Ally Financial Inc (ALLY) 2014 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the third-quarter 2014 Ally Financial earnings conference call. My name is Sheila and I will be your operator for today. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session toward the end of this conference. (Operator Instructions). As a reminder, this call is being recorded for replay purposes.

I would like to turn the call over to Mr. Michael Brown, Executive Director of Investor Relations. Please proceed, sir.

Thanks, Sheila. And thank you, everyone, for joining us as we review Ally Financial's third-quarter 2014 results. You can find the presentation we will reference during the call on the investor relations section of our website, Ally.com. I would like to direct your attention to the second slide of today's presentation regarding forward-looking statements and risk factors. The contents of our call will be governed by this language.

This morning our CEO, Michael Carpenter; and our CFO, Chris Halmy, will cover the third-quarter results. We will also have some time set aside for Q&A at the end. And to help in answering your questions we also have with us Jeff Brown, the CEO of our Dealer Financial Services Business.

Now, I would like to turn the call over to Michael Carpenter.

Good morning and thank you for joining the call. Let me start by taking you through a few highlights for the quarter as well as providing an update on our three-point plan to improve core return on tangible common equity. The third quarter was an excellent quarter both financially and operationally. We posted net income of $423 million with earnings per share of $0.74 and adjusted earnings per share of $0.53. This compares to income of $91 million a year ago and $323 million from the prior quarter. So by any account, the third quarter reflects the substantial progress for the Company.

Also echoing that is core income, which increased to $467 million compared to $271 million in the prior-year period and $417 million in the second quarter. Driving results were continued strong performance in the auto finance franchise with originations of $11.8 billion in the quarter being a high since becoming an independent company. And notably, originations for what we call our growth channel or the non-GM, non-Chrysler dealers continue to gain traction and were up 54% year over year. This is a testament to the broad base and strength and flexibility of the Ally franchise and is evidence that Ally can be a leader in a very crowded marketplace.

Automotive net financing revenue increased 6% year over year and auto earning assets increased 7% during a period in which used car prices normalized. Retail deposits of Ally Bank continue to grow with balances up 12% from last year and a loyal and expanding customer base driving that growth. This is all as we take a greater eye toward efficiency in how we gather deposits. These core fundamentals, as well as other factors, have translated to a solid quarter and steady progress on our three-point plan to improve profitability going forward.

As I mentioned before, our plan to achieve an acceptable ROTCE is based on three key areas -- net interest margin expansion, expense reduction, and regulatory normalization. And the bottom of slide 3 is our quarterly report card in these three areas. Our three key metrics for NIM expansion continued to improve in the third quarter. Net financing revenue was up 17% to $936 million, NIM was up 31 basis points to 2.65%, and Ally's cost of funds decreased by 50 basis points to 1.88%.

Our expenses continue to come down. And importantly, our adjusted efficiency ratio improved to 49% this quarter, down from 59% last year.

And lastly, we continue to experience incremental progress in achieving a more normalized regulatory environment for the Company. Most recently, with the support of our regulators, we conducted a tender offer for $750 million of legacy high-cost debt, and we think there is more progress to be achieved in liability management in this area in the future.

The progress Ally has been making on its three-point plan is generating significant levels of incremental capital, and we aim to redeploy some of this capital in the future. To anticipate a question, we have no specific plans for that redeployment at this moment. We are studying alternatives, and almost any scenario we are likely to embark on will require approval under the CCAR process.

To sum up, we are pleased with the quarter and with the progress on our longer-term plans. With that, let me turn to Chris Halmy for a more detailed account of results.

Thanks, Mike. Let's look at the details of the financials on slide 4. We had a really great quarter with various aspects of the results coming in favorable to what we had been expecting. Core pretax income excluding repositioning items was $467 million in the third quarter, up from $271 million last year and $417 million last quarter.

Let me take you through some of the drivers. Net financing revenue of $936 million was very strong and up $135 million year over year and up $24 million from last quarter. The significant year-over-year improvement is driven by combination of lower cost of funds and growth in our earning assets. The quarter-over-quarter improvement was driven primarily by lower cost of funds offset somewhat by lower lease revenue. Other revenue of $375 million was fairly flat year over year and quarter over quarter and provision expense of $102 million was down year over year due to an improved outlook on our forward retail auto credit losses.

We still expect credit losses to increase from current levels, but we don't expect them to increase as much as previous estimates. So we needed to bring our retail auto allowance down by $36 million this quarter. The quarter-over-quarter increase in provision was driven by seasonally higher charge-offs as well as the mortgage release last quarter that didn't repeat.

