortgage Finance segment, which contributed $8 million of pre-tax earnings, up $4 million from the prior year.

We bought about $0.5 billion of prime jumbo loans this quarter, which was offset by prepayments on the existing portfolio, so a pretty flat balance sheet this quarter. We expect to launch our direct-to-consumer product in the fourth quarter this year and anticipate more meaningful growth in earnings from this segment in the future.

Slide 18 gives the results from Corporate Finance, which reported a pre-tax income of $15 million. Net financing revenue was up again, driven by a growing asset base which was up almost $1 billion year-over-year.

The technology vertical we launched at the end of 2015 touches various industries in our loan portfolio and contributed to about 20% of the year-over-year growth. As we've mentioned, Corporate Finance is a great profitable business that continues to grow. So overall, my perspective as the CFO is that this was another solid quarter in the books.

And while we might not have hit the Street numbers, it does not change the more important long-term path we're on. We continue to strengthen our earnings profile. We're experiencing top line revenue growth, and all the fundamental trends are intact.

We're in a bit of a transition period where our lease portfolio is declining, and we're growing our provision along with loan growth. But we're making more money than we were a year ago, and we're buying back shares at a very attractive price. And we're better-positioned than we have ever been to drive attractive, long-term financial results.

And with that, I will turn it back to JB to wrap up..

Great. Thanks, Chris. So to sum it up, we continue to make progress on our strategic plan. We're generating strong EPS growth, with hopefully you have seen, a long runway to go. Deposit growth and consumer efforts remain an important part of the plan, and we're very pleased by performance in these areas.

Efficient capital deployment remains a priority, as does continuing to drive shareholder value, and that is evidenced by our position to prioritize returns versus growth in the Auto space. Looking ahead, we are encouraged by our position in digital financial services and the trends that support this area for the future.

We're focused on growing deposits and pursuing revenue diversification, including through fee income. And on the operating side, appropriately managing risk, expenses and capital allocation all remain important factors in value creation. So thanks for your time today, and let me turn it back to Michael Brown for Q&A..

Great. Thanks, JB. As we move into Q&A, we request that you please limit yourself to one question plus a single follow-up. If you have additional questions after the Q&A session, the IR team will be available. Operator, if you could please start the Q&A..

Our first question comes from the line of Eric Beardsley with Goldman Sachs. Your line is now open..

Hi, thank you. Just on the charge-offs, you'd been talking about having your NAALR going up from somewhere around 10 basis points year-over-year. I guess now we're up mid-30s in terms of the year-over-year charge-off rate. You mentioned that could slow.

First, could you just help us reconcile the delta that you have seen – first, your NAALR; and then, secondly, where you see that year-over-year change in charge-offs migrating to as we get into 2017?.

Yes, obviously the NAALR is up about 10 basis points, and that's still holding true. But when you look at the actual charge-off rate, one of the things you have to really take into consideration is the timing of charge-offs. When you look at a NAALR, NAALR is the expected rate over the life of those loans.

If you look at a charge-off rate, it's just the amount of loans that we charge off in any specific quarter. So when you think about the timing of that, there's obviously seasonality when certain vintages get into their peak loss periods.

So there are times obviously when your loss rate could be higher than your NAALR, but over the life of that loan it will get back into line. The other point that I think is important, and we talked a bit about this on the last earnings call, is that we did get pretty aggressive selling assets this year.

And when you sell assets, it obviously changes the charge-off rate as compared to the origination NAALR. And I think I estimated that last quarter in the range of around 7 basis points or something of the loss rate. So we're putting on a pretty consistent NAALR and a pretty consistent risk mix.

Having said that, charge-offs are continuing to migrate up. I don't think that's any surprise. I think we were telling you that, so I don't think there's a lot of mystery in that..

Got it. And sorry, just in terms of that pace, you mentioned that that pace of change could slow in 2017.

So I guess if we're running up 35 basis points, 36 basis points year-over-year now, how do you see that progressing?.

Yes, that's a good question. As I look in the fourth quarter, it's probably in that ballpark. But as you look into the 2017, it actually starts to moderate a bit. So the increase in 2017 in the charge-off rate should not be equal to the increase from 2015 to 2016. The reason for that is you just have more seasoning of the 2015, 2016 vintages.

So while I expect charge-offs to still go up in 2017, I don't expect them to go up at the same rate as they did from 2015 to 2016. And actually, as you look out to 2018 and even 2019 as we're doing our business plan, it really starts to flatten out..

Great. Thank you..

Our next question comes from the line of Eric Wasserstrom with Guggenheim Securities. Your line is now open..

