Bancorp Inc (TBBK) 2016 Q4 法說會逐字稿

Good day, ladies and gentlemen. And welcome to the Bancorp, Inc Q4 2016 earnings conference call.

(Operator Instructions)

As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. Andres Viroslav, you may begin.

Thank you, Sandra. Good morning and thank you for joining us today for Bancorp's fourth-quarter and FY16 financial results conference call. On the call with me today are Damian Kozlowski, Chief Executive Officer and Paul Frenkiel, our Chief Financial Officer.

This morning's call is being webcast on our website at www.thebancorp.com. There will be up replay of the call beginning in approximately 12 PM Eastern time today. The dial-in for the replay 855-859-2056 with a confirmation code of 51403334.

Before I turn the call over to Damian, I would like to remind everyone that when using the conference call the words believes, anticipates, expects, and similar expressions are intended to identify forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to risks and uncertainties which could cause actual results to differ materially from those anticipated or suggested by such statements. For further discussions of these risk and uncertainties please see the Bancorp's filings with the SEC. Listeners are cautioned not to place undue reliance on these forward-looking statements which speak only up to the date hereof. The Bancorp undertakes no obligation to publicly release the results of any revisions to forward-looking statements. Which may be made to reflect events or circumstances after the date hereof, or to reflect the occurrence of unanticipated events.

Now I would like to turn the call over to Bancorp's Chief Executive Officer, Damian Kozlowski. Damian?

Thank you, Andres. Good morning at this for joining us today. My name is Damian Kozlowski, I am CEO of Bancorp and the President of Bancorp Bank. I've been in these positions since June 1 and I welcome you to our fourth-quarter earnings call.

Discontinued operations in Walnut Street were reevaluated with updated values. Which resulted in a significant charge during the quarter. We completed a full review of both discontinued operations in Walnut Street and enhanced its governance process.

Our goal as stated before is to lower the risk in the portfolios, and complete an orderly wind down with the least future volatility. We had one credit inside discontinued operations where there was a suspected fraud leading to a write down. We have provided in our earnings release more detail on our credits from discontinued operations and have provided a chart that detail the asset types and other information.

We're continuing to make progress concerning our regulatory situation. We're in the process of creating a new integrated compliance plan that will build off our work in BSA and [mal] third-party risk and consumer compliance. This plan takes the detailed regulatory matters encyclopedia we have created in the previous quarter, and lays out a future state for the organization.

This project will be fully completed by the end of the second quarter and should improve our compliance operating environment significantly. The goal is to get at and resolve the root causes of our regulatory issues. We also have also hired key new management that has been approved by our regulators which be announced the first quarter.

Our run rate profitability showed improvement this quarter, reflecting elimination of the BSA look back expense and terminated in the prior quarter and other factors. Revenue momentum continues while expense cuts and restructuring are beginning to have an impact on profitability. While certain of the expense cuts are not immediate, we've targeted total 2017 expense reductions of $20 million.

Here are some additional highlights. As we have discussed previously, our integrated business plan has been completed and are now in the execution stage a version of the plan is on our website. As part of the plans' implementation we have created a detailed 2017 budget and strategic agenda for the Company. This budget has been approved by our Board and is consistent with the three-year plan.

We have also created a comprehensive goal setting process for the organization and it is based on the strategic plan. These goals cascade throughout the organization and each employee has goals that are based on the plan starting with me. My goals include our budget, financial targets, key strategic items for each business, and key enabling items that need to be accomplished to make our organization perform better across the enterprise.

Our expenses continue to show improvement. Our cost reduction effort has identified approximately $20 million in operating cost saves for 2017 over 2016. We have a signed agreement to sell our European operations. If this transaction is closed pending regulatory approval, it will reduce any restructuring charge visa vie winding down those operations.

As reported previously, we are completing the sale of our remaining HSA business, which will reduce our operating expenses significantly reduce number of accounts the Bank manages. The transaction is still pending final OCC approval and will likely be realized in the first or second quarter.

Loan revenue continues to growth year-over-year both year over year and quarter over [linked] quarter reflecting growth in loan balances and increasing interest rates. Continuing GDP growth should also support prepaid revenues.

Year-over-year gross dollar volume for prepaid cards increased 12% while related fee income increased 8%. Year over year loan growth was led by leasing, which grew 50% and link quarter loan growth was led by SBA which grew 5.8% or 23% annualized. In summary, we have continued to make progress in implementing our integrated plan and look forward to what we think will be a substantial change in operating performance in 2017.

I am now handing it over to our CFO, Paul Frenkiel.

Thank you, Damian. Our fourth-quarter results reflected a $5 million charge on a suspected fraudulent discontinued loan and a $25 million charge to the retained interest in Walnut Street. It is important to note that a significant portion of the charged Walnut Street is market and not credit driven. The charged to Walnut Street reflected continued clarification of market and credit loss related assumptions based on feedback from available sources, including updated market information and projections of potential future loan losses, based on new facts or circumstances.

While the majority of the remaining assets in Walnut Street are paying in accordance with their contractual loan agreements, information regarding market driven valuation assumptions and future potential losses continue to be updated and assessed for inclusion of fair value analysis.

Excluding BSA look back costs, which concluded in the third quarter of 2016, fourth-quarter non-interest expense reverse trend and exhibited a decrease from the third quarter of 2016. This reduction reflects the beginning of the implementation of identified expense reductions. As Damian noted for 2017, a total of $20 million in non salary related expense reductions have been targeted.

