PNC Financial Services Group Inc (PNC) 2013 Q2 法說會逐字稿

Good morning.

My name is France and I will be your operator for today.

At this time I would like to welcome everyone to The PNC Financial Services Group Earnings Conference Call.

All lines have been placed on a mute to prevent any background noise.

After the speakers' remarks there will be a question and answer session.

(Operator Instructions) As a reminder, this conference is being recorded.

I will now turn the call over to the Director of Investor Relations, Mr. Bill Callahan.

You may go ahead, sir.

Thank you and good morning.

Welcome to today's conference call for The PNC Financial Services Group.

Participating on this call is PNC's President and CEO Bill Demchak, and Rick Johnson, Executive Vice President and Chief Financial Officer.

Today's presentation contains forward-looking information.

Actual results and future events could differ, possibly materially, from those anticipated in our statements and from our historical performance due to a variety of risks and other factors.

Our forward-looking statements regarding PNC's performance assume a continuation of the current economic environment, and do not take into account the impact of potential legal and regulatory contingencies.

Information about such factors, as well as GAAP reconciliations and other information on non-GAAP financial measures we discuss, is included in today's conference call, earnings release, related presentation materials, and in our 10-K, 10-Q, and various other SEC filings and investor material.

These are all available on our corporate website, PNC.com, under the investor relations section.

These statements speak only as of July 17, 2013, and PNC undertakes no obligation to update them.

And now I'd like to turn the call over to Bill Demchak.

Thanks, Bill, and good morning, everybody.

Thanks for joining us today.

I am going to start by running through some of the highlights of our second-quarter earnings and talking about the progress we are making on some of our strategic priorities.

I will also share some views on the environment and how it is likely to affect us through the remainder of the year before I turn it over to Rick to run you through the actual results.

And then we will take your questions.

As you all have seen, we reported net income of $1.1 billion or $1.99 per diluted common share, with a return on average assets of 1.49%.

Obviously, these are big numbers.

And while we are pleased with the results, as we noted, we did have several select items in the quarter and let me run through a couple of these.

First, we sold some Visa Class B common stock and we realized a gain of $83 million.

As you all know, we have been monetizing our position in Visa over time.

And at the end of the second quarter, we still had approximately $750 million in unrealized gains.

And we also sold some securities early in the quarter when rates were low, which gave rise to some security gains and increased our asset sensitivity.

As rates rose later in the quarter, we reinvested those proceeds.

Now, the net effect was higher than normal security gains and lower than forecasted NII.

All else equal, it should benefit NII in future quarters.

In addition, higher interest rates improved the valuations of our commercial mortgage servicing rights and our derivative counterparty book.

Also, you have seen our provision for loan losses decline this quarter and was substantially below -- you know, I tell you our own expectations, as credit quality improved faster than our forecast.

And this is particularly true in the commercial space.

Having said all of that, on the negative side, we did record increased residential mortgage repurchase provisions this quarter, primarily in response to additional information from Freddie Mac.

Now, this is an issue that everybody in the industry is working hard to bring to a close as quickly as possible, and that is certainly our goal as well.

Now, apart from those select items, client fee income was really strong and, as you've seen, our capital ratios were strengthened.

We hit our expense numbers in the second quarter and we remain focused on improving our efficiency ratio, even as we make targeted investments through the remainder of the year to meet our clients' needs.

And as we look at where we are in relation to our long-term priorities, we are starting to see the tangible benefits of our long-term growth strategy and the shift of our revenue mix towards the fee income.

It's becoming visible as a result of this.

Last quarter, we talked about our efforts to capture more of our clients' investable assets and our investing and retirement cross-sell effort continues to gain traction.

And new primary client acquisitions, referral sales, brokerage fees, were all up linked quarter and year over year.

In the residential mortgage banking business, volume trends were actually quite good in the second quarter with loan originations of $4.7 billion, up 11% linked quarter and 30% over the second quarter in 2012, consistent with our strategic objectives.

We have expanded our seamless delivery program across our entire network of mortgage originators and brought our average time to close for loans going through the new process down to 38 days in May.

That's about 20 days better than our peer average of 58 days.

And we believe -- we think we can do even better.

And, importantly, we are already seeing customer satisfaction scores rise significantly from the past.

Now, clearly, higher rates here are going to slow application volume, and in turn, decrease gain on sale margins.

Notwithstanding this, it appears that our model of retail only originations focused on purchase transactions, increased capacity and the rollout of seamless delivery have all combined to mitigate the potential decline relative to our peers.

In the retail bank, we have had a lot of activity inside of our delivery channels as we work to build the bank of the future.

We consolidated 78 branches this quarter on top of the 30 we consolidated in the first quarter, and we are still targeting a total of about 200 for the year.

You will see, and we also announced, that we are phasing out traditional free checking.

And, despite this activity, attrition of our existing customers has been less than expected.

We actually added 55,000 new DDA households and grew average loans by about $300 million in the second quarter.

And C&IB, as we have been expecting for some time, the market has become more competitive, and it is more difficult to win new primary clients and grow loans while maintaining our risk and return thresholds.

So, while we continue to prospect for high quality new clients and grow loans, and we did add more than 200 clients in the second quarter in the corporate bank, our focus is shifting towards developing deeper and more valuable relationships with many of the 3000-plus new clients that we added over the last few years.

We continue to make good progress in growing our share in the new Southeast markets as well as the underpenetrated legacy markets like Chicago.

As we looked at what the Southeast is contributing in terms of new clients, and the positive effect of our Southeast operations on fee income, we can start to see the benefits of the RBC Bank acquisition coming into focus.

In the second quarter in the southeast, we added 11,000 DDA households in retail, 95 new primary clients in wealth, and we have also seen a dramatic increase in new client wins in corporate banking in the Southeast.

Year to date, over 20% of our new primary client wins in the corporate bank are coming from the Southeast markets.

Now, much like our ongoing efforts to bring our Midwest markets in line with the performance of legacy PNC markets, our play in the Southeast is part of a long-term strategy that's going to take time and patience.

But the market's receptivity to PNC continues to be enthusiastic and we are quite encouraged from it.

We talked in the past about how we are positioned to grow relative to some other institutions because we have a lot of leverage to pull depending on market conditions.

