H & R Block Inc (HRB) 2007 Q1 法說會逐字稿

Good day ladies and gentlemen, and welcome to the H&R Block first quarter earnings conference call.

My name is Melanie and I will be your coordinator for today.

At this time, all participants are in a listen-only mode.

We will conduct a question-and-answer session at the end of this conference. [OPERATOR INSTRUCTIONS] And as a reminder, this call is being recorded for replay purposes.

I would now like to turn the call over to Mr. Scott Dudley, the Assistant Vice President of Investor Relations.

Please proceed, sir.

Thank you.

Good afternoon.

Appreciate you joining us for our first quarter results call for fiscal 2007.

On the call today are Mark Ernst, Chairman and CEO, and Bill Trubeck, Executive Vice President and CFO.

They will each have some comments on our quarterly results and then we will open up the call for questions.

At that time, Bob Dubrish, President of Option One Mortgage, will also be available to answer questions.

To start, let me read our Safe Harbor statement.

Various comments that we make include certain estimates, projections, and other forward-looking statements.

The words will, plan, estimate, approximate, project, intend, remain, expect, believe, and variations thereof and similar expressions are intended to identify forward-looking statements.

These statements speak only as of the date on which they are made and are not guarantees of future performance.

Actual results may differ materially from those expressed, implied or forecast in the forward-looking statements.

Some factors that could cause actual results to differ include the uncertainties that the Company will achieve its revenue, earnings and earnings per share expectations for fiscal year 2007 or any quarter thereof and that actual financial results for fiscal year 2007 or any quarter thereof will fall within the guidance provided by the Company, the uncertainty of the impact and effective changes in the non-prime mortgage market including changes in interest rates, loan origination volume and levels of early payment defaults, changes in the Company's effective income tax rate, changes in economic, political, regulatory or competitive environments, the inability of H&R Block subsidiaries to successfully expand their businesses, litigation involving H&R Block and its subsidiaries, the uncertainty of the Company's ability to purchase shares of its common stock pursuant to its Board of Directors purchase authorization and other risks described from time to time in H&R Block's press releases and Forms 10-K, 10-Q, 8-K and other filings with the Securities & Exchange Commission.

H&R Block undertakes no obligation to publicly release any revisions to forward-looking statements to reflect events or expectations after the date of these remarks.

H&R Block provides a detailed discussion of risk factors in periodic SEC filings and you're encouraged to review these filings.

You should not that in conjunction with today's call there is an accompanying slide presentation which is posted to our Web site at www.hrblock.com.

In addition, a copy of our prepared remarks will be posted to our Web site shortly after the conclusion of this call.

I will now turn the call over to Mark Ernst.

Thanks, Scott.

Before discussing our results, let me note that H&R Block's annual shareholder meeting will take place a week from today on September 7th at 9 a.m.

Central time in Kansas City.

For shareholders who are unable to attend, we'll be providing a webcast of the meeting which will be accessible at hrblock.com.

Turning to results, I'll begin with an overview of our first quarter performance and then discuss the details for each of our segments.

Bill is going to follow with comments on our financial position and I'll conclude with the outlook for the remainder of the fiscal year.

Our first quarter results, a loss of $131 million, or $0.41 per share is larger than expectations, both ours and investors, due to recent developments in the mortgage business resulting in the recording of a larger provision for losses related to mortgage loan repurchases and premium recapture.

This provision is for expected losses on our first quarter loan production as well as loans originated and sold in prior quarters.

We experienced a significant and unanticipated increase in loan repurchase requests from investors as first payment defaults accelerated in July after being essentially flat since April.

This negative development overshadowed the results of the other segments which were in line with our expectations.

While there's evidence that the entire non-prime mortgage industry is experiencing higher repurchase requests, this is not a situation where misery loves company.

Option One's origination volume stabilized to about where we thought it would, and we continue to achieve greater cost savings.

However, the impact of the additional reserves led to a pretax loss of $5 million for the mortgage segment this quarter.

Tax Services results were in line with our expectations for the quarter.

Retail tax operations drove double-digit top line growth for the segment.

The pretax loss increased reflecting higher off-season costs associated with a greater number of offices.

Business Services delivered solid revenue growth and bottom line results that met our planned levels.

Revenues for RSM McGladrey's legacy business continued to experience good organic growth while its total revenues increased more than 60% over last year reflecting the American Express Tax and Business Services acquisition.

Business Services pretax loss was also higher year-over-year due to the inclusion of American Express TBS and its off-season losses this year.

The new Consumer Financial Services segment, which combines H&R Block Financial Advisors, Retail Mortgage and the Bank, reported a small loss on revenues that in line with our plan.

I'll now discuss the individual segments in more detail starting with Tax Services.

Revenue in the Tax segment grew by more than 15% to $66 million.

The pretax loss of $153 million was 6% higher than the prior year.

This increase is primarily due to the additional off-season costs of the offices we opened last year and costs associated with our current office expansion.

There is also modestly higher compensation and occupancy expenses in our base operations.

As you might imagine, we're deep into planning for the coming season.

As we look ahead, we're focused on two primary areas of execution this year.

First, plans are in place to ensure that our office openings will be executed without technology issues.

Second, we gained additional insights into client demands last year, and as a result we have a number of programs, initiatives and marketing efforts focused on acquiring and retaining clients throughout the entire tax season.

Those of you who have followed our company know that we choose, for competitive reasons, not to discuss in great detail our strategic and marketing efforts at this point in the year.

We look forward to sharing our plans as we get closer to January but we're very focused on being prepared to compete at that time.

Our office expansion for tax season 2007 is currently on track with the plans we discussed in June to add between 300 and 400 new traditional offices.

Last year you'll recall we opened about 750 traditional offices and about 250 new shared locations.

In digital tax we're looking forward to our second tax season under the direction of our new management team there.

With the benefit of a full planning period, we believe we can build upon last season's strong 23% growth in clients using our software and online solutions.

In addition, we believe that the multi-channel approach that H&R Block pioneered, in which clients can use a digital solution to prepare their return and also have access to advice and assistance from tax professionals, represents a distinct long-term advantage over our competitors.

We expect to expand further into this growing market segment.

Turning to Business Services, first quarter revenues increased nearly 62% significantly impacted by the addition of the American Express TBS business, however, our underlying growth remains strong.

Our legacy accounting businesses grew revenue 16% this quarter.

Given the seasonal nature of the tax and accounting business, RSM McGladrey normally reports a loss until the third and fourth quarters.

The pretax loss for this segment was $15 million compared to a loss of $7 million last year.

The higher loss reflects the additional normal off-season losses from the American Express TBS business which is generally more seasonal than our legacy RSM McGladrey operations.

The integration is coming together nicely and we're optimistic about the future for this business.

As I've commented before, RSM McGladrey is well positioned in its market and has a great reputation.

Despite that, the Company's level of brand awareness has room to grow.

We've recently launched a brand awareness campaign including national print media and a prominent PGA/LPGA sponsorship that we announced two weeks ago.

Let me turn to Consumer Financial Services.

This new segment, which became effective on May 1st is comprised of H&R Block Financial Advisors, H&R Block Mortgage Corp. and the new H&R Block Bank.

Due to the aggregation of these businesses within the segment, we won't be providing quite the level of detail around Financial Advisors as we have in the past, but we will provide those key statistics that are important operational measures.

For the first quarter of operations, the segment had $108 million in revenue and an $8 million pretax loss driven by losses from Financial Advisors and H&R Block Mortgage partially offset by profits from H&R Block Bank.