Discontinued loan balances continues to be reduced. September 30, 2016 unpaid discontinued loan principle of $410 million included $70 million of residential mortgages. That left approximately $340 million commercial loan principal.

During the third quarter, $340 million of commercial loan principal was reduced to $324 million primarily as a result of principle payment. The mark against those loans of $45 million at September 30, 2016, was increased to $50 million at December 31 primarily as result of the suspected loan fraud as noted previously. Thus, the $324 million of commercial loan principal, plus the quarter end mark $50 million resulted in approximately $274 million of net commercial loans at year-end, that compared to approximately $295 million of net commercial loans at September 30.

At December 31, 2016, the largest 12 discontinued loan relationships, each of which exceeded $8 million, amounted to $232 million and had a mark of $40 million out of the total year-end mark of $50 million. Of those, $232 million, $72 million were not performing and had $36 million of marks against them and were thus, 50% marked. Accumulative marks against the original outstanding principal for the remaining $232 million for those large relationships amounted to $60 million or approximately 24%. We have included a chart in the press release summarizing this analysis.

Year-over-year increases in our loan portfolio were reflected in the 34% increase in net interest income. Our largest percentage increase in loan balances was in leases which grew organically 25% over the year, with 50% overall growth after considering purchased portfolios. Continuing purchases of portfolios confirmed the viability of this growth strategy.

Loan balances, excluding loans held for sale, grew 14% year-over-year. Linked quarter loan growth on an annualized basis was approximately 8%. Our continuing lending lines of business have historically had low charge-offs.

Prepaid deposits are the largest funding source and should adjust only a portion of future increase in market interest rates. The interest margin will accordingly benefit with related rate increases on variable rate S block and SBA loans and the significant portion of the investment portfolio, which is rate sensitive.

The net interest margin for the quarter was 2.84% compared to 2.52% in Q4, 2015. The increase reflected a reduction in balances at the Federal Reserve Bank earning a nominal rate and the 25 basis points [debt] increase in December, 2015.

The reduction in Federal Reserve Bank balances and resulting improvement in net interest margin reflected the impact of the exit of nonstrategic deposits in first quarter of 2016. In December of 2016, The Federal Reserve Bank again raised interest rates and those is consensus for additional rate increases in 2017. These increases should increase net interest income, as a result of the aforementioned variable rate assets.

Fourth-quarter average prepay deposits, which are the primary driver of deposit growth, increased by approximately 16% over the prior-year fourth quarter. Bancorp supports many of the industries' leading players in payment. Continuing initiatives are projected to contribute to continuing GDP growth, which should support the income.

Loan growth continues to increase revenues, which should increase further as a result of the Feds' 2016 and future rate increases. We are moving ahead aggressively with the $20 million of targeted non salary expense reductions. All of those factors will support achievement of our budgetary goals in 2017.

Damian, this concludes the financial reports.

Thank you, Paul. Please open the call for questions.

(Operator Instructions)

William Wallace, Raymond James.

Good morning, Wally.

Hello, I guess have a few questions, but maybe just for a point of clarity, on the Walnut Street, you mentioned that the majority of the mark was driven by market not credit. Can you break out the difference? And maybe talk about both the method that you are using to value this trust, and why there is such a significant mark?

I was thinking of it as being more representative of collateral value given this was a troubled loan portfolio that you are using another form to work out. So I wasn't really thinking about a significant interest rate value in these loans. But maybe you could just provide a little clarity around that?

As a result of the markdown, the majority, and as you can see in the table in the press release, around 20% to 25% of the Walnut Street remaining values are non-performing. So the big market adjustment comes when you discount those future cash flows which will occur heavily over the next several years if you discount them back at a market rate for comparable type securities. We relied on a third party for input, and in terms of determining and updating those discount rates, and we will be specific as to those rates in the 10-K. But the largest factor was, in fact, the discount rate.

And what was the dollar amount that was related to the discount rate? What was the dollar amount that was related to credit?

There are multiple assumptions that go into the model in terms of trying to be predictive in terms of cash flows and so forth. So the actual amount of discount rate can actually vary in different scenarios.

We will be as specific as possible. We are relying heavily, as I said before, on the third party. And they have actually given us several scenarios, all within reasonable ranges. And we are going to rely on them to present that information for our 10-K, so I'm not going to speak to that now until I get their detailed written report.

So is the third party that you're speaking to, is that Angelo Gordon? The (multiple speakers) --.

No, that's the purchaser and the investor in the securitization. It is a reputable CPA firm that we use.

And is it being valued like a security?

Yes, it is basically being valued like a security. It is not a typical security. And it is unique, so actually a model has to be built from scratch to capture both the non-performing and the performing portion.

We've been through it; we have studied it. The third party came up with it. And we think it's a good presentation, and a good way to value the security.

Of course, as we move closer toward recognition and receipt of the cash flows, the amount of the discount mark reverses itself slowly quarter by quarter. So we felt that, overall, that was the appropriate way to value the security.

Of the three scenarios that were provided, is the value that you used for the market most conservative?

They all ended up pretty close to each other. So, I think we had a fairly tight range in terms of the different ways we could value it.

Okay. And when this was presented to us back in 2015, my recollection is that it was suggested that this was a portfolio of problem credits that were going to be managed by Angelo Gordon who invested in the trust. They were going to be working out these credits. Is that the case? Or should I think of it as a marketable security, where, if you can sell it, you will sell it, or what?

