The Bancorp, Inc. (TBBK) Q4 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to The Bancorp Inc. Q4 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [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 The Bancorp's fourth quarter fiscal 2016 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 a replay of the call beginning at approximately 12.00 PM Eastern Time today. The dial-in for the replay is 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 used in this conference call, the words believes, anticipates, expects and similar impressions 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 discussion of these risks 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 as of 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 The Bancorp's Chief Executive Officer, Damian Kozlowski. Damian?

Thank you, Andres. Good morning and thank you for joining us today. My name is Damian Kozlowski, I'm the CEO of Bancorp and the President of The Bancorp Bank. I've been in these positions since June 1. I welcome you to our fourth quarter earnings call. Discontinued operations and Walnut Street were reevaluated with updated values, which resulted in a significant charge during the quarter. We completed a full review of both discontinued in Walnut Street and enhanced it governance process. Our goals 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 by discontinued operations where there was suspected fraud leading to a breakdown. We have provided in our earnings release more detail on our credits from discontinued operations and have provided a chart to detail the asset types and other information. We are continuing to make progress concerning our regulatory situation. We are in a process of creating a new integrated compliance plan that will build off our work in BSA, AML, third-party risk and consumer compliance. This plan takes a 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 causes of our regulatory issues. We have also hired key new management that has been approved by our regulators, which will be announced in the first quarter. Our run rate profitability showed improvement this quarter, reflecting elimination of the BSA, lookback expense and terminated in the prior quarter and others 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 have targeted total 2015 expense reductions of $20 million. Here are some additional highlight. As we have discussed previously our integrated business plan has been completed and we 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 its based on the strategic plan. These goals cascade throughout the organization and each employee has goals that are based on the plans 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 as identified approximately $20 million in operating cost base 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 charges vis-à-vis winding down those operations. As reported previously, we are completing the sale of our remaining HSA business, which will reduce our operating expense and significantly reduce the 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 continue to growth both year-over-year and quarter over linked quarter, reflecting growth in loan balances and increasing interest rate. Continuing GDV 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 linked loan growth – linked 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 20170. I'm 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’s important to note that a significant portion of the charge to Walnut Street is market and not credit driven. The charge to Walnut Street reflected continued clarification of market and credit loss related assumptions. Based on feedback from available sources, including updated market information and projection of potential future loan losses, based on the facts or circumstances, while the majority of the remaining assets in Walnut Street are paying in accordance with the contractual loan agreements, information regarding market-driven valuation assumptions and future potential losses continue to be updated and assessed for inclusion in the fair value analysis. Excluding BSA lookback costs, which included in the third quarter of 2016, fourth quarter non-interest expense reverse trend and exhibited a decrease in the third quarter of 2016. This reduction reflect the beginning of the implementation of identified expense reductions. As Damian noted for 2017 total $20 million in non-salary related expense reductions have been targeted. Discontinued loan balances continue to be reduced. September 30, 2016 unpaid discontinued loan principal of $410 million included $70 million of residential mortgages, that left approximately $340 million of commercial loan principal. During the third quarter 349 of commercial loan principal was reduced to $324 million, primarily as result of principal payment. The mark of 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 of $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. Of those $232 million, $72 million were non-performing and had $36 million of marks against them and with us 50% mark. Cumulative 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 chart in the press release summarizing this analysis. Year-over-year increases in our loan portfolio were reflected in a 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 purchase 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 at 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 to only a portion of future increases in market interest rates. The interest margin will accordingly benefit with related rate increases on variable rate, SBLOC and SBA loan and a 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 point Fed 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 non-strategic deposits in first quarter 2016. December 2016, the Federal Reserve Bank again raised interest rates and there is was a 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 prepaid deposit which were the primary driver of deposit growth increased by approximately 16% over the prior year fourth quarter. Bancorp supports many of the industry's leading players and payments, continuing initiatives are projected to contribute to continuing GDV growth, which should support fee 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 to targeted non-salary expense reductions. All of those factors will support achievement of our budgetary goals in 2017. Damian, this concludes the financial report.

Thank you, Paul. Operator, please open the call for questions.

Certainly. [Operator Instructions] The first question comes from line of William Wallace with Raymond James. Your line is now open.

Good morning, Wally.

