The PNC Financial Services Group, Inc. (PNC) Q2 2013 Earnings Report, Transcript and Summary

William H. Callihan - Senior Vice President and Director of Investor Relations William S. Demchak - Chief Executive Officer, President, Director, Member of Executive Committee and Member of Risk Committee Richard J. Johnson

Gerard S. Cassidy - RBC Capital Markets, LLC, Research Division R. Scott Siefers - Sandler O'Neill + Partners, L.P., Research Division Paul J. Miller - FBR Capital Markets & Co., Research Division John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division Todd L. Hagerman - Sterne Agee & Leach Inc., Research Division Moshe Orenbuch - Crédit Suisse AG, Research Division Erika Penala - BofA Merrill Lynch, Research Division Kenneth M. Usdin - Jefferies & Company, Inc., Research Division Jack Micenko - Susquehanna Financial Group, LLLP, Research Division Matthew D. O'Connor - Deutsche Bank AG, Research Division Stephen Scinicariello - UBS Investment Bank, Research Division Matthew H. Burnell - Wells Fargo Securities, LLC, Research Division Betsy Graseck - Morgan Stanley, Research Division Nancy A. Bush - NAB Research, LLC, Research Division

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. [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 Callihan. 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 materials. 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'm 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's 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'll take your questions. As you've all seen, we reported net income of $1.1 billion or $1.99 per diluted common share, with the return on average assets of 1.49%. Honestly, these are big numbers. And while we're 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've 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've seen our provision for loan losses declined this quarter and was substantially below, I tell you, our own expectations, as credit quality improves faster than our forecast, and this…

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'll talk more about this later. We saw a 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, health care, 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 common 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…

[Operator Instructions] And our first question is from the line of Gerard Cassidy with RBC.

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 -- they're 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 drop. So the actual spread on the loans that we have on the book declined this quarter versus prior quarters. 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 are changing the utilization. Where we continue to see progress is in our asset-based lending, in our real estate, in some of our verticals, health care and public finance and in 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, Gerard, 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.

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're not as material as what you saw in the second quarter.

Yes. I mean, remember, part of the noise you're seeing inside the yields, inside the NIM and inside the net interest income was a conscious decision as we basically -- when rates going back to April, were down at $165 million in the 10-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 wreaks 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 NPR out on the Federal Reserve's interpretation of Basel, banks under a $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're a mandatory [indiscernible]B2 bank, that you don't have a choice, and you have to [ph] kind of AOCI, yes, so we're in.

You're in? Okay. And then finally, in terms of the outlook for the Tier 1 common 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.

Our next question is from the line of Scott Siefers with Sandler O'Neill. R. Scott Siefers - Sandler O'Neill + Partners, L.P., Research Division: Rick, I was hoping you could maybe speak a little to sort of the core NII number? And I think to sort of over-simplify it, I mean, you guys are 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 gains 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 and maybe call it the $2 billion-ish a quarter range? And what are the major kind of 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 the balances we'll add in lending will offset that in terms of what the impact would be on core net interest income. We've 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 on purchase accounting where you would expect that to continue to come quarter-over-quarter.

Yes. I mean, one thing I'd point out, with all the press on higher rates and how this helps in the future, we're rolling off securities with average yields. I don't know, they're at 3.25 or something, and we're replacing them at 2.75. So all else equal, what we've stayed equally invested, you'd still continue to see a decline. Having said that, we've been massively under-invested 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 is -- even at somewhat lower rates on our average is going to increase the amount of revenue we get from it. And we're -- we can argue about the levels, but one thing is certain, we're closer to fair value on fixed rate returns today than we were in April. R. Scott Siefers - Sandler O'Neill + Partners, L.P., Research Division: Okay, I appreciate that color then. And then, Rick, just want to make sure that I understand the guidance clearly. Just on the fee income side where you're expecting solid growth in the third quarter, that's off the sort of an adjusted number where you would remove some of the sort of 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 got the actual number there, it's all for that fee income number you see there, which is -- how much?

It's $1,294,000,000, Scott. You see we kind of drew a total of fee income. You take out the security gains, and that's where -- that's what we're talking about. R. Scott Siefers - Sandler O'Neill + Partners, L.P., Research Division: Perfect, okay.