And this quarter is an example of our ability to make money even as the environment changes.

It was an excellent -- you know, we think it was an excellent quarter, even without counting some of the select items.

And, while we are optimistic about the opportunities in the remainder of the year -- and Rick is going to provide an update on some of the guidance in a second -- clearly this remains a challenge in a competitive environment.

And that's probably a good place for me to turn it over to Rick to go through the quarterly results.

Well, thanks, Bill.

Good morning, everyone.

Let me begin with our balance sheet on slide 4.

Total assets increased by $3.6 billion on a linked quarter basis, as the growth in commercial and consumer lending was partially offset by a reduction in investment securities.

Investment securities were down $1.9 billion or 3% compared to the first quarter as we replaced a portion of the prepayments, maturities, and sales activities during the quarter, with forward settling positions.

I will talk more about this later.

We saw continued loan growth in the second quarter.

Total loans increased by $3.3 billion, or 1.8%, on a spot basis compared to the first quarter.

Commercial loan growth was the primary driver of our increase in loans.

Total commercial lending increased by $3 billion compared to the first quarter of 2013, as a result of increases in asset-based lending, healthcare, real estate, and public finance.

Consumer lending saw a modest increase of approximately $300 million on a linked quarter basis, primarily due to home equity loans and automobile lending, partially offset by paydowns in education lending and residential real estate.

Shareholders' equity increased by $600 million, or almost 2%, in the second quarter, primarily due to the growth in retained earnings partially offset by a decline in AOCI.

As a result, we ended the second quarter with strong capital ratios.

Our Basel I tier 1 comment ratio at the end of the second quarter is estimated to be 10.1%.

That's up 30 basis points since the end of the first quarter.

Our Basel III tier 1 pro forma common capital ratio was estimated to be 8.2% as of June 30, 2013, without the benefit of phase-ins, a 20-basis-point increase from March 31.

We achieved this improvement despite a $500 million after-tax decrease in security valuations as interest rates increased and spreads widened.

The growth in retained earnings and a modest decrease in risk-weighted assets exceeded the impact of the security valuation decline.

Although we now have final Basel III rules, we have not completed our review and continue to use the proposals for our estimate of Basel III common capital.

However, we are confident that the changes in the final rules from the proposals will not be negative to our common capital ratio.

We continue to believe we will be well-positioned to return additional capital to shareholders in 2014.

Turning to our second-quarter income statement on slide 5, our net income for the second quarter was $1.1 billion or $1.99 per diluted common share.

Our return on average assets for the second quarter was 1.49%, an increase of 15 basis points compared to the first quarter; a strong performance.

We produced $4.1 billion in revenue, up 3% compared to the first quarter, and 12% compared to the same quarter a year ago.

The increase was primarily driven by strong noninterest income performance, which increased $240 million or 15% on a linked quarter basis.

While customer fee income was strong, this quarter also included higher gains on asset sales and valuations.

I will give more information on these gains in a moment.

But you can see the details of these items on page 16 in the consolidated financial highlights.

Those increases were partially offset by a decline of $131 million, or 5% in our net interest income when compared to the first quarter, which was a result of lower core net interest income and lower purchase accounting accretion.

This decline is more than we expected, and I will provide more details shortly.

Second-quarter expenses of $2.4 billion were in line with expectations.

As a result, our pretax, pre-provision earnings were $1.6 billion, an increase of 4% compared to the first quarter and an increase of 67% compared to the same quarter a year ago.

Provision in the second quarter was $157 million, lower than the guidance we provided, to do better than expected improvement in commercial credit quality.

Looking to the third quarter, we expect the provision to be between $170 million and $250 million as we expect the impact of improvements and commercial credit quality to ease, and we expect an overall increase in credit exposure.

Now let's review the components of net income in more detail.

As you can see on slide 6, our total net interest income declined by $131 million or 5% on a linked quarter basis, primarily due to a 4% decline in core net interest income.

Approximately $50 million of the decline in net interest income was from securities, due to an expected decline in security yields and, in part, to the portfolio management activities mentioned previously.

We sold approximately $2 billion of securities in the quarter when long-term rates were lower, contributing to security gains of $61 million for the quarter.

We also had approximately $3 billion of security portfolio runoff throughout the quarter, due to prepayments and maturities.

We did put some of that money to work later in the quarter when interest rates were higher and spreads wider by purchasing securities for delivery in the third and fourth quarters.

While decreasing net interest income in the second quarter, these activities should benefit net interest income in the future.

As a result, we expect net interest income from securities to improve in the third quarter versus second quarter.

The remaining decline of $80 million resulted from a decline in net interest income from loans of $75 million.

The $75 million decline included a $20 million decline on maturing swaps related to loans; a larger than expected decrease in purchase accounting accretion of $45 million, primarily due to lower cash recoveries on commercial impaired loans; and a $10 million decline as loan yields were partially offset by higher loan balances.

While we do expect further pressure on loan yields, we do not expect a decline in net interest income from swap maturities and purchase accounting accretion to continue at these levels.

Keep in mind that cash recoveries on commercial impaired loans was only $10 million in the second quarter.

It can't get much lower.

Looking to the third quarter, we expect net interest income to be modestly down as the continuing impact of lower loan yields and a decline in scheduled purchase accounting accretion should be partially offset by loan and securities growth, including the portfolio of management activities we took from the second quarter.

For the full year, we now expect purchase accounting accretion to decline by approximately $350 million versus 2012, and in 2014 we expect purchase accounting accretion to be down approximately $250 million compared to 2013.

As you can see on slide 7, total noninterest income increased by $240 million, or 15%, in the second quarter compared to first quarter results.

Bill spoke to you about the progress we are making on our strategic priorities.

Further evidence of that can be seen in the growth we saw during the second quarter in our customer-facing fee categories.

Asset management fees increased by $32 million, or 10%, on a linked quarter basis.

Consumer service fees were up $18 million, or 6%, compared to the first quarter, primarily as a result of higher debit card, merchant services, brokerage, and credit card revenue.

Corporate services increased by $49 million or 18% linked quarter, which was primarily due to a $33 million increase in valuation gains from the impact of rising interest rates on commercial mortgage servicing rights valuations and a higher capital markets revenue.

Residential mortgage had strong loan sales revenues.