Total non-interest expense of $742 million was down $14 million year over year and $63 million quarter over quarter. The significant drop quarter over quarter was due to high weather losses we had in 2Q. I will cover more on expenses in a minute.

So overall, these results drove $423 million of GAAP net income, which includes $130 million of income from discontinued operations. Disc ops income was elevated by a one-time tax true up related to the sale of our mortgage business last year that came through during the quarter. After taking out $67 million of preferred dividends, this results in GAAP earnings of $0.74 per share, which obviously drives a nice increase in our book value this quarter to around $29 per share. We provide a walk here to our adjusted EPS metric of $0.53, which we view as being a very strong quarter. Adjusted EPS backs out the $0.27 for our discontinued operation results and adds back $0.06 for OID expense.

We have also highlighted on the page some of our other key metrics. Our unadjusted return on tangible common equity for the quarter was 10.3% with core ROTCE of 9.1%, up nicely both year over year and quarter over quarter. From an efficiency ratio perspective we stayed flat at 49% this quarter, not far from the mid-40s where we plan to exit 2015. So overall, a very strong quarter across the board.

Let's turn to slide 5 and we will look at the results by segment. I'll go through the details of each of these are segments in a minute so I'll just hit a few highlights here. Auto finance pretax income of $415 million was up $76 million year over year, given portfolio growth, strong lease performance and lower provision. Quarter-over-quarter results were impacted by lower net lease revenue as used car prices moderated and provision was up seasonally, both in line with our expectations.

Insurance, with pretax income of $60 million, rebounded from a disappointing second quarter as we had seasonally lower weather losses. Mortgage and corporate and other were both roughly breakeven this quarter. The significant improvement in corporate and other was driven by lower corporate cost of funds.

Let's turn to net interest margin on slide 6. Looking at the year-over-year trend, NIM was up 31 basis points as our cost of funds declined 50 basis points while our earning assets yield went down only four basis points. Quarter over quarter, our asset yield dropped 18 basis points due to lower lease yields, as expected. But that was more than offset by a 21-basis point decline in cost of funds. As we've said in prior quarters, we still expect used car pricing to continue to moderate, and thus we would expect to asset yields come down again in the fourth quarter. To mitigate the decline in asset yields we expect cost of funds to continue to decline meaningfully over time, which we discuss more on the next slide. So let's turn there.

We have added this slide this quarter to provide more transparency into the liability structure and detail the progress we have made as well as the opportunity for continued improvement. The top table shows the progress we have made since the end of 2012, when we embarked on the process of refinancing the balance sheet. Looking at the top line in the table, during 2013 and 2014 we reduced our high-cost unsecured footprint by $11 billion, taking it from $28 billion to about $17 billion today. And we have only refinanced a portion of that, which has brought the entire unsecured footprint down by over $9 billion over the last two years.

Looking into the future opportunity, we still have about $17 billion of what we consider to be high-cost legacy debt, which we define as having a coupon of over 5.5%. We detailed those securities in the table on the bottom. You can see we have a few maturities in December, February, and April that will mature naturally and result in decent cost of funds reductions.

And importantly, we have begun to attack the longer-dated maturities with our first to tender offer that closed earlier in the fourth quarter. We expect that would be the first in a series of transactions designed to utilize excess capital to improve profitability and drive long-term, sustainable EPS improvement. And not listed on this page are the Series A and Series G preferreds, which carry an 8.5% and 7% dividend load, respectively. That results in about $270 million of preferred dividends a year, and we have talked about addressing those as being another long-term opportunity to improve EPS. So there's a lot of potential here, and this will be an ongoing process over the coming months and years.

Moving on to slide 8, let's discuss deposits. As you'll see in the top right corner, retail deposits grew by $800 million in 3Q and are up 12% year over year. We have had good success this year in our deposit business with bringing both interest expense and noninterest expense down at the same time we continue to consistently grow our deposit and customer base. Ally Bank continues to rack up the awards. And importantly, we were recently named MONEY Magazine's Best Online Bank for the fourth year in a row as well as being recognized by Kiplinger's Personal Finance as the Best Online Bank.

The true franchise that we've built at Ally Bank should position us well to hold our rates steadier for longer in a rising interest rate environment as we compete more on service and customer experience versus purely rate, like some of our direct bank competitors.

