H & R Block Inc (HRB) 2008 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the first quarter 2008 H&R Block earnings conference call.

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

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

We will conduct a question-and-answer session towards the end of the conference.

(OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to Mr.

Scott Dudley, AVP Investor Relations.

Please proceed, sir.

Thank you.

Good morning, everyone.

Appreciate you joining us to discuss our fiscal first quarter 2008 results.

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

Bill will comment on our first quarter results, we will then open up the call for questions and our call today is scheduled for one hour.

To start let me provide our Safe Harbor statement.

Comments made on this call may contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934.

Such statements are based upon current information and management's expectations regarding the Company speak only as of the date on which they are made, are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict.

Therefore, actual outcomes and results could materially differ from what is expressed, implied or forecast in such forward-looking statements.

Such differences could be caused by a number of factors including, but not limited to, the uncertainty that the Company will achieve its revenue earnings and earnings per share expectations for the fiscal year 2008 or subsequent fiscal years, and that actual results for the fiscal year 2008 or subsequent fiscal years or any quarter thereof will fall within the guidance provided by the Company.

The uncertainty of the impact and effect of changes in the non-prime mortgage market including changes in interest rates, loan origination volumes, levels of early payment defaults and secondary market pricing and liquidity, uncertainties pertaining to the commercial paper market, changes in economic, political, regulatory or competitive environments, litigation involving H&R Block, Inc.

and its affiliates, the uncertainty regarding the closing of the sale of Option One, the uncertainty of the Company's ability to purchase shares of its common stock pursuant to its Board of Director's purchase authorization, and other risks described from time to time in H&R Block's press release and Forms 10-K, Forms 10-Q, Forms 8-K and other filings with the Securities and 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 those remarks.

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

You should note that in conjunction with today's call, there is an accompanying slide presentation which is posted to the Investor Relations section of our Web site at hrblock.com.

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

With that, let me turn the call over to Mark Ernst.

Great.

Thanks, Scott.

Good morning.

We have a lot to cover this morning and I want to limit our call to one hour so I'll have us get started.

I plan to cover, first, the status of our Option One Mortgage business operations and its sale.

I'll then spend a few minutes on our continuing operations results this quarter including the important announcements that we've made in the past week regarding our product line changes targeted at the crucial early season portion of our tax filers.

Bill Trubeck will then cover key items from a financial perspective and then we'll have time for your questions.

As you read in our press release this morning, we are engaged in discussions with Cerberus in an effort to modify our agreement to sell Option One in light of the turmoil that is occurring in the credit markets generally and the market for subprime loans specifically.

The mortgage origination market is in the midst of the most severe dislocation that it has seen in years, maybe the most severe since the 1930s.

The relative improvement in the market that we experienced in May and June when we were originating about $1billion per month, gave way to significant changes in July and August when rating agencies tightened the view they have for securities backed by mortgages, whether subprime or other loans.

These changes in July, along with an overall reassessment of the value of securities backed by subprime loans and the types of collateral that are salable in today's environment, has given way to significant changes in our origination business in response.

In July, we dramatically narrowed the type of collateral we would originate and repriced our loans substantially higher as the risk adjusted value of loans in the secondary market changed.

Despite those changes, in August the entire market found little or no appetite for any loans, despite what we can see as substantially improved collateral characteristics and indications of substantially better early payment default performance on the loans that are now being originated.

As a consequence, we have ceased originating any loans that do not fit the Fannie Mae or Freddie Mac purchase guidelines.

By mid August, we had stopped originating any loans that don't have a known source of disposition in the secondary market.

Today, that's through one of the agencies.

The consequence of that change is that we expect to slow our originations to a run rate of about $200 million per month beginning in September.

Along with these changes, we've taken substantial action to scale back the organization that originates and supports originations.

We reduced our staff by 615 people, and currently our origination organization has approximately 400 people remaining.

As reflected in my prior remarks, we're in an unprecedented environment for the mortgage lending industry.

As a result, we're engaged in discussions with Cerberus Capital Management in an effort to modify the agreement we entered into in April to sell Option One to Cerberus.

Certain closing conditions of this agreement currently are not being met.

Consequently, some of the key components of the discussions currently are the closing conditions requiring us to have $2 billion in loans funded within 60 days of closing and $8 billion minimum warehouse lines would be waived with certain other closing conditions being waived or modified.

We would be responsible for divesting or winding down Option One's remaining origination business which we would pursue immediately.

As a result, certain shutdown costs may be incurred.

Cerberus would purchase Option One's loan servicing platform.

We are both working toward advancing the December 31st contract termination date so that we can provide for an earlier resolution of the Option One situation.

Other sections of the contract may also be changed or eliminated.

While we hope to conclude the negotiations, we can't, of course, be sure that we will be able to do so.

If we're unable to reach agreement on the modifications, our existing agreement remains in effect and our intent would be to proceed with our current agreement.

As we trust you will appreciate, until our ongoing discussions are concluded, one way or the other we will not have any further comment.