As a result of this reporting change, you'll note that we're also reporting eliminations separate from corporate this quarter.

The level of intrasegment activity between Option One, H&R Block Mortgage and the Bank is now meaningful for financial reporting.

The most notable item is approximately $10 million in gain on sale revenue recorded in Mortgage Services from the sale of mortgage loans to H&R Block Bank.

This reflects the significant volume of loans sold to the Bank from Option One during the quarter.

This earnings elimination will decline from this large amount over the balance of the year.

With the launch of the Bank on May 1st, we began building the balance sheet with deposits, mortgage loans and investments.

Annualized net interest margin, which is net interest divided, revenue divided by average assets, was 3.65% for the quarter.

The efficiency ratio calculated, as non-interest expense divided by total revenue net of interest expense, was 35%.

We earned an annualized pretax return on average assets of 1.15% and ended the quarter with total assets of $567 million.

We expect most of these key measures to further improve as the Bank grows its asset base throughout the year.

At July 31 mortgage loans held for investment were $541 million and we expect to continue to purchase prime quality loans going forward in keeping with our plans to fully leverage the Bank's capital.

H&R Block Financial Advisors utilized the Bank on behalf of certain customers to hold $404 million in FDIC insured deposits.

H&R Block Mortgage now operates as a retail direct mortgage lender through twelve branch locations.

It sells its non-prime loans to Option One.

They originated a total of $844 million in loans during the first quarter with an average loan size of $175,000.

More than two-thirds of this production was non-prime and was sold to Option One with the remaining prime production sold to a third party.

H&R Block Financial Advisors showed steady progress steadily progressed -- steady progress in improving operations.

While the number of financial advisors declined slightly over the prior year, productivity increased due to effective development and recruitment of quality advisors.

As a result, production revenues increased 4% over the prior year.

Transactional revenues, essentially sales of individual securities, declined largely due to market conditions.

Annuitized revenues improved nicely in line with our emphasis on this revenue stream.

Current market conditions are challenging to this business.

We ended the quarter with $31.1 billion in assets under administration, down 2% from the prior quarter but up 4% compared to the prior year.

Moving to Mortgage Services, let me note that these results, along with prior period comparables, will reflect just the non-prime operations.

We now report our retail mortgage unit, H&R Block Mortgage, within the Consumer Financial Services business.

Mortgage revenues for the first quarter were $170 million, down 40% from the fourth quarter, primarily as a result of our incremental repurchase reserves.

As a result, we reported a loss for the quarter in Mortgage Services.

While these results are disappointing, they're reflective of the overall trend in the non-prime sector.

The market is undergoing changes due to changing home price appreciation and interest rate as well as tighter margins for bond investors.

With regard to first payment defaults, let me describe what's happened, explain why the sudden change in investor behavior was hard to anticipate, and outline what we're doing to address the situation.

As announced last week, we booked substantially larger loan repurchase provisions in the first quarter.

We added approximately $85 million to our repurchase reserves in addition to the traditionally assumed loss accrual of about $17 million related to repurchase activity for loans sold into the secondary market as well as for premium recapture.

While first payment defaults for us and the non-prime industry did rise somewhat during the quarter, the more significant impact arose from an increase in repurchase requests from whole loan buyers.

This action was especially pronounced in July, the last month of our fiscal first quarter, when first payment defaults increased to 3.82% and our actual and expected repurchases increased significantly.

This sudden shift caused us to evaluate the adequacy of our reserves for this quarter, the estimated remaining exposure from prior quarters, and the loss assumption that we used in our pricing decisions.

We made a number of modifications to our operations and products to counter the impact of this trend now and to improve loan performance and profitability for the future.

Based on our assessment of existing products and borrowers that have shown the greatest incidents of defaults, we're enhancing our underwriting, pricing and collateral guidelines.

We believe that these enhancements will better align our risk with our pricing, however, we do expect to experience some continued near-term repurchase activity from prior originations which we have now accounted for in our reserves.

First quarter non-prime loan production volume was $7.2 billion.

Option One also purchased $584 million of non-prime loans from H&R Block Mortgage for a combined volume of $7.8 billion.

That represents a decline of 26% year-over-year and a decline from $8 billion in the fourth quarter.

The non-prime originations from H&R Block Mortgage are included in total Mortgage segment volumes and are shown as intrasegment.

The average non-prime loan balance for the quarter was $205,000, up from $194,000 in the fourth quarter of fiscal 2006.

Our average non-prime loan balances today are 23% higher than they were a year ago.

FICO scores for our non-prime originations averaged 614, nearly flat compared to the fourth quarter while loan to value moved up about 2 percentage points to about 83%.

Interest only loans as a percentage of originations were 12% while 40-year loans comprised 33% of our overall production.

This is similar to the product mix in the fourth quarter of last year.

Just a reminder that we do not originate option ARMs, also referred to as negative amortization loans, which can result in higher financial stress for the borrower and potentially more problems for the lender.

Turning to rate changes, our increase in funded WACs outpaced the change in the two-year swap.

We increased our funded WAC by 17 basis points to 8.68% since the fourth quarter.

However, or excuse me, meanwhile the two-year swap rate moved up 9 basis points to 5.40% at the end of the first quarter.

Our net gain on sales gross margin declined to 81 basis points compared with 192 basis points in the fourth quarter of 2006.

This includes hedge gains of $13 million, or 16 basis points during the quarter reflecting interest rate changes and our policy of hedging our production pipeline.

Net gain on sales gross margin would have been 191 basis points absent the additional 110 basis points of loan loss reserves that we announced last week.

The value of retained mortgage servicing rights on loans originated and sold during the quarter was 64 basis points, down slightly from 68 basis points in the fourth quarter of 2006.

During the quarter we sold nearly 90% of our non-prime loans to the whole loan market with the remainder being securitized.

For the first quarter our costs of non-prime origination was 141 basis points, a bit better than the fourth quarter of 2006.

We saw a larger dollar decrease in costs than would appear from a basis point perspective as the benefits from staffing reductions, the technology implementation that we've discussed recently, are somewhat obscured by the higher volumes this quarter.

We continue to implement process improvements to leverage the benefits of the staffing and technology changes that we've made.

We expect to more fully benefit from this improved cost structure in the second quarter.

For purposes of understanding the underlying business performance and profit characteristics, it's usual to normalize for many of the moving parts in the business.

To illustrate, Slide 14 in the slides that we provided with this call, shows the key impact to margin this quarter.

We were operating at an origination margin level of about 88 basis points which was near the top end of the range for where we expected to be.

Prior to reporting the 26 basis point increase above what we previously assumed in loss reserves for the first quarter, and an additional 12 basis points for the recapture of premiums, as well as adjusting our loss reserves for prior quarter's production, we recorded 72 basis points of additional reserve and ended the quarter with a net origination margin of negative 22 basis points.

Servicing remained a bright spot in our mortgage operations.

Option One servicing portfolio at quarter end was $74.5 billion, up about $1 billion from the previous quarter.

Servicing revenue increased 7% sequentially to $109 million for the first quarter.

Servicing expenses also increased reflecting higher amortization of mortgage servicing rights related to the increase in the originated loan servicing portfolio.

Overall, servicing pretax income improved more than 60% over the fourth quarter to $21 million.

We've said for some time that we believe that the quality of our servicing is an advantage for us, and that it helps us set us apart in the industry.