Let's look at expenses on slide 9. Controllable expenses declined $19 million year over year, given overall streamlining of the Company. Year to date, we're down a total of $128 million from 2013. Quarter over quarter, we were up a bit as expected, given the equity compensation revaluation in the second quarter that didn't repeat. Like we said last quarter, there can be variability on a quarterly basis but we continue to make progress over time towards our efficiency ratio target.

Another thing to keep in mind is that we continue to invest in the core businesses, particularly as originations have come in stronger than expected. And we have also invested in our servicing operations, which has helped keep our credit costs lower. The significant quarter-over-quarter decrease in other noninterest expense to $273 million was driven mostly by a decline in weather-related losses this quarter.

Let's turn to capital on slide 10. We generated some good capital organically this quarter with $356 million of that income to common, which resulted in our Tier 1 common ratio increasing 30 basis points this quarter to 9.7%. Again, we view the capital we are building now as excess capital that we can redeploy over time, particularly as we get through the next CCAR process.

Let's move to asset quality on slide 11. In the upper left corner, consolidated charge-offs increased seasonally to 60 basis points, which was really driven by our retail auto charge-offs shown in the bottom right. Retail auto net losses increased to 93 basis points this quarter, in line with seasonal expectations. Remember that from a charge-off perspective the second quarter will typically be the lowest; fourth quarter will be our highest; and the first and third quarter should be in between. We continue to expect charge-offs to increase on a year-over-year basis from here, and we are maintaining around a 1.2% coverage ratio on the retail loan book.

In the bottom left corner, our second-quarter delinquency rate increased to 2.28% due to seasonality as well. Delinquencies are a point-in-time measure and typically increase from March 30 to December 31. Year-over-year delinquencies were up 18 basis points, which is consistent with our expectations and normalization of our portfolio. I should mention that we did execute an off-balance sheet securitization of higher-quality loans this quarter that resulted in our delinquency rate being about six basis points higher than it otherwise would have, largely due to a denominator effect.

Finally, our commercial order book is shown in the top right, where we once again had negligible losses for the quarter. Overall, the takeaway here is that asset quality continues to perform in line or better than expected, investments that we've made in servicing and risk managements are paying dividends, and our expectations as we look forward have actually improved from our expectations earlier this year.

Now let's turn to slide 12 and go through the segment results, starting with auto finance. We reported pretax income of $415 million, which is up $76 million year over year but down $46 million from last quarter. Net financing revenue continues to be strong at $850 million. This is up 6% year over year, driven primarily by portfolio growth and lease performance. The quarter-over-quarter decline is driven largely by lower net lease revenue, which you can see was down $25 million quarter over quarter.

Since used car prices and impacts to our net lease revenue are such hot topics, we added some additional disclosure down on the bottom right of the page. Here we show our internal used vehicle value index. And as a little background, this is an internally developed index based on our used vehicle performance as well as data from other external sources. We feel our index provides several benefits versus other publicly used indices including it is much more representative of Ally's portfolio mix, it allows for greater analysis of individual collateral, and we update it weekly versus monthly to more frequently capture movements in the market.

In the chart you can see how used vehicle prices have performed over time and our expectation through the end of 2016. As we have previously mentioned, our expectations are that used vehicle values will decline a little over 10% over the next two years, during which time we expect our leased portfolio to remain solidly profitable but just down from today's elevated levels. It's very important to understand that we expect these declines, and we have baked them into our forecasts and residuals setting process as we underwrite new leases. So obviously, used vehicle price-performance relative to our expectations is the key factor to keep in mind. And it's also important to note that used car prices are seasonal, so they will be nominally weaker in the fourth quarter and higher in the second quarter.

We also thought that it would be helpful to give you an estimate of our forecasted annual lease terminations. I will caution, however, that while we do our best to forecast these volumes, actual terminations may vary due to origination levels and potential OEM pull-ahead programs, which can affect the timing.

Now on to provision, which was down year over year, driven by a decline in our expectations for future credit losses, as I discussed earlier. Again, just to be clear we are still expecting losses to tick up in the portfolio, just not quite at the same magnitude as previously estimated. On a quarter-over-quarter basis, provision was up mainly due to seasonally higher charge-offs in 3Q. Asset balances were up 7% year over year, but we had a slight decline quarter over quarter as our strong consumer origination levels were offset by seasonally lower floor plan balances, and we also completed a $1.6 billion off-balance sheet securitization in the quarter.

For the origination discussion let's flip to slide 13. As Mike mentioned earlier, we had a very strong quarter with $11.8 billion, up both year over year and quarter over quarter. These origination levels are driven by strong performance across multiple channels, as shown in the top left chart. In the GM space we saw strong originations and increased penetration as a result of incentive program they ran this summer. We continue to be a major player in the Chrysler channel with our penetration slightly up this quarter, and our growth channel originations were up 54% from the prior year.