Hi. I guess, I 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 the result of the markdown the majority – as you can see in the table in the press release, that’s around 20% to 25% of the Walnut Street, remaining values are non-performing. So the big market adjustment comes when you discount those cash - 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 down rate and we'll be specific as to those rates in the 10-K, but that is - the largest factor was in fact the discount rate.

And can you - 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 – 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 different in areas. We'll be as specific as possible. We're relying heavily, as I said before on the third-party and they've actually given us several scenarios with different - all within reasonable ranges and we're 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 there, their detailed written report.

So is the third party that you're speaking to, is that Angelo Gordon? The

No, that’s the purchaser and the investor in securitization, it’s a reputable CPA firm that we use.

And is it being valued like a security?

Yes, basically being valued like a security, it’s not a typical security and it’s unique, though actually a model has to be built from scratch to capture both the non-performing and the performing portion. But we've been through it, we've study 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 the security - as we move closer toward recognition and receipt of the cash flows that discount - that discount - the amount of the discount bar 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 came very – the all ended up pretty close to each other. So I think we had a very – 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 yet there is a third-party because it was a sale the bank effectively gave up control of the ability to manage those loans and so forth. But we do have at least a little bit in of insight into how these loans are being resolved. So that has a chain, 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 business in the 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 had been done, bank had taken action to examine the collateral and subsequent to that we became familiar with information that that suggested that there was a fraud involved. I can't really speak and give more detail. Loan was over $10 million, somewhat over $10 million. But other than that, I can't really give you any more detail because it is suspected fraud and I just – we just can't go into more detail.

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

We'll check with counsel and see what we can provide in the K or otherwise. But obviously there is suspected fraud, there is 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 can provide more information.

So prior to the fraud they uncovered. The bank had as part of the process the review of both discontinued in Walnut, had engaged a third parties to review the collateral in full. That was not…

Of this…

Of this particular loan, a third party was engaged because we just wanted to check, as we're checking on all the loans, that was not – 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 that we can't give you any more color and we'll 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?

For the value of the collateral was shown as adequate for this loan , the issue was if there was a fraud involved related to the collateral…

If you think about it, there is been really two extensive reviews that 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 will which were in the Walnut Street structure and that was very detailed loan-by-loan and a focused on discontinued. Nothing that happens subsequently, the loan or this fraud, the loan to the mall was a fraud, was the result of that actual review, those were events that happened subsequently. So - and then after that because of the need to gather the he total picture and all the information that’s when we started an extensive review also the overall credits within and then the overall whether we had the correct perspective value based on changes in market rates on Walnut Street. So that that review took a while, it actually extended almost up to the time of these earnings calls and that our call report even had a different value in it. And we do - we believe and do feel very comfortable now that there is after six months of work looking at individual credit also assessing overall values, that we were 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're trying to be as transparent as possible and we're 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…

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, a different types of collateral. So it's not that easy and it depends on the loan, certain loans have personal guarantees where we feel extremely comfortable with the network of the individual. So our focus on 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…

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 is been in this order, one of cash, the simple cash flow, the second is the actual collateral value as a backup to that and third being a significant guarantee, but guarantee that we don't believe are significantly covered, we do not, so I made it clear, we do not include those in evaluation of those value of the loan. We'll take what you are saying to heart, Wally. We understand, and we are trying to be as transparent as possible in this situation. We understand the consternation around the two portfolios from two guys we're trying to work out the situation in a forthright transparent way, we'll 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…

You're going to see – we believe and I stress that, you're going to see 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, our website will be met. There were lot in the contract negotiation that were ongoing, where there's going to be significant amount of saves on our operating costs. So you'll see that 42ish number you know, moved down nicely we believe over the next few quarters and will be realizing gains and there were just you know a few of those things, like the Europe sale renegotiation of our operating platform costs, the HAS accounts that will be leaving us in the first – hopefully in the first quarter. All that has a dramatic impact on the operating cost of the firm. So the $20 million that we 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…

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

And if you look at the total amount of expense we did reverse trend, there was – you'll see in the 10-K that we did have a somewhat higher legal and we're trying to get a handle and better control of the legal.