We also believe that this platform will add even more value as we work aggressively to secure loan defaults.

Long-term loan performance trends remain positive despite the uptick in first payment defaults.

Twelve-month seasoned and beyond delinquency rates were 11%, down from about 12% last quarter.

As the changing real estate market plays out, we're monitoring consumer loan performance very closely and modifying our servicing practices and our product offers accordingly.

We realized a $500,000 net write-up of residuals in the first quarter which was recorded in other comprehensive income net of deferred taxes.

We recorded a $17 million of impairments residual interest which are reflected in the income statement.

We continually monitor the reasonableness of our valuation assumptions relative to actual loan performance, default rates and performance in the market.

Turning to the outlook for the Mortgage segment, we're taking a number of actions to improve the quality of loans originated.

Even with these steps, which include stricter underwriting and pricing guidelines, we still expect that non-prime origination volumes will average 7.5 to $8.5 billion per quarter.

Overall, we believe that net origination margins will return to a range of 70 to 85 basis points.

We believe that we're both reserved for the exposure that we have on past loans and that we've priced or modified products to take this getter cost into consideration for loan products in the environment today.

Before turning to the overall outlook, I'll now ask Bill to cover our financial position and other financial highlights.

Thank you, Mark.

I'll start with a few comments about our quarter end balance sheet.

Our cash position decreased to $390 million at the end of the first quarter from more than $690 million at April 30th, primarily due to our off-season working capital requirements, share repurchases and dividends.

Marketable securities trading was, or has increased $61 million since April 30th, and this is primarily related to our electing not to execute a net interest margin transaction until the second quarter.

Net receivables declined to $370 million compared to $468 million at year-end 2006 reflecting the normal patterns of our collections at our Business Services unit and related to our participation in Refund Anticipation Loans.

Mortgage loans held for investment increased to $541 million, and this line item consists of mortgage loans net of provision for losses and unamortized original costs, origination costs, rather, held by H&R Block Bank.

Beneficial interests and trusts decreased to $126 million from $188 million, and this was primarily attributable to a $3.6 billion decrease in loans held at our warehouse offset slightly by an increase in premium.

MSRs were essentially unchanged at $275 million for the first quarter compared with year-end 2006.

Changes in goodwill and intangible balances reflect normal amortization and included in the current position of long-term debt is $500 million of 8.5 senior notes that mature in April 2007 and we plan to refinance the notes at that time.

Income tax payments resulted in a $155 million change to other working capital.

During the first quarter we acquired $8.4 million treasury shares at a total cost of $186 million, or an average of $22.26 per share.

This was offset by a total of 1.4 million shares issued for long-term incentive plans.

As of July 31st we had approximately $175 million of equity targeted for share repurchase and acquisitions, and approximately 22.4 million shares remaining under the Board's repurchase authorization.

And finally, you should note that we plan to file our 10-Q for the first quarter 2007 within the next several days.

Since this document will be readily available soon, we have chosen not to provide a number of the financial tables that you may be accustomed to in our press release and earnings slide appendix.

Mark will now share with you our outlook for the remainder of the fiscal year.

Thanks, Bill.

While the performance of both segments was in line with our expectations, the shortfall in Mortgage Services had a disproportionate negative impact on our results this quarter.

Option One has already begun to aggressively address the causes of the higher loan defaults through a tighter set of underwriting criteria and pricing guidelines with special attention to certain geographic areas where more of the problem loans were originated.

At the same time, Option One will continue its focus of reducing origination costs to support profitability in a lower volume environment.

Given the shortfall in first quarter results stemming from conditions of the mortgage market, we now expect fiscal '07 earnings to be within the range of $1.60 to $1.85 per share.

We have not changed our view on the rest of the segments.

The volatility within our earnings range will continue to be a function of the mortgage market and our stability to effectively manage through the ongoing industry transition.

Although the current quarter's reported earnings were a disappointment, we're looking ahead to improve performance in the Mortgage segment given the plans that we have in place to address the immediate issue with loan defaults along with our existing initiatives to reduce cost of origination.

We continue to be excited by the additions, or the opportunities, that are RSM McGladrey including those from the Amex TBS.

We'll have more to say about Tax at our investor day in January, but we're making plans now for what we believe to be a solid season in retail tax complemented by further gains on the digital side.

And lastly, we're moving ahead with plans to realize the earnings potential within our new Consumer Financial Services segment, particularly through leveraging the capabilities of our new Bank.

With that, I'd say we're now ready to open up the lines for questions.

[OPERATOR INSTRUCTIONS]

Gentlemen, your first question comes from the line of Jennifer Pinnick with Morgan Stanley.

Please proceed.

Good afternoon.

Hi, Jennifer.

Hi.

I have a question on the reserves and on the mortgage.

Essentially you brought your guidance down $0.20 which was the increase in the reserves for the premium recapture.

I'm just wondering if I'm reading your comments clearly that you see no other effects from the pressures on this industry, on future reserving, on future volume expectations, on the cost margin, on the gain on sale premium and on the servicing portfolio?

So the -- your observation is correct that from our perspective the guidance is really reflecting the additions to reserves that we added disproportionately this quarter.

Our view of the business is, at least from the, look at the business that we have in the -- the way we see it performing today, that the volume levels that we have been at are appropriate, and we believe that they will continue to be in line with the way we've been originating before.

We have taken action to adjust our underwriting process, to target our products geographically a little bit tighter, and to price what we believe is appropriate for a higher level, and we are pricing for a higher level of expected early payment default levels, so that is already taken into consideration in the market in our pricing, and I think to a certain extent you can see that even already in the most recent quarter where the rate at which our WAC has increased was greater than the comparable market level of the two-year swap.

As rates have come down, I can tell you since then we've seen rates in the secondary market come down quite a bit from where they were at the end of July, and we have not really moved our rates down at all in our loan products, and the industry hasn't either.

I think everybody in the industry is acting on sort of this increased credit exposure, and we think that as a consequence of that, while we will be absorbing greater early payment default levels, and we have to price for that in the reserves and in the pricing that we do, that we've taken that fully into consideration in the way we have product out in the market today.

Maybe, Bob, do you want to add to that?

No, I think that's pretty much it.

Swaps are down, I think today, they're down about 30 basis points from the last six weeks, and we haven't seen any movement at all.

On the production side, also, we have started to make some of these changes, as we said, I think, and using the Midwest as an example, we actually changed our whole pricing mechanism really to stop making FICOs under 580.

And I think the risk there was if we did that with where we were going to lose volume.

In fact, our volume is up 30 days of the test and about 26% because we've been able to effectively price the product that we want to get in here that performs better more attractively.

So we are getting ready to do that in the East and the West, as we speak, and we're hoping to get that out in the next couple of weeks.

Now clearly, I think, Jennifer, it's fair to say that we could clearly be wrong, and I suppose in some respects we could widen out the guidance range that we provide to take into consideration things that we do not currently see on the horizon or expect to occur inside of our operations.

From our perspective I think we've always taken the position that we should share with you guidance based on how we see the business and expect the business to perform with some degree of variability in it, rather than trying to be either accessibly conservative or anticipate things that we don't really think are out there, and that's what this guidance reflects.

And I think if you look at it on a normalized slide, if we're, for argument sake, operating at about, with a new loss reserve, loan sale loss reserves, we're operating at about 50 basis points for the quarter.

We've already made changes where we've raised it, we've raised rates on a higher LTV loan, we've got the benefit from the rate environment.