There are no plans to sell the security. And, yes, there is a third party. Because it was a sale, the bank effectively gave [up] control of the ability to manage both loans and so forth. But we do have at least a little bit of insight into how these loans are being resolved. So that hasn't changed. But from an accounting point of view, we obviously want to do the most we possibly can to be proactive and value the asset appropriately.

Okay. Switching gears, the one credit in the (inaudible) portfolio if you can give us some specifics around the size of the credit, and what the potential fraud is and how that slipped through the cracks?

I can't speak in a lot of detail with respect to that loan. I can tell you that work has been done. The Bank had taken action to examine the collateral. And subsequent to that, we became familiar with information that suggested that there was a fraud involved.

I can't really speak and give more detail. The loan was over $10 million, or somewhat over $10 million. But other than that, I can't really give you any more detail because it is a suspected fraud. And we just can't go into more detail.

I wish you guys could provide some color. You are not giving us anything. It happened at --?

We will check with counsel and see what we can provide, in the K or otherwise. But obviously, in a suspected fraud, there's litigation. There's other issues. So, as of this call, I can't really speak to it. But we will check with counsel and see if we can provide more information.

But prior to the fraud being uncovered, the Bank had, as part of the process of review, both discontinued and Walnut, had engaged a third party to review the collateral in full. That was not the source (multiple speakers) of this particular loan.

A third party was engaged because we just wanted to check as we're checking out all the loans. That did not uncover the fraud. It was a subsequent event that uncovered the fraud.

So, not even a third party after its review had discovered it. It happened subsequent to that, in a very short period of time actually. But we can't give you any more color and we will try to give as much color in the 10-K.

Okay. I guess the bigger question is -- I mean, it would be helpful if -- I'm sorry, I'm stuttering because I can't formulate my questions here. But we keep getting these credits that pop up and you're taking really big marks on them, suggesting that they aren't being carried at collateral value. So maybe you could help us get some comfort as to what is the collateral value of this portfolio at credits versus the carrying value?

Because it seems that you're carrying a lot of these loans [involve] the collateral value. And then every time you have a problem, whether it's a fraud or a bankruptcy or whatever, you have to take these massive marks. And I guess I was under the assumption that the third-party review was marking these down with the value of collateral in mind, not necessarily the value of the cash flows?

Well, the value of the collateral was shown as adequate for this loan. The issue was that there was a fraud involved related to the collateral.

If you think about, there's been really two extensive reviews that have occurred since June. One was the initial review that we did when I entered the Company prior to raising capital, and that identified I believe nine credits, three which were in the Walnut Street structure. And that was very detailed loan by loan. And it focused on discontinued.

Nothing that happened subsequently, the loan or this fraud, the loan to the mall or the fraud, was the result of that actual review. Those were events that happened subsequently.

And then after that, because of the need to gather the total picture and all the information, that's when we started an extensive review also of the overall credits within, and then the overall, whether we had the correct respective value, based on changes in market rates on Walnut Street. So that review took a while. It actually extended almost up to this time of these earnings calls, in that our call report even had a different value in it.

And we believe and do feel very comfortable now that, after six months of work looking at individual credits, also assessing overall values, that we are much better on understanding the cash flows of each of these loans and the collateral values. And that's a statement that we believe is -- we are trying to be as transparent as possible. And we are trying to work through two very difficult portfolios. And we think we've made the adjustments necessary to significantly reduce the volatility in the future.

Okay. I appreciate that you guys feel more confident now. And perhaps for us to feel more confident, us being the analysts and the investor community, if you would be willing to share what your estimate of the collateral value of the 12 loan relationships of better than $8 million and the discontinued portfolio versus the carrying value, that would be helpful. Also, if you'd be willing to share what portion is out of market versus in market in the discontinued portfolio? And then the same for the Walnut Street Trust.

That might help us get more comfortable and maybe allow us to direct our questions in a manner that will inform us when we're making investment decisions. That's helpful for us to be able to see what you are seeing, to the extent that you are able to share it. I don't see why you couldn't share what the collateral (multiple speakers) --.

Okay. So we actually looked at that, Wally. And I did a lot of analysis and had other people look at it. It's a lot of different collateral -- different types of collateral. So it's not that easy.

And it depends on the loans. Certain of the loans have personal guarantees where we feel extremely comfortable with the net worth of the individual. So (multiple speakers) I will look at that again.

Paul, so what you're saying is, if I have a loan that I lent somebody $1 million and the collateral's worth $500,000, but their net worth is $5 million, I'll carry that at $1 million, is that what you're suggesting?

Yes, so, (multiple speakers) --.

But you have an estimate of the collateral value, so perhaps you would be willing to share that? And then, we can talk about personal guarantees and other collateral that you guys have recourse for. But we don't have any idea --?

There are always three sources of repayment, I'm sure you're aware of. And the Bank has been, in this order. One is simple cash flow of the loans, the second is the actual collateral value as a backup to that, and the third being a significant guarantee. Guarantees that we don't believe are significantly covered we do not -- just want to make it clear, we do not include those in evaluation of the value of the loan.

We will take what you're saying to heart, Wally. We are understand, and we are trying to be as transparent as possible in the situation. We understand the consternation around the two portfolios from two guys who are trying to work out the situation in a forthright and transparent way, we will try to disclose everything we can.

Thank you, Damian. I appreciate that. A few more questions, and then I will step out. I apologize for taking so much time.

The expense levels, I was surprised that given the significant headcount reduction that occurred late in the third quarter that we didn't see a meaningful drop in the expenses (multiple speakers) --?