Okay. So - there wasn't any severance or things like that in the fourth-quarter number…

There was a lot of little things clean up quarter-to-quarter comparisons, those type of things. We're being very aggressive and closing things out and negotiating endpoints. So I think you'll see you know, the first two quarter this year are going to be very telling. Obviously, for the performance of Bancorp. So you'll hopefully you know, we're going to continue on trend with revenue and you'll see those expense cuts both on the personnel, but especially on the operating side starting the trend down. So if you – you're at 42 now you know, in your $3 million to $4 million trending down over time, probably the first two quarters, should be very – we have very clean sight to it, let's put 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 k now, you have other run rate expenses there. So if you're using a model you're not going to get –you have to do, you have to adjust for some other expenses, but that’s correct, that’s roughly correct, that the 42 is more the base, that’s not far off.

Yes, okay.

Okay. We know when those expenses are coming from, some of our expenses are related to the revenue we creates. So you know, 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'll realize those saves. So depending on the revenue growth of the firm, hopefully it will be robust. If we – let's put it this way, if we don’t get those saves, it only because that's 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're 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, and deposits because of certain seasonal factors, but by the second quarter, our balance sheet will shrink that'll be helping us a lot. But also we think that within the first two quarters we'll create capital. There are other factors that may also help us like interest rate increases, but also disposition of certain assets that we've mentioned on these call before. So we think we're in a fairly good position in how the path to close the gap over the year and ultimately get to our capital minimum, we want to be at an 8.5%. I've communicated with our regulators about this. So right now we do not – this can change of course, there's multiple parties involved, there's myself, our management team, there is 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'll improve those ratios. Remember we're only talking about tier 1 capital really, all the other risk-based measures are very, very healthy and the reason is because they are the types of assets we hold, especially with SBA and SBLOC businesses don’t affect that, those ratios in the same proportion. So 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 --?

Again, Paul, talked to this. Our balance sheet at the end of the year was a little bit inflated for couple of reasons, one's gift cards, one is for the loans we're holding that were sold into a security. So you know once that bump – we have our first quarter bump due to seasonal tax return volume, but going into the second quarter, you'll see a deleveraging, there's one client and also the HSA business will reduce by $400 million more off that base. So you'll have a shrinking of the balance sheet, at the same time we believe we'll 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 be comfortable with the aggregate level of capital at the tier 1 level. Once again the risk-based capitals are not a concerned 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…

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're 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 is complicated. This is question I should never be asked on earning calls. But yes, there is a portion that will go into tier 1, 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 more than $25 million of valuation reserve that we're going to - that we have now. If you look at the fourth quarter results, we didn't recognize any tax benefit from the law and that add to our deferred tax asset. On the conservatism of accounting it doesn't allow you to recognize that, but in consultation with our accounts we'll look to - with the several - quarters of profitability in 2017 we'll look to reverse a significant portion of that.

Right, but assuming you reverse 100% of it, you're not…

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

Okay. All right. I'll step out. I have taken more time than I should. Thank you. I appreciate it.

Thank you, Wally.

Thank you. And our next question comes from the line of Frank Schiraldi with Sandler O'Neill. Your line is now open,

Hi, guys.

Hey, Frank. How are you?

Good, thanks. Just wanted to - 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?

Yes, that was – it really wasn’t a long-term movement in interest rate that was the issue, its really the discount rate compared to other securities that our third parties suggested with the one option or one way of looking at the security.

What we're 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. Okay, so there were marks taken. But when you look at the box at the end of the day and try to understand it vis-à-vis where the value on our balance sheet was, that’s driven by a new model that was created in what we want – what we're attempting to do here is get a value on the balance sheet that won't impacted by future volatility of those assets or changes in rates in the marketplace, right. So we're trying to provide yourself with a lot cushion based on the cash flows under a reasonable circumstance, and that's what we try to do because we appreciate that we can have continued volatility, either out of the discontinued portfolio or within the scope of the security. What we've also done is also put the structure on non-accrual, as another safety valve. So prospectively we were getting about $3 million of interest. We've also put that on non-accrual too because that will reduce the principal. So what we've done is try to set barriers, right, on the structure, knowing the collateral of being reviewed by a third party, so that the have value in our balance sheet is liked, is most likely, low volatility number, so that people - 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 visibility have been discounted appropriately using third-party rate in order to take notice of the losses that could occur, that’s a losses that have been identified, but the losses, additional losses that could occur based on the history of the portfolio. So that’s what it was done. The model today is very prospective, its based on the performance of what this structure should yield over the next year's and what the bank should ultimately get back, discounted on the inevitable unlikely occurrences that always happen in portfolio such as this based on third-party assessment of that potential volatility.

