Michael Brown - Ally Financial, Inc. Jeffrey Jonathan Brown - Ally Financial, Inc. Christopher A. Halmy - Ally Financial, Inc..

Moshe Ari Orenbuch - Credit Suisse Securities (USA) LLC (Broker) Elizabeth Lynn Graseck - Morgan Stanley & Co. LLC John Hecht - Jefferies LLC Christopher Roy Donat - Sandler O'Neill & Partners LP Richard B. Shane - JPMorgan Securities LLC John Gregory Micenko - Susquehanna Financial Group LLLP Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

Michael Matthew Tarkan - Compass Point Research & Trading LLC.

Good day, ladies and gentlemen and welcome to the Ally Financial Second Quarter 2017 Earnings Results 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. And as a reminder, this conference call may be recorded.

I would now like to turn the conference over to Michael Brown, Executive Director of Investor Relations. You may begin..

Thanks, and thank you everyone for joining us as we review Ally Financial's second quarter 2017 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 content of our conference call will be governed by this language. I'd also like to note slide three of today's presentation, where we've 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 are 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 of the presentation for full definitions and reconciliations. This morning our CEO, Jeff Brown, and our CFO, Chris Halmy will cover the financial results. We'll have some time set aside for Q&A at the end. Now, I'd like to turn the call over to Jeff Brown..

Thanks, Michael. Good morning, everyone. We appreciate you joining the call. I'll ask you turn to slide number 4 where I'll cover key highlights from the quarter. In general, we have strong financial results this quarter and nice rebound from 1Q. And importantly, we remain fully on track to deliver our financial targets and execute our strategic path.

A couple of financial highlights for 2Q, adjusted EPS of $0.58 is up 7% from last year, and total revenue is up $100 million year-over-year. I should note that both adjusted EPS and total revenue are record results since becoming publicly traded in 2014.

As we've said, the quarterly improvements are not always going to be a straight line, but the self-help earnings growth potential is significant and not overly dependent on outside factors. Within Auto Finance, the tone remains the same. We remain cautious but constructive.

Our credit metrics were in line with expectations and we're tracking to the range of 1.4% to 1.6% on average for the year. From an originations perspective, we continue to see healthy application flow and also the ability to buy loans at the right price with yields of 6.3% for year-to-date 2017 originations.

Obviously, a lot of market focus on SAAR, sales and industry volumes. To be clear, our application volume was up relative to a year ago and we are able to stay disciplined on the loans we're booking.

The lease portfolio had a nice rebound seasonally this quarter, as used vehicle prices declined about 5% year-over-year versus the 7% year-over-year decline we saw in 1Q. Essentially, the healthy trends to start 2Q that we discussed on the call last quarter continued throughout May and June, and I might also actually add July as well.

So, while reasons for caution remain, we feel incrementally constructive, particularly with a few more months under our belt that the portfolio is well positioned to drive better profitability and our business remains well positioned with dealers in the marketplace.

Outside of Auto, the Deposits business continues to grow with $1.7 billion of balance growth in 2Q to bring year-to-date growth to $7.2 billion. Our key customer product additions continue to advance on the mortgage and wealth management front.

Ally Home, which launched in December, is starting to see some growth accelerate off of a low starting point. Ally Invest, launched its integrated platform with the Deposits business in May. And our Corporate Finance business, while not new, continued to steadily grow and had its best quarter in over a couple of years.

As we said before, these are key growth areas that will start to provide a more meaningful contribution to earnings, particularly as we get into 2018.

Vehicle product penetration, customer growth and thoughtful business expansion are key strategic priorities in taking the Ally Bank franchise to the next level as we continue to do more with the leading digital bank in the U.S.

On the capital management front, we remain committed to being good stewards of shareholder's capital and I believe the successful CCAR results demonstrate that point. Our CCAR plan includes the ability to drive EPS-accretive share repurchases as well as slowly migrating the dividend higher this year and expanding our investor base.