We should -- we think we're going to reduce those losses through, by not offering certain types of a credit that performs poorly, and as we do this we're continuing to lower our costs of origination [inaudible].

I guess what it is.

Yeah.

So then, where do you see the normalized reserve?

Well, what we have done, it really depends on the product and where we're at.

What we have done, I think in general is, we're looking at normalized reserves or reserves going forward that are probably about double where we saw them about three months ago.

So if we were at, say, about 20 basis points of repurchase reserves in our pricing today, we probably have about 40 basis points on average across the product spectrum.

Okay.

And then one small question on the cost margin.

This quarter the 141 basis points is excluding H&R Block Mortgage.

Is that 145 an apples-to-apples comparison or does that include the H&R Block Mortgage in Q4 fiscal last year?

We've restated, or in effect, stripped that out from all the comparables, so those are comparable quarter-to-quarter.

Okay.

Thank you.

Thanks.

Gentlemen, your next question comes from the line of Kelly Flynn with UBS.

Please proceed.

Thanks.

I have a couple of questions.

First on the share repurchase, Bill, I know you touched on -- I think you said 170 million of equity targeted for repurchase.

That's correct.

Can you just revisit that?

Is that correct that would be 8 million shares or so and I guess that implies you come in around $16 million.

I had thought you guys might increase the buyback, speak to approaching 20 million plus.

Is that something that's still in the cards or does this mortgage situation impact on equity limit your buyback capabilities?

Kelly, I think in the last call we talked in terms of about 15 million shares being most likely for repurchase in the current year.

And I did reference in my comments that we had about $175 million set aside or available which could be used for either share repurchase or acquisitions or some combination thereof, and we're not ready to say at this point in time which way that's going to pan out.

I mentioned the authorization as well, and of course that's still there.

Certainly, what we do with, for the balance of the year in terms of earnings is in part a component of what we have available for share repurchase or would have available.

The only thing I'd add to that is, Kelly, we are continuing to work on ways in which we can narrow the scope of the balance sheet, I guess is the best way to say it and look at ways -- those things that are particularly capital intensive and where we can avoid holding assets that would have large capital requirements attached to them.

To the extent we have success in any of the things that we're working on in that area, it gives us more flexibility, so we are constantly looking and working on things like that.

Okay.

But at this point you're not willing to commit to anything above 15 million?

Well, again, I think we've got about, as Bill said, our current outlook is there's about $175 million of expected excess capital generation that we will deploy in one form or another over the course of the year.

If operating results vary, that will obviously go into that number as well, so I think it's just a little early for us to be trying to put a more precise number on it.

Okay.

Great.

And then switching gears just back to talking about the mortgage charge that you took, can you get into a little bit more detail on the types of loans that are experiencing the first payment defaults, you know, what types of loans, and I know you mentioned the Midwest, but anymore details on kind of the regional exposure?

And then also, you mentioned the 40 basis point assumption across the product spectrum.

Is it fair to say that you're assuming that it is at 40 basis points now and you're assuming it kind of flatlines and doesn't get any worse and why is that reasonable given what's going on with the real estate market?

Thanks.

Let me take a shot at a couple things there and then I'll have Bob join in.

I think we would prefer not to get into a lot of specifics about loan types and what's performing and what's not.

Not so much because we don't know, we actually know quite precisely, but for competitive reasons, we think this is one of the benefits of the way in which we operate and the insights we have into the market that we can tune our products very quickly based on insights that we're able to glean, so I'm not sure we really would prefer to -- or we'd prefer not to layout where we're making those changes and why we're making the changes that we are, not that it wouldn't be useful to you, but it would also be useful to our competitors.

You know, having said that, your point about is 40 now an adequate reserve level to be planning for and in effect to be pricing to.

We think that that is the right level based on the way in which we're now underwriting and where we are targeting.

It probably does allow for some slight deterioration in performance out there, but if the market gets much worse, you know, that could prove to be wrong.

I think that explains some of the volatility we know exists in this business.

Frankly, we're tracking performance now in terms of early payment performance in the month of August, and we've seen it improve over where it was in July.

We thought that would occur and we're feeling good that that is in fact occurring, but this market is clearly very much in a state of flux.

Bob?

I don't really have anything to add.

Can you just clarify, is it early payments that we're talking about as in the first two or three or is it the first payment?

Well, for us, because of our way in which we operate and the fact that we sell loans as soon as they're made into an off-balance sheet warehouse, that is a sale, for us, the first payment defaults are in effect in our reserves, have to be in our reserve numbers, but also, we are responsible for the first payment when we -- after we sell to a loan pool buyer, so in many cases we're probably responsible for the first two payments as is almost every originator out there.

Our reserve would be covering both those first two payments, and sometimes depending on the length of the time loans stay in the warehouse, it could even be the third payment.

So it really varies.

One of the things that we have been doing is shortening the time that we carry loans in the warehouse specifically to reduce our own internal exposure to that third payment.

Okay.

I'll get back in the queue.

Thank you.

Thanks.

Gentlemen, your next question comes from the line of Michael Millman with Soleil Securities.

Please proceed.

Thank you.

I guess mortgage is the hot topic of the day, so could you talk about a couple things?

One, it appears that your mortgage guidance is pretty much straight-lining the current environment.

Could you also talk, and so could you tell us whether that's, in fact, how you've looked at it or if it takes into account what you see happening in housing, in rates, and all the factors that go into this?

Two, on mortgage, can you talk about the cash flow being generated at these kinds of levels assuming whole loan sales?

Could you also talk about, it appears your rates are higher than the industry's, and how much of that's so and in this environment can you expect that not to pressure volume?

And then I have a couple other questions.

Okay.

Let me talk a little bit first about your question about guidance, and are we just simply straight-lining the current environment versus trying to anticipate where we would say the world will go.

I'd say we're probably, our guidance probably does take more of the current environment and assumes that this is the environment that we're operating in going forward, it probably does take that broadly into consideration and doesn't adjust an awful lot because, frankly, we can't predict, and I'm not sure we know how to predict, where the mortgage market and the housing market is going to go.

I think we've taken a more conservative stance in terms of the level of both originations and, clearly, the credit risk that's out there but, frankly, we have modified our product, our underwriting, any number of different aspects about our business model to take those things into consideration, and we think that along the way as we get insight into changes in any of these trends that we will very quickly be able to move that into changes in our product origination and our products that we offer in the market so that the operating margin and the operating performance levels that we've described are sort of a viable way, or appropriate way to see the expectation for the future.

But having said that, we can be wrong, and that's why we've always said that where we end up from a results perspective depends very highly for this company on what happens in the mortgage business.

On the cash flow side, we have had a strong bias toward cash and whole loan trades that you can see that in the 90% I think that we did this past quarter of our loan sales being in the whole loan side of the trade, and I think we continue to view that that's the appropriate, most appropriate way for us to operate the business.

Bob, do you want to comment on the rate environment, how, you know, the question was, it appears to some that the Option One rates are somewhat above others in the market and, you know, does that have an effect on either our business or our ability to attract volume in the business?

Our volume's been pretty steady, and so we haven't really seen any kind of really adverse impact from the volume.

It seems to me that in general the price, the environment in pricing today is much, there's not nearly the differences that there were maybe a year ago when we kind of took the lead and raised rates by 40 basis points, so I think that, you know, I mean our strategy has always been, try to be, we don't want to be the lowest but try to be close and can really try to take advantage of the experience that our sales people have and then the strong broker relationships we have.