And what we're -- where we're looking at, we're not expecting to repurchase reserve to repeat. And also in that, you have on the commercial side, the valuation on the CMSRs. We're not expecting that to repeat either at debt level but will grow off of those numbers, yes.

Our next question, from the line of Paul Miller with FBR. Paul J. Miller - FBR Capital Markets & Co., Research Division: Just a follow-up. On the valuation to CMSR number, can you remind us again where did that flowed through to and what that number was?

Yes. The actual number was 30 -- it was actually $45 million CMSR in the quarter. It was actually $11 million in the first quarter, so that's your increase of about $34 million. And that flows through your corporate service line, corporate service fee income. Paul J. Miller - FBR Capital Markets & Co., Research Division: Was there any one time items in the asset management? Was that just lumpiness that comes from the BlackRock investment?

Yes, and I think we just have to wait for BlackRock to release tomorrow. Paul J. Miller - FBR Capital Markets & Co., Research Division: Okay. And then, consumer services was also strong. Was there any onetime 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. Paul J. Miller - FBR Capital Markets & Co., Research Division: And is that a seasonal number, or is that just growth because you're 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. Paul J. Miller - FBR Capital Markets & Co., Research Division: Yes. And is the growth coming from the RBC and acquisition to Southeast [ph]? I mean, can you follow up a little bit, add some colors to that?

I would suggest that's in there, clearly, but it's not driving the number yet. Paul J. Miller - FBR Capital Markets & Co., Research Division: 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? We've seen rates go up. It looks like switching to more of a purchased market to a refi market, and how you fit into that?

Yes. Well, it's -- look, like everybody else, we expect that 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're kind of retail-only not through corresponded 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 it's the total percentage of the origination. So that'll help. But it's going to decline as total assets decline. We'll wait and see how much that is. But we feel pretty good on a relative basis as to where the company is positioned. They've done a good job reconfiguring the old National City Mortgage. Paul J. Miller - FBR Capital Markets & Co., Research Division: 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 6 months after we closed the thing, we're basically up and running. And we've been, as you heard in my comments, we've 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 were growing clients is 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 than competitive than the other markets.

Next question, from the line of John McDonald with Sanford Bernstein. John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division: Rick, can you give us some 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 the quarter, we didn't quite see as much growth as we're expecting in the loan book. We did have good growth, but it wasn't as much as we are hoping for. And then, I think, if you take a look at the charge-offs line as it relates to the commercial book, they were extremely low in the quarter. And so therefore, the pace of the improvement and credit quality in the commercial bank is much more than we have 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're going to continue to add credit exposure, net credit exposure to the portfolio overall. As a result, we've hedged our guidance back to the $170 million to $250 million range. John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division: Okay. So the form it would take would be just smaller reserve release with charge-offs probably still improving?

Well, the charge-offs on the commercial side were particularly low. That's 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's great that they do, and we hope they continue. But it's not really indicative of what we would say that's on our book.

So I would expect to see additional commercial reserve release, but I would not expect any on the consumer side. John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division: Got it, okay. And on the put-back provision, have both Fannie and Freddie now look back to the early 2000s for you guys? So just trying to gauge any room for additional surprises here or changes in their behavior.

Well, they did approach us in November and they asked for about 8,000 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're done. John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division: Okay. And then one bigger picture question. Return on assets, $149 million this quarter. I mean, close to your target. Just kind of think about how does that improve over time? And what's your longer-term target of where you'd 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, 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.

Next question from the line of Todd Hagerman with Sterne Agee. Todd L. Hagerman - Sterne Agee & Leach Inc., Research Division: Just a couple of questions. First is a follow-up on Mortgage. I think, Rick, you mentioned in terms of like the MSR or the servicing rather in R&W not to continue. But I guess the 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. It fell short a little bit in Q1. Obviously, Q2 was kind of not what was expected. But given the commentary we've 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, kind of -- 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 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're quite pleased. We had $4.7 billion in originations. Margin stayed flat at about 4%, 10% increase in origination revenue, we are pleased with that. But you're 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, Bill, if 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's going to happen. We feel pretty good about our position in inside of that decline in apps. But we, like everyone else, we're -- as we go through this, we're also going to have make our engine a little more efficient and take capacity out on the cost side, and I think you'll 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. Todd L. Hagerman - Sterne Agee & Leach Inc., Research Division: And where did you -- I would just 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, it's obviously a little softer.