Now, let's turn to slide number 5. Before I turn it to Chris, I'd like to highlight some of the key financial metrics we watch. We posted some pretty solid and consistent results over the last couple of years. But, I think we're starting to reach an inflection point where EPS growth should accelerate.

We don't have a crystal ball in the economy or market dynamics, but the underlying fundamentals continue to support the 15% EPS CAGR we've been discussing for a while.

Much of that path is driven by topline revenue growth and we had a nice jump in net financing revenue to $1.08 billion and we still see that grow into $1.25 billion a quarter sometime in 2019.

Deposits continue to climb higher, as well as a really consistent customer acquisition, and we continue to protect and grow book value per share quarter after quarter. So I feel great about how we're positioned as a company, particularly with respect to our nationwide digital footprint.

We are delivering steady progress and staying true to our guidance, and I think we've got plenty more room to run. And with that, I'll turn it to Chris for more details on the quarter..

Thanks, J.B. Starting at the top of page 6, I'll run through some of the key themes on the line item results. As J.B. mentioned, one of the big stories this quarter was the move in net financing revenue, which is up $89 million. I'll cover more details in a minute.

But the biggest driver, and something that will help propel revenue going forward, is the yield improvement on the retail auto loan side along with growing deposits with a cost disciplined approach. Other revenue was $388 million this quarter.

We always have some ins and outs from one quarter to the next, but I would expect other revenue to be in the $375 million to $400 million range for the next few quarters. Provision expense was $269 million.

While charge-offs came in as expected, one big driver this quarter was a 7 basis point increase in our retail auto coverage ratio, as we built up our allowance balance, which had about a $46 million impact on provision expense. This should not be a surprise, as we've discussed this a few times publicly over the past few months.

Non-interest expense was $810 million for the quarter, right in line with our expectations. This is the impact of additional weather losses in 2Q. Keep in mind that we did receive a benefit from the reinsurance agreement we put in place last quarter. So that limited our weather losses quite a bit.

Looking at some of the core metrics, adjusted EPS was solid at $0.58. Core ROTCE was 9.6% this quarter, which is in the 10% plus or minus target range for the year. However, we see opportunities to drive that higher over the next few years.

Adjusted efficiency ratio was 43.7% this quarter, and we feel good about achieving that level while still investing in the franchise. In the banking space, I'm pretty confident this is best-in-class and demonstrates the benefit of our model. Let's focus on some of the key dynamics of net financing revenue on slide 7.

First, some general comments on net interest margin. We're benefiting from higher asset yields, not only because of underlying benchmark moves, but also the optimization investment going on within the retail auto loan portfolio.

On the liability side, we haven't seen the same magnitude of increasing cost of funds because our deposit rates have lagged the benchmark moves and we are growing lower-cost deposits in lieu of higher cost, unsecured, and secured debt. Deposits continue to provide fuel for balance sheet growth.

And you can see we grew the average securities portfolio almost $2 billion this quarter at much higher rates than last year. We expect to continue to grow our securities and mortgage portfolio, as we are currently under-indexed relative to other banks.

While this could have a dampening effect on the NIM rate, these are more capital efficient assets that will allow us to continue to drive higher earnings and higher ROE.

While we experienced a pretty large jump in net financing revenue this quarter, we expect it to be steadily in this range for the remainder of the year, with further expansion as we move through 2018. Looking at some line items specifically, the retail auto loan yield was 5.8% this quarter, up 33 basis points year-over-year.

We've been putting loans on at 6.3% this year, so we still see room to run there. The lease portfolio yield had a nice rebound seasonally up to 6.6%, while balances continue to come down. The commercial auto portfolio yield increased quarter-over-quarter due to the move in LIBOR.

Balances were pretty flat, but we still expect those to come down in the coming months as the OEMs rationalize inventory levels. The Corporate Finance portfolio continued its modest growth trend. The yield on that portfolio this quarter improved from a nonaccrual loan that paid off, so we had some additional recovered NII.

Mortgage was pretty flat and we already touched on the securities book. On the liability side, we basically see the growth in deposits replacing both secured and unsecured debt. Now, for deposits, let's move to the next slide. Total deposits grew by $1.7 billion for the quarter, including $1.1 billion in the retail book.