Originations were up 11% on a linked quarter basis and the gain on sale margin of approximately 4% was flat compared to the first quarter.

This resulted in 10% increase in loan sales revenue to $190 million.

However, total residential mortgage fees were lower than first quarter, primarily due to an increase in repurchase demands, as Freddie Mac requested additional files on older vintage loans, primarily 2004 and 2005, as National City was a large originator with Freddie Mac during that period.

As a result, we recorded a provision of $73 million for residential mortgage repurchase obligations.

This provision covers new originations in the second quarter and the additional demand for loan files.

Finally, deposit service charges increased by $11 million, or 8%, linked quarter.

We also sold $2 million of our Visa Class B comment shares in the second quarter, resulting in a pretax gain of $83 million.

We continue to hold approximately 12.4 million shares of Visa Class B common stock with an estimated fair value of $950 million as of June 30, 2013.

These shares are recorded on our books at approximately $200 million, resulting in an unrecognized value of approximately $750 million pretax.

And, as I mentioned earlier, the securities sales resulted in a net gain of $61 million.

In addition, we saw an increase in revenue of $37 million, associated with the impact of higher market interest rates on valuations related to customer-initiated hedging activities.

Effectively, the higher interest rates reduced the fair value of our credit exposure on these activities.

Our diversified business resulted in non-interest income to total revenue increasing to 44% in the second quarter.

That compares to 40% in the first quarter and 30% during the second quarter of last year.

We continue to expect that full year total reported revenue will increase in 2013 compared to 2012.

Now turning to slide 8, second-quarter total expenses increased by $40 million, or 2%, as we expected.

This is primarily due to a $30 million non-cash charge on the redemption of trust preferred securities, along with a $22 million increase in marketing expenses.

As you recall, our goal is to achieve a total of $700 million in continuous improvement cost savings this year.

A significant portion of these dollars are being used to offset investments we are making in our businesses and infrastructure.

Through the first half of the year, we have captured approximately $600 million of annualized savings.

This gives us confidence that we will exceed our full year cost savings target.

For the third quarter, we currently expect non-interest expenses to be up modestly compared to the second quarter, and we expect full-year 2013 expenses on a reported basis to be below 2012 by at least 5%.

Our credit quality continued to improve in the second quarter, as you can see on slide 9. In the second quarter accruing loans past-due, nonperforming loans, and charge-offs were all lower compared to the first quarter.

Net charge-offs were $208 million, a decrease of $248 million, or 54%, reflecting, in part, the $140 million impact of the first quarter alignment with regulatory guidance related to consumer lending.

We also saw commercial charge-offs decline by $91 million to $30 million during the second quarter, although this level of commercial net charge-offs may not be sustainable.

As you can see on the chart, we released $57 million in reserves from our commercial book during the second quarter, primarily due to improved credit quality.

And we continue to maintain our reserves for consumer lending as we monitor our performance on refinancing interest-only home equity loan maturities.

As a result, our provision of $157 million declined by 33% on a linked quarter basis.

This reduced level of provisioning may not be sustainable.

Overall, PNC posted strong financial results in the second quarter, due in part to certain select items that may not continue at these levels.

Looking ahead to the third quarter, we do expect modest growth in loans and solid growth in fee income as defined on slide 7. We also expect net interest income to be down modestly and non-interest expense to be up modestly when compared to the second quarter.

And we expect the provision for credit losses to be between $170 million and $250 million as we expect the pace of commercial credit improvement to ease and net credit exposure to increase.

And, with that, Bill and I are ready to take your questions.

(Operator Instructions) Gerard Cassidy, RBC.

Good morning, guys.

Bill, can you give us more color on the competition on the commercial loan side?

Your yields, you show in your second-quarter report here, declined fairly meaningfully to 3.71% from 4.03% in the prior quarter.

Is it the Southeast or the Midwest?

Where is the real competition?

Well, first off, inside of that decline, a chunk of that -- Rick knows the number -- came from swaps that matured that were effectively A&L management long positions that we used to manage deposits, but we point them to loans.

And as they roll off, the reported yield on loans drops.

So the actual spread on the loans that we have on the book declined this quarter versus prior quarters.

You know, there's no increase or change, really, in the trend.

On the demand side, the fight for small business, commercial, middle-market, generic product is pretty fierce.

And we haven't seen much growth in that product, either outright new balances or changes in utilization.

Where we continue to see progress is in our asset-based lending and our real estate and some of our verticals, healthcare and public finance, and specialty lending segments where we just, frankly, we run into a lot less competition.

The smaller banks aren't playing in that space.

Yes, I think if I could help a little bit there, you also had in that total loan yield balance -- you had about a $40 million decrease in purchase accounting accretion related to cash recoveries, which is about 9 bps of the decline, as well as, to Bill's point, the decline related to the swap maturities.

So I wouldn't read anything into the trend line here.

Are there any swaps coming off in the second half of this year that could affect the yield?

There are, but they are not as material as what you saw in the second quarter.

Remember, part of the noise you are seeing inside of yields, inside of NIM, and inside of net interest income, was a conscious decision as we basically -- when rates going back to April were down at [1.65] in the [ten-year], we just let stuff roll off.

We weren't replacing anything and then we accelerated it through sales.

So, in effect, we took a lot of chips off the table, didn't replace, and then replaced towards the end of the quarter.

It wreaked havoc on our reported NIM and net interest income this quarter, but we think it was the right economic thing to do for the long-term.

Can you also share with us, with the final MPR out on the Federal Reserve's interpretation of Basel, banks under $700 billion in size will be able to choose if they want to keep the gains or losses in the securities portfolio in regulatory capital.

Have you guys figured out which way you're going to go on that yet?

I think the rule is that, if you are a mandatory opt-in B-II bank, that you don't have a choice and you have to (multiple speakers) AOCI.

Yes.

So we are in.

You're in.

Okay.

And then, finally, in terms of the outlook for the tier 1 comment ratio, assuming you get to your targets, do you think next year that we should expect a meaningful amount of shareholder -- capital return to shareholders?

Yes.

Great.

Thank you.

Next question, please.

Scott Siefers, Sandler O'Neill.

Good morning, guys.

Rick, I was hoping you could maybe speak a little to the core NII number.