Yes. But it's -- I mean, I would tell you, it's not lower by the same big percentage as I've heard bandied about. Todd L. Hagerman - Sterne Agee & Leach Inc., Research Division: Okay. And then just finally, perhaps, Bill, a little bit more. On the debt side, borrowing cost perhaps didn't come down as much as expected, some of that timing. I know that you've talked about in the past in terms of leverage on your wholesale borrowings, if you will. And just curious kind of, as you look out the back half of the year, how rates of on 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 do we -- how should we think about that in the back half of the year and the leverage on the borrowings?

I don't know -- I'm not sure I quite follow the leverage on the borrowings comment, but just on the... Todd L. Hagerman - Sterne Agee & Leach Inc., Research Division: I'm thinking about the spread and just in terms of leverage on your borrowing cost at this point.

Yes. Well, I mean, a couple of things. The majority -- the vast majority of the investment that we did in the back, clearly, 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, where you'll start seeing the improvement in income from the balances. The simple math is we're rolling off balances as they mature at 3-plus percent in yields and replacing them at 2.75%. But we're very under-invested relative to what we should be in terms of the value of deposits we hold. So we have a lot of room to put money to work at more rational rates. And rates today, they're rallying a bit today, but rates today are still almost 100 higher in the 10-year than they were in the tights [ph] at the beginning of the second quarter. Todd L. Hagerman - Sterne Agee & Leach Inc., Research Division: 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'm more sensitive to with the 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 to funding on wholesale borrowings? Is that where you're going? Todd L. Hagerman - Sterne Agee & Leach Inc., Research Division: Yes. Again, I mean, there is scheduled maturities and other opportunities within the debt, but...

Yes. Look, I think, by and large, and Rick can comment on it, that we've 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's the game we and every other bank in the country are playing right now.

[Operator Instructions] And our next question, from the line of Moshe Orenbuch from Crédit Suisse. Moshe Orenbuch - Crédit Suisse AG, Research Division: 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'm reading in too much, so correct me if that's not right, but can you talk a little bit about your thought process there?

Yes, sure. Look, we're not at all thinking we're 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 run-off, particularly run-off and then sales that occurred in the second quarter. So it's not as if we're going to go out and think, this is the panacea of we're 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's what you'll see us doing.

Our duration of equity is still negative what, 3, 3.5 years, something like that. That's still pretty sure. Moshe Orenbuch - Crédit Suisse AG, Research Division: 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's running in the third quarter. But any thoughts about where it ended the quarter versus the average? Just any kind of look into that?

No. Towards the end of the quarter, it was probably closer to 3.5% as opposed to 4%. But -- so it was coming down in terms of the overall margin.

Next question, from the line of Erika Penala from Bank of America.

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're going to beat that, so we're going to be below $10 billion.

Got it. And just one more question on the margin. Relative to your core loan yield, this 3.77. As you look at your production pipeline, where -- what's your replacement yield on the loan book?

It really depends on the business. I mean, asset-based lending is still getting good returns, commercial real estate still getting good yields. If we're adding it to our conduit, which is basically the securitization activities, that's very high quality paper. But you're probably only seeing under 50 basis points or even less. So it really depends on the mix of the book.

Right. I guess what we see and we hear from the businesses is the trend line in credit spread decline hasn't really changed, right? They've 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're originating in credit spread. It's just...

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'm wondering given your emphatic response earlier on 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 state and consider doing something like this in your backyard, given the implication for cost savings?

No.

Our next question, from the line of Ken Usdin from Jefferies. Kenneth M. Usdin - Jefferies & Company, Inc., Research Division: Just one more follow-up on the fee side and the outlook. There's a lot of moving parts, and I know you put this below the line type of stuff in there, but still a little bit confused on what you're actually saying about what fee base you grow off of? Is it just that $1,294 million 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. Ken, if you go to page -- Slide 7 of our presentation, we have fee income of $1,294,000,000. That's up from $1,251,000,000 in the first quarter. We're basically saying that we will grow fee income solidly from the $1,294,000,000. Kenneth M. Usdin - Jefferies & Company, Inc., Research Division: 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, I'm 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's hard to predict. And then within the $372 million, you have about $35 million due to rates going up on our client hedging activities and the credit exposure related to that to CVA. I'm not expecting that to repeat, so I think that number will be lower. But if you take that other category, particularly, we say that's about $250 million to $300 million is what you can expect out of us. Maybe, maybe a little higher than that now, maybe we should be pushing that up to $275 million to $300 million in the quarter given the growth in the company. Kenneth M. Usdin - Jefferies & Company, Inc., Research Division: Okay, great. That's helpful. The other question I have is just a follow-on. BlackRock, last quarter, in ancient [ph] quarter, there was a lot of back-and-forth just in the market, and I just want to give you guys the opportunity again just to level set everybody on just your thoughts around where you stand there? And then what half would eventually need to be taken for you guys to even get to a point where you'd consider some optionality -- exercising some optionality on the BlackRock stake?