So right now I think that, as we said earlier, we have not seen people go down even though the swaps have gone down, and that's a good sign, and I think part of it is to compensate for sort of the increased scrutiny that, you know, the increased credit enhancement levels that some of the rating agencies are putting on the higher LTV product and things, but I would say right now that from a pricing standpoint we feel -- I feel pretty good about it, I think we're [inaudible] on service now rather than [inaudible].

The one thing I would caution, Mike, I know some of the public sources that are out there are the broadly available sources that compare different companies rates.

They are genuinely picking up rate sheet numbers and there's variation in how different players, including us, use the rate sheet and how we negotiate rates and how we work with our brokers, so I'm not sure you can necessarily take that as sort of directly comparable.

Going back, Mark, to the cash flow, could you quantify what you'd expect the cash flow to be in Mortgage given your guidance for the year or what the quarter cash flow was?

Yeah.

It's obviously going to depend on whether there's any change in the disposition strategy, but I would tell you I don't think anything has changed.

In fact, if anything because some of these are in the reserving side and the residual reduction is also affecting earnings.

In some ways I would tell you I think that, you know, with the guidance we gave you at the beginning of the year, is really unchanged which is this year we would expect that the earnings of the Mortgage business is about where the cash flow coming out of the business would come in.

And to move to a couple other things, could you talk a little bit about this new segment?

It seems that it's being, at least in this quarter, driven by the retail mortgage business.

And secondly, could you talk about RALs?

There seems to be a lot of headwinds from Senate Finance Committee, from your favorite AG's, from some of their state pension funds and looking forward presumably will be more once you maybe get into pay stub loans and if indeed some of the companies move more aggressively into holiday loans even.

Let me take a shot at some of those.

Your observation, I think, is accurate that the variability that we would expect to see inside the Consumer Financial Services segment probably disproportionately comes from our retail mortgage business.

The other two businesses, Financial Advisor business continues to make good progress and it is at this point fairly predictable in its sort of quarterly contribution.

The Bank is also very predictable and will put stability in that number.

The retail mortgage business and the profitability of those retail mortgage loans that we're originating will create a bit of the volatility that we will end up seeing in this segment, but overall, I think that's, and that is a little bit of what happened this quarter.

On the refund lending side, you know, I don't know that the level of pressure and the level of noise that's out there on this is any greater at the moment than it has been for the most part over the years.

I think there is clearly some attempts by different people to spotlight and put a -- draw attention to this product category.

I think we have encouraged that in some ways because we already know that at H&R Block our product pricing and the way in which we offer these products we believe is the best in the industry already, and so the conversations that we've had with various different consumer advocates of various different sorts and describing where we're headed with that product line, where we're headed with trying to serve our clients well, I would tell you in general have been very, very productive conversations.

We have learned a lot about from their vantage points what would be good modifications or alterations to a product that we all know consumers want and we want to ensure that we're doing -- we're offering what consumers need in a very responsible way.

We've got really good input from a whole broad range of consumer advocates and we are looking at how we can use that input to modify some of the ways in which we offer that product, and it's just a little early for us to be talking about the details of that.

Can you modify your product if competition doesn't?

We can -- as the industry leader, we can do a lot of things.

I think the question really is to the extent we modify our products in some form, will it force competitors to have to do something in response or to follow our lead.

I think that's an interesting question that we don't know the answer to.

We'd like to think that if we led in terms of the ways in which we think we can improve the perception and the actual performance of that refund lending product, we'd like to believe that our responsible competitors would feel compelled to address that and follow our lead but, frankly, we're not there and we don't know.

Thank you.

Gentlemen, your next question is from the line of Michael Christodolou from Inwood Capital Management.

Please proceed.

Yes, a couple of mortgage questions.

Mark, are there any other conditions which could trigger H&R Block's recourse liability other than not making the first few payments?

Are there any other conditions with regard to FICO scores or income documentation that don't pan out once the loan is sold?

You know, I'll tell you, Mike, I think I know this, but Bob will correct me if I'm wrong.

I think for the most part in the due diligence, due diligence is typically the place where loans might fall out if somebody found that the loan wasn't -- the docs weren't really as representative of the loan file, so that's a place, but that will happen before the loan pool is actually sold.

Once sold, I think this is really the only way that there's exposure that comes back to us.

Certainly residuals is a way.

Fraud is a way, but those things I think for the most part we've got pretty good understanding of.

Are you getting any feedback from the market that buyers going forward here may want to somehow tighten up the conditions that they apply to buying loans?

Yeah, you know, for the most part we're taking the loans back at the buyers, so I'm not sure how they could tighten conditions even further.

You know, the way you effectively tighten conditions is you bid lower for a pool, and we have not seen -- we have seen that the depth of the market seems to be pretty solid for us, continues to be pretty solid, so nothing really jumps out at me as a good answer to that I think is a concern to us.

If you really look at the fact that they're asking us to buy back more of these first payment defaults than they have historically, you could make an argument that the securitization should actually perform better by taking all these loans out where in the past most of those loans stayed in the pool.

I think that's probably right.

And, Mark, I guess my last question, I appreciate your efforts to improve the forecasting credibility and investor's confidence in the Option One business model, and I have to say the business apparently deteriorated in July and it was disconcerting to see that Mr. Dubrish sold 60,000 shares late in July, and I'm not sure if you have any comments to that observation.

Well, I'm not sure that I do.

I would tell you that the insights that we got into the level of reserves and the need for this reserve increase came very, very late, so I have high degree of confidence in that we are continuing -- everybody in the management team, Bob included, is doing everything above board and on behalf of the shareholders.

Just want to make sure there's alignment there.

Thank you, gentlemen.

Gentlemen, your next question comes from the line of Thomas Russo of Gardner, Russo & Gardner.

Please proceed.

Hi, Mark.

I hope you can hear me on the call phone I apologize.

First question is to just to bring us up to date with your view on the benefits from your real estate [inaudible] whether you think it's helped in any way [inaudible] to restoring your competitive position?

That's the first question.

Tom.

Second question for Bill would be, you described benefiting [inaudible].

Tom, I apologize.

I didn't get either of those questions.

You really cut out.

And now you may have dropped off.

Gentlemen, your next question comes from the line of Mr. John Neff with William Blair.

Please proceed, Mr. Neff.

Hi.

Thank you.

I just want to make sure I understand the whole early payment default recourse versus first payment default recourse kind of building on a prior question.

I understand that the buyers of the loans have recourse on a first payment default basis contractually, but are you getting putbacks on loans that are further along than the first payment default?

In other words, is there a difference here between the contractual recourse and the reality of the recourse?

Yeah.

Well, so I think those are maybe two different questions.

The direct question to the second is there is no difference in terms of the contractual.

We're not taking more responsibility than the contractual amount, so the real issue is the timing after a loan has been made, the timing when it ultimately sells into a whole loan trade or to a securitization, and in the case of whole loan trades, the loan may have been in warehouse for I think right now on average about 45 days, which means that that first payment requirement has already been -- would have been passed while it was in the warehouse, and we are responsible for that first payment default, so our reserve number includes a reserve for defaults out of the warehouse on the very first payment.

Then we are responsible in the subsequent sale for the first payment then now due to the borrower, or to the buyer, the investor at the loan pool, which would be the second, or in some cases, the third.

So that's how it works.

Okay.

But it's not a situation where the fourth or fifth payment is defaulting and they're saying take the loan back [anyway]?