Collectively, the operational changes we've made are designed to mitigate risk to H&R Block shareholders from originating loans in today's market while preserving the value that exists in the Option One business through the existing Cerberus transaction or potentially a modified one.

During the quarter we took a series of valuation actions to reflect the dramatically changed market view of mortgage collateral.

The quality of loans currently being originated, measured by our experience with early payment defaults, has recovered substantially.

As you can see on the slide that we have up on the Web site, early payment default levels on new collateral have dropped to their lowest levels in over 15 months.

We've also seen increasing WAC levels even as the loan characteristics have been directed toward less risky loan types.

We've made changes to our loan product offerings in response to the market.

By early August we were no longer offering 2/28 and 3/27 loans and had shifted customers to 5/25 products.

We also essentially moved to all full documentation loans.

Previously, more than 20% of our loans had stated or limited documentation.

We no longer originate loans for non-owner occupied properties or loans above 90% combined loan to value.

On Slide 9, you can see the exposure that we have at quarter end to loans originated before we stopped taking loans that don't meet the Fannie Mae or Freddie Mac requirements.

At quarter end, we had $2.1 billion of loans in our warehouse.

We estimate that approximately $1.1 billion of those loans will meet the guidelines for sale to Fannie Mae.

$190 million of that was committed to be sold in mid August with a mid September settlement.

We sold $629 million in whole loan transactions in August, including $366 million of Fannie Mae eligible loans.

The remaining $500 million of Fannie eligible loans are in the process of being pooled for sale.

We marked the warehouse, net of applicable repurchase liability, to an average value of $0.92 on the dollar even though the collateral is much better than previously originated.

The WACs are higher and the early payment default performance is better.

This is a reflection of where we believe the market would have valued these performing loans at quarter end.

At quarter end we held approximately $240 million of loans outside the warehouse facilities that have been deemed to have some defect either in initial performance or collateral documentation.

We're working to correct any collateral documentation issues.

At quarter end we have recorded $115 million as an allowance for loan losses against these loans.

Residuals represent the third area of balance sheet exposure for us.

We've written all residuals from originations prior to January 2007 to zero and residuals originated in calendar year 2007 have a current carrying value of $90 million at quarter end.

There's no market indication of the value of these residuals directly in today's environment as the fear of anything that's subprime has reduced or eliminated liquidity to this market.

In addition to mortgage loans held for sale, we also recorded a $113 million repurchase liability including $68 million related to loans in the warehouse.

As mentioned earlier, the early payment default performance has continued to improve, however, the cure rate has dramatically declined while loss severity has increased resulting in $157 million repurchase reserve of which approximately $62 million is related to loans originated in prior quarters.

We tightened our valuation assumptions further, though the underlying collateral is performing as it was originally modeled to perform, to reflect this general market uncertainty.

We've increased our discount rate on residuals from 28% to 47% reflecting the continued uncertainty in the market.

The increase in discount rate resulted in a $50 million impairment this quarter.

We wrote down our beneficial interest in trust by $73 million reflecting that value I mentioned earlier of $0.92.

We also increased our repurchase reserves by $136 million specifically related to assumption changes including higher severity and higher kickout rates.

Turning to financial results, the Mortgage business incurred a pretax loss for the quarter of $331 million which is reflected in discontinued operations.

Driven primarily by the secondary market pressures I just noted, we incurred losses from our origination activities leading to a negative 586 basis point net gain on sale gross margin for the quarter.

We executed $3.1 billion of loan sales in the quarter with 44% executed as securitizations and 56% as whole loan sales.

As mentioned, we also significantly reduced the carrying value of residuals to reflect the sentiment of market participants for loan losses at the end of July.

We took additional reserves for repurchased loans reflecting further market value reduction for scratch and dent loans.

We recorded impairments to residual interest of $50 million compared to $17 million last year.

We experienced higher loan severity -- loan loss severity and due diligence kickouts driving an increase in actual and expected loan repurchase activity.

As a result, we recorded reserves of $157 million in the current year compared to $93 million in the prior year.

Loan origination levels for the first quarter were $3.3 billion, down substantially from $5.8 billion in the fourth quarter, reflecting our underwriting changes and the market conditions.

The cost of origination was 262 basis points, up from 245 basis points in the fourth quarter.

We have seen some positive indicators in the midst of these harsh market conditions.

In the first quarter the average loan balance continued to increase to $251,000, up from $234,000 in the fourth quarter.

The average WAC increased 17 basis points to 8.64% while the two-year swap moved up just 6 basis points.

We continue to raise coupons and we're currently originating loans with an average WAC of about 10.45%.

During the quarter, we incurred restructuring charges of $16 million and anticipate additional restructuring costs in the second quarter related to the previously announced closure of 12 loan processing offices and a staff reduction of 615.

At quarter end the balance sheet for our discontinued operations consisted of $1.9 billion of assets consisting primarily of $432 million in mortgage loans held for sale, $556 million of prepaids and other current assets, $95 million in the beneficial interest and trust, $90 million of residuals, $233 million of MSRs and $317 million of deferred tax assets.

When considering the $791 million of liabilities, this nets to a GAAP book value of $1.1 billion.