In the top right you can see the pop in subvented business, driven by the incentivized programs GM ran in the quarter. And it's notable that we had our second straight quarter of record used car loan originations. From an asset quality perspective -- we don't have it on the page, but our FICO mix skewed a little bit towards the prime end of the spectrum this quarter with our subprime mix dropping below 9%. In the bottom left you can see that our origination levels continue to drive modest consumer asset growth despite our off-balance sheet securitization. And in the bottom right, we show our commercial portfolio, which averaged $31.4 billion this quarter, up nicely year over year, but down a bit seasonally quarter over quarter.

Now, let's turn to insurance on slide 14. Our insurance business reported pretax income of $60 million this quarter, down $23 million year over year but up $83 million from last quarter. The main driver of the results both year over year and quarter over quarter is obviously the weather-related losses in our dealer floor plan insurance business. On a year-over-year basis weather-related losses were up slightly but mostly offset by lower vehicle service contract claims, which you can see on the bottom left of the page. As we have discussed, Q2 is a seasonal high for these losses so you saw that number come down quarter over quarter. Investment income remains strong at $53 million and written premiums were steady both year over year and quarter over quarter at $265 million.

Over on slide 15 we show results for both mortgage as well as our corporate and other segment. Mortgage reported a pretax loss of $3 million, which is up slightly year over year but down from the prior quarter. Remember, we had the provision release in Q2, which is the main driver here. Looking at corporate and other, you can see that we had a pretax loss of $5 million, which has improved significantly year over year and quarter over quarter as we have made progress reducing cost of funds and corporate overhead expenses.

So overall, we had a really great quarter across the board and are pleased with the performance of our core businesses and the progress we continue to make towards improving the long-term profitability of the Company. And with that, I will turn it back to Mike to wrap up.

Thanks, Chris. As I said at the start and Chris has certainly explained in detail, we do feel good about the progress in the quarter. Our franchises are showing their underlying strengths. And our key metrics are moving in the right direction.

We know that the path toward our goal of achieving the run rate of 9% to 11% core return on tangible common equity may not be in a straight line. As Chris as described, there are seasonal patterns to our business which investors need to understand.

We are also anticipating that lease revenue will continue to decline as used car prices retreat to normal levels. But we are expecting that this will remain within our expected underwritten levels; and furthermore, we believe that continued improvements to our cost of funds will more than offset these declines. We expect to remain on track with achieving our stated profitability and efficiency goals by the end of next year. And lastly, the U.S. Treasury continues to reduce their common equity holdings in Ally and currently has 11.4% of the stock. The US taxpayer has received $18.3 billion on the $17.2 billion they invested in Ally, over $1 billion more than what was invested in the Company. And they still on the 10.4%, which they will earn an attractive return on.

So thank you for joining the call today. And with that, I'll turn it over to Michael Brown for questions.

Thanks, Mike. 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 call, feel free to reach out to the Investor Relations team. So Sheila, with that we are ready to start the Q&A session.

(Operator Instructions) Sanjay Sakhrani of KBW.

I want to just touch on the yield. Good color on the yield. You guys talk about the fact that it has remained fairly flat despite a competitive environment, but you guys expect some decline in the yield over time. But can you just talk about why it has remained so resilient on a relative basis? Because you hear all sorts of bad stuff about the competition in this space.

And I'll just ask my second question up front. Mike, you have talked about your confidence in the government exiting out of its stake in the Company by the end of the year. Do you still hold that belief?

I'll try to take the first one, around asset yields. One of the reasons asset yields have remained resilient and actually have increased for us during 2014 really has to do with the lease performance. So, since we have actually booked pretty healthy gains on off-vehicle leases, those gains actually flow through the yield, which is actually increased our yield somewhat this year. Now, obviously our expectations is that used car prices will continue to come down; and therefore, the gains that we have experienced during 2014 on the off-lease vehicles will continue to come down and, therefore, will affect the overall yield. So I expect our normalized yield to come down.

But on both the retail and wholesale side, we continue to be competitive, but we continue to be able to hold our market share due to the relationships that we have with the dealers and we're able to really hold the overall yields on some of the other programs. So while I would lead everyone to believe that asset yields will continue to come down because of the lease performance, I do expect that over time, particularly given the large unsecured debt maturities we have in 2014, that cost of funds will more than offset that as we look out over the next year or 18 months.