You are going to see, we believe, and I stress this: You are going to see the expenses going down sequentially over the next few quarters. And the expense targets that we have that will produce our targets within our business plan on our website will be met.

There were a lot of contract negotiations that were ongoing, where there's going to be significant amount of saves on our operating costs. So you will see that [$42 million-ish] number move down nicely, we believe, over the next few quarters. And we will be realizing gains.

There are a few things like the Europe sale, renegotiation of our operating platform costs. The HAS accounts that will be leaving us hopefully in the first quarter. All that has a dramatic impact on the operating costs of the Firm. So the $20 million that we've identified will be coming off fairly rapidly.

Okay. Just for clarity, you did cut out $12 million of annual expense at the end of the third quarter. So there had to have been something that came in, in the fourth quarter. I don't know if it was accruals that you caught up on or what that took away that roughly $3 million of benefit that we were anticipating. So what was in the fourth-quarter number that wasn't in the third-quarter number I guess?

You will see a reduction. So we reverse trend in salary. You will see a reduction. There was some residual accrual related to the staff reductions.

Yes, we can only take a portion of it in the restructuring charge, and the rest of it had to be expensed in the fourth quarter.

And if you look at the total [non-interest] expense, we did reverse trend. You will see in the 10-K that we did have somewhat higher legal. And we are trying to get a handle and better control of the legal.

Okay. So (multiple speakers) there wasn't any severance or things like that in the fourth-quarter number?

It was a lot of little things, clean-up, quarter-to-quarter comparisons, those type of things. We are being very aggressive in closing things out, and negotiating endpoints. So I think you will see the first two quarters this year are going to be very telling, obviously for the performance of Bancorp.

So hopefully -- we're going to continue on trend with revenue. And you will see those expense cuts both on the personnel, but especially on the operating side, starting to trend down. So you are at $42 million now, and you are $3 million to $4 million trending down over time, probably the first two quarters, we have a very clean site to it, let's put it that way. We know where they are coming from.

And when you said in your prepared remarks that there's going to be $20 million of cost saves in 2017 over 2016, just for clarity, can you help us understand the base? If I back out all of the BSA look-back stuff, I get to about $158 million. Is that the number that you are using as a baseline, to the $20 million of cost saves?

Yes, but you have other run-rate expenses there. So if you're using a model, you have to adjust for some other expenses, but that's roughly correct. The $42 million is more of the base. That's not far off.

Okay.

But we know where those expenses are coming from. Some of our expenses are related to the revenue we created, too. So that's always a difficult calculation. But the ongoing expenses that we know we have, that we've identified in a very stringent process, we know we will realize those saves.

So depending on the revenue growth of the Firm -- hopefully it will be robust. Let's put it this way, if we don't get those saves, it will only be because our net income is up substantially because the revenue will be up so much.

Okay. Understood. And my last question before I hop out, just to maybe address capital. You raised capital -- in the past calls there's been discussion of an 8% minimum and a target of 8.5% to 9%. Can you talk a little bit -- I think an average of 7.1%.

Can you talk a little bit about the levers that you see to get that back up to the minimum of 8% or correct us if that minimum is not something we should be thinking about? And then what your view on accessing new capital to achieve that goal would be?

Okay. Right now we are not considering capital at the moment to increase our capital base. We are expecting capital accretion in the first couple of quarters. And we have identified $400 million of deleverage.

The first quarter we always have more volume in deposits because of certain seasonal factors. But by the second quarter, our balance sheet will shrink. That will be helping us a lot. But also we think that within the first two quarters we will accrete capital.

There are other factors that may also help us, like interest rate increases. But also disposition of certain assets that we have mentioned on these calls before. So, we think we are in a fairly good position, and have a path to close the gap over the year, and ultimately get to our capital minimum we want to be at, at 8.5%. I've communicated with our regulators about this.

So this can change, of course. There is multiple parties involved. There's myself, our Management team, there's the Board, there's regulators. But right now we think we can live within the capital constraints we have. And going into the year, we will improve those ratios.

Remember, we are only talking about Tier1 capital really. All the other risk-based measures are very, very healthy. And the reason is because the types of assets we hold, especially with SBA and our S-block businesses don't affect that -- those ratios -- in the same proportion. Right now we're fairly comfortable we can work our way to a higher capital base, without raising additional capital at this time.

Okay. And you said $400 million in deleverage that you have identified and does that --?

Our balance sheet at the end of the year was a little bit inflated for a couple of reasons. One's gift cards, one is for the loans we're holding that were sold into a security. So we have a first-quarter bump due to seasonal tax return volume. But going into the second quarter, you will see a deleveraging.

There's one client and also the HAS business will reduce about $400 million more off that base. So you will have a shrinking of the balance sheet at the same time we believe we will be accreting capital. So that should be able to close the gap, hopefully fairly quickly, and by the end of the year be in a position where everybody will be comfortable with the aggregate level of capital at the Tier1 level. Once again, the risk-based capitals are not a concern of anyone.

Okay. So, on a risk-weighted assets basis or tangible assets perspective, you expect more than $400 million of deleverage from the fourth-quarter level?

Correct. (Multiple speakers).

So what is the total? Where do you think your assets will be in the second quarter?

This is very hard to predict, but we are hoping to be around $4 billion.

Okay. And on the Tier1 capital side, do you have a DTA valuation allowance? If you're able to reverse that, will you be able to capture any of that in Tier 1 capital or are you full right now on the DTA portion of your Tier 1?

I love this complicated -- this is a question that should never be asked on any earnings call. But, yes, there is a portion that will go into Tier1. Paul, would you like to try to tackle that?