Thanks. Maybe if I can just follow-up on that question, I just want to make sure, Chris, that I understand that with respect to the 120 basis point NAALR, that's still what you expect the recent vintages to converge on as they move through their peak loss period.

Is that correct?.

That's correct..

Okay. And then maybe just stepping back a bit, I just want to make sure I understood or I'm interpreting correctly all of your comments about 2017 with respect to the balance sheet transitions and the origination transitions, et cetera.

But it sounds like what you're indicating is that while operating leverage will be more evident, PPNR growth could more or less match provision growth, but that the two diverge in the out years.

Is that correct?.

That's definitely directionally correct. So, what's happening in 2017 is as the lease portfolio continues to come down, we're not going to experience the level of lease revenue that we experienced this year or even last year. So that continues to come down.

But as the retail loan portfolio – retail auto loan portfolio continues to grow, that should offset a lot of that. But as you get to 2018, the lease portfolio hits a steady-state, so what you're going to have is growth in the retail loan portfolio both from a yield perspective and even from a balance perspective.

But what you also have is you have provision that basically flattens. So you start to see a real trajectory of an increase in profitability out in 2018 and 2019 because of that.

The other dynamic that I would say is that – is what you're also going to see in 2017 is you're going to see some significant unsecured debt maturities – really 2017, 2018 and 2019. Most of that will not get refinanced. And because of that, you're going to start to see an increasing net interest income, or NIM..

Thanks so much for clarifying..

Thank you..

Our next question comes from the line of Moshe Orenbuch with Credit Suisse. Your line is now open..

Great, thanks. Chris, maybe you could just follow-up on that because you had made some comments during the call about the need to upstream cash.

Could you talk about the pace actually in 2017 of those debt maturities, what that depends on?.

Yes, the only – we have about $4.5 billion dollars of debt maturities in 2017. A vast majority of that, honestly, is in like the first half of that, even the first quarter. What – the caveat I was giving you basically is we still have a requirement to hold 15% leverage ratio at our Bank.

Because of that requirement, obviously the Bank has, what I would consider trapped capital and, therefore, trapped cash that can't flow up to the parent company. We think of that as a temporary restriction that will get lifted at some point.

So, as the significant maturities come off, we may need to look at some temporary ways to raise some cash until that restriction is lifted. But having said that, when I think about the overall path of unsecured debt maturities – you can think about that whole $4.5 billion eventually being not refinanced at all and basically rolling off the books..

Maybe if you could just kind of – what would the cost be if you're replacing it on that interim basis, say, in 2017? And what is the probability that you could kind of get that authority to take the capital levels down below the 15%?.

Yes, we think that's a 2017-event. So I'm not – unfortunately, I don't want to predict the timing because it's been a little tough to predict, but we definitely think it's a 2017 event. Now, if we replace it with deposits, right, it's a difference between the 4.5% and basically 1.10%.

But if we have to replace it on interim basis, my guess is we can replace it in somewhere around a 2% cost of funds. So there will still be a significant decrease in interest expense associated with that, which is why I made the comment really on NIM.

I really expect NIM to come down in the fourth quarter, but that should really bounce back in the first half of the year as those debt maturities come off..

Got it. Thanks very much..

Our next question comes from the line of Chris Donat with Sandler O'Neill. Your line is now open..

Hey, Chris..

Good morning and thanks for taking my question. Wanted to ask for JB on the deposit growth, there is – it looks like there's clearly a lot that has been going right.

But as you think about the next three years or four years, can you talk a little bit about what might go wrong either in the interest rate environment or competitively or whatever? Because I get the math on the $40 billion or so, but just want to understand what sort of the risks around that might be..

Yes, I mean I think – let me take – that's a great question, Chris. So I mean we have had great progress both in attracting new customers and demand into the brand, as well as we heard from Chris just continued growth in our existing customer base.

I think important to that, we've got to continue investing in technology, and we are doing that within the Bank. A number of new technologies rolled out throughout the past 24 months, and we've got to stay kind of on the leading edge.

And, in fact, we have updated some of our deposit agreements in the past couple days on more seamless money transfer and things like that. So when you are a digital bank and no brick-and-mortar, technology and service, customer service have to be key points of emphasis at all times.

So, look, the other thing I think with respect to competitors, you know, Goldman's out with their offering, Synchrony is being pretty aggressive; Cap One is making good progress there. So you have the emergence of new players and other digital players.

But we're very proud of our overall brand positioning, the competitive offering that we have relative to the names I just mentioned there. So we feel good about trajectory and just think – obviously got to keep our heads down and stay focused there.

On the rate environment, I think the big question is ultimately what do we see – if and when The Fed ever gets moving. I think, as Chris pointed out, we're not going to holding our breath that we're going to see another 25 basis points this year. May or may not happen.