I guess, 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, right, so…

There is a little bit of interplay in the model on that Frank, because certain of the loan are fixed rate, but remember that the maturities are fairly short term and a good portion, I don't recall the portion off hand, but a good portion of the loans are variable rate. So as interest rates go up, and that's true, you're right absolutely right, the discount rate will necessarily go up, the rate on individual loans go up, so they basically offset. But if you look at the project interest rate its 75 basis points a year from now even if there are three Fed increases will be a year closer to the – we've already have had maturities of loans or the performing loans and then we'll be a year closer to the other one. So it has limited impact and I believe - Damian and I believe that, if you look at the model and alls the assumptions, we can only do what accounting let's us. But in this case and looking at what the third parties says and looking at the valuations and the third-party mark on the remaining loans it seems to be the proper balance…

Question is, is it a reasonable cushion. I know, we all know the history, many of you 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, I mean, the way this structure works is as Paul was saying, if those losses and those cash flows are actually accurate, the discount rate of course is - would be amortized in the reverse direction. Because that is a view of future you know, 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'd have a reversal obviously, based on the discount rate that would come back to the bank now. Having said that, and knowing the structure that’s the cushion for us. The second question cushion then now is and we discussed this because of the history of the structure, we put the whole thing on non0accrual, so we won't - we had been taking interest from the structure and now we will be using that interest that's generated from Walnut Street to pay down principal. I think those two cushion should give everybody - I know people will obviously question us and look, its got a history and we understand that and we're trying to do everything possible to put that aside, clean the desk of bank, so that we can get to work on producing of 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 okay, so is the loan you know, as I said before the interest on the loan is offsetting loans and interest rate in any given quarter you don't really see a lot of change, but you know, at the end of year – but after 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 did - okay, in essence we….

We did sell already.

It is sold…

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

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 known in third quarter we did dispose of another chuck of loans. So those conversations are ongoing. No decision has been made, but with any kind of - anything with a history its really you know, the price that someone would put on it, we think current value on the balance really does adequately portrayal - portray the non-volatile asset value now, discounted a course for the potential volatility. But that doesn't mean necessarily there's a buyer in the market who pay that number, even though that's the correct number to have on our balance sheet. But those conversations are very - you know, we do have conversations about that with different parties and we're going to continue look at. I want to wind it down as quickly as possible, let's put that way. So if we do find selective buyers or buyers for the whole portfolio we would execute on that.

Okay. And then 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 is another third party now, that’s seeing the situation and because of that we can't just - hopefully we'll be able to disclose more in the 10-K. But it’s very – there may or may not be that, let's put this way, there was a third party assessment to who gave the collateral a value. Then it was called into question by an action of the sponsor, that was uncovered through regular mean, let's put that way, that was related to the disposition of a business by that sponsor. And as soon as we can get more color, we will, but there are proceedings involved in other third parties that unfortunately we cannot 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 believe that collateral to be valid and we have a report on the 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 a bona fide collateral, by a third-party appraiser that does this for a living and then it got called in the question. Now the value of that collateral because of the suspected fraud, we have a responsibility to write it down under the circumstances we're in. However, that collateral may or may not have the value that the third-party access to it. But that would be a recovery. We're very conservative. The view of the bank today is to be very conservative in those situations and to be very aggressive with our 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 the near term write-down. 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 in assessed value immediately. If we recover more later, we can't delay in taking those - taking those situation on a very proactive basis and that’s sometimes when you're working out portfolios and they do have history you'll see some of these losses happen, since I've done this before you'll seem them upfront and in anybody on the phone who does this for a living with distressed asset, you usually see this happen upfront, you resolve the issues and then hopefully and you mitigate the loss, long-term loss and then hopefully you have gains at the backend and that’s exactly how we're approaching it just like a distressed manager would approach it, of course, fundamentally using bank rules and GAAP of course. But we're following those rules, of course, that’s 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 fair. One way or another I'd love to get there by the end of this year, would I be okay with A, I don't - I'm not okay with not getting paid. So we have to figure out a way of A, 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've taken a tremendous amount of action to make the bank better and it takes a while to get these things done and get them implemented. HSA [ph] sale of Europe took us seven or eight months to negotiate and make sure we had the right type of buyer. So – but these things are meaningful, they have real meaningful impact to the bottom line. So you should - they tend to collapse and then hit all at once. So you'll see a lot of this coming in the first 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, right. If you contract that -- the balance sheet by $400 million, then maybe you are like 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…