That brings total deposits to $86 billion or around 59% of our funding base. Overall, the industry growth rate for deposits in 2017 has been slower than last year, but we continue to take market share and remain well positioned as deposits move to online and mobile channels.

Customer growth continues to be very strong as we added 49,000 new customers during the quarter, with a lot of growth in the millennial demographic. The average rate on the retail deposit portfolio was up 1 basis point year-over-year and 3 basis points quarter-over-quarter.

We do expect deposit rates will be up 10 to 15 basis points next quarter, as we've seen a recent shift from online savings accounts to CD products, and we've adjusted some of our pricing upwards in response to competitive dynamics. This is the expected lag effect you see with deposit pricing as interest rates rise.

Keep in mind that our overall retail deposit rates have only increased a couple of basis points since December, while we've experienced a 75 basis points move in the Fed funds rate. However, as we've stated, we do expect that beta to increase in the medium term.

In general, deposits and customer growth continue to be a great source of strength for the company. As deposit pricing continues to lag and we experience improving yields on retail and commercial auto portfolios, we are well positioned for long-term margin expansion in the auto book.

Looking at capital on slide 9, the big story this quarter was CCAR where we were able to increase both our dividend and share buybacks. In total, we expect to distribute in the neighborhood of $1 billion to common shareholders over the next year, which is about 10% of our current market cap.

In the second quarter, we repurchased over 10 million shares, bringing the share count down to 452 million, a 6.5% reduction over the last four quarters. The deferred tax asset continues to come down impacted by pre-tax income and favorable movement in OCI. Let's turn to asset quality on slide 10.

Consolidated net charge-offs of 66 basis points were up 12 basis points year-over-year. The main driver was the year-over-year increase in retail auto charge-offs you can see in the bottom right.

At 120 basis points, retail auto net charge-offs were up 26 basis points year-over-year, and as expected, less than the 46 basis points year-over-year increase we saw last quarter.

We expect the year-over-year increase in the charge-off rate to decline again next quarter, which positions us to land in the 1.4% to 1.6% range for the full year per our prior guidance. Obviously, there are some large seasonal factors, which can make any given quarter higher or lower than our annual range.

Delinquencies were also up, but again to a lesser extent than a year-over-year increase we saw the last few quarters, as we expected. On the retail auto allowance side, you can see in the top right that we took the coverage ratio up 7 basis points to 1.5%.

The allowance balance for the retail auto portfolio is now over $1 billion, which will help absorb future losses. On slide 11, Auto Finance reported $347 million of pre-tax income, down $79 million from last year, but up $59 million from the prior quarter.

Net financing revenue was pretty flat from the prior year, as we successfully offset $100 million headwind from lower net leased revenue by increasing retail and commercial auto loan yields and balances. Other revenue was up in the quarter as we sold some loans at a gain similar to last quarter.

Provision expense was up year-over-year given higher losses as well as the allowance bill we just discussed. Looking at the bottom chart on lease, the portfolio is declining at a steady pace. We continue to expect it to level out at around $8 billion sometime early next year as we finish with the GM lease business.

We experienced a solid yield on the lease portfolio at 6.6% this quarter, which puts us well on pace for the 5.6% to 6% guidance we give you back in March. Used vehicle price, according to our internal index, declined around 5% year-over-year in the second quarter, which is not as severe as what we saw in 1Q.

If you go back to 2014, when we originated the leases that are maturing today, you could see that we did an excellent job in forecasting the decline in used vehicle prices, which is why we continue to see good profitability on these leases.

This is the expertise we talk about when it comes to setting residual values and the benefit of our SmartAuction platform. We would expect to continue to see seasonal patterns in our lease performance, as you can observe in the historical trend, particularly as you get into the fourth quarter when values are the weakest.

On the retail loan yield, at 6.3% year-to-date, we're running 50 basis points above the pace in 2016, while the loss content we expect will be pretty consistent in the 1.4% to 1.6% annual range. So that creates a nice dynamic for the portfolio going forward, with yields drifting higher and losses beginning to stabilize within a range.