The respective estimated tangible net asset value as calculated per the stock purchase agreement equaled $1.1 billion at July 31, 2007.

It's our intent to retain severe limits on the types of loans that we will originate as we work to resolve the finalization of the agreement with Cerberus.

To the extent this means we will only originate agency eligible collateral in amounts below our originally agreed levels for the contractual closing conditions, then we'll accept that contract risk.

We will not put H&R Block shareholder capital at risk to sustain a commercially unreasonable business.

As we discussed earlier, the mortgage industry has continued to be extremely volatile during the month of August.

To the extent the market conditions fail to improve, the Company estimates that the Mortgage business may continue to incur significant pretax impairments of approximately $150 million to $200 million in existing residuals, beneficial interest and trust and loans that are held for sale.

Turning to continuing operations results for the first quarter, revenue was $381 million, or 11% -- up 11% from last year.

The pretax loss improved about 7% from last year to $110 million, or a loss of $0.34 per share, slightly better than our expectations.

Our net loss for the quarter was $303 million, or $0.93 per share on a fully reported basis including discontinued operations.

The first quarter net loss a year ago was $131 million, or $0.41 per share.

Tax Services results were in line with our expectations for this off-season quarter in which we normally report a loss.

The pretax loss was higher versus the prior year due to investments and initiatives to drive client growth and normal operating expense increases.

The Consumer Financial Services segment reported improved earnings reflecting contributions for both H&R Block Financial Advisors and the H&R Block Bank.

Business Services delivered solid top line results that met our planned levels.

Revenues for RSM McGladrey's accounting, tax and consulting business continued to experience good organic growth.

Total reported revenues declined slightly from last year due to our phasing out of valuation services.

Business Services seasonal pretax loss was better year-over-year due to improved integration of the acquired American Express Tax and Business services firms.

The pretax loss in our tax segment of $172 million was 13% higher than the prior year and in line with our expectations for this off-season quarter.

The loss reflects costs associated with investments in technology to support our digital tax and our new commercial markets business and the off-season expenses associated with a recent acquisition of a tax operation in Las Vegas.

As you might imagine, we are deep into planning for the upcoming season.

We've made two announcements in the past 10 days that are significant for the coming tax season.

Last week, we announced the introduction of a new line of refund settlement products that we'll make available to the independent tax market through our TaxWorks commercial software platform.

These include access to a new 36% APR refund loan and a free bank account through H&R Block Bank under the ANEW brand.

This step, being taken in conjunction with leading refund lending banks, will help to accelerate transparency and greater value that this product design makes available to clients throughout the professional tax services industry.

We also announced yesterday that again, through the capability of H&R Block Bank, we will introduce a low-cost line of credit product to our tax clients as an extension of our highly successful Emerald Card prepaid debit account introduced last tax season.

The ability to develop these types of industry-shaping capabilities at prices that lead the industry can only be done because we aren't relying on third parties with limited interest in the impact of product designs.

Building on last year's success, we intend to seize the client at retention opportunity that's created by the popularity of the Emerald Card which is already in the hands of over 2 million clients.

We look forward to sharing details of our plans as we get closer to January, but we are intently focused on being prepared to aggressively compete at that time.

As a result of finalizing our settlement product offerings, we now expect that pretax margins in the tax segment will rise between 50 and 75 basis points this year versus our previous expectation for flat year-over-year margins.

Turning to Consumer Financial Services.

This segment delivered a great quarter.

First quarter revenues from continuing operations were up 45% over the prior year to $114 million reflecting the growth of H&R Block Bank in accordance with its plan and continued success at H&R Block Financial Advisors.

Consumer Financial Services delivered pretax earnings from continuing operations of more than $6 million for the quarter compared to a year ago loss of $3 million.

Importantly, Financial Advisors achieved its third straight quarter of profitability after $9 million of intangible amortization.

For the quarter the Bank realized an annualized pretax return on average assets of 1.34% with an efficiency ratio of 37% in line with our plans.

The net interest margin was 2.08% reflecting the continued impact of the flat yield curve.

The Bank ended the quarter with total assets of $1.3 billion primarily consisting of mortgage loans held for investment.

These loans are of high quality and are, in fact, considered prime by the OTS.

On average, the loan size is $219,000 with a 717 FICO and a combined loan to value of about 78%.

The average debt to income ratio for the borrowers of these loans is 34% and the average WAC is 7.27%.

Our overall level of classified assets declined at quarter end to 1.67% of total assets, down from 1.75% at the end of the prior quarter.

Nonetheless we are very watchful of credit performance and took the step to increase our reserve levels to 0.37% during the quarter, up from 26 basis points at the end of the prior quarter.

H&R Block Financial Advisors utilized the Bank to hold $734 million in FDIC insured deposits on behalf of certain customers.

Deposits from H&R Block tax clients were $129 million at quarter end.

H&R Block Financial Advisors continued to achieve improved results reflecting the operating changes made in the business over the last two years.

As I noted, HRBFA was profitable for the quarter and that includes $9 million of intangible amortization.