No.

It is certainly not that.

Okay.

Okay.

Can you give us an early read on sort of average FICO scores and LTVs on originations you've made so far here in the second quarter?

In other words, I guess one of the things I'm a little surprised at is that in the wake of the announcement that the LTVs are still creeping up, the FICO scores are basically flat and the average loan size is actually going up.

Yeah.

You know, there's a couple things that are going on inside the numbers that we've shown you this past quarter.

It is our objective to target where our loans are being originated and, frankly, the loan performance that we talked about is worse in small loan size kind of geographic areas, and I think as we have begun to put more focus on those loans that we think are going to perform the best, that has caused us to reduce the loans that we make in some of the smaller, or lower real estate value markets if you will, so that's going on.

You know, your question about so what are we seeing now in August, I mean these trends change fairly slowly and we haven't made a wholesale change.

We've really tightened quite a bit in terms of our underwriting standards, some of the documentation standards we have modified or pulled back from some products, but I wouldn't say this is a wholesale product drop as much as it is some various changes that we've made in our underwriting process and some of the standards that we apply.

And I think given the way the business works, we probably don't expect to really see these loans, they're in the pipeline now, we don't see them being originated probably for 30 or 60 more days.

Right.

I would tell you the bulk of the changes that we made happened in, later in July and now into August, so they would now be in the pipeline but they would not yet be in our originations.

Okay.

Good.

And then Bill, just a quick housekeeping question.

If you could just repeat the share buyback numbers you gave, and also a couple of references to this $175 million for possible, I guess, for share repurchase, but I didn't follow where that came from.

Thank you.

I'm sorry, the numbers that we referenced were $175 million available for either share repurchase or acquisitions, and without specifying either way we would be going, and the total number that we gave was the Board resolution authority which I believe is 22.4 million shares that remain, 22.4 million remaining under the Board repurchase, the various authorizations.

Thank you.

Uh-huh.

Gentlemen, your next question comes from the line of Kyle Cerminara from T. Rowe Price.

Please proceed.

I only have one question.

What is the current book value of the Mortgage business after this write-down that you took, and what are the components of that?

You know, Kyle, I don't have that number, those numbers here.

And typically, we don't break out the sort of book value, carrying values that we have of our various different operating businesses.

Is there any way you could give us some approximation of that value, book value?

Well, I'm trying to think.

Basically book value is essentially -- you can look at the assets that make up the business, and that's going to get very quickly to the overall value, so we have MSRs, we have residuals.

We have some loans that are being carried for sale, but that are on our balance sheet.

That's a relatively small number, I think, right now.

There's about $170 million of goodwill attached to this line of business.

Okay.

So about $600 million if you add up the $275 million of MSR, $145 million of residual, and then $170 million of goodwill, so about $600 million?

That sounds probably like it's close.

Okay.

Thank you.

Gentlemen, your next question comes from the line of Nate Redleaf with Imperial Capital.

Please proceed.

Hi, guys.

Just a couple questions about the secondary market for mortgages.

Have you seen a change in appetite in August for sort of higher risk, higher LTV type loans, and is that where you're moving your originations away from?

We are seeing from a rating agency perspective, they're requiring much greater levels of credit enhancement on the high LTV stuff.

We've in turn priced that higher and we're also looking at it, as Mark said earlier, this [inaudible] across the board kind of thing.

In certain regions we're eliminating those loans completely.

But there is, from a rating agency standpoint, they've changed considerably.

I think it's the thought process is that they have lowered their levels of appreciation for the whole loan values.

And I guess just a follow-up to that.

Are you seeing a noticeably higher increase in the percentage of people that are maybe trying to refinance loans at these higher LTVs that now, because the rates are going up and the credit quality is being more scrutinized, that are just not being able to qualify for a new refinancing?

I'm not sure we see that, but I think as we collect from these people they, we're, I think probably even up to a year ago about 27% of the defaulted loans paid us, and I think that, so what we're sort of speculating is that if [they're at] 100% LTV, we made the loan to them six months ago that they really can't go and refinance it.

Okay.

Thanks, guys.

Gentlemen, your next question comes from the line of Scott Schneeberger.

Please proceed.

Thank you.

Bill, just one question on capital expenditures.

I think you'd said for the upcoming year all else equal it would be reduced by about $50 million due to the reduced new tax [office] buildout.

Noticing that first quarter it was up, I think, the year-over-year from $30 million to $43 million.

Could you just give us a read on kind of what were the drivers in this quarter and what the outlook is for the full-year?

Yeah.

You're right.

The biggest piece of the variance there had to do with the Cap Ex for the new building, the office building here in Kansas City.

And that will quickly come to a close.

We're just -- that was the sort of finalization of that project.

Thanks.

So for the full-year can you put out an absolute number that you're thinking of for total company?

Maybe we [didn't] take that off line.

I don't know if there's any reason we can't share with you what we have, but I'm afraid I'd give you a number that is off.

It might be off.

Okay.

Fair enough.

Thanks.

Gentlemen, your next question comes from the line of Mark Sproule with Thomas Weisel Partners.

Please proceed.

Hi, guys.

It's Daniel Halsey in for Mark today.

Wondering if there is any new strategic thinking in terms of your Mortgage division?

In terms of a strategic shift, whether spinning off or.

I would tell you, Daniel, our view on that question has not changed.

We -- in fact, I would tell you that we get that question most often when the market is perhaps valuing a business like this at the lowest so, frankly, our point of view has not changed.

Okay.

Great.

Thanks.

Gentlemen, your next question comes from the line of Steve Belko with Cathay Financial.

Please proceed.

Just two questions again on mortgage.

Mark, I'm trying to understand if there's a way any of us could get comfortable that 40 basis points that you'd be reserving is an adequate level when I think if you looked at some of your competitors in June, you know, took those valuation repurchase reserves up to closer to 90 or 100 basis points.

I don't want to just look at the competitors, but is there any way of getting comfortable from public data that you could suggest?

So we, obviously, are tracking what the competitors are saying as well.

Frankly, the comparable, when you say the people are saying they're adding 70, 80, 90 basis points to reserves, the equivalent for us would have been 112, I think, something like that this quarter where we, because they are effectively booking additional reserves based on new insight into the kind of exposure for losses that they now believe may end upcoming back to them.

So I'd say that is the comparable and, in fact, our reserve levels that we think are pretty much in line with the way in which the others are at least talked about this publicly are viewing their own sort of risk in loan originations.

The best I can tell this is not -- this is the 40-year or 40 whatever the number is around there is not far off from what other people are effectively looking at inside their businesses.

Okay.

And then I'm just trying to get a better understanding of you're taking a reserve for the full value of those loans or is it some sort of haircut off the value of the loan?

I just, I'm not exactly sure I understand how this --

So the way the math works is because, it gets fairly complicated, we look at how many of the loans are defaulting or experiencing an early payment default that where we're responsible.

Four of those that are, you know, as a trend of where those are at, we are reserving as if 100% of anything that could be put back to us will be put back to us.

Then of those that are coming back to us, that 100% that could come back that we are assuming will come back, we are reserving that 30% of those will cure and that 70% will incur some loss, and the average loss we're assuming on those other 70% to come back to us is about 15% of the principle amount.

Okay.

So that the 70% you assume that they lose 15% of the principle?

That's it.

Do you have any idea if that's standard in the industry or --

That's really standard -- not standard.