Looking more at auto originations, let's turn to slide 12. We had another solid quarter of auto originations, as we kept a disciplined approach in our origination strategy and booked $8.6 billion of new loans. We feel great about the more diversified index of originations we're getting today.

41% came from the growth channel this quarter, which is non-GM Chrysler, the highest percentage from this channel. And our used loan originations are running higher than new loans, which we think is generally a good trade from a profitability perspective.

Moving to the balance sheet on the bottom two charts, in general, we continue to run a pretty flat auto balance sheet based on opportunities we're seeing in the marketplace. We're being disciplined around deploying capital and remain focused on returns and adding value for our dealers versus driving asset growth.

On the commercial side specifically, we continue to expect balances to come down a couple of billion dollars in the second half of the year as inventory levels are rationalized, and we're starting to see that trend already in July.

On slide 13, insurance reported a pre-tax loss of $21 million, slightly unfavorable to last year, driven by lower investment gains. The quarterly driver was higher weather losses we typically incur in the second quarter.

As we mentioned, we entered into a reinsurance agreement to mitigate earnings volatility and that impact is included within our results this quarter. We were able to cap our weather losses where the impact would have been worse had the agreement not been in place.

Written premiums were $220 million, which are down from the prior quarter and prior year, as the cost of that reinsurance nets down written premiums. Moving to slide 14, our Corporate Finance business continues to perform very well and earned pre-tax income of $35 million, up $21 million from the prior year.

The portfolio continues to grow and was up 19% from last year, while we also had a $9 million interest income recovery, which drove higher net financing revenue this quarter. Other revenue increased from the prior year as we continued to generate higher loan syndication and fee income.

Provision was up from the prior quarter due to some higher specific reserves, but asset quality remained strong and we continue to keep around a 2% coverage rate on this portfolio. Overall, we feel great about our ability to grow this business on a disciplined and low risk basis.

On slide 15, our mortgage finance business earned $7 million of pre-tax income, which was down $2 million. Asset balances were up from prime jumbo bulk purchase activity, driving net financing revenue 23% higher from last year.

We bought $800 million of bulk jumbo loans this quarter, as we continue to grow the held-for-investment portfolio as part of our diversification strategy into capital efficient assets. Provision expense was up a touch driven by the asset growth.

Noninterest expense was up from the prior year, as asset balances grew and we continue to invest in the buildout of Ally Home, our direct-to-consumer product offering. While originations to-date have been nominal, we expect a ramp-up production from here as we continue to increase marketing and consumer awareness of the Ally Home offering.

So overall, we had a strong quarter, with topline revenue growth, expanded margins, and credit metrics that are starting to stabilize. And with that, I'll turn it back to J.B. to wrap up..

Great. Thanks, Chris. I'll conclude by reiterating our plan to drive strong shareholder returns. Quite simply, the plan remains the same, as what we said last quarter and we are fully on track. We continued to optimize the Auto Finance business to position for strong profitability through the cycle.

We have a cautious but balanced approach from a risk management perspective and feel good that losses for the year are contained in the range we've discussed.

Obviously, there has been a lot of concern on consumer credit trends, but I'm confident when I say we've deployed our shareholders' capital with a very effective focus on generating appropriate risk-adjusted returns. We're not chasing volumes, we're not chasing risks, and we're not booking low-margin, no-margin loans.

We are simply staying disciplined. Importantly, we continue to support our dealers and their customers in the marketplace across our product lines. Customer growth is a strategic priority, and again, we added 49,000 deposit customers this quarter.

Our medium-term financial targets remain on track with respect to earnings growth in getting the ROTCE to around 12%. Optimizing capital deployment remains foundational for us. The key strategic priority remains to get more from the Ally brands and franchise that we've developed.

We are working hard operationally to provide a growth platform in Corporate Finance, Wealth Management and Mortgage, investing in technology and the customer interface, while still holding the line on our efficiency targets. We plan to demonstrate smart growth over time and the ability to expand our product mix and improve profitability.