Do you want to answer the Treasury?

Yes. Sanjay, let me try to answer the Treasury question. I'll be the first to say I had expected that we would be making more progress on that front than we have or they have. I would point out that this is not something we control or influence; it's absolutely their decision. I would also point out that they have absolutely no operational involvement or influence on the Company. It's purely limited to having the ability to select one board member. So at this point I look at them as a 10.4% shareholder who does not have a long-term objective of owning the stock. And I hope we will see an accelerated exit. I don't control it.

Thank you.

Eric Beardsley of Goldman Sachs.

Just on the consumer auto reserves, I was wondering if you could share a little bit more color as to what you are seeing there in terms of the relatively better expectations that caused you to lower the allowance.

Yes; there's a couple dynamics there. One is, particularly during the last couple of quarters, we have been exceeding our origination, some of our origination targets. And a lot of that has to do with higher-quality loans that we continue to put on the books, some of that driven really by the incentivized programs, which tend to attract a higher credit quality customer. So our book is skewing a little bit towards the higher credit quality, which will bring losses from a percentage basis really down.

But then, overall, we did expect losses really to be higher as we sit today and we look out over the next year than we are actually experiencing. Some of this is obviously driven by an improving economy. And therefore from an accounting perspective when you look at your expected next 12 months of charge-offs, it created a need for us to release some of the allowance this quarter. So --

Got it. And then just as a follow-up, would you say that you are competing more on price today or specifically in the third quarter than you were earlier in the year?

It's J.B., Eric. I'd say, you know, look, the environment remains still hypercompetitive, particularly in the super prime space. But I think where we excelled this quarter again with our service model and the ability to continue to rollout national campaigns. As I think Chris mentioned during his remarks, GM did run a number of programs throughout the third quarter. Our subvented volumes were up about $1 billion from where they have been running. And I think that speaks to our capability of when the manufacturer, when a manufacturer wants to put a big program out and in place, we can do it. So pricing is still ultracompetitive. But I think what you will really see come through this quarter is really the strength of our ability to execute.

I don't think during the year we have seen any evidence of increasing price competitiveness is the way I would describe it. I think it has been continuously competitive but not getting worse. And in fact, I think to some degree in the third quarter we saw some competitors back off a little bit.

Great, thank you.

Don Fandetti of Citigroup.

Yes. So I was wondering if you can talk about the commercial floor plan market share. It looks like it dipped down a little bit. Definitely there's a seasonality, but from a market share perspective, can you talk about what the outlook is there and if the competitive framework has changed? And then secondarily, if you could just walk through the quarter-over-quarter decline in funding costs. It seemed to be a little bit more than we had expected.

Yes. So, Don, on the floor plan penetration levels are still running for us mid-60s with respect to GM dealers and then mid-40s with respect to Chrysler dealers. And I think that has largely been consistent from where we have been at the past year or so. You do get small fluctuations in place. The one nice thing we have seen, and obviously we report the information, that floor plan dealer count has continued to come down. We actually saw that stabilize this quarter.

But I don't see any major changes there. I think we continue to have excellent delivery for our dealers. We see our dealer relationships strengthening rather than weakening. But you do see a lot of regional banks out there offering very aggressive rates to try to capture floor plan relationships. And again, our model is not to just compete on the price but come back to have a service offering that takes care of the dealers.

But when I look at the numbers I don't see any major change in penetrations with the two big OEMs that we are in place with today.

On the cost of funds side, to that question, really the biggest driver of that drop has to do with the zero coupon bond. The zero coupon bond that we tendered for at the end of the second quarter did result in an upfront payment of about $30 million. So if you think about both interest expense associated with that bond as well as the premium we really paid or the difference between the face and the book there, that really drove the quarter-over-quarter differential in cost of funds. So not having the zero coupon bonds, not paying that premium really drove a much lower cost of funds in the second quarter.

Thanks.

Cheryl Pate of Morgan Stanley.

Congratulations on a strong quarter, and we really appreciate the additional color on the leasing volume terminations. Just to that point, I'm wondering if you can share some color as to the portfolio mix within the leasing portfolio by car type versus truck, perhaps, to give us some idea of the sensitivities within the portfolio.

Yes. We have a pretty well diversified portfolio. And Cheryl, it's important for us to keep a diversified portfolio. So it's something that we consciously do because there is obviously different movements in car prices and truck prices at different times. To give you a little bit of the mix, today we are about 60% truck SUV and about 40% cars. So to give you just a little color on the dynamic there, as you are seeing gasoline prices come down, what we are seeing is we are seeing better demand on the truck and SUV side and we are seeing less demand on the car side. Obviously, that will flip back and forth, which is why it's very important for us when we write leases today to make sure that we have a diversified portfolio mix.