Yes, so, we are looking for some reversal in 2017, and hopefully a significant reversal of the more than $25 million of valuation reserve that we have now. If you look at the fourth-quarter results, we didn't recognize any tax benefit from the loss. And that adds to our deferred tax assets.

Out of conservatism, accounting does not allow you to recognize that. But in consultation with our accountants, we'll look to, with several quarters of profitability in 2017, we will look to reverse a significant portion of that.

Right, but assuming you reverse 100% of it, you're not (multiple speakers) --.

Yes, so, the specific rule is, yes, as Damian said, it will contribute. It will contribute directly to our earnings. So, how it will play out, as we accrete earnings, that earnings in the coming quarters will have zero tax expense because of our loss carryforwards. And further, in addition to that, you should actually see a credit to tax expense. So that will run through earnings, which will, therefore, contribute to capital, based upon our budgetary projections.

Okay. I will step out. I have taken more time than I should. Thank you. I appreciate it.

Thank you, Wally.

Frank Schiraldi, Sandler O'Neill.

Hey, guys.

Hey, Frank, how are you?

Good, thanks. Most of my questions have been hit probably there, but back to Walnut Street, so, Paul, it seems like the move in interest rates was really the biggest factor here in terms of the valuation down, quarter over quarter? So, 50 basis point of move in the longer end or whatever it was seems like not so significant to move Walnut Street as much as it did. I'm just wondering if you have some sort of interest rate sensitivity table you can share with us on the present value of these things?

It really wasn't the long-term movement in interest rates that was the issue. It's really the discount rates compared to other securities that our third party suggested would be one option or one way of looking at the security.

What we are trying to do is, when we reviewed the entire scope of activities for Walnut Street, we did look at the individual loan marks. And those loan marks are within the presentation we issued with earnings. So there were marks taken.

But when you look at the loss at the end of the day and try to understand it vis-a-vis where the value on our balance sheet was, that is driven by a new model that was created. And what we are attempting to do here is get a value on the balance sheet that will not be impacted by future volatility of those assets or changes in rates in the marketplace. So you are trying to provide yourself with a loss cushion based on the cash flows under a reasonable circumstance. And that is what we have tried to do, because we appreciate that we can't have continued volatility, either out of the discontinued portfolio or within the scope of the security.

What we have also done is also put the structure on non-accrual as another safety valve. So prospectively we were getting $3 million of interest. We have also put that on non-accrual, too. So that will reduce the principal.

So what we've done is try to set barriers on the structure, knowing the collateral being reviewed by a third party so that the value on our balance sheet is a most likely low volatility number. So we don't have to talk about it constantly changing quarter after quarter. And that we have a very good visibility to the cash flows. And even those cash flows with those visibilities have been discounted appropriately using third-party rates, in order to take notice of the losses that could occur. Not the losses that have been identified, but additional losses that could occur based on the history of the portfolio. So that's why it was done.

The model today is very prospective. It is based on the performance of what this structure should yield over the next years, and what the Bank should ultimately get back, discounted on the inevitable, unlikely occurrences that always happen in portfolios such as this, based on third-party assessment of that potential volatility.

It seems to me though as rates move, if you are marking this to market, and if you're looking at other securities, the third party is looking at other securities, as rates move that is going to create more volatility in that market price?

There is a little bit of interplay in the model on that, Frank, because certain of the loans are fixed rate. But remember, the maturities are fairly short term. And a good portion, I don't recall the proportion off hand, but a good portion of the loans are variable rate. So as interest rates go up, and that's true, you are absolutely right, the discount rate will necessarily go up. The rates on the individual loans go up, so they basically offset.

But if you look at the projected interest rates of 75 basis points a year from now, even if there are three Fed increases, we will already have had maturities of the performing loans. And then we will be a year closer to the other one. So it has limited impact. And Damian and I believe that if you look at the model and all the assumptions, we can only do what accounting lets us. But in this case, in looking at what the third party says, and looking at the valuations and the third-party marks on the remaining loan, it seems to be the proper balance.

Our question is, is it a reasonable cushion? We all know the history. Many of you have been following the banks for years. I've obviously only been here for six months. We know the history. We're trying to create a situation, knowing the history, but also working within the rules.

But we feel very comfortable working within the rules, that we now have a value on the balance sheet that will be far less volatile. It might actually -- the way the structure works is, as Paul was saying, if those losses and those cash flows are actually accurate, the discount rate, of course, would be amortized in the reverse direction. Because that is a view of future risk of cash flows on each of the A and B notes that we have in the portfolio. So if we actually get the cash flows that are predicted, you would have the reversal obviously, based on the discount rate that would come back to the bank.

Now, having said that and knowing the structure, that is a cushion for us. The second cushion then now is, and we discussed this because of the history of the structure, we put the whole thing on non-accrual. So we had been taking interest from this structure and now we will be using that interest that is generated from Walnut Street to pay down principal.

I think those two cushions should give everybody -- I know people will obviously question us. And look, it has a history. And we understand that. And we are trying to do everything possible to put that aside, to clean the desk of the Bank so we can get to work on producing profits in the future.

And are there any big bulky loans in Walnut that you would expect or are maturing in the short term here that we would expect any discount could get reversed right off the bat? Is there any calculation we can do to think about what discount could come back into the book over time given the average life of the portfolio, or some bulky stuff maturing in the short term?

On a quarterly basis, it really doesn't change that much, Frank. Because, as I said before, the interest on the loans is offsetting the loans on the interest rates. In any given quarter, you don't really see a lot of change. But after a year, it will be more meaningful, after about a year.