I think, to sort of oversimplify it, I mean, you guys are doing giving a lot of good color on what happened this quarter.

And I guess it boils down to as much a timing issue as anything else between the securities gain and then the reinvestment.

But, if you guys have a little more pressure in the third quarter, are we getting to a point where that core NII number kind of settles out in maybe call it the $2 billion-ish a quarter range?

And what are the major puts and takes that you see going forward that would impact that number?

Well, you're going to continue to see pressure on loan yields.

I mean, we would expect that to come down, but I think that balances we will add in lending will offset that in terms of what the impact will be on core net interest income.

We have already spoken briefly about the securities portfolio, where you will see a decline in yield there as well.

But, again, the reinvestments Bill mentioned in the third and fourth quarter should help us to be able to maintain that balance and grow net interest income.

The pressure is going to be on the scheduled accretion of purchase accounting, where you would expect that to continue to come quarter over quarter.

Yes.

I mean, one thing I would point out with all the press on higher rates and how this helps in the future, we are rolling off securities with average yields -- I don't know, Rick -- they are 3.25% or something -- and we are replacing them at 2.75%.

So all else equal, if we stayed equally invested, you would still continue to see a decline.

Having said that, we have been massively underinvested, and increasing that short position through the front end of this year as rates got lower and lower.

So our ability to increase invested balances, even at somewhat lower rates than our average, is going to increase the amount of revenue we get from it.

And we can argue about the levels, but one thing is certain.

We are closer to fair value on fixed rate returns today than we were in April.

Okay.

I appreciate that color there.

And then, Rick, just want to make sure that I understand the guidance clearly.

Just on the fee income side where you are expecting solid growth in the third quarter, that is off the -- sort of an adjusted number where you -- we'd remove some of the unusual items that you guys have called out.

Is that correct?

Yes.

Scott, if you go to Schedule 7 of the report there -- I don't know, Bill; you've got the actual number there -- it's off of that fee income number you see there, which is -- how much is it?

It's $1.294 billion, Scott.

You see we kind of drew [a total of] fee income.

It takes out the security gains and that sort of thing.

That's what we are talking about.

Perfect.

Okay.

I also just (multiple speakers)

And then, what we are looking at -- we are not expecting the repurchase reserve to repeat.

And also in that you have on the commercial side the valuation on the [CMSRs].

We are not expecting that to repeat either at that level.

But we will grow off of those numbers, yes.

Okay.

Perfect.

I appreciate it.

Next question, please.

Paul Miller, FBR.

Hey, just a follow-up on -- the valuation of the CSMR number, can you remind us again where did that flow through to and what that number was?

Yes, the actual number was (multiple speakers) -- was actually $45 million CMSR in the quarter.

It was actually $11 million in the first quarter, so that is your increase of about $34 million.

And that flows through your corporate service line -- corporate service fee income.

Was there any one-time items in the asset management?

Or is that just lumpiness that comes from the BlackRock investment?

Yes, and I think we will just have to wait for BlackRock to release tomorrow.

Okay.

And then on consumer services was also strong; was there any one-time items in there or was that just strong second-quarter performance?

No.

That's just adding customers and focused on the brokerage business, the retirement investment business, getting that to be more of an annuity product going forward.

No, that's just good growth.

And is that a seasonal number or is that just growth because you are increasing your customer base?

It's clearly seasonal off the first quarter, but you can see we've got strong growth year over year as well.

And is the growth coming from the RBC acquisition, South?

I mean, can you follow up a little bit, add some color to that?

I would suggest that that is in there, clearly, but it is not driving the number yet.

Not driving the number?

And on the mortgage side, can you talk a little bit about where do you see the gain on sale in the third quarter or is it too early to tell?

You know, we have seen rates go up.

It looks like switching to more of a purchase market to a refi market, and how you fit into that.

Yes, well, it is -- look, like everybody else, we expect it to decline as volumes decline and capacity and volume start matching.

Now, one thing that benefits us, and you see it in our printed numbers versus peers going back through time, is the fact that we are kind of retail only, not through correspondent channels.

So that will help us.

And we have been focused on purchase and have grown purchase, my guess would be at a pretty good clip relative to peers and as a total percentage of the origination.

So that will help.

But it's going to decline as total assets decline.

We will wait to see how much that is.

But we feel pretty good on a relative basis as to where the Company's positioned.

They've done a good job reconfiguring the old National City mortgage.

And have you been able to put lenders down South?

I mean, one of the discussions about RBC didn't have a lot of product offerings.

Are you able to get stuff down there, too?

Yes.

We have full product and client teams in all the markets down there and have had sort of six months after we close the thing, we are basically up and running.

And, as you heard it my comments, we have been growing clients across all lines of business, including wealth where they had literally nothing.

They didn't have a single employee.

But the reception on the corporate side, wealth and retail we are growing clients.

It's pretty good.

And, by and large, we find those markets, particularly on the retail side, to be less competitive than some of our other markets.

And on the commercial and corporate side, no more competitive than the other markets.

Okay.

Hey, guys, thank you very much.

Next question, please.

John McDonald, Sanford Bernstein.

Hey.

Good morning, guys.

Rick, can you give us a little more color on why the provision came in better than expected this quarter and why you see it going up a little bit next quarter?

Yes.

We just, during that quarter, we didn't quite see as much growth as we were expecting in the loan book.

We did have good growth, but it wasn't as much as we were hoping for.

And then I think if you take a look at the charge-off line, as it relates to the commercial book, they were extremely low in the quarter.

And so, therefore, the pace of the improvement of credit quality in the commercial bank is much more than we had anticipated.

Now, going forward, we just think that that pace of growth is going to ease a bit from where it is today.

And we think we are going to continue to add credit exposure -- net credit exposure to the portfolio overall.

As a result we have hedged our guidance back to the $170 million to $250 million range.

Okay.

So the form it would take would just be smaller reserve release but charge-offs probably still improving?

Well, the charge-offs on the commercial side were particularly low.

That is kind of our issue.

We don't operate the business.

We don't think of the business running at those levels in the near term.

It is great that they do and we hope they continue.

But it is not really indicative of what we would say is in our book.

So I would expect to see additional commercial reserve release.

But I would not expect any on the consumer side.

Got it.

Okay.

Thanks.