The amortization will be reduced to $3 million in the third quarter and then will cease.

This performance was supported by higher production, including continued strong sales of closed end funds and annuities, along with increased margins on sweep account balances.

The improved results reflect a 30% increase in advisor productivity over last year driven by organic growth and our success in recruitment of higher level producers in the past couple of years.

At quarter end we had $32.5 billion in assets under administration, up 6% from the prior year.

Business Services had a strong quarter experiencing good organic growth despite a slight decline in reported revenues.

Revenues for the quarter were down 1% to $193 million.

This is primarily due to reduced capital markets revenue as we have chosen to phase out business valuation services and focus solely on capital market transaction advisory services.

In addition to 9% revenue growth in its tax business, RSM McGladrey also had meaningful improvements in off-season losses compared to the prior year.

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 $2 million compared to a loss of $7 million last year.

The improvement reflects the efficiencies gained during the integration of the American Express TBS firms.

With that, let me turn the call over to Bill Trubeck who's going to discuss our discontinued operations and the balance sheet.

Thanks, Mark.

I'll start with a discussion of our corporate segment.

I'll also review results from our discontinued operations and I'll conclude with some comments related to capital, our balance sheet and other items related to our financial statements.

The pretax loss in corporate operations for the fiscal first quarter was $16 million, down significantly from $31 million a year ago, primarily due to lower interest resulting from refinancing our $500 million senior note to a bridge financing facility with a lower interest rate along with reduced legal costs.

This quarter, the results of our discontinued operations, in addition to Option One and H&R Block Mortgage Corp., also include results and related costs to sell two smaller lines of business previously reported in our Business Services segment.

We reported a loss from discontinued operations of $193 million net of tax, or $0.59 per share reflecting mainly the losses in Mortgage.

Our cash position decreased to $438 million at the end of the first quarter from more than $900 million at April 30, primarily due to our off-season working capital requirements, dividends, and losses at Option One.

Short-term borrowings, excluding our bridge loan, at the end of the quarter were $1.2 billion.

I want to comment on our announcement to draw $850 million on our committed backup lines of credit.

These lines, with total capacity of $2 billion, were put in place to give us flexibility and assure adequate liquidity for short-term needs.

In recent weeks, the commercial paper market has become increasingly constrained and unstable, especially for A2/P2 issuers like Block Financial.

As a result, we decided to substitute this more stable source of funds for our working capital needs.

These lines of credit extend through August of 2010 and are accessed today at a rate of LIBOR plus 30.5 basis points.

We're using proceeds to pay down commercial paper balances and to meet our ongoing working capital needs.

We expect to have adequate liquidity for the upcoming tax season and into our fiscal fourth quarter when we typically become cash flow positive.

Net receivables declined to $423 million compared to $556 million at year-end 2007 reflecting the normal pattern of collections at our Business Services unit and related to our participation in refund anticipation loans.

Changes in goodwill and intangible balances reflect normal amortization and the previously mentioned tax segment authorize -- acquisition, rather, in Las Vegas.

Lower income tax payments resulted in a $181 million change to other working capital.

Significant changes in year-over-year cash flow uses were driven by Option One's operating needs reflecting conditions in the subprime mortgage industry.

We issued 1.6 million shares from our treasury shares for option exercises, the employee stock purchase plan, and restricted shares.

We ended the quarter with 325 million shares outstanding.

The effective tax rate from continuing operations for the first quarter was approximately 40.2%.

The rate increased primarily due to changes in our estimated state tax rates.

Our discontinued operations reported an effective tax rate of 42.5% for the quarter.

And as we expected H&R Block continues to be below the minimum 3% OTS capital ratio.

Given the first quarter loss within discontinued operations and estimated losses during the second and potentially third quarters, we now expect that the Company will not be able to repurchase shares for treasury until some time in fiscal 2009.

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

Thanks, Bill.

Now the past year has seen the greatest amount of change in many years for H&R Block.

We are focusing the Company around our tax, accounting and related financial services businesses where we can create clear competitive advantage in the market.

We remain focused on managing through current volatile and fluid market conditions in Mortgage while reducing exposure to operating losses as we work toward closing the sale of Option One.

We're narrowing our range of expected earnings from continuing operations for fiscal year '08 to $1.30 to $1.45 per share reflecting a $0.05 per share increase in the low end of the range.

This change incorporates our finalized product design and strategy in Tax Services.

We'll have more to say about tax at our Investor Day in January, but we believe we are positioned for a very good season in retail tax fueled by solid execution and industry leading settlement products enabled by H&R Block Bank complemented by further gains on the digital side.

We expect that results of our discontinued operations will continue to have a negative impact on our earnings on a fully reported basis into the second and possibly third quarter of the fiscal year.

We expect our Consumer Financial Services profitability to more than double in fiscal year '08 versus last year as the Bank continues to expand and build on its success of this past year and as Financial Advisors further progresses against its business plan and strengthens its profitability.

We look for continued strong performance in RSM McGladrey's core accounting, tax, and consulting services as our investment in brand drives new business opportunities.