We've 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 5 times -- 5 times over inside of the things we own. Having said that, we recognized that through time, BlackRock has become more of an investment than a partnership. We recognized 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're contemplating that would do better for you than simply owning it today, and that's 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.

Our next question, from the line of Jack Micenko with SIG.

Most 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 said about $600 million annualized. Does exceed mean dollars, meaning there's 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 this expense guidance a little bit. It's getting a little more bullish than, I mean, originally I think we said we'd be flat core, and now we're seeing we're flat to down and we'll be a little more than 5%. But the practical truth is, 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're seeing on the day-to-day roll up of numbers, whether it's 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 it seriously, and we're encouraged by it.

Yes.

Okay. So moving forward, is it CIP 2.0, or is it just expense guidance is down x percent or whatever from here?

Well, what did you say to him? Are we -- we're going to be down by more -- what was your -- down by...

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

Okay. And every nickel we can find beyond that, we'll find.

Right. Exactly.

Our next question, from the line of Matt O'Connor from Deutsche Bank.

Just coming back to the size of securities book and just the capacity that you have to add over time. And I realize that you wouldn't do this, this quarter or next quarter, but just conceptually, if you wanted to get back from this negative 3-year duration of equity, I think you said to 0 or negative 1 year, what's 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 you will have noticed if you done the peer comparisons, if you look at our -- we put our after-tax loss up, but if you look at the pretax equivalent of that against the notional of our book, you'd come with a conclusion that it's a very short duration book. As we've said before, a big chunk of that is floating. So don't get hung up on the notional book relative to what we would do in terms of closing the duration gap on equity. With respect to outright by volume that we could do to get to a positive duration of equity, all I would tell you is it's a substantial amount. And there's been times in our history, in fact, we got this really right going into the rate rally post the crisis, I think our duration of equity was north of what, Rick? 3 or 4 years.

Yes, exactly.

So there's 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'm 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've made to date that are going out into the third and the fourth is you can expect about a $1.5 billion to $2 billion increase in average security balances going into the third quarter.

Okay. Maybe 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're not a drag, just...

It's 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 pick up to start forward, so that's what we did.

Okay, got it. So just -- I mean, in summary there, you had some swaps roll off in 2Q, you replaced them with some swaps 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'll have security balance increases in the third versus the second. And in both loans and securities, the yields will be down. And -- but to the tune of where purchase accounting accretion will cause you to have a modest decline in net interest income.

Our next question, from the line of Steve Scinicariello from UBS.

Just real quick, just given the strong loan growth that we saw in the quarter, I mean, up 1.75%, C&I up 3%, just kind of curious what were really some of the strong drivers there, and how sustainable? I know the growth is for modest -- guidance is for modest growth, but how sustainable are some of these kind of underlying trends that you're 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 a 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've 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 health care 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'd have a different take on what we could do. But the specialty stuff is -- continues to play out for us.

I think we're also on the consumer side, right? This is the first time we've 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 are 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 just sounds like you're 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 hope we'd be able to grow faster the 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're choosing to walk away given the spread or structure on the loan where 1.5 years ago, we wouldn't have because you would've been paid better for it. So that's probably the constraint is just relative competition and the degree to which the credit markets get overheated here.

And plus, we still have run-off in the education lending, we've get run-off in the non-strategic assets, residential mortgage, yes, exactly. So I think you're going to see balances that are putting pressure on downward as well.

Our next question, from the line of Matt Burnell with Wells Fargo.

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 this, heading into July, particularly in some of the verticals that you mentioned where you've seen somewhat stronger growth?