Excellent analysis and that's exactly right. But we think we'll be around 4. We're targeting about 4ish for the balance sheet level at the mid year point, you know, somewhere around mid year hopefully we'll get down somewhere around there. It depends on our business volume too because you know, if we're having a incredible growth then that's difficult to contain. But we'll have more accretion of that income. But the – that’s a very good analysis. We want at least 50 basis points of ROA for the bank 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 target.

Okay. And then 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 envelope - the expense envelope that we already talked about, the 168. So depending on the revenue scenarios as you look at the firm, you're looking around you know anywhere from 40 to you know the 38 or maybe a little bit less than 40 per quarter. So that gets you - but you know have we identified cost saves to get it to the 38 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 resolve, let's put that way, resolve our regulatory situations or other goodies in there that we get. But we don't account for any of those. We just think on the operating draws of the business, considering the changes we made, we should start trailing down nicely over the next couple of quarters and as we purge accounts like HSA 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 entail, we don’t expect any of those things, I am just saying that there is no – there is nothing more than the actions that we've already identified built into the base plan for the business. We're hoping for better, right, 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 one was just initial identification of people that we thought was - we were overstaffed, that with 20% of the people. The second phase was 20% of the expense base operating costs and those revolving 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’s kind of the reengineering phase, it will start mid year and that will last probably 6 to 8 month. But that - we haven't – 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, we'll - that side is yet to be identified, but that’s the cost mentality we have.

Thanks.

Thank you. And our next question comes from the line of Matthew Breese with Piper Jaffray. Your line is now open.

Good morning, everybody.

Hello, Matt.

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 asset. 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 carryforward, we won't have - we should not have any income, at a minimum we shouldn't have any income tax expense again income, pretax 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, so once you take the DTA, correct if I'm wrong, Paul, but once you take the full DTA and we really need two clean quarter before we can do that. So once you have two clean quarters, you're going quarters, then you do an assessment of future cash flows, future profitability and that obviously work with your account to do that. At that time if you believe you'll use it within a time period, you'll take that onto your – you'll basically will take it onto to your tax line and realize that in earnings and then you start getting taxed at normal rates.

Okay.

I mean, we expect to take it in the first two quarters if we execute on the business plan, then we'll 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, right. Yes, we said that we're planning to exceed that, if you take the $20 million, so what will happen is you'll see a less then that in the first quarter, but then you should see more by the fourth quarter.

There are some things that have – do have profound impacts, like the - by selling the healthcare business and doing other things, we've dramatically reduced the operating volumes for the business that has - that alone without negotiation significantly impacts the cost structure. So there are big chunk that have been identified, that will just happen whether or not we're good managers or not, to be honest with you. So I mean, some of the things we've done are I think are prudent good managerial things and there's other things that have been put motioning before I got here, that will actually impact the cost structure. I'm going to claim credit for them anyway. But there is some thing 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.

All right. 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 reason, right. So one of the key things are, you know we were simply going to reduce the amount of securities vis-à-vis loan, so that’s obviously a huge driver, deleveraging is a driver for the entire company obviously. So there is interest rate increases that could drive the margin. So there is a bunch of positive. It's hard to think of negative where we are now with our loan to deposit ratio and our amount of securities, on our margin side, its hard to push a scenario, considering our interest 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?

Yes, well, remember in the first quarter we have – we'll have a higher deposit balances going to our Federal Reserve Bank. So you'll see the normal seasonal decline, as it’s very difficult to predict the margin, 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 rate. One of the big positive the bank has is that we're not enjoying now, even more so than the rest – than our peers is that our cost of funds is only going to go up a fraction of market interest rate, 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?

To be honest, it’s safe. If you look at a reasonable model of the influences in the model that we use in order to predict the base level without interest rate increases. We do have a margin above 3%.