That will position us to truly be a more diversified, leading, modern digital banking franchise. Now with that, we're happy to take your questions and I'll turn it back to Michael..

Great, thanks J.B. 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 follow-up questions after the Q&A session, the IR team will be available after the call.

Operator, if you could please start the Q&A?.

Thank you Our first question comes from Moshe Orenbuch of Credit Suisse. Your line is now open..

Great, thanks. I think that the highlight in the quarter, as you had pointed out, was the growth in net interest income and you kind of talked a lot about the improvement in the loan yields relative to your deposit cost. And I'm assuming that that continues.

Could you talk a little bit about the ability to kind of reduce your debt footprint to where that stands, how that's going to evolve in the second half of this year and into 2018, and how much you think that could help over time?.

Sure, Moshe. Thanks for the question. When I think about first of all the unsecured debt, which usually is the biggest driver or the highest cost of funds, most of the remaining 2017 unsecured debt maturities are really back-ended. So we have some large maturities really in December.

So, I don't actually expect that unsecured debt is going to drive any incremental income this year. But as that rolls off at the end of the year, it will provide incremental benefits as we go into the beginning of 2018. So that's a positive.

As I think about the incremental deposits that we expect to come on for the remainder of the year, we will be continuing to replace some of the secured debt or the securitizations that we have on the books.

So that will be a positive trade for us, as well as we continue to expand the securities portfolio as well as the mortgage portfolio, so some of the deposit growth will go to really driving some of those capital efficient assets..

Okay, and maybe just a follow-up.

If you can kind of comment a little bit about what you're seeing in terms of the loan yields as you go into the second half? I mean, any changes from what you've seen in Q2 or does that process continue?.

Yes, I mean, year-to-date it's about 6.3%. 2Q was a little bit higher and we tend to have higher yields in the second quarter, because it honestly is more of a kind of used car quarter, so you tend to skew a little bit higher.

But as you get to the back half of the year, particularly in the fourth quarter, you tend to skew up in credit quality and therefore down in yields. So we feel pretty comfortable right now that we'll continue to book yields around that 6.3% for the remainder of the year.

The Fed is not really expected to make any moves until the end of the year or even beginning of next year. So we don't necessarily see the interest rate environment really changing that outlook..

Great. Thanks very much..

Thank you. Our next question comes from the line of Betsy Graseck of Morgan Stanley. Your line is now open..

Hi. Good morning. So one follow-up just on your comment around no more rate hikes this year, so therefore no more increase in deposit rates.

Is that how I should tie those two statements together?.

No. I was actually really referring to the auto yields when I said that. So I don't expect that auto yields will go up further this year because there will be no more kind of movement in the Fed funds. But let's talk about deposits for a second.

And as you saw my prepared comments, I did mention that I expect deposit rates to move up in the third quarter. We started to make some moves here on the back end of the second quarter, really in response to the recent moves by the Fed in March and in June. We expect that to be bit of a lag effect that's coming through.

So, as deposit pricing kind of lags that benchmark move, you will start to see that really in the third quarter. There's obviously a lot of competitive dynamics when it comes to raising deposits and we are watching that competitive environment pretty closely.

And a lot of that will depend both on the flows we're seeing as well as the overall benchmark rates..

Okay. And then you spoke during your prepared remarks regarding some fee guidance in other fee lines.

Could you just talk through the range you gave and what's going to drive outcome between high and low there?.

Yes, the variability in other revenue usually has to do with the gains we take when we sell either securities or loans. So, on a quarterly basis, from a balance sheet management perspective, we often sell loans or securities and they will generate certain amount of gains on a quarter-by-quarter basis. They could be higher also.

So, when I think about the variability of that $375 million to $400 million that I mentioned, and it's a similar range that you've seen over the last couple of years on a quarterly basis. It really just has to do with the variability of the gains we might see in the portfolio..

And so, if you strip out gains, then you know, what kind of....