Before going to questions, I'd like to note that H&R Block's annual shareholder meeting will take place a week from today on September 6th at 9:00 a.m.

Central Time in Kansas City.

Our Tax Services business experienced strong revenues this past year, significantly aided by the successful debut of H&R Block Bank.

We've taken other key actions in the past year, including the initiation of the sale of our Mortgage operations to narrow our focus -- in narrowing our focus within Business Services.

At that meeting, three of our independent directors are standing for re-election, Donna Ecton, Lou Smith and Ray Wilkins.

We urge you to vote for these highly qualified and experienced individuals.

We strongly believe that our three independent director nominees, together with our other directors, are the best team to oversee management's execution of our strategic plan which is already underway.

In our view, Breeden Partners has put forth no new ideas to improve shareholder value.

In fact, many of their proposed changes are identical to actions that were initiated by this Board and previously announced and which had begun implementation before Breeden Partners acquired a single share.

We believe that they are advocating a sale or disposition of the Bank, depriving shareholders of the Bank significant potential.

It's no coincidence that Tax Services business had a very successful early season this past tax season, the same year our Bank became operational.

By continuing to execute on our strategic plan, we believe that we are on track to deliver value for all of our shareholders.

This is not the time for costly distractions and organizational disruption.

We encourage all shareholders to vote their white proxy regardless of the size of their holdings in H&R Block.

With that, I think we are now ready to open up the lines for your questions.

(OPERATOR INSTRUCTIONS) Your first question comes from the line of Satish [Pulay] with Merrill Lynch Principal Finance.

Please proceed.

Hi.

I had a couple of quick questions please, if you didn't mind.

The first was regarding the healthy investment portfolio of about $1.2 billion.

Can you tell us when you last valued this portfolio and where you think the valuation is going?

My second question was basically around the drawdown that you've had against your CP backup facility.

I believe that that backup facility is currently operating under some (inaudible) conditions and effectively for example, a waiver of the requirement that you should reduce your total short-term outstanding debt to about $200 million at some point in the year.

How long do these waivers last and what are the conditions for those waivers to continue?

Thank you.

Sure.

So, let me, I'll address the question about the valuation of the warehouse and then I'll have Bill comment on sort of the back up facility.

We had, the valuation that we reflect in here is, or in this quarter, reflects a $0.92 on the dollar, or $0.92 of par for the loans that were held in the warehouse.

In total, that reflects where we estimate the value, the market would have marked those values as of July 31.

Frankly, given the illiquidity in the market, it's tough to find exactly where those would be marked in today's environment.

I think the estimates that we have seen would suggest that it could be 88, maybe 90 something like that if you had to mark them today, again.

So we think we took the sort of conservative and appropriate valuation at the end of July when we marked those to 92, but that's essentially where it's at.

Bill, want to comment on the question about the line?

Yes, with respect to the line, there is actually a $200 million net short-term debt clean down which only applies at our fiscal year end and it will not come into play until the end of our fiscal year and at that point in time we expect to be in compliance.

Thanks.

Thank you.

Your next question comes from the line of Kartik Mehta with FTN Midwest.

Please proceed.

Good morning.

Mark, I wanted to kind of understand a little bit about the Cerberus sales a little bit more.

As I read it and try to understand it, is it that Cerberus basically wants a servicing platform and that's what, that would be about, the only thing that will be sold out of Option One at this point in time?

Yes, so, this may be an inappropriate place to say.

You know, one of the things I want to be cautious of is that we not sort of let ourselves get too deep into discussing exactly where we're at in these negotiations because as you can imagine, negotiating in public is not a very effective strategy for us.

But generally speaking that is correct, that the way in which we have been discussing this is that the value of the servicing asset, the servicing business, is clearly quite valuable and we have been talking about a modification to the agreement that would have that business become part of Cerberus and/or be acquired by Cerberus and that the loan origination portion of Option One would be either divested by us or wound down by us.

When you talked in the press release, Mark, about the 150 to $200 million in potential losses, would that include the shutdown cost and based on today's value what it would take to write-down loans in the warehouse?

Yes, the 150 to $200 million is sort of a wide range guess, and I would emphasize that it's more of a guess.

It's more art than science, maybe that's a better way to say it.

In today's environment, the mark-to-market, which is essentially what our accounting has us doing, is we're marking all of our Mortgage balance sheet assets and even the warehouse balance sheet, warehouse values, we're marking those to what we estimate the market value to be at any cutoff point.

When we mark those, and so we took you through sort of the valuations that we mark to as of July 31st.

And to go back to sort of how the mortgage market has developed over the course of the last several months, it feels like it's been several years, but the last several months, we saw relative stability in May and June and I think everybody was thinking that we were getting to a point where things were reasonably stable, and then the agencies, the rating agencies took action in July that kind of changed the rules of the game pretty substantially.

That led to a reassessment of the value of everything on the balance sheet as market participants, I think, kind of got skittish about any collateral or any assets that were backed by subprime loans in some form.

That affects us both in the loans that we have in the warehouse, it affects loans that we hold on the balance sheet for resale and it effects the valuation of residuals.