And on the put-back provision, have both Fannie and Freddie now look back to the early 2000s for you guys?

I'm just trying to gauge any room for additional surprises here or changes in their behavior.

Well, they did approach us in November.

They asked for about 8000 files.

They came back in May and asked for something like 10,000 files.

So they had actually upped their interest in the files related to the old Nat City originations.

We hope they are done.

Okay.

And then one bigger picture question.

Return on assets, 1.49% this quarter, very close to your target.

Just kind of think about how does that improve over time.

And what is your longer-term target of where you would like to see ROA headed?

Well, John, I think in the past we've said we wouldn't hit 1.5% without some help from rising rates.

And we got it this quarter, but in a different kind of way in the impact on some of the asset yields and so on.

I still think -- we still need to have a higher rate environment to exceed 1.5% over time.

Okay.

Thanks.

Next question, please.

Todd Hagerman, Sterne, Agee.

Good morning, everybody.

Just a couple of questions; first, just a follow-up on mortgage.

I think, Rick, you mentioned, in terms of the MSR or the servicing rather [in R&W] not to continue.

But I guess kind of a broader question is the Company was fairly positive in terms of the outlook for mortgage coming into the beginning of the year, fell short a little bit in Q1.

Obviously Q2 was kind of not what was expected.

But given the commentary we have heard from some of your peers, I'm just trying to gain a sense or reconcile between the increased capacity, perhaps more capacity on the HARP side.

If you can get a better read in terms of the back half of the year, all else being equal, kind of where you see this trending -- particularly like the servicing, for example, has been threatening trending lower at a clip much faster, so to speak, relative to expectations at this point in the cycle.

Well, actually -- let me point out, in Q2 actually we were quite pleased.

We had $4.7 billion in originations.

Margins stayed flat at about 4%, a 10% increase in originations revenue.

We were pleased with that.

But, you are right.

We do expect those volumes to fall off in the second half of the year and the margins to go with it, as Bill mentioned a minute ago.

I don't know if, Bill, you have further to add to that.

No, I think that it's hard to argue that applications for the industry aren't going to fall with higher rates, so that is going to happen.

We feel pretty good about our position inside of that decline in apps.

But we, like everyone else, as we go through this, we are also going to have to make our engine a little more efficient and take capacity out on the cost side.

And I think you will start seeing people start to talk about that.

And while refinance is going down, our percentage of purchase mortgage this quarter was 28%, which was pretty high relative to others.

Yes.

(multiple speakers) I was just going to say, where did you end the quarter in terms of the forward pipeline relative to March?

I don't have that number in front of me.

No, but it's obviously a little softer.

Yes.

But I would tell you it's not lower by the same big percentages I've heard bandied about.

Okay.

And then, just finally, perhaps, Bill, a little bit more on the debt side -- you know, borrowing costs perhaps did not come down as much as expected; some of that timing.

I know that you have talked about in the past terms of leverage on your wholesale borrowings, if you will.

I am just curious as you look out the back half of the year, how rates in the long end have moved as they have in terms of order of magnitude, what kind of leverage can we really expect in the back half of the year?

As you noted, some of the debt was replaced here in the first half.

And how should we think about that in the back half of the year and the leverage on the borrowings?

I am not sure I quite follow the leverage on the borrowings comment, but just on the (multiple speakers) --

I'm thinking about the spread and just in terms of leverage on your borrowing costs at this point.

Well, a couple of things; the vast majority of the investment that we did in the back, literally, couple of weeks of the second quarter were forward settling.

So you're going to see stuff show up later in the third quarter and into the fourth quarter, whether you will start seeing the improvement in income from the balances.

You know, the simple math is we are rolling off balances as they mature at 3%-plus yields and replacing them at 2.75%.

But, we are very underinvested relative to what we should be in terms of the value of the deposits we hold.

So we have a lot of room to put money to work at more rational rates.

And rates today -- you know, they are rallying a bit today, but rates today are still almost 100 higher in the [ten-year] than they were in the [tights] at the beginning of the second quarter.

No.

I understand.

I guess part of the question was really the fact that you did issue some debt here in the first half of the year.

But I guess I am more sensitive to -- with that scheduled maturities in the back half and certain opportunities you may have otherwise, would we expect some of that to just roll off without being replaced?

Sorry, just dropping our cost of funding on wholesale borrowings?

Is that were you are going?

Yes.

Again, I mean, there are scheduled maturities and other opportunities within the debt, but.

Yes.

Look, I think, by and large, and Rick can comment on it, that we have kind of played out the ability to drop our cost of funding.

You will see us change our mix of funding, perhaps, as we look at bank notes and other things that we want to do as we get ready for LCR.

But I don't think you're going to see a big change in the cost of funding.

For us, it's really an issue of what's going on in the asset side, how we choose to invest in fixed rates through the rate cycle and our ability to grow loans at a decent risk-adjusted return, albeit, while credit spreads in general continue to decline.

I mean, that is the game we and every other bank the country are playing right now.

Thanks very much.

I appreciate it.

Next question, please.

(Operator Instructions) Moshe Orenbuch, Credit Suisse.

Great.

Thanks.

Just really following up on that last one.

I mean, most other banks have kind of sounded a little more hesitant to invest their liquidity at this point in the cycle than you.

And maybe I am reading in too much, so correct me if that is not right.

But can you talk a little bit about your thought process there?

Yes.

Sure.

Look, we are not at all thinking we are going long in this market, but we had literally gotten to the point where we were running everything off and not replacing anything off of what was already a very short position.

So simple prudence, given the backup in rates, at least has us replacing runoff -- particularly runoff and then sales that occurred in the second quarter.

So it's not as if we are going to go out and think this is the panacea of we are buying the market here, but it is enough of fair value or higher than simple prudence suggests that we ought to replace some.

And that is what you will see us doing.

Got it.

And our duration of equity is still negative -- what, three, 3.5 years.

Something like that.

So it is still pretty short.

Perfect.

And, separately, just on the mortgage gain on sale.

I mean, I know that you kind of didn't want to talk about where it is running in the third quarter, but any thoughts about where it ended the quarter versus the average?

Just any kind of look into that?

Towards the end of the quarter it was probably closer to 3.5% as opposed to 4%.