That is our experience, and we've got a little bit of bias in there for how we think that scratch and dent, which is essentially what these loans are pricing in the secondary market today, so it's probably higher -- it's not probably, it is higher today than it's been at some points in the past that 15% assumption.

Okay.

Thank you.

Yes.

Gentlemen, your next question is from the line of Scott Valentine of FBR.

Please proceed

Hi.

This is Dan Furtado in for Scott.

Two quick questions on mortgage.

First, about half of this reserve was due to prior period loans.

Are these prior period provisions centered on early payment defaults or is it due to -- I just want to make sure that the vast majority of this provision for prior periods is due to early payment defaults.

And the second question is this 40 basis points that we've been talking to, talking about, is this an expense or the balance of the allowance at the end of the period?

Thank you.

Thank you for asking that question because this 40 basis point thing is turning into a bigger number than it should.

All the reserve is for early payment defaults so there's not a reserve in there for something else other than that, and probably the big thing that has changed more so than almost even the level of early payment defaults, is the tolerance level of loan buyers to in fact put those back.

Historically, they would not always put those back to us, and they would many times keep them and keep them, the loan pools that cure them themselves, and today we have -- in July this is really the change we saw.

There was a big spike in the level of loans that were being put back to us, so our reserve now reflects that we assume anything that could come back will come back, so 100% of all loans that experience a first payment default to the pool buyer, or the investor, those loans will come back and that's what the reserving level is today.

Okay.

Perfect.

40 basis points, which we've talked about, the 40 basis points is our assumption about what the level of reserve we will need to have in the future for all future loan originations, what level that will be.

Perfect.

So the balance of the allowance is what that is.

No, that's not the balance of the allowance.

The balance of the allowance is -- I don't even know off the top of my head because it really has to do with the timing with which those loans come back to us.

The balance of the allowance took -- because we don't have an asset, I don't know how you'd describe a balance of an allowance quite.

The 40 basis points is not -- 40 basis points is how we are assuming that much loss has to be covered in pricing going forward.

Okay.

Okay.

On a quarterly basis?

On a daily basis we underwrite loans.

Got you.

Okay.

Perfect.

Thank you so much.

Gentlemen, your next question comes from the line of Thomas Russo with Gardner, Russo, Gardner.

Please proceed, sir.

Mr. Russo, please proceed.

Operator, so let me answer what we think Tom -- that we think we've interpreted from the last time what he was asking, so Bill's going to answer part of that question.

The only part of that question I think I heard --

What was the question?

I believe the question was or had to do with the filing of the Q, and our expectation right now is that we will file on the 7th of September and, again, a lot of the schedules you'll be looking for will be contained in the Q. So if it was more than that, I'm sorry, that's all I could pick up.

Somebody else I believe the other question had to do with the pace at which we've expanded the number of offices in Tax and how we're progressing against that.

I'll tell that you we're on track with what we talked about in June, the level of -- the number of offices and the one thing that we are discussed -- we are finding is that as we have scaled back the absolute number of offices by our scoring models of attractiveness of the location we think that we're able to zero in on even better as an overall cohort, a better set of performing locations to open up into.

If those weren't the questions, they should have been.

Gentlemen, your next question is from the line of Herb Buckbinder with Wachovia.

Please proceed.

Mark or Bob, could you just explain how we determine the cash effect of all these -- of the write-offs?

Do you have to wait until the mortgages come back and then you either resell them or you hold them?

I just to want get a feel for how this cash -- how you actually incur the cash losses from this transaction.

Yeah, Herb, actually the cash losses, assuming the loans actually come back as we are predicting, and we're now predicting 100% will come back, they would typically come back over the course of about five months, and then we will turn them and resell them pretty quickly typically, so within 30, at least once a quarter we're reselling scratch and dents, so the cash flow implication of it will work its way through, from our perspective, it happens in about 45 days.

But you would definitely resell all of these as opposed to try to -- you wouldn't try to keep them yourself?

We would not try to keep them necessarily.

We have historically had a policy of just simply quickly reselling.

There are specialized buyers out there for non-performing or loans that have misperformed, if you will.

We have been looking at whether or not there is a reclamation process that we can do through our servicing platform that could get us more value, but I would tell you the 15% that we've assumed as the loss rate on loans that don't cure that does not assume any improvement over what we've seen in the past just from selling.

All right.

The second question, then, it's a toughie, but with almost 90% of your shares held by institutions, does this put any added pressure on you to perform given increased amount of shareholder activism going on?

You had certainly a number of disappointments here lately.

I tell you that it's not as much about the institutional versus retail as it's about the quality of the investor and their understanding of the business that we're in.

I would, certainly, we, the entire management team, and I think the entire organization, understands that we need to perform well for shareholders.

Okay.

Thank you.

Gentlemen, your next question is from the line of David Sewell with Fannie Mae.

Please proceed.

Please proceed, Mr. Sewell.

Sir, please unmute your phone.

Gentlemen, your next question is from the line of Jim Delyle with Chapel Street Partners.

Please proceed, Mr. Delyle.

Hi.

Give me one second while I take it off speaker.

Good afternoon.

Hi.

Hi.

I'm backing into, backing in through your 70% or 30% cure assumed loss of 15%, and I back into something along the lines of the average loss per assume putback being, obviously, right around 10%, and backing in with $460 million, I'm sorry, $46 million worth of a loss, I come up to $460 million worth of loans that are likely behind that $46 million loss, and on a production of approximately $7.8 billion, I get something on the order of 6% of the production of first quarter is assumed to come back or under these calculations under EPD.

Is that fair?

Is my math correct?

Your math is around the right thing but I would tell you our internal -- I don't know exactly how did you the math, but ours is about 5%.

All righty.

You mentioned earlier that the major reason for the change in the reserving policy on the EPDs was the assumption of 100% putback as opposed to some other percentage.

What -- I guess what was the other percentage, or I guess another way of asking that question would be, that 5%, how does it relate to what you were seeing in previous quarters?

Yeah.

This is one where we have been trying to get our arms around that precise question, and I would tell you that at least with a caveat that what I'm about to tell you is directionally correct but it's still something that we're trying to put more precision around.

We would go back over the last, oh, year-and-a-half, two years, year-and-a-half, the average number of loans that would be put back to us was -- in comparison to the 5% that we're now reserving for, it was about 1.25%, so that is both reflective of higher EPDs, but it's more than higher EPDs.

We think actually the bulk of it, the largest share of it is a higher propensity of loan pool buyers to put loans back that they have the right to put back.

Okay.

You mentioned earlier that rather than get rid of the baby with the bath water and not selling out the misperformers, you're thinking about developing the capacity to turn them into better performers internally?

We're looking at that as whether or not that's a more productive way for us to get more value than just simply selling them away.

We would only do that, obviously, if we had a high degree of confidence that there's a way of improving the performance.

Clearly, we're not talking about a portfolio strategy.

It's really about how can you optimize the value from a loan that comes back to us.

Would that -- were you to go that route, would that require the development of a special servicing platform or the acquisition thereof?

Actually, we do loss engagement ourselves so we'd probably be beefing up that area if we decided to do that but it wouldn't be requiring a special servicer.

Where on the balance sheet can we track the loan, these EPDs?

I mean what line item of the balance sheet would they be in as you -- as they went from 100% that came in into the 10% realized losses against your reserves?

Yeah.

They're in the, I think, the mortgage loans held for sale line.

They are mortgage loans held for sale on the balance sheet.