So at the end of July, we marked those to our best estimate of what a market participant would value those at if they were to be disposed at that point and we took you through sort of the detail.

Since July, there has been, as I think everybody on this call knows, virtually no liquidity in the market and especially virtually no liquidity for assets related to subprime.

So, the 150 to $200 million is our best estimate at the moment that if the indications of kind of disposition value that we were seeing or being suggested in the market were to hold, that's the amount that we think would be required to mark our assets further down.

And last question, Mark.

What was the implications of all that be on the Bank and the 3% OTS requirement?

I realize one of them is that maybe you have to delay your share repurchase strategy that you were going to put in place.

Are there any other implications for just having to go get extra capital or something to meet the requirements?

Yes, you know, I think it's fair to say, we have, we've shared with the OTS a capital plan that reflects the sort of the outlook that we have for the Company in all this different operations and the impact that this is having, and that capital plan had us, under the 3% capital level for periods of time, between now and actually, I guess, over the next 18 months or so, and that has been shared with the OTS and we have been moving forward with their understanding of that being the plan.

In the event that things deteriorate in the Mortgage business beyond where we have projected and thought they would, that will cause us to have to reassess precisely what the relationship and what the capital requirements are for the OTS, but I think at the moment, we have a good understanding and good handle on the sort of generation of capital and when that will bring us back into compliance.

So basically, Mark, as it stands now, the plan you have in place should help you read what the OTS would like you to do?

Yes, we are clearly working against a plan that would bring us into compliance.

Thank you very much.

Thanks, Kartik.

Your next question comes from the line of Andrew Fones with UBS.

Please proceed.

Yes, hi.

I think you mentioned that the book value in the Mortgage business is currently about 1 or $1.1 billion.

It looks as though that's about the book value for the consolidated company as well.

If you sell the, if you're able to sell the servicing business and you shut down the remaining operations in your Mortgage business, where could that book value fall to?

Or asked differently, what would the write-down be for shutting down Mortgage?

Well, so essentially, I guess the question is what's or what would be the wind down costs if we were to move to our winding down the origination part of the Mortgage business, and frankly, at the moment, I'm not sure we have a real strongest it Matt Of that.

The indications that we have is that it could be something in the range of which $50 million to wind it down.

But frankly, again, it's just a little premature for us to be sort of getting there because again, we're very deep in negotiations.

Okay.

Thanks.

And then on the backup lines of credit that you said you've kind of rolled your commercial papering to, can you explain where the remaining amount of those lines is available for general working capital needs or whether that's just the remaining commercial paper to roll into?

No, that continues to be available for general corporate needs.

I can actually give you, if you'd like to know the amount of commercial paper that's outstanding that's outstanding currently at least of 8- 29 is about $678 million.

Okay.

Thanks.

And then a final question.

In terms of the potential closing of any servicing business, would you still say that falls within your guidance of by the end of the calendar year or do you have any thoughts on that?

Well, so certainly, we have an agreement that has an end date for the transaction as of December 31, and as we said, we are working to see whether or not we can move toward an earlier resolution I think for everybody's sake, both the organization at Option One and for everybody involved we think it would be valuable to bring earlier resolution to precisely what's going to happen with that business, but clearly, in the event we don't get to that point, we have a contract that has an end date of December 31.

Okay.

Thank you.

Your next question comes from the line of Scott Schneeberger with CIBC World Markets.

Please proceed.

Good morning, guys.

Hi, Scott.

Following up on Kartik's question about the time frame, well basically for losing the additional $200 million, what time frame did you have in mind for that?

Yes, that again, that was an estimate on our part of sort of if you had to mark the assets that are sort of mark-to-market assets, if you had to mark those at the late August time frame and cut that off and simply go and dispose of those assets, that was our kind of rough guess, rough estimate of sort of where the mark would have fallen in August.

And it's an attempt to share with you and dimensionalize just how, again, further the market had moved and how soft it had gotten as it has gotten out there, and again, as I noted earlier, we, because we are effectively from an accounting perspective a mark-to-market balance sheet, this is kind of our rough estimate off cycle of what the mark has gotten to now during August.

Okay.

Fair enough.

And so basically, the assumption though is as of this point, we'll keep going on to December with the Cerberus deal remains-[INAUDIBLE].

I'm sorry, I couldn't quite hear what you said.

So you're saying that's of mid August and your assumption is if we were to go to the end of December, that would be the amount basically here and now?

Yes, so here is the way to think about it.

We had assets as of the end of July that had not yet been disclosed of and we valued them for July's purpose at what we believe the sort of July 31 value in the market was.

We believe that the market deteriorated further now during the month of August, and it's hard to know exactly where it deteriorated to, simply because there's been so little liquidity that it's hard to get a bid for the kinds of assets or an indication of value for the kinds of assets that we're talking about in some cases.

So we are projecting, we had estimated based upon some sort of indirect measures of what the market was really valued or what the market is kind of trading these types of assets at that the mark from July 31 would have gone down between 150 to $200 million for the assets that we had then.