But, you know, so it was coming down in terms of the overall margin.

Got it.

Thanks.

Next question.

Erica Daniela, Bank of America.

Good morning.

My first question is a follow-up on your expense guidance.

Rick.

You said full-year expenses in 2013, lower by 5% year-over-year.

Is that a core number excluding some of the TruPs redemption charges and [merger] charges?

Or is that off of the reported number?

That is a reported number.

And, as you know, the TruPs and integration and all that will be effectively 5%.

And we are going to beat that, so we are going to be below $10 billion

Got it.

And just one more question on the margin.

Relative to your core loan yields of 3.77%, as you look at your production pipeline, what is your replacement yield on the loan book?

I think it really depends on the business.

I mean, asset-based lending is still getting good returns.

Commercial real estate is still getting good yields.

If we are adding it to our conduit, which is basically the securitization activities, that is very high quality paper.

But you're probably only seeing 150 basis points or even less.

So it really depends on the mix of the book.

I guess what we see and we hear from the business is that the trend line in credit spread decline hasn't really changed, right?

They have been kind of grinding in a couple of handful of basis points a quarter and that continues.

And notwithstanding the noise that you see in the reported numbers in the second quarter, the trend didn't really change in terms of what we are originating in credit spread.

It's just, you know (multiple speakers).

Got it.

Okay.

And just one more strategic one, Bill, if I can.

Clearly, there is a lot of news out there about a large European bank looking to sell a large bank in your neighborhood.

And I guess I am wondering, given your emphatic response earlier in the call about increasing capital return next year, is looking at this deal a total nonstarter for you?

Or would you potentially think about maybe liquidating your BlackRock stake and consider doing something like this in your backyard, given the implication for cost savings?

No.

That's perfect.

Thanks.

(laughter) Next question, please.

Ken Usdin, Jefferies.

Yes.

Hey, guys.

Good morning.

Just one more follow-up on the fee side and the outlook.

There is a lot of moving parts and I know you put this below the line type of stuff in there, but still a bit confused on what you're actually saying about what fee base you grow off of.

Is it just that [1294] piece that grows or -- because if the other -- I guess the question is, what happens with the other line that you put below the line?

Yes, if you go to slide 7 of our presentation, we have fee income of $1.294 billion.

That is up from $1.251 billion in the first quarter.

We are basically saying that we will grow fee income solidly from the $1.294 billion.

And then can you just give us a little context, then, of what's the driver underneath the other and why that wouldn't grow?

Well, I don't think, unless the opportunities present themselves, we are going to have a lot of net gains on securities, given where rates have moved to.

Potentially, as we consider monetizing Visa, we could have further gains there over time.

But that is hard to predict.

And then within the $372 million, you have about $35 million due to rates going up on our client hedging activities in the credit exposure-related debt to CBA.

I am not expecting that to repeat, so I think that number will be lower.

But if you take that other category, typically we say that's about $250 million to $300 million, is what you can expect out of us; maybe a little higher than that now.

Maybe we should be pushing that up to $275 million to $325 million, given the growth in the Company.

Okay.

Great.

That's helpful.

Thank you.

The other question I have is just a follow on.

BlackRock -- you know, last quarter [in the] quarter there was a lot of back and forth just in the market.

And I just wanted to give you guys the opportunity again just to level set everybody on just your thoughts around where you stand there, and then, what path would eventually need to be taken for you guys to even get to a point where you would consider some optionality -- exercising some optionality on the BlackRock stake.

You know, we have said the same thing for a long period of time.

BlackRock has been a phenomenal partner and investment for our Company.

I wish we had this issue five times over inside of the things we own.

Having said that, we recognize that through time BlackRock has become more of an investment than a partnership.

We recognize that we have a large position that we need to be cognizant of, because it takes up a big chunk of our capital on our balance sheet.

We currently like the returns that we get from it.

We know that because of the low tax base in that ownership, that an outright sale of that entity is not friendly for shareholders.

So the best thing I could say to you is that you should think of us as rational stewards of your capital.

We look at that position and think of ways to optimize it.

There is nothing currently on the table that we are contemplating that would do better for you than simply owning it today.

And that is where we are.

But we look at it all the time, as you would expect us to in any position we would hold that would be that large.

Understood.

Thanks, Bill.

Next question, please.

Jack Micenko, SIG.

Hi.

Good morning.

Most of the questions have been asked and answered, but I wanted to just go to the expense commentary, on track to exceed continuous improvement in the slide deck, and then commentary you said about $600 million annualized.

Does exceed mean dollars, meaning there is more than $100 million more to go of opportunity?

Or does exceed mean timing in terms of just realizing it sooner?

And then, remind us -- I believe most of the RBC expenses were more front end weighted there, but is there anything incremental on the RBC side still to go on the expense side?

No.

The RBC was already baked into our investments for the year.

Just, you had $150 million in 2013, which is the full year running rate of what we invested in 2012.

But we do plan to exceed the $700 million.

We haven't quantified by how much.

And I think that will contribute to the fact that we are going to exceed a 5% decline in year-over-year reported expenses.

I mean, I would tell you that Rick continues to hedge his expense guidance a little bit.

It's getting a little more bullish that, I mean, originally think we said we would be flat core and now we are saying we are flat to down, and we'll be a little more than 5%.

But the practical truth is that the Company has really gotten behind the notion that we need to drive a more efficient organization.

And we continue to be positively surprised by what we are seeing on the day to day roll up of numbers, whether its headcount or outright expenses.

So our guidance is what our guidance is, but I like what I am seeing.

I like the work the Company is doing.

I like the fact that the employees have kind of gotten a bit between their teeth and are taking this seriously.

And we are encouraged by it.

Okay.

So going forward, is it CIP 2.0 or is it just, hey, expense guidance is down X% or whatever from here?

Well, what did you say to him?

Are we -- we're going to be down more by -- what was your quote?

Down by (multiple speakers).

Our reported expenses will be down year-over-year by more than 5%.

Okay.

Fair enough, guys.

Thanks.

And every nickel we can find beyond that, we will find.

Exactly.

Next question, please.

Matt O'Connor, Deutsche Bank.

Hi, guys.

Just coming back to the size of the securities book and just the capacity that you have to add over time, and I realized that you wouldn't do this this quarter or next quarter.