The other comment I would make, Cheryl, is -- this is probably not obvious to people, but we look at residuals and we do so and we project on an individual model basis, and in that process we not only look at the vehicle, we look at what the manufacturer's strategy is vis-a-vis the vehicle in terms of promotion, we look at how the vehicle is behaving from an aftermarket reliability, et cetera, point of view. So we, within the overall mix, try to understand what's going on in the used car market. We literally are making pricing decisions and underwriting decisions on a model-by-model basis.

And please tell Betsy that we heard her loud and clear.

I appreciate the color on that. And then just secondly, as a follow-up, I appreciate the color on the liability management and quantifying the 5.5% plus high-cost debt and obviously saw some tendering earlier, last month. Just wondering if you could speak to maybe the opportunity there to continue to be proactive in calling that and particularly tying that as a potential offset to some of these used car pricing declines, which are already well embedded in your expectations.

So a couple things on that, which is we obviously have some big maturities in 2015, particularly in the first half, which will naturally mature, which will help overall cost of funds. So, while I don't necessarily expect to see a big cost of funds reduction over the next quarter or two, by the time you get into the middle of next year, because of some of those big unsecured debt maturities you will see a much bigger cost of funds reduction middle of the year next year.

But ahead of that and in really conjunction with utilizing some excess capital, you should expect that we will continue to do tender offers, to the extent that it makes economic sense for us to go ahead and do some of that. So the CCAR process continues to be an important process for utilizing capital and our expectation is that we will attempt to embed some type of capital usage for liability management on an ongoing basis into the next submission.

All right, great. Thanks very much.

David Ho of Deutsche Bank.

Just wanted to get a better sense of the trajectory of the credit provisioning from here. Obviously, adjusting for seasonality, can we expect the more favorable outlook to impact the reserve in future periods? And just remind us when do peak losses occur and when might you see some of the impact of the stronger, more recently stronger vintages and originations hitting the provision?

Yes, and it's always important to understand the seasonality. So the second quarter will always be the lowest quarter from a charge-off perspective and the fourth quarter will always be the highest. Now, from an overall -- from an overall charge-off rate perspective, our expectation is 2014 on an annualized basis will be somewhere in the low to mid-50s. Now, we do expect that to go into the 60s and eventually into the 70s out a couple of years from now. What will drive that is a charge-off rate associated with the retail auto loan book, which as we previously said, will on an annualized basis really go through 1%. Today it's below 1% but next year and the year after we would expect it to get through that 1% level.

So we don't expect, particularly on the retail auto loan allowance, we don't expect future allowance releases. We expect to continue to build allowance associated with a higher charge-off amount. But obviously, we look at this every quarter and we look at what our next 12 months projections are going to be. We have been positively affected by where charge-offs are in our outlook so we take that as a good thing.

Okay. And just following up on the funding cost, have you contemplated the possibility of ratings agency upgrades over time? Obviously, the ROA needs to go a little higher, a little reduction in the regulatory and government impact. But is that a possibility? And was that contemplated in some of the comments you made earlier?

Yes, great question. At the moment when we forecast out what our unsecured debt is going to be and the overall effect on the cost of funds, we are not baking into our forecast any type of significant upgrade. So to the extent that we do get upgraded, particularly through the investment-grade space, there could be potential upside associated with that. But I never like to bake into forecasts something I can control.

Great, thank you.

Rick Shane of JPMorgan.

You guys have explored this conversation or this topic with David and Eric, but I would love to delve a little bit more into the reserve release. Basically what you guys said was that the expectations of future losses are going to be a little bit below what you had previously assumed. I'd love to think about this in terms of what you've seen, is this a backwards-looking thing that you are just coming off of a lower charge-off rate, or are there forward indicators, macro indicators, that give you confidence in that?

And then one level deeper, which is do you see this as a frequency of default variance or a severity of default variance?

Yes, so a little detail. It's mostly forward-looking, so we are looking at really next 12 months and our expectations of the next 12 months. Some of it has to do with our portfolio mix that's skewing towards a higher quality, a higher FICO type loan. And when we look at the overall coverage ratio, if you think our coverage ratio, particularly on the retail auto loan, which is the loan class which is the driver here, we have about 1.2% coverage ratio to this, and we have a loss rate that is below 1% today. So, we are just well covered.