Now, between now and December a couple things will happen.

We have moved to minimize or truncate the exposure we have to this kind of asset generation by only originating today agency qualified loans so that we don't originate anymore collateral that would be subject to or put us at risk for a mark, a markdown, and at the same time, we we have not committed those sales or those assets for sale.

We are just simply suggesting that in today's environment if the market didn't get any better but didn't get any worse, the markdown would look something like 150 to $200 million on the assets that we had that were uncommitted at July 31.

Okay.

Thanks.

And say the year needs renegotiations with Cerberus, and say that doesn't pan out and as you said in your prepared remarks, continue to operate on the originally agreed agreement, are you or under the terms of the agreement would that fall under the term agreement that is the reusable efforts on your part?

It seems like it would be, but --

Yes, we've taken that action that we believe is in this environment the appropriate kind of way in which you can operate this kind of a business and to do anything else would not be responsible and we will as I said earlier not put our shareholders capital at risk to continue to originate loans in a business where it is unclear what the secondary market's appetite for those loans will be.

So we believe we're taking the appropriate action and to go beyond that I think probably doesn't enhance shareholder value by describing our position on that.

Okay.

Fair enough.

Thanks.

I'll switch gears here for a minute.

On your announcement recently about in the tax business for next year, you say in the August 21st especially on H&R Block Blank this year at 12, 800 H&R Block- to the type of loan that is at 36% API available to all clients, is that or does that mean that your route for this upcoming tax season will all be at 36% APR or does it really have to take a certain product in order to get that much-

Yes, you were cutting out a little bit but I think I got the essence of your question.

So what we announced was that in the coming year, two things will happen.

One is we will move all of our refund lending to a 36% APR level in the H&R Block network and then we are also in conjunction not with, and we'll do that in conjunction with HSBC.

And in conjunction with several of the other remaining large lenders in the industry, we are introducing that same product design at the same pricing level, and making it available to the independent channel, so that others in the industry can move to a similar product structure and a similar product level or pricing level, and so that is what in fact we are doing and that was the announcement.

We believe that as industry leaders this puts us in a strong position to help the industry move to a sort of a solid place with meeting this customer need that exists for access to credit at tax time, but do it in a very responsible way.

And we are hopeful that many others in the professional market will see the wisdom of doing the right thing for clients in the same way and we are helping to facilitate that by bringing out a commercial or a product that's available to the rest of the market in addition to the H&R Block network.

Our guidance reflects now those product changes.

So when we put out guidance earlier in the year and that's where the comment in the earlier comments was that we now expect that our margins in the tax business, tax segment will improve by between 50 to 75 basis points versus where we had been talking about before, which was flat.

That change is very much a reflection of the fact that as we have settled in on product design and product pricing for the coming year, we can see that this design is a little bit better than what we were projecting or what we were putting out as plans as we were coming out of the tax season last year.

So all in all, we think that it is reflective of both, you know, the right place to be from a value to consumers from an industry leadership perspective and at the same time, it's within the range of guidance that we expect for the earnings of that business.

Thanks.

To the extent that you can speak on it, in the guidance, now that you're discussing these improved margins, is your assumption on retail client serves that would take a refund anticipation, has that increased from when you prior gave the guidance and is that up year-over-year relative to the past fiscal year?

It is not changed from where we previously were thinking about, what we previously believed, when we were talking about guidance before so we were not expecting that with the product changes more people will take refund loans nor are we in the assumption at the moment, assuming that more people will choose to come to Block because of this product design.

Now, we have not been effective as successful as we would like in the past at communicating the value, the better value we have available through our refund loan pricing versus competitive alternatives, so we are not yet sort of convinced that we can suggest with confidence that we will acquire more clients because of that action.

And we are really doing it as much as anything else to insure that we have a solid sustainable long term business model in the refund lending side and the early season client part of our business.

Okay.

One more if I can squeeze it in.

I appreciate you taking all of these questions.

What I guess the essence of that prior question I was asked was all your clients this year, regardless of what attachment products whether they used H&R Block Bank, credit or debit cards or anything, they will all receive this APR?

Yes, that's correct.

Thank you.

Your next question comes from the line of Jennifer Pinnick with Morgan Stanley.

Please proceed.

Good morning.

Hi, Jennifer.

I have a question regarding the Bank.

Of the $1.3 billion in assets, how much of that is the Alt-A production that was from Option One and third party?

I don't know if I have that number right available.

It's probably about 800-$9 hundred million.

Okay.

And are you, is that your strategy going forward to continue to buy the Alt-A paper or have you moved to up the quality scale of the Mortgage?

You know, today we are not buying any loans from Option One into the bank, so as we are, as we see run-off in that portfolio, we are sometimes supplementing it with additional loans through bulk purchases from other sources, those are typically very high quality portfolios or or alternatively as we did this quarter, we will let the balance sheet shrink a bit, so we are not currently and don't expect to be buying from Option One.

Okay.

And your reserve level at 37 basis points are you comfortable there or where do you target your increase in your reserves to?