But just conceptually, if you wanted to get back from this negative three-year duration of equity, I think you said, to zero or negative one year, what is like a long-term goal for that?

And what would that mean in terms of adding securities or adding swaps to your current position?

Well, just a couple of comments on the book.

One of the things that you will have noticed if you have done the peer comparisons, if you look at our -- well, we put our after-tax loss up.

But if you look at the pretax equivalent of that against the notional of our book, you would come to the conclusion that it's a very short duration book.

And, as we've said before, a big chunk of that is floating.

So don't get hung up on the notional of the book relative to what we would do in terms of closing the duration gap on equity.

With respect to outright buy volume that we could do to get to a positive duration of equity, all I would tell you is it is a substantial amount.

There has been times in our history -- in fact, we got this really right going into the rate rally post the crisis.

I think our equity duration was north of -- what, Rick -- three, four years.

Yes.

Exactly.

So there is a lot of room to go from here and big impact, ultimately, on NII, when and if we get to that point.

But we haven't put out, and I am not going to quantify, what a year's worth of duration of equity is in terms of security balances.

But what you can take away is just based upon the portfolio activity we did in the second quarter, and the investments we have made to date that are going out into the third and the fourth, is that you can expect about $1.5 billion to $2 billion increase in average security balances going into the third quarter.

Okay.

And there would be some additional securities settling in the fourth quarter, then?

Correct.

And some swaps that are going to settle in 2014, which will also add net interest income over time.

Okay.

Meaning the swaps in 2014 -- that settle in 2014 are currently a drag?

Yes.

Well, they are not a drag.

They're just not there.

When we reinvested the proceeds, basically the drop price on a forward settled security and/or starting swap, the implied financing -- to bore you with details, the implied financing price of settling that forward was negative.

It was a big yield pickup to start forward, so that is what we did.

Okay.

Got it.

So just in summary there, you had some swaps roll off 2Q.

You replaced them with some swaps of that will kick in in 2014 and boost the net interest income then.

Yes.

I think the most important thing is we will have loan balance increases in the third quarter versus the second.

We will have security balance increases in the third versus the second.

And in both loans and securities, the yields will be down, but to the tune of where purchase accounting accretion will cause you to have a modest decline in net interest income.

Okay.

All right.

That's helpful.

Thank you.

Next question, please.

Steve Scinicariello, UBS.

Yes, just real quick, just given the strong loan growth that we saw in the quarter -- I mean up 1.75%, with C&I up 3%, just kind of curious what we are really some of the strong drivers there and how sustainable?

I know the growth is -- the guidance is for modest growth, but how sustainable are some of these kind of underlying trends that you are seeing just as you look ahead?

Well, on the commercial side, we continue to benefit from the verticals in the specialty lending.

So you saw growth in asset-based lending; interestingly, some of that growth coming on the back of utilization increases, which is the first time in a long time we have seen that.

And you see growth in real estate balances largely as a function of utilization increases as projects fund up and get completed, although we had good originations there as well.

Specialty lending in some of the verticals and in healthcare and public finance, our equipment leasing business, we feel pretty good about the activity in those businesses.

If we were relying on pure, plain-vanilla, senior secured, commercial middle market, I would have a different take on what we could do.

But the specialty stuff continues to play out for us.

I think we also, on the consumer side, this is the first time we have seen an increase in home equity -- net home equity balances.

I think as housing prices have rebounded a bit, people are getting a little bit more equity in their home and able to borrow against that.

So that was good to see that balance go up.

We haven't seen that in several quarters.

Yes.

Great.

So it just sounds like you are being a little conservative, maybe, on the modest growth outlook, perhaps, or what would be some of the constraining factors then?

I mean, look, we would hope we would be able to grow faster at a good risk-adjusted return.

I would tell you that the market, certainly in certain sectors, is getting increasingly competitive.

And there's areas where we are choosing to walk away, given the spread or a structure on a loan, where a year and a half ago we wouldn't have because you would have been paid better for it.

So that's probably the constraint.

It's just relative competition and the degree to which the credit markets get overheated here.

And, plus, we still have runoff in the education lending.

You've got runoff in the nonstrategic assets related to (multiple speakers) --

In restaurant, real estate (multiple speakers).

-- residential, mortgage.

Yes.

Exactly.

So I think you're going to see balances that are putting pressure on downward as well.

Got it.

Thanks so much.

Next question, please.

Matt Burnell, Wells Fargo.

Good morning, guys.

Just a follow-up on the last question in terms of borrower demand.

I guess I'm just curious as to whether or not you saw a meaningful decline in borrower demand as rates were going up in June.

And, if you did, if you saw an improvement in demand heading into July, particularly in some of the verticals you mentioned where you have seen somewhat stronger growth?

You know, we didn't -- in terms of funding and pipelines, I don't know that you saw it.

Anecdotally, when the rates first spiked, you know, you would hear a lot of comments of kind of deer in the headlights and people just choosing not to make a decision.

But in terms of just volumes, I don't know that that necessarily flowed through anything.

You know, we did see -- less so in our books given the business we are in, but in the leveraged credit side and high yield and the larger syndicated leveraged loans, we [obviously] saw a complete freeze in the market when rates get up as people were trying to react to that.

But that really didn't impact us.

Okay.

Then just a couple of housekeeping questions.

Rick, I think you said the -- if I heard you correctly, the portfolio duration of the AFS portfolio, you said, I believe, was between three and 3.5 years now?

Is that -- did I hear you correctly?

I would say --

(multiple speakers) duration of equity.

Yes.

That the duration of equity and that was a negative (multiple speakers).

Oh.

Okay.

The securities portfolio is about 2.5 to 3 years.

Okay.

So that really hasn't changed much since the end of the first quarter.

No.

Okay.

That's correct.

And then I noticed in the home equity portfolio, it looks like recoveries improved pretty visibly quarter over quarter at the highest level in more than a year.

Net charge-offs in that portfolio continue to come down.

But nonperforming asset balances are up about nearly 60% year-over-year.

Is there something going on there?

Or was that more due to just that regulatory guidance?

Well, keep in mind that the decline in the charge-offs in the home equity was because of the policy change we made in the first quarter, and that hit home equity as well as residential mortgage.

And, in total, that was about $134 million.