And obviously we have to abide by GAAP, and from an accounting perspective you need to make sure that your reserves are adequate but also accurate for the next 12 months. So as we look out the next 12 months we just don't expect a significant increase in the overall charge-offs. Do we expect it to continue to tick up? Yes. But overall, we feel very comfortable where our coverage ratio is and we really don't want to increase that coverage ratio until we start seeing a bigger increase when it comes to the actual charge-offs.

Now, to your question on frequency and severity, a lot of this is really going to be driven more on the frequency side than the severity side because we do expect used car prices to continue to come down, which will affect severity over time. So having said that, the biggest driver will be on the frequency end.

Great. Hey, Chris, that's helpful. I'll leave it at that. Thank you very much.

Moshe Orenbuch of Credit Suisse.

Maybe just to talk a little bit about the lease gains, they came down in line with what you had projected three months ago. Could you talk a little bit about how that line will develop in the forecast that you set out? Does it go down to zero? And maybe how that impacts the returns in that business?

I always try to focus everybody on the net lease revenue because net lease revenue really is the driver because when we look at, particularly from an accounting perspective, if we do our depreciation and forecast our depreciation correctly, you really will have no gain or loss from a lease perspective. So, we are obviously experiencing gains and pretty high gains this year because we didn't expect used car prices to be as high this year from a depreciation perspective.

So when I -- the important thing to understand also, related to leases, is that there's a real seasonality effect as well, both from a terminated units perspective as well as from a price. So, we normally see used car prices the highest in the second quarter. People get tax refunds, the springtime is coming, the weather is better. People -- unemployment gets better at that time. So you tend to see better used car prices in the springtime than you will see over the winter months.

So when you look at the overall net lease revenue and particularly what comes through the gain line, you'll see some fluctuations, particularly in the fourth quarter and the second quarter, which will be a little bit more dramatic because of the way used car prices will go up and down. But our expectation over time is that when you look at the overall net lease revenue this quarter that will continue to come down. But our expectation is that leases will continue to be a very profitable asset class for us moving forward.

Maybe just a quick follow-up -- could you talk a little bit about what the costs are of origination? How should we think about the interplay between originations this quarter being really strong and expenses? How do those two relate to one another?

There's a pretty big component of what I would call fixed cost there. So there's not -- from an originations perspective there's not a big variable cost that will drive expenses up. Now, having said that, though, when you have higher originations you tend to -- we will tend to have higher servicing costs, particularly on the lease side, because you need to do something with the car when it comes back. So higher originations will drive higher expenses later on, on the servicing side, but from an origination perspective doesn't really drive costs up in those current quarters.

Great, thanks very much.

Kirk Ludtke of CRT Capital Group.

A big picture question -- you've got this huge opportunity to reduce funding cost, and I'm sure it makes sense to lock it in before rates go up. I know it's hard to anticipate regulatory approval. But how long does it take? How many years does it take you to address the $16 billion of high cost of debt and the Series A and G preferreds?

We are not going to address the whole $16 billion or $17 billion. There are things like large OID associated with some of those bonds which would not make economic sense necessarily to take them out. But what I would say is that over the next couple of years, meaning through 2015 and 2016, the expectation is that we will get through -- will get to a much more normalized capital stack and funding structure, due particularly to the excess capital that we are generating today. So there is real opportunity over the next couple of years and then I think it starts to wane a little bit.

Great, thank you.

I would add one thing to that, which is both with regard to the zero coupon deal we did a while ago and also the bonds that we repurchased very recently, both of those required regulatory approval. From a regulatory point of view, actions which improve the safety and soundness i.e. profitability of the Company tend to be attractive from a regulatory point of view. So we have been able to get a couple things done outside of the CCAR process, but the CCAR process, which literally began this week, is really the next opportunity to have a serious dialogue with the regulators on what can we do next.

Great, thank you. That's helpful. And along the same lines, the average retail portfolio interest rate continues to trend down. There still seems to be some room here for some improvement, given where other banks take deposits. Assuming no change in interest rates overall, how do you see this trending? Do you see it as a major opportunity or do you think it will level off here?

You are talking about the cost of deposits to us?

Yes.

I would make a couple observations. We are in a transition. All right? So, we started building Ally Bank in 2009 and have invested a great deal of money in building what we think is a great franchise. It's got significant brand recognition. It's got tremendous consumer appeal. And it keeps getting recognized for the state of the art of its systems and so on and so forth.