I wanted 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 support margin growth and 3% is not outlandish by the end the year, as a normalized a margin for the back and 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’s not insignificant, it’s in the several hundred million dollars. The exact amount again is difficult predict, but we know that the IIRS payment for tax prepaid card, tax related prepaid cards that’s 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, we will have – that will impact the first quarter, until the quarters end we really won't know how much. We tried to estimate it and in some years we've got pretty close, but…

One of the – obviously a business model is what attracts a lot of attention.

You mean the liquidity obviously is one of the strongest part of this bank. It does affect our metrics in short terms during the year, but we wouldn’t want to trade for anything, let's put it that way, it creates an incredibly stable deposit base, but does have seasonal variation, it does screw with them – 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 as a bank and that’s helped us obviously get through you know 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 were hoping for continued GDV growth. We do have some - you always have, you lose and get some client relationships over those years. There's one that is - that was the purchase by a third-party that will be leaving us, but there's others in line. So you know, we're hoping for historic growth here. So having greater than 10% growth on the GDV level and high single digits is where we think we'll be. We're 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’s hard to look at that on a quarterly basis, because there is a whole bunch of different - the timing is – you got to look at that over years rather than quarters. But it’s going to continue, if you just , macro economically, it should continue to decrease over time The main drivers consolidation in the industry. It’s a maturing industry where you're getting a lot of new entrants and volume is the game and know and that’s so dissimilar that the securities interest prior to purging and state street [ph] all the volume. So it is clear people are getting out of the market. The volume is consolidating at the larger players, that’s why that supports our growth. But we're going to have become more efficient and more focused in order to make sure that we manage through that process property on a lot of costs and a lower and more volume in a lower fee environment. But that’s 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 payments and everything. So I - we assume that there is going to be erosion. We don't know when, and how much, but we assume that over time we'll have more volume, we'll have a tailwind of volume, but a headwind on per transaction fee over time. But you know that’s unnecessarily, there, you know, it starts and stops, sometimes you can have three or four years of no erosion and then one year he comes on and everything down 50% that happened in securities industry. It was fine and all of sudden everybody was trading everything for $0.99 and then giving it away for free, after everybody was paying $100 to trade, you just don’t know.

Right, okay. And then 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're looking at, it just – that one depends on the mix of loans. So as the large loans we had several pay offs, several loans which were lower - several large loans which were lower amounts. So we only looked at $232 million which is the remaining large loans. We only look at the prior mark on those specific loan as of backward, as the quarter end. But if you look at them, the way that the percentages came up, it was still 24%. However you look at it. We had marked those loan in total down 24%, which was comparable to the total again 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 and they – or they are no longer of large loan size I added that to the table – to the table last quarter in response to analyst request from the June meeting to look at the loan base and say okay, so we have in this quarter $232 million of large loans. But we had also charged down those and reduce the principal balances on our books for those loans or loan relationships that we add back the – that $20 million to the 232 and then that additional markdown goes in the numerator. So you get a truer sense of the total amount of marks in history of those loans.

Okay. I don't think I fully understand. Was there…

Okay. So let met take one more try at it. So we're looking at the current principal balances on certain loans after those principal balances have been reduced for certain mark. That we actually eliminated the mark by $0 million and reduced the principal balance because we didn't think on those loans as we thought it was truly uncollectible. In addition, we still have the $40 million of remaining - of mark where we didn’t charge it off because there is some thinking there might be a recovery and so forth. So those principal balance are on the books. What that table attempts or tormentors is adding by adding back those charged off if you will, reductions in principle back to principal and having a numerators, adding that to the numerator in addition to the current mark 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, I think there were two or three loans that were paid off or and finally settled and closed off the book. So that’s why that change…

So that changes interest; its recovery?

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

So the answer is yes

Yes, okay. That's all I had. Thank you very much.

Thank you.

Thank you. And I am showing no further questions at this time. I will like to turn the call over to Mr. Damian Kozlowski, CEO with any further remarks.

So I just want to thank everyone for being on the call today. We are making progress, I know its disappointing to see these marks the last - last two quarters, but we really do believe we're getting a handle on, making this company a lot more profitable in the short and especially in the long-term. We think that we'll 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 your may all disconnect. Everyone, have a great day,