Okay. And just in terms of -- you have marked it to market here, essentially, so why not try and sell it? Is it just too unique of a situation or --?

In essence, we did sell it, okay, now since we did -- .

It is sold already.

Yes, it's sold, but it's still on your balance sheet, so the investment. So, selling that investment.

Frank, that discussion between assets, Walnut Street structure and any other assets in discontinued, is an ongoing conversation. And if we have opportunities, we will dispose of it. As you know, in the third quarter we did dispose of another chunk of loans. So those conversations are ongoing. No decision has been made.

But with anything with a history, it's really the price that someone would put on it. We think the current value on the balance sheet really does adequately portray the non-volatile asset value now, discounted, of course, for the potential volatility. But that doesn't mean necessarily there's a buyer in the market who will pay that number, even though that's the correct number to have on our balance sheet.

But we do have conversations about that with different parties. I want to wind it down as quickly as possible, let's put it that way. So if we do find selective buyers, or buyers for the whole portfolio, we would execute on that.

Okay. Just one other on credit: I'm not sure if you talked about it, but the fraud in the quarter, can you share, how was that detected? Was that part of a review of going around looking at the collateral?

Unfortunately there's another third party now assessing the situation. Hopefully we will be able to disclose more on the 10-K. Let's put it this way, there was a third-party assessment of collateral who gave the collateral a value. Then it was called into question by an action of the sponsor. That was uncovered through regular means, let's put it that way, that was related to the disposition of a business by that sponsor.

And as soon as we can give more color, we will. But there are proceedings involved and other third parties that unfortunately we can't talk about on this call.

But you had a third party review all the collateral, and so you are saying, in this case --?

Weeks before, a third party reviewed the collateral, and believed that collateral to be valid. And we have a report on that collateral. This was part of the ongoing discontinued review that we had done. And we had identified that we wanted to go look at that collateral, just to check it, and we did that. And that collateral was there and it was bona fide collateral, by a third-party appraiser that does this for a living, and then it got called into question.

The value of that collateral, because of the suspected fraud, we have a responsibility to write it down under the circumstances we are in. However, that collateral may or may not have the value that the third party assessed to it. But that would be a recovery.

We are very conservative. The view of the Banks today is to be very conservative in those situations and to be very aggressive with sponsors that default. The mall is just one example. Once a problem was identified, we did everything to resolve the situation with the borrower. If not, we will aggressively enforce our rights.

Sometimes the aggressiveness does result in a near-term writedown. But the philosophy of the current Management team that those actions will result in a better disposition in the future. So, especially with portfolios that are difficult, we need to be aggressive and assess value immediately. If we recover more later, we can't delay in taking those situations on a very proactive basis.

And that sometimes, when you're working out portfolios, and they do have histories, you will see some of these losses happen. Since I've done this before, you will see them up front. And if anybody on the phone does this for a living with distressed assets, you usually see this happen up front. You resolve the issues. And then hopefully you mitigate the loss, the long-term loss. And then hopefully you have gains at the back end.

And that's exactly how we are approaching it, just like a distressed manager would approach it, of course fundamentally using Bank rules and GAAP, of course. We are following those rules, of course. But that is the mentality we have for those two portfolios.

Okay, and then just on capital, you talk about an 8.5% Tier 1, Damian, Tier 1 leverage. Is that a goal by the end of 2017? Or is that a longer-term goal?

No, I want to get there -- one way or another I would love to get there by the end of this year. I would be okay with 8%. I'm not okay with not getting to 8%. So we have to figure out a way of 8%, right?

The first two quarters is going to tell you everything. So I think you're going to know a lot. I've been here for six months now. We have taken a tremendous amount of actions to make the Bank better.

And it takes a while to get these things done and get them implemented. [HAS sale] of Europe took us seven or eight months to negotiate and make sure we had the right type of buyers. But these things are meaningful. They have real meaningful impact to the bottom line.

So they tend to collect and then hit all at once. So you will see a lot of this coming in the first and second quarter that will tell us a lot.

Okay. So if I think about the contraction, you talk about $400 million in the balance sheet, that should boost by like, what, by 80 basis points or something? So I don't know. If I think about the math, you're at a 6.8% at the Bank on a Tier 1 leverage. If you contract that -- the balance you have a $400 million, then maybe you are at 7.6%. And then as long as you put up a 40 basis point ROA or so this year, you will be at 8%, so is that a reasonable way to think about it and that's --?

That's an excellent analysis, and that's exactly right. But we think we will be around [4%]. We are targeting about [4%-ish] for the balance sheet level at the mid-year point. Somewhere around the mid-year, hopefully we will get down to somewhere around there. It depends on our business volume, too, because if we are having incredible growth then that's difficult to contain. But then we'll have more accretion of net income.

But that's a very good analysis. We want at least 50 basis points of ROA for the Banks next year, 2017. And as you know, from our presentation, we want at least 5% ROA. Those are hard-stop numbers for us. We will not consider ourselves in any way successful as a management team if we don't hit those two targets we have for 2017, those two near-term targets.

Okay. Just a quick one on expenses, if you take the $42 million expense base, and you say you're going to make up $20 million more in 2017, just take $5 million off that quarterly? And is that a reasonable run rate, $37 million a quarter?

So within the expense envelope that we already talked about, the $168 million, so depending on the revenue scenario as you look at the Firm, you are looking around anywhere from $40 million to the $38 million or maybe a little bit less the $40 million per quarter. But have we identified cost saves to get us to the $38 million range? Yes, absolutely. So you may not see that in the first quarter, but we should trail down.