We didn't -- in terms of fundings and pipelines, I don't know that you saw it. Anecdotally, when rates first spiked, you 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. We did see less so in our books given the business we're in, but on the leverage credit side and high yield in the larger syndicated leverage loans, we obviously saw a complete freeze in the market when rates went up, as people were trying to react to that. But that didn't really impact us.

Okay. Then just 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 3 and 3.5 years now. Is that -- did I hear you correctly?

I'd say...

It's duration of equity.

Yes, that's the duration of equity, and that was a negative [indiscernible]. 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. That's correct.

Okay. I noticed in the home equity portfolio, it looks like recoveries improved pretty visibly quarter-over-quarter at -- to the highest level in more than 1 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 is that more due to just the 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 kind of come down in terms of charge-offs. On nonperforming, you've got -- we're seeing a little bit of risk in the home equity. I think you've seen that nonperforming number going up each of the last 5 quarters.

But we have -- but inside of nonperforming, we have the same nickel balances, right?

We do.

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

Next question, from the line of Betsy Graseck with Morgan Stanley.

A couple of follow-up questions. One is on the Basel III final rules, 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?

We've got 1,000 pages we're looking through and we're studying the whole thing, but we really don't have a view right now on exactly how that's going to be handled. We're still sticking with, at least at the moment, in the ratios we put out here for you based on the original MTRs and based on our understanding of that.

Okay. Secondly, on the expense ratio. Bill, in the past, you've mentioned how part of the reason why structurally your expense ratio is higher than peers and your tax rate lower is because how you structure some of your affordable programs, affordable housing programs, if that's the correct term for it. And just wondering, is there anything afoot to potentially changing that structure, or you stick with what you got?

So we're not changing the business. It's a very high return business for us. It just looks confusing on the income statement. But the economics to shareholders are good, and so we'll 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's been a contributor to growth here this quarter. Could you give us a sense as to where it is on all the metrics that you manage to efficiency ratio, sales ratio, FTE efficiency, all that kind of stuff, how it is stacking in ranking relative to the rest of the bank? And what kind of time frame it takes to get to 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 experienced this quarter high or likely to persist?

Well, a couple of things. Without -- 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 that...

It's almost like the story at the top of the house. You get the purchase accounting accretion causing the efficiency to be good, and that's going to run off as we grow fee income.

But the core activity on those markets is well below what we -- in other markets, and that's the opportunity set. What you see in terms of growth is interesting because we continued to run off non-core balances in the market. There's a lot of investor owned real estate stuff that we just don't want. If we have been able to do that and replace it with clients that we do like and balances that we do like. The time line on it, 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 is in a 1- or 2- or a 3-year game. It's going to be a long-term game where we're 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're pleased with where we've gotten to today. My guess is it'll continue to improve through time based on what we're seeing.

Sure. So the rate of change that we're seeing this quarter likely to persist for a bit? I mean, obviously, it's kind of a fade out in terms of rate of change but increase in terms of total dollar contribution to overall PNC?

I'd like to think so, yes, yes.

I guess I'm just wondering, is it's possible at some point, to maybe sketch out that how you guys are seeing that rate of change in that time frame. It would 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 are regional, 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.

Our next question, from the line of Nancy Bush with NAB Research.

A couple of questions. Number one, Bill, you escaped the net of the leverage ratio at least this time around, which applies to the top 6 institutions. Do you have any concerns if that's going to get sort of pushed down the banking size ladder as time goes on?

Not particularly. They kind of came out with it. 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 -- did we put this out [ph]?

Well, even as defined, we exceed both the 5% or 6% number.

Yes, we're comfortably above at where we are today, and our business model would -- arguably, we're not changing our business model. So even as we grow and 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 has been a lot of complaining in Washington because the largest banks have increased market share so much, and the interim since the financial crisis and a lot of that share, of course, has been buying failed institutions, which the Congress folks seemed 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 pushed back 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?

I don't -- I just don't know, right? Everybody talks about that. As 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're trying to accomplish and grow. So since acquisitions haven't really 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.

So I think that was our last question. Bill, if you have any closing comments.

Yes. Just real quickly, so this is after 8 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'd just say thank you to Rick for helping us steer through what was a fairly remarkable 8 years for our company in the economy, and we greatly appreciate it.

Thank you, Bill.

Thanks a lot, everybody. We'll 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.