If I strip out gains, I think it's pretty steady. Then what you are dealing with really in the other revenue section is insurance income and then we have certain fee income from the Auto group like late fee income and servicing fee income. Most of that is pretty stable.

When I look out to 2018, 2019 where we expect expansion will be really when it comes to the wealth management and mortgage front. So as those two businesses really start to accelerate next year, we do expect to see some of that, what I would call, the core other revenue to really expand..

Okay, thanks..

Thanks, Betsy..

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

Hey, guys. Thanks, good morning. J.B., I'm just wondering given your comments on the competitive factors and we've heard some of the bigger banks are pulling back, I would assume that gives you guys the opportunity to both tighten and advance market share at the same time. So I'm wondering if you look that as favorably.

You also mentioned you're getting more applications in the quarter. I'm wondering do you think that's because the dealers are driving more apps to you just because they know you are going to be a more fluid and more consistent lender at this point in the cycle..

Thanks for the questions, John. I mean obviously from a competitive standpoint, what there's – we are open for business provided we can generate the appropriate risk-adjusted returns. And I think we are very comfortable with the level of originations we are booking on a quarterly basis. Could it retire? Yes. Could it drift a little lower? Yes.

I mean we're not volume driven right now. But there are a couple of other competitors that remain very committed to the space and are very comfortable with auto lending and again maybe a touch more smoke than fire that's out there.

But I think to your exact point, we have been able to tighten risk up a little bit relative to year-over-year, and you're also seeing much better yield performance. Chris pointed out, and I think I mentioned, the 6.3% and we think that's going to stay somewhere in zip code. So relative to a year ago, I think you see tighter credit, better yield.

That's a pretty good combination. And I think that's a result of what there have been two, three, four key names that have kind of stepped back from the space. But I don't want to apply that across the industry. I think there are still some -- what are very comfortable with what's going on out there.

So we think this is – positions us very well, part of the drivers of the margin expansion we are starting to see and part of the reason why we've got a pretty optimistic tone going forward..

Okay, that's great color, thanks. And then, Chris, just with respect to the A&L (32:16) build, looking at your comments last quarter and the early part of the credit call, the A&L (32:20) build was consistent with your comments then.

I'm wondering what – do you have any more specific comments about, you implied that continue to be built in the second half of the year, is the build at a similar pace, has it slowed down just given where you see things?.

Yes. When I think about the coverage rate going forward, it's obviously very subject to what I would consider our risk governance process every quarter. We run our models and we determine where the right coverage rate is going to be. So can I see it move higher, yes.

But I think it probably drifts higher from here as opposed to making such a substantial move like we made this quarter. We've been pretty consistent now for the past couple of quarters in this 1.4% to 1.6% range. So I have coverage now at – right in the middle of that range.

So depending on where we really see the charge-offs looking over the next 12 months, we'll probably have coverage what I would consider a little bit higher than what we expect those losses to be..

Great, very helpful. Thanks, guys..

Thanks, John..

Thank you. Our next question comes from the line of Christ Donat of Sandler O'Neill. Your line is now open..

Good morning. Thanks for taking my questions. Just wanted to check in on the net financing revenue and just make sure that we should not be annualizing the second quarter, I think -- I have caught -- expect some changes on deposit pricing and some other.

Can you just make sure that you help us through so if there are things we shouldn't be annualizing, we are not doing that as we think about the business going forward?.

No, there was a big jump in that financing revenue this quarter. But we expect it to be pretty steady in this range going forward. And as I get into 2018, we expect it to continue to increase.

Now as I think about the second half of this year, right, there is some ins and outs, meaning lease is always a little worse in the second half of the year than it is in the first half. I mentioned how deposit rates are expected to move up a bit.

I also mentioned our floor plan balances are going to come down probably a couple of billion dollars in the second half of the year, which will dampen some of the net financing revenue. But we also have a continued yield improvement on the retail loan side.

We also have a growing securities portfolio, and we still have unsecured debt and secured debt that will continue to run off. So I don't want to give you the impression that this is a one-time and it's going to start coming down.