I think at this point we feel like we've built the franchise. And the question really is one of optimizing the franchise at this point. And if you look at the numbers, as the franchise has continued to grow the operating efficiency side of things has improved quite dramatically. And the question is, what can we do on the cost of funds side?

And we basically, this year, have turned our attention, if you will, to optimizing that as well. So we have already made some significant changes. For example, we had an incentive for renewal which was significant. That has been reduced during the year. So we actually have the view that we can make the deposit franchise more efficient. Chris will tell you that today securitization and the bank are about a wash in terms of fundraising.

We think in a different environment and a rising rate environment that the bank is going to be a much more productive source of funding. And we believe that as rates rise the experience that we are likely to have in terms of the need to raise rates is going to be more consistent with the bank that has a true franchise than it is with a bank which is more hot money.

And so I think we believe that not only is Ally Bank a tremendously important strategic asset from a funding the Company point of view, but in fact it actually represents a meaningful upside on a go-forward basis in terms of our overall cost of funds.

Can I just add a comment, Mike?

Sure.

You will see Ally Bank continue to be in the competitive zone of direct banks on our pricing. That is our value promise to our customers. The question is whether you are at the high-end of that zone or at the low end of that zone. We believe and have done a lot of research and see day in and day out that the majority of our customers want us in the competitive zone and don't want to wake up surprised that we've dropped rates hugely, dramatically. They want to feel good about the banking relationship, but the vast majority of them don't want to have to look at the rates every single day.

And so, we are just much more conscious and intentional about how we do that. And frankly, we are not very interested in attracting people who change banks for the last basis point. Those won't actually be helpful to us in the years ahead. So, we are quite comfortable with how it has been proceeding and feel very good about it.

Great, thank you very much.

And Sheila, we have got time for one more question this morning.

Ken Bruce, Bank of America Merrill Lynch.

My question relates specifically to the mortgage portfolio. You are not making any money in that business. Obviously, you are losing a little bit. It's not much but there's quite a bit of capital tied up in those assets. Could you discuss what your thoughts are around that portfolio, what the efficacy of keeping it is at this point or if it's something that you might be able to sell and release some more excess capital to direct into other of your priorities?

At this point we are very comfortable with that mortgage portfolio. We are comfortable with the performance of it. And while the bottom line is pretty much a breakeven segment today, the contribution margin is actually pretty good on this business.

The other thing I would say is we have -- selectively it will be in small amounts, currently have bought a couple of pools of mortgage loans. And we think over time we will have opportunities actually to replenish some of this portfolio and make it more profitable over time. So it's a portfolio we like. And while it's a breakeven segment today, like I said, it is a pretty good contribution margin and our expectation is that it will continue to improve over time. And it's a business we want to be in, particularly from an investment purpose.

Okay. And moving on to something you addressed in some part, but I would like to understand a little bit around the priorities for capital management and the Series A and G. Obviously, there's quite a bit of controversy as to what the priorities are for dealing with that or what the issues are that are going to impact your decisions around that. And I'm hoping you could maybe tease out as to, in the -- as you consider things like upgrades, as you think about excess capital usage and CCAR and safety and soundness, all these different issues are going to impact how you deal with that particular series of high-cost debt. If you could give us any insight into your thinking, that would be very helpful.

Yes. Hopefully, it's not too controversial. But listen, we obviously have CCAR coming up. We are running our stresses, which will take the next month or six weeks to get through, which will give us a pretty good indication of the amount of capital that we will look to redeploy through this next CCAR process.

When it comes to both a Series A and a Series G perspective, we think about them very differently, meaning one, as in the Series G, really affects the Tier 1 common ratio. The Series A really affects the total capital, the Tier 1 capital level. So when we think about the two securities, they really touch different areas of the capital.

I think we have been pretty public to say that when we look at the preferred stack, meaning both Series A and our TruPs and a little bit of Series G, that we have probably too much from preferred perspective. Our restrictor really is on the Tier 1 common side of the equation. So the expectation is that we will deal potentially with both securities over the next couple of years. Series A becomes callable out in 2016, is not callable in 2015. That doesn't mean we can't look at it more like a debt security and look at potential tender offers. It's something that's on the table. But because those two securities really affect different parts of the capital stack, we think about them differently. And then overall, I would say that we want to deal with both of them over time.

Okay, thank you.

I would now like to turn the call over to Michael Brown for closing remarks.

Great. Thanks again, everyone, for joining us this morning. If you have additional follow-ups, feel free to reach out to Investor Relations. Thanks, Sheila.

Thank you for participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.