I think next year if The Fed goes, we're probably talking in the neighborhood of 25 basis points to 50 basis points at most. And so this is going to be a very slow upward path whenever The Fed gets moving.

And ultimately what happens to pass-throughs? So I think, as Chris has pointed out to you, and we've got in the appendix slides, we give you some perspective of – we're modeling roughly a 75% pass-through of those increases in rates. And if we dial that back to some which we think is more the norm, like 50%, it's pretty good upside.

But I think ultimately what competitors do that could shift kind of how we have to respond there. So those are the things we think about. But what – we are really proud of the brand. I think even some of the new brand campaign really attracting a new wave of customers in. We've got the lucky penny, out which is getting major media attention.

And then beyond all that, you think – we just think – we look at the major kind of secular shifts that are out there where you continue to see a trend of the large banks really closing branches, digital becoming more and more the norm.

And the digital rates that are out there are obviously much more attractive when we're offering a 1.10% rate relative to brick-and-mortars offering 15 basis points. Eventually that's going to really play into our hand, I think. So it is obviously – as we're pointing out, it's an important part of the mission, so we just got to keep executing..

Got it. And then sort of housekeeping question for Chris, looking at the end-of-period share count versus the average diluted share count, looks like your share repurchases were weighted toward the back end of the quarter.

Was there anything else going on the diluted share count besides share repurchases?.

No, there's nothing going on unusual to share repurchases. And keep in mind that we can't buy shares during a blackout period, so most of it was after our blackout period – released last quarter or so. So nothing unusual, though..

Got it. Okay. Thanks..

Our next question comes from the line of Rick Shane with JPMorgan. Your line is now open..

Hey, guys, thanks for taking my question. I'm not big on compliments on earnings calls, but I do want to say I really appreciate the narrative and how you wrap the slides around that. It really helps us think about the story. I do want to talk about Slide 8 a little bit.

And on Slide 8 you show the potential of deposit growth and the impact of the $40 billion of potential deposit growth. If we roll back to the previous slide, you experienced roughly $12 billion with the maturities. So that's easy. That absorbs $12 billion of that $40 billion.

The other opportunity – there is a $28 billion, essentially gap in terms of assets. And part of your story so far has been discipline in terms of asset growth, which we've really seen over the last year. I'm curious where you see that opportunity to deploy that capital.

And related to that, how do you hedge your basis risk on the mortgage portfolio that you're building?.

Yes. So let's talk about your first question, which is – when I think about the use of those deposits and asset growth, the places we will most likely deploy that is in an increased mortgage portfolio, okay, is one. And we're obviously building a direct-to-consumer business right now. So we do expect the assets in mortgage to increase.

Secondly, we actually have a very small securities portfolio relative to our peers. And there's a couple of reasons for that. One is because some of the capital restrictions that sit at the Bank. Some of it was because of just the rate environment we've seen over the last couple of years.

But we think we can obviously grow that securities portfolio to be much larger and much more in line with our peers. Both of those are assets come with very little capital. Both of them attract less capital than they do – than does an auto loan, as an example. The last one is we obviously want to keep growing our Corporate Finance business.

Now, I think the Corporate Finance business probably grows less than the other two, but it still probably has another $3 billion to $5 billion of growth in it. And then the other offset outside of asset growth is really going to be reducing some of the secured debt.

So we still have things like big secured facilities with the banks, and we're going to look to take a lot of those down over time. So you basically combine all those together and it represents about a 2% contribution margin..

Okay. Now, presumably – particularly with that securities portfolio which I think we would put into the treasury function, you will be taking on some interest rate risk.

How will you hedge that?.

Yes. We have a pretty – what I would call, we have a pretty sophisticated and active capital markets group. And we have a pretty robust outgo process that's really – that JB and I built when we came in this place.

So, we talk a lot about our expected view on the path of interest rates, both on the short end and the long end, and how we should basically use some derivatives like just swaps to basically position the balance sheet for our view on interest rates.

So, I would say we'll do it dynamically, and we will look to really decrease any of the risk associated with that. But it's something that I think we feel pretty comfortable with..

Okay. Great. Thank you, guys..

Thanks, Rick..

Our next question comes from the line of David Ho with Deutsche Bank. Your line is now open..

Good morning..

Good morning..

I was wondering if we could talk about the coverage ratios for the loan-loss reserves.

As we think about your comments related to slowing velocity of loss rate increases certainly in 2017 and into 2018, and then given the 12-months look, does that mean that the coverage ratios should start to be relatively flat and shouldn't see much of a lift outside some credit normalization?.