So the first quarter was inflated, I guess is what I would say, and obviously it's going to come down in terms of charge-offs.

Our nonperforming, you have got -- we are seeing a little bit of risk in the home equity.

I think you have seen that nonperforming number going up each of the last five quarters.

But we have -- but inside our nonperforming, we have those same [negative] balances, right?

We do.

Yes.

So it has been a change in what is considered nonperforming, which has caused some of that increase.

Okay.

Thanks for taking my questions.

Next question, please.

Betsy Graseck, Morgan Stanley.

Thanks.

Good morning.

Good morning, Betsy.

Hey, a couple of follow-up questions.

One is on the Basel III final rule, so that got done.

Wondering what BlackRock was designated as.

Is it designated as a financial institution and does that change how you think about it?

You know, we've got 1000 pages we are looking through and we are studying the whole thing, but we really don't have a view right now on exactly how that's going to be handled.

We are still sticking, at least at the moment, and the ratios we have put out here for you, based on the original MPRs and based on our understanding of that.

Okay.

Secondly, on the expense ratio, Bill, in the past, you have mentioned how part of the reason why structurally your expense ratio is higher than peers and your tax rate lower is because of how you structure some of your affordable programs -- affordable housing programs, if that is the correct term for it.

And I'm just wondering, is there anything afoot to potentially changing that structure, or are you sticking with what you've got?

We are not changing the business.

It's a very high return business for us.

It just looks confusing on an income statement.

But the economics to shareholders are good and so we will continue it.

Okay.

So the structure remains the same.

That's correct.

And then, just lastly on the Southeast franchise, I mean, we've talked a lot about how that has been a contributor to the growth here this quarter.

Could you give us a sense as to where it is in all the metrics that you manage to -- you know, efficiency ratios, sales ratios, FT efficiency, all that kind of stuff -- how it is ranking relative to the rest of the bank, and what kind of timeframe it takes to get to the rest of the bank levels?

I'm basically trying to understand are we going to be accelerating from here or is the rate of change that we experience this quarter high or likely to persist?

Well, a couple of things.

We don't have exact internal metrics where we'd compare efficiencies by regions, but I would tell you without having those that the Southeast is much worse than everywhere else.

And Rick is looking at me.

I guess because of accretion accounting (multiple speakers)?

Yes.

It's almost like the story at the top of the house.

You've got the purchase accounting accretion causing the efficiency to be good, and that is going to run off as we grow fee income and other lending.

But the core activity in those markets is well below what we --

Yes.

-- do in other markets.

And that is the opportunity set.

What you see in terms of growth is interesting because we continue to run off non-core balances in the market.

There is a lot of investor-owned real estate and stuff that we just don't want.

Yet we have been able to do that and replace it with clients that we do like and balances that we do like.

The timeline on it -- you know, we think of the Southeast as we want to turn that into the next Philadelphia or Cleveland or big market.

So we don't sort of -- this isn't a one- or two- or three-year game.

It's going to be a long-term game where we are in those markets and turn those markets into markets that behave like our legacy markets, which are materially more productive today than what we see in the South.

We knew that going in.

We are pleased with where we have got to today.

My guess is it will continue to improve through time, based on what we are seeing.

Sure.

So the rate of change that we are seeing this quarter, likely to persist for a bit.

I mean, obviously, it is going to kind of fade out in terms of rate of change, but increase in terms of total dollar contribution to overall PNC.

I would like to think so, yes.

Yes.

I guess I was just wondering, if it's possible at some point to maybe sketch out that -- how you guys are seeing that rate of change in that timeframe.

It would just be helpful, because I think a lot of the questions on the call have to do with -- as you well know, the expense ratio and just triangulating to that would be helpful.

Yes.

Fair enough.

I mean, we don't -- because we don't -- purposely don't do regional P&Ls given some things that are regional and some are centralized, we don't run the Company that way.

But we do look at metrics in the Southeast in terms of levels of activities and loan balances and clients, and we can do better and should do better going forward to put some of those metrics out to you guys.

Okay.

Cool.

Thank you.

Next question.

Nancy Bush, NAB Research.

Good morning, guys.

A couple questions; number one, Bill, you escaped the net of the of the leverage ratio, at least this time around, which applies to the top six institutions.

Do you have any concerns that's going to get sort of pushed down the banking size ladder as time goes on?

You know, not particularly.

They kind of came out with it and it doesn't impact us as defined, and it certainly hasn't come up in sort of any of the speeches that I've heard.

I would tell you (multiple speakers) -- do we put this out?

Well, even as defined, we exceed both the [5% and the 6% number] (multiple speakers).

(multiple speakers) Yes, we are comfortably above it where we are today in our business model.

Arguably, we are not changing our business model, so even as we grow, we continue to support those higher levels.

So it didn't cause us a lot of concern one way or the other.

Right.

Okay.

And on the issue of acquisitions -- future acquisitions, there's been a lot of complaining in Washington because the largest banks have increased market share so much in the interim since the financial crisis.

And a lot of that share, of course, has been buying failed institutions, which the Congress folks seem to ignore.

And you, of course, were the beneficiary of not a failed institution, but a marginal one, to put it nicely.

And do you foresee any point at which you think you might get pushback if you wanted to do another sizable deal?

I mean, are they going to sort of try to constrain the size of the banking industry as it stands right now?

You know, I just don't know, right.

Everybody talks about that.

It's a practical matter.

We got approval to do RBC.

We haven't really focused on it because we have enough on our plate today in terms of what we are trying to accomplish and grow.

So, since acquisitions really haven't been on our radar, we haven't been too sensitized to whether they would let us do it or not, to be honest with you.

Okay.

Thank you.

Yes.

So I think that was our last question, Bill.

Do you have any closing comments?

Yes, just real quickly, so this is after eight years of doing these calls, this is Rick's last time doing the call.

I'll be joined in the third quarter by Rob Reilly.

But on behalf of the firm, I just say thank you to Rick for helping us steer through what was a fairly remarkable eight years for our Company and the economy and we greatly appreciate it.

Thank you, Bill.

Thanks a lot, everybody.

We will see you in the third quarter.

Ladies and gentlemen, this concludes the conference call for today.

You may now disconnect your lines.

Have a great day, everyone.