There are other things we don't account for that hopefully as we get rid of our -- or resolve, let's put it that way -- resolve our regulatory situations. There are other goodies in there that we'll get. But we don't account for any of those.

We just think on the operating draws of the business, considering the changes we've made, we should start trailing down nicely over the next couple of quarters. And as we purge accounts like HAS and other things, we should lower the balance sheet size and also lower the operating run rate costs. And that's without assuming that there's any other types of restructuring of people or anything else.

None of that is built into it. We don't expect any of those things. I'm just saying that there's nothing more than the actions that we have already identified built into the base plan for the Business. We're hoping for better. So we're going to keep on working on it.

Just to mention, there's three phases we're going through on the expense side. I think I mentioned this before. Phase 1 was just an initial identification of people that we thought -- we were overstaffed. That was 20% of the people. The second phase was 20% of the expense-base operating cost. And those have all been identified and we're working through the system now.

And the next phase is the reengineering phase. We have a lot of duplication, like activities that are not centralized. That is the reengineering phase. It will start mid-year and that will last probably 6 to 8 months. But we don't know what the impact on the cost structure will be of that. But in my experience before, that can be another 20%. So that is yet to be identified, but that is the cost mentality we have.

Thanks.

Matthew Breese, Piper Jaffray.

Morning, everybody. Most of my questions have been answered, just a few modeling areas. When we talk about getting to your comfort zone on the capital levels in 2017, does that include recovering portions of DTA?

No, that would be a bonus.

We don't include any. In our base model we don't include any interest rate increases. And we include no DTA benefit or any disposition of assets, so the pure operating performance of the Company should result in 50 basis points and [of greater] 5% ROA. That's our goal.

Okay. And then with the DTA, and pardon me if you said this before. I just wanted to clarify. What is the guidance for the tax rate in the first and second half of 2017?

Okay. So because we have the carryforwards, we should not have any income. At a minimum, we should not have any income tax expense against -- pre-tax income in those quarters, or for that matter, for the rest of the year.

Do you anticipate paying taxes in 2018?

It depends if you take the full benefit in. Correct me if I'm wrong, Paul, but once you take the full DTA in, and we really need two clean quarters before we can do that. So once you have two clean quarters, then you do an assessment of future cash flows, future profitability. And that, obviously you work with your accountant to do that.

At that time, if you believe you'll use it within a time period, you will take that onto your tax line and realize it in earnings. And then you start getting taxed at normal rates.

Okay.

It would be great to take it in the first two quarters if we execute on the business plan. Then we will get the full benefit.

Right, okay. On the expense front, the message is get to a $38 million run rate by the end of the year, accurate?

Yes, that's at least the goal.

Yes, we are planning to exceed that, if you take the $20 million. So what will happen is you will see a less than that in the first quarter. But then you should see more by the fourth quarter.

There are some things that do have profound impacts like by selling the healthcare business and doing other things, we have dramatically reduced the operating volumes of the Business. That alone without renegotiation significantly impacts the cost structure. So there are big chunks that have been identified that will just happen, whether or not we are good managers or not, to be honest with you.

So some of the things we have done I think are prudent, good managerial things. And there is other things that have been put in motion even before I got here that will actually impact the cost structure. I'm going to claim credit for them anyway. But there are some things that were set on motion previously to my joining the Firm that I think were good moves. And we're just trying to get them done as quickly as possible to take advantage of the saves.

Okay. And then as you shift focus more towards the loan portfolio, less on the security side, what is your outlook for the margin year over year?

The margin will continue to increase -- the net interest margin -- for a couple of reasons. One of the key things, we are simply going to reduce the amount of securities vis a vis loans, so that's obviously a huge driver. Deleveraging is a driver for the entire Company, obviously. So there's interest rate increases that could drive some margin.

So there's a bunch of positive -- it's hard to think of negatives where we are now with our loan-to-deposit ratio, and our amount of securities on our margin side. It's hard to push a scenario considering our interest rate environment where our margin would actually go down.

Right. Let me try it this way, your net interest margin is up 32 basis points year over year. Is it possible we break the 3% level in 2017?

In the first quarter, we will have a higher deposit balances going to our Federal Reserve Bank, so you will see the normal seasonal decline. It's very difficult to predict the margin, A, for that reason, and because of deposit fluctuations. But as Damian said, most factors are trending in our favor, including the direction of interest rates.

One of the big positives the Bank has is that we are not enjoying now, even more so than our peers, is that our cost of funds is only going to go up a fraction of market interest rates. While the majority of our balance sheet is variable rate. So, that in itself will be a factor.

If the margin is too difficult to provide guidance on, perhaps we can try in terms of net interest income growth. What is your outlook for that?

Well, to be honest, if you look at a reasonable model of the influences, and the model that we use in order to predict the base level without interest rate increases, we do have a margin above 3%. I want to just accentuate what Paul said though. This is exceedingly hard to predict. And you can have a lower margin and higher profitability based on several scenarios.

But we do believe there is at least three factors that should support margin growth, and 3% is not outlandish by the end of the year as a normalized margin for the Bank. It could be potentially higher.

Okay. And just for the first quarter what is the seasonal inflow of deposits and does that mean that you think the margin will go down the first quarter but pop up towards the end of the year? Or you think the pace of expansion will be a little bit more modest?