Wonderful.

And if you could do me a huge favor here, there's a paragraph in here that I cannot get my brain around.

The paragraph in your release overall residual interest performed worse than expected realizing $17.3 million write-downs recorded as gain on sale, also realized net write-up of residuals.

Can you explain the difference between those two?

Sure.

When you have a write-up in residual, we don't take that as income, we take it into OCI and then we amortize that into earnings over the remaining life of the residual.

When we have a write-down in a residual, we take it immediately through earnings through the income statement, and that's why we break those two apart.

And another question going back to the EPDs.

What percentage of your originated mortgages do you have no residual interest say other than -- what percentage were basically sold without recourse and servicing released?

This quarter was 90%.

Not servicing released.

It's almost always service retained in our case, but in terms of not keeping the credit exposure beyond the EPD, it's 90% this quarter.

All right.

So as your EPDs to the extent that some of the higher EPD is the behavior of the borrower and a lot more of it, it seems is the behavior of the street, would there be any effect of this change in EPD on the valuation of your residuals?

Would you be changing your assumptions as to percentage likelihood of loss or EPD in the residuals?

I don't think it changes our view of EPDs in the residual, but it may alter our view of the future loan performance of the pool and, therefore, how you would value the expected cash flows and, therefore, how you would value the resid.

Is any of that recognized in this quarter's balance sheet?

Well, certainly our, if we did a small securitization this quarter our resid valuation in that transaction takes that into consideration.

I'd say the bigger place that that, you know, you're seeing the effect that far is in the $17 million write-down in residual values.

The lion's share of that was from an early '06 securitization residual where we think that older residuals are performing well because there was a lot of home price depreciations to hold up the values.

The more recent ones are the ones where we think there's more stress and that's where the write-downs came.

Okay.

One last question if I may.

I think having looked at the K about $10 billion or so of your servicing was subservicing.

Yes.

Is there any difference between your responsibility or your contingent liability, if you will, on an EPD of subservicing versus your originated servicing?

You know, certainly the servicing is not where the EPD responsibility is original -- comes from, it's actually our sale of the loans.

The fact that we do most of our loan sales servicing retained is just sort of because the business model that we have, so the servicing does not give rise to that obligation, it's really the sale of the loan pool that gives rise to that obligation.

On the subservice stuff, we don't have any responsibility for EPDs in those subservice loans.

Thank you very much.

Gentlemen, your next question comes from the line of Michael Hodes of GLG.

Please proceed.

Hi.

Good evening, guys.

Hi, Michael.

Really just two questions.

On the mortgage side I just want to make sure that I'm understanding you clearly.

You're basically saying that you've modified your underwriting in light of this EPD phenomena to exclude certain types of loans to borrowers with, let's say, low FICO scores or piggyback loans or whatever, and yet you don't feel that that's going to have an impact on volumes.

I just want to understand what the offset is?

Is seems like if you're changing your criteria to exclude things, what makes up the shortfall?

That's my first question.

And then secondly, on the stock buyback, you know, it looks to me that in the month of May you bought over 6 million shares yet between June and July you only bought 2 million, and I'm just trying to get a sense of what's behind that?

Is it a function of the stock being below a certain level?

Is there like a pacing algorithm that you use just so I could kind of understand how we might see this excess capital being deployed over the coming months?

Bob, do you want to comment on the loan question?

I guess there is a couple things.

The changes that we're making we're doing a couple of things.

We're changing guidelines in some cases, we're actually raising pricing on certain products which will offset, we think, what we now know is an increased risk.

The actual change we're making, though, it's not very much volume, but it has a much higher delinquency rate and EPD rate, so while we're changing the guidelines, it's not going to, we don't think it's going to have a big impact in volume.

As I mentioned earlier, and this is just a test in 30 days, but in the Midwest [inaudible] by eliminating the under 580 FICO and the losses that were associated with that, it actually allows us to price better product that we wanted to get in the door much more attractively.

And so, so far again in that market, anyway, our volume's up about 25% and it's the volume that we want, and we're not -- and so that's -- we're hoping that that will happen as well in the West and the East as we rollout the regional pricing.

And just one kind of related follow-up.

If the EPD issues were pronounced enough that you actually made underwriting changes in July, why is it that this charge which you deem to be material enough to release last week in a separate statement was made, you know, so far after the fact?

This was an issue in June when you reported the April quarter results, I'm not sure why, you know, it just hits you guys so suddenly.

Let me address that because, frankly, the big change in the level of reserving that we believe is appropriate now is reflects the, most significantly, it reflects the increase propensity of loan pool buyers to exercise the right to put these loans back.

We saw a substantial change in that behavior in the month of July, and that is what gave raise to our reassessment of whether or not the reserve levels that we have were appropriate and adequate at the end of the quarter.

So it wasn't something where we were believing that they were inadequate in May.

We didn't think we were inadequate in June.

Because of that the pool behavior, pool buyer behavior changed that we first saw very dramatically in the month of July.

That's what gave rise to our reassessment.

From the time we saw that behavior and did the work to reassess and really zero in on what's the most GAAP appropriate number that we had to take in these reserves, I think it was just days after we finalized that that we put the information out to the street.

I appreciate that.

And then just on the buyback?

You know, we generally don't have a pricing algorithm of any sort, you know, we do look at the levels at which we want to target.

We look at the capital levels that we are targeting at any quarter end and pacing our share repurchase against a number of different things, so I wouldn't read into anything, you know.

Certainly, the opportunity to buyback we believe in the month of, I guess, May, at the levels that were available at the time we thought was quite attractive, probably had we anticipated clearly had we anticipated that this was, this change was going to be definitive we might have seen that differently, but I think at the time we felt that those were very attractive levels.

Okay.

All right.

Thanks a lot, guys.

Gentlemen, your final question of the day comes from the line of Joe Vobero at Suttonbrook.

Please proceed, sir.

Hi.

Thanks for taking my question.

I hate to beat a dead horse.

I'm sure it's simple, I just don't understand the comment made earlier about the 40 basis points with respect to it being similar to a competitor supposedly adequately reserving at a level that would be like 110.

Can you help me understand that disconnect?

Well, again, the level of reserves that are being taken in a quarter, in this quarter at least for us, represents both, represents the entire increase in the reserve divided by, in a basis point sense, divided by this quarter's production even though some of that reserve is being increased to reflect loans that were sold in prior quarters that we now believe will come back to us at a higher rate than they have in the past.

That's why the reserve rates that we are booking this quarter is 100, and, I'm sorry? 119 basis points going forward, but that is 119 basis points against this quarter's production even though some of the exposure was for, from loans that were previously sold in other previous quarters.

The 40 basis points is essentially the level of losses that we are planning for in our pricing and in our underwriting process in the loan pools that we have, or the loan guidelines that we put out and that we are underwriting towards.

That is about double the level that we were experiencing six months ago, and, or saw as appropriate six months ago or even three months ago, so we've doubled the level of expected losses from these loans, and it really reflects both the propensity of pool buyers to put loans back as well as somewhat higher levels of EPDs.

Okay.

Okay.

Thanks.

My other questions were answered.

Great.

Thank you.

Ladies and gentlemen, this concludes our question-and-answer session for today.

I would now like the turn the call back over to Mr. Ernst for any closing remarks.

Please proceed, sir.

I think we've had as many as we can stand for today.

Thanks for joining us and staying with us.

If you have questions please feel free to give us a call.

Ladies and gentlemen, thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.