I actually think that we are going to be elevated in this area moving forward, and then as we get into 2018, we'll continue to expand..

Okay. Thanks for that one. And then just thinking about 2018 and looking at the lease book in particular, you commented that that probably stabilizes, we are at essentially the three-year anniversary of GM changing how they do leases.

Should we be thinking about any other changes in that lease book as it becomes sort of the older GM related business rolls off either in terms of yields or remarketing gains or should it be more steady state from what it has become over the last three years?.

Yes, I think it becomes much more steady state. We're going to be in this $8 billion range. It will be skewed towards Chrysler vehicles. And within Chrysler, Chrysler is more concentrated to trucks and SUVs. So because of that, our portfolio will be skewed more towards that.

And we feel really good about the way we're riding residuals today for the future income on that portfolio. But, we expect it to be a much smaller and much more consistent portfolio.

Honestly, Chris, I hope a year from now we are not talking about the sensitivity of used car prices on our lease portfolio, because our lease portfolio is going to be a fraction of what you're seeing on some of these OEM captives where -- who have lease portfolios in $40 billion type range and have real used car risk..

Got it, okay. Thanks very much, Chris..

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

Thanks for taking my questions this morning. When we look at the sequential move in lease residual gains, it's about $500 improvement.

I'm curious if that is entirely driven by improvements in used car prices, that 2% improvement that you cite or had you readjusted the residual values in the last couple of quarters? And part of it is I want to understand the sensitivity going forward..

Sure. Most of it is not really the 2% difference in used vehicle prices. Some of it is, but that's not the biggest piece of it. The biggest piece is really how we wrote the residuals in 2014. When I looked at the first quarter, the first quarter had certain cars that -- we were skewed more towards cars.

We had certain off-lease vehicles that were written really back in 2013. As we started to turn really the page on the year and the guidance of 2014, cars that were really coming off in the second quarter, we were much more conservative on the way we wrote those residuals.

So I would say the bigger factor has to do with how we projected used car values moving forward versus just the 2% gain on a quarter-over-quarter basis..

Okay. That's actually very helpful. Thank you very much, Chris..

Thanks, Rick..

Thank you. Our next question comes from the line of Jack Micenko of SIG. Your line is now open..

Hey good morning. Listening to the comments on deposits, I'm curious if that move from money market to CDs, was that – are you thinking about that being preemptive or is that reactionary? When you're moving into CDs, I'm guessing you can term out some of the costs and maybe save some of the later stage deposits base.

It looks like your deposit base is running a bit ahead of where you sort of modeled, but curious to think the strategy on the migration to CDs on the funding side?.

Yes, there's a little bit of that, Jack. And the way I would explain it is, as you started to see in movement in rates, especially in the competitive environment, you really start to see it on the CDs first. And CD rates have been pretty low over the last few years, so depositors were not necessarily attracted to going long.

As the Fed started moving this year, what you saw competitive dynamics in the market, you saw the CD rates start to move first before the online savings accounts or the money market rates. And because of that, the CD rates have started to become more attractive.

So you are starting to see a little bit of that shift out of the demand deposits into some of the CDs. We think that's positive, like you said, from an interest rate risk perspective as move out to have more CDs. So it's a combination of the market dynamic and what we think is kind of a good move overall..

Okay. And then on the commercial assets side, can you just walk us through some of the sensitivity there? I'm guessing most of the floor plan is LIBOR plus, so that's going to move right away. You had, I think, a recovery on the other part of the books. That kind of overstated the yields this quarter.

How do we think about percentages and timing on an incremental move on the short side?.

Yes. We have this $35 billion portfolio of commercial loans that are pretty much tied to LIBOR. So it is really sensitive to that. So as LIBOR moves, that commercial portfolio is going to move up, so that's really where that sensitivity lies. Most of that obviously the loan portfolio is all fixed. So the retail loan portfolio obviously is all fixed.

So that's sensitive, although, keep in mind, our loans are still only 2 year to 2.5 year loans, when you think about the duration. So when I think of long term, we're still pretty floating-rate type institution. So, I just want to mention also the net financing revenue, we did have a $9 million recovery. You heard that in the prepared comments.