We are already experiencing like the inflows and deposit levels are higher in this quarter. It is not insignificant. It is in the several hundred millions of dollars. The exact amount again is difficult to predict.

But we know that the IRS payment for tax-related pre-paid cards, that has been delayed, but a lot depends on that. And seasonal factors and behavioral factors, how quickly people spend the money and so forth. So, yes, that will impact the first quarter. Until the quarters end, we really won't know how much. We have tried to estimate it, and in some years we've gotten pretty close, but --.

Obviously, our business model is what attracts a lot of attention. The liquidity, obviously, is one of the strongest part of this Bank. It does affect our metrics and short terms during the year. But we wouldn't want to trade it for anything, let's put it that way.

It creates an incredibly stable deposit base; does have seasonal variation. It can screw with the metrics on a quarterly basis. But generally, the benefits of it are overwhelming to a financial institution like ours. It provides an enormous amount of liquidity to the Bank. And that has helped us obviously get through the last few years where that was never in question. That part of the Bank was never in question as being a strong part to support the business model.

Right, okay. And then turning to prepaid, what is the outlook for gross dollar volume growth in 2017? And what is the outlook for growth in prepaid-related deposits?

Yes, we are hoping for continued [GDV] growth. You lose and get some client relationships over those years. There's one that was purchased by a third party that will be leaving us, but there's others in line.

So, we are hoping for historic growth here. So having greater than 10% growth on the GDV level and high-single digits is where we think we will be. We are hoping for that. And I think we have a path to it.

Okay. Do you expect the overall margin on pre-paid card fees to GDV to continue to compress? It was 11 basis points this quarter, where does it go?

It is hard to look at that on a quarterly basis because you have to look at that over years rather than quarters. But it's going to continue; macroeconomically, it should continue to decrease over time.

The main driver is consolidation in the industry. It is a maturing industry where you are getting a lot of new entrants and volume [is the game], and that is so dissimilar than the securities interest prior to purging and [State Street] taking all the volume.

So it is clear people are getting out of the market. The volume's consolidating at the larger players. That's why that supports our growth. But we're going to have to become more efficient and more focused in order to make sure that we manage through that process without putting on a lot of cost, and more volume and a lower fee environment. But that is going to play over years.

Quarter over quarter is not a good metric in this particular area because of the way -- at least just looking at us, maybe looking at every player. It would be a better metric to look at everybody and put it together and see what happens. But it's very chunky depending on our schedule of payments and everything.

So we assume there's going to be erosion. We don't know when and how much, but we assume that over time we will have more volume. We will have a tailwind of volume, but a headwind on per-transaction fee over time. But it starts and stops.

Sometimes you can have three or four years of no erosion. And then one year it comes on and everything is down 50%. That happened in the securities industry. It was fine and all of a sudden everybody was trading everything for $0.99 and then giving it away for free after everybody was paying $100 a trade. You just don't know.

Okay. Just one on the discontinued operations: Balances went from $340 million to $324 million, so down $16 million. But the mark charge down on this went from $35 million to $20 million. So could you help me understand some of the components of the mark charge down, and why that was different quarter over quarter?

I know what you are looking at. That one depends on the mix of loans. So as the large loans we had several payoffs, several loans which were lower -- several of the larger loans which were lower amounts.

So we only looked at $232 million, which is the remaining large loans. We only looked at the prior marks on those specific loans as of the quarter end. But if you look at the way the percentages came up, it was still 24%. However you look at it, we had marked those loans in total down 24%, which was comparable to the total at the end of the last quarter.

So does that mean there was essentially recoveries on these loans that were charged down --?

No, they are just no longer -- they were paid off. Or they're no longer of large loan size. I had added that to a table last quarter in response to analyst requests from the June meeting to look at the loan base and say, okay we have in this quarter $232 million of large loans. But we had also charged down those and reduced the principal balances on our books for those loans or loan relationships. So we add back that $20 million to the $232 million and then that additional markdown goes into the numerator. So you get a truer sense of the total amount of marks and the history of those loans.

Okay. I don't think I fully understand. Was there --?

Okay. Let me take one more try at it. So, we are looking at the current principal balances on certain loans after those principal balances have been reduced for certain marks. So we actually eliminated the mark by $20 million and reduced the principal balance because we didn't think -- on those loans -- because we thought it was truly uncollectible.

In addition, we still have the $40 million of marks where we did not charge it off because there is some thinking that there might be a recovery and so forth. So those principal balances are on the books. What that table attempts or measures is by adding back those charge-offs, if you will, reductions in principal back to principal, and having a numerators, adding that to the numerator, in addition to the current marks, you get the total history of those loans in terms of all the markdown.

Right, so if these were previously large loans and they are no longer large loans, does that mean they are completely off the books? Or now they're captured in that other loan category?

Yes, I can't remember the number. But I think there were two or three loans that were paid off and finally settled and closed off the books. So that's why that changed.

So that changes interest; its recovery?

It is paid off of the loan, so therefore, the loan comes out of the denominator and the mark comes out of the numerator.

The answer is yes.

Got it. That's all I had. Thank you very much.

Thank you.

I'm showing no further questions at this time. So I would like to turn the call over to Mr. Damian Kozlowski, CEO, with any further remarks.

I just want to thank everyone for being on the call today. We are making progress. I know it is disappointing to see these marks the last two quarters. But we really do believe we are getting a handle on making this Company a lot more profitable in the short and especially in the long term. We think that will be clear to everyone as 2017 plays out.

And this concludes the presentation of the fourth-quarter earnings by Management. Thank you.

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