Yes, let me first address it, and then – we have Dave Shevsky in the room, our Chief Credit Officer, so I wouldn't mind if he jumped in as well. But, let me just address the coverage ratio. We did increase the coverage ratio this quarter and we did it probably at a faster rate than we would have expected a couple of quarters of ago.

So I think that's very fair. We did see used car values come down this quarter, really for the first time. They've really exceeded our expectations up until this point, but I think we're starting to hit that inflection point where we are seeing the used car values come down.

When you do your modeling for your allowance, you obviously take into consideration your current used car values and a little bit of where things are going. So we felt it was very prudent to increase that coverage ratio. So while the ratio is up, I think eventually we always felt we were going to get here.

It just probably came up quicker than we thought. Now, where the coverage ratio is going is obviously going to be dependent on where future used-car prices go as well as where the losses on the portfolios go as well.

The coverage ratio will always be higher because we don't only use the model losses, we also have some directional reserves associated with that. So it's a bit higher than we would've expected, which is a big contributor to the provision expense this quarter and where people probably weren't expecting. But we do feel pretty comfortable with it.

And as I look out over the next year, the expectation is losses will continue to tick up a bit. I think the coverage rate will follow that.

Dave?.

Yes, I will just say we feel really good about where it's going for a couple of reasons. As JB indicated, we really look at early indicators. Unemployment rate is still very favorable. First payments defaults are trending very favorable. Our roll rates in delinquencies are also very favorable, and our skips are favorable.

We've made some targeted changes, and we've said on our credit risk call we really are playing more in the belly of the curve, and we define that as 620 to 740, which is where most of our originations are, which we can optimize the price. We have taken down our non-prime. We were at 14%. We are today right around 11%, slightly below 11%.

So all those factors, I think, contribute to. We feel pretty good about where that coverage range is going..

Okay. And then in terms of where you think used price – used car prices will go, what are the major swing factors as we look into 2017? And maybe talk about potentially higher gas prices and that impact on the book and what you are maybe modeling there..

Yes, I think that's a perfect question for Tim Russi, who runs out auto business. Go ahead, Tim..

Sure. The forecast for supply of the vehicles is increasing. It's going to increase over the next couple of years. That's why we're being conservative on the used car prices. So we're watching a level of supply in the industry go above historical levels, and that's high levels of leasing.

As those – started three years ago and they are going to start to hit the market and have hit the market starting in the second half of this year. So you've got that dynamic.

Obviously, where gas prices were, you had a very favorable environment for larger vehicles and unfavorable for the smaller vehicles which, in fact, is a little bit of what we saw in the quarter..

You're good, Dave? All right, operator, if we could take the next question..

Our next question comes from the line of John Hecht with Jefferies. Your line is now open..

Hey hi. Good morning thanks, guys. Quick one on the deposits. I know Rick Shane touched on this a few questions back. But just in terms of maybe intermediate-term ways of thinking about modeling the business, the deposits have crept up as a percentage of liabilities.

And where would you think that – should we just keep that at the same trajectory through next year? How do we think about that in the intermediate-term?.

No. I think deposits as a percentage of the overall funding are going to continue to increase. So as I think about the balance sheet growth over the next couple of years, deposits will outstrip the balance sheet growth, so the percentage of deposits will continue to go up.

I think if you're modeling it, I expect that deposits will probably be up another $10 billion to $12 billion a year over the next few years. So – and that is actually retail deposits. So maybe $12 billion-plus when you put in the benefit of the broker deposits and/or the deposits we get from the wealth management platform.

So, all in all, you're looking at $12 billion-plus of deposits each year, and you probably have a balance sheet that grows closer to $7 billion or $8 billion..

Okay, that's very hopeful. And then looking at the origination mix this quarter, you had been increasing the used composition over time. There was a little bit of a reversion that there was maybe a little bit more new in terms of composition this quarter.

Is that just sort of the way the quarter fell in terms of maybe approvals or seasonality, number one? And number two is how should we think about that mix maybe through next year?.

Yes you have to really take into consideration the seasonality factor, which is why in my prepared comments I made a comment that it's up on a year-over-year basis. Because used cars tend to have their biggest sales months starting in the spring time into early summer. So you have to look at it on a year-over-year basis.

I think we've hit a little bit of a steady state. So we probably expect those deposits to range anywhere – I'm sorry, those used vehicle originations to range anywhere between 40% to 45% next year..

Perfect. Thanks very much..

That concludes today's question-and-answer session. I would like to turn the call back to Mr. Brown for closing remarks..

Okay, great. Thanks, operator. If you do have additional questions, feel free to reach out to Investor Relations after the call. Thanks for joining us this morning. Thanks, operator..

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program and you may now disconnect. Everyone, have a great day..