That was in our commercial finance book, so our middle market lending book. So I would look at that a little bit as a recovery that came through this quarter and a positive I wouldn't necessarily expect to repeat..

And that Corporate Finance book, is that LIBOR-based as well or, to your earlier point, is that fixed rate for shorter term loans?.

It's a mix. I mean, they're usually pretty short loans, meaning two-year to three-year type loans. But I would say it's mixed between fixed and floating..

Okay, thank you..

Thank you. Our next question comes from the line of Sanjay Sakhrani of KBW. Your line is now open..

Thanks, good morning. I guess the first question I had was on the yields. I know you guys have talked pretty extensively about it.

But when you think about the risk-adjusted yields, I mean are those improving as well?.

Yes, because when I think about even the last three years, meaning the 2015 vintage, the 2016 vintage and now the 2017 vintage, we actually think the loss content is pretty similar between the three years. But you've seen rates go up 50 basis points a year.

So we're pricing today close to 100 basis points higher in 2017 than when we were pricing in 2015. So, yes, when I think about it from a risk-adjusted perspective, we feel great about the profitability of this vintage..

And you guys talked about the competitive environment.

But I was wondering if you could talk about what sort of the OEMs are doing nowadays? I mean, are you seeing them sort of pick up the competition or drop off some?.

Well, you've seen some of the leasing volume, particularly with GM, go up pretty significantly and that's taken up some of the share..

Most probably, yes, that's probably the big one. I mean the couple of dynamics we're watching, Sanjay, obviously you have some of the factory shutdowns now occurring. So I think as Chris pointed out, expectations for the commercial book to start drifting lower on the back half of this year. So you are seeing some of the discipline there.

But on the consumer side, I think yes, Chris is right. I mean, GMF's lease book has gone from like $7 billion to nearly $40 billion over the past two and half years. So they've obviously taken quite a bit of lease share. So, you see that in the captive space.

But most of the banks, other than a couple of the names that have dialed back a little bit, most of the big banks that like the asset class are still in and still fighting strong every day and I mean that's probably all I'd say from kind of the OEM competitive perspective..

Yes..

Okay. And one final question on reserve coverage.

I guess, when we look at sort of the reserve coverage now at like 1.5%, I mean is that sort of the steady state rate or should we assume that it might move around still?.

Yes, I think I mentioned before, it's where in the 1.4% to 1.6% range, the charge-offs, the coverage rate right now is right smack in the middle of that. So I think there is a bias. The bias is that it will drift higher on a quarterly basis, but probably not close to the magnitude of the move you saw this quarter..

All right, tool. Thank you..

Thanks, Sanjay..

Thank you. And our next question comes from the line of Michael Tarkan of Compass Point. Your line is now open..

Thank you. Just a quick one from me. Can you tell me where we're on the Tier 1 leverage covenant and just whether that impacts 2017 guidance at all? Thanks..

Yes, I mean what I would say is probably consistent with what we've been saying for the past couple of calls, which is we remain in very active dialog with the regulators on the topic. I would say, I am encouraged by where things stand and therefore no concerns about any change in guidance for the rest of this year, or into the future.

I think we're having very positive conversations. It's obviously something we've been working at for quite some time. We understand the significance. So, I think the regulators understand the significance of it as well. And there were a couple of analyst reports that sort of said, hey this was absent, the CCAR results, there is something going on there.

And I'd say this was an entirely separate process from CCAR and it's something we're working through. But I think our track record on the regulatory front I think should speak for itself. We have made great progress in delivering the commitments what we've said and slowly chipping away, and I think this will be another one.

And I think will be back to the market in fairly short order..

Thank you..

You got it..

Thank you. And I'm showing no further questions at this time. I'd like to hand the call back over to Mr. Michael Brown for any closing remarks..

Great. Thanks very much. If you do have additional questions after the call, please feel free to contact investor relations. Thank you for joining us this morning. Thanks, operator..

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day..