Yes, you know, I think that as we have looked at projecting through the balance of the year, we are obviously very watchful of how the portfolio is performing, and as I noted, we actually saw it improve.

It's underlying sort of credit characteristics show improvement quarter-over-quarter or sort of April-July, but having said that, clearly, we understand the sort of the environment that's out there and I think as we've looked at our kind of projection for the balance of the year, I think we are projecting to move that level up a bit even from the 37 basis points that we have today.

Okay.

And with the increased balance sheet risk and the limited leverage you're able to take on given, holding the bank under the H&R Block umbrella, what is the longer term benefit here if these products that you are cross-selling to the tax can be outsourced to another bank?

Yes, you know, I think that's actually sort of at the heart of the questions that have come up related to the Bank, capital, and sort of the different views that we have on that capability.

You know, and one of the challenges for all of us I think is that we are now 12 months into sort of being able to control our own product design but let me tell you at least strategically how I think about it and we can talk about sort of the hypothesis about whether you could outsource it.

One of the challenges we have had in our tax business is that we have turned over our product development for the early season part of the client base to third parties.

Essentially there are three banks in the United States that provide virtually all the product to the tax industry and the leader of those HSBC is our business partner but in the process of them providing product to the tax industry, what's happened over the last five or more years is that the typical products that are available to clients through tax providers has become commoditized.

You can get refund loans of all shapes and sizes but essentially you can get them virtually anywhere and we have seen a proliferation of competitive locations that offer the same kind of early season access to credit that we used to have as a key differentiator for H&R Block's tax business, you can now get that just about anywhere.

We have not had the ability up until last year to manufacture or have control over product design for this early season client until we had our ability to control the product itself, and that's what had and block Bank and the Emerald Card in particular gave us the ability to do in its first year and we believe we saw good success with that in its first year.

But the real test of that will be now in its second year as we see the effect that the clients that we offered that product to and who took that product, how they performed for our tax business relative to other clients who did not have access to their product.

If, and we are really looking for to see several specific things that we expect should come from clients and this relationship that we can expand, the most notable of those will be, we hope, greater retention of clients.

We have seen in other product types where we've bundled products of a similar nature with our client base that we have seen meaningful lifts in client retention.

And the early season client that the Emerald Card bank product was targeted at is the most notoriously disloyal or least loyal part of our client base, so we are hopeful that this strategy of expanding this kind of capability and putting it in the hands of clients in the early season will give us a loyalty advantage that we have not had up to this point.

In the event that that works so that's one important sort of economic lever that we are looking for from the bank.

The second economic lever is the ability to use the bank to drive product design that works for early season clients that our competitors can't match.

Yesterday we announced we will be expanding the Emerald Card product to approve a form of a line of credit available to them year around.

We believe that's another example of something we can do as a product manufacturer that we would be unable to do potentially if we had to outsource this kind of capability.

Now, it remains to be seen whether those capabilities and the reasons that we are putting them in the hands of our tax clients will yield the kind of loyalty lift and client acquisition improvements that we are looking for from this sort of broadened account and client relationship.

If it works, it will give us a distinct advantage with our tax clients in a critical early season part of the market where we have not had a competitive differentiation in a number of years and if it doesn't work, if we don't see the kind of economic lift that we expect from that, then I think we would be in a position to reassess whether or not the constraints that come along with being in the banking business are appropriate constraints to impose on H&R Block shareholders but, frankly, we won't know that until we get into the current tax filing season and see the effects that we are looking for from these products.

So that's how we think about it.

Okay.

Great.

And then, on the Mortgage side, if Cerberus doesn't accept the renegotiated term, is it still your intention to be out of Mortgage by December 31?

Well, it is certainly our intention that for H&R Block shareholders, we're not looking to continue to be in the operating in the Mortgage business.

When and exactly how that would happen I guess is fairly fluid at the moment and so saying by December 31 we would be out, by December 31 we will know what happens with the Cerberus contract one way or the other.

Okay.

And then on the tax side, the operating margin expansion expectation, does any of that come from reduced office openings?

Is you mentioned --

Yes, we didn't mention the office opening plans but basically it does not.

We are opening a modest number of additional points of presence in the tax business kind of consistent with a scale back plan.

Frankly, our ability to limit office ex expansion and location expansion is critically dependent on our ability to have differentiated products that would cause clients to seek H&R Block out versus going to alternatives where you can get essentially the same kind of refund loan or other product.

So to the extent what we believe strategically is to the extent we have differentiated products that are appealing to consumers, it allows us to expand more slowly or reduce our need for expansion and leaves us in a position where we can use product design as a preferred way to differentiate H&R Block so the margin expansion is related to product design.

It's not related to either limiting or expanding our office openings.

(OPERATOR INSTRUCTIONS) This concludes the question-and-answer session.

I'd now like to turn the call over to Mr.

Mark Ernst for the closing remarks.

Great.

I want to thank you for joining us this morning, and clearly , if you have other questions we are available to talk with you offline.

Thank

Ladies and gentlemen, that concludes the presentation.

You may now disconnect and have a great day.